Part 1. Derivatives Markets and Instruments

Question 1

Derivative

Answer 1

A security that derives its value from the value or return of another asset or security.

Exchange-traded derivatives = standardised and backed by a clearing house.

Question 2

Over-the-counter market

Answer 2

A dealer market with no central location, include custom instruments known as forwards and swaps.

Largely unregulated markets, where each contract is with counter party, which may expose the owner of derivative to default risk.

Question 3

Forward commitment

Answer 3

A legally binding promise to perform some action in the future, this includes forward contracts, future contracts, and swaps

• these contracts can be written on equities, indexes, bonds, foreign currencies, physical assets or interest rates,

Question 4

Contingent claim

Answer 4

A claim that depends on a particular event, and only require a payment if a certain threshold price is broken (such as of price is above X or the rate is below Y).

e.g. options - depend on stock price at some future date, credit derivatives - depend on the credit event such as a default or ratings downgrade.

Question 5

Forward contract

Answer 5

When one party agrees to buy and the counterparty to sell a physical or financial asset at a specific price on a specific date in the future.

reasons:

• speculate on future price of an asset
• hedge an existing exposure to the risk of asset price or interest rate changes

intuition:

• if expected future price of asset increases over the life of the contract, the right to buy at the forward price will have a positive value, and obligation to sell will have an equal negative value, and vice versa.

long forward position = the party to forward contracts who agrees to buy the financial or physical asset.

short forward position = the party to forward contract who agrees to sell or deliver the asset.

deliverable forward contract = settled by short delivering the underlying asset to the long.

Question 6

Cash-settled forward contract (NDFs)

Answer 6

When one party pays cash to the other when the contract expires based on the difference between forward price and the market price of the underlying asset (i.e. spot price) at the settlement date.

Question 7

Future contracts

Answer 7

A forward contract that is standardised and exchange-traded, and traded in an active secondary market subject to greater regulation, backed by a clearinghouse, and require a daily cash settlement of gains and losses.

Question 8

Future contracts similar to forward:

Answer 8

1. Can be either deliverable or cash-settled contracts.

2. Have contract prices set so each side of contract has value of zero value at the initiation of the contract.

Question 9

Future contracts differ to forward:

Answer 9

1. Future contracts trade on organised exchanges, but forwards are private contracts and typically do not trade.
2. Future contracts are standardised, but forwards are customised contracts satisfying the specific needs of parties involved.
3. Clearing house is the counterparty to all future contracts, but forwards with originating counterparty, hence have counterparty (credit) risk.
4. The government regulates futures markets, and forward contracts are usually not regulated and not trade in organised markets.

Question 10

Settlement price

Answer 10

The average of the prices of trades during the last period of trading, called closing period, which is set by the exchange.

• specification reduces the opportunity of traders to manipulate the settlement price.
• used to calculate the daily gain or loss at the end of each trading day.
• on its final day of trading, the settlement price is equal to spot price of underlying asset (i.e. future prices converge to spot prices as future contracts approach expiration).

Question 11

Settlement price example

Answer 11

• For each contract traded there is a buyer (long) and seller (short).
• The long has agreed to buy asset at contract price at settlement date, and short agreed to sell at that price.

Open interest = the number of futures contracts of specific kind outstanding at any given time, and increase when traders enter new long and short positions, and vice versa.

Question 12

Use of futures contracts:

Answer 12

• Speculators use future contracts to gain exposure to changes in price of asset underlying the contract.
• Hedgers use future contracts to reduce an existing exposure to price changes in the asset (i.e. hedge asset price risk, wheat futures use to reduce uncertainty about price he will receive for wheat in harvest time).

Question 13

Clearing house

Answer 13

• This guarantees traders in future markets to honour their obligations, by splitting each trade once it is made and acting as the opposite side of each position.
• Acts as the buyer to every seller and seller to every buyer, allowing either side of trade to reverse positions at future date without having to contract the other side of initial trade, and traders to enter market knowing they would be able to reverse/reduce their position.
• Its guarantee removes counterparty risk (i.e. to a trade to not fulfil their obligation at settlement) from futures contracts.

Question 14

Margin

Answer 14

This is the money that must be deposited by both the long and short, as performance guarantee prior to entering into a futures contract.

Mark to Market = each day margin balance in futures account is adjusted for any gains and losses in value of futures positions based on new settlement price.

Initial margin = the amount that must be deposited in futures account before a trade may be made, relatively low and equals one days maximum price fluctuation on total value of assets covered.

Maintenance margin = the minimum amount of margin that must be maintained in futures account, if balance in account fall below this through daily settlement of gains and losses, additional funds must be deposited to bring margin balance back to initial margin account.

