Lecture 8-9 Part 1

Question 1

Banks may deal with interest rate risk either by;

Answer 1

by reducing that risk through duration gap management or by transferring risk to another party.

Question 2

One common device used by individuals, non-financial

businesses and banks for transferring risk?

Answer 2

Buying insurance

Question 3

more commonly used method of transferring risk in

interest rate risk management?

Answer 3

the use of derivative

securities.

Question 4

Derivatives definition?

Answer 4

A financial asset that is primarily designed to manage a specific risk exposure.

Question 5

value of a derivative is based on?

Answer 5

The value is based on or is derived from underlying assets such as shares / share indices, bonds, currency and non financial products such as minerals, wool, wheat, live cattle, oranges, orange juice, electricity etc.

Question 6

Properties of derivatives?

Answer 6

– No intrinsic value by itself; Unlike shares

Question 7

Most common derivative commodities?

Answer 7

Commodities in Australia’s ASX (Australian Securities Exchange)
• Grain Futures and Options (ie, Wheat , Barley, Canola, Sorghum)
• Wool Futures and Options
• MLA/SFE Cattle Futures (Delisted in 2009)

Question 8

There are two derivative markets:

Answer 8

i. The privately traded OTC market dominated by
banks and large securities firms that custom-design
products for users.
ii. The organised exchanges that offer standardised
contracts and a clearing house for handling transactions.

Question 9

In Australia, the major banks are key participants in the derivative markets.
They are involved for three main reasons:

Answer 9

i. Banks use derivatives to hedge their own risks
ii. Banks act as market makers by running ‘books’ in
different derivatives
iii. Banks may seek to increase their returns through
speculation and arbitrage transactions in derivative
markets.

Question 10

Typically, banks engage trading in some derivative instruments
where the price / value of the contract is based on the value of some underlying assets, what are those assets?

Answer 10

either currency or interest rates

Question 11

Banks take a number of different approaches in derivatives?

Answer 11

• Take a forward position;
• Long / Short in futures;
• Take up an option which may or may not be exercised;
• Use a swap – where we start off with one set of inflows and outflows and exchange them for another.

Question 12

The financial instruments can be used as/to?

Answer 12

• as part of an investment strategy for the FI concerned;
• as part of service provided to a customer with the bank as one side of the contract and a customer on the other;
• to offset the impact on equity of changing interest rates;
• to offset declines in the value of one product by realising gains in another related product – hedging

Question 13

What is hedging?

Answer 13

offsetting price changes so that the impact of any price changes is minimised. If we can minimise the impact of unfavourable changes in value, we can minimise the impact on net profit.

Question 14

What is a Forward contract?

Answer 14

Forward contract is a contract between 2 parties to buy or sell
the underlying asset at a price agreed upon today for delivery
at an agreed date in the future.

Question 15

Characteristics of Forward Contracts:

Answer 15

• Price and delivery time are set in the contract;
• No money changes hands when the contract is initiated – may be an
admin fee ;
• At the date the contract is initiated, it has no value;
• They are OTC contracts as they are customized to meet the needs of the counterparties and involve counterparty risk

Question 16

What is a futures contract?

Answer 16

A futures contract is a standardised agreement to buy or sell a specified quantity of a financial instrument on a specified future date at a set price.
– Highly institutionalized form of forward contracting

Question 17

Characteristics of Futures;

Answer 17

• Standardised in size;
• Anonymous;
• Exchange-traded contracts, marked to market daily, with
protection against defaults provided by the exchange
i.e.
through the imposition of exchange-clearing margins.

Question 18

Who oversees future exchange?

Answer 18

Futures contracts are always traded on an exchange with purchase, sale
and delivery overseen by a clearing house.

Question 19

Important difference of Futures contracts from Forward contract: settlement risk?

Answer 19

Important difference from Forward contract: settlement risk.

Question 20

Futures margin requirements and settlement procedures:

Answer 20

• Deposit an initial margin to ensure enough money on hand to cover losses in events of adverse price changes
• Australian Clearing House (ACH) and ASX Clear (Futures) mark to market all open future positions and require members to settle all losses and gains on daily basis
• Brokers set maintenance margins pegged to the contract’s price volatility and maximum price change permitted by exchange

Question 21

Focus in BTP on what Futures and Options markets traded on ASX?

Answer 21

• 90 Day Australian Bank Accepted Bill Futures and Options*

* 3 Year and 10 Year Australian Treasury Bond Futures and Options*

Question 22

ASX’s Australian 3 and 10 Year Bond Futures and Options are the benchmark derivatives
products for the trading and hedging what?

Answer 22

medium to long-term AUD fixed interest securities and

interest rate swaps.

Question 23

3 and 10 year bond futures:
• Face Value ?
• Coupon rate?

Answer 23

• Face Value of A$100,000

* Coupon rate of 6% per annum

Question 24

What calculation do you use for the price/ value of a ASX 90 Day BAB/Bank Bills?

Answer 24

P= 1,000,000/ (1+(r x(90/365)))

Question 25

What calculation do you use for the price/ value of a ASX 10 Year Treasury Bond Futures (T-Bonds)?

Answer 25

P=1,000x[(c(1-v^20))/I)+100v^20]