Derivatives Exam 1-Book Notes

What ended the great moderation?

Great Recession of 2008.

The risk to an institution's financial condition resulting from adverse movements in the level or volatility of market prices. (such as price risk)

Market risk

A chance to make risk less profits with no investment.

arbitrage

What are financial assets?

include stocks, bonds, and currencies-both real and financial assets have tangible value.

The existence of arbitrage opportunity implies that markets are somehow ___________.

inefficient

Market Manipulation

• The law requires that to prove manipulation, the manipulator 1) must be shown to have the ability to set an artificial futures price, 2) must have intended to set an artificial price and 3) must have succeeded in setting such a price. • Bear Raid: take large short positions in a company's stock, spread unfavorable rumors that depress the stock further, and buy back those shares when the shareholders panic and unload their stock holdings at depressed prices. o Also extends to futures markets.

Floor trading abuses

• To protect customers, the Commodity Exchange Act and exchange rules ban fictitious trading. This is a broad category of transactions in which no bona fide, competitive, open-outcry trade takes place. The following floor-trading practices violate the CEA. o Accommodation trades allow others to benefit at the expense of a floor broker's customer Busting or undoing a customer's already executed order to help another customer. Cuffing trades by delayed filling of a customer's order to benefit another trader. o Bucketing happens when a broker directly or indirectly takes the opposite side of a customer's trade without an open and competitive execution of the order on an exchange o Cross trading is an offsetting or noncompetitive match of the buy order of one customer against the sell order of another. o Curb (Kerb) trading takes place by telephone or by other means after the official market has closed. o Ginzy trading happens when a floor broker, in executing an order, fills a portion of the order at one price and the remainder at another price to avoid the exchange's rule against trading at fractional increments or "split ticks." o Prearranged trading takes place when two brokers agree on a price beforehand. o A wash sale is a sell and buy transaction for the same commodity initiated without the intent to make a bona fide transaction.

If you subtract a portfolio with a payoff of x from another portfolio with a payoff of x, the value of the new portfolio is zero for sure on the maturity date. It also has a value of zero today.

"Nothing comes from nothing comes from nothing"

Algorithmic trading represents ______% of all equity volume.

60

When did derivatives become popular?

70's and 80's when corporations wanted to hedge risk.

When a finance academic states that "markets are efficient" she means an informationally efficient market. What is that?

A market where asset prices quickly absorb and "fully" reflect all relevant information.

Derivatives trade in zero net supply markets, which mean what?

Buyer has a matching seller

Currencies are now floating with one another, although their values are frequently managed by __________.

Central Banks • More volatile than fixed exchange rates. • Huge foreign exchange derivatives market was created to hedge the new risk. o International Monetary Market opened in 1972.

The risk that a counter party will fail to perform on an obligation.

Credit Risk

A typical company faces what 3 types of risks?

Currency risk, interest rate risk, and commodity price risk.

A financial contract that derives its value from an underlying asset's price, such as a stock or commodity, even from an underlying financial index like an interest rate.

Derivative Derivatives can both reduce risk (hedge) and magnify risk.

What were one of the causes of the Great Recession?

Derivatives

What is SE?

Difference between assets and liabilities

Efficient markets Hypothesis is presented with respect to three different information sets.

Efficient markets hypothesis is presented with respect to three different information sets. 1. Weak-Form Efficiency: Assets that stock prices reflect all relevant information that can be gathered by examining current and past prices. a. Technical analysis will not generate returns in excess of the risk involved. b. If the market is weak-form efficient, there are no arbitrage opportunities. 2. Semi strong-for Efficiency: assets that stock prices reflect not only historical price information but also all publicly available information relevant to those stocks. a. Fundamental analysis involves reading accounting and financial information about a company to determine whether a share price is overvalued or undervalued. If strong -form efficiency holds, fundamental analysis would be out of business. 3. Strong-Form Efficiency: assets that stock prices reflect all relevant information, both public and private, that may be known to any market participant a. If this is true, even insiders will not make trading profits in excess of the risk involved.

From the Mid 1940's to the early 1970's, the world economy operated under the Bretton Woods system. What type of exchange rates were used under this?

