Futures vs. Forwards Contracts
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Questions and Answers

What does the holder of the floating leg in a swap pay their counterparty?

  • The fixed interest rate multiplied by the notional amount
  • The expected capital gains on the underlying asset
  • The average market price of the underlying asset
  • The total dividends paid out by a selected underlying asset (correct)

What is the typical value condition at the signing of a swap contract?

  • The value of the fixed leg is equal to the value of the floating leg (correct)
  • The value of the fixed leg is zero
  • The value of the floating leg is predetermined to be lower
  • The value of the fixed leg is higher than the floating leg

How do dividends compare to price movements in share prices from a risk management perspective?

  • Dividends influence risk management equally to price movements
  • Dividends have a minor impact compared to price movements (correct)
  • Dividends have a greater impact than price movements
  • Dividends are irrelevant to risk management strategies

What type of forwards consider the payments and reinvestment of dividends?

<p>Total return forwards (D)</p> Signup and view all the answers

What is the term for the buyer of an options contract?

<p>Holder (B)</p> Signup and view all the answers

What is an asset swap primarily used for?

<p>To alter the interest rate or currency exposure of an investment (D)</p> Signup and view all the answers

What does a call option give the holder the right to do?

<p>Buy an underlying asset (A)</p> Signup and view all the answers

What does an investor achieve by buying a floating rate note and entering a swap?

<p>A synthetic fixed-rate investment (D)</p> Signup and view all the answers

In a reverse asset swap scenario, what does an investor do?

<p>Buy an underlying fixed-rate investment while paying floating rates (B)</p> Signup and view all the answers

What is meant by the term 'strike price' in options trading?

<p>The price at which the option can be exercised (B)</p> Signup and view all the answers

How is 'in-the-money' defined in terms of an options contract?

<p>When the current price of the underlying asset is above the strike price for a call option (A)</p> Signup and view all the answers

Which of the following best describes asset swaps?

<p>They can denote both the swap arrangement and the combined package (A)</p> Signup and view all the answers

Which element contributes to the extrinsic value of an option?

<p>Time value (D)</p> Signup and view all the answers

What is a European-style option characterized by?

<p>Can be exercised on its expiry day only (C)</p> Signup and view all the answers

What determines the pay-off when an option expires?

<p>Settlement price (C)</p> Signup and view all the answers

What does the term 'premium' refer to in options trading?

<p>The cost of the option paid by the buyer (B)</p> Signup and view all the answers

What is a key characteristic that differentiates futures from forwards?

<p>Futures are always exchange-traded. (B)</p> Signup and view all the answers

What advantage do forward contracts have over futures contracts?

<p>More flexibility in contract terms. (C)</p> Signup and view all the answers

Which of the following represents a disadvantage of using forward contracts?

<p>Potential counterparty risk. (D)</p> Signup and view all the answers

In the context of hedging, why might a company prefer forward contracts?

<p>They can match specific payment schedules. (C)</p> Signup and view all the answers

How are the rates for forward contracts determined?

<p>By the interest rate differential and the current FX spot rate. (A)</p> Signup and view all the answers

What is the implication of not marking to market for forward contracts?

<p>Reduced working capital intensity for hedges. (B)</p> Signup and view all the answers

What can lead to low liquidity in the forwards market?

<p>Increasing customization and specialized contracts. (D)</p> Signup and view all the answers

What aspect of forward contracts might discourage some participants?

<p>Potential for credit or default risk. (D)</p> Signup and view all the answers

What occurs to a knock-in option when the underlying asset reaches a predetermined price?

<p>It is activated and starts to exist. (A)</p> Signup and view all the answers

What defines the payoff structure of a binary option?

<p>It pays a fixed amount or nothing at all. (B)</p> Signup and view all the answers

What defines an interest rate swap?

<p>An OTC derivative involving the exchange of interest payments between two parties (C)</p> Signup and view all the answers

Which option allows the holder to choose whether it will be a call or put at a predetermined time?

<p>Chooser option (D)</p> Signup and view all the answers

Which type of swap involves exchanging fixed interest payments?

