Derivatives Tutorial Flashcards
1
Q
What are derivatives?
A
Definition: Financial contracts whose value derives from an underlying asset, index, rate, or another financial instrument.
Purpose: Used for speculation, hedging, or arbitrage in financial markets.
2
Q
Key points about derivatives:
A
Types: Common types include futures, options, swaps, and forward contracts.
Underlying Assets: Can be based on stocks, bonds, commodities, currencies, interest rates, or market indices.
Risk Management: Used for managing financial risks by providing exposure to price movements without owning the underlying asset.
Leverage: Allows investors to control a larger position with a smaller amount of capital, amplifying both gains and losses.
Market Liquidity: Derivatives often contribute to market liquidity and price discovery.
3
Q
How are derivatives used in risk management?
A
They allow investors to hedge against price fluctuations by minimizing potential losses on investments.
4
Q
Define leverage in the context of derivatives.
A
Leverage refers to using borrowed funds to amplify potential returns (or losses) from an investment.
5
Q
What is the purpose of using derivatives for speculation?
A
Speculators use derivatives to profit from anticipated price movements without owning the underlying asset.
6
Q
What is a contrived instrument?
A
A contrived instrument refers to a financial or investment product that is artificially created or structured using complex arrangements to serve specific purposes or meet particular needs.
7
Q
Why are contrived instruments created?
A
They are designed to address specific market conditions, offer unique investment opportunities, or cater to the specific needs or goals of investors or institutions.
8
Q
What characterizes a contrived instrument?
A
Complexity and non-standard structure are typical features of contrived instruments, often combining different financial elements or derivatives in their design.
9
Q
What are some potential risks associated with contrived instruments?
A
Complexity can make it challenging to understand the risks involved, leading to increased exposure to unexpected market movements or difficulties in accurately assessing potential returns.
10
Q
Give an example of a contrived instrument.
A
A collateralized debt obligation (CDO) that combines various debt securities into a new investment product, often with different risk tranches, is an example of a contrived instrument.
11
Q
What is “mark to market”?
A
“Mark to market” is an accounting method that values assets or liabilities at their current market price.
12
Q
When is “mark to market” commonly used?
A
It’s often used for financial instruments like stocks, bonds, derivatives, and other assets that frequently change in value.
13
Q
What are the benefits and drawbacks of “mark to market” accounting?
A
Benefits include transparency and a more accurate representation of current values, but drawbacks involve potential volatility in reported values, especially in unstable markets.
14
Q
What is a notional amount?
A
The notional amount is the nominal or face value of a financial instrument, often used to calculate payments but not necessarily exchanged.
15
Q
How is the notional amount different from the actual value?
A
The notional amount represents the amount used to calculate payments or returns in financial contracts, while the actual value exchanged might be based on factors such as interest rates, asset prices, or other variables.
16
Q
In what financial instruments is the notional amount commonly used?
A
It’s commonly used in derivatives contracts, such as options, swaps, and futures, to calculate payments or obligations without necessarily exchanging the entire notional amount.
17
Q
Why is the notional amount important in derivatives?
A
It determines the size of the contract and helps in calculating cash flows or payments, but the parties typically settle the difference in values rather than exchanging the full notional amount.
18
Q
Does the notional amount represent actual money exchanged?
A
No, the notional amount doesn’t necessarily change hands; it’s used as a reference for calculating contractual payments or obligations based on market movements.
19
Q
What does “off-balance-sheet” refer to in finance?
A
“Off-balance-sheet” items are assets, liabilities, or financing activities not recorded on a company’s balance sheet.
20
Q
What are linear derivatives?
A
Linear derivatives have a linear relationship between the underlying asset’s price and the derivative’s value. The payoff structure is directly proportional to the changes in the underlying asset’s price.
21
Q
Can you provide examples of linear derivatives?
A
Futures and forwards contracts are examples of linear derivatives because their values move in a linear fashion concerning the changes in the underlying asset’s price.
22
Q
What characterizes nonlinear derivatives?
A
Nonlinear derivatives have a payoff structure that does not correspond directly or proportionally to changes in the underlying asset’s price. Their value can exhibit complex or nonlinear relationships with the underlying asset.
23
Q
What are examples of nonlinear derivatives?
A
Options contracts, such as vanilla options, exhibit nonlinear behavior. The relationship between the value of an option and the underlying asset’s price is nonlinear due to factors like volatility, time decay, and strike price.
24
Q
How do linear and nonlinear derivatives differ in terms of payoff structures?
A
Linear derivatives have a straightforward relationship between the derivative’s value and the underlying asset’s price, whereas nonlinear derivatives have more complex and nonlinear relationships that are influenced by various factors.
