Podcast
Questions and Answers
Which statement best describes the role of derivatives in today's financial world?
Which statement best describes the role of derivatives in today's financial world?
- Derivatives are an essential tool for risk management, speculation, and arbitrage, integral to various financial activities. (correct)
- Derivatives are primarily used for hedging purposes and have limited impact on the broader economy.
- Derivatives are a niche product used only by specialized financial institutions.
- Derivatives are considered outdated financial instruments, gradually being replaced by simpler investment options.
What distinguishes a derivative from other financial instruments?
What distinguishes a derivative from other financial instruments?
- It represents direct ownership of a physical commodity.
- It is traded exclusively on regulated exchanges.
- Its value is derived from the value of an underlying asset or variable. (correct)
- Its value is directly determined by market supply and demand.
How has the derivatives market evolved since the late 20th century?
How has the derivatives market evolved since the late 20th century?
- It has shifted its focus away from risk management and toward pure speculation.
- It has significantly expanded to include derivatives based on new asset classes like credit, weather, and electricity. (correct)
- It has remained relatively stagnant, with few new types of derivative products emerging.
- It has become more tightly regulated, leading to a decrease in overall market activity.
What are the primary uses of derivatives in financial markets?
What are the primary uses of derivatives in financial markets?
What is the significance of derivatives markets relative to other financial markets?
What is the significance of derivatives markets relative to other financial markets?
Which of the following is an example of an underlying variable for a derivative?
Which of the following is an example of an underlying variable for a derivative?
In addition to traditional assets, derivatives can be based on:
In addition to traditional assets, derivatives can be based on:
What impact did derivatives have on the credit crisis that started in 2007?
What impact did derivatives have on the credit crisis that started in 2007?
What was the initial primary function of the Chicago Board of Trade (CBOT) when it was established in 1848?
What was the initial primary function of the Chicago Board of Trade (CBOT) when it was established in 1848?
How did the introduction of electronic trading impact derivatives markets?
How did the introduction of electronic trading impact derivatives markets?
What is the primary role of a clearing house in derivatives trading?
What is the primary role of a clearing house in derivatives trading?
What is the main difference between exchange-traded and over-the-counter (OTC) derivative markets?
What is the main difference between exchange-traded and over-the-counter (OTC) derivative markets?
What critical function does margin serve in the context of derivatives trading and clearing houses?
What critical function does margin serve in the context of derivatives trading and clearing houses?
In the context of OTC derivatives, what is the role of a Central Counterparty (CCP)?
In the context of OTC derivatives, what is the role of a Central Counterparty (CCP)?
What is a key component typically included in bilateral clearing agreements for OTC derivatives?
What is a key component typically included in bilateral clearing agreements for OTC derivatives?
What was a significant change in banking practices following the credit crisis related to derivatives?
What was a significant change in banking practices following the credit crisis related to derivatives?
What drove many derivative products, created from risky mortgages, to become worthless?
What drove many derivative products, created from risky mortgages, to become worthless?
What distinguishes the way banks value derivatives now compared to before the credit crisis?
What distinguishes the way banks value derivatives now compared to before the credit crisis?
How has the mechanism of trading on derivative exchanges changed over time?
How has the mechanism of trading on derivative exchanges changed over time?
What is indicated by banks changing the proxies they use for the 'risk-free' interest rate to reflect their funding costs?
What is indicated by banks changing the proxies they use for the 'risk-free' interest rate to reflect their funding costs?
What distinguishes 'to-arrive' contracts from the current futures contracts?
What distinguishes 'to-arrive' contracts from the current futures contracts?
Which entities are the primary participants in the over-the-counter (OTC) derivatives markets?
Which entities are the primary participants in the over-the-counter (OTC) derivatives markets?
Which of the following is considered to be the key advantage of the clearing house arrangement in derivatives trading?
Which of the following is considered to be the key advantage of the clearing house arrangement in derivatives trading?
A US corporation treasurer aims to hedge against exchange rate fluctuations for a future payment of £1 million in 6 months. According to the quotes in Table 1.1 (May 6, 2013), what action should the treasurer take?
A US corporation treasurer aims to hedge against exchange rate fluctuations for a future payment of £1 million in 6 months. According to the quotes in Table 1.1 (May 6, 2013), what action should the treasurer take?
What distinguishes a forward contract from a spot contract?
What distinguishes a forward contract from a spot contract?
A trader enters a short forward contract to sell one unit of an asset at a delivery price of $K$. At maturity, the spot price of the asset is $S_T$. What is the trader's payoff?
A trader enters a short forward contract to sell one unit of an asset at a delivery price of $K$. At maturity, the spot price of the asset is $S_T$. What is the trader's payoff?
