What is Risk? Risk is defined as the unexpected volatility of asset prices and/or earnings. There are two major soures of risk : 1) Business Risk - It is the risk that arises out of business decisions. Example : Decision by senior management to create a new product line is a business risk when there is a drop in demand for the product 2) Financial Risk - It is the risk that arises out of firm's financial market activities. Example : The value of the securities goes down because of market volatility Stop Loss Limit : A tool used to limit the loss in a position by eliminating the position after a threshold loss has been exceeded. Ex: A trader would have set a limit of loss of 10% of the current stock price. If the current stock price is $10.00 and the price falls below $9.00 the trader would sell his stock. Advantages of Stop Loss Limit: • Easy to calculate • Easy to explain • Can be aggregated across assets Disadvantages of Stop Loss Limit: • Since it is an ex-post (after the loss has occurred) this does not prevent the actual loss from occurring A tool that limits the risk factor exposure. Ex: A trader can set the duration limit (set the option duration limit) to 1 yr, if the Interest change is more than 1% from the current rate. Exposure Limit : Advantages of Exposure Limit: • Identify the exposure of an asset to an applicable risk factor Disadvantages of Exposure Limit: • Difficult to calculate • Difficult to explain • Cannot be aggregated across assets • Fails to quantify the volatility of the risk factors and correlations between risk factors Financial Risk Management Valueatrisk VaR : A tool that defines the maximum loss over a defined period of time at a stated level of confidence. Ex: Portfolio A will have a VAR of $1 million in 1 yr at 95% confidence level. Advantages of VAR: • It is an ex-ante tool (Before the fact has occurred) • Captures risk factors and variation and co-variation of risk factors • Can be aggregated across assets and with different risk characteristics Disadvantages of VAR: • Need accurate inputs otherwise VAR results will not be accurate Accelerating principal swap is a FOREX/FX trading term.A swap is a derivative financial instrument wherein two counterparties agree upon to exchange one stream of cash flows against another stream. Common accounting terminologies and their expansion: Common accounting terminologies and their expansion is given below : FAS - Financial Accounting Standards Board Statement SAS - Statement on auditing standards SSAE - Statement on standards for attestation engagements SSARS - Statement on standards for Accounting and review services Accelerating Principal Swap - FOREX TRADING TERM : Total return swap is a swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. This is owned by the party receiving the set rate payment. Total Return Swap : Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually having to own it. These swaps are popular with hedge funds because they get the benefit of a large exposure with a minimal cash outlay. B-Share Investment Banking Term: A class in a family of multi-class mutual funds. This class is characterized by a back-end load structure that is paid only when the fund is sold What is a Perfect market? A perfect market has the following characteristics : 1) No cost of trading or enforcing contracts 2) Investors have identical information 3) No taxes are levied 4) There are no restrictions on the buying or selling of securities 5) Purchase and sale of securities donot affect the market price of securities American Depositary Share – ADS: A U.S. dollar-denominated equity share of a foreign-based company available for purchase on an American stock exchange. American Depositary Shares (ADSs) are issued by depository banks in the U.S. under agreement with the issuing foreign company; the entire issuance is called an American Depositary Receipt (ADR) and the individual shares are referred to as ADSs. Depending on the level of compliance with U.S. securities regulations the foreign company wishes to follow, the company may either list its shares over-the-counter (OTC) with low reporting requirements or on a major exchange like the NYSE or Nasdaq. Listings on the latter exchanges generally require the same level of reporting as domestic companies, and also require adherence to GAAP accounting rules. Forex/FX: The market in which currencies are traded. The forex market is the largest, most liquid market in the world with an average traded value that exceeds $1.9 trillion per day and includes all of the currencies in the world. A- share Investment Banking Term: In a family of multi-class mutual funds, this is the class that is usually characterized by a loaded fee structure. Class A mutual fund units will commonly have a front- or rear-end load, to compensate for the sales person's commission. Not all fund companies follow this class structure; however, it is the prominent method of distinction Futures Contract: Futures Contract is a contract/agreement between the buyer and the seller to buy or sell an asset at a certain time in the future at a specified price. Futures contracts are traded on exchanges - CBOT (Chicago Board Of Trade), CME (Chicago Mercantile Exchange). The two parties involved in the contract don't know each other. So the exchange provides a mechanism that provides the two parties a guarantee that the contract will be made. Blue Skying: Blue Skying is the process of getting the security approved for sale to the public within a state. This is popularly called as "Blue Skying" the issue. Blue skying must happen under the following conditions: 1) Broker dealers must be licensed 2) Broker dealers must be registered where security is sold 3) Security should be approved before sale Compliance department monitors that the above mentioned three steps are met during the process of blue skying. Bond Futures : A bond future is a contractual obligation for the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond future can be bought in a futures exchange market and the prices and dates are determined at the time the future is purchased. Operational Risk : Corporate firms operate under complex systems and processes. There are many instances wherein the system can fail. Risk associated with failure of system and people as a whole/ failure of people and systems is generally categorized as operational risk.In general, any risk other than market risk and credit risk is an operational risk.Risks associated with business can also be called as operational risks. Operational risks are of great significance where there is lot of people interaction. some very good examples are CRM(customer relationship Management) etc..Regulatory standards are mandated to prevent the failure of the systems.A popular regulatory standard used in Banking and financial services industry is Basel II. Basel emerged as Basel I and has matured to Basel II. This dictates the Banking Institution's regulatory compliance. Asset or Nothing Call Option: Asset or Nothing Call Option is an option