25
What is Delta in the context of derivatives?
Delta measures the rate of change in the derivative's price concerning changes in the price of the underlying asset.
26
How does Delta relate to nonlinear derivatives?
In nonlinear derivatives, Delta represents the rate of change of the derivative's price concerning changes in the underlying asset's price, but this relationship is not constant and can vary across different price levels and times.
27
What does a Delta value of 0.5 mean for an option?
A Delta of 0.5 for an option implies that for every $1 increase in the underlying asset's price, the option's price would theoretically increase by $0.50, assuming other factors remain constant.
28
How does Delta change in nonlinear derivatives like options?
In nonlinear derivatives such as options, Delta is not constant and varies based on factors like the option's strike price, time to expiration, and changes in volatility.
29
Why is understanding Delta important for traders dealing with nonlinear derivatives?
Delta helps traders assess the sensitivity of options or other nonlinear derivatives to changes in the underlying asset's price, aiding in risk management and strategy development.
30
Does Delta apply to linear derivatives like futures or forwards?
No, Delta isn't applicable to linear derivatives like futures or forwards because these contracts have a linear payoff structure. Their value moves in a direct, proportional manner with changes in the underlying asset's price.
31
How do linear derivatives behave concerning changes in the underlying asset's price?
Linear derivatives have a constant exposure or sensitivity to the underlying asset's price movements. For instance, a one-unit change in the underlying asset's price leads to an equal and linear change in the derivative's value.
32
What measures the sensitivity or exposure of linear derivatives to underlying asset price changes?
Instead of Delta, linear derivatives use other metrics like the contract's size or quantity to determine their sensitivity to changes in the underlying asset's price.
33
Why is Delta not relevant for linear derivatives?
Delta measures the non-linear relationship between the option price and the underlying asset's price, a feature that linear derivatives like futures or forwards do not possess.
34
What is volatility in derivatives?
Volatility represents the degree of variation or fluctuation in the price of the underlying asset, and it's a crucial factor influencing the value of nonlinear derivatives.
35
How does volatility affect non-linear derivatives like options?
In non-linear derivatives such as options, higher volatility generally leads to an increase in the option's price. This is due to the increased likelihood of the underlying asset's price reaching the option's strike price.
36
Why is volatility important in non-linear derivatives?
Volatility impacts the option's price, as it affects the probability of the underlying asset reaching certain price levels within a specific time frame, influencing the option's potential profitability.
37
How do traders and investors manage volatility in non-linear derivatives?
Traders use strategies like buying or selling options to hedge against or speculate on changes in volatility. They might also use complex option strategies designed to profit from volatility changes.
38
Can volatility impact linear derivatives like futures or forwards?
While linear derivatives' values are directly linked to the underlying asset's price and not influenced by volatility in the same manner as options, extreme volatility can still impact market conditions and the underlying asset's pricing.
39
How does volatility affect linear derivatives like futures or forwards?
Volatility itself doesn't impact the value of linear derivatives directly. Instead, their value is directly linked to the price movement of the underlying asset.
40
Why is volatility less relevant for linear derivatives?
Linear derivatives have a straightforward relationship with the underlying asset's price. They are not sensitive to changes in market volatility because their value is determined by the direct movement of the underlying asset's price.
41
Do changes in volatility influence trading behavior in linear derivatives markets?
While volatility might not directly impact the value of linear derivatives, extreme volatility can impact market sentiment and behavior, potentially influencing trading volume and liquidity in the underlying asset's market.
42
How are strategies involving volatility different in linear derivatives compared to non-linear derivatives?
In linear derivatives, strategies involving volatility focus more on the overall market conditions and sentiment, as volatility itself doesn’t directly affect their value. In contrast, non-linear derivatives like options are directly influenced by changes in volatility.
43
What are credit derivatives?
Credit derivatives are financial instruments that allow investors to manage credit risk by transferring the risk of default on loans, bonds, or other credit assets.
44
How do credit derivatives work?
They involve transferring credit risk from one party (the seller or issuer of the derivative) to another (the buyer), typically through contracts like credit default swaps (CDS).
45
What is a common type of credit derivative?
Credit default swaps (CDS) are widely used credit derivatives. In a CDS, the buyer makes periodic payments to the seller in exchange for protection against potential default on a specific underlying asset.
46
What's the purpose of using credit derivatives?
Credit derivatives enable investors to manage and hedge against credit risk, providing insurance-like protection against defaults or credit events.
47
How can credit derivatives impact financial markets?
