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67.4 Which of the following statements is least accurate?
A. Futures contracts are easier to offset than forward contracts. B. Forward contracts are generally more liquid than futures contracts. C. Forward contracts are easier to tailor to specific needs than futures contracts. 
B. Forward contracts are usually less liquid than futures contracts because they are typically private transactions tailored to suit both parties, unlike futures contracts, which are usually for standardized amounts and are exchange traded.



67.13 A public, standardized transaction that constitutes a commitment between two parties to transfer the underlying asset at a future date at a price agreed upon now is best characterized as a(n):
A. swap B. futures contract C. exchangetraded contingent claim 
B. (futures contract) The transaction is a commitment, which eliminates the contingent claim answer; the transaction is standardized, which is a characteristic of futures contracts; and the transaction is for single delivery at a future date, which is, in general, not a characteristic of a newlyinitiated swap contract.



Arbitrage

Occurs when equivalent assets or combination of assets sell for two different prices.



Risk Management

The process of identifying the desired level of risk, identifying the actual level of risk, and altering the latter to equal the former. Often this process is described as hedging, which refers to the reduction, and if possible, the elimination of risk.



Price Discovery

Futures markets provide valuable information about the prices of the underlying assets on which futures contracts are based. Popular opinion, geographic dispersion of input data, BlackScholes, expiration and volatility implications.



Notional Principle

The value of the asset represented by the purchase of a derivative contract.



Contingent Claims

Derivatives in which the payoffs occur if a specific event happens. (Options) which give the party the right, but not the obligation to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time. ABS, convertible bonds, callable bonds, and stock options for example.



Forward commitments

Forward contracts, futures contracts, and swaps. Forward contracts are firm and binding agreements to engage in a transaction at a future date They obligate each party to complete the transaction, or alternatively, to offset the transaction by engaging in another transaction that settles each party's financial obligation to the other.



Forward contract

The forward contract is an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset at a future date at a price established at the start. The underlying asset could be a stock or bond, foreign currency, commodity, combos, or interest rates. Private and customized which usually indicates a higher degree of creditworthiness, however the setup allows for the possibility of default.



Futures contract

A forward commitment that is assembled via an exchange (and/or clearinghouse) which provides adequate risk recovery for participating parties.



Swap

A private agreement between two parties to exchange a series of future cash flows. Some of the most successful swaps are those which negotiate the fixed and floating rate agreements. (paying a fixed amount and receiving something unknown in return, i.e. rates, stocks, commodities)



Options

A contingent claim which allows the purchaser the right to buy or sell the underlying asset at a fixed price, and via the exchange, an option price is calculated which represents the required cost of entering into the contingent claim. The right is exercised according to the purchasers' decision, however the exchange (through its clearinghouse) guarantees the originator's (sellers) performance to the buyer. OTC options do exist. Options also require a cash payment from the option buyer to the option seller. If the option is not exercised by expiration date, it will expire.

American (exercise through expiration)
European (exercise only on expiration) cash/stock (and/or?) 

IMM index

International Monetary Market, division of the Chicago Mercantile Exchange, and represents the value is 100  rate quoted as a percent priced into the contract by the futures market of a 90day Tbill, LIBOR.



Actual futures price of a tBill, eurodollar futures (LIBOR), or an FRA

100[1(Rate/100)*(90/360)]



tbills and eurodollar futures

minimum tick size is $25 and available expirations are the next two months plus March, June, September, and December. based on 90day $1,000,000



S&P 500 Stock Index Futures

The contract implicitly contains a multiplier, which is multiplied by the quoted futures price to produce the actual futures price. Multiplier for SP500 is $250, while for the mini SP500 it is $50. Futures expirations are March, June, September, and December, and expire on the Thursday preceding the third Friday of the month.



Conversion factor and cheapesttodeliver.

Conversion factor is the price of a 1 dollar par bond with a coupon and maturity equal to those of the deliverable bond and a yield of 6 percent. Thus, if the short delivers a bond with a coupon greater (less) than 6 percent , the conversion factor exceeds (is less than) 1.
Cheapesttodeliver is the bond that minimizes the loss associated with the conversion factor. 


Intermediate and Longterm interest rate futures contracts.

US Treasury bond futures contracts covers $100,000 par value of US Treasury bonds and the expiration months are March, June, September, and December. The minimum tick size is (1/32) or $31.25.



