Forwards, Futures and Options

What is a clearing house?

A clearinghouse or clearing division is an intermediary between a buyer and a seller in a financial market. In acting as the middleman, the clearinghouse provides the security and efficiency that is integral for financial market stability. To mitigate default risk in futures trading, clearinghouses impose margin requirements.

What is a futures contract?

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future.

Why is a call option riskier than the stock itself?

Because a call option is equivalent to a levered position in the stock. Built into the price of every option is a time premium. As time passes, that premium diminishes.To make big money in puts or calls, the stock doesn't just need to move in the right direction. It needs to make a sharp move in the right direction in a short period of time.

What is the difference between futures and forwards?

Both forward and futures contracts involve the agreement between two parties to buy and sell an asset at a specified price by a certain date. A forward contract is a private and customizable agreement that settles at the end of the agreement and is traded over-the-counter. A futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.

If a put is not available - how can you get the same payoff?

Buy calls, put cash in the bank and sell shares.

American option price vs European Option Price

Counterparts should be the same price

Diversification vs Hedging

Diversification = done by range of assets to lower correlation Hedging = kind of diversification, but for pre specified assets

What is a forward?

Essentially a tailormade futures contract.

In the Money

Excercise price of a call option is below the current asset or price of put option is above the current assett

Out the money

Exercise price of the call option is above the current asset price. Put option is below the current asset price.

What is a forwards contract?

Fixed price of an asset, knowing exactly how much it will costs and you will receive in the future. contract between two parties to buy or sell an asset at a specified price on a future date

Futures Price Formula

Ft = S0( 1 +rf - y )^t S0 = spot price rf = risk free rate y = dividend yield or interest rate

What is basis risk?

Futures price - spot price Changes during the life of a futures contract

What is a european option?

Gives the holder the right but not the obligation to buy or sell a specified quantity of underlying asset at a fixed price and date. Holder has to pay a premium to the write or the option when entering contract

What is hedging?

Hedging is a financial strategy designed to reduce risk by balancing a position in the market. For example, an investor that owns a stock could hedge the risk of the stock going down by buying put options on that security or other related businesses in the industry.

What are the two types of Margins?

Initial Margin - to cover changes in futures prices Maintenance margin - defines a level at whcih a margin call is issued

What is a straddle position?

Long Call and a Long Put at the same at the money exercise price. A straddle is a neutral options strategy that involves simultaneously buying both a put option and a call option for the underlying security with the same strike price and the same expiration date. Starts negative because of the cost of premium.

How does maturity affect price of an option?

Longer the maturity, the higher the price. because the longer you have to deide to buy.

Forwards vs Options

Options protect you against adverse price movemen of the underlying asset in the same way a forwards contract does, but also allows for poential gains if market moves in favour.

Put-Call formula without dividends

Price is less without dividends

Pricing of forward/future

Price of forward/future = best estimate of future price

What is a call option?

Right to buy

What is a put option?

Right to sell

Price of Futures Ft

S0 = spot price rf = risk free interest rate y = dividend yeild or interest rate

How to hedge when short of cash?

Sell an option - because wont be able to afford the premium of buying an option

What is the difference between a short call and a long put?

Short Call = You sell someone the right but not the obligation to purchase at a later date. Long Put = You buy the right to sell at a later date.

Time value for Forwards/Futures

To compensate for the expected loss in time value, futures prices should be below forward prices in order to reduce the total payment stream.

What is the Black Scholes formula?

Value of Call Option = (delta * Share price) - bank loan

What is the fundamental relationship for European Options

Value of call + Present value of exercise price = Value of Put + Share Price Also the put-call parity

What is basis risk?

When two sides of the hedge do not move exactly together

What is exercise/strike price?

smount for which the underlying asset can be bough (call) or sold (put)

What is a margin call?

a demand by a broker that an investor deposit further cash or securities to cover possible losses.

What is an american option?

An option that can be exercised before the expiration date.

Closing a futures contract before maturity

1. Close down the futures position before maturity o the futures - realise gain or loss from the change in the futures price 2. Cover the underlying transaction on a sport market (at the current spot price) No basis risk = any increase or decrease in the spot price is exactly offset by a gain (loss) from the futures Basis Risk = Gain from the futures might be insufficient to offset the spot price increase

What is a long position?

A long—or a long position—refers to the purchase of an asset with the expectation it will increase in value—a bullish attitude.

What is a short position?

A short position refers to a trading technique in which an investor sells a security with plans to buy it later

What is a Strangle Position?

A strangle is an options strategy in which the investor holds a position in both a call and a put option with different strike prices, but with the same expiration date and underlying asset. A strangle is a good strategy if you think the underlying security will experience a large price movement in the near future but are unsure of the direction. Buying options out the money will make them cheaper. e.g. before the quarterly results

What is marking-to-the-market?

Marking-to-the-market refers to adjusting the contract price to the current market price of an open contract for purposes of determining if additional cash is required Mark to market can present a more accurate figure for the current value of a company's assets, based on what the company might receive in exchange for the asset under current market conditions. However, during unfavorable or volatile times, MTM may not accurately represent an asset's true value in an orderly market.

What factors affect option premia?

The main factors affecting an option's price are the underlying security's price, moneyness, useful life of the option and implied volatility. As the price of the underlying security changes, the option premium changes. As the underlying security's price increases, the premium of a call option increases, but the premium of a put option decreases. The moneyness affects the option's premium because it indicates how far away the underlying security price is from the specified strike price

What is the intrinsic value?

The payoff that would be received from the option if the underlying asset was at its current price when the option expires

What is a Butterfly Spread?

These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration. Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.

At the money

gives zero cash cash flow if exercised immediately

What is speculation?

investment in stocks, property, etc. in the hope of gain but with the risk of loss