Lecture 8-9

Question 1

Advantages and disadvantages of hedging with futures?

Answer 1

Hedging with futures can reduce the firm’s
losses if prices move adversely but they also
eliminate gains if prices move favourably.
Example of James wanted to purchase long term bonds.

Question 2

Where are options traded?

Answer 2

on the Australian

Securities Exchange

Question 3

Calls definition:

Answer 3

Calls: A Call option gives the holder the right (but not the obligation) to buy a specified asset at a specified price (strike or exercise price) any time up until a specified expiration date (exercise date)

Question 4

Puts definition:

Answer 4

Puts: A Put option gives the holder the right (but not the obligation) to sell a specified asset at a specified price (strike or exercise price) any time up until a specified expiration date (exercise date)

Question 5

Exercise Price (Strike Price):

Answer 5

Price at which the asset may be

purchased in the case of calls, or sold in case of puts.

Question 6

Expiration date:

Answer 6

Last date on which an option can be exercised.
– American options – can be exercised up to expiration
– European options – can only be exercised at expiry.

Question 7

Option premium:

Answer 7

Price paid by the option buyer to the seller of the

option, whether a put or a call, for the right to exercise.

Question 8

Options advantages:

Answer 8

Allow you to limit your losses, take advantages of
any gains and decide later what you want to do – for
a price (option premium)

Question 9

The price of an option (the premium) depends

on a number of factors:

Answer 9

–The price variance of the underlying asset
– The changes in the price of the underlying asset
relative to the option’s exercise price
– The dividends of the underlying share
– The time left until the option expires
– Interest rates

Question 10

There are 4 Basic Options strategies:

Answer 10

1. Buying a call
   – You have the right (not obligation) to buy at pre determined price.
2. Writing a call
   – You are obligated to sell at pre-determined price if holder
   exercises
3. Buying a put
   – You have the right (not obligation) to sell at pre determined price
4. Writing a put
   – You are obligated to buy at pre-determined price if holder
   exercises

Question 11

Are call option holders profit capped or not?

Answer 11

No uncapped.

Question 12

Are put option holders profit capped or not?

Answer 12

Capped

Question 13

Caps:

Answer 13

protect borrowers against rising interest rates by restricting variable-rate loans to a maximum interest rate.

Question 14

FIs sell caps to borrowers why?

Answer 14

as part of a loan agreement or stand

alone

Question 15

what is a ceiling agreement?

Answer 15

between a bank and its customer specifies

the maximum lending rate on a loan and, therefore, protects the customer from interest rate risk.

Question 16

An interest rate cap is characterised by:

Answer 16

– A notional principal (ie, same as the loan amount)
– An interest-rate reference rate
– A cap rate (strike/exercise price)
– Period of agreement including payment dates and interest-rates dates.

Question 17

A Maximum rate facility is?

Answer 17

is a floating-rate facility with a
cap agreement within it, with the roll-over dates for the
drawn down of the loan and the cap agreement synchronised.
Ie, with a capped floating rate loan, when interest
rates rise above the guarantee or strike price, the rate
is capped and the borrow pay no more than the guarantee.

Question 18

what is a floor agreement?

Answer 18

A floor agreement specifies the minimum rate of
interest on a loan and, therefore, protect the bank from interest rate risk. If interest rates go below the floor, the customer pays the bank the difference between
the actual rate and the floor rate.

Question 19

To protect against decreasing interest rates, FI will…

Answer 19

To protect against decreasing interest rates, a FI
will often take out a stand alone floor option with
another financial services provider so that the FI do
not earn less as rates fall.

Question 20

An interest rate floor guarantee pays off if;

Answer 20

An interest rate floor guarantee pays off if the interest rate falls below the exercise price struck in the floor.

Question 21

A collar is formed by?

Answer 21

purchasing a cap and selling a floor back to the bank simultaneously.
– Ie, by prescribing the limits on min and max i-rates
(purchased when holder is concerned about excessive
volatility in i-rates)

Question 22

Zero-cost collar is where:

Answer 22

he premium for the cap will equal the premium for the floor.

Question 23

Pricing model for caps, floors and collars:

Answer 23

Black-Scholes model (not covered in BTP)

Question 24

Swap Contracts what are they?

Answer 24

Over-the-counter financial products that have been developed by the financial markets to allow parties to enter into a contractual agreement to exchange cash flows
– Swaps are not a source of funding for a borrower (ie
underlying loan contract and swap contract are 2
separate contractual commitments)
– Can be intermediated or direct swap

Question 25

2 main types of swap contracts:

Answer 25

1) Interest rate swaps: Agreements between 2 parties to exchange a series of interest payments based on a notional principal amount for a specified period
2) Cross-currency swaps

Question 26

Interest Rate Swaps types of swaps;

Answer 26

• Vanilla swap: Fixed-for-floating interest rate

* Basis swap : Floating-for-floating interest rate swap

Question 27

Swap purpose?

Answer 27

Purpose: remove uncertainty for both parties