We can generally classify risk as being diversifiable or non-diversifiable:
Diversifiable – risk that is specific to a specific investment – i.e. the risk that a single company’s stock may go down (i.e. Enron). This is frequently called idiosyncratic or non-systemic risk.
Non-diversifiable – risk that is common to all investing in general and that cannot be reduced – i.e. the risk that the entire stock market (or bond market, or real estate market) will crash. This is frequently called systematic risk .
The market “pays” you for bearing non-diversifiable risk only – not for bearing diversifiable risk.
In general the more non-diversifiable risk that you bear, the greater the expected return to your investment(s).
Many investors fail to properly diversify, and as a result bear more risk than they have to in order to earn a given level of expected return.
A derivative (or derivative security) is a financial instrument whose value depends upon the value of other, more basic, underlying variables.
Some common examples include things such as stock options, futures, and forwards.
It can also extend to something like a reimbursement program for college credit. Consider that if your firm reimburses 100% of costs for an “A”, 75% of costs for a “B”, 50% for a “C” and 0% for anything less.
There is an example from the bond-world of a derivative that is used to move non-diversifiable risk from one set of investors to another set that are, presumably, more willing to bear that risk.
Disney wanted to open a theme park in Tokyo, but did not want to have the shareholders bear the risk of an earthquake destroying the park.
They financed the park through the issuance of earthquake bonds.
If an earthquake of at least 7.5 hit within 10 km of the park, the bonds did not have to be repaid, and there was a sliding scale for smaller quakes and for larger ones that were located further away from the park.
Normally this could have been handled in the insurance (and re-insurance) markets, but there would have been transaction costs involved. By placing the risk directly upon the bondholders Disney was able to avoid those transactions costs.
Presumably the bondholders of the Disney bonds are basically the same investors that would have been holding the stock or bonds of the insurance/reinsurance companies.
Although the risk of earthquake is not diversifiable to the park, it could be to Disney shareholders, so this does beg the question of why buy the insurance at all.
This was not a “free” insurance. Disney paid LIBOR+310 on the bond. If the earthquake provision was not it there, they would have paid a lower rate.
Positions – In general if you are buying an asset – be it a physical stock or bond, or the right to determine whether or not you will acquire the asset in the future (such as through an option or futures contract) you are said to be “LONG” the instrument .
If you are giving up the asset , or giving up the right to determine whether or not you will own the asset in the future, you are said to be “SHORT” the instrument .
In the stock and bond markets, if you “short” an asset, it means that you borrow it, sell the asset, and then later buy it back.
In derivatives markets you generally do not have to borrow the instrument – you can simply take a position (such as writing an option) that will require you to give up the asset or determination of ownership of the asset.
Usually in derivatives markets the “short” is just the negative of the “long” position
Commissions – Virtually all transactions in the financial markets requires some form of commission payment.
The size of the commission depends upon the relative position of the trader: retail traders pay the most, institutional traders pay less, market makers pay the least (but still pay to the exchanges.)
The larger the trade, the smaller the commission is in percentage terms.
Bid-Ask spread – Depending upon whether you are buying or selling an instrument, you will get different prices. If you wish to sell, you will get a “BID” quote, and if you wish to buy you will get an “ASK” quote.
The point of the preceding slide is to demonstrate that the bid-ask spread can be a huge factor in determining the profitability of a trade.
Many of those option positions require at least a 10% price movement before the trade is profitable.
Many “trading strategies” that you see people propose (and that are frequently demonstrated using “real” data) are based upon using the average of the bid-ask spread. They usually lose their effectiveness when the bid-ask spread is considered.
Market Efficiency – We normally talk about financial markets as being efficient information processors.
Markets efficiently incorporate all publicly available information into financial asset prices.
The mechanism through which this is done is by investors buying/selling based upon their discovery and analysis of new information.
The limiting factor in this is the transaction costs associated with the market.
For this reason, it is better to say that financial markets are efficient to within transactions costs . Some financial economists say that financial markets are efficient to within the bid-ask spread.
A futures contract is similar to a forward contract in that it is an agreement between two parties to buy or sell an asset at a certain time for a certain price. Futures, however, are usually exchange traded and, to facilitate trading, are usually standardized contracts. This results in more institutional detail than is the case with forwards.
The long and short party usually do not deal with each other directly or even know each other for that matter. The exchange acts as a clearinghouse . As far as the two sides are concerned they are entering into contracts with the exchange. In fact, the exchange guarantees performance of the contract regardless of whether the other party fails.
The largest futures exchanges are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME).
Futures are traded on a wide range of commodities and financial assets.
Usually an exact delivery date is not specified, but rather a delivery range is specified. The short position has the option to choose when delivery is made. This is done to accommodate physical delivery issues.
Harvest dates vary from year to year, transportation schedules change, etc.
The date when the option expires is known as the exercise date, the expiration date, or the maturity date.
The price at which the asset can be purchased or sold is known as the strike price .
If an option is said to be European, it means that the holder of the option can buy or sell (depending on if it is a call or a put) only on the maturity date. If the option is said to be an American style option, the holder can exercise on any date up to and including the exercise date.
An options contract is always costly to enter as the long party. The short party always is always paid to enter into the contract
The short position again has granted the option to the long position. The short has to buy the stock at price K, when the long party wants them to do so. Of course the long party will only do this when the stock price is less than the strike price.
Thus, the payoff function for the short put position is:
Since the short put party can never receive a positive payout at maturity, they demand a payment up-front from the long party – that is, they demand that the long party pay a premium to induce them to enter into the contract.
Once again, the short and long positions net out to zero: when one party wins, the other loses.
Options Contracts Long Position Short Position Net Position
The standard options contract is for 100 units of the underlying. Thus if the option is selling for $5, you would have to enter into a contract for 100 of the underlying stock, and thus the cost of entering would be $500.
For a European call, the payoff to the option is:
Max(0,S T -K)
For a European put it is
Max(0,K-S T )
The short positions are just the negative of these:
So who trades options contracts? Generally there are three types of options traders:
Hedgers - these are firms that face a business risk. They wish to get rid of this uncertainty using a derivative. For example, an airline might use a derivatives contract to hedge the risk that jet fuel prices might change.
Speculators - They want to take a bet (position) in the market and simply want to be in place to capture expected up or down movements.
Arbitrageurs - They are looking for imperfections in the capital market.
When we start examining the actual pricing of derivatives, one of the fundamental ideas that we will use is the “law of one price”.
Basically this says that if two portfolios offer the same cash flows in all potential states of the world, then the two portfolios must sell for the same price in the market – regardless of the instruments contained in the portfolios.
This is only true to “within transactions costs”, i.e. the bid-ask spread on each individual instrument.
Sometimes one portfolio will have such lower transactions costs that the law will only approximately hold.
An equity-linked CD is just one example of financial engineering – the notion that investors are really just purchasing potential future cash flows and that any two sets of identical potential future cash flows must sell for the same price.