CISI derivatives: End of Chapter questions

What are over-the-counter (OTC) products?

contracts entered into away from an exchange

How would a London Metal Exchange (LME) warrant be used in the delivery process?

each LME warrant represents one lot of a specific type/grade of metal. The buyer of the metal (or holder of the warrant) presents this to an LME-listed warehouse and, upon receipt of the warrant, it will deliver to the holder the precise amount and grade of metal that it represents.

What are the main elements of a liquid market?

f the spread between the bid and the ask price is narrow and trades of a reasonable size can be done at those quotes

In the derivatives market, what is meant by gearing?

he measure of the amount of cash/initial investment spent on establishing a futures or options position, compared to the actual value of the underlying position.

Why do corporate bonds pay a higher yield than government bonds?

higher risk

Why is the foreign exchange (FX) market unique?

huge trading volume, leading to high liquidity. geographical dispersion. continuous operation: 24 hours a day except weekends, ie, trading from 20:15 GMT on Sunday until 22:00 GMT Friday, variety of factors that affect exchange rates.

Who are market makers?

market participants who quote both a buy and a sell price for a financial instrument or commodity

Where are the FCA rules relating to the custody and safeguarding of client money and client assets contained?

Client Assets Sourcebook (CASS)

What are 'softs'?

a label for a particular set of commodities that includes cocoa, sugar and coffee. Agricultural commodities include grains, such as wheat and soya beans, as well as livestock and seed oils. Stuff that is grown

How is variation margin for a future's position calculated?

= ticks moved on the day (today's closing price - yesterday's closing price) x the contract's tick value x number of contracts of the open position.

Describe the main difference between European-style and American-style options.

A European-style option can only be exercised at expiry, whereas an American-style option can be exercised over a set period up to the expiry date

What are two main routes for most customers wanting to invest in derivatives?

A discretionary account operates where the client entrusts money to a regulated firm Pooled Funds, These are collective investment schemes (CISs) managed by regulated fund management companies on behalf of investors

What is a covered short call?

referred to as a buy-write strategy. It is constructed by combining a long underlying position with a short call position.

What is a bond?

A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond.

What is a market-linked product?

A structured product, is generally an investment strategy that is based on derivatives, such as futures, options and, to a lesser extent, swaps.

What is an equity warrant?

An equity warrant gives its holder the right to buy a company's shares over the life of the warrant at a fixed exercise price, which is usually at a premium over its current price at the time the warrant is issued.

Why does the interbank money market exist?

An interbank market for money exists simply because banks' balances with their central bank rise and fall as cash is received and paid. A bank with a shortfall will need to borrow from a bank with a surplus - hence there is an interbank market.

Describe the three main types of exchange membership.

Brokers - may only trade for third parties (including clients and other members). Dealers - may trade for their own account. They can also trade for other members providing that they are authorised by the appropriate regulatory body. Broker-dealers - are entitled to trade both for third parties and their own account.

What are some of the ways derivatives are used in ETF trading?

As participants in the futures markets, many ETFs do not hold any securities but are made up entirely of portfolios of futures contracts. This is often done for two reasons - either to track an index or asset which is not easily reproducible, or to short markets which are generally difficult or impossible to borrow the actual securities.

Which exchanges allow mutual offset?

CME Group and the SGX

In 2013, which organisation became Russia's main financial market regulator?

Central Bank of the Russian Federation

How do collars relate to caps and floors?

Contracts that incorporate both a cap and a floor. For a borrower, a cap provides a fixed worst-case level of interest but allows the customer to pay the market rate if this turns out better. A collar allows the customer to pay a better market rate in the same way, but only down to a certain level. Beyond that level the customer must pay interest at another fixed best-case level. In return for this reduced opportunity, the customer pays a lower premium for the option.

Who are most likely to be among the most conservative users of derivatives?

Corporate Treasures

How is a contract's invoice amount calculated?

EDSP x scale factor x number of contracts

What are prime brokers?

refers to the central trade processing, reporting, financing and servicing of the account activities of clients and traders that a broker may provide. These normally include:

A prime broker's role in relation to derivatives is primarily responsible for what?

Efficient and best execution of all trades Ensuring confirmation of client trades through the required trade documentation Settlement of trade cash flows, to provide cash financing or securities lending as pre-agreed and when needed. Providing custody and safekeeping of all assets, as well as any risk management systems that the client may require. keeping clients aware of all issuer correspondence, such as annual meetings and corporate actions.

What is Euronext?

Europe's largest exchange, spanning Amsterdam, Brussels, Lisbon, Paris and London, referred to respectively as the Amsterdam, Brussels, Lisbon, Paris and London ICE markets.

In what way is a clearing fund paid for?

Every clearing member is required to contribute to the clearing fund

What happens when novation occurs?

Every exchange uses a clearing house, which clears all trades and supervises the processing and delivery of all trades executed on that exchange. The process by which the clearing house becomes counterparty to all trades

Name the 11 Principles for Business.

Integrity Skill, care and diligence Management and control Financial prudence Market conduct Customers' interests Communication with clients Conflicts of interest Customers: relationships of trust Clients' assets Relations with regulators

Name the three types of client accounts.

