Week 8, Handling interest rate risk: using derivative instruments Flashcards
How may banks deal wit interest rate risk
Banks may deal with interest rate risk either by reducing that risk through duration gap management or by transferring risk to another party
What is the definition of derivatives,
Where is the value of a derivative based on
A financial asset that is primarily designed to manage a specific risk exposure
The value is based on or is derived from underlying assets such as shares/ shares indices, bonds, currency and non-fiction products such as minerals, wools, wheat, live cattle, oranges, orange juice
In Australia the banks are the key participants in the derivative markets. What are the three main reasons they are involved
What are two main underlying assets that banks deal with when engaging in derivative instruments
- Banks use derivatives to hedge their own risks
- Banks act as market makers by running ‘books’ in different derivatives
- Banks may seek to increase returns through speculation and arbitrage transactions in the derivative markets
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Typically, banks engage in some derivative instruments where the price/ value of the contract is based on the value of some underlying assets – either currency or interest rates
Define hedging
Hedging – offsetting price changes so that the impact of any price changes in minimised. If we can minimise the impact of unfavourable changes in value, we can minimise the impact on net profits
Define a forward contract
What are the characteristics of a forward contract
Forward contract is a contract between two parties to buy or sell an underlying asset at a price agreed on today for delivery at an agreed future date
• Characteristics of Forward Contract
Price and delivery time are set in the contract
No money changes hands when the contract is initiated – may be an admin fee ;
At the date the contract is initated, it has no value;
They are OTC contracts as they are customized to meet the needs of the counterparties and involve counterparty risk
Define a futures contract
What are the characteristics of a Futures
A futures contract is a standardized agreement to buy or sell a specified quantity of financial instruments on a specified future date at a set price. Highly institutionalized form of forwarding contracting
• Characteristics of Futures
Standardised in size
Anonymous
Exchange – traded contracts, markets to market daily with protection against defaults provided by the exchange i.e. through the imposition of exchange-clearing margins
What is an importance difference between forward and futures contract
Important difference for Forward contract: Settlement Risk is an issue when dealing with forward
Explain the process in which the settlement process works
o Deposits an initial margin to ensure enough money on hand to cover the loss in event of adverse price changes
o Australian Clearing House (ACH) and ASX Clear ( Futures) mark to market all open future position and require members to settle all losses and gains on a daily basis
o Brokers set maintenance margins pegged to the contract’s price volatility and maximum price change permitted by exchange
What are the interest rate futures and options traded on the Australain securities exchange (7 points)
o 30 day interbank Cash Rate Future and Options
o 90 day Australian Bank Accepted Bill Futures and Optons
o 3 year and 10 year Australian treasury Bond Futures and Options
o 3 and 10 Interest Rate Swap Futures
o New Zealand 30 day official Cash rate future
o 90 day New Zealand Bill futures and options
o 3 year and 10 year New Zealand Government Stock Futures and Options
Explain how a contract holder can close and open position in a futures contract
Draw diagram
Contract holders can either hold their position until settlement or leave the market by taking an equal and opposite position in the same contract for the same settlement date
Look at example in lecture 8 page 4
