Chapter 4 Flashcards
Risk response
What is the basic principle behind managerial decisions in the context of risk and opportunity?
Managerial decisions are usually decisions to deliberately take risks in order to realize opportunities. The actual decision depends on risk attitude and the relationship between risk and opportunity.
Name two measures that can be used to assess the relationship between risk and opportunity.
Sharpe Ratio: The Sharpe Ratio measures the excess return per unit of risk. 2. Return on Risk-adjusted Capital (RoRaC): RoRaC measures the net result in excess of the risk-free result per unit of risk.
Explain the business model of an insurance company.
Insurance companies pool the risks of many policyholders and compensate those who suffer a loss. They generate profits by charging premiums that exceed the expected losses and administrative costs.
What are typical prerequisites that have to be met before an insurance company would consider offering protection?
- The risk must be insurable, i.e. it must be possible to estimate the probability of occurrence and the amount of damage.
- The risk must be accidental, i.e. it must not be intentionally caused by the policyholder.
- The potential damage must be significant enough to justify the cost of insurance.
Name three factors that drive the attractiveness of an insurance policy as an instrument of risk response.
- The amount of the premium: The lower the premium, the more attractive the insurance policy.
- The scope of coverage: The broader the scope of coverage, the more attractive the insurance policy.
- The financial strength of the insurer: The more financially sound the insurer, the more secure the policyholder’s claims will be in the event of a loss.
Define and explain the instruments “future” and “option”.
A future is a standardized contract that obligates the buyer to purchase and the seller to sell a specific asset at a predetermined price on a future date. An option is a contract that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) on or before a specific date (maturity).
What are the main differences between futures and options in the context of risk management?
Futures represent a firm commitment to buy or sell the underlying asset, whereas options provide the right, but not the obligation, to do so. Futures do not require an upfront premium, while options do.
What is the effect of these differences (between futurs and options) on risk response?
Futures provide a complete hedge against price fluctuations, but also limit the potential for profit. Options offer more flexibility and the possibility of participating in favorable price movements, but also involve the risk of losing the premium paid.
What is the put-call parity?
The put-call parity is a relationship between the prices of a European call option, a European put option, the underlying asset, and the risk-free interest rate. It states that a portfolio consisting of a long position in the underlying asset and a short position in a European call option with the same strike price and maturity is equivalent to a portfolio consisting of a long position in a European put option with the same strike price and maturity and a risk-free bond that pays the strike price at maturity.
Explain the basic idea of the Cox-Ross-Rubinstein model.
The Cox-Ross-Rubinstein model is a discrete-time model for valuing options. It assumes that the price of the underlying asset can either go up or down by a certain factor in each time period. The model uses a risk-neutral probability measure to calculate the expected payoff of the option and discounts this payoff back to the present value using the risk-free interest rate.
What are the four main strategies for risk response?
The four main strategies for risk response are:
1. Risk avoidance: Eliminating the risk by not engaging in the risky activity
2. Risk reduction: Implementing measures to reduce the probability or impact of the risk
3. Risk transfer: Shifting the risk to another party (e.g. through insurance)
4. Risk acceptance: Deciding to bear the risk without taking action
What is hedging and how is it used in risk management?
Hedging is a risk management strategy that involves taking an offsetting position in a related security to reduce the risk of adverse price movements. It is commonly used to manage market risks such as currency, interest rate, and commodity price risks.
Explain the concept of diversification in risk management.
Diversification involves spreading investments across different assets or markets to reduce overall risk. By combining assets with low or negative correlation, the impact of poor performance in one area can be offset by better performance in another.
What is the difference between static and dynamic hedging?
Static hedging involves setting up a hedge position and maintaining it unchanged until expiration. Dynamic hedging involves continuously adjusting the hedge position in response to changes in market conditions or the underlying asset’s price.
