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Derivatives
CFA Level 2 Derivatives
58
Finance
Post-Graduate
04/13/2013

Additional Finance Flashcards

 


 

Cards

Term

For call options, a larger gamma means _______

 

Number of calls needed to hedge (formula)

Definition

For call options larger gamma means that as the asset price increases, the delta of option A increases more than the delta of option B.

 

The number of calls to hedge is:

(– 1/delta)x(number of shares)

Term
Normal backwardation
Definition

Normal backwardation means that expected futures spot prices are greater than futures prices. It suggests that when hedgers are net short futures contracts, they must sell them at a discount to the expected future spot prices to get investors to buy them. The futures price rises as the contract matures to converge with spot prices.

Term
Normal contango
Definition

Normal contango occurs when the futures price is greater than the expected asset price at contract expiration. The statement that high demand to buy the contract could increase the contract price is also correct. Note the contrast with contango, which means the futures price is above the asset's spot price. (LOS 49.f)

Term
Put-call parity for options on forward contracts
Definition

Put-call parity for options on forward contracts is:

c0 + (X – FT) / (1+R)T = p0

 

c = call option

FT = forward price at time t

Term
A payer swaption gives:
Definition

A payer swaption gives one the right to enter a swap in the future as the fixed-rate payer / (pay a fixed rate below market if rates rise)

 

Term

When interest rate changes are negatively correlated with the price changes of the asset underlying a futures/forward contract:

(Futures/forwards) contracts are higher

Definition
Forwards are higher. Mark-to-market feature on futures makes them unattractive to futures buyers
Term

 Exercising an in-the-money swaption effectively generates

Definition

an annuity over the term of the underlying swap 

 

Term

A positive payoff to a receiver swaption each quarter is the:

Definition
interest saved by receiving the higher fixed rate
Term
Portfolio variance (formula)
Definition

Portfolio variance = σ2p =

(1 / n) σ 21 + [(n − 1) / n]cov

Term

To initiate an arbitrage trade if the futures contract is underpriced, the trader should:

(long/short) the asset

(invest/lend) at risk free rate

(buy/sell) futures

Definition

short the asset, invest at the risk-free rate, and buy the futures.

Term

Delta of an instantaneously riskless hedged portfolio:

Definition

A riskless portfolio is delta neutral; the delta is zero.

Term

A large OAS indicates (2 things):

Definition

A large OAS indicates a wider risk-adjusted spread and lower relative price

Term

Option cost measures:

Definition

prepayment risk

Term

In general, the (highest/lowest) OAS and (highest/lowest) option cost is most attractive

Definition

highest OAS; lowest option cost

Term
For an MBS, OAS is:
Definition

The spread (k) that must be added to all of the spot rates along each interest rate path that will force equality between the average present value of the path’s cash flows and the market price (plus accrued interest) for the MBS being evaluated

Term

An investor who anticipates the need to exit a pay-fixed interest rate swap prior to expiration might:

(buy/sell) a (payer/receiver) swaption

Definition

buy a receiver swaption

Term

The swap spread will increase with:

Definition

 

an increase in the credit spread embedded in the reference.

 

 

The swap spread is the spread between the fixed-rate on a market-rate swap and the Treasury rate on a similar maturity note/bond. Since the fixed rate is calculated from the reference rate yield curve, it is increased as the credit spread embedded in the reference rate yield curve increases.

 

Term
Gamma (def + when is it greatest?)
Definition

Gamma measures rate of change in delta as underlying stock price changes

 

Gamma, the curvature of the option-price/asset-price function, is greatest when the asset is at the money.

Term

The price of a forward contract:

Definition

is the settlement price for the underlying asset. 

 

The price of a forward contract is the price of the underlying asset that the long will pay to the short at settlement (for a deliverable contract). The value of a forward contract comes from the difference between the forward contract price and the market price for the underlying asset. This difference between price and value is a key concept to understand. A forward contract has only one price, which applies to both the long and to the short.

Term

An arbitrage transaction involving asset swap spread relative to CDS spread can be problematic when:

Definition

asset swap spread is less than CDS spread

 

When asset swap spreads are less than CDS spreads on an equivalent credit exposure, the indicated arbitrage is problematic because it requires a short position in the asset swap. A short position in an asset swap requires that the subject bond must be shorted; however, many bonds cannot be shorted because they have no liquid market.

Term
Fixed rate on annual pay swap (formula/problem)--also on Gmail
Definition
[image]
Term

Regarding deep in-the-money options on forwards, it is _______ worthwhile to exercise calls and/or puts early

Definition

NEVER

 

Unlike futures, forwards do not generate any cash at exercise even when they are deep in-the-money so there is no advantage to early exercise.

