Topic 7 Flashcards
Define derivative?
A financial instrument whose value depends on and is derived from the value of some other underlying asset
2 differences between derivatives and outright purchases?
Derivatives provide an easy way for investors to profit when price declines
In derivative’s transactions, one persons loss is another persons gain
What is the purpose of derivatives?
To transfer risk from one person to another tf shifting risk to those who can bear it -> increase in carrying capacity of economy
Main problem with derivatives?
Allow people/firms to conceal the true nature of some financial transactions
What is a forward?
An agreement between buyer and seller to exchange a commodity/financial instrument for a specified amount of cash on a prearranged future date
Define future?
A forward contract that has been standardised and sold through an organised exchange
3 specifications on a forward contract?
1) seller (short position) will deliver a set quantity of a commodity/financial instrument
2) buyer (long position) will buy at a predetermined price
3) transaction on a predetermined delivery date
Why can forwards sometimes be difficult to sell?
They are often customised tf difficult to sell
How do long and short positions benefit from forwards contracts?
Short position benefits from a decline in price
Long position benefits from an increase in price
How do parties ensure the obligations are met?
A clearing corporation is used for the transaction (tf also anonymous)
Explain how the clearing corporation works?
1) clearing corporation required a deposit from both parties (called margin in a margin account!)
2) posts daily gains/losses on the contract to the margin account of the involved parties (called marking to market!)
3) if account falls below minimum then the contract is sold tf no more participation of person
2 ways futures allow transfer of risk and explained?
Speculation - speculators try to make profit by betting on price movements
Hedging - producers and users of commodities use futures markets to hedge their risks (ie. If they are a seller of commodities they will bet on the price going down, therefore if it goes down they get return and if it goes up they get the higher price anyway, buyers of commodities do opposite)
On settlement of date the price of the futures contract = ?
The value of the underlying asset
Define arbitrage wrt financial instruments?
The practice of buying and selling financial instruments in order to benefit from temporary price differences
In hedging, who is the buyer and who is the seller of futures contracts?
Buyer of contract: the USER of the commodity who needs to insure against the price rising
Seller of contract: the PRODUCER of the commodity who needs to insure against the price falling
In speculation, who is the buyer and who is the seller of futures contracts?
Buyer: person who believes the market price of the commodity or asset will RISE
Seller: person who believes ‘ ‘ will FALL
In a futures contract, what happens to the buyer of the futures contract margin account after a rise in the value of the asset? What position are they?
Their account is credited; they are the LONG position
In a futures contract, what happens to the seller of the futures contract margin account after a rise in the price of the asset? What position are they?
They are debited; they are the short position
Note: long and short positions depends on whether they are buying or selling the contract, not whether they are credited or debited
Explain how an arbitrageur can help to equilibrate the prices of a specific bond in two separate markets? (5 steps)
1) they buy in low price market then sell in high
2) this increases demand in one market and supply in another
3) increase demand -> higher price in low price market
4) increase supply -> lower price in high price market
5) this continues until prices are equal
Who is the option writer and who is the option holder in an options contract?
Writer = seller Holder = buyer
Define call option?
The right to buy a given quantity of an underlying asset at the strike price on or before a specific date
What is it called an options contract?
Because the writer is obliged to sell if ‘call’, but the holder is NOT required to buy if they don’t want
What does:
In the money
At the money
Out of the money mean?
In the money: stock price > strike price
At the money: stock price = strike price
Out of the money: stock price less than strike price
Define put option?
The right of the holder to sell underlying asset at predetermined price on or before the fixed date
How are options transactions guaranteed?
Use a clearing corporation
Difference between European and American options?
European can only be exercised on the day they expire; American options can be exercised on any date from day of writing to expiration date
3 benefits of options?
Very versatile tf can be traded in many combinations
Allow investors to get rid of unwanted risks
Allow investors to bet that prices will be volatile
What are the market makers in options trading and what do they do?
Market makers are the dealers who engage in regular purchase and sale of the underlying asset
They own the underlying asset so they can deliver it and are willing to buy the underlying asset so they can sell it to someone else
Learn guide to options table
Now
What are interest rate swaps?
Interest rate swaps allow one party, for a fee, to alter the stream of payments it makes or receives (avoids IR risk)
Explain simple example of IR swaps?
One party makes payments based on fixed interest rate, and in exchange the other makes payments on floating interest rate for a fee
Ie. One party takes on the risk of floating rates for a fee
How are interest rate swaps priced?
1) firm notes IR on US treasury bonds of same maturity as swap (benchmark)
2) swap rate = benchmark rate + premium
Define swap rate and swap spread?
Swap rate = rate to be paid by fixed payer
Swap spread = premium paid
What can the swap spread indicate?
Measure of risk in the economy
Explain a main risk in IR swaps and why it is a problem?
Risk that one of the parties will default
Since swaps are not traded on organised exchanges they can be very difficult to resell
Define credit default swaps?
Credit derivative allowing lenders to insure themselves against risk a borrower will default
Explain how CDSs work?
Buyer of CDS makes payments (like insurance premiums) to seller, who agrees to pay buyer if underlying loan/security defaults. Buyer pays fee to transfer CREDIT RISK. Agreement is LT and requires collateral from both buyer and seller
Explain 3 ways CDS contributed to 2008 FC?
1) they fostered uncertainty over who bears the risk on a loan
2) made leading CDS mutually vulnerable
3) made it easier for CDS sellers to conceal risk (chains of CDSs)
