Risk management fundamentals and assessment methods

Risk Management [1]

If you believe a stock will appreciate and want to risk little to speculate that the stock will rise what are your option?

Holding a call option is fairly low risk because it would allow me to buy future stocks at a current price. An increase in stock value would limit my losses and allow me to profit by means of leveraged speculation. As a holder exercising a call option, I would be able to benefit from the same profit in underlying stock by paying only a minimal amount of money. By risking only a small percentage of my capital towards an insurance premium, I am potentially able to benefit from trends and hedge away risks within the call-option deadline.

Potential losses can be offset against either long-or-short stock portfolios by means of trading call strategies. A Fiduciary call would allow for a reduced capital outlay by means of replacing stock with a corresponding amount of call options, which would shield stock from losses beyond strike price. A Bull Call Spread would take advantage of moderate underlying stock risings by using short call options as a means to cover long call options. Similarly, a Calendar Call Spread would enable me to profit from stagnant or moderate-rising stock by writing or buying call options of different expiration dates. Finally, Stock Replacement -- a strategy based on studied hedging and Deep in the Money call options, would allow for higher profit while reducing risk and volatility.

2. If I can simultaneously 'Buy a call and Sell a put' to the same underlying asset, with each option having the same strike price and time to expiration have I created a synthetic forward? That is, the price premium of buying the call is the same as the premium I will get for writing the put for the same underlying asset. This would have the effect of allowing me to take control or own the asset for nothing. Can this be accomplished? Why or why not?

Simultaneously buying a call and selling a put will neutralize the resulting premium balance, although a net option premium would still have to be paid. Synthetic Forward Contracts are risk-reducing investment strategies, though further strategies should still be implemented in order to counteract potential losses. Likewise, a short trigger option would enable me to create a Synthetic Forward Contract in order to hedge a long position, by simultaneously selling a put struck below the original put being sold. Similarly, an at-maturity trigger forward would be nulled if a pre-determined trigger level is breached by the Synthetic Forward's expiration date.

3. Why would a manufacturer elect to use a long call strategy instead of a forward contract to hedge the risk associated with variable costs?

Most forward contracts are not listed on a stock exchange, since they establish the delivery of a future product only after a contract has been made. Prices are locked in a future contract, whereas a long call option allows for a more profitable outcome because it is an investment based on the underlying number of stock shares purchased, as opposed to the specific amount of the initial investment. While holding a long call option, a manufacturer retains the right to purchase at any time an equivalent number of underlying shares at the predetermined strike price until the expiration date is reached, thus multiplying profits at the expense of a low-capital premium.

4. Why are synthetics created and/or calculated when the actual derivative is available?

Synthetics are created to mirror an investor's own assets. For example, an investor might be interested on acquiring a seller's derivative assets, i.e. bonds. However, if the actual bonds are not available, the holder might invest in a separate fund as a substitute for the actual derivative. Consequently, a network of trade is created where the holder invests in financial protection. If the security derivative does not default, the investor is left with multiple profits from his synthetic selling accounts as well as earnings made from investments in financial protection. In other words, credit protection multiplies synthetic derivatives, in lieu of the actual underlying derivative securities.

5. Explain the impact transaction costs have on the ability to make arbitrage profits in forward and futures markets.

Transactions of costs affect profit because such fees as commissions and tax take away from potential arbitrage gain. Likewise, mispriced security and arbitrage implementation of strategies also affect the overall monetary turn-out in the forward or future markets.

6. Name some advantages that futures contracts have over forward contracts

Positions of future contracts are easily closed, as well as more financially liquid than the forward contract. Future contracts also eliminate counter-party credit risk. Finally, the standardization of futures allow for an easier and less expensive opening position.

Part II. Multiple Choice Questions

10. What phrase is often used interchangeably with the phrase market capitalization?

B) Market value

11. What phrase might be used to describe the initial transaction a short seller initiates when shorting an equity security?

D) Covering

12. What kind of risk does not disappear when spread across many investors?

B) Nondiversifiable

16. Which of the following phrases is used to describe an option where the strike price is approximately equal to the asset price?

A) At-the-money

17. Which of the following phrases is used to describe an option where immediate exercise results in a positive payoff?