Professional Documents
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Arul kumar
17MIME12016
ASSIGNMENT – 1
1. Explain top 7 option strategies which hedge the market risk. Explain each
strategy with suitable example.
But most managers do not hedge their entire long market value with
short positions.
Suppose ABC Co is trading at $20 per share when XYZ Co. comes
along and bids $30 per share which is a 25% premium.
The stock of ABC will jump up, but will soon settle at some price
which is higher than $20 and less than $30 until the takeover deal is
closed.
Let’s say that the deal is expected to close at $30 and ABC stock is
trading at $27.
To seize this price-gap opportunity, a risk arbitrageur would purchase
ABC at $28, pay a commission, hold on to the shares, and eventually
sell them for the agreed $30 acquisition price once the merger is
closed.
Thus the arbitrageur makes a profit of $2 per share, or a 4% gain,
less the trading fees.
# 4 CONVERTIBLE ARBITRAGE
In such a case, both its bond and stock prices are likely to fall heavily. But
the stock price will fall by a greater degree for several reasons like:
# 6 FIXED-INCOME ARBITRAGE
A Hedge fund has taken the following position: Long 1,000 2-year
Municipal Bonds at $200.
After your first year, the amount that you have made assuming that you
choose to reinvest the interest in a different asset will be:
The Hedge Fund Manager Shorts Interest Rate Swaps for two companies
that pays out 6% annual interest rate (3% semi-annually) and is taxed at
5%.
Now if this is what the Manager pays out, then we must subtract this from
In this type of strategy, the hedge funds buy the debt of companies that are
If the company has yet not filed for bankruptcy, the manager may sell short
# 8 GLOBAL MACRO
This hedge fund strategy aims to make profit from large economic
impact they will have on the markets. Based on that they develop
investment strategies.
of the pound sterling in 1992. He then took a huge short position of over
Hedging Strategies
Here's how it works to protect you from risk. Let's say you bought stock.
You thought the price would go up but wanted to protect against the loss if
the price plummets. You'd hedge that risk with a put option. For a small fee,
you'd buy the right to sell the stock at the same price. If it falls, you exercise
your put and make back the money you just invested minus the fee.
Hedge funds pay their managers a percent of the returns they earn. They
receive nothing if their investments lose money. That attracts many
investors who are frustrated by paying mutual fund fees regardless of its
performance.
Hedge fund use of derivatives added risk to the global economy, setting the
stage for the financial crisis of 2008. Fund managers bought credit default
swaps to hedge potential losses from subprime mortgage-backed
securities. Insurance companies like AIG promised to pay off if the
subprime mortgages defaulted.
This insurance gave hedge funds a false sense of security. As a result,
they bought more mortgage-backed securities than was prudent. They
weren't protected from risk, though. The sheer number of defaults
overwhelmed the insurance companies. That's why the federal government
had to bail out the insurers, the banks, and the hedge funds.
The real hedge in the financial system was the U.S. government, backed
by its ability to tax, incur debt and print more money. The risk has been
lowered a bit, now that the Dodd-Frank Wall Street Reform Act regulates
many hedge funds and their risky derivatives.
Conclusion:
If a investor had invested Rs.1000 before one week ago now he would had
got position Rs.1,474.73
3. Explain the Basel norms I, II and III in detail.
History:
On 26 June 1974, a number of banks had released payment of
Deutsche Marks (DEM - German Currency at that time) to Herstatt
(Based out of Cologne, Germany) in Frankfurt in exchange for US
Dollars (USD) that was to be delivered in New York. Because of time-
zone differences, Herstatt ceased operations between the times of
the respective payments. German regulators forced the troubled
Bank Herstatt into liquidation .The counter party banks did not receive
their USD payments. Responding to the cross-jurisdictional
implications of the Herstatt debacle, the G-10 countries, Spain and
Luxembourg formed a standing committee in 1974 under the
auspices of the Bank for International Settlements (BIS), called the
Basel Committee on Banking Supervision. Since BIS is
headquartered in Basel, this committee got its name from there. The
committee comprises representatives from central banks and
regulatory authorities.
Basel I:
Under these norms: Assets of banks were classified and grouped in five
categories according to credit risk, carrying risk weights of 0%(Cash,
Bullion, Home Country Debt Like Treasuries), 10, 20, 50 and100% and no
rating. Banks with an international presence are required to hold capital
equal to 8% of their risk-weighted assets (RWA) - At least, 4% in Tier I
Capital (Equity Capital + retained earnings) and more than 8% in Tier I and
Tier II Capital. Target - By 1992.
One of the major role of Basel norms is to standardize the banking practice
across all countries. However, there are major problems with definition of
Capital and Differential Risk Weights to Assets across countries, like
Basel standards are computed on the basis of book-value accounting
measures of capital, not market values. Accounting practices vary
significantly across the G-10 countries and often produce results that
differ markedly from market assessments.
Other problem was that the risk weights do not attempt to take account of
risks other than credit risk, viz., market risks, liquidity risk and operational
risks that may be important sources of insolvency exposure for banks.
Basel II:
So, Basel II was introduced in 2004, laid down guidelines for capital
adequacy (with more refined definitions), risk management (Market Risk
and Operational Risk) and disclosure requirements.
- use of external ratings agencies to set the risk weights for corporate,
bank and sovereign claims.
- Operational risk has been defined as the risk of loss resulting from
inadequate or failed internal processes, people and systems or from
external events. This definition includes legal risk, but excludes strategic
and reputation risk, whereby legal risk includes exposures to fines,
penalties, or punitive damages resulting from supervisory actions, as well
as private settlements. There are complex methods to calculate this risk.
disclosure requirements allow market participants assess the
capital adequacy of the institution based on information on the scope
of application, capital, risk exposures, risk assessment processes, etc.
Basel III:
It is widely felt that the shortcoming in Basel II norms is what led to the
global financial crisis of 2008. That is because Basel II did not have any
explicit regulation on the debt that banks could take on their books, and
focused more on individual financial institutions, while ignoring
systemic risk. To ensure that banks don’t take on excessive debt, and that
they don’t rely too much on short term funds, Basel III norms were
proposed in 2010.
- Requirements for common equity and Tier 1 capital will be 4.5% and 6%,
respectively.