Chapter 16 - Risk MGMT

Question 1

Risk-averse

Answer 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

Question 2

Diversification

Answer 2

a risk mgmt 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

Question 3

Hedging

Answer 3

making an investment to reduce the risk of adverse (unfavorable) price movements in an asset. Normally, a hedge cossets of taking an offsetting position in a related security, such as a futures contract

Question 4

Insurance

Answer 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 for the insured.

Question 5

Correlation

Answer 5

a statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio mgmt

Question 6

Systematic Risk

Answer 6

the risk inherent to the entire market or entire market segment. AKA “un-diversifiable risk” or “market risk”

Question 7

Beta

Answer 7

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

Question 8

Unsystematic Risk

Answer 8

risk that affects a very small number of assets. Sometimes referred to as “specific risk”

Question 9

Futures Contract

Answer 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. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.

Question 10

Forward Contract

Answer 10

a cash market transition in which delivery of the commodity is deferred until after the contract has been made. Although this delivery is made in the future, the price is determined on the initial trade date

Question 11

Swap

Answer 11

traditionally, the exchange of one security for another to change maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently swaps have grown to include currency swaps and interest rate swaps

Question 12

Hedgers

Answer 12

a person making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in related security, such as a futures contract

Question 13

Speculators

Answer 13

A person who trades (i.e. derivatives, commodities, bonds, equities, or currencies) with a higher-than-average risk, in return for a higher-than-average profit potential. Speculators take large risks, especially with respect to anticipating future price movements, or gambling, in the hopes of making quick, large gains

Question 14

Forward Price

Answer 14

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 a predetermined date in the future

Question 15

Spot Price

Answer 15

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

Question 16

Size of Contract

Answer 16

the amount of the commodity that will be delivered

Question 17

long

Answer 17

the buying of a security such as stock, commodity or currency, with the expectation that the asset will rise in value. In the context of options, the buying of an options contract

Question 18

Short

Answer 18

the sale of a borrowed security, commodity, or currency with the expectation that the asset will fall in value. In the context of options, it is the sale (AKA “writing”) of an options contract

Question 19

Options

Answer 19

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

Question 20

European Option

Answer 20

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

Question 21

American Option

Answer 21

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

Question 22

Strike Price or Exercise Price

Answer 22

the state 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

Question 23

Underlying (in derivatives)

Answer 23

the security that must be delivered when a derivative contract, such as a call or put option, is exercised

Question 24

Underlying (in equities)

Answer 24

the common stock that must be delivered when a warrant is exercised or when a convertible bond or convertible preferred share is converted to common stock

Question 25

Call Option

Answer 25

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 specific time

Question 26

Put Option

Answer 26

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 a put option estimates that the underlying asset will drop below the exercise price before the expiration date

Question 27

Call or put owner

Answer 27

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

Question 28

Call or put writer

Answer 28

the writer owns the underlying asset and sells an option contract on the underlying security. The writer of a call has a bearish outlook (expects falling share prices), while the writer of a put has a bullish outlook (expects rising share prices).

Question 29

premium

Answer 29

the total cost of the option

Question 30

In the Money

Answer 30

For a call option, when the option’s strike price is below the market price of an underlying asset. For a put option, when the strike price is above the market price of the underlying asset

Question 31

Intrinsic Value of Option

Answer 31

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

Question 32

Time Value of Option

Answer 32

reflects expectations of an option’s profitability associated with exercising it at some point in the future

Question 33

Derivative Security

Answer 33

a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage

Question 34

Leverage

Answer 34

the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment

Question 35

Spot or cash markets

Answer 35

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

Question 36

Equity Components

Answer 36

stock-like instruments

Question 37

Debt Components

Answer 37

bond-like instruments

Question 38

Options Components

Answer 38

Interest rate caps and floors, stock calls and puts

Question 39

Arbitrage

Answer 39

the simultaneous purchase and sale of an asset in order to profit from a difference in price. This usually takes place on different exchanges or marketplaces. AKA “Riskless profit”

Question 40

Law of One Price

Answer 40

Equivalent combinations of securities that results in identical cash flows must have the same cost or price