Consider a stock worth $60 that pays no dividends. The risk-free interest rate is 5% per year. What should the one-year forward price of this stock be, according to the provided information?
Consider a stock worth $60 that pays no dividends. The risk-free interest rate is 5% per year. What should the one-year forward price of this stock be, according to the provided information?
What does the 'bid' price in Table 1.1 represent from the bank's perspective?
What does the 'bid' price in Table 1.1 represent from the bank's perspective?
On May 6, 2013, a company entered a 3-month forward contract to sell GBP at $1.5538 per GBP. What is their obligation?
On May 6, 2013, a company entered a 3-month forward contract to sell GBP at $1.5538 per GBP. What is their obligation?
According to Figure 1.1, how did the size of the OTC derivatives market compare to the size of the exchange-traded derivatives market in June 2008?
According to Figure 1.1, how did the size of the OTC derivatives market compare to the size of the exchange-traded derivatives market in June 2008?
If the spot exchange rate on November 6, 2013, is $1.6000 per GBP, what is the value to the US corporation of its long forward contract to buy £1 million at $1.5532 per GBP?
If the spot exchange rate on November 6, 2013, is $1.6000 per GBP, what is the value to the US corporation of its long forward contract to buy £1 million at $1.5532 per GBP?
What is the significance of a Central Counterparty (CCP) in an OTC transaction, according to the provided information?
What is the significance of a Central Counterparty (CCP) in an OTC transaction, according to the provided information?
A trader holds a long forward contract on one unit of an asset with a delivery price of $K$. If the spot price of the asset at maturity ($S_T$) is less than $K$, what does this imply for the trader?
A trader holds a long forward contract on one unit of an asset with a delivery price of $K$. If the spot price of the asset at maturity ($S_T$) is less than $K$, what does this imply for the trader?
A corporation has a short forward contract on GBP. If the spot exchange rate increases significantly before the contract's maturity, what is most likely to happen?
A corporation has a short forward contract on GBP. If the spot exchange rate increases significantly before the contract's maturity, what is most likely to happen?
What is the primary reason for using forward contracts on foreign exchange?
What is the primary reason for using forward contracts on foreign exchange?
In the context of forward contracts, what does 'delivery price' refer to?
In the context of forward contracts, what does 'delivery price' refer to?
What conclusion can be drawn about the relationship between spot and forward prices?
What conclusion can be drawn about the relationship between spot and forward prices?
Which trading strategy involves purchasing securities considered undervalued and shorting those considered overvalued, with minimal exposure to overall market direction?
Which trading strategy involves purchasing securities considered undervalued and shorting those considered overvalued, with minimal exposure to overall market direction?
Which hedge fund strategy focuses on investing in the debt and equity of companies in developing countries, as well as the countries' debt themselves?
Which hedge fund strategy focuses on investing in the debt and equity of companies in developing countries, as well as the countries' debt themselves?
Which of the following is the most accurate characterization of over-the-counter (OTC) derivatives markets?
Which of the following is the most accurate characterization of over-the-counter (OTC) derivatives markets?
A US company, ImportCo, needs to pay £10 million in three months. They hedge using the forward market at a rate of 1.5538. If the spot rate in three months is 1.4000, what is the result of their hedging activity?
A US company, ImportCo, needs to pay £10 million in three months. They hedge using the forward market at a rate of 1.5538. If the spot rate in three months is 1.4000, what is the result of their hedging activity?
ExportCo hedges its foreign exchange risk by selling £30 million forward at an exchange rate of 1.5533. If the exchange rate in August proves to be higher than 1.5533, then:
ExportCo hedges its foreign exchange risk by selling £30 million forward at an exchange rate of 1.5533. If the exchange rate in August proves to be higher than 1.5533, then:
An investor owns 1,000 shares at $28 and buys ten July put option contracts with a strike price of $27.50, costing $1,000. If the market price falls to $26, what is the net value of the portfolio, considering the cost of the options?
An investor owns 1,000 shares at $28 and buys ten July put option contracts with a strike price of $27.50, costing $1,000. If the market price falls to $26, what is the net value of the portfolio, considering the cost of the options?
How do options differ from forward contracts in hedging strategies?
How do options differ from forward contracts in hedging strategies?
A speculator believes the British pound will strengthen against the US dollar. Which action aligns with this belief?
A speculator believes the British pound will strengthen against the US dollar. Which action aligns with this belief?
What is the primary goal of speculators in futures and options markets?
What is the primary goal of speculators in futures and options markets?
Which trading strategy involves profiting from the price discrepancies after a merger or acquisition is announced?
Which trading strategy involves profiting from the price discrepancies after a merger or acquisition is announced?
