Professional Documents
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Introduction
Event Risk
An unforeseen event can affect revenue and costs Increased fuel prices in 1973 in the USA caused
these risks
Price Risk
Arises when future cash flows are affected by
changes
Credit Risk
Arises when customers credit rating falls
bankruptcy increase
Risk Management
Risk is unavoidable Operating and business, and event risk, can be
management only by formulating appropriate strategies based on anticipation Price risk, which occurs on a regular basis, can be managed using derivative securities Credit risk can be managed through derivative securities
Hedging
Hedging is undertaken to reduce the risk of unknown
future prices
Hedging is done using derivative securities
Forward Contracts
Provide the holder of contracts with the right to buy or
sell the underlying asset at a future time at a price that is agreed upon at the time of entering into the contract Both parties obligated to fulfill the contract Short-term, non-negotiable Typically over-the-counter
Futures Contracts
Provide the holder of the contract with the right to buy
or sell the underlying asset at a future time at a price agreed upon at the time of entering into the contract
Both parties obligated to fulfill the contract
cash flow will be produced and the company will face upside risk
When prices move against a company, decreased
cash flow will result and the company will face downside risk
When hedging, attention is placed on downside risk
Options Contracts
An option buyer has the right to either buy or sell the
underlying asset at a fixed price, at a future time Option buyers have no obligation to fulfill contracts, whereas the writers have to fulfill the obligations if called upon to do so Options provide protection against downside risk, while preserving upside potential; under forwards and futures, upside potential is foregone Options can be either over-the-counter or traded in exchanges
not known
Investors in fixed-income securities face interest rate
riskthe value of fixed-income securities are directly related to interest rate movements
Borrowers and lenders face interest rate risk, as
Floating-rate Loans
Floating-rate loans are loans where interest rates are
not fixed for the whole term of the loan, and are set at periodic intervals during the loan period based on basic interest rates in the economy
Example: 6-month MIBOR + 200 points Interest rates on loans will be reset every 6 months. Interest rates will be 2% above the 6-month MIBOR
at that time
Premium
January 1, 2011 July 1, 2011 January 1, 2012 July 1, 2012
2011 Dorling Kindersley (India) Pvt. Ltd.
rate
price risk
Risk of changes in the rate at which cash flows
Currency Risk
Currency risk, or exchange rate risk, arises when
Cover everything
Selective hedging
the hedger (downside risk) The hedger could face huge losses if the price moves against them (upside risk) Speculators can lose a large amount if prices move against their expectations Options can also result in losses even though they provide upside potential due to the cost of options as one needs to pay for buying the options Exotic derivatives and credit derivatives result in losses due to not understanding the nature of products
2011 Dorling Kindersley (India) Pvt. Ltd.