Chapter 14: Derivatives

Question 1

derivative

Answer 1

A contract between two parties that derives its value from the value of some other underlying asset

Question 2

A forward contract (forwards)

Answer 2

A tailor-made, privately negotiated contract between two parties (known as counterparties) to trade a specified asset on a specified date in the future at a specified price.

• No cash changes hands until the maturity of the contract.
• It reduces price risk by fixing now what the price will be, the forward price is an estimate of the future asset price.
• There is a risk of default.
• usually delivered
  The buyer has taken a long position, the seller a short position

Question 3

Who might use a forward?

Answer 3

The main motive is to reduce risk (called hedging). Or could be done to speculate.

Any company dealing in raw materials (oil, steel, grain) might wish to protect themselves from rising prices ie an airline for oil.

Any company buying materials in a forreign currency, to remove the risk of a currency becoming more expensive.

Sellers who fear prices will fall.

Question 4

hedging

Answer 4

teh process of reducing the risk of loss arising from adverse price movements

Question 5

speculating

Answer 5

the process of increasing risk in an attempt to make profit from favourable price movements.

Question 6

market risk

Answer 6

risk that market conditions, eg asset prices, change in an adverse direction

Question 7

credit risk

Answer 7

risk that the other counterparty defaults on the agreement

Question 8

futures

Answer 8

A standardised, exchange-traded contract to trade a specified asset at a specified date in the future at a specified price.

Similar to a forward but traded on an exchange (through a clearing house) and both parties make their agreement with the clearing house.

The exchange decides the contracts so they are normally offered in specified packages (eg 1000 barrels of crude oil) with specified delivery dates.

They are normally settled by making a cash payment equal to the net profit/loss rather than by physcial delivery of the underlying asset.

Question 9

spot price v futures price

Answer 9

The price of an asset for immediate delivery
v
The price of an asset for delivery at x date

Question 10

margin

Answer 10

Buyers of futures give an initial margin payment to the exchange. This is required to cover some or all of the risk arising from adverse price movements.

Futures contracts are marked to market each day, meaning at the end of the dayt he futures price is compared with the previous dats price and variation margin is paid to each account according to profit/loss. No cash changes hands however.

The exchange sets a minimum amount and if the margina ccount falls below this it triggers a margin call (a call from the exchange for more money)

The buyer and seller can close out the future before the buy/sell date (they make and equal and opposite sell/buy.

Question 11

winners and losers

Answer 11

if the future price increases, the long position gains money from the futures contractand the short loses money.

and vice versa

Question 12

single stock futures

Answer 12

an agreement to buy or sell one particular share, usually in batches of a hundred, at a specified price at a particular date in the future.

could be used during a takeover bid. This occurs when one company (the predator) wants to buy up the shares of another company (the target)

Question 13

stock index futures

Answer 13

based on a notional portfolio of shares represented by a particular index.

the monetrary value of the future is calculated as a multiple of the index

Question 14

bond future

Answer 14

based on a standardised or notional bond, which is linked to actual bonds according to rules determined by the exchange.

They can be used by companies that wish to issue bonds in the future to raise finance.

Question 15

currency futures

Answer 15

involves buying or selling once currency for a specified porice in terms of another currency at a specified time

Question 16

short interest rate future

Answer 16

• fuiture on a short-term interest rate (e.g. 3 months).
• Used by many companies to reduce the risk of a change in interest rates.
• Quoted as 100-implied annual interest rate
• implied interest rate is the expected annual interest rate convertible quarterly
• Based on a notional deposit but no capital or itnerest changes hands; they are cash-settled through the margin

Question 17

Options

Answer 17

An option gives an investor the right, but not the obligation, to buy or sell a specified asset on a specified date at a specified price
Two parties
1. The holder (or buyer) of the option, who has the right but not the obligation to buy/sell the asset
2. the write (or seller) of the option, who has to honour the option given to the buyer

The seller charges a premium for giving the buyer the option. If the option is not exercised the premium paid is wasted.
Only writers give a margin payment as they carry unlimited risk (buyers only risk the premium)

Call option - to buy ( right, not obligation)
Put option - to sell (right, not obligation)

exercise price/ strike price
exercise date/expiry date/maturity date

American option can be exercised on or before the expiry date. European only “on”

Question 18

Swaps

Answer 18

A contract between two parties to exchange one series of payments for another

Question 19

interest rate swaps

Answer 19

A contract between two parties to exchange one series of variable payments (based on the level of a short-term interest rate) for a series of fixed payments

Question 20

currency swaps

Answer 20

a contract to exchange a series of interest payments and a capital sum in one currenct for a series of interest payments and a capital sum in another currency