chapt 11 part 1 Flashcards

1
Q

What is an underlying asset

A

the securities on which derivative contracts are based

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2
Q

what are forward contracts

A

a price that is established today for future delivery

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3
Q

What are spot contracts

A

a price that is established today for immediate delivery

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4
Q

what does derivative mean

A

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

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5
Q

what are the two basic types of derivative securities

A
  1. forwards, futures, and swaps

2. options

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6
Q

what do forward and spot contracts reflect

A

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

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7
Q

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

A

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

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8
Q

How are forwards traded

A

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

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9
Q

can forward be for any time frame

A

yes, which makes them incredibly flexible

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10
Q

what does It mean by speculate

A

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

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11
Q

what is naked position

A

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

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12
Q

what does it mean by long

A

the investor owns something

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13
Q

what does it mean by short

A

the investor owes something

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14
Q

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

A

yes

therefore there is a possibility of a gain or a loss

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15
Q

how do banks make money on forward contacts

A

by buying and selling forward contacts at slightly different prices

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16
Q

is there an immediate cash outlay for a forward contact

17
Q

what is credit (counterparty) risk

A

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

18
Q

how can the bank reduce its risk

A

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.

19
Q

what are the limits for a bank to sell forwards

A

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

20
Q

why do most financial instituitons become involved in forward markets

A

for hedging purposes

21
Q

what is hedging

A

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

22
Q

what is exposure

A

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

23
Q

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

A

a long US dollar exposure

24
Q

short US dollar exposure happens when what

A

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

25
do most companies want to speculate
no they do not, because they are not in the business of speculating. they want to avoid this exposure
26
doing nothing and exchanging the US dollars when received is equivalent to
engaging in currency speculation
27
what is removing a naked position called
covering or hedging
28
the payoff for the naked short position is what kind of image
mirror image or complete opposite of the naked long position
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
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)
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
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
31
Synthetically to create a forward contact a Canadian bank would borrow in the Canadian money market by issuing what is termed as
banker's accpetances or BAs
32
what are BAs
short term notes that are fully guaranteed or "accepted" by the bank.
33
what is LIBOR
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
34
what is a commodity
something traded based solely on price, because it is undifferentiated and can be traded without requiring physical examination
35
what would an example of a commodity be
precious metal , its value is immediately recognizable and not subject to dispute
36
what is contango
when a forward price exceeds the spot price
37
what are storage costs
the price charged for holding a commodity for future delivery
38
what is conveince yield
the benefit of preimium derived form holding the asset rather than holding a derivative
39
what is cost of carry
the total cost of buying a commodity spot and then carrying it or effecting physical delivery when the forward contract expires