Chapter 7 - Derivatives Flashcards

Question

# A way to understand what factors contribute to an options price movement Options Greeks - Gamma | What is it, when is it lowest/highest, when negative/positive

Answer 1

- Measures the sensitivity of an options delta to a change in the underlying asset price - I.e. rate of change of delta - Always positive when buying options and negative when selling - ATM options close to expiry have the greatest gamma - Deeply ITM and OTM have the lowest Gamma

Answer 2

- Measures the sensitivity of an options premium to a 1% change in its implied volatility - I.e. a measure of the volatility in the market - Always positive when buying and negative when selling - Higher for longer dated and ATM options

Answer 3

- Measures the sensitivity of an options premum due to the passage of time (1 day) - Also known as time decay - Always negative when buying and positive when selling - Greatest for ATM options nearing expiry

Answer 4

- Allow trades to lock in the price for a fixed number of bitcoins at an agreed price on an agreed future date - in 2017, two derivative marketplaces offered cash settled futures contracts: 1. CME Group - used an aggregrate price from four major crypto exchanges 2. Cboe Global Markets - used price on Gemini Exchange only (drawback of this was prices across venues can vary drastically) however discountinued product in 2019 due to low trading volumes - Products were primarily designed for institutional investors to allow themm to speculate or hedge without needing to directly hold the cryptocurrency - Some brokerages (Ameritrade) offered futures to select retail clients, signalling wider acceptance of the digital asset class

Answer 5

- Launched in 2017 by FTX US (now collapsed) but now offered by other firms to sophisticated investors looking to hedge or speculate on Bitcoin - Some argue the entire crypto market is a derivatives market, as the price of many altcoins is directly tied to Bitcoins price - This is partly as many exchanges do not allow you to buy altcoins in fiat currencys, so Bitcoin is used as a bridge asset

Answer 6

- Physical involves the seller delivering the underlying asset. More common in commodity derivatives - Cash involves the seller paying a net amount reflecting the value of the position of the buyer. Cash goes from person out the money to person in the money. More common in financial derivatives e.g. index futures

Answer 7

- Must be fair to buyer and seller - Must be indifferent to buying and holding the physical asset or buying at a future date - so no arbitrage opportunities - Fair Value = cash price + cost of carry - Cost of carry includes finance costs, income and storage costs (depends on type of contract) - Fair value of commodity contract = cash price + finance costs + storage costs - Fair value of equity index future = cash price + finance cost - income - In exam, if cost of carry figures given as p.a, ensure they are multiplied by time to expiry over 365

Answer 8

1. Underlying Asset Price - higher asset price = more valuable call options, less valuable puts 2. Strike Price - higher strike price = less valuable call options, more valuable puts 3. Time to Maturity - longer the term of the option, the greater the risk to the option writer it will expire in-the-money and so the higher the premium for calls and puts 4. Implied Volatility - the more volatile the underlying asset , the more likely the option will expire in-the-money, so the higher the premium for calls and puts. Implied volatility is derived from premiums, which allows comparisons between options. Most important parameter for option pricing 5. Income Yield - greater income yield means greater sacrafice of call option holder of not holding the asset but greater benefit to put option holder. Therefore higher income yield means less valuable call premium and more valuable put premium 6. Short-Term Interest Rates - higher rates means more income for call option holder on their cash meaning higher call premium and lower put premium All of these factors feed into a pricing model which can be used to estimate the price of the option

Answer 9

- Exchange traded derivative participants must accept rules and terms of relevant exchange - OTC derivatives governed by standardised legal frameworks (International Swaps and Derivatives Association, ISDA) - agreements negotiated between counterparties before trading - ISDA published the Narrowly Tailored Credit Event (NTCE) Supplement to restore market confidence in the Credit Default Swaps (CDSs) market with two key provisions: 1. failure to pay credit deteriroration requirement - if a firms failure to pay does not directly result from deterioration in the issuers creditworthiness, this will not result in a default 2. amendment to the definition of 'outstanding principal balance' - if a bond is issued at a discount, the discounted level will not be used as the reference point for determining the payout in the event of default

Answer 10

- With exchange traded, parties trade with the exchange itself, meaning no credit exposure to the other party - Bilateral risk with OTC derivatives

