Chapter 16: Diversifying, Hedging, Insuring, and Derivative Securities

Question 1

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

Answer 1

Risk-averse

Question 2

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

Answer 2

Diversification

Question 3

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

Answer 3

Hedging

Question 4

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

Answer 4

Insurance

Question 5

In the world of finance, a statistical measure of how two securities move in relation to each other. Used in advanced portfolio management

Answer 5

Correlation

Question 6

The risk inherent to the entire market or entire market segment

Answer 6

Systematic risk (un-diversifiable risk or market risk)

Question 7

A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole

Answer 7

Beta

Question 8

Risk that affects a very small number of assets

Answer 8

Unsystematic risk (specific risk)

Question 9

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

Answer 9

Futures contract

Question 10

A cash market transaction in which delivery of the commodity is deferred until after the contract has been made

Answer 10

Forward contract

Question 11

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

Answer 11

Swap (includes currency and interest rate swaps)

Question 12

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)

Answer 12

Notional Amount

Question 13

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

Answer 13

Hedgers

Question 14

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

Answer 14

Speculators

Question 15

The action by which an underlying commodity, security, cash value, or delivery instrument covering a contract is rendered and received by the contract holder

Answer 15

Delivery date

Question 16

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

Answer 16

Forward price

Question 17

The current price at which a particular commodity can be bought or sold at a specified time and place

Answer 17

Spot price

Question 18

The amount of the commodity that will be delivered

Answer 18

Size of contract

Question 19

The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value

Answer 19

Long

Question 20

The sale (writing) of a borrowed security, commodity or currency, with the expectation that the asset will fall in value

Answer 20

Short

Question 21

Costs incurred because of an investment position

Answer 21

Cost of carry

Question 22

A limit on the amount of money that can be paid under a claim

Answer 22

Cap

Question 23

An amount subtracted from an individual’s adjusted gross income to reduce the amount of taxable income

Answer 23

Deductibles

Question 24

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

Answer 24

Options

Question 25

An option that can only be exercised at the end of its life

Answer 25

European option

Question 26

An option that can be exercised anytime during its life. The majority of exchange-traded options are this

Answer 26

American option

Question 27

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

Answer 27

Strike Price or Exercise Price

Question 28

The day on which an options or futures contract is no longer valid and therefore ceases to exist

Answer 28

Expiration date

Question 29

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

Answer 29

Call option

Question 30

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

Answer 30

Put option

Question 31

The amount of the asset that will be delivered

Answer 31

Size of option contract

Question 32

The investor expects the underlying stock price to rise or fall respectively, they own the option

Answer 32

Call or put owner

Question 33

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

Answer 33

Call or out write

Question 34

The total cost of an option

Answer 34

Premium

Question 35

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

Answer 35

In the money

Question 36

The amount the option is in the money and the difference between the current asset price and the strike price

Answer 36

Intrinsic Value Option

Question 37

Reflects expectations of an options profitability associated with exercising it at some future point in time

Answer 37

Time value of an option

Question 38

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

Answer 38

Derivative security

Question 39

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

Answer 39

Spot or cash markets

Question 40

Stock-like instruments

Answer 40

Equity components

Question 41

Bond like instruments

Answer 41

Debt components

Question 42

Interest rate caps and floors, and stock calls and puts

Answer 42

Option components

Question 43

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

Answer 43

Arbitrage or Riskless profit

Question 44

Says that equivalent combinations of securities that results on identical cash flows must have the same cost or price

Answer 44

Law of one price