The bank

Question 1

Define a derivative

Answer 1

a financial instrument that has its price be determined on the basis of the price of some other asset

Question 2

are derivatives bets or risk reducing?

Answer 2

all depends on the context in which the derivative is used.

Question 3

elaborate o nthe process of trading a financial asset

Answer 3

There are 4 steps:
1) Locate buyer and seller, and agree on a price
2) Trade must be cleared. The obligations of each party is determined and specified
3) THe trade must be settled. This is the actual delivery.
4) Once completed, ownership records are updated.

Careful examination of step 3: Settlement, for either party, can occur at different times

Question 4

define notional value

Answer 4

The scale of a position. if we have 100 share contract, each for 100 bucks, the notional value 10000

Question 5

define lease rate

Answer 5

payment required by the lender

Question 6

define a forward contract

Answer 6

a contract where we set the terms today, but the obligation happen sometime in the future.

Question 7

importnat characteristic of forward contracts

Answer 7

they represent obligations. Cannot back out.

Question 8

what is spot price

Answer 8

Current price. useful when talking in relation to forwards because it clearly spearates the prices

Question 9

define a long position

Answer 9

A party is said to be the long position if their position makes money when the underlying asset goes up.

Question 10

define a short position

Answer 10

a short position is one that generally lose money if the asset goes up. Makes money if the underlying goes down.

Question 11

what is the payoff for a long forward

Answer 11

The long party in a forward is the one who will acquire the asset.

at expiration, he makes: spot price at expiration - forward price

The forward price was determined at the time when the contract was initially made. Therefore it is treated as fixed.

Question 12

What is the payoff of a short forward

Answer 12

The short forward position will make money if the asset goes down. Therefore, we have:

payoff = forward price - spot price at expiration

Question 13

define a funded position

Answer 13

A funded position is one that is fully payed for from the beginning

Question 14

what is bermudan option

Answer 14

can only exercise during specific periods of time

Question 15

what is important to remember when computing profit, like option profit?

Answer 15

Must make sure that cash terms are in the same period. We need to either discount the payoff, or compound the initial price.

Question 16

how to go from payoff diagram to profit diagram

Answer 16

subtract the future value of the initial price

Question 17

define a floor

Answer 17

the term floor is used to indicate the simple purchse of a put option to protect a natural long position in some asset. The floor makes a floor in terms of how much money one can lose.

Question 18

what is the opposite of a floor

Answer 18

a cap

Question 19

elaborate on caps

Answer 19

insurance against a short position. Limits how much we can lose, but not in regards to if the asset moves up

Question 20

define covered writing

Answer 20

selling/writing options when you have a lng position in the underlying

Question 21

opposite of covered writing

Answer 21

naked writing

Question 22

elaborate on naked writing

Answer 22

selling options without being hedged with owning the asset already

Question 23

elaborate on covered calls

Answer 23

Sellign call options when also owning the long asset.

A covered call gives you funds from the premium, which you collect if the stock does not move beyond the strike price. However, if the stock price declines, we also lose money from the asset itself.

If the stock goes beyond stirke, we lose the asset.

However, we have limited loss on the upside, and sort of limited on the downside. However, the downside risk is larger.

A covered call is exactly like a regular written put.

covered calls is a low volatility strategy.

Question 24

elaborate on covered puts

Answer 24

Writing a put while holdoing a short position in the asset.

Same as a written call

Question 25

elaborate on synthetic forwards

Answer 25

a long forward is a position where we acquire the asset for a specified price. We can do this with options. Buy a call at strike K. Write a put at strike K. This will force you to end up with the asset for price K. If the asset increase in value, the synthetic forward is profitable for us because we buy at K, and K is a lower value. If the asset decrease in value, we will likely be forced to buy it at K when K is higher than spot. Hpowever, this is the same as a regular forward.

Question 26

differnece between synthetic and real forwards

Answer 26

synthetic forwards use options, which require premium. Regular forwards have no premium. Therefore, there must be some sort of relationship that relates the benefit of using a specific strike price K against the cost of C and profit from P.

Question 27

relate the strike price K of the synthetic forward to the option premium

Answer 27

This will create the put call parity equation. As the long position, we earn premium from the put, but pay the call premium. We also choose the strike price. If the stirke price is equal to the forward price, we know that the put and call premium must be equal. Otherwise, one could create aribtrage iwht the actual forward contract. Then we also know that the differnce between the forward price and strike price must be equal to the difference between the premiums. PV(forward price) - PV(K) = C - P The ACTUAL way of reasoning is this: We compare the cost of buying the forward and the cost of buying the synthetic: PV(Forward price) = C - P + PV(K) And we get: C - P = PV(Forward price) - PV(K) which is put call parity

Question 28

what is the price of a commodity

Answer 28

THe price of a commodity is the price that has to be payed NOW for access to the commidiuty when it is available.

Question 29

key regarding commodities

Answer 29

We differ between commodities also based on availabaiblity. Corn available at time X is not the same commodity as time available at time Y.

Question 30

Recall the formula for the forward price of a financial asset

Answer 30

F_{0,T} = S_0 e^((r-∂)t) We compound with r to refelct the alternative cost of being able to invest the delayed cash in risk free asset in the meantime. Then we discount by the ∂ to account for the fact that by delaying payment, we give up dividends. Specifically, we give up e^(∂t) amount of dividends

Question 31

elaborate on differences associated with commodities that are not present in financial contracts

Answer 31

1) Storage costs 2) carry markets: if the commoditiy owner is compensated for storing the commodity through the forward price, the market is a carry market. 3) Lease rate. relates to short selling 4) convenience yield

Question 32

elaborate on the two types of commodity market conditions

Answer 32

Contango and backwardation Contango refers to the case where the forward curve is sloping upward. Backwardation refers to a downward sloping forward curve.