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CFA Session 17
Derivatives
43
Finance
Undergraduate 4
01/29/2010

Additional Finance Flashcards

 


 

Cards

Term
What are Exchange traded Derivatives and Over the counter markets
Definition
Exchange-traded derivative= traded on an exchange and are standardized and backed by a clearing house

Over the counter market= dealer market with no central location, largely unregulated markets
Term
Forward commitment and Contingent claims
Definition
Forward commitment= Legally binding promise to perform some action in the future

Contingent claim= claim to a payoff that depends on a particular event
Term
What are benefits and criticisms of derivatives
Definition
Benefits:
- provide price information
- Allow risk to be managed and shifted among market participants
- Reduce transaction costs

Criticisms
- risky
- sometimes likened to gambling
Term
what is arbitrage?
Definition
An important concept in valuing derivative securities. Arbitrage opportunities arise when assets are mis-priced.

Riskless arbitrage= earning more than the risk-free rate with no risk. OR earning an immediate gain with no future liability
Term
What is a covered call?
Definition

Covered= owning the stock that covers the obligation to deliver stock assumed in writing the call

 

Would write a covered cal to if you think the stock's price is not going to go up any time soon and you want to increase your income by collecting on the call premiums.

 

 

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Term
What is a protective put?
Definition

An investment management technique designed to protect a stock from a decline in value. Constructed by buying a stock and put option on that stock.

 

Maximum gains on a protective put are unlimited, but reduced by the put premium paid. Maximum losses are limited to (S0 – X) + put premium paid.

 

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Term
Call option components
Definition
  • The call holder will exercise the option whenever the stock’s price exceeds the strike price.
  • The sum of the profits and losses of the buyer and seller of the call option is always zero.
Call Option
Maximum loss Maximum gain
Buyer (long) Premium Unlimited
Seller (short) Unlimited Premium
Breakeven X + premium

 

Term
Put option Components
Definition
  • The put holder will exercise the option whenever the stock’s price is less than the strike price.
  • The sum of the profits between the buyer and seller of the put option is always zero.
Put Option
Maximum loss Maximum gain
Buyer (long) Premium X − Premium
Seller (short) X − Premium Premium
Breakeven X − Premium
Term
Forward Contract
Definition
A forward contract is a bilateral contract that obligates one party to buy and the other to sell a specific quantity of an asset, at a set price, on a specific date in the future.  Typically neither party to the contract pays anything to get into the contract
Term

Long forward position or

Long

Definition
The party to the forward contract that agrees to buy the financial or physical asset has a long forward position and is called the long
Term

Short forward position or

Short

Definition
The party to the forward contract that agrees to sell or deliver the asset has a short forward position and is called the short
Term
Default risk or counterparty risk
Definition
Each party to a forward contract is exposed to default risk or counterparty risk, the probability that the other party (the counterparty) will not perform as promised. 
Term
Cash settlement
Definition
An alternative settlement method is cash settlement.  Under this method, the party that has a position with negative value is obligated to pay that amount to the other party
Term
Forward contract terminate the position
Definition
A party to a forward contract can terminate the position prior to expiration by entering into an opposite forward contract with an expiration date equal to the time remaining on the original contract
Term
End user of a forward contract
Definition
The end user of a forward contract is typically a corporation government unit or nonprofit institution that has existing risk they wish to avoid by locking in the future price of an asset
Term
Dealers
Definition
Dealers are often banks but can alos be nonbank financial institutions such as securities brokers
Term
Equity forward contracts
Definition
Equity forward contracts where the underlying asset is a single stock, a portfolio of stocks, or a stock index, whor in much the same manner as other forward contracts. 
Term
Forward contracts on Zero-Coupon and Coupon Bonds
Definition
Forward contracts on short- term, Zero-Coupon bonds (T-bills in the U.S.)  and Coupon interest paying Bonds are similar to those on equities.  While equities do not have a maturity date, bonds do, and the forward contract must settle before the bond matures.
Term
Eurodollar Deposit
Definition

Eurodollar Deposit is the term for deposits in large banks outside the U.S. denominated in U.S. dollars.  The lending rate on dollar denominated loands between banks is call the London Interbank Offered Rate (LIBOR).  It is quoted as an annualized rate based on a 360-day year.  LIBOR is used as a reference rate for floating rate U.S. dollar denominated loans worldwide.

LIBOR is published daily by the British Banker's Association and is compiled from quotes from a number of large banks. 

Term
Euribor
Definition

There is also an equivalent Euro lending rate called Euribor

or Europe Interbank Offered Rate. 

Euribor, established in Frankfurt, is published by the European Central Bank.

