Use of derivatives

Question 1

Financial Futures

Answer 1

Financial futures are contracts between two parties to trade an asset on a set date in the future at a specified price. Futures contracts are standardised, exchange-tradable contracts for trading a specified asset on a set date in the future at a specified price.

Question 2

Futures were originally developed for

Answer 2

agricultural and other commodities, but financial futures are based on underlying financial instruments.

Question 3

Difference between future and forwards

Answer 3

Futures differ from forwards in that futures are standardised and exchange-tradeable, while forwards are agreements between two parties to trade a specified asset at a set date in the future at a set price.

Question 4

Financial futures exist in which four main categories:

Answer 4

bond futures, short interest rate futures, stock index futures, and currency futures.

Question 5

Each party to a futures contract must deposit a sum of money known as _________with the _________, which acts as a cushion against potential losses from future adverse __________.

Answer 5

Each party to a futures contract must deposit a sum of money known as margin with the clearing house, which acts as a cushion against potential losses from future adverse price movements.

Question 6

Initial margin is deposited when the contract is first

Answer 6

struck, and additional payments of variation margin are made daily.

Question 7

Before the contract expires, the buyer and the seller normally_______the futures position by entering into ___________contracts

Answer 7

Before the contract expires, the buyer and the seller normally “close out” the futures position by entering into equal but opposite contracts.

Question 8

The exchange requires traders to deposit margin funds to cover the current negative value of any outstanding contracts and an extra amount to cover

Answer 8

any likely future volatility in the contract over a short period.

Question 9

Explain how futures contracts may be useful to bidding companies during pricing negotiations,
when various companies are presenting bids for a large construction project.

Answer 9

Solution
When companies submit bids for construction projects they are exposed to currency and interest
rate movements during the period that the bids are being considered.
Using futures contracts the current market rates can be used to price the bids, and then the
company can hedge its exposure through futures contracts. Even if market rates move during the
bidding process, the company can still be confident that its bid price is sufficient to undertake the
project profitably.
Of course if the bid fails, the company has been exposed to the markets to the extent of the
hedge

Question 10

Bond futures

Answer 10

Bond futures require physical delivery of a bond, and eligible bonds are listed by the exchange.

Question 11

interest rate futures

Answer 11

Protection against interest rate risk: A company with a floating-rate loan can use interest rate futures to protect itself against the risk of rising interest rates.

Question 12

Fixing future interest payments:

Answer 12

A company can fix its future interest payments by using interest rate futures to fund any increase in the interest rate payable.

Question 13

Hedging against interest rate fluctuations: By

Answer 13

selling short interest rate futures, a company can lock in the current interest rate to hedge its borrowing costs in the future

Question 14

Offset the cost of borrowing:

Answer 14

In case the interest rates rise, the profit made on selling the interest rate futures will offset the company’s higher borrowing costs.

Question 15

Stock Index Futures:

Hedge against share price rise:

Answer 15

A predator company can use stock index futures to hedge the risk of an increase in the target company’s share price during a takeover bid

Question 16

Offset the higher cost of the bid:

Answer 16

The profit made on futures contracts can offset the higher cost of the bid in case the stock market rises sharply.

Question 17

Limitations:

Answer 17

There could be limitations to this hedging strategy as the share price of the target company may not move in line with the market index.

Question 18

Currency Futures:

Fixing the value of receipts/payments:

Answer 18

Currency futures can be used to fix the value of foreign receipts or payments by selling the dollars forward.

Question 19

Hedging against uncertainty:

Answer 19

Currency futures can be used to hedge against uncertainty in foreign receipts or payments.

Question 20

Additional flexibility: Futures contracts

Answer 20

provide additional flexibility to the company in case of changing circumstances.

Question 21

Forwards:

Non-standardised contract:

Answer 21

Forwards are non-standardised and privately negotiated contracts between two parties to trade a specified asset at a specified price on a set date in the future.

Question 22

Not traded on exchanges:

Answer 22

Forwards are not traded on exchanges like futures contracts.

Question 23

Futures are standardised: The main difference between forwards and futures

Answer 23

is that futures are standardised and can be traded in a recognised exchange.

Question 24

Question
Explain how futures contracts may be useful to bidding companies during pricing negotiations,
when various companies are presenting bids for a large construction project.

