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Exam FM/2 Review Hedging and investment strategies

Exam FM/2 Review Hedging and investment strategies. What is risk management?. Different ways of reducing your potential losses, or securing your gains Diversifiable risk can be hedged, while nondiversifiable or systematic risk cannot

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Exam FM/2 Review Hedging and investment strategies

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  1. Exam FM/2 ReviewHedging and investment strategies

  2. What is risk management? • Different ways of reducing your potential losses, or securing your gains • Diversifiable risk can be hedged, while nondiversifiable or systematic risk cannot • There will likely be simple word problems involving the concept of hedging

  3. Financial instruments • Options can be combined in infinite ways to pursue many different strategies • Synthetic forward • Obtain stock in future at price fixed today • Buy call, sell put at same strike price • Spread • Bear • Buy call and sell higher call or buy put and sell higher put • Profit with increase, up to a limit • Bull (opposite of bear) • Sell a call and buy a higher call or sell a put and buy a higher put • Profit with decline in price, to a limit

  4. Financial instruments cont. • More spreads • Box • Combination of long and short synthetic forwards or bull and bear spreads • No market risk, so only useful for borrowing or lending money • Ratio • Buying and selling unequal numbers of options • Can be used for more complicated hedging strategies • Collars • Buy a put and sell a higher call, basically a short forward with a flat range in the middle • Commonly used when owning the stock, then it’s a collared stock • If premiums are equal, it’s a zero cost collar

  5. Financial instruments cont. • Straddles • Purchase call and put with same strike price • Profit with volatility in either direction • Write a straddle to bet on stability • Strangles • Straddle with out-of-the-money options to reduce costs • Reduced profit with volatility, but lose less in the middle • Butterfly spread • Write a straddle, then buy put and call on far sides for protection • Bets on stability while protecting against losses in either direction • Can be asymmetric to shift location of peak • Paylater • Sell a put and write two lower puts, so that the premiums cancel out • This “insurance” costs less if not needed, but more if it is needed

  6. Take the following premiums for one-year European options for an underlying asset with a current spot price of $100. The risk-free annual effective rate of interest is 8.5%. Determine the net financing cost (net premiums) of: 1. A 100-110 bull spread using call options 2. A 100-120 box spread 3. A ratio spread using 90 and 110-strike options, with a payoff of 20 at expiration price 110 and payoff of 0 at expiration price 120 4. A collar with a width of $10 using 90 and 100-strike options 5. A straddle using at-the-money options 6. An 80-120 strangle 7. A butterfly spread with a at-the-money straddle and insurance options out $10

  7. Answers 1. $4.46 2. $18.43 3. -$12.53 4. -$11.38 5. $23.75 6. $10.02 7. -$8.01

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