1) Can you describe the trade life-cycle ?
REC VEMC CSR
R isk Assessment
E xecution (placing the trade)
C apture (skeleton details, minimum information required)
V alidation (especially for OTC derivatives)
E nrichment (adding additional essential information)
M atching (counterparties agreeing)
C learing (counterparty obligations)
C onfirmation (or affirmation - both parties?)
S ettlement (carried out by custodian)
R econciliation (with custodians and reporting)
2) What is a Failed Trade ?
A trade that does not settle on the contractual settlement date.
Normally caused by a disagreement between parties on whether the delivered item meets the agreed specifications.
3) What is a Custodian ?
A custodian is responsible for the safe keeping of the securities and other assets in electronic or physical form.
Most also offer services including: administration, transaction settlement, collecting dividends and interest.
4) What does STP stand for ?
STP - Straight Through Processing
This is achieved by allowing information that has been electronically entered to be transferred from one party to another in the settlement process without manually re-entering the same pieces of information repeatedly over the trade life-cycle.
5) What do the following abbreviations mean ?
BPV - Basis Point Value
CCP - Central Counterparties
CUSIP - Committee on Uniform Security Identification Procedures
DTD - Document Type Definition
ESMA - European Securities and Markets Authority
FINRA - Financial INdustry Regulatory Authority
FIXML - Financial Information eXchange Markup Language (standardised: equities, futures, options)
FpML - Financial Products Markup Language (customised: interest rate swaps and forwards)
ISDA - International Swaps and Derivatives Association
ISIN - International Securities Identification Number
MIFID - Markets in Financial Instruments Directive
MDDL - Market Data Definition Language (xml message format for exchanging information)
RIXML - Research Information eXchange Markup Language
SWIFT - Society for the Worldwide Interbank Financial Telecommunication
6) Can you describe Central Counterparty Clearing ?
In an attempt to reduce the systematic risk of the OTC market and to increase transparency standard OTC derivatives need to be cleared through a central counterparty.
The largest volume of OTC contracts is interest rate contracts, currency contracts and credit default swaps.
7) Can you give a description of the different Financial Markets ?
Money Market - This is short-term borrowing and lending of money and credit. Maturities are less than 1 year and in most countries this is OTC.
Capital Market - This is medium and long-term borrowing and includes equities and bonds
Cash Market - (spot market) This is for immediate settlement.
Foreign Exchange Market - This is for all global currencies
8) Can you describe the Money Market ?
They are all priced on the basis of the forward rate.
This market is mainly OTC and can be divided into two main categories:
Unsecured Cash - (Interbank Lending/Deposit Market) The interest rate is fixed for that period and the principal amount plus the interest is repaid at the maturity of the deposit.
The periods are typically O/N (overnight), T/N (tomorrow/next) and everything up to 12 months.
Secured Cash - certificates of deposit, treasury bills, repurchase agreements
9) Can you give some examples of Money Market Instruments ?
Treasury Bills - (exchange and OTC)
Repurchase Agreement - (exchange and OTC)
Certificate of Deposit (CD) -
Interest Rate Forwards (FRA) -
Interest Rate Futures - (treasury bond futures)
Interest Rate Options - (options on interest rate futures)
10) Can you describe a Treasury Bill ?
These are zero coupon bonds issued by the US for terms of up to 12 months.
They are sold at a discount.
11) Can you describe a Repurchase Agreement ?
This is an agreement to sell and buy back at a fixed date at a fixed price.
The investments can be bonds or equities.
12) Can you describe a Certificate of Deposit ?
This is a savings certificate with a fixed interest rate and maturity date.
The amount cannot be accessed before the maturity date.
They are normally issued by commercial banks.
13) Can you describe the Futures Market ?
This is where the delivery of an instrument takes place at a future date.
14) Can you give a list of the different Asset Classes ?
Interest Rates - Government Bonds, Forward Rate Agreements, Interest Rate Futures / Swaps / Options
Credit - Corporate Bonds, Loans, Asset Swaps, Total Return Swaps, Credit Default Swaps
Equities - Stocks, Stock Indices, Convertible Bonds
Foreign Exchange - FX Forwards, FX Swap, Cross Currency Swap, FX Future
Commodities - Base Metals, Precious Metals
15) Can you give the names of any derivatives that are traded Over The Counter ?
These are bespoke contracts (70% are interest rate derivatives).
Interest Rate Forwards (FRA)
Interest Rate Swaps (same currency, remove interest rate risk)
FX Swaps (different currencies, remove exchange rate risk)
Cross Currency Swaps (different currencies, remove interest rate risk and exchange rate risk)
Credit Default Swaps (single name)
Total Return Swaps
Interest Rate Options (options on Interest Rate Futures)
16) Can you give the names of any derivatives that are traded on an Exchange ?
These are standardised contracts
Exchange Traded Funds
Single Stock Futures
Equity Index Futures
Equity Index Options
Interest Rate Futures (government bond futures and STIR futures)
Interest Rate Options (options on interest rate futures)
17) What is a Tick ?
A tick is a price increment in which prices are quoted.
The exact meaning and size varies depending on the instrument.
Most European and Asian bonds are quoted in decimals so the tick size is 1/100 or 1%.
18) What is the Settlement Date ?
Also known as the contractual settlement date.
It may be different to the actual settlement date (if there is a problem or delay)
This is the date the agreed contract starts.
19) What does it mean to be 'Dovish' or 'Hawkish' ?
Dovish - an inflation dove is somone who favours lower interest rates.
Hawkish - an inflation hawk is someone who favours higher interest rates.
20) What is a Basis Point ?
A basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
21) What is a Payoff Diagram ?
A payoff diagram shows the profit and loss situation for a particular strategy at a number of different share prices.
22) What is a Relative Value trade ?
This is when you simultaneously buy and sell related instruments hoping to benefit from their change in relative value.
23) What is a Trade Blotter ?
A trade blotter is a record of trades made over a period of time.
24) What is the term EuroDollar ?
This term refers to US dollar deposits at foreign banks or foreign branches of American banks.
These are basically just regular dollars outside of the US banking system.
The US dollar is the global reserve currency which means this market is the largest (and probably the most important) in the world.
This market influences the price of every type of financial instrument globally.
The EuroDollar market can be thought of as a deposit and loan market for offshore dollars.
This market is practically cashless and is made up of balance sheets.
The reason for the name is because at the beginning most of the dollar denominated deposits were held in European banks.
25) What is the term EuroSterling ?
Also known as europound.
This term refers to UK pound deposits at foreign banks or foreign branches of UK banks.
26) What is the term EuroCurrency ?
This refers to any currency deposited in a bank that is not in the home country where the currency was issued.
