Chapter 2 & 3: Derivatives

Question 1

Derivative

Answer 1

A derivative is a financial instrument of which the value depends on the value of another underlying asset.

Question 2

Futures contract

Answer 2

A futures contract is a standardised, exchange-tradeable contract between two parties to trade a specified asset at a certain future date for a specified price.

Question 3

What details does a futures contract typically specify?

Answer 3

• the unit of trading
• how the settlement rice is to be determined
• exact details of the underlying asset (i.e. type and quantity)
• delivery arrangements - date and place of delivery
• tick size

Question 4

What are the advantages of having the clearing house be the counterparty to all trades?

Answer 4

• The clearing house largely removes counterparty credit risk between the buyer and the seller.
• Each contract is indistinguishable from all the others (can close out positions more easily).

Question 5

Margin

Answer 5

The collateral each party to an exchange-traded derivative must deposit with the clearing house.
Acts as a cushion against potential losses, which the parties may suffer from future adverse price movements.

Question 6

The margining process

Answer 6

• When the transaction is first struck, initial margin is deposited with the clearing house.
• The balance in the margin account is changed on a daily basis to reflect gains and losses on the contract.
• If the balance falls below the maintenance margin the investor is required to deposit a variation margin.
• The variation margin ensures the clearing house’s exposure to counterparty risk is controlled.
• This system also makes it unlikley that an investor will default.

Question 7

Marking to market

Answer 7

• Process of daily margin requirement changes.
• Fall in value = topped up with additional payments to enable clearing house to continue giving its guarantee.

Question 8

Closing out prior to delivery

Answer 8

Closed out prior to delivery by taking opposite positions in the contract.
E.g. Buyers of a contract can later close out their positions by selling an equivalent contract.

Question 9

Open interest

Answer 9

The number of contracts outstanding at any one time.

Question 10

Price limits

Answer 10

Price limits ensure orderly markets. These protect the clearing house from excessive credit risk.
If price of contract moves up or down by more than the price limit, then the exchange will halt trading in that contract - allows variation margins to be collected.

Question 11

Role of the clearing house.

Answer 11

• counterparty to all trades
• guarantor of all deals (removing credit risk)
• registrar of deals
• holder of deposited margin
• facillitator of the marking to market process.

Question 12

Option

Answer 12

Gives an investor the right, but not the obligation, to buy/sell a specified asset on a specified future date at a set price (strike/exercise price)

Question 13

Advantages and disadvantages of OTC market compared to exchange trading.

Answer 13

Advantages:

• ability to tailor contracts to buyer’s precise requirements.

Disadvantages:

• non-standardised contracts reduce or eliminate marketability
• high dealing costs
• no quoted market values
• possibility of greater credit risk if not dealing with clearing house as guarantor. Many have CCP step in after negotiation though.

Question 14

Forward

Answer 14

A forward contract is a non-standardised and privately negotiated contract between two parties to trade a specific asset on set date in future at specified price.

May be cleared through CCP.

Question 15

Swaps

Answer 15

A swap is a contract between two parties under which they agree to exchange a series of payments according to a prearranged formula.
May be non-standardised.

Question 16

Guarateed equity products (GEPs)

Answer 16

GEPs offer a return that’s linked to an equity index, but with a minimum guaranteed return, often of zero.

Question 17

Structured notes

Answer 17

Structured notes are non-standard securities that are structured so as to meet the particular risk and return requirements of investors. Often contain embedded options and/provide payments that vary in some pre-specified way.

Question 18

Payoffs from a forward contract (long and short position)

Answer 18

Long position:
ST-K
Short position
K-ST

Question 19

Call option

Answer 19

Gives the holder the right to buy the underlying asset by a certain date and for a certain price.

Question 20

Put option

Answer 20

Gives the holder the right to sell the underlying asset by a certain date and for a certain price.

Question 21

Payoffs from call option (long and short position)

Answer 21

Long position:
= max(ST-K,0) - O
Short position:
= O - max(ST-K,0)

Question 22

Payoffs from put options (long and short position)

Answer 22

Long position:
max(K-ST,0) - O
Short position:
O - max(K-ST,0)