Week 7- Risk Management & Financial Derivatives Flashcards
What is the financial definition of risk?
The possibility that the actual cash flows from an investment or any other business transaction will be different from the expected cash flows
what is the purpose of risk managment?
risks can be mitigated, managed which can lead to a competitive advantage
what are the reasons for managing risk (3)?
1) To reduce chances of financial distress
2) To direct management attention towards day to day activities under their control
3) To assure firms will have adequate cash flows to make needed investments
what are the two main strategies managers can use to minimise risk?
1) Non- Hedging: doesnt use financial derivatives
2) Hedgeing: does use financial derivatives
Explain some of the Non- Hedging Strategies
1) Acquisition of additional information to make informed decisions
2) Diversification
3) Use patents and copyrights to protect against competition
4) Insurance
5) Multi purpose assets to redeploy to other uses
What tool do managers use to reduce risk with hedging strategies?
Derivatives
What is a Hedge?
A transaction that limits the risk associated with fluctuations in the price of shares and bonds etc.
What is a financial derivative?
A ‘financial contract’ between the issuer and holder that provides protection againest adverse movements in the prices of shares, bonds etc. (underlying asset)
What types of financial derivatives are there?
Fowards, Futures and Options
How can financial derivatives be traded (2)?
1) standardised derivative contracts are traded on organised exchanges
2) Privately (known as over the counter derivatives)
How are most financial derivatives traded?
On the secondary market i.e Investors buy assets from other investors rather than from the issuing company
What is a forward derivative?
An agreement to buy or sell an asset at some point in the future at a price agreed today
what is the obligation of foward contracts?
that both the buyer and the seller perform under the terms of the contract i.e not an option
What is the specifiied future price called in forward contracts?
delivery price
What is the current price of an asset in a forward contract?
spot price
What is a future contract?
Standardised contract sold on an organised exchange to buy or sell an asset at a specific future time and at a specific price
Do future contracts use delivery and spot prices too?
Yes
What are the similarities between future and forward derivatives?
1) Both lock in a price today for the purchase or sale of something in a future time period
2) Both commit both parties to the contract
3) Both involve only one future transaction
4) The party who is selling has a”short position” and the party that is buying has a “long position” in both types of contract
5) No money changes hands between the two parties when the contract is made
What is Maturity in financial derrvatives?
When the time comes to sell/buy the asset at the specified price in the contract
What are the differences between future and forward derivatives?
1) Forward contracts specify precise delivery dates
2) Future contracts are typically short term and buyer can choose any delivery date during the month
3) Since there is an organised market for futures, contracts are more liquid and lower risk than forward contracts that are traded privately i.e a buyer with a june future contract to buy cotton and a june contract to sell the same amount of cotton does not bear any risk
4) Futures have less credit risk than forwards since the prices of futures are marked to the market daily (future contracts require daily settlements between buyer and seller for gains and losses. The loser must pay the` winner each day)
What is an Option derivative?
A financial contract that allows the holder of the contract to walk away from the purchase/contract at any point and gives no obligation to buy if it is not beneficial to them
What is the exercise price in option derivatives?
The price at which the owner takes up their right to buy (or sell), aka they are “exercising the option”
How do American and European options differ?
American options can be exercised at any time up to the options expiry date whereas European options can only be exercised on the expiry date
what is the right to buy called in option derivatives?
the call option
