55 Questions
What is the purpose of hedging in investment management?
To reduce portfolio risk
In derivative trading, what does OTC stand for?
Over-The-Counter
Which of the following is considered a financial asset?
Bonds
Where do exchange-traded derivatives like those on the Chicago Mercantile Exchange (CME) take place?
On an organized exchange
Which role do derivatives play in investment management besides hedging?
Anticipating future cash flows
What is the purpose of using futures to fix the price of an asset before receiving a large cash inflow?
To hedge against the risk of prices decreasing before receiving the cash flow.
How do derivatives such as futures help in making swift changes to the asset allocation of a fund?
By reducing the risk involved in implementing changes to the asset allocation.
What is the primary goal of arbitrage in financial markets?
To take advantage of pricing anomalies between derivatives and underlying assets.
When can a portfolio manager potentially profit from a pricing anomaly between a derivative and its underlying asset?
When the derivative is cheaper than its underlying asset.
What distinguishes speculation from other investment strategies mentioned in the text?
Speculation requires assuming additional risk in pursuit of higher profits.
What is the key distinguishing feature of a futures contract according to the text?
It is exchange-traded and dealt on standardized terms.
In a futures contract, which party agrees to deliver the asset at a future date?
The seller
Why might an electricity-generating company enter into a futures contract for crude oil according to the text?
To secure a fixed price for future oil purchases.
What distinguishes a futures contract from an options contract?
Futures contracts obligate both parties to fulfill the transaction.
For an oil company, what is a likely motivation to engage in a futures contract for oil production according to the text?
To guarantee future sales prices of their oil production.
What does it mean when a market participant opens a trade?
Entering into a future contract as a buyer
In the context of futures markets, what does 'going long' mean?
Committed to buying the underlying asset at the pre-agreed price
What is the primary commitment of the person who is 'short' in a futures contract?
To deliver the underlying asset
When a future is closed out without physical delivery, what term is used for this process?
Closing out the trade
Which action distinguishes 'closing' in a futures contract from 'opening'?
Making a closing sale before the delivery date
What happens if an opening buyer in a futures contract avoids delivery?
The buyer makes a closing sale
What is the primary difference between being 'long' and being 'short' in futures trading?
Long positions are for buyers, while short positions are for sellers.
What is typically done with physical assets underlying most futures?
They are closed out instead of being delivered.
What motivates an opening buyer in a futures contract to make a closing sale before delivery?
To settle their position without physical delivery.
What could happen if a market participant opens a trade and later decides to close it?
The trade will be settled without physical delivery.
What is the key difference between an option and a future contract?
An option grants the right, but not the obligation, to buy or sell, whereas a future is a binding obligation.
What distinguishes options traded on an exchange from those traded off-exchange in the OTC market?
OTC options are bespoke contracts, while exchange-traded options have standard sizes and terms.
What characterizes the relationship between a buyer and seller in an option contract?
The buyer pays a premium to have the right, but not the obligation, to buy or sell from the seller.
Why might investors choose to trade options in the OTC market instead of on an exchange?
Investors can customize contract terms in OTC options beyond standardized sizes and terms of exchange-traded options.
What feature of options makes them attractive compared to futures contracts?
Options provide the right but not the obligation to buy or sell an asset.
What term is used to describe the seller of a put option?
Writer
In exchange-traded contracts, how do buyers and sellers settle the contract?
Through a clearing house that is part of the exchange
What is the motivation for exchanges to match transactions between option holders and writers?
To avoid involvement in transactions between buyers and sellers
What is the obligation of the seller when a buyer exercises a call option?
To deliver the asset at the exercise price
Why do exchanges require a clearing house for settling option contracts?
To manage risks associated with delivery and exercise
What is the key difference between a 'covered' and a 'naked' position in options trading?
Having the underlying asset vs. not having the underlying asset
In the context of options contracts, what does the holder have the right to do?
Exercise the option to buy
If an options writer has a 'naked' position, what does it imply?
The writer does not have the underlying asset
What is the primary motivation for an investor to exercise an options contract?
Buy or sell shares at favorable prices
Why does a writer of an options contract face unlimited theoretical losses in certain scenarios?
Lack of holding underlying assets to meet obligations
What is the purpose of the two exchanges of cash flow known as the legs of the swap?
To allow one party to pay a fixed rate and the other party to receive a variable rate
What is typically used as a benchmark rate for calculating variable interest rates in swaps?
LIBOR
In the context of swaps, what role does the notional amount play?
It represents the amount borrowed by one party to fund a project
How is the floating rate typically set in a swap agreement?
Benchmark rate plus a fixed percentage
What term is used to describe the variable interest rate in swap agreements?
'Floating' rate
What is the primary purpose of interest rate swaps mentioned in the text?
To insure against unexpected interest rate changes
In an interest rate swap, what is meant by 'notional principal'?
The hypothetical amount used to calculate interest payments
Why might a company with variable rate borrowing enter into an interest rate swap?
To hedge against potential losses from unfavorable interest rate changes
What distinguishes an interest rate swap from a traditional loan?
Swaps involve the exchange of cash flows while loans do not
How does entering into an interest rate swap benefit a company like Company A in the text?
By reducing the impact of interest rate fluctuations on project profitability
What is the purpose of credit derivatives like a credit default swap (CDS)?
To provide insurance against adverse credit events.
What determines the value of credit derivatives such as a credit default swap (CDS)?
Credit events related to a third-party company.
How does a credit default swap (CDS) differ from traditional swap agreements?
In CDS, one party provides credit protection against credit events.
Why might an organization choose to enter into a swap agreement?
To lock in a fixed interest rate and hedge against variable rates.
Which financial concept best describes the function of the variable interest rate in a swap agreement?
Hedging
Learn about derivatives in finance, a financial instrument whose value is derived from an underlying asset such as bonds, shares, commodities, and currencies. Discover how derivatives are traded between parties in the financial market.
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