For example Japanese yen deposited at a bank in China would be called eurocurrency.
27) Can you give some examples of popular hedge fund strategies ?
*) Long Only
*) Relative Value
*) Event Driven
28) What is a Reset Date ?
The point in time when the initial fixed interest rate switches to a floating interest rate.
29) What is the Martingale System ?
This is one of the oldest and most well-known betting systems in existence.
The strategy is to double your bet after every loss so that the first win recovers all previous loses, plus win a profit equal to the original stake.
30) What is the Martingale Measure ?
Also known as risk neutral probabilities.
This is the fundamental concept in the no-arbitrage pricing of instruments which links prices to expectations.
31) Can you describe what a PnL Explain report is ?
Also known as a pnl attribution report.
This is a report commonly used by traders and product control that explains the daily fluctuation in the value of a portfolio and the reasons for those changes.
The report includes the following:
*) PnL due to change in time
*) PnL due to change in interest rates
*) PnL due to changes in volatility (?)
*) PnL due to changes in price of underlying (equity, commodities)
There are two methods for generating this report
*) Sensitivites method - calculating option sensitivies
*) Re-evaluation method - calculates based on yesterdays price compared to todays price.
32) What is a Spot Price ?
A spot price is the value of an asset at that particular moment in time.
33) What is the difference between Realised Profit and Unrealised Profit ?
Realised - this is the profit from completed trades that have actually been executed.
Unrealised - this is the profit that would have been made if the trades were executed.
34) When you trade on an exchange what is the difference between Maintenance Margin and Variation Margin ?
Maintenance Margin - the minimum level required to be held at the clearing house (set by the exchange).
Variation Margin - the additional amount required to cover any loses.
35) What is Alpha ?
This is a measure of the active return on an investment compared to a suitable market index.
An alpha of -1% means the investment underperformed the market.
36) What is the Hedge Ratio ?
When trying to hedge a position you need to know what the hedge ratio is.
hedge ratio = volatility of position / volatility of hedging instrument
When hedging bonds there are two different ways you can calculate the hedge ratio
Conversion Factor - (price factor) can be used for deliverable bonds
Modified Duration - (basis point value)
37) What are Derivatives and why are they used ?
Derivatives are instruments that are derived from one or more underlying asset classes.
They are used to reduce risk, transfer risk or to create leverage.
38) What is Delta ?
This is the 'change in the price of the derivative' with respect to the 'change in the price of the underlying'.
For example if a stock option has a delta of 0.6 this means that if the price of the underlying equity increases by $1, the price of the option will increase by $0.6 (all else being equal).
Call options have a positive delta.
Put options have a negative delta.
39) What is Gamma ?
This is a second order derivative with respect to the 'price of the underlying'.
This tells us how fast the delta is changing with respect to a 'change in the price of the underlying'.
40) What is Vega ?
This is how the price of a derivative changes with volatility.
41) What is Rho ?
This is how the price of a derivative changes with interest rates.
42) What is Theta ?
This is how the price of a derivative changes with time.
43) Can you describe a Total Return Swap ?
This is a type of credit derivative.
An agreement between two parties to swap the total return from an underlying asset for a regular fixed or floating cash flow.
This involves owning (or buying) an underlying asset and then selling the total returns.
This instrument lets you get exposure to and benefit from an underlying asset without actually owning it or having it on your balance sheet.
Equity - single stock, index (dividends, capital gains)
Bond - (coupons)
44) Can you describe a Partial Return Swap ?
This is a type of credit derivative.
Exactly the same as a total return swap except it only gives exposure to a percentage of the total return.
45) Can you describe a Reverse Total Return Swap ?
This is a type of credit derivative.
This involves selling the underlying asset and buying the total returns.
Typically for equities.
46) What is a Forward ?
An agreement to buy (or sell) an asset at a fixed price on a particular date in the future.
These are traded over the counter (not on an exchange).
47) Why would someone buy a Forward ?
If you have a commitment to buy something in the future you can buy a forward agreement that will lock in the price that you will have to pay.
48) What information do you need to price a Forward ?
Delivery Price - The price agreed to pay for the asset
Maturity Date - The date of delivery
49) Can you draw the payoff diagram for buying a Forward ?
payoff = (S - E)
50) How do you price a Forward ?
price = S - e-rtE
51) What is the difference between a Forward and a Future ?
A future is a standardised Forward contract that is traded on an exchange.
Forwards do not have to conform to the standards of a particular exchange.
A forward will always be cheaper than an equivalent future with identical characteristics because it introduces credit risk.
This credit risk is due to there being no clearing house and therefore no guarantee.
52) Can you describe the different types of Swaps ?
Interest Rate Swap - same currency, removes interest rate risk
FX Swap - different currencies, removes exchange rate risk (spot transaction and a forward transaction)
Cross Currency Interest Rate Swap - different currencies, removes interest rate risk and removes exchange rate risk.
53) What is an Interest Rate Swap ?
This is a type of interest rate derivative.
This lets you remove interest rate risk.
Both legs are in the same currency.
This is an agreement to swap a stream of interest rate payments for a different stream of interest rate payments.
This is typically fixed against floating.
There are no single currency fixed against floating interest rate swaps as the risk can be calculated.
54) Why would you buy an Interest Rate Swap ?
Banks - to hedge the risks of their issue
Companies - to control the cost of their funding
Insurance - to hedge interest rate exposure
Hedge Funds - to execute difference types of leverage bets with respect the following:
*) market direction
*) the shape of the volatility surface
*) to build up relative value trades
*) for gamma trading
55) Can you give some examples of different types of Interest Rate Swaps ?
Fixed for Floating - (vanilla / most common)
Floating for Floating (Basis Swap) -
56) Can you describe the two different cashflows for an Interest Rate Swap ?
Both cash flows are in the same currency
57) How do you price an Interest Rate Swap ?
58) What in an Overnight Index Swap ?
This is an Interest Rate Swap where the floating side references an overnight index such as SONIA and has no intermediate cash flow exchanges only a cumulative exchange at the end.
59) What is a FX Swap ?
This lets you remove exchange rate risk.
The two cash flows are in different currencies
This is a type of foreign exchange derivative.
There are two legs, a spot transaction and a forward transaction which are entered at the same time for the same quantity.
60) Why would you buy a FX Swap ?
61) Can you give some examples of different types of FX Swaps ?
Spot to Forward -
Forward to Forward -
62) Can you describe the two different cash flows in a FX Swap ?
Lets imagine that we have an amount in Euros and we need to change it into US dollars in 3 months time.
Spot Transaction - The equivalent amount of dollars is bought (using Euros at the current exchange rate).
Forward Transaction - At the end of the contract the same amount of Euros is bought (using Dollars at the agreed forward rate).
