Financial Engineering

Question 1

Risk management strategies

Answer 1

- External Risk:
Currency risk
Interest rate risk
Market risk
Inflation risk

-Internal risk
Liquidity risk
Credit risk
Refinancing risk
Regulatory or legal risk

Question 2

Interest rate risk

Answer 2

Mitigate:

• Match duration, term and interest basis
• Enter into forward rates
• Interest rate swaps, caps and floors, collars

Question 3

Refinancing risk

possibility that an individual or company would not be able to replace a debt obligation with new debt at a critical time for the borrower

Answer 3

• Avoid concentrating the refinancing of loans and bonds -spread maturities
• Ensure that sources of finance are widely distributed

Question 4

Liquidity risk

Answer 4

• Hold on to cash resources or unused banking facilities

- Use cash flow budgets

Question 5

Credit risk

Answer 5

• Make use of aging analysis of trade receivables
• Use credit agencies
• Avoid concentration exposure

Question 6

Market and commodity price risk

Answer 6

• Use futures, forwards, swaps and options to manage commodity price risk for inputs
• Use natural hedge for outputs

Question 7

Forwards and futures

Answer 7

• Legal contract between two parties
• Price agreed today for a forward price
• Always a winner and loser

Question 8

Option contracts

Answer 8

• Gives owner right not obligation
• Premium paid immediately, exercise price on expiry

American: Option holder can exercise at any time up to expiry date
European: Option holder can only exercise on expiry date and not at any time before

Question 9

Contract for Difference (CFD)

Answer 9

• Essentially a future contract
• Margin deposit-price derived from an asset
• May be subject to counterparty risk
• Interest payments made, dividends received
• Floors to limit downside, but close
• Asset securitisation