Term
Forward rate-agreement (FRA)
Definition
FRA can be viewed as a forward contract to borrow/lend money at a certain rate at some future date.  These contracts settle in cash, but no actual loan is made at the settlement date
Term
Long position in an FRA
Definition
Long position in an FRA is the party that would borrow the money (long the loan with the contract price being the interest rate on the loan).  If the floating rate at contract expiration (LIBOR or Euribor) is ABOVE the rate specified in the forward agreement, the LONG position in the contract can be viewed as the right to BORROW at BELOW MARKET RATES and the long will receive a payment
Term
Short position in an FRA
Definition

Short position in an FRA is the party that the right to lend at rates HIGHER THAN MARKET RATES. 

If the reference rate at the expiration date is

BELOW the contract rate,

the SHORT will receive a cash payment from the long. 

Term
Currency Forward contract
Definition
Under the terms of a Currency Forward contract, one party agrees to exchange a certain amount of one currency for a certain amount of another currency at a future date.  This type of forward contract in practice will specify an exchange rate at which one party can buy a fixed amount of the currency underlying the contract.
Term

True/False

An Equity forward contract can be written on a total return basis (excluding dividends) but are typically based solely on an index value.

Definition

False

 

An Equity forward contract can be written on a total return basis (INCLUDING dividends) but are typically based solely on an index value.

Term

TRUE/FALSE

Index forwards settle in cash based on the nominal amount and the percentage difference between the index value in the forward contract and the actual index level at settlement.

Definition
TRUE
Term

TRUE/FALSE

The London Interbank Offered Rate (LIBOR) is an international reference rate for Eurodollar deposits and is quoted for 30-day, 60-day, 90-day, 180-day, or 360-day (1-year) terms.

Definition
True
Term

True/False

Euribor is the equivalent for long-term Euro-denominated bank deposits (loans to banks)

Definition

False

 

Euribor is the equivalent for SHORT-term Euro-denominated bank deposits (loans to banks)

Term

True/False

 

For both LIBOR and Euribor, rates are expressed as monthly rates and actual interest is based on the loan term as a proportion of a 360-day year

Definition

False

 

For both LIBOR and Euribor, rates are expressed as ANNUAL rates and actual interest is based on the loan term as a proportion of a 360-day year

Term
FRAs
Definition

Forward rate agreement (FRAs) serve to hedge the uncertainty about short-term rates (e.g. 30 or 90-day LIBOR) that will prevail in the future.  If RATE RISE, the LONG receives a payment at settlement. 

 

The SHORT receives a payment if the specified RATE FALLS to a level below the contract rate.

Term

True/False

 

Currency forward contracts specify that one party will deliver a certain amount of one currency at the settlement date in exchange for a certain amount of another currency

Definition
True 
Term

True/False

 

Under cash settlement, multiple cash payments is made before settlement based on the differences between the exchange rate fixed in the contract and the market exchange rate at the settlement date.

Definition

False

 

Under cash settlement, A SINGLE cash payments is made AT settlement based on the difference between the exchange rate fixed in the contract and the market exchange rate at the settlement date.

Term
The short in a deliverable forward contract_________
Definition
is obligated to deliver the specified asset
Term
On the settlement date of a forward contract______
Definition
the short MAY be requied to sell the asset.  --the short is required to deliver the asset at settlement, not to make a cash payment
Term
A dealer in a forward contract market____
Definition
may enter into a contract with another dealer
Term
Forward contracts on 90-day T-bills _____
Definition
If short-term yields increase unexpectedly after contract initiation, the short will profit on the contract
Term

 

Eurodollar time deposits

Definition
Eurodollar time deposits are U.D. dollar denominated accounts with banks outside the U.S. and are quoted as an add-on yield rather than on a discount basis
Term
One difference between LIBOR and Euribor is that____
Definition
they are for different currencies
Term
LIBOR-based FRA
Definition
FRAs can be based on interest rates for 30, 60, or 90-day periods
Term

Example:

Consider a $2 million FRA with a contract rate of 5% on 60-day LIBOR.  If 60-day LIBOR is 6% at settlement, the long will____

Definition
(.06-.05) * (60/360)*$2 million *1/(1+.06/6) = $3,300.33
Term

Example:

Party A entered currency forward contract to purchase 10 million euro at an exchange rate of $.98 per euro.  At settlement, the exchange rate is $.97 per euro.  If the contract is settled in cash, Party A will_____

Definition
($.98-$.97)*10 million = $100,000 loss.  The long, Party A, is obligated to buy euros at $.98 when they are only worth $.97 and must pay $.01*10 million=$100,000
Term

Example:

If the quoted discount yield on a 128-day, $1 million

T-bill DECREASES from 3.15% to 3.07%, how much has the holder of the T-bill gained or lost?

Definition

The actual discount has decreased by:

(.0315-.0307)*128/360=.0284% of $1 million or $284.

 

A decrease in the discount is an increase in value

 

Gained $284

 

Term

Example:

90-day LIBOR is quoted as 3.58%. 

How much interest would be owed at maturity for a

90-day loan of $1.5 million at LIBOR +1.3%?

Definition

(.0358+.013)[90/360]*$1.5 million = $18,300

Both LIBOR and any premium to LIBOR are quoted as annualized rates

 

$18,300 interest owed at maturity

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