Unit 6: Derivatives

Student Workbook
Unit 6
Learning Chapter
Learning Outcomes
Unit Aim: Understand the key features of Objective Section
futures, options and swaps. 6.1.1 Know the uses and application of derivatives 1
6.2.1 Know the definition and function of a future 2
Relevance of this unit to the course:
6.3.1 Know the definition and function of an option 3
This unit builds on the previous financial
Understand the following terms
assets units, as well as making connections to 6.3.2 • Calls 3
unit 2 and unit 8. • Puts
Understand the following terminology around futures / options
• Long
• Short
• Open
• Close
6.4.1 • Covered
2 and 3
• Naked
• Holder
• Writing
• Premium
6.5.1 Understand the characteristics of the derivatives and commodity markets 6
Understand the potential advantages and disadvantages of investing in the
6.5.2 derivatives and commodity markets
6
6.6.1 Know the definition and function of an interest rate swap 4
6.7.1 Know the definition and function of credit default swaps 5
2
How to use this student workbook
Throughout this student workbook, look out for the different icons to support your learning:

Understand and learn – these sections will help you to develop your knowledge and
understanding of the assessed learning objectives.

Apply and practise – Practise and test your newly acquired learning by undertaking a range
of activities to help you prepare for the multiple choice assessment at the end of the course.

Further your knowledge – Consolidate your understanding of key concepts by reading and
interacting with current, credible resources to help further enhance your learning.

3
Introduction to derivatives
A derivative is a financial instrument whose price is based on the price of another asset called ‘the
underlying’. Which of the following could be an underlying? Give reasons for your answers.

The underlying? Reason The underlying? Reason

US Dollar Market index

Wheat Bonds

Gold Corn

Exchange Traded Funds Cocoa Beans

Sugar Crude Oil

Stocks Yen
4
Module Learning Outcome 6.1
6.1.1: Know the uses and application of derivatives 5
What are derivatives?
Watch the video What are derivatives? and answer the following questions.

1. In your own words, briefly explain derivatives. 3. What are derivatives used for?

2. What are the 3 products that form the derivative market?

Define these products with examples.

6
*CISI is not responsible for the accuracy, legality or content of any external sources referenced in this workbook
The uses and application of derivatives
A derivative is a financial instrument whose price is based on the price of another asset which is known as
the underlying asset or simply ‘the underlying’. They are chiefly designed to be used to reduce the risk faced
by organisations and individuals, known as hedging.

Give 3 examples of each type of underlying asset:

Financial Assets: Commodities:

1. 1.

2. 2.

3. 3.
7
Derivatives play an important role in the investment management of many large portfolios and funds and
are used in different ways. Fill in the blanks below:

is a technique used by portfolio managers to reduce the impact of price

Risk
Anticipated
Fix
Adverse
Hedging
Mismatched
Differs
Free
movements on a portfolio’s value. Risk Free
Anticipated
Fix
Adverse
Hedging
Mismatched
Differs

Anticipating future cash flows is closely linked to the idea of hedging. If a portfolio manager expects to receive a large in-
flow of cash to be invested in a particular asset, then futures can be used to the price at which it
will be bought in order to offset the risk that prices that will have risen by theDiffers
Risk
Anticipated
Fix
Adverse
Hedging
Mismatched
timeFree
the cash is received.

Changes in asset allocation of a fund can be used to take advantage of short term movements in
the market or to implement a change in strategy. The changes can be made Risk more
Anticipated
Fix
Adverse
Hedging
Mismatched
Differs
Free quickly and less expensively using deriv-
atives than actually buying and selling the securities within the portfolio.

Arbitrage is the process of deriving a profit from buying AND selling the same asset in two differ-
ent markets at the same time, where theRiskprice
Anticipated
Fix
Adverse
Hedging
Mismatched
Differs
Free between the markets. If the price of a derivative
and its underlying asset are Risk Free
Anticipated
Fix
Adverse
Hedging
Mismatched
Differs
, then a portfolio manager may be able to profit from the pricing
anomaly. Risk Free
Anticipated
Fix
Adverse
Hedging
Mismatched
Differs
8
Module Learning Outcome 6.2 – Futures
6.2.1 – Know the definition and function of a future

Module Learning Outcome 6.4 – Futures Terminology

6.4.1 – Understand the following terminology around futures
• Long • Open • Covered
• Short • Close • Naked 9
What are futures and forwards?
Watch this CISI YouTube video about forwards and futures and read the section in chapter 6 of your course
workbook. Answer the following questions.

