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Financial Derivatives > Forwards > Flashcards

Forwards Flashcards

1
Q

What is globalisation in financial markets?

A

Globalisation refers to worldwide markets and firms, creating new diversification opportunities for investors.

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2
Q

What innovations have become important in financial markets?

A

Privatisation, securitisation, and off-balance sheet funding have become more important.

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3
Q

What new technologies are impacting financial markets?

A

Computers, real-time digital data feeds, e-banking, and FinTech are significant new technologies.

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4
Q

What has been the impact of developments in financial markets over the last 20 years?

A

Developments have led to unprecedented growth in most economies but have also resulted in more unstable growth.

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5
Q

What recent financial crises have occurred?

A

Recent crises include Mexico and Latin America (1995), the dot-com bubble (2000), and Argentina (2002).

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6
Q

What vulnerabilities do financial institutions face?

A

Financial institutions become particularly vulnerable to highly leveraged firms, high concentration of risks, and high dependency on information technology.

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7
Q

What is credit risk?

A

Credit risk is the risk of loss due to the failure of a counterparty or issuer to meet its obligations.

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8
Q

What is market risk?

A

Market risk is the risk of loss due to adverse movements in exchange rates, interest rates, equity, or commodity prices.

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9
Q

What is liquidity risk?

A

Liquidity risk is the risk of loss because markets are insufficiently liquid to realize an asset or secure new funding at a normal price.

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10
Q

What is operational risk?

A

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, systems, or from external events.

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11
Q

What is business risk?

A

Business risk is the risk of loss resulting from underperformance.

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12
Q

What is a derivative?

A

A derivative is an instrument whose price is derived from the price of an underlying asset or from an underlying index.

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13
Q

What are the advantages of financial derivatives?

A

Advantages include low transaction costs, high leverage, price quality, rapid execution, coverage of many risk factors, and separation of risks.

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14
Q

What are the main instruments in the OTC market?

A

Interest rate forwards, swaps, and options dominate the OTC market, followed by FX instruments.

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15
Q

What are the categories of derivatives?

A

Type 1: Both parties have fixed obligations (forwards, futures, swaps). Type 2: Only the writer has an obligation (options).

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16
Q

What are exchanged traded derivatives?

A

Exchanged traded derivatives are traded on organized exchanges with standardized terms and conditions, minimal counterparty risk due to margin provisions.

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17
Q

What are OTC derivatives?

A

OTC derivatives are private contracts between two parties without any clearing house involvement, posing potential counterparty risk.

18
Q

What is pure hedging?

A

Pure hedging is a financial strategy aimed at reducing risks in a firm using offsetting financial instruments while avoiding new risks.

19
Q

What are the advantages of derivatives for hedging?

A

Advantages include efficiency, leverage, price quality, rapid execution, and low transaction costs.

20
Q

What are the fundamental reasons for using derivatives in hedging?

A

Derivatives cover many risk factors, allow tailoring and debundling, and provide greater flexibility in risk management.

21
Q

What are the risks associated with hedging?

A
  1. The underlying of the hedging instrument is not an exact match of the asset held. 2. The maturity of the hedging instrument is not exactly the same as the desired maturity.
22
Q

What is a rate of exchange?

A

The price of one currency in terms of another.

23
Q

How is the rate of exchange expressed?

A

As the number of units of the underlying currency that are equal to one unit of the base currency.

24
Q

What does a spot transaction involve?

A

The immediate purchase or sale of currencies.

25
Q

How does a spot transaction differ from a forward transaction?

A

A forward transaction involves delivery of currencies at a certain date in the future.

26
Q

How do you convert a known amount of the underlying currency to the base currency using the rate of exchange?

A

Divide the underlying currency amount by the rate quoted.

27
Q

What are fixed rates in foreign exchange?

A

Rates that remain constant for a specified period.

28
Q

What are bid-ask quotes?

A

The prices at which a trader can buy (ask) or sell (bid) a currency.

29
Q

What is a forward contract?

A

An obligation to trade in an asset at a pre-determined price at a pre-determined date.

30
Q

When is payment made in a forward contract?

A

At delivery, with foreign exchange delivery typically after two days.

31
Q

Where do forward transactions take place?

A

In OTC markets, directly between two counterparties.

32
Q

What is the common duration for forward contracts?

A

Periods between one and 12 months are most common, but can cover up to 10 years.

33
Q

What is a forward premium/discount?

A

The difference between the forward rate and the spot rate.

34
Q

What are the two choices for companies with future foreign currency transactions?

A
  1. Wait until the settlement date and fulfill the transaction at the prevailing spot rate. 2. Arrange a forward contract to hedge the foreign currency value.
35
Q

What is arbitrage?

A

The simultaneous buying and selling of securities, currency, or commodities in different markets to take advantage of differing prices for the same asset.

36
Q

What does the law of one price imply in financial markets?

A

In an efficiently functioning market, arbitrage opportunities should not exist.

37
Q

What are holding costs?

A

Cash outflows by holding an asset, including financing, storage, insurance, spoilage, and transportation costs.

38
Q

What are holding benefits?

A

Cash inflows by holding an asset, such as dividends, coupon payments, and convenience yield.

39
Q

What does covered interest rate parity imply?

A

The relationship between interest rates and forward exchange rates.

40
Q

What does forward rate bias suggest?

A

Currencies with high interest rates may appreciate, contrary to the interest rate parity theory.

41
Q

What is a currency carry trade?

A

A strategy involving borrowing at a low interest rate in one currency and investing in a higher-yielding asset in another.

Financial Derivatives (8 decks)

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