Podcast
Questions and Answers
What is the fundamental characteristic that defines a derivative instrument?
What is the fundamental characteristic that defines a derivative instrument?
- Its value is determined by interest rates.
- It is used only for speculation purposes.
- It is traded exclusively on exchanges.
- Its value is derived from the value of an underlying asset. (correct)
Which of the following is NOT a primary function of derivatives markets?
Which of the following is NOT a primary function of derivatives markets?
- Facilitating speculation
- Eliminating market volatility (correct)
- Enabling arbitrage
- Hedging risks
How does a clearing house mitigate credit risk in exchange-traded derivatives?
How does a clearing house mitigate credit risk in exchange-traded derivatives?
- By guaranteeing profits for all traders
- By lobbying for stricter regulations
- By acting as an intermediary and requiring margin deposits (correct)
- By monitoring news events
What is the key distinction between exchange-traded and over-the-counter (OTC) derivative markets?
What is the key distinction between exchange-traded and over-the-counter (OTC) derivative markets?
What was a primary driver behind increased regulation of OTC derivative markets after the 2007-2008 financial crisis?
What was a primary driver behind increased regulation of OTC derivative markets after the 2007-2008 financial crisis?
In the context of forward contracts, what does taking a 'long position' mean?
In the context of forward contracts, what does taking a 'long position' mean?
A US company anticipates receiving a large payment in euros in six months. How can it use a forward contract to hedge its foreign exchange risk?
A US company anticipates receiving a large payment in euros in six months. How can it use a forward contract to hedge its foreign exchange risk?
What is the key difference in obligation between a forward contract and an option?
What is the key difference in obligation between a forward contract and an option?
Which of the following best describes the use of futures contracts for speculation?
Which of the following best describes the use of futures contracts for speculation?
An investor holds a call option on a stock. What is the investor's potential loss if the option expires unexercised?
An investor holds a call option on a stock. What is the investor's potential loss if the option expires unexercised?
How do arbitrageurs typically exploit price discrepancies in different markets?
How do arbitrageurs typically exploit price discrepancies in different markets?
Which statement best captures the risk management lesson learned from the 2007-2008 financial crisis regarding derivatives?
Which statement best captures the risk management lesson learned from the 2007-2008 financial crisis regarding derivatives?
What is the role of Swap Execution Facilities (SEFs) in OTC derivative markets?
What is the role of Swap Execution Facilities (SEFs) in OTC derivative markets?
What does the term "systemic risk" refer to in the context of financial markets?
What does the term "systemic risk" refer to in the context of financial markets?
How does leverage amplify both potential gains and losses when using derivatives for speculation?
How does leverage amplify both potential gains and losses when using derivatives for speculation?
What is the difference between American and European options regarding exercise?
What is the difference between American and European options regarding exercise?
An arbitrageur observes that a stock is trading at different prices on two exchanges. To exploit this opportunity, the arbitrageur should:
An arbitrageur observes that a stock is trading at different prices on two exchanges. To exploit this opportunity, the arbitrageur should:
A company uses a forward contract to lock in the exchange rate for a future payment in a foreign currency. If the spot rate at the time of the payment is more favorable than the forward rate, what is the primary consequence for the company?
A company uses a forward contract to lock in the exchange rate for a future payment in a foreign currency. If the spot rate at the time of the payment is more favorable than the forward rate, what is the primary consequence for the company?
What is the primary reason hedge funds utilize derivatives in their investment strategies?
What is the primary reason hedge funds utilize derivatives in their investment strategies?
What is the key difference between buying a call option and selling a put option?
What is the key difference between buying a call option and selling a put option?
Which of the following market participants would most likely use derivatives to reduce exposure to adverse price movements?
Which of the following market participants would most likely use derivatives to reduce exposure to adverse price movements?
How did Je´roˆme Kerviel exploit Socie´te´ Ge´ne´ral's trading system, and what was the result?
How did Je´roˆme Kerviel exploit Socie´te´ Ge´ne´ral's trading system, and what was the result?
A trader buys a call option with a strike price of $50. At expiration, the underlying asset is trading at $45. What is the trader's profit/loss, ignoring the option premium?
A trader buys a call option with a strike price of $50. At expiration, the underlying asset is trading at $45. What is the trader's profit/loss, ignoring the option premium?
