Financial markets can be categorized into two types.
1.Money markets
2.Capital markets
Money markets are the markets through which governments or corporates raise money to meet their short term money requirements (like meeting their working capital requirements). The government, through money markets can raise money for very short periods like 15 days also.
Capital markets are the markets through which corporate bodies raise money for their long term needs
Capital markets can again be categorise as
1.primary markets
2.Secondary markets
Q : What is derivative - Sandeep Kanao
Wikipedia's definition :
A derivative is a
financial instrument whose value is based on one or more underlying assets. In practice, it is a
contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties.
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Q : What are different types of derivatives
The most common types of derivatives are: forwards, futures, options, and swaps. The most common underlying assets include: commodities, stocks, bonds, interest rates and currencies.
Q : What is discount factor
The present value P of an amount to be paid N years in the future (F) at a discount rate of i per annum is P = F(1 + i)-n. The factor (1 + i)-n is the Discount Factor for the present value of $1 received at stated future date.
Example :
Find the present value for $1,000,000 paid 5 years in the future at a discount rate of 7½% per annum. It will be @$696,559
Q : What is market data
Wikipedia's definition :
Market data is
quote and
trade-related data associated with
equity,
fixed-income,
financial derivatives,
currency, and other investment
instruments. Market data is numerical price data, reported from trading venues, such as
stock exchanges. The price data is attached to a
ticker symbol and additional data about the trade.
Q : What is option
An option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price.
An option which conveys the right to buy something is called a call option; an option which conveys the right to sell is called a put option. The reference price at which the underlying may be traded is called the strike price or exercise price.
Q : What is future option
Future is a trade whose settlement is going to take place in the future. These contracts are traded on the stock exchanges and it can change many hands before final settlement is made. The advantage of a future is that it eliminates counterparty risk.
Q: What is forward option
In forwardoption a buyer and a seller enter into a contract at a specified quantity of an asset at a specified price on a specified date.
Q : What is basis
The difference between the spot price and the future price
Q : How is the trading done on the exchange?
Buying of futures is margin based. You pay an up front margin and take a position in the stock of your choice. Your daily losses/ gains relative to the future price will be monitored and you will have to pay a mark to market margin. On the final day settlement is made in cash and is the difference between the futures price and the spot price prevailing at that time.
For example, if the future price is Rs 300 and the spot price is Rs 330, then you will make a cash profit of Rs 30. In case the spot price is Rs 290, you make acash loss of Rs 10. Thus futures market is a cash market.
Q: How does the mark to market mechanism work?
Mark to market is a mechanism devised by the stock exchange to minimize risk.
In case you start making losses in your position, exchange collects money to the extent of the losses up front. For example, if you buy futures at Rs 300 and its price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This is over and above the margin money that you pay to take a position in the future.
Q : But I hear a lot of jargons about options? What are all these jargons? - Sandeep Kanao
There are some basic terminologies used in options. These are universal terminologies and mean the same everywhere.
a. Option holder : The buyer of the option who gets the right
b. Option writer : The seller of the option who carries the obligation
c. Premium: The consideration paid by the buyer for the right
d. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price.
e. Call option: The option that gives the holder a right to buy
f. Put option : The option that gives the holder a right to sell
g. Tenure: The period for which the option is issued
h. Expiration date: The date on which the option is to be settled
i. American option: These are options that can be exercised at any point till the expiration date
j. European option: These are options that can be exercised only on the expiration date
k. Covered option: An option that an option writer sells when he has theunderlying shares with him.
l. Naked option: An option that an option writer sells when he does not have the underlying shares with him
m. In the money: An option is in the money if the option holder is making a profit if the option was exercised immediately
n. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately
o. At the money: An option is in the money if the option holder evens out if the option was exercised immediately
Q : How is the premium of an option calculated?
In practice, it is the market that decides the premium at which an option is traded.
There are mathematical models, which are used to calculate the premium of an option.
There are more advanced probabilistic models like the Black Scholes model and the Binomial Pricing model that calculates the options. One need not go deepinto those and it would suffice to say that option calculators are readily available.
