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21 Cards in this Set
- Front
- Back
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Benefits of Risk Bearing Institutions |
- bearing risk collectively in large group; cost efficient - professional management (expertise & training in managing financial risk) - administrative services (claim handling or buying/selling securities for investment) - investment in information (obtain data necessary to make well-informed risk-bearing decisions) - investment in infrastructure (obtain essential resources such as reinsurance or trading floors useful in bearing risk)
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Examples of Risk Bearing Institutions |
- ex.: pension plans, mutual funds (reduce investment risk by joining other investors to buy well-diversified portfolio of investments), insurance companies
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Covariance |
- interrelationship of two stocks (in this case) - measures how two RVs move relative to each other - positive when they move together in same direction, negative when they don't |
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Correlation Coefficient |
- ability to reduce risk through diversification depends heavily on degree of correlation found across all members in risk group - +1- perfectly positive, -1- perfectly negative
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Zero Correlation |
- statistically independent of each other, often found among different types of insurable risks like traffic accidents and fires |
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Diversification: Negatively Correlated Groups |
- optimal conditions for risk diversification to reduce risk - by adjusting stock weights, optimal portfolio can be created regardless or growth/recession - perfect negative correlation, risk eliminated completely |
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Diversification: Positively Correlated Groups |
- offers no risk reduction in groups b/c STD of portfolio equal to STD of returns for each stock - can try to reduce risk by increasing number of exposure units in pool, but portfolio STD of risk pools always greater than pool of independent exposures - cannot be diversified away effectively as independent pools - many CAT losses are positively correlated |
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Diversification: Uncorrelated groups |
- insurance risk pooling assumption- potential losses of all exposure units independently distributed - can reduce risk with relatively modest pools - infinitely large pools- measure of risk is zero demonstrating that insurer can eliminate risk completely through diversification of independent pool members
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Hedging |
- taking two financial positions simultaneously whose gains offset each other - correlation coefficient: -1
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Example of hedging: insurance |
- insured firm has loss, gains right to collect insurance proceeds - firm has hedged loss exposure b/c event that causes damage (loss), which causes offset gain (claim against insurer)
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Other examples of hedging |
- currency risk - interest rate risk - commodity price risk
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Currency Risk |
- loss potential caused by unfavorable fluctuations in value of domestic currency relative to foreign currencies |
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Interest Rate Risk |
- loss potential caused when changes in interest rates reduce market value of fixed-income securities - when interest rate rises, value of fixed income securities fall, and vice versa - longer time to maturity= more volatile market price for fixed-income securities |
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Commodity Price Risk |
- input price risk - output price risk
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Derivatives |
- financial instrument whose value is based on value of underlying financial asset or commodity |
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Examples of Derivatives
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- futures contract - forwards contract - swaps - call option - put option |
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Futures/forwards contracts |
- futures: order to buy or sell asset later at specified price - forward- same but not traded on organized exchange |
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Swaps |
- Counterparties' exchange cash flows of one party's financial instrument for those of the other party's financial instrument |
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Call Option |
- the right, but not obligation, to buy underlying asset
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Put option |
- the right, but not obligation, to sell underlying asset |
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Natural Diversification |
- occurs across uncorrelated risk - when risks naturally offset themselves, techniques like insurance or hedging aren't required, and can reduce costs of corporate risk management - good example is relationship between hazard and financial risks |
