Session 16&17&18 Flashcards
Cash settlement
Negative side of the contract pays the positive side when delivery is not practical
Early termination of forward
- one party pays the other cash= value inherited in the contract till that time– the counter party does’t have to accept
- Enter to an offsetting contract:
- with different counterpart(default risk still exists but no price risk)
- with the same counter party(no default risk)
Equity forward contract
Stock-Portfolio-Equity index
Forward rate agreement (FRA)
Exchange fixed rate for floating rate payment
- Notional amount
- Fixed rate = forward (contract) rat e
- Floating rate (LIBOR) is underlying rate
- Long gains when LIBOR>contract rate
Long: obligation to take a (hypothetical) loan at the contract rate-gains when reference rate goes up
Short: obligation to give a (hypothetical) loan at the contract rate- gains when reference rate goes down
Year: 360.
Settlement price
average of trades during closing period, used to calculate margin
Margin calculation
Margin call, next day??
Methods to terminate a futures position at expiration
Reversal (offsetting trade)- most common method
Delivery of asset (less than 1%)
Cash settlement
Exchange of physicals: between two parties that have reverse contracts, they offset between each other and then exchange assets by their way
Eurodollar
Easily confused with the currency pair EUR/USD or Euro FX futures, eurodollars have nothing to do with Europe’s single currency that was launched in 1999. Rather, eurodollars are time deposits denominated in U.S. dollars and held at banks outside the United States. A time deposit is simply an interest-yielding bank deposit with a specified date of maturity.
As a result of being outside U.S. borders, eurodollars are outside the jurisdiction of the Federal Reserve and subject to a lower level of regulation. As eurodollars are not subject to U.S. banking regulations, the higher level of risk to investors is reflected in higher interest rates.
The name eurodollars was derived from the fact that initially dollar-denominated deposits were largely held in European banks. At first these deposits were known as eurobank dollars. However, U.S. dollar-denominated deposits are now held in financial centers across the globe and referred to as eurodollars.
Similarly, the term eurocurrency is used to describe currency deposited in a bank that is not located in the home country where the currency was issued. For example, Japanese yen deposited at a bank in Brazil would be defined as eurocurrency.
Eurodollar futures
The eurodollar futures contract was launched in 1981 by the Chicago Mercantile Exchange (CME), marking the first cash-settled futures contract. On expiration, the seller of cash settled futures contracts can transfer the associated cash position rather than making a delivery of the underlying asset.
The underlying instrument in eurodollar futures is a eurodollar time deposit, having a principal value of $1,000,000 with a three-month maturity.
Tick size
The tick size of a trading instrument is its minimum price movement; in other words, it is the minimum increment in which prices can change. The tick value is what each price movement is worth in terms of dollars. A stock, for instance, has a tick size of 0.01, with a tick value of one cent. The e-mini S&P 500 contract has a tick size of .25 with a tick value of $12.50; each time price moves .25 (from 1110.50 to 1110.75 for example) the value changes $12.50, either up or down depending on the direction of the price movement.
Treasury bond futures
- for treasury bonds with maturities greater than 15 years.
- deliverable
- face value of 100,000$
- quoted as a percent and fraction of 1% (1/32) of face value: 99-16 = 99.5%
Option seller
writer- short
Option pricing vs futures pricing
Option: price of the contract (call/put premium)
Futures: price of the underlying for delivery date
Underlying asset price in options
exercise/strike price
American option price vs european
american >= european
Moneyness of options
In the money- at the money-out of the money
Option price/value
C= Intrinsic value (moneyness) + Time value
Intrinsic value:
call: max(0,S-X)
put: max (0,X-S)
Types of options (underlying assets)
commodity options stock options bond options index options options on futures
Options on futures
calls: option to enter a futures contract as the long at a cpecific futures price.
puts: option to enter a futures contract as the short at a cpecific futures price.
**at exercise, futures position is marked to market
Futures contracts on interest rate
exactly opposite to a contract on fixed income security
Interest rate options payoff
call payoff: max[0,(LIBOR-strike price)]notional amount
put payoff: max[0,(strike price-LIBOR)]notional amount
Year: 360.
Interest rate options payoff term (vs FRA)
payoffs are made at the end of the interest rate term- e.g. we should wait 180 days after exercise date if the option was on an 180 days LIBOR to realize the payoff
unlike FRA, we do not discount the future gain here, it would be paid by the writer 180 days after expiration
short put interest rate option + long call interest rate option
= FRA (could help to price an FRA)
Interest rate caps and floors (floating rate debts)
caps: equivalent to series of long interest rate calls
floor: equivalent to series of short interest rate puts
use the benefits of LIBOR going down the floor to neutralize the damages from LIBOR going down! –> short a floor and long a cap
RFR effect on option values
increase in RFR–>
increase in call values
decrease in put values
Volatility effect on option values
higher volatility in S–>
higher prices in both puts and calls
(e.g. in calls, in higher tops you buy and gain more, but there’s no difference between small downs or big downs because anyway you won’t sell)
Swap
A swap is a derivative in which two counterparties exchange cash flows of one party’s financial instrument for those of the other party’s financial instrument. (swaps trade in over the counter markets)
*there’s a limited trading of these contracts (swap and forward) in secondary markets.
**in currency swaps the amount is actually exchanged at the beginning and paying back at the end.
Notional principal (swap)
amount used to calculate periodic payments.
Tenor
time period covered by swap
Settlement dates
payment due dates in swaps
Swap termination
- mutual agreement/payment with counterparty
- enter offsetting swap
- exercise swaption
- sell position with permission of counterparty
Swaption
an option on a swap (that lets you enter an offsetting swap)
Currency swap types
fixed for fixed
fixed for floating
floating for floating
Plain vanilla interest rate swap
fixed interest rate payments are exchanged for floating rate payments.
- notional amount is not exchanged at the beginning or end of the swap because both loans are in same currency and amount.
- interest payments are netted, on settlement dates only the difference is paid by the party owing the greater amount.
- floating rate payments are typically made arrears, payments is made at end of each period based on the beginning of period LIBOR.
Fixed rate payment at t (plain vanilla)
=(swap FR - LIBORt-1)(T/360)(NP)
notional principal
Equity swap
payments based on equity returns are exchanged for fixed rate or floating rate payments.
equity return based on:
individual stock/ Stock portfolio/ stock index
- can be capital appreciation or total return including dividends.
- equity return payer receives any negative equity return from interest payer (interest payer may have to pay more than the interest)
- returns for equity are calculated based on equity value change(%) times notional principal
Covered call strategy (Position)
writer owns the stock and sells a call.
- any loss from price decline will be reduced by premium received
- writer trades the stock’s upside potential for the option premium.
Protective put strategy
Long the stock and long a put
- any gain on the stock will be reduced by the premium paid
- put buyer pays for protection against stock price falling bellow the strike price
