Chapter 4: Principles of Exchange-Traded Derivatives

Question 1

What is the Equation for the Fair Value (Arbitrage free value)?

Answer 1

Fair Value of Future = Cash Price of Underlying (spot price) + Costs of carry (what would it cost to hold the asset until its delivery date)

Question 2

What are the 3 Factors Relating to Cost of Carry?

FIS

Answer 2

Financing, Insurance & Storage

Question 3

How to Calculate the Fair Value of Equity Index Futures?

Answer 3

FV = Cash price of index + cost of carry (interest) - benefits of carry (dividends)

Question 4

What is the IASB definition of Fair Value?

Answer 4

A futures fair value is equal to its current market price.

Question 5

What is the Definition of Convergence?

Answer 5

As the future approaches delivery, the fair value converges with the cash price.

Question 6

What Should an Investor do When a Future is Trading Above its Fair Value?

What does this consist of?

Answer 6

Cash and Carry Arbitrage

• Buy cash and hold
• Sell the future

Question 7

How to Calculater Basis when Pricing Futures?

Answer 7

Basis = Cash Price - Futures Price

Question 8

What is a Contango Market?

Is this normal?

Answer 8

When the basis is negative.

Yes this is normal.

Question 9

What is Backwardation?

In futures markets?

Answer 9

Whe the basis is positive.

Question 10

What is Basis Risk?

Also known as hedging risk?

Answer 10

Where the basis of a position has either widened or narrowed.

Question 11

What Happens when Basis Moves from a Contango Market to a Backwardation Market?

Has it strengthened or weakened?

Answer 11

It has strengthened (narrowed).

Question 12

What Happens when Basis Moves from a Backwardation Market to a Contango Market?

Has it strengthened or weakened? WW

Answer 12

It has weakend (widened).

Question 13

In a Contango Market, What Would a Savvy Investor do When the Basis Strengthens (Narrows)?

With cash and futures.

Why?

Answer 13

Sell the future (short) and buy the cash (long).

As the future is expected to fall (Sell) and the cash is expected to rise (Buy).

Question 14

How is the Premium Calculated?

Answer 14

Premium = Intrinsic Value + Time Value

Question 15

What is the Link with Time Value Size and Time til Maturity?

How are these correlated?

Answer 15

The greater the time til maturity, the greater the time value.

Question 16

What are the Elements of Time Value?

What does the value comprise itself from?

Answer 16

• Time to Expiry
• Volatility of underlying asset
• Other elements (dividends or interest etc)

Question 16

Calculate the Intirnsic Value and Time Value of this Equation.

Call K100 of Asset B @ 14 (premium) when Asset B = 110?

Answer 16

• Intrinsic Value = 10 (Asset B price = 110 - Call = 100)
• Time Value = 4 (14 premium = 10 (IV) - X)

Question 16

What is the Black Scholes Model?

Answer 16

An options pricing model that provides the premium value, when all factors have been inputted.

Question 17

Calculate the Intirnsic Value and Time Value of this Equation.

Call K250 of Asset B @ 8 (premium) when Asset B = 210?

Answer 17

• Intrinsic Value = 0 (not -40 as you wouldnt exercise the option out-the-money)
• Time Value = **8 ** (as there is no intrinsic value)

Question 17

Why Can Intrinsic Value Never be Less than 0? (Out-the-money)

Answer 17

Beacuse if an option was OTM, you’d be an idiot to exercise it.

Question 18

What Happens to Time Value as Expiry Date Approaches?

Answer 18

It get lower, until it reaches 0

Question 19

Who Does the Erosion of Time Value Act in Favour of?

The writer or the holder?

Answer 19

The writer.

It acts against the holder (as price falls in line with underlying asset)

Question 20

What are the Types of Volatility?

How is it calculated?

Answer 20

• Implied
• Future
• Historic

Question 21

What is the Impact on Call and Put Options Time Value When Dividends Rise?

What happens when dividends fall?

Answer 21

• Call - Time Value Falls
• Put - Time Value Rises

And vice versa, for when dividends fall?

Question 22

What is the Impact on Call and Put Options Time Value When Interest Rises? ## Footnote What happens when Interest Rates fall?

Answer 22

* Call - Time Value Rises * Put - Time Value Falls And vice versa, for when dividends fall?

Question 23

When is Time Value Greatest? ## Footnote When pricing options?

Answer 23

**When the option is at the money.** As there is no certainty whether the option will stay at the money (go in or out), and there is no intrinsic value.

Question 24

What is the Definition of Delta?

Answer 24

The sensitivity of an option premium to a **change** in the price of the **underlying**.

Question 25

What is the Equation for the Delta?

Answer 25

Change in the value of an option premium / change in the value of the underlying.

Question 26

What is the Change in the Premium when; Delta = **0.39** and the Underlying increases from **90 to 95**?

Answer 26

D = Change in option / Change in underlying 0.39 = X / (95-90) 0.39 * 5 = **1.95** premium change.

Question 27

What is the Typical Delta for Options: ATM, ITM & OTM? ## Footnote What are the number?

Answer 27

ITM = **1** ATM = **0.5** OTM = **0.01**

Question 28

What is the Key Point to Remember for Calls and Puts Deltas? ## Footnote Which is positive and which is negative?

Answer 28

Calls = Positive Puts = Negative

Question 29

What is Cumulative Delta? ## Footnote Examples.

Answer 29

Options as a relative number of futures positions.

Question 30

How Might One Hedge a Portfolio of **+1.5?** ## Footnote What would be needed to balance this?

Answer 30

Buy options with a delta of **-1.5**, so that delta is neutral (=0) i.e 3x ATM options as (delta = 0.5)

Question 31

What is the Definition of Gamma?

Answer 31

The sensitivity of an options delta to a change in the price of the underlying.

Question 32

Is Gamma Negative or Positive for Long Positions? ## Footnote What about short positions?

Answer 32

Positive for long Negative for short

Question 33

When is Gamma Greatest? ## Footnote For which option?

Answer 33

For a short dated ATM option.

Question 34

What is the Definition of Vega? | Is it + / - for long options, where is it greatest? ## Footnote V for v......

Answer 34

Sensitivity of an option premium to a 1% change in implied volatility. Positive for long options, and is greatest for ATM options.

Question 35

What is the Definition of Theta? | Is it + / - for long options, where is it greatest? ## Footnote T is for T.........

Answer 35

Sensitivity of an option premium to a change in unit of time. Negative for long options, greatest or ATM options. Increases as approaches expiry.

Question 36

What is the Definition of Rho? | Is it + / - for call options, where is it greatest? ## Footnote R is for r.........

Answer 36

Sensitivity of an option premium to a 1% change in interest rates. Positive for calls, and ATM / ITM options have a relatively higher Rho Higher for longer-dated options

Question 37

What is the Forumla for Put-Call Parity Theorem?

Answer 37

Call - Put = Cash - (Strike / (1+r)*t*)

Question 38

What is a Reversal Trade? ## Footnote What trades need to be entered to replicate this?

Answer 38

- Synthetic Long (buy call and sell put) - Sell future / underlying

Question 39

What is a Conversion Trade? ## Footnote What trades need to be entered to replicate this?

Answer 39

* Synthetic Short (Sell call and buy put) * Buy future / underlying