Chap.4_Hedging risk with financial markets

Question 1

How can a company manage (financial) risks? Cite the main strategies.

Answer 1

1. Avoidance.
2. Self hedging.
3. Hedging: insurance; financial securities (derivatives).

Question 2

Define avoidance/self-hedging. Provide one concrete example.

Answer 2

1. Avoidance: Consists in simply avoiding taking the risk. Example: Fixing a minimum rating to grant a loan to a client.
2. Self-hedging: Consists in not hedging a risk. Example: When a company makes the active decision to consider the risk to occur anyway, it then becomes a cost instead of a risk.

Question 3

Explain how hedging can help a company overcome a risk.

Answer 3

Hedging allows a company to in freeze and transfer the risk to a third party (in exchange for a compensation).

Question 4

What is the “position”, in the context of financial markets?

Answer 4

When the company trades a given asset, it has a position on this asset.

Question 5

What is a long/short position on the market on a given asset?

Answer 5

1. Long position the company has bought the asset.
2. Short position the company has sold the asset.

Question 6

On which assets is it possible to have a “position”?

Answer 6

Position applies to all kinds of assets.

Question 7

What are your expectations if you are long/short an asset?

Answer 7

1. If you’re long: Expectation of increase in the asset’s price.
2. If you’re short: Expectation of decrease in the asset’s price.

Question 8

What are you afraid of if you are long/short an asset?

Answer 8

1. If you’re long: Fear of decrease in the asset’s price.
2. If you’re short: Fear of increase in the asset’s price.

Question 9

What is short selling?

Answer 9

Short selling happens when you do not own the asset you sell.

Question 10

What is a derivative product? Name and explain two examples of it.

Answer 10

A derivative product is a financial security “whose value depends on (or derives from) other more basic market variables” (called the underlying asset). Examples: futures/forwards, and swaps.

Question 11

What is a future/forward?

Answer 11

Contract through which:
1. The buyer commits to buy something (the underlying asset) from the seller, on a pre-specificied date (the delivery or maturity or expiration date) at a pre-specified price (the future/forward price).
2. The seller commits to sell and deliver something (the underlying asset) to the buyer on a pre-specificied date (the delivery or maturity
or expiration date) at a pre-specified price (the future/forward price).

Question 12

What is the difference between futures and forwards?

Answer 12

Question 13

What is the value of a long/short position in a forward contract at maturity? Represent it graphically.

Answer 13

Question 14

Who makes a profit in a future contract, and under which conditions?

Answer 14

1. The buyer makes a profit if the price of the underlying asset increases.
2. The seller makes a profit if the price of the underlying asset decreases.

Question 15

How should you close a position in a forward?

Answer 15

1. Either the contract is kept until maturity (Note: maturity dates are usually in March, June, September, and December).
2. Or you liquidate your position before the settle/maturity date: if you have a long position, you can take the reverse (short) position on the exact same contract.

Question 16

What is the swap? What are the main types of swaps?

Answer 16

A swap is an agreement between two parties to exchange cash flows in the future.
The main types of swaps are:
1. Interest rate swaps.
2. Foreign exchange swaps.

Question 17

What are the main types of swaps? Define them.

Answer 17

1. Interest rate swaps.
2. Foreign exchange swaps.

Question 18

What is an interest rate/FX swap? Define it and explain what kind of risk it helps overcome.

Answer 18

1. Interest rate swaps: swaps where parties “exchange” two interest rates, usually one fixed and one floating rate. Deals with interest rate risk.
2. Foreign exchange swaps: where parties ‘”exchange” one currency pair on the spot and forward market. Deals with forex risk.

Question 19

What is an option?

Answer 19

An option is a forward contract that the buyer is not obliged to fulfill; it is thus a forward contract whose value (for the buyer) cannot be negative.

Question 20

What is the difference between options and forwards?

Answer 20

Options are forward contracts that the buyer is not obligated to fulfill; whereas forwards are contracts that legally bind the buyer and the seller to buy or sell at a pre-specified date for a pre-specified amount.

Question 21

What is a call/put?

Answer 21

1. Call: it’s a buy option; it gives its buyer (or owner) the right, but not the obligation, to buy a fixed quantity of an underlying asset at a fixed price (strike or exercise price) on a pre-specified date (maturity or expiration date).
2. Put: it’s a sell option; gives its buyer (or owner) the right, but not the obligation, to sell a fixed quantity of an underlying asset at a fixed price (strike or exercise price) on a pre-specified date (maturity or expiration date).

Question 22

If you buy a call/put, what are your strategy and expectations?

Answer 22

1. The buyer of a call: expects an increase in the price of the underlying asset.
2. The buyer of a put expects a decrease in the price of the underlying asset.

Question 23

What does “exercising an option” mean?

Answer 23

When the buyer (owner) of the option enforces the
agreement and buys or sells the underlying asset at the agreed-upon price.

Question 24

What are the different types of options?

Answer 24

Question 25

What is the payoff of a long/short position in a call/put (mathematically)?

Answer 25

Question 26

What is the payoff of a long/short position in a call/put (graphically)?

Answer 26

Question 27

Explain how you could use options as a portfolio insurance? (in full English/graphically)

Answer 27

An investor who holds a diversified portfolio can anticipate a decrease in share prices but does not want to sell them (otherwise he would lose any possibility to make profits if his forecast is wrong).
He has two strategies:
1. Buy puts written on all the shares he has in his portfolio.
2. Buy a risk-free bond and a call written on all the shares in his portfolio.