Chapter 5: Risk Handling Techniques Flashcards
What is essential in risk handling technique
bearing risk collectively as a member of group or pool
Risk Diversification
reduce risk by combining individual exposure into group and sharing average loss
Covariance
measures how two random variables move together
Correlation
a linear relationship between random variables does not mean causation. Adjusted by dividing the covariance of random variables by their individual standard deviation
Positive Correlation
Positively linear relationship (move together)
Zero correlation
no linear relationship
negative correlation and vital for?
negative linear relationship (move opposite), vital for risk diversification
Hedging
Take two financial positions simultaneously whose gains and loses will offset each other limiting risk
Hedging example with insurance
buy insurance but suffer financial loss, but gain as loss is covered by insurance.
Hedging example with stocks
some go up and some go down
Common Hedged Financial Risk
- Currency
- Interest
- Commodity
Currency Risk
loss potential caused by unfavourable fluctuation in value of domestic currency relative to foreign currency
Interest Risk
loss potential caused when changes in interest rate reduce market value of fixed income securities
Commodity Risk
fluctuation in price for variety of commodity products etc metals, agriculture, petroleum
Commodity Output Price Risk
Changes in market price affect price at which can sell product
Commodity Input Price Risk
Change in price increase or decrease in manufacturing costs
Derivative Securities
Financial instrument where value derived from financial asset/commodity
Future Contract
order placed by trader in advance to buy or sell asset/commodity later at specified price
Forward contract
not traded on organized exchange, privately managed arrangements
Currency Swap
Countries lend currency to each other
Traded Options
legal right to buy or sell commodity/financial asset at agreed price for a specific period
Option Holder
party with long position, right to buy or sell under agreed terms
option writer
party with short position, obligated to buy or sell based on choice of option holder
call option
option to buy underlying asset
put option
option to sell underlying asset
