Unit 2: Part 3- Derivatives & Hedging Techniques

Question 1

What is hedging?

Answer 1

Hedging is a strategy that is aimed at minimising or eliminating risks. Perfect hedge is where you eliminate all risk

Question 2

What are approaches to managing exchange rate risk?

Answer 2

do nothing, invoicing in the home currency, identifying net transaction exposure (matching & netting), leading & lagging, money market hedging, forward exchange contracts & foreign currency derivatives

Question 3

What does doing nothing to manage exchange rate risk mean?

Answer 3

If passive strategy (owners uniformed etc. very risky). Active strategy (actively decide to do nothing: equilibrium/average position lead to a neutral impact, no transaction costs & low frequency/low value transactions)

Question 4

What does invoicing in the home currency mean?

Answer 4

requires customers & suppliers to use your home currency (almost eliminates foreign currency risk & may be unacceptable to trading partners)

Question 5

What is leading & lagging?

Answer 5

where a company is aware of volatility in foreign exchange market, adjusts the timing of a payment request or disbursement to reflect expectations about future currency movements (lead payments are payments in advance & lagged payments are delaying payments beyond their due date)

Question 6

When would you expect a company to lead and to lag?

Answer 6

If home currency appreciates, you would expect company to lag and if home currency depreciates, you would expect company to lead (to get a better lead)

Question 7

What does matching & netting mean for managing exchange rate risk?

Answer 7

Matching focuses on ‘matching’ receipts & payments in the same currency. Whereas netting is an approach that is used to settle inter-company balances

Question 8

What is a forward contract?

Answer 8

A forward contract is an agreement between a firm & a commercial bank to exchange a specified amount of a currency specified exchange rate at a specified rate in the future.

Question 9

What are derivatives?

Answer 9

Derivatives are financial instruments whose returns are derived from those of another financial instrument: cash/spot markets (immediate delivery) & derivative markets

Question 10

What does the derivative market refer to?

Answer 10

The derivatives market refers tothe financial market for financial instruments such as futures contracts or options that are based on the values of their underlying assets

Question 11

What is a futures contract?

Answer 11

A futures contract is a contract between 2 parties to buy or sell an asset at a particular price agreed today, for delivery at some point in the future

Question 12

What does it mean that futures contracts are exchange traded?

Answer 12

Future contracts are exchange traded, buyers & sellers do not transact directly with each other. Trading made possible by the standardised nature of the contracts.

Question 13

What does it mean when a trader takes a long or short position?

Answer 13

A trader takes a short position when selling a futures contract, which corresponds to selling the currency forward. A trader takes a long position when buying a futures contract, which corresponds to buying the currency forward

Question 14

What are currency options?

Answer 14

Currency options provides the right but NOT the obligation to purchase or sell currencies at specified (strike) prices. They are classified as calls (right to buy a currency) or puts (right to sell a currency)

Question 15

What are customised options?

Answer 15

Customised options offered by brokerage firms & commerce banks are traded in the over-the-counter market. Option owners can sell or exercise their options, or let their options expire.

Question 16

When might a firm purchase currency call or put options?

Answer 16

Firms may purchase currency call options to hedge payables, project bidding, or target bidding. Firms may purchase currency put options to hedge receivables, interest earned or sales of assets

Question 17

When might companies face interest rate risk?

Answer 17

Interest rate risk is faced by companies with floating & fixed rate debt. Interest rate risk can arise from gap exposure & basic risk

Question 18

What are approaches to managing interest rate risk?

Answer 18

smoothing, asset & liability management, matching, FRAs, swaps and collars, caps & floors

Question 19

What is smoothing?

Answer 19

a simple approach to hedge against interest rate movement of loans or deposits

Question 20

What is asset & liability management?

Answer 20

This relates to the periods or durations for which loans (liabilities) & deposits (assets) last. Matching is a better solution.

Question 21

What is matching?

Answer 21

Matching is an internal approach used by banking sector to manage changes in interest rates. Interest rates on assets are matched with interest rates on liabilities

Question 22

What are forward rate agreements (FRAs)?

Answer 22

a company can enter into an agreement now to fix the interest for borrowing. Delivery: at a certain time, method: OTC contract & units: tailored to requirements

Question 23

What are interest rate derivatives that can be used to hedge interest rate risks?

Answer 23

interest rate futures, interest rate options, interest rate swaps and interest rate caps, floors & collars

Question 24

What is interest rates futures contracts?

Answer 24

used to hedge against changes in the rate of interest between now and date in the future. Borrowers: sell futures= hedge against interest rate rises. Lenders: buy futures= hedge against interest rate falls

Question 25

What is an interest rates option?

Answer 25

An interest rate options grants the buyer, the right (but not the obligation) to an agreed interest rate at a future maturity date. On the expiry of the option, the buyer must decide whether or not to exercise the right (more flexible & expensive than FRAs) or to expire it

Question 26

What are interest rate swaps?

Answer 26

Interest rate swaps are when 2 parties agree to exchange interest payments at an agreed nominal amount for an agreed period of time. Swaps are used to hedge against adverse interest rate movements

Question 27

What are interest rate caps?

Answer 27

contract that gives the purchaser the right to set a maximum level for the interest rate payable. Compensation is paid to the purchaser if interest rates rises above the level

Question 28

What are interest rates florr?

Answer 28

contract that gives the purchaser the right to set a minimum level for the interest rates payable. Compensation is paid to the purchaser if interest rates drops below this level.

Question 29

What are interest rates collars?

Answer 29

Interest rate collar is essentially a combination of interest rate cap & floor. It is a contract that gives the purchaser protection from interest rate rises (above a certain level) & interest rate declines (below a certain level). Compensation is paid to the purchaser if interest rates drop below this the level floor level or above the cap level