A US speculator purchases £250,000 in the spot market at 1.5470 dollars per pound, anticipating the exchange rate will be 1.6000 dollars per pound in April. Instead of purchasing in the spot market, the speculator could have taken a long position in futures contracts. What is the amount for each futures contract?
A US speculator purchases £250,000 in the spot market at 1.5470 dollars per pound, anticipating the exchange rate will be 1.6000 dollars per pound in April. Instead of purchasing in the spot market, the speculator could have taken a long position in futures contracts. What is the amount for each futures contract?
Consider an ImportCo needing to pay £10 million. They decided to hedge using the forward market at a rate of 1.5538. If they didn't hedge and the exchange rate is 1.6000, how much would the £10 million cost?
Consider an ImportCo needing to pay £10 million. They decided to hedge using the forward market at a rate of 1.5538. If they didn't hedge and the exchange rate is 1.6000, how much would the £10 million cost?
What is the primary purpose of hedging?
What is the primary purpose of hedging?
What unique benefit do options offer for hedging compared to forward contracts?
What unique benefit do options offer for hedging compared to forward contracts?
Which trading stragety involves taking a long position in an undervalued convertible bond and a short position in the underlying equity?
Which trading stragety involves taking a long position in an undervalued convertible bond and a short position in the underlying equity?
A US speculator anticipates the British pound will strengthen and takes a long position in four CME April futures contracts on sterling. If current exchange rate is 1.5470 dollars per pound and the April futures price is 1.5410 dollars per pound and the exchange rate turns out to be 1.6000 dollars per pound in April, what is the speculators profit?
A US speculator anticipates the British pound will strengthen and takes a long position in four CME April futures contracts on sterling. If current exchange rate is 1.5470 dollars per pound and the April futures price is 1.5410 dollars per pound and the exchange rate turns out to be 1.6000 dollars per pound in April, what is the speculators profit?
An investor owns stock as part of a portfolio. The forward price is $58, but they sell the stock for $60 and enter a forward contract to buy it back at $58 in one year. They invest the proceedings at 5% earning $3. What is the net financial impact of this strategy compared to keeping the stock?
An investor owns stock as part of a portfolio. The forward price is $58, but they sell the stock for $60 and enter a forward contract to buy it back at $58 in one year. They invest the proceedings at 5% earning $3. What is the net financial impact of this strategy compared to keeping the stock?
How do futures contracts differ from forward contracts?
How do futures contracts differ from forward contracts?
What role does an exchange play in futures contracts?
What role does an exchange play in futures contracts?
Which of the following assets are commonly the underlying assets in futures contracts?
Which of the following assets are commonly the underlying assets in futures contracts?
If the demand to go long on a futures contract exceeds the demand to go short, what is the likely effect on the futures price?
If the demand to go long on a futures contract exceeds the demand to go short, what is the likely effect on the futures price?
What distinguishes an option from a forward or futures contract?
What distinguishes an option from a forward or futures contract?
What is a 'strike price' in the context of options contracts?
What is a 'strike price' in the context of options contracts?
What is the key difference between American and European options?
What is the key difference between American and European options?
What is the typical quantity of shares covered by one exchange-traded equity option contract?
What is the typical quantity of shares covered by one exchange-traded equity option contract?
How does the price of a call option generally change as the strike price increases?
How does the price of a call option generally change as the strike price increases?
All other factors being equal, how does the value of an option tend to change as its time to maturity increases?
All other factors being equal, how does the value of an option tend to change as its time to maturity increases?
An investor instructs a broker to buy one December Google call option contract with a strike price of $880. What right does this contract give the investor?
An investor instructs a broker to buy one December Google call option contract with a strike price of $880. What right does this contract give the investor?
Which of the following is generally true about bid-offer spreads for options compared to the underlying stock?
Which of the following is generally true about bid-offer spreads for options compared to the underlying stock?
An investor buys a call option contract for Google shares with a strike price of $880, paying $5,630 for the contract which covers 100 shares. If, by the expiration date, the market price of Google shares is $900, what is the investor's profit or loss, taking into account the initial cost of the option?
An investor buys a call option contract for Google shares with a strike price of $880, paying $5,630 for the contract which covers 100 shares. If, by the expiration date, the market price of Google shares is $900, what is the investor's profit or loss, taking into account the initial cost of the option?
What is the significance of the Chicago Board Options Exchange (CBOE)?
What is the significance of the Chicago Board Options Exchange (CBOE)?
If an investor sells a put option contract with a strike price of $840, receiving $3,100 for it, and the stock price falls to $800 by the expiration date, what is the investor's net profit or loss?
If an investor sells a put option contract with a strike price of $840, receiving $3,100 for it, and the stock price falls to $800 by the expiration date, what is the investor's net profit or loss?
Which of the following best describes the role of a hedger in the derivatives market?
