DERIVATIVE MARKETS AND INSTRUMENTS

The cornerstones of the exchange-traded derivatives market are the ______________ and the ____________.

1. Market Makers (or Dealers) 2. Speculators

Derivates can also be classified according to the ______________ of contract. Which of the 5 types of derivatives are forward commitment? Which are contingent claim?

1. Nature 2. Future, Forwards, and Swaps 3. Options (primary) and Credit Derivatives

In some cases for Forward Contracts, the delivery of the asset is not necessary, except they just exchange cash. These contracts are called?

1. Non-Deliverable Forwards (NDFs) or 2. Cash-Settled Forwards or 3. Contracts For Differences

Derivatives exchanges clear and settle all contracts ____________, whereas most securities exchanges require ______________.

1. Overnight 2. Two business days

To standardize a derivative contract means that its terms and conditions are __________________ by the exchange and there is ___________ ability to alter those terms.

1. Precisely specified 2. Very Limited

In Forward Contracts, ________ is the spot price at time=0 and _______ is the spot price at t=T. What is the notation for forward price?

1. S_0 2. S_T (unknown) 3. F_0(T) - this value is established at t=0 and applies to contract expiring at time=T

__________________ means a loss of flexibility: A participant can do only the transactions that are permitted on the exchange. _______________ means a loss of both privacy and flexibility.

1. Standardization 2. Regulation

Exchange-Traded derivatives are ______________, whereas OTC derivatives are _____________.

1. Standardized 2. Customized

The clearing and settlement process of an exchange-traded derivatives market: A. provides a credit guarantee. B. provides transparency and flexibility. C. takes longer than that of most securities exchanges.

A.

A futures contract is best described as a contract that is: A. standardized. B. subject to credit risk. C. marked to market throughout the trading day.

A. A futures contract is a standardized derivative contract. B is incorrect because through its clearinghouse the futures exchange provides a credit guarantee that it will make up a loss in the event a losing party cannot pay. C is incorrect because a futures contract is marked to market at the end of each day, a process in which the futures clearinghouse determines an average of the final futures trade of the day and designates that price as the settlement price.

A characteristic of forward commitments is that they: A. provide linear payoffs. B. do not depend on the outcome or payoff of an underlying asset. C. provide one party the right to engage in future transactions on terms agreed on in advance.

A. Because forward commitments provide linear payoffs.

Which of the following statements about derivatives is not true? A. They are created in the spot market. B. They are used in the practice of risk management. C. They take their values from the value of something else.

A. Derivatives are used to practice risk management and they take (derive) their values from the value of something else, the underlying. They are not created in the spot market, which is where the underlying trades.

Which of the following statements explains a characteristic of futures price limits? Price limits: A. help the clearinghouse manage its credit exposure. B. can typically be expanded intra-day by willing traders. C. establish a band around the final trade of the previous day.

A. Price limits are important in helping the clearinghouse manage its credit exposure. Sharply moving prices make it more difficult for the clearinghouse to collect from parties losing money. B is incorrect because typically the exchange rules allow for an expansion of price limits the next day (not intra-day) if traders are willing. C is incorrect because price limits establish a band relative to the previous day's settlement price (not final trade).

Which of the following statements describes an aspect of margin accounts for futures? A. The maintenance margin is always less than the initial margin. B. The initial margin required is typically at least 10% of the futures price. C. A margin call requires a deposit sufficient to raise the account balance to the maintenance margin.

A. The maintenance margin is always significantly lower than the initial margin. B is incorrect because the initial margin required is typically at most (not at least) 10% of the futures price. C is incorrect because a margin call requires a deposit large enough to bring the balance up to the initial (not maintenance) margin.

In contrast to contingent claims, forward contracts: A. have their prices chosen by the participants. B. could end in default by either party. C. can be exercised by physical or cash delivery.

B In a forward contract, either party could default, whereas in a contingent claim, default is possible only from the short to the long. A is incorrect because the forward price is set in the pricing of the contract such that the starting contract value is zero, unlike contingent claims, under which parties can select any starting value. C is incorrect because both forward contracts and contingent claims can be settled by either physical or cash delivery.

Which of the following statements most accurately describes exchange-traded derivatives relative to over-the-counter derivatives? Exchange-traded derivatives are more likely to have: A. greater credit risk. B. standardized contract terms. C. greater risk management uses.

B.

Compared with exchange-traded derivatives, over-the-counter derivatives would most likely be described as: A. standardized. B. less transparent. C. more transparent.

B. Over-the counter-derivatives markets are customized and mostly unregulated. As a result, over-the-counter markets are less transparent in comparison with the high degree of transparency and standardization associated with exchange-traded derivative markets.

Exchange-traded derivatives are: A. largely unregulated. B. traded through an informal network. C. guaranteed by a clearinghouse against default.

C.

Which of the following characteristics is not associated with exchange-traded derivatives? A. Margin or performance bonds are required. B. The exchange guarantees all payments in the event of default. C. All terms except the price are customized to the parties' individual needs.

C. Exchange-traded contracts are standardized, meaning that the exchange determines the terms of the contract except the price. The exchange guarantees against default and requires margins or performance bonds.

