Financial Derivatives Overview

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Questions and Answers

Which of the following accurately describes a derivative?

It is a financial instrument that is independent of any underlying asset.

It derives its value from the price of an underlying instrument such as stocks or commodities. (correct)

It is exclusively used for non-financial transactions.

It always requires immediate execution without future commitments.

What is the primary difference between options and forwards/futures contracts?

Options provide the buyer the right, but not the obligation, to buy/sell. (correct)

Options require the parties to transact at the spot market price.

Forwards/futures offer flexibility in contract terms while options do not.

Forwards/futures always have a higher financial risk compared to options.

In which market are customized contracts typically utilized?

Derivatives Market

Over-the-Counter Markets (correct)

Spot Market

Exchange Listed Markets

What is the primary purpose of arbitrage in financial markets?

To profit from price discrepancies across different markets. Signup and view all the answers

Which statement is true regarding American options?

They provide flexibility by allowing exercise at any time before or on the expiration date. Signup and view all the answers

What does it mean for a call option to be considered 'in the money'?

The asset's price is higher than the strike price. Signup and view all the answers

Which scenario best describes the position of a writer of a put option?

The writer expects asset prices to remain above the strike price. Signup and view all the answers

Which of the following best describes intrinsic value for a put option?

The difference between the current market price and the strike price when the asset is below the strike price. Signup and view all the answers

What does the term 'open interest' refer to in options trading?

The total number of option contracts that are currently outstanding. Signup and view all the answers

What is the correct definition of a European option?

It gives the owner the right to exercise the option only on the expiration date. Signup and view all the answers

What does a high Put/Call Ratio (PCR) indicate about market sentiment?

Investors are likely to be more bearish. Signup and view all the answers

How is the intrinsic value of a European call option determined when at the money?

Intrinsic Value = 0 Signup and view all the answers

What is the minimum value of an out-of-the-money American put option?

0 Signup and view all the answers

Which factor is most likely to increase the time value of an option?

Higher volatility of the underlying asset Signup and view all the answers

What happens to the time value of an option as it approaches its expiration date?

It typically decreases. Signup and view all the answers

Study Notes

Underlying Instruments

Financial instruments include bonds, stocks, currencies, indexes, and derivatives.
Non-financial instruments include commodities (metals, grains, livestock, electricity, gas, oil) and weather-related derivatives.

Derivatives

A derivative is a financial contract whose value derives from an underlying asset, executed at a future date.
Types of derivatives: Options, Forwards/Futures, and Swaps.

Options

Options are contracts that give the purchaser the right, but not the obligation, to buy/sell an underlying asset at a specific price before or at expiration.

Forwards/Futures

Contracts obligating the exchange of goods at a predetermined future date and price.

Swaps

Agreements where two parties exchange future cash flows from different financial instruments.

Speculation & Markets

Speculating involves predicting market movements and taking action based on those beliefs.
Spot market transactions involve immediate delivery of financial instruments.

Arbitrage

Arbitrage profits occur when traders take advantage of price discrepancies in different markets.

Option Types

American Option: Can be exercised any time before or on expiration.
European Option: Can only be exercised on the expiration date.

Option Pricing

Premium: The cost paid by the buyer to the seller for rights conferred by the option.
Exercise Price (Strike Price): The price agreed for the execution of the option contract.
Intrinsic Value: The current value of the option if exercised today, calculated differently for call and put options.

Market Efficiency

Law of one price: The price of an identical asset should be the same across markets.
Arbitrage indicates market inefficiencies.

Position Types

Long Position: Taker of the option; expects price to rise.
Short Position: Writer of the option; expects price to fall.

Call vs. Put Options

Call Options: Right to buy; profitable if the asset price exceeds the strike price.
Put Options: Right to sell; profitable if the asset price is below the strike price.

Market Indicators

Open Interest: Total number of outstanding option contracts.
Put/Call Ratio (PCR): Analyzes market sentiment—higher PCR indicates bearishness.

Intrinsic and Time Value

The intrinsic value varies with the underlying asset's spot price relative to the strike price.
Time value reflects the potential for value increase prior to expiration, higher for options with longer durations and greater volatility.

Option Boundaries

Options cannot sell for less than zero.
Maximum values differ between American and European options, with American options generally having higher potential due to early exercise privileges.

Earnings and Dividends

Dividends affect the intrinsic value of options, making it advantageous to exercise before dividends are distributed.

Early Exercise

American options provide the flexibility to exercise before expiration, unlike European options, which do not allow pre-expiration exercise.

These notes encompass critical aspects of derivatives, options, their pricing mechanisms, market behaviors, and the implications of dividends and early exercise.### Options Pricing and Characteristics

Time Value: The value of options increases with more time to expiration, while less time decreases value.
American vs. European Options:
- American Puts are valued higher than European Puts due to the flexibility to exercise at any time before expiration.
- American Calls are valued greater than or equal to European Calls.
- Early exercise of American Puts is optimal only if stock prices drop sufficiently; dividends decrease the likelihood of early exercise.

Interest Rates Influence

Call Options:
- Call options allow investors to save capital by investing a smaller amount upfront, leaving the rest for other investments, like term deposits.
- Example: Investing 1,000inacalloptionallows1,000 in a call option allows 1,000inacalloptionallows9,000 to be placed in a term deposit, potentially yielding more upon execution of the option.
Put Options:
- Puts offer the right to sell at a future date, essentially delaying a sale.
- Higher interest rates decrease the value of put options as immediate sale offers better investment opportunities.

Volatility Effects

Increased volatility raises the value of both Call and Put options.
- Calls can yield higher profits if the market rises, but losses are capped.
- Puts limit losses to the premium paid, making them valuable if anticipating price declines.

Put-Call Parity

A crucial concept in options trading that relates the price of call and put options.
It involves two portfolios:
- Portfolio A contains a European Put option and a stock.
- Portfolio B contains a European Call option and a bond at a risk-free rate.
Payoffs of both portfolios are equivalent at expiration, maintaining parity:
- When stock price (ST) is less than exercise price (X): Payoff equals X.
- When ST is greater than X: Payoff equals ST.

Value Relationships

For European options:
- Value of a European Put: Call Option + Bond - Stock
- Value of a European Call: Stock + Put Option - Bond
American options can incorporate present value of dividends into their valuations.

Example Scenarios

Example 1:
- ANZ Call Options:
  - Cost: 0.52,SpotPrice:0.52, Spot Price: 0.52,SpotPrice:15.74, Expiration Time: 86/365, Exercise Price: $16.00.
- ANZ Put Options:
  - Cost: 0.60,samespotpriceandexpiration,exerciseprice:0.60, same spot price and expiration, exercise price: 0.60,samespotpriceandexpiration,exerciseprice:16.00.
- Higher put cost explained by it being "in the money" while the call is "out of the money."
- Calculations validate that Put-Call Parity holds under given conditions.
Example 2:
- Demonstrating that "At the Money" call options will be worth more than “At the Money” put options when the spot price equals the exercise price.
- Manipulation of put-call parity formula shows that call price equals put price plus the risk-free rate.

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Description

This quiz covers the foundational concepts of financial and non-financial derivatives, including various underlying instruments such as bonds, stocks, and commodities. Learn about how derivatives derive their value and the essential terms of the derivative market. Test your understanding of these concepts with this engaging quiz.