Risk Management Cslo the Reason Why it

Risk Management

CSLO

The reason why it is important to understand the role of the financial markets is: because of globalization. As, this has caused shifts in: the economy and the way people are interacting with each other. One way to effectively comprehend what is taking place is with, the indices reflecting how these transformations are impacting the world economy. This means that ordinary people need to have an: understanding of the markets and the way they are reacting to various events. This will help them to determine, what will occur in the economy over the next nine months to one year. As, prudent individuals can begin to plan on: profiting from these changes or they could protect their assets. In either case, understanding the markets in this aspect will help everyone to more effectively prepare for uncertainties. This is how you can be able to increase your net worth and protect it during times when it could be facing severe challenges (i.e. bear markets).

The way that I was able to learn about derivatives and the role in the economy is seeing there long-term effect. As, these instruments have been used as an effective way of helping to mitigate risks in the market (i.e. hedging). However, the last several years have meant that more investors have become involved in these areas. Their main objectives are to increase their overall return and reduce their risks dramatically.

Yet, they do not understand the possible risks and the impact that it could have on their portfolio. This is because the use of derivatives, have become so common in the markets that most people assume that they are invested safe areas (without investigating them further). The reason why is because this asset class has been utilized so much, that is now of part of modern portfolio thinking. This means that these kinds of investments are: one way that a number of institutional and individual investors are trying to diversify their holdings. The problem is that globalization can take a risky investment and spread it around the world. If there is a bubble in a particular area, this could cause investors to take larger risks without realizing what is happening. At which point, they are exposed to changes in the economic cycle. Once this occurs, it means that they could see dramatic losses in their portfolio.

A good example of this can be seen with the recent financial crisis. As, derivatives were at the heart of the tranches that were: sold to investors of subprime mortgages. This is when the investment banks, bundled a number of high profile mortgages together. The idea was to: reduce the risks of default and increase the total return that they were providing.

Prior to 2007, many investment bankers claimed that the risks were reduced because of: the pool (i.e. tranche) and could they could purchase put options to protect themselves. The problem was that there were no public markets, where these products were trading and no one understood the true value of them. This made purchasing any kind of puts difficult.

Once the economy began to slow, investors were left holding assets that could not be sold and there was no way to accurately value them. What made the situation worse is that large financial institutions (i.e. banks) began to face liquidity problems. This is because they were holding, a large number of these assets on their balance sheets. Since this there was no way to accurately value or sell them they were essentially worthless (creating a liquidity crisis). This experience shaped my views of derivatives and their role in the economy. As, they are a great way to be to: provide protection (if they are used properly). However, during bull markets and times of strong economic expansion, is when the risks increase exponentially. Therefore, some kind of balance and common sense needs to be used when becoming involved in this particular asset class.

The role of buying and selling assets is based off of the laws of supply and demand. This means that there will be times when you will have excessive demand (bull markets) and supply (bear markets). These forces will cause the indices to overreact in both directions. This is due to the fact that excessive supply is pushing the markets beyond normal valuations. Once this begins to happen, is when investors need to be prepared for sudden changes. As, they must use strategies (such as: hedging) to protect their portfolio. While at the same time realizing, that bubbles or extreme slowdowns can linger for a period of months to years. This is why the markets are constantly going between: various phases of contraction and expansion over long periods of time. If the prudent investor can understand these factors, they will be able to avoid becoming influenced by: irrational pessimism or exuberance.

CSLO 2

The reason why it is important to understand risks is because, of the changes that have been occurring in the world of investing. This has caused the total number of threats facing investors to rise dramatically. In order to understand the world that we live in and how to account for possible uncertainties requires recognizing these hazards. Otherwise, anyone who fails to understand risk and its dynamics, are at the mercy of events that are occurring. This can have devastating consequences on the lives of individuals and their families. Where, if they are not prepared for sudden changes; they could have an adverse impact on their standard of living and economic well being. Therefore, everyone needs to realize these risks and how to account for them.

Financial risk management was learned through seeing actual events unfolding in the markets. As, managers made decisions that were: ill advised and had a negative impact on their business. This is because they did not fully understand these dangers. This influenced my thinking by serving as a cautionary tale about how to understand the hazards a corporation is facing.

A good example of this can be seen with Enron. What happened was: the different actions that managers were engaged in, did not take into account the risks of various projects. This caused the company to face cost overruns, to the point that it began to impact their balance sheet. To hide these losses management began to create special purpose entities. This led to the accounting scandal, because managers did not plan for risks on the various projects they were involved in. These events shaped how I would view risks and the importance of comprehending strong management techniques to mitigate these effects.

Understanding financial assessment is when: you can take various ideas that were presented and can make an accurate determination about investment decisions. This helps to make financial planning more effective.

However, over the last several years the competitive environment internationally, has meant that a shift has occurred. This has caused the total amount of financial information that is available to increase. The reason why, is because the competitive environment is causing more information to be made available to the public. Over the course of time, this can create confusion for some people as they have too much information available (which leads to indecision). When you are able to understand financial assessments, this will help you to effectively sort through the various pieces of information. Where, you have the knowledge and the experience to know what resources are the most valuable (over other pieces that you are looking at). In the competitive international environment, this approach is necessary for making the most informed decisions (based on all available information).

The seller's and the buyer's risks are not the same. The reason why is because, the objectives are different between the two parties. As, the buyer wants to: receive the product or services that they require at a fair price. While the seller, is trying to increase their profit margins from delivering these products and services to customers.

