chapt 11 part 1 Flashcards
What is an underlying asset
the securities on which derivative contracts are based
what are forward contracts
a price that is established today for future delivery
What are spot contracts
a price that is established today for immediate delivery
what does derivative mean
not original, came from something else (or derived from something else)
what are the two basic types of derivative securities
- forwards, futures, and swaps
2. options
what do forward and spot contracts reflect
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
because forward rates are the price today for future delivery, they reflect what
the fact that foreign currency is not worth the same amount when it is received at different points in time
How are forwards traded
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
can forward be for any time frame
yes, which makes them incredibly flexible
what does It mean by speculate
make an educated guess about the future value of something in hopes of profiting from it
what is naked position
a position that leaves the investor exposed to changes in the value of the underlying asset
what does it mean by long
the investor owns something
what does it mean by short
the investor owes something
with forwards, do investors have to fulfill their contract regardless what happens to the value of the asset?
yes
therefore there is a possibility of a gain or a loss
how do banks make money on forward contacts
by buying and selling forward contacts at slightly different prices
is there an immediate cash outlay for a forward contact
no ,
what is credit (counterparty) risk
the risk that a borrower will not fulfill a contract or make a required payment
how can the bank reduce its risk
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.
what are the limits for a bank to sell forwards
only up to the business approved credit and only for legitimate business purposes
why do most financial instituitons become involved in forward markets
for hedging purposes
what is hedging
reducing the risk of adverse price movement by taking an offsetting position in a derivative to eliminate exposure to an underlying price
what is exposure
the extent to which value is affected by an external event, such as a change in exchange rate
if a Canadian company exports to the US and waits for its US customer to pay, it has what
a long US dollar exposure
short US dollar exposure happens when what
when a Canadian company imports goods form the US and then has to pay the US dollar invoice at some future time
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
doing nothing and exchanging the US dollars when received is equivalent to
engaging in currency speculation
what is removing a naked position called
covering or hedging
the payoff for the naked short position is what kind of image
mirror image or complete opposite of the naked long position
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
- either enter the inter-bank market to offset its exposure by trading with other banks
or - synthetically create forward foreign exchange contracts using IRP (interest rate parity)
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
- 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
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
what are BAs
short term notes that are fully guaranteed or “accepted” by the bank.
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
what is a commodity
something traded based solely on price, because it is undifferentiated and can be traded without requiring physical examination
what would an example of a commodity be
precious metal , its value is immediately recognizable and not subject to dispute
what is contango
when a forward price exceeds the spot price
what are storage costs
the price charged for holding a commodity for future delivery
what is conveince yield
the benefit of preimium derived form holding the asset rather than holding a derivative
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
