Chapter 5 - Application Of Derivatives In Risk Management Flashcards
What are the several ways in which derivatives are used
- Transferring market risk
- Modifying the payoff structure of an asset
- Enhancing the yield of an asset
- Lowering the funding cost to borrowers
- Changing the interest costs on liabilities from fixed to floating rates and vice versa
Characteristics of a forward contract
- Non-standardizes customised agreement between two parties to buy and sell an asset at a specified price on a particular date.
- They are private arrangements that occur OTC
What futures contracts
- Standardised contract creates to solve the problems of the forward contract
- Traded on a futures exchange
- Purchase price is predetermined by supply and demand
What are parameters predefined in the futures contract
- Expiration time of the contract
- Quality and quantity of the underlying asset
- Delivery of the underlying asset
- Settlement conditions of the contract
Only price is not predefined
How does the futures cobtract address the issues with the forward contracts
- Staandardizof the contracts improve liquidity
- The clearing house as a counter-party ensures liquidity
- Credit guarantees via its clearing house through daily settlement of gains and losses (Marked-to-market)
Similarities and differences between forwards and futures
Similarities
1. Effective tool in managing both interest rate and equities
Differences
- Forwards can be tailored to the specific needs of the counterparties but have higher default risk and less liquidity
- Futures are traded on an exchange minimizing risk of default
What does the beta of a portfolio tell us
How a portfolio compares with the entire market with regards to it volatility or systematic risk
What is the formulanfor calculating beta
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
What are the 3 types of foreign exchange risk that businesses deal with
- Transaction exposure
- Economic exposure
- Translation exposure
What is transaction exposure
This isnwhenna company expects cash flow in foreign currency to be received or paid at a later date or in the future
What is economic exposure
This type of exposure occurs when changes in currency value affects business competitiveness
What is translation exposure
This deals with the risk of converting foreign-denominated financial statements into domestic currency units
What are the strategies for hedging currency risks
Receiving foreign currency - long position - sell forwards contracts
Paying foreign currency - short position - buy forwards contracts
What are the two ways options can be structured
American style and European style
What is the American style of structuring an options
The option can be exercised before the expiry date
What is the European style of structuring options
It is exercised on the expiry date
What are the two ways options can be settled
Cash or by delivery of the underlying asset
What is a covered call
It is a position taken by a manager who buys an underlying security and sell a call option
Why do people sell covered call strategies
- To make additional portfolio revenue
2. Because the manager does not expect the price of the asset to change over time
What is a protective put
A long position in an underlying security and buying a put option
What are other names for the protective put
Portfolio insurance or hedge Portfolio.
What are the benefits of a protective put
Limits downside risk to the price paid for the put
What is a swap
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
What is the notional principal amount
It is the predetermined nominal value (cash flow for the swap)
What are 5 ways that swaps can be used
- Converting loans from fixed to floating rates and vice versa
- Changing the duration of fixed income portfolios
- Changing a foreign-currency bond obligation to a domestic one and vice versa
- Diversifying a concentrated equity portfolio
- Changing allocation of stocks and bonds
