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International Finance And Capital Markets > Risk Management > Flashcards

Risk Management Flashcards

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1
Q

what is a futures contract

A

a futures contract is an agreement that requires a party to buy or sell something at a designated future date at a predetermined price

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2
Q

how does marking-to-market work?

A
  1. Initial margin is marked to market at the close of trading on each subsequent day

For an investor in a long position FP^, the investor makes a gain and vice versa

  1. If the balance falls below the maintenance margin, the investor receives a margin call and is expected to top up the account to the initial margin level the next day
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3
Q

What happens in a futures contract when the FP goes up in a long positions

A

buyer makes a gain

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4
Q

What happens in a futures contract when the FP goes up in a short position

A

Seller makes a loss

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5
Q

What is the spot price

A

market price of the underlying asset

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6
Q

What is the futures price

A

the delivery price that the futures price is currently at

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7
Q

whats the difference between futures and spot price now and in the future

A

when the futures contract is entered in the futures price and spot price is different

when the delivery period is reached the futures price and spot price are the same

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8
Q

what is a forward contract

A

a forward contract is an agreement reached by two parties to undertake an exchange at a certain time in the future for a certain price

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9
Q

Difference between forward and futures

who are the parties involved

A

Any two market participants ( hedgers, speculators, arbitrageurs)

Market participants vs futures exchange

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10
Q

Difference between forward and futures

The flexibility of the contract

A

Tailor made contract (more flexible)

Exchange bases contract ( less flexible)

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11
Q

Difference between forward and futures

Liquidity of the contract

A

Less liquid

More liquid

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12
Q

Difference between forward and futures

Marking to market

A

not required

Required on a daily basis

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13
Q

Difference between forward and futures

Cashflow

A

No CF during the life of the contract

Required on a daily basis

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14
Q

Difference between forward and futures

Credit risk

A

Higher risk

Lower risk

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15
Q

What are the assumptions when determining forward prices

A
  1. No transactions costs
  2. Taxation impact not considered
  3. Borrowing rate = lending rate = riskfree interest rate
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16
Q

Determine forward Price

What do you do if the forward price is greater at M0

A
  1. Enter into a forward contract to sell the stock for … 0
  2. Buy one stock for Stock price -
  3. Borrow that price at 5% for 3 months +
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17
Q

Determine forward Price

What do you do if the forward price is greater at M3

A
  1. Sell the stock +
    2, Repay loan and interest -

Calculate net CF

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18
Q

Determine forward Price

What do you do if the forward price is less at M0

A
  1. Enter into a forward contract to buy the stock at …. 0
  2. Short sell one stock for .. +
  3. Invest … for 3 months -
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19
Q

Determine forward Price

What do you do if the forward price is less at M3

A
  1. Receive investment +
  2. Buy the stock at and close the short position -

Calculate net CF

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20
Q

What are 2 concerns when determining futures prices

A
  1. CFs of futures contracts resulting from marking to market practice on a daily basis
  2. Futures contracts are more liquids than forward contracts
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21
Q

What are hedging strategies fro using futures

A

Long hedging

Short Hedging

22
Q

What is short hedging

A

A short position in the futures contract

When a hedger already owns an asset and expects to sell it in the future

When an asset is not owned right now but will be owned in the future

23
Q

What is long hedging

A

A long position in the futures contract

When a hedger knows it will purchase an asset in the future and wants to lock in a price now

24
Q

Why does short hedging work when an investor owns an asset and expects to sell it in the future

A

When the market price goes down, short hedging eliminates the risk due to the loss made in the commodity market being offset by the gain realised in the futures market and vice versa

25
Q

why is long hedging the right strategy for an investor who wishes to purchase an asset in the future and wants to lock in the price now

A

When the market goes up, long hedging eliminates the risk due to the loss made in the commodity market being offset by the gain realised in the futures market

26
Q

in reality, can we always find the asset whose price is being used for hedging purpose perfectly matches the asset whose price is being hedged

A

NO - cross hedging occurs when the asset whose price is being hedged is different from the asset underlying the futures

27
Q

In reality, is the size of the asset used for hedging purpose always the same as that asset whose price is being hedged

A

NO - Hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure

28
Q

In reality, is 1 always the optimal hedge ratio

A

No, Setting the hedge ratio equal to 1 is not always optimal, especially when cross hedging is being used

