Derivatives

Question 1

Derivative

And 3 types

Answer 1

A financial instrument which value is derived from an underlying asset.

3 types :
Forwards/futures
Options
Swaps

Question 2

Why are derivatives different from bonds (2)

Answer 2

Derivatives allow investors to profit from price declines.

In derivatives, one person’s loss is always another persons gain.

Question 3

Purpose of derivatives

Answer 3

Transfer risk.

Derivatives increase the risk-carrying capacity of the economy as a whole. (since goes to people willing to take the most risk!)

Question 4

Downside of derivatives

Answer 4

Can conceal true nature of transactions

(This happend in financial crisis! So more risk taking so caused the crisis)

Question 5

Forward contract

Answer 5

Agreement to exchange an asset at a specified price and future date.

Question 6

Futures contract

Answer 6

A future is a forward contract that has been sold through an organized exchange.

Question 7

In futures…

When does the seller/short position benefit?

When does the buyer/long position benefit

Answer 7

When price of their underlying asset falls (since they will receive a better price than what it’s worth)

When price increases. (worth more than what they paid in the agreement!)

Question 8

Clearing corporation

Answer 8

3rd party to guarantee parties meet obligations

(So reduces risk for buyers & sellers)

Question 9

How do clearing companies reduce risk? (2) And what are they called?

Answer 9

Require both parties to place deposit with the corp.
called posting margin in a margin account

Posts daily gains and losses on margin account - called marking to market

Question 10

What if margin account falls below minimum (maintence margin)

Answer 10

Clearing corporation will sell the contracts, ending the person’s participation in the market

Question 11

Why use/employ future markets

Answer 11

To hedge risks

Question 12

Why are futures popular for speculation

Answer 12

Cheap - only need small amount (margin) to buy futures

Question 13

What must happen on settlement/deliver date? (Where the buyer receives the security)

Answer 13

Price of futures must equal price of underlying asset.

if not, abritrage risk-free profit is possible

Question 14

If price of a specific bond is higher in one market than another…

Answer 14

Arbitrageur can buy at low price and sell at high. This increases demand in cheap market, and supply in high, raising price in cheap, and lowering price in high, which continues until price equal in both markets.

Question 15

Seller & buyer in options

Answer 15

seller is option writer
buyer is option holder

Question 16

Call option

Answer 16

The right to buy a given quantity of an underlying asset at a predetermined price, (strike price) at/before a specific date.

Recall the buyer is the option holder (in the name, they HOLD the option to buy or not1)

Question 17

Writer’s obligations (the seller)

Answer 17

Writer (seller) must sell share if and when the holder (buyer) uses the call option

Question 18

Is the holder required to buy the shares?

Answer 18

No (hence why called option!)

Question 19

If an option is said to be ‘in the money’

‘at the money’

‘out of the money’ …..

Answer 19

Price of stock is above the strike price, exercising the option is profitable.

price of stock = strike price

price of stock < strike price so exercising will make a loss (so shouldnt exercise it)

Question 20

Put option

Answer 20

Gives the holder (the seller now!) the right but not the obligation to sell the underlying asset at a predetermined price on or before a fixed date.

Question 21

Writer in a put option

Answer 21

Writer is the buyer now in a put option: Obliged to buy shares if holder chooses to exercise the option.

(Holder/seller exercises if strike price>current price)

Question 22

2 types of options

Answer 22

American options - can be exercised on any date till expiration

European options - exercised only on date of expiration.

Question 23

Call option - who is it good for

Answer 23

Buyers - as it ensures cost of buying asset will not rise (since it is buying at a predetermined price (strike price))

Question 24

Put option - who is it good for

Answer 24

Sellers - , ensures price at which the asset can be sold will not go down.

Question 25

As mentioned, one person benefits one loses in options.

