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CWM Financial Markets > OTC Derivatives > Flashcards

OTC Derivatives Flashcards

1
Q

What is a forward contract?

A

An agreement to buy or sell an asset at a certain price at a certain time in the future

Effectively an OTC Future

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2
Q

How do Forwards differ from futures?

A

No standardisation in contracts (more flexibility / bespoke)

No central exchange = more counterparty risk

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3
Q

What is a forward rate agreement?

A

An agreement to:

  • Buy or sell an interest rate fixed today
  • But starting in the future

Buyer pays fixed rate
Seller receives fixed rate

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4
Q

Who benefits if rates go up and who benefits if rates go down (with an FRA)

A

Buyer benefits when rates go up
Seller benefits when rates go down

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5
Q

How are FRAs settled?

A

Cash settled on settlement date

(don’t exchange a principal amount just pay the difference on settlement)

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6
Q

What is the formula to work out the net settlement amount for an FRA?

A
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7
Q

What day count convention do the UK use?

A

ACT / 365

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8
Q

What day count convention does the US and EU use?

A

Act / 360

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9
Q

What is the formula to calculate a forward FRA rate?

A
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10
Q

Why are FRAs useful?

A

As they trade OTC they can be tailor made to suit a hedger’s exposure

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11
Q

In regard to STIR - What is a cap?

(Short term interest rates)

A

A call on interest rates

Paysout if interest rates rise above the strike price

Cap = Head = High up = good if price goes up

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12
Q

For a CAP, what is the:

1) Need
2) Benefit

A

1) Protection against rising floating rates
2) Cost of protection is known and limited to fee / premium

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13
Q

In regard to STIR - What is a floor?

(Short term interest rates)

A

A put on interest rates

Paysout if interest rates fall below strike

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14
Q

If a cap rises above strike price what happens?

A

The cap seller, will pay the difference between the floating rate and the strike.

If it falls, nothing happens and the cap remains in place for the life of the deal.

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15
Q

When would someone use an interest rate floor?

A

A lender is offering a floating rate, they wish to protect themselves from the lost interest if rates are to fall

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16
Q

What is a collar?

A

Combines a cap and a floor

Protection against a rise and institute a floor.

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17
Q

For a floor, what is the:

1) Need
2) Benefit

A

1) Protection against LIBOR falling below floor level
2) Cost of protection known

18
Q

What is a contract for difference?

A

Agreement between two counterparties

Exchange the difference between opening and closing price of an instrument

Cash settled

19
Q

What are the uses/benefits of CFDs?

A

1) Allow long / short position without having to own the stock
2) No stamp duty or broker fee
3) Can leverage position (extend gains)
4) No set maturity expiry
5) Stop loss included
6) Cheap easy exposure to foreign markets

20
Q

What are some of the drawbacks of a CFD?

A

1) Incurs a daily financing charge
2) Overnight interest incurred
3) Requires a margin of up to 30%

21
Q

How do CFDs differ from spread bets?

A

1) No expiry / maturity on a CFD
2) Spread bets are considered gambling and as such no tax is due.

22
Q

What is a swap?

A

An OTC derivative contract where one party exchanges a cash flow stream against another.

These payments are known as “legs of the swap”

23
Q

What is exchanged in an interest rate swap?

A

A fixed leg against a floating leg

24
Q

What is the reasoning for entering into an interest rate swap?

A

Hedge positions.

e.g. a bank receiving a fixed income stream (mortgages) but paying a variable rate on savings.

25
Q

What is a swaption?

A

An option to enter into a swap

Allows a firm to manage risk / take advantage of cheaper funding

Wholesale market - not open to the public

26
Q

What is a currency swap?

A

Counterparties exchange principal + interest in one currency for another

27
Q

What are the reasons for entering into a currency swap?

A

1) Obtain funding in foreign FX cheaper than borrowing directly
2) Hedging transaction risk (on existing foreign loans)

In short: replace unpredictable cash flows (due to fx movements) with predictable flows

28
Q

What is an equity swap?

A

Exchange returns on an index with a fixed / floating rate of interest

Creates a synthetic portfolio of shares (no need to buy all underlying)

29
Q

What is a credit derivative?

A

Credit derivatives relate to credit events relating to another company.

30
Q

What is a credit default swap?

A

Insurance against a credit event in exchange for regular premiums

31
Q

What are the three main types of credit default swap?

what are they

A

1) Basic - on a single asset
2) Index - on movements on an index
3) Basket - on a basket of goods

32
Q

Which CDS carries the highest initial premium?

A

Basket - as it gains protection against a wider spread of securities

33
Q

hich

What are index CDSs comparable to?

A

Total return swaps

34
Q

What is defined in a CDS contract?

A

1) Trigger Points
2) Time Limits
3) Payment schedules

OTC - can all be made bespoke

35
Q

What is a credit spread?

A

The difference between the yield on an asset and the yield on a reference asset (e.g. a govt bond benchmark)

36
Q

What are credit spread options used for?

A

Credit spreads help to hedge against changes in credit spreads,

The buyer would likely already have exposure and is looking to hedge against a wideing of the spread.

37
Q

What is a CDO? How does it work?

A

Collateralized Loan Obligation

A bundle of a bundle (e.g. bundle of MBSs)

Split and priced into tranches based on risk (more risk = less price but higher returns)

Senior low risk -> junior higher risk

38
Q

How is a CDO created?

A

SPV issue bonds in order to purchase underlying assets

Income pays back investor in tranches

39
Q

What is a CBO? How does it work?

A

Collateralized bond obligation

Bundle of junk grade bonds -> combined to make investment grade

Divesification in issuers and rating creates an investment grade security.

40
Q

What is a synthetic CDO?

A

A CDO which pays its tranches through the premiums on a CDS.

If CDS defaults - synthetic cdo on the hook for losses - starting from bottom up

CWM Financial Markets (58 decks)

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