Define each of the following terms:
- a. Derivatives
- b. Enterprise risk management
- c. Financial futures; forward contract
- d. Hedging; natural hedge; long hedge; short hedge; perfect hedge; symmetric hedge; asymmetric hedge
- e. Swap; structured note
- f. Commodity futures
a)
To define: The term derivatives.
Explanation of Solution
An indirect claim security whose value (in whole or in part) is derived from the market price of the other securities traded in the market is known as derivative.
The market in which securities with derived values are traded is called derivative market. It comprises instruments like options (call or put options), interest rate futures, swaps, commodity futures and exchange rate futures.
b)
To define: The term enterprise risk management.
Explanation of Solution
Enterprise risk management is the process designed by the top managerial authorities in an enterprise by which potential uncertain events that might impact the enterprise and manage risk to be within its risks appetite to offer reasonable guarantee regarding the achievement of enterprise objectives.
c)
To define: The financial future contract and forward contract.
Explanation of Solution
Future contract are the contracts by which buyer or seller can buy or sell the financial assets in the future specified date at the prices decided today. This is used by the investors if the estimated future value of the financial assets is going to increase or to decrease to earn profit and reduce their losses.
Futures are available for Treasury bill, CDs, bonds, currencies, stock indices, E dollar and treasury notes.
The forward contracts are quite similar to future contracts, but the main difference between them is that actual delivery takes place under forward contract whereas under future contracts actual delivery of goods does not takes place. Under futures, virtual delivery is made to the investors’ account.
d)
To define: The terms natural hedge, long hedge, short hedge, perfect hedge, symmetric hedge and asymmetric hedge.
Explanation of Solution
A transaction is said to be hedging by which firm tries to reduce the risk of damages caused due to the fluctuations in interest rates, exchange rates and stock prices.
Natural hedging: A transaction by which the risk of both the counterparties is reduced, this transaction is known as natural hedging.
Long hedge: It means the purchase of future contract as investor believes that the prices of the financial assets will increase whereas the short hedge is to sell the future contract with anticipation of fall in the future prices.
Perfect hedge: The transaction which completely offsets the gain or loss on the non-hedged position is called perfect hedge.
Symmetric hedge: When the upward and downward prices changes can be protected by using a transaction that hedge is known as symmetric hedge. For instance, reduce risk by using future contracts.
Asymmetric hedge: An asymmetric hedge covers only one-directional changes in price more than other. For instance, options are used to cover asymmetric hedges.
e)
To define: The term swaps and structured notes.
Explanation of Solution
Swaps: Swaps is an interchanging of cash payment obligations. It used by the firm so that they can reduce their risk as this contract allows the firm to exchange the risk or debt of another party whose debt contract terms are more attractive.
Structured note: A debt obligation resulting from another debt obligation which allows risk dividing of risks to give investors whatever they desire for.
f)
To define: The term commodity futures.
Explanation of Solution
Commodity futures contracts: Commodity futures contracts are futures contracts that permits the trading of commodities such as oilseed, gold or other metal, livestock, fiber, meats, wood, and grains. There is a list of commodities for which futures are traded.
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Chapter 24 Solutions
Intermediate Financial Management
- Define each of the following terms: c. Financial futures; forward contractarrow_forwardDescribe forwards, futures, and swaps. What are the features of each type of derivative and how are these derivatives used to hedge risk or speculate?arrow_forwardDescribe Derivatives Used to Hedge Risk.arrow_forward
- a)describe the major differences between futures and forwards. b)describe delivery and settlement in derivative markets. c)describe financial engineering and hybrids. d)discuss the three presuppositions for a well-functioning financial market.arrow_forwardIdentify the major derivative securities used to hedge against risk.arrow_forwarda)define interest rate swaptions, and differentiate between payer swaptions and receiver swaptions. b)define forward swaps. c)define risk management. d)discuss reasons for practicing risk management. e)discuss how firms can benefit from risk management.arrow_forward
- How do forwards, futures, and swaps hedge risk?arrow_forwardIndicate the type of hedge each activity described below would represent. Activity 1. An options contract to hedge possible future price changes of inventory. 2. A futures contract to hedge exposure to interest rate changes prior to replacing bank notes when they mature. 3. An interest rate swap to synthetically convert floating rate debt into fixed rate debt. 4. An interest rate swap to synthetically convert fixed rate debt into floating rate debt. 5. A futures contract to hedge possible future price changes of timber covered by a firm commitment to sell. 6. A futures contract to hedge possible future price changes of a forecasted sale of aluminum. 7. ExxonMobil's net investment in offshore drilling operations in Brazil. 8. An interest rate swap to synthetically convert floating rate interest on an available-for-sale debt investment into fixed rate interest. 9. An interest rate swap to synthetically convert fixed rate interest on a held-to-maturity debt investment into floating rate…arrow_forwarda)explain current credit risk and potential credit risk. b)describe the primary methods of managing derivative credit risk. c)explain what is meant by netting, and discuss various forms of netting. d)define credit derivatives. e) describe the four primary types of credit derivatives: total return swap, credit swap/credit default swap, credit spread option, credit-linked securityarrow_forward
- Bond ratings primarily reflect which of the following? Reinvestment risk, Default risk , Interest rate risk, Yield curve riskarrow_forwardDerivative instruments acquired to hedge exposure may be classified as either a fair value hedge or a cash flow hedge. Discuss these two types of hedges and provide numerical examples for each.arrow_forwardDistinguish between margins in the securities markets and margins in the futures markets.arrow_forward
- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning