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FM > Chapter 9 - Managing Financial risks: interest rate and others > Flashcards

Chapter 9 - Managing Financial risks: interest rate and others Flashcards

1
Q

Derivative definition

A

Financial instrument whose value derives from an underlying financial item

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2
Q

Futures contract definition

A

Standardised exchange contract to buy/sell specific amount of notional underlying financial item on a certain date. They fix the price for buying or selling.

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3
Q

Forward contract definition

A

Binding agreement to buy or sell an item for settlement at a future date at a price agreed today

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4
Q

Futures definition

A

Standardised contract to buy or sell a specific amount of commodity, currency or financial instrument at an agreed price on a stipulated future date. They are bought and sold on exchanges

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5
Q

If someone buys futures not having traded before, what position do they open

A

Long position in futures contracts

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6
Q

If someone sells futures without previously having traded them before, they open

A

a short position

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7
Q

What are index futures

A

futures contracts on a portfolio of shares represented by a stock market index, used to protect investors against falls in value (important for e.g. pension funds)

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8
Q

Price of FTSE100 index futures contract

A

67000

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9
Q

Futures - To protect the value of a portfolio when worried about prices falling

A

Sell futures now
if the index falls, buy at lower price
gain will offset loss

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10
Q

Objective of a futures hedge

A

remove price risk by fixing price in advance

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11
Q

Disadvantage of futures hedge

A

price fixed so any upside removed

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12
Q

Futures - contract size definition

A

fixed quantity which can be bought or sold with one futures contract
has to be whole number

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13
Q

Futures - Contract price

A

price at which the futures contract is bought or sold

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14
Q

Futures - settlement date

A

date when trading on a particular futures contract stops and all accounts are settled

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15
Q

Futures - initial margin

A

Deposit that must be paid, size usually depends on the contract but often 5% of the value and this is refunded when contract is closed. Covers any losses in first day trading

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16
Q

Futures - Basis

A

Difference between futures contract price and spot price
= Spot price - futures price

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17
Q

Two factors that prevent futures market giving perfect hedge

A

value of commodity hedged must be rounded to whole number of contracts
basis risk - change in spot over period is not matched exactly by changes in futures price

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18
Q

Option - definition

A

gives buyer the right, but not the obligation to buy or sell a specific quantity of an item at a fixed price on or before a set date

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19
Q

What are over the counter options

A

tailor made options for specific needs made with financial institutions. can be for any number of shares or other stocks

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20
Q

What is a call option q

A

Investor is entitled to buy the shares at exercise price within specified period

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21
Q

What is a put option

A

investor is entitled to sell shares at exercise price within specified period

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22
Q

Strike price definition

A

price written into the option (also exercise price)

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23
Q

When is an option in the money

A

if exercised today, profit would be made as exercise price is more favourable than current market price

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24
Q

When is an option out of the money

A

if it were exercised today a loss would be made. Exercise price is less favourable than current market price

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25
Q

When is an option at the money

A

if exercise price = market price of underlying share

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26
Q

Types of options

A

Share options
Pure options - buy or sell assets that already exist
Currency option - buy or sell currency

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27
Q

Disadvantage of OTC options

A

all different so can’t be traded as no market for them

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28
Q

American style option

A

can be exercised any day up to expiry date

29
Q

European style option

A

exercised only on its expiry date

30
Q

What is the value of an option

A

sum of intrinsic value and time value

31
Q

What is the intrinsic value of an option

A

assume expires today, minimum value is zero, out of the money options intrinsic clause zero. In the money options value is difference between exercise price and market price

32
Q

Time value for a call option depends on

A

expectation that the market price will rise

33
Q

time value for a put otpion

A

depends on the expectation that the market price of the underlying item will fall

34
Q

Time value depends on three factors

A
  • Time to expiry (longer worth more)
    volatility of market price (more volatile more value)
  • General interest rates (TV money) - PV of exercise price
35
Q

Where magnitude of interest risk is immaterial compared to overall cash flows one option