Answer 11

- Risk that one party will fail to fulfil their side of the deal, either by not paying or not delivering underlying asset - Risk applies to both OTC and Exchange Traded (although risk is lower due to margins) - Settlement risk can arrive from counterparty default, operational errors or timing mismatches so can be managed with robust clearing arrangements and collateralisation - Dealing risk arises during execution and management of derivative transactions including trade booking errors or mismatched terms and can be managed via clear procedures, reliable trade systems and robust oversight

Answer 12

- Cash and Futures price should move in line with each other however the basis is not constant - If a Futures price is higher than the cash price this is known as Contango (under normal market conditions, you would expect commodities prices to be higher than cash prices) - Often caused by factors such as inflation expectations and cost of carry (cost of holding asset until expiry) - If a Futures price is lower than the cash price this is known as Backwardation - Most common in bond or interest rate markets when long term interest rates are higher than short term - Can also occur in commodity markets when there is a very steep premium for material available for immediate delivery

Answer 13

- Difference between cash price (spot price) and Future price or difference between near and far future price - Basis will narrow to zero at expiry as cost of carry diminishes - Basis = Cash Price - Futures Price - When basis becomes more negative or less positive, it is said to weaken - When basis becomes more positive or less negative, it is said to strenghten - Supply and Demand are biggest factor in movement of basis

Answer 14

- Exchange clearing house is taking on contingent liability when guaranteeing contracts (where a loss might arrise, but it is not possible to be certain of its amount)

Answer 15

- Paid by the clearing house member at the outset to compensate for any possible loss from the trade which protects the clearing house - Returned when the position is closed out - Can be cash or collateral e.g. bank guarantees or bonds but these must be denominated in currency of issuing country - The clearing member calculates the clients margin by looking at recent price volatility of the contract and often considering the most the underlying asset could move - The margin is re-calculated every business day so a top up may be required - If the initial margin amount is exhausted, the clearing house can call for extra intra day margin which is immediatley taken via direct debit - No initial margin on option contracts as a premium is taken - The required margin can increase near the delivery date to ensure position holders have the underlying asset to deliver or spare funds for settlement. This minimises speculative and delivery pressues by forcing those who do not want to take actual delivery to close or roll position

Answer 16

- When a trader has multiple positions in the same contract (e.g. long June FTSE 100 and short Sept FTSE 100), the initial margin will be lower as the positions offset each other - called intra commodity spreads - Spreads between different instruments known that exhibit correlation in price are called inter commodity spreads

Answer 17

- A payment made by one counterparty to the other to settle the loss/gain caused by price movements - Collected by the clearing house, paid to the exchange and then onto the other party - The exchange establishes the settlement price every day for calculation of mark-to-market variation margin - Some exchanges take the settlement price as the closing price, some use a closing range - At end of day, all positions are marked-to-market based on settlement price and the profit/loss is then calcuated and must be paid to/received from the clearing house as variation margin by 10am the following day - Variation Margin = ticks moved on the day x tick value x no of contracts - where ticks moved on the day = (closing price - previous closing price) / tick size - Each member has a bank account that the clearing house has access to via a direct debit system called Protected Payments System so variation margin payments can be taken automatically - If variation margin can't be paid, it is taken from the initial margin and the position is closed out

Answer 18

- Clearing Member can ask their client to deposit more than the initial margin (e.g. 25-50%) - This allows variation margin to be taken more easily without having to keep going back to the member - If a set level is triggered, the member will issue a margin call and the client will be expected to top up their account

Answer 19

- Level of variation/daily margin is determined by the change in the price of the underlying asset. This is easy to calculate for futures where there is a direct relationship. More complicated with options as multiple factors such as volatility or time decay will influence the price

Answer 20

- Margin requirements are based on the net positions held by the member firm - Where there are a variety of positions held at the same time, the total margin due is based on the new liquidation values of the different positions - This means profits from one position can be used to offset losses on another

Answer 21

- Cover for initial, variation and maintenance margin can be provided using collateral - No closed list as to the types of collateral acceptable, however there are criteria e.g. the asset must be of high quality and easy to liquidate - Examples of what is accepted include cash in most major currencies, bank guarentees, certificates of deposit and govt debt from countries such as the US or UK - Equities may be accepted with special agreement, provided they meet criteria above - Undated bonds, swiss bonds are not acceptable, and the bonds must be denominated in the currency of the issuing county - Collateral is also marked-to-market daily and is subject to published 'haircut' (full market value is not credited) - The securities that are used as collateral are lodged with depositories and custodians

