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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
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