Question practice Flashcards
Are finance charges relevant cash flows for investment appraisal
No
Simulation - advantages
Can change variables simultaneously
Gives more info about outcomes and relative prob
Useful for problems that can’t be reduced to mathematical solution
Simulation - disadvantages
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
Sensitivity analysis is
technique for assessing how risky a project is by considering how much factors could vary in adverse direction before non-viable
Advantages of sensitivity analysis
Gives feel for input factors that non outcome is sensitive to - may lead to reassessment.
Could take steps to feel more comfortable
Problems with sensitivity analysis
Only gives subjective signals that can be hard to interpret
difficult to assess relative sensitivities
rather ‘static’ only considers one variable at a time
Problems with expected value
Hard to give probabilities to each input factor
gives an average, hides information, would be good to understand all outcomes
What does FRA enable
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
How do interest rate futures work
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
Disadvantages of interest rate futures
Standardised in terms of size, duration and term
Advantages of interest rate futures
Can be traded so hedge can be released at any time if conditions change
What are futures price equal to
= 100 - rate
If interest rates rise, futures prices
Fall - to gain sell
How can interest rate guarantees/short term interest rate caps be used
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
How to calculate hedge efficiency
gain on futures/loss in portfolio
reasons for hedge inefficiency
basis risk
rounding of number of contracts to a whole number
If worry about portfolio falling when buy and sell futures
sell now
buy future at lower price if does fall
Why does basis risk arise
spot price of underlying asset is not perfectly correlated with the change in the futures price
Risks of interest rate swaps
- 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)
Advantages of futures
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(
Disadvantages of futures
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 $
