Derivatives

Question 1

Futures vs. Forwards

Answer 1

• Futures contracts are similar to forward contracts in that both:
  
  • Can be either deliverable or cash-settled contracts.
  • Have contract prices set so each side of the contract has a value of zero at the initiation of the contract.
• Futures contracts differ from forward contracts in the following ways:
  
  • Futures contracts trade on organized exchanges. Forwards are private contracts and typically do not trade.
  • Futures contracts are standardized. Forwards are customized contracts satisfying the specific needs of the parties involved.
  • A clearinghouse is the counterparty to all futures contracts. Forwards are contracts with the originating counterparty and, therefore, have counterparty (credit) risk.
  • The government regulates futures markets. Forward contracts are usually not regulated and do not trade in organized markets.

Question 2

Long Call

Short Call

Long Put

Short Put

Answer 2

• Long call: the buyer of a call option—has the right to buy an underlying asset. Long asset exposure.
• Short call: the writer (seller) of a call option—has the obligation to sell the underlying asset. Short asset exposure.
• Long put: the buyer of a put option—has the right to sell the underlying asset. Short asset exposure.
• Short put: the writer (seller) of a put option—has the obligation to buy the underlying asset. Long asset exposure.

Question 3

Risk-Neutral Pricing

Answer 3

With a long and short position in an asset and a replicating portfolio, the payoffs on this hedged portfolio are certain, so investor risk aversion does not affect the value of the hedged portfolio or the value of the derivative.

Risky Asset + Derivative Position = Risk Free Asset

Question 4

Forward Contract Value

Answer 4

Question 5

Option Premium

Answer 5

Option Premium = Intrinsic Value + Time Value

The buyer pays the writer a sum of money called the option premium, or just the “premium.”

• Intrinsic value of a call option = Max [0, S - X]
• Intrinsic value of a put option = Max [0, X - S]

Question 6

American vs. European Options

Answer 6

• American options allow the owner to exercise the option any time before or at expiration.
• European options can be exercised only at expiration.
• Value of American option will equal or exceed value of European option. They will have identical values except for:
  
  • call options on dividend paying stocks and
  • in-the-money put options.

Question 7

Factors that affect option value

Answer 7

Question 8

Put-call parity for European option

Answer 8

c + X / (1 + R_f)^T = S + p
That is, the value of a call at X and the present value of the exercise price must equal the current asset price plus the value of a put or there would be an opportunity for profitable arbitrage.

Question 9

Put-call forward parity

Answer 9

F₀(T) / (1 + R_f)^T + p₀ = c₀ + X / (1 + R_f)^T

Question 10

Value of long position and short position at expiration

Answer 10

• Long position = Spot price of underlying - forward price agreed in the contract
• Short position = Forward price agreed in the contract - Spot Rate of underlying

Question 11

REIT Revaluation Approaches

Answer 11

• Asset-based valuation: NAV / number of shares
• Income-based valuation: Income or cash flow / Capitalization rate
  
  • Measure cash flow
    
    • FFO: Net income adjusted for depreciation, gains / loses on asset sales
    • AFFO (similar to free cash flow): FFO - capital expenditures

Question 12

Intrinsic value

Answer 12

Intrinsic value is another term for exercise value.