<p>Fixed/fixed swap (B)</p> Signup and view all the answers

What best describes a compound option?

<p>An option that provides the right to purchase another option. (A)</p> Signup and view all the answers

What happens to a knock-out option when the underlying asset reaches its predetermined price?

<p>It ceases to exist. (A)</p> Signup and view all the answers

In a fixed/floating swap, which rate typically represents the changing interest rate?

<p>Floating interest rate (C)</p> Signup and view all the answers

What type of option is a rainbow option also known as?

<p>Multi-asset option (C)</p> Signup and view all the answers

What is not a feature of a floating/floating swap?

<p>The cash flows are guaranteed (B)</p> Signup and view all the answers

What happens at each payment date in a fixed/fixed swap?

<p>A net payment is made based on the difference between the two rates (B)</p> Signup and view all the answers

What will happen if the share price of ABC falls below the strike price of 700p for a long call option?

<p>The option expires worthless. (D)</p> Signup and view all the answers

What is the largest type of swap in the derivatives market?

<p>Interest rate swaps (A)</p> Signup and view all the answers

Which of the following is a characteristic of calls on calls as a type of compound option?

<p>It contains two strike prices and expiration dates. (A)</p> Signup and view all the answers

How often does interest accrue in a fixed versus six-month floating swap?

<p>Every six months (D)</p> Signup and view all the answers

Which statement correctly describes a characteristic of swaps?

<p>Swaps have a variety of forms based on underlying assets (C)</p> Signup and view all the answers

What is indicated by a narrow bid/offer spread in a market?

<p>The market is deep and possibly more liquid. (C)</p> Signup and view all the answers

Which of the following factors contributes to a liquid market?

<p>Large amounts can be traded without causing significant price movements. (B)</p> Signup and view all the answers

How is volume defined in the context of liquidity?

<p>The number of contracts traded in a given period, counted once for each contract. (D)</p> Signup and view all the answers

What effect does high liquidity typically have on trading costs?

<p>Decreases trading costs as spreads are tighter. (C)</p> Signup and view all the answers

Which characteristic is NOT associated with a liquid market?

<p>A high bid/offer spread. (D)</p> Signup and view all the answers

What is 'open interest' in relation to liquidity?

<p>The cumulative number of contracts still held by market participants. (D)</p> Signup and view all the answers

What role do derivatives exchanges play in promoting liquidity?

<p>They offer contracts that are liquid and easily traded. (D)</p> Signup and view all the answers

What term describes the market's ability to absorb sudden shifts in supply and demand without significant price changes?

<p>High liquidity. (B)</p> Signup and view all the answers

Flashcards

Long

The buyer of an options contract.

Short

The seller of an options contract.

Call Option

An option giving the holder the right to buy an underlying asset for a specific price (the strike price) on or before a specified date.

Put Option

An option giving the holder the right to sell an underlying asset for a specified price on or before a specified date.

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Strike Price

The price at which the option can be exercised.

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Settlement Price

The price that determines the payoff when the option expires.

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Premium

The non-returnable cost of buying an option

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In-the-Money (ITM)

The difference between the strike price and the current market price of the underlying asset.

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Forward Contract

A financial contract that obligates two parties to exchange an asset for a predetermined price at a future date.

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Futures Contract

Futures contracts are standardized contracts traded on exchanges, providing fungibility and liquidity.

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Customizable Features of Forwards

The ability to customize the terms of a forward contract to specific needs, such as the size, date, and specific grade of the asset.

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OTC Trading of Forwards

Forward contracts are typically traded over-the-counter (OTC), meaning directly between two parties, often with banks or investment firms.

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Counterparty Risk in Forwards

The risk that a counterparty to a forward contract may not fulfill their obligations, resulting in potential financial losses.

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Flexible Margining in Forwards

The flexibility to adjust the margin and collateral requirements for a forward contract, allowing for tailored risk management.

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Wide Range of Underlying Assets in Forwards

Forward contracts are available for a diverse range of underlying assets, including commodities, currencies, and equities.

