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Manual for SOA Exam FM/CAS Exam 2. - · PDF fileManual for SOA Exam FM/CAS Exam 2. Chapter 7. ... currency exchange rates and interest rates are potential ... 5/52 Chapter 7. Derivatives

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    Chapter 7. Derivatives markets.

    Manual for SOA Exam FM/CAS Exam 2.Chapter 7. Derivatives markets.

    Section 7.1. Derivatives.

    c2009. Miguel A. Arcones. All rights reserved.

    Extract from:Arcones Manual for the SOA Exam FM/CAS Exam 2,

    Financial Mathematics. Fall 2009 Edition,available at http://www.actexmadriver.com/

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 2/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Risk sharing

    I A risk is a contingent financial loss. Changes in commodityprices, currency exchange rates and interest rates are potentialrisks for a business. A farmer faces the possible fall of theprice of his/her crop. Surging oil prices can wipe out airlinesprofits. Manufacturing companies face high rising prices ofcommodities. These changes in prices could hurt the viabilityof a business.

    I Many of the risks faced by business are diversifiable. A risk isdiversifiable if it is unrelated to another risk. Markets permitdiversifiable risks to be widely shared.

    I Risk is nondiversifiable when it does vanish when spreadacross many investors.

    I A way to do risk sharing for companies is to do contracts toavoid risks.

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 3/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Risk sharing

    I A risk is a contingent financial loss. Changes in commodityprices, currency exchange rates and interest rates are potentialrisks for a business. A farmer faces the possible fall of theprice of his/her crop. Surging oil prices can wipe out airlinesprofits. Manufacturing companies face high rising prices ofcommodities. These changes in prices could hurt the viabilityof a business.

    I Many of the risks faced by business are diversifiable. A risk isdiversifiable if it is unrelated to another risk. Markets permitdiversifiable risks to be widely shared.

    I Risk is nondiversifiable when it does vanish when spreadacross many investors.

    I A way to do risk sharing for companies is to do contracts toavoid risks.

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 4/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Risk sharing

    I A risk is a contingent financial loss. Changes in commodityprices, currency exchange rates and interest rates are potentialrisks for a business. A farmer faces the possible fall of theprice of his/her crop. Surging oil prices can wipe out airlinesprofits. Manufacturing companies face high rising prices ofcommodities. These changes in prices could hurt the viabilityof a business.

    I Many of the risks faced by business are diversifiable. A risk isdiversifiable if it is unrelated to another risk. Markets permitdiversifiable risks to be widely shared.

    I Risk is nondiversifiable when it does vanish when spreadacross many investors.

    I A way to do risk sharing for companies is to do contracts toavoid risks.

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 5/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Risk sharing

    I A risk is a contingent financial loss. Changes in commodityprices, currency exchange rates and interest rates are potentialrisks for a business. A farmer faces the possible fall of theprice of his/her crop. Surging oil prices can wipe out airlinesprofits. Manufacturing companies face high rising prices ofcommodities. These changes in prices could hurt the viabilityof a business.

    I Many of the risks faced by business are diversifiable. A risk isdiversifiable if it is unrelated to another risk. Markets permitdiversifiable risks to be widely shared.

    I Risk is nondiversifiable when it does vanish when spreadacross many investors.

    I A way to do risk sharing for companies is to do contracts toavoid risks.

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 6/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Derivatives

    Definition 1A derivative is a contract which specifies the right or obligation toreceive or deliver certain asset for a certain price. The value of aderivative contract depends on the value of another asset.

    They are several possible reasons to enter into a derivative market:

    I Risk management. Parties enter derivatives to avoid risks.I Speculation. Parties enter derivatives to make money. A

    marketmaker enters into derivatives to make money.I Reduce transaction costs. Derivatives can be used to reduce

    commodity costs, borrowing costs, etc.I Arbitrage. When derivatives are miss priced, investors can

    make a profit.I Regulatory arbitrage. Sometimes business enter into

    derivatives to get around regulatory limitations, accountingregulations and taxes.

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 7/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Derivatives

    Definition 1A derivative is a contract which specifies the right or obligation toreceive or deliver certain asset for a certain price. The value of aderivative contract depends on the value of another asset.

    They are several possible reasons to enter into a derivative market:

    I Risk management. Parties enter derivatives to avoid risks.I Speculation. Parties enter derivatives to make money. A

    marketmaker enters into derivatives to make money.I Reduce transaction costs. Derivatives can be used to reduce

    commodity costs, borrowing costs, etc.I Arbitrage. When derivatives are miss priced, investors can

    make a profit.I Regulatory arbitrage. Sometimes business enter into

    derivatives to get around regulatory limitations, accountingregulations and taxes.

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 8/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Derivatives

    Definition 1A derivative is a contract which specifies the right or obligation toreceive or deliver certain asset for a certain price. The value of aderivative contract depends on the value of another asset.

    They are several possible reasons to enter into a derivative market:

    I Risk management. Parties enter derivatives to avoid risks.

    I Speculation. Parties enter derivatives to make money. Amarketmaker enters into derivatives to make money.

    I Reduce transaction costs. Derivatives can be used to reducecommodity costs, borrowing costs, etc.

    I Arbitrage. When derivatives are miss priced, investors canmake a profit.

    I Regulatory arbitrage. Sometimes business enter intoderivatives to get around regulatory limitations, accountingregulations and taxes.

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 9/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Derivatives

    Definition 1A derivative is a contract which specifies the right or obligation toreceive or deliver certain asset for a certain price. The value of aderivative contract depends on the value of another asset.

    They are several possible reasons to enter into a derivative market:

    I Risk management. Parties enter derivatives to avoid risks.I Speculation. Parties enter derivatives to make money. A

    marketmaker enters into derivatives to make money.

    I Reduce transaction costs. Derivatives can be used to reducecommodity costs, borrowing costs, etc.

    I Arbitrage. When derivatives are miss priced, investors canmake a profit.

    I Regulatory arbitrage. Sometimes business enter intoderivatives to get around regulatory limitations, accountingregulations and taxes.

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 10/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Derivatives

    Definition 1A derivative is a contract which specifies the right or obligation toreceive or deliver certain asset for a certain price. The value of aderivative contract depends on the value of another asset.

    They are several possible reasons to enter into a derivative market:

    I Risk management. Parties enter derivatives to avoid risks.I Speculation. Parties enter derivatives to make money. A

    marketmaker enters into derivatives to make money.I Reduce transaction costs. Derivatives can be used to reduce

    commodity costs, borrowing costs, etc.

    I Arbitrage. When derivatives are miss priced, investors canmake a profit.

    I Regulatory arbitrage. Sometimes business enter intoderivatives to get around regulatory limitations, accountingregulations and taxes.

    c2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam FM/CAS Exam 2.

  • 11/52

    Chapter 7. Derivatives markets. Section 7.1. Derivatives.

    Derivatives

    Definition 1A derivative is a contract which specifies the right or obligation toreceive or deliver certain asset for a certain price. The value of aderivative contract depends on the value of another asset.

    They are several possible reasons to enter into a derivative market:

    I Risk management. Parties enter derivatives to avoid risks.I Speculation. Parties enter derivatives to make money. A

    marketmaker enters into derivatives to make money.I Reduce transaction costs. Derivatives can be used to reduce

    commodity costs, borrowing costs, etc.I Arbitrage. When derivatives are miss priced, investors can

    make a profit.

    I Regulatory arbitrage. Sometimes business enter intoderivatives to get around regulatory limitations, accountingregulations and

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