Chapter 24: Risk Management Flashcards
What does it mean to hedge?
A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.
Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. In this example, you cannot prevent a flood, but you can work ahead of time to mitigate the dangers if and when a flood occurs. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn’t free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.
What are derivitaves?
Contracts such as options and futures who payoffs are determined by the values of other financial variables.
The simplest derivative investment allows individuals to buy or sell an option on a security. The investor does not own the underlying asset but he or she makes a bet on the direction of price movement via an agreement with counterparty or exchange. There are many types of derivative instruments, including options, swaps, futures and forward contracts. Derivatives have numerous uses while incurring various levels of risks but are generally considered a sound way to participate in the financial markets.
What questions should a sensible risk strategy answer?
What are the major risks that the company faces and what are the possible consequences?
Is the company being paid for taking risks?
Can the company take any measures to reduce the probability of a bad outcome or to limit its impact?
Can the company purchase fairly prices insurance to offset any losses?
Can the company use derivatives, such as options or futures to hedge the risk?