The option writer can take a huge loss. (In call option, loss if have to sell at a lower price than current price, in put option loss if have to buy at a higher price than strike

So what kind of people do this? (2)

Answer 25

Speculators - willing to take the risk bet prices will not move against them. E.g invest in out of money options, i.e if predict rise, and buy at option cheap price and then exercise option to buy it at the cheap price and sell at the high price!

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

Question 26

2 parts of an option price, and formula

Answer 26

Intrinsic value - value if exercised immediately

Time value - fee paid for the option’s potential benefits

Option price = Intrinsic value + time value

Question 27

How do we calculate time value

a) for a call option

Answer 27

Finding expected present value

a) we take probability of a favourable outcome (a higher price) x the payoff

E.g 0.6 success x payoff

Question 28

Effect of increasing SD of stock price on time value?

Answer 28

Increased volatility, increasing options time value. (Since max potential price will be higher)

Question 29

What does the value of financial instruments depend on? (4)

Answer 29

Size of promised payment (pos rel)
timing of payment - pos rel
likelyhood payment will be made
circumstances of payment

Question 30

Longer the time to expiration…

Answer 30

bigger the likely payoff when option does expire, thus more valuable.

Think: stocks overtime get larger and larger from initial price!

Question 31

What does the likelihood an option will pay off depend on? (2)

Answer 31

volatility - more time value (VOLATILITY HAS NO COSTS TO OPTION HOLDER, ONLY BENEFITS, SINCE IT CAN SELL WHEN IT WANTS, SO SELL AT A HIGH ANOMALY) higher standard deviation - more variability = more chance to move into the money

price of underlying asset - cheap/expensive more likely to have returns?

Question 32

Swaps

Answer 32

Contracts that allow traders to transfer risk just like other derivatives.

Question 33

2 types of swaps

Answer 33

Interest-rate swaps which allow one party, for a fee, to alter the stream of payments it makes or receives.

Credit-default swaps (CDS) is derivative that allows lenders to insure themselves against risk of a borrower defaulting

Question 34

Interest rate swaps

Answer 34

2 parties exchange periodic interest payments, based on a notion principal

In the simplest type of interest-rate swap, 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 35

What is meant by pricing interest-rate swaps

Answer 35

Figuring out fixed interest rate to be paid.

Question 36

How is this done?

Answer 36

Identify the benchmark: US treasury bond rate with the same maturity as the swap.

Question 37

What is the swap rate, and the formula

Answer 37

The rate paid by the fixed-rate payer.

Benchmark rate (the treasury bond) + premium

Question 38

Why is the swap spread useful to know?

Answer 38

(difference between benchmark interest rate & the swap rate. (I.e the premium))

Useful as a measure of risk. When swap spread increases, sign economic conditions are deteriorating. Since higher premium charged on the swap rate

Question 39

Main risk in an interest-rate swap and evaluation.

Answer 39

One of the parties may default.

Eval: risk is not high as other side can enter another agreement to replace the one that failed.

Question 40

Are futures and options and swaps traded on organised exchanges?

Answer 40

Only futures and options are.

Swaps are very difficult to resell, as are forwards (since customised)

Question 41

Credit default swaps (CDS)

Answer 41

Derivative that allows lenders to insure themselves against risk of a borrower defaulting

Question 42

How does it work?

Answer 42

Buyer of CDS (the loaner) makes payments to the insurer (insurance premiums), and seller agrees to pay buyer if their borrower defaults.

I.e buyer pays to transfer part of their risk of default (credit risk) to the seller.

Question 43

What does the CDS require

Answer 43

Collateral, to protect against inability to pay for either party of the insurance

I.e collateral from both sides, if buyer cannot make the insurance payments, or if insurer can suddenly not provide the credit if borrower defaults.

Question 44

How did CDS contribute to financial crisis (3)

Answer 44

Uncertainty about who bears credit risk

CDS sellers were mutually vulnerable (how can u insure others if risk urself!)

CDS made it easier for sellers of insurance to assume & conceal risk (so more risky borrowing etc)