Final Flashcards
(15 cards)
Derivative
A derivative is a financial contract whose value is based on the price or performance of an underlying asset, index, or rate, such as stocks (options), commodities (futures), currencies (forwards), or interest rates (swaps).
Forward Contract
A forward contract is a private, customized agreement between two parties to buy or sell an asset at a specified price on a future date.
Futures Contract
A futures contract is a standardized agreement traded on an exchange to buy or sell an asset at a predetermined price on a specified future date.
Government of Canada Futures Contract
hypothetical 6% government of Canada bond, semiannual payments, with ten years until maturity, $100,000 per contract
Forward and Futures Contracts Differences
Futures are standardized, regulated, and traded on exchanges with daily marking-to-market and margin requirements, reducing counterparty risk. Forwards are over-the-counter (OTC) contracts, customizable to the parties’ needs, and expose each side to greater default risk since they lack centralized clearing. Futures are generally more liquid, while forwards offer more flexibility.
Short hedge
A short hedge is a strategy where a producer or seller, such as a farmer selling wheat, an oil company selling crude, or a copper miner selling metal, sells futures contracts to lock in a price and protect against falling prices.
Long hedge
A long hedge is a strategy where a buyer, such as a bakery buying wheat, an airline buying jet fuel, or a car manufacturer buying aluminum, purchases futures contracts to secure a price and protect against rising prices.
Swaps
A swap is a contractual agreement between two parties to exchange streams of cash flows or financial obligations over time, commonly used to manage exposure to interest rate fluctuations (e.g., fixed-for-floating interest rate swaps), currency risk (currency swaps), or commodity price volatility (commodity swaps such as oil or natural gas).
An interest rate swap is a contract where two parties agree to exchange interest payments on a set amount of principal (called the notional amount). Typically, one party pays a fixed interest rate while the other pays a floating rate (like LIBOR or SOFR), with the payments netted and exchanged at regular intervals, without swapping the actual principal.
Interest rate swaps are often used to hedge against interest rate risk — for example, by converting a variable-rate loan into fixed payments — or to reduce financing costs by taking advantage of favorable market rates.
CGB Contract
The CGB futures contract is a standardized, exchange-traded agreement to buy or sell a $100,000 face value, 10-year Government of Canada bond (6% coupon) at a future date. Futures prices rise when interest rates are expected to fall, and fall when rates are expected to rise.
Mark-to-Market
In futures trading, the mark-to-market procedure updates the value of each futures contract at the end of every trading day to reflect its current market price. Profits and losses are calculated daily based on the change in the contract’s value, and these amounts are credited or debited to each trader’s margin account. If the account falls below a required minimum (the maintenance margin), a margin call is issued, requiring the trader to deposit more funds to maintain the position. This daily settlement process helps limit counterparty risk.
5 Factors for Options Prices
Stock Price (Underlying Asset Price)
Call options: Value increases when the stock price rises.
Put options: Value increases when the stock price falls.
Strike Price (Exercise Price)
A higher strike price lowers the value of a call and raises the value of a put, all else equal.
Time to Expiration
More time generally increases an option’s value because there’s a greater chance of becoming profitable (this is called time value).
Volatility of the Underlying Asset
Higher volatility increases the value of both calls and puts, since it raises the probability of large favorable price movements.
Risk-Free Interest Rate
When interest rates rise, call options tend to increase in value and put options tend to decrease, because the cost of delaying payment (buying later) is lower for calls and higher for puts.
Spot Rates
The spot rate is the current interest rate or price for immediate settlement of a transaction.
Forward Rates
The forward rate is the agreed-upon interest rate or price for a transaction that will occur at a specified future date.
Trade-off theory
is the idea that a company chooses its optimal capital structure by balancing the benefits of debt (like tax savings from interest deductions) against the costs of debt (like financial distress and bankruptcy risk).
