Derivatives

Question 1

Properties of forwards

Answer 1

• Contract to buy or sell an asset on agreed basis in the future such as
  o Units/quantity of the asset
  o Delivery date or dates
  o Currency of trading
  o Settlement method – physical delivery vs cash
  o Price of the asset
  o Specifications and other details
• They are non- standardised
  o details are tailormade and negotiated between trading parties
• They are traded over the counter - not on exchange trades
• There is risk of default and credit risk from the counterparty - no guarantees

Question 2

Description of futures

Answer 2

• They are similar to forwards in definition
• They are standardised contracts and can be exchanged on the recognised exchange
  o The details surrounding asst to be traded, ( except price ) are predetermined
  o Price is negotiated for between the parties involved in exchange
  o These are highly liquid, marketable and there is ease of administration as there are
  a lot of identical futures
• Exchange traded on a recognised exchange
  o Functions of exchange
  ▪ Setting details of standardised contracts
  ▪ Authorise who can trade on the exchange and brings buyers and sellers
  together
  ▪ Operates as a clearing house
• Checks that the buyer and seller match each other
• Clears future trades and settle margin payments
• Acts as a party to every trade – acts simultaneously as buyer and
  seller
  ▪ The exchange guarantees each side of the original bargain
  Removes the credit risk to each individual party ( risk of one party
  defaulting on the agreement )
• Each party pays a margin to the clearing house and variation margin
  will depend on the price movements of the underlying assets
• This is done by clearing house to uphold the guarantee
  ➢ Long position – having economic exposure to the asset ( positive exposure ) , contracted to
  take delivery of the asset ( buying the asset)
  ➢ Short position – having negative economic exposure to the asset , has to deliver the asset in
  the future ( sell the asset )

Question 3

Types of Options

Answer 3

• is the right, but not obligation, to buy or sell an asset
• The option writer sells the option ( shorts the option ) and they receive the option premium
• Two types of options :
  o Call options ( The right, but not obligation, to buy an asset for a specified price)
  o Put options ( The right , but not obligation to sell an asset at specified price )
  o Specified price traded at is called strike/ exercise price
  o Traded options are option contracts with standardised features actively traded on
  organised exchanges
• Can be traded on either exchanges or over the counter
• We have European and American options which look at the timing of
  exercising the option
• American option : option to exercise on a date before expiry
• European option : option exercised on a date at expiry

Question 4

Warrants

Answer 4

• Option issued by company over its own shares
• The holder has the right to purchase the shares at specified price at specified time in the
  future
• Has similar characteristics to a call option
• Most warrantees are equity warrants
• May add this as an added benefit to making bonds attractive to potential investors
• Makes the bond attractive to other sectors and hence being able to get finance
  easily
• Makes it cheaper to raise the debt and hence more efficient as investors will be
  willing to pay more for the added benefit – higher prices and hence lower bond
  yields

Question 5

Use of derivatives

Answer 5

• Used to set future prices in advance – prices of raw material, oil and electricity
• Gives financial institutions the ability to alter the structure of their portfolio without
  needing to trade in underlying asset
• Counterparty may require collateral and derivatives are not cheap