Answer 22

- Some exchanges allow members to extend credit to their clients to cover margin requirements - Credit lines are subject to regulatory rules specifying the circumstances in which lending money is acceptable

Answer 23

- Collateral Management is the process that allows market participants to reduce counterparty credit exposue arising from longer maturity OTC derivative contracts (e.g. a bank in a swap with a company, if markets fall in favour of the bank, the banks credit risk exposure to the company is greater as it has a loss on the swap position) - If bank considers the credit risk of trading with a paticular counterparty too great, it may ask for additional collateral up to the value of the size of the risk they are taking - Banks will also ensure they have up-to-date and accurate measures of its credit exposure to a counterparty - This collateral is called margin and asking for more collateral if the value of the trade rises, is making a margin call - If the bank assigns a reduced value to the collaterals market value, this is known as a haircut

Answer 24

- Clearing is the process by which derivatives trades are confirmed and registered - The clearing house then becomes the legal counterparty to every transaction on a principal-to-principal basis in a process known as novation (the clearing house becomes the buyer to every seller and the seller to every buyer and so the original contract becomes two seperate contracts) - 4 steps a clearing house takes to protect itself: 1. only permits firms that meet its membership and financial criteria 2. only deals directly with clearing members (who have large financial resources requirements) 3. margin system (to eliminate counterparty credit risk) 4. relies on own financial resources including credit with banks and insurance - Monitors all open positions and facilitates settlement process - Clearing houses maintain a default fund (which is cash paid in by all members), in case margin payments do not cover the default of a member - Advantages of clearing house: 1. Most counterparty risk is removed as each trade is guaranteed - only counterparty risk is if clearing house defaults which is unlikley as they are backed by significant financial resources 2. Contracts become easy to trade - easy to close out a trade by taking an equal and opposite position

Answer 25

- The clearing system is split into three tiers: the clearing house, clearing members and then non-clearing members - Clearing members are divided into two categories: 1. General - clear trades for themselves, their direct clients and other exchange members 2. Individual - clear trades for themselves and their direct clients - Clearing houses are often owned by their members, the exchange, or both

Answer 26

1. A market order is sent to a broker, who then registered the trade via a clearing member who will put details into the confirmation and matching system called ICE connect 2. Once an equal and opposite trade is found, the trades are matched and registered via ICE Clear Europe 3. The trade is then assigned to either a segregated 'client' account, or a non-segregated 'house' account, at the request of the client 4. Contract is novated, resulting in ICE Clear Europe becoming the counterparty to the two transactions 5. ICE Clear Europe guarantees the performance of the contract (known as principal to principal guarentee)

Answer 27

- Pool of funds contributed to by clearing members for us in case of default for all contracts cleared by the clearing house - Amount you are required to contribute is based on a risk assessment using each clearing members level of uncovered risk, which is based on trading activity

Answer 28

- ISDA has developed standard derivatives documentation to reduce the time and cost of negaotiating derivative transactions: 1. Master Agreement - central, legally binding document setting out standard terms such as termination events, events of default, netting 2. Schedule - master agreement can be customised with a schedule 3. Collateral Support Documents - only applicable if the parties require collateral 4. Confirmation - sets out the commerical terms of the trade 5. Definitions Booklet - defines certain terms

Answer 29

1. London Metal Exchange - trades futures and options on range of metals 2. ICE Futures Europe - all trading done electronically on wide range of energy products, equity index's and single stock futures 3. Chicago Mercantile Exchange (CME) - trades futures on a wide range of commodities, short-term interest rates, FX, equity indicies, weather and real estate 4. Eurex - electronically traded market and worlds largest derivative exchange trading range of futures and options on short term interest rates, equities and indicies 5. China Financial Futures Exchange (CFFEX) - electronically traded market using CFFEX system. CSI 200 index futures are only contract traded 6. B3 - some agriculatural contracts traded physically, all others electronic on agicultural, metals, FX and range of domestic interest rates

Answer 30

- A futures position is traded for the physical underlying asset - Can be used to open, close or switch a futures position for the underlying asset or if you want the asset now - Substitutes cash settlement for physical delivery and frequently used in the oil and gas market - Agreement will be negotiated privately between 2 parties and the exchange then notified of the agreement as the holder of the future has changed - Often called 'Against Actuals' or 'Futures for Cash' - Efficient as impact on the market is lessened

