Introduction to derivatives

Question 1

What are the 4 steps to trade financial assets on a financial market?

Answer 1

1. Buyer&Seller must find each other
2. Trade is cleared through a clearinghouse
3. Trade is settled
4. Ownership records are updated

Question 2

What does it mean for a trade to be cleared?

Answer 2

Both sides must specify their obligations (pay or handover an asset)

Question 3

What is a clearinghouse?

Answer 3

Intermediary between the buyer&seller (matches them and keeps track of their obligation and payment)

Question 4

What are the advantages of “over-the-counter” trading?

Answer 4

1. Easier to trade LARGE quantities (avoiding fees)
2. OTC may create custom financial assets (NOT available on financial markets)
3. Can trade MANY financial assets in A SINGLE transaction

Question 5

What are the four measures of market size and activity?

Answer 5

1. Trading volume (market activity)
2. Market value
3. Notional value (market size of derivative)
4. Open interest (market size of derivative)

Question 6

Describe trading volume.

Answer 6

Number of units that change hands in a period.

Question 7

Describe market value.

Answer 7

Value of a company on an exchange based on the price of its stocks. MV = #Stocks x $ per share

Question 8

Describe notional value.

Answer 8

Value of a derivative relative to some underlying asset

NV = #options x #stock in 1 option x $ of stock

Question 9

Describe open interest.

Answer 9

Number of contract for which there is a future obligation for one party to perform.

Question 10

What are the purposes for derivatives?

Answer 10

1. Risk management
2. Speculation
3. Reduced transaction costs
4. Regulatory arbitrage (ex : delay taxes)

Question 11

What is a market-maker ?

Answer 11

Dealer (stands ready to buy or sell). Buys low and sells high

Question 12

What is the bid-ask spread?

Answer 12

Bid price: price at which the MM buys an asset
Ask price: price at which the MM sells an asset
Bid-ask spread = Ask price - bid price

Question 13

What are the different kind of stock orders?

Answer 13

1. Market order
2. Limit order
3. Stop-loss order

Question 14

Describe a market order.

Answer 14

Buy or sell the stock immediately

Question 15

Describe a limit order.

Answer 15

Specifies the maximum buying price or the minimum selling price. Fulfilled when the price is available.

Question 16

Describe a stop-loss order.

Answer 16

Specifies that the stock is sold if the price decreases to the specified amount. The actual sales price may be less since the stock is sold at the market price.

Question 17

What are the purposes of short selling?

Answer 17

1. Speculation
2. Financing
3. Hedging

Question 18

How does shot selling a stock work?

Answer 18

1. Borrow stock
2. Sell stock
3. If the stock pays dividends, you must pay them to the lender
4. Buy the stock back and return to lender.

Question 19

The dividends received during the short sell process are taxable and tax-deductible for whom?

Answer 19

Taxable for the lender

Tax-deductible for the borrower

Question 20

What is the lease rate?

Answer 20

Dividends rate the borrower pays.

Question 21

Describe the haircut and the two possible interest rates on the haircut (repo rate and short rebate).

Answer 21

Haircut : $ put as collateral to assure the lender the borrower will buy back the shares.
If the asset borrowed is an obligation : interest on collateral is called the repo rate
If the asset borrowed is a stock : interest on collateral is called the short rebate