Derivatives

Question 1

What is a forward contract

Answer 1

One party agrees to buy the underlying for a specified price on a specified future date

Question 2

What do we call the seller of a contract is?

Answer 2

A hedger

Question 3

What securities are OTC?

Answer 3

Forwards, most swaps and some options

Question 4

What are the characteristics of OTC securities

Answer 4

Custom instruments, created and traded by dealers in a market with no central location.

Markets are less regulated and less transparent

Each side of the trade has counter party risk

Question 5

What is a forward commitment

Answer 5

Legally binding promise to perform some action in the future

Question 6

What value does a forward contract have at inception?

Answer 6

0

Question 7

What is a contingent claim

Answer 7

Payoff depends on a future event

E.g. Credit default swap

Question 8

Characteristics of a futures contract?

Answer 8

Similar to forwards but is standardised and exchange traded.

Both buyer and seller deposits march

Question 9

What is marking to market?

Answer 9

At the end of each day clearing house adjusts the margin of both buyers and sellers of a future

Question 10

What is the put call parity?

Answer 10

Question 11

What is hedge accounting?

Answer 11

Permits companies to recognize gains and losses on some derivative hedges at the same time as changes in the values of assets or liabilities being hedged

Question 12

What is replication

Answer 12

Creating a portfolio with cash market transactions that have the same payoffs as a derivative for all possible future values of the underlying

Question 13

What is the no arbitrage price of a forward?

Answer 13

Question 14

What is convenience yield?

Answer 14

Opportunity to sell an underlying asset if the price is temporarily high

Question 15

What can we also describe the relationship between the spot and forward prices as being?

Answer 15

As continuously compounded returns

Question 16

What is the formula for the value to the investor of a forward

Answer 16

Question 17

What is a FRA?

Answer 17

Derivative contract that has an interest rate as its underlying

Question 18

What a happens to price changes and value changes for futures contracts

Answer 18

Price changes and the value returns to 0

Question 19

When the asset price is positively correlated to interest rates what’s better long futures or forwards?

Answer 19

Futures

Question 20

What do interest rate forward contracts exhibit?

Answer 20

Convexity bias - increase in the reference rate decreases a forwards value by less than a decrease in the reference rate increases its value

Question 21

What will happen if there is an increase in the risk free rate to call values?

Answer 21

Increase in call value

Question 22

Formula for put call forward parity at time 0?

Answer 22

Question 23

Value of a forward

Answer 23

Question 24

Formula for put call parity

Answer 24

Question 25

How to discount a call option back to today?

Answer 25

Question 26

What is the hedge ratio formula?

Answer 26

Question 27

What does the hedge ratio show us?

Answer 27

How many shares needed to replicate or hedge one option (Delta)

Question 28

What happens to futures prices as they come towards expiration?

Answer 28

Converge to the spot price

Question 29

What is the lower bound of a call options value?

Answer 29

The underlying price - PV of the options exercise price or zero which ever is greater

Question 30

What is option moneyness?

Answer 30

Expresses the relationship between the underlying price and the exercise price

Question 31

What is the call option exercise value?

Answer 31

Any time before maturity = t

Question 32

Who does time decay benefit

Answer 32

Option sellers

Question 33

What is the upper bound of a call option

Answer 33

Price of the underlying

Question 34

What happens to a put option if there is a decrease in risk free interest rates

Answer 34

Value of the put option increases

Question 35

What is the law of one price

Answer 35

That securities with identical future cash flows should have the same price

Question 36

What is replication

Answer 36

Creating a portfolio of cash market transactions that has the same payoff as a derivative for all possible future values of the underlying

Question 37

For no arb condition to hold what must happen

Answer 37

The security at time 0 (S0) must equal the PV of the bond

Question 38

No arbitrage price of a forward

Answer 38

Question 39

Example of conscience yield

Answer 39

Selling an asset when the price has risen

Question 40

What is the value to the forward buyer at settlement?

Answer 40

Question 40

What do costs and benefits of holding the underlying asset do to the forward price

Answer 40

- increase in costs of the underlying increase the no arbitrage price of the forward - increase in benefits reduces the no arbitrage price

Question 41

What is convexity bias

Answer 41

Convexity bias is the difference in price changes for a given change in yield between interest rate futures and interest rate forward contracts. Interest rate forward contracts are non linear (convex) interest rate futures are linear

Question 42

Put call parity

Answer 42

Notion that portfolios with identical payoffs must sell for the same price

Question 43

What types of derivatives are best described as contingent claims?

Answer 43

Options

Question 44

What is the put call forward parity at time 0

Answer 44

Question 45

What is the risk neutral expected payoff of an option?

Answer 45

Question 46

When calculating option payoffs what do we not include?

Answer 46

The premium

Question 47

What happens to forward prices with increases in interest rates?

Answer 47

They increase as the risk free rate increase so the opportunity cost is greater

Question 48

What is the beta of a fixed income arbitrage strategy?

Answer 48

0 - market neutral

Question 49

The replacement of existing trades on a swap execution facility by the central counterparty is what?

Answer 49

Novation

Question 50

Is payoff the same as profit?

Answer 50

No - payoff is before premium received or got rid of

Question 51

Concept of put call parity demonstrates the equivalence of what type of call and put

Answer 51

Fiduciary call and protective put