International Markets and Derivatives: Futures, Forwards, Swaps, and Options

Explain the difference between a call option and a put 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).

What is a covered call?

A covered call is when you own the stock and write a call. If the stock passes the excise price, then you will be forced to sell later on for whatever that price may be. However, the extra profit from the sale of the option gives you a cushion against downside potential.

What is hedging? What are some different types of futures hedges?

Hedging is protecting against the movement of prices. Long Hedging, Short Hedging, and Cross Hedging are three different types of hedges.

What is a maintenance margin?

It ensures that the balance in the margin account is never negative; it can be lower than the initial margin.

What is a margin call?

It happens if the balance falls below the maintenance margin the trader gets a margin call and has to top up the margin account to the initial margin level.

What is the Binomial Option Pricing Method? How is it used?

It is a method used to provide a mathematical valuation of an option at each point in the time frame specified. It takes a risk-neutral approach to valuation and assumes that underlying security prices can only increase or decrease with time until the option expires worthless. It concerns itself with designing portfolio payoff to be equal no matter how the stock price (the underlying) moves.

What is the Black-Scholes Model?

It is a model that is widely used to determine the value of European call and put options. It states that the value of a call option is determined by subtracting the present value of the exercise from from the current stock price.

What makes up the value of an option?

It is a sum of the intrinsic value of the option, and the time value of the option. The former is the profit that could be made with immediate exercise, and the latter is the difference between the actual price of an option and its intrinsic value.

What is a forward contract? What is the opposite of a forward contract?

It is an OTC agreement to buy or sell an asset at a certain time in the future for a certain price (called the delivery price). The actual payment in a forward contract is settled at maturity. The opposite of a forward contract is called a spot contract (payment immediately).

What is a swap? Why are they used?

It is an agreement to exchange cash flows at specified future times according to certain specified rules. They can be seen as multi-period extensions of forward contracts, and are primarily used to allow the quick, cheap, and anonymous restructuring of the balance sheet.

What is a derivative? What are some different types of derivatives?

It is an instrument whose value depends on the values of other more basic underlying variables. Several types include forwards, futures, swaps, and options.

What is a clearing house?

It is an intermediary between buyers and sellers of financial instruments. Further, it is an agency or separate corporation of a futures exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data. Clearing houses act as third parties to all futures and options contracts, as buyers to every clearing member seller, and as sellers to every clearing member buyer.

What is the initial margin? What value does it typically have? What influences the degree of the initial margin required by a clearing house?

It is the amount that must be deposited at the time the contract is entered into: o The trader can withdraw any balance in excess of the initial margin o Usually at about 5-15% of total value of contracts held - it does allow some leverage o Contracts written on assets with more volatile prices require higher margins

What is the hedge ratio? As an option becomes more and more in the money, does the hedge ratio increase or decrease? Why?

It is the number of shares necessary in the model to hedge a short position. As an option becomes more in the money, the hedge ratio increases, because for in the money options, exercise is more likely, and option holders benefit by a full dollar for each dollar increase in the stock, as though they already owned it.

What are collars?

It is the practice of buying a call at the strike price X1, and writing a call with the same expiration date at X2. This is done to bracket wealth between two bounds - profit is capped at both ends. The maximum payoff is X1-X2 - Option prices.

What is a protective put?

It is when you long the stock and long the put, to limit your losses. If the stock passes the strike price, then you don't exercise the option, and just take the price of the option as the transaction cost. But, if the price of the stock falls, you can always sell the stock at the strike price. You limit your costs to whatever the price of the option is.

What is the put-call parity theorem?

It says that the price of a stock today and its put price are equal to the call price plus the face value of a bond discounted by the risk-free rate over T periods. If these price are not equal, than an arbitrage opportunity exists.

What is the Spot-Futures parity theorem?

It states that the market costs for acquiring an asset for some date in the future must be the same, no matter if you buy and store an asset or hold a long futures position on the same asset. Implicit in the theorem is the idea that futures prices and spot prices will converge at maturity; the relationship endorsed in the spot-futures parity theorem can be used to develop futures pricing relationships.

Are parity theorems applicable to forwards or futures? Why? Why would there be deviation from parity?

Parity theorems apply strictly to forward pricing because they assume the contract proceeds are realized only on delivery. Futures prices can deviate from parity values when the market gives a systematic advantage to either the long or short position.

