Reasons to use derivatives - answer-1. To manage/reduce risk
2. To speculate - like placing a bet on what will happen in the future
3. To reduce transaction costs
4. To minimize taxes/avoid regulatory issues
Market order - answer-a request to buy or sell a stock at the current market price - ...
SOA Exam IFM
Reasons to use derivatives - answer-1. To manage/reduce risk
2. To speculate - like placing a bet on what will happen in the future
3. To reduce transaction costs
4. To minimize taxes/avoid regulatory issues
Market order - answer-a request to buy or sell a stock at the current market price - advantage: can
immediately own or sell the stock
disadvantage: the price could move more favorably in the future
Limit order - answer-An order to a broker to buy a specific stock only if its price is below a certain level,
or to sell a specific stock only if its price is above a certain level
-Advantage: can trade at a better price
-Disadvantage: could never be executed if price does not reach cutoff point
Stop-loss order - answer-an order to sell a particular stock whenever the price of the asset falls to (or
below) a certain price.
-Advantage: you are able to minimize losses before they get worse
-Disadvantages: you could sell lower than specified cutoff point if there is a big jump in price, could
never be executed
Short-selling - answer-1. Borrow shares of stock now
2. Immediately sell the borrowed stock
3. Buy the shares back at a future time
Haircut - answer-Additional collateral placed with lender by short-seller to compensate for risk that the
short-seller is unable to afford to buy the stock back (it belongs to the short-seller)
,Short rebate and repo rate - answer-The interest earned on the collateral from short-selling in the stock
market and bond market, respectively. These rates are typically lower than market interest rates and are
based on supply and demand.
Lease rate - answer-The payment required by the lender during a short-sale to cover missed dividend
payments.
Four ways of buying a stock - answer-1. Outright purchase: pay for the stock at time 0 and receive it at
time 0
2. Forward contract: pay for the stock at time T and receive it at time T
3. Prepaid forward contract: pay for the stock at time 0 and receive it at time T
4. Fully leveraged purchase: receive the stock at time 0 and pay for it at time T (borrow the money to
buy the stock now)
Five differences between forwards and futures - answer-1. Customization - futures are standardized,
forwards can be customized
2. Marked-to-market - gains and losses are settled daily in futures
3. Liquidity - forward agreements are difficult to enter/exit
4. Credit risk - reduced in futures because gains/losses are determined frequently
5. Pricing limits - forwards do not have price limits, but futures do (trading is halted if price drops below
X% during a trading day)
Bermudan-style option - answer-An option that can only be exercised at specific times during its term.
Floor - answer-The combination of a long asset and a long put or a long call and a long bond
(asset+put=call+bond)
Cap - answer-The combination of a short asset and a long call or a long put and a short bond (-
asset+call=put-bond)
Covered call - answer-When the writer of a call also owns the stock he is obligated to sell;
Used to increase income in a time when you do not expect the stock price to increase;
, Can be written out of the money to add insurance that the stock won't get called away;
Trading away chance of stock appreciating in future for income now
Covered put - answer-When the writer of a put also sells the stock he is obligated to buy. Beneficial if
the writer believes the price of the stock will decrease, so they can minimize their losses.
Bull spread - answer-An option spread created by buying a call and selling a higher-strike call, or buying
a put and selling a higher-strike put. Used when an investor believes the price of an asset will increase
between two strike prices.
Bear spread - answer-An option spread created by selling a call and buying a higher-strike call or selling a
put and buying a higher-strike put. Used when an investor believes the price of the asset will decrease
between two strike prices.
Box spread - answer-A four option strategy consisting of buying a bull spread and buying a bear spread,
where one spread uses calls and the other uses otherwise identical puts. Used to lend/borrow money -
equivalent to a zero-coupon bond.
Ratio spread - answer-An option strategy created by buying m options at one strike price and then
selling n options with a different strike price, where m is not equal to n.
Collar - answer-An option strategy created by purchasing a put at a lower strike price and selling a call at
a higher strike price. Used when investor wishes to benefit from the stock price decreasing.
Collared stock - answer-An option strategy created as a combination of a purchased collar with a long
stock.
Straddle - answer-An option strategy created by purchasing both a call and a put with the same strike
and time to expiration. Used when investor believes the price of the underlying asset will experience
large moves in either direction.
Strangle - answer-An option strategy created by purchasing a put and a higher-strike call, each with the
same time to expiration. Used when investor believes the price of the underlying will experience large
moves, but desires a low initial cost.
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