Chapter 5 - Application Of Derivatives In Risk Management

Question 1

What are the several ways in which derivatives are used

Answer 1

1. Transferring market risk
2. Modifying the payoff structure of an asset
3. Enhancing the yield of an asset
4. Lowering the funding cost to borrowers
5. Changing the interest costs on liabilities from fixed to floating rates and vice versa

Question 2

Characteristics of a forward contract

Answer 2

1. Non-standardizes customised agreement between two parties to buy and sell an asset at a specified price on a particular date.
2. They are private arrangements that occur OTC

Question 3

What futures contracts

Answer 3

1. Standardised contract creates to solve the problems of the forward contract
2. Traded on a futures exchange
3. Purchase price is predetermined by supply and demand

Question 4

What are parameters predefined in the futures contract

Answer 4

1. Expiration time of the contract
2. Quality and quantity of the underlying asset
3. Delivery of the underlying asset
4. Settlement conditions of the contract

Only price is not predefined

Question 5

How does the futures cobtract address the issues with the forward contracts

Answer 5

1. Staandardizof the contracts improve liquidity
2. The clearing house as a counter-party ensures liquidity
3. Credit guarantees via its clearing house through daily settlement of gains and losses (Marked-to-market)

Question 6

Similarities and differences between forwards and futures

Answer 6

Similarities
1. Effective tool in managing both interest rate and equities

Differences

1. Forwards can be tailored to the specific needs of the counterparties but have higher default risk and less liquidity
2. Futures are traded on an exchange minimizing risk of default

Question 7

What does the beta of a portfolio tell us

Answer 7

How a portfolio compares with the entire market with regards to it volatility or systematic risk

Question 8

What is the formulanfor calculating beta

Answer 8

Bi = Cov(ri-rm)/var(rm)

Where

• Bi is the market variance of the asset
• ri is the expected return on the asset
• rm is the average expected return of the market

Question 9

What are the 3 types of foreign exchange risk that businesses deal with

Answer 9

1. Transaction exposure
2. Economic exposure
3. Translation exposure

Question 10

What is transaction exposure

Answer 10

This isnwhenna company expects cash flow in foreign currency to be received or paid at a later date or in the future

Question 11

What is economic exposure

Answer 11

This type of exposure occurs when changes in currency value affects business competitiveness

Question 12

What is translation exposure

Answer 12

This deals with the risk of converting foreign-denominated financial statements into domestic currency units

Question 13

What are the strategies for hedging currency risks

Answer 13

Receiving foreign currency - long position - sell forwards contracts

Paying foreign currency - short position - buy forwards contracts

Question 14

What are the two ways options can be structured

Answer 14

American style and European style

Question 15

What is the American style of structuring an options

Answer 15

The option can be exercised before the expiry date

Question 16

What is the European style of structuring options

Answer 16

It is exercised on the expiry date

Question 17

What are the two ways options can be settled

Answer 17

Cash or by delivery of the underlying asset

Question 18

What is a covered call

Answer 18

It is a position taken by a manager who buys an underlying security and sell a call option

Question 19

Why do people sell covered call strategies

Answer 19

1. To make additional portfolio revenue

2. Because the manager does not expect the price of the asset to change over time

Question 20

What is a protective put

Answer 20

A long position in an underlying security and buying a put option

Question 21

What are other names for the protective put

Answer 21

Portfolio insurance or hedge Portfolio.

Question 22

What are the benefits of a protective put

Answer 22

Limits downside risk to the price paid for the put

Question 23

What is a swap

Answer 23

An agreement between two parties to exchange sequences of cash flows over a period of time.

Note initially one of the sequence cash flows is uncertain at the beginning

Question 24

What is the notional principal amount

Answer 24

It is the predetermined nominal value (cash flow for the swap)

Question 25

What are 5 ways that swaps can be used

Answer 25

1. Converting loans from fixed to floating rates and vice versa
2. Changing the duration of fixed income portfolios
3. Changing a foreign-currency bond obligation to a domestic one and vice versa
4. Diversifying a concentrated equity portfolio
5. Changing allocation of stocks and bonds