Introduction to Business Risk - Questions with Answers | FIN 444, Assignments of Options and Futures

Download Introduction to Business Risk - Questions with Answers | FIN 444 and more Assignments Options and Futures in PDF only on Docsity! CHAPTER 1: INTRODUCTION END-OF-CHAPTER QUESTIONS AND PROBLEMS 1. (Introduction) Business risk is the risk associated with a particular line of business, whereas financial risk is the risk associated with stock prices, exchange rates, interest rates and commodity prices. An example would be that a firm might be in the business of manufacturing furniture. Business risk would reflect the uncertainty of the furniture market, whereas financial risk would reflect the risk associated with the interest rates that would impact their borrowing costs. In addition a business might also be affected by exchange rates. Some of the financial risks can also be business risks. The business risk of a bank, for example, is highly affected by interest rate and exchange rate risk. 2. (Introduction) Real assets consist of the tangible assets of the economy; however, for our purposes we also define them to include such intangible assets as management talent, ideas, brand names, etc. They are distinguished from financial assets, which are securities. These securities represent claims on business firms, which own the real assets, or on governments. 3. (Risk Preference) An investor who is risk averse does not like risk and will not take on additional risk without the expectation of higher return. Such an individual will try to get the highest return for a given amount of risk or the lowest risk for a given amount of return. An individual who is risk neutral will simply seek the highest return without regard to risk. 4. (Return and Risk) Financial markets distinguish the qualities of stocks and bonds by their prices. The markets set the price so that the return expected by investors is appropriate for the level of risk. In competitive and efficient markets, the expected return will vary directly with the level of risk. If one wishes to earn a higher return, it is necessary to assume more risk. This is the risk-return trade-off. Investors trade off risk against return. The risk-return trade-off will also hold in derivative markets. The risk-return trade-off is a fundamental result of the nature of competition in the marketplace. Attractive, low-risk investments will have their prices driven up and this will lower the expected returns. High-risk investments will have their prices driven down and this will result in higher expected returns. 5. (Return and Risk) The expected return consists of the risk-free rate and a risk premium. The risk-free rate is the return one expects from investing money today and, thereby, foregoing the consumption that could be obtained. A risk premium is the additional return that one expects to receive by virtue of assuming risk. 6. (Market Efficiency and Theoretical Fair Value) An efficient market is one in which prices reflect the true economic values of the assets trading therein. In efficient markets, no one can earn returns that are more than commensurate with the level of risk. Efficient markets are characterized by low transaction costs and by the rapid rate at which new information is incorporated into prices. 7. (Arbitrage and the Law of One Price) Arbitrage is a type of investment transaction that seeks to profit when identical goods are priced differently. Buying an item at one price and immediately selling it at another is a type of arbitrage. Because of the combined activities of arbitrageurs, identical goods, primarily financial assets, cannot sell for different prices for long. This is the law of one price. Arbitrage helps make our markets efficient by assuring that prices are in line with what they are supposed to be. In short, we cannot get something for nothing. A situation involving two identical goods or portfolios that are not priced equivalently would be exploited by arbitrageurs until their prices were equal. The "one price" that an asset must be is called the “theoretical fair value.” Chapter 1 1 End-of-Chapter Solutions 8. (Arbitrage and the Law of One Price) The law of one price is violated if the same good is selling at different prices. On the surface it may appear as if that is the case; however, it is important to look beneath the surface to determine if the goods are identical. Part of the cost of the good is convenience and customer service. Some consumers might be willing to pay more because the dealer is located in a more desirable section of town. Also, the higher priced dealer may have a better reputation for service and customer satisfaction. Buyers may be willing to pay more if they feel that the premium they pay helps assure them that they are getting a fair deal. It is important to note that many goods are indeed identical and, if so, they should sell at the same price, but the Law of One Price is not violated if the price differential accounts for some economic value. 9. (The Storage Mechanism) Storage is simply holding the asset. Some assets, like commodities, require considerable storage space and entail significant storage costs. Others, like stocks and bonds, do not consume much space but, as we shall see later, do incur costs. Storage enables us to more adequately meet our consumption needs and, thus, provides for a more efficient alteration of our consumption patterns across time. For example, we can store grains for the winter. In the case of stocks and bonds, we can store them and sell them later. The proceeds from the sale of the securities can be used to meet consumption needs at the later time. Likewise, storage enables speculators to hold goods and securities in the hope of selling them later at a profit. In addition, storage plays an important role in defining the relationship between spot instruments and derivatives. 10. (Delivery and Settlement) In futures markets, delivery seldom occurs. Since delivery is always possible, however, an expiring futures contract will be priced like the spot instrument. The knowledge that futures prices will eventually converge to spot prices is important to the pricing of futures contracts. 11. (The Role of Derivative Markets) Derivative markets provide a means of adjusting the risk of spot market investments to a more acceptable level and identifying the consensus market beliefs. They make trading easier and less costly and spot markets more efficient. These markets also provide a means of speculating. 12. (Criticisms of Derivatives Markets) On the surface, it may be difficult to distinguish speculation from gambling. Both entail high risk with the expectation of high gain. The major difference that makes speculation somewhat more socially acceptable is that it offers benefits to society not conveyed by gambling. For example, speculators are necessary to assume the risk not wanted by others. In gambling, there is no risk being hedged. Gamblers simply accept risk without there being a concomitant reduction in someone else's risk. 13. (Misuses of Derivatives) Derivatives can be misused by speculating when one should be hedging, by not having acquired the requisite knowledge to use them properly by acting irresponsibly when using derivatives such as by being overly confident of one’s ability to forecast the direction of the market. 14. (The Role of Derivative Markets) The existence of derivative markets in the United States economy and indeed throughout most modern countries of the world undoubtedly leads to a much higher degree of market efficiency. Derivatives facilitate the activities of individual arbitrageurs so that unequal prices of identical goods are arbitraged until they are equal. Because of the large number of arbitrageurs, this is a quick and efficient process. Arbitrage on this large a scale makes markets less capable of being manipulated, less costly to trade in, and therefore more attractive to investors. (The opportunity to hedge also makes the markets more attractive to investors in managing risk.) This is not to say that an economy without derivative markets would be inefficient, but it would not have the advantage of this arbitrage on a large scale. It is important to note that the derivative markets do not necessarily make the U.S. or world economy any larger or wealthier. The basic wealth, expected returns, and risks of the economy would be about the same without these markets. Derivatives simply create lower cost opportunities for investors to align Chapter 1 2 End-of-Chapter Solutions