Final

Question 1

What is Hedging and Why is it Done?

Answer 1

• investment that protects your finances from a risky situation
• done to minimize or offset chance that your assets will losse value

Question 2

2 Subcategories of Derivatives

Answer 2

• Option-Based Contracts
• Forward-Based Contracts

Question 2

Derivative

Answer 2

a contract whose payoff (or value) is determined by the value of something else (underlying asset)
-> “value that’s derived from something else”

Question 3

Forward Contract

Answer 3

agreement BETWEEN 2 PARTIES to exchange a commodity, security, or foreign currency at specified date in future at pre-agreed price

Question 4

Futures Contract

Answer 4

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

Question 5

Characteristics of Forward Contracts

Answer 5

• 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)

Question 6

Forward Price

Answer 6

price specified at the initiation of a forward contract

Question 7

5 Features of Forward Contracts

Answer 7

• Linearity
• No Money Down
• Settlement at Maturity
• Counterparty Risk
• Customization

Question 8

Forward Contracts - Linearity

Answer 8

payoffs are symmeterical -> one party’s gain is another party’s loss

Question 9

Forward Contracts - No Money Down

Answer 9

in theory, no money is exchanged at initiation

Question 10

Forward Contracts - Settlement at Maturity

Answer 10

in theory, no money is exchanged until maturity date of contract

Question 11

Forward Contracts - Counterparty Risk

Answer 11

liklihood the other party unable to meet its obligation at maturity date

Question 12

Forward Contracts - Customization

Answer 12

customized to buyers and sellers preferances (OTC); not publicly traded on an exchange

Question 13

Characteristics of Futures Contracts

Answer 13

• 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

Question 14

What do Forward (Future) Prices Suggest?

Answer 14

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

Question 15

Option Based Contract

Answer 15

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

Question 16

Call Option

Answer 16

the right, not obligation, to BUY an asset

Question 17

Put Option

Answer 17

the right, not obligation, to SELL an asset

Question 18

American Option

Answer 18

an option that can be exercized at ANY TIME UNTIL expiry date

Question 19

European Option

Answer 19

an option that can be exercised ONLY ON expiry

Question 20

Bermudan Option

Answer 20

an option that can be be exercised ONLY during a PREDIFINED PORTION of its life

Question 21

Option Based Contract Characteristics

Answer 21

• buyer of option acquires right NOT OBLIGATION to initiate specific transaction in exchange for payment of a premium
• under specific terms and conditions

Question 22

4 Features of Option Based Contracts

Answer 22

• Non-Linearity
• Money Down
• Settlement at Exercise
• Customization

Question 23

Option Based Contracts - Non-Linearity

Answer 23

payoffs are asymmetrical since owner of option not obligated to exercise option -> one party’s gain not necessarily another party’s loss

Question 24

Option Based Contracts - Money Down

Answer 24

at initiation, an option premium is paid to buyer from seller

Question 25

Option Based Contracts - Settlement at Exercise

Answer 25

options settled at exercise when money is potentially exchanged

Question 26

Options Based Contracts - Customization

Answer 26

options available OTC and on formal exchanges

Question 27

When are options exercised?

Answer 27

when they are "in the money"

Question 28

Insurance ________ wealth if a loss does not occurs

Answer 28

decreases

Question 29

Insurance _________ increases wealth if a loss does occur

Answer 29

increases

Question 30

Insurance _________ the _________ of wealth around the expected level of wealth

Answer 30

reduces; variability (standard deviation)

Question 31

Factors Affecting Demand for Insurance

Answer 31

- Premium Loadings - Income and Wealth - Information - Other Sources of Indemnity - Non-Monetary Losses

Question 32

What does homeowner insurance cover?

Answer 32

- first-party property - third-party liability - indirect losses

Question 33

What is homeowners insurance?

Answer 33

a multiple line, multiple peril policy

Question 34

What is Section 1 in Homeowners Insurance, and what does it include?

Answer 34

Section 1 is property and it includes: A. Dwelling Building B. Detatched Private Structures C. Personal Property D. Additional Living Expenses

Question 35

What is Section 2 of Homeowners Insurance, and what does it include?

Answer 35

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