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Financial Markets 2014 > Topic 6 - Derivative markets > Flashcards

Topic 6 - Derivative markets Flashcards

1
Q

6.01 - What is risk?

A

The possibility or probability of something occurring that is unexpected or unanticipated.

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2
Q

6.02 - What are the two key categories and their definition?

A

Operational Risk - exposure that may impact on the normal commercial functions of a business
Financial Risk - exposure that results in unanticipated changes in projected cash flows or the structure & value of balance sheet assets & liabilities.

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3
Q

6.03 - Give three examples of both Op risk and Financial risk?

A

Op Risk - Technology, property, personnel, competitors, disasters, govt policy & suppliers
Financial Risk - interest rate, fx, liquidity, credit & capital risks.

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4
Q

6.04 - Effective risk management requires a structured process. This process would include what steps?

A

1) identify risk exposures
2) analyse impact of exposures
3) assess organisational attitude to exposure and impact
4) select appropriate risk management strategy/product
5) establish controls
6) implement strategy
7) monitor, report, review and audit.

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5
Q

6.05 - What is a futures contract?

A

It is an agreement between two parties to buy/sell a specified commodity or financial instrument at a specified date in the future at a price determined today.

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6
Q

6.06 - what is an exchange-traded contract?

A

A standardised financial contract traded on a formal exchange. Futures contracts are exchange-traded contracts.

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7
Q

6.07 - What does a futures strategy require the risk manager to do?

A

Conduct a transaction in the futures market today that corresponds with the transaction to be carried out in the physical market at a later date.

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8
Q

6.08 - What is the role of the clearing house?

A

Records transactions conducted on an exchange and facilitates value settlement and transfer

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9
Q

6.09 - What is the initial margin?

A

A deposit lodged with a clearing house to cover adverse price movements in a futures contract.

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10
Q

6.10 - What is ‘marked-to-market’?

A

The periodic repricing of an existing contract to reflect current market valuations

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11
Q

6.11 - What is the maintenance margin call?

A

The top-up of an initial margin to cover adverse futures contract price movements.

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12
Q

6.12 - Who are the four main participants of the futures market? and what do they provide to the market?

A

Hedgers, Speculators, Traders and Arbitragers

They provide depth and liquidity to the market improving its efficiency.

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13
Q

6.13 - What are the strategies for the futures market, for buying when prices are rising or selling when prices are falling?

A

Prices are about to rise and you are buying - buy contract now
Prices are about to fall and you are selling - sell contract now

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14
Q

6.14 - What are the problems with hedging in the futures market?

A 
Futures contracts are standardised so it may not be possible to perfectly match your exposure:
* Size of contract
* Grade of underlying commodity
* Expiry date
This will leave some residual risk.
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15
Q

6.15 - What is a forward contract?

A

A financial instrument primarily designed to enable the management of a specified risk.

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16
Q

6.16 - What is the biggest difference between a forward contract and a future contract?

A

They are offered over the counter by financial institutions and so therefore mitigate the problems of futures.

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17
Q

6.17 - What are the two main types of forward contracts?

A

1) Forward rate agreements (FRAs)

2) Forward foreign exchange contracts

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18
Q

6.18 - What is a forward rate agreement (FRA) and what does it allow the holder to do?

A

An over-the-counter product used to manage interest rate risk exposures, which allows a borrower to manage future interest rate risk by locking in an interest rate today that will apply at a specified future date.

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19
Q

6.19 - What is the FRA agreed rate?

A

The fixed interest rate stipulated in the FRA at the start of the contract.

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20
Q

6.20 - What is the FRA Settlement date?

A

The date when the FRA agreed rate is compared with the reference rate to calculate the compensation amount.

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21
Q

6.21 - What is the FRA contract period?

A

It is the term of the interest rate protection built into the FRA.

22
Q

6.22 - What is an option contract?

A

An option gives the buyer the right, but not the obligation to buy or sell a specified commodity or financial instrument at a predetermined price (exercise or stake price) on or before a specified date (expiration date)?

23
Q

6.23 - What are the types of options?

A
  • Call options - give the option buyer the right to buy the commodity or instrument at the exercise price.
  • Put options - give the option buyer the right to sell the commodity or instrument at the exercise price.
24
Q

6.24 - Options will only be exercised if it is in the buyer’s best interests. When can options be exercised?

A
  • Only on expiration date (European option); or

* Any time up to expiration date (American option).

25
Q

6.25 - What is the ‘premium’ when referring to an option?

A

The price paid by an option buyer to the writer (seller) of the option.

26
Q

6.26 - What is the exercise price or strike price when referring to an option?

A

It is the price specified in an options contract at which the option buyer can buy or sell.

27
Q

6.27 - What does ‘in-the-money’ refer to when discussing options?

