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FM > Interest Rate and Other Financial Risk > Flashcards

Interest Rate and Other Financial Risk Flashcards

1
Q

What is a forward?

A

Binding agreement to buy or sell (borrow or lend) something in the future at a price agreed today.

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2
Q

What is a future?

A

Forward contracts that have been standardised. The contract is separate from the transaction so can be traded easily. A deposit is made to cover potential losses (“initial margin”)

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3
Q

7 steps to hedging?

A

1) Buying or selling?
2) Date?
3) No. of contracts.
4) Go to transaction date and write down the underlying transaction.
5) Calculate the gain/loss on futures contract.
7) Net cost.

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4
Q

What is a 5-8 FRA?

A

An FRA on a notional 3 month loan/deposit starting in 5 months time.

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5
Q

What is an FRA priced at 3.2-2.6?

A

Fixes the borrowing cost at 3.2% or investment return at 2.6%.

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6
Q

How would you fix the interest received on a deposit? (FRA)

A

Selling an FRA.

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7
Q

How would you fix the interest paid on a loan? (FRA)

A

Buying an FRA.

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8
Q

How is an interest rate future quoted?

A

100-the expected market reference rate.

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9
Q

How would you fix the interest paid on a loan? (IRF)

A

Selling a futures contract.

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10
Q

How would you fix the interest received on a deposit? (IRF)

A

Buying a futures contract.

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11
Q

What is a negotiated option?

A

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, even if underlying transaction falls through. BETTER BUT MORE EXPENSIVE.

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12
Q

What is a traded option?

A

The right but not the obligation to buy (call) or sell (put) a futures contract. Therefore a profit on the future can be realised but a loss can be avoided by letting the option lapse. A premium is payable regardless.

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13
Q

A pro and a con of standardised products?

A

+ Generally cheaper.

- Can only be bought in standard expiry dates and sizes so hard to get perfect hedge.

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14
Q

What are the two parts of an FRA transaction?

A

1) Borrowing/Investing is carried out on the open market at the prevailing rate.
2) The FRA results in either a payment from the bank or a payment to the bank, depending on the buy/sell prices.

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15
Q

How do you pick an expiry date for interest rate hedging?

A

Pick the first date after the borrowing/lending starts.

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16
Q

What is the formula for the No. of contracts when hedging interest rates?

A

(Amount Borrowed/Size of Contract) x (Period of Borrowing/3 Months)

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17
Q

How do you calculate the profit or loss of a future?

A

% Change x Contract Size x 3/12 (for a 3 month future) x Number of Contracts

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18
Q

How do you calculate the option premium? (IRF)

A

% x Contract Size x 3/12 (for a 3 month option expiry) x Number of Contracts

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19
Q

When would an interest rate swaps be applicable?

A

A business wants to borrow at a fixed rate, but gets a relatively better rate on a variable loan (or vice versa).

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20
Q

What are the three steps for a interest rate swap?

A

1) Borrow at the preferred favorable 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.

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21
Q

If you are concerned about a portfolio of shares falling what should you do? (Futures and Options)

A

Sell futures contracts.

Buy put options.

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22
Q

How do you pick an expiry date for index hedging?

A

The first date after they need to sell.

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23
Q

What is the formula for the No. of contracts when hedging indexs?

A

Value of the Portfolio/(£10 x Futures Price/Strike Price)

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24
Q

How do you calculate the profit or loss on an index future?

A

Points x £10 x No. of Contracts

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25
Q

How do you calculate the profit or loss on an index option?

A

Points x £10 x No. of Contracts

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26
Q

What is an American Style option?

A

Can be exercised at any point until the expiry date.

27
Q

What is an European Style option?

A

Can be exercised only on the expiry date.

28
Q

What does “In the money” mean?

A

Exercising today would give a profit.

29
Q

What does “Out of the money” mean?

A

Exercising today would give a loss.

30
Q

What does “Intrinsic value” mean?

A

The profit (ignoring the premium) that would arise by exercising today. “Out of the money” options have an intrinsic value of 0.

31
Q

What option should you buy if you’re hedging borrowing/fx payment?

A

Puts.

32
Q

What option should you buy if you’re hedging depositing/fx receipt?

A

Calls.

33
Q

What should you do with futures contracts if you’re hedging borrowing/fx payment?

A

Sell them.

34
Q

What should you do with futures contracts if you’re hedging depositing/fx receipt?

