Lecture Derivatives - An introduction: Chapter 16 - Financial engineering and risk management. This chapter presents the following content: Introduction and background, financial engineering, risk management. | © 2004 South-Western Publishing Chapter 16 Financial Engineering and Risk Management Outline Introduction and background Financial engineering Risk management Introduction and Background Financial engineering: Is a relatively new derivatives endeavor Has led directly to improvements in the process of risk management Introduction and Background (cont’d) Risk management awareness is associated with various phrases: Asian flu Global contagion Orange County “We take the risks because of the potential reward” Financial Engineering Synthetic put Engineering an option Gamma risk Synthetic Put Financial engineering is the popular name for constructing asset portfolios that have precise technical characteristics In the early days of the CBOE there were no puts; only calls traded Can construct a put by combining a short position in the underlying asset with a long call Synthetic puts were the first widespread use of financial engineering Synthetic Put (cont’d) + = short stock + long call = long put Engineering an Option There are a variety of tactics by which wealth can be protected without disturbing the underlying portfolio Shorting futures provides downside protection but precludes gains from price appreciation Writing a call provides only limited downside protection Buying a put may be the best alternative Engineering an Option (cont’d) Strategy Advantages Disadvantages Short futures Low trading fees; Easy to do Lose upside potential; Possible tracking error Write calls Generate income Lose most upside potential; Inconvenience if exercised; Limited protection Buy puts Reliable protection Premium must be paid; Hedge may require periodic adjustment Engineering an Option (cont’d) Extensive purchase of individual equity puts is inefficient in a large portfolio Portfolio may contain dozens of stocks, resulting in numerous trading fees, managerial time, and high premium cost Index options or futures options are best suited . | © 2004 South-Western Publishing Chapter 16 Financial Engineering and Risk Management Outline Introduction and background Financial engineering Risk management Introduction and Background Financial engineering: Is a relatively new derivatives endeavor Has led directly to improvements in the process of risk management Introduction and Background (cont’d) Risk management awareness is associated with various phrases: Asian flu Global contagion Orange County “We take the risks because of the potential reward” Financial Engineering Synthetic put Engineering an option Gamma risk Synthetic Put Financial engineering is the popular name for constructing asset portfolios that have precise technical characteristics In the early days of the CBOE there were no puts; only calls traded Can construct a put by combining a short position in the underlying asset with a long call Synthetic puts were the first widespread use of financial engineering Synthetic Put (cont’d) +
