Question practice

Question 1

Are finance charges relevant cash flows for investment appraisal

Answer 1

No

Question 2

Simulation - advantages

Answer 2

Can change variables simultaneously
Gives more info about outcomes and relative prob
Useful for problems that can’t be reduced to mathematical solution

Question 3

Simulation - disadvantages

Answer 3

Not a decision making technique, just gives info
Expensive and time consuming
Some depend on assumptions re probability distribution and relationships between variables that might be inappropriate
Difficult to implement in practice

Question 4

Sensitivity analysis is

Answer 4

technique for assessing how risky a project is by considering how much factors could vary in adverse direction before non-viable

Question 5

Advantages of sensitivity analysis

Answer 5

Gives feel for input factors that non outcome is sensitive to - may lead to reassessment.
Could take steps to feel more comfortable

Question 6

Problems with sensitivity analysis

Answer 6

Only gives subjective signals that can be hard to interpret
difficult to assess relative sensitivities
rather ‘static’ only considers one variable at a time

Question 7

Problems with expected value

Answer 7

Hard to give probabilities to each input factor
gives an average, hides information, would be good to understand all outcomes

Question 8

What does FRA enable

Answer 8

Company lock into interest rate
Independent of loan itself, prevailing rate paid on that
FRA results in cashflow from FRA offsetting higher/lower interest costs

Question 9

How do interest rate futures work

Answer 9

Lock into interest rate, but standardised in terms of size, duration and term and are tradable on exchanges
often closed before maturity with gain/loss offsetting higher/lower interest when borrowing

Question 10

Disadvantages of interest rate futures

Answer 10

Standardised in terms of size, duration and term

Question 11

Advantages of interest rate futures

Answer 11

Can be traded so hedge can be released at any time if conditions change

Question 12

What are futures price equal to

Answer 12

= 100 - rate

Question 13

If interest rates rise, futures prices

Answer 13

Fall - to gain sell

Question 14

How can interest rate guarantees/short term interest rate caps be used

Answer 14

Limit impact of adverse movement but benefit from favourable, give right, not obligation to deal at agreed interest rate at future date.
If rates rise, exercise option locking in rate, if fall let lapse and benefit from lower rate

Question 15

How to calculate hedge efficiency

Answer 15

gain on futures/loss in portfolio

Question 16

reasons for hedge inefficiency

Answer 16

basis risk
rounding of number of contracts to a whole number

Question 17

If worry about portfolio falling when buy and sell futures

Answer 17

sell now
buy future at lower price if does fall

Question 18

Why does basis risk arise

Answer 18

spot price of underlying asset is not perfectly correlated with the change in the futures price

Question 19

Risks of interest rate swaps

Answer 19

• counterpart may default before agreement is completed
• interest/exchange rates may move unfavourably
• Financial accounts may be misleading
• often longer term, FRA/Options are short term (<12m)

Question 20

Advantages of futures

Answer 20

Transaction costs are lower as they can be traded
exact date of payment/receipt doesn’t need to be known as they don’t have to be closed out until the underlying transaction takes place *subject to expiry(

Question 21

Disadvantages of futures

Answer 21

Contracts cannot be tailored to user’s exact requirements
hedge inefficiencies are caused by standard contract sizes and basis
only limited currencies available
more complex if neither of the currencies used is $