payoff that is equal to the asset's price if the asset is above the strike price, otherwise the payoff is zero.These types of options don't function like regular (plain vanilla) options that pay the difference between the exercise (strike) price and market price at expiry.This pays out one unit of asset if the spot is above the strike at maturity. Alligator Spread : Alligator spread is an unprofitable spread regardless of favorable market movements and due to large commissions charged upon the transactions. An alligator spread is usually used in the options market to describe a collection of put and call options that may not be profitable. What is Arbitrage? Arbitrage is a kind of hedging technique used in investment management.In general simultaneous selling and buying of stocks to offset losses is referred to as arbitrage. sometimes it helps us achieve profit with less risk. Swap Bank: Swap bank is a financial institution that acts as an intermediary for interest and currency swaps. The function of these intermediaries is to find counterparties for those who want to participate in swap agreements. The swap bank typically earns a slight premium for facilitating the swap. Characteristics of futures contract: Following characteristics are specified in the futures contract : Futures contract trade on organized exchanges and have terms that is standardized Forward contracts are private customized contracts Exotic Options Vs Options : Exotic Options Vs Options is a popular confusion among the investor community/ someone who is new to investment banking/option trading. Exotic options are a special kind of options. Unlike normal options they are traded over the counter(OTC), where as normal options are traded in exchanges. Exotic options differ from normal American or European options. The difference comes from way in which exotic options are structured - underlying securities which comprise the option, manner in which investor receives payoff. There are many categories of exotic options like -Mountain range options, atlas options etc Econometrics, What is an econometrics? Econometrics is a social science that applies tools to the analysis of the economic phenomenon.Tools are economic theory, mathematics and statistical inference.Econometrics is the science that applies mathematical statistics to the economic data. Data used for analysis can be of three types: 1) Time-series 2) Cross-sectional 3) Pooled Options Non-linear derivative: Option is a kind of non-linear derivative.Options are traded both in exchanges and over-the-counter (OTC). There are two types of options : 1) Call Option 2) Put Option Call option gives the holder the right to buy the underlying asset at a specified price at a specified date. Put option gives the holder the right to sell the underlying asset at a specified price at a specified date. The price in the contract is known as strike price or the exercise price. The date mentioned in the contract is known as expiration date or maturity. Futures Contract And Characteristics: Futures Contract Highly standardized contract specified by exchange The person who buys/sells futures contract is obligated to buy/sell the assets at agreed upon time and at agreed upon price Futures contract is used by speculators who take advantage of price fluctuations of the underlying asset to get a profit Futures contract is used by hedgers to reduce the risk of the underlying asset Characteristics of Futures Contract Price quotation Contract Size Quality of asset Delivery Time Delivery Location Position Limits Daily Price Limits Standard Deviation And Normal Distribution: Standard Deviation: Also known as volatility Describes the spread of returns over the many periods Larger the standard deviation, greater the risk about the returns Denoted by Sigma Normal Distribution: Can be used to describe the probabilities of outcomes of returns using just the mean and the standard deviation Used for calculate returns distribution in many applications Used to determine the probability of returns above or below a certain level of return Cumulative z-table is used to calculate the probability that a return will be below or above a predefined level Financial Risk Management: Financial risk management (FRM) is the process of deducting, assessing and managing financial risks. What is value at risk(VaR)? VaR is defined as the maximum loss over a defined period of time at a stated level of confidence given normal market conditions Types of Var : 1) Delta normal VaR 2) Historical VaR 3) Monte-carlo VaR Enterprise Risk Management: Enterprise Risk Management is the process of managing all of a corporation's risk within an integrated framework.Enterprise risk management helps an organization to obtain a better risk-return trade off, carry out strategic plan in a better fashion,gain competetive advantage, create shareholder value.Instead of managing the risks in a business one at a time ERM (Enterprise Risk Management) manages the risk in a cohesive framework. Corporate Bond Corporate Notes : Corporations borrow long term capital through debt instruments known as bonds.Corporations borrow intermediate term financing through notes.Corporations borrow short term financing through commercial loans. Corporations borrow using short term instruments like commercial papers. Tick Size: Tick size is the minimum price of fluctuations of the contract.Exchange sets price movement per day Contract that moves down by its daily price limit is known as price down Contract that moves up by its daily price limit is know as price up Exchange sets max no of contracts a speculator may hold to prevent speculators from having undue influence on market Position limits does not apply for hedgers Delivery Date: The final date by which the underlying commodity for a futures contract must be delivered in order for the terms of the contract to be fulfilled.The maturity date of a currency forward contract. Commodity Swap: A swap where exchanged cash flows are dependent on the price of an underlying commodity. This is usually used to hedge against the price of a commodity. Closing out positions: Investors reversing their positions.Short futures contract position closes out a position by buying the same contract.Long futures contract position closes out a position by selling the same contract Reversing a position is also known as offsetting trade.Closing out a position negates an initial position Buyers and sellers are unimportant in a future contract.Exchange guarantees all trade Parametric Value At Risk (VaR) What is a derivative contract? A derivative contract is a contract that derives its value from an underlying security. Properties Of Derivative Contract : 1) Finite period 2) Predefined life 3) predefined reference rate/price What is the difference between securities and derivatives? 1) A security is issued to raise capital to fund projects whereas derivatives are not issued to raise capital. 2) Securities are considered non zero sum games whereas derivatives are considered zero sum games