Hedging

Question 1

Forward (interest rates)

Answer 1

A binding obligation to buy or sell something at a point in the future but at a fixed price today. Avoids downside risk, but no possibility of upside potential.

Question 2

Future (interest rates)

Answer 2

A contract whose value varies with an underlying product. This is a standardised product.

Question 3

Negotiated option

Answer 3

The right but not the obligation to buy or sell something at a point in the future at a price fixed today. No downside risk but still retains upside potential.

Question 4

Traded option

Answer 4

The right but not the obligation to buy (call) or sell (put) a futures contract. A premium is payable regardless of whether the option is exercised.

Question 5

FRA’s

Answer 5

A borrower will buy a FRA and a lender will sell a FRA

Question 6

Borrowing (futures)

Answer 6

Sell future contracts

Question 7

Depositing (futures)

Answer 7

Buy futures contracts

Question 8

Borrowing (options)

Answer 8

Buy Put options

Question 9

Depositing (options)

Answer 9

Buy Call options

Question 10

What to do with interest rate swaps

Answer 10

1) Borrow at the unpreferred favourable rate. 2) Swap payments with a counterparty who wants variable but has borrowed at a fixed rate. 3) The amount of the payments ensures that the benefit of the reduced interest rates is split between the two parties.

Question 11

Share options - Call option

Answer 11

the option to buy the shares later

Question 12

Share options - Put option

Answer 12

The option to sell shares later

Question 13

Share options - In the money

Answer 13

Exercising today would give a profit

Question 14

Share options - Out of the money

Answer 14

Exercising today would give a loss

Question 15

Share options - Intrinsic value

Answer 15

The profit that would arise by exercising today.

Question 16

Share options - Time value

Answer 16

Calculated by taking the intrinsic values from the option premium..

Question 17

Transaction risk

Answer 17

Where a transaction is to be settled in a foreign currency, the risk that the exchange rate will change between the date of contract and the date of settlement of the fund.

Question 18

Economic risk

Answer 18

The risk that the values of the business will be affected by long run changes in exchange rates

Question 19

Translation risk

Answer 19

The risk that reported performance will be affected by exchange rate movements.

Question 20

Currency hedging - Futures and traded options

Answer 20

If it is a purchase need to sell futures today or BUY PUT options. If it is a receipt need to BUY futures today and BUY call options

Question 21

Interest rate parity theory

Answer 21

Exchange rates move to compensate for differences in interest rates.

Question 22

Purchasing Power Parity Theory

Answer 22

Exchange rates move to compensate for differences in inflation rates.