Post on 02-Jun-2018
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Risk
A probability or threat of damage,
liability, loss, or any other negativeoccurrence that is caused by external orinternal vulnerabilities, and that may be
avoided through preemptive action.
Financial Risk is defined as the chancethat an investment's actual return willbe different than expected. This includes
the possibility of losing some or all ofthe original investment.
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Types of Risk
FUNDAMENTAL TYPE OF RISK
Systematic Risk- It influences a large number of assets.This type of risk is both unpredictable and impossible tocompletely avoid.
Unsystematic Risk- This kind of risk affects a verysmall number of assets. An example is news that affects
a specific stock such as a sudden strike by employees.
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Types of Risk
Foreign-Exchange Risk- When investing in foreign countriesyou must consider the fact that currency exchange ratescan change the price of the asset as well. Foreign-exchange risk applies to all financial instruments that are
in a currency other than your domestic currency.
Interest Rate Risk- Interest rate risk is the risk that aninvestment's value will change as a result of a change ininterest rates. This risk affects the value of bonds more
directly than stocks.
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Types of Risk
Political Risk- Political risk represents the financial risk that acountry's government will suddenly change its policies. This is amajor reason why developing countries lack foreign investment.
Market Risk- Also referred to as volatility, market risk is the day-to-day fluctuations in a stock's price. Market risk applies mainlyto stocks and options. As a whole, stocks tend to perform wellduring a bull market and poorly during a bear market - volatilityis not so much a cause but an effect of certain market forces.Volatility is a measure of risk because it refers to the behavior, or
"temperament", of your investment rather than the reason forthis behavior.
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Risk Reward Return
The risk-return tradeoff is the balance an investor must decide on
between the desire for the lowest possible risk for the highest possible
returns.
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Derivatives
Derivative is an instrument that
does not have a value of its own,
rather it derives its value/price
on the basis of some other
instrument, hence the name
Derivative.
In derivatives transactions, one
partys loss is always another
partys gain
The main purpose of derivatives is
to transfer risk from one person
or firm to another, that is, to
provide insurance
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Usage of Derivatives
To hedge risks
To speculate (take a view on the future direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without incurring the
costs of selling one portfolio and buying another
Derivatives improve overall performance of the economy
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Derivatives
Derivatives exchange is a market whereindividuals trade standardized contracts that havebeen defined by the exchange
The Chicago Board of Trade, established in 1948 isthe oldest exchange to trade derivatives
It brought farmers and merchants together andstandardized the qualities and quantities of the
grains traded Chicago Mercantile Exchange was established in
1919 in order to trade futures
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Major kind of Derivatives
1. Forwards and futures
2. Options
3. Swaps
These derivatives are traded on following markets
Over the counter
Exchange traded markets
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Kinds of Derivatives
Forwards and Futures
A forward, or a forward contract, is:
An agreement between a buyer and a seller to
exchange a commodity or a financial instrument for a
pre specified amount of cash on a prearranged future
date
Example: interest rate forwards
Forwards are highly customized, and are much less
common than the futures
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Example of Futures
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Features of Forward contract
>Forward contracts are bilateral contracts and are are exposed tocounter party risk
> Each contract is custom design and is unique in terms of contract size,expiration date, asset type and quality
> The specified price in forward contract is referred to as delivery price.The forward price of particular forward contract at a particular time is
the delivery price that would apply if the contract would have entered at
that time. Both price are equal at the time the contract is entered into.
However, as the time passes the forward price changes while delivery
price remains same>The forward contract has to be settled by delivery of the asset onexpiration date
> If the party wishes to reverse the contract, then it has to deal with thesame counter party
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Forward contract Payoff
So in a long forward contract, you have a positive payoff only if the Spot Price (S) > Contract
Price (K) since in a long forward contract you have an obligation to buy. Hence, if S>K, then you
can buy it at lower cost and sell it into the market at a higher price and earn profits. In a short
forward contract, if S
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Features of Futures
>All futures contract have standardized specification i.e. quantity ofasset, quality of asset, date and month of delivery, unit of price quotation,
location of settlement.
