Final Flashcards
What is Hedging and Why is it Done?
- investment that protects your finances from a risky situation
- done to minimize or offset chance that your assets will losse value
2 Subcategories of Derivatives
- Option-Based Contracts
- Forward-Based Contracts
Derivative
a contract whose payoff (or value) is determined by the value of something else (underlying asset)
-> “value that’s derived from something else”
Forward Contract
agreement BETWEEN 2 PARTIES to exchange a commodity, security, or foreign currency at specified date in future at pre-agreed price
Futures Contract
contract TRADED on an EXCHANGE that allows an entity to buy or sell a SPECIFIED QUANTITY of commodity or a financial secutiy at a specified price on a specified future date
Characteristics of Forward Contracts
- privately negotiated, over-the-counter (OTC) contract
- user promises and thus is OBLIGATED to buy or sell an asset at a specified future date -> NOT AN OPTION, MUST UPHOLD
- sold at specified price at contract initiation (forward price)
Forward Price
price specified at the initiation of a forward contract
5 Features of Forward Contracts
- Linearity
- No Money Down
- Settlement at Maturity
- Counterparty Risk
- Customization
Forward Contracts - Linearity
payoffs are symmeterical -> one party’s gain is another party’s loss
Forward Contracts - No Money Down
in theory, no money is exchanged at initiation
Forward Contracts - Settlement at Maturity
in theory, no money is exchanged until maturity date of contract
Forward Contracts - Counterparty Risk
liklihood the other party unable to meet its obligation at maturity date
Forward Contracts - Customization
customized to buyers and sellers preferances (OTC); not publicly traded on an exchange
Characteristics of Futures Contracts
- STANDARDIZED contracts on formal exchange
- there’s DAILY RESETTLEMENT (“marking to market” or “cash settled”) between parties through a clearing house
- parties required to post PERFORMANCE BOND (margin) -> this collaterizes the transaction
- all above characteristics increase liquidity, increase competitive pricing, and reduce counterparty risk
What do Forward (Future) Prices Suggest?
the forward price is a “no-abitrage price” determined by balanced supply and demand -> any forward price above or below this price could lead to 0 cost, riskless profits for traders
Option Based Contract
contract giving HOLDER the RIGHT, but NOT obligation, to buy or sell an asset at a specified price at any time during a specified period in the future -> the WRITER of option is OBLIGATED to perform obligation on option contract
Call Option
the right, not obligation, to BUY an asset
Put Option
the right, not obligation, to SELL an asset
American Option
an option that can be exercized at ANY TIME UNTIL expiry date
European Option
an option that can be exercised ONLY ON expiry
Bermudan Option
an option that can be be exercised ONLY during a PREDIFINED PORTION of its life
Option Based Contract Characteristics
- buyer of option acquires right NOT OBLIGATION to initiate specific transaction in exchange for payment of a premium
- under specific terms and conditions
4 Features of Option Based Contracts
- Non-Linearity
- Money Down
- Settlement at Exercise
- Customization
Option Based Contracts - Non-Linearity
payoffs are asymmetrical since owner of option not obligated to exercise option -> one party’s gain not necessarily another party’s loss
Option Based Contracts - Money Down
at initiation, an option premium is paid to buyer from seller
Option Based Contracts - Settlement at Exercise
options settled at exercise when money is potentially exchanged
Options Based Contracts - Customization
options available OTC and on formal exchanges
When are options exercised?
when they are “in the money”
Insurance ________ wealth if a loss does not occurs
decreases
Insurance _________ increases wealth if a loss does occur
increases
Insurance _________ the _________ of wealth around the expected level of wealth
reduces; variability (standard deviation)
Factors Affecting Demand for Insurance
- Premium Loadings
- Income and Wealth
- Information
- Other Sources of Indemnity
- Non-Monetary Losses
What does homeowner insurance cover?
- first-party property
- third-party liability
- indirect losses
What is homeowners insurance?
a multiple line, multiple peril policy
What is Section 1 in Homeowners Insurance, and what does it include?
Section 1 is property and it includes:
A. Dwelling Building
B. Detatched Private Structures
C. Personal Property
D. Additional Living Expenses
What is Section 2 of Homeowners Insurance, and what does it include?
Section 2 is Liability and it includes:
E. Personal Liability
F. Voluntary Medical Payments
G. Voluntary Payment for Property Damage
H. Voluntary Compensaiton for Residence Employee
