Week 1

Question 1

Derivative Definition

Answer 1

A financial instrument that has a value determined by the price of something else (the underlying)

Question 2

Uses of Derivatives

Answer 2

1. Risk management
2. Speculation
3. Reduce transaction costs
4. Regulatory arbitrage

Question 3

Over-the-Counter (OTC) Market

Answer 3

Large traders trade many financial claims directly with a dealer by bypassing organized exchanges.

Not as easy to observe or measure and is generally less regulated

Value of OTC trading > value traded on exchanges

Question 4

Forward Contracts

Answer 4

A binding agreement (obligation) to buy/sell an underlying asset in the future, at a price set today.

Specifies:

1. Features and quantity of asset to be delivered
2. Delivery logistics
3. The price the buyer will pay at the time of delivery

Question 5

Payoff Forward Contract

Long and Short

Answer 5

Long forward = spot price at exp. - forward price

Short forward = forward price - spot price at exp.

Question 6

Types of Settlement (Forward Contract)

Answer 6

Cash settlement: less costly and more practical

Physical delivery: often avoided due to significant costs

Question 7

Call Option Definition

Answer 7

A non-binding agreement (right but not obligation) to buy an asset in the future, at a price set today

Preserves the upside potential

Question 8

Payoff/Profit of a Purchased Call

Answer 8

Payoff = max[0, spot price at exp. - strike price]
Profit = payoff - FV(option premium)

Question 9

Types of Call Options

Answer 9

European-style: can be exercised only at expiration
American-style: can be exercised at any time before expiration
Bermudan-style: can be exercised during specified periods

Question 10

Put Option Definition

Answer 10

A put option gives the owner the right but not the obligation to sell the underlying at a predetermined price during a predetermined time period.

The seller of a put option is obligated to buy if asked.

Question 11

Payoff/Profit of a Purchased (Long) Call

Answer 11

Payoff = max[0, spot price at exp. - strike price]
Profit = payoff - FV(option premium)

Question 12

Payoff/Profit of a Written (Short) Put

Answer 12

Payoff = -max[0, strike price - spot price at exp.]
Profit = payoff + FV(option premium)

Question 13

When do call & put options before more profitable?

Answer 13

A call option becomes more profitable when the underlying asset appreciates in value

A put option becomes more profitable when the underlying asset depreciated in value

Question 14

What do the profit graphs look like for the different options?

(Forward, Call, Put)

Answer 14

Long forward - diagonal up
Short forward - diagonal down

Long call - straight(down) then up
Short call - straight(up) then down

Long put - up then straight(down)
Short put - down then straight(up)