1. What is the difference between forward and future contracts? 4. When was the world’s first financial futures contract introduced?

2. When and where was the world’s first derivatives exchange 5. What are two distinct features of a futures contract?
opened?

3. Describe a commodities futures contract?

10
Derivatives and their uses
Read the five scenarios below where two counterparties have entered into a contract to exchange money for
an asset. Write down which asset you think is being traded (What asset is the financial transaction derived
from?) and answer the questions that follow.

1. 2.
What asset is What asset is
being traded? being traded?

Airline Oil Company Brewery Farmer

e.g. British Airways e.g. Shell e.g. Shepherd Neame

11
 What asset is
3.
being traded?

Derivatives
and their uses
Bakery Farmer
e.g. Allied Bakeries

4. What asset is 5. What asset is

being traded? being traded?

Electronics manufacturer Mining Company Medium sized UK plc Investment Bank

e.g. Sony e.g. Rio Tinto e.g. JP Morgan

12
Uses and futures
In scenarios 1-4, the contracts put in place between the buyer and Scenario 5 involves a different type of asset in the agreement. What
seller are negotiated directly between the two parties and stipulates: do you think are the reasons for both counterparties for entering
into this agreement?
• The price of the asset
• The quantity of the asset
• The quality of the asset
• The delivery of the asset on a set date paid

These are known as forward contracts. Why are contracts like this put
in place? Think about what the two parties stand to gain with this type
of agreement. Write down your thoughts below for each scenario:

13
Futures – True or False?
True False

A future is an agreement between a buyer and a seller

A futures contract is a legally binding obligation between 2 parties

In a futures contract, the buyer agrees to pay a pre specified amount for
the delivery of a respecified quantity of an asset at a moveable date
A buyer of a futures contract can only negotiate the date and location of
delivery, not the price of the underlying asset.
Futures allow assets and commodities to be traded for future settlement
at a price agreed today.

14
Futures terminology
Read the section about futures terminology in chapter 6 of the course workbook and match the
term and definitions below:

Definition Term

The term used for the position taken by the buyer of the future
Naked
Close
Long
Short
Open
Covered
The term used for the position taken by the seller of the future
Naked
Close
Long
Short
Open
Covered
Describes the initial trade, when it first enters into a future
Naked
Close
Long
Short
Open
Covered
Most physical assets don’t end up being delivered and so this happens instead. If this
doesn’t happen, the buyer pays agrees sum and receives the underlying asset.
Naked
Close
Long
Short
Open
Covered
When the seller of the future has the underlying asset that will be needed if physical
delivery of the underlying commodity takes place.
Naked
Close
Long
Short
Open
Covered
The term used when the seller of the future does NOT have the asset that will be needed if
physical delivery of the underlying commodity is required.
Naked
Close
Long
Short
Open
Covered 15
Using futures terminology
Look at the example below and decide which of the 6 futures terms (open, close, short, long, naked, covered)
relate to the buyer and/or the seller. Terms may apply to both. Give reasons for your answers.

Buyer Seller

Covered Futures Contract Covered

Legally binding obligation
Open between two parties Open

Short Short

Long Long

Close Close
Buyer Seller
Naked e.g. British Airways e.g. Shell Aviation Naked

Reasons: Reasons:

16
Further your knowledge – Futures
Watch the video ‘What are futures’ and write your
own case study/ scenario explaining how futures
work in practice. You should include information
about:

• The asset and parties involved

• The forward contract (what should be included?)
• A change in the contract
• The impact on all parties
• The impact of bringing in a third party

*CISI is not responsible for the accuracy, legality or content of

any external sources referenced in this workbook 17
Multiple choice questions
1. When a counterparty using derivatives has no interest in the 2. When derivatives are traded directly between counterparts,
underlying asset, they are said to be; it is known as;

A. Accumulating A. OTC

B. Hedging B
 . ETF

C. Speculating C. OTT

D. Mitigating D. ECB

18
Multiple choice questions
3. Which ONE of the following is described as having gone short 4. The seller in a futures contract agrees to;
in a futures transaction?

