Principles of OTC Derivatives Flashcards
how do OTC markets provide confidentiality?
only the market participants and whoever they wish to inform is aware of the deal that’s been completed.
how does the value of the underlying in OTC markets compare to ETD?
much larger
what are the main OTC products?
swaps, swaptions, forward rate agreements, caps, floors and collars
what is a pip?
the smallest price increment in a currency
what does the quote 1.300/05 mean (£/$)?
1.3000 is the bid for GBP (buy pounds and sell dollars at this rate)
1.305 is the offer for GBP (sell pounds and buy dollars at this rate)
what would be considered a forward deal?
any FX contract that matures one day beyond the normal spot date (T+2)
what does it mean if there is a premium on the spot rate?
the base currency will become less expensive relative to the pair currency- forward points will be subtracted from the spot rate to get the forward rate which will be at a discount.
what happens to the forward points as time goes on?
if forward points are positive (adding to the spot rate), this will increase over time. if they are negative (subtracting from the spot rate) they will become more negative of a forward the longer to maturity.
what happens to the quoted spread as time goes on?
quoted spread will always widen as contracts that are further out carry more risk for the dealer
what is a forward delivery premium?
when the forward quote increases, meaning the base currency is at a premium in the forward market- the additional forward points will be deducted from the spot rate
how does speculation work with the forward FX market?
since rates are based on the interest rate differential between the two currencies, it is used to speculate on the expected changes in the difference between the two
what is a cap?
an option product which is used to protect the cost of a floating-rate borrowing over a series of settlement period
how does a cap work in practice?
the investor can buy a cap which will put a maximum on the cost of borrowing across period known as ‘rollovers’. At the end of this period, if the rollover interest rate is higher than the cap strike rate, the borrower will receive the difference
what are floors?
options that enable the holder to demand a minimum rate of interest paid on a deposit regardless of a fall in prevailing interest rates.
what are floors used for?
to protect the income on a floating-rate investment by putting a minimum return on each rollover period. if the rollover interest rate is lower than the floor at the end of the period, the difference will be paid to the holder
what is a collar?
contract that includes both a cap and a floor.
what are the mechanics of a collar ?
cap provides them with fixed worst-case level of interest (max amount to be paid) but allows the customer to pay the market rate if this turns out to be better (lower than the cap strike rate).
allows the customer to pay a better market rate but only down to a certain level (the floor)
what happens if the market rate goes below the floor in a collar option?
the customer must pay interest at another fixed best-case level, they’ll pay a lower premium for the option for this reduced opportunity
how does the zero-premium function work with a collar?
collar can be constructed so that the two premiums paid to buy the cap and when the floor is sold, net to zero
what are credit derivatives?
instruments whose value depends on the agreed credit events relating to a third party company
what is a credit default swap?
where a party buying credit protection makes periodic payments or an upfront fee to receive an agreed comp. if there is a credit event relating to some third party or parties
what can be considered a credit event?
- default
- significant fall in asset price/value
- bankruptcy
- debt restructuring
- merger or demerger
- certain govt actions
what are the 3 types of CDSs?
single-name or basic: based on a specific asset as reference to a credit event
basket: based on basket of securities, could be based on the first to default
index: based on the movements of a particular index
how are most CDSs priced?
using the reduced-form pricing approach, credit event process is modelled directly into the swap’s price based on the probability of default
what is the most widely used measure of the PD?
default swap/asset swap spread- premium will be paid to investors over a reference rate to hold the asset e.g., SONIA
what is a credit-linked note?
a form of funded credit derivative, structured as a security with an embedded CDS, allowing the issuer to transfer a specific credit risk to credit investors, the issuer will then be not obligated to repay any debt if a specific event occurs.
essentially just a bond which is linked to a specific credit event which if it were to happen would mean the issuer wouldn’t have to pay back the debt.
what is the coupon in a CLN linked to?
the performance of a reference asset. offers borrowers a hedge against credit risk and gives investors a higher yield on the note for accepting exposure to a specific credit event.