A

do nothing and accept movement

36
Q

Risks from interest rate movements factors

A

Fixed v floating debt
Term of loan (exposed by repay earlier)
Term loan / overdraft facility
Deposit at floating rate

37
Q

How to reduce interest rate risks

A

pool assets and liabilities
FRAs
Interest Rate futures
Interest rate options
Interest rate swaps

38
Q

How does pooling assets and liabilities work

A

some interest risk may cancel each other out - if both assets and liabilities exposed and rate rises more payable on liabilities but offset by higher interest received on assets

39
Q

FRA allow lenders/borrowers to

A

fix a rate of interest with a term that starts in future and lasts for several months, purchased OTC from a bank

40
Q

FRA - if actual interest rate is higher than rate fixed by FRA agreed

A

bank pays customer the difference

41
Q

FRA - if the actual interest rate is lower than the rate fixed by the FRA

A

customer pays bank the difference

42
Q

FRA - Borrower will

A

buy to fix rate

43
Q

FRA - investor will

A

Sell to fix rate on future deposit

44
Q

Limitations of fRA

A

Usually only available for amounts > £500,000
difficult to obtain for periods more than 12 months
remove upside potential

45
Q

Advantages of FRA

A

For period of FRA, protect borrower/investor from adverse market interest rate movements
OTC - can e tailored to amount and duration required

46
Q

Interest rate futures are

A

standardised and hence cannot always be matched with specific interest exposures

47
Q

What is bought with interest futures

A

entitlement to interest receipts

48
Q

What is sold with interest rate futures

A

promise to make interest payments

49
Q

Borrowers wishing to hedge against interest rate rise will

A

Sell now and buy to close

50
Q

Lenders/depositors wanting to hedge against the possibility of falling interest rates will

A

buy futures now and sell to close

51
Q

What are STIRS

A

Short term interest rate futures contracts
contracts on notional deposits/loans for three months beginning on a standard future date

52
Q

What is the price of interest rate futures contract

A

100 - r

53
Q

Interest rate futures - to hedge against risk of future increase in interest rates, a borrower will

A

sell to buy and close at lower price

54
Q

When does maturity mismatch occur

A

if actual term of lending/borrowing does not match notional period of futures contract (3m)

55
Q

Maturity mismatch equation number of futures contracts =

A

amount of actual loan/futures contract size * length of loan/3m

56
Q

What is an interest rate guarantee/short term interest rate cap(put)/floor(call)

A

term for interest rate option which hedges interest rate for single period up to one year

57
Q

Traded interest rate options are available as

A

options on interest rate futures

58
Q

Option to buy

A

call option

59
Q

option to sell

A

put option

60
Q

Strike price definition

A

price that will be paid for futures contract if exercised

61
Q

Interest rate options - if a company needs to hedge borrowing it should

A

purchase a put option - option to sell futures

62
Q

Interest rate options - If a company needs to lend/deposit money it should

A

purchase call option - option to buy futures

63
Q

Define interest rate swap

A

agreement whereby parties to the agreement exchange interest payments on notional amount of principal at intervals over a period of years

64
Q

Advantages of interest rate swaps

A
  • hedge exposure over long period
  • change net payment fixed to floating
  • costs are less than terminating loan and taking out another
  • available for Longer periods
  • flexible as tailor-made and reversible
  • can do cross currency
65
Q

For n interest rate swap to benefit both parties

A
  • each must borrow in the market where it has comparative advantage
    both parties must want the interest of the opposite type to which they have the comparative advantage
66
Q

Risks of interest rate swaps

A
  • counter party risk
  • position/market risk
  • transparency risk
67
Q

Counterparty risk

A

Risk that counterparty to a swap will default before completion of agreement.
Lessen by using reputable intermediary

68
Q

Interest rate swap
Position/Market risk

A

risk of unfavourable market movements of interest / exchange rates after entering swap

69
Q

Transparency risk

A

risk that swap activity may lead to accounts of party involved being misleading

FM (11 decks)

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