6. Hedgeing (I)
transaction to reduce or eliminate an exposure to risk
• an investment position intended to offset potential losses of
other investment
• the idea is to protects assets against unfavourable movements
in value of the underlying asset
• hedging on stock, industry, market, country level
• hedging is wiedly using derivatives
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7. Hedgeing (II)
• crucial element is negative correlation of assets
• financial instruments bought as a hedge transfer risk to
different party
• tend to has opposite-value movements to the underlying
• It can reduce the variability of the asset value changes / cash
flow
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8. Hedging tools / methods
• short selling
• options
• features/forwards
• swaps
• other derivatives
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9. Short selling
• long position vs short position
• short selling is selling of borrowed assets
• profit is difference between price at borrow date and price of
re-purchase
• short selling is widely treated as speculative technique
• short selling is regulated by financial regulators
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10. stock price hedgeing
• Two companies from same industry as trader is interested in
Asset A and want to hedge industry risk
• Day1: trader creates a portfolio
– Asset A price: $5, position of 100 = $5000
– Asset B price: $10, short position of 50 = $5000
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11. stock price hedgeing
• Two companies from same industry as trader is interested in
Asset A and want to hedge industry risk
• Day1: trader creates a portfolio
– Asset A price: $5, position of 100 = $5000
– Asset B price: $10, short position of 50 = $5000
• Day 2: industry good news
– Asset A price: $6, value $6000, profit $1000
– Asset B price: $12, value $5500, loss $600
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12. stock price hedgeing
• Two companies from same industry as trader is interested in
Asset A and want to hedge industry risk
• Day1: trader creates a portfolio
– Asset A price: $5, position of 100 = $5000
– Asset B price: $10, short position of 50 = $5000
• Day 2: industry good news
– Asset A price: $6, value $6000, profit $1000
– Asset B price: $12, value $5500, loss $600
• Day3: industry crash
– Asset A price: $3, value $3000, loss $2000
– Asset B price: $6, value $3000, profit $2000
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13. hedging issues
• usual high brokerage fees and commissions
• complexity of the derivatives – risk of misunderstanding or
misconduct
• complexities associated with the tax and accounting
consequences
• combined with leverage is so-called ‘weapon of mass
destruction
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16. modern portfolio theory
• portfolio - collection of securities that together
provide an investor with an attractive trade-off
between risk and return
• portfolio theory - concept of making security choices
based on portfolio expected returns and risks (risk-
return trade-off)
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18. portfolio types
• market portfolio – all tradable assets on market
• main index portfolio – all main index assets
• efficient portfolio – portfolio with:
– maximum expected return for a given level of risk
– minimum risk for a given expected return
• optimal portfolio – collection of securities that
provides an investor with the highest level of
expected return
• zero-risk portfolio - constant return portfolio
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19. diversification (I)
• diversification means reducing risk by investing in a
variety of assets
• it means: don't put all your eggs in one basket
• diversified portfolio will have less risk than the
weighted average risk of its elements
• often less risk than the least risky of its parts
• crucial element is selection of assets with low
correlation
• correlation values:[-1,1]
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22. divrsification (II)
• specific risk and systematic risk
• individual, specific securities are much more risky
than the market
• specific risk can be lowered by diversification
• systematic risk is a limit for diversification efficiency –
can not be eliminated by diversification
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24. Asset specific risk – variance / sd
• specicfic risk could be measured by variance and standard
deviation of the asset
• sd and var how far a set of numbers are spread out from each
other (from mean/expected value)
• variance:
• standard deviation (sq root ov variance):
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25. Assets historical return and sd
Based on annual returns from 1926-2004
Avg. Return SD
Small Stocks 17.5% 33.1%
Large Co. Stocks 12.4% 20.3%
L-T Corp Bonds 6.2% 8.6%
L-T Govt. Bonds 5.8% 9.3%
U.S. T-Bills 3.8% 3.1%
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26. Asset systematic risk - beta factor
• systematic risk can be measured as the sensitivity of a stock’s return to
fluctuations in returns on the market portfolio
• the systematic risk is measured by the beta coefficient, or β.
• variation in asset/portfolio return depends on return of market portfolio
% change in asset return
b= % change in market return
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27. Beta Factor Interpretation
• if b = 0
– asset is risk free
• if b = 1
– asset return = market return
• if b > 1
– asset is riskier than market index
if b < 1
– asset is less risky than market index
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31. VaR (I)
• Market risk not much in Basel II scope
• VaR (Value-at-Risk) – standard market risk method
• In its simplest form: market VAR takes the banks’s market risks
and estimates how much they might lose over a given time
period
• Example: if bank has a one-day, 99% VaR of $50 million, then
99 days out of 100 it should not expect to lose more than $50
million.
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32. VaR (II)
• The volatility of the underlying asset
– e.g. equity or bond price, currency rate
• A matrix of correlations
– e.g. the historical price relationships between equities, interest rates,
currencies, credit spreads, and so on);
• A liquidation period
– e.g. one day, one week, one month or however long a firm thinks it
will take to unwind or neutralize its risk
• A statistical confidence level
– e.g. 95% or 99%
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33. VaR problems
• VAR does not tell how big the loss might be on the 100th day
• it is based on historical correlations which can break down in
times of market stress,
• it is based on statistical assumptions (which may or may not
become true)
• VAR can really only be used for marked-to-market portfolios
(revalued every day)
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