week 1

Question 1

What is a derivative?

Answer 1

A derivative is a contract/instrument whose value depends on, or is derived from, the value of another
asset (the underlying). Basic ones include: futures, forwards, swaps, options

Question 2

Why are derivatives important?

Answer 2

-recognise risk
-understand risk
-exploit risk (arbitrage, speculation)
-protect against risk (hedging)
-evaluate results after allowing for risk.

Question 3

What is hedging

Answer 3

• Forming a portfolios of assets to reduce risk
• Entails a cost
• Premium paid or profit foregone

Question 4

What is speculation

Answer 4

• Earning a profit in return for accepting risk
• Hedgers pay speculators for taking on the risk

Question 5

What is arbitrage

Answer 5

• Earning riskless, costless profit by trading
• The action of arbitragers drives markets towards equilibrium

Question 6

What is leverage

Answer 6

Traders can increase both risk and return by leverage.

Question 7

If a hedger makes profit what happens to speculator

Answer 7

profit for speculator decreases, as hedgers and speculators take opposite positions, which there is zero sum returns

Question 8

What is an call option

Answer 8

Right to but or sell a specified asset at agreed price in the future. Price is exercised on strike. Long position - agree to buy. So other person shorts it

Question 9

What is a forward

Answer 9

Trade specified asset at future time and place. No cash flow until asset delivered, short position must deliver the asset e.g. tenancy agreement. Futures and swaps are forwards.

Question 10

Difference between forwards and options

Answer 10

Forward: Obligated to complete transaction, binding agreement, no upfront cost, unlimited potential gain/loss.
Option: Right but not obligation to execute contract. Premium to seller for right to exercise option. Limited risk as max loss = premium paid. Can be left to expire.

Question 11

Explain long call, long forward, short call, and short forward

Answer 11

Long call: Right but not obligation to buy. S = spot price. Don’t have to execute. No limit on profit, max loss = premium paid.
Short call: Obligation to buy, no limit on losses. Where you sell.
Long forward: Obligation to buy. No limit on loss or profit.
Short forward: Obligation to sell. No limit on losses

Question 12

What is the intrinsic value of a call?

Answer 12

The minimum value of a call. A positive value when being exercised, and 0 when out the money. Can only apply the rules to an american call. S-X. At expiration a call option is worth intrinsic value.

Question 13

What is the time value of a call?

Answer 13

The difference between price and intrinsic value.