Term
Recourse/non-recourse re: commercial and residential MBS
Definition

CMBS are non-recourse. Residential mortgages are recourse, meaning that the lender can go back to the homeowner for payment if the collateral is insufficient.

Term

What is the difference between spot and futures prices at expiration?

Definition

The difference between the spot and the futures price must be zero at expiration to avoid arbitrage.

Term

Value of currency forward contract to long (formula):

 

Forward price (formula):

Definition

Vt= [St / (1 + Rf)(t/365)] − [FP/ (1 + Rd)(t/365) 

 

FP(currency) = S0 x [(1+RD)t / (1+RF)t]

Term

Figure out payment in a plain-vanilla swap

Definition

A U.S. firm (U.S.) and a foreign firm (F) engage in a four year plain-vanilla annual pay currency swap. The U.S. firm pays fixed in the FC and receives floating in dollars. The fixed rate at initiation and at the end of the swap was 5%. The variable rate at the end of year 1 was 4%, at the end of year 2 was 6%, and at the end of year 3 was 7%. At the beginning of the swap, $2 million was exchanged at an exchange rate of 2 foreign units per $1. At the end of the swap period the exchange rate was 1.75 foreign units per $1. 

At the end of year 3, firm F will pay firm U.S.: 

 

A plain-vanilla currency swap pays floating on dollars and fixed on foreign. The floating rate cash flows on the settlement date are based on the previous period's ending floating interest rate 0.06 x $2,000,000 = $120,000. 

Term

Prepayment tranching is also referred to as:

Definition

time tranching

 

Prepayment tranching refers to when an asset or mortgage backed security is subdivided so some components are exposed to more prepayment risk than others. 

Term

The delta of an option is (formula for call and put + def):

Definition

Deltacall = ($change in option price) / ($change in asset price)

 

Deltaput = Deltacall - 1

 

the dollar change in option price per $1 change in the price of the underlying asset.

Term
The price of a swap (defined) + (behavior over life of swap)
Definition

Price does not change over life.

 

The price of a swap, quoted as the fixed rate in the swap, is determined at contract initiation and remains fixed for the life of the swap.

Term

What is the situation called when a futures price continuously increases over its life because most hedging strategies are short hedges?

Definition

Normal backwardation means that expected futures spot prices are greater than futures prices. It suggests that when hedgers are net short futures contracts, they must sell them at a discount to the expected future spot prices to get investors to buy them. The futures price rises as the contract matures to converge with spot prices.

Term
Deep in-the-$ options on forwards -- if and when to early exercise?
Definition

Never

 

Unlike futures, forwards do not generate any cash at exercise even when they are deep in-the-money so there is no advantage to early exercise.

Term
How is the planned amortization class (PAC) protected against prepayment risk?
Definition

Have a fixed principal repayment schedule that must be satisfied as long as support tranches exist

 

PAC tranche has significant protection against prepayment risk at the expense of support/companion tranches

Term

When interest rates and asset values are positively correlated, the futures price tends to be _____ than forward price? When IR and asset price negatively correlated?

Definition

Positively correlated - the futures price tends to be higher 

 

Negatively correlated - the futures price tends to be lower

Term

If rf < dividend yield (on futures contract)

Definition
Backwardation would occur
Term

Compared to purchasing bonds directly, an investor may participate in the CDS market as a:

Definition
protection seller
Term

Market value CDO vs Cash Flow CDO

Definition

The manager of a market value CDO will actively manage the portfolio to generate sufficient cash flows.

 

This is in contrast to a cash flow CDO, where the portfolio is structured at inception in such a way that its principal and interest payments can pay the tranches and trading profits will not be needed to support the cash flows of the CDO.

Term

Early maturing tranches offer relatively greater protection against _______ risk.

 

longer-term tranches offer relatively greater protection against _______ risk.

Definition

(1) Extension

 

(2) Contraction

Term

Put-call parity for options on forward contracts at the initiation of the option where the forward price at that time (time=0) is FT, can best be expressed as: (in terms of put)

Definition

Put call parity for stocks (with discrete time discounting) is: c0 + X / (1 + R)T − S0 = p0.

 

Noting that for the forward contract on an asset with no underlying cash flows, S0 = FT / (1 + R)T, and substituting, we get c0 + (X − FT) / (1 + R)T = p0

Term
Estimated prepayment given SMM:
Definition

Prepayment = (SMM)(Principal Bal. Outstand. - Monthly Principal Pmt.)