Which of the following best describes the role of a hedger in the derivatives market?
What is the primary difference between American and European options regarding when they can be exercised?
What is the primary difference between American and European options regarding when they can be exercised?
In the context of options trading, what does it mean to have a 'short position'?
In the context of options trading, what does it mean to have a 'short position'?
A U.S.-based company, ExportCo, anticipates receiving €5 million in three months. To hedge against potential exchange rate fluctuations, what action should ExportCo take using forward contracts?
A U.S.-based company, ExportCo, anticipates receiving €5 million in three months. To hedge against potential exchange rate fluctuations, what action should ExportCo take using forward contracts?
What distinguishes hedge funds from mutual funds regarding regulation and investment strategies?
What distinguishes hedge funds from mutual funds regarding regulation and investment strategies?
An arbitrageur observes that the same asset is trading at different prices on two different exchanges. What action would they likely take?
An arbitrageur observes that the same asset is trading at different prices on two different exchanges. What action would they likely take?
What is the role of the exchange, such as the CBOE, in options trading transactions?
What is the role of the exchange, such as the CBOE, in options trading transactions?
What is the profit for an investor who purchases a call option to buy 100 shares of a company at a strike price of $50 per share, pays a premium of $5 per share for the option, and the market price rises to $60 per share at expiration?
What is the profit for an investor who purchases a call option to buy 100 shares of a company at a strike price of $50 per share, pays a premium of $5 per share for the option, and the market price rises to $60 per share at expiration?
Which of the following is NOT a typical characteristic of hedge funds?
Which of the following is NOT a typical characteristic of hedge funds?
What is the initial cash flow effect of selling one call option contract with a premium of $2.50 per share, where one contract represents 100 shares?
What is the initial cash flow effect of selling one call option contract with a premium of $2.50 per share, where one contract represents 100 shares?
ImportCo needs to pay £5 million in six months. If they decide to hedge using forward contracts, which action should they take?
ImportCo needs to pay £5 million in six months. If they decide to hedge using forward contracts, which action should they take?
When an option is not exercised by the expiration date, what is the outcome for the buyer of the option?
When an option is not exercised by the expiration date, what is the outcome for the buyer of the option?
If a trader is described as having a 'long position' in options, this means they are:
If a trader is described as having a 'long position' in options, this means they are:
Why do arbitrage opportunities tend to be small and short-lived in most financial markets?
Why do arbitrage opportunities tend to be small and short-lived in most financial markets?
What fundamental assumption underlies most arguments concerning futures prices, forward prices, and option contract values?
What fundamental assumption underlies most arguments concerning futures prices, forward prices, and option contract values?
What is a key danger associated with the versatility of derivatives?
What is a key danger associated with the versatility of derivatives?
What control is most important for corporations to set up to ensure derivatives are being used for their intended purpose?
What control is most important for corporations to set up to ensure derivatives are being used for their intended purpose?
What was the primary lesson learned from the SocGen's big loss in 2008 involving Jerome Kerviel?
What was the primary lesson learned from the SocGen's big loss in 2008 involving Jerome Kerviel?
In the context of risk management, what is a critical question that financial institutions should always be asking?
In the context of risk management, what is a critical question that financial institutions should always be asking?
What was Jerome Kerviel's initial role at Société Générale before becoming a junior trader?
What was Jerome Kerviel's initial role at Société Générale before becoming a junior trader?
What specific tactic did Kerviel employ to conceal his unauthorized trading activities?
What specific tactic did Kerviel employ to conceal his unauthorized trading activities?
Which of the following best describes the underlying cause of Barings Bank's collapse due to Nick Leeson's actions?
Which of the following best describes the underlying cause of Barings Bank's collapse due to Nick Leeson's actions?
What was the primary trading activity that John Rusnak engaged in that led to substantial losses for Allied Irish Bank?
What was the primary trading activity that John Rusnak engaged in that led to substantial losses for Allied Irish Bank?
In the context of the 2006-2007 period, what critical oversight contributed to the credit crisis?
In the context of the 2006-2007 period, what critical oversight contributed to the credit crisis?
How did Kerviel exploit his understanding of SocGen's procedures?
How did Kerviel exploit his understanding of SocGen's procedures?
What specific market indices were traded by Jerome Kerviel at SocGen?
What specific market indices were traded by Jerome Kerviel at SocGen?
What common thread links the rogue trader losses at Barings Bank, Allied Irish Bank and Société Générale?
What common thread links the rogue trader losses at Barings Bank, Allied Irish Bank and Société Générale?
What assumption regarding future house prices proved to be a critical flaw in risk assessments leading up to the 2007 credit crisis?
What assumption regarding future house prices proved to be a critical flaw in risk assessments leading up to the 2007 credit crisis?
