1. OTC derivatives comprise five broad classes: interest rate, foreign exchange, equity, commodity, and credit default swaps.
- Explanation: OTC (Over-The-Counter) derivatives are financial contracts that are privately negotiated and traded directly between two parties without going through a centralized exchange. These derivatives are classified into five main categories based on the underlying assets they are linked to: interest rates, foreign exchange rates, equity shares, commodities, and credit default swaps (CDS).
2. Interest rate derivatives dominate the five classes. As of December 2017, interest rate derivatives had a notional principal outstanding of $426.6 trillion, which represented 80% of the total notional principal of OTC derivatives of $531.9 trillion.
- Explanation: Among the five categories, interest rate derivatives have the largest notional principal outstanding, which means they account for the highest total value of contracts. In December 2017, the notional principal outstanding for interest rate derivatives was $426.6 trillion, making up 80% of the total notional principal outstanding for all OTC derivatives, which was $531.9 trillion.
3. The second and third largest categories were foreign exchange derivatives and credit default swaps, respectively, followed by equity and commodity derivatives.
- Explanation: After interest rate derivatives, foreign exchange derivatives had the second-largest notional principal outstanding, and credit default swaps had the third-largest. Equity and commodity derivatives followed after those two categories in terms of notional principal value.
4. Measuring OTC derivatives exposure through notional principal can be misleading. A basic fixed-for-floating coupon interest rate swap, for example, does not have principal risk because only the coupon cash flows are exchanged at each settlement. Furthermore, even coupon risk is lower, because only the net cash flows are exchanged.
- Explanation: Notional principal value represents the face value or reference amount on which payments are calculated in OTC derivatives contracts. However, it does not reflect the actual risk exposure or the amount at stake in the contract. Some derivatives, like interest rate swaps, involve the exchange of interest rate payments rather than the principal itself. This means that the risk lies in the interest rate fluctuations and not the principal amount.
Example: In a basic fixed-for-floating coupon interest rate swap, Party A agrees to pay a fixed interest rate to Party B, while Party B agrees to pay a floating interest rate (e.g., LIBOR) to Party A. The notional principal is only used to calculate the interest payments, but the principal amount is not exchanged between the parties.
5. When considering cash flows, the swap may have a negative value to a party when its counterparty defaults. As a result, transaction value is often seen as a more useful measure for OTC derivatives, including the ratio of transaction value to notional principal value. The ratio is typically relatively small, and was close to 2% (at December 2017) for interest rate and foreign exchange derivatives.
- Explanation: The actual risk exposure in an OTC derivative contract can be assessed by looking at the transaction value, which takes into account the net present value of future cash flows. If one party defaults, the other party may face losses based on the transaction's current value. Transaction value gives a more accurate representation of risk compared to notional principal value.
Example: Let's say Party A and Party B enter into a 5-year interest rate swap with a notional principal of $10 million. After some time, the interest rate movements have made the transaction value of the swap negative for Party A, indicating potential losses if Party B defaults.
The ratio of transaction value to notional principal value would be the absolute value of the transaction value divided by the notional principal value. If the transaction value is -$200,000 and the notional principal is $10 million, the ratio would be 2% (-$200,000 / $10,000,000 * 100). This 2% represents the proportion of the notional principal that is at risk based on the current value of the contract.
Certainly! Here are some multiple-choice questions based on the information provided:
1. Which of the following is NOT one of the five broad classes of OTC derivatives?
a) Interest rate derivatives
b) Credit default swaps
c) Currency rate derivatives
d) Equity derivatives
Answer: c) Currency rate derivatives
2. As of December 2017, what percentage of the total notional principal of OTC derivatives did interest rate derivatives represent?
a) 20%
b) 50%
c) 60%
d) 80%
Answer: d) 80%
3. Which category of OTC derivatives had the second-largest notional principal outstanding as of December 2017?
a) Credit default swaps
b) Foreign exchange derivatives
c) Equity derivatives
d) Commodity derivatives
Answer: b) Foreign exchange derivatives
4. What is the main reason why measuring OTC derivatives exposure through notional principal can be misleading?
a) Notional principal does not consider the market interest rates.
b) Notional principal does not account for the creditworthiness of the parties.
c) Notional principal does not reflect the actual risk exposure.
d) Notional principal does not include the maturity date of the contracts.
Answer: c) Notional principal does not reflect the actual risk exposure.
5. Which factor makes the transaction value a more useful measure for OTC derivatives compared to notional principal value?
a) Transaction value considers the nominal amount of the contract.
b) Transaction value reflects the face value of the underlying asset.
c) Transaction value takes into account the net present value of future cash flows.
d) Transaction value calculates the total interest payments over the contract period.
Answer: c) Transaction value takes into account the net present value of future cash flows.
6. In an interest rate swap, what is the primary risk exposure for the parties involved?
a) Principal fluctuations
b) Coupon cash flows
c) Currency exchange rates
d) Commodity price movements
Answer: b) Coupon cash flows
7. What was the approximate ratio of transaction value to notional principal value for interest rate and foreign exchange derivatives at December 2017?
a) 10%
b) 25%
c) 50%
d) 2%
Answer: d) 2%
No comments:
Post a Comment