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Homework answers / question archive / QUESTION TWO (25 marks) Derivatives are specific types of instruments that derive their value over time from the performance of an underlying asset: e

QUESTION TWO (25 marks) Derivatives are specific types of instruments that derive their value over time from the performance of an underlying asset: e

Finance

QUESTION TWO (25 marks)

Derivatives are specific types of instruments that derive their value over time from the performance of an underlying asset: e.g. equities, bonds, commodities. A derivative is traded between two parties – who are referred to as the counterparties. These counterparties are subject to a pre-agreed set of terms and conditions that determine their rights and obligations. Derivatives can be traded on or off an exchange and are known as: a) Exchange-Traded Derivatives (ETDs): Standardized contracts traded on a recognized exchange, with the counter parties being the holder and the exchange. The contract terms are non-negotiable and their prices are publicly available, b) Over-the-Counter Derivatives (OTCs): Bespoke contracts traded off-exchange with specific terms and conditions determined and agreed by the buyer and seller (counterparties). As a result OTC derivatives are more illiquid, e.g. forward contracts and swaps.

Required

Explain how a commercial bank can manage its risk using the following derivative instruments:

i)

Options

[5 marks]

ii)

Futures

[5 marks]

iii)

Forwards

[5 marks]

iv)

Swaps

[5 marks]

v)

Swaptions

[5 marks]

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A.Options-Options are generally used as two types. Call option will be providing the bank with the right to buy a certain amount of security whereas put option will be providing a right to sell a certain amount of security so bank will be trying to counter its existing exposure by holding an option which will be protecting against the downside of the exposure and bank can do that by purchasing the put option on that exposure or bank and even try to sell the call option on that exposure. These options are never obligatory nature and they are just their rights.

B.Futures-Futures will be standardized contracts which are used by the bank in order to their exposure and they will be trying to long a certain amount of futures on securities or they can even goes shot on certain amount of securities and these position will be based upon the counter position of the existing exposure the bank will be holding in order to protect the downside.these are obligated to be exercised before the maturity date.

C.Forwards-Forward contracts are type of derivative which are nonstandardized and customized contract in nature and bank will be trying to enter into these forward contracts in order to deal with various exposures and they will be taking Counter position in order to help their exposure and it can also be said that there will be a large amount of counterparty risk involved various contracts.

D.Swaps-Bank can swap their exposure with another type of exposure or cash flows and it will be trying to protect themselves against risk. It will be helping the commercial bank in exchange of the risk related to interest payment by swapping floating rate with fixed rate and vise versa and bank can apply swaps in currency swaps also.

E.Swaptions- Swaptions will be providing with the right to the commercial bank in order to enter into a swap and these will be just providing with the rights  and these are not obligatory in nature so this will help the commercial bank in order to hedge their exposure.