Leverage is
- Used as a tool to multiply gains/losse
- Common ways to attain leverage is borrow money, buy assets, use derivatives
- Derivatives is an attractive option because of its low transaction costs and low initial investments as opposed to security where the entire amount has to be invested in the beginning in purchasing the security
- Leverage is directly proportional to volatility/variability
Function and purposes of financial institutions as they relate to financial risk management:
Financial institutions
- Act as party/counterparty in assuming risk
- Create market instruments to share and hedge risks
- Have well trained risk management professionals to monitor risk on a continuous basis
- Charge fee for their services either directly or indirectly through their financial instruments
Example: Major financial institutions like Bank of America, JP Morgan Chase, Merrill Lynch
Following are the basic definitions for a few terms that we will encounter in the FRM chapters:
Volatility:
- Uncertainty in the change in the value of a security
- Measured in terms of standard deviation or variance (square of standard deviation)
Sensitivity:
- Degree of reaction to a change in event in terms of the price of a security
- Measured in terms of the probability of occurrence of an event provided certain events that happen at that time
Deregulation:
- Less government regulation (intervention) or policing on certain industries
- Aimed at creating competition in a industry
- Increases fair play among the major competitors and investment climate in the industry concerned
Example: Deregulation in banks have led to reaction in interest rates
Globalization:
- Doing business outside of current borders
- Prone to currency exchange risk
Example: Outsourcing/Off shoring of jobs to China and India
