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Flashcards in Derivatives Systematic risk Deck (16)
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1
Q

Explain how derivatives can expand productivity.

What is the danger of derivatives and how are they caused.

A

Facilitate separation of risk-bearing ability from asset
ownership thereby expanding productivity. The financial systems allows investors to shift risk to people who can handle it.

Danger arises when investors take on more risk than
they can bear through fraud, ignorance or hubris.

  • Hubris is overcoming confidence, excessive pride or self confidence.
  • Problem arises when you get rewarded to take on the risk, people may take on more risk as they are rewarded for taking on that risk.
2
Q

Define systematic risk and how this can have brooder consequences.

A

Systemic risk: when a few investors take on so much
risk that default by them threatens the whole system>

The risk is not too severe if they lose their own money, but what happens if they are allowed to take on so much risk that it effect the whole economy.

3
Q

Derivatives are securities that get value…

Why are they classified as contingent claims

A

Securities that get their value from the price of other
securities.

Derivatives are contingent claims because their payoffs depend on the value of other securities

4
Q

Define a hedger and speculator in relation to a call option.

A

Hedge investor: Someone who enters into a position through derivatives and also owns the security. They are able to deliver the security no matter how high its price rises. Can not be bankrupt as they can deliver the asset irrespective of the price.

Speculators: Someone who enters into a position through derivatives but does not own the underlying security. They promise to deliver the difference between the exercise price and the security price. They are not hedged against unfavorable price movements. Potential loss is infinite and the speculator can go bankrupt if they cant afford to make up the difference.

5
Q

How can derivatives cause the “Death Spiral” of companies.

A

Many derivatives contracts require that a company
suffering a credit downgrade immediately supply collateral to counter-parties. If derivatives are marked to market than when the price moves unfavorably they call this credit. If everyone does this at once. This can cause a death spiral of credit collapse.

6
Q

Is a fat tail or normal distribution more valuable when associated with higher option value and why.

What is the problem of using a normal distributions, What is the implication of price on this.

A

The fat tail is more valuable. There is a higher likely hood of a favorable event despite a riskier likelihood of unfavorable event since downside risk is capped whilst upside is not.

In practice the normal distribution underestimates the likelihood of extreme events occurring. Extreme events occur more frequently, than the normal distribution curve indicates. Behavioral finance suggest that we also tend to underestimate extreme events as it is unfamiliar.

Therefore option price will be systematically underestimated as prices are modeled on a normal distribution rather than a skewed distribution, they will be sold cheaply.

7
Q
  1. Explain the components of the strangle option strategy
  2. how does it profits,
  3. draw a payoff diagram
  4. What is the writer of the strangle betting on
  5. What is an important element often forgotten.
A
  1. Long strangle: Buy call and put with same maturity and different exercise price.
  2. The strangle is a bet on volatility.
    To make a profit, the change in stock price must exceed the cost of both options. You need a large change in stock price in either direction or a black swan event
  3. The writer of a strangle is betting the stock price will not
    change much
  4. Your betting that it will drop dramatically or increase dramatically, you don’t care in which direction, you just want extreme event to occur.

Timing is important, if the extreme or black swan event occurs in time, than it becomes profitable.

8
Q

Define a collar bracket and its components

How can the options market be used to manage risk, explain using “zero-cost collars

Draw a pay off diagram

A

A collar brackets the value of a portfolio between two bounds.

The company buys a put option to sell the underlying asset at a certain price. To pay for its put option, the company writes (ie, sells) a call option at a price that equals the cost of its put option. It sells the upside as a price to pay for the isurance of a fall in the underlying asset price.

(Payoff Diagram) The Strike price of the call is the maximum value of the portfolio. The long put is the lowest value of the portfolio.

9
Q

Define a forward contract and who has a long and who has a short position

What are the cost, risks and benefits to mining companies of entering forward contract to guarantee the price they receive for their commoditite

A

Agreements to buy or sell an asset at a certain time in
the future for a certain price.

Party agreeing to buy at fixed price in future has “long
position”. Party agreeing to sell has “short position”

NANANANAN need to go over with brian PG 17 of LS

10
Q

If you have capital to invest what factors would you consider to determine whether to invest in a call option or a direct share purchase. What is the potential of returns.

A

It depends on how much risk you want to take on and how certain you are of the movement in the share price.

Variance of return is higher in an all option portfolio compared to the variance of the all equity portfolio.

Potentially a higher return than simply a direct share purchase.

11
Q

If the derivative is not backed by the underlying assets what other factors contributes to their value.

A

Unless the derivatives contract are backed by underlying assets, their ultimate value also depends on the creditworthiness of the counter party.

12
Q

Explain the circumstance that define a “black swan event”

A

First: It is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility

Second: it caries an extreme impact

Third: in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable

13
Q

What is the best financial representation of credit risk define the representation.

Explain the process in which this “ financial representation” is lower than total written derivatives

A

Net current credit exposure: For a portfolio of derivative contracts, the gross positive fair value of contracts, less the amount of netting benefits. This metrics is most representative risk in a derivative portfolio.

Notional derivatives are at 237 trillion and represent the number of derivative contract written in the world. People take on risk and try and offset the risk by writing another contract. SO net current credit exposure are much lower.

14
Q

How did Nassim Taleb make a profit from people underestimating extreme events

A

The advantage of people underestimating extreme events. Deep out of the money, put or call options must be underpriced.

For deep out of the money to be back in the money, extreme events has to occur and since it’s underestimated, those options should sell for less than its fair price.

15
Q

Why does the RBA warn violent disruptions

A

We are in a period of low volatility since 6-7 years after the GFC extreme volatility has disappeared as a result of QE

But if there is a government policy change, then there can be violent changes as changes in interest rates is proportionately greater at the lower end.

16
Q

What is the equity Premium Puzzle

A

Real return to shares has a higher variance than real return to nominally risk-free assets

Investors require higher expected return to hold shares

Puzzle: Difference in required rate of return seems implausibly high. Historical equity premium of around 6% in excess of the risk free rate seems excessive.

Risk premium is excessive because implied risk aversion is implausibly high. This has bought down the risk free rate and increased the risk premium compared to historical averages. (graph of efficient frontier). Which is why equities could be argued to be undervalued and people should invest in equities now.

Over the longer period one can argue that equity and bonds are just as risky once adjusted for returns. If investors come to understand that equity is not risky, the discount rate will go down. this will further increase the price of equities.