Fixed- all currencies begged to the dollar. • Problems arose when gold prices soared. Counties converted their currencies into dollars and bought cheap gold from the United States, making huge profits. o This was considered arbitrage: a trade that makes riskless profits with no investments. • U.S. gold reserves suffered a terrible decline. • Richard Nixon abandoned the Bretton Woods in 1971.

The Chicago Board of Trade developed the first interest rate derivative contract in 1975. What was it called?

Ginnie Mae Futures

Many Economists believed that a new era of greater macroeconomic stability had dwned, dubbed the __________ _________.

Great Moderation • In the two decades before the new millennium, fluctuations in the growth of real output and inflation had declined, stock market volatility was reduced, and business cycles were tamed. o Ben Bernanke was a prominent supporter of this view.

What are notional variables?

Include interest rates, inflation rates, and security index, which exist as notions rather than as tangible assets.

How have markets changed to accommodate derivatives trading?

Introduction of new contracts and new exchanges Consolidation and linking of exchanges The Introduction of computer technology

The idea that the same payoffs no matter how they are created, trade at the same price.

Law of one price

The risk that contracts are not legally enforceable or documented correctly.

Legal Risk

This risk can be two types: one related to specific products or markets and the other related to the general funding of the institution's derivative activities.

Liquidity Risk

Nobel Laureate __________ argued in 1986 that regulations and taxes cause financial innovation.

Merton Miller Ronald Coase said that the desire to lower transactions costs also influences financial innovation. "Trading moves to those markets where transaction costs and regulatory constraints are minimized."

________________ have more restricted investment policies and lower management fees than hedge funds.

Mutual Funds

The risk that deficiencies in information systems or internal controls will result in unexpected loss.

Operational Risk

In 1997, Robert Merton and Myron Scholes won the nobel prize for developing the Black-Scholes-Merton (BSM) model for _____________.

Option valuation has a number of restrictive assumptions. These restrictive assumptions limit the application of the model to particular derivatives, those for which interest rate risk is not relevant.

Mathematical formulas that price derivatives in terms of related securities.

Pricing models

What factores have fueled the growth of derivatives markets?

These include regulatory reforms, an increase in international commerce, population growth, political changes, the integration of the world's economy, and revolutionary strides in information technology (IT).

Modern portfolio theory encourages investors to construct a portfolio in a ____________ fashion.

Top Down 1. Do an asset allocation: which means deciding how to spread your investment across broad asset classes such as bonds and stocks. 2. Do security selection: which means deciding which securities to hold within each asset class. 3. Periodically revisiting these issues and rebalancing the portfolio accordingly.

T/F. Derivatives were unimportant during the 60's

True

T/F. In the absence of arbitrage, all portfolios or securities.

True

T/F. It is hard to hedge operations risk.

True

T/F. Shares in most closed-end funds trade at a discount from their asset value. This represents potential arbitrage.

True

Most US commodity exchanges operate under a free crowd system. What is this?

Where floor members simultaneously bid and offer their own or customer accounts. • By contrast, the NYSE operates under a specialist system that allows dual trading. • Front running: trading based on an impending transaction by another person. (type of abuse)

______ end mutual fund share prices are often claimed to represent arbitrage opportunities

closed end

What are real assets?

include land, buildings, machines, and commodities

What are the 3 different types of arbitrage opportunities?

mispricing across space, mispricing across time, when the sum of the parts' prices differ from the price of the whole.

If markets are weak-form efficient, do arbitrage opportunities exist?

no

Portfolio risk is measured by what?

the portfolio return's standard deviation.

Derivatives help to what?

• Advance or postpone cash flows (borrowing and lending) • Accumulate wealth (saving) • Protect against unfavorable outcome (insurance or hedging) • Commit funds to earn a financial return (investment) • Accept high risks in the hope of big returns (speculation or gambling) o Goes along with magnifying the scale of one's financial returns (leverage)

Subsequent researchers have relaxed these restrictive assumptions and developed pricing models suitable for derivatives with ________ interest rate risk.

• Standard model used is the Heath-Jarrow-Morton (HJM) model. Can be used to price interest rate derivatives, long lived financial contracts, and credit derivatives. o Credit derivatives now compose a huge market.