Which of the following statements regarding the settlement of forward contracts is correct? A. Contract settlement by cash has different economic effects from those of a settlement by delivery. B. Non-deliverable forwards and contracts for differences have distinct settlement procedures. C. At cash settlement, when the long party acquires the asset in the market, it effectively pays the forward price.

C. In the case of cash settlement, the long can acquire the asset, effectively paying the forward price, F0(T). Cash paid is F0(T) - S_T So if you want to buy S_T, it's S_T - (S_T - F_0(T)) or otherwise written as S_T - (amount paid in cash)

Market makers earn a profit in both exchange and over-the-counter derivatives markets by: A. charging a commission on each trade. B. a combination of commissions and markups. C. buying at one price, selling at a higher price, and hedging any risk.

C. Market makers buy at one price (the bid), sell at a higher price (the ask), and hedge whatever risk they otherwise assume. Market makers do not charge a commission. Hence, A and B are both incorrect.

Which of the following characteristics is associated with over-the-counter derivatives? A. Trading occurs in a central location. B. They are more regulated than exchange-listed derivatives. C. They are less transparent than exchange-listed derivatives.

C. OTC derivatives have a lower degree of transparency than exchange-listed derivatives. Trading does not occur in a central location but, rather, is quite dispersed. Although new national securities laws are tightening the regulation of OTC derivatives, the degree of regulation is less than that of exchange-listed derivatives.

Which of the following factors is shared by forwards and futures contracts? A. Timing of profits B. Flexible settlement arrangements C. Nearly equivalent profits by expiration

C. Comparing the derivatives, forward and futures contracts have nearly equivalent profits by the time of expiration of the forward. A is incorrect because the timing of profits for a futures contract is different from that of forwards. Forwards realize the full amount at expiration, whereas futures contracts realize their profit in parts on a day-to-day basis. B is incorrect because the settlement arrangements for the forwards can be agreed on at initiation and written in the contract based on the desires of the engaged parties. However, in the case of a futures contract, the exchange (not the engaged parties) specifies whether physical delivery or cash settlement applies.

Which of the following is the best example of a derivative? A. A global equity mutual fund B. A non-callable government bond C. A contract to purchase Apple Computer at a fixed price

C. Mutual funds and government bonds are not derivatives. A government bond is a fundamental asset on which derivatives might be created, but it is not a derivative itself. A mutual fund can technically meet the definition of a derivative, but as noted in the reading, derivatives transform the value of a payoff of an underlying asset. Mutual funds merely pass those payoffs through to their holders.

In standardization: _____________ refers to the process by which the exchange verifies the execution of a transaction and records the participants' identities.

Clearing

Derivatives can be created and traded over a central exchange (exchange-traded) or over-the-counter. Which of the 5 types are exchange-traded? Which of the 5 types are over-the-counter?

Exchange-Traded 1. Options 2. Credit Derivatives 3. Futures OTC 1. Forwards 2. Swaps

Most of the dealer banks associated with OTC Derivatives Markets are members of a group called the?

International Swaps and Derivatives Association (ISDA)

Derivatives, in and of themselves, are characterized by a relatively high degree of ______________, meaning that participants in derivatives transactions usually have to invest only a small amount of their own capital relative to the value of the underlying. As such, small movements in the underlying can lead to fairly large movements in the amount of money made or lost on the derivative.

Leverage

The standardization of contracts facilitates the creation of a more ___________ market.

Liquid

Derivatives ______________ the performance of the underlying asset before paying it out in the derivatives transaction.

Transform

Underlying assets such as equity, fixed-income, currency, and commodity markets are said to trade in ______________ markets or ____________ markets. And their prices are sometimes referred to as? Though we usually just refer to them as?

1. Cash 2. Spot 3. Cash Prices or Spot Prices 4. Stock Prices, Bond Prices, Exchange Rates, and Commodity Prices

The clearinghouse is able to provide this credit guarantee by requiring a _____________, usually called the ______________ or _____________, from the participants to the contract.

1. Cash Deposit 2. Margin Bond 3. Performance Bond

For OTC, the participants are traded by dealers in a market with no _______________. The dealer marries the interested parties into a ______________ contract with a _________________. This exposes both parties to ____________ risk. Are OTC derivates regulated or unregulated?

1. Central Location 2. Custom-Negotiated 3. Counterparty 4. Default 5. Unregulated

For exchange-traded, the participants trade over a central exchange backed by a ________________. The commitments are ______________ contracts managed by the (1). Are exchange traded derivates regulated or unregulated?

1. Clearinghouse 2. Standardized 3. Regulated

Derivatives exchanges use their _______________ to provide a guarantee to the winning party that if the loser does not pay, the (1) will pay the winning party.

1. Clearinghouses

The backbone of OTC Derivatives markets is the set of _______________, which are typically? That's why sometimes these markets are also known as?

1. Dealers 2. Banks 3. Dealer Markets

In Forward Contracts, the long (buyer) is required to pay __________, for which he receives an asset worth __________. Explain.

1. F_0(T) 2. S_T 3. If S_T > F_0(T), this worked out in the long (buyers) favor. The difference between these two is the value of the contract.

