Financial Assets and Risks
Financial Assets and Risks
Financial Assets and Risks
Financial assets and risks are closely related. Every asset carries a value and a risk. The value of an asset is the price the owner can get by selling it. In liquid markets, e.g. for shares of big corporations, government bonds or commodities, where many units of standardized assets are traded, the price of an asset is clearly defined at any given point of time. For other asset classes, like real estate or shares of small companies the only way to determine the value of an asset with certainty is to actually sell it. In these cases valuation models and recent prices paid for similar assets are used to determine an asset value. But such valuations are more or less educated guesses. I want to stick for this discussion of the relationship between financial assets and risks with liquid assets which have a known market price at all times.
The Risk
After defining the value of an asset, the next question is: What is the meaning of the term "risk" in the context of financial markets? Modern trading platforms give us a current price of any liquid asset with precision. But what will be the price of tomorrow, next month or next year? We do not know. The price can change, most probably will change. But we do not know in which direction. This uncertainty about the future price of an asset is called the financial risk of the asset. Risk is a complicated concept with at least three dimensions:
The direction and magnitude of the price change
The probability that this change will indeed happen
The timing
Risks are also traded, but the price of a risk can be positive or negative. In our day to day thinking, we associate a negative price with the word "risk." If we would profit from the same outcome the risk in question carries a positive value for us. Outside of finance and mathematics we would use for that the term "hope" instead of "risk." But the distinction between "hope" and "risk" relates solely to our subjective position relative to the outcome in question. It is possible, and in the financial world standard, that one party's risk is the counterpart's hope. For example a high price for wheat may be the farmer's hope, but the baker's risk.
But for this article, I use the term risk for the probability and magnitude of a possible change regardless of the question whether we desire or fear that specific outcome. I do not differentiate between "hope" and "risk".
Trading Risks
Because the same event can be good for one person and at the same time very bad for somebody else, it makes sense to trade risks. Both could share the pain and the gain and improve their ability to plan their businesses.
Investment banks developed tools to separate financial assets and risks form one another. One very simple example would be a contract between the farmer and the bakery spelling out that the bakery will buy a certain quantity of wheat in autumn from the farmer for a specified price. This price could be a little higher than the current price, thus giving the farmer an extra profit. But it would protect the bakery from a possible huge price rise making the bread too expensive for the bakery`s customers. This generic future contract could be a good deal for both sides.
Futures and Options
The contracts used to separate financial assets and risks are called derivate contracts. The example between the farmer and the bakery is a future contract, in which they agree to a sale of a certain quantity of a certain asset for a predetermined price at a specified time in the future. This future contract is binding for both sides, the farmer must sell and the bakery must buy.. Another generic form of a derivate contract is an option. The option comes in two forms: The call and the put.
The Call
The farmer could sell a call to the bakery. In this case the bakery would pay the farmer for the right to buy a certain quantity of wheat in autumn for a specified price, the "strike price".
This contract is legally binding for the seller of the option, the farmer. The buyer of the option, the bakery, exercises its right if he chooses. Otherwise the contract will expire.
The Put
The bakery could sell a put option to the farmer. In that case the farmer would pay the bakery for the right to deliver a certain quantity of wheat in autumn for a specified price, the "strike price".
This contract is legally binding for the seller of the option, the bakery. The buyer of the option, the farmer, exercises his right if he chooses. Otherwise the contract will expire. Please note that the buyer of the option is now the seller of the underlying asset.
Hedges
If you combine two risks, the combined risks may be smaller than the sum of the two original risks. Think about an area with frequent hurricanes: It could make sense to bet on a profit of insurance companies and to bet at the same time on a profit of building companies. In a strong hurricane season, the insurance would bleed and the builder would profit. In a weak hurricane season, the insurance company would gain and the builder would lose. If you buy insurance company shares and shares of the home builder, you can smooth out the difference between years with strong hurricanes and years with weak hurricanes. If you use options on the shares of both companies in the right way, you may even be able to profit financially from the uncertainty about the hurricanes.
Warning
Be careful. Derivate contracts are very powerful tools with a high leverage. They allow you to treat financial assets and risks separately. If you mishandle them, the result can be very and painful and dangerous. Never enter a contract, if you do not understand all implications completely.
http://www.articlesbase.com/investing-articles/financial-assets-and-risks-2828460.html
Review of dell inspiron 537s Floor Buffers And Polishers Review Just Host Review - The Truth Baltimore Boutique Hotels Aren't Always Too Much Money Follow These Clues On Ways To Get Super Disco Triactol Breast Enlargement Review - How To Increase Breast Size Naturally With Triactol Serum Bluehost Review Maryland Luxury Hotels Shouldn't Be Too Much Money Take Advantage Of These Hints On Ways To Nab Hot Baltimore Waterfront Accommodation Don't Have To Be Over Your Budget Pay Attention To These Hints On Pavtube Blu-Ray Ripper For Mac Review How to Break 80 Review - What Are They Saying About How to Break 80? Uk2 Review Emicsoft Mts Converter Review Imacsoft Ipod To Mac Transfer Review