7.3 Derivative Benefits, risks, and Issuer and Investor Uses Flashcards
Derivatives provide information about the value of underlying assets beyond what can be observed in the cash market. For example:
Equity futures prices give an indication of investors’ expectations about where the market is going.
Interest rate futures contracts reflect expectations about central bank monetary policies.
Commodity futures prices reveal information about the dynamics of the relationships between producers and consumers.
Options prices imply assumptions about the volatility of the underlying assets.
Compared to spot markets for underlying assets, derivatives markets offer several important operational advantages, including:
Lower transaction costs
Lower cash requirements
Greater liquidity due to lower capital requirements
The ability to easily take short positions
risks of derivatives
Lack of Transparency
Basis Risk
Liquidity Risk
Counterparty Credit Risk
Destabilization and Systemic Risk
Basis Risk
incurred when the derivative underlying does not match the exposure being hedged.
For example, corn farmers who sell a corn futures contracts will perfectly hedge their exposure to changes in the value of their crop
However, a refinery that expects to purchase Western Canadian Select crude oil in the spot market in three months may hedge its exposure by trading futures contracts based on the price of West Texas Intermediate crude oil. While prices of the two grades of crude oil may be highly correlated, the refinery in this example will be exposed to basis risk
Common derivative-based hedging strategies used by issuers include:
Both forward commitments and contingent claims can be used to create a cash flow hedge.
–> For example, an American exporter that is expecting to receive a large euro-denominated payment can use a forward currency contract to lock in a dollar amount to be received. Similarly, a company that has issued floating rate debt can enter an interest rate swap to achieve certainty over its outgoing interest payments.
A fair value hedge
net investment hedge
A fair value hedge
used to establish certainty over the fair value of an asset or liability.
–> For example, an oil producer can sell futures contracts to preserve the value of its inventory in anticipation of a decrease in the price of crude oil.
–> Using an interest rate swap to convert the nature of an obligation from fixed-rate to floating-rate is another example of a fair value hedge.
net investment hedge
using either a foreign currency bond or a derivative instrument (e.g., currency forward, currency swap) to offset the exchange rate exposure of the equity in its foreign operations.
Examples of possible uses of derivatives by investors include:
A hedge fund can use oil futures contracts to speculate on movements in the price of the underlying commodity without having to make a significant cash outlay or incur storage costs.
A defined-benefit pension plan can enter an interest rate swap to increase the duration of its fixed-income portfolio without having to purchase any new bonds.
A university endowment with a bullish view about a company can pay a premium for a call option to gain leveraged exposure to its stock.
A foundation that expects equity prices to remain relatively stable can enhance its returns by selling a call option on an underlying stock index that it currently owns.
Which of the following statements is most accurate?
A
Implementing a cash flow hedge requires a forward contract
B
A foreign currency bond may be used to implement a net investment hedge
C
Converting floating-rate debt into a fixed-rate obligation is an example of a fair value hedge
B
A foreign currency bond may be used to implement a net investment hedge
Net investment hedges are used to offset the currency risk associated with the equity of a company’s foreign subsidiary. Instruments that can be used to implement these types of hedges include foreign currency bonds as well as derivatives such as currency forward contracts and FX swaps.
A company is seeking to manage its exposure to rising interest rates over a six-month period before it expects to take out a new bank loan. By using interest rate futures rather than a forward rate agreement, the company would most likely:
A
eliminate its potential exposure to liquidity risk.
B
reduce its exposure to counterparty credit risk.
C
increase its likelihood of qualifying for hedge accounting treatment.
B
reduce its exposure to counterparty credit risk.
Over-the-counter derivatives, such as forward rate agreements, leave parties exposed to the potential that their counterparty will be unable to meet its contractual obligations. Exchange traded futures contracts have effectively no counterparty credit risk exposure because parties are required to meet margin requirements.
Last year, ACME Devices issued $100 million of five-year debt with a 4.5% annual coupon rate. By entering into an interest swap with a face value of $100 million as the fixed-rate receiver, the company is most likely executing a:
A
fair value hedge.
B
cash flow hedge.
C
net investment hedge.
A
fair value hedge.
By receiving the fixed-rate leg of the interest rate swap, ACME will be effectively converting its debt obligation from fixed to floating. The company will have less certainty about its outgoing cash flows, but it will have hedged the fair value of its liability.
Which of the following statements is most accurate?
A
The existence of derivatives markets makes markets for underlying assets more efficient and increases their liquidity
B
Derivatives markets are more liquid than spot markets for underlying assets but do not impact the liquidity of these markets
C
Derivatives markets are more liquid than spot markets for underlying assets but do not impact the efficiency of these markets
A
The existence of derivatives markets makes markets for underlying assets more efficient and increases their liquidity
osition his fund to profit from his expectation that interest rates will fall over the next six months:
Selling a European-style interest rate option contract
Buying an interest rate futures contract
If both contracts mature in six months and have the Secured Overnight Financing Rate (SOFR) as their underlying, Friedman’s analysis will most likely focus on how these derivative instruments differ with respect to:
A
basis risk.
B
liquidity risk.
C
counterparty credit risk.
B
liquidity risk.
Liquidity risk arises due to differences in cash flow timing. In this example, the European-style interest rate option contract will not require trigger any cash flows between the initiation date and the maturity date. By contrast, futures contracts carry liquidity risk due to the potential for additional margin deposits.
According to hedge accounting rules, changes in the fair value of a qualifying derivative instrument are least likely to impact a company’s:
A
equity.
B
net income.
C
other comprehensive income.
B
net income.
Mark-to-market changes in the value of a derivative that qualifies for hedge accounting treatment bypass a company’s income statement and are recorded directly in other comprehensive income, which is an equity account on the balance sheet.
Which of the following statements is most accurate?
A
The existence of derivatives markets makes markets for underlying assets more efficient and increases their liquidity
B
Derivatives markets are more liquid than spot markets for underlying assets but do not impact the liquidity of these markets
C
Derivatives markets are more liquid than spot markets for underlying assets but do not impact the efficiency of these markets
A
The existence of derivatives markets makes markets for underlying assets more efficient and increases their liquidity
