Flashcards in L1 - Why are derivatives so interesting? Deck (3)
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1
Q
what is the difference between a structured product with derivatives and an insurance policy?
A
- if you take out insurance, you will only be paid if the event occurs, and will be paying a premium until that time or the insurance is cancelled
- Will your shareholders tolerate this?
- What happens in the case of earthquakes –> if the damage scale is large enough the insurance company doesn’t have to meet your claim
- you will only have one pool of counterparties
- AIG went bankrupt when Lehman Brothers collapsed –> didn’t pay insurances claims and had to be bailed out by the government
- The use of a derivative product to hedge the risk:
- doesn’t completely mitigate all the damages
- if you create this liability and sell it as a bond (CAT bonds)–> you pay periodic payments and if the event occurs you simply don’t pay back the debt
- many investors in bonds so you can spread to risk across multiple counterparties
- Although this is riskier so you will pay a premium on the bonds –> senior bond
2
Q
Can we predict financial prices?
A
- Nobody can perfectly forecast the movement of financial prices
- Therefore, behind the derivatives pricing models we find a simple idea: prices change just like random prices we can observe in physics
3
Q
What is the alternative tick rule the SEC brought in Feb 2010?
A
- Under this rule, when the price of a stock has decreased by more than 10% in one day, there are restrictions on short selling for that day and the next.
- These restrictions are that the stock can be shorted only at a price that is higher than the best current bid price. Occasionally there are temporary bans on short selling.
- This happened in a number of countries in 2008 because it was considered that short selling contributed to the high market volatility that was being experienced.