Fabozzi Chapter 28

Front 1

What is a cash and carry trade?

Back 1

strategy that involves borrowing cash to purchase a security and "carrying" that security to the futures settlement date; this will force the futures price down and bid up Asset XYZ's price in order to eliminate profit; when futures price is greater than the cash market price

Front 2

What is a reverse cash and carry trade?

Back 2

a security is sold short and the proceeds received from the short sale are invested; this will raise the futures price and lower the cash price to eliminate the profit; when futures price is less than the cash market price

Front 3

What is the financing cost?

Back 3

in the pricing of a futures contract, the interest rate of borrowing until the settlement date

Front 4

What does the equilibrium futures price equal?

Back 4

F = P + P(r-y)
F = futures price
P = cash market price
r = Financing cost
y = cash yield

Front 5

What is the net financing cost or cost of carry or, simply, carry?

Back 5

it = (r-y) in the futures pricing model; difference between the cost of financing and the asset's cash yield

Front 6

What is positive carry?

Back 6

y>r; futures price will sell at a discount to cash price

Front 7

What is negative carry?

Back 7

y<r; futures price will sell at a premium to cash price

Front 8

What is price convergence at the delivery date?

Back 8

at delivery date, futures price must be equal to the cash market price

Front 9

When and why will actual futures prices diverge from theoretical futures prices?

Back 9

1. no interim cash flows- no changes in futures prices; exchange does not change variation margin; assumes that dividends are paid at the delivery date and not at some time in between
2. assume borrowing and lending rate are the same; typically borrowing rate is higher than the lending rate;
upper boundary: F = P + P(rb-y); lower boundary: F = P + P(rl-y); boundaries surround equilibrium
3. transaction costs
4. short selling- when you short sell you must put up margin, also asset may be borrowed
5. known deliverable asset and settlement date; e.g. US T bond futures- do not know the specific T bond to be delivered or date of delivery
6. deliverable is a basket of securities; it is expensive to buy or sell every security included in the index
7. different cash treatments of cash and futures transactions- model ignores taxes, especially the difference in cash market and futures market transactions

Front 10

What is an option's intrinsic value?

Back 10

economic value if an option is exercised immediately; difference between the current price and the strike price

Front 11

What does in the money mean?

Back 11

when an option has intrinsic value

Front 12

What does out of the money mean?

Back 12

when the strike price of a call option exceeds the current asset price; no intrinsic value

Front 13

What does at the money mean?

Back 13

an option for which the strike price is equal to the current asset price

Front 14

When is a put option in the money?

Back 14

when the asset price is below the strike price

Front 15

When is a call option in the money?

Back 15

when the asset price is above the strike price

Front 16

What is time premium?

Back 16

the amount by which the option's market price exceeds its intrinsic value; the time premium of an option will increase with the amount of time remaining to expiration; price of option minus the intrinsic value

Front 17

What is the put-call parity relationship?

Back 17

the relationship between the price of a call option and the price of a put option on the same underlying instrument, with same strike price and the same expiration date

Front 18

What are the 6 factors that influence the price of an option?

Back 18

1. current price of the underlying asset
2. strike price
3. time to expiration of the option
4. expected price volatility of the underlying asset over the life of the option
5. short-term, risk-free interest rate over the life of the option
6. anticipated cash payments on the underlying asset over the life of the option

Front 19

How does the current price of the underlying asset affect the price of the option?

Back 19

rise in current price causes:
call price to increase
put price to decrease

Front 20

How does the strike price affect the price of an option?

Back 20

rise in strike price (eventhough its fixed):
call price to decrease
put price to increase

Front 21

How does the time to expiration of the option affect the price of an option?

Back 21

if time to expiration increases (options are wasting asset, more time for a favorable price change when there's more time):
call price and put price increase

Front 22

How does the expected price volatility of the underlying asset over the life of the option affect the price of an option?

Back 22

if volatility increases, more an investor is willing to pay (anticipates a greater chance of a favorable price shift) and more an option writer would demand, so call price and put price increase

Front 23

How does the short-term, risk-free interest rate over the life of the option affect the price of an option?

Back 23

higher short-term interest rates mean cost of buying the underlying asset and carrying go up, so you'd rather have an option to buy it with higher interest rates; call price increases and the put price decreases

Front 24

How do anticipated cash payments on the underlying asset over the life of the option affect the price of an option?

Back 24

higher cash payments tend to make actually holding the asset more attractive than buying an option; so, call price decreases and put price increases