SW - RISK MANAGEMENT & DERIVATIVES

1. Define/Describe each of the following (10 pts)

a) The general relationship between risk and return in the context of

investment opportunities
In general, investment opportunities that offer higher returns also entail higher
risks.

b) Risk aversion
Risk aversion is the preference of lower risk, if the expected return is the same.

c) The concept of beta

Beta is the measure of a stock’s market risk.

d) Credit Risk
Credit risk is the possibility that the promised cash flows (principal and
interest) may not be paid in full.

e) Financial derivative
A financial derivative is a contract or agreement that is used to avoid
fluctuations that may threaten the firm’s funds, and whose value depends upon
the price of some (underlying) security or commodity.

2. Differentiate the following (20 pts)

a) Unsystematic risks vs. Systematic risks

Unsystematic risks (business-specific risks) are random events that push the
returns on individual stocks up or down, the effects of which can be cancelled
by diversifying.

On the other hand, Systematic risks are risks that can be reduced but not
entirely eliminated through diversification.

b) Forward vs. Futures contracts

Forward contracts are contracts between two parties that are not
standardized, and has one delivery date when the final cash settlement usually
takes, place at the end of the contract.
 On the other hand, Futures are standardized contracts that are traded on an
exchange, and has a range of delivery dates when settlement is made daily
closed out prior to maturity.

c) Call Option vs. Put Option

A call option is a contract that gives a purchaser the right, but not the
obligation, to buy the underlying security from the writer of the option at the
specified price on or before the specified date.

On the other hand, a put option is a contract that gives a purchaser the right,
but not the obligation, to sell the underlying security to the writer of the option
at the specified price on or before the specified date.

d) “In the Money” vs. “Out of the Money” in a Put Option

In a Put Option, “In the Money” is a situation where the price of the underlying
is less than the exercise price, and the holder will exercise the option.

Whereas, “Out of the Money” is a situation where the price of the underlying is
greater than the exercise price, and the seller will just let the option expire.

e) Spot Contract vs. Forward Contract

A spot contract is an agreement between a buyer and a seller at time zero,
when the seller of the asset agrees to deliver it immediately and the buyer
agrees to pay for that asset immediately.

A forward contract is a contractual agreement between a buyer and a seller at

time zero to exchange a specified asset for cash at some later date at a price set
at time zero.