Chapter 16: Diversifying, Hedging, Insuring, and Derivative Securities Flashcards
Describes an investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk
Risk-averse
A risk management technique that mixes a wide variety of investments within a portfolio. It is designed to minimize the impact of any one security on overall portfolio performance
Diversification
Making an investment to reduce the risk of adverse price movements in an asset. Normally consists of taking an offsetting position in a related security
Hedging
A contract (policy) in which an individual or entity receives financial protection or reimbursement against losses from an insurance company. The company pools clients risks to make payments more affordable
Insurance
In the world of finance, a statistical measure of how two securities move in relation to each other. Used in advanced portfolio management
Correlation
The risk inherent to the entire market or entire market segment
Systematic risk (un-diversifiable risk or market risk)
A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole
Beta
Risk that affects a very small number of assets
Unsystematic risk (specific risk)
A contractual agreement generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre determined price in the future. Detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange
Futures contract
A cash market transaction in which delivery of the commodity is deferred until after the contract has been made
Forward contract
Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed
Swap (includes currency and interest rate swaps)
The total value of a leveraged positions assets. Commonly used in the options, futures, and currency markets because in them a very little amount of invested money can control a large position (have a large consequence for the trader)
Notional Amount
A person making an investment to reduce the risk of adverse price movements in an asset. Consists of taking an offsetting position in a related security
Hedgers
A person who trades with a higher-than-average risk, in return for a higher than-average profit potential. Take large risks especially with respect to anticipating future price movements, or gambling, in the hopes of making quick, large gains
Speculators
The action by which an underlying commodity, security, cash value, or delivery instrument covering a contract is rendered and received by the contract holder
Delivery date
The predetermined delivery price for an underlying commodity, currency or financial asset decided upon by the long (the buyer) and the short (the seller) to be paid at a predetermined date in the future
Forward price
The current price at which a particular commodity can be bought or sold at a specified time and place
Spot price
The amount of the commodity that will be delivered
Size of contract
The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value
Long
The sale (writing) of a borrowed security, commodity or currency, with the expectation that the asset will fall in value
Short
Costs incurred because of an investment position
Cost of carry
A limit on the amount of money that can be paid under a claim
Cap
An amount subtracted from an individual’s adjusted gross income to reduce the amount of taxable income
Deductibles
A privilege sold by one party to another that offers the buyer the right, but not the obligation, to buy(call) or sell (put) a security at an agreed-upon price during a certain period of time or on a specific date
Options
An option that can only be exercised at the end of its life
European option
An option that can be exercised anytime during its life. The majority of exchange-traded options are this
American option
The stated price per share for which underlying stock may be purchased (for a call) or sold (for a put) by the option holder upon exercise of the option contract
Strike Price or Exercise Price
The day on which an options or futures contract is no longer valid and therefore ceases to exist
Expiration date
An option contract giving the owner the right (but not the obligation) to buy a specified amount of an underlying security at a specified price within a specified time
Call option
An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of this option estimates that the underlying asset will drop below the exercise price before the expiration date
Put option
The amount of the asset that will be delivered
Size of option contract
The investor expects the underlying stock price to rise or fall respectively, they own the option
Call or put owner
The writer owns the underlying asset and sells an option contract on the underlying security. The writer of a call has a bearish outlook while the writer of a put has a bullish outlook
Call or out write
The total cost of an option
Premium
For a call option, when the options strike price is below the market price of the underlying asset. For a put option, when the strike price is above the market price of the underlying asset
In the money
The amount the option is in the money and the difference between the current asset price and the strike price
Intrinsic Value Option
Reflects expectations of an options profitability associated with exercising it at some future point in time
Time value of an option
A security whose price is dependent upon or derived from one or more underlying assets. It is merely a contract between two or more parties. It’s value is determined by fluctuations in the underlying asset. Most are characterized by high leverage
Derivative security
A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective
Spot or cash markets
Stock-like instruments
Equity components
Bond like instruments
Debt components
Interest rate caps and floors, and stock calls and puts
Option components
The simultaneous purchase and sale of an asset in order to profit from a difference in the price. This usually takes place on different exchanges or marketplaces
Arbitrage or Riskless profit
Says that equivalent combinations of securities that results on identical cash flows must have the same cost or price
Law of one price