Which event led to increased scrutiny and regulation of the OTC derivatives market?
Which event led to increased scrutiny and regulation of the OTC derivatives market?
In what way do options offer a different approach to hedging compared to forward contracts?
In what way do options offer a different approach to hedging compared to forward contracts?
Suppose you believe a stock price will decrease substantially in the near future. Which strategy would allow you to profit most from this?
Suppose you believe a stock price will decrease substantially in the near future. Which strategy would allow you to profit most from this?
What is the role of margin in futures trading?
What is the role of margin in futures trading?
A cocoa farmer in Ghana is concerned about price fluctuations before harvest. How can derivatives markets help manage this risk?
A cocoa farmer in Ghana is concerned about price fluctuations before harvest. How can derivatives markets help manage this risk?
What are the three main categories of traders in derivatives markets?
What are the three main categories of traders in derivatives markets?
An airline wants to protect itself against rising jet fuel costs. What type of derivative instrument would be most suitable?
An airline wants to protect itself against rising jet fuel costs. What type of derivative instrument would be most suitable?
Which of the following is TRUE regarding the profit potential of speculators using options?
Which of the following is TRUE regarding the profit potential of speculators using options?
How did the growth of standardized OTC derivatives and central clearing affect counterparty risk?
How did the growth of standardized OTC derivatives and central clearing affect counterparty risk?
What is the relationship between bid and offer (ask) prices in a market?
What is the relationship between bid and offer (ask) prices in a market?
Which factors contribute to the popularity and success of derivatives markets?
Which factors contribute to the popularity and success of derivatives markets?
What critical risk management practice should corporations adopt, as learned from cases like Socie´te ´ Ge ´ ne ´ ral?
What critical risk management practice should corporations adopt, as learned from cases like Socie´te ´ Ge ´ ne ´ ral?
Given a stock that pays no dividends, and the ability to borrow or lend money at 6% per year, what is most likely the 1-year forward price of a $40 stock?
Given a stock that pays no dividends, and the ability to borrow or lend money at 6% per year, what is most likely the 1-year forward price of a $40 stock?
What is the correct formula for the payoff from a short position in a forward contract on one unit of an asset?
What is the correct formula for the payoff from a short position in a forward contract on one unit of an asset?
What distinguishes a futures contract from a forward contract?
What distinguishes a futures contract from a forward contract?
What is the primary role of a clearing house in derivatives markets?
What is the primary role of a clearing house in derivatives markets?
How does electronic trading impact derivatives markets?
How does electronic trading impact derivatives markets?
What is a 'Swap Execution Facility' (SEF) and what purpose does it serve?
What is a 'Swap Execution Facility' (SEF) and what purpose does it serve?
In the context of OTC derivatives, what does bilateral clearing entail?
In the context of OTC derivatives, what does bilateral clearing entail?
How is the 'gross market value' of an OTC derivative transaction calculated?
How is the 'gross market value' of an OTC derivative transaction calculated?
A trader takes a long position in a forward contract. At the contract's maturity, the spot price is less than the delivery price. What is the outcome for the trader?
A trader takes a long position in a forward contract. At the contract's maturity, the spot price is less than the delivery price. What is the outcome for the trader?
What is the relation between spot prices and forward prices, assuming a stock pays no dividends?
What is the relation between spot prices and forward prices, assuming a stock pays no dividends?
How do exchanges standardize futures contracts to facilitate trading?
How do exchanges standardize futures contracts to facilitate trading?
What is the key difference between American and European options regarding when they can be exercised?
What is the key difference between American and European options regarding when they can be exercised?
An investor buys a call option. If the stock price does not rise above the strike price by the expiration date, what happens?
An investor buys a call option. If the stock price does not rise above the strike price by the expiration date, what happens?
How can options be used differently from forward contracts for hedging purposes?
How can options be used differently from forward contracts for hedging purposes?
A speculator believes the price of an asset will decrease. Which derivative position aligns with this speculation?
A speculator believes the price of an asset will decrease. Which derivative position aligns with this speculation?
How do futures markets provide leverage for speculators?
How do futures markets provide leverage for speculators?
What is a key difference between using futures and options for speculation, regarding potential losses?