Regarding futures contracts and initiating the delivery process and when delivery can take place.

The short initiates the delivery process and actual delivery can occur on any business day of the delivery month.



When maintaining margin requirements and the value of the futures price reduces the balance to below the maintenance margin, what is the amount necessary to maintain goodstanding with the clearinghouse?

The trader must deposit sufficient funds that bring the balance up to the initial margin requirement.



Interest rate option

An option in which the underlying is an interest rate. Whereas an FRA is a commitment to make one interest payment and receive another at a future date, an interest rate option is the right to make one interest payment and receive another. The underlying is the unknown interest rate, say for example 180day LIBOR. (callsright to make a known interest payment for an unknown interest payment /putsright to make an unknown interest payment and receive a known interest payment)



Payoff of an interest rate call

(Notional Principal) Max(0,Underlying rate at expirationExercise rate)*(Days in underlying rate/360)



Payoff of an interest rate put

(Notional Prinicipal) Max(0, Exercise rate  underlying rate at expiration)*(Days in underlying rate/360)



Interest rate collar

A combination of a long cap and a short floor or a short cap and a long floor. (in use for interest rate options)



Payoff value of a call option. Both European (cT)
American (Ct) Also, intrinsic value. Buyer of the call option. 
cT=Max(0,StX)
Ct=Max(0,StX) Intrinsic value and lower bound Co>=Max(0,SoX) 


Payoff of a put option. Also, intrinsic value and lower bound.

Pt=Max(0,XSt)
IS intrinsic value and lower bound Po>=Max(0,XSo) 


Intrinsic Value

Depending on whether it is a call or put, it is the value Max(0,StX) or Max(0,XSt)



Minimum & Maximum Values of Options

cO>=0 cO<=So
Co>=0 Co<=So pO>=0 pO<=X/(1r)^t Po>=0 Po<=X 


Yield curve

A graph which illustrates the interest rate (%) on the xaxis (yield) against the years to maturity on yaxis. A widening gap between the yields on 10year and twoyear Treasuries signals growth in the economy and corporate profits.



Lower bounds for European and American calls.

c0>=Max(0,SoX(1/r)^t)
Co>=Max(0,SoX(1/r)^t) 


Lower Bound for European and American puts.

pO>=Max(0,X/(1+r)^tSo)
Po>=Max(0,XSo) 


Fiduciary Call

Buy Call, either worth 0 @ St or worth StX
Buy Bond, with current value X/(1+r)^t, worth X @ St (bond must mature on expiration day and has a face value equal to the exercise price of call: IF St > X, then reward is stock price at expiration minus the exercise price (X/(1+r)^t) minus fees, if St <=X, then reward is X/(1+r)^t, minus fees. 


Protective Put

Buy the put for pO and buy the underlying for So. IF St>Xprice, then put expires worthless and value @ expiration equals Stfees. IF St<=Xprice, then put is exercised for XpriceSt, and value at expiration = Xpricefees. (european puts)



PutCall parity

cO + X/(1+r)^t = pO + So
cO=pO+SoX/(1+r)^t pO=cOSo+X/(1+r)^t IF righthand size is greater than the lefthand side, the protective put is overpriced and you should buy the fiduciary call and sell the overpriced combination. 


Synthetic put
putcall parity 
the right hand side of equation:
p0=c0s0+X/(1+r)^t *equivalence of a put is a synthetic put putcall parity c0+X/(1+r)^t = p0 + s0 


Synthetic call

the right hand side of equation:
c0=p0+s0X/(1+r)^t *is equivalent to a call 


American Options, Lower Bounds & Early Exercise

intrinsic value are the lower bounds
C0=Max(0,StX) P0=Max(0,XSt) Exercising Early(rates &*volatility*): marketable value of call on a bullrun vs. cash payments exercise puts when putcall parity exceeds required margin(transaction costs) XSo>Po(+fees) for arbitrage. 


Describe putcall parity on cash flows for underlyings.

c0+X/(1+r)^t=p0+[SoPV(cf,0,t)]
reduce underlying by the present value of its cash flows over the life of the option. 