What is the primary benefit of using futures contracts for speculation, as opposed to directly buying an asset in the spot market?
What is the primary benefit of using futures contracts for speculation, as opposed to directly buying an asset in the spot market?
In the context of options trading, what does the strike price represent?
In the context of options trading, what does the strike price represent?
How does the potential loss differ when using options versus futures contracts for speculation?
How does the potential loss differ when using options versus futures contracts for speculation?
What is the fundamental principle behind arbitrage?
What is the fundamental principle behind arbitrage?
Why might a large investment bank be better suited to take advantage of arbitrage opportunities compared to a small investor?
Why might a large investment bank be better suited to take advantage of arbitrage opportunities compared to a small investor?
In the context of speculation using options, what happens to a call option if the stock price falls below the strike price by the expiration date?
In the context of speculation using options, what happens to a call option if the stock price falls below the strike price by the expiration date?
A speculator believes a stock price will increase from $50 to $60 in the next month. They can either buy 100 shares or use the $500 to buy call options with a strike price of $55. Which statement best describes the leverage effect in this scenario?
A speculator believes a stock price will increase from $50 to $60 in the next month. They can either buy 100 shares or use the $500 to buy call options with a strike price of $55. Which statement best describes the leverage effect in this scenario?
An arbitrageur notices a stock trading at $200 on the New York Stock Exchange and 150 on the London Stock Exchange when the exchange rate is $1.30 per pound. Ignoring transaction costs, what action should the arbitrageur take to exploit this opportunity?
An arbitrageur notices a stock trading at $200 on the New York Stock Exchange and 150 on the London Stock Exchange when the exchange rate is $1.30 per pound. Ignoring transaction costs, what action should the arbitrageur take to exploit this opportunity?
Consider a scenario where a speculator buys futures contracts expecting the price of an asset to rise. If the price falls instead, what is the likely outcome for the speculator?
Consider a scenario where a speculator buys futures contracts expecting the price of an asset to rise. If the price falls instead, what is the likely outcome for the speculator?
How does an initial margin requirement in futures trading enable leverage?
How does an initial margin requirement in futures trading enable leverage?
A stock is trading at $75. A call option with a strike price of $80 costs $2. If the stock price rises to $85 by the expiration date, what is the profit from exercising the call option, ignoring the initial cost?
A stock is trading at $75. A call option with a strike price of $80 costs $2. If the stock price rises to $85 by the expiration date, what is the profit from exercising the call option, ignoring the initial cost?
Which of the following best describes the relationship between risk and reward when comparing speculation using spot markets, futures, and options?
Which of the following best describes the relationship between risk and reward when comparing speculation using spot markets, futures, and options?
What is the likely impact of successful arbitrage activity on the prices of an asset in different markets?
What is the likely impact of successful arbitrage activity on the prices of an asset in different markets?
Suppose a speculator uses options and the market moves against their prediction. What is a key advantage of using options in this scenario?
Suppose a speculator uses options and the market moves against their prediction. What is a key advantage of using options in this scenario?
If a company observes an arbitrage opportunity but decides not to act upon it due to high transaction costs, what does this suggest?
If a company observes an arbitrage opportunity but decides not to act upon it due to high transaction costs, what does this suggest?
Which of the following best describes the role of banks as market makers in OTC derivative markets?
Which of the following best describes the role of banks as market makers in OTC derivative markets?
What was a primary motivation behind the regulatory changes in OTC derivative markets following the 2007-2008 financial crisis?
What was a primary motivation behind the regulatory changes in OTC derivative markets following the 2007-2008 financial crisis?
Why was the bankruptcy of Lehman Brothers particularly impactful on the derivatives market?
Why was the bankruptcy of Lehman Brothers particularly impactful on the derivatives market?
Which of the following factors contributed significantly to Lehman Brothers' downfall?
Which of the following factors contributed significantly to Lehman Brothers' downfall?
What is 'systemic risk' in the context of financial markets?
What is 'systemic risk' in the context of financial markets?
What is the primary function of Swap Execution Facilities (SEFs) in the context of OTC derivatives markets?
What is the primary function of Swap Execution Facilities (SEFs) in the context of OTC derivatives markets?
What is the role of a Central Counterparty (CCP) in the trading of standardized derivatives?
What is the role of a Central Counterparty (CCP) in the trading of standardized derivatives?
What is the purpose of requiring all derivatives trades to be reported to a central registry?
What is the purpose of requiring all derivatives trades to be reported to a central registry?
How does the average transaction size typically differ between OTC and exchange-traded derivatives markets?
How does the average transaction size typically differ between OTC and exchange-traded derivatives markets?
According to the data from the Bank for International Settlements (BIS), how does the size of the OTC derivatives market compare to the exchange-traded derivatives market (as of December 2012)?
