Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

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Hong Kong does go up and the HSI rises to 15,000, the speculator can sellthe three-month futures contract at 15,000 and take a 500 point profit. Butwe know that the chance for the market to go up or down is 50/50 if themarket follows a random walk. In other words, the speculator has a 50percent chance of losing and a 50 percent chance of winning. The speculatormay lose a substantial amount of money if his prediction of market does notmaterialise.The third kind of participants are arbitrageurs. Arbitrageurs look foropportunities to lock in a riskless profit by simultaneously buying and sellingthe same (or similar) financial product in different markets. The fundamentalbehind arbitrage is that financial markets are not perfect. From time totime, price differential of the same product between different markets indifferent parts of the world at the same time does exist, especiallycombining the currency element. For us, arbitrage strategy will not work,because the transaction cost will probably wipe out the profit even if wedo find an arbitrage chance. Big investment houses incur very little transactioncost. They are the major players in this market. But remember Barings, itsmanagement put the company to the ground using a supposedly risklessarbitrage strategy.When bank regulators conduct examinations, it is sensible for them to findout what the institution's strategic goal in derivatives business is. Is it a hedger,speculator or arbitrageur? Regulators can also review the institution's revenuereport to identify the sources of treasury revenues. If 80 percent of aninstitution's treasury revenues are from position-taking activity, examiners usuallywould watch that institution's treasury operation a bit closer. The reason isthat position-takers in treasury instruments, both cash and derivatives, arespeculators. In other words, they are gamblers. As we have just discussed,when you take an out-right position in any financial instrument, there is a50 percent chance that the price of that instrument will go up and a 50percent chance it will go down. As soon as you have taken an out-rightposition, you have no control over what the price will be in the next minute.Some Fundamentals of Derivatives
Should we criticise banks for engaging in position-taking business? Notreally. All businesses involve some degree of risk taking and speculation.Banking business is no exception. But it all depends on how much a bankspeculates. Most banks conduct derivatives business because they have toserve their clients who either take or hedge their business risks. They cometo banks for solution. In the process of serving these clients, it isinevitable for banks to take some out-right positions. Also, banks' tradingactivities can facilitate liquidity which would reduce transaction cost for allmarket participants. In addition, banks take positions because they have toget the "market feel" to better serve their clients. Moreover, from time totime, banks have their own views on interest rate or exchange ratemovements. It is perfectly all right for them to take out-right positions inthose circumstances. When banks engage in position-taking activities, theyhave to consider a number of things, such as the capital level of theinstitution, business strategies, trading expertise, management's understandingof the markets, systems and controls, back-office supports, etc.Some Fundamentals of Derivatives
Page 2 and 3: THE UNIVERSITY OF HONG KONGLIBRARIE
Page 4 and 5: VI- . .7 « i8^p ! ««^^OOSHSlVCJ
Page 6 and 7: Ever since derivatives took centre-
Page 8 and 9: denominator, value at risk, which c
Page 10 and 11: the kind of information that superv
Page 12 and 13: This book is a team effort of the H
Page 14 and 15: While most market participants defi
Page 16 and 17: of this investment is 6.32 percent
Page 18 and 19: Mathematically, the relation betwee
Page 20 and 21: $10,000. (For simplification of pre
Page 24 and 25: 3OF ATHEPRICING OF A FORWARD CONTRA
Page 26 and 27: COST OF CARRYIn the above example,
Page 28 and 29: interest rate swap rates. From thes
Page 30 and 31: Borrowers, on the other hand, usual
Page 32 and 33: Again we use our method of having t
Page 34 and 35: ates, the forward rate for the peri
Page 36 and 37: 5In this chapter, we will discuss w
Page 38 and 39: often complain that there is too mu
Page 40 and 41: ABC also has three cash flows:1. It
Page 42 and 43: Assuming that there is no transacti
Page 44 and 45: simulation techniques and mathemati
Page 46 and 47: The calculation of credit risk proc
Page 48 and 49: The payments are exchanged every th
Page 50 and 51: the reference rate. When this type
Page 52 and 53: Effectively this is just a 2-year s
Page 54 and 55: This measure of duration is referre
Page 56 and 57: analysis, it also has its shortcomi
Page 58 and 59: Percentage change in price due to d
Page 60 and 61: 8OFOptions are generally perceived
Page 62 and 63: OPTION'S PAYOFF PATTERNWhat about a
Page 64 and 65: Volatility is the most important fa
Page 66 and 67: fANDTrading options becomes more po
Page 68 and 69: You need to hold 7 shares of stock
Page 70 and 71: di = [ln(IOO/IOO) + (0.06 + O.P/2)
Page 72 and 73:
is10In the previous chapter, we dis
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stock will go up in the near future
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If the stock price of A continues t
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OF AN11In the previous two chapters
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at-the-money option approaches its
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12Mortgage-backed securities (MBS)
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NEGATIVE CONVEXITYFor MBS, there is
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MULTI-CLASSIn 1983, Freddie Mac int
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13What is a hedge? According to the
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management to enter into swap and o
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transaction. For this criterion to
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CREDIT DEFAULT SWAPThe simplest for
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APPLICATION OF CREDIT DERIVATIVESYo
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in the US. Equally innovative, cred
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THE VARIANCE-COVARIANCE METHODThe t
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"cell" would have a cash flow expos
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Daily profit and loss ranked in asc
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of the market factor. Through this
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3. Most value at risk models use hi
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16ANDIn Chapter 5, we talked about
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price) of 9,000. For this transacti
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and the June 3-month futures rate i
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needs to take the necessary busines
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ief, the policies and procedures sh
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The derivatives industry can be com
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ANDONOFINTRODUCTION1. The Monetary
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MANAGEMENT AND CORPORATE5. As the B
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ensure that there is sufficient awa
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15. Branches of foreign banks which
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20. Where the institution considers
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RISK MEASUREMENT25. Having identifi
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) the tendency of the relevant mark
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38. The measurement of the market r
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market, credit and liquidity risk o
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Consideration must be given to the
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55. As noted earlier, the market or
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changes in portfolio value;d) the r
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66. A basic and essential safeguard
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73. It is essential that the intern
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Market liquidity risk is the risk t
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Furthermore, contracts with the sam
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There are three main VAR approaches
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Options risk should be captured; ri
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Annex D1. NOTIONAL OR VOLUME LIMITS
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assumptions on which they are based
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* There should be a unit independen
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- the customer had specifically req
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addition and deletion of operators,
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• Profits and losses resulting fr
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This book is due for return or rene
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