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Management
LECTURE 2
LECTURE CONTENTS
• Risk
• Risk Catagories
Financial Markets and Their Role
in the Global Economic System
• The financial system produces and distributes financial
services to the public.
• Among its most important services is a supply of credit which
allows businesses, households, and governments to invest
and acquire assets they need for daily economic activity.
• Another key role played by markets operating within the
financial system is to stimulate an adequate volume of savings
(i.e., funds left over after current consumption spending by
households and earnings retained by businesses) and to
transform those savings into an adequate volume of
investment (i.e., the purchase of capital goods and the buildup
of inventories of goods to sell).
• In turn, investment generates new products and services and
creates new jobs and new businesses, resulting in faster
economic growth and a higher standard of living.
• One important way to view the financial system of money and
capital markets is by examining its seven key functions or roles
in meeting the financial needs of individuals and institutions,
including generating and allocating savings, stimulating the
accumulation of wealth, providing liquidity for spending,
providing a mechanism for making payments, supplying credit
to aid in the purchase of goods and services, providing risk
protection services, and supplying a channel for government
policy in helping achieve the nation’s economic goals
(including maximum employment, low inflation, and
sustainable economic growth).
RISK
• Risk refers to the probability of loss, while exposure
is the possibility of loss, although they are often used
interchangeably.
• Risk arises as a result of exposure.
• There are three main sources of financial risk:
– Financial risks arising from an organization’s exposure to
changes in market prices, such as interest rates, exchange
rates, and commodity prices
– Financial risks arising from the actions of, and transactions
with, other organizations such as vendors, customers, and
counterparties in derivatives transactions
– Financial risks resulting from internal actions or failures of
the organization, particularly people, processes, and
systems
RISK AND RETURN
RELATIONSHIP
RISK AND RETURN RELATIONSHIP
• There is always a trade-off b/w risk and return.
• The greater the risk the higher the return.
• But! The trade off is b/w risk and expected return not actual
return.
• Expected return is the weighted average of the possible
returns where the weight applied to a particular return equals
the probability of that return occuring.
Example:
You invest $100,000 for 1 year.
Alternatives
1. Buy T-bills yielding 5% pa. (0 risk and return of 5%)
2. Invest $100,000 in stock.
Below is the table for return in one year for investing in Equity
Probability return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 -10%
0.05 -30%
Professor Harry Markowitz (1952): “Don’t put all your eggs in one basket”.
• There are two main concepts in Modern Portfolio Theory, which are;
– Any investor's goal is to maximize Return for any level of Risk
– Risk can be reduced by creating a diversified portfolio of unrelated assets
• Quantifying Risk
A convenient Measure is Standard Deviation of
Return over one year
E(R2) – [E(R)]2
• Efficient Frontier
DERIVATIVE MARKETS
DERIVATIVE MARKETS
• A derivative is a financial instrument that offers a return
based on the return of some other underlying asset.
• It trades in a market in which buyers and sellers meet and
decide on a price; the seller then delivers the asset to the
buyer and receives payment.
• The price for immediate purchase of the underlying asset is
called the cash price or spot price.
• A derivative also has a defined and limited life:
– A derivative contract initiates on a certain date and terminates on a
later date. Often the derivative's payoff is determined and/or made on
the expiration date, although that is not always the case
TYPES OF DERIVATIVES
• Derivative contracts are created on and traded in two distinct but related types of
markets: exchange traded and over the counter.
• Exchange-traded contracts have standard terms and features and are traded on an
organized derivatives trading facility, usually referred to as a futures exchange or
an options exchange.
• Over-the-counter contracts are any transactions created by two parties anywhere
else.
• Derivative contracts can be classified into two general categories:
– forward commitments and
– contingent claims.
• forward commitments, two major classifications exist:
– exchanged-traded contracts, specifically futures,
– and over-the-counter contracts, which consist of forward contracts and swaps.
TYPES OF DERIVATIVES –
FORWARD COMMITMENTS
• The forward contract is an agreement between two parties in which one
party, the buyer agrees to buy from the other party, the seller, an
underlying asset at a future date at a price established at the start.
• The contract is customized in a sense that the parties to the transaction
specify the forward contract's terms and conditions, such as when and
where delivery will take place and the precise identity of the underlying.
• Each party is subject to the possibility that the other party will default.
• Forward contracts in the financial world take place in a large and private
market consisting of banks, investment banking firms, governments, and
corporations.
• The underlying asset could be a security (i.e., a stock or bond), a foreign
currency, a commodity, or combinations thereof, or sometimes an interest
rate. (In case of Interest Rates, the contract is not on a bond from which
the interest rate is derived but rather on the interest rate itself)
• The forward market is a private and largely unregulated market.
Futures Contracts
• A futures contract is a variation of a forward contract that has
essentially the same basic definition but some additional
features that clearly distinguish it from a forward contract.
• a futures contract is not a private and customized transaction.
• It is a public, standardized transaction that takes place on a
futures exchange.
• A futures exchange, like a stock exchange, is an organization
that provides a facility for engaging in futures transactions
and establishes a mechanism through which parties can buy
and sell these contracts.
• The contracts are standardized, which means that the
exchange determines the expiration dates, the underlying,
how many units of the underlying are included in one
contract, and various other terms and conditions.
Comparison of the Forward & Futures Markets
Forward Markets Futures Markets