3. Managing Financial Risk Flashcards
What is a forward contract?
A binding agreement to exchange a set amount of goods at a set future date (at a price agreed today)
Tailor made and binding
What is a Derivative?
A financial security whose value is derived from the value and characteristics of an underlying security
What is a future?
A standardised contract to buy or sell a specific amount of a commodity, currency or financial instrument at a particular price on a stipulated future date
What is an option?
An option is similar to a future or a forward, except that the holder of the option can choose whether or not to go through with the transaction
What is a call option?
The investor is entitled to BUY at the exercise price
What is a put option?
The investor is entitled to SELL at the exercise price
What are Forward Rate Agreements? (FRA)
FRAs allow borrowers or lenders to fix their future rate of interest
A borrower will buy a FRA and this will be separate from the underlying loan
What are the limitations of FRAs?
They’re usually only available on loans of at least £500,000
Difficult to obtain for periods longer than a year
They remove any potential upside
What are the advantages of FRAs?
They protect the borrower/investor from adverse market interest rate movements
They can be tailored to the amount and duration required, whereas some other hedges (like futures) are standardised
When would a Call option be ‘in the money’?
If exercise price is less than the underlying shareprice
What is an OTC option?
An Over The Counter option
Advantages of swaps
Can switch from fixed to floating interest, arrangement costs are usually less than terminating existing loan, long term, flexible and can make interest rate savings
Disadvantages of swaps
Risk that counterparty will default before completion
Unfavourable market movements
May lead to financial statements appearing misleading
