Managing market risk

Managing Market Price RiskConcept of Close Out and Open InterestB.DhevaAIT-07-006

Market RiskMarket 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 RISKEquity 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 riskHedgeSpeculationArbitrage Swaps

HEDGEMaking 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.

EXAMPLEThe 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.

HEDGEA 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.

SPECULATIONThe 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.

EXAMPLEOne-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 futuresIf 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.

SPECULATIONAdditionally, 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.

SPECULATORSSpeculators 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."

ARBITRAGEThe 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."

ARBITRAGEIt 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.

EXAMPLESuppose 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.

EXAMPLEWalmart runs out of copies of DVDWalmart 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.

SwapsTraditionally, 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.

OPEN INTERESTOpen 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 INTERESTOpen 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

EXAMPLETrader A enters a trade by buying one contractOpen interest increases to 1Trader B enters a trade by buying four contractsOpen interest increases to 5Trader A exits their trade by selling one contractOpen interest decreases to 4Trader C enters a trade by buying four contractsOpen interest increases to 8

USESOpen 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.

Managing market risk

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Managing market risk