Chapter 24/25 Flashcards
(45 cards)
What is a hedge?
A strategy used to reduce risk in financial transactions
Hedging involves taking a position in a financial derivative to offset potential losses.
Name the types of financial derivatives used for hedging.
- Forward
- Futures
- Swap
- Option
What does volatility measure in risk management?
The degree of variation in returns; higher volatility indicates higher risk
Volatility affects cash flows and overall firm value.
How can firms reduce risk in cash flows?
By reducing dependence on volatile business factors
This can lead to more stable cash flows and returns.
What is hedging (immunization)?
Reducing exposure to fluctuations in business factors to lessen correlation with cash flow volatility.
List the most influential business factors in risk management.
- Interest Rate
- Exchange Rate
- Commodity Price
What is a financial derivative?
A security that derives its value from another asset
It has no intrinsic value on its own.
What are the two steps involved in the hedging process?
- Identify types of volatility impacting firm value
- Choose appropriate financial derivative to neutralize volatility
What is a risk profile?
A tool for identifying and measuring exposure to factor risks
It visually represents the relationship between factor price changes and firm value changes.
What does a steeper slope in a risk profile indicate?
Greater exposure to risk, necessitating more management.
What is the purpose of a forward contract?
To agree on the price of an asset today for future delivery
It locks in a price despite market fluctuations.
What are the two positions in a forward contract?
- Long - agrees to buy the underlying asset
- Short - agrees to sell the underlying asset
List characteristics of a forward contract.
- Legally binding
- Tailored to parties’ needs
- Can be large in size
- Limited to creditworthy corporations
What is a futures contract?
An exchange-traded forward contract with standardized terms.
What eliminates credit risk in futures contracts?
The clearinghouse and margin requirements
Futures are marked-to-market daily.
What are the pros and cons of futures contracts?
Pros: No credit risk
Cons: Initial investment, lack of flexibility, basis risk.
What is a swap in financial derivatives?
A long-term agreement to exchange cash flows based on specified relationships.
What types of swaps are common?
- Interest Rate Swaps
- Currency Swaps
What is unique about options in financial derivatives?
They give the holder the right, but not the obligation, to buy or sell an asset.
What distinguishes a call option from a put option?
A call option allows buying an asset, while a put option allows selling an asset.
What happens when an option is exercised?
- Long position of the call pays cash to buy the underlying asset
- Short position of the call receives cash and sells the underlying asset
What factors determine the price of an option?
Characteristics of the underlying asset and the nature of transferred rights.
What is the expiration date in options?
The date after which the option is worthless
American options can be exercised any time before expiration, while European options can only be exercised at expiration.
What are the key variables of an option?
- Expiration date
- Exercise (strike) price
- Current price of the underlying asset
- Price at expiration
- Risk-free rate
- Volatility
