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Financial Engineering > Financial Engineering Exam 1 > Flashcards

Financial Engineering Exam 1 Flashcards

1
Q

Risk

A

when we don’t know what the outcome is, but we do know the distribution of the outcomes

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2
Q

Uncertainty

A

when we don’t know what the outcome is, and we don’t know the distribution

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3
Q

Financial Engineering

A

The application of mathematical methods to the solution of problems in finance

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4
Q

Examples of Derivatives

A

o Futures Contracts
o Forward Contracts
o Swaps
o Options

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5
Q

Futures Contracts are traded on

A

Exchanges

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6
Q

Forward Contracts are traded on

A

OTC Markets

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7
Q

Swaps are traded on

A

OTC Markets

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8
Q

Options Contracts are traded on

A

Exxchanges

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9
Q

Purpose of Derivatives

A

o To hedge risks
o To speculate (take a view on the future direction of the market)
o To lock in an arbitrage profit
o To change the nature of a liability
o To change the nature of an investment without incurring the costs of selling one portfolio and buying another

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10
Q

Futures Contract

A

an agreement to buy or sell an asset at a certain time in the future for a certain price

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11
Q

oSpot Contract

A

an agreement to buy or sell the asset immediately (or within a very short period of time

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12
Q

Long Position

A

The party that has agreed to buy

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13
Q

Short Position

A

the party that has agreed to sell

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14
Q

Arbitrage Opportunity If F>P at expiration

A
  • Short the futures contract
  • Buy the asset
  • Make a delivery
    Profit = Number of positions ( F-P )
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15
Q

Arbitrage Opportunity If F < P

A
  • Buy Futures Contract
  • Short the asset
  • Wait for delivery
  • Profit =Number of Positions * ( P-F )
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16
Q

Items in contract

A 
o  Asset
o  Contract size
o  Delivery arrangements
o  Delivery month 
o  Price quotes
o  Price limits
o  Position limits
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17
Q

Futures are settled _____

A

Daily

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18
Q

Futures Settlement Price

A

the price just before the final bell each day. It is used for the daily settlement process

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19
Q

Futures Maintenance Margin

A

margin call if the balance drops under the maintenance margin

20
Q

Forward Contracts

A

o Similar to futures except trade in OTC markets
o Not standardized
o Not settle daily
o Popular with currencies and Interest Rates

21
Q

which is a larger market in forward contracts, OTC or exchanges?

A

OTC is much larger by over 6 times

22
Q

Should companies hedge or not? Yes:

A

Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables

23
Q

Should companies hedge or not? No:

A

o Shareholders can make their own hedging decisions
o Shareholders diversify risk
o Prices of products may fluctuate to reflect cost of inputs.
o Explaining a loss on the hedge can be difficult
o Hedging may lead to worse outcomes if competition does not hedge

24
Q

Short hedge

A

when you know you will sell and asset in the future and want to lock in the price

25
Q

Long Hedge

A

when you know you will purchase in the future and want to lock in the price

26
Q

Issues with Hedging Futures

A

o No futures with same underlying asset -> cross hedge

o Delivery of futures does not match desired maturity -> basis risk

27
Q

Basis Risk

A

o Difference between spot and futures
o Exists because of the uncertainties about the basis when the hedge is closed out
bt=St-Ft

28
Q

Cross Hedging Process

A

o Choose a future contract with the price most coorelated with the asset to be hedged
o Calculate the minimum variance ratio
o Calculate the optimum number of contracts

29
Q

Hedging Using Index Futures

A

There are equations to determine the number of future contracts needed to be shorted to hedge

30
Q

Fair-value

A

the cost of buying shares based on the value of the stock market futures that expire at the next expiry date (front month)

31
Q

Fair-value 2

A

is the price of the contract at which the buyer (seller) is neutral between buying (selling) now at the exchange and buying (selling) a futures contract

32
Q

Investment Assets

A

Assets held by at least some traders purely for investment purposes

33
Q

Consumption assets

A

assts held primarily for consumption

34
Q

Pricing of Forwards (and futures)

A

o Based on arbitrage arguments
o Works really well for investment assets
o But does not work well for consumption assets – because timing matters. With consumption assets if you need it now, you need it now

35
Q

Short Selling

A

Selling securities that you do not own, in hopes that the price goes down and you can repurchase and return at a cheaper price

  • Unlimited losses (shares can theoretically go to infinity)
  • Limited gains (shares can only go to 0)
36
Q

Swaps

A

an agreement to exchange cash flows at specified future times according to certain specified rules

37
Q

Interest Rate Swaps

A

Exchanging interest payments on notional principal for a number of years
- Does not swap principal

38
Q

Typical Use of IR swaps

A

Convert a liability or an investment from

  • fixed rate to floating rate
  • floating rate to fixed rate
39
Q

Criticism of the Competitive Advantage Argument

A
  • Any advantage should be arbitraged away in efficient markets
  • However – the more creditworthy company bears the risk of default of the less creditworthy
40
Q

Valuation of an IR Swap

A
  • Initial swaps are worth close to 0
  • Changes in IR will result in one party benefiting and one paying the price
  • Actual valuation of IR swaps will NOT be on exam
41
Q

Eurodollar

A

deposits denominated in US dollars at banks outside of the US
- The Eurodollar market is the largest source of global finance

42
Q

Advantages of Eurodollar

A
  • Not under the jurisdiction of the Federal Reserve

- Deposits are subject to much less regulation than similar Deposits within the U.S (including Reserve requirements)

43
Q

Disadvantages of Eurodollar

A
  • Not covered by FDIC insurance
  • Political risk
  • Eurodollars have a higher interest rate
44
Q

Fixed for Fixed Currency Swaps

A
  • Exchanging principal and interest payments at a fixed rate in one currency for principal and interest payments at a fixed rate in another currency for a number of years.
  • Principal amount exchanged at the beginning and the end of swap
45
Q

Fixed for Fixed Currency Swaps - Typical Uses

A
  • Conversion from a liability in one currency to a liability in another currency
  • Conversion from an investment in one currency to an investment in another currency
  • COMPANY WANTS TO ALIGN CURRENCIES OF ASSTS AND LIABILITIES TO REMOVE ER RISK

Financial Engineering (1 decks)

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