Answer 31

- Exchange a futures position for a corresponding related OTC swap - Also known as exchange for risk - OTC swap must be for the same underlying asset and delivery month e.g. an equity index future is exchanged for an equity swap - Privately negotiated and then reported back to the exchange - A benefit is that the OTC swap holder would no longer have to make margin payments - Benefit to the now future position holder is the reduction in credit risk

Answer 32

- Price transparency is key for investor confidence which is vital for an exchange who derive their income from investor fees - Exchange disseminates the trade reporting info through a price feed to its members - Real time price and trade info also available through quote vendors such as Reuters and Bloomberg - Screens show best bid(B)/offer(A) spread as well as opening and closing prices, volume traded, open interest, day's high and low price - Each futures expiry month has a unique letter - March (H), June (M), September (U), December (Z)

Answer 33

- Members are required to compile trade reports and submit them to the exchange - Exchange specifies the time limit to submit the reports, failing to do so can result in disciplinary action - ICE connect submits reports automatically - OTC trades subject to interal timing reports which are recored by internal risk management system - Block trades are reported to exchange within specified time of verbal agreement being reached

Answer 34

- Once a deal has taken place, position is allocated to the relavant account (principal account if executed for firm itself or client account if on behalf of a client) - Details of trade reported into admin system used by the exchange and then assigned to one of three accounts: 1. House - for all own trades of the clearing member 2. Segregated - most exchanges require member firms to place client assets in a segregated account so they can't be used to pay member's own liabilities 3. Non-Segregated - assets not protected in event of member default

Answer 35

- OTC contracts are bespoke and highly flexible - Exchanged traded contracts with same expiry are fungible - Exchange traded contracts are liquid as traded on exchange - Limited counterparty risk with Exchange traded as counterparty is the clearing house - Regulation is light for OTC contracts - Exchange traded contracts have published trading activity and prices - OTC contracts can be used to precisely hedge an underlying position

Answer 36

1. Limit Order 2. Market Order 3. Market if Touched - a limit order that turns into a market order if the market trades at or through a price 4. Opening Order - an order to be executed during the official opening period 5. Closing Order - as above but at end of day 6. Good till Cancelled (GTC) - order is live until client specifies otherwise (most orders are 'Good For the Day (GFD) 7. Immediate or Cancel - execute whole order or cancel (a.k.a fill or kill) 8. Stop Loss - closes position if price moves below a set level 9. Limit Order - as above but stipulates two prices within which the stop loss operates 10. Day Order - expires at end of day if not executed

Answer 37

- To calculate number of contracts needed to hedge a portfolio using Futures: - No. of contracts = portfolio value / futures value x h where - h is the hedge ratio (which for an equity portfolio is Beta) - h = - (volatility of the portfolio/volatility of the futures) or - h = - (portfolio duration/futures duration) - and futures value = futures price x contract size - A correctly hedged portfolio should exhibit no risk whatsever assuming portfolio is fullly diversified however risk may arrive due to using the incorrect hedging ratio (by incorrectly assessing beta), from unsystematic risk which can't be hedged or can only be eliminated with further diversification

Answer 38

1. Hedging - won't be perfect due to inaccurate or a change to beta and changes in basis 2. Imminent cash flow - if you are expecting a large cash inflow, but expect the market to rise, can purchase futures to benefit from this before buying the actual asset 3. Moving quickly between markets - can quickly change the profile of the portfolio due to speed of dealing and lower costs compared with trading the underlying assets 4. Speculation - can take an agressive position in an underlying index without having to own the underying securities

Answer 39

- When trading gilt futures, the underlying bond does not exist and is instead based on publisged list of gilts that can be delivered between 8.75 and 13 years - To put all those gilts on a level playing field, the exchange calculates a price factor for each of the deliverable bonds which in turn determines the price to be paid for each bond - Seller will deliver whichever bond is cheapest to deliver - Used if portfolio manager believes a bond portfolio will decrease in value due to rising interest rates. No of contracts to sell to hedge = (portfolio value/futures value) x h where h = -portfolio duration / futures duration)

Answer 40

- This gives the option holder the right to buy an asset at 100p in three months for a premium of 10p - This is a bullish strategy so you want the asset price to rise - If the price rises above the strike price, the gain is unlimited - Limited loss of 10p (the premium) - Break even is 110p (premium paid plus exercise price) - ITM on diagram excludes premium paid - If the option expired at 105p, you would still exercise as the loss would then be 5p rather than 10p - If the strike price was lower in the above example, the premium paid would be higher as it is more likely the option would expire in the money

