Derivatives

Question 1

Derivative Markets: Derivatives

Answer 1

• A derivative security derives its value from the price of another (underlying) asset or an interest rate
• Futures and some options are traded on organized exhanges
• Forward contracts, swaps, and some options are custom instruments created by dealers

Question 2

Derivative Markets: Forward Commitments and Contingent Claims

Answer 2

Question 3

Derivative Markets: Forward Contracts

Answer 3

• Customized: No active secondary market
• Lond obligated to buy; short obligated to sell
• Specified asset (currency, stock, index, bond)
• Specified date in the future
• Long gains if asset price is above forward price
• Short gains if asset price is below forward price

Question 4

Derivative Markets: Futures Contracts

Answer 4

• Like forward constract but standardized
• Exchange-traded, active secondary market
• Require margin deposit
• No defauly (counterparty) risk

Question 5

Derivative Markets: Swaps

Answer 5

• Equivalent to a series of forward constracts
• Simple interest rate swap
• One party pays a fized rate of interest
• One party pays a variable (floating) rate of interest
• Payments can be based on interest rates or stock/portfolio/index returns
• Can involve 2 different currencies

Question 6

Derivative Markets: Purpose and Criticism of Derivative

Answer 6

• Derivatives are criticized as being risky and likened to gambling
• Benefits of derivatives markets
  
  • Provide price information
  • Lower transaction costs
  • Allow the transfer of risk

Question 7

Derivative Markets: Role of Arbitrage

Answer 7

• Arbitrage is possible when two securities or portfolio have identical future payoffs but different marker prices
• Trading by arbitrageurs will continue until they affect supply and demand enough to bring asset price to efficient (no-arbitrage) levels
• Arbitrage relations are used to value derivatives

Question 8

Forwards: Forward Contract Positions

Answer 8

Long position_ (will buy)_

The party to the forward constract that agreees to buy the underlying or physical asset

Short position_ (will sell)_

The party to the forward contract that agrees to sell/deliver the asset

Neither party pays at contract initiation

Question 9

Forwards: Forward Contract Settlement

Answer 9

• Delivery: Short delivers underlying to long for payment of the forward price
• Cash settlement: Negative side of contract pays the positive side

Question 10

Forwards: Early Termination of Forward

Answer 10

1. One party pays the other cash (buys their way out)
2. Enter into an offsetting contract
   
   • With a different coutnerparty (Default risk still exists)
   • With same (origianl) counterparty (no default risk)

Question 11

Forwards: Dealers and End Users of Forwards

Answer 11

• A dealer creates a derivative contract and will quote a price to take a long or short position
• An end user is typically a corporation or institution seeking to transfer an existing risk

Question 12

Forwards: Equity Forward Contracts

Answer 12

Question 13

Forwards: Equity Index Forward - Problem

Answer 13

Question 14

Forwards: Forward on Zero-Coupon Bonds - Example

Answer 14

Question 15

Forwards: LIBOR-Based Loan Example

Answer 15

Question 16

Forwards: FRA

Answer 16

Forward Rate Agreement (FRA)

Exchange fixed-rate for floating-rate payment

• Notional amount
• Fixed rate = forward (contract) rate
• Floating rate (LIBOR) is underlying rate
• Long gains when LIBOR > contract rate

Long position can be viewed as the obligation to take a (hypothetical) loan at the contract rate(i.e. borrow at the fized rate); gains when reference rate increases

Short position can be views as the obligation to make a (hypothetical) loan at the contract rate (i.e. lend at the contract rate; gains when reference rate decreases

Question 17

Forwards: FRA - Example

Answer 17

Question 18

Forwards: FRA Settlement Payment to Long

Answer 18

Question 19

Forwards: Currency Forward Contracts

Answer 19

• Currency forward contracts are committment to buy or sell a certain amount of a foreign currency for a fixed amount of another currency in the future
• As with other forwards, cash settlements is the amount necessary to compensate the party who would be disadvantaged by the actual change in market rate as of the settlement date

