FIN2543 Financial Risk

Management
Assignment 2 Part A (chapter 1-6)

Name: Mirza Mushtaq Ahmed

Course: Bachelors in Actuarial Finance
Lecturer: Mr. Mak Yong Sam
Date: 14 April 2017

1. What is risk? Explain the general approach for risk management and its objectives.

Risk
The basic concept is the combination of the probability of an event occurring and its
consequences for project objectives is the risk of uncertainty It is not limited to consideration
of losses, but looks at the extent and probability of all of the deviations. As,
In business, risk is the possibility that a company will have lower than anticipated profits, or
that it will experience a loss rather than a profit.
In finance, risk is the possibility that shareholders will lose money when they invest in a
company that has debt, if the company's cash flow proves inadequate to meet its financial
obligations.
Types of risk

Systematic Risk

Unsystematic Risk

Credit or Default Risk

Foreign-Exchange Risk

Interest Rate Risk

Political Risk

Market Risk

Risk Management
Risk management is the process of identification, analysis and either acceptance or mitigation
of uncertainty in investment decision-making. Essentially, risk management occurs anytime
an investor or fund manager analyses and attempts to quantify the potential for losses in an
investment and then takes the appropriate action (or inaction) given their investment
objectives and risk tolerance. Inadequate risk management can result in severe consequences

for companies as well as individuals. For example, the recession that began in 2008 was
largely caused by the loose credit risk management of financial firms.

Objective

Process

Step 1: Identify the Risk.

Step 2: Analyse the risk
Step 3: Evaluate or Rank the Risk.
Step 4: Treat the Risk.
Step 5: Monitor and Review the risk.

10. a. Define a forward a contract.

A forward contract is a customized contract between two parties to buy or sell an asset at
a specified price on a future date. A forward contract can be used for hedging or
speculation, although its non-standardized nature makes it particularly apt for hedging.
Unlike standard futures contracts, a forward contract can be customized to any
commodity, amount and delivery date. A forward contract settlement can occur on a cash
or delivery basis.

b. Explain how a forward contract works by giving an example:

Forward contracts do not trade on a centralized exchange and are therefore regarded as
over-the-counter (OTC) instruments. While their OTC nature makes it easier to
customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree
of default risk. As a result, forward contracts are not as easily available to the retail
investor as futures contracts.
Consider the following example of a forward contract. Assume that an agricultural
producer has 2 million bushels of corn to sell six months from now, and is concerned
about a potential decline in the price of corn. It therefore enters into a forward contract
with its financial institution to sell 2 million bushels of corn at a price of $4.30 per bushel
in six months, with settlement on a cash basis.

11. State the differences between a forward contract and a future contract.

Forward Contract

Futures Contract

Definition

A forward contract is an agreement

between two parties to buy or sell an
asset (which can be of any kind) at a
pre-agreed future point in time at a
specified price.

A futures contract is a standardized

contract, traded on a futures exchange,
to buy or sell a certain underlying
instrument at a certain date in the
future, at a specified price.

Structure &
Purpose

Customized to customer needs.

Usually no initial payment required.
Usually used for hedging.

Standardized. Initial margin payment

required. Usually used for speculation.

Transaction
method

Negotiated directly by the buyer and

seller

Quoted and traded on the Exchange

Not regulated

Government regulated market (the

Commodity Futures Trading
Commission or CFTC is the governing
body)

Institutional
guarantee

The contracting parties

Clearing House

Risk

High counterparty risk

Low counterparty risk

Guarantees

No guarantee of settlement until the

date of maturity only the forward
price, based on the spot price of the
underlying asset is paid

Both parties must deposit an initial

guarantee (margin). The value of the
operation is marked to market rates
with daily settlement of profits and
losses.

Contract
Maturity

Forward contracts generally mature

by delivering the commodity.

Future contracts may not necessarily

mature by delivery of commodity.

Depending on the transaction

Standardized

Opposite contract with same or

different counterparty. Counterparty
risk remains while terminating with
different counterparty.

Opposite contract on the exchange.

Market
regulation

Expiry date
Method of pretermination

Contract size

Market

Depending on the transaction and the

requirements of the contracting
parties.

Standardized

Primary & Secondary

Primary

12. a. Define an interest rate swap.

Interest rate swap

An interest rate swap is an agreement between two parties (known as counterparties) where
one stream of future interest payments is exchanged for another based on a specified principal
amount. Interest rate swaps often exchange a fixed payment for a floating payment that is
linked to an interest rate (most often the LIBOR). A company will typically use interest rate
swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally
lower interest rate than it would have been able to get without the swap.

b. Explain how an interest swap works. Give an example.

For example, let's say Cory's Tequila Company (CTC) is seeking to loan funds at a fixed
interest rate, but Tom's Sports Inc. (TSI) has access to marginally cheaper fixed-rate funds.
Tom's Sports can issue debt to investors at its low fixed rate and then trade the fixed-rate cash
flow obligations to CTC for floating-rate obligations issued by TSI. Even though TSI may
have a higher floating rate than CTC, by swapping the interest structures they are best able to
obtain, their combined costs are decreased - a benefit that can be shared by both parties.

