General Derivatives Flashcards
(7 cards)
What is a derivative?
A contract which involves two parties agreeing to a future transaction. Its value depends on (or derives from) the value of another underlying variable (e.g., price of a stock, price of hogs or amount of snow falling at ski resort).
What are the benefits of derivatives?
Short position: Benefit from a decline in the value of the underlying asset.
Leverage: Invest only a small amount of your own capital. Payment of margin/deposit upfront rather than the entire asset’s value.
Low transaction cost: Derivatives often have lower transaction costs than the underlying asset.
More liquidity: Derivatives markets tend to be highly liquid.
What are the primary uses of derivatives?
Hedging: Reducing the risk of potential future movements in a market variable.
Speculation: Betting on the future direction of a market variable.
Arbitrage: Taking offsetting positions in two or more instruments to lock in a profit.
Explain carefully the difference between hedging, speculation, and arbitrage.
A trader is hedging when he has an exposure to the price of an asset and takes a position in a derivative to offset the exposure. In a speculation the trader has no exposure to offset. He is betting on the future movements in the price of the asset. Arbitrage involves taking a position in two or more different markets to lock in a profit.
Give three reasons why the treasurer of a company might not hedge the company’s exposure to a particular risk.
(a) If the company’s competitors are not hedging, the treasurer might feel that the company will experience less risk if it does not hedge.
(b) The shareholders might not want the company to hedge because the risks are already hedged within their portfolios.
(c) If there is a loss on the hedge and a gain from the company’s exposure to the underlying asset, the treasurer might feel that he or she will have difficulty justifying the hedging to other executives within the organization.
A corn farmer argues “I do not use futures contracts for hedging. My real risk is not the price of corn. It is that my whole crop gets wiped out by the weather.”Discuss this viewpoint. Should the farmer estimate his or her expected production of corn and hedge to try to lock in a price for expected production?
If weather creates a significant uncertainty about the volume of corn that will be harvested, the farmer should not enter into short forward contracts to hedge the price risk on his or her expected production. The reason is as follows. Suppose that the weather is bad and the farmer’s production is lower than expected. Other farmers are likely to have been affected similarly. Corn production overall will be low and as a consequence the price of corn will be relatively high. The farmer’s problems arising from the bad harvest will be made worse by losses on the short futures
position. This problem emphasizes the importance of looking at the big picture when hedging. The farmer is correct to question whether hedging price risk while ignoring other risks is a good strategy.
What is a basis point?
0.01%