A. Pay a pre-specified amount for an asset

A. Guarantor
B
 . Take delivery of an asset at a pre-specified future date
B. Holder
C. Take delivery of a pre-specified quantity of an asset
C. Seller
D. Deliver the asset on a pre-specified future date
D. Buyer

19
Multiple choice questions
5. What is the only element of a futures contract that is open to 6. If a futures contract is not closed by the specified delivery
negotiation between buyer and seller? date, which of the following will happen;

A. Underlying quantity A. The buyer will take delivery of the asset

B. Purchase price B
 . The seller will not deliver the asset

C. Future date C. A closing sale is made by the buyer

D. Delivery location D. The buyer will not pay the seller

20
Multiple choice questions
7. When both parties have an interest in the underlying asset in a 8. Rose has committed to buy 1000 barrels of crude oil for
futures contract, they are said to be; $105 per barrel in 3 months’ time on a derivatives exchange.
Which of the following best describes Rose’s position;

A. Hedging
A. Short futures
B. Speculating
B
 . Short options
C. Taking a short position
C. Long futures
D. Taking a long position
D. Long options

21
Module Learning Outcome 6.3 – Options
6.3.1: Know the definition and function of an option
6.3.2: Understand the following terms
• Calls • Puts

Module Learning Outcome 6.4 – Terminology

6.4.1 – Understand the following terminology around options
• Holder • Writing • premium 22
What are options?
Watch this CISI YouTube video about options and read the section in chapter 6 of your course workbook.
Answer the following questions.

1. What are options? 3. What is the term given to the pre-agreed price at which an option
buyer is able to buy or sell a specified quantity of an underlying asset?

2. What does the term “exercise the option” mean? 4. What is the premium?

23
What are options?
5. What is a call option? 7. What is another term for the buyer of the option?

6. What is a put option? 8. What is another term for the seller of the option?

24
Options – True or False?
True False

In exchange traded options contracts, buyers and sellers deal directly

with each other
The premium paid by a buyer to an exchange is non-refundable

In a call option, the writer is obliged to sell the underlying asset

In a put option, the writer is obliged to buy the underlying asset

The premium represents the payment by the buyer for the option

25
Options example
Read the example about Jersey PLC in the options 2. Explain how and when she could make a profit?
section of chapter 6 in the course workbook and
apply this to the scenario below:

Romi holds a £2.80 call option for ABC plc which ends on 2nd
December. She paid a premium of 15p.

1. Explain how Jenny’s option works? 3. What is the maximum loss Jenny could make?

26
Fill in the remaining blanks:

An option gives the buyer the right but not the obligation to buy or sell a specified of an
underlying asset at a pre-agreed Off exchange
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke
price, on or before a pre-specified future date or between two
Off exchange
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke
specified dates. The seller, in exchange for the payment of a , grants the option to the buyer.
Off exchange
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke

When options are traded on an they will be in sizes and terms. When
Off
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke
investors want to trade outside of exchange
these terms they can do so Off exchange in the
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke
market where the contract is . Off exchange
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke Bespoke
Off
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
exchange
Off exchange
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke

A is the buyer and owner of an option.

Off exchange
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke

A is the seller of an option.

Off exchange
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke

The seller of an option, in exchange for the payment of a , grants the option to the buyer.
Off exchange
Premium
Standardised
Exercise
Writer
Quantity
Exchange
OTC
Holder
Bespoke

27
Options – Shares in Beckenham Ventures
1. What would happen if Beckenham
Shares in Beckenham Ventures Plc are trading at 125p. Venture PLC share price rise above
170p?
Investor Smith believes the share Investor Jones thinks the shares are
price is going to rise sharply over the going nowhere.
course of the next three months.

