ABOUT THIS CONTENTNotes from various chapters in the core finance textbook, Financial Management, Concepts and Applications by Ramesh K.S. Rao.
Source: Financial Management, Concepts and Applications by Ramesh K.S. Rao
- Strategic risk is the cash flow variability produced by changes in the firm’s economic environment. By reducing cash flow volatility, managers can also reduce associated costs like financial distress, taxes and agency costs.
- Hedging is a means of reducing strategic risk, which in turn can reduce agency costs, taxes and the cost of financial distress, all of which can increase firm value.
- Comparison of pairs of derivative concepts.
- Speculation is taking above average risk with the expectation of receiving substantial returns. Speculators willingly assume large risk. Hedging is a tool for reducing strategic risk in hopes of improving the timing or consistency of cash flows and minimize downside exposure while creating large upside potential.
- Primary assets are the primitive financial or physical assets that are exchanged in the marketplace like stock, bonds, and real estate. Derivatives are securities that derive their value from some underlying primitive security.
- Long position – you are in it for appreciation. Hoping the value of the asset will rise so you can sell it in the future (or buy and sell in the case of an option). A short position is the exact opposite – hoping for the value of an asset to fall.
- A spot price is the price today in the cash market. The futures price is some price in the future in the futures market.
- A put option is an option to sell a security at a certain striking price. Put holders have a short position. If the price of a stock drops below the striking price, the option has value and the holder is in the money (because they can sell at a higher price). A call option is an option to buy a security at a certain striking price. Call holders have long positions, hoping that the price of a security will rise above its striking price, when the holder can buy below market value and be in the money.
- European options can only be exercised on the maturity date. American options can be exercised at any time prior to maturity.
- A futures contract is a contract to buy and sell an asset at a futures price on a certain delivery date. Futures can be closed out before their maturity and are traded on exchanges. Forward contracts are obligations to buy and sell an asset at a forward price on a delivery date. They are not traded on exchanges, are used primarily in the foreign exchange markets and cannot be close out prior to maturity. Futures are privately negotiated and are therefore not liquid.