63) What is a Cross Currency Interest Rate Swap ?
Also known as a currency swap or cross currency swap.
This is a type of interest rate derivative.
This lets you remove exchange rate risk
This lets you remove interest rate risk
The two cash flows are in different currencies.
The parties agree to swap a principal amount in one currency (plus interest) during a specific period for a corresponding amount (plus interest) in a different currency.
These are traded over the counter (not on an exchange)
64) Can you give some examples of different types of Cross Currency Interest Rate Swaps ?
Mark to Market -
Non Mark to Market -
65) Can you describe the two different cash flows for a Cross Currency Interest Rate Swap ?
The pricing element is known as the basis spread.
66) What is the Cost of Carry ?
This is the interest collected (or paid) every night.
67) What is an Option ?
An agreement that gives the investor the right (but not the obligation) to buy (or sell) an asset at a specific price on a particular date in the future.
68) Why would someone buy an Option ?
If you have a commitment to buy something in the future you can buy an option contract to provide some protection against the price that you will have to pay.
When this day comes you can compare the current price with the price stated in the option contract.
If the current price is higher than the option price then you can execute the option which allows you to buy at the lower price.
69) What is a Call Option ?
A Call Option gives the investor the right (but not the obligation) to buy an asset at a specific price on a particular date in the future.
70) What is a Put Option ?
A Put Option gives the investor the right (but not the obligation) to sell an asset at a specific price on a particular date in the future.
71) What do the following abbreviations means:
Long Call - buying a call option
Short Call - selling a call option
Long Put - buying a put option
Short Put - selling a put option
72) What information do you need to price an option ?
*) Price of the Underlying Asset
*) Volatility of the Underlying Asset
*) Risk Free Interest Rate
*) Strike Price (the agreed price the asset can be bought or sold at)
*) Maturity Date
Dividend information if the asset is an Equity
Coupon rate if the asset is a Bond
73) What is the difference between a European Option and an American Option ?
A European option can only be exercised on the maturity date where as an American option can be exercised at any time.
74) Under what circumstances would you exercise an American Call Option on an Equity that pays no dividend ?
Never. American options are rarely exercised early.
All options have a positive time value and are usually worth more not exercised.
Owners who want to close out of an option position would prefer to sell it and sacrifice "some" time value rather than exercise early and sacrifice "all" the time value.
75) What is the Drift ?
This is a measure of the average rate of growth of the underlying asset.
76) What is the Option Premium ?
This is the price of the option contract.
77) What aspects do you have to consider when buying and selling options ?
Premium - The amount charged for the right
Strike Price - The agreed price the asset can be bought or sold at
Maturity Date - The date when the option can be exercised
Historical Volatility - derived from past data, usually the previous x number of daily closes
Implied Volatility - considers past data and also takes a view on the future
78) What is Historical Volatility ?
This is the annualized standard deviation of past stock price movements.
It measures the daily price changes in the stock over the past year.
79) What is Implied Volatility ?
This is derived from an option's price and shows what the market "implies" about the underlying asset's volatility in the future.
Implied volatility shows the market's opinion of the asset's potential movement in the future.
It does not forecast direction.
80) Why is the Implied Volatility so important ?
The higher the Implied Volatility, the higher the option premium.
When the price of the underlying falls, the implied volatility increases ?
When the price of the underlying increases, the implied volatility decreases ?
Knowing where implied volatility levels are and where they are likely to go, can make a substantial difference to the outcome of a strategy.
Implied volatility offers an objective way to test forecasts and identify strategy entry and exit points.
81) How can you calculate Implied Volatility ?
Implied Volatilty can not be observed in the market and can only be determined by knowing all the other variables and using a model.
The Black Scholes Model is modified so market price becomes an input and volatility is the output.
The most traded options are the ones that are 'at-the-money' so it is these ones that are generally used in a model.
82) What is a Volatility Smile ?
These are implied volatility patterns that arise in pricing options.
Graphing the implied volatility against different strike prices for a given expiry produces a skewed smile instead of the expected constant volatility.
When there are higher prices for 'out-of-money' options this implies a deficiency in the Black Scholes Model which assumes constant volatility.
83) What is an 'Uncovered' Option ?
This is an option that is not backed by the an offsetting position in the underlying.
Also known as a naked option.
84) What is a 'Barrier' Option ?
Similar to a plain vanilla option but with the presence of one or two trigger prices.
If a trigger price is touched the option is either activated or erased.
A single barrier has one trigger price.
A double barrier has two trigger prices.
85) Can you describe the main types of Barrier Options ?
Up and Out - barrier level is higher than spot (option is erased)
Down and Out - barrier level is lower than spot (option is erased)
Up and In - barrier level is higher than spot (option is activated)
Down and In - barrier level is lower than spot (option is activated)
86) Why would someone buy a Barrier option ?
These are cheaper than vanilla options.
87) What is a 'Lookback' option ?
The payoff is the highest or lowest price that the spot trades at over the life of the option.
Lookback Call - right to buy at a strike price equal to the lowest price the spot traded at.
Lookback Put - right to sell at a strike price equal to the highest price the spot traded at.
88) What is an 'Asian' option ?
This type of option has its payoff determined by the average price of the underlying over a defined period.
89) What is a 'Quanto' option ?
The underlying is denominated in one currency but the instrument is settled in a different currency at some fixed interest rate.
Also known as a Fixed Exchange Rate Option or a Foreign Asset Option.
90) What is a 'Composite' option ?
The underlying is denominated in one currency but the instrument is settled in a different currency. The interest rate is not fixed but floating
Also known as a Floating Exchange Rate Option or a Foreign Asset Option.
91) What is a 'Rainbow' option ?
This type of option is exposed to two or more sources of uncertainty.
A normal option is exposed to one, normally the price of the underlying.
A good example might be to value natural resources deposits. Such assets are exposed to two uncertainties - price and quantity.
92) Can you draw the payoff diagram for buying a European call option ?
payoff = max(Current Price - Strike Price, 0)
93) Can you draw the payoff diagram for selling a European call option ?
payoff = -max(Current Price - Strike Price, 0)
94) Can you draw the payoff diagram for buying a European put option ?
payoff = max(Strike Price - Current Price, 0)
95) Can you draw the payoff diagram for selling a European put option ?
payoff = -max(Strike Price - Current Price, 0)
96) What is the Put-Call Parity ?
This is a relationship that must exist between the price of a European Call option and the price of a European Put option that has the same exercise price and maturity date.
It says that: if I buy a call option and an amount of cash equal to the present value of the exercise price then this gives me exactly the same payoff as selling a put option and buying the actual asset.
If this relationship did not exist then there would be an opportunity for risk-less profit (or arbitrage).
97) Can you explain the concept of moneyness ?