Investor Jones writes (sells) the

Investor Smith buys a 150p call option call option. Investor Jones charges
for three months. investor Smith a non-refundable
premium of 20p.

2. What would happen if Beckenham Venture PLC share price rise to 3. What would happen if Beckenham Venture PLC share price rise to
155p? 127p?

28
Options – Shares in Gameshare PLC
1. What would happen if Gameshare PLC
Shares in Gameshare Megastore Plc are trading at 240p. shares are trading at 160p?

Investor Smith believes the share Investor Jones believes the share
price will fall sharply over the next price will rise slightly.
three months.

Investor Jones writes a put option for

Investor Smith buys the option Gameshare Megastore plc shares at
written by Mr Jones for a 220p for three months.
premium of 30p

2. What would happen if Gameshare PLC shares are trading at 210p? 3. What would happen if Gameshare PLC shares are trading at 230p?

29
Further your knowledge – options
Watch the video to recap your knowledge about
options and answer the following questions:

1. What are the uses of options?

2. Summarise the key features of an option.

*CISI is not responsible for the accuracy, legality or content of 30

any external sources referenced in this workbook
Module Learning Outcome 6.5
– Derivatives / Commodity Markets
6.5.1: Understand the characteristics of the derivatives and commodity markets
6.5.2: Understand the potential advantages and disadvantages of investing in the derivatives and commodity markets 31
Derivatives Markets
There are broadly two groups of derivatives in the derivatives market: Over The Counter (OTC) derivatives
and Exchange-Traded Derivatives (ETD). Read section 6 in chapter 6 of the course workbook and place the
following terms under correct heading
OTC ETD

Traded privately between parties

Standardised features

Participants need to post a margin for all transactions

The larger market in terms of value of contracts traded daily

Mainly takes place in Europe and the UK currently

Guarantees given to each party that trade will eventually be settled

Uses intermediary for all trades

Interest rate swaps mainly traded this way

32
Physical Markets
Using section 6 in chapter 6 of the course workbook, Read the example on base and precious metals in the course
workbook and explain the factors that could influence supply
name five commodity markets:
and demand.

1.

2.

3.

4.

5.

33
European Derivatives Exchanges
The main derivative exchanges in Europe are shown below. List where they are located and the
different types of derivatives that they trade.

Derivatives Exchange Trades in…

ICE Futures Europe

Eurex

Intercontinental Exchange (ICE)

London Metal Exchange (LME)

34
Who does what?
1. Which exchange trades German bond futures? 3. Which exchange trades options on the FTSE100?

2. Which exchange trades American agricultural futures and 4. Which exchange trades derivatives on soft commodities as well as
options? financial derivatives?

35
Who does what?
5. Which exchange trades energy commodity contracts? 7. Which exchange is based in London but has a global market with
international membership?

6. Where would you trade a jet fuel futures contract?

36
Advantages and disadvantages
Summarise the main advantages and disadvantages of investing in the derivatives and commodity markets
in the table below. Use chapter 6 to help.

Advantages Disadvantages

37
Further your knowledge
Complete the commodities and energy markets
module (1 hr) on the professional refresher
section of the CISI learning platform.

38
Commodities
Watch the panel discussion about commodities
focusing on gold and uranium on the CISI TV
channel through the learning platform.

39
Module Learning Outcome 6.6 – Swaps
6.6.1: Know the definition and function of an interest rate swap 40
What is a swap?
Watch the video about swaps and read the section in chapter 6 of your course workbook then answer
the following questions.

1. What is a swap? 3. Are swaps standardised or unique?

2. What is an interest rate swap? 4. What are the “legs of a swap”?

41
*CISI is not responsible for the accuracy, legality or content of any external sources referenced in this workbook
What is a swap?
5. What is the purpose of an interest rate swap? 7. What is another term for the variable rate of interest?

6. T he variable interest rate is usually based on a market reference

rate such as the SOFR. What does SOFR stand for?

