Derivatives

Question 1

Define:

American-style Option

Answer 1

An option contract which can be exercised at any time up to the expiration date.

As opposed to Bermuda style and European style

Question 2

Define:

Arbitrage-free pricing

Answer 2

Determining the price of a derivative based upon the assumption that the market is free of arbitrage opportunities.

Question 3

Define:

At the money

Answer 3

When the underlying asset price = exercise price of the option contract on that asset.

The option is “at the money”

Question 4

Define:

Bermuda-style Option

Answer 4

Option contract that can be exercised on specified dates up to the option’s expiration date.

As opposed to American style or European style

Question 5

Define:

Call

Answer 5

Option contract which gives the holder the right, but not the obligation, to buy an underlying asset at a fixed price over a specific period of time.

Question 6

Define:

Delta

Answer 6

Sensitivity of a derivative’s price to changes in the value of the underlying asset.

Question 7

Define:

Derivatives

Answer 7

Financial instruments, or contracts, whose value is derived from (dependent upon) the performance of an underlying asset, index, reference rate, or other financial instrument

Question 8

Define:

Equity swap

Answer 8

A financial derivative contract between two parties that involves the exchange of cash flows or returns based on the performance of an underlying equity or equity index.

Question 9

Define:

ESG investing

Answer 9

Making investment decisions based partially upon considerating of environmental, social, and governance factors.

Question 10

Define:

European-style option

Answer 10

Option contract that can only be exercised on its expiration date.

as opposed to American style and Bermuda style options

Question 11

Define:

Exercise

Answer 11

Utilizing the right to buy or sell the underlying (which is granted by the option contract).

Question 12

Define:

Exercise value

Answer 12

The value provided by exercising the option.

Question 13

Define:

Exercise price

aka strike price

Answer 13

The price at which the option holder has the right to buy or sell the underlying.

Question 14

Define:

Fixed-for-floating swap

aka plain vanilla swap

Answer 14

Interest rate swap with one party paying a fixed rate and the other paying a floating rate (in the same currency).

Question 15

Define:

Forward contract

Answer 15

An agreement between two parties to buy/sell an underlying asset at a later date for a price established at the start of the contract. Forwards are typically settled with delivery of the asset, and are highly customizable (as opposed to standardized futures contracts which are often not settled with delivery).

Question 16

Define:

Forward rate agreements

FRAs

Answer 16

Forward contracts where underlying is an interest rate. Both parties agree to apply a fixed rate to the notional value at a given point in the future. If the floating market reference rate differs at that point then a cash flow (the difference between rates) gets paid to the party that the difference favors.

The party long the FRA benefits if the floating ends above the fixed

Different from interest rate swap, which involves a series of cash flow exchanges.

Question 17

Define:

Forward curve

Answer 17

A graphic representation of the relationship between expected future interest rates and maturities, each having the same timeframe (ex. 1 year forwards).

“what is the one year forward rate in one year”

Forward curve is above spot curve if spot curve is upward sloping and below if downward sloping.

Question 18

Define:

Forward rate

Answer 18

The interest rate on a fixed income security traded in a forward market (to be entered into in the future).

ex. agreeing to a rate on a one year bond, to be entered into in one year.

Question 19

Define:

Forward market

Answer 19

Market in which contracts for the future sale of assets, commodities, or other financial instuments are agreed upon.

Question 20

Define:

Forward price

Answer 20

The fixed price or rate which the transaction (to occur at the expiration of forward contract) will take place. Agreed on at the initiation of the contract.

Question 21

Define:

Futures contract

Answer 21

Similar to a forward contract but is more standardized and includes things like clearinghouse guarantee, daily settlement of +/-, and an organized trading facility.

Question 22

Define:

Futures price

Answer 22

The price of a futures contract, and in essence the price at which the future transaction for the underlying asset will take place.

Question 23

Define:

FX swap

Answer 23

When offsetting FX spot and forward contract transactions occur. This is done to extend, or roll, a prior FX forward position.

only two settlement dates involved (this differs from a currency swap)

Question 24

Define:

Gamma

Answer 24

A measure of the how sensitive the option’s delta is to a change in the value of the underlying.

As the relationship that delta captures is not linear, gamma is a measure of that relationships convexity.

Question 25

Define:

Implied forward rates

Answer 25

Break-even reinvestment rate that links the return on a shorter-term zero-coupon bond to the return on a longer-term zero-coupon bond.

Calculated from spot rates

Question 26

Define:

Implied volatility

Answer 26

The volatility that option traders use to price an option, often derived using market variables and the Black Scholes formula.

Question 27

Define:

In the money

ITM

Answer 27

When the option has intrinsic value, and exercising the option would result in a profit for the option holder. For a call, if the price of the underlying > the strike price. For a put, if the price of the underlying < the strike price.

Question 28

Define:

Interest rate swap

Answer 28

A swap where underlying is an interest rate.

Question 29

Define:

Inverse floater

Answer 29

A type of leveraged structured financial instrument with cash flows that move in the opposite direction of changes in the reference rate.

