Introduction to Financial Risk Management

1. Introduction to Financial Risk Management It is only by risking our persons from one hour to another that we live at all William James The Will to Believe, 1897 An Introduction to Derivatives and Risk Management, 8th ed.

2. Chapter Objectives • Provide brief introductions to the different types of derivatives: options, forward contracts, future contracts, swaps • Reacquaint you with the concepts of risk preference, short-selling, repurchase agreements, the risk-return relationship, market efficiency • Define the important concept of theoretical fair value, which will be used throughout the book An Introduction to Derivatives and Risk Management, 6th ed.

3. Chapter Objectives (cont’) • Explain the relationship between spot and derivative 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. An Introduction to Derivatives and Risk Management, 6th ed.

4. Business Risk vs. Financial Risk • Risk : Uncertainty of future returns. • Business Risk : Risk associated with particular line of business (e.g. future sales, cost of inputs in future) • Financial Risk : risk associated with stock prices, exchange rates, interest rates & commodity prices An Introduction to Derivatives and Risk Management, 6th ed.

5. Derivatives • A derivative is a financial instrument whose return is derived from the return on another instrument (their performance depends on how other financial instruments perform) • Derivatives serve as a valuable purpose in providing a means of managing financial risk. • By using derivatives, companies and individuals can transfer, for a price, any undesired risk to other parties who either have risks that offset or want to assume that risk. An Introduction to Derivatives and Risk Management, 6th ed.

6. Derivatives can be based on • Real assets; physical assets such as agricultural commodities, metals etc. • Financial assets; stocks, bonds/loans, & currencies An Introduction to Derivatives and Risk Management, 6th ed.

7. Derivative Markets and Instruments • In the markets for assets, purchases & sales require that the underlying asset be delivered either immediately or shortly thereafter. • Payment usually is made immediately although credit arrangements are sometimes used. • Because of this characteristics, we refer these markets as cash markets or spot markets. An Introduction to Derivatives and Risk Management, 6th ed.

8. Derivative Markets and Instruments • Options • Definition: a contract between two parties that gives one party, the RIGHT(not obligation) to buy/sell something from/to the other party, at a later date at a price agreed upon today. • Option terminology • price/premium • Call (buy)/put (sell) • exchange-listed vs. over-the-counter options An Introduction to Derivatives and Risk Management, 6th ed.

9. Derivative Markets and Instruments (continued) • Forward Contracts • Definition: a contract between two parties for one party (AN OBLIGATION) to buy/sell something from/to the other at a later date at a price agreed upon today • Exclusively over-the-counter (unorganized exchanges) An Introduction to Derivatives and Risk Management, 6th ed.

10. Derivative Markets and Instruments (continued) • Futures Contracts • Definition: a contract between two parties for one party (AN OBLIGATION) to buy/sell something from/to the other at a later date at a price agreed upon today; subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default • Exclusively traded on a futures markets (organized exchanges) An Introduction to Derivatives and Risk Management, 6th ed.

11. Derivative Markets and Instruments (continued) • Options on Futures (also known as commodity options or futures options) • Definition: a contract between two parties giving one party the RIGHT to buy or sell a futures contract from or to the other at a later date at a price agreed upon today • Mixture Options on Futures markets • Exclusively traded on a futures exchange An Introduction to Derivatives and Risk Management, 6th ed.

12. Derivative Markets and Instruments (continued) • Swaps and Other Derivatives • Definition 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 and hybrids. Their creation is a process called financial engineering. • The Underlying Asset • Called the Underlying • A derivative derives its value from the underlying. An Introduction to Derivatives and Risk Management, 6th ed.

13. Some Important Concepts in Financial and Derivative Markets • Risk Preference • Risk aversion vs. risk neutrality • Risk averse-not a risk taker • Risk neutral-risk taker • Risk premium • Additional return you expect to earn on average to justify taking the risk An Introduction to Derivatives and Risk Management, 6th ed.

14. Some Important Concepts in Financial and Derivative Markets (continued) • Short Selling • Normally, an investor would buy a stock & later sell it. In short selling, the order is reversed where you sell 1st & later buy the stocks (you begin & end up with no stock). • Allow short seller to profit from a decline in stock’s price. • Short seller borrow stock from broker, later he must purchase a share of a same stock in the market to replace the stock that was borrowed An Introduction to Derivatives and Risk Management, 6th ed.

15. Some Important Concepts in Financial and Derivative Markets (continued) • Repurchase Agreements (Repos) • A legal contract between a seller and a buyer; the seller agrees to sell currently a specified asset to the buyer-as well as buy it back (usually) at a specified time in the future at an agreed future price. • Repos are useful because they provide a great deal of flexibility to both the borrower and lender. An Introduction to Derivatives and Risk Management, 6th ed.

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 An Introduction to Derivatives and Risk Management, 6th ed.

17. Some Important Concepts in Financial and Derivative Markets (continued) • Market Efficiency • In Efficient market, price fluctuate randomly & investors cannot consistently earns abnormal returns. An Introduction to Derivatives and Risk Management, 6th ed.

18. Some Important Concepts in Financial and Derivative Markets (continued) • Theoretical Fair Value • It suggests that somewhere out there is the real value of the asset. If we could perhaps make lots of money buying when the asset is priced too low & selling when it priced too high. • In order to find that true economy value of the asset, it requires a model of how the asset is priced. E.g. CAPM & APT Models. • Derivatives emphasis is placed on determining the theoretical fair value of a derivative contract. An Introduction to Derivatives and Risk Management, 6th ed.

19. The Role of Derivative Markets • Risk Management • Hedging-reduces investor’s risk Setting risk to an acceptable level • Speculation (opposite to hedging) • Price Discovery-an important info. about prices as its provide forecast of future spot prices. An Introduction to Derivatives and Risk Management, 6th ed.

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 • Market efficiency • Derivative market provide means of managing risks, discovering prices, reducing costs, improving liquidity, selling short, & making the market more efficient. An Introduction to Derivatives and Risk Management, 6th ed.

21. Criticisms of Derivative Markets • Speculation • Comparison to gambling An Introduction to Derivatives and Risk Management, 6th ed.

22. Misuses of Derivatives • High Degree of Leverage - Powerful instruments as small price changes can lead to large gains and losses. • To use derivatives without having the requisite knowledge is dangerous. • Inappropriate use – investors tend to use it for speculation without taking into account market efficiency. • In Efficient market, price fluctuate randomly & investors cannot consistently earns abnormal returns. An Introduction to Derivatives and Risk Management, 6th ed.

23. Derivatives and Your Career • Financial management in a business • Small businesses ownership • Investment management • Public service Source of Information on Derivatives http://chance.swlearning.com Summary An Introduction to Derivatives and Risk Management, 6th ed.

24. (Return to text slide) An Introduction to Derivatives and Risk Management, 6th ed.