Risk Management Flashcards
what is a futures contract
a futures contract is an agreement that requires a party to buy or sell something at a designated future date at a predetermined price
how does marking-to-market work?
- 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
- 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
What happens in a futures contract when the FP goes up in a long positions
buyer makes a gain
What happens in a futures contract when the FP goes up in a short position
Seller makes a loss
What is the spot price
market price of the underlying asset
What is the futures price
the delivery price that the futures price is currently at
whats the difference between futures and spot price now and in the future
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
what is a forward contract
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
Difference between forward and futures
who are the parties involved
Any two market participants ( hedgers, speculators, arbitrageurs)
Market participants vs futures exchange
Difference between forward and futures
The flexibility of the contract
Tailor made contract (more flexible)
Exchange bases contract ( less flexible)
Difference between forward and futures
Liquidity of the contract
Less liquid
More liquid
Difference between forward and futures
Marking to market
not required
Required on a daily basis
Difference between forward and futures
Cashflow
No CF during the life of the contract
Required on a daily basis
Difference between forward and futures
Credit risk
Higher risk
Lower risk
What are the assumptions when determining forward prices
- No transactions costs
- Taxation impact not considered
- Borrowing rate = lending rate = riskfree interest rate
Determine forward Price
What do you do if the forward price is greater at M0
- Enter into a forward contract to sell the stock for … 0
- Buy one stock for Stock price -
- Borrow that price at 5% for 3 months +
Determine forward Price
What do you do if the forward price is greater at M3
- Sell the stock +
2, Repay loan and interest -
Calculate net CF
Determine forward Price
What do you do if the forward price is less at M0
- Enter into a forward contract to buy the stock at …. 0
- Short sell one stock for .. +
- Invest … for 3 months -
Determine forward Price
What do you do if the forward price is less at M3
- Receive investment +
- Buy the stock at and close the short position -
Calculate net CF
What are 2 concerns when determining futures prices
- CFs of futures contracts resulting from marking to market practice on a daily basis
- Futures contracts are more liquids than forward contracts
What are hedging strategies fro using futures
Long hedging
Short Hedging
What is short hedging
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
What is long hedging
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
Why does short hedging work when an investor owns an asset and expects to sell it in the future
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
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
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
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
NO - cross hedging occurs when the asset whose price is being hedged is different from the asset underlying the futures
In reality, is the size of the asset used for hedging purpose always the same as that asset whose price is being hedged
NO - Hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure
In reality, is 1 always the optimal hedge ratio
No, Setting the hedge ratio equal to 1 is not always optimal, especially when cross hedging is being used
Between unique risk and market risk which is reduced by diversification and hedging
Unique risk = Diversification
Market risk = Hedging
what is a commodity future
oil, sugar coffee
what are financial futures
Stock index futures = FTSE 100
Interest Rate Futures = Bonds
Currency Futures = Exchange rate
What hedging strategy should be used for a equity portfolio
Short Hedge
Short stock index futures right now and to close the position at a later date
What should investors do to reduce the portfolio beta
Take a short position
What should investors do to increase the portfolio beta
Take a long position
What is an option
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
What is the difference between a european option and an american option
european option can only be exercised on the expiration date
American options can be exercised at any time up to the expiration date
What does a long position give the purchaser
the right not an obligation
What does a short position give the seller(writer)
an obligation not a right
What are the general principles for the one step binomial model
- In the finance world there is no arbitrage opportunity
- To setup a riskless portfolio consisting of stocks and options
- ER(P) = Risk-free interest rate
- To work out the cost of setting up the portfolio and option price
What are the steps to value a call option using one step binomial model
- Draw binomial tree according to the information
- Set up a riskless portfolio
- work out the present value of the portfolio and the cost of setting up a portfolio
- to work out the present value(price) of the option (f)
What does the one step binomial suggest about a european call
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
What are the assumptions for the risk-neutral valuation
- Theoretically, to value options under the assumption that the finance world is risk neutral
- Practically, p refers to the probability of the price going up in the risk-neutral world if defined as (e^rT - d)/( u-d)
what steps should you follow to value a european call in a risk-neutral valuation
- Work out the probability of the stock price going up in a risk neutral world
- To work out the value of the option at M3
- To work out the value of the option by discounting the expected value at the risk free interest rate
What steps should you follow to value a european call using the two-step binomial tree
- To work out the value of the option at the maturity date
- To value the option at Node B
- To value the option at Node C
- To value the option at Node A
What steps should you follow to value a european PUT using the two-step binomial tree
- To work out the value of the option at the maturity date
- To value the option at Node B
- To value the option at Node C
- To value the option at Node A
What are the assumptions for BSM
- Stock price behaviour corresponds to the lognormal model with u and sigma? constant
- There are no transaction costs or taxes. All securities are perfectly divisible
- there are no dividends on the stock during the life of the option
- there are no riskless arbitrage opportunities
- security trading is continuous
- investors can borrow or lend at the same risk free rate of interest
- the short term risk free rate of interest, r is constant
When applying BSM to value european option when S is small relative to K
S is very small relative to K
- D1 and D2 become negatively large
- N(d1) and N(d2) are close to 0
- Call price is close to 0
- Probability that the call will mature in the money St>K is small
- unlikely the call will be exercised
N(d1) and N(d2) represent the probability that the call option will expire in the money
When applying BSM to value european option when S exceeds K by a large amount
- D1 and D2 become very large
- N(d1) and N(d2) are close to 1
- Call price is close to s0-Ke^-rt
- Probability that the call will mature in the money St>K is large
- Highly likely the call will be exercised
N(d1) and N(d2) represent the probability that the call option will expire in the money
What is the european call option value
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
What is a riskless portfolio
- A long position in Triangle shares of stock
2. A short position in one call option
What is option delta
option delta = number of shares needed for each call to set up a riskless portfolio
Change in call price/Change in stock price
