Derivative Securities

Question 1

What is a derivative security?

Answer 1

It is an instrument whose value derives from the value of some other (underlying) asset.

Question 2

What are forward contracts?

Answer 2

A forward contract is a private agreement between two parties to trade:

• a defined underlyign asset
• on a specified future date
• at a specified future price

Forwards do not require an upfront price to be paid by either party.

Question 3

How do future contracts differ from forward contracts?

Answer 3

A futures contract is like a forward contract that is standardised and listed on an exchange. Since it is standardised, it can be readily traded between market participants. This characteristic enables a futures sontract to be “reversed” before the agreed future date.

Question 4

Whats the difference between a speculator and a hedger?

Answer 4

A speculator has no pre-existing risk related to the proce of the underlying asset. They voluntarily takes on a risk they would not otherwise have had.

A hedger has a pre-existing tisk related to the price of the underlying asset. By entering the forward contract, the hedger takes on a risk that is expected to offset the pre-existing risk.

Question 5

What is long and short hedging?

Answer 5

Long hedging is when the hedger has a short position in the underlying asset.

Short hedging is when the hedger has a long position in the underlying asset.

Question 6

What are options?

Answer 6

Options are the right (not obligation) to force a transaction to occur in the future on terms ad conditions agreed to now. There are two basic types:

• call: option to buy
• put: option to sell

Note that there is a cash flow (the option price) at the initiation of the contract.

Question 7

What’s the difference between an American and European option?

Answer 7

The option is American because it can be exercised on or before expiry.

The option is European if it can only be exercised on and not before expiry.

Question 8

What is the time value of a call?

Answer 8

The amount Max [S-X,0] is reffered to as a call option’s intrinsic value. Anything above a positice intrinsic value is called the time value. This is to reflect the fact that this value exists only because the option has some life left.

Question 9

How does call prices change in response to share price change?

Answer 9

The percentage change in option price in every case is greater than the percentage change in the share price. Option prices have high “elasticity”

Question 10

What gives options value?

Answer 10

• The risk-free interest rate
  
  • The higher the rate, the lower the call price
  • The higher the rate, the higher the put price
• Volatility of the return on the shares
  
  • Higher volatility means higher call and put prices