Derivatives Tutorial Terms 2. Flashcards
What is liquidity risk?
Liquidity risk is the risk associated with the inability to quickly buy or sell an asset in the market without significantly affecting its price, leading to potential losses or increased costs.
How does liquidity risk arise?
Liquidity risk arises when there is a scarcity of buyers or sellers in a market for a particular asset, resulting in limited trading activity and increased price volatility.
What are the factors contributing to liquidity risk?
Market conditions, asset type, trading volume, economic events, and investor sentiment can all contribute to liquidity risk by affecting the ease of buying or selling assets.
Why is liquidity risk important?
Liquidity risk can impact an investor’s ability to execute trades at desired prices, potentially leading to losses or missed opportunities, and it can affect the stability and functioning of financial markets.
How do investors manage liquidity risk?
Diversification, maintaining cash reserves, using liquid assets, and conducting thorough market analysis are strategies used by investors to mitigate the impact of liquidity risk.
What are lookback options?
Lookback options are exotic options that grant the holder the right to buy (call) or sell (put) the underlying asset at its most favorable price during the option’s term.
How do lookback options work?
These options consider the highest (for call options) or lowest (for put options) price of the underlying asset during the option period, allowing the holder to exercise the option at that advantageous price.
What are the variations of lookback options?
There are two main types: “fixed strike” lookback options, where the strike price is set at the option’s inception, and “floating strike” lookback options, where the strike price is determined at expiration based on the asset’s price during the option period.
What is the purpose of using lookback options?
Lookback options are used to provide holders with the potential to benefit from the best possible price movement of the underlying asset during the option’s duration, reducing risk and maximizing potential profit.
How do lookback options differ from standard options?
Unlike standard options with fixed strike prices, lookback options provide the holder with the advantage of exercising the option at the most favorable price during the option period.
Lookback options offer flexibility by allowing the holder to benefit from the optimal price movement of the underlying asset during the option’s lifespan, potentially enhancing profitability and risk management.
What is margin in finance?
Margin refers to the funds or collateral that traders or investors deposit with their broker or exchange to cover potential losses from their positions.
How is margin used in trading?
Margin allows traders to increase their purchasing power by borrowing funds from their broker to enter larger positions in the market, amplifying both potential gains and losses.
What is initial margin?
Initial margin is the minimum amount of funds required to open a new position, ensuring that traders have enough collateral to cover potential losses.
What is maintenance margin?
Maintenance margin is the minimum amount of funds required to keep a position open. If the value of the position falls below this level, traders may need to deposit additional funds (a margin call) to meet the requirement.
Why is margin important?
Margin allows traders to leverage their investments, potentially increasing profits but also amplifying risks. It’s essential to manage margin carefully to avoid significant losses.
Understanding and effectively managing margin requirements is crucial for traders and investors to leverage their positions while also mitigating the risks associated with trading on margin.
What is collateral?
Collateral is an asset or property pledged by a borrower to a lender as security for a loan or credit, reducing the lender’s risk of loss if the borrower defaults.
How is collateral used in lending?
Lenders require collateral to secure loans, providing them with an asset they can claim if the borrower fails to repay the loan or meet the terms of the agreement.
What are examples of collateral?
Examples of collateral include real estate (such as a house), vehicles, investment accounts, valuable possessions, or any asset with sufficient value to cover the loan amount.
Why is collateral important in lending?
Collateral offers lenders a form of protection, reducing the risk associated with lending money by providing them with an asset they can seize and sell to recover losses if the borrower defaults.
How does collateral benefit borrowers?
Offering collateral can enable borrowers to access loans or credit with more favorable terms, including lower interest rates or larger loan amounts, due to reduced risk for the lender.
Collateral serves as a form of security for lenders and can be crucial for borrowers to obtain loans or credit, offering both parties protection in lending transactions.
What is mark-to-market accounting?
Mark-to-market accounting is a method where assets and liabilities are valued at their current market prices or fair values, reflecting changes in their worth over time.
How does mark-to-market accounting work?