how does a CLN work in practice?
a bank would issue a loan, at the same time they would issue a CLN linked to this loan, the coupon would be based on the creditworthiness of the loanee. If the loanee remains solvent, the bank has to repay the CLN in full otherwise the CLN holders become the insolvent company’s creditors and take on the original loan.
what are credit spread options?
an option on the difference between the yield on a particular asset and some agreed benchmark
how does a credit spread option work?
strike rate is set for the spread, option buyer pays a premium upfront and receives any difference between the spread and the strike if the spread rises above the strike. pay-off is based on the spot/spread being over or under that of the reference security
what are credit spread options designed to do?
hedge against (for the buyer) or capitalise (for the seller) on changes in credit spreads
what happens with credit default options on single credits?
extinguished upon default without any cash flows, other than the upfront premium paid by the buyer of the option
what are collateralised debt obligation?
a type of structured asset-backed security whose value any payments are derived from a portfolio of fixed-income underlying assets
what are collateralised debt obligations split into?
different risk classes, or tranches where senior tranches are considered the safest securities
how is a collateralised debt agreement structured?
a corporate entity is constructed to hold assets as collateral and to sell the packages of cash flows to investors
how does an SPV work within a collateralised debt obligation?
SPV acquires a portfolio of underlying assets, it then issues bonds (CDOs) with different tranchses and the proceeds are used to purchase the portfolio of underlying assets
how is risk and return defined for a CDO?
depends directly on how the CDO and its tranches are defined, indirectly on the performance of the underlying assets
what is a CBO?
collateralised bond obligation. derivative security that creates an investment grade bond from a pool of high-risk junk bonds.
what is a Bermudan option?
can be exercised on any specific dates between the original purchase of the option and its expiry
what is an asian option?
cash-settled OTC option that pays the difference between the average rate of the underlying assets price and a predetermined strike rate
what is an average strike price option?
strike price is set at the expiration date to be the average rate of the underlying over the life of the option.
what is a cliquet/ratchet option?
series of ATM options, locks in the difference between the old and new strike price between the series and pays it out as profit
what is a lookback option?
where the strike price isn’t determined until the option has been exercised, can be exercised at any price that has occurred during the options life
put: highest price
call: lowest price
what is a barrier option?
where the existence/pay out of the option depends on if the price of the underlying asset crosses a pre-determined level
can be broken down into knock in or knock out?
what is the general rule in settlement/payment of OTC options?
buyer will pay the premium on either the next business day or T+2 at the latest
what are structured products?
securities that have cash flows which are contingent on other securities and frequently have embedded derivatives that determine risk and return of the investment
what are the different types of structured products in terms of bonds?
- callable
- puttable
- convertible
what must be considered when valuing structured bond products?
the value of the bond itself as well as the embedded option
what are capital protected products?
offer a guaranteed repayment of principle (upon maturity) as well as the opportunity to participate in price gains of the underlying instrument.
what are the aims of the ISDA?
- provide standard market terms
- minimise administration
- facilitate cross-border trading
what are the two most important issues dealt with by the master agreement?
- termination events (outside of the party’s control)
- events of default (one of the party’s fault)
- netting (payment netting and close-out netting)
what are ISDA protocols?
set of documents that are widely used by market participants and that define procedures associated with specific financial transactions
what is collateral management?
process that allows market participants to reduce the counterparty credit exposure from longer-maturity contracts
why may a bank ask for collateral?
if they think the credit risk is too great or if the counterparty has already reached the credit limit in place
how can banks stay up to date on credit exposure?
by ensuring ops processes all deal tickets and term sheets
where is collateral usually deposited?
normally held in a third party account to protect from it being used to meet an liabilites
what is asking for mor collateral known as?
making a margin call
whose decision is it on acceptable collateral?
bank/broker
what are the benefits of SwapClear?
- reduction in credit risk
- reduction in regulatory capital requirements
- reduction of operational risk
- reduction of ops and admin costs
