Module 8: Market And Credit Risk Management Flashcards
What is a financial instrument?
A financial instrument is a contract that gives rise to a financial asset for one party to the contract and
a financial liability or equity instrument for the other party (the counterparty).
-Primary financial instruments include things such as shares, bonds, currencies and interest rates. These instruments are defined as primary by the fact that they have an associated, measurable value.
-Secondary financial instruments often referred to as derivatives, are financial instruments whose
value is derived from an underlying asset. Examples include futures, forward contracts, options and
warrants.
What is debt factoring?
Debt factoring is an arrangement to have debts collected by a factor company, which advances a
proportion of the money it is due to collect.
Explain what a currency futures contract is?
Currency futures are standardised contracts for the sale or purchase at a set future date of a set
quantity of currency.A currency future is essentially a standardised, market-traded forward exchange contract.
A future represents a commitment to an additional transaction in the future that limits the risk of
existing commitments. Currency futures are not nearly as common as forward contracts, and their
market is much smaller.
Advantages of futures to manage risks
Transaction costs should be lower than other methods.
Futures are tradeable and can be bought and sold on a secondary market so there is pricing
transparency, unlike forward contracts where prices are set by individual financial institutions.
The exact date of receipt or payment of the currency does not have to be known, because the
futures contract does not have to be closed out until the actual cash receipt or payment is made.
Disadvantages of futures
The contracts are in standard sizes and cannot be tailored to the user’s exact requirements.
Only a limited number of currencies are the subject of futures contracts (although the number of
currencies is growing, especially with the rapid development of Asian economies).
Unlike options (see below), they do not allow a company to take advantage of favourable currency
movements.
How can matching and smoothing manage interest rate risk?
Matching is where liabilities and assets with a common interest rate are matched. For example subsidiary A of a company might be investing in the money markets at LIBOR and subsidiary B is borrowing through the same market at LIBOR. If LIBOR increases, subsidiary B’s
borrowing cost increases and subsidiary A’s returns increase. The interest rates on the assets and
liabilities are therefore matched.
This method is most widely used by financial institutions such as banks, who find it easier to match the
sizes and characteristics of their assets and liabilities than commercial or industrial companies.
Smoothing is where a company keeps a balance between its fixed rate and floating rate borrowing. A rise in interest rates will make a floating rate loan more expensive but this will be compensated for
by the less expensive fixed rate loan. The company may however incur increased transaction and
arrangement costs.
What is arbitrage?
Arbitrage is the process of buying an instrument in one market and selling it either instantly or over a
very short time horizon on another market, exploiting differences in the price to make a profit.Theoretically, the price of an instrument should be identical whichever market it is traded in. In reality,
however, even with the development of multi-national and global trading this is not always the case.
Therefore arbitrage can be and is a major use of derivatives.
What is a forward contract?
A forward contract, like a future, is a binding promise to purchase or sell a set amount or value of an
underlying asset at a set future time. Unlike a future, forwards are not traded; they are bespoke
contracts between two parties.
What is money market hedging?
Money market hedging involves borrowing in one currency, converting the money borrowed into another currency and putting the money on deposit until the time the transaction is completed,
hoping to take advantage of favourable exchange rate movements.
What are warrants? Call and put warrants?
Warrants are financial instruments issued by banks, governments and other institutions, which are
traded on the ASX. Warrants may be issued over securities (such as shares), a basket of different
securities, a share price index, debt, currencies, or commodities.
A call warrant gives the warrant holder the right to buy the underlying asset from the warrant issuer.
A put warrant gives the warrant holder the right to sell the underlying asset to the issuer.
