Exam 1 Study Guide: Basic Concepts

Flashcards mapping basic derivative concepts, slide references, formulas, definitions, and numerical examples for Exam 1.

What is a derivative?

A security whose price is dependent upon or derived from one or more underlying assets. Understanding the underlying is required to value the derivative.

What are the three core uses of derivatives outlined in Section I.B?

1. Hedging: Transferring business (sales, inputs, weather, fuel) or financial (interest rates, FX) risks.\n2. Speculating: Gaining directional exposure without buying the underlying.\n3. Increasing Leverage: Capital-efficient exposure while controlling defined risk.

What are the basic mechanics of Call options, Put options, and Strike Price?

A Call provides the right (not obligation) to buy, a Put provides the right (not obligation) to sell, and the Strike Price is the transaction price set in advance. Options cost a premium and act as a time-wasting asset.

How does buying a Put option compare to short selling stock in terms of maximum loss according to the AMZN example?

Short stock carries unlimited upside loss, whereas buying a $950 Put for $25 caps max loss to the $25 premium.

What were the return percentages for AAPL stock versus Call options at a stock price of $S = \$180$ in the speculation example?

A $165k stock outlay resulted in a +9.09% stock return, whereas 10 Call options ($3,500 outlay) resulted in a +329% option return.

How do Southwest Airlines (SWA) and ExxonMobil (XOM) use options to hedge fuel risk?

Southwest Airlines (a jet fuel consumer) buys Dec $55 calls, while ExxonMobil (an oil producer) sells Dec $55 calls. Risks are transferred and dispersed via market makers.

What is the difference between Initial Margin and Maintenance Margin?

Initial Margin is the capital required to open a position ($24,000 in the S&P example), whereas Maintenance Margin is the minimum threshold required to hold the position ($21,000).

What is the formula for Notional Value, and how is it calculated in the S&P example?

$\text{Notional Value} = \text{Price} \times \text{Multiplier}$. In the S&P example: \2,450 \times 250 = \$612,500$.

What is marked-to-market daily cash settlement?

Daily cash settlement where gains and losses are credited/debited to accounts at the end of each trading day (unlike equity holdings where cash does not move daily).

When does a margin call occur and what action is required?

Occurs when account equity drops below maintenance margin (e.g., $25k − $6,250 loss = $18,750 < $21k). Requires depositing funds back to maintenance level or facing immediate liquidation.

What is a forward contract?

A bilateral custom agreement to buy/sell at a later date for a price agreed today; obligation to perform by both parties (no optionality).

What is a futures contract and how does it differ from a forward contract?

Futures are standardized exchange-traded contracts subject to daily mark-to-market settlement. They are highly liquid forward contracts allowing easy offset prior to maturity.

What is a swap contract?

Agreement to exchange future cash flows; portfolio/combination of forward contracts without physical asset purchases. Cash-flow differentials settled directly.

What is arbitrage and how does it impact prices?

Buying and selling the same (or synthetic) asset in different venues at different prices for risk-free profit. It forces prices into equilibrium.

What is the formula for Arbitrage Profit/Loss, and what was the profit in the 3COM Sep 40 Call example?

$\text{Arbitrage P/L} = (\text{Bid}_{\text{High}} - \text{Ask}_{\text{Low}}) \times \text{Multiplier} \times \text{Contracts}$. In the 3COM example: CBOE (Ask 1.75) vs. PHLX (Bid 1.89) gives Buy at 1.75, sell at 1.89 for $0.14 profit per share ($14/contract, $1,400 for 100 contracts).

What is the difference between Bid and Ask (Offer) prices?

Bid is the price a dealer/market maker is willing to pay. Ask (Offer) is the price a dealer/market maker is willing to sell for.

What is a spot price?

Current market price of the underlying asset for immediate delivery (e.g., actual cash S&P 500 Index level vs. S&P 500 September futures price).

What is the difference between Physical Delivery and Cash Delivery at contract expiration?

Physical Delivery requires actual delivery of the physical commodity to an approved storage location (e.g., Crude Oil, Wheat, Corn). Cash Delivery settles net dollar gains or losses in cash at expiration without underlying asset transfer (e.g., Equity Index options, VIX futures and options).

What does derivative Parity mean at expiration?

At expiration, derivative is valued at the exact mathematical difference between the underlying price and exercise price: $|S - K|$. Example: 2475 Call with $S = \$2,487.25$ settles at exactly $12.25.

How is Intrinsic Value defined and calculated for Calls and Puts?

Amount an option is in-the-money prior to expiration ($\text{Max}(0, S - K)$ for Calls, $\text{Max}(0, K - S)$ for Puts; 0 if OTM). Example: Crude Oil at $49.40, Sep $49 Call has intrinsic value = $0.40.

What is Extrinsic Value and how is it calculated?

Option premium over intrinsic value ($\text{Extrinsic Value} = \text{Option Price} - \text{Intrinsic Value}$). Represents remaining time value/volatility. Example: $0.85 Call price − $0.40 Intrinsic = $0.45 Extrinsic.

What are the key limitations of derivatives outlined in Section I.D.9?

Structural complexity, time decay (wasting asset), dependence on underlying instrument, counterparty default risk (especially OTC), and leverage risk.

What are the main advantages of derivatives provided in the supplementary material?

Enhanced risk management/hedging, price discovery regarding volatility, operational advantages (lower transaction costs, liquidity, ease of shorting), and market efficiency.

What are the core pricing drivers related to underlying asset characteristics?

Implied vs. historical volatility, days to expiration (calendar vs. trading days), and prevailing interest rates.

How do the formulas for Return on Margin and Return on Notional compare?

$\text{Return on Margin} = \frac{\text{Profit}}{\text{Maintenance Margin}}$ vs. $\text{Return on Notional} = \frac{\text{Profit}}{\text{Notional Value}}$.