Introduction to Capital Market: Financial Risk Management
These are some of my notes while studying fundamentals of Financial derivatives and Financial risk management.
Q : What is Capital Market ?
Financial markets can be categorized into two types.
Capital markets are the markets through which corporate bodies raise money for their long term needs
Capital markets can again be categorized as
Q : What is Market Risk?- Money markets
- Capital markets
Capital markets are the markets through which corporate bodies raise money for their long term needs
Capital markets can again be categorized as
- primary markets
- Secondary markets
Market risk is the risk associated with the fluctuations in the value of investments.
Q: What are the 4 market risks observed?
- Equity risk – risk of changes in stock prices
- Interest rate risk – risk of changes in interest rates
- Currency risk – risk of change in foreign currency rates
- Commodity risk – risk of change in commodity prices
Q: What is notional amount?
This is principal amount (face value) to be paid. It remains the same thus called notional.
Q : What is Value-at-risk (VaR) : explained by Gurpreet
Value-at-Risk can be defined as the maximum loss that is expected from holding a security or portfolio over a given period of time (1- day, 10 Days etc) and at a given probability (defined a confidence level).
Q : What is Stress testing ?
Stress testing can be defined as a technique used to determine the stability of a portfolio during a period of financial crisis. The most widely used method of stress testing is Monte Carlo simulation.
- A scenario is a set of values/changes , one for every risk factor.
- Stress testing is a single/ multiple scenario risk measure used to address model risk associated with statistical risk measures such as VaR.
- The size of potential losses related to specific scenarios is determined by stress testing and scenario analysis. However, it needs an expert judgement to select an appropriate scenario.
Q : What is derivative - Gurpreet Singh
Wikipedia's definition :
A derivative is a financial instrument whose value is based on one or more underlying assets. In practice, it is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties.[1][2]
Q : What are different types of derivatives
The most common types of derivatives are: forwards, futures, options, and swaps. The most common underlying assets include: commodities, stocks, bonds, interest rates and currencies.
Q : What is discount factor
The present value P of an amount to be paid N years in the future (F) at a discount rate of i per annum is P = F(1 + i)-n. The factor (1 + i)-n is the Discount Factor for the present value of $1 received at stated future date.
Example :
Find the present value for $1,000,000 paid 5 years in the future at a discount rate of 7½% per annum. It will be @$696,559
Q : What is market data
Wikipedia's definition :
Market data is quote and trade-related data associated with equity, fixed-income, financial derivatives, currency, and other investment instruments. Market data is numerical price data, reported from trading venues, such as stock exchanges. The price data is attached to a ticker symbol and additional data about the trade.
Q : What is option
An option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price.
An option which conveys the right to buy something is called a call option; an option which conveys the right to sell is called a put option. The reference price at which the underlying may be traded is called the strike price or exercise price.
Q : What is future option
Future is a trade whose settlement is going to take place in the future. These contracts are traded on the stock exchanges and it can change many hands before final settlement is made. The advantage of a future is that it eliminates counterparty risk.
Q: What is forward option
In forward option a buyer and a seller enter into a contract at a specified quantity of an asset at a specified price on a specified date.
Q : What is basis
The difference between the spot price and the future price
Q : How is the trading done on the exchange?
Buying of futures is margin based. You pay an up front margin and take a position in the stock of your choice. Your daily losses/ gains relative to the future price will be monitored and you will have to pay a mark to market margin. On the final day settlement is made in cash and is the difference between the futures price and the spot price prevailing at that time.
For example, if the future price is Rs 300 and the spot price is Rs 330, then you will make a cash profit of Rs 30. In case the spot price is Rs 290, you make a cash loss of Rs 10. Thus futures market is a cash market.
Q: How does the mark to market mechanism work?
Mark to market is a mechanism devised by the stock exchange to minimize risk.
In case you start making losses in your position, exchange collects money to the extent of the losses up front. For example, if you buy futures at Rs 300 and its price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This is over and above the margin money that you pay to take a position in the future.
Q : But I hear a lot of jargons about options? What are all these jargons? - Gurpreet Singh
There are some basic terminologies used in options. These are universal terminologies and mean the same everywhere.
a. Option holder : The buyer of the option who gets the right
b. Option writer : The seller of the option who carries the obligation
c. Premium: The consideration paid by the buyer for the right
d. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price.
e. Call option: The option that gives the holder a right to buy
f. Put option : The option that gives the holder a right to sell
g. Tenure: The period for which the option is issued
h. Expiration date: The date on which the option is to be settled
i. American option: These are options that can be exercised at any point till the expiration date
j. European option: These are options that can be exercised only on the expiration date
k. Covered option: An option that an option writer sells when he has the underlying shares with him.
l. Naked option: An option that an option writer sells when he does not have the underlying shares with him
m. In the money: An option is in the money if the option holder is making a profit if the option was exercised immediately
n. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately
o. At the money: An option is in the money if the option holder evens out if the option was exercised immediately
Q : How is the premium of an option calculated?
In practice, it is the market that decides the premium at which an option is traded.
There are mathematical models, which are used to calculate the premium of an option.
There are more advanced probabilistic models like the Black Scholes model and the Binomial Pricing model that calculates the options. One need not go deep into those and it would suffice to say that option calculators are readily available.
