Chapter 4: Principles of Exchange-Traded Derivatives

Question 1

How is the price of a future derived?

Answer 1

Price of asset plus the cost of holding the position, e.g. financing

Question 2

What is the Cost of Carry and what makes it up (4)?

Answer 2

Cost of holding the physical asset until expiry date
finance costs
security costs
storage costs
insurance

Question 3

What is the fair value of a future?

Answer 3

cash price + cost of carry
If a future cost more than this, it would make more sense to purchase and hold the physical asset

Question 4

How is the fair value of an equity index future calculated?

Answer 4

As other costs are negligible, only the net finance costs need to be considered

Question 5

What is the formula for net finance costs for equity index futures?

Answer 5

interest - present value of dividends

Question 6

How does the IASB define the fair value of a future?

Answer 6

The price at which it can be traded between two market participants at any given time

Question 7

What is a contago?

Answer 7

A market where the net cost of carry to hold the asset to delivery are higher than cash prices

Question 8

What is backwardation?

Answer 8

Markets where there is a net benefit to holding the asset to delivery, where futures prices are lower then cash prices

Question 9

When is backwardation most common?

Answer 9

When long term interest rates are higher than short term rates
In commodity markets when there is high demand for immediate delivery

Question 10

What is convergence in futures?

Answer 10

Cost of carry tends to zero as expiry approaches
This means that cash and futures prices eventually meet

Question 11

What is basis & its formula?

Answer 11

Measure of the difference between cash and futures prices
Basis = cash price - futures price

Question 12

What is the basis in contango markets?

Answer 12

Contango is where futures > cash
Thus negative

Question 13

What is the basis in backwardation markets?

Answer 13

Cash > futures
Thus positive

Question 14

How does basis differ towards expiry in contango vs backwardation markets?

Answer 14

In contango markets (eg, equity index), the basis strengthens towards
expiry.
In backwardation markets (eg, STIR and bond futures), the basis weakens towards expiry.

Question 15

What should a trader do if they expect the basis to strengthen?

Answer 15

Buy near dated instrument
Sell far dated instrument

Question 16

What should a trader do if they expect the basis to weaken?

Answer 16

Sell near dated instrument
Buy far dated instrument

Question 17

How does the gap differ between contango and backwardation markets for a strengthening basis?

Answer 17

Contago - narrowing gap
Backwardation - widening gap

Question 18

What is basis risk?

Answer 18

That a future will move differently to that of its underlying asset

Question 19

What is the only way to eliminate basis risk?

Answer 19

Hold future till expiry, futures and cash prices will converge

Question 20

What is a cash and carry arbitrage?

Answer 20

Where a future is trading above its fair value
Buy the underlying asset, sell the future

Question 21

What is a reverse cash and carry arbitrage?

Answer 21

Where a future is trading below fair value
Buy future, sell underlying asset

Question 22

What is the premium made up of? (2)

Answer 22

Intrinsic Value (IV) + Time Value (TV)

Question 23

What is intrinsic value?

Answer 23

The difference between the strike price and the assets underlying price

Question 24

What is the definition of in-the-money and out-the-money options?

Answer 24

ITM - Has IV
OTM - No IV

Question 25

What is the rate at which time value decays?

Answer 25

Exponential, increases as it approaches expiry

Question 26

At what strike price does TV increase?

Answer 26

ATM More uncertainty about whether will expire ITM or OTM

Question 27

How would TV differ for ITM OTM ATM

Answer 27

TV reflects uncertainty about likelihood of exercise ITM - High probability of exercise, low TV OTM - High probability of being abandoned, low TV ATM - Highest uncertainty of exercise, high TV

Question 28

How does volatility impact TV?

Answer 28

Higher volatility, higher TV

Question 29

What are the three types of volatility to be considered?

Answer 29

Historic - past Future - no one can predict Implied - market view on future volatility based on options pricing

Question 30

How is the Implied Volatility figure derived?

Answer 30

Options pricing models Black-Scholes

Question 31

What is limitation of Black-Scholes?

Answer 31

Only good for European options as cannot factor in early exercise

Question 32

What is the Stochastic Alpha, Beta, Rho (SABR) pricing model?

Answer 32

Uses different levels of implied volatility to price options on the same underlying asset It uses the volatility smile, states that IV is greater for options that are deep ITM or OTM

Question 33

Why would options pricing change based on interest rates?

Answer 33

Options are basically financing Buyer of a call gets to keep money in bank Seller has to own the shares So premium would go up for example

Question 34

What is Put/Call Parity?

Answer 34

Call and put premium must be fair in relation to one another, otherwise arbitrage opportunities present themselves

Question 35

What is the put/call parity formula?

Answer 35

C - P = S - K C = call premium P = put premium S = spot price K = strike price

Question 36

When does the put/call parity formula apply?

Answer 36

All options at expiry and futures at all times

Question 37

When does the put/call parity formula need to be adjusted?

Answer 37

To take account for the cost of carry for options when the underlying asset when it is not a future or a forward, and has a possible income flow that is paid before option expires E.g. option on a share with upcoming dividend

Question 38

What is the adjusted put/call parity formula?

Answer 38

Strike changes K/(1+r)^t Where r = the annual risk-free rate t = time to expiry in years

Question 39

What is the delta of an option?

Answer 39

Sensitivity of the options price to changes in the price of underlying

Question 40

What are the two ways to arbitrage options mispricings? (on futures)

Answer 40

If call is cheap (create synthetic long) Buy call, sell put, sell future - called reversal If put is cheap (create synthetic short) Buy put, sell call, buy future - called conversion Basically create a synthetic version of whatever asset you want, and take the opposite side on the spot - locked in profit

Question 41

What is the calculation for delta?

Answer 41

change in premium / change in price of underlying

Question 42

What is the cumulative delta?

Answer 42

Delta of a combined portfolio Gives sensitivity and direction bias of a portfolio

Question 43

What does delta hedging hedge against? And what risks remain?

Answer 43

Price risk Time decay, volatility and basis still remain

Question 44

What is Vega?

Answer 44

Measure of how a 1% change in implied volatility affects an options price Greatest for ATM options Greatest for long dated

Question 45

What is Gamma?

Answer 45

Gamma is the rate of change of delta Small when deep ITM or OTM

Question 46

What is Theta?

Answer 46

Theta is the measure of the rate of decline of an options value due to the passage of time Long options have negative theta, it's working against you Short options have positive theta

Question 47

What is Rho?

Answer 47

Measures how much an options value will change from a 1% change in interest rates least used - this relationship is fairly stable has minimal impact to pricing usually around 0.02 to 0.04

Question 48

How will an increase in rates impact calls and puts?

Answer 48

Call premium goes up Put premium goes down

Question 49

How long does it usually take for premium to be paid?

Answer 49

T+1

Question 50

Which is the only position that requires margin for equity index and stock options? And what kind of margin?

Answer 50

Short requires initial margin

Question 51

Which is the only position that does not require margin for Bond and STIR options? And what kind of margin?

Answer 51

Long, does not require initial margin