A

The immediate exercise of the option would result in a profit

28
Q

6.28 - What does ‘at-the-money’ refer to when discussing options?

A

The value of the asset is equal to the exercise price.

29
Q

6.29 - What does ‘out-of-the-money’ refer to when discussing options?

A

The immediate exercise of the option would result in a loss.

30
Q

6.30 - What are the factors affecting an option contract premium?

A

1) Intrinsic value
2) Time value
3) Price volatility
4) Interest rates

31
Q

6.31 - What does ‘intrinsic value’ refer to in relation to an option contract premium?

A

The market price of the underlying asset relative to the exercise price. The greater the intrinsic value, the greater the premium, ie a positive relationship.

32
Q

6.32 - What are positive, negative and zero relationships when referring to options with an intrinsic value?

A
  • Positive - ‘in-the-money’ - exercise at a profit
  • Negative - ‘out-of-the-money’ - won’t exercise
  • Zero - ‘at-the-money’.
33
Q

6.33 - What does ‘time value’ refer to in relation to an option contract premium?

A

The longer the time to expiry, the greater the possibility that the option will be able to be exercised for a profit (ie. positive relationship). If the spot price moves adversely, the loss is limited to the premium.

34
Q

6.34 - What does ‘price volatility’ refer to in relation to an option contract premium?

A

The greater the volatility of the spot price, the greater the chance of exercising the option for a profit or loss. The greater the spot price volatility - the greater the option premium (positive relationship).

35
Q

6.35 - What does ‘interest rates’ refer to in relation to an option contract premium?

A

Interest rates have opposite impacts on put and call options - positive between interest rates and call price - negative between interest rates and put price.

36
Q

6.36 - What is a swap product and what are the two ways to enter into a swap?

A

An over-the-counter financial product allowing parties to enter into a contractual agreement to exchange cash flows. They can be entered into as an intermediated swap or a direct swap.

37
Q

6.37 - What is the difference between an intermediated swap and a direct swap?

A

An intermediated swap is conducted through a financial intermediary, where as direct is not.

38
Q

6.38 - What are the two main types of swap contracts?

A
  • Interest rate swaps

* Cross-currency swaps

39
Q

6.39 - What is an interest rate swap?

A

It is the exchange of interest payments associated with a notional principal amount.

40
Q

6.40 - What is the ‘notional principal amount’ when referring to interest rate swaps?

A

It is the underlying amount specified in a contract that is used to calculate the value of the contract.

41
Q

6.41 - What is the difference between a vanilla interest rate swap and a basis interest rate swap?

A

A vanilla swap is a swap of a series of fixed interest rate payments for floating interest rate payments and a basis swap is a swap of a series of two different reference rate interest payments.

42
Q

6.42 - What is the swap rate?

A

It is the fixed interest rate specified in a swap contract.

43
Q

6.43 - What are cross-currency swaps?

A

Where two parties, such as a bank and a company, agree to exchange a principal amount followed by the exchange of periodic interest payments during the term of the swap, then re-exchange the principal amount at the swap completion date.

44
Q

6.44 - What is credit risk?

A

The possibility that an obligor (borrower) will not meet a future financial commitment (interest or principal) to a lender.

45
Q

6.45 - What is a credit default swap (CDS)?

A

It is an agreement transferring credit risk from the protection buyer to the protection seller on the payment of a premium.

46
Q

6.46 - What is CDS protection seller?

A

It is where an institution that writes a CDS, accepts the credit risk of a reference entity and undertake to compensate the protection buyer if a specified credit default event occurs.

47
Q

6.47 - What is a reference entity?

A

An obligor (borrower) with a debt or loan obligation to the CDS protection buyer (eg. a corporation or government).

48
Q

6.48 - What is a CDS protection buyer?

A

It is a lender or investor buying a CDS to transfer risk associated with a reference entity.

49
Q

6.49 - The credit default swap (CDS) will specify a credit default event, what are some examples of a credit default event?

A
  • bankruptcy
  • obligation acceleration
  • obligation default
  • cash payment failure
  • repudiation or moratorium of debt by a nation state.
50
Q

6.50 - In the event of credit default by the reference entity the most common forms of settlement are what?

A

Physical settlement - Protection buyer delivers the notional value of the debt.
Cash settlement - Protection seller pays a net cash amount to the protection buyer.

51
Q

6.51 - CDSs attracted a lot of attention during the GFC, why?

A

Because many of the ‘toxic’ mortgage securities were insured by CDS. As the mortgage bond market and the mortgage derivatives markets suffered large losses, the CDS rose in value. This movement exposed issuers of CDSs to significant and rapidly growing liabilities.

52
Q

6.52 - Which company was most dramatically impacted by the exposure to CDS when the GFC occurred?

A

AIG - American International Group

Financial Markets 2014 (8 decks)

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