Lower bounds for European Options

c0>=Max(0,[SoPV(cf,0,t)]X(1+r)^t
p0>=Max(0,X/(1+r)^t[SoPV(cf,0,t)] 


Volatility

Higher volatility increases call prices and put prices because it increases possible upside and possible downside values on the underlying without hurting outofthemoney options. Only variable that affects option prices that isn't directly observable in open contract or market, must be estimated. Also called the instantaneous standard deviation, and as such is denoted sigma. SEE V1, Reading 9! sqrt[(E(xxbar)^2)/(n1)]



Delta

Sensitivity of the option price to a change in the price of the underlying.



Gamma

Measure of how well the delta sensitivity measure will approximate the option price's response to a change in the price of the underlying.



Rho

Sensitivity of the option price to the riskfree rate.



Theta

Rate at which the time value decays as the option approaches expiration.



Vega

Sensitivity of the option price to volatility.



Reading 70, #10 Unless far out of the money, or far in the money, for otherwise identical options, the longer the term to expiration, the lower the price for:
A. American call options, but not Euro call options B. both European call options and American call options C. neither Euro call options nor American options. 
C. neither Euro call options or American options
cO(T2)>=cO(T1) & T1 being the one expiring earlier C0(T2)>=C0(T1) 


What is the profit potential when an investor writes (sells) a call for Co premium (with strike @ X), owns a stock @ So, and is exercised @ price St.

The profit potential equals the premium for the option (Co) minus the difference of the exercise price (X) and the purchase price (So).



For the buyer of a call option:
Profit of a call option @ expiration, both inthemoney, or outofthemoney? 
II=StXco, when St > X ; (in the money)
II=(co) , when St <=X ; (out of the money) 


For the seller of a call option:
Profit of a call option @ expiration, both inthemoney, or outofthemoney? 
II= Max(0,StX)+co = ct + co, when St>X (inthemoney for buyer & exercised) yet also depends on what the call seller paid for the underlying (So)
II= Max(0, StX) + co = ct + co = o + co, when St<=X; (outofthemoney) 


Breakeven price of underlying at expiration in regards to the purchase of a call option with exercise price of X.

St*=X+co

remember the multiplier effect of 100


Breakeven of underlying at expiration when a put option is purchased or sold (for po) and exercised @ exercise price (X)?

X(St+po)=0
XStpo=0 Xpo=St St=Xpo 
fluctuations in po : seller would reap a profit if po is greater than the difference between the exercise price and the underlying @ expiration, and the buyer would only exercise if the exercise price is greater than the underlying at expiration plus the option premium. So therefore the seller would have the advantage because the buyer put money down. seller has the spread and the profit of a put option for the buyer = II =exercise price minus the underlying price minus the option premium (XStpo) yet in the moneyness catches more than not. (who's the wiser? Seller or buyer?)


Call option value for buyer @ expiration

Ct=max(0,StX)



Put option value for buyer @ expiration

Pt=max(0,XSt)



Call option value for seller @ expiration.

Ct when exercised (St>X) (Ct=Max(0,StX))
yet the seller pockets the option premium, then either sells the underlying, which was either purchased at another value (better if less than the exercise price, X, thus profiting), or purchases the underlying at market value, thus losing profit; or it expires without exercising and seller keeps the option premium. 


Put option value for seller @ expiration.

Pt =Max(0,XSt)



Profit of a put option for seller:

Pt=Max(0,XSt)
Value @ expiration= Pt Profit:II= Pt+Po Max profit = Po Max loss =XPo Breakeven: St*=XPo 


Profit of a put option for buyer:

Pt=max(0,XSt)
Value @ expiration = Pt Profit: II = PtPo Max. profit = XPo Max. loss = Po Breakeven: St*=XPo putcall parity: Co+X/(1+r)^t = Po+So 


Covered call

Depending on whether exercised or not
Own stock for So Sell call for Co if exercised (or not) then either sell So for X and collect Co, or (collect Co) if exercised profit would be X+CoSo Vt=StMax(0,StX) Profit II = VtSo+co Max profit = XSo+co Max loss = Soco Breakeven: St*=Soco 


Protective put

Value @ expiration: Vt=St+Max(0,XSt)
Profit: II = VtSopo Max profit: infinity Max loss: So+poX Breakeven: St*=So+po 


Collar Option Strategy

Sell a call option to gain the premium to pay for the put option. Strive to sell the call option at a higher cost in relation to the underlying (Co(Soco)) than the cost to purchase the premium. Not necessarily the case, when the probabilities of exercising the options and the underlying moves are in your favor.



