chapt 11 part 1

Question 1

What is an underlying asset

Answer 1

the securities on which derivative contracts are based

Question 2

what are forward contracts

Answer 2

a price that is established today for future delivery

Question 3

What are spot contracts

Answer 3

a price that is established today for immediate delivery

Question 4

what does derivative mean

Answer 4

not original, came from something else (or derived from something else)

Question 5

what are the two basic types of derivative securities

Answer 5

1. forwards, futures, and swaps

2. options

Question 6

what do forward and spot contracts reflect

Answer 6

the amount of the foreign currency that one Canadian dollar would buy (mid-day rates for large wholesale transactions b/w major banks) not rates that ordinary investors or retail clients would pay

Question 7

because forward rates are the price today for future delivery, they reflect what

Answer 7

the fact that foreign currency is not worth the same amount when it is received at different points in time

Question 8

How are forwards traded

Answer 8

it is a bank instrument. an ordinary invidual can only access the forward freign exchange market through the bank (principal) because they are not traded in any open market but traded OTC markets

Question 9

can forward be for any time frame

Answer 9

yes, which makes them incredibly flexible

Question 10

what does It mean by speculate

Answer 10

make an educated guess about the future value of something in hopes of profiting from it

Question 11

what is naked position

Answer 11

a position that leaves the investor exposed to changes in the value of the underlying asset

Question 12

what does it mean by long

Answer 12

the investor owns something

Question 13

what does it mean by short

Answer 13

the investor owes something

Question 14

with forwards, do investors have to fulfill their contract regardless what happens to the value of the asset?

Answer 14

yes

therefore there is a possibility of a gain or a loss

Question 15

how do banks make money on forward contacts

Answer 15

by buying and selling forward contacts at slightly different prices

Question 16

is there an immediate cash outlay for a forward contact

Answer 16

no ,

Question 17

what is credit (counterparty) risk

Answer 17

the risk that a borrower will not fulfill a contract or make a required payment

Question 18

how can the bank reduce its risk

Answer 18

by dealing only with companies with which it already has a bnaking relationship and line of credit with. banks can tghen control the risk that the counterparty imposes on them.

Question 19

what are the limits for a bank to sell forwards

Answer 19

only up to the business approved credit and only for legitimate business purposes

Question 20

why do most financial instituitons become involved in forward markets

Answer 20

for hedging purposes

Question 21

what is hedging

Answer 21

reducing the risk of adverse price movement by taking an offsetting position in a derivative to eliminate exposure to an underlying price

Question 22

what is exposure

Answer 22

the extent to which value is affected by an external event, such as a change in exchange rate

Question 23

if a Canadian company exports to the US and waits for its US customer to pay, it has what

Answer 23

a long US dollar exposure

Question 24

short US dollar exposure happens when what

Answer 24

when a Canadian company imports goods form the US and then has to pay the US dollar invoice at some future time

Question 25

do most companies want to speculate

Answer 25

no they do not, because they are not in the business of speculating. they want to avoid this exposure

Question 26

doing nothing and exchanging the US dollars when received is equivalent to

Answer 26

engaging in currency speculation

Question 27

what is removing a naked position called

Answer 27

covering or hedging

Question 28

the payoff for the naked short position is what kind of image

Answer 28

mirror image or complete opposite of the naked long position

Question 29

If a bank sells to many US dollar forward contracts to its customers, so that the bank itself is now exposed, it can do what

Answer 29

1. either enter the inter-bank market to offset its exposure by trading with other banks
   or
2. synthetically create forward foreign exchange contracts using IRP (interest rate parity)

Question 30

suppose that a bank has sold too man us dollar forward contacts and wants to create forward foregin exhcane contracts to offset its own exposure. how does it do this

Answer 30

1. by first borrowing Canadian dollars for one year and then exchanging Canadian dollars for US dollars at the spot rate .
   next the bank would invest the US dollar proceceds for one year at the US interest rate
   the result
   is that it nows exactly how many US dollars it will own at the end of the year
   - it will also know exactly how many Canadian dollars it will owe

Question 31

Synthetically to create a forward contact a Canadian bank would borrow in the Canadian money market by issuing what is termed as

Answer 31

banker’s accpetances or BAs

Question 32

what are BAs

Answer 32

short term notes that are fully guaranteed or “accepted” by the bank.

Question 33

what is LIBOR

Answer 33

London international bank offered rate

• the key interst rate for Canadian banks when borrowing and lending US dollars;
• a “Free” market rate that is not under direct government control

Question 34

what is a commodity

Answer 34

something traded based solely on price, because it is undifferentiated and can be traded without requiring physical examination

Question 35

what would an example of a commodity be

Answer 35

precious metal , its value is immediately recognizable and not subject to dispute

Question 36

what is contango

Answer 36

when a forward price exceeds the spot price

Question 37

what are storage costs

Answer 37

the price charged for holding a commodity for future delivery

Question 38

what is conveince yield

Answer 38

the benefit of preimium derived form holding the asset rather than holding a derivative

Question 39

what is cost of carry

Answer 39

the total cost of buying a commodity spot and then carrying it or effecting physical delivery when the forward contract expires