Risk management Flashcards
Advantages and disadvantages of futures over forwards?
Advantages:
- Transaction costs of futures should be lower and they can be traded
- The exact date of receipt or payment of the does not need to be known because the futures contract does not have to be closed out until the underlying transaction takes place (subject only to the expiry date of the futures contract)
Disadvantages:
- The contracts cannot be tailored to the user’s exact requirements
- Hedge inefficiencies are caused by standard contract sizes and basis
- Only a limited number of currencies are available with futures contracts
- The procedure for converting between two currencies neither of which is the $ is more complex with futures compared to a forward contract
Three factors that affect the time value of options
The time period to expiry of the option. The longer the time to expiry, the more the option is worth.
The volatility of the market price of the shares. For example, if the share price becomes more volatile this will increase the probability of the options becoming either in the money or, if they are already in the money, becoming deeper in the money. This would increase the value of the options.
The general level of interest rates. The exercising of the option will be at some point in the future, and so the value of the option depends on the present value of the exercise price. For example, for the call options on shares if interest rates rise the options will become more valuable.
The two factors that affect intrinsic value
The exercise price:
For a call option: The lower the exercise price in relation to the share price the higher will be the intrinsic value and this will make the option more valuable.
For a put option: The higher the exercise price in relation to the share price the higher will be the intrinsic value and this will make the option more valuable.
The share price:
For a call option: As the share price rises the option becomes deeper in the money and more valuable as the intrinsic value increases. The reverse is the case for a fall in the share price.
For a put option: As the share price falls the option becomes deeper in the money and more valuable as the intrinsic value increases. The reverse is the case for a rise in the share price.
Advantages of options/futures
- the option to exercise or abandon
- options possible to calculate the maximum a company will have to pay
- traded in a liquid market, if not required can close out
Disadvantages of options/futures
- futures lock you in to a rate
- options come with a premium
- margin requirements, may have to meet margin calls
- not possible to construct perfect hedge with standardise contract sizes
Seven reasons a company might want to do an interest rate swap
(1) To obtain a lower rate of interest on its preferred type of debt by exploiting the quality spread differential between two counterparties
(2) To achieve a better match of assets and liabilities
(3) To access interest rate markets that might otherwise be closed to the firm (or only accessible at excessive cost)
(4) To hedge interest rate exposure by converting a floating rate commitment to a fixed rate commitment (or vice versa)
(5) To restructure the interest rate profile of existing debts (avoiding new loans/fees)
(6) To speculate on the future course of interest rates
(7) They are available for longer terms than other methods of hedging interest rate exposure
Risks of entering into a swap
- risk of default of the other counterparty
- unfavourable changes in market rate after entering swap
- risk that the impact of the swap is to undermine the clarity and transparency of the firm’s FS
How should a money market hedge be executed if you are receiving currency ($) in 3 months?
- Borrow $ today for 3 months at $ borrowing rate
- Sell the $ for £ today at spot rate
- Deposit your £ at today lending rate
How should a money market hedge be executed if you are paying currency ($) in 3 months?
- Deposit $ today for 3 months at $ deposit rate
- Sell the $ for £ today at spot rate
- Accrue interest at £ borrowing rate
Risks of trading abroad OTHER than currency risk
Government stability
Political and business ethics
Economic stability
Import restrictions
Remittance restrictions
Special taxes, regulations for foreign companies
Trading risks – physical risk, credit risk, liquidity risk etc
Intrinsic value of a call equation
share price - exercise price
Intrinsic value of put equation
exercise - share price
If the company is in its overdraft, what do you need to do to the premium?
Multiply it by the relevant borrowing rate as it’s assumed they borrowed it
Difference between future and FRA
(1) Involves standardisation as regards amount, terms and periods
(2) Involves contracts which are traded on exchanges
(3) Involves (usually) closing out the contract before maturity
(4) Involves the potential for basis risk
(5) Involves the potential for hedge inefficiency
(6) Involves a different mechanism for quoting prices