House - for all proprietary trades of the clearing member. Segregated - for trades that the member firm is registering on behalf of a segregated client. In the event of the member firm's default, these positions will be protected against having to meet the defaulting firm's liability. Non-segregated - client trades that are not segregated and, therefore, are not protected in the event of the firm's default. These can be considered commingled and are typically numbered accounts within an omnibus account from another institution or at the broker itself.

Who manages Financial products Markup Language (FpML)?

ISDA

Describe a Bermudan option.

In between European and American options since they can be exercised on any specified dates between the original purchase of the option and its expiry

How is initial margin used?

Initial margin seeks to protect the clearing house (and in turn the broker) from the worst-case loss a position could potentially incur in one day.

What is contango?

Markets where there is a net cost of carry in holding the asset to delivery, futures prices are higher than cash prices

In the US, what does the Securities and Exchange Commission (SEC) regulate?

Options on currencies undertaken on exchanges (eg, currency options on PHLX). Options on individual stocks. Options on stock indices. The Chicago Board Options Exchange (CBOE) - a major centre for equity-based options. The International Securities Exchange (ISE) - the world's largest equity options exchange.

Describe the order flow for screen-traded systems.

Orders are input and then executed and reported by the system. There is no need to match trade details afterwards with a counterparty, as the trades are already matched when the order book links together a buyer and a seller.

What is a cabinet trade?

Sometimes traders prefer to close out the position for a nominal amount in order to crystallise a loss for tax or accounting purposes, in other words, when the option is ITM at its expiration enough to cover any delivery cost associated with exercising the option.

What is SPAN?

Standard Portfolio Analysis of Risk, is the leading system used to calculate daily margin requirements. has the capacity to allow for both inter-maturity and inter-commodity spreads.

How soon does delivery generally take place in the foreign exchange (FX) spot market?

T+2

How is an assignment notice used?

The formal notification that the terms of the contract must be fulfilled.

What is the purpose of price limits?

The idea is that, at a time when markets are subject to extreme price movements, a trading halt gives participants time to calm down and take a more reasoned view about trading conditions.

What is a puttable bond?

a bond with a put option embedded in it. The put can be exercised by the holder of the bond, again under certain circumstances defined for that particular bond - on certain dates, and at a certain strike price (often lower than par). This, in effect, allows the holder to insist on early redemption of the bond, which it might do if interest rates rise so that it can buy a new bond at a higher yield.

What is a non-deliverable forward (NDF)?

a cash-settled, short-term forward contract on a thinly traded or non-convertible international currency, where the profit or loss at the time of the settlement date is calculated by taking the difference between the agreed-upon exchange rate and the spot rate at the time of settlement, for an agreed-upon notional amount of funds.

How do straddles and strangles work?

They attempt to profit from a change in the volatility of the underlying asset. Long positions anticipate an increase in volatility and short positions anticipate a decrease.

What causes liquidity risk?

This arises from situations in which a party interested in trading a specific contract or asset cannot do so because no-one in the market is willing to quote a price for that contract or asset at which the party is prepared to trade.

What is a credit linked note?

a form of funded credit derivative. It is structured as a security, with an embedded CDS allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay the debt if a specified event occurs. This eliminates the need for a third-party insurance provider. Under this structure, the coupon or price of the note is linked to the performance of a reference asset. It offers borrowers a hedge against credit risk, and gives investors a higher yield on the note for accepting exposure to a specific credit event.

What is a block trade?

a large transaction made between an exchange member and a wholesale client. The exchange specifies the size of the transaction that is required before it becomes a block trade. Block trades are allowed to be negotiated away from the central order book as long as they are reported into the exchange once they are agreed.

What is the closing range?

a measure of the range or spread of prices that are quoted during a specified time just before daily trading ends.

A variance swap would be a derivative with what type of underlying?

a measure of the volatility of the underlying.

What is commercial paper (CP)?

a money market instrument that is issued by large financial and non-financial institutions, as a short-term borrowing facility. The debt is unsecured, but is normally backed by unused bank-based credit lines. Maturities normally range from two to nine months and are denominated in minimums of US$500,000 or similar amounts in other currencies. US domestic CP market is the largest

According to the Conduct of Business Sourcebook (COBS), what are the three categories of client?

a retail client a professional client, or an eligible counterparty

What is a forward contract?

an OTC transaction in which the delivery of the commodity/asset is deferred until a date in the future that is specified in the contract. Although the delivery is made in the future, the price is determined on the initial trade date.

What is a swaption?

an arrangement where a buyer pays an upfront sum for the right to enter into a swap agreement by a pre-agreed date in the future.

How are weather derivatives used?

an enable businesses, such as insurance companies, to protect themselves against losses caused by unexpected shifts in weather conditions.

Describe an exchange for physical (EFP).

an off-market transaction that involves the swapping (or exchanging) of an OTC position for a futures position

How would you describe an Asian option?

an option where the pay-off is not determined by the underlying price at maturity, but by the average underlying price over the entire length or a specified part of the contract.

