Hedging

Question 0

WHAT IS A FORWARD?

Answer 0

Binding agreement to exchange a set amount of goods at a set price agreed today.

Question 1

WHAT ARE THE 3 TYPES OF FOREIGN CURRENCY RISK?

Answer 1

Transaction risk - risk of adverse exchange rate movements

Translation risk - risk that the organisation will make exchange losses when the accounting results of its foreign branches or subsidiaries are translated into home currency.

Economic risk - effect of exchange rate movements on the international competitiveness of a company

Question 2

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF FORWARDS?

Answer 2

ADVANTAGES

• both parties have certainty so are better enabled to budget
• eliminates risk completely
• no downside risk

DISADVANTAGES

• no upside potential
• risk re-exposed if transaction falls through

Question 3

WHAT IS A FUTURES?

Answer 3

A commitment to an additional transaction in the future that limits the risk of existing commitments.

Question 4

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF FUTURES?

Answer 4

ADVANTAGES

• eliminates risk completely
• no downside risk

DISADVANTAGES
- no upside potential
- can only be bought in standard contracts for set dates, perfect hedge may not be
achieved

Question 5

TO PROTECT AGAINST A PRICE RISE DO YOU BUY OR SELL FUTURES?

Answer 5

Buy

Question 6

TO PROTECT AGAINST A PRICE FALL DO YOU BUY OR SELL FUTURES?

Answer 6

Sell

Question 7

WHAT IS AN INDEX FUTURES AND DO YOU BUY/ SELL THEM?

Answer 7

They are used to protect against falls in values of portfolio shares.

You would sell future contracts today as we are protecting against a price fall.

Question 8

WHAT IS AN INDEX OPTION AND DO YOU BUY/ SELL THEM?

Answer 8

Used to protect against a fall in value of portfolio of shares.

You would sell put options today.

Question 9

HOW DO YOU CALCULATE THE CONTRACT SIZE OF AN INDEX OPTION?

Answer 9

Exercise price x £10

Question 10

HOW DO YOU CALCULATE THE CONTRACT NUMBER ON INDEX OPTIONS?

Answer 10

Current portfolio value / contract size

Question 11

HOW DO YOU CALCULATE THE PREMIUM ON AN INDEX OPTION?

Answer 11

Points (per table) x £10 x # contracts

Question 12

WHAT IS A CALL OPTION?

Answer 12

Buy shares

Question 13

WHAT IS A PUT OPTION?

Answer 13

Sell shares

Question 14

WOULD A BORROWER BUY OR SELL TODAY?

Answer 14

Sell today (put option)

Question 15

WOULD A LENDER BUY OR SELL TODAY?

Answer 15

Buy (call option)

Question 16

HOW DO YOU CALCULATE THE PROFIT OR LOSS ON A INTEREST RATE FUTURES?

Answer 16

Interest on loan (% x £ x months) (X)
Futures outcome:
Opening rate 100 - i
Closing rate 100 - i
# x contract size /4 x contract # X
__
Net effect X

Question 17

DO YOU ADD OR DEDUCT THE FOWARD RATE FROM THE SPOT RATE WHEN IT IS QUOTED AT A

1) PREMIUM
2) DISCOUNT

Answer 17

Premium = deduct
Discount = add

Question 18

WOULD AN EXPORTER BUY OR SELL FUTURES TODAY?

Answer 18

Sell futures

Question 19

WOULD AN IMPORTER BUY OR SELL FUTURES TODAY?

Answer 19

Buy futures

Question 20

FOR A MARKET HEDGE, WHAT WOULD YOU DO IF YOU WERE TO RECEIVE $ IN THE FUTURE?

Answer 20

Borrow $ and covert to £ = buy put options.

Pay $ interest and receive £ interest.

Question 21

FOR A MARKET HEDGE, WHAT WOULD YOU DO IF YOU WERE TO PAY $ IN THE FUTURE?

Answer 21

Borrow £ and covert to $ = buy call options.

Pay £ interest and receive $ interest.