p.1
Evolution of Derivative Instruments
How long have derivative instruments been in existence compared to stocks and bonds?
Derivative instruments are relatively new, with financial derivatives being less than 40 years old, while stocks and bonds have been traded for over a century.
p.3
Swaps and Their Applications
What is a swap contract?
A transaction in which two parties simultaneously exchange cash flows based on a notional amount of the underlying asset.
p.5
Forward, Futures, and Options Contracts
How is the forward price typically determined?
Through negotiation, which can lead to unfair pricing due to bargaining positions.
p.10
Risk Management Techniques Using Derivatives
What are two benefits of increased trading volume due to speculative trading?
It reduces transaction costs for hedgers and increases market liquidity.
p.10
Key Players in Derivative Markets
What is the role of speculators in the market?
They take risks, allowing hedgers to pass on their risks.
p.14
Global Trading Trends in Derivatives
What economic conditions contributed to the booming equity markets in 2020?
Ultra-loose monetary policies and historically low interest rates.
p.10
Types of Derivative Instruments
What types of assets are included in financial derivatives?
Foreign currencies, equity futures, and bond futures.
p.5
Types of Risks in Derivative Trading
What happens to counterparty risk in futures contracts?
It is transferred to the exchange, which guarantees the trades.
p.11
Types of Risks in Derivative Trading
What is inflation risk?
The loss of purchasing power resulting from inflationary conditions.
p.2
Introduction to Derivative Instruments
What is a common misconception about derivatives?
That they are inherently problematic; in reality, they can reduce risks if used intelligently.
p.17
Introduction to Derivative Instruments
What are derivative instruments?
Financial contracts whose value is derived from the price of an underlying asset.
p.4
Risk Management Techniques Using Derivatives
What is a key benefit of a forward contract?
It eliminates price risk by locking in the price/cost.
p.1
Types of Risks in Derivative Trading
What misconception exists regarding derivative instruments?
There is a misconception that derivatives are inherently risky and should be avoided.
p.7
Swaps and Their Applications
What is an interest rate swap (IRS)?
A transaction in which parties exchange cash flows based on two different interest rates.
p.6
Forward, Futures, and Options Contracts
What are margin calls?
Requirements for the party with losing positions to pay up as losses accrue.
p.7
Swaps and Their Applications
What role does ISDA play in the popularity of IRS?
ISDA has streamlined and standardized much of the paperwork for IRS, reducing costs and simplifying the process.
p.13
Risk Management Techniques Using Derivatives
What is the risk-return trade-off?
The positive correlation between risks and returns, making risk management challenging.
p.8
OTC vs. Exchange-Traded Derivatives
What is a disadvantage of exchange-traded derivatives?
Customization is not possible.
p.7
OTC vs. Exchange-Traded Derivatives
How does OTC trading differ from exchange trading?
OTC trading involves customized transactions between parties, with all terms negotiable.
p.17
Introduction to Derivative Instruments
How do derivatives differ from stocks and bonds?
Derivatives are contracts based on underlying assets, while stocks and bonds represent ownership or debt in a company.
p.17
Types of Derivative Instruments
What are the four common categories of derivative instruments?
Forwards, futures, options, and swaps.
p.4
Forward, Futures, and Options Contracts
Why were futures contracts developed?
To manage risk more effectively than forward contracts.
p.12
Types of Risks in Derivative Trading
What is liquidity risk?
The risk arising from thin or illiquid trading, leading to higher price volatility and difficulty in quickly selling an asset.
p.4
Forward, Futures, and Options Contracts
What is a characteristic of forward contracts?
They are customized contracts between two parties.
p.17
Key Players in Derivative Markets
What do speculators use derivatives for?
To bet on price movements of the underlying asset.
p.6
Types of Derivative Instruments
What is financial engineering?
The designing of risk management solutions to complex risks using derivatives.
p.13
Risk Management Techniques Using Derivatives
What is an example of an on-balance sheet method for managing equity risk?
Diversifying the investment and/or using asset allocation strategies.
p.15
Evolution of Derivative Instruments
What was the first exchange in Chicago focused on?
Agricultural commodities.
p.3
Types of Derivative Instruments
What are the three most common derivative instruments?
Forwards, futures, and options.
p.3
Forward, Futures, and Options Contracts
How is a futures contract different from a forward contract?
A futures contract is a standardized and exchange-traded form of a forward contract.
p.4
Forward, Futures, and Options Contracts
What types of parties are typically involved in a forward contract?
A producer and a consumer.
p.10
Types of Risks in Derivative Trading
What is a primary negative effect of speculative activity in financial markets?
