STFM Midterm Notes

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Risk Management

Reasons to Manage Risk


"Risk management” helps an organization to identify, evaluate,
analyze, monitor, and mitigate the risks that threaten the achievement
of the organization's strategic objectives in a disciplined and systematic
way.

Most people don’t like surprises, especially when it has an


organizational impact. A risk manager’s goal is to map out all potential
risks and then work to prevent them or best manage them. It’s
impossible to think of every possible risk scenario and address them
all, but a risk manager makes unpleasant surprises less likely and
severe. Risk manager or the risk management department should be the
first place an employee turns to when it seems like something serious
could go wrong. Here’s a good chance a plan is already in place.

Believe it or not, risk management strategy plays an important role in


planning for the future. Through an increased awareness of hazards,
and therefore possible risks, your department can create a strategy that
effectively controls hazards and risks moving forward.

Derivatives
Derivatives - A type of financial contract whose value is dependent on
an underlying asset, group of work, or benchmark.

Natural Hedges - Situations in which aggregate risk can be reduced by


derivatives transactions between two parties known as counterparties.

Non-Symmetrical Hedge - Asymmetric Hedging is structuring an


investment hedge to offset risk in other holdings with an asymmetric
payoff such that the potential profit from the hedge is materially
greater than the amount of risk taken to achieve it.

Option Types and Markets


Strike (Exercise, Price) - The price that must be paid for a share of
common stock when an option is exercised.

Types of Options
Call Option - An option to buy, or “call,” a share of stock at a certain
price within a specified period.

Put Option – An option to sell a share of stock at a certain price within


a specified period.

Long-term Equity Anticipation Security (LEAPS) - A long-term option


that is listed on the exchanges and tied to individual stocks and stock
indexes.

Factors that Affect the Value of a Call


Option
 The higher the stock’s market price in relation to the strike price,
the higher the call option price.
 The higher the strike price, the lower the call option price.
 The longer the option period, the higher the option price.

Exercise Value vs. Option Price


Exercise Value - Refers to the amount of profit that an option holder
could potentially make by exercising their option. For a call option, it
is the difference between the current stock price and the option’s strike
price.
Option Price - Refers to the cost of buying or selling an option.

Price of an Option Depends on Three Other


Factor
1. The option’s time until expiration.
2. The vari-ability of the stock price.
3. The risk-free rate.

Introduction to Option Pricing Models


Option Pricing Models - The concept of a riskless hedge is used in
option pricing models to illustrate how it works. An investor buys
shares of stock and simultaneously sells a call option on the stock. If
the stock price increases, the investor will earn a profit on the stock but
lose money from selling the call option. If the stock price declines, the
investor will lose on their investment in the stock but gain from selling
the call option.

The steps used to estimate the current value of the call option are
shown:

1. Assumptions of the example.


2. Find the range of values at expiration
3. Equalize the range of payoffs for the stock and the option
4. Create a riskless hedged investment
5. Pricing the call option

Objective of Option Pricing Models


The goal of option pricing model is to calculate the probability that an
option will be exercised, or be in the money. Underlying asset price,
exercise price, volatility, interest rate, and time to expiration.

The Black-Scholes Option Pricing Model


(OPM)
 It was developed in 1973, helping give risk to the rapid growth in
options trading.
 Derived from the concept of a riskless hedge
 This model calculates the value of an option as the difference
between the expected PV of the terminal stock price and the PV of
the exercise price. Involves extremely complicated mathematics
that goes far beyond the scope of this introductory finance text.
 Founder of the Black-Scholes Model is Fischer Black and Myron
Scholes.

Forward and Futures Contracts


These are agreements to buy or sell an asset at specific price on a
specific date in the future.

Forward Contract – A contract under which one party agrees to buy a


commodity/asset at a specific price on a specific future date and the
other party agrees to make the sale.

There are 4 components to consider in forward contracts:

1. Assets
2. Expiration Date
3. Quantity
4. Price

How do Forward Contracts Work?


 Forward Price – The price that was set by both parties
 Long – The party who agrees to buy the commodity/asset
 Short – The party who agrees to sell the commodity/asset

What are Forward Contracts Used For?


 Forward contracts are used to hedge against potential losses.

Futures Contract – Standardized contracts that are traded on exchanges


and are “marked to market” daily, but where physical delivery of the
underlying asset is never taken.

Types of Futures
 Commodity futures - for commodities like oil or grains or wheat
 Currency futures- for currencies like dollar or peso
 Metal futures - for elements like gold or silver
 Treasury futures - for bonds and other financial instruments

Who Trades Future Contracts


 Hedgers - These are businesses or individuals that use futures
contracts for protection against volatile price movements in the
underlying commodity.
 Speculators - Speculators are independent traders and investors.

Other Types of Derivatives

Swap
 Two parties agree to exchange obligations to make specified
payment streams.
 Swaps can involve side payment
 Currency swaps are similar to interest rate swaps

Inverse Floater
 A note in which the interest rate paid moves counter to market
rates.
 Floating-rate note has an interest rate that rises and falls with some
interest rate index.

Structured Notes
 A debt obligation derived from another debt obligation.
 Another important type of structured note is backed by the interest
and principal payments on mortgages.
 A variety of structured notes can be created, ranging from notes
whose cash flows can be predicted with virtual certainty to other
notes whose payment streams are highly uncertain.

Using Derivatives to Reduce Risk

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