Derivatives!

basic derivative features

legal agreement between counterparties with a financial intermediary, specific maturity, quantity to underlying, set price

derivatives can be either

contingencies (rights) or commitments (obligations)

how do derivatives affect the market

allow short selling, diversification, risk hedging, reduced capital required, lower transaction costs and more liquid than underlying

derivatives on an index can be

options, futures, forwards, swaps

derivatives on the realized volatility of equities help control

dispersion of return, not direction

the underlying for a swap can be

bonds or interest rates

derivatives on a bond are associated with the

cheapest to deliver bond and conversion factor

in an interest rate swap, if you would like a floating rate,

you pay floating and receive fixed to cover your current fixed rate obligation (effectively, you pay each other’s debt)

a swap can also be used for what portfolio purposes?

change portfolio duration

currency derivatives are used for either

directional investing or hedging

for commodities derivatives, brokers don’t allow

delivery, will close out before delivery date

the difference between a forward and a future is that

forwards are OTC while futures are exchange-traded

how does a credit default swap work from the buyer’s perspective

the buyer of the CDS is betting on a bad outcome, is short the credit quality of the company and long the spread

the over-the-counter market features

the dealer or market-maker as the counterparty, custom terms, less transparency, no daily settlement

the exchange-traded market features

the clearinghouse as the counterparty, standard terms, transparency, daily settlement, margin requirements, liquidity

central clearing applies to what derivatives?

futures, some OTC contracts like swaps

what does a central clearinghouse manage?

credit risk, clearing, settlement

forwards specify

contract size, underlying, future cash flow exchanges, date, future price

if the spot price rises above the forward price, the seller ___ and the buyer ____

loses, buyer gains

derivatives are a

zero-sum game, one person’s win is equal to the other’s loss

daily settlement or mark to market requires that both sides

keep some level of maintenance margin

if the volatility of the underlying increases, the

initial margin required increases

forced liquidation for derivatives

contract is closed after failed margin call

circuit breakers for futures

percent limits on how much the price can change

a swap is commonly what frequency?

quarterly

a plain vanilla interest rate swap is

fixed for floating, 5 years long, annual resets on floating’s reference rate

how do floating rates work again?

determined at beginning of period and paid at end

in a currency swap, what is different?

the principal is also exchanged

floating for fixed swap is equal to what two bond positions?

short floating bond, long fixed bond

a floating for fixed swap adds what to a portfolio?

positive duration

swaps on the first day are based on

par bond rates

swaps may include

collateral or central clearing

european options

OTC, can only exercise at maturity

american options

exchange-traded, can exercise any time

intrinsic value of an option

how much it is in the money

time value in options is higher for

longer maturities

time value

decays over the life of an option until zero at expiration

if you are long a put, you are effectively short the

underlying, so you benefit if spot price drops

long options have limited ___ while short options have limited ____

losses, gains

for options and other contingent derivatives, counterparty risk only exists for the

long side

the credit default swap spread on IG bonds is typically

1%

the credit default swap spread for HY bonds is typically

5%

if the market spread for a credit default swap is different than standard terms, what needs to happen?

one party must pay upfront

the credit protection buyer does what in a CDS?

buys the CDS, is short the credit quality, pays the set spread amount regularly because they expect a future spread increase and want to lock in a low protection rate

if the issuer relevant to a CDS default, the seller

covers the buyer’s losses and spread payments cease

a CDS is typically

quarterly

a CDS is settled how?

marked-to-market

in the event that spot price is above forward price, how do forward and option profits compare?

forward profit greater than long call profit (cost of buying call) or short put profit (gain limited to put premium)

3 benefits of derivatives from a risk perspective

risk allocation, transfer (hedging), and management (minimize somehow) without trading the underlying

futures trade on what index?

GLOBEX, constant trading, signals where underlying will open or market beliefs (federal funds rate futures)

operational advantages of derivatives

reduce cash outlay, lower transaction costs (no storage or transportation), increased liquidity, ability to short

risks of derivatives

highly speculative, high leverage, lack of transparency with complex embedded derivatives, basis risk, liquidity risk (due to margin changes), counterparty credit risk, destabilization and systemic risk

basis risk

divergence between spot and forward price, applies to imperfect hedges (mismatched expirations or underlying vs spot)

counterparty credit risk is lower if

exchange-traded, especially with price limits

for commitment derivatives like forwards and futures, counterparty risk is

two-sided

destabilization and systemic risk

risk and leverage can create market stress is equity depletes and margin calls are unanswered

concentration risk in derivatives refers to

huge companies that make the market

non-financial companies uses derivatives to hedge in what ways

forwards for asset values, rate swaps for liabilities, futures for revenues or expenses

derivative gains and losses are reported on the

income statement unless they qualify as hedge accounting

cash flow hedge

absorb variable cash flows at a floating rate or price, such as forex, interest rates, commodity prices

fair value hedge

offset changes in value of asset or liability, such as with rate swap to increase duration

net investment hedge

offset foreign exchange risk of overseas equity

for hedge accounting, gains and losses are recorded

in OCI until underlying transaction recognized

arbitrage is defined as

opportunity for riskless profit

prices in derivative contracts are quoted

per unit

if you sell a futures contract, you are agreeing to

delivery

what two factors contribute to a higher forward price?

longer maturity, higher rate

replication

the use of borrowing with spot transactions to replicate a forward (or vice versa)

a complete hedge earns the

risk-free rate

to hedge a long cash position,

short a forward

cost of carry

net cost of owning the underlying

if the benefits of owning the asset are greater than the costs,

forward is less than spot price, backwardation

another name for forwardation is

contango

benefits of the underlying include

dividends, interest, convenience yield

for a forex forward, if the rate on the price currency is less than rate on base currency,

forward price is less than spot price, base currency trades at a discount

what characterizes the contango curve?

upward sloping, well-supplied market, high storage cost, low convenience yield, all forward prices above spot

the value of a forward at inception is

zero

the value of a forward changes due to

time, interest rates, price of underlying

as rates rise, the value of a forward

rises

as time passes, the value of a forward

decreases

if underlying price rises, the value of a forward

rises

being long is a forex forward is a bet that the spread between the two currency’s rates will

increase

interest rate forwards are called a

forward rate agreement

to periodize annual rates, multiply by

days/yr

in a forward rate agreement, the price is ____, the underlying is ____

an implied forward rate, a deposit amount

the contract period in an forward rate agreement is the time between

when contract is agreed to and when it is settled (the beginning of the period when the market rate is locked in)

the deposit period in a forward rate agreement is the time between

when the agreement is settled (the market rate is locked in) and when the payment occurs

forward rate agreements are advanced settled, meaning

the outcome is known when the market rate is locked in, so payoffs are discounted back from the next period and settled at that point

the future payments in forward rate agreement are discounted to present value at settlement using

the market reference rate

banks are in the derivative market for

hedging

at initiation, option value is

not zero

a restricted option from price movements is called

locked limit

convergence for futures or forwards means

futures price equals spot price at expiration

the futures price at inception is always

higher than spot price

why might a hedge’s gains/losses be fully included on the income statement and not qualify for hedge accounting (OCI)?

if the hedge was imperfect, in timing, quantity, or otherwise

liquidity risk for futures refers to

margin calls

the value of a futures contract is different than a forward because

it is reset to zero every day by marking-to-market by change in futures price

forward value is cumulative, meaning it is

compared to its original value of zero at inception

interest rates futures are different than forward rate agreements because they are

advanced settled without discounting back

the long position in an interest rate futures contract

earns the previously-set MRR, gains if the rate decreases