Speculative activity tends to hurt more than help.
p.2
Introduction to Derivative Instruments
How does the value of a derivative instrument change?
It rises and falls based on the value of its underlying asset.
p.8
Types of Risks in Derivative Trading
Why might a financial institution avoid OTC transactions?
To mitigate counterparty risk, they prefer dealing with creditworthy entities.
p.8
Types of Risks in Derivative Trading
What is counterparty risk in OTC transactions?
The risk that either party in the transaction may default.
p.3
Evolution of Derivative Instruments
What is required for newly evolved derivative products to survive?
They must provide increased benefits or 'value added' over existing products.
p.8
Types of Derivative Instruments
What are the four types of derivatives mentioned?
Forwards, swaps (OTC), and futures, options (exchange-traded).
p.17
Forward, Futures, and Options Contracts
What is the operational advantage of options over futures/forwards?
Options provide the right, but not the obligation, to buy or sell, allowing for more strategic flexibility.
p.17
Key Players in Derivative Markets
Who are the key players in derivatives markets?
Hedgers, speculators, and arbitrageurs.
p.17
Risk Management Techniques Using Derivatives
What is the primary use of derivatives by hedgers?
To manage risk associated with price fluctuations of underlying assets.
p.7
OTC vs. Exchange-Traded Derivatives
What are the two broad categories of derivatives?
Exchange-traded derivatives and OTC derivatives.
p.9
Key Players in Derivative Markets
How does arbitrage contribute to price discovery?
By ensuring that prices in different markets do not diverge, enhancing the alignment of product prices.
p.15
Global Trading Trends in Derivatives
Name three renowned derivative exchanges located in Chicago.
Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), and Chicago Board Options Exchange (CBOE).
p.15
Global Trading Trends in Derivatives
What has been the trend in trading volume for futures and options from 2002 to 2020?
Traded volume increased more than sevenfold.
p.11
Types of Risks in Derivative Trading
What does interest rate risk refer to?
Changes in asset values due to changes in nominal interest rates.
p.18
Key Players in Derivative Markets
What is the objective of hedgers in derivative markets?
To reduce or eliminate the risk of price fluctuations in the underlying asset.
p.18
Forward, Futures, and Options Contracts
Does the absence of physical delivery make financial derivatives less suited for hedging, arbitrage, or speculation?
No, they can still effectively manage risk and provide opportunities for profit.
p.3
Forward, Futures, and Options Contracts
What is a forward contract?
A contract between two parties agreeing to carry out a transaction at a future date at a price determined today.
p.5
Forward, Futures, and Options Contracts
What is a forward contract?
A forward contract is an agreement to buy or sell an asset at a specified future date for a price that is negotiated today.
p.12
Types of Risks in Derivative Trading
What is interest rate risk?
The risk that a change in interest rates can change the cost of funds or financing.
p.1
Types of Risks in Derivative Trading
What are some examples of financial scandals involving derivative instruments?
Examples include Barings PLC, Sumitomo Corporation's $2.6 billion losses on copper derivatives, and Societe Generale's €4 billion losses in 2008.
p.6
Forward, Futures, and Options Contracts
What process does the exchange use to manage risk in futures contracts?
The margining process and daily marking-to-market.
p.10
Types of Derivative Instruments
What distinguishes commodity derivatives from financial derivatives?
Commodity derivatives have a physical underlying asset and involve actual physical settlement.
p.5
Forward, Futures, and Options Contracts
How do futures contracts overcome the problem of multiple coincidence of wants?
By allowing transactions in the futures contract maturity closest to the needed maturity and in the required quantity.
p.5
Forward, Futures, and Options Contracts
What advantage do futures contracts have over forward contracts regarding pricing?
Futures prices are market-clearing prices determined by the interaction of many buyers and sellers, ensuring fairness.
p.10
Types of Risks in Derivative Trading
Why is it difficult for regulators to control speculative activity?
There is a fine line separating hedging and arbitrage from speculation.
p.6
Forward, Futures, and Options Contracts
What are the three advantages of options over forwards and futures?
Downside protection, upside potential, and flexibility in achieving different objectives.
p.11
Types of Risks in Derivative Trading
What does market/price risk refer to?
Changes in an asset’s price due to changes in market conditions, demand/supply, or sentiments.
p.14
Global Trading Trends in Derivatives
What was the growth rate of traded volume in derivatives in 2020 compared to 2019?
More than a threefold increase from 11.4% in 2019.
p.16
Global Trading Trends in Derivatives
How did the trading volume of financial derivatives in 2020 compare to 2019?
