Derivatives Flashcards
Probably the fastest growing sector of the financial markets today is that of derivatives, so named because they derive from another product. The buying of $1m for sterling is the product. The option to buy $ for sterling later at a price we agree today is the derived product. Borrowing $1m at a floating rate for five years is the product. A bank offering (for a fee) to compensate the borrower should rates rise above a given level in the next five years is the derived product and so on. In the currency rates, interest rates, bonds, equities and equity indices, there is volatility. Where there is volatility, there are those who believe they know what the next price movement is and back their judgement with money (the speculators). Then there are those who will lose money from a given price movement and seek to protect themselves from this (the hedgers). Both will use the derivatives markets for this purpose. The interesting paradox is that one is using them to take risks and the other to reduce risks. Finally there are those who perceive pricing anomalies and seek to exploit this (the arbitrageurs). The most important derivatives are Foreign Rate Agreements (FRAs), futures, forwards, options and swaps.
- What are main features of financial derivatives?
Tradable (liquid) market for underlying assets; transfer of risk; volatile or changeable in price dependent on value of underlying assets; derivatives can be used to (in)decrease portfolio risk; arbitrage, speculation and hedging possibilities; Organized or ‘open’ or ‘standard’ contracts and ‘over-the-counter’ (OTC) contracts.
Probably the fastest growing sector of the financial markets today is that of derivatives, so named because they derive from another product. The buying of $1m for sterling is the product. The option to buy $ for sterling later at a price we agree today is the derived product. Borrowing $1m at a floating rate for five years is the product. A bank offering (for a fee) to compensate the borrower should rates rise above a given level in the next five years is the derived product and so on. In the currency rates, interest rates, bonds, equities and equity indices, there is volatility. Where there is volatility, there are those who believe they know what the next price movement is and back their judgement with money (the speculators). Then there are those who will lose money from a given price movement and seek to protect themselves from this (the hedgers). Both will use the derivatives markets for this purpose. The interesting paradox is that one is using them to take risks and the other to reduce risks. Finally there are those who perceive pricing anomalies and seek to exploit this (the arbitrageurs). The most important derivatives are Foreign Rate Agreements (FRAs), futures, forwards, options and swaps.
- What is a financial future and forward contract? Give two differences between future and forward contracts.
These are contracts to deliver and pay for a real or financial asset (e.g. real estate, shares or bonds) on a prearranged date in the future for a specific price. Futures are traded on an official organised FX so they carry standardised terms, amounts and maturities, while forwards are traded on the OTC market, which is tailored exactly to their required quantity and maturity. Futures relate to a broad variety of financial instruments including bonds, CDs, currencies and indexes and are highly liquid because they can be sold and bought in the secondary market, while forward contracts are highly illiquid and not negotiable, there is no secondary market.
Probably the fastest growing sector of the financial markets today is that of derivatives, so named because they derive from another product. The buying of $1m for sterling is the product. The option to buy $ for sterling later at a price we agree today is the derived product. Borrowing $1m at a floating rate for five years is the product. A bank offering (for a fee) to compensate the borrower should rates rise above a given level in the next five years is the derived product and so on. In the currency rates, interest rates, bonds, equities and equity indices, there is volatility. Where there is volatility, there are those who believe they know what the next price movement is and back their judgement with money (the speculators). Then there are those who will lose money from a given price movement and seek to protect themselves from this (the hedgers). Both will use the derivatives markets for this purpose. The interesting paradox is that one is using them to take risks and the other to reduce risks. Finally there are those who perceive pricing anomalies and seek to exploit this (the arbitrageurs). The most important derivatives are Foreign Rate Agreements (FRAs), futures, forwards, options and swaps.
- What is an essential difference between interest rate and currency swap?
Only interest payments are swapped so there is no exchange of principal versus an initial exchange of principal amounts of two currencies at the spot exchange rate (see p.242).
