Finc Derivatives Exam 23/24
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37 Terms
Q. Difference 1 between forwards and futures?
A. Forwards are OTC, futures trade on exchanges.
Q. Difference 2 between forwards and futures?
A. Futures are standardised, forwards are customised.
Q. Credit risk difference?
A. Forwards have higher credit risk.
Q. Why do futures have lower credit risk?
A. Clearing house guarantees performance.
Q. What does hedging with derivatives mean?
A. Using contracts to reduce financial risk.
Q. Main argument for firms hedging?
A. Reduces cash flow volatility.
Q. Another benefit of hedging?
A. Lowers probability of financial distress.
Q. Argument against hedging?
A. Hedging can be costly.
Q. Another criticism of hedging?
A. Shareholders can diversify risk themselves.
Q. When is hedging most justified?
A. When market imperfections exist.
Q. What is daily settlement?
A. Daily adjustment of gains and losses.
Q. Which contracts use daily settlement?
A. Futures contracts.
Q. How does daily settlement work?
A. Positions are marked to market each day.
Q. Why is daily settlement important?
A. It reduces credit risk.
Q. What is risk-neutral pricing?
A. Pricing assuming investors are risk-neutral.
Q. Key assumption in risk-neutral pricing?
A. Expected return equals the risk-free rate.
Q. Does risk-neutral pricing reflect real preferences?
A. No.
Q. Why is risk-neutral pricing used for options?
A. It simplifies valuation.
Q. Why is it appropriate for option pricing?
A. Arbitrage ensures correct prices.
Q. Motive 1 for using interest rate swaps?
A. Managing interest rate risk.
Q. Example of hedging with a swap?
A. Fixed-rate payer swaps into floating.
Q. Motive 2 for using interest rate swaps?
A. Reducing borrowing costs.
Q. Example of cost reduction?
A. Firm exploits cheaper fixed-rate borrowing.
Q. What is comparative advantage in swaps?
A. Firms borrow where they are relatively cheaper.
Q. How does comparative advantage create gains?
A. Firms swap to preferred interest exposure.
Q. Typical comparative advantage pattern?
A. One firm cheaper in fixed, another in floating.
Q. Limitation 1 of comparative advantage argument?
A. It may reflect credit risk differences.
Q. Limitation 2?
A. Gains may disappear after credit adjustment.
Q. Why may comparative advantage be misleading?
A. Markets price risk efficiently.
Q. Who captures most gains in practice?
A. Often the swap bank.
Q. Why do swaps entail credit risk?
A. One party may default.
Q. When does credit risk arise in a swap?
A. When the swap has positive value.
Q. Is credit risk symmetric?
A. No.
Q. Relationship between swap value and credit risk?
A. Higher value increases exposure.
Q. Which party faces credit risk?
A. The party owed money.
Q. What happens to credit risk over time?
A. It changes with swap value.
Q. How is swap credit risk managed?
A. Collateral and netting agreements.
Note 
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