Answer 41

- You are selling the (writing) the right to buy XYZ at 100p in three months for a premium of 10p - You therefore have the obligation to sell the asset at 100p if the option is exercised by the holder - This is a bullish strategy so you want the asset price to fall - If the price rises above the strike price, the loss is unlimited - Your gain is limited to 10p (the premium) - Break even is 110p (premium received plus exercise price) - Covered call means you own the underlying asset, naked call means you don't - Income maximiser funds use covered calls to enhance their income

Answer 42

- You are buying the right to sell XYZ at 110p in three months for a premium of 15p - This is a bearish strategy as you want the price to fall - Loss is limited to the premium paid - Gain is limited as you are further ITM when the price falls, but the most you can make is when the price falls to zero - Break even of above is 95p (which is the exercise price minus the premium paid) - The higher the strike price, the higher the premium, as you are more likely to end up ITM - This is a useful strategy for hedging using a protective put

Answer 43

- You are selling the right to sell XYZ at 110p in three months for a premium of 15p - This is a bullish strategy as you want the price to rise (or remain above the strike price) - Loss is limited, as it will increase as the price falls but the most it can fall is to zero - Limited gain of 15p (the premium) - Break even is 95p (which is the exercise price minus the premium received)

Answer 44

- Holding a long position in XYZ, whilst also selling a call option with the right to buy XYZ at 100p in three months for a premium of 10p. - This is a bullish strategy as you want the price to rise, and if it did you would gain money from underlying asset and receive the premium - Loss is limited to the asset price going to zero (minus the premium paid) - Gain on the call option limited to 10p (premium), gain on underlying is unlimited - Break even point is the initial value of XYZ minus the call premium - Often used by income maximiser funds as a way to enchance income - Naked call is when a call option is written without owning the underlying asset - this is illegal in many parts of the world

Answer 45

- Holding a long position in XYZ whilst also buying a put option with the right to sell XYZ at 110p in three months for a premium of 15p - This is a moderatey bearish strategy as you retain the upside potential of the underlying asset, whilst limiting the downside risk - Loss is limited to the premium paid (15p) plus the loss from a drop in the asset price - Gain is unlimited - Break even is the initial value of the stock plus the put premium - Example of how to hedge a long position in a stock, where underlying is protected on the downside, but allows unlimited profit on the upside - Long put plus a long underlying = Long call

Answer 46

1) Define a call: right (but not obligation) to buy an asset at a set price for a premium 2) Describe the strategy: - Buy a low strike call for 100p for a 10p premium - Sell a high strike call for 100p for a 5p premium - Both assets have the same expiry and underlying asset 3) Calculate the net premium: Buy at 10p and sell at 5p so -5p 4) Maximum Gain: difference in strike prices minus the premium of 5p so 110 - 100 - 5 = 5p Maximum Loss: net premium of 5p 5) Break even: on a call = low strike + net premium = 100p + 5p = 105p 6) Draw diagram and explain: - this is a cheaper way to access a 100p call as you are giving away the benefit above 110p (however this wouldn't be an issue if you did not believe asset price will go this high) - if price is less than 100p, neither call is ITM and max loss is 5p - if price between strikes, 100p option is ITM - if price is above 110p, high strike is exercised against us, forcing us to sell at 110p

Answer 47

1) Define a put option: gives holder the right to sell at a preset price for a premium 2) Describe the strategy: - Buy a low strike put at 100p for a 5p premium - Sell a high strike put at 110p for a 10p premium - Both strikes will have the same expiry and underlying asset 3) Calculate the net premium: Buy at 5p and sell at 10p so +5p 4) Maximum Gain: this is the net premium of 5p Maximum Loss: difference in strike prices minus the net premium: 110 - 100 - 5 = 5p 5) Break even: on a put = high strike minus the net premium so 110 - 5 = 105p 6) Draw diagram and explain: - if strike price is above 110p, both options are OTM so you earn premium of 5p - if price is between strikes, 110p is ITM so you are obliged to buy at 110p - If strike price is below 100p, 100p put is ITM so you sell at 100p with a max loss of 5p

