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Flashcards in Derivatives Deck (80)
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1
Q

What is a future?

A

An agreement to buy/sell a standard quantity of a specified asset on a fixed future date, at a price agreed today.

Key features:

  • Exchange-traded.
  • Standardised contracts.
  • High liquidity.
  • Clearing and settlement systems in place (no counter party risk).
  • Low initial costs - but margin requirements exist.
2
Q

What is a ‘long-future’?

A

The buyer of the future enters into an obligation to buy on a future date.

3
Q

What is a ‘short-future’?

A

The seller of the future is under obligation to sell on a future date.

4
Q

How are ETFs traded on the futures market?

A

They are traded in standardised parcels known as contracts.

5
Q

What is a forward?

A

A future but OTC traded.

Key features:

  • OTC traded.
  • Contract negotiable.
  • Possibility of limited liquidity.
  • Counter party/default risks.
  • Costs high - but margin requirements rarely required.
6
Q

What are the three types of investors that would use futures?

A

Speculator: Risk-takers seeking large profits.
Hedger: Someone seeking to reduce their risk.
Arbitrageur: Someone seeking risk-free profits by exploiting market inefficiencies.

7
Q

Why would a speculator buy a future (‘go-long’)?

A

Buying an underlying asset for a pre-determined price at a future date, with the expectation of the underlying asset’s value rising in this time.

8
Q

Why would a speculator sell a future (‘go-short’)?

A

Selling an underlying asset for a pre-determined price at a future date, with the expectation of the underlying asset’s value falling in this time.

9
Q

How would a hedger protect against a fall in price of a particular asset?

A

Short-hedge (‘going-short’): using a future to reduce the risk of existing cash positions.

e.g. If an oil producer fears the price of oil will fall in the future, they may wish to sell futures of his desire price to remove this uncertainty.

10
Q

How would a hedger protect against a rise in price of a particular asset?

A

Long hedge (‘going-long’): using a future to protect against a rise in price.

e.g. If a company relied on oil for their business, but feared the oil prices were set to rise, they may enter the futures market and buy oil at a later date at a fixed price.

11
Q

What does tick size refer to?

A

The smallest permitted quote on one contract e.g. one percentage point, £10 etc.

12
Q

What does tick value refer to?

A

The monetary change in the value of one contract if there is one-tick change in the quote.

13
Q

How do you calculate the fund manager’s profit/loss of a futures contract?

A

Profit/loss = No. of ticks the price has changed by x Tick Value x No. of contracts

14
Q

What is index arbitrage?

A

Trading price anomalies between index pricing and futures contracts on the index.

An index arbitrageur trades in the cash and futures markets when the differences between the theoretical futures price and the actual futures price are sufficiently large to create arbitrage profits: a trader will sell the futures index if it is expensive and buy the underlying stock, or buy the futures contract when it is cheap and sell short underlying stocks. Hence, index arbitrage plays an important role in linking futures prices and cash prices.

15
Q

FTSE 100 Index Future (equity based index):

A
  • Fixes the price at which the underlying index may be bought or sold at a specific future date.
  • Contract size: Index Value x £10.
  • Cash-settled.
  • Quote given in index points.
  • Tick Size: 0.5 index points
  • Tick Value: £5 (0.5 x £10)
16
Q

3-Month Sterling Future (interest-rate based index):

A
  • Provides a means to gain/hedge interest-rate exposure for a period of 3-months from a given future date.
  • Contract size: £500,000 (this amount does not change hands, only the interest effect).
  • Cash-settled (the difference in value between the interest bill for 3 months at the rate agreed and the actual rate that arises.
  • Quote: 100 - Rate of Interest (IR↑, futures prices ↓)
  • Tick Size: 0.01% (0.0001).
  • Tick Value: £12.50 (£500,000 x 0.01% x 3/12).
17
Q

Long (10 year) Gilt Future:

A
  • Provides a means to gain/hedge exposure to UK Gilts. It effectively represents a bond index contract.
  • Contract size: £100,000 nominal of notional 4% gilt.
  • Physically-settled (the seller of the future must deliver gilts and the buyer must pay the pre-agreed price).
  • Quote: Per £100 NV.
  • Tick Size: 0.01% (1 basis point).
  • Tick Value: £10
18
Q

What does beta (β) refer to?