The decline in trading volume appears to have turned around in 2020.
p.14
Types of Derivative Instruments
Which category of derivatives grew the fastest in 2020?
Options, with a growth rate of 44%.
p.3
Evolution of Derivative Instruments
What drives the evolution of derivative instruments?
Product innovation in response to increasingly complex business needs.
p.2
Types of Derivative Instruments
What is an example of a derivative instrument?
A Crude Palm Oil (CPO) futures contract.
p.2
Forward, Futures, and Options Contracts
What distinguishes derivative market transactions from spot market transactions?
Derivative transactions allow for future transactions at prices determined today, while spot transactions are for immediate delivery at current prices.
p.8
Forward, Futures, and Options Contracts
What is a key decision criterion for choosing between OTC and exchange-traded contracts?
The need for customization.
p.8
Key Players in Derivative Markets
What are the three broad categories of players in derivative markets?
Hedgers, arbitrageurs, and speculators.
p.8
Key Players in Derivative Markets
What is the primary objective of hedgers in derivative markets?
To manage or reduce risk.
p.13
Risk Management Techniques Using Derivatives
What are the three broad steps in risk management?
1. Identifying the source and type of risk, 2. Measuring the extent of the risk, 3. Determining the appropriate response/methods.
p.17
Types of Risks in Derivative Trading
What types of risks can different derivative instruments manage?
Market/equity price risk, interest rate risk, credit risk, and exchange rate risk.
p.6
OTC vs. Exchange-Traded Derivatives
How are swaps categorized in terms of trading?
They are over-the-counter (OTC) instruments.
p.2
Introduction to Derivative Instruments
What are derivative instruments?
Financial instruments that derive their value from the value of an underlying asset.
p.9
Key Players in Derivative Markets
What is the primary role of arbitrageurs in the derivatives market?
To engage in arbitrage by taking advantage of price differentials between markets.
p.12
Types of Risks in Derivative Trading
What are anticipatory losses?
Losses that occur before an issuer actually declares bankruptcy.
p.1
Types of Risks in Derivative Trading
What was the significant loss associated with Long-Term Capital Management (LTCM)?
LTCM experienced a loss of approximately $4 billion in late 1998.
p.12
Types of Risks in Derivative Trading
What is currency or exchange rate risk?
The risk of changes in investment income due to fluctuations in exchange rates.
p.9
Key Players in Derivative Markets
What is the main characteristic of speculators in the derivatives market?
They take positions based on their expectations of future price movements without offsetting positions.
p.13
Risk Management Techniques Using Derivatives
What are traditional risk management methods primarily based on?
On-balance sheet techniques.
p.6
Types of Derivative Instruments
What do options provide their holders?
The right but not the obligation to buy/sell the underlying asset at a predetermined price.
p.18
Global Trading Trends in Derivatives
Why have interest rate derivatives become less popular in recent years?
Due to low interest rates and reduced volatility, which diminishes their appeal for hedging.
p.16
Types of Derivative Instruments
What are the main categories of financial derivatives?
Equity index futures and options, single stock futures and options, currency, and interest rate derivatives.
p.3
Forward, Futures, and Options Contracts
What does an option contract provide to the holder?
The right but not the obligation to buy or sell the underlying asset at a predetermined price.
p.5
Types of Risks in Derivative Trading
What is a major problem associated with forward contracts?
Counterparty risk, which refers to the default risk of the counterparty in the contract.
p.16
OTC vs. Exchange-Traded Derivatives
How do financial derivatives compare to nonfinancial derivatives in terms of trading volume?
The total traded volume of financial derivatives is three to four times higher than that of nonfinancial commodity-based derivatives.
p.1
Types of Risks in Derivative Trading
What was the largest derivatives loss in history as of 2008?
The largest derivatives loss was over €4 billion announced by Societe Generale in 2008.
p.7
Swaps and Their Applications
Why has the interest rate swap (IRS) become popular since its introduction in 1981?
Due to its effectiveness in managing interest rate risk and the standardization efforts by ISDA.
p.1
Introduction to Derivative Instruments
What is the purpose of the chapter on derivatives?
To provide an introduction to derivative instruments and their trading, giving an overview of derivatives and their markets.
p.12
Types of Risks in Derivative Trading
What does political risk refer to?
Risks faced by international investors due to unfavorable regulatory changes, such as expropriation or unfavorable tax requirements.
p.7
OTC vs. Exchange-Traded Derivatives
What is a key feature of exchange-traded derivatives?
They are standardized in terms of contract size, maturity, and delivery process.
p.13
Risk Management Techniques Using Derivatives
What is a limitation of on-balance sheet techniques?