This describes whether an option is 'in', 'at' or 'out' of the money.
98) What is an 'in-the-money' option ?
An option is described as in-the-money when there would be a positive cash flow if exercised.
A Call option is in the money when Current Price > Strike Price
A Put option is in the money when Current Price < Strike Price
99) What is a 'deep-in-the-money' option ?
An option is described as deep-in-the-money when there is big difference between the strike price and the current price of the underlying asset.
These options trade at (or very close) to their intrinsic values.
As an option moves deeper into the money, the delta approaches 1 which means for every point change in the price of the underlying, there is an equal and simultaneous change in the price of the option in the same direction.
100) What is an 'at-the-money' option ?
An option is at-the-money when the strike price is very close to the current price of the underlying asset.
An option is at-the-money when Current Price = Strike Price meaning Intrinsic Value = 0
101) What is an 'out-of-the-money' option ?
An option is described as out-of-the-money when there would be a negative cash flow if exercised.
Intrinsic Value = 0
102) What is a 'deep-out-of-the-money' option ?
An option is deep-out-of-the-money when the current price of the underlying asset is less than the strike price.
103) What type of options are traded the most ?
The most actively traded options are the ones that trade 'at-the-money'.
Deep in the money and deep out of the money rarely trade.
104) What is the Intrinsic Value ?
This is defined as the difference between the exercise price and the current price.
This is basically the amount that the option is worth.
Defined as the maximum of zero and the value the option would have if it were exercised immediately.
For example, if a call option (100 shares) has an exercise price of £30 and the share price is currently trading at £40 than the call option has an intrinsic value of (40-30) £10 (per share). If the current price is less than the exercise price the call option has no intrinsic value.
105) What is the Intrinsic Value of a Call Option when the Current Price > Strike Price ?
Current Price - Strike Price
This option is "in the money"
106) What is the Intrinsic Value of a Call Option when the Current Price < Strike Price ?
This option is "out of the money"
107) What is the Intrinsic Value of a Put Option when the Current Price > Strike Price ?
This option is "out of the money"
108) What is the Intrinsic Value of a Put Option when the Current Price < Strike Price ?
Strike Price - Current Price
This option is "in the money"
109) What is the Time Value ?
This is the difference between the premium (price of the option) and the intrinsic value ?
110) What are the risk measurements (sensitivities or greeks) ?
Delta - This is the amount an option price is expected to move for a 1 dollar change in the underlying. Calls have a positive delta. Puts have a negative delta.
Gamma - This is how fast the delta is changing
Vega - How the price of the option changes with volatility
Rho - How the price of the option changes with interest rates
Theta - How the price of the option changes with time
Quoted in terms of 1 day.
111) What would the delta be for the following types of options at expiry ?
Call Option - In the Money: 1
Call Option - Out of the Money: 0 (zero)
Call Option - At the Money: 0.5
Put Option - In the Money: -1
Put Option - Out of the Money: 0 (zero)
Put Option - At the Money: -0.5
112) Can you describe some Option Strategies ?
(Covered Call) - buy asset, sell call option (neutral position)
(Married Put) - own asset, buy put option (bullish, hope price increases)
(Bull Call Spread) - buy call option, sell call option at a higher exercide price (bullish)
(Bear Put Spread) - buy put option, sell put option at a lower exercide price (bearish)
(Protective Collar) - buy 'out of the money' put option, sell 'out of the money' call option (locks in profit after a long position has made gains)
(Long Straddle) - buy call and put simultaneously with same strike (hope price will move in either direction)
(Long Strangle) - buy call and put simultaneously with put strike below call strike (hope price moves significantly in either direction)
(Butterfly Spread) - combination of a bull spread and a bear spead using 3 different strike prices
(Iron Condor) - combination of two different strangle positions
(Iron Butterfly) - combination of a long or short straddle with a buy or a sell of a strangle
113) How do you price a European Option on an Equity ?
There are a number of different approaches
Black Scholes - (PDE, analytical closed form solution)
Binomial Tree - (Numerical Method) slow (trinomial trees)
Finite Differences - (Numerical Method)
Monte Carlo - (Numerical Method) extremely slow
Risk Neutral Valuation - (Numerical Method)
114) How do you price an American Option on an Equity ?
Black Scholes -
Binomial Tree (Numerical Method)
Implicit Finite Differences - (Numerical Method)
Monte Carlo - (Numerical Method) - You must obtain the optimal exercise threshold function
Least Square Method -
115) How do you price a European Option on a Bond ?
There are three different approaches which you could use:
*) Ignore the Term Structure - Black Scholes because it has an assumption that the risk free interest rate is constant
*) Model the Term Structure - continuous models
*) Match the Term Structure - discrete models
116) Can you use the Black Scholes model to price an Option on a Bond ?
No. There are three reasons why this is not a suitable model.
*) The model assumes that the volatility of the underlying is constant. As a bond moves closer to maturity the price volatility decreases.
*) The probability distribution assumes lognormal which means the price can take on any positive value. The price of a bond can never exceed the sum of the coupons plus the principle. The black-scholes model can produce a price that exceeds this.
*) The model assumes that the risk free interest rate is constant. A change in the short term interest rate will affect the other interest rates along the yield curve.
117) Can you use Binomial Trees based on Prices to price an Option on a Bond ?
No. This model suffers from the same problems as the Black Scholes model.
118) Can you use Binomial Trees based on Yields to price an Option on a Bond ?
No. This model does not satisfy the put-call parity relationship and therefore allows arbitrage opportunities.
119) Can you describe the different types of Equity Derivatives ?
Exchange - Single Stock Options
Exchange - Single Stock Futures
Exchange - Equity Index Options
Exchange - Equity Index Futures
Exchange - Options on Equity Index Futures
OTC - Warrants
OTC - Contracts for Difference (type of equity swap)
OTC - Equity Return Swaps
OTC - Equity Index Return Swaps
120) What exchanges are Equity Derivatives traded on ?
CME Group - Chicago Mercantile Exchange
121) What is a Share ?
Also known as equity or stock.
An ordinary share is an instrument that a company can use to raise money.
If the company gets into financial trouble, the shareholders are the last people to get any money back.
122) What is a Preference Share ?
A preference share is the same as a normal share except in the event of liquidation they are paid out earlier.
Dividends for preference shares are set at a specific rate.
There are two categories:
Cumulative - if the company does not pay a dividend then the amount if owed to them
Non-Cumulative - if the company does not pay a dividend then the amount is lost.
123) What are the different types of Preference Shares ?
Participating - can benefit from a larger dividend
Convertible - can be converted to ordinary shares
Callable - company can buy back the shares at a later date
124) Why would someone buy a Share ?
