Derivatives Part 1

Question 1

Define derivatives

Answer 1

Financial instrument who’s value depends on the value of another underlying instrument
Settled at a future date
Leveraged instrument

Question 2

OTC & ETD

Answer 2

OTC- Traded directly Counterparty risk
Bespoke - More expensive
Not fungible
Swaps, Forwards, Options, CFDs

ETD - Traded on an exchange
Minimal counterparty
risk as the exchange becomes counterparty
Standardised
Liquid and cheap
Futures, Options
gaining exposure to underlying asset without having to physically own the underlying asset

Question 3

Futures

Answer 3

 A promise to buy or sell an asset for a certain price at a certain time in the future
 Exchange-traded forward contract
 Standardised contracts
 Guaranteed by the exchange
 Unit traded is a contract
 Liquid, cheap and easy to trade

Question 4

Futures settlement

Answer 4

equity index futures often cash settled
lot of commodities they would be physical delivery
rolling - roll it in to next contract - front contract is the contract closest to settlement (march, june, september, december)
open interest - how many long and short interest there is in the market

Question 5

Trading on ICE Futures Europe

Answer 5

clearing house then becomes the buyer to ever seller and the seller to every buyer
become central counterparty, never any relationship
between buyer and seller

Will be some initial margin e.g. £2,000 per contract
Variation margin calculated at end of each day based
on tick movement and will receive gain/give money for loss

maintenance margin can be set up to stop the constant flow of money from VM

Question 6

Futures transparency and reporting

Answer 6

Screens will show best bid (B), best offer (A), opening, closing prices, last trade price, open
interest, volume, day’s highs and lows

Month Codes March - H, June - M, September - U, December - Z

Question 7

Role of the Clearing House

Answer 7

 Clearing is the process by which derivatives are confirmed and registered
 The clearing house becomes the legal counterparty to every transaction on a principal to principal basis in a process known as novation
 Removes most counterparty risk by guaranteeing each trade
 Steps taken to protect itself: Margin, default fund, insurance policies, lines of credit with major banks

Question 8

Initial Margin

Answer 8

Clearing house calculates initial margin to be paid by the clearing member at the outset of a trade
to compensate for any future possible losses from the trade
 Returned when the position is closed out
 Clearing member calculates client’s margin (broker margin)
 May be cash (most major currencies) or collateral

recomputed every business day - intra day margin call to top-up

Question 9

Variation Margin

Answer 9

Positions are marked-to-market at the close of every day
 based on the daily settlement price
 Profit/loss measured and paid/received from the clearing house to the clearing member

Variation margin = ticks moved on the day x tick value x no of contracts
 Ticks moved on the day = (Closing Price – Previous closing price) / Tick Size

Question 10

Exchange for Physical (EFP)

Answer 10

Exchanges a futures position for the underlying physical asset
 Can be used to open, close or switch a futures position for
the underlying asset.
 Frequently used in the oil and gas market
 Agreement will be negotiated privately between the 2 parties
 Exchange will be informed of the agreement

Question 11

Exchange for Swaps

Answer 11

Exchanges a futures position for a corresponding related
OTC swap
 Also known as an Exchange for Risk
 OTC swap must be for the same underlying asset and same delivery month

Question 12

Futures Pricing

Answer 12

fair value = cash price + cost of carry (finance costs, storage costs, income)

Question 13

Basis

Answer 13

Cash Price - Futures Price

narrows to zero at expiry

negative in contango, positive in backwardation

Question 14

Futures Hedging

Answer 14

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠 = -
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑙𝑢𝑒/𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑉𝑎𝑙𝑢𝑒 × ℎ

h = beta for equities
h = portfolio duration/futures duration for bonds

Issues:
issue as you have to estimate beta, taken from
historical data

might be a change in the basis

will still be unsystematic risk as cannot hedge

if you have a hedge in backwardation and you hold till expiry you can not be hedged as you may lose money on both deals - basis risk

Question 15

Strategies using futures

Answer 15

1. hedging
2. Imminent cash flow - Anticipating changes in the market
3. Moving quickly between markets
4. Speculation

Question 16

put and call options

Answer 16

long a call option = buy/holding
short a call option = sell/writer
Long a put option = holder has a short position and right to sell
Short a put option = writer has a long position and
the obligation to buy

Question 17

Option Specifications

Answer 17

european = only exercise on exercise date
american = can exercise anytime
bermudan = series of distinct exercise dates e.g. once a week

Question 18

Bull Spread using calls

Answer 18

Buy a call with low strike and sell a call with High strike
Max loss is net premium
max gain is difference in strikes - absolute value in net premium
breakeven = low strike + absolute value in net premium

mildly bullish

Question 19

Bull Spread using puts

Answer 19

buy low strike put and sell high strike put

max loss = difference
between strikes minus net premium

max gain = net premium

breakeven = high strike - net premium

Question 20

Bear Spread with Puts

Answer 20

buy high strike put and sell low strike put

max gain = difference in strikes - absolute value in net premium

Max loss = net premium

breakeven = high strike - net premium

mildly bearish

Question 21

Bear Spread with Calls

Answer 21

buy high strike call and sell low strike call

max gain = net premium

max loss = difference in strikes - premium

breakeven = low strike + net premium

Question 22

Long Straddle

Answer 22

buy a call and buy a put with the same strike and
the same expiry and same underlying

