Tag: loans
Nov
25
Risk-Return for Options
The maximum amount that an option buyer can lose is the option price. The maximum profit that the option writer can realize is the option price. The option buyer has substantial upside return potential, while the option writer has substantial downside risk.
Notice that, unlike in a futures contract, one party to an option contract is not obligated to transact—specifically, the option buyer has the right but not the obligation to transact. The option writer does have the obligation to perform. In the case of a futures contract, both buyer and seller are obligated to perform. Of course, a futures buyer does not pay the seller to accept the obligation, while an option buyer pays the seller an option price.
Consequently, the risk/reward characteristics of the two contracts are also different. In the case of a futures contract, the buyer of the contract realizes a dollar-for-dollar gain when the price of the futures contract increases and suffers a dollar-for-dollar loss when the price of the futures contract drops. The opposite occurs for the seller of a futures contract. Options do not provide this symmetric risk/reward relationship. The most that the buyer of an option can lose is the option price. While the buyer of an option retains all the potential benefits, the gain is always reduced by the amount of the option price. The maximum profit that the writer may realize is the option price; this is offset against substantial downside risk. This difference is extremely important because investors can use futures to protect against symmetric risk and options to protect against asymmetric risk.
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Aug
25
Overbidding
In the heat of a deal, the acquirer may bid up the price beyond the limits of reasonable valuations. It is all too easy to find benchmarks that justify a higher price or bargain away important nonprice terms that restrict the ability of the acquirer to achieve planned-for savings and growth. Remember the winner’s curse: If you are the winner in a bidding war, why did your competitors drop out (bearing in mind that they too may have scratched to find the last penny for their bid!)?
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Nov
19
MANAGING FOREIGN EXCHANGE RATE RISK
Banks are exposed to a number of potential foreign exchange risks. Foreign exchange risks may arise as a result of cash exposures or from exposures to instruments denominated in a foreign currency. Risks arise when there is a mismatch between the value of assets it owns denominated in a foreign currency and the value of what it owes in the same currency. A mismatch may also occur as a result of payments it expects to receive, or is committed to make, in a foreign currency at a future time. The former exposures are referred to as spot positions and the latter forward positions:
Long.A bank may have a long spot foreign currency position if it has foreign currency in the form of cash or owns an asset denominated in a foreign currency. It may have a long forward position if it expects to receive a future payment in a foreign currency or expects to receive an asset at a future date that is denominated in a foreign currency. Short. A bank may have a short spot foreign currency position if it owes foreign currency in the form of cash (for example, in the form of a deposit taken by a bank in a foreign currency) or a financial instrument denominated in a foreign currency. It may have a short forward position if it is committed to making a future payment in a foreign currency or to deliver an asset at a future date that is denominated in a foreign currency.
The overall spot and forward position is calculated for each foreign currency by adding up the individual spot and forward positions in that currency. It has a flat position if its assets in one currency are equal to its liabilities in both the spot and forward markets.
A US bank that has a long spot position in euros worth $100m at current exchange rates but also owes yen to the value of $100m does not have a flat position. It has a long euro position and a short yen position. If the bank also owes the equivalent of $100m in euros at current exchange rates for delivery in one month’s time the bank does have a flat euro position overall even though it is long in the spot market and short in the forward.
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