Probably the fastest growing sector of the financial markets today is that of derivatives, so named because they derive from another product. The buying of $1m for sterling is the product. The option to buy $ for sterling later at a price we agree today is the derived product. Borrowing $1m at a floating rate for five years is the product. A bank offering (for a fee) to compensate the borrower should rates rise above a given level in the next five years is the derived product and so on. In the currency rates, interest rates, bonds, equities and equity indices, there is volatility. Where there is volatility, there are those who believe they know what the next price movement is and back their judgement with money (the speculators). Then there are those who will lose money from a given price movement and seek to protect themselves from this (the hedgers). Both will use the derivatives markets for this purpose. The interesting paradox is that one is using them to take risks and the other to reduce risks. Finally there are those who perceive pricing anomalies and seek to exploit this (the arbitrageurs). The most important derivatives are Foreign Rate Agreements (FRAs), futures, forwards, options and swaps.
- What is the difference between official (organized) and over-the-counter market? Give an advantage of trading in an organised exchange and an advantage of trading in an over-the-counter (OTC) market. In which of these markets are financial futures, forwards and options contracts traded?
An official market is an organized exchange market with official quotations, while the OTC-market is an informal dealer-based market. Advantages official (organized) market: guaranteed every contract: counterparty risk of default is reduced (better documentation); requires capital base and margins to be taken; constantly monitors players and a clearing fund; a more advanced secondary market; more transparency. Advantages OTC-market: contracts more accordance to preferences investor; more gentle impact on prices (less volatile); counterparty risk is minimal. Futures are traded on organised markets, forwards on OTC-markets and options on both. See p.232.
Probably the fastest growing sector of the financial markets today is that of derivatives, so named because they derive from another product. The buying of $1m for sterling is the product. The option to buy $ for sterling later at a price we agree today is the derived product. Borrowing $1m at a floating rate for five years is the product. A bank offering (for a fee) to compensate the borrower should rates rise above a given level in the next five years is the derived product and so on. In the currency rates, interest rates, bonds, equities and equity indices, there is volatility. Where there is volatility, there are those who believe they know what the next price movement is and back their judgement with money (the speculators). Then there are those who will lose money from a given price movement and seek to protect themselves from this (the hedgers). Both will use the derivatives markets for this purpose. The interesting paradox is that one is using them to take risks and the other to reduce risks. Finally there are those who perceive pricing anomalies and seek to exploit this (the arbitrageurs). The most important derivatives are Foreign Rate Agreements (FRAs), futures, forwards, options and swaps.
- How a fixed interest rate liability can be transformed into a variable interest rate liability?
Give two possibilities.
Through an interest rate swap; through an early plan or term of redemption (more flexibility, but also more costs); a spread in maturity in credit portfolio, i.e. average interest payments during the whole business cycle.
Probably the fastest growing sector of the financial markets today is that of derivatives, so named because they derive from another product. The buying of $1m for sterling is the product. The option to buy $ for sterling later at a price we agree today is the derived product. Borrowing $1m at a floating rate for five years is the product. A bank offering (for a fee) to compensate the borrower should rates rise above a given level in the next five years is the derived product and so on. In the currency rates, interest rates, bonds, equities and equity indices, there is volatility. Where there is volatility, there are those who believe they know what the next price movement is and back their judgement with money (the speculators). Then there are those who will lose money from a given price movement and seek to protect themselves from this (the hedgers). Both will use the derivatives markets for this purpose. The interesting paradox is that one is using them to take risks and the other to reduce risks. Finally there are those who perceive pricing anomalies and seek to exploit this (the arbitrageurs). The most important derivatives are Foreign Rate Agreements (FRAs), futures, forwards, options and swaps.
- Interest rates can be covered through interest rate options and Foreign Rate Agreements
(FRAs).
a. What is the difference between an interest rate option and a FRA?
b. Mention an advantage and a disadvantage of both instruments.
a) Covering through interest options = agreement between a bank and a firm by which a firm gets the right on a contractual agreed fixed interest rate in the future.
Covering short-term interest rate risk through FRA = interest rate forward contract in which the interest rate to be paid or received on a specific obligation for a set period of time, beginning at some time in the future, is determined when the contract is signed.
b) Advantage option more flexibility; possibility to benefit from interest rate reduction
Disadvantage option: payment of commission
Advantage FRA: interest rate risk bank disappeared (costs deposit remain FRA interest rate)
Disadvantage FRA: no benefit from low interest rate