According to the data from the Bank for International Settlements (BIS), how does the size of the OTC derivatives market compare to the exchange-traded derivatives market (as of December 2012)?
What is a key difference between trading OTC derivatives and exchange-traded derivatives?
What is a key difference between trading OTC derivatives and exchange-traded derivatives?
How did Lehman Brothers' management culture contribute to its eventual bankruptcy?
How did Lehman Brothers' management culture contribute to its eventual bankruptcy?
In the context of OTC derivative markets, what does 'posting collateral' refer to?
In the context of OTC derivative markets, what does 'posting collateral' refer to?
Which of the following is an example of how increased regulation has changed the OTC derivatives market?
Which of the following is an example of how increased regulation has changed the OTC derivatives market?
What does the term 'leverage ratio' signify in the context of financial institutions like Lehman Brothers?
What does the term 'leverage ratio' signify in the context of financial institutions like Lehman Brothers?
Flashcards
Derivative
Derivative
A financial instrument whose value is derived from other underlying variables.
Hedging (with derivatives)
Hedging (with derivatives)
Using derivatives to reduce financial risk.
Speculation (with derivatives)
Speculation (with derivatives)
Using derivatives to bet on the future direction of an asset's price.
Arbitrage (with derivatives)
Arbitrage (with derivatives)
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Over-the-Counter (OTC) Derivatives
Over-the-Counter (OTC) Derivatives
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Futures Contract
Futures Contract
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Options Contract
Options Contract
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Swap
Swap
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Securitization
Securitization
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Derivatives Exchange
Derivatives Exchange
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Chicago Board of Trade (CBOT)
Chicago Board of Trade (CBOT)
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Chicago Mercantile Exchange (CME)
Chicago Mercantile Exchange (CME)
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Chicago Board Options Exchange (CBOE)
Chicago Board Options Exchange (CBOE)
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Clearing House
Clearing House
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Margin
Margin
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Open Outcry System
Open Outcry System
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Electronic Trading
Electronic Trading
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Algorithmic Trading
Algorithmic Trading
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Over-the-Counter (OTC) Markets
Over-the-Counter (OTC) Markets
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Central Counterparty (CCP)
Central Counterparty (CCP)
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Bilateral Clearing
Bilateral Clearing
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OTC Agreement
OTC Agreement
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Posted Collateral
Posted Collateral
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Forward Contract
Forward Contract
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Spot Contract
Spot Contract
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Over-the-Counter (OTC) Forward Contract
Over-the-Counter (OTC) Forward Contract
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Long Position (Forward Contract)
Long Position (Forward Contract)
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Short Position (Forward Contract)
Short Position (Forward Contract)
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Hedging Foreign Currency Risk
Hedging Foreign Currency Risk
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Delivery Price (K)
Delivery Price (K)
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Spot Price at Maturity (ST)
Spot Price at Maturity (ST)
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Payoff: Long Forward Contract
Payoff: Long Forward Contract
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Payoff: Short Forward Contract
Payoff: Short Forward Contract
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Forward/Spot Price Relationship
Forward/Spot Price Relationship
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Bid-Offer Spread
Bid-Offer Spread
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Gross Market Value
Gross Market Value
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Strike Price (Exercise Price)
Strike Price (Exercise Price)
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Expiration Date (Maturity)
Expiration Date (Maturity)
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American Option
American Option
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European Option
European Option
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Call Option
Call Option
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Put Option
Put Option
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CBOT and CME
CBOT and CME
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Going long
Going long
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Going short
Going short
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Forward Contract Strategy
Forward Contract Strategy
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Market Makers
Market Makers
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Credit Crisis
Credit Crisis
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Lehman Brothers Bankruptcy
Lehman Brothers Bankruptcy
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Swap Execution Facilities (SEFs)
Swap Execution Facilities (SEFs)
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Central Counterparties (CCPs)
Central Counterparties (CCPs)
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Central Registry
Central Registry
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Systemic Risk
Systemic Risk
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Bank for International Settlements (BIS)
Bank for International Settlements (BIS)
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Exchange-Traded Markets
Exchange-Traded Markets
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Short-Term Debt Funding
Short-Term Debt Funding
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Collateral Posting
Collateral Posting
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Leverage Ratio
Leverage Ratio
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Dick Fuld
Dick Fuld
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OTC Market Size vs. Exchange-Traded
OTC Market Size vs. Exchange-Traded
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Option Price
Option Price
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Option Contract (US)
Option Contract (US)
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Option Not Exercised
Option Not Exercised
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Call Option Profit
Call Option Profit
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Cash Inflow (Selling Option)
Cash Inflow (Selling Option)
