(Topic 3) Derivatives Market

Question 1

What is a derivative?

Answer 1

A financial instrument whose value is based on the value of another financial instrument, asset or commodity (underlying asset).

Simply seen as bets on the development of future events.

Question 2

What are the 4 types of derivatives?

Answer 2

• Futures
• Forwards
• Options
• Swaps

Question 3

What is a futures contract?

Answer 3

A standardised contract allowing an investor to buy or sell a fixed quantity of a commodity or asset at a specific date.

Buying one contract means you take a long position & expect delivery.
Selling one contract means you take a short position & deliver the contract yourself.

Question 4

What is a forwards contract?

Answer 4

An unstandardised contract consisting of an agreement between 2 parties. It is not traded on an exchange, instead traded over the counter (OTC).

The agreement allows for counter-party risk.

Question 5

What is an options contract?

Answer 5

A contract that gives an individual the option, but not the obligation to buy (call)/sell (put) an underlying asset for a fixed price at a certain date and time frame.

Question 6

What is a swaps contract?

Answer 6

It gives the holder the option to swap the cash flow of the underlying asset with an alternative asset’s stream of cash flow - similar to an insurance contract

Question 7

Why are futures and forwards used?

Answer 7

• Hedging business risk (locking into an interest rate or exchange rate)
• Hedging portfolio risk
• Speculating and using the leverage provided by derivatives

Question 8

What are some of the features of a forwards contract?

Answer 8

• Large range of delivery dates
• Amount to be exchange is negotiable
• Each party face counter party risk
• No margin required
• Contract illiquid
• Covers over 50 currencies (including major ones)
• Profit/loss is released on maturity
• Contract is completed on delivery

Question 9

What are some of the features of a futures contracts?

Answer 9

• Limited range of delivery dates
• Amount to be exchanged is standardised
• Contracts are guaranteed by exchange
• Margin required
• Relatively liquid
• Covers only major currencies
• Profit/loss can be realised earlier if sold on
• No delivery occurs due to reversed trade

Question 10

The amount of contracts that still expect delivery are called _____ _______.

Answer 10

Open interest.

Question 11

What kind of investor takes this kind of risk?

High leverage implied small amounts relative to a large portfolio can be invested to insurer against movements.

Answer 11

Hedgers

Question 12

What kind of investor is this?

High leverage appealing to those who want to take more risk or think they can predict the future better.

Answer 12

Speculators.

Question 13

What are some of the features of currency futures?

Answer 13

• Lock into exchange rate and avoid losses
• Especially popular in developing countries with high export levels
• Currency will be exchanged at fixed rate in the future
• Cover more than just main currencies
• Highly interlinked with interest rates

Question 14

How are options used in real estate markets>

Answer 14

To secure the right to purchase large parcels of land from different owners at a fixed price in the future.

Question 15

What is an American option?

Answer 15

The option can be executed any time prior to expiration or on the expiration date.

Question 16

What is a European option?

Answer 16

The option can only be executed upon expiration.

Question 17

What is the stake price?

Answer 17

The price at which an underlying asset can be bought or sold.

Question 18

What is the expiration date?

Answer 18

The last date an option can be executed (time to maturity).

Question 19

What is intrinsic value?

Answer 19

The profit gained if executed immediately (can never be negative as the individual has the choice not to execute).

Question 20

What is the calculation of the time value?

Answer 20

Option price - intrinsic value = time value

Question 21

What types of options are there? (3 main)

Answer 21

• Stock and stock indices
• Interest rate
• Currency

Question 22

What is the main use of an option?

Answer 22

To transfer risk.

One party would like to transfer risk of movements to a second party

Question 23

Similar to a futures contract, the profits of the long and short positions of call and put options are _________.

Answer 23

Symmetric

Question 24

What does the term “writing naked” mean?

Answer 24

Issuing an option without owning the underlying asset, essentially gambling and risking considerable loss.

Question 25

Why would an investor buy a call option?

Answer 25

• Speculation (can offer high leverage, but there is no obligation to execute, so at moat the initial price of the option is lost)
• Hedging other risk (similar to an insurance policy)

Question 26

What are some trading strategies based on options?

Answer 26

Straddle
- Going long (buying) on a call & put option with the same strike price and expiry date.

Strangle
- Going long (buying) on a call & put option with the same expiry date, but with different strike prices.

Question 27

What is a swap?

Answer 27

An agreement between 2 parties to exchange 2 different forms of payment obligations.

The most common swaps are interest rate swaps and exchange rate swaps.

Swaps are over-the-counter instruments, so investors are exposed to counter party risk.

Question 28

What are interest rate swaps used for?

Answer 28

• To hedge interest rate risk
• To restructure debt
• To reduce cost of financing

Question 29

What is a currency swap?

Answer 29

The swapped loans are denoted in different currencies, useful for international trade.

Question 30

What is the role of derivatives?

Answer 30

• To insure against the probability of default
• Investors could swap cash flows in case some of the mortgages defaulted, similar to insurance
• (prior to crisis, issuers were not regulated like insurance companies)
• (during crisis, companies who issued swaps could not fulfil their promise - CP risk)