This creates a conflict between the two when it comes to risk. From the perspective of the buyer, they want quality and reasonable prices. When they do not receive what they paid for is when the risks increase for this party. This is due to the fact that they are using the product or service to address a specific need. While the seller, wants to increase their profits and reduce costs. From their viewpoint, the risks are based on: lower profit margins or possible losses in selling the product. This is significant, because it showing how the two perspectives for risk are not the same.

CSLO 3

Understanding the use of the currency contract will help business and individuals to account for possible risks they will face. This usually occurs with a business conducting trade or a person encountering these issues when they are traveling. These two factors have become a major part of the global economy. With the ability, to go from: one country to the next and free trade becoming the areas of focus for most governments. This means that they will enact policies that will encourage more people to travel to their region and trade with local businesses. Over the course of time, this has created a shift in the importance of the currency contracts. As, they are used as a way to reduce risks from: the volatility in the movements of the numerous currencies contracts. When you understand how this asset class works, you can be able to account for possible risks and increase your profit margins from the instability in prices.

Commodities futures are an effective way for investors and businesses to be able to efficiently price the costs of various natural resources. This helps to: improve transparency and trade by ensuring that everyone has easy access to the markets. Over the course of time, this will allow the economy to grow by: providing an effective mechanism of trading a host of commodities. This makes business more productive, as they can respond to changes in the costs of raw material in real time. For the consumer, this is providing them with a large assortment of products to choose from at affordable prices.

A good example that shaped these experiences was the increases in the cost of crude oil in 2008. At the time, many of the pundits claimed that businesses could handle higher costs of commodities. The reason why is because, demand was strong from many Asian countries. However, as prices continued to climb higher this began to have an impact on wholesale costs. As, manufacturers began to pass: the large cost increases in commodities prices to their customers. Once they reached above $120 per barrel is when many consumers began to feel these effects. At which point, they began to cut back on their spending (which helped to fuel the recession). This is important, because it shows how understanding commodity futures will help to: provide insights about the overall strengths or weaknesses associated with economic activity moving forward.

Understanding energy and housing futures will provide specific insights as to the underlying strengths of the economy. This is because these two areas are: an important part of daily life for everyone. As, they have an inverse relationship with one another, which will have an impact on the economy. When you see energy prices rising, this will have an impact on housing futures with consumers having less money to spend. While a decline in energy prices and an increase in home values will fuel an expansion in consumer spending. This is because prices are low and the higher values, from real estate are making consumes feel wealthier. When you put these elements together, they are showing how understanding the relationship between them, will provide insights about the strength of economic activity.

CSLO 4

The put call parity will help investors to identify trading opportunities that are based upon their unique risk to reward objectives. This allows them to identify opportunities that can provide them with the returns that they are looking for. While at the same time, it is helping them to offset the underlying risks in the stock. As, any kind of investment that does not fit in line within these various parameters should be rejected as unsound. The reason why, is because the risk to reward dynamics have changed. Once this occurs, it means that investors will become exposed to sudden volatility. Therefore, using the put call parity will identify those investments that can provide more consistent returns and reduce risks. This makes selecting investments easier, as the strategy is taking into account these different factors. ("Put Call Parity," 1996)

The Binominal Price model is important, because it is providing a simple and interactive structure for understanding the different trading opportunities. Where, an investor can utilize this model to look at a wide variety of options with varying expiration dates. Using American options, this increases their ability to improve their return. As, they can sell the option at: any time before expiration date, which gives investors greater amounts of flexibility. This helps them to increase their return and reduce their risks, as this is easier to understand in comparison with other models (i.e. The Black Scholes formula). ("Binomial Option," 2011)

An example of how this influenced the learning process occurred with the announcement of a possible arbitrage situation. In these kinds of events, traders are taking a number of aggressive positions by: purchasing puts on one company and the calls on the other. The basic idea is to use the price irregularities to increase their overall return. However, in a number of cases, it is difficult to determine the risk to reward ratios because of the large increases in volume. When you are using Binomial Pricing, it is easier to see potential opportunities and risks. This is because it is taking out, the activities of arbitrage related trades. Once this occurs, investors can decide if a particular situation is in line with their risk to reward objectives. ("Binomial Option," 2011)

The Black Scholes formula is one of the most common strategies that are utilized in the options markets. This is because it is one of the most accurate theories for accounting for risks. The way it works is when investors own a stock. They can reduce their risks to almost zero by: purchasing a put option. The reason why this philosophy has proven to work so successful is due to the fact, that it takes into account a number of different parameters. To include: the position cannot be traded if it is an arbitrage situation, the stock cannot pay a dividend, the company must allow for odd lot trades (buys for less than 100 shares) and the fees for the transaction have to be kept to minimum. This is important, because if investors can follow these parameters they can be able to dramatically reduce the underlying risks in the security. At the same time, it will help them to identify trading opportunities for prudently increasing their return. (Larson, 2009)

As a result, the utilization of Black Scholes formula is another tool that: many individuals and institutional investors will use to increase their overall returns. Since it was introduced in 1973, this has helped to provide a technique that can reduce risk and objectively evaluate the security (based on preset conditions). Like the other theories that were discussed, if the stock is not fitting in line with various parameters for the strategy. Then, the risks are higher than normal and the trade should be avoided. This is significant, because it is showing how traders will use this model to objectively evaluate various risks and rewards. As, this tool is providing a method of accounting for these factors and increasing the total return. Once this occurs, it means that the portfolio is more balanced against possible adverse changes in the future. (Larson, 2009)

CSLO 5

Derivatives can be misused to create the impression, that a particular asset class is a safe investment. When in reality, it could be increasing the overall risks that: individuals or institutional investors are facing. This is problematic, because it can allow for large asset bubbles to develop and the false belief that everyone is protected.