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ECB004 Introduction to Financial Economics > WEEK 9 - Derivatives > Flashcards

WEEK 9 - Derivatives Flashcards

1
Q

What is a Derivative?

A

an asset whose performance is based on the behaviour of the value of an underlying asset

The legal right that becomes an asset, with its own and its the right that’s purchased or sold

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2
Q

What is an option?

A

Contract giving one party the right but not the obligation to buy/sell asset, commodity or some other underlying asset at a given price or before a specified date

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3
Q

What is a share option?

A

Share call option gives purchaser a right, but not the obligation, to buy a fixed number of shares at a specified price at some time in the future

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4
Q

What does one option contract relates to in the ICE Futures Europe?

A
  • One option contract relates to a quantity of 1000 shares
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5
Q

What is a seller of the option who receives the option referred to as?

A

The seller is referred to as the writer

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6
Q

EXAMPLE OF CALL OPTION ON GOLD SHARES

A

SEE IN NOTES

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7
Q

What is the Premium?

A

What you have to pay per share. The longer the time, the higher the probability the share price will be above exercise price

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8
Q

How does the time value arise?

A

The potential for the market price of the underlying to change in a way that creates intrinsic value

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9
Q

What is the Intrinsic Value of an option?

A

The pay-off that would be received if the underlying were at its current level when the option expires

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10
Q

What is Exercise Price?

A

The price at which you have a right to buy

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11
Q

What is an In-the-money option?

A

Positive value

- Value today higher than the exercise price

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12
Q

What’s an Out-the-money option?

A

Negative Value

- Value today is lower than exercise price

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13
Q

What is an At-the-money option?

A

The share price and the exercise price is the same

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14
Q

EXAMPLE IN CALCULATING THE RIGHT TO PURCHASING

A

SEE IN NOTES

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15
Q

What is a call option?

A

Right to buy

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16
Q

What is a put option?

A

Right to sell

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17
Q

What happens if you don’t exercise the option?

A

The P/L will always equal the premium

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18
Q

When do you break even?

A

The share price you bought at + The Premium

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19
Q

What are the examples of option writing strategies?

A

i) Writing a covered call option

ii) Writing an uncovered (naked) call option

20
Q

What is a covered call option?

A

Investor writes a covered call when they do own a long position in the underlying asset

21
Q

What is an uncovered (naked) call option?

A

investor writes an uncovered call when they do not own a long position in the underlying asset

22
Q

EXAMPLE OF OPTION WRITING STRATEGIES

A

SEE IN NOTES

23
Q

What is a put option?

A

A put option gives the holder the right, but not the obligation, to sell a specific quantity of shares on or before a specified date at a fixed exercise price.

24
Q

EXAMPLE OF PUT OPTIONS OVER SILVER

A

SEE IN NOTES

25
Q

Put option holder profit graph (Buyer)

A

SEE IN NOTES

26
Q

Put option holder profit (Writer)

A

SEE IN NOTES

27
Q

What is Hedging in Option trading?

A

The concept is in order to offset any potential losses you might experience on one investment, you would make another investment specifically to protect you.

28
Q

EXAMPLE OF HEDGING

A

SEE IN NOTES

29
Q

What are Forwards?

A

Agreement between two parties to undertake an exchange at an agreed future date at a price agreed now

30
Q

What are some of the elements of Forwards?

A
  • Forward contracts are tailor-made
  • ‘Over-the-counter instruments’
  • Risk of default
  • Difficult to cancel
31
Q

What are Futures?

A

Agreement between two parties to undertake a transaction at an agreed price on a specified future date

32
Q

What are some of the elements of Futures?

A
  • Exchange-based instruments
  • The exchange provides standardised legal agreements traded in highly liquid markets
  • Clearing house becomes the formal counterparty to every transaction
  • With futures you are committed and unable to back away
33
Q

What is a clearing house?

A

Intermediary between buyers and sellers of financial instruments.
-Further, it is an agency or separate corporation of a futures exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data

34
Q

What does the clearing house operate?

A

A margining system

35
Q

What are the differing types of margins that the clearing house implements?

A

-Initial Margin:
Likely to be in the region of 0.1% to 15% of the value of the underlying

-Daily marking to market
Daily settling of gains and losses due to changes in the market value of the security

  • Maintenance Margin:
    Minimum amount of equity that must be maintained in a margin account.

-Variation Margin:
(Mark To Market Margin) additional amount of cash you are required to deposit to your futures trading account after your futures position have taken sufficient losses to bring it below the “Maintenance Margin”.

36
Q

What is a settlement?

A
  • Physical delivery of the underlying asset
  • Mostly closed out before the expiry of the contract and all that changes hands is cash
  • “Reverse their trade” before the contract expires
  • Hedgers may use the futures market not as a way of obtaining goods but as a way of offsetting the risk of the prices of goods moving adversely
  • Cash settlement
37
Q

HEDGING WITH SHARE INDEX FUTURE EXAMPLE

A

SEE IN NOTES

38
Q

What are Short term interest rate futures?

A
  • Notional fixed-term deposits, usually 3 month periods starting at specific time in the future
  • Buyer of one contract is buying the right to deposit money at a particular rate of interest for 3 months
  • Unit of trading for a three month sterling time deposit is £500,000
  • Cash delivery by closing out the futures position is the means of settlement
39
Q

How are short term interest contracts quoted?

A

Quoted on an index basis rather than on the basis of the interest rate itself.
The price is defined as:
P = 100 - 1

Where:

  • P = Price index
  • i = The future interest rate in % terms
40
Q

What are the advantages of Options?

A
  • Downside risk is limited but the buyer is able to participate in favourable movements in the underlying
  • Available on or off exchanges. Exchange regulation and clearing house reduce counterparty default risk for those options traded on exchange
  • There are highly liquid markets so keen option positioning quickly at low cost.
41
Q

What are the advantaged of Futures?

A
  • Can create certainty: Specific rates locked in
  • Exchange trading only. Exchange regulation and clearing house reduce counter-party default risk
  • No premium is payable (However margin payments are required)
  • Very liquid markets. Able to reverse transactions quickly and cheaply
42
Q

What are the advantages of Forwards

A
  • Can create certainty: Specific rates locked in
  • Tailor made,off exchange: Not standardised as to size, duration and terms. Good for companies with non-standard risk exposure
  • No margins or premiums payable
43
Q

What are the disadvantages of Options?

A
  • Highly liquid markets, may make trading thin and premiums become distorted and offsetting transactions costly and difficult
  • Premium payable reduces returns when market movements are advantageous
  • Margins required when writing options
44
Q

What are the disadvantages of Futures?

A
  • No right to let the contract lapse. Benefits from favourable movements in underlying are forgone
  • In hedge position if the underlying does not materialise, future position owner can experience switch from covered to uncovered
  • Many exchange restrictions- on size of contract, duration, trading times
  • Margin calls require daily work for back office
45
Q

What are the disadvantages of Forwards and FRAS?

A
  • No right to let the contract lapse (Benefits from favourable movements in underlying forgone)
  • In a hedge position if the underlying transaction does not materialise the forward position owner can see switch from covered to uncovered
  • Greater risk of counterparty default (not exchange traded) therefore counterparty is not clearing house. (This may change for many OTC derivatives as they move to derivatives)
  • Generally min contract size for millions rather than few thousand (as on the futures or options market)
  • More difficult to liquidate position

ECB004 Introduction to Financial Economics (13 decks)

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