Derivatives and Financial Markets
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Questions and Answers

What is a characteristic of a forward contract's payoff profile?

  • Linear (correct)
  • Constant
  • Non-linear
  • Exponential

    • 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 ______.

    <p>stock</p> Signup and view all the answers

    Match the following terms with their definitions:

    <p>Forward Contract = Speculation A type of financial derivative = Reducing risk through a financial instrument</p> Signup and view all the answers

    What is the default risk in a forward contract?

    <p>None</p> Signup and view all the answers

    A forward contract is a unilateral contract.

    <p>False</p> Signup and view all the answers

    What is the purpose of a forward contract for a hedger?

    <p>To reduce risk through a financial instrument</p> Signup and view all the answers

    What is the purpose of hedgers in financial markets?

    <p>To transfer risks efficiently</p> Signup and view all the answers

    A spot contract is a bilateral agreement that involves the exchange of cash flows over a period of time.

    <p>False</p> Signup and view all the answers

    What is the term for selling borrowed securities?

    <p>Short selling</p> Signup and view all the answers

    A spot contract involves the delivery and payment of an asset within a maximum of ______ days.

    <p>3</p> Signup and view all the answers

    Match the following market participants with their roles:

    <p>Hedgers = Reduce risk exposure Speculators = Earn a profit by taking on risk Arbitrageurs = Exploit price differences</p> Signup and view all the answers

    What is the term for an agreement that includes value creation through flexibility?

    <p>Real options</p> Signup and view all the answers

    Default risk is a concern in spot contracts.

    <p>True</p> Signup and view all the answers

    What is the term for holding a long position in an asset?

    <p>Holding the asset</p> Signup and view all the answers

    What is the main purpose of trading a forward contract to hedge?

    <p>To eliminate cash flow uncertainty from a future transaction</p> Signup and view all the answers

    A forward contract is a standardized contract that can be traded on an exchange.

    <p>False</p> Signup and view all the answers

    What is the term for the risk that one party will default on their obligations in a forward contract?

    <p>Default risk or credit risk</p> Signup and view all the answers

    A forward contract is an agreement to buy or sell an underlying asset at a certain time in the future, known as the ______________________ date.

    <p>maturity</p> Signup and view all the answers

    Match the following terms with their corresponding definitions:

    <p>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</p> Signup and view all the answers

    What is the primary reason for a party to take a long position in a forward contract?

    <p>To hedge against an existing exposure</p> Signup and view all the answers

    A forward contract can be transferred unilaterally to another third party.

    <p>False</p> Signup and view all the answers

    What is the term for the process of settling a forward contract in cash, rather than through physical delivery?

    <p>Cash settlement</p> Signup and view all the answers

    What is the primary classification of derivatives?

    <p>Linear and Non-linear</p> Signup and view all the answers

    A spot contract involves the exchange of cash flows over a period of time.

    <p>False</p> Signup and view all the answers

    What is the main purpose of derivatives?

    <p>Risk management</p> Signup and view all the answers

    A derivative is an instrument whose payoff depends on one or several other uncertain __________ variables.

    <p>underlying</p> Signup and view all the answers

    What is the term for selling borrowed securities?

    <p>Short selling</p> Signup and view all the answers

    Default risk is a concern in forward contracts.

    <p>True</p> Signup and view all the answers

    Match the following types of derivatives with their descriptions:

    <p>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.</p> Signup and view all the answers

    Why are derivatives important?

    <p>They are the biggest financial markets with outstanding notionals that are a multiple of world GDP.</p> Signup and view all the answers

    What is the primary purpose of trading a forward contract for a hedger?

    <p>To eliminate cash flow uncertainty from a future transaction</p> Signup and view all the answers

    A forward contract is a standardized contract that can be traded on an exchange.

    <p>False</p> Signup and view all the answers

    What is the purpose of settling a forward contract in cash?

    <p>When physical delivery is not practical or not possible.</p> Signup and view all the answers

    Forward contracts are settled at the ______________________ date.

    <p>maturity</p> Signup and view all the answers

    Match the following positions with their definitions:

    <p>Long = obligation to buy Short = obligation to sell</p> Signup and view all the answers

    Why would a party take a long position in a forward contract?

    <p>To eliminate cash flow uncertainty from a future transaction</p> Signup and view all the answers

    A forward contract can be transferred unilaterally to another third party.

    <p>False</p> Signup and view all the answers

    What is the main risk associated with forward contracts?

    <p>Default risk (credit risk)</p> Signup and view all the answers

    What is the primary purpose of a spot contract?

    <p>To buy or sell an asset at a certain price with immediate delivery and payment</p> Signup and view all the answers

    A spot contract is a bilateral agreement that involves the exchange of cash flows over a period of time.

    <p>False</p> Signup and view all the answers

    What is the term for holding an asset, expecting its price to increase?

    <p>Long position</p> Signup and view all the answers

    A spot contract involves the delivery and payment of an asset within a maximum of __________ days.

    <p>3</p> Signup and view all the answers

    Match the following users of derivatives with their roles:

    <p>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</p> Signup and view all the answers

    What is the term for selling borrowed securities?

    <p>Short selling</p> Signup and view all the answers

    Derivatives enable users to transfer risks efficiently.

    <p>True</p> Signup and view all the answers

    What is the term for an agreement that includes value creation through flexibility?

    <p>Real option</p> Signup and view all the answers

    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.

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    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.

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