Answer 48

- This theorem combines a long put position with a long position in the underlying instrument, both for the same delivery date and has the same payoff profile as a long call position for the same delivery date - long put + long underlying asset = long call

Answer 49

- Requires entities that enter into any form of derivative contract to report that contract to a trade repository, implement new risk management standards, and clear via a CCP, OTC derivative - 3 aims: 1. Enhance Transparency - detailed info on derivative contracts reported to trade repositories 2. Mitigate Credit Risk - mandatory central counterparty clearing for standardised OTC contracts (e.g. interest rate swaps) 3. Reduce Operational Risk -participants must monitor and mitigate operation risk (e.g. fraud or human error)

Answer 50

- Aims to increase transparency and liquidity of certain OTC transactions following the GFC - Aims to reduce counterparty risk by requiring a CCP to act as counterparty to certain OTC trnasactions - Has improved financial stability and consumer protection - But regulatory burden in banking sector has harmed lending, investment, jobs and economic growth

Answer 51

- Via a collateral support document as part of ISDA documentation - Defines rules on collateral i.e. threshold amounts, minimum transfer amounts

Answer 52

- Gives holder the right to buy a set number of shares for a set price on or before a set date - Issued by and exercisable on the company - Often acts as an equity sweetner and issued alongside debt (debt can often then be issued with a lower coupon) - Warrant premium is how much extra you have to pay for shares when buying through a warrant compared to usual way - Gearing is how much exposure you have to the underlying shares using the warrant compared to the exposure you would have by buying the shares in the market - Expiration date is date the warrant expires

Answer 53

1. Advantages - Immediate cash raised without need to pay dividends, and then further cash raised when exercised - Increases attractiveness of debt issue if warrants included as an equity sweentner and often means the coupon they need to pay can be lower - After issuance, warrants detatched from det and traded seperately - Drop in share price could mean the warrants expire worthless 2. Disadvantages - New shares could be issued at a significant discount - May need to increase dividends paid to not adversely affect share price - They can dilute existing shareholders

Answer 54

1. Advantages - Benefits of holding debt (income) whilst maintaining equity upside potential - Geared investment so can be way to access shares cheaply - Detachable so can be traded seperately 2. Disadvantages - Geared investment, so lossess could be high - Risk of takeover - which accelerates the exercise date to the takeover date - If not exercised, have sacrificed yield on the debt for nothing - Warrant does not give rights to voting or dividends

Answer 55

Warrants are: - Issued by a company rather than an exchange - Dilutive when the shares are issued - Customisable (option contracts standardised) - Longer lifetime (usually up to 5 years), whereas options measured in months - Similarities include they would both expire worthless if not exercised and do not carry voting rights

Answer 56

Warrant Value = (A / (1+q)) x number of shares - where A = value of an equivalent option derived from a suitable pricing model - q = percentage increase in the number of shares in issue once the warrant is exercised

Answer 57

- Premium is how much more expensive it is to buy the warrant and exercise it, than buy the shares in the open market and is equal to: - = (warrant price + exercise price - share price) / share price - Gearing shows how many more shares you can buy with warrant and is equal to: - % = share price / warrant price

Answer 58

- Gives investor right to buy or sell an underlying asset at a specified price on or before a set date (so can be a call or put) - Issued by financial institutions rather than own company (like with warrants) over wide range of products such as shares, commodities, FX rates - Non dilutive (like warrants) as use existing shares - 'Covered' means you must own the underlying asset - Premium paid is max loss, gain unlimited so leveraged - Typical lifespan is 6 months to 1 year

Answer 59

- Used for covertables that can only be converted at maturity: 1) Calculate future share price from current: = share price x (1+g)^n 2) Calculate future conversion value: = conversion ratio x future share price 3) If the future value is under £100, use £100 as the redemption value, otherwise if future value is over £100, use this. Calculate PV using annuity formula

Answer 60

- Assumes you will convert to shares with the dividend income will exceed the income from the convertible: 1) Find the conversion value today: = share price x conversion ratio 2) Calculate the basic dividend received on the shares: = dividend per share x conversion ratio 3) Calculate the future expected dividend for each period: = basic dividend x (1+g)^n 4) Calculate the difference between the coupon and future expected dividend for each period 5) Sum the PV of the positive differences 6) Add to today's conversion value

