Chapter 5 - Application Of Derivatives In Risk Management Flashcards Preview

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Flashcards in Chapter 5 - Application Of Derivatives In Risk Management Deck (25)
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1
Q

What are the several ways in which derivatives are used

A
  1. Transferring market risk
  2. Modifying the payoff structure of an asset
  3. Enhancing the yield of an asset
  4. Lowering the funding cost to borrowers
  5. Changing the interest costs on liabilities from fixed to floating rates and vice versa
2
Q

Characteristics of a forward contract

A
  1. Non-standardizes customised agreement between two parties to buy and sell an asset at a specified price on a particular date.
  2. They are private arrangements that occur OTC
3
Q

What futures contracts

A
  1. Standardised contract creates to solve the problems of the forward contract
  2. Traded on a futures exchange
  3. Purchase price is predetermined by supply and demand
4
Q

What are parameters predefined in the futures contract

A
  1. Expiration time of the contract
  2. Quality and quantity of the underlying asset
  3. Delivery of the underlying asset
  4. Settlement conditions of the contract

Only price is not predefined

5
Q

How does the futures cobtract address the issues with the forward contracts

A
  1. Staandardizof the contracts improve liquidity
  2. The clearing house as a counter-party ensures liquidity
  3. Credit guarantees via its clearing house through daily settlement of gains and losses (Marked-to-market)
6
Q

Similarities and differences between forwards and futures

A

Similarities
1. Effective tool in managing both interest rate and equities

Differences

  1. Forwards can be tailored to the specific needs of the counterparties but have higher default risk and less liquidity
  2. Futures are traded on an exchange minimizing risk of default
7
Q

What does the beta of a portfolio tell us

A

How a portfolio compares with the entire market with regards to it volatility or systematic risk

8
Q

What is the formulanfor calculating beta

A

Bi = Cov(ri-rm)/var(rm)

Where

  • Bi is the market variance of the asset
  • ri is the expected return on the asset
  • rm is the average expected return of the market
9
Q

What are the 3 types of foreign exchange risk that businesses deal with

A
  1. Transaction exposure
  2. Economic exposure
  3. Translation exposure
10
Q

What is transaction exposure

A

This isnwhenna company expects cash flow in foreign currency to be received or paid at a later date or in the future

11
Q

What is economic exposure

A

This type of exposure occurs when changes in currency value affects business competitiveness

12
Q

What is translation exposure

A

This deals with the risk of converting foreign-denominated financial statements into domestic currency units

13
Q

What are the strategies for hedging currency risks

A

Receiving foreign currency - long position - sell forwards contracts

Paying foreign currency - short position - buy forwards contracts

14
Q

What are the two ways options can be structured

A

American style and European style

15
Q

What is the American style of structuring an options

A

The option can be exercised before the expiry date

16
Q

What is the European style of structuring options

A

It is exercised on the expiry date

17
Q

What are the two ways options can be settled

A

Cash or by delivery of the underlying asset

18
Q

What is a covered call

A

It is a position taken by a manager who buys an underlying security and sell a call option

19
Q

Why do people sell covered call strategies

A
  1. To make additional portfolio revenue

2. Because the manager does not expect the price of the asset to change over time

20
Q

What is a protective put

A

A long position in an underlying security and buying a put option

21
Q

What are other names for the protective put

A

Portfolio insurance or hedge Portfolio.

22
Q

What are the benefits of a protective put

A

Limits downside risk to the price paid for the put

23
Q

What is a swap

A

An agreement between two parties to exchange sequences of cash flows over a period of time.

Note initially one of the sequence cash flows is uncertain at the beginning

24
Q

What is the notional principal amount

A

It is the predetermined nominal value (cash flow for the swap)

25
Q

What are 5 ways that swaps can be used

A
  1. Converting loans from fixed to floating rates and vice versa
  2. Changing the duration of fixed income portfolios
  3. Changing a foreign-currency bond obligation to a domestic one and vice versa
  4. Diversifying a concentrated equity portfolio
  5. Changing allocation of stocks and bonds