Derivatives

Q. Explain the relationship between beta and cross hedging in the case of a portfolio of equity securities is being hedged by an S & P 500 index contract?

A. Cross hedging is required when a derivative security does not exist with which to hedge on equity position. The common derivative used is the index contract. Since the index and the equity position may not have the identical price movement patterns, it is necessary to use a hedge ratio when implementing the cross hedge. The beta is the best proxy for a hedge ratio in this type of cross hedge.

Week 10- interest rate forwards and futures Ch 7

Q. More precise measurement band for price sensitivity?

A. Convexity – Measures the extent to which duration changes as the bonds yield changes. We can use convexity in addition to duration to obtain a more accurate prediction of the new bond price.

Q. Which of the following formula are used to determine the cheapest to deliver?

A. invoice price minus market price

Q. Short bond futures of the most interest at expiration?

A. Cheapest

Q. What is the pure yield curve and why is it common to present coupon based yield curves in practice?

A. The pure yield curve is a graph of annualized zero coupon yields for existing hypothetical zero coupon treasury securities. Coupon bonds are often used to present the yield curve since they are easier to find that zeros.

Q. Explain the expectations hypothesis and its ability to accurately forecast interest rates?

A. The expectations hypothesis is a generally held belief that the implied forward rate equals the spot rate of interest that will occur in the future. Since risk premiums exist this forecast is biased and usually does not accurately predict interest rates.

Q. Explain the process of creating a synthetic forward rate agreement?

A. This is done by trading a series of zero coupon bonds so as to simulate FRA (forward rate agreement) cash flows at time 0, time t and time t+s. Short at time 0 the PV of a zero coupon...