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Purpose of Derivatives (Chp. 1) - ✔✔1) Risk Management
2) Speculation
3) Reduced Transaction Costs
4) Regulatory Arbitrage/minimize taxes
Hedging (Chp. 1) - ✔✔Guaranteeing a buying or selling price.
Short Selling Purposes (Chp. 1) - ✔✔1) Speculation
2) Financing
3) Hedging
Break - Even Analysis (Chp. 2) - ✔✔Determine the value of each assumption parameter
so that the NPV is 0.
Risk Measures (Chp. 2) - ✔✔1) Variance (no coherent characteristics)
2) Semi-Variance (no coherent characteristics)
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,3) VaR (does not satisfy subadditivity unless normal)
4) TVaR (always coherent)
Sensitivity Analysis (Chp. 2) - ✔✔Calculating the change in the NPV resulting from a
change in ONE variable at a time.
Designed to identify the variables that are most influential on the success or failure of a
project.
Coherent Risk Measures - ✔✔1) Translation Invariance
g(x+c) = g(x) + c
Adding a positive amount to a risk adds an equivalent amount to the risk measure.
2) Positive Homogeneity
g(cx) = (c)g(x)
Multiplying a positive amount to a risk will adjust the risk measure in a proportional
manner.
3) Subadditivity
g(x+y) ≤ g(x) + g(y) [Upside]
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, g(x+y) ≥ g(x) + g(y) [Downside]
It is not possible to reduce the capital required to manage a risk by splitting it into
separate parts. There are diversification benefits from combining risks as long as the
two risks are not perfectly correlated.
4) Monotonicity
g(x) ≤ g(y) if Pr(x ≤ y) = 1 [Upside]
g(x) ≥ g(y) if Pr(x ≥ y) = 1 [Downside]
If one risk always exceeds another, the corresponding risk measures must be similarly
ordered.
Scenario Analysis (Chp. 2) - ✔✔Calculate the NPV by changing several variables at a
time.
Scenario analysis accounts for the fact that variables are interrelated.
Capital Asset Pricing Model Assumptions [CAPM] (Chp. 6) - ✔✔1) Buy and sell at
competitive market prices. No taxes or transactions costs. Can borrow and lend at risk
free rate
2) hold only efficient portfolios of traded securities
3) Homogeneous Expectations regarding volatility, correlations, and expected returns
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