29
Q

Between unique risk and market risk which is reduced by diversification and hedging

A

Unique risk = Diversification

Market risk = Hedging

30
Q

what is a commodity future

A

oil, sugar coffee

31
Q

what are financial futures

A

Stock index futures = FTSE 100
Interest Rate Futures = Bonds
Currency Futures = Exchange rate

32
Q

What hedging strategy should be used for a equity portfolio

A

Short Hedge

Short stock index futures right now and to close the position at a later date

33
Q

What should investors do to reduce the portfolio beta

A

Take a short position

34
Q

What should investors do to increase the portfolio beta

A

Take a long position

35
Q

What is an option

A

An option is a contract giving one party the right, but not the obligation, to buy or sell a financial instrument, commodity or some other underlying asset at a given price on or before a specified date

36
Q

What is the difference between a european option and an american option

A

european option can only be exercised on the expiration date

American options can be exercised at any time up to the expiration date

37
Q

What does a long position give the purchaser

A

the right not an obligation

38
Q

What does a short position give the seller(writer)

A

an obligation not a right

39
Q

What are the general principles for the one step binomial model

A
  1. In the finance world there is no arbitrage opportunity
  2. To setup a riskless portfolio consisting of stocks and options
  3. ER(P) = Risk-free interest rate
  4. To work out the cost of setting up the portfolio and option price
40
Q

What are the steps to value a call option using one step binomial model

A
  1. Draw binomial tree according to the information
  2. Set up a riskless portfolio
  3. work out the present value of the portfolio and the cost of setting up a portfolio
  4. to work out the present value(price) of the option (f)
41
Q

What does the one step binomial suggest about a european call

A

the value of a european call option is the present value of the expected value of the option discounted at the risk-free interest rate

42
Q

What are the assumptions for the risk-neutral valuation

A
  1. Theoretically, to value options under the assumption that the finance world is risk neutral
  2. Practically, p refers to the probability of the price going up in the risk-neutral world if defined as (e^rT - d)/( u-d)
43
Q

what steps should you follow to value a european call in a risk-neutral valuation

A
  1. Work out the probability of the stock price going up in a risk neutral world
  2. To work out the value of the option at M3
  3. To work out the value of the option by discounting the expected value at the risk free interest rate
44
Q

What steps should you follow to value a european call using the two-step binomial tree

A
  1. To work out the value of the option at the maturity date
  2. To value the option at Node B
  3. To value the option at Node C
  4. To value the option at Node A
45
Q

What steps should you follow to value a european PUT using the two-step binomial tree

A
  1. To work out the value of the option at the maturity date
  2. To value the option at Node B
  3. To value the option at Node C
  4. To value the option at Node A
46
Q

What are the assumptions for BSM

A
  1. Stock price behaviour corresponds to the lognormal model with u and sigma? constant
  2. There are no transaction costs or taxes. All securities are perfectly divisible
  3. there are no dividends on the stock during the life of the option
  4. there are no riskless arbitrage opportunities
  5. security trading is continuous
  6. investors can borrow or lend at the same risk free rate of interest
  7. the short term risk free rate of interest, r is constant
47
Q

When applying BSM to value european option when S is small relative to K

A

S is very small relative to K

  1. D1 and D2 become negatively large
  2. N(d1) and N(d2) are close to 0
  3. Call price is close to 0
  4. Probability that the call will mature in the money St>K is small
  5. unlikely the call will be exercised

N(d1) and N(d2) represent the probability that the call option will expire in the money

48
Q

When applying BSM to value european option when S exceeds K by a large amount

A
  1. D1 and D2 become very large
  2. N(d1) and N(d2) are close to 1
  3. Call price is close to s0-Ke^-rt
  4. Probability that the call will mature in the money St>K is large
  5. Highly likely the call will be exercised

N(d1) and N(d2) represent the probability that the call option will expire in the money

49
Q

What is the european call option value

A

stock price minus the present value of the stock price, adjusted for the probability that the stock price will exceed the strike price when the option expires

50
Q

What is a riskless portfolio

A
  1. A long position in Triangle shares of stock

2. A short position in one call option

51
Q

What is option delta

A

option delta = number of shares needed for each call to set up a riskless portfolio

Change in call price/Change in stock price

International Finance And Capital Markets (4 decks)

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