Chapter 4 - Introduction to risk management Flashcards
elaborate on what sort of position a short forward contract acrually is
A short forward contract is a position that make bucks if the underlying asset depreciate in value.
In the world of forwards, if an asset depreciate in value, and you want to make profit on this, you should aim for locking in a higher price. Meaning, the forward price represent a higher level than the actual future realized value. If the asset happen to depreciate, we will benefit from it since we already locked in the forward price.
To clarify: Long vs short is NOT about the expectation of movement, but it is about when you make you money. In what scenarios will you be profitable.
explain the distinction between hedging and insurance
Hedging is used to describe a scenario where we basically lock in the value we get. If we are hedged, we have no risk, but we also have no possibility of further upside potential than the hedge outcome.
Insurance on the other hand, is more of a fail-safe approach. We are not locking in a specific profit, but we are reducing our losses to various extends
whati s the most common objection towards purchasing insruance?
it is expensive. This is because of the natural assymmetry of the deal. One party receive all upside potential, but buys a contract that removes the risk of losses. Naturally this will be ridicously expensive.
I suppose that when accounting for the premium of the insruance put, the forward price hedging is just as good an option.
How can we reduce the asymmetry of the insurance?
1) Reduce the strike price (allow larger losses)
2) Share some of the profits
are there any fundamental differences between insurance on things like gold and on for instance cars?
Adverse selection.
if you are the party that need to acquire a certain asset, how can you insure it? for instance, say you need steel or something for production
We purchase a call option.
If the asset increase a lot of value, we’d loose profits otherwise.
If it tanks, we are good because we can buy it at the lower price.
name a good reason to use derivatives to manage risk
It becomes interesting when taxes are considered.
taxes makes us consider dollars of profit and dollars of losses very differently.
for instance, if tax rate is 40%, a dollar of profits are worth 0.6 for us. however, a dollar of losses is still worth a dollar.
what can we say about the “magic” that happens when we hedge to get certain profits vs expected value returns?
The case is that one scenario gives us negative expected value of profits. But if we use forwards, we can guarantee a certain positive profit.
What has happened?
We have transferred the net income from a less valued state to a more high valued state. This raise the expected value of the cash flows.
Elaborate on the profit function and how it works to give an argument about certain profit vs uncertain profits
the profit function is something we need to figure out how to make. Typically it is not very hard, because it simply relates a certain variable value to a certain profit. we can extend to multiple dimensions if there are various input factors that provide uncertainty.
The profit function has basically two modes. It obviously reflect with 100% certainty what our profit will be if the variable takes on a specific value.
But since we do not necessarily know this value, we can opt for the probability distribution and find expected value of profit.
I see 2 interesitng things about the profit curve:
1) If it is concave (or locally concave in relevant areas), the uncertain profit always lie below the certain profit, due to how rules of math works. no combination of points and probabilities of those points will be able to move the expected value point above the concave function. This means that there is a benefit in reducing uncertainty (obviously, but still).
2) Any way to lock in certain profits will be preferable (for a specific level of variable(s)) to the uncertain value. Now, this also means that we cannot get better profits, which the concave uncertain function would still give you the possibility to achieve.
Because of this, the alternative of locking in profits without uncertainty yield better profits than its equivalent uncertain variable value, but it also removes our ability to earn higher profits completely
so ultimately, it is your aversion to risk that determines whether the hedge is a good idea or not. The conclusion is that the expected profit on a concave profit function will benefit from certainty.
why is tax deductions on profits on later years because of losses in early years, not really that sunshine?
Present value and time value of money makes it more beneficial to earn as much profits early on, rather than later.
reasons to hedge
taxes
financial distress costs
costly external funancing (if you go for a loss, you have to handle it. you might not go bankrupt, but you have to find obligations somewhere)
reasons not to hedge
Financial costs like fees, the bid ask spread.
recall what is entails to pay the bid ask spread
the bid ask refers to the compensation that market makers take on providing liquidity. They buy low and sell high, creating a spread. The spread is based on the supply and demand and the perception of the fair price, yet when you trade a share you will end up paying for this difference.
buying insurance is expensive. how can we reduce it?
We can reduce it by giving away some of the profits. Specifically, give away everything above a certain asset value. We do this with selling a call. The combination of buying the put and writing the call is called a collar, and it provide us some premium that can help pay for the expensive insruance.
The call is actually a covered call, important to notice, because we will produce the asset.
elaborate on zero cost collars
Zero cost collars are defined as those who have same value of the premium. The outcome of a zero cost collar would therefore be that we can pay a premium, and receive the same amount of premium, and have a position where we are insured against losses below a certain strike, but at the cost of never getting profits above the other strike.
But how can we create it?
Recall put call parity.
C - P = PV(ForwardPrice) - PV(K)
If C and P are the same, we need:
PV(forwardPrice) = PV(K)
