1 Flashcards
Name 3 factors that have driven financial trends
Globalisation
Financial innovations
New technologies
How has globalisation affected financial markets
Cross-border mergers and acquisitions have made financial markets and firms more worldwide. Country affiliation become less important that sector affiliation
What is off sheet financing
An accounting practice where companies keep assets and liabilities from being reported on balance sheets
What is a security
A traceable financial asset
What is securitisation
Taking not easily or non tradable assets and pooling them together to sell tradable shares to investors
What new technologies have driven growth
Computers, e-banking, high frequency trading etc
What have these developments lead to
High growth but high instability
What has caused instability?
Highly leveraged firms ie high proportion of debt within capital structure
High concentration of risks
Large dependence on technology
What is credit risk
The risk loss as a result of the failure of counterparty or issuer to meet obligations
What is market risk
The risk loss as a result in change in exchange rates, interest rates , equity or commodity prices
What is liquidity risk
The risk loss as a result of markets being insufficiently liquid to realise an asset or secure funding at a normal price
What is operational risk
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events
What is business risk
The risk of loss resulting from under performance
What is a derivative
A derivative is a financial instrument whose price is derived from price of an underlying asset or index
When price of asset changes payoff of derivative changes
What are the four categories of derivatives
Futures, swaps, options, forwards
What are other examples of derivatives
Credit derivatives - used as investment vehicles by insurance companies or protection mechanisms by mutual funds
Equity options/ swaps
What are the types of derivatives
Type 1 - Have fixed obligation
Forwards, futures, swaps
Type 2 - Only writer has obligation, holder has rights but not obligations and pays premium to writer
Options
What are the advantages of financial derivatives
Low transaction costs
Leverage
Price quality
Rapid execution
Covers many risk factors
What are exchange traded derivatives
Traded on an organised exchange
Terms and conditions standardised
Prices readily available
Clearing house acts as guarantor that parties fulfil obligations
Minimal counter party risk due to margin provisions
What are OTC derivatives?
Private contracts between 2 parties without clearing house involvement
Potential counterparty risk
When banks enter into OTC derivatives contracts they assess credit worthiness of counterparty
Subject to regulation
What is pure hedging?
A financial strategy aimed at reducing undesirable risks in a firm often by using off setting financial instruments and avoiding introducing new risks
How are derivatives relevant to hedging
Derivatives help hedge a portfolio rapidly at a low cost
What is closing down?
The most direct way to remove undesirable risks is by closing down the corresponding position/activity
Why might it be necessary to hedge instead of closing down?
Closing down not always possible/practical
Position may have to be kept for commercial/legal reasons
Position may be large compared to market liquidity
Transaction cost of closing down may be too large
May contain other desirable risks
British airways hedging example
British airways needs fuel to operate planes
Oil prices can very drastically
If oil prices increases lead to less profit
Cannot remove this risk easily
They could look at derivatives based on oil prices to minimise risks
This is hedging
What are the advantages of derivatives for hedging
Cover many risk factors - volatilities, weather
Tayloring and debundling
Why is hedging not perfect
The underlying of hedging instrument is not exact match of the asset held
Maturity of hedging instrument is not an exact match of desired maturity
