Week 7 - Risking up and Risk hedging

Question 1

What is a motivation to use leverage?

Answer 1

To earn a return on the borrowed funds that is greater than the cost of the borrowed funds

Question 2

How do you calculate the duration of leveraged portfolio?

Answer 2

You divide the value of leveraged portfolio by the inital equity amount and mulitply it by the duration of the leveraged portfolio

Question 3

How can manager create leverage?

Answer 3

through the use of derivative instruments
borrowing funds via a collateralized loan arrangement

Question 4

What is a Repo agreement?

Answer 4

is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date

Question 5

What is a Futures contract?

Answer 5

agreement between a buyer (seller) and an established exchange or its clearinghouse in which the buyer (seller) agrees to take (make) delivery of something at a specified price at the end of a designated period of time

Question 6

What are the two major Exchanges for futures contracts?

Answer 6

Chicago Mercantile Exchange Group (CME Group)
Euronext London International Financial Futures Exchange (Euronext Liffe)

Question 7

What are the major futurte contracts used for risk control?

Answer 7

Eurodollar futures
U.S. Treasury futures

Question 8

What is the underlying instrument for the Treasury bond future?

Answer 8

$100,000 par value of a hypothetical 20-year 6% coupon bond

Question 9

What is an interest rate swap?

Answer 9

Two parties agree to exchange periodic interest payments

Question 10

What are the important terms of the credit risk hedging documentation?

Answer 10

Reference entity = the issuer of the debt instrument
Reference obligation = the particular debt issue for which credit protection is being sought

Question 11

What is a CDS? And its primary purpose?

Answer 11

In a credit default swap, the protection buyer pays a fee to the protection seller in return for the right to receive a payment conditional upon the occurrence of a credit event by the reference obligation or the reference entity

Its primary purpose is to hedge the credit exposure to a particular asset or issuer

Question 12

What happens to CDS when a credit event occurs?

Answer 12

There are no further payments of the swap premium
A termination value is determined. Market practice is physical delivery: the protection buyer delivers a specified amount of the face value of bonds of the reference entity to the protection seller