Derivatives – Options and Futures Flashcards

What is 'hedging' with derivatives and why do investors use it?

Answer: Using derivatives to reduce or offset the risk of adverse price movements in existing portfolio positions, protecting against losses while retaining upside potential

Hedging involves taking an offsetting derivative position to protect against adverse price movements. For example, buying put options on an equity portfolio protects against a market fall. It is analogous to insurance — paying a premium (cost) to limit potential losses.

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

Answer: A derivative allowing traders to speculate on price movements of an underlying asset without owning it, settling the difference in price between opening and closing the contract

A CFD is an OTC derivative where the parties agree to exchange the difference in the value of an underlying asset between the contract's opening and closing. CFDs allow leveraged exposure to equities, indices, commodities, and currencies without physical ownership, but carry significant risks.

What is 'margin' in futures trading?

Answer: A deposit of good faith (initial margin) placed with the exchange by both buyer and seller, and daily variation margin calls to cover any losses on the position

Futures trading requires both parties to post initial margin as security. Daily mark-to-market means if the position moves against a party, they receive a variation margin call requiring them to post additional funds. Failure to meet a margin call results in the position being closed.

What is an 'interest rate swap' and what is it used for?

Answer: An agreement between two parties to exchange interest rate cash flows — typically one party pays a fixed rate and receives a floating rate (or vice versa) — used to manage interest rate risk

In an interest rate swap, one party pays a fixed interest rate and receives a floating rate (e.g., SONIA), or vice versa, on a notional principal amount. Corporations use them to convert fixed-rate debt to floating (or vice versa), managing interest rate exposure cost-effectively.

What does it mean for a call option to be 'in the money'?

Answer: The current market price of the underlying asset is above the option's strike price, so the option has intrinsic value

A call option is in the money (ITM) when the underlying asset's market price is above the strike price — meaning the holder could profit by exercising (buying at strike and selling at market price). The intrinsic value is market price minus strike price.

What is 'theta' in options pricing?

Answer: The rate at which an option's time value decays as it approaches expiry — also known as time decay

Theta measures the time decay of an option's premium — as the option approaches its expiry date, all else being equal, its time value diminishes. Theta is negative for option buyers (their option loses value with time) and positive for option writers.