Comprehension

9.4.1 Answer the questions using the active vocabulary and Unit 7 Glossary.

1. What are financial derivatives? It is a security whose price is dependent upon or derived from one or more underlying assets

2. When is a financial institution said to have taken a long position? When it buys a security with the expectation that the asset will rise in value.

3. When is a financial institution said to have taken a short position? Whet it trades borrowed security with the expectation that the asset will fall in value.

4. Why are both positions risky unless they offset each other?

5. What is the basic principle of hedging?

6. How can a forward contract be defined?

7. Give an example of an interest-rate forward contract. How does it hedge against interest rate risk? The First National Bank to sell to the Rock Solid Insurance Company, one year from today, $5 million face value of Treasury bonds at a price that yields the same interest rate on these bonds as today’s, say 6%. The First National offsets its long position in bonds by an equal short position for the same bonds with a forward contract.

8. What are the advantages and disadvantages of forward contracts?

9. How does a financial futures contract remedy the problems associated with forward contracts? Buyers and sellers contract not with each other but with the clearinghouse associated with the futures exchange

10. What is the difference between a forward contract and a futures contract?

11. Where are financial futures contracts traded?

12. Why is the financial futures market more liquid than the forward contracts market?

13. What are the functions of a clearing house?

14. What risks does a stock index futures contract eliminate?

15. What makes stock index futures contracts highly liquid?

16. What is an option? What makes it superior to forward or futures contracts in terms of hedging? It is a financial derivative that represents a contract sold by one party (option writer) to another party (option holder). Options are superior to forward or futures contracts because they allow to reduce the risk of holding an asset.

17. What kinds of options do you know?

18. What kind of option would you prefer to buy (call or put), if you expect the price of a stock to rise?

19. What kind of option would you prefer to sell (put or call), if you expect the price of a stock to rise?

20. How does the amount of premium depend on the strike price, the term of expiration, and the volatility of prices?

21. What do you know about different types of swaps?