A

Buy them.

35
Q

How do you calculate the number of index options contracts required?

A

(Portfolio Value)/(Strike Price x £10)

36
Q

How would you lay out the answer to an “advise the board on whether to hedge” question? 2 parts.

A
  1. Lay out all the different scenarios in a table (including “do nothing”).
  2. Wordy answer referring to the calculations. (Weak £ is good for exporter, what does the forward premium/discount suggest, staff time/costs involved in hedging).
37
Q

2 advantages of using futures contracts as opposed to forward contracts when hedging foreign currency exposure.

A

+Transaction costs of futures should be lower and they can be traded.
+The exact date of receipt or payment of the foreign currency does not need to be known because the futures contract does not have to be closed out until the underlying transaction takes place (subject only to the expiry date of the futures contract).

38
Q

4 disadvantages of using futures contracts as opposed to forward contracts when hedging foreign currency exposure.

A
  • The contracts cannot be tailored to the user’s exact requirements.
  • Hedge inefficiencies are caused by standard contract sizes and basis.
  • Only a limited number of currencies are available with futures contracts.
  • The procedure for converting between two currencies neither of which is the $ is more complex with futures compared to a forward contract.
39
Q

What are the two key problems with using cryptocurrency to settle international transactions?

A
  1. Exchangeability. Bitcoins are only exchangable for a narrow range of currencies e.g. GBP, USD, EUR. Less of an issue for a UK company.
  2. Price volatility. Cryptocurrency exchange rates are extremely volatile. Can hedge against this with a forward but the rate quoted may be unattractive.
40
Q

What is the impact on the value of a call option if the market price increases?

A

Up.

41
Q

What is the impact on the value of a put if the market price increases?

A

Down.

42
Q

What is the impact on the value of a call if the exercise price increases?

A

Down.

43
Q

What is the impact on the value of a put if the exercise price increases?

A

Up.

44
Q

What is the impact on the value of a call if the time to expiry increases?

A

Up.

45
Q

What is the impact on the value of a call if the volatility increases?

A

Up.

46
Q

What is the impact on the value of a call if the interest rate increases?

A

Up.

47
Q

What is the impact on the value of a put if the volatility increases?

A

Up

48
Q

What is the impact on the value of a put if the time to expiry increases?

A

Up.

49
Q

What is the impact on the value of a put if the interest rate increases?

A

Down.

50
Q

A benefit of an option?

A

Allows you to exploit upside potential and protect downside risk.

51
Q

5 advantages of an interest rate swap?

A
  1. Arrangement costs are significantly cheaper than terminating an existing loan and taking out a new one.
  2. Interest savings are possible.
  3. Available for longer periods where hedging won’t work.
  4. Makes it possible to obtain the preferred “type” of interest rate (fixed or floating).
  5. Swapping to a fixed improves cash flow planning.
52
Q

How do you calculate the intrinsic value of an option?

A

Difference between the current share price and the exercise. If they’re out of the money then they have an intrinsic value of 0.

53
Q

How do you calculate the time value of an option?

A

Deduct the intrinsic value from the premium.

54
Q

3 factors that affect the time value of an option…

A
  1. Time to expiry.
  2. Volatility.
  3. Interest rate.
55
Q

2 factors that affect the intrinsic value of an option…

A
  1. Market price.

2. Exercise price.

56
Q

If the option premium is 2.2% instead of 2.2% pa how do you calculate the premium?

A

Just 2.2%*the total amount. (Don’t pro-rate)

57
Q

1 pro and 2 cons of a currency Forward?

A

+Tailored specifically.

  • No secondary market if the transaction falls through.
  • No upside potential.
58
Q

1 disadvantage of a money market hedge?

A

May use up credit lines.

59
Q

1 pro and 3 cons of currency Futures?

A

+Secondary market if the transaction falls through.

  • Standard contract sizes so no perfect hedge.
  • Basis risk.
  • Margin requires (possibly further liquidity if margin calls are made)
60
Q

2 cons of OTC currency options?

A
  • No secondary market.

- Expensive initially.

61
Q

When evaluating interest rate hedging options, what is a good figure to quote?

A

The amount interest rates would need to rise or fall to be worth the hedge.

62
Q

When laying out a MMH answer what should you put to the left of the currencies?

A

Whether you’re borrowing or investing it.

63
Q

If you have time on a hedging question what should you always do?

A

Explain the steps with a little narrative.

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