Chapter 9 Flashcards
What is a derivative
Financial instrument whose value is derived from the value and characteristics of an underlying financial item
How do you calculate the hedge efficiency
Hedge efficiency = gain (or loss) on the hedging instrument / gain (or loss) on the hedged item
What is a forward contract
Agreement to exchange a set amount of goods at a set future date at a price agreed today
OTC - not traded
What is a futures contract
Standardized contract to buy or sell a specific amount of a commodity, currency or financial instrument at a particular price on a stipulated future date
Traded
What is the notional size of an index future contract
Notional value of the index value * £10
What are 2 pros of index futures
Hedges away any downside risk of share prices falling
Can close out futures position at any time
What are 6 disadvantages of index futures
Standardized contracts, so may over/ under hedge
Only an appropriate hedge if the share portfolio is similar to the index
Removes any upside potential
Must post initial margin to the exchange at the start
Must post variation margin if you make losses on futures position
Basis risk leads to hedge not being 100% efficient
What are the difference between American and European options
American options - can be exercised at any point until expiry - traded options
European options - can only be exercised on expiry date - OTC or traded
What is the intrinsic value of an option
Is what the option would be worth if exercised today
Eg share price 100, strike price 95 then intrinsic value of call option would be 5.
What is the time premium for options
What 3 things drive it
Time premium is the difference between the total value and the intrinsic value
Time to expiry (longer to expiry is more valuable)
Volatility of the underlying (higher vol of underlying share price, greater the option value)
General level of interest rates ( if interest rates high, call options become more desirable as the PV of the exercise price to be paid decreases
What is the hint to remember for index linked derivatives
Homer Simpson = hold - sell
If given a number of exercise prices in an index hedge which one should you choose
Middle one
What is one pro of an index option
What are 3 cons of index options
Pro:
Protects from downside risk and allows buyer to benefit from upside
Cons:
Standardized contracts so may over/ under hedge
Only an appropriate hedge if share portfolio similar to index
Option premium can be expensive
What are 5 ways of reducing interest rate risk
Pooling of assets and liabilities - can cancel out interest rate movements where they both have exposure to interest rate movements
Forward rate agreements
Interest rate futures
Interest rate options
Interest rate swaps
What does a 3-6 FRA mean
FRA starts in 3 months and lasts for 3 months
Do borrowers buy or sell FRAs
Buy
What are 2 pros of FRAs
Hedges away downside risk
Tailored to the investor
What are 4 cons of FRAs
Usually only available for loans > 500k
Usually for < 1 year
Removes any upside potential
Difficult to exit
What is the usual size of interest rate futures and how often do they last
£500k
3 months
Who would sell a interest rate futures contract
Borrowers
Remember Bull shit
Borrowers Sell Interest fuTures
What is the maturity mismatch and which derivative does it apply to
Borrowing period / 3 - used when calculating number of contracts
Used in interest rate futures and options
What is the calculation to work out the outcome of the hedge in interest rate futures
((Sell price - buy price)/ 100) * #contracts* 500k * 3/12
What are 2 pros of interest rate futures
Hedges away downside risk
Can close out position at any time
What are 4 cons of interest rate futures
Removes any upside potential
Standardized contracts (over/ under hedge)
Basis risk may lead to hedge not being 100% efficient
Must post margin to the exchange
What is one advantage of interest rate options
Protects from downside risk and allows buyer to benefit from upside
What are 3 disadvantages of interest rate options
Option premium can be expensive and must be paid
May over/under hedge as standardized contracts
Basis risk may lead to hedge not being 100% efficient
What are 3 pros of interest rate swaps
Can either provide fixed or floating interest
Can be longer term than FRAs/futures/ options
Can be used to achieve lower borrowing costs for each counterparty
What are 4 cons of interest rate swaps
Swap to pay fixed interest you lose the upside potential of variable assets
If you swap to pay floating interest you risk the impact of rising interest rates
There is a risk that the swap counterparty defaults
Risk that the swap might make our accounts appear misleading
