Derivative Just Missing 73 from Kaplan duplicate text

What is a derivative?

A financial security whose value is derived from the value of another asset or variable (the underlying) at a future date.

What is the underlying in a derivative contract?

The asset, security, or variable that determines the derivative's value.

Examples: Stock, bond, interest rate, currency, commodity, stock index.

Why is a derivative called a "derivative"?

Because its value is derived from (depends on) another asset or variable.

What are the four basic features of a derivative contract?

• Underlying

• Contract (specified) price

• Contract size

• Settlement date

What is the contract (specified) price?

The price agreed upon by the two parties when the derivative contract is created.

What is the contract size?

The quantity of the underlying asset covered by the contract.

What is the settlement date?

The future date when the contract is settled.

At contract initiation, what is the value of most derivative contracts?

Zero to both parties.

Exam Tip: The contract price is typically set so neither side has an advantage initially.

What is a deliverable derivative contract?

A contract where the underlying asset is physically delivered at settlement.

What is a cash-settled derivative contract?

A contract where the parties exchange cash instead of the underlying asset.

What are the two settlement methods for derivatives?

• Physical (deliverable) settlement

• Cash settlement

What is an exchange-traded derivative?

A standardized derivative traded on an organized exchange.

What does "standardized" mean for exchange-traded derivatives?

The contract terms (size, expiration, etc.) are predetermined by the exchange.

Who guarantees exchange-traded derivative contracts?

The central clearinghouse.

What role does the central clearinghouse play?

It becomes the buyer to every seller and the seller to every buyer, guaranteeing contract performance.

Why is counterparty risk lower for exchange-traded derivatives?

Because the central clearinghouse guarantees payment.

What is an over-the-counter (OTC) derivative?

A privately negotiated derivative contract between two counterparties.

What is the main advantage of OTC derivatives?

They can be customized to meet the needs of the counterparties.

What are the disadvantages of OTC derivatives?

• Less regulation

• Less transparency

• Higher counterparty credit risk

Why do OTC derivatives generally have greater counterparty risk?

There is typically no central clearinghouse guaranteeing the contract.

How can counterparty risk in OTC markets be reduced?

Through a central clearing mandate for certain OTC contracts.

Which type of derivative is more customizable?

OTC derivatives.

hich type of derivative is more standardized?

Exchange-traded derivatives.

Which market is generally more transparent?

Exchange-traded markets

Which market is generally less regulated?

OTC markets.

Which derivative market has lower counterparty credit risk?

Exchange-traded derivatives.

What is a forward contract?

A contract where both parties are obligated to buy/sell an asset at a predetermined price on a future date.

Does a forward contract give a right or an obligation?

Obligation

Where are forward contracts traded?

Over-the-counter (OTC).

What is a futures contract?

An exchange-traded forward contract that is standardized and settled daily.

What does daily settlement mean?

Gains and losses are settled every day rather than only at expiration.

What is a call option?

The right, but not the obligation, to buy an asset at the exercise (strike) price.

What does a call buyer hope happens?

The asset price increases.

What does a call seller hope happens?

The asset price stays below the exercise price.

What is a put option?

The right, but not the obligation, to sell an asset at the exercise (strike) price.

What does a put buyer hope happens?

The asset price falls.

What does a put seller hope happens?

The asset price rises.

What is an interest rate swap?

One party pays a fixed interest rate, while the other pays a floating interest rate on a notional principal.

What is a credit default swap (CDS)?

A contract in which the protection seller pays if a specified credit event (default) occurs.

What is a call option's value at expiration?

Max(0, Stock Price − Exercise Price)

What is a call option's profit?

Max(0, Stock Price − Exercise Price) − Premium

When does a call option have value?

When Stock Price > Exercise Price

When does a call option expire worthless?

When Stock Price ≤ Exercise Price

What is a put option's value at expiration?

Max(0, Exercise Price − Stock Price)

What is a put option's profit?

Max(0, Exercise Price − Stock Price) − Premium

When does a put option have value?

When Exercise Price > Stock Price

When does a put option expire worthless?

When Stock Price ≥ Exercise Price

Q: Who benefits when stock prices rise?

Position	Wants Price To...
Call Buyer	Rise ↑
Put Seller	Rise ↑

Who benefits when stock prices fall?

Position	Wants Price To...
Put Buyer	Fall ↓
Call Seller	Fall ↓

Position: Call Buyer and Put Seller

Wants Price: Rise Upwards

Position: Call Seller and Put Buyer

Wants Price: Fall down

What is a forward commitment?

A derivative that obligates parties to buy, sell, or make payments in the future.

Which derivatives are forward commitments?

• Forward contracts

• Futures contracts

• Most swaps

Memory Trick: FFS = Forwards, Futures, Swaps

What is a contingent claim?

A derivative that only has a payoff if a specified event occurs.

Which derivatives are contingent claims?

• Options

• Credit derivatives (CDS)

Why is an option called a contingent claim?

