Lecture 8 Flashcards
(26 cards)
What is a derivative?
An instrument whose value is linked to / derived from something else
What are derivatives used for?
Hedging & speculation
What is hedging?
Reducing existing exposures
What is speculation?
Taking on new exposures
What are major types of derivates?
- Forwards / futures
- Options
- Swaps
What is a spot contract?
Immediate delivery, immediate payment
What is a forward contract?
Exchange given asset for given price at given date
What is a futures contract?
Like a forward, but standardised, with liquid secondary market
What does FRA stand for?
Forward Rate Agreement
How does a FRA work?
Fixes the interest rate on a loan to be made in the future
How does a margin call work?
Exchange calls losing side on futures contract & demands margin in excess of losses
What is a margin call for?
Limits default risk on futures contracts
What is a key difference between forwards & futures?
Futures are settled daily, forwards are settled at end of contract
Is a call option holder long or short?
Long
Is a put option holder long or short?
Short
What is the cost of buying an option called?
The premium
What can make options more valuable?
Underlying asset with high volatility
What is one way of valuing standard options?
Black-Scholes option pricing model
What is a swap?
Agreement to exchange a series of cash flows in the future
Swaps can be thought of as…
A series of individual forward agreements
How are swaps generally used?
Hedging interest rate / foreign exchange exposure
What do derivatives achieve?
- Cheap & efficient hedging / speculation
- Take very specific exposures
What is the danger of derivatives?
Huge exposures with little cash up front
What is ‘reading the markets’?
Inferring people’s expectations from prices