Answer 61

- Convertibles are priced as a vanilla bond with an embedded equity option - Option cannot be traded seperately as it is incorporated into the bond - Holder of convertible will either receive the nominal amount of the bond or the shares - Value of convertible is therefore value of conventional bond plus value of equity option - Equity option will be priced using a market model - If option is at maturity there is no time value, intrinsic value is difference between market price of shares and exercise price of the option

Answer 62

1. Advantages - Flexiblilty - can be customised in terms of size, date, quality, delivery point - Wide range of underlying assets - Available from most commericial banks 2. Disadvantages - Counterparty risk - risk one party may default as they are OTC so no clearing house - Cost - higher transaction costs due to bespoke nature - Liquidity - more difficult to sell on due to bespoke nature

Answer 63

- Type of forward contract which is an agreement to buy or sell an interest rate which is fixed today but starting in future, and which is revalued using benchmark rates (e.g. SONIA) - Benchmark rate is determined on first day of FRA period and then applies to maturity - Cash payment made on difference between agreed fixed rate and level of benchmark rate on agreed future date - Based on notional principal amount but this is not exchanged - Helps protect variable rate loans from interest rate rises - 3x6 FRA means rate that begins in 3 months and ends in 6 months - Net Settlement Amount = NP x ((BR-FRArate) x d/B) / (1 + (BR x d/b)) - FRArate = (r2n2 - r1n1) / nFRA (1+(r1n1/B))

Answer 64

- Agreement between counterparties to exchange the difference between the opening and closing price of an asset (index, stock commodity etc) - Allows investors to go short/long without owning the underlying asset but losses are unlimited - Cash settled - No upfront cost, as they are traded on margin (usually 30%), and no costs such as stamp duty or broker fees which you'd need to pay if purchasing the asset outright - No expiry (unlike options or futures), CFD rolls over till next trading day if required - Difference to spread bettting is no fixed maturity and profits are taxed (spread bettting are tax free as considered gambling)

Answer 65

- Right but not obligation to enter into an interest rate swap for a premium

Answer 66

- Packaged products based on derivatives which feature protection of capital if held to maturity but also participation in underlying asset - Can be listed or OTC - If listed, will be traded on LSE and settle T+3, with two way pricing provided by issuer - Normally created for specific high net worth clients to meet their exact needs but due to complex nature often unsuitable for unsophisticated retail investors - Advantages include: 1. Protection of initial capital investment whilst still providing exposure to an asset 2. Tax efficient access to fully taxable investments (i.e. no stamp duty) 3. Enhanced returns through leverage - less leveraged than prior to GFC, now more used for diversification 4. Reduced risk and volatility 5. Low correlation with other asset classess Disadvantages include: 1. May need to be held to maturity to secure gains 2. Can be complex with need for advisor to assess value for money 3. Credit risk of issuer 4. Liquidity 5. Often no income

Answer 67

- Started as guarenteed bonds in life offices but have since been developed with innovative combinations including terms like kick out plans - Listed structured products were developed due to need for greater flexibility so don't need to be held to maturity to realise gains

Answer 68

- Listed structured product terms are at discretion of issuing bank - They are held and settled in a CSD 1) Index Based Product Trackers - Replicates the performance of an underlying index - Usually long dated or undated - No leverage so price moves in proportion to underlying asset - No dividends paid and any income stream built into capital value - Can be currency hedged when tracker is on foreign index 2) Accelerated Trackers - Growth on the upside is leveraged to set value provided value of underlying is above initial value. - I.e. 200% accelerated tracker means if index is 10% above initial value at maturity, you receive back initial investment plus 200% - 1:1 relationship on the downside - To access this, investor sacrafices right to income stream 3) Reverse Tracker (a.k.a bear certificates) - Similar to standard tracker but pays out if index falls 4) Dual Index Products (a.k.a digitals) - Has two reference indicies rather than one - Pays out provided both indicies above predefined level 5) Discount Tracker - Tracks an index but is capped above a certain level so is cheaper 6) Capital Protected - Gain exposure to growth which is capped in exchange for capital protection 7) Structured Capital at Risk Products (SCARPS) - Similar to above as aim to return original investment, but have variable floors rather than fixed which are based on barriers so you can potentially lose all your investment 8) Kick out plans (a.k.a Autocalls) - Can mature on yearly anniversary before their maturity date if predefined conditions met such as index being above its starting level on the observation date - Would then pay out original capital plus accumulated growth

Chapter 7 - Derivatives Flashcards

(95 cards)