Week 7- Risk Management & Financial Derivatives

Question 1

What is the financial definition of risk?

Answer 1

The possibility that the actual cash flows from an investment or any other business transaction will be different from the expected cash flows

Question 2

what is the purpose of risk managment?

Answer 2

risks can be mitigated, managed which can lead to a competitive advantage

Question 3

what are the reasons for managing risk (3)?

Answer 3

1) To reduce chances of financial distress
2) To direct management attention towards day to day activities under their control
3) To assure firms will have adequate cash flows to make needed investments

Question 4

what are the two main strategies managers can use to minimise risk?

Answer 4

1) Non- Hedging: doesnt use financial derivatives
2) Hedgeing: does use financial derivatives

Question 5

Explain some of the Non- Hedging Strategies

Answer 5

1) Acquisition of additional information to make informed decisions
2) Diversification
3) Use patents and copyrights to protect against competition
4) Insurance
5) Multi purpose assets to redeploy to other uses

Question 6

What tool do managers use to reduce risk with hedging strategies?

Answer 6

Derivatives

Question 7

What is a Hedge?

Answer 7

A transaction that limits the risk associated with fluctuations in the price of shares and bonds etc.

Question 8

What is a financial derivative?

Answer 8

A ‘financial contract’ between the issuer and holder that provides protection againest adverse movements in the prices of shares, bonds etc. (underlying asset)

Question 9

What types of financial derivatives are there?

Answer 9

Fowards, Futures and Options

Question 10

How can financial derivatives be traded (2)?

Answer 10

1) standardised derivative contracts are traded on organised exchanges

2) Privately (known as over the counter derivatives)

Question 11

How are most financial derivatives traded?

Answer 11

On the secondary market i.e Investors buy assets from other investors rather than from the issuing company

Question 12

What is a forward derivative?

Answer 12

An agreement to buy or sell an asset at some point in the future at a price agreed today

Question 13

what is the obligation of foward contracts?

Answer 13

that both the buyer and the seller perform under the terms of the contract i.e not an option

Question 14

What is the specifiied future price called in forward contracts?

Answer 14

delivery price

Question 15

What is the current price of an asset in a forward contract?

Answer 15

spot price

Question 16

What is a future contract?

Answer 16

Standardised contract sold on an organised exchange to buy or sell an asset at a specific future time and at a specific price

Question 17

Do future contracts use delivery and spot prices too?

Answer 17

Yes

Question 18

What are the similarities between future and forward derivatives?

Answer 18

1) Both lock in a price today for the purchase or sale of something in a future time period
2) Both commit both parties to the contract
3) Both involve only one future transaction
4) The party who is selling has a”short position” and the party that is buying has a “long position” in both types of contract
5) No money changes hands between the two parties when the contract is made

Question 19

What is Maturity in financial derrvatives?

Answer 19

When the time comes to sell/buy the asset at the specified price in the contract

Question 20

What are the differences between future and forward derivatives?

Answer 20

1) Forward contracts specify precise delivery dates
2) Future contracts are typically short term and buyer can choose any delivery date during the month
3) Since there is an organised market for futures, contracts are more liquid and lower risk than forward contracts that are traded privately i.e a buyer with a june future contract to buy cotton and a june contract to sell the same amount of cotton does not bear any risk
4) Futures have less credit risk than forwards since the prices of futures are marked to the market daily (future contracts require daily settlements between buyer and seller for gains and losses. The loser must pay the` winner each day)

Question 21

What is an Option derivative?

Answer 21

A financial contract that allows the holder of the contract to walk away from the purchase/contract at any point and gives no obligation to buy if it is not beneficial to them

Question 22

What is the exercise price in option derivatives?

Answer 22

The price at which the owner takes up their right to buy (or sell), aka they are “exercising the option”

Question 23

How do American and European options differ?

Answer 23

American options can be exercised at any time up to the options expiry date whereas European options can only be exercised on the expiry date

Question 24

what is the right to buy called in option derivatives?

Answer 24

the call option

Question 25

what is the right to sell called in option derivatives?

Answer 25

the put option

Question 26

When will a holder of a call option exercise their right to buy?

Answer 26

if the value of the asset is lower than the market rate on the expiry date of the option because they can’t buy the asset for any cheaper on the market.

Question 27

When will a holder of put option exercise their right to sell?

Answer 27

If the value of the of the asset is higher than the market rate on the expiry date of the option because they cant sell the asset for any higher on the market

Question 28

See notes for put and call option diagrams

Question 29

What are the assumptions made by the option pricing model?

Answer 29

• no transaction costs
• no taxes
• constant risk free interest rate
• stocks pay no dividends
• European type
• No restriction on short sales
• Markets operate continuously

Question 30

What is the symbol for exercise price?

Answer 30

E

Question 31

What does S0 mean?

Answer 31

Stock price at T0

Question 32

What does S1 mean?

Answer 32

Price of stock at T1`

Question 33

What does U mean?

Answer 33

Upward movement of stock price

Question 34

what does D mean?

Answer 34

downward movement of stock price

Question 35

what does Cu mean?

Answer 35

payoff if there is an upward movement of stock price

Question 36

What does Cd mean?

Answer 36

Payoff if there is a downward movement of stock price

Question 37

What does the hedge ratio symbolise?

Answer 37

How many shares we should buy for every written call

Question 38

What is R?

Answer 38

1+r

Question 39

What is P?

Answer 39

Pseudo Probability (the probability given to the Cu and Cd)

Question 40

How do you calculate U?

Answer 40

1+ S1-S0/S0

Question 41

How do you calculate D?

Answer 41

1+ S1-S0/S0

Question 42

What is put-call parity?

Answer 42

Used to find the value of the put once we know the call