While they can mitigate risk for investors, misuse or improper valuation of credit derivatives played a role in the 2008 financial crisis, highlighting their potential to amplify systemic risks if not managed properly.
48
What are the risks associated with credit default swaps?
While they can provide risk mitigation, improper valuation or misuse of CDS can amplify systemic risks and contribute to market volatility if not managed properly.
49
What is a yield spread?
A yield spread refers to the difference in yield between different financial instruments or securities, often used to compare the risk or return between them.
50
How is yield spread calculated?
Yield spread is calculated by subtracting the yield of one security or asset from another with a similar maturity but different risk profile or credit quality.
51
What does a wider yield spread indicate?
A wider yield spread usually indicates higher perceived risk or uncertainty in the market. It might suggest that investors demand a higher return for holding riskier assets compared to safer ones.
52
What are examples of yield spread differences?
Treasury yield spreads, such as the difference between the yield of a Treasury bond and a corporate bond of similar maturity, or the yield difference between bonds with different credit ratings, illustrate yield spread differences.
53
How do yield spread differences impact investment decisions?
Investors and analysts use yield spread differences as indicators of market sentiment, risk appetite, and to make decisions on asset allocation or trading strategies.
54
What are options on credit risky bonds?
Options on credit risky bonds are derivative contracts providing the right, but not the obligation, to buy or sell a bond at a predetermined price (strike price) on or before a specified date (expiration), with the underlying asset being a bond with credit risk.
55
How do these options on credit risky bonds differ from standard options?
These options are based on bonds with credit risk, adding an additional layer of complexity due to the uncertainty of the bond issuer's creditworthiness, impacting the option's value.
56
What strategies can investors employ with these options?
Investors can use these options to hedge against or speculate on credit risk associated with bonds. Strategies may involve buying put options for protection against bond default or selling call options to generate income.
57
What factors influence the value of options on credit risky bonds?
Factors such as changes in the bond issuer's credit quality, market perceptions of credit risk, interest rates, and time to expiration impact the value of these options.
58
What risks are associated with trading options on credit risky bonds?
Apart from typical options risks, these options are exposed to credit risk. If the bond defaults, the option may become worthless or have reduced value, leading to potential losses.
59
What does delta measure in options?
Delta measures the rate of change in the option's price concerning changes in the underlying asset's price.
60
What is the formula to calculate delta for a call option?
For a call option:
61
What is the formula to calculate delta for a put option?
For a put option:
62
How is d1 calculated ?
63
What is volatility in finance?
Volatility measures the degree of variation in the price or returns of a financial instrument, indicating the level of risk or uncertainty associated with it.
64
How is historical volatility calculated?
Historical volatility is computed as the standard deviation of past returns. For instance, daily returns over a year can be used to calculate annualized volatility.
65
What is implied volatility?
Implied volatility is derived from option prices and represents the market's expectation of future volatility. It reflects the market's consensus on potential future price fluctuations.
66
How is volatility used in option pricing models like Black-Scholes?
Volatility is a crucial input in option pricing models. Higher volatility generally leads to higher option prices, as it indicates a greater likelihood of significant price movements.
67
How can investors use volatility in portfolio management?
Investors use volatility to assess risk, build diversified portfolios, and implement risk management strategies. They may also adjust their strategies based on changes in market volatility.
68
What is default risk?
Default risk, or credit risk, is the chance that a borrower or issuer of debt may fail to meet their financial obligations, leading to a loss for lenders or investors.
69
What factors contribute to default risk?
Factors such as the borrower's credit history, financial health, industry conditions, economic downturns, and market fluctuations impact default risk.
70
How is default risk assessed?
Credit rating agencies assess default risk by assigning credit ratings based on the issuer's ability to repay debts. Ratings range from AAA (low risk) to D (default).
71
What are the consequences of default for investors?
Investors in defaulted securities may face partial or total loss of investment principal and missed interest payments, impacting their overall returns.
72
How do investors manage default risk?
Investors manage default risk by diversifying their portfolios across various assets, conducting thorough credit analysis, and potentially using credit derivatives or hedging strategies to mitigate losses.
73
What is the risk-free yield curve?
The risk-free yield curve plots the yields of government securities, typically Treasury bonds, against their respective maturities, showing the relationship between yield and time to maturity.
74
How is the risk-free yield curve used?
It serves as a benchmark for pricing various financial instruments and assessing market expectations regarding future interest rates and economic conditions.
75
What does a normal risk-free yield curve look like?
A normal yield curve slopes upward, indicating higher yields for longer-term maturities, reflecting the time value of money and the risk of tying up funds for an extended period.
76
What are the different shapes of the risk-free yield curve?