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Long vs Short Positions
Long vs Short Positions
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Hedging
Hedging
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Speculation
Speculation
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Arbitrage
Arbitrage
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Hedgers
Hedgers
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Speculators
Speculators
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Arbitrageurs
Arbitrageurs
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Hedge Funds
Hedge Funds
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Writing an Option
Writing an Option
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Hedging
Hedging
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Risk Assessment in Hedging
Risk Assessment in Hedging
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Long/Short Equities Strategy
Long/Short Equities Strategy
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Convertible Arbitrage
Convertible Arbitrage
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Distressed Securities Investing
Distressed Securities Investing
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Emerging Markets Investing
Emerging Markets Investing
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Global Macro Strategy
Global Macro Strategy
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Merger Arbitrage
Merger Arbitrage
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Purpose of Hedging
Purpose of Hedging
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Protective Put Option
Protective Put Option
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Forward Contracts for Hedging
Forward Contracts for Hedging
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Options Contracts for Hedging
Options Contracts for Hedging
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Speculation Using Futures/Options
Speculation Using Futures/Options
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Currency Speculation Example
Currency Speculation Example
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Futures Contract Profit
Futures Contract Profit
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No-Arbitrage Principle
No-Arbitrage Principle
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Versatility of Derivatives
Versatility of Derivatives
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Rogue Trader
Rogue Trader
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Risk Limits and Monitoring
Risk Limits and Monitoring
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Versatile instruments
Versatile instruments
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Derivatives Usage Controls
Derivatives Usage Controls
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Proactive Risk Assessment
Proactive Risk Assessment
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Kerviel's Fraud
Kerviel's Fraud
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Rogue Trader Losses Lessons
Rogue Trader Losses Lessons
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Equity Index Arbitrage opportunity
Equity Index Arbitrage opportunity
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Trusting Derivatives Traders
Trusting Derivatives Traders
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Apparent arbitraging
Apparent arbitraging
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Spot Market Speculation
Spot Market Speculation
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Leverage
Leverage
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Margin Account
Margin Account
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Initial Margin
Initial Margin
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Options Speculation
Options Speculation
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Strike Price
Strike Price
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Option Payoff
Option Payoff
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Options Leverage
Options Leverage
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Loss Potential: Options vs. Futures
Loss Potential: Options vs. Futures
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Transaction Costs
Transaction Costs
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Arbitrage Impact on Prices
Arbitrage Impact on Prices
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Cross-Market Arbitrage
Cross-Market Arbitrage
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Exchange Rate
Exchange Rate
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Study Notes
- Derivatives have greatly increased in importance in finance in the last 40 years, necessitating an understanding of their function, application, and pricing for those in and outside the finance sector.
- Derivatives can be used for hedging, speculation, or arbitrage, transferring risks in the economy.
- A derivative's value is derived from basic underlying variables like asset prices, or even non-financial variables like weather.
- Derivatives markets have developed to include credit, electricity, weather and insurance derivatives, alongside new risk management and regulations for over-the-counter markets.
- Derivatives played a role in the credit crisis of 2007 when products created from risky mortgages lost value due to declining house prices.
- Regulations for derivatives markets have increased as a result of the credit crisis, and banks now have to keep more capital for the risks they take, and pay attention to liquidity.
- Banks' valuation of derivatives has evolved, with greater emphasis on collateral arrangements and credit issues, and adjustments to risk-free interest rate proxies to reflect funding costs.
Exchange-Traded Markets
- A derivatives exchange involves trading standardized contracts defined by the exchange.
- The Chicago Board of Trade (CBOT), established in 1848, was created to standardize grain trading.
- The first futures-type contract, known as a to-arrive contract, was developed within a few years and became popular with speculators.
- The Chicago Mercantile Exchange (CME) was established in 1919 as a rival futures exchange.
- The CME and CBOT have now merged to form the CME Group, which also includes the New York Mercantile Exchange, the commodity exchange (COMEX), and the Kansas City Board of Trade (KCBT).
- The Chicago Board Options Exchange (CBOE) began trading call option contracts on 16 stocks in 1973, creating an orderly market for options.
- Put option contracts started trading on the exchange in 1977.
- The CBOE now trades options on over 2,500 stocks and many different stock indices.
- Once a trade is agreed upon by two traders, the exchange clearing house manages the risks by acting as an intermediary.
- Traders are required to deposit funds (margin) with the clearing house to ensure obligations are met.
- Derivatives exchanges have largely moved from the open outcry system to electronic trading.
- Electronic trading has led to the growth of high-frequency and algorithmic trading within the derivatives markets.
Over-The-Counter Markets
- Many derivatives trades occur in the over-the-counter (OTC) market involving banks, financial institutions, fund managers, and corporations.
- Once an OTC trade is agreed, it can be presented to a central counterparty (CCP) or cleared bilaterally.
