C1 Intro to Financial Risk

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    Chance & Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 1: 1

    Introduction to Financial Risk

    Management

    It is only by risking our persons from onehour to another that we live at all

    William James

    The Will to Believe, 1897

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    Chapter Objectives

    Provide brief introductions to the different typesof derivatives: options, forward contracts, futurecontracts, swaps

    Reacquaint you with the concepts of risk

    preference, short-selling, repurchaseagreements, the risk-return relationship, marketefficiency

    Define the important concept of theoretical fair

    value, which will be used throughout the book

    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 2

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    Chapter Objectives (cont)

    Explain the relationship between spot andderivative markets through the mechanisms

    of arbitrage, storage, and delivery. Identify the role that derivative markets play

    through their four main advantages.

    Address some criticisms of derivatives.

    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 3

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 4

    Business Risk vs. Financial Risk

    Risk : Uncertainty of future returns.

    Business Risk : Risk associated with

    particular line of business (e.g. futuresales, cost of inputs in future)

    Financial Risk : risk associated with stockprices, exchange rates, interest rates &commodity prices

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 5

    Derivatives

    A derivative is a financial instrument whose

    return is derived from the return on anotherinstrument(their performance depends onhow other financial instruments perform)

    Derivatives serve as a valuable purpose inproviding a means of managing financialrisk.

    By using derivatives, companies and

    individuals can transfer, for a price, anyundesired risk to other parties who eitherhave risks that offset or want to assume thatrisk.

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    Derivatives can be based on

    Real assets; physical assets such asagricultural commodities, metals etc.

    Financial assets; stocks, bonds/loans, &

    currencies

    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 6

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 7

    Derivative Markets and Instruments

    In the markets for assets, purchases & sales requirethat the underlying asset be delivered eitherimmediately or shortly thereafter.

    Payment usually is made immediately although creditarrangements are sometimes used.

    Because of this characteristics, we refer thesemarkets as cash markets or spot markets.

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 8

    Derivative Markets and Instruments

    Options

    Definition: a contract between two parties thatgives one party, the RIGHT(not obligation) to

    buy/sell something from/to the other party, at alater date at a price agreed upon today.

    Option terminology

    price/premium

    Call (buy)/put (sell)exchange-listed vs. over-the-counter options

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 9

    Forward Contracts

    Definition: a contract between two parties for oneparty (AN OBLIGATION) to buy/sell somethingfrom/to the other at a later date at a price agreedupon today

    Exclusively over-the-counter (unorganizedexchanges)

    Derivative Markets and Instruments

    (continued)

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 10

    Futures Contracts

    Definition: a contract between two parties for oneparty (AN OBLIGATION) to buy/sell somethingfrom/to the other at a later date at a price agreedupon today; subject to a daily settlement of gainsand losses and guaranteed against the risk thateither party might default

    Exclusively traded on a futures markets(organized exchanges)

    Derivative Markets and Instruments

    (continued)

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 11

    Options on Futures (also known as commodityoptions or futures options)

    Definition: a contract between two parties givingone party the RIGHT to buy or sell a futurescontract from or to the other at a later date at aprice agreed upon today

    MixtureOptions on Futures markets

    Exclusively traded on a futures exchange

    Derivative Markets and Instruments

    (continued)

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 12

    Swaps and Other DerivativesDefinition of a swap: a contract in which two

    parties agree to exchange a series of cash flows

    Exclusively over-the-counter

    Other types of derivatives include swaptions andhybrids. Their creation is a process calledfinancial engineering.

    The Underlying Asset

    Called the Underlying A derivative derives its value from the underlying.

    Derivative Markets and Instruments (continued)

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 13

    Some Important Concepts in Financial

    and Derivative Markets Risk Preference

    Risk aversion vs. risk neutrality

    Risk averse-not a risk takerRisk neutral-risk taker

    Risk premium

    Additional return you expect to earn on average

    to justify taking the risk

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 14

    Some Important Concepts in Financial

    and Derivative Markets (continued) Short Selling

    Normally, an investor would buy a stock & latersell it. In short selling, the order is reversed whereyou sell 1st & later buy the stocks (you begin & endup with no stock).

    Allow short seller to profit from a decline in stocks

    price.

    Short seller borrow stock from broker, later hemust purchase a share of a same stock in themarket to replace the stock that was borrowed

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    Some Important Concepts in Financial

    and Derivative Markets (continued) Repurchase Agreements (Repos)

    A legal contract between a seller and a buyer; theseller agrees to sell currently a specified asset tothe buyer-as well as buy it back (usually) at aspecified time in the future at an agreed futureprice.

    Repos are useful because they provide a great

    deal of flexibility to both the borrower and lender.

    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 15

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 16

    Some Important Concepts in Financial

    and Derivative Markets (continued) Return and Risk

    Risk : Uncertainty of future returns

    The Risk-Return tradeoff (see Figure 1.1, p. 7) Positive relationship between risk and return.

    Risk, Return

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 17

    Market Efficiency

    In Efficient market, price fluctuate randomly &investors cannot consistently earns abnormal

    returns.

    Some Important Concepts in Financialand Derivative Markets (continued)

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    Some Important Concepts in Financialand Derivative Markets (continued)

    Theoretical Fair Value

    It suggests that somewhere out there is the realvalue of the asset. If we could perhaps make lotsof money buying when the asset is priced too low

    & selling when it priced too high.

    In order to find that true economy value of theasset, it requires a model of how the asset ispriced. E.g. CAPM & APT Models.

    Derivatives emphasis is placed on determining thetheoretical fair value of a derivative contract.

    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 18

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 19

    The Role of Derivative Markets

    Risk Management

    Hedging-reduces investors risk Setting risk to anacceptable level

    Speculation (opposite to hedging)

    Price Discovery-an important info. about prices as itsprovide forecast of future spot prices.

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    D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Ch. 1: 20

    The Role of Derivative Markets

    (continued) Operational Advantages

    Lower transaction costs compare to spot market.

    Provide greater liquidity than the spot markets.Ease of short selling