Risk Management

Market Risk

Market risk is the risk that the value of

a portfolio, either an investment
portfolio or a trading portfolio, will
decrease due to the change in value of
the market risk factors.
 Types of Market Risk

Equity risk: the risk that stock prices will

change.
Interest rate risk: the risk that interest
rates will change.
Currency risk: the risk that foreign
exchange rates will change.
Commodity risk: the risk that commodity
prices (e.g. corn, copper, crude oil) will
change.
 Managing Market Risk

Hedge

Speculation

Arbitrage

Swaps
 HEDGE

Making 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.
 HEDGE

A reduction in risk will always mean a

reduction in potential profits.
Hedging, for the most part, is a technique by
which you will not make money but by which
you can reduce potential loss.
If the investment you are hedging against
makes money, you will have typically reduced
the profit that you could have made, and if the
investment loses money, your hedge, if
successful, will reduce that loss.
 EXAMPLE
The best way to understand hedging is to think of it
as insurance. if you buy house insurance, you are
hedging yourself against fires, break-ins or other
unforeseen disasters.
When people decide to hedge, they are insuring
themselves against a negative event.
This doesn't prevent a negative event from
happening, but if it does happen and you're
properly hedged, the impact of the event is
reduced.
 SPECULATION

The process of selecting investments

with higher risk in order to profit from
an anticipated price movement.
Speculation should not be considered
purely a form of gambling, as
speculators do make an informed
decision before choosing to acquire the
additional risks.
 SPECULATION

Additionally, speculation cannot be

categorized as a traditional investment
because the acquired risk is higher than
average.
More sophisticated investors will also
use a hedging strategy in combination
with their speculative investment in
order to limit potential losses.
 EXAMPLE

One-year euro futures are currently priced at

$1.20.
You expect the dollar will depreciate to $1.32 in
the next 12 months.
What should you do? Buy these futures
If you are proved right you will earn a profit.
Any level above $1.20 will generate a profit.
If the dollar is at or below $1.20 a year from
now, however, your investment in futures will be
a total loss.
 SPECULATORS

Speculators are interested in making money

by taking a view on future price movements.
Commodity futures allow speculators to create
high leveraged positions to undertake
calculative risk, with the objective of correctly
predicting the market movement.
"A speculator is a man who observes the
future, and acts before it occurs."
 ARBITRAGE

The simultaneous purchase and sale of

an asset in order to profit from a
difference in the price.
"the opportunity to buy an asset at a low
price then immediately selling it on a
different market for a higher price."
 ARBITRAGE

It is a trade that profits by exploiting

price differences of identical or similar
financial instruments, on different
markets or in different forms.
Arbitrage exists as a result of market
inefficiencies.
 EXAMPLE

Suppose Walmart is selling the DVD

for$10. However, I know that on eBay
the last 20 copies of DVD have sold
between $25 and $30. Then I could go
to Walmart, buy copies of the movie and
turn around and sell them on eBay for a
profit of $15 to $20 a DVD.
 EXAMPLE

Walmart runs out of copies of DVD

Walmart raises the price on remaining
copies as they've seen an increased
demand for the movie
The supply of DVDs increases on eBay,
which causes the price to fall.
 Swaps

Traditionally,
the exchange of one
security for another to change the
maturity (bonds), quality of issues
(stocks or bonds), or because
investment objectives have changed.
Recently, swaps have grown to include
currency swaps and interest rate swaps.
 Example

Bank
A B

LOAN HIGHER LOWER

INTEREST
DEPOSIT HIGHER LOWER
INTEREST
 OPEN INTEREST

Open interest is a calculation of the

number of active trades for a particular
market.
Open interest is calculated using futures
and options contracts, so it is available
for almost any futures or options
markets.
 OPEN INTEREST

Open interest is calculated by adding all

of the contracts that are associated with
opening trades and subtracting all of
the contracts that are associated with
closing trades.
For example, if three traders (trader A,
trader B, and trader C) are all trading in
the futures market, their trades might
affect the open interest in the following
way
 EXAMPLE

Trader A enters a trade by buying one contract

Open interest increases to 1
Trader B enters a trade by buying four contracts
Open interest increases to 5
Trader A exits their trade by selling one contract
Open interest decreases to 4
Trader C enters a trade by buying four contracts
Open interest increases to 8
 USES

Open interest is usually used as an

indication of the strength of a price
movement.
Increasing open interest shows that
there is strength behind the current
price movement, and decreasing open
interest shows that there is a weakening
of the current price movement.
 CLOSE OUT POSITION

Close out position means to liquidate an

option position before the expiry date.
In that situation, an investor can either
exercise the contract or close out the
contract (both buyers and sellers).
 CLOSE OUT POSITION

To close out a long position (a purchased

option), the investor orders a "closing sale".
The clearing corporation transfers the long
position to another investor, and the investor
making the closing sale is paid a premium.
To close out a short position (a sold option),
the investor orders a "closing purchase". The
clearing corporation transfers the short
position to another investor, and the investor
making the closing purchase pays a premium.
 The Best Feeling in the World Is
Finally Knowing You Took a Step In
The Right Direction.
A Step Towards the Future Where
Everything That You Never Through
was Possible, Is Possible.