Some derivatives doubts

  1. From Schweser mock, “the fixed rate on a particular swap is the same for any interested party regardless of the credit quality”. Does it really work like this? How come?

  2. An increase in the Dividend growth rate would increase the spot price of the equity index. Holding i constant, futures price should also increse. I agree and it seems normal that the spot price increases, hence the increase in the future all else equal (I assume dividend yield stays the same also…)

However, what about this assumption on a future on a stock? Current price should also increase, but what about the PV of the dividends to be received? Is there a direct answer or it depends on the impact?

  1. Options on futures/forwards: there is a benefit of early exercise on futures, so with mark-to-market American options on futures are more valuable than European. I know this is normally the case, but could anyone explain a bit more on this specific case?

  2. From Schweser also, mark-to-market a FRA reduces credit risk to ZERO to all parties. Is that correct? I agree that you can alleviate credit risk by marking-to-market but I don’t think you can actually eliminate credit risk.



I can answer 1. and 3. 1. The concept of the fra, is that you can borrow at a rate fixed in advance. Fixed rate is the same regardless of credit quality, because the actual loan isnt made. Only the net difference between the values are paid. 3. Since futures are marked to market every day. At the end of each trading day, one party will have some positive amount in his account. If a person holds an american option on the future, he can exercise it anytime. So he will exercise it when the mark to market would get him a positive amount, and then he can reinvest that amount. Whereas, a european option can only be exercised on a specific date, so even if his position is profitable as per the mark to market, he cant do anything about it. The key thing to note, is that we are talking about the options and not the futures themselves.

Understood 3.

Regarding 1, I was actually speaking about an IRS, but in any case I think the credit quality of your counterparty should be taken into account, shouldn’t it? Even if the loan is not entered into, there is a guy owing you money (or the other way around and he/she should care about you)!

Thanks and let’s see if so can answer 2 and 4

Cheers up!