It can be normal (upward-sloping), inverted (downward-sloping), or flat, each shape indicating different market expectations and economic conditions.
77
How does the risk-free yield curve reflect market sentiment?
Changes in the curve shape or steepness can signal market expectations about inflation, economic growth, or central bank policies, influencing investor behavior.
78
What is a credit spread?
A credit spread refers to the difference in yields between two securities with similar maturities but differing credit ratings or levels of risk.
79
How is credit spread calculated?
Credit spread is calculated by subtracting the yield of a risk-free security, such as a Treasury bond, from the yield of a bond with credit risk of similar maturity.
80
What does a wider credit spread indicate?
A wider credit spread suggests higher perceived risk associated with the higher-yielding security relative to the risk-free security. It indicates that investors demand a higher return for holding a riskier asset.
81
How are credit spreads used in financial analysis?
Credit spreads are used to assess market perceptions of credit risk, compare relative riskiness between different bonds, and evaluate the overall health of credit markets.
82
How can changes in credit spreads impact financial markets?
Widening credit spreads can indicate deteriorating credit conditions or increased market risk aversion, potentially impacting borrowing costs, investor sentiment, and market volatility.
83
What is risk in finance?
Risk represents the possibility of losing some or all of the invested capital or the likelihood that actual returns will differ from expected returns.
84
What are the main types of risk in finance?
Common types of risk include market risk (due to fluctuations in the market), credit risk (associated with default), liquidity risk (difficulty in selling assets), and operational risk (from internal processes or systems).
85
How is risk assessed in finance?
Risk assessment involves analyzing the probability of potential losses or deviations from expected outcomes. It includes quantitative analysis, stress testing, and qualitative evaluations.
86
Why is risk management important in finance?
Effective risk management helps investors and organizations identify, mitigate, and manage potential risks, allowing for better decision-making and protection against adverse events.
87
How do investors mitigate risk?
Investors use various strategies like diversification, hedging, asset allocation, and employing risk management tools (like derivatives) to mitigate risk in their portfolios.
88
What underlying assets can American-style options be based on?
American-style options can be based on various underlying assets like stocks, stock indices, exchange-traded funds (ETFs), or commodities.
89
Are American-style options more valuable than European-style options?
American-style options generally have higher premiums than European-style options due to their added flexibility, allowing for early exercise.
90
What is an interest rate swap (IRS)?
An interest rate swap is a financial contract where two parties agree to exchange interest rate payments based on a notional principal amount.
91
How do interest rate swaps work?
In an interest rate swap, one party typically pays a fixed interest rate while the other pays a floating (variable) interest rate based on an agreed-upon notional amount, allowing each party to manage their interest rate exposure.
92
What's the purpose of an interest rate swap?
Interest rate swaps are used to manage or hedge against interest rate risk, allowing entities to switch between fixed and floating interest rates to better align with their risk preferences or funding needs.
93
What are the types of interest rate swaps?
The two primary types are fixed-for-floating swaps, where one party pays a fixed rate and receives a floating rate, and floating-for-floating swaps, where both parties exchange different floating rates (e.g., different currencies or indices).
94
Where are interest rate swaps traded?
Interest rate swaps are often traded over-the-counter (OTC), customized to fit specific needs, and not traded on exchanges, making them flexible but less standardized.
95
What is Asset Liability Management (ALM)?
ALM is a financial strategy that aims to align the management of assets and liabilities to mitigate risk, optimize funding costs, and ensure liquidity and solvency.
96
What does ALM involve?
ALM involves analyzing and balancing a company's or institution's assets and liabilities in terms of their maturity, interest rate, liquidity, and currency to manage risk exposure effectively.
97
Why is ALM important?
ALM helps organizations maintain a healthy balance between their assets and liabilities, reducing exposure to market risks, interest rate fluctuations, liquidity shortages, and mismatches between cash inflows and outflows.
98
What tools are used in ALM?
Various tools like cash flow matching, duration gap analysis, scenario analysis, stress testing, and risk management instruments (e.g., derivatives) are employed in ALM to assess and manage risks.
99
Who uses ALM?
Banks, insurance companies, pension funds, and other financial institutions utilize ALM to ensure their financial health, stability, and long-term sustainability.
100
What are Average Rate Options?
Average Rate Options are derivatives whose payoff is based on the average price or rate of an underlying asset over a predefined period, rather than the spot price at a specific moment.
101
How do Average Rate Options differ from standard options?
Unlike standard options, which are settled based on the spot price at expiry, Average Rate Options use an average price or rate over a defined period as the reference for settlement.
