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Chapter 1 Flashcards

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1
Q

What is a derivative?

A

A financial instrument whose value is dependent on the value of another, underlying asset.

Derivatives can be used for various purposes including hedging, enhancing returns, and asset allocation.

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2
Q

What are the main types of derivative contracts?

A
  • Forwards
  • Futures
  • Options

These contracts can be traded in different marketplaces, including exchanges and over-the-counter markets.

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3
Q

What is hedging in the context of derivatives?

A

A process to reduce market risk.

Hedging is utilized by investors to protect against potential losses.

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4
Q

What are the two marketplaces for derivatives?

A
  • Exchange-traded derivatives
  • Over-the-counter derivatives

Regulators encourage transactions on exchanges to improve transparency and reduce counterparty risks.

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5
Q

What is a futures contract?

A

A standardized, exchange-tradable contract between two parties to trade a specified asset on a set date in the future at a specified price.

The price agreed upon is closely related to the price of the underlying asset.

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6
Q

What types of futures exist?

A
  • Financial futures (e.g., bond, currency, interest rate, equity index)
  • Commodity futures (e.g., gold, pork bellies)

These futures are based on either financial instruments or physical commodities.

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7
Q

What is the role of a clearing house in futures trading?

A

It acts as a counterparty to both the buyer and seller, guaranteeing each side of the transaction.

This arrangement reduces counterparty credit risk.

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8
Q

What is margin in the context of exchange-traded derivatives?

A

Collateral that each party must deposit with the clearing house to cushion against potential losses.

Initial margin is deposited at the start, and variation margin adjusts daily based on price movements.

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9
Q

What is the maintenance margin?

A

The specified level to which an investor must top up their margin account if it falls below that level.

Payments to restore the margin are termed variation margin.

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10
Q

Define tick size in futures contracts.

A

The minimum price movement allowed for a contract.

For example, a tick size of $0.01 means prices can only change in increments of that amount.

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11
Q

What is the significance of the contract size in futures trading?

A

It specifies the quantity of the underlying asset to be traded.

For instance, a contract size of 1,000 shares means the trade involves that number of shares.

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12
Q

True or False: Only members of the exchange can deal directly on the exchange.

A

True.

Other investors must use a member firm as a broker.

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13
Q

Fill in the blank: The clearing house ensures that the link between the buyer and seller is _____ .

A

broken.

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14
Q

What happens if the market moves against a party in a futures contract?

A

The risk of default on the agreement may increase.

This is why margin requirements are important.

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15
Q

What is the value of a futures contract based on?

A

The likely maximum overnight movement in the contract’s price

This reflects the volatility of the underlying asset.

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16
Q

What happens when the price of the underlying asset increases for the buyer of a futures contract?

A

It is good news, as they agreed to buy at a specified fixed price.

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17
Q

What is marking to market in futures trading?

A

The process of daily adjustment of margin accounts to reflect profits and losses.

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18
Q

What is the initial margin for 20 FTSE 100 Index Futures if set at £3,000 per contract?

A

£60,000

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19
Q

How is profit calculated when the futures price rises to 6,535?

A

12 points x £10 per point x 20 futures contracts = £2,400

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20
Q

What is the process of closing out a futures position before delivery called?

A

Taking an opposite position

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21
Q

What does it mean if the margin account balance falls below the maintenance margin level?

A

The investor must pay in additional margin.

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22
Q

What is the delivery process in futures markets?

A

The settlement process for futures contracts.

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23
Q

What is the overall cash settlement based on?

A

The difference between the market price at delivery and the agreed futures price.

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24
Q

What is open interest in futures contracts?

A

The number of contracts outstanding at any one time.

