Investments 2 Midterm Quiz 1 PDF

**Midterm Quiz 1** **Chapters 1-6** **Investments 2** **Date of Exam: 2/19/2025** Investment: the current commitment of money or resources in the expectation of deriving greater resources in the future. Fixed income (debt) securities: promise to make fixed payments in the future. Equities (sto...

**Midterm Quiz 1** **Chapters 1-6** **Investments 2** **Date of Exam: 2/19/2025** Investment: the current commitment of money or resources in the expectation of deriving greater resources in the future. Fixed income (debt) securities: promise to make fixed payments in the future. Equities (stocks): claims to a share of the profit of a corporation Derivatives: make payments that depend on the prices of other financial assets Forwards and futures: arrangements calling for future delivery of an asset at a predetermined price Swaps: agreements to exchange a sequence of cash flows at future times according to specified rules Options: give the holder the right but not the obligation to buy or sell an asset at a certain price Global derivatives market: 700 trillion Global equity market size: 120 trillion Global fixed income market size: 140 trillion Hedgers: reduce the risk that they face from potential future price movements of asset; make the outcome more certain but not necessarily yield a profit Speculators: use derivatives to bet on the future movements in the price of an asset; unlike hedging, in a speculation the trader has no exposure to offset Arbitrageurs: lock in risk-less profits by simultaneously entering into transactions in two or more markets. First documented option trading: 580 BC, Thales Forward contract: an arrangement calling for future delivery of an asset at a predetermined price (initially used for agricultural commodities) Wheat example: a farmer who sells wheat is subject to price risk. For example, if the price of wheat drops, his revenue would decrease. A miller who processes wheat to flour is also subject to price risk. For example, if the price of wheat increases, the cost also increases. Therefore you can hedge the risk by entering a wheat forward contract --- farmer delivers wheat after harvest at a predetermined price. This protects both buyer and seller from price fluctuation. Future markets formalize and standardize forward contracting --- traded in a centralized market (also called an exchange), there is a standardized contract regarding commodity size, quality, delivery date, and price. Traders post margin: profits or losses from changes in future prices are settled daily (also called marking to market). **Forward Contract** **Futures Contract** --------------- ---------------------- ---------------------- Trading place Over the counter Exchange Contract item Customized items Standardized items Settlement End of the period Marking to market Long position: agrees to buy the underlying asset in the future Short position: agrees to sell the underlying asset in the future Chicago board of trade (CBOT): Established in 1848. Developed the futures contract in the United States (to- arrive contract). Merged with the Chicago mercantile exchange (CME) in 2007 --- became the cement group. CME was established in 1919 --- introduced S&P 500 index futures in 1982. Dojima Rice Exchange: First futures exchange. Established in 1697 in Osaka, Japan. Future contracts were originally designed with commodities as the underlying assets. Examples of innovative futures: weather futures, film futures, bitcoin futures Bitcoin: the first decentralized cryptocurrency, not backed by physical assets or government promises --- invented in 2008 by Satoshi Nakamoto Bitcoin futures were introduced by the Chicago mercantile exchange (CME) in 2017. One contract is 5 bitcoins. In 2021, micro bitcoin futures were introduced. One contract is 1/10 the size of one bitcoin. Swap: an agreement to exchange a sequence of cash flows at future times according to certain specified rules. Interest rate swap: exchanges a sequence of cash flows corresponding to different interest rates Example: transform a floating rate loan into a fixed rate loan by entering a swap agreement. Currency swap: exchange a sequence of cash flows corresponding to different currencies Example: British company with investments in the United States, enter swap agreement to receive British pounds and pay U.S. dollars First swap trading: 1981, IBM and the World Bank currency swap. Total return swap: exchanges the total return of an asset for a fee Leveraged ETF uses derivatives to amplify returns of an underlying asset Mechanism to amplify return --- use total return swap: receive the return of s&p 500 and pay a fee (exposure to additional 1x the daily performance of the s&p 500) Expense ratio of vanguard s&p 500 ETF (unreversed): 0.03 percent Expense ratio of pro shares ultra s&p 500 ETF (2x levered): 0.89 Call option: the right to buy an asset at a specified exercise/ strike price on or before a specified expiration date Call holders have the option to exercise it or leave it unexercised --- exercise if it is "in the money" meaning stock price \> exercise price. "Out of the money" for a call option would mean that exercise price \> stock price. Premium: purchase price of an option Profit to option holder = option payoff at expiration -- option premium Call holder will earn profits if payoff at expiration \> premium If 0 \< payoff at expiration \< premium, option will also be exercised to cover some premiums paid Put option: the right to sell an asset at a specified exercise/ strike price on or before a specified expiration date. Put holders --- have the option to exercise it or leave it unexercised --- exercise if "in the money" stock price \< exercise price --- leave unexercised if "out of the money" stock price \> exercise price. Premium: purchase price of an option Profit to option holder = option payoff at expiration -- option premium Put holder will earn profits if payoff at expiration \> premium If 0 \< payoff at expirations \< premium, option will also be exercised to cover some premiums paid A futures/ forward contract gives the holder the obligation to buy or sell an asset at a certain price An option gives the holder the right but not the obligation to buy or sell an asset at a certain price Insurance element with options -- the price for such insurance is the option price or option premium An American option can be exercised at any time during its life A European option can be exercised only at maturity Bermuda option: a type of financial option that allows the holder to exercise the option on specific predetermined dates before expiration, rather than only at expiration (like a European option) or at any time before expiration (like an American option). Put and call brokers and dealers\' association (PCBD): set up in early 1900s in new york -- brings option buyers and sellers together -- investors cannot sell options in the market after purchasing it: no secondary market -- counterparty risk: no guarantee that the option writer would honor the contract Chicago board options exchange (CBOE): established in 1973 \-- margin requirements to mitigate counterparty risk Options