Answer 24

Solution
When companies submit bids for construction projects they are exposed to currency and interest
rate movements during the period that the bids are being considered.
Using futures contracts the current market rates can be used to price the bids, and then the
company can hedge its exposure through futures contracts. Even if market rates move during the
bidding process, the company can still be confident that its bid price is sufficient to undertake the
project profitably.
Of course if the bid fails, the company has been exposed to the markets to the extent of the
hedge.

Question 25

Question
Outline how stock index futures could help hedge the risk that share prices rise during a takeover
bid.

Answer 25

Solution
The predator company could purchase sufficient stock index futures to hedge the amount of its
cash offer. If the stockmarket rises sharply and the company is forced to raise the amount of its
bid, it should make sufficient profit on its futures contracts to offset this higher cost.

Question 26

3-month interest rate future
This is based on an artificial index which is defined as:

Answer 26

Index = 100 – (4  the implied 3-month interest rate expressed as a percentage)
For example, if the implied (ie the rate that investors expect at the expiry of the contract)
interbank 3-month rate were 0.5% (or 2% pa), then the index would stand at 98. An investor can
buy or sell this index as if it were a normal asset. Indeed, being an exchange traded contract, the
investor can sell it before buying it (known as going ‘short’ on the index). Provided the investor
buys it back before expiry they need never deliver it. This is very common.

Question 27

Options

Answer 27

Definition: An option gives an investor the right, but not the obligation, to buy or sell a specified asset on a specified future date.

Question 28

Options -Buyer’s Right and Seller’s Obligation:

Answer 28

The buyer of an option has the right but not the obligation to take up the option at the specified exercise price. The seller (writer) of an option has the obligation to honour the option given to the buyer.

Question 28

options; Margins and Premiums: The writer of the option pays a margin to the clearing house. The buyer pays a premium to the writer.

Answer 28

Margins and Premiums: The writer of the option pays a margin to the clearing house. The buyer pays a premium to the writer.

Question 29

Types of Options:

Answer 29

A call option gives the right, but not the obligation, to buy a specified asset on a set date in the future for a specified price. A put option gives the right, but not the obligation, to sell a specified asset on a set date in the future for a specified price. An American style option is an option that can be exercised on any date before its expiry. A European style option is an option that can be exercised only at expiry. Traded options are available on individual equities and also on financial futures contracts.

Question 30

Uses of Options:

Protect against Adverse Movements:

Answer 30

Options allow a company to protect itself against adverse movements in the financial environment while retaining the ability to profit from favourable movements.

Question 31

Uses of Options: Choice to Exercise:.

Answer 31

Since an option is a right to buy (or sell) an asset rather than an obligation to do so, the company that holds the option can choose to exercise it or not, depending on whether events move in its favour or move against it

Question 32

Option as No Liability:

Answer 32

Therefore the option never becomes a liability to the company.Example: For example, a company that has borrowed at variable interest rates could purchase options to protect itself against increases in market interest rates. If rates fall the company will only suffer the loss of the premium paid to purchase the options.

Question 33

swap

Answer 33

A swap is a contract between two parties to exchange a series of payments according to a prearranged formula.
One party is usually a bank (market maker) and the other is a company.

Question 34

swap

Answer 34

The present value of cashflows is negative for the investor and positive for the issuing organization.

Question 35

Counterparties are the parties involved in a swap agreement.
Market risk and credit risk are two types of risks that counterparty to a

Answer 35

swap faces.

Question 36

Types of swaps - Interest rate swaps:

Answer 36

In an interest rate swap, one party pays a fixed series of amounts for a certain term, and the other party pays variable amounts based on a short-term interest rate.
Both sets of payments are in the same currency, and the deposit is purely a notional one.
The fixed payments are interest payments on a deposit at a fixed rate, while the variable payments are the interest on the same deposit at a floating rate.

Question 37

A company may enter into an interest rate swap to hedge the investment mismatch risk or to benefit from

Answer 37

expected changes in the money-market rate.

Question 38

Types of swaps - Currency swaps:

In a currency swap,

Answer 38

two parties exchange a fixed series of interest payments and a capital sum in one currency for a fixed series of interest payments and a capital sum in another currency.
The nominal amounts used to calculate the interest payments are different in the two currencies.
At the end of the contract, the nominal amount of each position is exchanged.
A company may enter into a currency swap to reduce foreign exchange risk or to obtain a better interest rate in another currenc

Question 39

Question
A US company is involved in a large overseas project, where an overseas asset will earn profits in
yen for 10 years and then be sold at the end of the 10-year period.
Outline how a currency swap could be used by this company to manage its risk.