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25
What happens to open interest as delivery approaches?
It will likely reduce towards zero.
26
What are price limits in futures markets?
Limits on how much the price of a futures contract can move in one trading day.
27
What roles does the clearing house fulfill?
* Counterparty to all trades * Guarantor of all deals * Registrar of deals * Holder of deposited margin * Facilitator of the marking to market process
28
Define call option
A contract that gives the holder the right, but not the obligation, to buy an underlying asset at a set price.
29
Define put option
A contract that gives the holder the right, but not the obligation, to sell an underlying asset at a set price.
30
What is the exercise or strike price?
The price at which the holder of an option can buy or sell the underlying asset.
31
What is a writer in options trading?
The party that is obligated to trade if the holder of the option decides to exercise it.
32
What does premium refer to in the context of options?
The price paid for an option.
33
List the four basic positions an investor could hold in options.
* Buying a call option * Buying a put option * Writing (selling) a call option * Writing (selling) a put option
34
True or False: Buying a put is the same as selling a call.
False
35
What are the key differences between an option and a future?
* Options provide the right but not the obligation to trade * Futures obligate both parties to trade at the agreed price
36
What is the definition of a call option?
A call option is a financial contract that gives the holder the right, but not the obligation, to buy an underlying asset at a specified price before a certain date.
37
What is the definition of a put option?
A put option is a financial contract that gives the holder the right, but not the obligation, to sell an underlying asset at a specified price before a certain date.
38
Explain why buying a put is not the same as selling a call.
Buying a put gives the right to sell an asset, while selling a call obligates the seller to sell an asset if the option is exercised.
39
What are the key differences between an option and a future?
Options provide the right but not the obligation to trade, while futures obligate both parties to trade an asset at a specified future date.
40
Why aren't buyers of options required to deposit margin?
Buyers of options are not required to deposit margin because they have the right but not the obligation to exercise the option.
41
What is required from writers of options in terms of margin?
Writers are required to pay initial margin and may need to pay variation margin if the underlying asset price moves against them.
42
What are over-the-counter (OTC) derivatives?
OTC derivatives are financial contracts that are privately negotiated and not traded on an exchange.
43
What are the two important OTC markets mentioned?
* Interest rate swaps * Forward currency contracts
44
What is a Central Clearing Party (CCP)?
A CCP is an entity that facilitates clearing and settlement of financial transactions, helping to reduce credit risk.
45
What are the advantages of OTC markets compared to exchange trading?
* Tailored contracts * Flexibility in negotiation
46
What are the disadvantages of OTC markets compared to exchange trading?
* Low marketability * High dealing costs * Lack of market values * Potentially greater credit risk
47
What is a forward contract?
A forward contract is a non-standardized agreement between two parties to trade a specified asset at a set price on a future date.
48
What is a swap in financial terms?
A swap is a contract between two parties to exchange a series of payments based on prearranged terms.
49
What are the two most common types of swaps?
* Interest rate swaps * Currency swaps
50
What are guaranteed equity products (GEA)?
GEA offer returns linked to an equity index with a minimum guaranteed return, often of zero.
51
What are structured notes?
Structured notes are non-standard securities tailored to meet specific investor risk and return requirements.
52
What role does a clearing house play in futures trading?
* Counterparty to all trades * Guarantor of all deals * Registrar of deals * Holder of deposited margin
53
What is the process of settlement in the futures market known as?
The process of settlement in the futures market is known as delivery.
54
What is open interest in futures contracts?
Open interest refers to the total number of futures contracts that have not been closed out at any one time.
55
What is the marking to market process?
Marking to market is the process of adjusting the margin account balance to reflect current market values.
56
What does it mean for an option to be 'American'?
An American option can be exercised at any time before its expiration date.
57
Fill in the blank: A financial futures contract is a ______ agreement to trade a specified quantity of an underlying financial security on a specified date and at a specified price.
[standardized and exchange-tradable]
58
What is the main advantage of the OTC market?
The main advantage is the ability to tailor contracts to buyers' precise requirements.
59
What is a futures contract?
A standardised and exchange-tradable, legally binding agreement to trade a specified quantity of an underlying financial security or instrument on a specified date and at a specified price.
60
Why do trading volumes increase close to delivery in the futures market?
Because of: * speculation increases as to the likely settlement price * traders not wanting to reach settlement close out their positions.
61
What is the maximum profit for a buyer of a futures contract?
Unlimited.
62
What is the worst-case scenario for a buyer of a futures contract?
The price of the underlying asset drops to zero.
63
What is the maximum loss for a buyer of a futures contract?
The price agreed for the future.
64
What is the maximum profit for a seller of a futures contract?
The price agreed for the future.
65
What is the maximum loss for a seller of a futures contract?
Unlimited.
66
What role does the clearing house play in futures trading?
The clearing house becomes the party to every trade, removing the exposure of each trader to the possibility of default by the other trader.
67
What is an initial margin in the context of futures trading?
The initial margin is paid by the trader to the clearing house at the outset of each open position.
68
What happens if a margin account balance falls below a specified level?
The trader will need to deposit additional margin with the clearing house.
69
What is a call option?
A call option gives its holder the right, but not the obligation, to buy a specified asset on a set date in the future for a specified price.
70
What is a put option?
A put option gives its holder the right, but not the obligation, to sell a specified asset on a set date in the future for a specified price.
71
What is the exercise price?
The price at which an underlying security can be sold to (for a put) or purchased from (for a call) the writer or issuer of an option.
72
Who is the writer of an option?
The seller of that option.
73
What is the option premium?
The small amount of money paid upfront to the writer of the option.
74
What happens if you exercise a call option?
You must pay the writer the exercise price.
75
What happens if you exercise a put option?
The writer pays you the exercise price for the specified asset.
76
Fill in the blank: Buying a put allows you to choose whether or not to _______.
sell the underlying asset.
77
Fill in the blank: An option gives the holder an option, whereas a future means both parties have an _______.
obligation.
78
What is the main advantage of the OTC market?
The ability to tailor contracts to the buyer's precise requirements.
79
What are the main disadvantages of the OTC market?
Non-standard contracts reduce marketability, high dealing costs, no quoted market values, greater credit risk without a clearing house.
80
What is market risk in the context of swaps?
The risk that market conditions will change so that the present value of the net outgo under the agreement increases.
81
What is credit risk in the context of swaps?
The risk that the other counterparty will default on its payments.
82
Why is credit risk not the same as default risk on a loan?
Credit risk is only a problem when the swap has a positive value to you, whereas a loan always has a positive value.
83
What minimizes credit risk in swaps?
If the swap is subject to margin payments through a clearing house or Central Clearing Party (CCP).

F105 (13 decks)

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