Because it only pays off if the option finishes in the money.

Call Value at Expiration

Max(0, Stock Price − Exercise Price)

Put Value at Expiration

Max(0, Exercise Price − Stock Price)

Call Profit

Call Value − Premium Paid

Put Profit

Put Value − Premium Paid

Futures Characteristics

Exchange-traded, standardized, daily settlement and more liquid

Forwards Characteristics

OTC, Customized, Settle at expiration, and less liquid

Advantages of derivatives

The ability to change or transfer risk; discover information about expected prices or volatility; gain operational advantages; and improve market efficiency.

How can derivatives help change or transfer risk?

They allow users to modify or transfer exposure to the risks of underlying assets or interest rates.

How do derivatives provide information discovery?

They provide information about expected prices or volatility of underlying assets or interest rates.

What are the operational advantages of derivatives?

Ease of short sales, low transaction costs, greater leverage, and greater liquidity.

How can derivatives improve market efficiency?

They facilitate trading, price discovery, and risk transfer, which can contribute to more efficient markets.

What are the main risks of derivatives?

Implicit leverage, basis risk, liquidity risk, counterparty credit risk, and systemic risk.

What is implicit leverage in derivatives?

The ability of derivatives to create a large exposure relative to the amount of capital invested.

What is basis risk?

The risk that a hedge will not perfectly offset the exposure because the derivative and underlying position do not move exactly together.

What is liquidity risk in derivatives?

The risk that required cash flows cannot be met when they are due.

What is counterparty credit risk?

The risk that the counterparty to a derivative contract will fail to fulfill its contractual obligations.

What is systemic risk from derivatives?

The risk that problems involving derivatives could spread throughout the financial system and threaten financial market stability.

What are the main uses of derivatives by issuers?

Managing risks associated with changes in asset and liability values and earnings volatility caused by changes in underlying securities or interest rates.

How can issuers use derivatives to manage asset and liability risk?

They can hedge changes in the values of assets and liabilities caused by movements in underlying securities or interest rates.

How can issuers use derivatives to manage earnings volatility?

They can hedge exposure to changes in underlying securities or interest rates that would otherwise cause fluctuations in earnings.

What are the main uses of derivatives by investors?

Hedging, modifying, or increasing exposure to the risk of an underlying asset or interest rate.

How can investors use derivatives for hedging?

They can reduce or offset exposure to unwanted risks associated with an underlying asset or interest rate.

How can investors use derivatives to modify exposure?

They can increase, decrease, or otherwise change their exposure to the risk of an underlying asset or interest rate.

How can investors use derivatives to increase exposure?

They can use derivatives to gain greater exposure to an underlying asset or interest rate without directly purchasing the underlying asset.

What is the key difference between issuer and investor uses of derivatives?

Issuers primarily use derivatives to manage asset, liability, and earnings risks, while investors use them to hedge, modify, or increase exposure to underlying risks.

What is the basis for valuing derivative securities?

A no-arbitrage condition.

What happens when the forward price is too high?

An arbitrageur sells the forward and buys the underlying asset.

What happens when the forward price is too low?

An arbitrageur buys the forward and sells short the underlying asset.

What happens to the forward price as arbitrage occurs?

Arbitrage moves the forward price toward its no-arbitrage level.

What is replication?

Creating a portfolio using cash market transactions that has the same payoffs as a derivative for all possible future values of the underlying.

Why is replication important for derivative valuation?

It allows us to calculate the no-arbitrage forward price of an asset.

What does a replicating portfolio do?

It produces the same payoffs as the derivative for all possible future values of the underlying.

What is the no-arbitrage forward price when there are no costs or benefits of holding the underlying asset?

The spot price compounded at the risk-free rate over the time until expiration.

What is the basic no-arbitrage forward price formula when there are no costs or benefits of holding the underlying?

Forward price = Spot price × (1 + risk-free rate)^time.

What is the cost of carry?

The benefits of holding the asset minus the costs of holding the asset.

How do greater costs of holding an asset affect its no-arbitrage forward price?

They increase the no-arbitrage forward price.

How do greater benefits of holding an asset affect its no-arbitrage forward price?

They decrease the no-arbitrage forward price.

What is the relationship between holding costs and the forward price?

Higher holding costs lead to a higher no-arbitrage forward price.

What is the relationship between holding benefits and the forward price?

Higher holding benefits lead to a lower no-arbitrage forward price.

What is the purpose of the no-arbitrage condition in forward pricing?

To ensure there is no opportunity to earn a risk-free profit by trading the forward and underlying asset.

If the forward price is above the no-arbitrage price, what strategy creates an arbitrage opportunity?

Sell the forward and buy the underlying asset.

If the forward price is below the no-arbitrage price, what strategy creates an arbitrage opportunity?

Buy the forward and sell short the underlying asset.

Value of a forward contract at initiation

Zero.

Value of a forward contract to the buyer during its life

Spot price of the asset minus the present value of the forward contract price.