Hedging

Question 1

Pros of forwards?

Answer 1

1) Tailored

2) No risk of hedge efficiency (futures)

Question 2

Cons of forwards?

Answer 2

1) Legally binding, can’t be dissolved
2) Not tradeable
3) Subject to risk of your receipt not paid (if receipt)
4) Used on large transactions only
5) Limited currencies
6) No potential upside

Question 3

Pros of futures?

Answer 3

1) Tradable
2) Use for smaller transactions
3) Flex using no. of contracts

Question 4

Cons of futures?

Answer 4

1) Can be inefficient hedge > part unprotected
2) No potential upside
3) Limited currencies

Question 5

Pros of OTC options?

Answer 5

1) Tailored

2) Benefit from upside

Question 6

Cons of OTC options?

Answer 6

1) Not tradable

2) Expensive premiums

Question 7

Pros of options?

Answer 7

1) Benefit from upside

Question 8

Cons of options?

Answer 8

1) Expensive premiums

Question 9

Pros of swaps?

Answer 9

1) Both parties benefit “comparative advantage”
2) Arrangement costs < than terminating existing loan and taking out new
3) Make interest rate savings
4) Available for longer periods of time
5) Flexible

Question 10

Cons of swaps?

Answer 10

1) Risk the counter party will default
2) Risk of an adverse movement in interest/exchange rates
3) Risk that the accounts may be misleading

Question 11

What is the definition of “real options”?

Answer 11

• “Real” because it usually for projects involving a tangible asset instead of financial instrument
• Not a derivative, but for actual opportunities a business may take advantage or may realise

Question 12

What is the mnemonic for real options?

Answer 12

FLexibile
Abandonment
Timing

FOllow on
Growth

Question 13

If you are a borrower do you buy or sell FRAs?

Answer 13

Buy

Question 14

If you are a lender do you buy or sell FRAs?

Answer 14

Sell

Question 15

If you are a borrower do you buy or sell futures?

Answer 15

Sell

Question 16

If you are a lender do you buy or sell futures

Answer 16

Buy

Question 17

If you are a borrower do you call (buy) or put (sell) options?

Answer 17

Put (sell)

Question 18

If you are a lender do you call (buy) or put (sell) options?

Answer 18

Call (buy)

Question 19

If you are making payment in FX, and the contract is in GBP, do you buy or sell a future?

Answer 19

Sell

Question 20

If you are getting a receipt in FX,and the contract is in GBP, do you buy or sell a future?

Answer 20

Buy

Question 21

If you are making payment in FX, and the contract is in FX, do you buy or sell a future?

Answer 21

Buy

Question 22

If you are getting a receipt in FX,and the contract is in FX, do you buy or sell a future?

Answer 22

Sell

Question 23

If you are making payment in FX, where do you borrow and where do you lend in a money market hedge?

Answer 23

Borrow GBP
Lend FX
“PLease first” > you always start at the known FX amount

Question 24

If you are getting a receipt in FX, where do you borrow and where do you lend in a money market hedge?

Answer 24

Borrow FX

Lend GBP

Question 25

What is purchase power parity?

Answer 25

The law of one price: (1+if) / (1+iuk) This is the same with inflation and interest rates.

Question 26

What are the currency risks ?

Answer 26

1. Transaction 2. Economic 3. Translation

Question 27

What is the intrinsic value of an option?

Answer 27

The value if it's expiry date were to be today

Question 28

What is the time value of an option?

Answer 28

The difference between intrinsic value and actual premium

Question 29

What makes the time value larger?

Answer 29

1. The length of time till expiry 2. Volatility of the underlying security 3. General interest rates

Question 30

What are the two things that affect intrinsic value?

Answer 30

1. Share price | 2. Exercise price