Answer 39

Solution
A currency swap would essentially switch all of the yen payments into US dollars at a known
exchange rate. Even if the amounts of the yen profits fluctuate, a swap based on the expected
profits would go a long way to hedge the overall currency risk involved.
At the end of the period the asset will be sold for yen. The exchange of nominal at the end of the
currency swap hedges this final payment as well (albeit in an approximate manner)

Question 40

Question
Suggest why the company may choose to enter into this swap agreement.

Answer 40

Solution
Possible reasons include:
 It expects the money-market rate to rise over the period such that at the end of the 10-
year period the company will receive more interest than it is paying.
 It has fixed rate income and variable rate finance outgo over the 10-year period. It can
reduce this investment mismatch risk by making this swap

Question 41

The most likely explanation for an investor buying a call option is that they expect:
A the value of the underlying security to increase.
B the value of the underlying security to fall.
C interest rates to rise.
D a stock market crash.

Answer 41

Answer = A
A call option gives the buyer the right to buy the underlying security at a set price. This will be
worth doing if the market price on the expiry date is higher than the exercise price.
If interest rates rise, we might expect the value of shares to fall, so it would not be worth buying a
call option. (It might be worth buying a put option, though.)

Question 42

Margin is:
A the cost of buying an option.
B the cost of buying a future.
C a deposit paid to the seller of a future or writer of an option by the purchaser.
D a deposit paid to the clearing house by the buyer and seller of a future and the writer of an
option

Answer 42

Answer = D
The margin exists to protect the clearing house against credit loss

Question 43

Which of the following strategies would NOT help a company to reduce its exposure to rising
interest rates?
A the negotiation of an interest rate swap
B the purchase of a put option on an interest rate future
C the purchase of a bond future
D the sale of an interest rate future [2

Answer 43

Answer = C
The company could swap a floating interest rate for a fixed interest rate to protect it from rising
interest rates.
It could sell an interest rate future. If interest rates rise, the price of the interest rate future falls
and thus a profit could be made on the future to offset the rise in interest rates.
By buying a put option on an interest rate future, it is buying the option to sell. It will exercise this
right if interest rates rise.
It would not buy a bond future. If interest rates rise, the price of the bond future will fall. It
would make a loss on the future as well as suffering from higher interest rates

Question 44

Outline the nature of interest rate swaps and outline how currency swaps differ from interest rate
swaps.

Answer 44

Interest rate swaps
Interest rate swaps are deals arranged with banks as the main market makers in an ‘over-thecounter’ market, ie the arrangements are made on an individual basis: there is no set format or
contract for interest rate swaps. [1]
In a swap the two parties agree to swap a series of payments with each other. They are agreements
to exchange streams of cashflow. [1]
In an interest rate swap, there is no exchange of capital amounts. [1]
In the most common form of interest rate swap one party agrees to pay to the other a regular series
of fixed interest payments on the nominal capital for a certain term. In exchange, the second party
agrees to pay a series of variable interest payments on the nominal capital. [1]
Currency swaps
Currency swaps are agreements to exchange a series of interest payments and a capital sum in one
currency for a series of interest payments and a capital sum in another. [1]
This contrasts with interest rate swaps, where there is no exchange of capital sums. [1]
[Maximum 5]

Question 45

Compare futures and exchange-traded options. [5

Answer 45

Both futures and options are derivative instruments: their value depends on the performance of
an underlying asset. [1]
Both are standardised contracts, traded on derivative exchanges. [1]
A future gives the obligation to trade in a specified quantity of a specified asset at a specified price
on a specified date. [1]
An option gives the right but not the obligation to trade in a specified quantity of a specified asset at
a specified price on or before a specified date. [1]
Options come in two varieties: call options being the right to buy, and put options being the right to
sell the underlying. [1]
The buyer of an option will have to pay a premium to the seller, whereas buyers and sellers of
futures do not pay one another at outset. Only the clearing house deposit or margin is required,
which is subsequently returned. [1]
The buyer and the seller of a future must both deposit margin with the clearing house. With an
options contract, only the seller (writer) has to deposit margin. [1]