Name: Vũ Thị Hải Student’s ID: 11181456 Class: Advanced Finance 60C DERIVATIVES – MID-TERM TEST Question 1: A derivative is an instrument that derives its value from an underlying asset The underlying asset can be in the form of equity, interest rate, commodities or even currency Derivatives are used to hedge aganist various types of risk that help the firm to share risk and invest in projects with relatively higher risk In term of sharing risk, according to Rajesh Kumar, in Strategies of Banks and Other Financial Institutions, 2014, financial institutions and corporations use derivative financial instruments to hedge their exposure to different risks, including commodity risks, foreign exchange risks, and interest rate risks Basically hedging consists of taking a risk position that is opposite to an actual position that is exposed to risk A company that takes variable-interest, short-term loans or that reissues commercial paper as it matures faces interest rate risk In such cases, the firm might hedge its position by entering into a transaction that would produce a gain of almost the same amount as the potential loss if interest rates increase Forwards, futures, and options can be used to hedge exposure to the effects of changing interest rates Foreign exchange futures contracts can be used by firms to hedge foreign exchange risks Interest rate swaps, which form a major chunk of derivatives, is used to hedge interest risk In interest rate swaps, the fixed interest payments are exchanged for floating rate payments or vice versa without exchanging the underlying principal amounts Derivatives hedging techniques using interest rate swaps and interest rate caps can help institutions retain core longer-duration assets to manage interest rate risk A business that must buy a commodity in the future is exposed to the risk of a rapid increase in the price of that commodity A “futures” contract—a common derivative—can be used to reduce risk exposure to volatile commodity prices When you buy a commodity futures contract you agree (today) to the price that you will pay to take delivery of a commodity in the future The seller of the contract is obligated to deliver the commodity on a specified date in the future for that price The future could mean a few months or a few years Commodity futures contracts are traded on regulated exchanges Trading commodity futures on organized exchanges dates back to Japanese rice exchanges in the 17th century Then and now, the exchange specifies the quantity and quality of the physical commodity that the futures contract is based on “Forwards” are very similar to futures, but they are not traded on exchanges They are traded over-the-counter (OTC) between two parties who may customize the forward contract to meet their specific risks In addition, one of the more common corporate uses of derivatives is for hedging foreign currency risk, or foreign exchange risk, which is the risk a change in currency exchange rates will adversely impact business results Companies depending heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs Airlines, for example, consume lots of jet fuel Historically, most airlines have given a great deal of consideration to hedging against crude-oil price increases For instance, Monsanto produces agricultural products, herbicides, and biotechrelated products It uses futures contracts to hedge against the price increase of soybean and corn inventory: Monsanto uses futures contracts to protect itself against commodity price increases these contracts hedge the committed or future purchases of, and the carrying value of payables to growers for soybean and corn inventories A 10 percent decrease in the prices would have a negative effect on the fair value of those futures of $10 million for soybeans and $5 million for corn We also use natural-gas swaps to manage energy input costs A 10 percent decrease in the price of gas would have a negative effect on the fair value of the swaps of $1 million Furthermore, stock equity options—another common derivative—can be used to increase or decrease exposure to the risk of rapidly fluctuating stock market prices There are two types of option contracts: “calls” and “puts” The owner of a call option owns the right, but not the obligation, to buy an asset at a specified price (known as the option’s strike price) by a specific date in the future For example, the $400 Amazon.com April 2014 call option would give the option owner the right, but not the obligation, to buy Amazon.com stock for $400 between now and April Call options rise in value when the underlying stock, in this case Amazon.com, rises The owner of a put option owns the right, but not the obligation to sell an asset at a specified strike price by a specified date in the future The April 2014 $330 Amazon.com put option would give the holder the right, but not the obligation, to sell Amazon stock for $330 between now and April Puts rise in value when the underlying stock falls Options trade on regulated exchanges, like the Chicago Board of Options Exchange, the Chicago Mercantile Exchange, and the International Securities Exchange Options also trade over-the-counter, away from regulated exchanges High-risk investments that may have potential for significant gains (or losses) Buyand-hold investors generally make money when the stocks they’ve invested in go up in price The benefits of derivatives also apply to investment risks A pension fund manager with a large portfolio of corporate bonds can protect the value of their portfolio by entering into a derivative contract Executing a derivative trade that increases in value as prices in the bond market fall will allow a manager to steady investment returns, and reduce losses in periods of short-term volatility Question 2: The correct answer is B is an agreement to buy or sell a specified amount of an asset at a predetermined price on the expiration date of the contract Future contract is an agreement to buy or sell a specified amount of an asset at a predetermined price on the expiration date of the contract Particularly, in a futures contract, two parties agree that one party (buyer) will purchase an underlying asset from the other party (seller) at a future date and fixed price they agree on when the contract is signed The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date Question 3: The correct answer is B $5,500 profit The profit per ounce: $4.10 - $3.00 = $1.10 The profit of the contract: $1.10 * 5,000 = $5,500