Futures contracts are specialized versions of ____________ contracts that have been ________________ and that trade on a futures exchange.

1. Forward 2. Standardized

_______________ obligate the parties to engage in a transaction at a future date on terms agreed upon in advance, whereas ______________ provide one party the right but not the obligation to engage in a future transaction on terms agreed upon in advance.

1. Forward Commitments 2. Contingent Claims

In _______________, contracts entered into at one point in time that require both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start. The parties establish the identity and quantity of the underlying, the manner in which the contract will be executed or settled when it expires, and the fixed price at which the underlying will be exchanged. This fixed price is called the _________________.

1. Forward Commitments 2. Forward Price.

What are the five types of derivatives discussed for CFA Level I

1. Forwards 2. Futures 3. Swaps 4. Options 5. Credit Derivatives

The market makers stand ready to buy at one price and sell at a _____________ price. With standardization of terms and an active market, market makers are often able to buy and sell almost simultaneously at different prices, locking in small, short-term profits—a process commonly known as ____________. In some cases, however, they are unable to do so, thereby forcing them to either hold exposed positions or find other parties with whom they can trade and thus lay off (get rid of) the risk. This is when ______________ come in.

1. Higher 2. Scalping 3. Speculators

For OTC Derivatives Markets, the dealers _____________ agree to buy or sell various derivatives. Why?

1. Informally 2. Dealer is not obligated to do so

The buyer of a derivative is referred to as the? The seller is referred to as the?

1. Long or Holder 2. Short

OTC derivative markets operate at a _________ degree of ___________ and oversight than do exchange-traded derivative markets

1. Low 2. Regulation

The payout for the long is? short is?

1. S_T - F_0(T) 2. F_0(T) - S_T

Exchange markets are said to have _________________, which means that full information on all transactions is disclosed to exchanges and regulatory bodies.

1. Transparency

The long and short in a forward contract are involved in a _______________ game, which means?

1. Zero-Sum Game 2. That one's gains are the other's losses Although there are some transaction costs, they are minimal and can usually be ignored

A beneficial opportunity created by the derivatives market is the ability to: A. adjust risk exposures to desired levels. B. generate returns proportional to movements in the underlying. C. simultaneously take long positions in multiple highly liquid fixed-income securities.

A.

Which of the following statements best describes the payoff from a forward contract? A. The buyer has more to gain going long than the seller has to lose going short. B. The buyer profits if the price of the underlying at expiration exceeds the forward price. C. The gains from owning the underlying versus owning the forward contract are equivalent.

B.

Which of the following is not a characteristic of a derivative? A. An underlying B. A low degree of leverage C. Two parties—a buyer and a seller

B. All derivatives have an underlying and must have a buyer and a seller. More importantly, derivatives have high degrees of leverage, not low degrees of leverage.

Derivatives are similar to insurance in that both: A. have an indefinite life span. B. allow for the transfer of risk from one party to another. C. allow for the transformation of the underlying risk itself.

B. Insurance is a financial contract that provides protection against loss. The party bearing the risk purchases an insurance policy, which transfers the risk to the other party, the insurer, for a specified period of time. The risk itself does not change, but the party bearing it does. Derivatives allow for this same type of risk transfer.

Which of the following statements best portrays the full implementation of post-financial-crisis regulations in the OTC derivatives market? A. Transactions are no longer private. B. Most transactions need to be reported to regulators. C. All transactions must be cleared through central clearing agencies.

B. although under full implementation of new regulations a number of OTC transactions have to be cleared through central clearing agencies, there are exemptions that cover a significant percentage of derivative transactions.

A derivative is best described as a financial instrument that derives its performance by: A. passing through the returns of the underlying. B. replicating the performance of the underlying. C. transforming the performance of the underlying.

C.

The exchange-traded variant of forward contracts (which are OTC contracts) are?

Future Contracts (or just Futures)

In future contracts, the agreed upon price is known as the?

Futures Price

______________ liquidity means little trading interest and a high level of uncertainty (bid and ask price are far apart).

Low

Are forward contract assets or liabilities?

Neither

Are OTC instruments in derivative markets standardized? So this means that in Exchange-Traded, you can almost simultaneously buy low and sell high. Not in OTC.

No

In forward contracts, is money exchanged at the start of the contract?

No

Are mutual funds and exchange-traded funds considered derivatives? Why or why not?

No, they simply pass through the returns of their underlying securities while derivatives "transform" the perforamnce of the underlying asset before paying it out in the derivatives transaction.

Financial expert uses derivatives to manage?

Risk

In standardization: _______________ refers to the related process in which the exchange transfers money from one participant to the other or from a participant to the exchange or vice versa.

Settlement

The value of the underlying asset of a derivative is the ___________ of risk.

Source

Although defaults can occur in forward contracts, only one party can default on the other? Which party?

The one who owes more can default, the other party can not default

How are derivatives similar to insurance?

They both allow for the transfer of risk from one party to another They both have a definite life span and expire on a specified date

There are two parties of a derivate: the buyer and the seller. The seller is sometimes also known as the?

Writer

What is the value of a forward contract at the start?

Zero