To become part owner of the company and to share in the risks and rewards of the company's operations.
In the hope that the share price increases so they can make money (from capital gains)
In the hope that the dividend increases as the company becomes more profitable.
To give them the right to vote at the AGM.
125) What affects the price of an equity ?
Inflation and Deflation
126) What effect would an increase in interest rates have on the price on an equity ?
When interest rates go up the risk ssociated with equities goes up.
When interest rates go up credit card and mortgage interest rates go up. This means people have less disposable income which means they spend less so businesses will see a drop in revenue.
When interest rates go up businesses have to pay more to borrow money. This can slow down the growth of the company and result in a drop in earnings.
When interest rates go up the estimated future cash flows will drop which will result in a lower share price.
If enough companies experience a drop in share price then the equity indices will also drop.
127) What aspects do you have to consider when buying and selling Equities ?
Profitability of the company, price to earnings ratio, earnings growth, dividend history, return on equity, return on invested capital.
128) Who decides what the dividend is ?
The company decides but it must have the shareholders approval.
129) Does a company have to pay a dividend ?
130) If the company made a loss could they still pay a dividend ?
131) Can you give some examples of corporate actions ?
(Rights Issue) - Company issues more shares to existing shareholders (at a discount) and is used to raise money
(Stock Split) - Company offers a 2-for-1 to lower its share price and increase liquidity
(Buy Back) - Company buys a lot of its own shares to reduce the number in circulation and therefore hoping to increase the share price.
(Merger) - One company surrenders its stock to another company
(Acquisition) - One company buys a majority stake in another company
(Spin Off) - Part of the company is separated as an independent business
132) What does Ex-Dividend mean ?
When a dividend is going to be paid there is a point where the shareholder loses the entitlement to the dividend.
133) What normally happens to the share price when an equity does Ex-Dividend ?
The share price falls to offset the disadvantage of not getting the dividend.
134) What is the difference between an Index and a Benchmark ?
Index - is a statistical tool designed to measure performance over time.
Benchmark - is an index that serves as the measurement yardstick for a portfolio by comparing portfolio characteristics such as returns, risk, component weights and exposure to sectors, styles and other factors to the benchmark.
135) What is an Equity Index ?
This is a basket of individual shares that are put together as a single unit.
136) Can you describe the different methods used to construct equity indexes ?
Float Weighted - (cap weighted) components are weighted according to the total market value of their outstanding shares.
Price Weighted - (share weighted) affected by changes in price (not that common)
Equally Weighted - every stock has the same weight regardless of size
Market Cap Weighted - (value weighted) market capitalisation weighted includes all the shares (very uncommon)
137) Can you give some examples of different types of Equity Indexes ?
S&P 500 - float weighted
FTSE 100 - float weighted
Dow Jones Industrial Average - price weighted
Nikkei 225 - price weighted
S&P 500 Equal Weight - equally weighted
138) What is a Contract for Difference ?
This can be thought of as an equity swap traded on margin.
Allows speculation on share price movements without the need for ownership
A contract to deliver the difference between the current value and the value when the contract was made
This allows speculation without having to own the asset
Traded in most countries except the US
Always traded on margin accounts and has significant counterparty risk
139) What is a Warrant ?
Traded on exchanges but have liquidity risk.
Long Term instruments
Frequently attached to bonds or preferred stock, used to enhance the yield and make the bond or stock more attractive
Used by companies as a sweetener for an equity or bond issue
Very popular in Canada and Hong Kong.
140) What is a Quanto Equity ?
A foreign equity that is traded as a local equity without a currency translation.
141) Can you describe a Single Stock Option ?
The right but not the obligation to buy (or sell) a quantity of stock at a set price before an expiry date.
Traded on exchanges they have transparency and liquidity.
142) What is the difference between a Single Stock Option and a Warrant ?
Warrants are issued by the company itself.
Warrants usually have longer maturity periods, years rather than months.
Warrants cause dilution because the company is obliged to issue new stock.
143) Can you describe a Single Stock Future ?
A contract to deliver 100 shares on a specific date in the future.
The price is based on the price of the underlying plus the cost of carry minus any dividends.
Provides investors with good leverage.
144) What is an Equity Index Future ?
This is a forward contract where the underlying is an equity index.
S&P 500 Future - the value of the contract is $250 multiplied by the value of the S&P 500 index.
S&P 500 Emini Future - the value of the contract is $50 multiplied by the value of the S&P 500 index.
145) What is an Equity Return Swap ?
Also known as total return swap, cash settled equity swap.
An agreement between two parties to swap the total return from an equity (dividends and capital gain) for a regular fixed or floating cash flow.
146) What is an Equity Index Option ?
This is an option to buy or sell a quantity of an equity index for cash settlement.
S&P 500 Option (SPX) - the value of the contract is the value of the S&P 500 index.
S&P 500 Mini Option (XSP) - the value of the contract is 10% of the value of the S&P 500 index.
147) What effect would an increase in interest rates have on the price of an equity ?
When interest rates increase it becomes more expensive to borrow money and also causes an increase in prices which reduces the supply of money.
This makes is more expensive for companies to borrow and therefore slows down their growth.
If the company experiences a drop in earnings then the stock price will fall.
If enough companies experience a decline then the equity indices will also fall.
With a lower expectation for growth there will be less share price appreciation making equities less desirable and more risky.
148) What is a Bond ?
The term bond refers to a loan which typically has a fixed rate of interest (the coupon rate). The most common types of bonds are those issued by governments (treasuries and gilts).
149) Why would someone buy a bond ?
To invest their money into a particular company or government and to receive regular fixed interest payments.
The longer the term the better the interest rate
When the bond reaches the maturity date the principal amount is returned.
150) How would you describe the price of a bond ?
The price is the Net Present Value of all future cash flows.
151) What information do you need to price a bond ?
Principal - the amount that will be paid when the bond matures.
Coupon Rate - the rate of interest paid. (either annually or semi-annually)
Maturity Date - the date the principal will be paid back.
Risk Free Interest Rate - or discount rate.
152) What affects the price of a bond ?
Interest Rates - when interest rates increase, the price decreases
Inflation - when inflation increases, the price decreases
Credit Rating - when the rating increases, the price increases
153) What is a Government Bond ?
Also known as Sovereign Debt
US - called Treasuries
UK - called Gilts
Germany - called Bunds
154) Can you give the names of the different types of US government bonds ?
Bills - issued for terms of 1, 3, 6 and 12 months (Zero Coupon Bonds, sold at discount)
Notes - issued for terms of 2, 3, 5 and 10 years
Bonds - issued for terms of 30 years
155) Can you describe the different ways you can purchase US Government Bonds ?