What is a key difference between using futures and options for speculation, regarding potential losses?
Explain what actions an arbitrageur would take if a stock is trading at different prices on two exchanges?
Explain what actions an arbitrageur would take if a stock is trading at different prices on two exchanges?
Why are true arbitrage opportunities short-lived in financial markets?
Why are true arbitrage opportunities short-lived in financial markets?
What is the lesson learned from Socie´te ´ Ge´ne´ ral's experience with Je´roˆme Kerviel?
What is the lesson learned from Socie´te ´ Ge´ne´ ral's experience with Je´roˆme Kerviel?
What key risk management practice should financial institutions adopt based on the credit crisis of 2007-2008?
What key risk management practice should financial institutions adopt based on the credit crisis of 2007-2008?
How might a company hedge foreign exchange risk using forward contracts?
How might a company hedge foreign exchange risk using forward contracts?
What is the primary goal for a company that hedges its risks?
What is the primary goal for a company that hedges its risks?
In what ways are derivatives markets successful?
In what ways are derivatives markets successful?
What distinguishes hedgers from speculators in derivatives markets?
What distinguishes hedgers from speculators in derivatives markets?
How do arbitrageurs contribute to market efficiency?
How do arbitrageurs contribute to market efficiency?
What actions can a US company take to hedge against the risk of a weakening British pound (GBP) prior to receiving payment in GBP?
What actions can a US company take to hedge against the risk of a weakening British pound (GBP) prior to receiving payment in GBP?
What is the cost an investor will need to remit to the exchange, through the broker, if the investor instructs a broker to buy one December call option contract on Google with a strike price of $880, given that the offer price is $56.30 and an option contract is a contract to buy or sell 100 shares?
What is the cost an investor will need to remit to the exchange, through the broker, if the investor instructs a broker to buy one December call option contract on Google with a strike price of $880, given that the offer price is $56.30 and an option contract is a contract to buy or sell 100 shares?
If the price of Google does not rise above $880 by December 21, 2013, and the investor obtained at a cost of $5,630 the right to buy 100 Google shares for $880 each, what will happen?
If the price of Google does not rise above $880 by December 21, 2013, and the investor obtained at a cost of $5,630 the right to buy 100 Google shares for $880 each, what will happen?
An investor sells one September put option contract with a strike price of $840 at the bid price of $31.00, leading to an immediate cash inflow of $3,100. However, the stock price falls and the option is exercised when the stock price is $800. What will happen?
An investor sells one September put option contract with a strike price of $840 at the bid price of $31.00, leading to an immediate cash inflow of $3,100. However, the stock price falls and the option is exercised when the stock price is $800. What will happen?
ImportCo hedges its foreign exchange risk by buying pounds (GBP) from the financial institution in the 3-month forward market at 1.5538. If the exchange rate is 1.4000 what happens?
ImportCo hedges its foreign exchange risk by buying pounds (GBP) from the financial institution in the 3-month forward market at 1.5538. If the exchange rate is 1.4000 what happens?
If spot price is 1.5470 dollars per pound and the April futures price is 1.5410 dollars per pound, what can the speculator realize?
If spot price is 1.5470 dollars per pound and the April futures price is 1.5410 dollars per pound, what can the speculator realize?
If a speculator considers that a stock is likely to increase in value over the next 2 months, what alternative is far more profitable?
If a speculator considers that a stock is likely to increase in value over the next 2 months, what alternative is far more profitable?
What would an arbitrageur do if the stock price is $150 in New York and £100 in London at a time when the exchange rate is $1.5300 per pound?
What would an arbitrageur do if the stock price is $150 in New York and £100 in London at a time when the exchange rate is $1.5300 per pound?
What must both financial and nonfinancial corporations do to avoid encountering problems?
What must both financial and nonfinancial corporations do to avoid encountering problems?
A US company expects to have to pay 1 million Canadian dollars in 6 months. Which of the following is true regarding options to manage the risk?
A US company expects to have to pay 1 million Canadian dollars in 6 months. Which of the following is true regarding options to manage the risk?
Which of the following is NOT true regarding the three broad categories of traders (hedgers, speculators, and arbitrageurs)?
Which of the following is NOT true regarding the three broad categories of traders (hedgers, speculators, and arbitrageurs)?