It involves revaluing assets and liabilities at their current market prices regularly, with any changes in value impacting the reported financial statements.
Where is mark-to-market accounting commonly used?
It is commonly used in financial markets for securities, derivatives, and trading instruments where prices fluctuate frequently.
What are the advantages of mark-to-market accounting?
It provides more accurate and transparent financial information, reflecting real-time changes in asset values, aiding in better decision-making.
What are the challenges of mark-to-market accounting?
It can lead to increased volatility in financial statements, especially during market fluctuations, impacting reported profits or losses.
What is market risk?
Market risk refers to the possibility of financial losses arising from changes in market conditions, including interest rates, exchange rates, commodity prices, and equity prices.
How does market risk affect investments?
Market risk impacts the value of investments, as changes in market conditions can lead to fluctuations in asset prices, potentially causing losses for investors.
What are the types of market risk?
Common types of market risk include equity risk (related to stock prices), interest rate risk (due to changes in interest rates), currency risk (associated with exchange rate fluctuations), and commodity risk (linked to changes in commodity prices).
How do investors manage market risk?
Investors employ various risk management strategies, such as diversification, hedging with derivatives, using stop-loss orders, or implementing portfolio rebalancing, to mitigate the impact of market risk.
Why is market risk important?
Understanding and managing market risk is crucial for investors and financial institutions to safeguard portfolios against potential losses caused by market fluctuations, ensuring effective risk management.
Market risk is an inherent part of investing, and acknowledging and managing this risk is essential to create a diversified and resilient investment portfolio.
What is a market maker?
A market maker is an entity, often a brokerage firm or financial institution, that stands ready to buy and sell securities or other financial instruments at quoted prices, providing liquidity to the market.
What is the role of a market maker?
Market makers play a crucial role in maintaining liquidity by continuously offering to buy or sell securities, ensuring that there’s a market for investors to execute trades.
How do market makers profit?
Market makers profit from the bid-ask spread, which is the difference between the prices at which they are willing to buy (bid) and sell (ask) a security. They aim to buy at a lower price and sell at a higher price, earning a profit from this spread.
Why are market makers important?
Market makers enhance market efficiency by ensuring that there is a constant flow of buying and selling, which helps to maintain liquidity, reduce price volatility, and facilitate smoother trading for investors.
Are market makers present in all financial markets?
Market makers are commonly found in most liquid financial markets, such as stock exchanges, options, foreign exchange (forex), and other securities markets.
Market makers are integral to financial markets, as they help ensure the smooth functioning of trading by providing liquidity, which is essential for investors to buy and sell securities efficiently.
What is naked option writing?
Naked option writing involves selling options contracts (calls or puts) without holding a corresponding position in the underlying asset.
How does naked option writing work?
A seller writes (sells) options contracts, collecting the premium, but without owning the underlying asset or having a hedge position to cover potential losses.
What are the risks of naked option writing?
The main risk of naked option writing is unlimited potential losses. For naked call writing, there’s potential for unlimited losses if the underlying asset’s price rises significantly. For naked put writing, losses can occur if the asset’s price declines sharply.
Why do traders use naked option writing?
Traders might use naked option writing to collect premiums or generate income. However, it’s a high-risk strategy and requires careful monitoring.
How is naked option writing different from covered option writing?
In covered option writing, the seller has an offsetting position (like owning the underlying asset) to cover potential losses. Naked option writing does not have such protection.
Naked option writing can generate income through premiums but poses significant risks due to potential unlimited losses. Traders should exercise caution and fully understand the risks before employing this strategy.
What is netting in finance?
Netting is a process that combines or offsets multiple positions, payments, or transactions to determine a single net value.
How does netting work?
In finance, netting involves offsetting gains and losses or combining multiple transactions to calculate a single net amount, reducing the number of transactions or exposures.
What are the types of netting?
There are various types of netting, including payment netting, where multiple payments between parties are offset to determine a single net amount, and position netting, where various positions or contracts are offset to calculate a consolidated position.
Why is netting used in finance?
