Introduction to financial risk management

Question 1

what is financial risk management

Answer 1

the management of volatility risks in FX, debt, commodity and stock markets, mainly through the use of derivatives.

Question 2

what are the major decisions to be made by management concerning financial risk management?

Answer 2

whether to hedge either fully, partly or not at all; how to hedge and the magnitude and duration of any hedge

Question 3

what is interest rate volatility?

Answer 3

the fluctuation on variable interest rates. Hedging against adverse changes in interest rates can stabilise borrowing costs

Question 4

what is commodity price volatility and how can it be hedged?

Answer 4

the volatility of materials, and in the price that will be received when products are sold. Hedging includes: forwards, futures, commodity swaps and options.

Question 5

what is a derivative instrument?

Answer 5

an instrument whose value depends on the values of other more basic underlying variables. derivatives are either traded on an exchange, or customised by dealers, so as to meet a customer’s requirements - these are known as OTC derivatives. derivative financial instruments, such as futures, options and swaps, are commonly used to manage financial risks.

Question 6

explain a futures contract?

Answer 6

a contract between 2 parties, which allows one party to buy something from the other at a later date, but at a price agreed upon today. they are exclusively traded on a futures exchange.
Examples include:
agricultural commodities
metals
energy
currency
financial futures: interest rates and shares.

Question 7

explain forwards contracts

Answer 7

a forward contract is like a futures contract, however, instead of being traded exclusively on a futures exchange, they are traded OTC.

Question 8

what is an option?

Answer 8

an option is a contract between 2 parties that gives the buyer the right (but not obligation) so buy or sell something from the seller. This is also done at a later date but agreed upon today

Question 9

Explain the following option terminology:
option premium price
call option
put option
exercise (strike) price

Answer 9

option premium price: the price of the option
call option: the right to buy
Put option: the right to sell
Exercise price: the agreed price

Question 10

what are the 3 reasons for trading derivatives?

Answer 10

hedging: to reduce financial risk
speculation: to seek profit by taking a view on the future direction of markets
Arbitrage: to seek ‘risk-free’ profit, by exploiting price differentials across different markets for the same underlying asset.

Question 11

how are futures contract terms and conditions specified?

Answer 11

size, quotation unit, minimum price fluctuation, contract grade and training hours

Question 12

what are the delivery terms of a futures contract?

Answer 12

delivery date and time, and delivery or cash settlement

Question 13

explain a margin deposit

Answer 13

the initial margin is a specified amount of cash and/or marketable securities, which must be deposited with the futures broker for each traded contract. the margin requirement helps to ensure that traders don’t default on their obligation. Margin requirements are set by the futures exchange at approximately 5-7% of the underlying contract value. futures trading is highly leveraged. the balance in the traders account is adjusted to reflect daily settlement prices i.e. accounts are marked to market on a daily basis.

Question 14

what is the maintenance margin?

Answer 14

the maintenance margin is a predetermined level of value whereby if a traders losses fall below the maintenance margin, additional margin will have to be deposited to restore the account to the initial margin.

Question 15

what is the role of the clearing house in regards to futures contracts?

Answer 15

it is an intermediary between buyers and sellers. traders effectively buy from, or sell to the clearing house. the number of bought and sold contracts is equal, therefore, the margin of the clearing house is zero. the clearing house minimises the risk to default to traders because it absorbs any losses due to non-performance of traders. it means that buyers and sellers do not have to negotiate on an individual basis, nor bear each others default risk. Purpose of initial and maintenance margins is to provide protection to the clearing house and ultimately to traders.

Question 16

what does closing out a futures contract involve?

Answer 16

entering into an equal and opposite trade. For example, a bought futures position in 2 december gold will be closed out by selling two gold futures contracts of the same delivery month.

Question 17

why are most futures contracts closed out before maturity?

Answer 17

for most assets, it is generally inconvenient and costly to take or make delivery.
and;
speculators have no interest in delivery

Question 18

explain the delivery of a futures contract

Answer 18

if a contract is not closed out before maturity, it is usually settled by delivering the asset underlying the contract. when there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. the buyer takes the delivery.

Question 19

what are open positions (open interest)?

Answer 19

the total number of contracts outstanding. it is equal to the number of unliquidated short and long positions created when traders open new positions. for any given delivery month, the number of long positions must equal the number of short positions. open interest reflects the level of activity and liquidity of a given contract.

Question 20

what is the futures contract settlement price?

Answer 20

the price before the close each day. it is used for the daily settlement (mark-to-market) process.

Question 21

explain the 5 futures order types

Answer 21

1. market order - immediately at best price
2. limit order - specifies a price, and order to be executed at this price or better
3. stop-loss order - order to be executed at best price once a bid or offer is made at that price or lower. purpose is to close out a loss-making position.
4. stop-limit order - combination of stop and limit order
5. market-if-touched order - executed at best available price after a trade occurs at the specified price. purpose is to ensure that profits are taken.

Question 22

explain a forward contract in greater detail?

Answer 22

a forward contract is an agreement to buy or sell an asset at a certain time in the future, for a specified price at the time of entering the contract. there is no daily settlement based on the movement of the underlying asset’s price. At maturity of the contract, one party buys the asset for the agreed price from the other party - usually physical delivery takes place

Question 23

how does a forward contract work?

Answer 23

they are OTC agreements between 2 parties. they can be categorised as:
customised
private
essentially unregulated
credit risk

the initial value of the contract is 0

Question 24

what are the differences between forwards and futures contracts

Answer 24

1: interaction: forwards are between 2 parties, whereas futures are exchange traded
2. standards: forwards are non-standard contracts, whereas futures are standardised
3. delivery date: forwards usually have a specified delivery date, whereas futures have a range of delivery dates
4. settlement: forwards are settled at maturity, whereas futures are settled daily.
5. close out: forwards are usually closed out at maturity and delivery or cash settlement usually occurs. futures are usually closed out prior to maturity.