C13: Risk Management with Derivatives

What are financial derivatives?

Financial instruments whose payoffs are derived from underlying assets such as bonds, stocks, or interest rates

Why did financial derivatives become important?

Increased volatility in interest rates and markets increased demand for risk management

What is hedging?

Engaging in a financial transaction to reduce or eliminate risk

What is a long position?

Buying or holding an asset, exposed to price decreases

What is a short position?

Selling an asset (or agreeing to sell), exposed to price increases

What is the basic principle of hedging?

Offset a long position with a short position or a short position with a long position

If a bank owns a bond and fears interest rate increases, what should it do?

Take a short position (sell forward/futures)

If a firm expects to receive foreign currency, what hedge should it take?

Take a short position in that currency

What is a forward contract?

An agreement to buy or sell an asset at a specified future date and price

What are the four key features of a forward contract?

Asset, quantity, price, and delivery date

What is the main advantage of forward contracts?

Flexibility (customized contracts)

What is the main disadvantage of forward contracts?

Lack of liquidity and difficulty finding counterparties

What is another major problem with forward contracts?

Default risk (counterparty may not fulfill contract)

Why do forward markets have low liquidity?

Contracts are customized and not easily tradable

What is a financial futures contract?

A standardized agreement to buy or sell an asset at a future date

How do futures differ from forwards?

Standardized, tradable, and lower default risk

Why are futures markets more liquid?

Standardization and ability to trade contracts before expiration

What is arbitrage in futures markets?

Risk-free profit that ensures futures price equals underlying price at expiration

What happens to futures price at expiration?

It equals the underlying asset price

What is a micro hedge?

Hedging a specific asset

What is a macro hedge?

Hedging an entire portfolio

How do you calculate number of futures contracts for hedging?

Value of asset ÷ value of one futures contract

What is a margin requirement?

Initial deposit required to enter a futures contract

What is marking to market?

Daily settlement of gains and losses in futures contracts

How do futures reduce default risk?

Clearinghouse + margin + daily settlement

Why can futures contracts avoid delivery?

Offsetting positions cancel contracts

What is foreign exchange risk?

Risk from changes in exchange rates

How do you hedge FX risk with forwards?

Sell foreign currency forward if expecting to receive it

How do you hedge FX risk with futures?

Sell futures contracts equivalent to exposure

What is an option?

A contract giving the right (not obligation) to buy or sell an asset

What is the strike price?

The price at which the asset can be bought or sold

What is the premium?

The price paid for the option

What is a call option?

The right to buy an asset

When do you buy a call option?

When expecting prices to rise

What is a put option?

The right to sell an asset

When do you buy a put option?

When expecting prices to fall

What is the key difference between option buyer and seller?

Buyer has a right; seller has an obligation

What are American options?

Can be exercised anytime before expiration

What are European options?

Can be exercised only at expiration

What is "in the money" (call)?

Price > strike price

What is "out of the money" (call)?

Price < strike price

What is "in the money" (put)?

Price < strike price

What is the payoff of a call option at expiration?

Max(0, S − X)

What is the payoff of a put option at expiration?

Max(0, X − S)

Why are option profits nonlinear?

Loss is limited to premium, gains are potentially large

Why are futures profits linear?

Gains/losses move one-for-one with price changes

What is the key advantage of options over futures?

Limited downside risk

What is the key disadvantage of options?

Premium cost

What happens to call premium when strike price increases?

It decreases

What happens to put premium when strike price increases?

It increases

What happens to option premiums when time to expiration increases?

They increase

Why does longer expiration increase option value?

More price variability → higher potential gains

What happens to option premiums when volatility increases?

They increase

Why does volatility increase option value?

“Upside potential without downside risk”

What is a futures option?

An option on a futures contract

Why are options often written on futures instead of bonds?

Futures markets are more liquid

How do options hedge risk differently than futures?

Protect downside while allowing upside gains

Why might banks prefer options over futures?

Avoid large losses and accounting issues

What is a swap?

A contract exchanging one set of payments for another

What are the two main types of swaps?

Interest-rate swaps and currency swaps

What is an interest-rate swap?

Exchange of fixed-rate payments for variable-rate payments

What is notional principal?

The amount used to calculate payments (not exchanged)

How do swaps help manage risk?

Convert fixed-rate exposure to variable or vice versa

Why are swaps advantageous over balance sheet changes?

Lower transaction costs and preserve relationships

What is a major advantage of swaps?

Long-term hedging (up to 20 years)

What are disadvantages of swaps?

Default risk and low liquidity

Why do swaps have default risk?

No centralized clearing like futures

What role do intermediaries play in swaps?

Match counterparties and reduce information problems

What are credit derivatives?

Derivatives used to hedge credit risk

What is a credit option?

Option tied to bond price or credit spread

What is a credit spread?

Difference between risky and risk-free interest rates

What is a credit swap?

Exchange of loan payments to diversify risk

What is a credit default swap (CDS)?

Insurance-like contract paying out upon default or downgrade

What is a credit-linked note?

A bond with embedded credit option

How do credit derivatives reduce risk?

Transfer credit risk to another party

What is a major danger of derivatives?

High leverage leading to large losses

Why are derivatives compared to “financial weapons”?

They allow massive risk exposure

What is the key systemic risk of derivatives?

Large interconnected exposures can spread failure

Why are banks major players in derivatives?

They act as intermediaries

Why are notional values misleading?

Actual risk exposure is much smaller

What is the main real risk in derivatives?

Credit risk and speculative trading

What is the overall trade-off with derivatives?

Risk reduction vs potential for large losses