13. a. Define a currency swap

Currency swap
In a currency swap, the parties to the contract exchange the principal of two different
currencies immediately, so that eachparty has the use of the different currency. They also
make interest payments to each other on the principal during thecontract term.
In many cases, one of the parties pays a fixed interest rate and the other pays a floating
interest rate, but both could payfixed or floating rates. When the contract ends, the parties
re-exchange the principal amount of the swap.

b. Explain how a currency swap works by giving an example

Originally, currency swaps were used to give each party access to enough foreign currency to
make purchases in foreignmarkets. Increasingly, parties arrange currency swaps as a way to
enter new capital markets or to provide predictablerevenue streams in another currency.

For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based
company needs to acquire U.S. dollars. These two companies could arrange to swap
currencies by establishing an interest rate, an agreed upon amount and a common maturity
date for the exchange. Currency swap maturities are negotiable for at least 10 years, making
them a very flexible method of foreign exchange.
For another example, a company knows that it will need British
pounds in the future and another company knows that it will need U.S.
dollars, they agree to swap the two at the agreed upon exchange rate. This eliminates the risk
that the exchange rate will change in a way that is disadvantageous to one party or the other.
Currency swaps were originally done to get around exchange controls.

14. a. Define an equity swap.

Equity swap
Equity swap is an exchange of cash flows between two parties that allows each party to
diversify its income, while still holding its original assets. The two sets of nominally equal
cash flows are exchanged as per the terms of the swap, which may involve an equity-based
cash flow (such as from a stock asset) that is traded for a fixed-income cash flow (such as a
benchmark rate), but this is not necessarily the case. Besides diversification and tax benefits,
equity swaps also allow large institutions to hedge specific assets or positions in their
portfolios.
Equity swaps can exist where one counter party agrees to make to the other counterparty a
series of payments that are determined by the return on a stock or stock index and the other
party makes a series of payments to the first party based on a floating money market index or
a fixed rate or return from another stock or index.

b. Explain two applications of an equity option.

Speculation

Speculation is the act of trading in an asset, or conducting a financial transaction, that has a
significant risk of losing most or all of the initial outlay, in expectation of a substantial gain.
With speculation, the risk of loss is more than offset by the possibility of a huge gain;
otherwise, there would be very little motivation to speculate. While it is often confused with
gambling, the key difference is that speculation is generally tantamount to taking a calculated
risk and is not dependent on pure chance, whereas gambling depends on totally random
outcomes or chance.
For example, while acquiring an additional property (in addition to one's principal residence)
with the intention of renting it out would qualify as a bona fide investing activity, buying half
a dozen condominiums with minimal down payments for the purpose of "condo-flipping"
would undoubtedly be regarded as speculation.
Speculation has its benefits in a free economy. By their willingness to assume the other side
of the trade (for a price, of course), speculators provide market liquidity and narrow the bidask spread, enabling producers to hedge price risk. Speculative short-selling may also keep
rampant bullishness in check and prevent the formation of asset price bubbles.

Hedging
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, such as a futures
contract.
For example, if Morty buys 100 shares of Stock plc. (STOCK) at $10 per share, he might
hedge his investment by taking out a $5 American put option with a strike price of
$8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8
any time in the next year. If a year later STOCK is trading at $12, Morty will not exercise the
option and will be out $5; he's unlikely to fret, however, since his unrealized gain is $200
($195 including the price of the put). If STOCK is trading at $0, on the other hand, Morty will
exercise the option and sell his shares for $8, for a loss of $200 ($205). Without the option, he
stood to lose his entire investment.

The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the
"hedge ratio." Delta is the amount the price of a derivative moves per $1.00 movement in the
price of the underlying asset.

15 a. Define what an option is. How does an option work? Give an example.
An option is a financial derivative that represents a contract sold by one party (option writer)
to another party (option holder). The contract offers the buyer the right, but not the obligation,
to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike
price) during a certain period of time or on a specific date (exercise date).

b. What is the difference between a call option and a put option?

Call option
A call option is an agreement that gives an investor the right, but not the obligation, to buy a
stock, bond, commodity or other instrument at a specified price within a specific time period.
Call options are typically used by investors for three primary purposes. These are tax
management, income generation and speculation.
An options contract gives the holder the right to buy 100 shares of the underlying security at a
specific price, known as the strike price, up until a specified date, known as the expiration
date. For example, a single call option contract may give a holder the right to buy 100 shares
of Apple stock at a price of $100 until Dec. 31, 2017. As the value of Apple stock goes up, the
price of the options contract goes up, and vice versa. Options contract holders can hold the
contract until the expiration date, at which point they can take delivery of the 100 shares of
stock or sell the options contract at any point before the expiration date at the market price of
the contract at the time.
Put option
A put option is an option contract giving the owner the right, but not the obligation, to sell a
specified amount of an underlying security at a specified price within a specified time. This is
the opposite of a call option, which gives the holder the right to buy shares.

