Chapter 10: Derivatives and Other Instruments

Question 1

Futures

Answer 1

• Agreement between two parties, one agreeing to sell, one to buy.
• Terms and conditions of trade are made now, but the trade will be in the future
• Once contract is made it is binding on the parties
• exchange traded

Question 2

What is the long position of a future?

Answer 2

The future buyer of the underlying asset, things the price of assets will rise.
* max gain is unlimited, max loss is limited to the price of the future

Question 3

Short position of a future

Answer 3

• Future seller
• thinks the price of the underlying assets will fall
• max gain is limited to the price of the future, max loss is unlimited

Question 4

What is the fair value of a future

Answer 4

• the cash price of underlying + cost of carry
• carry includes: interest rates, storage, insurance

Question 5

Basis

Answer 5

• quantifies the difference between the cash price of the underlying assets and the futures price
• Basis = cash price - futures

Question 6

Contango

Answer 6

• means that basis is negative = the cash price is less than the price of the future

Question 7

Backwardation

Answer 7

• means that basis is positive, cash price is greater than the price of the future
• might occur where a temporary shortage of the underlying, pushing up the price and producing a back market
• can occur when there is an overall benefit rather than cost of carry

Question 8

Contingent liability

Answer 8

• the investor faces a potential liability uncertain at the present time
• all futures transactions are contingent liability transactions

Question 9

Forwards

Answer 9

• OTC traded
• higher degree of flexibility to the parties involved, no exchange to standardise the terms of the contract
• direct counterparty risk with opposite side of trade
  *No central market place

Question 10

Contracts for difference

Answer 10

• Describes a cash settled derivative, no physical delivery
• example: interest rate futures and futures in equity index
• many are physically settled
• pays the difference in the settlement price between the open and closing trades

Question 11

Arbitrage

Answer 11

• risk-free profit by exploiting anomalies and inconsistencies in the prices between two related but different markets
• ex. if cars were cheaper in France than UK, buy French car and sell in the uk

Question 12

When can arbitrage be used?

Answer 12

• between an index and its derivative
• if an asset and the cost of carry is cheaper than the price on the future contract, an investor can exploit it by buying and holding the asset and shorting the future (agreeing to sell at a future date)

Question 13

Closing out of a future - what is is and how is it done?

Answer 13

• to sell the future before its expiry date
• achieved by entering into a second equal but opposite contract in order to offset the terms and conditions of the first
• ex. if agreed on an opening purchase, they make a closing sale

Question 14

Roll contracts

Answer 14

• used to extend a future contract whereby the investor does not want to proceed to take delivery or make delivery, but want to remain exposed to the asset
• involves two trades, one to close our the current contract that is approaching delivery, and a second to open a new position in a longer-dated contract

Question 15

Roll yield

Answer 15

*for roll contracts, the two contracts will not be priced the same
* in a contango market, the far dated contract will be priced higher –> negative roll yield

Question 16

What can be used to hedge?

Answer 16

• futures, buy shorting FTSE 100 futures, if the market does down, they will be hedged, and if the market goes up, they will lose money BUT their portfolio will rise

Question 17

What does beta measure?

Answer 17

Volatility of a portfolio in relation to the index
If higher than 1 = more volatile, if less than 1 = less volatile

Question 18

What is beta hedging

Answer 18

• uses beta to determine how many future contracts are needed for the hedge
• if beta 1.2 this means 1.2 x as many future contracts are needed as before

Question 19

Options

Answer 19

• gives the buyer the right to buy or sell an underlying asset at a fixed price on or before a given date in the future
• buyer has a choice (seller has a potential obligation)

Question 20

Difference between futures and an option?

Answer 20

• in options, the buyer has a choice
• the buyer of an option pays a premium to the seller

Question 21

Call option

Answer 21

Right to buy the underlying asset

Question 22

Put option

Answer 22

Right to sell the underlying asset

Question 23

Short position

Answer 23

Sell

Question 24

Long position

Answer 24

Buy

Question 25

American vs. European style options

Answer 25

• America style = buyer can exercise their rights at any time
• Europeans = can only exercise at expiry

Question 26

What losses/gains are there for the buyer and seller of a call option?

Answer 26

• Max profit for buyer = unlimited
• Max Loss for buyer = the premium
• Breakeven point is strike price plus premium

Question 27

Delta - what it is & calculation

Answer 27

• measure of the sensitivity of the option premium to changes in the underlying value of the asset
• Delta = Change in Option Premium / Change in price of the underlying asset

Question 28

Is the delta positive or negative for calls?

Answer 28

• positive, between 0 and 1

Question 29

How will interest rates rising affect equity call options?

Answer 29

• the time value of call options increase and premium increases

Question 30

What is the benefit of using options to hedge?

Answer 30

• only down-side risk is hedged, do not need to execute the option if does not want to

Question 31

Covered Call

Answer 31

• made up of a short call option and a long position in an underlying asset
• used to generate income in a static market

Question 32

When are protective puts normally used?

Answer 32

To hedge against a falling market

Question 33

Who are the main operators in the swap market?

Answer 33

Financial organisations, such as banks and other money market institutions

Question 34

What type of market are SWAPS traded on

Answer 34

OTC