Which of the following is NOT labeled as one of the trading strategies followed by hedge funds?
Which of the following is NOT labeled as one of the trading strategies followed by hedge funds?
What could a speculator do if they think that the British pound will strengthen relative to the US dollar over the next 2 months?
What could a speculator do if they think that the British pound will strengthen relative to the US dollar over the next 2 months?
How did the standardization of contracts by the Chicago Board of Trade (CBOT) in 1848 primarily benefit farmers and merchants?
How did the standardization of contracts by the Chicago Board of Trade (CBOT) in 1848 primarily benefit farmers and merchants?
How does the use of a Central Counterparty (CCP) in OTC derivative markets reduce systemic risk?
How does the use of a Central Counterparty (CCP) in OTC derivative markets reduce systemic risk?
In the context of forward contracts, what differentiates the 'payoff' from the 'profit' for a party holding a long position?
In the context of forward contracts, what differentiates the 'payoff' from the 'profit' for a party holding a long position?
What is the key implication of the standardization of futures contracts for market participants?
What is the key implication of the standardization of futures contracts for market participants?
How does the writer of a call option profit if the option is not exercised by the expiration date?
How does the writer of a call option profit if the option is not exercised by the expiration date?
What actions would an arbitrageur take if they observe that the futures price for a commodity is significantly higher than its spot price, considering storage costs are negligible?
What actions would an arbitrageur take if they observe that the futures price for a commodity is significantly higher than its spot price, considering storage costs are negligible?
Why do regulators often require banks to increase their capital reserves in response to increased activity in derivatives markets?
Why do regulators often require banks to increase their capital reserves in response to increased activity in derivatives markets?
Derivatives are utilized by hedge funds, but what is a key difference between hedge funds and mutual funds regarding derivative use?
Derivatives are utilized by hedge funds, but what is a key difference between hedge funds and mutual funds regarding derivative use?
What is the most significant reason why concerns about systemic risk have grown in the wake of increased OTC derivative trading?
What is the most significant reason why concerns about systemic risk have grown in the wake of increased OTC derivative trading?
How does the existence of arbitrageurs contribute to market efficiency?
How does the existence of arbitrageurs contribute to market efficiency?
Why did Lehman Brothers' bankruptcy in 2008 have such a significant impact on derivatives markets?
Why did Lehman Brothers' bankruptcy in 2008 have such a significant impact on derivatives markets?
What is the relationship between bid and offer (ask) prices in a market, and what does the spread represent?
What is the relationship between bid and offer (ask) prices in a market, and what does the spread represent?
How can options be used differently from forward contracts to manage risk?
How can options be used differently from forward contracts to manage risk?
Why is setting risk limits and monitoring trader activities especially important for firms engaged in derivatives trading?
Why is setting risk limits and monitoring trader activities especially important for firms engaged in derivatives trading?
A company wants to protect itself against a rise in the price of a commodity it needs in the future. Which derivative strategy is most suitable for this?
A company wants to protect itself against a rise in the price of a commodity it needs in the future. Which derivative strategy is most suitable for this?
What is a major lesson learned from the 2007-2008 financial crisis regarding risk management?
What is a major lesson learned from the 2007-2008 financial crisis regarding risk management?
How did Je´roˆme Kerviel exploit Socie´te´ Ge´ne´ral's trading system, resulting in a substantial loss for the bank?
How did Je´roˆme Kerviel exploit Socie´te´ Ge´ne´ral's trading system, resulting in a substantial loss for the bank?
How does increased transparency in OTC derivatives markets, achieved through mandatory reporting to central registries, aim to improve market efficiency?
How does increased transparency in OTC derivatives markets, achieved through mandatory reporting to central registries, aim to improve market efficiency?
What is the key difference between speculation using futures contracts versus using options, regarding potential losses?
What is the key difference between speculation using futures contracts versus using options, regarding potential losses?
Under what circumstances might a company choose not to hedge a known future foreign exchange exposure?
Under what circumstances might a company choose not to hedge a known future foreign exchange exposure?
Flashcards
Derivative
Derivative
A financial instrument whose value is derived from other, more basic variables.
Hedging
Hedging
Reducing risk from potential future movements in a market variable.