- A CCP stands between the two parties to avoid default risk.
- Bilateral clearing involves an agreement covering transaction termination, settlement calculations, and collateral posting.
- Banks often act as market makers, quoting bid and offer prices for commonly traded instruments.
- OTC derivatives markets were largely unregulated prior to the 2007 credit crisis.
- Regulations have been introduced to improve transparency, market efficiency, and reduce systemic risk.
- Standardized OTC derivatives in the United States must be traded on swap execution facilities (SEFs).
- A CCP is required for most standardized derivatives transactions globally.
- All trades must be reported to a central registry.
- The over-the-counter market is larger than the exchange-traded market.
- By December 2012, the over-the-counter market had grown to 632.6trillionandtheexchange−tradedmarkethadgrownto632.6 trillion and the exchange-traded market had grown to 632.6trillionandtheexchange−tradedmarkethadgrownto52.6 trillion.
- The gross market value of all over-the-counter transactions outstanding in December 2012 was about $24.7 trillion.
Forward Contracts
- A forward contract is an agreement to buy or sell an asset at a future time for a certain price, and is traded in the over-the-counter market.
- A long position involves agreeing to buy the underlying asset, while a short position involves agreeing to sell it.
- The quotes for the exchange rate between the British pound (GBP) and the US dollar (USD) might be made by a large international bank on May 6, 2013, and is for the number of USD per GBP.
- Forward contracts can hedge foreign currency risk.
- A treasurer can agree to buy £1 million 6 months forward at an exchange rate of 1.5532 to hedge against exchange rate moves.
- The payoff from a long position in a forward contract is ST - K, where K is the delivery price and ST is the spot price at maturity.
- The payoff from a short position in a forward contract is K - ST.
- The forward price of a stock that pays no dividend is the current stock price grossed up at the risk free rate for the same period.
Futures Contracts
- A futures contract is an agreement to buy or sell an asset at a future time for a certain price, typically traded on an exchange.
- The exchange specifies standardized features of the contract.
- The Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) are the largest exchanges for futures contracts.
Options
- Options are traded both on exchanges and in the over-the-counter market.
- A call option gives the holder the right to buy an asset, while a put option gives the holder the right to sell.
- The price in the contract is the exercise or strike price, and the date is the expiration date or maturity.
- American options can be exercised any time up to the expiration date, but European options can only be exercised on the expiration date.
- The largest exchange for trading stock options is the Chicago Board Options Exchange (CBOE).
- The price of a call option decreases as the strike price increases, while the price of a put option increases as the strike price increases.
- Options become more valuable as their time to maturity increases.
- There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts, with buyers having long positions and sellers having short positions.
Types of Traders
- Derivatives markets attract hedgers, speculators, and arbitrageurs, creating liquidity.
- Hedgers use derivatives to reduce risk from market movements.
- Speculators use them to bet on the future direction of a market variable.
- Arbitrageurs take offsetting positions to lock in a profit.
Hedgers
- Hedgers reduce their risks with forward contracts and options.
- To hedge foreign exchange risk, a company can buy pounds in the forward market, fixing the price to be paid to the British exporter.
- Options can also be used for hedging.
- Options allow investors to protect themselves against adverse price movements in the future while still allowing them to benefit from favorable price movements
- Forward contracts are designed to neutralize risk where as option contracts offer insurance.
Speculators
- Speculators take positions in the market, betting on the price of an asset going up or down.
- Futures and options provide a way to obtain leverage for speculation.
- The futures market allows the speculator to obtain leverage with a relatively small initial outlay.
- For a given investment, the use of options magnifies the financial consequences, but the loss is limited to the amount paid for the options.
- When a speculator uses futures, the potential loss as well as the potential gain is very large.
Arbitrageurs
- Arbitrage involves locking in a riskless profit by simultaneously entering into transactions in two or more markets.
- Arbitrage opportunities cannot last for long.
- The existence of arbitrageurs means that only very small arbitrage opportunities are observed in the prices that are quoted in most financial markets.
Dangers
- Derivatives are very versatile instruments that can be used for hedging, speculation, and arbitrage
- Versatility of derivatives can cause traders who have a mandate to hedge risks or follow an arbitrage strategy to become speculators with disastrous results.
- Controls should be set up to ensure derivatives are being used for their intended purpose as well as adhering to risk limits.
- Financial institutions should always be dispassionately asking ‘‘What can go wrong?’’, and they should follow that up with the question ‘‘If it does go wrong, how much will we lose?"
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Description
Explore the role, evolution, and uses of derivatives in today's financial markets. Understand their impact on the credit crisis and the significance of derivatives markets. Learn about trading, clearing houses, and the differences between exchange-traded and OTC markets.