There is a limit to how much equity risk can be reduced with diversification; systematic risk remains.
p.18
Introduction to Derivative Instruments
What is the role of derivative instruments in financial engineering?
They are used to manage risk, enhance returns, and create new investment opportunities.
p.18
Types of Derivative Instruments
Differentiate between commodity and financial derivatives.
Commodity derivatives are based on physical goods, while financial derivatives are based on financial instruments or indices.
p.18
Global Trading Trends in Derivatives
What would a fixed exchange rate regime imply about the need for currency derivatives?
It would significantly reduce the need for currency derivatives as there would be less currency risk.
p.16
Global Trading Trends in Derivatives
What significant event caused a sharp fall in the volume of financial derivatives in 2019?
The onset of the COVID-19 pandemic.
p.12
Types of Risks in Derivative Trading
What is default or credit risk?
The risk associated with changes in the financial integrity of the counterparty or issuer of an asset.
p.7
Swaps and Their Applications
What is a currency swap?
A transaction where parties exchange one currency for another.
p.6
Forward, Futures, and Options Contracts
What is the purpose of initial margins in futures contracts?
To reduce the incentive to default.
p.10
Types of Derivative Instruments
What are some examples of physical underlying assets in commodity derivatives?
Agricultural commodities like wheat and coffee beans, and metals like gold and silver.
p.6
Forward, Futures, and Options Contracts
What inadequacies of futures contracts led to the development of options?
Futures locked-in prices, preventing benefits from favorable price movements.
p.7
Swaps and Their Applications
What is the Islamic variant of the interest rate swap called?
Islamic Profit Rate Swap.
p.17
Types of Derivative Instruments
What is the difference between commodity and financial derivatives?
Commodity derivatives have tangible underlying assets and physical settlement, while financial derivatives are based on financial assets and are cash settled.
p.7
OTC vs. Exchange-Traded Derivatives
What advantage does exchange trading provide regarding counterparty risk?
The exchange acts as an intermediary, transferring counterparty risk onto itself.
p.8
OTC vs. Exchange-Traded Derivatives
What is a disadvantage of OTC derivatives related to pricing?
There is little transparency in pricing.
p.13
Risk Management Techniques Using Derivatives
What is a significant problem with on-balance sheet techniques?
They may require changing the nature of how a company does business.
p.15
Global Trading Trends in Derivatives
What was the total traded volume of derivatives in 2002?
About 6.2 billion contracts.
p.15
Evolution of Derivative Instruments
What instruments were initially offered by Chicago exchanges?
Instruments to hedge agriculture-related risks.
p.18
Types of Risks in Derivative Trading
In what way might some activities of speculators hurt markets?
They can lead to increased volatility and potential market manipulation.
p.18
OTC vs. Exchange-Traded Derivatives
What are some disadvantages of exchange-traded derivatives?
Less flexibility and potential for lower customization.
p.4
Forward, Futures, and Options Contracts
What do two parties agree upon in a forward contract?
To complete a transaction at a future date at a price determined today.
p.1
Global Trading Trends in Derivatives
What has been the trend in trading volume for derivative instruments in recent years?
Trading volume in derivatives has shown impressive growth and has outpaced the trading volume of the underlying assets.
p.5
Forward, Futures, and Options Contracts
What is a futures contract?
A standardized forward contract that can be traded on an exchange, with set terms for size, maturity, and quality.
p.2
Types of Derivative Instruments
What are the three main types of derivative instruments discussed in the chapter?
Forwards, futures, and options.
p.2
Forward, Futures, and Options Contracts
Why are forwards discussed only as a precursor to futures contracts?
Because forwards have a fairly simple structure compared to futures.
p.2
Introduction to Derivative Instruments
What is the root word of 'derivative' and what does it signify?
The word 'derive', indicating that these instruments derive their value from elsewhere.
p.12
Risk Management Techniques Using Derivatives
What is the purpose of risk management?
To reduce the risks faced by investors.
p.6
Swaps and Their Applications
What are swaps?
Customized bilateral transactions where parties exchange cash flows at fixed intervals.
p.7
OTC vs. Exchange-Traded Derivatives
Why might a corporation use currency derivatives in OTC trading?
To hedge against potential depreciation of a currency they expect to receive payments in.
p.13
Risk Management Techniques Using Derivatives
What is an advantage of using off-balance sheet techniques?
There is no need to change the way one does business, maintaining competitiveness and customer convenience.
p.18
Risk Management Techniques Using Derivatives
Differentiate between on-balance sheet and off-balance sheet hedging methods.
