Managing Financial Risk (green)

Question 0

WHAT IS FUTURES?

Answer 0

Futures is just a forwards which has been standardised (in terms of delivery dates and amounts).

The contract which guarantees the price (known as the futures contract) is separate from the transaction itself allowing the contracts to be easily traded.

To protect against a price rise, a business will buy the future today and sell it at the expiry date (when the price is the same as the spot rate).

To protect against a fall in prices, a business will sell the future today and buy it back at the expiry date (when the price will be the same as the spot price).

Question 1

WHAT IS FORWARDS?

Answer 1

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

Tailor made agreement between two parties for any amount at any time.

Can be awkward to cancel if the need arises.

Question 2

WHAT IS AN OPTION?

Answer 2

An option gives the right but not the obligation to by or sell (or lend or borrow) a specific quantity of an item at a predetermined price (the exercise price) with a stated period (American style) or a fixed date (European style).

Options can therefore be:

• exercised if exercise price is better than the spot rate
• abandoned is if exercise price is worse than the spot rate

In order to be given the option, the buyer pays a fee (known as as option premium) to the writer of the option.

Question 3

WHAT IS A CALL OPTION?

Answer 3

An option to buy something (or to lend money).

Question 4

WHAT IS A PUT OPTION?

Answer 4

An option to sell something (or to borrow money).

Question 5

WHAT IS A TRADED OPTION?

Answer 5

It is similar to a forwards contract (it is tailor made) but it has the option to exercise or abandon.

Question 6

FORWARD/ FUTURES VS. OPTIONS

Answer 6

FORWARD/ FUTURE
- eliminates risk completely
- no downside risk but no upside potential
- if the underlying transaction falls through, business re-
exposed to risk

OPTION

• downside risk eliminated
• upside potential retained
• if underlying transaction falls through there is still no risk
• more expensive

Question 7

OTC VS. STANDARDISED PRODUCTS

Answer 7

OTC

• can be for any amount at any date
• tends to be more expensive unless for large amounts

STANDARDISED

• only set dates and amounts, may not provide a perfect hedge
• can be closed out easily if underlying transaction falls through

Question 8

IN WHAT 5 WAYS CAN INTEREST RATE RISK BE MANAGED?

Answer 8

1) pooling of assets as liabilities - risk may be netted off
2) forward rate agreements (FRA)
3) interest rate futures
4) interest rate options
5) interest rate swaps

Question 9

WHAT IS A FORWARD RATE AGREEMENT (FRA)?

Answer 9

A commitment to an interest rate on a future loan.

Like a forward it is a tailor made product. However, like a future, the contract which guarantees the interest is separate from the transaction.

Question 10

WHAT IS AN INTEREST RATE FUTURES (IRF)?

Answer 10

Very similar to FRAs but are for standardised amounts on predetermined dates.

Question 11

WHAT IS AN INTEREST RATE OPTION?

Answer 11

Gives the buyer the right but not the obligation to borrow/ lend at an agreed interest rate at a future date.

OVER THE COUNTER INTEREST RATE OPTIONS
Tailor made agreements between two parties that give the party buying the option the right to borrow/ lend at a fixed rate.

TRADED INTEREST RATE OPTIONS
These are options on interest rate futures. They give the holder the option to buy or sell one futures contracts on or before the expiry of the option at a specific price (known as the strike price). The strike price closest to the spit rate should be used unless told otherwise.

Question 12

WHY MIGHT WE HAVE AN IMPERFECT HEDGE?

Answer 12

1) Rounding number of contracts
Must be rounded to nearest whole number, meaning an element of risk still
remains

2) Closing out before the expiry date
The futures price may not exactly match the spot rate at the date it is closed
out. The difference (known as the basis risk) will make the hedge imperfect.

Question 13

WHAT IS A BASIC SWAP (PLAIN VANILLA)?

Answer 13

An agreement whereby two parties agree to swap a floating stream of interest payments for a fixed stream of interest payments and vice versa.

The companies involved are termed ‘counter parties’.

Question 14

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF A SWAP?

Answer 14

ADVANTAGES
- used to hedge against an adverse movement in interest rates
- used to obtain cheaper finance
- swaps can run for up to 30 years ( preferable to futures in the
long term)
- costs involved in a swap are less than costs involved in
refinancing

DISADVANTAGES
- counter party risk (risk the counter party will default)
- market risk (the risk of an adverse movement in interest or
exchange rates
- transparency risk (risk that accounts may be misleading)

Question 15

WHAT IS AN INDEX FUTURES?

Answer 15

A futures contract whose value depends on the FTSE 100 index.

Regardless of what happens on the FTSE 100 the company receives a guaranteed value for its portfolio.

Question 16

WHAT IS AN INDEX OPTION?

Answer 16

An option to buy (call) or sell (put) a notional portfolio of shares whose value mirrors the FTSE Index.

Question 17

WHAT IS TRANSACTION RISK?

Answer 17

The risk that an exchange rate will change between now and grew subsequent settlement date.

It arises primarily on imports and exports.

Question 18

WHAT IS ECONOMIC RISK?

Answer 18

The variation in the value if the business (i.e the present value of future cash flows) die to unexpected changes in exchange rates.

It is the long term effect of transaction risk.

Question 19

IN WHAT 4 WAYS CAN TRANSACTION RISK BE MANAGED?

Answer 19

1) Invoice in home currency
Insist all customers pay up you in your home currency and pay for all imports in
home currency.

2) Leading and lagging
If exporter expects currency to depreciate over next few months, must try to
obtain payment immediately. If importer expects currency to depreciate obverse
next few months, should try to delay payment. (Thus is technically not hedging,
just speculation).

3) Matching
If a company has receipts and payments on the same foreign currency due at the
same time they can simply match them against each other.

4) Foreign currency bank accounts

Question 20

WHAT ARE THE TWO REASONS FOR INTEREST RATE FLUCTUATIONS?

Answer 20

1) Spot rates, forward rates and interest rate parity theory (IRPT)
Claims that the difference between the spit rate and the future
exchange rate is equal to the difference between interest rates
available in the two currencies.

2) Purchasing Power Parity (PPP)
Claims that the rate if exchange between two currencies depends
on the relative inflation rates within the respective countries. PPP is
base on ‘The Law of One Price’:
- in equilibrium, identical goods must cost the same regardless of
the currency in which they are sold
- the country with the higher rate of inflation will be subject to a
depreciation of its currency