FIL241 Chapter 11 Exam Questions & answers 2022

FIL241 Chapter 11 Exam Questions & answers 2022What are derivative security? A financial instrument whose value depends on the value of the underlying asset. A contract between two people (or institutions) where one person's gain in the other person's loss. What are the types of derivative securities? Futures, forwards, options, and swaps. By use: to manager interest rate, commodity price, stock market price, and foreign exchange risk. What are the characteristics of derivative securities? Very risky when used for speculation. The expected return on a well-diversified portfolio of derivatives is zero before transaction costs (negative, taking into consideration transaction costs). How can you use forward contracts? To hedge risk (lock in your price for a future transaction) and to speculate. What risk is associated with forward contracts? Default by the other party; other-hedging risk. What are the differences between forward (or futures) and spot markets? In spot markets, the agreement about all the conditions of a transaction and the execution of the transaction happen at the same time. In the forward (futures) markets, the conditions are agreed upon in advance. What are the differences between futures and forward contracts? Futures are standardized and traded on exchanges. They require clearinghouse participation to guarantee transactions. What are margin requirements? How do they work? To reduce the risk to the clearinghouse, the buyers and sellers of futures contracts are required to deposit a certain amount with the clearinghouse. The initial margin is the amount one has to deposit at the time of entering futures contracts. The maintenance margin is the lowest allowed estimated value of the margin account. Every day, the clearinghouse estimates profits or losses on the futures contract and what would be left in the margin account if the contract would be executed today (compares the futures contract price and the spot market price). Margins are also used in other transactions where participants can lose more than they invested (e.g., short selling). Explain the delivery on future contracts. Usually, the underlying asset is not delivered. Instead, the clearinghouse estimates the loss or profit on the contract and pays or receives it, canceling the contract. How are futures market instruments created? Exchanges develop new products based on demand from customers. Who are the two groups of futures market participants? How do they affect the markets? Hedgers and speculators. Larger number of participants makes it possible for more instruments to exist and increase their liquidity. When speculators trade on information, they increase the market efficiency. What are different types of options? How can they be used? Call option (right to buy). Put option (right to sell). Hedging (especially when the amount that needs to be hedged is very uncertain) (buying options); speculation (for the buyer of options, the losses are limited to the amount they pay when buying the option; writing (selling) options is very risky) How can we estimate the gains and losses on options? From the buyer perspective: always include the premium as a negative cash flow; compare the exercise and spot prices to decide if to exercise the option—if exercise, also include the difference between the exercise and spot prices. Which factors affect option value? The strike (exercise) price relative to the price of the underlying asset (If the option would be exercised today, what would be the profit or loss from the exercise?). Volatility of the underlying asset (greater volatility, greater option value and thus its premium). What are swap contracts? How are they used? Agreements to exchange future cash flows of different patterns (e.g., exchange an obligation to pay adjustable interest rate on a loan for an obligation to pay fixed interest rate). For risk management (hedging) and speculation. What are credit default swaps? Essentially, an insurance contract that pays when there is a default on bonds or similar securities (e.g., mortgage backed securities). It pays enough to ensure that a bondholder of this bond would receive all coupon payments and face value as promised by the bond contract. One does not have to own a bond to buy the credit default swap on it. Some people made a lot of money by using these securities during the last financial crisis. It is likely that they speeded up the crash, which is beneficial to the economy. CDS prices depend on the default risk of the underlying asset. Thus, they can be used as measures of default risk (an alternative to credit ratings).