Speculation
Speculation
Betting on the future direction of a market variable.
Arbitrage
Arbitrage
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Forward contract
Forward contract
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Futures contract
Futures contract
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Call option
Call option
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Put option
Put option
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Strike price
Strike price
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Expiration date
Expiration date
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American option
American option
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European option
European option
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Derivatives exchange
Derivatives exchange
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Over-the-counter (OTC) market
Over-the-counter (OTC) market
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Market size (derivatives)
Market size (derivatives)
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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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Payoff (long forward)
Payoff (long forward)
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Payoff (short forward)
Payoff (short forward)
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Standardization (exchanges)
Standardization (exchanges)
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Central counterparty (CCP)
Central counterparty (CCP)
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Systemic risk
Systemic risk
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Swap execution facilities (SEFs)
Swap execution facilities (SEFs)
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Algorithmic trading
Algorithmic trading
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Credit risk
Credit risk
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Margin (derivatives)
Margin (derivatives)
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Open outcry system
Open outcry system
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Study Notes
- Derivatives have become increasingly vital in finance in the last 40 years.
- Derivatives are used in various financial applications, including hedging, speculation, and arbitrage.
- Derivatives can be defined as financial instruments whose value depends on other underlying variables, often the prices of traded assets.
- Since 1988, derivatives markets have expanded to include credit, electricity, weather, and insurance derivatives.
- New regulations have been introduced to oversee over-the-counter derivatives markets.
- Derivatives played a significant but controversial role in the 2007 credit crisis, particularly those linked to risky mortgages.
- Post-crisis, derivatives markets are now subject to stricter regulations, including increased capital requirements for banks.
Evolution of Derivatives Valuation
- Banks' approaches to valuing derivatives have evolved, with greater emphasis on collateral arrangements and credit issues.
- Banks have changed the proxies they use for the ‘‘risk-free’’ interest rate to reflect their funding costs.
Exchange-Traded Markets
- A derivatives exchange is a marketplace where standardized contracts are traded.
- The Chicago Board of Trade (CBOT) emerged in 1848, initially standardizing grain trading, and later developed futures-type contracts.
- The Chicago Mercantile Exchange (CME) was established in 1919; the CME and CBOT have merged to form the CME Group.
- The Chicago Board Options Exchange (CBOE) began trading call option contracts in 1973 and put option contracts in 1977.
- The exchange clearing house manages risks between traders by acting as an intermediary.
- Traders are required to deposit funds (margin) with the clearing house to ensure obligations are met.
- Margin requirements and clearing houses are discussed in more detail in Chapter 2.
Transition to Electronic Markets
- Derivatives exchanges have largely shifted from the open outcry system to electronic trading.
- Electronic trading has facilitated the growth of high-frequency and algorithmic trading.
Over-the-Counter Markets
- In the over-the-counter (OTC) market, trades occur directly between banks, financial institutions, fund managers, and corporations.
- Once an OTC trade has been agreed, the two parties can either present it to a central counterparty (CCP) or clear the trade bilaterally.
- A CCP is like an exchange clearing house, and bilateral clearing requires an agreement covering transaction terminations, settlement amounts, and collateral.
- Banks often act as market makers, providing bid and offer prices for commonly traded instruments.
- Post-2007 credit crisis, OTC derivatives markets face new regulations to enhance transparency, efficiency and reduce systemic risk.
Regulatory Changes in OTC Markets
- Standardized OTC derivatives in the United States must be traded on swap execution facilities (SEFs).
- CCPs are required for most standardized derivatives transactions.
- All trades must be reported to a central registry.
Market Size
- Both OTC and exchange-traded markets are substantial, the OTC market is larger than the exchange-traded market.
- By December 2012, the over-the-counter market had grown to $632.6 trillion and the exchange-traded market had grown to $52.6 trillion.
- The gross market value of all over-the-counter transactions outstanding in December 2012 to be about $24.7 trillion.
Forward Contracts
- A forward contract is an agreement to buy or sell an asset at a future date for a predetermined price.
- A long position involves agreeing to buy the asset, while a short position involves agreeing to sell.
- Forward contracts on foreign exchange are popular.
- Banks provide quotes for spot and forward foreign-exchange transactions.