42
*CISI is not responsible for the accuracy, legality or content of any external sources referenced in this workbook
Swaps activity
ABC plc and XYZ plc enter into a 1-year interest rate swap with a notional amount of £1 million. ABC plc
makes an agreement with XYZ plc to exchange a rate of LIBOR* plus 1% for a fixed annual rate of 5%.

1. I f the LIBOR rate stays at roughly 4%, what would the value of 3.  hich of the two companies has lost out as a result of this swap
W
the legs of the swap agreement be? deal if the rate of LIBOR is 4.7%?

2.  hat would the value of the legs of the swap agreement be if

W
the LIBOR rate was trading at 4.75%?

* The London Interbank Offered Rate (LIBOR) is a set of interest rates calculated from submissions by large global banks. LIBOR rates are 43
supposed to represent the cost of borrowing among the banks.
Module Learning Outcome 6.7
– Credit Default Swaps
6.7.1: Know the definition and function of credit default swaps 44
What are credit default swaps?
Read the section about credit default swaps in the course workbook and on the Investopedia web page.
Answer the following questions.

1. What is the function of credit derivatives? 3. What is a credit derivative?

2. What is a credit event? 4. Why is a credit default swap different to other type of swaps?

45
*CISI is not responsible for the accuracy, legality or content of any external sources referenced in this workbook
Further your knowledge
Complete the derivatives module (1 hr) on the
professional refresher section of the CISI learning
platform.

46
End of Unit 6
Multiple Choice Assessment 47
Test your knowledge
1. The premium for an exchange traded 2. The ‘holder’ of an option is another
option is paid: name for the

A. Directly to the Exchange A. Writer

B. Directly to the Writer B. Buyer
C. Directly to the Holder C. Seller
D. Directly to a Custodian D. Granter

48
Test your knowledge
3. A premium is most likely to be paid 4. The exercise price relates to which
type of derivative?
A. When a futures contract is opened
A. Futures
B. A
 t the beginning of an option
contract B. Forwards
C. When a futures contract is closed C. Swaps
D. When an option contract lapses D. Options

49
Test your knowledge
5. What is ‘the underlying’ in relation to a 6. Which of the following is not a
derivative? major form of derivative?

A. The asset from which the A. Options

derivative’s price is determined
B. Forwards
B. The price of the financial instrument
C. Equities
C. T he contract put in place between
D. Futures
two counterparties
D. T he terms set out in the derivatives
contract
50
Test your knowledge
7. The first derivatives exchange, 8. Which of the following is NOT a
established in 1848 was the feature of a futures contract?

A. CBOE A. It is exchange traded

B. CBOT B. It is dealt on standardised terms
C. CSIT C. O
 nly the price is open to
negotiation
D. OPEC
D. T he date of delivery can be
negotiated

51
Test your knowledge
9. When the seller of a future does not 10. What does the term ‘long’ refer to in
own the underlying asset, which of the futures terminology?
following best describes their position?
A. T he position taken by the buyer
A. Covered of the future
B. Naked B. T he position taken by the seller
of the future
C. Long
C. T he timescale specified by the
D. Open futures contract
D. T he position taken either by the
buyer or seller of the future 52
Test your knowledge
11. Which of the following is NOT true about 12. Which of the following is true when
the premium paid in an options contract? derivatives are traded OTC?

A. It is paid at the beginning of the A. They have standardised terms

contract
B. T erms are negotiated directly
B. It is refundable between counterparties?
C. I t is paid to an exchange for C. They are traded on exchange
exchange traded options contracts
D. T hese are legally binding
D. I t is paid by the eventual holder of obligations for both counterparties
the option
53
Test your knowledge
13. The exercise price relates to which type 14. A call option is where:
of derivative?
A. T he buyer has the right to buy the
A. Futures asset at the exercise price
B. Forwards B. T he seller is obliged to take delivery
and pay the exercise price
C. Swaps
C. T he buyer has the right to sell the
D. Options
underlying asset at the exercise price
D. Either the buyer or the seller can
waive their obligation
54
Test your knowledge
15. Sellers of options are referred to as: 16. Which of the following is NOT a drawback
of investing in a derivative markets?
A. Holders
A. Professional investment skills and
B. Writers
experience are required
C. Exchangers
B. Counterparty default risk
D. Buyers
C. P
 otential to lose more than the initial
outlay
D. Offers the ability to speculate on a
range of assets and markets
55
Test your knowledge
17. Which of the following is NOT a credit 18. Company A has entered into an interest
event? rate swap with an investment bank.
Company A originally borrowed £1. What
term is given to the original amount on
A. A fall in an assets value
which the swap cash flows are based?
B. Bankruptcy
C. Debt restructuring A. The negligible

