Topic 17: Financial Risk Management Part II (Sem 2)

Question 1

Swap Contract

Answer 1

An agreement by two parties to exchange, or swap, specified cash flows at specified intervals in the future.

Typically involves currencies, interest rates or commodities.

They are not publicly traded on recognised exchanges because they are custom made arrangements between two parties

Banks often act as swap dealers and play a key role in the swaps market.

NOTE: CHECK EXAMPLES IN NOTES

Question 2

Option Contract

Answer 2

An agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specific price for a set period of time.

NOTE: CHECK EXAMPLES IN NOTES

Question 3

Option Contract (Call Option)

Answer 3

An option the gives the owner the right, but not the obligation, to buy an asset.

Note:
Buying a call option allows the buyer to profit from a rise in price
Selling a call option forces the seller to make a loss from a rise in price

Question 4

Option Contract (Put Option)

Answer 4

An option that gives the owner the right, but not the obligation, to sell an asset.

Note:
Buying a put option allows the buyer to profit from a fall in price.
Selling a put option forces the seller to make a loss from a fall in price.

NOTE: CHECK EXAMPLES IN NOTES

Question 5

Key benefit of an Option

Answer 5

It provides a one way bet to benefit from price changes. An option allows you to avoid ‘bad’ downside risk, but benefit from ‘good’ upside risk. Due to this feature options are usually expensive and involve a fee.

Question 6

Hedging with options

Answer 6

NOTE: CHECK EXAMPLES IN NOTES

Question 7

Summary

Answer 7

Option contracts are a very useful hedging tool because they allow a one sided bet - protection against the downside risk, whilst retaining the ability to profit from the upside risk.

Derivatives are an increasingly important part of financial risk management however are also quite risky.