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Availability of Forwards from Banks

Forward contracts are widely available from commercial banks, providing access to a broad market.

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Interest Rate Swap

A derivative where two parties exchange streams of future interest payments, based on a specified principal amount and a set period.

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Fixed/Floating Swap

A swap where one party pays a fixed interest rate, and the other party pays a floating interest rate.

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Floating/Floating Swap

A swap where both parties pay floating interest rates.

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Fixed/Fixed Swap

A swap where both parties pay a fixed interest rate on the principal amount.

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Counterparties

The parties involved in an interest rate swap.

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Principal Amount

The predetermined amount of capital that the swap is based on.

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Legs of the Swap

The streams of interest payments exchanged in an interest rate swap.

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Reset Date

The date when a floating interest rate is determined for a swap.

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Knock-in Option

A type of option that is activated (starts to exist) when the price of the underlying asset reaches a predetermined level (the barrier).

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Liquidity

The ease with which an asset, like a stock, can be bought or sold without significantly impacting its price or incurring high costs.

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Knock-out Option

A type of option that ceases to exist when the price of the underlying asset reaches a predetermined level (the barrier).

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Bid/Offer Spread

The difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept.

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Market Depth

The ability of a market to absorb sudden changes in supply and demand without large price swings.

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Binary Option

An option that pays a fixed amount or nothing at all, depending on whether the price of the underlying asset is above or below a certain price at maturity.

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Chooser Option

An option that allows the holder to choose whether it is a call option or a put option at a predetermined point in time.

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Open Interest

A measure of market liquidity reflecting the total number of outstanding contracts or positions.

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Compound Option

An option that grants the owner the right to purchase another option (call or put) with specific strike prices at predetermined dates.

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Volume

A measure of market liquidity indicating the total number of contracts traded during a specific period, usually a day.

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Rainbow Option

An option that is based on the price movements of multiple underlying assets, such as a basket of commodities, securities, or currencies.

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Low Price Elasticity of Demand

A market where price changes are relatively small in response to changes in supply or demand.

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Liquid Market

A market where it is relatively easy to trade due to characteristics like low spreads, high volumes, and many buyers and sellers.

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Long Call

An option that gives the holder the right, but not the obligation, to buy one share of a company's stock at a specific price (the strike price) before a certain date (expiration date).

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Illiquid Market

The opposite of a liquid market, characterized by difficulty in trading, high spreads, and limited buyers or sellers.

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Long Put

An option that gives the holder the right, but not the obligation, to sell one share of a company's stock at a specific price (the strike price) before a certain date (expiration date).

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Dividend Swap

A type of swap where one party pays a fixed rate of interest, while the other receives the dividend payments from an underlying asset (e.g., a single stock, a basket of shares, or an index).

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Total Return Equity Swap

An equity swap where one party pays a fixed rate of return and receives dividend payments, while the other pays the total return of an underlying asset (e.g., a stock index), which includes both price changes and dividends.

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Total Return

The total return of an asset includes both price changes and dividend payments.

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Asset Swap

An investor creates a synthetic investment with a different interest rate or currency exposure by combining an existing investment with a swap.

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Floating Rate Note (FRN)

A type of note that pays an interest rate that is linked to a benchmark rate, such as LIBOR, SONIA, or a specific money market rate.

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Total Return Forward

A forward contract that considers the payment and reinvestment of dividends on the underlying shares included in the index.

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Fixed Leg of a Dividend Swap

In a swap, the fixed leg is determined by the expected average dividends over the swap's term, ensuring the swap's value is zero at initiation.

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Floating Leg of a Dividend Swap

In a swap, the floating leg's value is determined by the actual dividend payments received from the selected underlying asset.

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Study Notes

Futures vs. Forwards

  • Futures are exchange-traded contracts, while forwards are typically traded over-the-counter (OTC) with banks or investment firms.
  • Futures contracts are standardized, offering fungibility, while forwards offer more customization.
  • Futures contracts are marked-to-market daily, with profits paid out daily. Forwards are typically not marked-to-market daily, and profits are paid at maturity, potentially reducing working capital needs for hedging.