D. A rise in an assets value B. The nominal

C. The notional
D. The notable
56
Test your knowledge
19. The cash flows of an interest rate swap 20. Which are the most common form of
are known as which of the following swaps?
terms?
A. Interest Rate Swaps
A. Flows
B. Credit Default Swaps
B. Trades
C. Currency swaps
C. Feet
D. Commodity Swaps
D. Legs

57
Test your knowledge
21. Arbitrage is the

A. process of deriving a risk free profit from simultaneously buying

and selling the same asset in two different markets
B. t echnique employed by portfolio managers to reduce the impact
of adverse price movements on a portfolio’s value
C. process of changing an asset allocation of a fund
D. t echnique used to fix the price of an asset and offset the risk of
rising prices when expecting to receive a large inflow of cash to
pay for the asset
58
Test your knowledge
22. Which of the following statements is correct:

A. Both futures and options can ONLY be exchange traded

B. A
 future is a legally binding obligation whereas an option only
gives the right to buy or sell
C. A
 option is a legally binding obligation whereas a future only gives
the right to buy or sell
D. Buyers pay a premium to buy futures

59
Monitoring my progress – Unit 6

My multiple choice assessment mark is / 22

I am happy with the progress that I made on the multiple choice assessment
Yes No

To improve my knowledge and understanding, I now need to….

1.
2.
3.

60
Need more help?
If you feel that your multiple choice score can
be improved further, complete the end of unit 6
multiple choice questions in the course workbook.

61
Answers
Page 4 Arbitrage is the process of deriving a risk free profit from buying AND selling the same asset
All are examples of underlying assets in two different markets at the same time, where the price differs between the markets. If the
price of a derivative and its underlying asset are mismatched, then a portfolio manager may be
Page 7 able to profit from the pricing anomaly.
Financial Assets could include:
1. Bonds Page 10
2. Shares 1. Forward and futures contracts involve two parties agreeing to buy and sell an asset at a
3. Stock market indices specified price by a specific date.
4. Interest rates A forward contract is a private, customizable agreement that settles at the end of the
agreement and is traded over the counter (OTC).
Commodities could include:
1. Oil A futures contract has standardized terms and is traded on an exchange, where prices are
2. Silver settled daily until the end of the contract.
3. Wheat 2. When and where was the world’s first derivatives exchange opened? 1848 in Chicago
4. Coffee 3. A commodities futures contract enables standardised qualities and quantities of a
5. Sugar commodity to be traded for a fixed future price on a stated delivery date. Unlike the forward
contracts that preceded it, a futures contract can itself be traded.
Page 8
Hedging is a technique used by portfolio managers to reduce the impact of adverse price 4. 1975
movements on a portfolio’s value. 5. It is exchange traded and is dealt on standardised terms where only the price is open to
negotiation
Anticipating future cash flows is closely linked to the idea of hedging. If a portfolio manager
expects to receive a large inflow of cash to be invested in a particular asset, then futures can Page 11
be used to fix the price at which it will be bought in order to offset the risk that prices that will 1. Jet fuel
have risen by the the time the cash is received. 2. Wheat/hops