Determining survivability of a 7year project with probabilities (P1, P2, P3, w/P3 being the probability for the remaining 5 years).

(1P1)*(1P2)*(1P3)^5=probability of survival



Expected NPV of a probabilityweighted project with a certain chance of survival (S%) and a payoff of ($S) and a certain chance of failure (F%) with an CFo of $1 million.

Expected NPV=(S%*$S)+(F%*CFo)



Hedge Fund fee + return when:
base management fee = b% incentive fee for profits over Rf = i% Rf=T% Return = R% 
b%+[i%*(R%T%)] = fee %
Net return = R%fee % 


What is the return premium for commodities, in the sense of the geometric return of a rebalanced portfolio?

G = M  (s^2/2)
where G = geometric return M = arithmetic return s = volatility 


Financial assets tend to perform weakly in the late stages of economic recovery, when there are inflation shocks and also when monetary policy becomes restrictive. At this time, how are commodities usually reacting?

At these times commodities tend to have strong returns because investors perceive that global capacity utilization is high, a shortage of raw commodities is at hand, and inflation is lurking around the corner. Ultimately, rising commodity prices will trigger further monetary tightening, which is not good news for bonds or equities. Clearly, the commodity markets are a natural complement to traditional markets and provide the element of time diversification of returns that is so beneficial in controlling portfolio risk.



perfectly elastic

(chg. Q/avg. Q) / (chg. P/avg. P)
smallest possible increase in price causes an infinitely large decrease in the quantity demanded 


Elastic

% decrease in Q demanded exceeds the % increase in P



Unit elastic

% decrease in Q equals the % increase in P



Inelastic

% decrease in Q is less than % increase in P



close substitutes

smallest possible increase in price of one good causes and infinitely large increase in the Q demanded of the other good



crosselasticity

% chng. Q/% chg. P (substitute/complement)



elastic & supply

% increase in Q supplied exceeds the % increase in P



inelastic & supply

% increase in Q supplied is less than the % increase in P



The more elastic the demand, the more the tax falls on the:

seller (pink pens)



The more inelastic the demand, the more the tax falls on the:

buyer



The elastic the supply, the more the tax falls on the:

buyer (sand for silicon chips)



The more inelastic the supply, the more the tax falls on the:

seller (bottled water)



In principle and in practice rent ceilings are most likely to:
a. be fair b. be efficient c. prevent the housing market from operating in the social interest 
c. In principle and in practice rent ceilings are inefficient and unfair. They prevent the housing market from operating in the social interest.



With regard to organizational structure and the calculation of costs and profits, which of the following statements is most accurate? Compared to accounting costs, economic costs tend to be:
A. lower, especially for large firms organized as corporations B. higher, especially for large firms organized as corporations C. higher, especially for small firms organized as propietorships 
C. Accounting costs do not include implicit costs (opportunity costs); small proprietorships would have a higher proportion of implicit costs than would corporation, because the opportunity cost of the owner's time and capital is not included in the accounting cost.



Which of the following best describes the elasticity of demand in a perfectly competitive market?
A. The firm elasticity is zero and the market elasticity is infinite. B. The elasticity is infinite and the market elasticity is zero. C. The firm elasticity is infinite and the market elasticity is some finite number. 
C. Infinite elasticity reflects perfect elasticity of demand. This characterizes the elasticity of demand for the products of a firm operating in a perfectly competitive market. If the firm increases prices, customers will go to another firm. However, the market demand is not perfectly elastic as it depends on substitutability with other products. Market elasticity will be greater than zero but less than infinite.



Monopolistic competition is a market structure in which:

A large number of firms compete.
Each firm produces a differentiated product. Firms compete on product quality, price, and marketing. Firms are free to enter and exit. 


Herfindahlhirschman Index

the square of the percentage market share of each firm summed over the largest 50 firms (or all if less than 50).
HHI less than 1000: competitive (monopolistic competition) HHI between 1000 & 1800: moderately competitive (oligopoly) HHI exceeds 1800: uncompetitive 


Fourfirm concentration ratio

percentage of the value of sales accounted for by the largest four firms.



Economic profit in the shortrun

Produce the quantity demanded where MC = MR at the price on the demand curve to maximize economic profit.
In the longrun equilibrium in monopolistic competition, price does exceed marginal cost. 


Oligopoly is a market structure in which:

Natural or legal barriers prevent the entry of new firms.
A small number of firms compete. 