From what do vertical spreads attempt to profit?

attempt to profit from a directional movement in the underlying

What measure are most exchanges now required to have, to resolve trading disputes and maintain confidence in the exchange?

audit trail

What are intra-market spreads based on?

based on the simultaneous buying and selling of futures with different expiry dates, but on the same underlying asset.

Name the conditions for being a SwapClear clearing member.

be an LCH shareholder Contribute to LCH's default fund meet minimum resource requirements make regular financial reports to LCH maintain adequate systems and records and employ operations staff with adequate expertise in swaps

What are inflation swap payments based on?

benchmarks such as the Retail Prices Index (RPI) in the UK, the eurozone's Harmonised Index of Consumer Prices (HICP), or the US Consumer Price Index (CPI).

List the three key elements in the Financial Conduct Authority's (FCA's) current approach.

broad-based standards in preference to detailed rules outcomes-based regulation increasing senior management responsibility

How do you calculate the fair value of a future?

cash price + cost of carry

What is the key advantage of cash settlement over physical delivery?

cash settlement avoids the need for the asset to be delivered and the consequent need for precise specification of quantity, quality and location. Cash settlement also allows contracts to be based on non-deliverable underlying assets, such as STIR deposits

What are contracts for difference?

contracts, where the underlying is intangible, are known as contracts for differences (CFDs) and are cash-settled.

Describe the activities of an arbitrageur

exploit price anomalies in two markets. They observe that the same underlying asset or financial instrument is selling at two different prices in two different markets. They undertake a transaction whereby they buy the asset or instrument at the lower price in one market and sell it at the higher price in the other market, at the same time. It gives them a risk-free profit

Name the main components of cost of carry.

finance costs (interest) over the period. security costs (such as the case for precious metals). storage costs. insurance.

What is a benefit of the flexible exchange (FLEX) facility?

gives any exchange member the freedom to customise the trades with respect to the strike/exercise price and expiration date

How do flexible exchange (FLEX) options differ from standardised exchange products?

in allowing users to specify certain parameters that are normally specified by the exchange within the terms of the contract. They give the ability to customise key contract terms like exercise price, exercise style and expiry date.

In what way is margin collected?

initial margin is largely collected when a position is first established, and then variation margin may be collected as that position worsens.

What are give ups?

involves a member firm indicating that a deal it is doing should be allocated or 'given up' to a second member. This is also described as an allocation. Give-ups are the sending of a trade to another member of the exchange. The member to whom the trade is given up is said to be performing a give-in.

How is collateral used?

is something of value and is held against the risk of default by a counterparty.

With options, who initiates delivery?

it is the buyer (long) who initiates delivery by exercising the option.

Describe pit trading.

open outcry (called ring trading at the LME) is the original trading method. It is a quote- or price-driven system, where traders quote the prices for which they are willing to buy or sell specific contracts.

What is the fair value of a future?

price that will be fair to both the buyer and seller of the contract.

When considering best execution, what factors must be taken into account?

price, cost, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of an order.

What is the EDSP?

the ICE Europe market's term for a future's closing price.

What is the Financial Market Supervisory Authority (FINMA) responsible for?

the Swiss financial regulator. It is an independent body with responsibilities including the supervision of Swiss banks, insurance companies, stock exchanges, futures exchanges, securities dealers, and financial intermediaries. FINMA is responsible for combating money laundering and, where necessary, it conducts financial restructuring and bankruptcy proceedings.

What is used to minimise settlement risk?

the establishment of a netting system/ agreement

Identify the key advantage of over-the-counter (OTC) derivatives hedges.

the flexibility that this contract gives to an investor

How do bearer shares differ from ordinary shares?

the issuer does not maintain a register and simple possession of the certificate is sufficient evidence of ownership

In the options market, what is the premium?

the price of the option - the price paid.

How does the process of 'clearing' work?

the process by which derivatives trades are confirmed and registered. Registration is with a clearing house that becomes legal counterparty to every transaction. The legal process whereby the clearing house becomes the counterparty to all trades is called novation. This involves substituting the clearing house as the buyer to every seller and the seller to every buyer. Hence, every original exchange contract becomes two new contracts; the original contract no longer exists.

What is the arbitrage channel?

the range of prices within which there will be no possibility to arbitrage owing to transaction costs outweighing any potential benefits.

What is meant by the term 'bust the settlement'?

the term used for reversing the closing action and reopening a position.

What is one of the key attractions of exchange-traded contracts?

there is no counterparty risk: the clearing house guarantees the delivery of all contracts.

What three choices do holders of futures contracts have?

to close out the contract before expiry, or to roll the position forward by closing out the existing position and simultaneously establishing a new position in a new quoted month, or to proceed to delivery.

What is the main reason for using synthetics?

to create positions that may not be available on the underlying asset

When using futures to hedge an equities portfolio, how is its beta useful?

when calculating how many contracts you will need to trade to be fully hedged. A share's beta is the measure of its relative volatility or risk versus the market. Therefore, a portfolio's beta is the weighted average of the individual betas of the shares that make up the portfolio.

What triggers automatic exercise?

when the price of the underlying asset is at or above a certain level for a call or at or below a certain level for a put,