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Intro & Review

Intro & Review - Econ 174 FINANCIAL RISK MANAGEMENT...

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Econ 174 – FINANCIAL RISK MANAGEMENT LECTURE NOTES Foster, UCSD October 16, 2011 A. Financial Markets and Securities [Read Only -- Review] 1. Definitions: a) Financial instruments or securities. 1) Equity instruments ( e.g. , corporate stocks) -- ownership shares in a business or piece of real property. Holders receive a dividend or share of profit from issuer. 2) Debt instruments ( e.g. , bonds, notes) -- promises to repay borrowed money. Holder (the lender) receives interest from issuer (the borrower). 3) Derivative securities (options, futures, rights, warrants) -- opportunity to buy or sell some other asset. Value is derived from the performance of the underlying assets. 4) Portfolio – A collection of securities owned by one entity. b) Financial activities. 1) Financing -- raising money (financial capital). Debt financing -- borrowing money (bond issues, mortgage and other loans). Equity financing -- selling ownership shares (stock issues, new partnerships). 2) Risk management ( i.e. , hedging) – adjusting portfolio composition to reduce volatility of value and rate of return. 3) Speculation – taking risky positions in assets, betting on price increases/decreases. 4) Arbitrage – simultaneously buying and selling assets to construct a position with zero risk and $0 net investment that generates π 0 and E(π) > $0. 2. Financial Markets: a) Financial market -- institution, place or arrangement for trading investment securities. 1) Primary financial markets -- trading of new issues of stocks and bonds, often through investment banks. The flow of funds in primary markets represents true financing -- borrowers raising money from lenders. 2) Secondary financial markets -- trading of previously issued securities among investors. No true borrowing or lending takes place on the secondary market. b) Financial markets are sometimes partitioned as follows: 1) Money market -- short-term interest-bearing debt securities. 2) Fixed income capital market -- longer-term, higher risk corp/govt bonds and notes. 3) Equity capital market -- corporate common and preferred stock. 4) Derivative markets – options and futures exchanges; OTC market in forward contracts, swaps, MBS/CDO/CMO/CDS.
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Ec 174 INTRO/REVIEW p. 2 of 11 3. Risk Aversion, Hedging and Insurance: a) Assumptions. 1) Rational investors maximize expected utility of end-of-period wealth U = u(W). 2) Assume diminishing MU: u'(W) > 0; u"(W) < 0. b) You face a risky situation in which your ending wealth is uncertain. 1) In SW1, wealth will be W 1 and utility u(W 1 ) with probability p. 2) In SW2, wealth will be W 2 and utility u(W 2 ) with probability 1 − p. 3) The relevant expected values: Expected wealth: E(W) = (p)W 1 + (1−p)W 2 Expected utility: E[u(W)] = (p)u(W 1 ) + (1−p)u(W 2 ) c) Diminishing MU implies that you are risk averse, and would be willing to pay $P > 0 to avoid the risk to your end-of-period wealth. d)
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Intro &amp; Review - Econ 174 FINANCIAL RISK MANAGEMENT...

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