Derivatives

Question 1

Name the first derivatives exchange

Answer 1

Chicago Board of Trade (CBOT)

Question 2

What is a derivative?

Answer 2

A derivative is a financial instrument whose price is based on the price of another asset, known as the ‘underlying’. The underlying could be a financial asset, a commodity, a currency, an index or indeed a range of other reference assets such as weather. Examples of financial assets include bonds and shares, and commodities include oil, gold, silver, corn and wheat.

Question 3

What is hedging?

Answer 3

The purchase or sale of a commodity, security or other financial instrument for the purpose of offsetting the profit or loss of another security. This is a technique employed by portfolio managers to reduce portfolio risk, such as the impact of adverse price movements on a portfolio’s value. This could be achieved by buying or selling futures contracts, buying put options or selling call options.

Question 4

Anticipating future cash flows

Answer 4

Closely linked to the idea of hedging, if a portfolio manager expects to receive a large inflow of cash to be invested in a particular asset, then futures can be used to fix the price at which it will be bought and offset the risk that prices will have risen by the time the cash flow is received.

Question 5

Asset allocation changes

Answer 5

Changes to the asset allocation of a fund, whether to take advantage of anticipated short-term directional market movements or to implement a change in strategy, can be made more swiftly and less expensively using derivatives such as futures than by actually buying and selling securities within the underlying portfolio.

Question 6

Arbitrage

Answer 6

The process of deriving a risk-free profit from simultaneously buying and selling the same asset in two different markets, when a price “difference between the two exists. If the price of a derivative and its underlying asset are mismatched, then the portfolio manager may be able to profit from this pricing anomaly.

Question 7

Speculation

Answer 7

Involves assuming additional risk (betting) in an effort to make, or increase, profits in the portfolio.

Question 8

What is a future?

Answer 8

A future is a legally binding agreement between a buyer and a seller. The buyer agrees to pay a pre-specified amount for the delivery of a particular pre-specified quantity of an asset at a pre-specified future date. The seller agrees to deliver the asset at the future date, in exchange for the pre-specified amount of money

Question 9

What are the two distinct features of a futures contract?

Answer 9

1. It is exchange-traded – for example, on derivatives exchanges, such as ICE Europe in London or the Chicago Mercantile Exchange (CME) in the US.
2. It is dealt on standardised terms – the exchange specifies the quality of the underlying asset, the quantity underlying each contract, the future date and the delivery location. Only the price is open to negotiation. In the above example, the oil quality will be based on the oil field from which it originates (eg, Brent crude – from the Brent oil field in the North Sea), the quantity is 1,000 barrels, the date is three months ahead and the location might be the port of Rotterdam in the Netherlands.

Question 10

Opening

Answer 10

Undertaking a transaction which creates a long or short position.

Question 11

Long

Answer 11

The term used for the position taken by the buyer of the future. The person who is ‘long’ in the contract is committed to buying the underlying asset at the pre-agreed price on the specified future date.

Question 11

Short

Answer 11

The position taken by the seller of the future. The seller is committed to delivering the underlying asset in exchange for the pre-agreed price on the specified future date.

Question 12

Open

Answer 12

The initial trade. A market participant opens a trade when it first enters into a future. It could be buying a future (opening a long position) or selling a future (opening a short position).

Question 13

Close

Answer 13

The physical assets underlying most futures that are opened do not end up being delivered: they are closed-out instead. For example, an opening buyer will almost invariably avoid delivery by making a closing sale before the delivery date. If the buyer does not close out, they will pay the agreed sum and receive the underlying asset. This might be something the buyer is keen to avoid, for example because the buyer is actually a financial institution simply speculating on the price of the underlying asset using futures.

Question 14

Covered

Answer 14

When the seller of the future has the underlying asset that will be needed if physical delivery takes place.

Question 15

Naked

Answer 15

When the seller of the future does not have the asset that will be needed if physical delivery of the underlying commodity is required. The risk could be unlimited.

Question 16

Option

Answer 16

An option gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a pre-agreed exercise price, on or before a pre-specified future date or between two specified dates. The seller, in exchange for the payment of a premium, grants the option to the buyer.

Question 17

Premium

Answer 17

The amount of cash paid by the holder of an option to the writer in exchange for conferring a right.

Question 18

What is the key difference between a future an option?

Answer 18

A key difference between a future and an option is, therefore, that the option gives the right to buy or sell, whereas a future is a legally binding obligation between the counterparties.

Question 19

What are the two main classes of options?

Answer 19

1. A call option is when the buyer of the option has the right to buy the asset at the exercise price if they choose to. The seller is obliged to deliver if the buyer exercises the option.
2. A put option is when the buyer of the option has the right to sell the underlying asset at the exercise price. The seller of the put option is obliged to take delivery and pay the exercise price if the buyer exercises the option.

