6
2 Concepts of Finance
risk. And managing risk is the predominant occupation of financial economists. They
build a collection of tradeable quantities—a portfolio—with the aim to minimize the
risk, or equivalently, the variance of the portfolio. This balancing of risks is called
hedging.
2.2 Hedging and Shorting
At first sight, adding several fluctuating variables results in a variable that fluctuates
even more than its constituents. This is true, unless two or more constituents are
anti-correlated. We therefore need a quantity that increases in value, when a stock
decreases in value, and vice-versa. This could be an asset that is in high demand,
while another asset is in low demand. As a first example consider investing in the
stock of a consumer good, such as Apple
® Inc., and in Gold. In times of global
unrest, the value of the Gold will increase and in times of tranquility people will buy
more consumer goods, which increases the value of the Apple stock. A second, more
down-to-earth, example is based on the stock of a maker of raincoats and umbrellas
and the stock of a soft-drink maker, such as Pepsi. In a wet summer the maker of
rain-gear will thrive and in a sunny summer, the maker of soft-drinks. The stocks in
these examples are only moderately anti-correlated. The third example is perfectly
anti-correlated and is based on the possibility of betting on a falling stock value. This
mechanism is called shorting and is based on me first borrowing (at no or little cost)
the stock from a broker with the promise to give it back at a later time. Upon receiving
the borrowed stock, I immediately sell it at market value, the spot-price. At the later
time I need to purchased back the stock at market value before giving it back to the
original owner. But if the stock value has decreased in the intervening time, I pay
less than I initially received when I sold the borrowed stock. Thus I make a profit,
given by the difference in price. This mechanism constitutes a derived commodity,
which is anti-correlated with the underlying stock price.
Note that this procedure—shorting—of using an underlying asset, the stock constitutes a financial tool, that allows us to achieve a particular financial goal, here
hedging a risk. Such tools or mechanisms, which are functions of the basic assets,
the stocks or other commodities, are called derivatives. They are the tools of financial
engineering, the mechanics of managing risk. We will discuss a number of them in
the following sections.
2.3 Derivatives
The most straightforward financial tool is a forward contract, which is an agreement
between two parties and as such it is called an over-the-counter (OTC) product. In a
forward contract two parties agree to trade an asset at a later time for an agreed-upon
price that may be different from today’s price. It protects the producer against the
2 Concepts of Finance
risk. And managing risk is the predominant occupation of financial economists. They
build a collection of tradeable quantities—a portfolio—with the aim to minimize the
risk, or equivalently, the variance of the portfolio. This balancing of risks is called
hedging.
2.2 Hedging and Shorting
At first sight, adding several fluctuating variables results in a variable that fluctuates
even more than its constituents. This is true, unless two or more constituents are
anti-correlated. We therefore need a quantity that increases in value, when a stock
decreases in value, and vice-versa. This could be an asset that is in high demand,
while another asset is in low demand. As a first example consider investing in the
stock of a consumer good, such as Apple
® Inc., and in Gold. In times of global
unrest, the value of the Gold will increase and in times of tranquility people will buy
more consumer goods, which increases the value of the Apple stock. A second, more
down-to-earth, example is based on the stock of a maker of raincoats and umbrellas
and the stock of a soft-drink maker, such as Pepsi. In a wet summer the maker of
rain-gear will thrive and in a sunny summer, the maker of soft-drinks. The stocks in
these examples are only moderately anti-correlated. The third example is perfectly
anti-correlated and is based on the possibility of betting on a falling stock value. This
mechanism is called shorting and is based on me first borrowing (at no or little cost)
the stock from a broker with the promise to give it back at a later time. Upon receiving
the borrowed stock, I immediately sell it at market value, the spot-price. At the later
time I need to purchased back the stock at market value before giving it back to the
original owner. But if the stock value has decreased in the intervening time, I pay
less than I initially received when I sold the borrowed stock. Thus I make a profit,
given by the difference in price. This mechanism constitutes a derived commodity,
which is anti-correlated with the underlying stock price.
Note that this procedure—shorting—of using an underlying asset, the stock constitutes a financial tool, that allows us to achieve a particular financial goal, here
hedging a risk. Such tools or mechanisms, which are functions of the basic assets,
the stocks or other commodities, are called derivatives. They are the tools of financial
engineering, the mechanics of managing risk. We will discuss a number of them in
the following sections.
2.3 Derivatives
The most straightforward financial tool is a forward contract, which is an agreement
between two parties and as such it is called an over-the-counter (OTC) product. In a
forward contract two parties agree to trade an asset at a later time for an agreed-upon
price that may be different from today’s price. It protects the producer against the