Risk management, insurance, futures, and options

speaker: Keng Kiat event: Sharing is Caring #13 ** what is risk? risk = uncertainty of a certain event credit risk counterparty risk ** ways to manage risk management

• diversification
• hedging
• insurance ** stock returns are mean reverting measure risk as standard deviation ** efficient market hypothesis every stock is correctly priced
• weak form market incorporates all historical stock prices into the price -> technical analysis no longer makes money
• semi strong form market incorporates all public information -> fundamental analysis no longer makes money
• strong form all private/public information is incorporated into the price

** diversification stock A: sin(x) + x stock B: -sin(x) + x

A and B are inversely correlated.

Portfolio of 50% A and 50 % B has zero risk

Adding more stocks tend to decrease the risk, up to a limit that cannot be diversified away, unless you add other instruments such as bonds.

risk = systemic risk (system wide) + diversifiable risk (due to individual companies)

** short a stock sell a stock you don’t own, then buy is back later gain if the stock drops

** market neutral strategy risk of index = market risk short the index, removes the market risk because when market does down, shorting gains when market goes up, shorting loses

** hedge fund usually focuses on selecting the portfolio and shorting the index to remove market risk

charges 2 and 20

** risk - returns graph for two uncorrelated stocks A, B

the risk - returns for the portfolio consisting of A and B is the line joining A and B

By shorting, the line can be extended. But retail investors cannot short.

portfolio envelope

• minimum variance portfolio
• above MVP is the efficient portfolio frontier

risk free rate: the rate of government bonds

tangency portfolio: tangent of risk free rate to porfolio envelope -> proportion to invest in risk-free vs risky assets

gradient of the tangent is the sharpe ratio = (R_p - R_m) / sd_p

indifference curve is the returns I need for a given risk

By adjusting the indifference curve until it touches the tangency portfolio, that is the point to invest in which takes into account risk tolerance

yahoo finance has a simple API to get csv data

adjusted close accounts for stock splits and dividends ** practical terms securities selection

use efficient portfolio analysis to compute weights

every 6-12mths, rebalance again ** hedging forward contract, eg. fix exchange for yen-sgd to eliminate forex risk exchange your risk with another investor, trade your upsides to reduce the down side counterparty risk futures is a standardize forward contract requires collatoral (margin) to service the contract margin transferred per day, limits loss ** insurance transfer down sides to insurance company insurance company expects fixed payment, premiums

people that are more likely to experience the down side are more likely to take up the insurace -> leads to increase in premiums -> leads to less low risk people taking insurance

moral hazard: people who take insurance tend to take higher risks as they do not experience the down sides ** options most common form of insurance ** do not advise investing in gold gold (similarly bitcoin) do not have intrinsic value, the value is assigned by the market

unlike a company that produce value and pays dividends ** companies hedge away their risk starbucks buys futures in coffee, to hedge away the price of coffee airlines buys futures in oil, to hedge away the price of oil