Question 20

Who are the writers?

Answer 20

Party selling an option. The writers receive premiums in exchange for taking the risk of being exercised against.

Question 21

Call Option:

Answer 21

Holder: The holder has the right, but not the obligation , to exercise the option to buy.

Writer: The writer receives a premium from the holder and is obliged to sell if called upon to do so.

Question 22

Put Option:

Answer 22

Holder: The holder has the right, but not the obligation , to exercise the option to sell.

Writer: The writer received a premium from the holder and is obligated to buy if called upon to do so.

Question 23

What is a Swap?

Answer 23

A swap is an agreement to exchange one set of cash flows for another. Swaps are a form of OTC derivative and are negotiated between the parties to meet their different needs, so each tends to be unique.

Question 24

Interest Rate Swaps

Answer 24

Interest rate swaps are the most common form of swaps. They involve an exchange of interest payments and are usually constructed whereby one leg of the swap is a payment of a fixed rate of interest and the other leg is a payment of a floating rate of interest.

Question 25

Credit Default Swap

Answer 25

Credit derivatives are instruments whose value depends on agreed credit events relating to a third-party company, for example, changes to the credit rating of that company, or an increase in that company’s cost of funds in the market, or adverse credit events relating to it. Credit events are typically defined as including a material default, bankruptcy, a significant fall in an asset’s value, or debt restructuring for a specified reference asset.

Question 26

What are the two distinct groups of derivatives?

Answer 26

OTC Derivatives and Exchanged-traded derivatives.

Question 27

OTC Derivatives

Answer 27

OTC derivatives are ones that are negotiated and traded privately between parties without the use of an exchange. Interest rate swaps are just one of a number of products that are traded in this way. The OTC market is the larger of the two in terms of value of contracts traded daily. Trading takes place predominantly in Europe and, particularly, in the UK.

Question 27

Exchange-traded derivatives

Answer 27

Exchange-traded derivatives are ones that have standardised features and can, therefore, be traded on an organised exchange, such as single stock or index derivatives. The role of the exchange is to provide a marketplace for trading to take place but, in addition, it also provides some form of guarantee that the trade will eventually be settled. It does this by placing an intermediary (the central counterparty or CCP) between the parties to each trade and by requiring participants to post a margin, which is a proportion of the value of the trade, for all transactions that are entered into.

Question 28

What are the main advantages of investing in derivatives:

Answer 28

1. Enables producers and consumers of goods to agree on the price of a commodity today for future delivery, which can remove the uncertainty of what price will be achieved for the producer and the risk of lack of supply for the consumer. 2. Enables investors and portfolio managers to hedge (reduce) the risk associated with a portfolio of investments. 3. Enables investment firms to hedge the risk associated with a portfolio or an individual stock. 4. Offers the ability to speculate on a wide range of assets and markets to make large bets on price movements using the geared nature of derivatives.

Question 29

What are the main disadvantages of investing in derivatives?

Answer 29

1. Some types of derivatives investing can involve the investor losing more than their initial outlay and, in some cases, facing potentially unlimited losses. 2. Derivatives markets thrive on price volatility, meaning that professional investment skills and experience are required. 3. In the OTC markets, there is a risk that a counterparty may default on their obligations, and so it requires great attention to detail in terms of counterparty risk assessment, documentation and the taking of collateral.

Question 30

What are the main uses of derivatives?

Answer 30

Derivatives can be used for hedging or speculation. Hedging could be a producer entering into futures contract to secure a price for their goods or an investment management using futures or options to protect against a stock market fall. They are used for speculation to profit from movements in prices as a relatively small premium or margin payment secures exposure to a much larger underlying position.

Question 31

What is the seller of a future known as?

Answer 31

The seller of a future is referred to as the short or taking a short position.

Question 32

What is an investor who enters into contract for the delivery of an asset in their months' time knows as?

Answer 32

This is the seller of a future who is described as the short or taking a short position.

Question 33

What is the name given to the seller of an option?

Answer 33

The seller of an option is the writer of the option.

Question 34

What type of option gives the holder the right to sell an asset?

Answer 34

A put option gives the right to sell the asset.

Question 35

What is the price paid for an option know as and who is it paid to?

Answer 35

The price paid for an option is known as a premium. It is paid by the holder to the writer of the contract.

Question 36

What is an interest rate swap?

Answer 36

An interest rate swap is an over the counter derivative which involves two counterparties exchanging cash flows; this could be where one pays a fixed rate interest on a notional amount and the other pays a floating rate.

Question 37

What type of derivative is not exchanged-traded , ie , negotiated and traded privately between parties to the transaction?

Answer 37

OTC derivatives are ones that are negotiated and traded privately between parties without the use of an exchange.