Chapter 6 - Derivatives Flashcards
What is a commodity?
A raw material or agricultural product (e.g. sugar, wheat, oil, copper) that can be bought and sold. Derivatives of commodities are traded on exchanges (e.g. oil futures on ICE futures).
What four major forms do derivatives take?
- Forwards
- Futures
- Options
- Swaps
What is a Derivative?
A derivative is a financial instrument whose price is based on the price of another asset.
It based on something called teh underlying asset or the underlying.
What are derivates used for?
- Hedging
- Anticipating future cash flows
- Asset allocation change
- Arbitrage
What is hedging?
Hedging is a technique employed by portfolio managers to reduce the impact of adverse price
movements on a portfolio’s value; this could be achieved by selling a sufficient number of futures
contracts or buying put options.
What is Anticipating future cash flows?
in relation to derivatives.
(Closely linked to the idea of hedging) if a portfolio manager expects to receive a large inflow of cash to be invested in a particular asset, then futures can be used to fix the price at which it will be bought and offset the risk that prices will have risen by the time the cash flow is received.
What is Asset allocation changes?
in relation to derivatives
changes to the asset allocation of a fund, whether to take advantage of anticipated short-term directional market movements or to implement a change in strategy, can be made more swiftly and less expensively using derivatives such as futures than by actually buying and selling securities within the underlying portfolio.
What is Arbitrage?
in relation to derivatives?
Process of deriving a risk-free profit from simultaneously buying and selling the same asset in two different markets, when a price difference between the two exists. If the price of a derivative and its underlying asset are mismatched, then the portfolio manager may be able to profit from this price anomaly.
What are Futures contracts?
not to be confused with “whats a derivative”
A future is an agreement between a buyer and a seller. A futures contract is a legally binding obligation
between two parties.
It invloves a set price at which a stated amount of a commodity would be delivered between counterparties at a pre-specified future date.
What are the legally binding obligations of a future contract between two parties?
- The buyer agrees to pay a prespecified amount for the delivery of a particular prespecified quantity
of an asset at a prespecified future date. - The seller agrees to deliver the asset at the future date, in exchange for the prespecified amount of
money.
What are the two distinct features of a futures contract?
- Exchange traded - on derivatives exchanges such as ICE Europe (London) or Chicago Mercantile Exchange (CME) (US).
- Dealt on standardised terms - exchange specifies the quality of the underlying asset, the quantity underlying each contract, the future date and delivery location - only the process is open to negotiation.
What do the terms “Long” and “Short” mean?
In relation to the terminology of derivatives
Long – the term used for the position taken by the buyer of the future. (commits to buying the asseT)
Short – the position taken by the seller of the future. (commits to selling the asset)
What do the terms “Open” and “Close” mean?
In relation to the terminology of derivatives
Open - the initial trade
Close - the physical assets underlying most futures that are opened do not end up being delivered:
they are ‘closed-out’ instead.
The physical assets underlying most futures that are opened do not end up being delivered:
they are ‘closed-out’ instead.
What do the terms “Covered” and “Naked” mean?
In relation to the terminology of derivatives
Covered – when the seller of the future has the underlying asset that will be needed if physical
delivery takes place.
Naked – when the seller of the future does not have the asset that will be needed if physical delivery
of the underlying commodity is required. The risk could be unlimited.
What is an Option?
Derivatives
Gives buyer the right (not obligation) to buy or sell a specified quantity if an underlying asset at a pre-agreed exercise price, on or before prespecified future date or between two specified dates.
The seller, in exchange for the payment of a premium, grants the option to the buyer.
These are exchange traded in standardised terms and can also be traded off-exchange (OTC) where the contracts specs are deterimined by the parites.
What is the key difference between a future and an option?
An option gives the right to buy or sell, whereas a future is a legally binding obligation between counterparties
What is a “Call Option” and a “Put Option”?
- A call option is when the buyer has the right to buy the asset at the exercise price, if they choose to. The seller is obliged to deliver if the buyer exercises the option.
- A put option is when the buyer has the right to sell the underlying asset at the exercise price. The seller of the put option is obliged to take delivery and pay the exercise price, if the buyer exercises the option.
Who owns the option when it is bought?
The buyers also reffered to as the holders.
The sellers are reffered to as the writers of the those options.
What does it mean when the writer of an option is “taking a call” or “taking for the put”?
It means they have sold a put or call option to a holder
Where can options be traded?
- Exchanges - here will be in standardised sizes and terms.
- OTC - not standardised terms, thus contracts spec by the parties is bespoke.
What are the two types of Options you can buy?
- Call Option
- Put Option
What rights and obligations does the holder have in a call and put option?
Derivatives
Call Option - Holder has right but not obligation to buy
Put Option - Holder has the right but not the obligation to sell.
What does the writer receive when selling a call option and what is their obligation?
Derivatives
A premium from the holder andthe writer is obligated to sell.
