NaimExplain

What does the FRA specify? - FRA agreed date, fixed at start of FRA - notional principal amount of the interest cover - FRA settlement date when compensation is paid - contract period on which the FRA interest rate cover is based (end date) - reference rate to be applied at settlement date

What are the disadvantages of FRAs? Risk of non settlement i.e. credit risk. No formal market exists and concern about difficulty closing out FRA position is overcome by entering into another FRA opposite to the original agreement.

What are the advantages of an FRA? - Tailor made, over the counter contract providing greater flexibility with respect to contract period and the amount of each contract - Unlike futures contract, FRA has no margin payments

What is the payment for a FRA? Involves the difference between the agreed interest rate and the actual interest rate at settlement Unlike a loan, no exchange of principal occurs.

What is a forward rate agreement? An over the counter product enabling the management of an interest rate risk exposure. It is an agreement between two parties on an interest rate level that will apply at a specified future date.

What is the cross commodity hedging risk? Use of a commodity or financial instrument to hedge a risk associated with another; often necessary as futures contracts are available for few commodities or instruments. - Have to select contract that has price movements highly correlated with the price of the commodity to be hedged

What is the basis risk? A perfect hedge requires zero initial and final basis risk. - Initial basis risk: the difference between the price in the physical market and the futures market at the commencement of the hedging strategy - Final basis risk: the difference at the completion of a hedging strategy

What is the margin payment risk? Initial margin required when entering into a futures contract, future cash required if prices move adversely, opportunity costs associated with margin requirements.

What is the standard contract size risk? Owing to contract size the physical market exposure may not exactly match the futures market exposure, making a perfect hedge impossible.

What are the financial risk exposures that futures contracts can manage? Cost of funds (borrowing hedge) Yield on funds (investment hedge) Foreign currency transaction Value of a share portfolio

Who are speculators? Expose themselves to risk in attempt to make profit. Enter the market with the expectation that the market price will move in a direction that is favourable for them.

What are the strategies that hedgers use? Straddle - buying and selling of contracts with different delivery dates to take advantage of price variances. Spread position - buying and selling of related, same delivery date contracts to benefit from price variances

What is the function of hedgers? Attempt to reduce the price risk from exposures to changes in interest rates, exchange rates and share prices. Take the opposite position to the underlying exposed transaction.

Why are futures market participants important? They provide depth and liquidity to the futures market, improving its efficiency

When can futures markets be established? Futures markets can be established for any commodity or instrument that: - Is freely traded - Experiences large price fluctuations at times - Can be graded on a universally accepted scale in terms of its quality - Is in plentiful supply, or cash settlement is possible

Describe contract delivery. Most parties to a futures contract: - manage a risk exposure or speculate - Do not wish to actually deliver or receive the underlying commodity/instrument and close out the contract prior to the delivery date ASX trade 24 requires financial futures in existence at the close of trading in the contract month to be settled with the clearing house through: - Cash settlement (cash payment at delivery date) - Standard delivery (delivery of the actual underlying financial security)

How is a contract closed out? Involves entering into an opposite position. Example: -Company S initially enters into a sell 1 10y Tbond contract with company B -Company S would close out by entering into a buy 1 10yr Tbond contract for delivery on the same date with company R -the second contract reverses the first contract and company S would not longer have an open position in the futures market

How are margin requirements repriced? A contract is marked-to-market on a daily basis by the clearing house. Repricing of the contract daily reflects current market valuations. Subsequent margin calls can be made to top up the initial margin to cover adverse price movements

Why are margin requirements imposed? To ensure traders are able to pay for any losses they incur owing to unfavourable price movements in the contract

What are margin requirements? Both the buyer (long position) and seller (short position) pay an initial margin held by the clearing house, rather than the full price of the contract