Term
Excess servicing spread on ABS (formula):
Definition

=Gross weighted avg coupon - Servicing Fee 

=Spread Available to pay Tranches

Net Weighted Average Coupon

= Excess Servicing Spread

Term

The writer of a receiver swaption has:

Definition

an obligation to enter a swap in the future as the fixed-rate payer

Term

Excellent Swap value question (hard) (formula)

Definition

Question ID#:88315 

Term
The payoff on a receiver swaption is most like that of a:
Definition
call option on a coupon bond
Term
Prepayment benchmark for closed-end home equity loans is ________
Definition
issuer specific
Term

Consider a fixed-rate semiannual-pay equity swap where the equity payments are the total return on a $1 million portfolio and the following information:

180-day LIBOR is 5.2% 

360-day LIBOR is 5.5% 

Dividend yield on the portfolio = 1.2%

What is the fixed rate on the swap?

Definition

5.4234%. 

 

Question ID#: 127305

Term

Calculate the price (expressed as an annualized rate) of a 1x4 forward rate agreement (FRA) if the current 30-day rate is 5% and the 120-day rate is 7%.

Definition

A 1x4 FRA is a 90-day loan, 30 days from today.

 

FR (x,y) = [(1+ R(x+y))/(1+ R(x))] – 1

R(x) = Current x-day rate * (x/360)

R(y) = Current y-day rate * (y/360)

 

Annualized rate is FR(x,y) * (360/t)

t = t-day loan (90 in example), do y-x months


The actual rate on the 30-day loan is: R30 = 0.05 x 30/360 = 0.004167
The actual rate on the 120-day loan is: R120 = 0.07 x 120/360 = 0.02333

The annualized 90-day rate = 0.0190871 x 360/90 = .07634 = 7.63% 

 

FR (30,90) = [(1+ R120)/(1+ R30)] – 1 = (1.023333/1.004167) – 1 = 0.0190871



Term

 

The measure of prepayments associated with securities backed by auto loans is called:

Definition

 

absolute prepayment speed

Term

 

SBA loan payments are based on:

Definition

 

the reference rate at the beginning of each period

Term

 

Number of call options needed to create a delta neutral hedge when LONG a stock:

Definition

 (# shares of stock long) / (Delta of a call option)

 

=X options or (X/100) contracts.

 

If long the stock, short the calls.

Term

Futures Arbitrage:

 

If futures market price < no-arbitrage price

Definition

*If futures market price > no-arbitrage price, use C-a-C

(futures contract ovepriced)

 

Use cash and carry (futures contract underpriced)

 

Initiation:

(1) Borrow $ for term of contract (RFR)

(2) Buy underlying asset at spot price

(3) Sell a futures contract at current F price

 

At expiration:

(1) Deliver the asset and receive the futures contract price

(2) Repay the loan plus interest

Term

(2) Backwardation

(3) Contango

(4) Normal backwardation

(5) Normal contango

Definition

(2) Futurs price < spot price

(3) Futures price > spot price

(4) Futures price < expected spot price

(5) Futures price > expected spot price

Term

Futures Arbitrage:

 

If futures market price < no-arbitrage price

Definition

Reverse cash and carry (futures contract underpriced)

 

Initiation:

(1) Sell asset short

(2) Lend short sale proceeds at RFR

(3) Buy futures contract at market price

 

Expiration:

(1) Collect loan proceeds

(2) Take delivery of asset for futures price and cover short sale commitment

Term

Put-call parity for European Options

(a) left side of equation called

(b) right side called

Definition

C0 + X/(1+Rf)t = P0 + S0

 

(a) fiduciary call

(b) protective put

Term
Binomial Option Pricing Model (OPM)
Definition

Size of downward movement (D) factor is:

D = 1/U

 

Risk-neutral probabability of an upward movement:

Pr(Up) = (1+Rf-D) / (U-D)

 

PV(Call) = Weight Avg. of Payoffs / (1+rf)t

Term
Expiration value of a 2-year caplet and floorlet
Definition

Expiration (Caplet) = Max[0,(1-yr rate - cap rate)*Notional Principal] / (1+1-yr rate)

 

Expiration (floorlet) = Max[0, (Floor rate-1-yr rate)*NP] / (1+1-yr rate)

 

Value of cap (floor) = sum of caplets (floorlets)

Term
Assumptions of Black-Scholes-Merton model (6):
Definition

(1) Price of underlying asset follows lognormal distribution



(2) Continuous RFR is constant and known

 

(3) Volatility of underlying asset is constant and known

 

(4) Markets are frictionless

 

(5) Underlying asset generates no cash flows

 

(6) European options only

Term
BSM model not appropriate (4):
Definition

(1) Valuing IR options and options on bond prices

 

(2) When assumption of constant/known volatility of underlying asset is violated

 

(3) Significant taxes and transaction costs

 

(4) American options

Term
Put/call parity for OPTIONS ON FORWARDS/FUTURES:
Definition
C0 + (X-FT)/(1+Rf)t = P0
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