48 Questions
What is a characteristic of a forward contract's payoff profile?
Linear
A forward contract is a bilateral contract.
True
What happens to the payoff of a forward contract when the price of the underlying increases by Ä1?
The payoff of the derivative increases also with Ä1.
The payoff profile of a forward contract is a shifted version of the payoff profile of the ______.
stock
Match the following terms with their definitions:
Forward Contract = Speculation A type of financial derivative = Reducing risk through a financial instrument
What is the default risk in a forward contract?
None
A forward contract is a unilateral contract.
False
What is the purpose of a forward contract for a hedger?
To reduce risk through a financial instrument
What is the purpose of hedgers in financial markets?
To transfer risks efficiently
A spot contract is a bilateral agreement that involves the exchange of cash flows over a period of time.
False
What is the term for selling borrowed securities?
Short selling
A spot contract involves the delivery and payment of an asset within a maximum of ______ days.
3
Match the following market participants with their roles:
Hedgers = Reduce risk exposure Speculators = Earn a profit by taking on risk Arbitrageurs = Exploit price differences
What is the term for an agreement that includes value creation through flexibility?
Real options
Default risk is a concern in spot contracts.
True
What is the term for holding a long position in an asset?
Holding the asset
What is the main purpose of trading a forward contract to hedge?
To eliminate cash flow uncertainty from a future transaction
A forward contract is a standardized contract that can be traded on an exchange.
False
What is the term for the risk that one party will default on their obligations in a forward contract?
Default risk or credit risk
A forward contract is an agreement to buy or sell an underlying asset at a certain time in the future, known as the ______________________ date.
maturity
Match the following terms with their corresponding definitions:
Hedging = To eliminate cash flow uncertainty from a future transaction Speculation = To take a position without the existence of an underlying existing exposure Bilateral Contract = A contract that is traded on an exchange Default Risk = The risk that one party will default on their obligations
What is the primary reason for a party to take a long position in a forward contract?
To hedge against an existing exposure
A forward contract can be transferred unilaterally to another third party.
False
What is the term for the process of settling a forward contract in cash, rather than through physical delivery?
Cash settlement
What is the primary classification of derivatives?
Linear and Non-linear
A spot contract involves the exchange of cash flows over a period of time.
False
What is the main purpose of derivatives?
Risk management
A derivative is an instrument whose payoff depends on one or several other uncertain __________ variables.
underlying
What is the term for selling borrowed securities?
Short selling
Default risk is a concern in forward contracts.
True
Match the following types of derivatives with their descriptions:
Forwards = A customized contract between two parties to buy or sell an asset at a future date. Futures = A standardized contract that can be traded on an exchange. Swaps = A contract that involves the exchange of cash flows between two parties. Options = A contract that gives the buyer the right, but not the obligation, to buy or sell an asset.
Why are derivatives important?
They are the biggest financial markets with outstanding notionals that are a multiple of world GDP.
What is the primary purpose of trading a forward contract for a hedger?
To eliminate cash flow uncertainty from a future transaction
A forward contract is a standardized contract that can be traded on an exchange.
False
What is the purpose of settling a forward contract in cash?
When physical delivery is not practical or not possible.
Forward contracts are settled at the ______________________ date.
maturity
Match the following positions with their definitions:
Long = obligation to buy Short = obligation to sell
Why would a party take a long position in a forward contract?
To eliminate cash flow uncertainty from a future transaction
A forward contract can be transferred unilaterally to another third party.
False
What is the main risk associated with forward contracts?
Default risk (credit risk)
What is the primary purpose of a spot contract?
To buy or sell an asset at a certain price with immediate delivery and payment
A spot contract is a bilateral agreement that involves the exchange of cash flows over a period of time.
False
What is the term for holding an asset, expecting its price to increase?
Long position
A spot contract involves the delivery and payment of an asset within a maximum of __________ days.
3
Match the following users of derivatives with their roles:
Hedgers = To manage risk Speculators = To take a position in the market to profit from price movements Arbitrageurs = To take advantage of price differences in different markets
What is the term for selling borrowed securities?
Short selling
Derivatives enable users to transfer risks efficiently.
True
What is the term for an agreement that includes value creation through flexibility?
Real option
Study Notes
Derivatives and Financial Markets
- Derivatives enable efficient risk transfer.
- Many financial products have embedded derivatives, such as bonds and structured products.
- Real options allow enhanced NPV calculations by including value creation through flexibility.
Users of Derivatives
- Hedgers: reduce risk by locking in a price.
- Speculators: take on risk to potentially gain from price movements.
- Arbitrageurs: exploit price differences between markets.
Spot Contracts
- A spot contract is an agreement to buy or sell an asset at a certain price with immediate delivery (max. 3 days).
- Holding an asset is a long position, and selling borrowed securities is a short position.
- Long positions gain if the asset price increases, while short positions gain if the asset price decreases.
Forward Contracts
- A forward contract is an agreement to buy or sell an underlying asset at a certain time in the future (maturity date) for a contracted delivery price.
- Long positions obligate buying, while short positions obligate selling.
- Delivery modes include physical delivery or cash settlement.
- Forward contracts can be used for hedging (eliminating cash flow uncertainty) or speculation (taking a position without an underlying exposure).
Characteristics of Forward Contracts
- Bilateral contracts directly negotiated between buyer and seller.
- Highly customizable contracts tailored to the needs of the parties.
- Settled at the maturity date (expiration date).
- Both parties are exposed to default risk (credit risk).
- Obligations cannot be transferred unilaterally to another third party.
Payoff and Linearity of Forward Contracts
- The payoff profile of a forward contract is linear, with a Ä1 increase/decrease in the underlying price resulting in a Ä1 increase/decrease in the payoff.
- The payoff profile of a forward is a shifted version of the payoff profile of the underlying asset.
Introduction to Financial Markets
- Derivatives enable efficient transfer of risks and are embedded in many financial products, such as bonds and structured products.
Setting the Scene
- Users of financial markets include hedgers, speculators, and arbitrageurs.
Spot Contracts
- A spot contract is an agreement between two parties to buy or sell an asset at a certain price with immediate delivery and payment.
- Holding an asset is a long position, and selling borrowed securities is a short position.
- The payoff of a spot contract depends on the asset price.
Derivatives
- A derivative is an instrument whose payoff depends on one or several underlying uncertain variables.
- Types of derivatives include linear products (forwards, futures, and swaps) and non-linear products (options).
- Derivatives can be classified based on the underlying asset (equity, interest rate, currency, commodity, etc.) or the nature of the market (exchange-traded or over-the-counter).
Importance of Derivatives
- Derivatives are important because they represent the largest financial markets with outstanding notionals that are a multiple of world GDP.
Forward Contracts
- A forward contract is an agreement between two parties to buy or sell an underlying asset at a certain time in the future for a contracted delivery price.
- Positions in a forward contract include long (obligation to buy) and short (obligation to sell).
- Delivery modes include physical delivery or settlement in cash.
- Forward contracts are used to hedge or speculate, and they are highly customizable, bilateral, and settled at the maturity date.
Learn about derivatives, their role in financial markets, and their various applications. Understand the different types of users of derivatives and their roles in managing risk.
Make Your Own Quizzes and Flashcards
Convert your notes into interactive study material.
Get started for free
