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Flashcards in derivatives market Deck (46)
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1

explain the first economic purpose of the futures market?

Price discovery: provides information to public about future spot prices. Increases competitiveness of markets

2

explain the 2nd economic purpose of a futures market?

Risk transference: Enables investors & borrowers to protect
assets & liabilities against risks e.g. changes in interest rates,
exchange rates & security prices

3

explain the 3rd economic purpose of a futures market?

Lower transaction costs.
But markets are zero sum games. i.e. one person’s loss is
another’s gain

4

Name the 4 types of derivative markets

1. Futures markets (organised exchange market)
2. Forward markets (OTC markets)
3. Options contracts (many organised markets)
4. Swap markets (OTC markets)

5

What are the 2 types of Options?

- Call Options

- Put Options

6

What are the 2 types of Swaps?

- Interest rate swaps

- Currency swaps

7

How are Derivatives defined?

Derivatives are financial instruments whose value is linked to and derived from somewhere else.

8

What could derivatives be linked to?

Derivatives could be linked to almost anything;
-Commodities
- Interest Rates
- Equities and Equity Indices
- Bonds
- Currencies
- Weather

9

what is a futures contract?

Legally binding agreement to buy or sell a specified quantity of a
specified commodity/financial instrument for a specified delivery date in the future at a price agreed upon at setting up of contract

• A futures contract = highly standardised contract in terms of amounts,
prices & conditions

10

what is hedging?

- transferring the risk of unanticipated changes in
prices, interest rates or exchange rates to another party.

11

long position on a futures contract

• Agreement to buy in the future
• Will have money to invest in future
• believes (will profit if) market will go up

12

short position on futures contract

• Agreement to sell in the future
• Has shares to sell in future.
• Believes (will profit if) market will fall

13

what is an initial margin?

• Funds put up as security for guarantee of
contract fulfilment at time futures position is established.

• Paid by both buyer & seller to clearing house

• Set by futures exchange for its members who then set margin
for client

14

what is a maintenance margin call?

Any adverse price movement in the market must be covered
daily by further deposit of funds

15

What does a clearing house do?

- guarantees contract performance to both parties by becoming opposite party in all transactions
- records transactions, handles margin processes, helps
settlement & transfer

16

final settlement of futures contract may be ____ or _____?

standard delivery or cash settlement.

17

why are Majority of financial futures closed out before expiry
date?

- they Reverse trade by taking a position in market equal &
opposite to that already held

• Example: Company currently holds a 6-month futures
contract to “sell one five-year govt bond” so goes into futures
market & buys a contract to “buy one five-year govt bond”
with same delivery date

18

what is a arbitrageur?

• someone taking advantage of price differentials between two markets & making riskless profits.

Example: differentials between futures contract price & physical
spot price of the underlying commodity

19

Explain the 4 types of risk involved with hedging

1. Standard Contract Size – 90-day bank bill —$1,000,000 Face Value
– 3 year Govt. bond —$100,000 Face Value
– Listed Company Share —1,000 shares

2. Margin Risk -
• Initial margin- buyers & sellers need to pay initial margin (2-10% of futures contract)

3. Basis Risk
• A perfect hedge requires there to be zero initial & final basis risk between the physical and futures markets

4. Cross-commodity Hedging

20

what is a forward contract?

• Are similar to futures in that they are agreements to buy or
sell an asset at a certain time in the future for a certain price
but NOT traded on a futures exchange

• They are private agreements between 2 FIs or between FI &
client i.e. OTC products

21

What is an FRA?

Forward Rate Agreement
Forward contract for loans that today fixes the interest rate on a loan that will be made in the future.

22

what is an option?

• An option gives the buyer the right, but not the obligation to
buy or sell ‘commodities’ at a specified price (exercise price
or strike price), on or before a specified date (expiration date)

23

what is a call option?

gives the buyer the right to buy the ‘commodity’ at
the exercise price

24

what is a put option?

gives the buyer the right to sell the ‘commodity’ at the
exercise price (or strike price)

25

when can options be exercised?

– Exercisable at any time up to maturity (American)

– or Exercisable only at maturity (European)

26

How does a buyer of a call make profit?

– when price of underlying physical price greater than strike price

27

how does the buyer of a put make profit?

– when price of underlying physical price less than strike price

28

option sellers are known as what?

-writer

e.g. a writer of a call option must sell underlying shares to
holder of the call if they exercise option.

29

what type of markets are options sold in?

• Exchange-traded options have options clearinghouse
– Novation, Margin requirements
– Administration such as exercise notices sent to writer
– Most holders & writers close out before exercise date

• Over-the-counter options offered by banks are a major part
especially for interest-rate-related options

30

what relationship do interest rates and calls have?

– Positive relationship between interest rates & the price of a call