A put becomes more valuable as the price of the underlying stock depreciates relative to
the strike price. For example, if you have one Mar 08 Taser 10 put, you have the right to sell
100 shares of Taser at $10 until March 2008 (usually the third Friday of the month). If shares
of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 in
the market and sell the shares to the option's writer for $10 each, which means you make
$500 (100 x ($10-$5)) on the put option. Note that the maximum amount of potential profit in
this example ignores the premium paid to obtain the put option.

c. State the difference between American option and European option.

American option
An American option is an option that can be exercised anytime during its life. American
options allow option holders to exercise the option at any time prior to and including
its maturity date, thus increasing the value of the option to the holder relative to European
options, which can only be exercised at maturity. The majority of exchange-traded options are
American.
European option
European Options can only exercise on the expiry date. European options are typically valued
using the Black-Scholes or Black model formula. This is a simple equation with a closedform solution that has become standard in the financial community.

There are four key differences between American- and European-style options:
1. Underlying
All optional stocks and exchange traded funds (ETFs) have American-style options.
Among the broad-based indices, only limited indices such as the S&P 100 have
American-style options. Major broad-based indices, such as the S&P 500, have very
actively traded European-style options.

2. The Right To Exercise

Owners of American-style options may exercise at any time before the option expires,
while owners of European-style options may exercise only at expiration.
3. Trading of index options

American index options cease trading at the close of business on the third Friday of
the expiration month. (A few options are "quarterlies," which trade until the last
trading day of the calendar quarter, or "weeklies," which cease trading on Friday of

the specified week.)

European index options stop trading one day earlier - at the close of business on the
Thursday preceding the third Friday.

4. Settlement Price
This is the official closing price for the expiration period and establishes which
options are in the money and subject to auto-exercise. Any options that are in the
money by 1 cent or more on the expiration date are automatically exercised unless the
option owner specifically requests his/her broker not to exercise.

American index options cease trading at the close of business on the third Friday of
the expiration month. (A few options are "quarterlies," which trade until the last
trading day of the calendar quarter, or "weeklies," which cease trading on Friday of
the specified week.)

European index options stop trading one day earlier - at the close of business on the
Thursday preceding the third Friday.

16. There are 2 main functions that an investor would use an option. Explain briefly the two
functions of an option.

Speculation
You can consider speculation wagering on the development of a security. The upside of
alternatives is that you are not restricted to making a benefit just when the business sector

goes up. In light of the adaptability of alternatives, you can likewise profit when the business
sector goes down or even sideways. Theory is the region in which the enormous cash is made
and lost. The utilization of choices in this way is the reason alternatives have the notoriety of
being unsafe. This is because of when you purchase a choice, you must be right in deciding
the heading of the stock's development, as well as the size and the planning of this
development. To succeed, you should effectively foresee whether a stock will go up or down,
and you must be right about how much the cost will change and in addition, the time
allotment it will take for this to happen. What's more, keep in mind commissions! The blend
of these components implies the situation is anything but favourable for you.
Hedging
The other capacity of choices is hedging. Think about this as a protection arrangement.
Pretty much as you safeguard your home or auto, choices can be utilized to guarantee your
speculations against a downturn. Faultfinders of alternatives say that in the event that you are
so uncertain of your stock pick that you require a fence, you should not make the venture.
Then again, there is undoubtedly supporting techniques can be valuable, particularly for vast
organizations. Indeed, even the individual speculator can advantage. Envision that you needed
to exploit innovation stocks and their upside, yet say you additionally needed to confine any
misfortunes. By utilizing choices, you would have the capacity to confine your drawback
while getting a charge out of the full upside in a financially well-informed way.

17. Define the following terms of an option:Strike price

A strike price is the price at which a specific derivative contract can be exercised. Strike
prices are mostly used to describe stock and index options, in which strike prices are fixed in
the contract. For call options, the strike price is where the security can be bought (up to the
expiration date), while for put options the strike price is the price at which shares can be sold.

Premium
The difference between the higher prices paid for a fixed-income security and the security's
face amount at issue.

The specified amount of payment required periodically by an insurer to provide coverage

under a given insurance plan for a defined period of time. The premium is paid by the insured
party to the insurer, and primarily compensates the insurer for bearing the risk of a payout should the insurance agreement's coverage be required.

In the money
For a call option, when the option's strike price is below the market price of the underlying
asset.
For a put option, when the strike price is above the market price of the underlying asset.
Being in the money does not mean you will profit, it just means the option is worth
exercising. This is because the option costs money to buy.

Out of the money

Out of the money is a call option with a strike price that is higher than the market price of the
underlying asset, or a put option with a strike price that is lower than the market price of
the underlying asset. An out of the money option has no intrinsic value, but only possesses
extrinsic or time value. As a result, the value of an out of the money option erodes quickly
with time as it gets closer to expiry. If it is still out of the money at expiry, the option will
expire worthless.