Forward Contracts (Example)

  • A company with future yen payments can use EUR/JPY forward contracts to lock in exchange rates today for future payments.
  • These OTC transactions allow for customized amounts and dates to match specific payments.
  • Forward rates are based on the spot exchange rate and interest rate differences between euros and yen. Euro interest rates are often slightly lower than yen, leading to a euro premium or lower cost in forwards.

Advantages of Forwards

  • Flexibility in size, date, underlying asset grade/quality, and delivery point.
  • Enhanced margin and collateral terms.
  • Wider range of underlying assets available.
  • Availability from various commercial banks.

Disadvantages of Forwards

  • Potential counterparty risk, especially when not cleared through a central clearinghouse.
  • Lower liquidity in some cases, due to specialized contracts reducing fungibility.

Options Terminology

  • Long (buyer): Owns the option contract.
  • Short (seller): Sells the option contract.
  • Call option: Right to buy an underlying asset at a specific price (strike price) on or before a specific date.
  • Put option: Right to sell an underlying asset at a specific price (strike price) on or before a specific date.
  • Strike price/exercise price: Price at which the option can be exercised.
  • Settlement price: Price determining option payoff at expiry.
  • Premium: Cost of the option to the buyer (non-refundable).
  • In/Out-of-the-money: Option profit/loss based on the difference between the strike price and the underlying asset's current price. "At-the-money" signifies breaking even.
  • Intrinsic value: Only in-the-money options have intrinsic value.
  • Extrinsic value: Option premium beyond intrinsic value, arising from time value, implied volatility, and interest rates.
  • Time value: Extrinsic value reflecting the option's probability of increasing in intrinsic value due to remaining time until expiry. Longer expiration dates usually equal higher time value.
  • European-style option: Can only be exercised on the expiry date.
  • Barrier option: Path-dependent option valuation influenced by the underlying asset hitting a specific price. Knock-in options start existing when the trigger price is reached. Knock-out options exist at outset, but expire when the trigger price is hit.
  • Binary/Digital option: Pays a fixed amount or nothing, depending on the underlying asset's price at maturity or certain points before.
  • Chooser option: Holder can decide if an option is a call or put at a predetermined time during the option's life.
  • Compound option: Gives the right to purchase another option at specific strike prices and dates during its life (calls on calls, calls on puts, etc.).
  • Rainbow option/Multi-asset option: Options on multiple underlying assets (e.g., basket of commodities, securities, currencies).

Options Risks, Rewards, and Profit & Loss

  • Basic options diagrams (long call, short call, long put, short put) depict profit/loss based on underlying asset prices at expiry.

Liquidity

  • Liquidity in equity markets refers to the ease of converting shares to cash. Liquid markets are deep, enabling absorption of supply/demand shifts without major price fluctuations.
  • Liquid markets feature narrow bid-ask spreads, reasonable-sized trades without affecting price significantly, and high volumes of buyers/sellers around the bid/ask spread.
  • High liquidity encourages trading and reduces trading costs.

Swaps

  • Swaps are OTC derivative contracts where two parties exchange future cash flows, based on a principal amount over a period.
  • Types of swaps:
    • Fixed/floating: Parties swap fixed and floating rate cash flows (coupon swaps).
    • Floating/floating: Both payment streams are based on floating rates (basis swaps).
    • Fixed/fixed: Parties swap fixed interest rates on the principal.
  • Swaps value is typically zero at inception, with the fixed leg usually equal to expected average dividends over the swap's term.

Asset and Total Return Swaps

  • Asset swaps facilitate changing interest rate or currency exposure of an investment.
  • Total return forwards consider dividend payouts and reinvestment, and the return on the underlying index itself. While dividends impact forwards, their effect is typically minor compared to price fluctuations.

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Description

This quiz explores the differences between futures and forwards in financial contracts. It covers aspects like trading mechanisms, customization, and payment structures. Ideal for those looking to understand derivatives in finance.

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