(R48) Derivative Markets and Instruments

Question 1

Define Derivative

Answer 1

• Financial contract between 2 parties whose value depends on the value of some other underlying asset. - Buyer or seller agrees to buy or sell a specific asset at a specific price on a specific date

Question 2

Purpose of derivatives

Answer 2

• Transfers wealth, does not create it (derivatives are a zero sum game) - Used for hedging and speculation

Question 3

Exchange-traded derivatives

Answer 3

• Standardized contracts for futures and options - no counterparty risk because of clearing house - Transparency - Highly regulated

Question 4

Two types of exchange traded derivatives

Answer 4

Futures and options

Question 5

Over-the-Counter (OTC) derivatives

Answer 5

• Dealer market - Customizable contracts for forwards and swaps - Low regulation - Privacy

Question 6

Two types of OTC derivatives

Answer 6

Forwards and swaps

Question 7

Forward Commitment

Answer 7

Obligation entered into at one point in time that require both parties to engage in a transaction at future date on terms agreed upon today. No money is required to change hands at inception. (OTC Contract)

Question 8

Forward Price

Answer 8

The fixed price or rate at which the transaction scheduled to occur at the expiration of a forward contract will take place. This price is agreed on at the initiation date of the contract. Notation is F_o

Question 9

What does long and short mean in derivatives markets?

Answer 9

• Long means buyer - long takes delivery in futures contract - Short means seller - short must deliver to a specific location

Question 10

What is the difference between future spot price and forward price? Does long or short profit if spot price is greater than forward price?

Answer 10

• Future spot price (S_T): The price of an asset at a future date
• Forward price (F_o): The future price agreed upon today

If (S_T) > (F_o) then the long (buyer) profits

Question 11

Futures Commitment

Answer 11

• Futures contracts are much like forward contracts, but are exchange-traded, liquid, and require daily settlement (mark to market) of any gains or losses. Subject to daily price limits and require a margin.
• Futures and spot prices converge on final day
• Value at contract initiation is always equal to zero

Question 12

Define swaps

Answer 12

An OTC contract in which 2 parties agree to swap a series of cash flows whereby one party pays a variable rate and other party pays variable rate or fixed rate. Value of swap at inception is zero. Type of commitment

Question 13

Non-deliverable forwards

Answer 13

Cash-settled forward contracts, used predominately with respect to foreign exchange forwards.

Question 14

Option

Answer 14

A financial instrument that gives one party the right, but not the obligation, to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time. (Also known as contingent claim)

Question 15

Three types of commitments

Answer 15

1. Forward commitment
2. Futures commitment
3. Swap

Question 16

Two types of contingent claims

Answer 16

1. Options
2. Credit Derivatives

Question 17

American style vs. european style options

Answer 17

• American: can be exercised anytime before expiration
• European: can only be exercised on the expiration date

Question 18

Options

Answer 18

A financial instrument that gives one party the right, but not the obligation, to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time. (Type of contingent claim)

Question 19

Credit Derivatives

Answer 19

A contract in which one party has the right to claim a payment from another party in the event that a specific credit event occurs over the life of the contract.

Question 20

Credit default swap (CDS)

Answer 20

A type of credit derivative in which one party, the credit protection buyer who is seeking credit protection against a third party, makes a series of regularly scheduled payments to the other party, the credit protection seller. The seller makes no payments until a credit event occurs.

Question 21

Call Option

Answer 21

An option that gives the holder the right to buy an underlying asset from another party at a fixed price over a specific period of time

Question 22

Put Option

Answer 22

An option that gives the holder the right to sell an underlying asset to another party at a fixed price over a specific period of time.

Question 23

Calculate the value of a call at expiration (payoff) and profit from the buyers perspective

Answer 23

Value of call (payoff): C_T = Max (0, S_T-X)

Profit: π = Max (0, S_T-X) - C₀)

S_T: Spot price at a future date

X: strike price

C₀: original price paid for the call

Question 24

Calculate the value of a call at expiration (payoff) and profit from the sellers perspective

Answer 24

Value of call (payoff): C_T = -Max (0, S_T-X)

Profit: π = -Max (0, S_T-X) + C₀)

S_T: Spot price at a future date

X: strike price

C₀: original price paid for the call

Question 25

For calls:

• In the Money
• Out of the Money
• At the Money

Answer 25

In the money: S_T > X

At the money: S_T = X

Out of the money: S_T < X

S_T: Spot price at a future date

X: strike price

Question 26

Calculate the value of a put at expiration (payoff) and profit from the buyers perspective

Answer 26

Value of put (payoff):P_T = Max (0, X-S_T)

Profit: π = Max (0, X-S_T) - P₀

S_T: Spot price at a future date

X: strike price

P₀: original price paid for the put

Question 27

Calculate the value of a put at expiration (payoff) and profit from the sellers perspective

Answer 27

Value of put (payoff): P_T = -Max (0, X-S_T)

Profit: π = -Max (0, X-S_T) + P₀

S_T: Spot price at a future date

X: strike price

P₀: original price paid for the put

Question 28

For puts:

• In the Money
• Out of the Money
• At the Money

Answer 28

In the money: X > S_T

At the money: X = S_T

Out of the money: X < S_T

S_T: Spot price at a future date

X: strike price

Question 29

Underlying

Answer 29

An asset that trades in a market in which buyers and sellers meet, decide on a price, and the seller then delivers the asset to the buyer and receives payment. The underlying is the asset or other derivative on which a particular derivative is based.

Question 30

Arbitrage Pricing

Answer 30

• The simulataneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio, in order to obtain a risk less profit on the price differential.
• Arbitrage can be expected to force the prices of two securities or portfolios of securities to be equal if they have the same future cash flows regardless of future events.

Question 31

Non-deliverable forwards

Answer 31

Cash-settled forward contracts, used predominately with respect to foreign exchange forwards.

Question 32

Locked limit

Answer 32

A condition in the futures markets in which a transaction cannot take place because the price would be beyond the limits.