A

The volatility of the portfolio relative to the index.
(β of market = 1).
- A portfolio with a beta of 1.00 has the same volatility as the market.
- A portfolio with a beta of 1.20 is 20% more volatile than the market.
- A portfolio with a beta of 0.80 is 20% less volatile than the market.

19
Q

To hedge a portfolio fully, how can a portfolio manager calculate the number of futures contracts (N) to sell?

A

N = (Portfolio Value / Futures Value) x β

always round up

20
Q

How do you calculate the Futures Value?

A

Futures Value = Futures Quote x £10

21
Q

What is the ‘basis’ of a futures contract?

A

The numerical difference between a cash price and a futures price.

Basis = Spot Price - Futures Price

22
Q

When is the market in ‘contango’?

A

When the future prices are higher than the current cash (spot) prices. The market is at a ‘premium’.

This is considered normal as the FP = cash price + cost of carry.

23
Q

When is the market in ‘backwardation’?

A

When the future prices are lower than the current cash (spot) prices. The market is at a ‘discount’.

This is considered a ‘supply squeeze’ in which S↓ and P↑ in the SR and S↑ and P↓ in the LR.

24
Q

What does the convenience yield refer to?

A

The benefit associated with holding an underlying asset, rather than the contract or derivative product.

25
Q

What is an option?

A

A contract that confers the right, but not the obligation, to buy or sell an asset at a given (strike price) on or before a given date (expiry date).

26
Q

What is a call option?

A

Gives the holder the right to buy an asset for the agreed strike price on or before the expiry date.

27
Q

What is a put option?

A

Gives the writer the right to sell an asset for the agreed strike price on or before the expiry date.

28
Q

What are American-style options (most common)?

A

Options that allow the holders to exercise their option at anytime before the expiry date.

29
Q

What are European-style options?

A

Holders can only exercise on the expiry date.

30
Q

What are Asian options?

A

Where payoff depends on the average price of the underlying asset over a given period of time.

31
Q

What are Bermudan options?

A

Hybrids of American and European-style options. They can only be exercised on pre-determined dates before the expiry date.

32
Q

What is the option premium?

A

The cost of an option paid by the holder to the writer that is paid immediately. The premium will comprise the option’s intrinsic value and its time value.

33
Q

What is the motivation behind buying a call option (‘long-call’)?

A

Buying a call option gives the investor the right to buy an asset up until a given expiry date. This is a bullish strategy which is motivated by a view that an asset’s price will rise.
Risk: Premium paid.
Reward: Unlimited.

34
Q

What is the motivation behind selling a call option (‘short-call’/’naked writing’)?

A

Selling a call option means the investor has a duty to deliver an asset at a fixed price up until the expiry date. This is a bearish strategy in which the call writer believes the asset price will either stay the same or fall.
Risk: Unlimited.
Reward: Premium received.

35
Q

What is the motivation behind buying a put option (‘long-put’)?

A

Buying a put option gives the investor the right to sell an asset at a fixed price in the future. This is a bearish strategy in which the investor hopes to profit from a fall in the asset’s price.
Risk: Premium paid.
Reward: Greatest profit will be if the price of the asset falls to zero (strike price - premium paid).

36
Q

What is the motivation behind selling a put option (‘short-put’)?

A

Selling a put option provides the writer with an obligation to purchase an asset at a fixed price. This is a bullish strategy in which the writer is hoping that the asset price will exceed the strike price and the put will not be exercised.
Risk: If the price of the asset falls to 0, the writer will have to pay the exercise price + the premium paid for the asset.
Reward: Premium paid.

