Addressing Risk Flashcards
What is a Forward Contract?
A forward contract is a legally binding agreement to exchange a set amount of goods at a set price at a set date in the future today.
What is a Future?
A standardised contract to buy/sell a specific amount of something at a particular price on a stipulated future date
What is an Option?
An option is the same as a future, but the holder has the option not to go through with the transaction
What factors affect the time value of an option?
1) The time period to expiry of the option - Longer time to expiry the higher the time value of the option
2) The volatility of the underlying security price - More volatile leads to higher time value of the option
3) The general level of interest rates
What is a Forward Rate Agreement (FRA’s)
FRA’s allow borrows/lenders to fix their future rate of interest
What are the advantages of FRA’s
For the period of the FRA, the borrower/lender is protected from adverse market interest rate movements
FRA’s can be tailored to the amount and duration required
What are the Disadvantages of FRA’s
The are usually only available on loans over £500,000
They are difficult to obtain for periods over 1 year
Any upside potential is removed
How would borrowers use future contracts to hedge their interest rate risk
Selling futures now
Buying futures when the future is closed out
How would savers hedge against the interest rate risk?
Buy futures now
Sell futures at the date the contract is closed out
What are the advantages of interest rate swaps?
Enable to switch from floating rate to fixed rate interest
Arrangement costs are generally less than terminating the existing loan and taking out a new one
They are available for longer periods than short-term hedging methods
What is interest rate parity theory?
The difference between the spot rate and forward rate can be predicted by the difference in interest rates between the 2 countries
What is the relationship between the spot rate and forward rate?
Spot rate x [1+if/1+iuk] = Forward Rate
if = Foreign Interest Rate iuk = Domestic Interest Rate
How do you set up a money market hedge for a foreign currency payment?
1) Borrow payment amount in the home currency now
2) Convert the money borrowed to the currency of payment
3) Put the money on deposit in the foreign currency
4) Settle the liability using the deposit plus interest
How do you set up a money market hedge for a foreign currency receipt?
Borrow an appropriate amount in the foreign currency today
Convert immediately to home currency
Place on deposit in home currency
What are the advantages of currency futures?
1) Transaction date flexibility as the future doesn’t need to be closed out until the settlement date
2) Exchange regulated market
3) Easy to buy and sell future contracts
