Derivatives Extra

What is a forward contract?

A forward contract is an argeement between two parties, where one party agrees to deliver an asset to the other at an agreed upon price and date. This way, both sides are protected from the price volatility of the underlying asset.

What is a future contract?

A future contract is a standardized forward that trades on an exchange. Futures provide greater liquidity to contract holders but less flexibility.

Why do future contracts provide more liquidity to contract holders?

• Futures are standardized terms

• Centralized trading on exchanges in high volumes

• This means it is easier to enter and exit positions

What is the difference between over-the-counter and exchange trading?

• An OTC market is a decentralized market where trades are not listed on a formal exhange

• OTC trading is largley made up of non standard contracts (forwards)

• OTC market is more flexible but mroe risky and less liquid

What is a foreign currency swap?

What is an intrest rate swap?

An interest rate swap is a forward contract in which one stream of future interest payments is exchnaged for another. Interest rate swaps usually involve the exchange of a fixed interest rate payment for a floating rate payment.

Does principle get exchanges in a foreign currency swap?

Yes, foreign currency swaps require an exchange of principle at the outset and the maturity of the swap.

What causes swap spreads to widen or narrow?

The swap spread is the difference between the negotiated and the fixed rate in an interest swap. When interest rates are expected to rise, paying fixed and receiving floating becomes more desireable, and the difference between the two widens. The opposite is true for when interest rates are expecred to fall.

What is a swap spread?

The swap spread is the difference between the negotiated and the fixed rate in an interest swap. When interest rates are expected to rise, paying fixed and receiving floating becomes more desirable and the difference betweeen the two widens. The opposite is true for when interest rates are expected to fall.

What is a swap?

A swap exchanges future cash flows between participating parties. Essentially, swaping risk for predictability. Common forms of swaps include interest rate swaps, currency swaps, and credit default swaps.

What is a Mortgage Backed Security?

• Mortgage backed securities is a debt security that is backed by a collection or mortgages

• An MBS is an asset backed security that is traded on the secondary market, and enables investors to profit from the mortgage business without the need to directly buy or sell home loans

Describe the convexity of a Mortgage Backed Security?

What is a bond?

What has higher absolute rho, a straight bond or an in-the-money convertible?

What is a convertible?

When would a trader seek to profit from shorting futures?

The trader in the short position believes that the asset will decrease (below market expectations).

What is the difference between futures and forwards?

Futures are standardized and traded on exchanges, while forwards are more flexible and traded over-the-counter.

What is a currency swap?

Currency swaps are agreements between two parties to trade one currency for another at a present rate over a given period. There are also interst rate variaitons for currency swaps which include fixed rate to fixed rate, floating rate to floating rate or fixed rate to floating rate.

What are the benefits of an interest rate swap?

Interest rate swaps can reduce or increase exposure to fluctuations in interest rates.

What is a basis swap?

A basis swap is a forward contract, which is similar to an interest rate swap, however of one type of floating rate is exchanged for another type of floating rate.