Changes in asset allocation of a fund can be used to take advantage of anticipated short Page 12
term movements in the market or to implement a change in strategy. The changes can be 1. Wheat
made more quickly and less expensively using derivatives than actually buying and selling the 2. Copper
securities within the portfolio. 3. Interest rates
62
Answers
Page 14 Page 18 - 21
A future is an agreement between a buyer and a seller - TRUE 1C
A futures contract is a legally binding obligation between 2 parties - TRUE 2A
In a futures contract, the buyer agrees to pay a prespecified amount for the delivery of a 3C
respecified quantity of an asset at a moveable date - FALSE 4D
A buyer of a futures contract can only negotiate the date and location of delivery, not the price 5B
of the underlying asset - FALSE 6A
Futures allow assets and commodities to be traded for future settlement at a price agreed today. 7A
-TRUE 8C

Page 15 Page 23 - 24
Long = the term used for the position taken by the buyer of the future • What are options? An option gives a buyer the right, but not the obligation, to buy or sell
a specified quantity of an underlying asset at a pre-agreed exercise price, on or before a
Short = the term used for the position taken by the seller of the future
prespecified future date or between two specified dates. The seller, in exchange for the
Open = describes the initial trade, when it first enters into a future payment of a premium, grants the option to the buyer.
• What does the term “exercise the option” mean? When an option buyer chooses to proceed
Close = Most physical assets don’t end up being delivered and so this happens instead. If this
with the purchase of an asset by the agreed date.
doesn’t happen, the buyer pays agrees sum and receives the underlying asset.
• What is the term given to the pre-agreed price at which an option buyer is able to buy or sell
Covered = When the seller of the future has the underlying asset that will be needed if physical a specified quantity of an underlying asset? Exercise price
delivery takes place • What is the premium? The premium is the money paid by the buyer/holder to the exchange
Naked = The term used when the seller of the future does NOT have the asset that will be (and then by the exchange to the seller/writer) at the beginning of the option contract; it is
needed if physical delivery of the underlying commodity is required. not refundable.
• What is a call option? ‘Call option’ is when the buyer has the right to buy the asset at the
Page 16 exercise price, if they choose to. The seller is obliged to deliver if the buyer exercises the
Long – the buyer option.
Short – the seller • What is a put option? ‘Put option’ is when the buyer has the right to sell the underlying asset
Naked – the seller at the exercise price. The seller of the put option is obliged to take delivery and pay the
Covered – the seller exercise price if the buyer exercises the option.
Open – both • What is another term for the buyer of the option? Holder
Close – the buyer • What is another term for the seller of the option? Writer 63
Answers
Page 25 Page 28
In exchange traded options contracts, buyers and sellers deal directly with each other FALSE 1. What would happen if Beckenham Venture PLC share price rise above 170p? Investor Smith
The premium paid by a buyer to an exchange is non-refundable TRUE will exercise the option as he has made a profit. He has to pay 150p per share and has
In a call option, the writer is obliged to sell the underlying asset TRUE already paid 20p for the option
In a put option, the writer is obliged to buy the underlying asset TRUE 2. What would happen if Beckenham Venture PLC share price rise to 155p? Investor Smith
The premium represents the payment by the buyer for the option TRUE might exercise the option as the 5p profit on the purchase of the share will defray part of the
20p cost of the option premium
Page 26
1. Romi’s call option gives her the right but not the obligation to buy ABC shares at £2.80 any 3. What would happen if Beckenham Venture PLC share price rise to 127p? Investor Smith will
time up to 2nd December not exercise the option and allow it to expire. Investor Smith loses the 20p premium already
2. Romi will make a profit by exercising her option to buy if the share price rises above £2.95 paid to Investor Jones.
(£2.80 + 15p) before 2nd December. She could also make a profit by selling her option
Page 29
before 2nd December depending on the option trading price at the time.
1. What would happen if Gameshare PLC shares are trading at 160p? Investor Smith will
3. 15p (the premium she paid)
definitely exercise the option as he has made a profit – he can sell the shares for 220p each
Page 27 and has paid the 30p premium.
An option gives the buyer the right but not the obligation to buy or sell a specified quantity 2. What would happen if Gameshare PLC shares are trading at 210p? Smith might exercise the
