risk management
EXC3613
Risk Management with derivatives
Geir Høidal Bjønnes geir.bjonnes@bi.no 1
Introduction
• Learning objectives:
1.
2.
3.
4.
What is a derivative?
What is the role of Derivatives and Derivatives Markets
Firms’ risk exposures
Hedging price risk with derivatives
• McDonald: Chapter 1
2
Example
• Consider a farmer that grows wheat and is expecting to yield 10,000 bushels of crop in 3 months. He is afraid that the price of wheat might drop at the period of harvest and would like to insure against this risk.
• Consider also a baker that buys and stores wheat every year during the harvest period. He faces the risk that the price of wheat might increase during that period and would like to hedge against this risk.
3
Example
• The farmer and the baker agree to enter into the following contract: In 3 months from today the baker will buy from the farmer
10,000 bushels of wheat for $5 per bushel.
• The actual price of wheat may be below or above $5 in 3 months. The contracts acts an insurance against this price risk. 4
What is Risk?
• We dislike uncertainty because we fear the possible adverse outcomes
• In order to quantify risk we need to know for each adverse outcome: – Its cost and
– Its probability
• There exist several measures of risk, e.g. volatility
(variance/standard deviation of the return on an asset)
5
Managing Risk
• Risk is unavoidable whatever it is that we try to do
• In several occasions we can do something to decrease the amount of risk we bear:
– Act in a way that the amount of risk is less
– Give out part or all of the risk to another party
• In a risk management decision we compare the cost of decreasing the risk with the cost of the risk that we decrease and then make the decision
6
Diversifiable vs non-diversifiable risk
• Diversifiable risk: unrelated to other risks. If many investors share a small piece of such risk, then there
Risk Management with derivatives
Geir Høidal Bjønnes geir.bjonnes@bi.no 1
Introduction
• Learning objectives:
1.
2.
3.
4.
What is a derivative?
What is the role of Derivatives and Derivatives Markets
Firms’ risk exposures
Hedging price risk with derivatives
• McDonald: Chapter 1
2
Example
• Consider a farmer that grows wheat and is expecting to yield 10,000 bushels of crop in 3 months. He is afraid that the price of wheat might drop at the period of harvest and would like to insure against this risk.
• Consider also a baker that buys and stores wheat every year during the harvest period. He faces the risk that the price of wheat might increase during that period and would like to hedge against this risk.
3
Example
• The farmer and the baker agree to enter into the following contract: In 3 months from today the baker will buy from the farmer
10,000 bushels of wheat for $5 per bushel.
• The actual price of wheat may be below or above $5 in 3 months. The contracts acts an insurance against this price risk. 4
What is Risk?
• We dislike uncertainty because we fear the possible adverse outcomes
• In order to quantify risk we need to know for each adverse outcome: – Its cost and
– Its probability
• There exist several measures of risk, e.g. volatility
(variance/standard deviation of the return on an asset)
5
Managing Risk
• Risk is unavoidable whatever it is that we try to do
• In several occasions we can do something to decrease the amount of risk we bear:
– Act in a way that the amount of risk is less
– Give out part or all of the risk to another party
• In a risk management decision we compare the cost of decreasing the risk with the cost of the risk that we decrease and then make the decision
6
Diversifiable vs non-diversifiable risk
• Diversifiable risk: unrelated to other risks. If many investors share a small piece of such risk, then there