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Financial Derivatives > 1 > Flashcards

1 Flashcards

1
Q

Name 3 factors that have driven financial trends

A

Globalisation
Financial innovations
New technologies

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2
Q

How has globalisation affected financial markets

A

Cross-border mergers and acquisitions have made financial markets and firms more worldwide. Country affiliation become less important that sector affiliation

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3
Q

What is off sheet financing

A

An accounting practice where companies keep assets and liabilities from being reported on balance sheets

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4
Q

What is a security

A

A traceable financial asset

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5
Q

What is securitisation

A

Taking not easily or non tradable assets and pooling them together to sell tradable shares to investors

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6
Q

What new technologies have driven growth

A

Computers, e-banking, high frequency trading etc

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7
Q

What have these developments lead to

A

High growth but high instability

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8
Q

What has caused instability?

A

Highly leveraged firms ie high proportion of debt within capital structure
High concentration of risks
Large dependence on technology

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9
Q

What is credit risk

A

The risk loss as a result of the failure of counterparty or issuer to meet obligations

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10
Q

What is market risk

A

The risk loss as a result in change in exchange rates, interest rates , equity or commodity prices

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11
Q

What is liquidity risk

A

The risk loss as a result of markets being insufficiently liquid to realise an asset or secure funding at a normal price

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12
Q

What is operational risk

A

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events

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13
Q

What is business risk

A

The risk of loss resulting from under performance

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14
Q

What is a derivative

A

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

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15
Q

What are the four categories of derivatives

A

Futures, swaps, options, forwards

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16
Q

What are other examples of derivatives

A

Credit derivatives - used as investment vehicles by insurance companies or protection mechanisms by mutual funds
Equity options/ swaps

17
Q

What are the types of derivatives

A

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

18
Q

What are the advantages of financial derivatives

A

Low transaction costs
Leverage
Price quality
Rapid execution
Covers many risk factors

19
Q

What are exchange traded derivatives

A

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

20
Q

What are OTC derivatives?

A

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

21
Q

What is pure hedging?

A

A financial strategy aimed at reducing undesirable risks in a firm often by using off setting financial instruments and avoiding introducing new risks

22
Q

How are derivatives relevant to hedging

A

Derivatives help hedge a portfolio rapidly at a low cost

23
Q

What is closing down?

A

The most direct way to remove undesirable risks is by closing down the corresponding position/activity

24
Q

Why might it be necessary to hedge instead of closing down?

A

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

25
Q

British airways hedging example

A

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

26
Q

What are the advantages of derivatives for hedging

A

Cover many risk factors - volatilities, weather
Tayloring and debundling

27
Q

Why is hedging not perfect

A

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

Financial Derivatives (3 decks)

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