What are the seasonal price patterns of agricultural commodities?

Prices rise before a harvest and then fall at the harvest when the new crop becomes available for consumption. The price of the commodity following the harvest must rise at the rate of the total cost of carry (C) - interest plus non-interest bearing costs - to induce holders of the commodity to store it willingly for future sale instead of selling it immediately. Typically, inventories head close to zero before a harvest.

How are profits/losses realized on forward/future contracts?

Profit/Losses are the difference between the spot price at maturity and the agreed upon forward/future price.

What is speculation? Why is it common on futures markets?

Speculation is the idea that traders want to profit from movements in futures prices, taking long and short positions depending on if they believe the price of something will rise and fall, respectively. Speculation is common on futures markets because transaction costs are much lower and future margins allow speculators to achieve much greater leverage than from direct trading on a commodity.

What are the similarities/differences between forwards and futures?

They are both agreements between two parties to buy or sell assets at a certain time in the future for a certain price; however, futures are exchange traded, and are available on a wide array of underlyings.

What differentiates futures contracts on commodities from other types of futures contracts?

They are differentiated by storage costs, insurance costs, and an allowance for spoilage of the goods in storage, all thrown under the variable, C.

What do the terms 'in the money', 'out of the money', and 'at the money' refer to?

They refer to the profitability of exercising an option: 'in the money' means it would be profitable, 'out of the money' means that the exercise is unprofitable, and 'at the money' means that the asset price and the exercise price are equal.

What is the comparative advantage argument?

Usually one institution wants to get a currency or an interest rate that another has, and so they will engage in a swap to take advantage of the opportunities of other firms.

How is the practice of measuring volatility related to the Black-Scholes Model?

Volatility is the only factor in the model that needs to be estimated, whether through historical price data or implied volatility. Implied volatility finds its genesis as the volatility for which the Black-Scholes Model equals the market prices. Traders and brokers often quote implied volatilities rather than monetary prices.

What is a straddle?

When you buy both a call and a put on a stock, each with the same exercise price and the same expiration date. It is for investors who expect the stock to be volatile; both of the options have a price that, together, constitute the maximum loss for the investor. As long as the underlying swings heavily enough in either direction, the costs of the put and call will be dwarfed by the movement of the underlying.

Name some of the possible underlyings in a futures contract.

a) Agricultural commodities b) Metals and minerals c) Foreign currency d) Financial Futures (e.g. interest rates futures or stock index futures)

Name some examples of exotic options.

a) Asian options b) Barrier options c) Lookback options d) Currency translated options e) Binary options

What are some option-like securities?

a) Callable bonds b) Convertible securities c) Warrants d) Collateralized loans

Give examples for the potential underlyings of options.

a) Stock options b) Index options c) Futures options d) Foreign currency options e) Interest rate options

Of agricultural futures, metal/energy futures, and financial futures, which is the largest in terms of trading volume? Which is the smallest?

1) Financial futures 2) Agricultural Futures 3) Metal/Energy Futures

What is the difference between linear and non-linear derivatives? Name some examples of each type.

A linear derivative is one whose payoff is a linear function. For example, a futures contract has a linear payoff in that every one-tick movement translates directly into a specific dollar value per contract, while a non-linear derivative is one whose payoff changes with time and space. Nonlinears include exchange traded options, OTC options, and warrants; linear products include futures, forwards, and swaps.

What is the difference between a long hedge and a short hedge?

A long hedge is when you lock in the long side of a contract, and buy the asset on the spot at the date of maturity; a short hedge is when you hold the asset until maturity, and short the future to deliver the asset in question at maturity.

What is the difference between a long position and a short position?

A long position is an agreement to purchase; a short position is an agreement to sell.

What is a clearing house margin? How does it function? What is its purpose?

A margin is cash or near-cash securities deposited by an investor with his or her broker, adjusted daily to reflect daily settlements. Its purpose is to minimize the possibility of a loss through a default on a contract, and also to ensure that the trader is able to satisfy the obligations of a futures contract.

What is the difference between an American option and a European option?

An American option can be exercised at any time before expiration or maturity. A European option can only be exercised on the expiration or maturity date.

Why do we use derivatives?

o To hedge risks o To reflect a view on the future direction of the market o To lock in an arbitrage profit o To change the nature of a liability o To change the nature of an investment without incurring the costs of selling one portfolio and buying another