Derivatives

Question 1

What are hard and soft commodities

Answer 1

Hard - mining
Soft - Grown

Question 2

what is the blockchain?

Answer 2

digital ledger that processes transactions

Question 3

what are the 2 purposes of mining

Answer 3

Confirms transaction legitimate

creates new currency

Question 4

Give 3 features of Crypto

Answer 4

Anonymous
Not backed by central banks
Not regulated by FMSA 2000

Question 5

What is gearing in relation to D and what’s the effect

Answer 5

D costs a fraction of underlying asset - this magnifies losses/gains

Question 6

What is a future

Answer 6

Legally binding agreement to buy/sell at future date at already agreed price

Question 7

What is a margin

Answer 7

Upfront small payment in futures contract should either party unfulfil. Adjusted daily based on value, might not to be topped up

Question 8

4 reasons why hedge with futures

Answer 8

equities have to be held by manager

selling a large portfolio would move the price against manager

Futures more liquid and would not move price

cheaper

Question 9

Explain how FTSE 100 index future works

Answer 9

Work out how many full contracts needed

Work out portfolio loss

Work out future gain

Question 10

What is contango and backwardation

Answer 10

Contango - Price higher than underlying asset

Backwardation - Price lower than underlying asset

Question 11

What is an option?

Answer 11

An option gives the buyer the right, but not the obligation, to buy or sell a specified asset at
a fixed price before or on a certain date in the future.

The fixed price is called the ‘strike
price’ or ‘exercise price’.

Question 12

How are options paid for?

Answer 12

Buyer/holder pays the premium = cost of the option+ commission, but no margin

seller/writer receives the premium, but pays commission and initial/ongoing margin

Question 13

Describe exercising the option

Answer 13

Using the right before expiry

European - only at expiry
American - anytime

Question 14

Describe selling the option

Answer 14

Traded option can be sold

Made up of intrinsic and time value

Question 15

What is intrinsic value (options)

Answer 15

Call option has it if underlying asset price above strike price

Put option has it if underlying asset below strike price

This is all in the money (not at or out)

Question 16

What is Time value (options)

Answer 16

Amount investor will pay above intrinsic value in hope price will change

Eg at or out the money only has time value not intrinsic

Time value always 0 at expiry

Question 17

Explain how options expiring worthless works

Answer 17

Would be a loss if exercising out the money

So let expire and you only lose premium

Question 18

What’s the max and min you lose in call and puts as holder writer

Answer 18

Call/Holder - unlimited/premium
Call/Writer - Premium/unlimited

Put/Holder - Strike price-premium / premium
Put/Writer - Premium / Strike price-premium

Question 19

What do call/put want to happen to exercise price

Answer 19

Call wants low, put wants high

Question 20

As well as time to maturity affecting premium what else does?

Answer 20

Volatility

Question 21

What is time value equation

Answer 21

Difference between premium and intrinsic value

Question 22

Give 3 reasons to use D to hedge

Answer 22

1. Hedge future purchase in case goes up ( goes up then worked, goes down then cheaper to buy)
2. Hedge portfolio cos cant have large cash
3. Change asset allocation active (long and expensive so hedge)

Question 23

Give 8 uses of derivatives

Answer 23

Asset allocation
Capturing volatility
Remove IR/currency risk
Fund manager changes
Increase risk
Remain in cash eg when ir high
Hedge without going into cash, expensive dealig charges
Increase income by writing options

Question 24

What is the difference between covered and uncovered Option calls?

Answer 24

Writer owns asset as opposed to having to go and buy it to give away if they lose

Question 25

How are F and O taxed?

Answer 25

CGT unless it's their job (income tax) or fixed interest underlying asset

Question 26

How are call, put and expiry options taxed?

Answer 26

Call - cost is treated as part of total cost Put - Cost is an allowable deduction Expiry - Capital loss

Question 27

How are Futures closed or not closed taxed?

Answer 27

Closed - money received included as profit money paid can be deducted Not closed - Each part treated as a disposal, same as above

Question 28

What is a warrant? (5)

Answer 28

Traded on LSE so available to retail holder has the right, but not the obligation, to buy shares at a fixed price at a predetermined date in the future Effectively a long term call option so no income and geared Often given free by new IT Can sell or exercise (but wouldnt if exercise price above market price of shares)

Question 29

What is a covered warrant? (3)

Answer 29

An option but always cash settled. Max loss for investor is amount paid. Covered as writer hedge by buying stock or through D

Question 30

3 types of collective D vehicles

Answer 30

1. Futures Options Funds - can invest in D provided covered by underlying asset 2. Geared Futures Options Funds - 20% allowed in derivatives 3. Capital protected unit trust and oeic: Limited issue and could offer a % of rise or full capital protection (like a structured product)

Question 31

What is a Contract for difference: (3)

Answer 31

Trade shares using gearing via a margin Very liquid so used for speculation/hedging 30:1 cap on gearing and auto close out when funds fall to 50% of margin needed to maintain open position

Question 32

Give 4 risks of derivatives trading

Answer 32

Amplified losses due to leverage Volatility requires additional margin payments Additional margin required can enforce closures if unable to meet Potential for full loss

Question 33

Give 3 returns for derivatives:

Answer 33

Gearing allows for increased profits from small movements Leverage means a smaller margin required Can speculate without holding underlying asset