Topic 7

Question 1

Define derivative?

Answer 1

A financial instrument whose value depends on and is derived from the value of some other underlying asset

Question 2

2 differences between derivatives and outright purchases?

Answer 2

Derivatives provide an easy way for investors to profit when price declines

In derivative’s transactions, one persons loss is another persons gain

Question 3

What is the purpose of derivatives?

Answer 3

To transfer risk from one person to another tf shifting risk to those who can bear it -> increase in carrying capacity of economy

Question 4

Main problem with derivatives?

Answer 4

Allow people/firms to conceal the true nature of some financial transactions

Question 5

What is a forward?

Answer 5

An agreement between buyer and seller to exchange a commodity/financial instrument for a specified amount of cash on a prearranged future date

Question 6

Define future?

Answer 6

A forward contract that has been standardised and sold through an organised exchange

Question 7

3 specifications on a forward contract?

Answer 7

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

Question 8

Why can forwards sometimes be difficult to sell?

Answer 8

They are often customised tf difficult to sell

Question 9

How do long and short positions benefit from forwards contracts?

Answer 9

Short position benefits from a decline in price

Long position benefits from an increase in price

Question 10

How do parties ensure the obligations are met?

Answer 10

A clearing corporation is used for the transaction (tf also anonymous)

Question 11

Explain how the clearing corporation works?

Answer 11

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

Question 12

2 ways futures allow transfer of risk and explained?

Answer 12

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)

Question 13

On settlement of date the price of the futures contract = ?

Answer 13

The value of the underlying asset

Question 14

Define arbitrage wrt financial instruments?

Answer 14

The practice of buying and selling financial instruments in order to benefit from temporary price differences

Question 15

In hedging, who is the buyer and who is the seller of futures contracts?

Answer 15

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

Question 16

In speculation, who is the buyer and who is the seller of futures contracts?

Answer 16

Buyer: person who believes the market price of the commodity or asset will RISE

Seller: person who believes ‘ ‘ will FALL

Question 17

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?

Answer 17

Their account is credited; they are the LONG position

Question 18

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?

Answer 18

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

Question 19

Explain how an arbitrageur can help to equilibrate the prices of a specific bond in two separate markets? (5 steps)

Answer 19

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

Question 20

Who is the option writer and who is the option holder in an options contract?

Answer 20

Writer = seller
Holder = buyer

Question 21

Define call option?

Answer 21

The right to buy a given quantity of an underlying asset at the strike price on or before a specific date

Question 22

What is it called an options contract?

Answer 22

Because the writer is obliged to sell if ‘call’, but the holder is NOT required to buy if they don’t want

Question 23

What does:
In the money
At the money
Out of the money mean?

Answer 23

In the money: stock price > strike price

At the money: stock price = strike price

Out of the money: stock price less than strike price

Question 24

Define put option?

Answer 24

The right of the holder to sell underlying asset at predetermined price on or before the fixed date

Question 25

How are options transactions guaranteed?

Answer 25

Use a clearing corporation

Question 26

Difference between European and American options?

Answer 26

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

Question 27

3 benefits of options?

Answer 27

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

Question 28

What are the market makers in options trading and what do they do?

Answer 28

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

Question 29

Learn guide to options table

Answer 29

Now

Question 30

What are interest rate swaps?

Answer 30

Interest rate swaps allow one party, for a fee, to alter the stream of payments it makes or receives (avoids IR risk)

Question 31

Explain simple example of IR swaps?

Answer 31

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

Question 32

How are interest rate swaps priced?

Answer 32

1) firm notes IR on US treasury bonds of same maturity as swap (benchmark)
2) swap rate = benchmark rate + premium

Question 33

Define swap rate and swap spread?

Answer 33

Swap rate = rate to be paid by fixed payer

Swap spread = premium paid

Question 34

What can the swap spread indicate?

Answer 34

Measure of risk in the economy

Question 35

Explain a main risk in IR swaps and why it is a problem?

Answer 35

Risk that one of the parties will default

Since swaps are not traded on organised exchanges they can be very difficult to resell

Question 36

Define credit default swaps?

Answer 36

Credit derivative allowing lenders to insure themselves against risk a borrower will default

Question 37

Explain how CDSs work?

Answer 37

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

Question 38

Explain 3 ways CDS contributed to 2008 FC?

Answer 38

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)