Exam 1 Ch.1

What is an option contract? What is a call option? What is a put option? What is American option? What is European option?

A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price) American vs European Options An American option can be exercised at any time during its life A European option can be exercised only at maturity at maturity Options vs Futures/Forwards A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price

What is financial derivative? What are its main functions? Why is it important?

A derivative is an instrument whose value depends on the values of other more basic underlying variables Derivatives play a key role in transferring risks in the economy

What is a future contract? What are characteristics of a future contract?

A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time) The futures prices for a particular contract is the price at which you agree to buy or sell at a future time It is determined by supply and demand in the same way as a spot price Examples of Futures Contracts Agreement to: buy 100 oz. of gold @ US$1100/oz. in December sell £62,500 @ 1.5500 US$/£ in March sell 1,000 bbl. of oil @ US$40/bbl. in April

What is a clearing house? What is central counterparty?

Central counterparty clearing (CCP), also referred to as a central counterparty, is a financial institution that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts.

What is a forward contract? What are characteristics of a forward contract?

Forward contracts are similar to futures except that they trade in the over-the-counter market Forward contracts are popular on currencies and interest rates The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities

What is option moneyness ATM/ITM/OTM? At what moneyness should an option be exercised?

Moneyness is the real value of an option. Investors calculate an option's trading price by adding its intrinsic value to its time decay value. To determine if an option is in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM), a trader must compare the underlying asset's market price to the option's strike price. http://www.traderslaboratory.com/forums/topic/7250-moneyness/

What is hedging? What is speculating?

Speculation involves trying to make a profit from a security's price change, whereas hedging attempts to reduce the amount of risk, or volatility, associated with a security's price change. Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset.

How is future contracts' counterparty risk managed?

The Future Contract is a standardized forward contract between two parties wherein they agree to buy or sell the underlying asset at a predefined date in the future and at a price specified today. The future contracts are a relatively less risky alternative of hedging against the fluctuations in the currency market.

What is delivery of forward/future contract? How is a forward/future contract delivered?

The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.

What is spot market? What is spot price? What is forward/future price? What is future spot market price?

The spot market is where financial instruments, such as commodities, currencies and securities, are traded for immediate delivery. Delivery is the exchange of cash for the financial instrument. A futures contract, on the other hand, is based on the delivery of the underlying asset at a future date. Exchanges and over-the-counter (OTC) markets may provide spot trading and/or futures trading. Spot Price The current price of a financial instrument is called the spot price. It is the price at which an instrument can be sold or bought at immediately. Buyers and sellers create the spot price by posting their buy and sell orders. In liquid markets, the spot price may change by the second, as orders get filled and new ones enter the marketplace. The futures prices for a particular contract is the price at which you agree to buy or sell at a future time It is determined by supply and demand in the same way as a spot price Forward Price The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities

How is forward contracts' counterparty risk managed?

he Forward Contract is an agreement between two parties wherein they agree to buy or sell the underlying asset at a predetermined future date and a price specified today. The Forward contracts are the most common way of hedging the foreign currency risk.

Payoff of a long forward/future contract; Payoff of a short forward/future contract

http://www.4gaccounts.com/payoff-on-forward-contracts/

Payoff of a long call option; Payoff of a long put option; Payoff of a short call option; Payoff of a short put option;

https://study.com/academy/lesson/how-to-calculate-payoffs-to-option-positions.html

How to hedge an importer's exchange rate risk using future contracts/options?

https://www.allbusiness.com/how-to-use-currency-hedging-to-protect-your-import-or-export-business-15051093-1.html

How to hedge a stock portfolio's downside risk using future contracts/options?

https://www.investopedia.com/articles/trading/09/offset-risk-options-futures-hedge-funds.asp

How to hedge an investments' rising cost using future contracts/options?

https://www.investopedia.com/articles/trading/09/offset-risk-options-futures-hedge-funds.asp

How to hedge an exporter's exchange rate risk using future contracts/options?

https://www.investopedia.com/ask/answers/061615/what-forward-contract-against-export.asp

Types of derivatives? Use of financial derivatives.

•Futures Contracts •Forward Contracts •Swaps •Options To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another