On-balance sheet involves recording the derivatives on the balance sheet, while off-balance sheet does not.
p.5
Forward, Futures, and Options Contracts
What is the novation principle in futures contracts?
It means the exchange acts as an intermediary, guaranteeing each trade and transferring counterparty risk from the parties to the exchange.
p.9
Key Players in Derivative Markets
How do arbitrageurs identify opportunities?
By closely following quoted prices of the same asset in different markets for price divergences.
p.16
Evolution of Derivative Instruments
Which type of derivatives were introduced later, financial or nonfinancial?
Financial derivatives were introduced much later than nonfinancial derivatives.
p.4
Types of Risks in Derivative Trading
What is one problem associated with forward contracts?
The issue of multiple coincidence, where parties must find a counterparty with opposite needs.
p.8
OTC vs. Exchange-Traded Derivatives
What is one advantage of OTC derivatives?
Customization is possible.
p.13
Risk Management Techniques Using Derivatives
What are off-balance sheet techniques in risk management?
Risk management techniques involving derivatives that are detached from the underlying transaction.
p.18
Key Players in Derivative Markets
Who are the key categories of players in derivative markets?
Hedgers, speculators, and arbitrageurs.
p.18
Forward, Futures, and Options Contracts
What is an advantage of cash settlement over physical settlement?
Cash settlement reduces the costs and complexities associated with the physical delivery of assets.
p.17
Forward, Futures, and Options Contracts
What is the operational advantage of futures over forwards?
Futures are standardized and traded on exchanges, providing liquidity and reducing counterparty risk.
p.9
Key Players in Derivative Markets
What actions do arbitrageurs take when they find a price divergence?
They buy in the market with the lower price and sell in the market with the higher price.
p.9
Key Players in Derivative Markets
Why is quick action necessary for arbitrageurs?
Because arbitrage opportunities can quickly disappear.
p.9
Key Players in Derivative Markets
What types of markets can arbitrageurs operate between?
They can arbitrage between spot, futures, and options markets.
p.2
Types of Risks in Derivative Trading
What can cause serious problems in the use of derivatives?
The misuse of derivatives, often driven by irrational speculation and greed.
p.11
Forward, Futures, and Options Contracts
What is cash settlement in financial derivatives?
Cash settlement means the buyer receives the monetary equivalent of the asset instead of the actual underlying asset.
p.11
Forward, Futures, and Options Contracts
Why might cash settlement be used instead of physical delivery?
Because the underlying asset may not exist in tangible form or physical settlement could be cumbersome.
p.13
Risk Management Techniques Using Derivatives
Why do hedge positions involving derivatives not show up in the balance sheet?
Because they are off-balance sheet techniques.
p.9
Risk Management Techniques Using Derivatives
What is hedging and why is it considered useful?
Hedging allows businesses to reduce price fluctuations, helping them plan better and reduce costs, benefiting society.
p.8
OTC vs. Exchange-Traded Derivatives
What is a key advantage of exchange-traded derivatives?
They are very liquid and can be easily reversed.
p.9
Key Players in Derivative Markets
What societal benefits arise from arbitrage activity?
It helps in proper price discovery and reduces the distortionary effects of government regulation.
p.15
Global Trading Trends in Derivatives
What has caused Chicago exchanges to lose their monopoly?
The emergence of other exchanges challenging their dominance.
p.18
Types of Risks in Derivative Trading
How might the absence of speculators hurt hedgers?
It could reduce market liquidity, making it harder for hedgers to enter or exit positions.
p.18
OTC vs. Exchange-Traded Derivatives
Compare OTC with exchange-traded derivatives.
OTC derivatives are customized and traded directly between parties, while exchange-traded derivatives are standardized and traded on exchanges.
p.13
Risk Management Techniques Using Derivatives
How can a fund manager manage risk using stock options?
By taking large sectoral exposure while using stock options to hedge the risk.
p.18
Introduction to Derivative Instruments
What is financial engineering?
The process of creating new financial instruments or strategies using derivatives.
p.18
Key Players in Derivative Markets
What benefit do arbitrageurs bring to derivative markets?
They help ensure that prices remain aligned across different markets by exploiting price discrepancies.
p.18
Types of Risks in Derivative Trading
What are some key types of risks in derivative trading?
Market risk, credit risk, liquidity risk, and operational risk.
p.18
Key Players in Derivative Markets
What benefits do speculators bring to derivative markets?
They provide liquidity and can help in price discovery.
p.18
OTC vs. Exchange-Traded Derivatives
What are some advantages of OTC derivatives?
Customization and flexibility.