Netting simplifies and streamlines financial calculations by reducing the number of individual transactions or positions, minimizing risk and administrative overhead.
Where is netting commonly used?
Netting is prevalent in various financial sectors, including derivatives trading, foreign exchange markets, clearinghouses, and settlement systems.
Netting helps streamline financial processes by consolidating multiple transactions or positions, simplifying calculations, reducing risk exposure, and minimizing administrative complexities in various financial operations.
What is open interest?
Open interest represents the total number of active, outstanding options or futures contracts in a financial market that have not yet been closed or delivered by the end of a trading day.
How is open interest different from trading volume?
Trading volume refers to the total number of contracts traded during a specific period, whereas open interest specifically represents the total number of contracts that remain open at the end of the day.
What does increasing open interest suggest?
Increasing open interest may indicate growing market participation, suggesting a higher level of investor interest or new positions being established.
How is open interest used in market analysis?
Analysts use open interest to assess market liquidity, potential price trends, or the strength of current price movements by analyzing changes in open interest alongside price movements.
What happens when contracts with open interest expire?
Contracts with open interest at their expiration typically result in delivery or settlement, or traders can close out their positions before expiration.
Open interest provides insights into market activity and trader sentiment, helping analysts and traders gauge market participation and potential future price movements.
What are path-dependent options?
Path-dependent options are exotic options whose payoff is determined not only by the price of the underlying asset at expiration but also by the price path the asset takes during the option’s lifetime.
How do path-dependent options work?
The payoff of path-dependent options is based on the price path of the underlying asset, which may involve tracking the highest, lowest, average, or any other specified price levels reached by the asset during the option’s duration.
What are the types of path-dependent options?
Examples include lookback options, Asian options, barrier options, and shout options. Each type calculates the payoff based on different criteria related to the underlying asset’s price path.
What is the significance of path-dependent options?
Path-dependent options offer flexibility and the potential for unique payoffs based on the intricate price movements of the underlying asset throughout the option’s life.
How do path-dependent options differ from standard options?
Standard options (like European or American options) have payoffs determined solely by the asset’s price at expiration, whereas path-dependent options consider the entire price trajectory during the option’s existence.
Path-dependent options provide investors with diverse strategies and payoffs by incorporating the complex price movements of the underlying asset, offering potential advantages but also complexity in their valuation and risk assessment.
What is potential exposure?
Potential exposure represents the maximum possible financial loss an individual or entity could incur due to market movements, counterparty default, or adverse changes in asset prices.
How is potential exposure calculated?
Potential exposure is often calculated by assessing the maximum potential loss based on the value of the assets, market volatility, counterparty risk, and the specific terms of financial contracts or investments.
What factors contribute to potential exposure?
Factors include market volatility, the value and composition of the investment portfolio, the duration and nature of financial contracts, and the creditworthiness of counterparties.
Why is potential exposure important?
Understanding potential exposure helps individuals or institutions manage risk by assessing the maximum potential financial impact of adverse market movements or counterparty default.
How do individuals or entities mitigate potential exposure?
Hedging strategies, diversification, setting risk limits, using derivatives, and conducting thorough risk assessments are among the methods used to mitigate potential exposure.
Assessing potential exposure is crucial for risk management, enabling individuals or entities to make informed decisions and implement strategies to protect against potential financial losses.
What is the put-call parity theorem?
The put-call parity theorem is an options pricing principle that demonstrates the relationship between the prices of European call and put options with identical underlying assets, strike prices, and expiration dates.
What does the put-call parity theorem state?
Put-call parity asserts that the sum of the prices of a European call option and a European put option, both on the same underlying asset and with the same strike price and expiration date, equals the current price of the underlying asset plus the present value of the strike price.
How is the put-call parity equation expressed?
The put-call parity equation is represented as: C + PV(K) = P + S, where C is the call option price, P is the put option price, PV(K) is the present value of the strike price, and S is the current price of the underlying asset.
Why is put-call parity important?
Put-call parity provides a framework to ensure the consistency of options pricing and helps in identifying mispriced options, aiding arbitrage opportunities.
