To generate a high trading volume there can only be a few contracts each with

To generate a high trading volume there can only be a

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To generate a high trading volume, there can only be a few contracts, each with very specific amounts and maturity dates, and there needs to be sufficient demand for these contracts o not enough for there to be a need to hedge, must be a need to change the amount hedged 2. The insurance futures described in 16.2 were not a success. The weather contracts described in (16.3) seem to be moderately successful. Can you account for the difference? Who is likely to be interested in insurance or weather futures? Why would they want to trade them? Is basis risk an issue? Basis risk- imperfect match between futures contact and the position being hedged. Happens because- timing, contract size, and the underlying assets Accounting for difference= o no need to change hedge for catastrophe future because catastrophes are so random.
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o can change hedge for weather future based on weather patterns, and other information. o without need to change hedge, there is not enough trading volume, exchange can’t cover high fixed cost of making market, cannot offer low trading fees, locals do not want to enter market, market illiquid, etc. Likely to be interested= o insurance: real estate, normal businesses o weather futures: farmers, agriculture, businesses in places with extreme weather Why want to trade= o trade weather futures based on changing weather patterns and info, don’t really trade catastrophe futures unless some heightened risk of catastrophe Basis risk= o a lot more basis risk for catastrophe future bc size of claim is so variable and unlikely that hedge fits perfectly o a lot less basis risk for weather future bc weather patterns are predictable so hedge will match risk closer than for catastrophe future 3. Is there an OTC alternative to insurance futures? Other alternatives? Why might they be more attractive? OTC alternative – o an insurance swap because of the similarity between the wagers of futures and swaps. o Because OTC derivatives are expensive, this would not be the best option Other alternatives: BETTER o reinsurance, self-insurance, captive insurers, cat bonds o Reinsurance and captive insurers/self-insurers are more attractive because they’re cheaper, they cut out the middleman **Credit Default Swap: seller of the swap gets regular payments, in exchange for the promise to provide credit protection in the case of default **Property swap: wager on the index that measures property values C. Read “Credit derivatives: Risky business” (Item 16.4) and “Property derivatives: fear of flying” (Item 16.5) and answer the following: 1. Are these exchange-traded or OTC derivatives? What are the relative advantages of exchange-traded and OTC derivatives in this case? They are both OTC derivatives because swaps are OTC derivatives. o they involve financial intermediary (pension plan or deutsche bank) to make the market Credit swap advantages- o OTC: addresses more specific risks, risk of different lenders will vary but will be known risk is relatively stable, doesn’t change too much
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o Exchange: liquid, easier to close or change risk (especially for seller if they don’t want exposure anymore)
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