Bid Auction (non-competitive) - do direct and accept any yield
Bid Auction (competitive) - using a broker and specifying a yield
Secondary Market - using a broker
156) Can you give the names of the different types of german government bonds ?
Schatz - less than 2 years
Bobl - 3 - 5 years
Bund - 10 - 30 years
157) What is a Domestic Bond ?
A bond denominated in the currency of the country in which it was issued.
A UK corporate bond trading in the UK, denominated in sterling.
158) What is a Foreign Bond ?
A bond trading in a different country and denominated in a different currency.
A UK corporate bond trading in the US, denominated in dollars.
159) What is a Eurobond ?
A bond trading in a different country and denominated in its local currency.
A UK corporate bond trading outside the UK, denominated in sterling.
160) What is a Global Bond ?
A bond trading in multiple countries and denominated in the corresponding local currencies.
A UK corporate bond trading in the US, deniminated in dollars and also trading in Japan, denominated in yen.
161) What is a Junk Bond ?
A junk bond is any bond that is not investment grade, which has a rating of BB or lower.
Also known as high yield
162) What is a Zero Rated Bond ?
Also called a zero coupon bond.
This is a bond that has no coupon and is therefore issued at a discount to its face value.
163) What is a Subordinated Bond ?
These have lower priority than other bonds in the event if liquidation.
They have a lower credit rating and higher risk.
164) What is a Convertible Bond ?
This is a type of bond that can be converted into equity at a later date, usually at a premium to the market value. They typically carry a low coupon rate and are usually less volatile that regular shares.
Can be converted into shares at some pre-announced ratio
Investors can obtain the upside of equity like returns while being protected with regular bond like coupons
165) Can you describe Duration ?
This is a measurement of how sensitive a bond is to changes in interest rates.
The first derivative of the price with respect to interest rates.
166) Can you describe Convexity ?
This is a measurement of how quickly the duration is changing.
The second order derivative of the price with respect to interest rates.
167) What is the DV01 ?
How much an asset moves when the interest rate moves by 1 basis point.
168) What is the Yield To Maturity ?
Also known as bond yield
The yield to maturity of a bond is the total return from all the cash flows when you hold the bond to maturity.
169) How do you calculate the Yield To Maturity of a bond ?
In Excel you can use a number of different worksheet functions including the iterative Goal Seek approach.
yield = (coupon rate / bond price) ?
170) What is the difference between Nominal Yield and Real Yield ?
Nominal Yield is the coupon rate or coupon yield.
Real Yield takes inflation into account.
171) What is the Nominal Spread for a Corporate Bond ?
Also known as the yield to maturity spread.
It is the difference (in basis points) between the yield to maturity of the Corporate Bond and the yield to maturity of a Government Bond with the same characteristics.
This indicates the credit risk associated with the Corporate Bond.
It provides a very simple way of comparing 2 bonds with the same maturity.
This only uses one point on the curve.
172) What is the Z-Spread for a Corporate Bond ?
Also known as the zero volatility spread.
It is the constant amount (in basis points) that needs to be added to all the different spot rates for the present value to equal the bond price.
Each cashflow is discounted at the appropriate spot rate plus the z-spread.
This uses the whole curve and is calculated using an iterative approach.
173) What is a Floating Rate Note ?
This is a bond that has a variable coupon that is paid quarterly.
They are linked to a money market reference rate, such as LIBOR plus a spread.
For example a coupon might be 3 months USD LIBOR +0.1%
174) Can you describe what a Spot Rate is ?
A spot rate is the yield to maturity on a zero coupon bond.
It is therefore equivalent to the discount rate that converts the par values to its present value.
175) What is the Zero Coupon Curve ?
Also known as the spot curve.
This is the plot of simply compounded interest rates up to one year and of annually compounded interest rates for longer than one year.
This is obtained by using on-the-run US Treasury securities, off-the-run US Treasury securities or a combination of both or US Treasury coupon strips.
The instruments you use should not have any credit risk, liquidity risk or any pricing anomalies.
176) Can you describe the term 'Yield Curve' ?
This is a very ambiguous term and is used loosly to describe different curves that are deduced from interest rate market quotes.
Unless explicitly stated this refers to the zero-coupon curve.
177) Why would someone buy a Bond Call Option ?
They are expecting a decline in interest rates and an increase in bond prices.
178) What is a Bond Return Swap ?
An agreement between two parties to swap a fixed rate based on LIBOR with the total return from a bond (coupons).
179) What is the Time Value of Money ?
One pound today is worth more than one pound tomorrow, assuming interest rates are positive.
180) What is Compounding Interest ?
This is interest calculated on the initial amount plus the previous accumulated interest.
Also known as interest on interest.
181) What is the current Libor rate ?
Overnight was 0.472%
182) Can you describe the different types of Interest Rate Derivatives ?
Exchange - Interest Rate Futures (Government Bonds, STIR)
Exchange - Interest Rate Options (options on Interest Rate Futures)
Exchange - Interest Rate Swaps
Exchange - Interest Rate Swap Futures (futures on Interest Rate Swaps)
OTC - Interest Rate Forwards (Forward Rate Agreements)
OTC - Interest Rate Options (caplet, caps, floorlet, floors, swaptions)
OTC - Interest Rate Swaps
OTC - Interest Rate Swap Futures (futures on Interest Rate Swaps)
183) What exchanges are Interest Rate Derivatives traded on ?
CME Group - Chicago Mercantile Exchange
ICE Futures Group (previously LIFFE) -
BM&F Bovespa - (Brazil Mercantile and Futures Exchange)
184) What is the Short Rate ?
This is the continuously compounded annualized instantaneous short term interest rate.
This is the interest rate earned in a small time period.
185) What is LIBOR ?
LIBOR is the name given to a group of interest rates used in the money markets
These are key reference rates for 10 different currencies including (USD, GBP, CHF, JPY, EUR).
They are fixed every day in London at 11:00am and the rates are set for all maturities less than 1 year.
18 banks submit rates. The highest 25% (4) are discarded. The lowest 25% (4) are discarded. The remaining 10 are averaged.
Maturities (7) - overnight, 1w, 1m, 2m, 3m, 6m, 12m
Libor rates are quoted to the nearest 1/16th = 0.0625
186) What is USD LIBOR ?
This is a key reference rate used for inter-bank transactions that are made in Dollars.
187) What is EURIBOR ?
This is the key reference rate used for inter-bank transactions that are made in Euros.
This is fixed every day in Brussels at 11:00am and the rates are set for all maturities less than 1 year.
23 banks submit rates. The highest 15% are discarded. The lowest 15% are discarded. The rest are averaged.
Maturities (8) - 1w, 2w, 1m, 2m, 3m, 6m, 9m, 12m
188) What do the following abbreviations mean ?