Question 20

Futures: Chacteristics

Answer 20

Question 21

Futures: Forwards vs. Futures

Answer 21

Question 22

Futures: Margin Terms

Answer 22

Question 23

Futures: Trade - Example

Answer 23

Question 24

Futures: Price Limits

Answer 24

Question 25

Futures: Marking-to-Market

Answer 25

Question 26

Futures: Margin Calculation Example

Answer 26

Question 27

Futures: Methods to Terminate a Futures Position at Expiration

Answer 27

Question 28

Futures: Closing a Futures Trade by Offset

Answer 28

Question 29

Futures: Contract Delivery Options

Answer 29

Question 30

Futures: Eurodollar Futures

Answer 30

Question 31

Futures: Treasury Bond Futures

Answer 31

Question 32

Futures: Stock Index Futures

Answer 32

Question 33

Futures: Currency Futures

Answer 33

Question 34

Options: Basics

Answer 34

Question 35

Options: Terminology

Answer 35

Question 36

Options: Moneyness

Answer 36

Question 37

Options: Call Option - Example

Answer 37

Question 38

Options: Put Option - Example

Answer 38

Question 39

Options: Exchange-Traded vs. OTC Options

Answer 39

Question 40

Options: Underlying Assets

Answer 40

Question 41

Options: Interest Rate Options

Answer 41

Question 42

Options: Two Interest Rate Option = One FRA - Graph

Answer 42

Question 43

Options: Interest Rate Caps and Floors

Answer 43

Question 44

Options: Cap and Floor Payoffs

Answer 44

Question 45

Options: Interest Rate Option - Problem

Answer 45

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Question 46

Options: Value

Answer 46

Question 47

Options: Notation

Answer 47

Question 48

Options: Minimum and Maximum Values

Answer 48

Question 49

Options: Differ by Exercise Price

Answer 49

Question 50

Options: Deriving Put-Call Parity (European Options)

Answer 50

Question 51

Options: Parity Conditions and Synthetic Options

Answer 51

Question 52

Options: Put-Call Parity - Problem

Answer 52

Question 53

Options: Time, Volatility, RFR, and Stock Price

Answer 53

Question 54

Options: Cash Flows on the Underlying Asset

Answer 54

Question 55

Swaps: Overview

Answer 55

Question 56

Swaps: Characteristics

Answer 56

Question 57

Swaps: Terminology

Answer 57

Question 58

Swaps: Termination

Answer 58

Question 59

Swaps: Currency Swaps - Example

Answer 59

Question 60

Swaps: Plain Vanilla Interest Rate Swap

Answer 60

Question 61

Swaps: Plain Vanilla Interest Rate Swap - Formula

Answer 61

Question 62

Swaps: Fixed-for-Floating Swap Example

Answer 62

Question 63

Swaps: Equity Swaps

Answer 63

Question 64

Swaps: Equity Swaps - Example

Answer 64

Question 65

Swaps: Equity Swaps - Problem

Answer 65

Question 66

Risk Management: Call Intrinsic Value/Payoff at Expiration

Answer 66

Question 67

Risk Management: Profit and Loss: Call Options

Answer 67

Question 68

Risk Management: Put Intrinsic Value/Payoff at Expiration

Answer 68

Question 69

Risk Management: Profit and Loss: Put Options

Answer 69

Question 70

Risk Management: Call Profit and Loss - Problem

Answer 70

Question 71

Risk Management: Covered Call Strategy

Answer 71

Question 72

Risk Management: Covered Call - Problem

Answer 72

Question 73

Risk Management: Payoffs and Profits - Covered Call

Answer 73

Question 74

Risk Management: Protective Put Strategy (Position)

Answer 74

Question 75

Risk Management: Protective Put - Example

Answer 75

Question 76

Risk Management: Profit and Payoff - Protective Put

Answer 76