L6 - Derivatives Flashcards
1
Q
What are Derivatives?
A
- Derivatives are the securities whose prices are determined by or derived from the price of other securities. For instance, the value of a call option depends on the value of the underlying equity.
- Derivatives allow a company and investor to control the level of risk they are willing to bear.
- They are the standard risk management tool used by modern corporations
The three we will be looking at are:
- Options contracts
- Forwards contracts
- Futures contracts
2
Q
What are the Options?
A
- An option is a contract that gives its owner the right to buy or sell an asset at a fixed price on or before a given date. It gives the buyer the right, but not the obligation.
- Exercising the options: The act of buying or selling the underlying asset via the option contract.
- Strike or exercise price: The fixed price in the option contract at which the holder can buy or sell the underlying asset.
- Expiration date: The maturity date of the option; after this date, the option is dead.
- American and European options: An American option may be exercised any time up to the expiration date. A European option differs from an American option in that it can be exercised only on the expiration date
3
Q
What is a Call option?
A
- The owner has the right to buy an asset for a fixed price during a set period.
- Example: The owner has the right to buy the asset for £7 on or before 15 July
- The Call Option is out of the money if the share price is lower than the exercise price. The holder will not exercise the option if it is out of the money. -
- The Call Option is in the money if the share price is higher than the exercise price.
LOOKING AT VALUE NOT PROFIT
4
Q
What is a Put Option?
A
- The owner has the right to sell an asset for a fixed price during a set period
- Example: The owner has the right to sell the asset for £50 on or before 15 July
5
Q
What does writing an option mean?
A
- An investor who writes (sells) a call on equity must deliver shares of the equity to the holder (buyer) if the holder exercises the call. •
- For example, if the share price and exercise price are £60 and £50, respectively, at the expiration date, a rational holder will exercise the option since the equity price > the exercise price. And the seller will buy the equity in the open market (£60) and sell it to the holder at the exercise price (£50), which means that the seller will lose the difference (£10). The holder (buyer) makes what the seller loses. •
- However, if the equity price < the exercise price at the expiration date, a rational holder will NOT exercise the option and hence the liability of the seller will be zero.
- Similarly, an investor who sells a put on equity must purchase the shares of the equity if the put option holder exercises the put. The seller loses on this deal if the equity price < the exercise price at the expiration date.
6
Q
How do you value an option?
A
- We learned what the options are worth on the expiration date. In this part, we will determine the value of options when you buy them before expiration.
- The value of the call is share price minus the present value of the exercise price. The value of put is the present value of the exercise price minus the share price.
- For instance, assume that the value of a share (S) is £75. The strike/exercise price of the call option is £55. The interest rate on the risk-free asset is 5% annually.
- The value of call one-year before the expiration = £75 - £55/(1+0.05) = £22.619.
7
Q
What is the two-state (binomial Option model)?
A
8
Q
What is the Black-Scholes Option Pricing Model?
A
- Looking at a very small periods –> the BS model will act like the binomial model taking on only two states
- This repeats over time and the BS option pricing model works based off this extension of the binomial pricing model.
9
Q
What are the Greeks?
A
- The ‘Greeks’ measure the rate of change in the value of a call or put with respect to the factors effecting the option values presented in the previous table (i.e., share price, exercise price, etc.).
- Delta: Rate of change in the value of an option with respect to a change in the underlying equity’s share price.
- Gamma: Rate of change in delta with respect to a change in the value of the underlying share price .
- Theta: Rate of change in the value of an option with respect to the change in time to maturity of the option.
- Vega: Rate of change in an option’s value with respect to changes in its implied volatility.
10
Q
What is the difference between Hedging and Speculating?
A
11
Q
What are Forwards contract?
A
- A forward contract is a contractual agreement made today for delivery and payment at a future date (certain time and certain price). Both the buyer and the seller are obligated to perform under the terms of the contract.
- An agreement today to buy oil at $30, six months from now. Cash will change hands in six months’ time.
12
Q
What is a Futures contract?
A
- A standardized contractual agreement traded on an exchange for an asset to be delivered and paid for at a future date.
- Futures contracts can be closed out, meaning that an offsetting position is taken (i.e. a futures contract to buy an asset on a specific date is closed off by taking a futures contract to sell the same asset on the same date)
- Futures contracts are marked to the market meaning that the trader’s account is updated on a daily basis with the change in futures contract value.
13
Q
What is the difference between Futures and Forwards?
A
- Future contracts are usually settled with monetary exchange rather than the delivery of the underlying
14
Q
How do you hedge with future contracts?
A
- Long if you think the underlying price is going to go up
- Short if you anticipate to sell in the market at a future date but expect prices to fall
Ends up reducing price risk
