Derivatives and Alternative Investments
Derivative building blocks
Forwards, futures, options and swaps. Know that a forward is a private, customised obligation to trade at a set price on a future date, while a futures contract is standardised, exchange-traded and daily-marked-to-market through a clearing house. Options confer a right, not an obligation: calls give the right to buy, puts the right to sell; buyers pay a premium and have limited loss, writers receive premium and carry larger obligations.
Payoffs and uses
Be able to sketch intrinsic value: a call payoff at expiry = max(S − K, 0), a put = max(K − S, 0). Understand hedging, speculation and arbitrage motives. Know put-call parity conceptually: a protective put and a covered call replicate equivalent risk profiles. Swaps exchange cash flows - interest rate swaps fixed for floating, currency swaps principal and interest.
Alternatives
Hedge funds (varied strategies, fee structures with management and performance fees, lock-ups), private equity and venture capital (illiquid, long horizon), real estate, commodities and infrastructure. Know the diversification argument and the counterarguments: illiquidity, valuation smoothing, leverage and high fees.
Traps
Questions confuse the buyer and writer of an option, or claim futures have no counterparty risk (the clearing house mitigates but does not eliminate it). Watch for the assertion that forwards are marked to market daily - they are not.
Worked example
You buy a call with strike 50 for a premium of 3. At expiry with the stock at 60, payoff = 10, profit = 7. Below 50 the option expires worthless and the maximum loss is the 3 premium. Break-even = 53.
Rule of thumb
Options: buyer pays premium, risk capped; writer receives premium, risk open. Futures: both sides obligated.