Question 15

Price limits

Answer 15

• These are exchange-imposed limits on how each days settlement price can change from previous day’s settlement price.
• If equilibrium price at which traders would willingly trade is above the upper limit or below lower limit, trades cannot take place.
  e. g. daily price limit on futures of $0.02, settled the previous day at $1.04, the following trading day, traders wish to trade at $1.07 due to changes in market conditions/expectations no trades take place.
• SP reported at $1.06 (purpose of mark to market), contract made a limit move, and price a limit up from previous day.
• SP changes to $1.02, the price said to be a limit down, if trades cannot take place as limit move, either up or down, price is said to be locked limit since no trades can take place/locked to existing positions.

Question 16

Swaps

Answer 16

The agreements to exchange a series of payments in periodic settlement dates over a certain time period (e.g. quarterly payments over 2 years).

• at each settlement date, the 2 payments are netted so only one payment is made.
• party with greater liability makes payments to other party, with length of swap being the tenor of swap; and contract ends on termination date.

Question 17

Why are swaps similar to forwards?

Answer 17

• swaps typically require no payment by either party at initiation.
• swaps are custom instruments.
• swaps are not traded in an organised secondary market.
• swaps are largely unregulated.
• default risk is an important aspect of contracts.
• most participants in swap market are large institutions.
• individuals are rarely swap market participants.

Question 18

Plain vanilla IR swap

Answer 18

When one party makes fixed-rate interest payments on a notional principal amount specified in the swap in return for floating rate payments from other party.

basic swap = trading one set of FRP for another.

• the party who wants FRIP agrees to pay fixed rate interest, and has pay-fixed side of swap.
• counterparty who receives the fixed payments agrees to pay variable-rate interest has pay-floating side of swap = floating rate payer.
• payments owed by one party to other on notional principal that is stated in swap contract.

Question 19

Option contract

Answer 19

This gives its owner the right but not obligation to either buy or sell an underlying asset at given price (exercise/strike price), while option buyer can choose whether to exercise an option, the seller is obligated to perform if buyer exercises option.

owner of:

• call option - the right to purchase the underlying asset at specific price for a specified time period.
• put option - the right to sell the underlying asset at specific price for specified period of time.

Question 20

Option writer

Answer 20

The seller of an option, with 4 possible positions:

1. Long call - buyer of call option has right to buy underlying asset.
2. Short call - writer/seller of call option has obligation to sell underlying asset.
3. Long put - buyer of put option has right to sell the underlying asset.
4. Short put - writer/seller of put option has obligation to buy underlying asset.

Question 21

Option premium

Answer 21

The price of an option.

American options = may be exercised at any time up to and including the contracts expiration date.

European options = can be exercised only on the contracts expiration date.

Question 22

Credit derivative

Answer 22

A contract that provides a bondholder (lender) with protection against a downgrade or default by the borrower.

e.g. credit default swap (CDS) - an insurance contract against default, where bondholder pays a series of cash flows to credit protection seller and receives a payment if bond issuer defaults.

Question 23

Credit spread option

Answer 23

A type of credit derivative, typically a call option based on bond’s yield spread relative to benchmark.

If bond’s credit quality decreases, its yield spread will increase, and bondholder will collect a payoff on the option.

Question 24

Option calculation explanations:

Answer 24

• buyer of puts/seller of calls will profit when price of underlying asset decreases.
• buyer of calls/seller of puts will profit when price of underlying asset increases.
• generally, put buyer believes underlying asset is overvalued, and will decline price.
• generally, call buyer anticipated an increase in underlying assets price.

Question 25

Pros and cons of derivatives:

Answer 25

Pros:

• provide price info
• allow risk to be managed, and shifted among market participants
• reduce transaction costs

Cons:

• too risky, especially to investors with limited knowledge of complex instruments, as high leverage involved in derivative payoffs, sometimes likened to gambling.

Question 26

Arbitrage

Answer 26

• concept in valuing/pricing derivatives
• riskless
• if return > than risk free rate can be earned by holding portfolio of assets that produces a certain (riskless) return, then arbitrage opportunity exists.
• arise when assets are mispriced
• trading arbitrageurs continue until they affect supply and demand enough to bring asset prices to efficient levels.

Question 27

2 arbitrage arguments:

Answer 27

1. Based on law of one price:

• 2 securities/portfolios have identical cash flows in future, regardless of future events should have same price.
• A & B have identical future payoffs, A is priced lower than B, buy A, and sell B.
• there is immediate profit and payoff of A will satisfy future liability of being short on B.

2. Arbitrage requires an investment:

• if portfolio of securities or assets have certain payoff in future, there is no risk investing in portfolio.
• to prevent profitable arbitrage, the return on portfolio is risk free rate.
• if certain return on portfolio > risk free rate, the arbitrage would be borrow at Rf, invest, and keep excess of portfolio return above risk-free rate must be paid on the loan.
• if certain return on portfolio < risk free rate, the arbitrage would sell the portfolio, invest proceeds at Rf, and earn more than it will cost to buy back the portfolio at future date.