Content that is not examined according to Pengfei Flashcards
(14 cards)
What is a ‘zero-sum game’ of forward contracts?
Any gain realised by one party is exactly equal to the loss incurred by the other party. The profit of the long position equals the loss of the short position and vice versa. Therefore, the net payoff of both parties combined is always zero at contract maturity.
What is an FRA?
A forward rate agreement (FRA) is an agreement to exchange a predetermined fixed rate for a reference rate that will be observed in the market at a future time. Both rates are applied to a specified principal, but the principal itself is not exchanged. Only the difference due to different interest rates is paid.
FRAs are often used to hedge against interest change to reduce the volatility of a company’s earnings or debt.
What is a fixed-for-fixed currency swap?
A financial agreement where two parties exchange fixed interest payments in different currencies over a set period.
At the start, both parties exchange a fixed amount (principal) in their respective currencies.
Each party pays a fixed interest rate on the principal they received.
At the end of the swap, the principal amounts are exchanged back at the original rate.
Example: A US company borrowing in euros and a European company borrowing in USD swap their fixed-rate interest payments to hedge exchange rate risk.
The primary purpose of a currency swap is to transform a liability (or investment) denominated in one currency into a liability (or investment) denominated in another currency.
Briefly describe the principal exchange of a fixed-for-fixed currency swap.
In a fixed-for-fixed currency swap, the principal amounts in two different currencies
are exchanged at the beginning of the contract at the spot exchange rate.
- Throughout the swap’s life, each party pays fixed interest on the principal they
received, in that currency.
- At maturity, the same principal amounts are re-exchanged, reversing the initial
exchange.
What are the upper bounds for the price of options (above which arbitrage would be possible)?
c ≤ S0 and C ≤ S0
P ≤ X
p ≤ Ke^-rT
What are the lower bounds for the price of options (above which arbitrage would be possible)?
c ≥ max(S0 - Ke^-rT, 0)
p ≥ max(Ke^-rT - S0, 0)
What is a bull spread?
Long low strike price option, short higher strike price option (same underlying asset, same maturity). Limits upside and downside risk. Done if the investor anticipates a moderate increase in price.
What is a bear spread?
Long high strike price option, short low strike price option.
An investor who enters into a bear spread is expecting the stock price to decline slightly.
What is a butterfly spread?
Long one high strike and one low strike price option, short two middle strike price options.
An investor who enters into a butterfly spread is expecting the stock price to fluctuate slightly near middle price.
What is a principal-protected note?
Combination of a zero-coupon bond and an option to protect the principal with upside potential. The return earned by an investor depends on the performance of the underlying asset but a PPN guarantees a minimum return equal to the investor’s initial principal amount.
What is a covered call?
Long stock + short call option
Generates premium income but upside limited to premium
What is a protected call?
Short stock + Long call option
Downside limited to premium
What is a covered put?
Short stock + Short put option
What is a protective put?
Long stock + Long put option
Downside limited to premium, unlimited upside