Q : I keep reading about option Greeks? What are they? They actually sound like Greek and Latin to me.
There are something called as option Greeks but they are nothing to be scared of. The option Greeks help in tracking the volatility of option prices.
The option Greeks are
a. Delta: Delta measures the change in option price (the premium) to the change in underlying. A delta of 0.5 means if the underlying changes by 100 % the option price changes by 50 %.
b. Theta: It measures the change in option price to change in time
c. Rho: It is the change in option price to change in interest rate
d. Vega: It is the change in option price to change in variance of the underlying stock
e. Gamma: It is the change in delta to the change in the underlying. It is a double derivative (the mathematical one) of the option price with respect to underlying. It gives the rate of change of delta.
These are just technical tools used by the market players to analyze options and the movement of the option prices.
Wikipedia's definition :
A derivative is a financial instrument whose value is based on one or more underlying assets. In practice, it is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties.[1][2]
Q : What are different types of derivatives
The most common types of derivatives are: forwards, futures, options, and swaps. The most common underlying assets include: commodities, stocks, bonds, interest rates and currencies.
Q : What is discount factor
The present value P of an amount to be paid N years in the future (F) at a discount rate of i per annum is P = F(1 + i)-n. The factor (1 + i)-n is the Discount Factor for the present value of $1 received at stated future date.
Example :
Find the present value for $1,000,000 paid 5 years in the future at a discount rate of 7½% per annum. It will be @$696,559
Q : What is market data
Wikipedia's definition :
Market data is quote and trade-related data associated with equity, fixed-income, financial derivatives, currency, and other investment instruments. Market data is numerical price data, reported from trading venues, such as stock exchanges. The price data is attached to a ticker symbol and additional data about the trade.
Q : What is option
An option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price.
An option which conveys the right to buy something is called a call option; an option which conveys the right to sell is called a put option. The reference price at which the underlying may be traded is called the strike price or exercise price.
Q : What is future option
Future is a trade whose settlement is going to take place in the future. These contracts are traded on the stock exchanges and it can change many hands before final settlement is made. The advantage of a future is that it eliminates counterparty risk.
Q: What is forward option
In forward option a buyer and a seller enter into a contract at a specified quantity of an asset at a specified price on a specified date.
Q : What is basis
The difference between the spot price and the future price
Q : How is the trading done on the exchange?
Buying of futures is margin based. You pay an up front margin and take a position in the stock of your choice. Your daily losses/ gains relative to the future price will be monitored and you will have to pay a mark to market margin. On the final day settlement is made in cash and is the difference between the futures price and the spot price prevailing at that time.
For example, if the future price is Rs 300 and the spot price is Rs 330, then you will make a cash profit of Rs 30. In case the spot price is Rs 290, you make a cash loss of Rs 10. Thus futures market is a cash market.
Q: How does the mark to market mechanism work?
Mark to market is a mechanism devised by the stock exchange to minimize risk.
In case you start making losses in your position, exchange collects money to the extent of the losses up front. For example, if you buy futures at Rs 300 and its price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This is over and above the margin money that you pay to take a position in the future.
Q : But I hear a lot of jargons about options? What are all these jargons? - Gurpreet Singh
There are some basic terminologies used in options. These are universal terminologies and mean the same everywhere.
a. Option holder : The buyer of the option who gets the right
b. Option writer : The seller of the option who carries the obligation
c. Premium: The consideration paid by the buyer for the right
d. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price.
e. Call option: The option that gives the holder a right to buy
f. Put option : The option that gives the holder a right to sell
g. Tenure: The period for which the option is issued
h. Expiration date: The date on which the option is to be settled
i. American option: These are options that can be exercised at any point till the expiration date
j. European option: These are options that can be exercised only on the expiration date
k. Covered option: An option that an option writer sells when he has the underlying shares with him.
l. Naked option: An option that an option writer sells when he does not have the underlying shares with him
m. In the money: An option is in the money if the option holder is making a profit if the option was exercised immediately
n. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately
o. At the money: An option is in the money if the option holder evens out if the option was exercised immediately
Q : How is the premium of an option calculated?
In practice, it is the market that decides the premium at which an option is traded.
There are mathematical models, which are used to calculate the premium of an option.
There are more advanced probabilistic models like the Black Scholes model and the Binomial Pricing model that calculates the options. One need not go deep into those and it would suffice to say that option calculators are readily available.
Q : I keep reading about option Greeks? What are they? They actually sound like Greek and Latin to me.
There are something called as option Greeks but they are nothing to be scared of. The option Greeks help in tracking the volatility of option prices.
The option Greeks are
a. Delta: Delta measures the change in option price (the premium) to the change in underlying. A delta of 0.5 means if the underlying changes by 100 % the option price changes by 50 %.
b. Theta: It measures the change in option price to change in time
c. Rho: It is the change in option price to change in interest rate
d. Vega: It is the change in option price to change in variance of the underlying stock
e. Gamma: It is the change in delta to the change in the underlying. It is a double derivative (the mathematical one) of the option price with respect to underlying. It gives the rate of change of delta.
These are just technical tools used by the market players to analyze options and the movement of the option prices.
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