Derivatives

Question 1

Define Derivative

Answer 1

1. Financial Contract that derives its value from value of underlying investment.

Question 2

How can derivatives be traded?

Answer 2

1. Exchange Traded
2. Traded OTC - created and sold to customers

Question 3

Difference between OTC Derivatives and Exchange Traded Derivatives

Answer 3

1. OTC - tailored to suit client requirements
2. Exchange Traded - standardised terms

Question 4

What is a Future

Answer 4

1. An exchange-traded forward contract
2. Legally binding agreement to buy or sell asset at specified date, for specified price.
3. Buyers have ‘Long Position’ - hope for rise
4. Seller has ‘Short Position’ - hope for fall

Question 5

How does money change hands under Futures

Answer 5

1. Buyer and seller deposit initial margin with independent 3rd party - London Clearing House (LCH)
2. The initial margin is used to fulfil either side of the contract.

Question 6

What are options

Answer 6

1. Gives the buyer the right, but not obligation to buy or sell at specified price on specified date.
2. Fixed price called ‘Strike Price’ or ‘Exercise Price’

Question 7

What is a Call and Put option

Answer 7

1. Call option - right to buy the asset
2. Put option - right to sell asset

Question 8

How does money change hands under an option

Answer 8

1. The buyer pays the premium (cost of option plus additional commission)
2. The seller recieves this but pays commission and margin payments.
3. Initial Margin held by LCH.

Question 9

Choices under options

Answer 9

1. Exercise the option:
   
   • if can only be done at expiry - European-style option
   • if at any time - American-style Option
2. Sell Option before expiry
3. Let option expire worthless

Question 10

What are the two components of the value of options

Answer 10

1. Intrinsic Value:
   
   • call - if asset above strike price
   • put - if asset below strike price
2. Time Value:
   
   • Amount above intrinsic value investor is willing to pay
   • Depends on time to expiry

Question 11

Uses for Futures and options

Answer 11

1. Hedging a future purchase - buy futures or call options
2. Hedging a portfolio vs. a fall - sell futures or put options
3. Change Asset Allocation - sell the underlying assets or buy/sell futures
4. Speculation - if expecting a fall - sell long futures

Question 12

Risks of options

Answer 12

1. For Buyer - limited to premium paid
2. For seller - unlimited
3. Seller is ‘covered’ if they own the underlying stock

Question 13

How are Options Taxed

Answer 13

1. Call option exercised - cost of option is cost of purchase
2. Put option exercised - cost of option is allowable deduction from sales proceeds
3. IF expires worthless - disposal for CGT = capital loss