FINA 471: Exam #1

Speculation

- Bet on the future direction of the market - Take more risk in the hope of making profits

Features of forward contracts

- Customized - Non-standard and traded over the counter (not on exchanges) - No money changes hands until maturity - Non-trivial counter party (default/credit) risk

Features of futures contracts

- Exchange-traded "forward contracts" - Standardized, with specified delivery dates, locations - Guaranteed by the clearing house - Gains/ losses settled daily (marked to market) - Margin required as collateral to cover losses

OTC market

- Forwards and options are traded here (as well as swaps, historically speaking) - A telephone and computer-linked network of dealers - Financial institutions often act as market makers

Exchange market

- Futures and options are traded here

Arbitrage

- Getting something out of nothing, usually by creating 2 portfolios with identical cash flows and profit from the price difference

Where are swaps traded?

- Historically, swaps are traded in the OTC markets, but recent regulatory actions are pushing them to move to regulated trading venues (Swap Execution Facilities)

Storage cost & rate of storage cost

- Holding an asset may incur storage costs (negative income) - 'u' is the continuously compounded rate of storage cost

Treasury rates

- Interest rates an investor earned on treasury securities - May be too low to be a good proxy for the risk-free rate

LIBOR (London Interbank Offered Rate) rates:

- Interest rates at which banks offer to lend unsecured short-term funds to other banks in the London interbank market - Approximately equal to the short-term borrowing rate of an AA-rated company (not risk free!) - Often used as a proxy for the risk-free by derivative traders

Long hedge

- Is appropriate when you know you will purchase an asset in the future and want to lock in the price

Short hedge

- Is appropriate when you know you will sell an asset in the future & want to lock in the price - An asset you already own and expect to sell in the future

Stock index

- Is the (possibly scaled) value of a hypothetical portfolio of stocks - Used to track the movement of the overall stock market or some specific market sectors

Basis risk arises because of:

- Mismatch between the expiration date of the futures and the actual buying/selling date of the asset (date mismatching) - Mismatch between the asset to be hedged and the asset underlying the futures (asset mismatching)

What are derivatives used for?

- Risk management (hedging) - Speculation - Arbitrage

Perfect hedging

- The asset to be hedged = the underlying asset of the futures contract - The expiration date of the futures = the actual buying/selling date of the asset - Risk is completely eliminated - In general, these two conditions may not hold

A forward contract specifies:

- The features and quantity of the asset to be delivered - The "expiration date" - The price the buyer will pay at the time of delivery: "the forward price"

A forward contract specifies...

- The features and quantity of the asset to be delivered - The expiration date - The price the buyer will pay at the time of delivery: "the forward price"

American options can be exercised...

...at any time during its life

Effective interest rate depends on...

...both quoted interest rate and compounding frequency

European options can be exercised...

...only at maturity

Basis Risk

= Spot price of asset to be hedged - futures price of contract used = St - Ft

Forward

A binding agreement (right AND obligation) to buy/sell an underlying asset at a predetermined date in the future, at a price set today

Forward contract

A binding agreement (right and obligation) to buy/sell an underlying asset at a predetermined date in the future, at a price set TODAY

Forward rate agreement

A forward rate agreement (FRA) is an agreement that a certain rate will apply to a certain principal during a certain future time period - Long FRA: agreed to borrow at the forward rate - Short FRA: agreed to lend at the forward rate If the interest rate specified in an FRA eq

Maintenance margin

A margin call is issued if account balance falls below maintenance margin

Zero rate

A n-year zero rate is the rate of interest earned on a nyear zero coupon bond

Futures

A standardized forward contract traded on exchanges

Long-term rate

A weighted average of short-term rate and forward rate

Swaps

An agreement to exchange cash flows at specified future times - can be viewed as a package of forward contracts

Options

An instrument that conveys the right (FOR THE HOLDER), but not the obligation, to engage in a future transaction

Forward rate

An interest rate which is specified now for a loan that will occur at a future date.

Cash and carry

Buy the underlying asset and enter into a short forward position

Margin requirements are used to minimize

Default risk

The payoff on a forward contract is its value at _____________.

Expiration

Investment asset w/ no income and no storage cost

Formula; the spot price is the present value of the forward price

What are the main types of derivatives? (4)

Forward, futures, swaps, options

Result of entering a forward/futures contract?

Has zero value when initiated: you do not have to pay to enter into the contract.

Hedging vs. Speculation

Hedging -- to reduce exposure to risk Speculation -- to create exposure to risk

Cross hedge

Hedging an exposure to the price of one asset with the contract on another asset

An option gives the ______ the right (not obligation) to buy or sell at a certain price which is the __________.

Holder, strike price

Future contracts are the same as forwards in principle except for some ________ and _________ differences

Institutional, pricing

Spot price

Is for immediate, or almost immediate delivery (can be contrasted with the futures price)

If spot price is more volatile than the futures price, futures position should be relatively _______ to hedge the risk (changes in the spot price).

Large

In forwards & futures markets, the party that has agreed to buy has a _______ position, and the party that has agreed to sell has a _________ position.

Long, short

In options markets, the party that has bought the options has a _______ position, and the party that has sold the options has a _________ position.

Long, short

If the correlation is _____, futures contract is not an effective hedge, so one should be more conservative in taking futures position.

Low

Optimal hedge ratio

Minimize the uncertainty of the value of the hedged position

Compounding frequency

Notes

A(n) _________ contract is an agreement to buy or sell 100 shares (in the US).

Option

Call option

Option to buy

Put option

Option to sell

An option always has a _______ value. You have to pay a _______ to get it.

Positive, premium

Forward/futures contract gives the holder both the _____ and _______ to buy or sell at a certain price.

Right, obligation

Spot rate

Same as the spot price

Reverse cash and carry

Short-selling the asset and enter into a long forward position

If spot price is less volatile than the futures price, futures position should be relatively _______ to hedge the risk (changes in the spot price).

Small

Derivative

Something that comes from something else; A financial instrument whose value depends on the values of other more basic underlying values

Initial margin

The amount to be deposited when entering into a contract

Marking to market

The daily loss or gain enters into the margin account at the end of each trading day

Settlement price

The price at which a contract traded just before the final bell of each day

Implied forward rate

The rate of interest for a future period implied by current zero rates, i.e., the forward rate that rules out arbitrage.

Advantages of OTC markets

Virtually no default risk, highly liquid