37
Q

How are options priced?

A

Premium = Intrinsic Value + Time Value

Intrinsic Value = Underlying Asset Price - Call Price
Time Value = Probability of further volatility.

38
Q

What impact of volatility on call/put premiums?

A

Volatility refers to how much the underlying price of the asset varies.
Volatility ↑, Call/Put Premiums ↑
Volatility ↓, Call/Put Premiums ↓

39
Q

What is the impact of changes in the interest-rate on call/put premiums?

A

IR ↑, Call Premiums ↑, Put Premiums ↓

40
Q

What five factors influence the fair value of options?

A
  • Value of the underlying asset.
  • Time until expiry.
  • Interest-rate.
  • Exercise price.
  • Volatility.
41
Q

What is the option delta?

A

The sensitivity of the change in the option price with respect to a change in the underlying asset price. This is important in understanding a portfolio’s overall volatility..

e.g. If the price of a share increased by 10p, and a call option increased by 3p, the delta would be 0.3 (3p/10p).

42
Q

What is option gamma?

A

The sensitivity of delta to a change in the theoretical value of a call/put option as time to expiry increases.

43
Q

What is option theta?

A

The sensitivity of option price with respect to the passing of time.

44
Q

What is option vega?

A

The sensitivity of option price with respect to a change in the volatility of the underlying asset.

45
Q

What is option rho?

A

The sensitivity of an option price with respect to a change in interest rates.

46
Q

What is the motivation behind a ‘long-straddle’?

A

A long-straddle occurs to an investor buying a call option and a put option with the same exercise price and expiry. This is a ‘volatility trade’ in which the investor considers the market to either move up or down considerably, but is not sure in which direction.
Risk: Total premiums paid.
Reward: Unlimited

47
Q

What is the motivation behind a ‘short-straddle’?

A

A short-straddle occurs when an investor sells a call option and a put option with the same exercise price and expiry. This is a ‘stability trade’ in which the investor believes the market will trade within a narrow range.
Risk: Unlimited.
Reward: Total premiums sold.

48
Q

How do ‘long-strangles’ and ‘short-strangles’ differ from ‘long-straddles’ and ‘short-straddles?

A

The are both very similar to their respective counter-parts, the difference is that the call and put options have different strike prices. These strategies are therefore more risky to undertake.

49
Q

What does a hedge ratio of less than 100% suggest?

A

That the portfolio would have increased in value by more if the hedge had not been effected.

50
Q

What does a hedge ratio above 100% suggest?

A

The portfolio benefitted from the hedge.

51
Q

What are Contracts for Difference (CFDs) (‘cash-settled derivatives’)?

A

An agreement between two parties to exchange the difference between the opening price and the closing price of a contract. Cash passes between buyer and seller at expiry, rather than a physical asset or future.

52
Q

What is an equity swap?

A

A CFD where one party agrees to pay another the return on a money-market deposit (e.g. LIBOR) and in exchange receives the total return on an equity investment (capital gains and dividends). There is no exchange of principal.

Settlement Amount = (Return (%) - Fixed (%)) x Principal Amount

53
Q

What are interest-rate swaps?

A

Swapping a fixed rate of interest within a floating rate. Applied to a common notional principal amount. Similar to equity swaps.

54
Q

What are currency swaps?

A

Agreed principal sums of two currencies are exchanged at inception. Interest is paid on these sums at pre-agreed rates for the term of the swap. The principal sums are then swapped back at the end of the swap.

Not a CFD as the difference in payments cannot be netted.

55
Q

What are inflation swaps?

A

Used to transfer inflation risk between counter-parties. They are similar to fixed vs floating interest rate swaps, but instead use real rate coupon vs floating rate and also pay a redemption enhancement at maturity.

56
Q

What do convertible corporate bond/preference share enable investors to do?

A

Convert their bonds/preference shares into shares into shares in the company at a specified date. The rate of conversion is fixed at the time of issue and represents an option to purchase the shares at a given price.