>Clearing house acts as intermediary or middlemen in futures. It gives
guarantee for the performance of the parties to each transaction. It is thecountry party for every contract
>At the close of trading day, each contract is marked to market.Settlement price is established to calculate profit or loss of each member
>When a person enters into a futures contract, he is required to depositfunds with broker called as margin. The basic objective of margin accountis to act as collateral security in order to minimize the risk of failure by
either party in the futures contract
>Most of the futures contract are settled in cash
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Futures contract
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Hedging and Speculating with
Futures
Agents hedge against adverse events in the market using futures
market
E.g. manager wishes to insure the firm against the rise in interest rates and
the resulting decline in the rise in interest rates and the resulting decline in the
value of bonds the firm holds value of bonds the firm holdsCan sell a futures contract and lock in a price
Producers and users of commodities use futures extensively to hedge
their risks extensively to hedge their risks
Farmers, oil drillers (producers) sell futures contracts for Farmers, oil drillers
(producers) sell futures contracts for their commodities and insure themselvesagainst price their commodities and insure themselves against price declines
Food processing companies, oil refineries (users) buy Food processing
companies, oil refineries (users) buy futures contracts to insure themselves
against price futures contracts to insure themselves against price increase
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Hedging and Speculating with
Futures
Speculators try to use futures to make a profit by betting on price
movements: profit by betting on price movements:
Sellers of futures bet on price decreases
Buyers of futures bet on price increasesFutures are popular because they are cheap
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Arbitrage and Futures Prices
On the delivery date, the price of the futures contract must equalthe price of the asset the contract the seller is obligated to deliver
If this were not true, it would be possible to earn instantaneous risk
free profit
If bond price were below the futures price, buy a bond, sell the
contract, deliver the bond, and earn the profit
Practice of simultaneously buying and selling financial instruments
to benefit from temporary price difference is called arbitrage
Existence of arbitrageurs ensures that at delivery date, the futures
price equals the market price of the bond
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Option Contracts
Optionis a contract entered between two parties whereby one party obtainsthe right and not the obligation, to buy or sell a particular asset, at a specified
price on or before the specified date
The person who acquires the right is known as option buyer or option holder
and the person is called option seller or option writer
The seller of the option for giving such option to the buyer charges an amountknown as option premium
TWO TYPES OF OPTION
Call options
Gives the holder an option to buy an asset at the specified price and time
Put options
Gives the holder an option to sell an asset at the specified price and time
The specified price in such contract is called Exercise price or strike price
the specified date is called expiration date or maturity date
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Option Contracts
American OptionIt can be exercised at any time before the expiration date
European Option
It can be exercised only on the expiration date
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Option Contracts
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Swap Contracts
A swap is an agreement between two counter partiesto exchange cash flows in the future.
Under the swap agreement, various terms like thedates when the cash flows are to be paid, the
currency in which to be paid and the mode of
payment are determined and finalized by the parties.
Usually the calculation of cash flows involves thefuture values of one or more market variables.
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Warrants and Convertibles
Warrants
Warrant is just like an option contract where the holder hasthe right to buy shares of a specified company at a certainprice during the given time period.
If the holder exercised the right, it increases the number of
shares of the issuing company, and thus, dilutes the equitiesof its shareholders.
Warrants are usually issued as sweeteners attached tosenior securities like bonds and debentures so that they aresuccessful in their equity issues in terms of volume and price.
Warrants are highly speculative and leverage instruments,
so trading in them must be done cautiously.
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Warrants and Convertibles
ConvertiblesThese are hybrid securities which combine the basic attributesof fixed interest and variable return securities. Most popularamong these are convertible bonds, convertible debentures
and convertible preference shares. These are also called equityderivative securities.
They can be fully or partially converted into the equity sharesof the issuing company at the predetermined specified termswith regards to the conversion period, conversion ratio and
conversion price.These terms may be different from company to company, asper nature of the instrument and particular equity issue of thecompany.
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Features of Forward Contracts
1. It is an agreement between the two counterparties in which one is buyer and
other is seller. All the terms are mutually agreed upon by the counterparties at the
time of the formation of the forward contract.
2. It specifies a quantity and type of the asset (commodity or security) to be sold
and purchased.
3. It specifies the future date at which the delivery and payment are to be made.
4. It specifies a price at which the payment is to be made by the seller to the buyer.
The price is determined presently to be paid in future.
5. It obligates the seller to deliver the asset and also obligates the buyer to buy the
asset.
6. No money changes hands until the delivery date reaches, except for a small
service fee, if there is.