Derivatives and Alternative Investments Flashcards

What is the key difference between a futures contract and an options contract?

Answer: A futures contract obliges both parties to transact, whereas an option gives the holder the right but not the obligation

The fundamental difference is that a futures contract creates an obligation for both buyer and seller to complete the transaction at expiry, while an option gives the holder (buyer) the right, but not the obligation, to buy or sell. The option writer (seller) has an obligation if the holder exercises.

An investor buys a call option on shares with a strike price of GBP 5.00 and pays a premium of GBP 0.50. At what share price does the investor break even?

Answer: GBP 5.50

The break-even point for a call option buyer is the strike price plus the premium paid. Strike price (GBP 5.00) + Premium (GBP 0.50) = GBP 5.50. The share price must exceed GBP 5.50 for the investor to make a profit.

What is the primary purpose of using derivatives for hedging?

Answer: To reduce or offset the risk of adverse price movements in an existing position

Hedging uses derivatives to protect an existing position against adverse price movements. For example, a fund manager holding UK equities might buy put options or sell futures to protect against a market fall. The hedge reduces potential losses but may also limit potential gains.

Which of the following is classified as an alternative investment?

Answer: A hedge fund using a long/short equity strategy

Hedge funds are classified as alternative investments, along with private equity, property, commodities, and infrastructure. They differ from traditional investments (equities, bonds, cash) by often using complex strategies such as long/short positions, leverage, and derivatives.

What does 'gearing' or 'leverage' mean in the context of derivatives?

Answer: The ability to gain large exposure to an asset for a relatively small initial outlay

Gearing (leverage) in derivatives means that an investor can gain a large exposure to the price movements of an underlying asset by committing only a fraction of its full value (e.g., a margin deposit or option premium). This amplifies both potential gains and losses.

What is a 'contract for difference' (CFD)?

Answer: An agreement to exchange the difference in value of an asset between the opening and closing of the contract

A CFD is a derivative contract where two parties agree to exchange the difference in the value of an underlying asset between the opening and closing of the contract. The investor does not own the underlying asset but profits or loses based on price movements. CFDs are leveraged products and carry significant risk.