max loss = net premium

max gain = no max gain

breakeven = strike +/-
premium - two breakevens

long volatility strategy - max loss is if market doesnt move at all

Question 23

Short Straddle

Answer 23

sell a call and sell a put with same strike expiry and underlying

max gain = net premium

Max loss = no max loss

breakeven = strike +/-
premium - two breakevens

Short Volatility

Question 24

Long Strangle

Answer 24

buy high strike call and buy low strike put

max loss = net premium

max gain = no max gain

breakeven = call strike + net premium
put strike - net premium. 2 breakevens

long volatility

Question 25

Option Greeks - Delta

Answer 25

Measures the sensitivity of an option premium to a change in the underlying asset price  Measured as a percentage  Proxy for how likely the option will be exercised  e.g. Delta of 50% means if the underlying stock price moves by £1 the option premium will move by 50p Deeply ITM options have a delta of 100%  Deeply OTM options have a delta of 0% Calls have positive delta, puts have negative delta

Question 26

Options Greeks - Gamma

Answer 26

 Measures the sensitivity of an option’s delta to a change in the underlying asset price  Always positive when buying options (puts or calls) and negative when selling options  ATM options close to expiry have the greatest gamma  Deeply ITM and OTM have the lowest gamma

Question 27

Option Greeks - Vega

Answer 27

 Measures the sensitivity of an option’s premium to a 1% change in its implied volatility  Always positive when buying options and negative when selling options  Higher for longer dated options and ATM options

Question 28

Option Greeks - Theta

Answer 28

 Measures the sensitivity of an option’s premium due to the passage of time (1 day)  Also known as time decay  Always negative when buying options and positive when selling options  Greatest for ATM options as we near expiry  Offsets the benefit of gamma

Question 29

Warrants compared to call options

Answer 29

they're dilutive (new shares are issued) whereas call options are not warrants are not standardised unlike call options, longer maturities on warrants - usually measured in years OTC vs exchange traded

Question 30

Warrants Adv/Dis to issuer

Answer 30

raise cash immediately with no need to pay dividends, increases the attraction of the debt issue warrants are detachable so can be traded separately if share price falls then warrants won't be exercised so new no shares will need to be issued. on exercise shares will be issued at a discount to the current share price if warrants are exercised then will have to increase the total dividend paid

Question 31

Warrants Adv/Dis to Investor

Answer 31

geared - cheaper than buying the shares get income yield on bond and upside to equity cheaper than calls due to dilutive effect suffer less time value due to longer maturity geared so can lose more money takeover - exercise date is accelerated to takeover date - lose time value.

Question 32

Calculating Warrant Value

Answer 32

A = (Value of an equivalent option) Q = percentage increase in the number of shares in issue once the warrant is exercised A/(1+Q) x number of shares

Question 33

traditional vs covered warrants

Answer 33

Traditional Warrants: Issued by company over its own shares New shares issued upon exercise Call warrants only Maturities typically several years Restricted liquidity Held by individuals and by institutions Priced according to supply and demand Covered Warrants: Issued by bank or institution over other assets No new shares issued Call, put, and exotic warrant structures Maturities typically one or two years Good liquidity Designed for private investors Priced according to fair value models

Question 34

Covered Warrants

Answer 34

Securitised derivatives – options ‘covered’ by the underlying investment  Issued by financial institutions  Can be issued over a range of products, shares, commodities, exchange rates, indices  Available as calls or puts  Trade at fair value  Cover ratio - one covered warrant how many of the underlying does that give the right to buy

Question 35

Convertibles & Contingent Convertibles (CoCo)

Answer 35

A bond with an embedded option giving the holder the right to convert the bond into a fixed number of ordinary shares in the issuer CoCo - Conversion is contingent upon another event occurring e.g. solvency ratios dipping below a certain level

Question 36

Adv/Dis of convertibles to Issuer

Answer 36

ADV: marketable, no immediate dividend having to pay - no dilution for existing shareholders. can pay a lower coupon on the bond suitable where assets are not available to secure straight finance suitable for projects with long payback periods DIS: have to pay coupon regardless of profitability cannot be certain they are issuing deferred share capital

Question 37

Adv/Dis of convertibles for investor

Answer 37

ADV: marketable security of fixed income with upside potential of equity, higher in cap structure than equity, offer higher income yields than shares. DIS: lower yield than a straight vanilla bond, if share price doesn't rise then they sacrificed yield for no benefit, attractiveness might be tainted by call options

Question 38

Convertible ratio, price, value and premium

Answer 38

 Conversion Ratio  Number of shares that the bond can be converted into  Conversion Price = Convertible price / conversion ratio  Conversion Value = Current share price x Conversion ratio  Conversion Premium = (conversion price - share price)/share price

Question 39

Valuation of convertibles models

Answer 39

Dividend valuation method: calculate future share price, calculate future conversion value, price bond Crossover/income based method: find conversion value today, calculate the basic dividend, calculate the future expected dividend, calculate the difference between future coupon and future dividend. sum of PVs of all positive differences, add todays conversion value Option/warrant pricing method: value of convertible must be worth value of bond + warrant convertible will always trade at a premium of vanilla bond due to time value of warrant and the intrinsic value once the share price is above the conversion price (value of bond + equity call option premium/(1 + percentage number of shares increase) x conversion ratio