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Question 1

What is a derivative

Answer 1

A derivative is a financial instrument who’s value depends on, is derived from the value of some other financial instrument called the underlying asset

Question 2

What is the purpose of derivatives

Answer 2

• is to transfer risk from one person or firm to another.
• By shifting risk to those willing and able to bear it, derivatives increase the risk-carrying capacity of the economy as a whole.

Question 3

Why are derivatives different from outright purchases of bonds

Answer 3

• provide an easy way for investors to profit from price declines
• one persons loss Is another persons gain

Question 4

What is the downside of derivatives

Answer 4

Allows individuals and firms to conceal the true nature of certain financial transactions

Question 5

What is a forward

Answer 5

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

Question 6

What is a future

Answer 6

is a forward contract that has been standardised and sold through an organized exchange.

Question 7

What does a future contract specify

Answer 7

the seller (short position) will deliver some quantity of a commodity or financial instrument
▶- to the buyer (long position) on a specific date
▶ called the settlement or delivery date, for a predetermined price.

Question 8

Downside of futures

Answer 8

They are difficult to resell

Question 9

How do forward and future contracts work

Answer 9

1. No payments are made when the contract is agreed to
2. The seller benefits from decline in the price of the underlying asset
3. The buyer benefits form increases I the price of the underlying asset

Question 10

Who mediates the contracts

Answer 10

The clearing cooperation operates like a large insurance company and is the counter party to both sides of the transaction

Question 11

What is clearing cooperations do

Answer 11

• Guarantee that the parties will meet their obligations
• This lowers this risk buyers and seller face
• Post daily gains and losses on the contract to the margin account of the parties involved

If someone’s margin account falls below the minimum the clearing cooperation will sell the contracts and end the persons participation

Question 12

What does the clearing cooperation require

Answer 12

• requires both parties to a futures contract to place a deposit with the cooperation
  (Margin)
• This guarantees that when the contract comes due, the parties will be
  able to meet their obligations.

Question 13

What is marking to marker

Answer 13

The clearing corporation also posts daily gains and losses on the contract to the margin account of the parties involved.

Question 14

What do futures do

Answer 14

Transfer the risk between buyer and seller and though hedging or speculation

Fixed the price that the buyer will need to pay

Question 15

Who may use futures contracts

Answer 15

Producer and users of commodities ans speculators who bet on price movement

Question 16

Why are future contracts popular

Answer 16

They are cheap as you only need to invest a small amount to the margin account to purchase

Question 17

What happens on the settlement date

Answer 17

the price of the futures contract must equal the price of the underlying asset the seller is obligated to deliver.

Question 18

What is arbitrage

Answer 18

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

Question 19

What does an arbitrageur do

Answer 19

• They can buy at the low price and sell at the high price
• This increases demand in one market and supply in another
• The increase in demand raises price in that market
• the increase in supply lowers the price in the other market
• this continues until the prices are equal

Question 20

What are options

Answer 20

Agreements between two parties the seller (writer)
And the buyer (holder)

Question 21

What is a call option

Answer 21

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

Question 22

What does the writer do

Answer 22

The writer must sell the share if and when the holder chose to use the call option

Question 23

What does the holder do

Answer 23

They are not required to buy the shares

Question 24

What is in the money

Answer 24

If the price of the stock is above the strike price of the call option and this is profitable

Question 25

What is at the money

Answer 25

If the price of the stock exactly equals the strike price

Question 26

What is out of the money

Answer 26

When the strike price exceeds the price of the stock

Question 27

What is a put option

Answer 27

gives the holder the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date.
- this makes the writer obliged to buy the shares if the holder choses to excessive the option

Question 28

What are the two types of options

Answer 28

American options can be exercised on any date from the time they are written to the expiration’s date
European options .

can be exercised only on the day they expire.

Question 29

What does a call option ensure

Answer 29

that the cost of buying the asset will not rise.

Question 30

What does the put option ensure

Answer 30

For someone who plans to sell the asset in the future, a put option ensures that the price at which the asset can be sold will not go down.

Question 31

Who can take a large loss from options

Answer 31

Speculators willing to take the risk and bet that prices will not move against them.

Dealers, called market makers, who engage in the regular purchase and sale of the underlying asset.

Question 32

What do market makers do

Answer 32

Own the underlying asset so they can deliver it, and
are willing to buy the underlying asset so they have it ready to sell to someone else

Question 33

Why are options good

Answer 33

Options are very versatile and can be bought and sold in many combinations.
They allow investors to get rid of risks they do not want.
Finally, options allow investors to bet that prices will be volatile.

Question 34

How do you price options (2)

Answer 34

• Intrinsic value: the value of the option if it is exercised immediately.
• Time value of the option: the fee paid for the option’s potential benefits.

Option price = Intrinsic value + time value of the option

Question 35

What are swaps

Answer 35

Contracts that allow traders to transfer risk just like other deeivative

Question 36

What are the two types of swaps

Answer 36

Interest-rate swaps which allow one swap party, for a fee, to alter the stream of payments it makes or receives.
B. Credit-default swaps (CDS) which are a form of insurance that allow a buyer to own a bond or mortgage without bearing its full default risk.

Question 37

What are interest rate swaps

Answer 37

agreements between two counterparties to exchange periodic interest-rate payments over some future periods, based on an agreed-upon amount of principal: notional principal.

one party agrees to make payments based on a fixed interest rate, and in exchange the counterparty agrees to make payments based on a floating interest rate.

Question 38

Why are swaps different from futures and options

Answer 38

Unlike futures and options, swaps are not traded on organised exchanges.

Question 39

What is a credit default swap

Answer 39

is a credit derivative that allows lenders to insure themselves against the risk that a borrower will default.

The buyer of a CDS makes payments, like insurance premiums, to the seller, and the seller agrees to pay the buyer if an underlying loan or security defaults.

Question 40

What does the CDS buyer give to the seller

Answer 40

The CDS buyer pays a fee to transfer the risk of default, the credit risk, to the CDS seller

CDS agreement often lasts several years and requires that collateral be posted to protect against the inability to pay of either the seller or the buyer of the insurance.

Question 41

Why did cds contribute to the financial crisis (3)

Answer 41

Fostering uncertainty about who bears the credit risk on a given loan or security.

Making the leading CDS sellers mutually vulnerable.

Making it easier for sellers of insurance to assume and conceal risk.