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CWM Financial Markets > Risks of Derivatives > Flashcards

Risks of Derivatives Flashcards

1
Q

How do exchanges minimise risk through legal obligations?

derivatives

A

Member firms must agree to the terms and conditions to participate in the exchanges (this can include margin requirements and setting up direct debits to cover collateral)

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2
Q

Who enforces the legal risk of OTC derivatives?

A

ISDA - International Swaps and Derivatives Association

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3
Q

How do the ISDA enforce legal contracts?

A

Create a bilateral agreement that both parties must agree to before opening a trade.

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4
Q

What is the ISDA’s point of contention in CDSs?

A

What constitutes a default event

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5
Q

What event lead to the scrutiny of CDS default events (credit events)

A

Hedge fund induced a homebuilder to miss a payment in exchange for favourable refinancing

In return the hedge fund received a CDS insurance premium and profit

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6
Q

In response to the CDS incident what did the ISDA institute?

A

Narrowly tailored credit event supplement - it sought to better define what a default event was

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7
Q

What did the failure to pay supplement do?

A

If a failure to pay does not result in the deterioration in the creditworthiness of a firm, it is not a default event.

e.g. the hedge fund default would not of counted

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8
Q

What did the outstanding principal balance supplement do?

A

If an asset was issued at a discount, the value of the CDS payment will be benchmarked against the discounted value.

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9
Q

What 5 things can constitute a credit event?

A

1) Default
2) Bankruptcy
3) Fall in asset value / price
4) Merger / Demerger
5) Debt restructuring

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10
Q

What constitutes a debt restructuring credit event?

A

If the priority or status of an asset is changed (asset covered under CDS) then a payment is due.

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11
Q

Once a CDS payout is made, what happens to the swap?

A

It is closed

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12
Q

What two ways can a contract be settled?

A

Cash

Physical

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13
Q

Why are CDSs bespoke and what can be tailored?

A

They trade OTC

What the trigger points are

Relevant to the characteristic of the underlying

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14
Q

What is a contango?

A

When the cash price of an asset is less than the forward price

Also known as a premium

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15
Q

What assets are normally in contango?

Why?

A

Physical commodities

Futures prices reflect the cost of carry making them greater than the spot price.

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16
Q

Why can assets normally in contango fall into backwardation?

A

Supply disruptions

Seasonality

Also known as a discount

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17
Q

What is backwardation?

A

When the cash price of an asset is greater than the forward price

18
Q

What assets are usually in backwardation and when?

A

Bonds and STIRs

When long term interest rates are greater than short term interest rates

19
Q

What happens to contango and backwardation as time to expiry convirges on 0

A

They narrow until reaching 0 at maturity

20
Q

What is basis risk?

A

Basis risk in commodities and futures refers to the risk that the difference between the spot price of the commodity and the futures price (the basis) will change unfavorably.

21
Q

When are clearing houses at most risk

A

When a liability is uncertain, e.g. an option

22
Q

What 4 ways do clearing houses protect against risk?

A

1) Only deal with member firms
2) Require Margin
3) Use their own financial resources (e.g. credit line with a consortium of banks or have a default account
4) Insurance policies

23
Q

What is initial margin?

A

The margin required to be posted at the outset of a trade.

24
Q

What can be placed as initial margin

A

Cash or collateral (an asset with value)

25
Q

Who doesn’t need to post initial margin?

A

Buyers of options

Loss is limited to premium

26
Q

How is initial margin calculated?

A

Volatility - what is the most an asset could move in a single day

27
Q

If a clearing house determines the most a FTSE forward could move is 300 points, what is the initial margin?

A

300 * £10 = £3,000

28
Q

When is initial margin calculated.

Why does this mean that it can require topping up?

A

Calculated daily and collected each morning before the market opens.

Increased volatility means more margin may be required to be comfortable.

Intra-day margin

Members have direct debits which the clearing house will use to increase margin.

29
Q

What are spreads and how do they effect initial margin?

A

Spreads refer to having a position in the same asset or correlated assets which offset the margin required.

E.g. long July ftse future and short a September FTSE future, these positions offset and will reduce the margin

30
Q

What is an example of a spread through correlated assets?

A

Brent Crude and Oil and Gas Futures

31
Q

When else might initial margin increase?

Why is this done?

A

Approaching expiry

Reduce short term speculative pressures

Force less capitalised speculators to close out positions and reduce risk.

Ensure delivery can be made / received.

32
Q

What are the three types of margin?

A

1) Initial
2) Variation
3) Maintenance

33
Q

How is variation margin calculated?

A

Ticks Moved * Tick Price * Contracts

34
Q

How is ticks moved calculated?

A

Todays close - Yday’s close / tick size

35
Q

What is the hedge ratio, what problem does it fix?

A

Calculates the number of contracts needed to fully hedge a position.

Fixes the assumption that the portfolio has a Beta of 1.

Have to sell more or fewer contracts based on the volatility

36
Q

What is the formula for hedge ratio?

A

Portfolio Value / Futures Value * h

Where h is beta

37
Q

How is H calculated in the hedge ratio?

A

Volatility / Duration

Can be either portfolio or future

38
Q

What is risk that arises in a hedged portfolio called?

A

Residual Risk

Arises even in a portfolio with the corerct hedge ratio

39
Q

What are 2 examples of residual risk?

How can risk still arise?

A

1) Using the incorrect hedge ratio as a result of incorrectly assessing the beta
2) Unsystematic risk within the portfolio that the hedge cannot eliminate

Unsystematic risk can only be eliminated by further diversification

39
Q

What does Unsystematic risk within the portfolio that the hedge cannot eliminate mean?

A

Company specific factors that a future cannot hedge - e.g. management risk or a product fails.

Index future moves with the market as a whole, not individual companies

40
Q
A

CWM Financial Markets (58 decks)

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