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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
When is an option at the money
if exercise price = market price of underlying share
26
Types of options
Share options Pure options - buy or sell assets that already exist Currency option - buy or sell currency
27
Disadvantage of OTC options
all different so can't be traded as no market for them
28
American style option
can be exercised any day up to expiry date
29
European style option
exercised only on its expiry date
30
What is the value of an option
sum of intrinsic value and time value
31
What is the intrinsic value of an option
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
Time value for a call option depends on
expectation that the market price will rise
33
time value for a put otpion
depends on the expectation that the market price of the underlying item will fall
34
Time value depends on three factors
- Time to expiry (longer worth more) volatility of market price (more volatile more value) - General interest rates (TV money) - PV of exercise price
35
Where magnitude of interest risk is immaterial compared to overall cash flows one option
do nothing and accept movement
36
Risks from interest rate movements factors
Fixed v floating debt Term of loan (exposed by repay earlier) Term loan / overdraft facility Deposit at floating rate
37
How to reduce interest rate risks
pool assets and liabilities FRAs Interest Rate futures Interest rate options Interest rate swaps
38
How does pooling assets and liabilities work
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
FRA allow lenders/borrowers to
fix a rate of interest with a term that starts in future and lasts for several months, purchased OTC from a bank
40
FRA - if actual interest rate is higher than rate fixed by FRA agreed
bank pays customer the difference
41
FRA - if the actual interest rate is lower than the rate fixed by the FRA
customer pays bank the difference
42
FRA - Borrower will
buy to fix rate
43
FRA - investor will
Sell to fix rate on future deposit
44
Limitations of fRA
Usually only available for amounts > £500,000 difficult to obtain for periods more than 12 months remove upside potential
45
Advantages of FRA
For period of FRA, protect borrower/investor from adverse market interest rate movements OTC - can e tailored to amount and duration required
46
Interest rate futures are
standardised and hence cannot always be matched with specific interest exposures
47
What is bought with interest futures
entitlement to interest receipts
48
What is sold with interest rate futures
promise to make interest payments
49
Borrowers wishing to hedge against interest rate rise will
Sell now and buy to close
50
Lenders/depositors wanting to hedge against the possibility of falling interest rates will
buy futures now and sell to close
51
What are STIRS
Short term interest rate futures contracts contracts on notional deposits/loans for three months beginning on a standard future date
52
What is the price of interest rate futures contract
100 - r
53
Interest rate futures - to hedge against risk of future increase in interest rates, a borrower will
sell to buy and close at lower price
54
When does maturity mismatch occur
if actual term of lending/borrowing does not match notional period of futures contract (3m)
55
Maturity mismatch equation number of futures contracts =
amount of actual loan/futures contract size * length of loan/3m
56
What is an interest rate guarantee/short term interest rate cap(put)/floor(call)
term for interest rate option which hedges interest rate for single period up to one year
57
Traded interest rate options are available as
options on interest rate futures
58
Option to buy
call option
59
option to sell
put option
60
Strike price definition
price that will be paid for futures contract if exercised
61
Interest rate options - if a company needs to hedge borrowing it should
purchase a put option - option to sell futures
62
Interest rate options - If a company needs to lend/deposit money it should
purchase call option - option to buy futures
63
Define interest rate swap
agreement whereby parties to the agreement exchange interest payments on notional amount of principal at intervals over a period of years
64
Advantages of interest rate swaps
- 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
For n interest rate swap to benefit both parties
- 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
Risks of interest rate swaps
- counter party risk - position/market risk - transparency risk
67
Counterparty risk
Risk that counterparty to a swap will default before completion of agreement. Lessen by using reputable intermediary
68
Interest rate swap Position/Market risk
risk of unfavourable market movements of interest / exchange rates after entering swap
69
Transparency risk
risk that swap activity may lead to accounts of party involved being misleading

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