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Financial Engineering > Financial Engineering Exam 1 > Flashcards

Financial Engineering Exam 1 Flashcards

(45 cards)

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1
Q

Risk

A

when we don’t know what the outcome is, but we do know the distribution of the outcomes

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2
Q

Uncertainty

A

when we don’t know what the outcome is, and we don’t know the distribution

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3
Q

Financial Engineering

A

The application of mathematical methods to the solution of problems in finance

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4
Q

Examples of Derivatives

A

o Futures Contracts
o Forward Contracts
o Swaps
o Options

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5
Q

Futures Contracts are traded on

A

Exchanges

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6
Q

Forward Contracts are traded on

A

OTC Markets

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7
Q

Swaps are traded on

A

OTC Markets

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8
Q

Options Contracts are traded on

A

Exxchanges

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9
Q

Purpose of Derivatives

A

o To hedge risks
o To speculate (take a view on the future direction of the market)
o To lock in an arbitrage profit
o To change the nature of a liability
o To change the nature of an investment without incurring the costs of selling one portfolio and buying another

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10
Q

Futures Contract

A

an agreement to buy or sell an asset at a certain time in the future for a certain price

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11
Q

oSpot Contract

A

an agreement to buy or sell the asset immediately (or within a very short period of time

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12
Q

Long Position

A

The party that has agreed to buy

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13
Q

Short Position

A

the party that has agreed to sell

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14
Q

Arbitrage Opportunity If F>P at expiration

A
  • Short the futures contract
  • Buy the asset
  • Make a delivery
    Profit = Number of positions ( F-P )
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15
Q

Arbitrage Opportunity If F < P

A
  • Buy Futures Contract
  • Short the asset
  • Wait for delivery
  • Profit =Number of Positions * ( P-F )
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16
Q

Items in contract

A 
o  Asset
o  Contract size
o  Delivery arrangements
o  Delivery month 
o  Price quotes
o  Price limits
o  Position limits
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17
Q

Futures are settled _____

A

Daily

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18
Q

Futures Settlement Price

A

the price just before the final bell each day. It is used for the daily settlement process

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19
Q

Futures Maintenance Margin

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A

margin call if the balance drops under the maintenance margin

20
Q

Forward Contracts

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A

o Similar to futures except trade in OTC markets
o Not standardized
o Not settle daily
o Popular with currencies and Interest Rates

21
Q

which is a larger market in forward contracts, OTC or exchanges?

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A

OTC is much larger by over 6 times

22
Q

Should companies hedge or not? Yes:

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A

Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables

23
Q

Should companies hedge or not? No:

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A

o Shareholders can make their own hedging decisions
o Shareholders diversify risk
o Prices of products may fluctuate to reflect cost of inputs.
o Explaining a loss on the hedge can be difficult
o Hedging may lead to worse outcomes if competition does not hedge

24
Q

Short hedge

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A

when you know you will sell and asset in the future and want to lock in the price

25
Long Hedge
when you know you will purchase in the future and want to lock in the price
26
Issues with Hedging Futures
o No futures with same underlying asset -> cross hedge | o Delivery of futures does not match desired maturity -> basis risk
27
Basis Risk
o Difference between spot and futures o Exists because of the uncertainties about the basis when the hedge is closed out bt=St-Ft
28
Cross Hedging Process
o Choose a future contract with the price most coorelated with the asset to be hedged o Calculate the minimum variance ratio o Calculate the optimum number of contracts
29
Hedging Using Index Futures
There are equations to determine the number of future contracts needed to be shorted to hedge
30
Fair-value
the cost of buying shares based on the value of the stock market futures that expire at the next expiry date (front month)
31
Fair-value 2
is the price of the contract at which the buyer (seller) is neutral between buying (selling) now at the exchange and buying (selling) a futures contract
32
Investment Assets
Assets held by at least some traders purely for investment purposes
33
Consumption assets
assts held primarily for consumption
34
Pricing of Forwards (and futures)
o Based on arbitrage arguments o Works really well for investment assets o But does not work well for consumption assets – because timing matters. With consumption assets if you need it now, you need it now
35
Short Selling
Selling securities that you do not own, in hopes that the price goes down and you can repurchase and return at a cheaper price - Unlimited losses (shares can theoretically go to infinity) - Limited gains (shares can only go to 0)
36
Swaps
an agreement to exchange cash flows at specified future times according to certain specified rules
37
Interest Rate Swaps
Exchanging interest payments on notional principal for a number of years - Does not swap principal
38
Typical Use of IR swaps
Convert a liability or an investment from - fixed rate to floating rate - floating rate to fixed rate
39
Criticism of the Competitive Advantage Argument
- Any advantage should be arbitraged away in efficient markets - However – the more creditworthy company bears the risk of default of the less creditworthy
40
Valuation of an IR Swap
- Initial swaps are worth close to 0 - Changes in IR will result in one party benefiting and one paying the price - Actual valuation of IR swaps will NOT be on exam
41
Eurodollar
deposits denominated in US dollars at banks outside of the US - The Eurodollar market is the largest source of global finance
42
Advantages of Eurodollar
- Not under the jurisdiction of the Federal Reserve | - Deposits are subject to much less regulation than similar Deposits within the U.S (including Reserve requirements)
43
Disadvantages of Eurodollar
- Not covered by FDIC insurance - Political risk - Eurodollars have a higher interest rate
44
Fixed for Fixed Currency Swaps
- Exchanging principal and interest payments at a fixed rate in one currency for principal and interest payments at a fixed rate in another currency for a number of years. - Principal amount exchanged at the beginning and the end of swap
45
Fixed for Fixed Currency Swaps - Typical Uses
- Conversion from a liability in one currency to a liability in another currency - Conversion from an investment in one currency to an investment in another currency - COMPANY WANTS TO ALIGN CURRENCIES OF ASSTS AND LIABILITIES TO REMOVE ER RISK

Financial Engineering (1 decks)

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