L 5/6 - Derivatives Flashcards
(34 cards)
What is a derivative?
A financial contract or instrument that dervies its value from the value of something else
What are exchanges characterised by?
Low credit risk (default risk of counter party)
What is an advantage of OTC instead of Exchanges other than that there is a larger volume?
Contract can be tailored to specific needs of parties
What is a disadvantage of OTC?
Credit risk involved (contract not honoured)
What are the 3 types of derivatives?
- Futures and forwards
- Swaps
- Options
What is a forward commitment?
A legal obligation to engage in a certain transaction in the spot market at a future date at terms agreed upon today
What are forwards?
Customised and private contracts between two parties whereby one party has the obligation to buy an asset, and the counterparty has the obligation to sell the asset, at a specific price on a specific date in the future
What are futures?
Standardised derivative contracts whereby one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a price agreed upon at contract initiation
What are swaps?
These contracts give rise to obligations for both parties to exchange a series of cash flows in the future
What is a contingent claim?
A derivative in which the outcome or payoff is determined by the outcome or payoff of an underlying asset, conditional on some event occurring
What are options?
Derivative instruments that give their holds the choice (not obligation) to buy or sell the underlying from or to the seller of the option
What is a credit derivative?
A contract that transfers credit risk from one party (the credit protection buyer) to another party (the credit protection seller), where the latter protects the former against a specific credit loss
What is an asset-backed security?
A derivative in which a portfolio of debt instruments is pooled and claims are issued on the portfolio in the form of tranches, which have different priorities of claims on the payments that come in from the pool of debt securities
What is price?
Price, as it relates to options, forwards, futures, and swaps, refers to the fixed price at which the underlying transaction will take place
What is value?
On the other hand, the value of these contracts fluctuates in response to changes in the price of the underlying asset
What is arbitrage?
A trading strategy where an investor simultaneously buys and sells an identical or similar asset on different markets, taking advantage of price discrepancies to generate a risk-free profit
How do we treat arbitrage when valuing derivatives?
Within a model all derivative instruments must be priced so that no profitable arbitrage opportunities remain. That is, the prices cannot be exploited without taking a risk
What is a forward contract formally?
A forward contract is an agreement/obligation between two parties at time t to buy or sell an asset at a future date T > t at a predetermined price K (the delivery price)
What is long position?
Agrees to buy the asset (at a future date at a certain price)
What is short position?
Agrees to sell the asset
What is delivery/forward price?
Price of the asset at the delivery date
What is spot price?
Price of the asset in the spot market
What is the price of a forward contract?
The fixed price or rate at which the underlying transaction will occur at contract expiration
What is the value of a forward contract?
The amount that a counterparty would need to pay or receive to get out of its forward position
