Chapter 12
Derivatives and Foreign Currency: Concepts and Common Transactions
Answers to Questions

1

Derivative is the name given to a broad range of financial securities. Their common characteristic is that the derivative contract’s value to the investor is directly related to fluctuations in price, rate, or some other variable that underlies it. Interest rate, foreign currency exchange rate, commodity prices and stock prices are common types of prices and rate risks that companies hedge.

2

A Forward is negotiated directly with a counterparty, while a future is a standard contract traded on an exchange. The exchange traded instrument has less risk of non-performance, and is commonly cheaper to transact. But standard contracts might not fit all companies’ needs. The forward carries the risk of counterparty default, but each contract can be tailored to exact needs.

3

An option gives the holder the right to buy or sell the underlying at a set price. The writer of an option has the obligation to either buy or sell. Options are often traded on exchanges and have low transaction costs.
Because an option is an agreement on a single transaction, they are not helpful in managing the risk of a stream of future transactions. A swap is an agreement to exchange a series of future cash flows. These are often negotiated, but there are some standardized exchange-traded swaps.

4

Net settlement means the instrument can be settled in cash for the net value. The parties in a net settlement do not have to buy or sell physical products and then realize the cash flows. Only one payment needs to be made, either from the holder or the writer of the instrument.

5

A transaction is measured in a particular currency if its magnitude is expressed in that currency. Assets and liabilities are denominated in a currency if their amounts are fixed in terms