of an underlying asset at a pre-agreed exercise price, on or before a pre-specified future date or option as the 10p profit on the sale of shares will defray part of the 30p cost of the option
between two specified dates. The seller, in exchange for the payment of a premium, grants the premium
option to the buyer. 3. What would happen if Gameshare PLC shares are trading at 230p? Smith will not exercise the
When options are traded on an exchange they will be in standardised sizes and terms. When option and allow it to expire. Smith will lose out on the 30p premium and keep the shares.
investors want to trade outside of these terms they can do so ’off exchange’ in the OTC market Jones makes 30p frpm the premium
where the contract is bespoke.
A holder is the buyer and owner of an option
A writer is a seller of an option.
The seller of an option, in exchange for the payment of a premium, grants the option to the
buyer
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Answers
Page 32 Page 35 – 36
Traded privately between parties OTC 1. Which exchange trades German bond futures? Eurex
Standardised features ETD 2. Which exchange trades American agricultural futures and options? ICE
The larger market in terms of value of contracts traded daily OTC
3. Which exchange trades options on the FTSE100? ICE Futures Europe
Interest rate swaps mainly traded this way OTC
Mainly takes place in Europe and the UK currently OTC 4. Which exchange trades derivatives on soft commodities as well as financial derivatives? ICE
Guarantees given to each party that trade will eventually be settled ETD Futures Europe
Uses intermediaries for all trades ETD 5. Which exchange trades energy commodity contracts? ICE
Participants need to post a margin for all transactions ETD 6. Where would you trade a jet fuel futures contract? ICE
Page 33 7. Which exchange is based in London but has a global market with international membership?
Potential answers include: LME
• Agricultural markets
• Base and precious metals Page 37
• Energy markets Advantages
• Power markets • Enables producers and consumers of goods to agree the price of a commodity today for
• Plastic markets future delivery, which can remove the uncertainty of what price will be achieved for the
• Emissions markets producer and the risk of lack of supply for the consumer.
• Freight and shipping markets • Enables investment firms to hedge the risk associated with a portfolio or an individual stock.
• Offers the ability to speculate on a wide range of assets and markets to make large bets on
The factors that influence supply include the availability of raw materials and the costs of
price movements using the geared nature of derivatives.
extraction and production
Disadvantages
Demand comes from underlying users of the commodity eg the demand for metals in rapidly • Some types of derivatives investment can involve the investor losing more than their initial
industrialising economies such as China and India. it also originates from investors such outlay and, in some cases, facing potentially unlimited losses.
as hedge funds which might buy metals in anticipation of excess demand or incorporate
• Derivatives markets thrive on price volatility, meaning that professional investment skills and
commodities into specific funds.
experience are required.
• In the OTC markets, there is a risk that a counterparty may default on their obligations,
and so it requires great attention to detail in terms of counterparty risk assessment,
documentation and the taking of collateral. 65
Answers
Page 43 Test your knowledge
1. If the LIBOR* rate stays at roughly 4%, what would the value of the legs of the swap 1A
agreement be? 2B
• ABC pays 5% of £1m = £50,000 3B
• XYZ pays 5% of £1m = £50,000 4D
2. What would the value of the legs of the swap agreement be if the LIBOR rate was 5A
trading at 4.75%? 6C
• ABC pays 5% of £1m = £50,000 7B
• XYZ pays 5.75% of £1m = £57,500 8D
9B
3. Which of the two companies has lost out as a result of this swap deal if the rate of
10A
LIBOR is 4.7%?
11B
• XYZ will lose out
12B
13D
Page 45
14A
1. Credit derivatives are used to enable an organisation to protect itself against
15B
unwanted credit exposure (or risk) by passing on that exposure to someone else.
16D
They can also be used to increase credit exposure, in return for income.
17D
2. Credit events are typically defined as including a material default, bankruptcy, a 18C
significant fall in an asset’s value, or debt restructuring for a specified reference asset. 19D
3. Credit derivatives are instruments whose value depends on agreed credit events 20A
relating to a third party company. For example a credit derivative’s value may depend 21A
on changes to the credit rating of a company or an increase in a company’s cost of 22B
funds in the market or credit events relating to it.
4. A credit default swap is more like an option or a type of insurance. It is not based on a
exchange of cash flows.

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