Question 30

Define:

Moneyness

aka intrinsic value of the option

Answer 30

Relationship between the price of the underlying and the option’s exercise price.

Question 31

Define:

Option

Answer 31

Gives a party the right, but not the obligation, to buy/sell an underlying asset from/to another party (at a fixed price for a specific period of time).

type of contingent claim

Question 32

Define:

Protective put

Answer 32

Combiing a long position in an asset with a long put position.

Question 33

Define:

Put

Answer 33

Option giving the holder the right to sell an underlying asset (at a fixed price for specific period of time).

Question 34

Define:

Put–call parity

Answer 34

An equation expressing the equivalence (parity) of a portfolio of a call and a bond with a portfolio of a put and the underlying, which leads to the relationship between put and call prices.

C + PV(X) = S + P

Question 35

Define:

Put–call–forward parity

Answer 35

The relationship among puts, calls, and forward contracts.

C + PV(F) = S + P

Question 36

Define:

Replication

Answer 36

Using another asset, portfolio, and/or derivative in order to create/mimic characteristics of a particular asset.

Question 37

Define:

Rho

Answer 37

A measure of the sensitivity of an option’s price to the risk-free rate.

Question 38

Define:

Swap contract

Answer 38

An agreement between two parties to exchange a series of future cash flows.

Question 39

Define:

Time value

Answer 39

Due to the uncertainty of how the price the underlying may change over the remaining life of the option.

Option premium = intrinsic value + time value

Question 40

Define:

Theta

Answer 40

Relationship between the time value of an option and the passing of time.

Question 41

Define:

Total return swap

Answer 41

A swap in which one party agrees to pay the total return on a security in exchange for periodic payments (usually based on fixed or floating rate).

Question 42

Define:

Vega

Answer 42

A measure of the sensitivity of an option’s price to changes in the underlying’s volatility.

Question 43

Define:

Volatility

Answer 43

In option pricing: standard deviation of the continuously compounded returns on the underlying asset.

Question 44

Define:

Basis Risk

Answer 44

Risk that expected value of a derivative is different from the value of the underlying.

Question 45

Define:

CDS credit spread

Answer 45

Difference in yield between CDS and risk free benchmark.

Question 46

Define:

Cash flow hedge

Answer 46

When a derivative is designated as a hedge for accounting purposes as it is used to reduce volatility due to variable cash flows related to things like forex, interest rates, commodities).

Question 47

Define:

Central clearing mandate

Answer 47

Requires OTC derivatives be cleared by a central counterparty.

Came into affect following the great financial crisis of 2008

Question 48

Define:

Convexity bias

Answer 48

Between interest rate futures and interest rate forwards there is a difference in price sensitivity to changes in yield.

convex for forwards but linear for futures

Question 49

Define:

Fair value hedge

Answer 49

When a derivative is designated as a hedge for accounting purposes as it is used to reduce fluctuation in fair value of an asset or liability related to things like forex, interest rates.

Question 50

Define:

Central Counterparty

(CCP)

Answer 50

Intermediary which clears most derivative contracts and assumes counterparty credit risk between the parties involved.

Question 51

Define:

Futures contract basis point value

BPV

Answer 51

change in price of the contract per 1 basis point change in yield.

similar to bpv with fixed income securities.

Question 52

Define:

Futures margin account

Answer 52

Money which is held by clearinghouse on behalf of involved counterparties in order to ensure obligations are met.

Question 53

Define:

Hedge

Answer 53

When a derivative contract is used to mitigate exposure to adverse movements in an underlying (asset, rate, risk).

Question 54

Define:

Hedge accounting

Answer 54

Accounting standards which allow hedging instruments to offset a transaction or balance sheet item in order to reduce volatility.

Question 55

Define:

Hedge ratio

Answer 55

Used to determine the number or amount of a hedging instrument required to hedge or offset the risk associated with a specific exposure.

instrument could be futures contracts, options contracts, or other derivatives

Question 56

Define:

Net investment hedge

Answer 56

Designation when a derivative or foreign bond is used to offset exchange rate risk.

for hedge accounting

Question 57

Define:

Novation process

Answer 57

Process which substitutes the initial swap execution facility (SEF) contract with identical trades facing the central counterparty (CCP), essentially transfering rights and obligations of the contract to the CCP which then acts as counterparty.

Question 58

Define:

Par swap rate

Answer 58

The fixed rate that makes the value of the fixed leg equal to the value of the floating leg on a fixed for floating interest rate swap.

Question 59

Define:

Swap

Answer 59

OTC derivative contract where two parties agree to exchange a series of cash flows.

Question 60

Define:

Swap execution facility

SEF

Answer 60

Regulated swap trading platform which multiple dealers can access and execute swaps.

Institued following GFC of 2008

Question 61

Define:

Swap rate

Answer 61

Fixed rate paid by the fixed rate payer in a swap agreement.

Question 62

Define:

Time Value Decay

aka theta decay

Answer 62

Related to theta sensitivity, the time value declines faster as time passes (as experiation nears).

theta decay is exponential not linear