Q : I keep reading about option Greeks? What are they? They actually sound like Greek and Latin to me.
There are something called as option Greeks but they are nothing to be scared of. The option Greeks help in tracking the volatility of option prices.
The option Greeks are
a. Delta: Delta measures the change in option price (the premium) to the change in underlying. A delta of 0.5 means if the underlying changes by 100 % the option price changes by 50 %.
b. Theta: It measures the change in option price to change in time
c. Rho: It is the change in option price to change in interest rate
d. Vega: It is the change in option price to change in variance of the underlying stock
e. Gamma: It is the change in delta to the change in the underlying. It is a double derivative (the mathematical one) of the option price with respect to underlying. It gives the rate of change of delta.
These are just technical tools used by the market players to analyze options andthe movement of the option prices.
Q : What is portfolio
Q : What is scenario
Q : What is curve
Q : What is surface
Q : What is shock
Q : What is stress
Q : What is hedging
Q : What is swap
Q : What is smile
Q : What is model
Q : What is VaR
Q : How do you price
Q : What is greek
As above
Q : What is delta
As above
Q : What is gamma
As above
Q : What is vega
As above
Q : How to calculate spot value
Q : What is slide
Q : What is deal
Q : How can I arbitrage and make money in derivatives?
Arbitrage is making money on price differentials in different markets. For example, future is nothing but the future value of the spot price. This future value is obtained by factoring the interest rate.
But if there are differences in the money market and the interest rates change then the future price should correct itself to factor the change in interest. But if there is no factoring of this change then it presents an opportunity to makemoney- an arbitrage opportunity.
Q : What are the other strategies using derivatives?
The other strategies are also various permutations of multiple puts, calls and futures. They are also called by exotic names , but if one were to observe them closely, they are relatively simple instruments.
Some of these instruments are:
Butter fly spread: It is the strategy of simultaneous buying of put and call
Calendar Spread - An option strategy in which a short-term option is sold and a longer-term option is bought both having the same striking price. Either puts or calls may be used.
Double option – An option that gives the buyer the right to buy and/or sell a futures contract, at a premium, at the strike price
Straddle – The simultaneous purchase and sale of option of the samespecification to different periods.
Tandem Options – A sequence of options of the same type, with variable strike price and period.
Bermuda Option – Like the location of the Bermudas, this option is located somewhere between a European style option which can be exercised only at maturity and an American style option which can be exercised any time theoption holder chooses. This option can be exercisable only on predetermined
dates
Q : What is Backwardation
The price differential between spot and back months when the nearby dates are at a premium. It is the opposite of ‘contango.’
Q: What is Butterfly spread
The placing of two inter-delivery spreads in opposite directions with the centre delivery month common to both. The perfect butterfly spread would require no net premium paid.
Q: What is Calendar Spread
An option strategy in which a short-term option is sold and a longer-term option is bought both having the same striking price. Either puts or calls may be used.
Q : What is Call option
An option that gives the buyer right to buy a futures contract at a premium, at the strike price.
Q: What is Contango
The price differential between spot and back months when the marking dates are at a discount. It is the opposite of ‘backwardation.’
Q: What is In-the money option
An option with intrinsic value. A call option is in-themoneyif its strike price is below the current price of the underlying futures contract and a put option is in-the-money if it is above the underlying.
Q. : What is Kerb trading
Trading by telephone or by other means that takes place after the official market has closed. Originally it took place in the street on the kerb outside the market.
Q. : What is Margin call
A demand from a clearing house to a clearing member or from a broker to a customer to bring deposits up to a required minimum level to guarantee performance at ruling prices.
Q. What is Mark to market
A process of valuing an open position on a futures market against the ruling price of the contract at that time, in order to determine the
Q : What is Out-of-the money option
An option with no intrinsic value. A call option is out-of-the money if its strike price is above the underlying and a put option is so if its below the underlying.
Q. What is option premium
Q. What is Spread - Sandeep Kanao
The difference between the bid and asked prices in any market.