clearing operation (OCC): keeps the record of all long and short positions and monitors the margin accounts Hedgers: reduce the risk that they face from potential future price movements of asset; make the outcome more certain, but not necessarily yield a profit Speculators: use derivatives to bet on the future movements in the price of an asset; unlike hedging, in a speculation the trader has no exposure to offset Arbitrageurs: lock in riskless profits by simultaneously entering into transactions in two or more markets. Hedging using forwards/ futures can neutralize risk by fixing the price that the hedger will pay or receive for the underlying asset -- makes outcome more certain, but does not necessarily yield a profit Protective put: long stock, long put -- gives you the right to sell the share for the exercise price, therefore guarantees minimum proceeds of puts exercise price X -- need to pay premium for the put -- useful for risk management as it provides a form of insurance Using options investors can protect themselves against adverse price movements in the future but still gain from favorable price movements -- the price for suck insurance if the option price or option premium Futures trading provides leverage for investors by magnifying returns -- reason: initial margin in futures trading represents a small percentage of contracts value, typically 3% to 12% Options provide a form of leverage -- good outcomes become very good, bad outcomes could result in the whole investment being lost Arbitrageurs: lock in riskless profits by simultaneously entering into transactions in two or more markets Continuous compounding has useful simplifying properties and is widely used in derivatives pricing E2.71828 = important number A forward contract is an arrangement calling for future delivery of an asset at a predetermined price --- transactions are governed by an agreement between two sides: no daily settlement of profit/loss, but collateral may have to be posted. At the end of the life of the contract, one party buys the asset for the agreed price from the other party. Long position: agree to buy the underlying asset in the future Short position: agree to sell the underlying asset in the future Futures markets formalize and standardize forward contracting --- traded in a centralized market (also called an exchange) --- standardized contract on commodity size, quality, delivery, date and price --- traders post margin: profits or losses from changes in futures prices are settled daily (marking to market) Futures contract asset: can be commodities and non commodities The contract size: the amount of asset that has to be delivered under one contract Price quotes: how prices will be quoted For physical delivery: outstanding futures contracts are settled by delivering the underlying assets --- the investor with the short position files a motive of intention to deliver with the exchange --- notice includes delivery details such as the grade of the commodity and the delivery location Most contracts are closed out before maturity. Closing out a futures position is easy --- the investor just needs to enter into an offsetting trade Some futures contracts are settled only in cash --- why? It is inconvenient or impossible to deliver the underlying asset Contracts are traded until an expiration day; all outstanding contracts are then declared to be closed out. As delivery period approaches, futures price converges to the spot price of the underlying asset --- when delivery period is reached the futures price equals or is very close to the spot price Mechanism --- arbitrage activities between the futures and the spot market Convergence of futures price to spot price, traders have the following arbitrage opportunities if the futures price is above the spot price: buy the asset at, short the futures contract: agree to sell the asset at, make delivery of the asset and received, or lock in a risk less profit As a trader exploits the arbitrage opportunity, the futures prices will fall and the spot price will rise Convergence of futures price to spot price, traders have the following arbitrage opportunities if the futures price is below the spot price: long the futures contract: agree to buy the asset at, take delivery of the asset and pay, sell the asset at, or lock in a risk less profit. To mitigate default risk, futures exchanges require investors to deposit funds in a margin account Initial margin is the amount of funds that must be deposited at the time the contract is entered Marking to market: balance in the margin account is adjusted daily to reflect the investors gain or loss (daily settlement) Maintenance margin: minimum margin that the investors account can fall to before additional funds must be put into the account --- investor would need to bring the account back to the initial margin --- minimum levels are specific end by the exchange --- margin requirement depends on volatility of underlying asset: it is greater when volatility is higher Margin call: the notification that the investor must put up additional funds when margin in account falls below maintenance margin When the underlying asset and maturities are the same, the differences between forward and futures prices are generally sufficiently small, and it is reasonable to assume that forward and futures prices are the same Investment assets: assets held by man traders purely for investment purposes Investment assets that do not provide income --- non dividend paying stock, zero coupon bond Investment assets that provide income to the holders --- a dividend paying stock, a coupon bond We use arbitrage approach to determine the forward and futures prices by relating their prices to the spot prices and other observable market variables such as interest rate Consumption assets: assets held primarily for consumption --- benefits from holding physical asset: owners keep the inventory for consumption value No arbitrage: initial costs= present value of cash inflow How to determine forward and futures prices when the underlying asset provides the holder an income yield: the income is expressed as a percentage of the asset price at the time the income is paid, usually with continuous compounding --- for many assets, or helps simplify the forward/ futures pricing Stock index: there are many stocks in the portfolio that pay dividends at different times, we can use average dividend yield to price the forwards/ futures Foreign currency: the holder of a foreign currency can earn interests in the foreign country, we can use risk-free rate in the foreign currency to price the forwards/ futures Benefits of holding a consumption asset is that it can be treated as positive "income: Convenience yield: a measure of the benefits from the holding a physical asset that are not obtained by holding a forward/ futures contract Cost of carry: risk free interest rate + storage cost -- income yield, when applicable Other things being equal, a higher costs of carry leads to a higher forward/ futures price relative to the spot price Other things being equal, a higher convenience yield leads to a lower forward/ futures price relative to the spot price