RISK DERIVATIVES - L1

• What is a derivative?

  An instrument whose value depends on another asset
• Why are derivatives important?

  They transfer risks in the economy
• What types of underlying assets can derivatives be based on?

  Stocks, currencies, interest rates, commodities
• What is a key feature of many financial transactions?

  They have embedded derivatives
• What approach to capital investment decisions is widely accepted?

  The real options approach
• Where are derivatives traded?

  On exchanges and over-the-counter markets
• What is the role of banks in derivatives trading?

  They acted as market makers before 2008
• What are central counterparties (CCPs)?

  They handle transactions in OTC markets
• How do OTC transactions compare to exchange-traded transactions?

  OTC transactions are much larger
• What are the ways derivatives are used?

  • To hedge risks
  • To speculate on market direction
  • To lock in arbitrage profits
  • To change the nature of a liability
  • To change the nature of an investment
• What is a forward contract?

  An agreement to buy or sell an asset later
• What is the forward price in a forward contract?

  The delivery price if negotiated today
• What is a long position in a forward contract?

  The party that agrees to buy an asset
• What is a short position in a forward contract?

  The party that agrees to sell an asset
• How does the forward price vary?

  It may differ for contracts of different maturities
• What is the payoff from a long forward position?

  ST - K
• What is the payoff from a short forward position?

  K - ST
• What is the total payoff if the exchange rate is $1.6000/£?

  $46,800
• What is the total loss if the exchange rate is $1.5000/£?

  -$53,200
• What is a futures contract?

  An agreement to buy or sell an asset later
• How does a futures contract differ from a forward contract?

  Futures are traded on an exchange
• What is the standardization of futures contracts?

  Contracts have specific quantities for assets
• What is the CME Group?

  A group of exchanges for trading futures
• How is the futures price determined?

  By supply and demand like spot prices
• What is the profit calculation for a futures contract?

  Difference between selling and buying prices
• What is the role of hedgers in futures trading?

  To protect against price movement
• What is a long hedge?

  Protecting against a rise in purchase price
• What is a short hedge?

  Protecting against a fall in selling price
• What do speculators do in futures trading?

  Profit from movements in futures prices
• What is the purpose of hedging?

  To reduce risk in financial transactions
• What is the outcome of hedging?

  No guarantee it will be better than no hedging
• What is the profit calculation for a US company hedging with a long position?

  $15,585,000 for £10 million
• How does ExportCo hedge its foreign exchange risk?

  By selling £20 million in the forward market
• What is the total amount ExportCo receives from selling £20 million?

  $31,066,000
• What is the risk of hedging?

  It may not always yield better outcomes
• What is the profit calculation for a US speculator buying in the spot market?

  $13,250 profit from the spot market
• What is the profit calculation for a US speculator using futures contracts?

  $14,750 profit from futures contracts
• What is the loss calculation for a US speculator in the spot market?

  -$11,750 loss from the spot market
• What is the loss calculation for a US speculator using futures contracts?

  -$10,250 loss from futures contracts
• What is the profit from the arbitrage opportunity?

  $300 profit from the arbitrage