Derivitaves

Question 1

What is a derivative

Answer 1

A derivative is a financial instrument whose value depends on, or derives from, the value of another asset:

Question 2

What are the 4 types of derivatives

Answer 2

• Futures
• Forwards
• Swaps
• Options

Question 3

What are some examples of underlying assets ?

Answer 3

• Stocks
• Currencies
• Interest Rates
• Commodities
• Debt intruments
• Electricity
• Insurance payouts

Question 4

What are over-the-counter markets

Answer 4

markets where traders working for banks, fund managers and corporate treasures contact each other directly

Question 5

How can derivatives be traded

Answer 5

They can be traded in the Over-the-counter markets

Question 6

What are some key features of over the counter markets

Answer 6

• Tailor-made contracts
• Flexibility in negotiations
• Larger than the exchange-traded market
• Telephone and computer-linked network of dealers
• Subject to higher credit risk

Question 7

What are forwards contracts

Answer 7

• An Agreement to buy or sell an asset at a certain future time for a certain price
• Traded in the OTC market
• Tailor-made instruments
• Available for long maturities
• The party that agrees to buy the underlying asset has what is termed a long position
• And the party that agrees to sell the underlying asset has what is termed a short position
• Binding agreement for both sides

Question 8

What are payoffs from forwards contracts

Answer 8

Depends on:

F - Delivery price of the underlying assset specified at the forward contract

St - Spot price of the asset at the maturity of the contract

Question 9

What is the spot price ??

Answer 9

The price the asset can be bought and sold immedietly

Question 10

Payoff from a long position in a forward contract

Answer 10

Spot price - Delivery price

Question 11

Payoff from a short position in a forward contract

Answer 11

Delivery price - Spot price

Question 12

What are futures contracts

Answer 12

• Agreement to buy or sell an asset for a certain price at a specified future time
• Similar to forward contracts, but futures are traded on an exchange instead of OTC
• Available on a wide range of commodities and financial assets
• Standardised contracts
• Specifications need to be defined, what can be delivered, where it can be delivered and when it can de delivered
• These contracts are settled daily

Question 13

Give an example of a futures contract

Answer 13

It is genuinly just a contract to buy or sell an asset at a certain price at a specified time

So an agreement to buy:

• 100Oz of gold for £1400 per oz in sept 2017

-10,000Bu of corn at £370 per Bu in June 2017

Agreement to sell:

Sell 500bbl of oil at £40 per bbl in april 2017

Question 14

What are options contracts

Answer 14

• A call options gives the holder the right to buy the underlying asset on or by a certain date for a certain price
• A put option gives the holder the right to sell the underlying asset on or by a certain date for a certain price
• An American option can be exercised at any time up to the expiration date
• A European option can only be exercised on the expiration date

Question 15

What does premium mean in terms of options contracts

Answer 15

The price at which options are bought and sold, an option gives the holder (the investor) a right and this has to be paid

Question 16

What is the exercise or strike price

Answer 16

The price at which the right to buy (sell) the underlying asset of a call (put) option is set

Question 17

What is the expiration date and maturity

Answer 17

The date in the contract by/on which the option can only be exercised

Question 18

What are some differences between options and futures/forwards

Answer 18

• Forwards/futures is a commitment to buy or sell at a certain date and a certain price
• Where as an option gives the holder the right to buy or sell, so they dont have to, also on or by a certain date

-Options are traded on both OTC markets and in exchanges

Question 19

What are the 3 different types of traders

Answer 19

• Hedgers
• Speculators
• Arbitrageors

Question 20

What are Hedgers ?

Answer 20

Hedgers is the first, they use derivates to reduce risk that they face from potential future movements in a market variable

Question 21

What are the 2 types of hedging

Answer 21

• Long hedge
• Short hedge

Question 22

What is Long Hedging ??

Answer 22

If one is commited to buying assets on a future date she can fix the future price by taking a long position in futures on the asset, so essentially you are hedging against the possibility of a rise in price

Question 23

What is short Hedging ?

Answer 23

If one is committed to selling assets on a future date they can fix the selling price by taking a short position in futures on the asset, so this is hedging against the possibility of a fall in price

Question 24

What is the purpose of Hedging

Answer 24

The purpose of hedging is to reduce risk, there is no guarantee that the outcome with hedging will be better than the outcome without hedging

Question 25

What is Speculation

Answer 25

This is the act of trading in an asset or conducting a financial transaction that has a significant risk of losing most or all of the initial outlay with the expectation of a substantial gain. Speculators are betting on future changes in the price of an asset, eithing increases or decreases.

Question 26

What is Arbitrage

Answer 26

This is the simultaneous purchase and sale of an asset to profit from a difference in price - like exchange rates