Hedging with Forward Contracts
- Forward contracts are used to hedge against foreign currency risk.
- Example: A US corporation can use a forward contract to lock in the exchange rate for a future payment in British pounds.
- Both sides make a binding commitment.
Payoffs from Forward Contracts
- 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.
Forward Prices and Spot Prices
- Spot and forward prices are related; the forward price of a stock should reflect the spot price grossed up by the risk-free interest rate.
- Arbitrageurs exploit any discrepancies between spot and forward prices to make a risk-free profit.
Futures Contracts
- A futures contract is an agreement to buy or sell an asset at a future date for a predetermined price.
- Futures contracts are typically traded on an exchange, which standardizes contract features and guarantees performance.
- The CME Group is a major exchange for futures contracts, covering a wide range of commodities and financial assets.
- Futures prices are determined by supply and demand.
Options
- Options, traded on exchanges and OTC, come in two types: calls and puts.
- A call option grants the holder the right to buy an asset at a specific price (strike price) by a certain date (expiration date).
- A put option grants the holder the right to sell an asset under the same conditions.
- American options can be exercised anytime up to expiration, while European options can only be exercised on the expiration date.
- Options provide the right, but not the obligation, to act, distinguishing them from forwards and futures.
- There is a cost to acquiring an option.
Exchange-Traded Options
- The Chicago Board Options Exchange (CBOE) is the largest exchange for stock options.
- Option prices vary based on strike price, time to maturity, and market conditions.
- Call option prices decrease as the strike price increases, while put option prices increase as the strike price increases.
- Option trading involves buyers and sellers of calls and puts, with buyers holding long positions and sellers holding short positions.
Types of Traders
- Derivatives markets attract hedgers, speculators, and arbitrageurs.
Hedgers
- Hedgers use derivatives to reduce the risks associated with price movements in a market variable.
Hedging with Forwards
- A company can hedge its foreign exchange risk by using forward contracts to lock in the price to be paid or received in a foreign currency.
- Hedging reduces risk but does not guarantee a better outcome than not hedging.
Hedging with Options
- Options can hedge; an investor can buy put options to protect against a decline in a stock price.
- Hedging with options involves paying a premium for the right to sell at a specific price.
Forwards vs. Options for Hedging
- Forward contracts neutralize risk by fixing prices, while options provide insurance against adverse price movements, allowing benefit from favorable movements.
Speculators
- Speculators use derivatives to bet on the future direction of a market variable, either upward or downward.
Speculation with Futures
- Speculators can use futures contracts to take a leveraged position in a market.
- Futures require a margin account.
Speculation with Options
- Options can be used for speculation; call options can generate greater profits but entail a higher risk of complete loss.
Futures vs. Options for Speculation
- Futures offer high potential gains and losses, while options limit the maximum loss to the option's purchase price.
Arbitrageurs
- Arbitrageurs exploit price discrepancies in different markets to lock in a riskless profit by simultaneously entering into transactions in two or more markets.
- Arbitrage opportunities are short-lived due to the actions of arbitrageurs.
- The existence of arbitrageurs ensures that only small arbitrage opportunities exist in financial markets.
Dangers of Derivatives
- Derivatives can be used for hedging, speculation, and arbitrage.
- Traders may become speculators, yielding disasterous results.
- It is important for both financial and nonfinancial corporations to set up controls.
- Risk limits should be set and the activities of traders should be monitored daily to ensure that these risk limits are adhered to.
SocGen’s Big Loss in 2008
- Je ´ ro ˆ me Kerviel joined Socie ´ te ´ Ge ´ ne ´ ral (SocGen) in 2000 to work in the compliance area.
- From 2005, he traded equity indices and took big positions in equity indices and created fictitious trades to make it appear that he was hedged.
- In January 2008, his unauthorized trading was uncovered by SocGen.
- Over a three-day period, the bank unwound his position for a loss of 4.9 billion euros.
- The key takeaway is one should define unambiguous risk limits for traders and then to monitor what they do very carefully to make sure that the limits are adhered to.
The Credit Crisis
- Risk managers did express reservations about the exposures of the companies for which they worked to the US real estate market.
- There is an unfortunate tendency to ignore risk managers.
- The key lesson from the credit crisis is that 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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