LIBOR - London InterBank Offered Rate
SONIA - Sterling OverNight Index Average (similar to LIBOR but is an end of day average of unsecured overnight borrowings)
EURIBOR - EURopean InterBank Offered Rate
EONIA - Euro OverNight Index Average
STIR - Short Term Interest Rate (less than 1 year)
OIS - Overnight Index Swap
189) What is an Interest Rate Forward ?
Also known as a forward rate agreement (FRA).
This is an agreement to borrow (or lend) a notional amount of cash for a period of up to 12 months, starting at any point in the next 12 months.
The fixed rate is the agreed Forward Rate or FRA rate.
The floating rate (or reference rate) is the fluctuating interest rate.
The 2 most common floating rates are LIBOR and Euribor.
They allow us to lock in a fixed interest rate for borrowing (or lending) cash.
There is no exchange of principal just the interest differential which is paid on the settlement date.
These are cash settled and discounted at the beginning.
This is an off the balance sheet product.
This instrument is different to all the other money market instruments for the following reason:
The buyer of the FRA is borrowing the notional amount at a fixed rate
The seller of the FRA is lending the notional amount at ?
Example is 0R3 (3 month forward rate for today)
Example is 3R6 (3 month forward rate starting in 3 months)
Example is 3R9 (6 month forward rate starting in 3 months)
190) Why would someone buy an Interest Rate Forward ?
191) How is the price of an Interest Rate Forward calculated ?
3R6 is priced at todays implied 3 month forward, 3 month interest rate.
192) What is an Interest Rate Future ?
This is an agreement to buy (or sell) a cash amount on a date in the future based on the rate ?
This type of instrument is often divided into two categories, those that are long-term and those that are short-term (less than one year).
These are settled daily using a margin mechanism.
Examples of long-term interest rate futures are government bond futures
Examples of short-term interest rate futures are EuroDollar futures
193) Why would someone buy an Interest Rate Future ?
It lets you lock in a forward borrowing (or lending) interest rate for a given amount for a period of 3 months.
These are used to hedge against the risk that interest rates will move in an adverse direction.
This is in contrast with spot borrowing (or lending) which would be fully funded and unsecured for a period of 3 months.
A sequence (or strip) of interest rate futures can be used to hedge a bond that match as close as possible to the expiry date.
194) How is the price of an Interest Rate Future calculated ?
195) What is the difference between an Interest Rate Forward and an Interest Rate Future ?
Both are agreements to borrow (or lend) a notional amount for a period of time with a fixed interest rate starting on the contract settlement date.
Buying an Interest Rate Future is equivalent to lending money.
Buying an Interest Rate Forward is equivalent to borrowing money.
196) Can you describe a Government Bond Future ?
Also known as long term interest rate futures.
These allow traders to gain exposure to the underlying asset as well as allowing them to hedge the risks associated with these assets.
These require actual physical delivery when settled.
US Treasury Bond 30 year - contract size is $100,000, coupon 6%
US Treasury Note 10 year
US Treasury Note 5 year
US Treasury Note 2 year
US Treasury Bill 90 day
Euro/German Bund - contract size EUR100,000
Euro/German BOBL - contract size EUR100,000
Euro/German Schatz - contract size EUR100,000
197) Can you describe a Short-Term Interest Rate Future ?
These are exchange-traded time deposit contracts where the instrument is a Short Term Interest Rate.
These are cash settled, traded on margin on an exchange.
These are forward contracts on the implied 3 month interest rate.
Most of these contracts have delivery dates: March, June, September, December
They can be listed on a 10 year cycle.
Serial months do exist for the nearest months although liquidity is low.
This contract derives its value from the interest rate at maturity.
Often used to price and hedge interest rate swaps.
The minimum price fluctuation reduces when close to expiry.
198) Can you give some examples of the different types of STIR Futures ?
EuroDollar 1 month - $3,000,000 (12 sequential months)
EuroDollar 3 month - $1,000,000 (launched in 1981)
EURIBOR 3 month - EUR 1,000,000 (launched in 1999)
Short Sterling 3 month - £500,000
EuroSwiss 3 month - CHF 1,000,000
EuroYen 3 month - Y 100,000,000
30 day Fed Funds - $5,000,000
199) How is the price of a STIR future calculated ?
The price is calculated as 100 minus the implied interest rate on the expiry date.
The price is determined by the appropriate 3 month LIBOR reference rate.
During the life of a contract the price will be closely related to the implied forward rate for the date of expiry.
STIR Future contracts move like bonds.
When rates go up their price goes down. When rates go down their price goes down.
These prices/interest rates are often called the money-market rates.
200) Can you describe a EuroDollar Future ?
Unless otherwise specified this has a 3 month maturity.
201) How is the price of a EuroDollar Future calculated ?
The prices are determined by the markets forecast of the 3 month USD LIBOR interest rate.
The prices are determined by subtracting the forecasted interest rate from 100.
For example, if on a particular day an investor buys a single three-month contract at 95.00 (implied settlement LIBOR of 5.00%):
if at the close of business on that day, the contract price has risen to 95.01 (implying a LIBOR decrease to 4.99%), US$25 will be paid into the investor's margin account; or
if at the close of business on that day, the contract price has fallen to 94.99 (implying a LIBOR increase to 5.01%), US$25 will be deducted from the investor's margin account.
On the settlement date, the settlement price is determined by the actual LIBOR fixing for that day rather than a market-determined contract price.
202) How is the price of a Euribor Future calculated ?
Minimum price movement is 0.005 (EUR 12.50)
Delivery months are March, June, September, December
28 delivery months are available
The nearest 6 months are consecutive serial calendar months.
203) How is the price of Short Sterling Future calculated ?
Delivery months are March (H), June (M), September (U), December (Z).
204) What does the term Basis mean ?
This is the gap between the cash price and the futures price.
205) What is the TED spread ?
This is the Treasury Bill Future and the EuroDollar Future spread.
The difference between the rates on 3-month future contracts with the same expiry date.
This is often used as an indicator of credit risk.
206) What is an Interest Rate Option ?
Also known as Options on Interest Rate Futures.
This is an interest rate derivative where the underlying asset is directly related to an interest rate.
They are traded on Exchanges and OTC.
All options on STIR Futures are American
Similar to an interest rate forward except it has an exercise rate instead of an exercise price.
Options on Interest Rate Futures (STIR Futures)
Options on Certificates of Deposit
US Treasury Bond 30 year -
US Treasury Bond 5 year -
EuroDollar options - (american)
Euribor options - (american)
207) What is the difference between an Interest Rate Option and a Bond Option ?
Interest Rate Option - the right to borrow a pre-determined notional amount at a fixed rate starting a few days after the option expiry.