102
What underlying assets are used in Average Rate Options?
They can be based on various underlying assets, including currencies, interest rates, commodities, or stock indices.
103
How is the payoff determined in Average Rate Options?
The payoff is calculated based on the difference between the average rate or price and the strike price of the option.
104
What is the advantage of using Average Rate Options?
Average Rate Options can help mitigate the impact of market fluctuations at a single point in time, providing a more averaged and smoothed-out approach to settlement.
105
What are barrier options?
Barrier options are derivative contracts where the right to buy or sell the underlying asset only exists (knock-in) or disappears (knock-out) when the price of the underlying asset reaches a specified barrier level.
106
How do barrier options work?
Barrier options have a barrier price set above (up-and-in or up-and-out) or below (down-and-in or down-and-out) the current price of the underlying asset. When the asset price hits the barrier, the option can become active (knock-in) or expire worthless (knock-out).
107
What are the types of barrier options?
Barrier options can be classified as up-and-in, up-and-out, down-and-in, or down-and-out, depending on whether the barrier needs to be crossed to activate or deactivate the option.
108
What is the advantage of using barrier options?
Barrier options offer flexibility and customization, allowing investors to tailor contracts based on their risk tolerance and market views by incorporating specific price levels.
109
How do barrier options differ from standard options?
Unlike standard options with fixed activation and expiration, barrier options depend on the underlying asset's price reaching predetermined barrier levels for activation or deactivation.
110
What is basis in finance?
Basis represents the difference between the current price of a futures contract or derivative and the price of the underlying asset.
111
How is basis calculated?
Basis is calculated as the difference between the futures price and the spot price of the underlying asset at a given point in time.
112
What does a positive basis indicate?
A positive basis suggests that the futures price is higher than the spot price, indicating that the market expects the asset's price to increase over time.
113
What does a negative basis indicate?
A negative basis suggests that the futures price is lower than the spot price, indicating that the market expects the asset's price to decrease over time.
114
Why is basis important in financial markets?
Basis is crucial for arbitrage opportunities and understanding market expectations regarding the future direction of asset prices, aiding in trading and investment decisions.
115
What is the Black-Scholes model?
The Black-Scholes model is a mathematical formula used to calculate the theoretical price of European-style options based on various factors like the current stock price, strike price, time to expiration, risk-free interest rate, and volatility.
116
Who developed the Black-Scholes model?
The Black-Scholes model was developed by Fischer Black, Myron Scholes, and Robert Merton in the early 1970s and earned them a Nobel Prize in Economics in 1997.
117
What does the Black-Scholes model assume?
The model assumes the stock price follows a random walk (geometric Brownian motion), the option can't be exercised before expiration, and markets are efficient with no transaction costs or dividends.
118
What is the formula for the Black-Scholes model for a call option?
119
What is the significance of the Black-Scholes model?
The Black-Scholes model revolutionized options pricing, providing a theoretical framework for determining the fair value of options and influencing financial markets and risk management practices.
120
What is a collar in finance?
A collar is an options strategy involving the simultaneous purchase of a protective put and the sale of a covered call on the same underlying asset, creating a range or "collar" within which the asset's price can move.
121
How does a collar work?
By buying a put option, the investor can limit downside risk, while selling a call option generates income but caps potential gains. This combination sets boundaries (floor and ceiling) within which the asset's price can fluctuate.
122
What are the components of a collar?
A collar comprises a long (purchased) put option, providing downside protection, and a short (sold) call option, generating income and capping potential gains.
123
When is a collar used?
Investors use collars when they want to protect their investment from downside risk while being willing to limit potential gains within a certain range.
124
What is the risk and reward profile of a collar?
A collar reduces downside risk but also limits potential upside gains, providing a bounded range for the asset's price movement.
125
What is a commodity swap?
A commodity swap is a derivative contract where two parties exchange cash flows based on the price changes of commodities, typically oil, natural gas, metals, or agricultural products.
126
How does a commodity swap work?
In a commodity swap, one party may agree to pay the other party a fixed price while receiving payments based on the floating market price of the specified commodity, or vice versa.
127
What is the purpose of a commodity swap?
Commodity swaps allow participants to manage or hedge against commodity price risk. They can also be used for speculation or to gain exposure to specific commodity price movements.
128
Who uses commodity swaps?
Entities such as commodity producers, consumers, traders, and investors use commodity swaps to manage price risk associated with fluctuations in commodity prices.
129
How do commodity swaps differ from other types of swaps?
Commodity swaps differ from interest rate swaps or currency swaps as they involve the exchange of cash flows based on the price movements of physical commodities rather than interest rates or currencies.