57
Q

What is the conversion ratio (CR) for a convertible?

A

The number of new shares which will be exchanged for one convertible bond/preference share.

58
Q

Conversion price:

A

= Par Value of Convertible / Conversion Ratio

59
Q

Conversion value:

A

= Current Share Price x Conversion Ratio

60
Q

Conversion Premium:

A

(Conversion Price - Share Price) / Share Price x 100

61
Q

What is an equity warrant?

A

An equity warrant gives you the right, but not the obligation, to buy a company’s shares at a fixed exercise price, before an expiry date.

62
Q

What are the differences between an equity warrant and a call option?

A
  • Equity warrants are longer dated when issued.
  • The exercise of an equity warrant results in new shares being issued.
  • Equity Warrants are traded on stock exchanges, not on derivative markets.
63
Q

How do you calculate the formula (intrinsic) value of an equity warrant?

A

Formula Value = (Current Stock Price - Exercise Price) x No. of new Shares created

64
Q

What is the formula to calculate the percentage premium (PP) of an in-the-money warrant?

A

PP = (Warrant Price - Formula Value) / (No. of new shares creates x Stock Price)

65
Q

What are covered warrants and their key features?

A

Covered warrants give an investor the right to buy (call) or sell (put) an asset at a specific price within a specified time period. They can be described as long-dated call options.

  • The difference is that they are listed on the LSE and issued by investment banks.
  • Cash-settled (no stamp-duty on exercise).
66
Q

What is an unfunded credit derivative?

A

A bilateral contract between two counter-parties where each is responsible for making payments. Any cash or physical settlement under the contract is without resource to other assets.

67
Q

What is a funded credit derivative?

A

Involves the protection seller making an initial payment that is used to settle any potential credit event.

68
Q

What is a credit default swap?

A

If an issuing company defaults, then investors have the ability to swap over the debt for cash. It is effectively an insurance product.

69
Q

What is a collaterised debt obligation (CDO)?

A

An asset-backed investment vehicle designed to remove debt assets and their credit risk from an organisation’s balance sheet in return for cash.

70
Q

What are total return swaps?

A

A way of transferring total economic exposure, including credit and market risk, of an underlying asset. The payer gives all economic exposure associated with an asset without selling it, to the receiver.

71
Q

What is a synthetic CDO?

A

A CDO in which the underlying credit exposure of the issuer is taken on by the CDO using a credit default swap rather than through selling the debt assets to an SPV. They invest in high-quality debt and boost income by selling CDSs, increasing return at an increased risk.

72
Q

Why would a fund manager use FTSE 100 futures?

A
  • For leverage of the portfolio.
  • To lower transaction costs.
  • The FTSE 100 future is usually more liquid than the underlying cash market.
73
Q

If you were to own a portfolio of gilts and are concerned that interest rates may rise in the near future, what action should be taken to protect the value of your portfolio?

A

Sell a long gilt future.

74
Q

What is the initial margin?

A

A refundable good faith deposit based on the worst probable one day’s loss. It is calculated as a net figure by ICE Clear Europe.
It is paid by both the buyer and seller.

75
Q

What would the time value be of a warrant on its expiry date?

A

Zero

76
Q

Which index is used as the basis for a ICE Futures Europe stock index future?

A

The FTSE 100 Index Future:

  • Trades on ICE Futures Europe.
  • Cash-settled at £10 per point.
  • Delivery months: March, June, September and December.
77
Q

Should a depositor go long a short to hedge?

A

Long

78
Q

What would be the impact on the options prices if there was an increase in interest rates?

A

Call Premiums ↑,

Put Premiums ↓

79
Q

What is the variation margin?

A

It is the daily marketing-to-market procedure , ensuring that losses on derivative positions are paid on the exchange. It is paid in respect of the futures position based on the price movements of the previous day.

80
Q

What is a tranche of a CDO?

A

CDOs issue various tranches of securities.