Bond Option - the right to buy a bond at a particular strike price when the option expires.
208) Can you draw the payoff for buying an Interest Rate Option ?
Similar to other options except the "days to maturity" is taken into account.
The payoff is not made until the end of the number of days attached to the rate.
For example if an interest rate option expires in 60 days and is based on 180-day LIBOR, the holder will not be paid for 180 days.
payoff = max (0, underlying asset - exercise price) * (days in rate / 360) * notional
209) Can you describe some different types of Interest Rate Options ?
Caplet - This is a European call option on an interest rate, typically LIBOR or EURIBOR
Cap - This is a portfolio of caplets having the same strike price.
Floorlet - This is a European put option on an interest rate.
Floor - This is a portfolio of floorlets having the same strike price.
Swaption - This is an interest rate derivative.
*) short term options on short-term interest rates
*) medium term options on short-term interest rates
*) short term options on bonds (bond options)
*) medium term options on bonds (bond warrants)
These are traded on both exchanges and OTC.
210) Can you describe the different types of Foreign Exchange Derivatives ?
FX Swap (different currencies, removes exchange rate risk)
211) What exchanges are Foreign Exchange Derivatives traded on ?
212) Can you describe the Foreign Exchange market ?
Largest market, round the clock trading 24 hours a day.
213) What is a Foreign Exchange Future ?
This is a forward contract that locks in an exchange rate.
214) What is a Foreign Exchange Swap ?
A swap that exchanges the principal and interest in one currency for the principal and interest in another currency.
215) What is a Foreign Exchange Option ?
216) Can you describe the different types of Single Name Credit Derivatives ?
Floating Rate Note -
Credit Linked Note -
Credit Default Swap (single name)
Credit Default Index Swap -
Credit Default Option -
Total Return Swap -
Credit Spread Option -
Asset Swap -
Asset Swap Spread -
Options on Credit Default Swaps (single name)
Options on Credit Default Index Swaps -
Credit Spread Forward -
Synthetic Collateralized Debt Obligation -
Credit Index Futures
217) What exchanges are Credit Derivatives traded on ?
218) What is a Credit Linked Note ?
They are structured instruments that pay a floating interest rate linked to a market rate such as LIBOR.
They also have an embedded credit default swap that protects you from certain credit events.
219) What is a Credit Default Swap ?
This is an agreement in which one party buys protection against losses occurring due to a credit event of a reference entity up to the maturity date of the swap.
220) What is a Credit Default Index Swap ?
This is a credit derivative that is standardised
There are two different types of corporate CDS indices:
CDX - contain north american companies and emerging market companies
iTraxx - contain companies from the rest of the world
221) What is a Total Return Swap ?
Transfers both credit and market risk.
222) What is an Asset Swap ?
This is the combination of a defaultable bond with a fixed-for-floating interest rate swap.
223) Can you describe the different types of Commodity Derivatives ?
224) What exchanges are Commodity Derivatives traded on ?
CME - Chicago Mercantile Exchange
CBOT - Chicago Board of Trade
NYMEX - New York Mercantile Exchange
BM&F - Brazil Mercantile and Futures Exchange
LCE - London Commodity Exchange
LME - London Metal Exchange
225) What are the different types of commodities ?
Energy - oil, gas, electricity, coal
Agricultural - grains, oilseeds, livestock
Metals - base, precious
226) How are commodities traded ?
Over The Counter
227) How do you price a commodity ?
228) What affects the price of a commodity ?
Supply and demand
Storage and Transportation
Natural Disasters and Conflict
229) What effect would an increase in interest rates have on the price of a commodity ?
230) What is a Commodity Forward ?
buy or sell a commodity (or commodity index) at an agreed price on a future date.
231) What is a Commodity Option ?
the right to (but not the obligation) to buy (or sell) a commodity (or commodity index) at an agreed price during a specified period.
232) What is a Commodity Swap ?
An agreement between two parties to exchange sequences of payments during a specified period, where at least one sequence of payments is tied to a commodity price or commodity index.
233) What is Monte Carlo Simulation ?
This is a technique that uses statistical sampling to approximate solutions to quantitiative problems.
It simulates the underlying process and then calculates an average result.
234) How can you improve the precision of a Monte Carlo Simulation ?
Increase the number of trials.
235) What type of model would you use to price the following instruments ?
Option on an Equity - Black Scholes
Option on a Bond -
Option on a Currency - Black Scholes
Option on a Commodity - Black
Option on an Interest Rate Instrument -
Option on a Future or Forward - Black
236) What important assumptions does the Black Scholes model make ?
*) the returns on the underlying asset are normally distributed
*) the price of the underlying asset follows a geometric brownian motion
*) the options are european and can only be accessed at maturity
*) the risk free interest rate is known and is constant
*) the volatility of the underlying is known and is constant.
*) no dividends are paid on the underlying asset
237) Can you write down the Black Scholes Equation ?
This equation has infinitely many solutions so we need to impose boundary conditions.
238) What is the Blacks model ?
This is a variation of the Black Scholes model where the spot price of the underlying asset is replaced by a discounted futures price.
This formula can be derived from the Margrabes formula
This can be described as a log-normal forward model.
Can be used to price STIR Options
239) What is the difference between the Black Scholes model and the Blacks model ?
Black Scholes - focuses on the diffusion of the Spot price on the assumption of Geometric Brownian Motion. This model is used when the spot price is easily available and the drift term is just the risk free rate (Equivalent Martingale Measure)
In equity and FX markets,
Black - This model is used when the Spot price is not easily available and determining the drift term is quite complicated.
240) Can you give some examples of One-Factor Short Term Interest Rate Models ?
Merton (1973) -
Vasicek (1977) -
Rendleman-Bartler (1980) -
Cox-Ingersoll-Ross (1985) -
Ho-Lee (1986) -
Hull-White (1990) -
Black-Derman-Toy (1990) -
Black-Karasinski (1991) -
Kalotay-Williams-Fabozzi (1993) -
241) Can you describe an Arbitrage Free Option Pricing model ?
Also called yield curve option pricing model.
These models can accommodate different volatility assumptions along the yield curve.
242) What is the Vasiceks model ?
This is a model that can be used to price options on bonds.
The short rate is assumed to satisfy a stochastic differential equation.
This is a special version of the Ornstein-Uhlenbeck process with constant volatility.
Interest rates can be negative
it is mean reverting
uses a normal distribution ?
243) What is the Cox-Ingersoll-Ross model ?
Volatility depends also on the square root of the short rate ensuring the interest rate is not negative.
Use chi-squared distribution
244) What is the Black-Derman-Toy model ?
Uses discretely compounded interest rates
245) What is the Garman-Kohlhagen model ?
This is a model for pricing European Options on Currencies.
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