Derivatives Markets and Instruments

What is the law of one price?

2 securities or portfolios that have identical cash flows in the future should have the same price

What is an OTC market?

A dealer market with no central location

What is futures contract?

A forward contract that is standardized and exchange-traded

What is an American option?

Can be exercised at any time up to and including the contract's expiration date

What is a European option?

Can be exercised only on the contract's expiration date

What are 2 other names for cash-settled forwards?

Contracts for differences or non-deliverable forwards (NDFs)

What are price limits?

Exchange-imposed limits on futures on how each day's settlement price can change from the pervious day's settlement price

What is an option?

Gives it owner the right to either buy or sell an underlying asset at a given price

What is a call option?

Gives its owner the right but not the obligation to buy an underlying asset at a given price for a specified time period

What is a put option

Gives its owner the right to sell an underlying asset at a given price for a specified time period

What is the purpose of a clearinghouse?

Guarantees traders in the futures market rill honor their obligations by splitting each trade once its made and acting as the counterparty for each position (long/short)

What is a credit default swap?

Insurance against default where the bond holder pays a series of cash flows to a credit protection seller and receives a payment of the issuer defaults

Define limit move, limit up, and limit down

Limit move - when trades take place at/above/below the limit Limit up - price reaches the upper limit Limit down - price reaches lower limit

How many payments are made at each settlement date?

One (netted) payment

What is a forward contract?

One party agrees to buy and another counterparty to sell a physical or financial asset at a specific price on a specific date in the future

What is a plain vanilla interest rate swap?

One party makes fixed payments on a notional principal amount in return for floating rate payments from another party

What are cash-settled forward contracts?

One party pays cash to the other when the contract expires based on the difference between the forward price and the market price of the underlying asset (spot price) at the settlement date

What is a deliverable forward contract?

One that is settled by the short delivering the underlying asset to the long

What is the seller of an option also called?

Option writer

What type of derivative usually trades on an exchange?

Options and futures contracts

What type of derivative trades usually trade OTC?

Swaps and forwards

What is a big criticism of derivatives?

That they are "too risky" especially to investors with limited knowledge of complex instruments

What is a settlement price?

The average of the prices of the trades during the last period of trading, called the closing period

Who sets margin requirements?

The clearinghouse

What does it mean to "buy" and "sell" a futures contract?

To buy means to take the long side To sell means to take a short side

What is a basis swap?

Trading one set of floating rate payments for another

When will the forward price have a negative value?

When the expected future price of the asset decreases over the life of the contract, the right to buy at the forward price will have a negative value (right to sell has a positive value)

When will the forward price have a positive value?

When the expected future price of the asset increases over the life of the contract, the right to buy at the forward price will have a positive value (right to sell has a negative value)

What is a locked limit?

When trades can't take place due to a limit move Traders are locked into their existing positions

What is a credit spread option?

-A call option based on a bond's yield spread relative to a benchmark -Bondhollder will collect a payoff on the option if its yield spread increases due to a decrease in credit quality

What is a contingent claim?

-A claim that depends on a particular event -Only require payment if a certain threshold price is broken

What is a forward commitment?

-A legally binding promise to perform some action in the future -Includes forward contracts, futures contracts, and swaps

What are the main reasons futures contracts are different than forward contracts?

-Futures trade on organized exchanges -Futures contracts are standardized whereas forwards are customized -A clearing house is the counterparty for futures (no counterparty risk) -The government regulates futures markets and forwards contracts are usually not regulated

What is the difference between a speculator and a hedger?

-Speculators use futures to gain exposure to price changes in the asset -Hedgers use futures to reduce existing exposure to price changes in the asset

What are the payments owed by one party to another in a swap called?

A notional principal

What is a derivative?

A security that derives its value from the value or return of another asset or security

What is marking to market?

Adjusting the margin balance in a futures account for any gains and losses based on new settlement prices every day

What is a swap?

An agreement to exchange a series of payments on periodic settlement dates over a certain time period

What is the difference between a futures and equity margin account?

An equity account only requires you to add funds to bring margin back up to the maintenance margin amount (not the initial margin)

What is margin with regard to futures markets?

Money that must be deposited by both the long and short as a performance guarantee prior to entering into a futures contract

What happens when the margin balance falls below the maintenance margin in a futures margin account?

More funds need to be deposited to bring the balance back up to the INITIAL MARGIN

Has a clearinghouse ever defaulted on a contract?

No

What is a maintenance margin?

The minimum amount of margin that must be maintained in a futures account

What is open interest?

The number of futures contracts of a specific kind that are outstanding at any given time (increases when traders enter new long and short positions)

What is arbitrage?

The opportunity to earn a return greater than the risk free rate by holding a portfolio of riskless assets

What is the price of an option referred to as?

The option premium

Which party in a forward contract has the long position?

The party who agrees to buy the asset

Which party in a forward contract has the short position?

The party who agrees to sell or deliver the asset

What are the biggest benefits of derivatives?

They allow risk to be transferred and shifted among parties, reduce transaction costs