Managing Equity Market Risk by Using Derivatives

Managing Equity Market Risk by Using Derivatives

 

       
Experts have always advised investors to reduce risk in their investment portfolio by diversifying. However, even the most diversified portfolio fluctuates according to market movement. In this article, we take a closer look at managing equity market risks with the use of derivatives. By the end of this article, you as an investor will be able to identify:

• the two basic risks inherent in an investment portfolio; and
• how futures, as a form of derivatives, is used to manage market risks and turn one’s investment profile from equity to risk-free bond.

What is Equity Market Risk?
In the equity market, risk basically means the unpredictability of the expected return and how it affects the investment portfolio. There are two basic risks inherent in an investment portfolio: unsystematic risk or firm-specific risk (diversifiable) and systematic risk or market risk (non-diversifiable). When a portfolio is diversified, it basically means the firm-specific or asset-specific risk arising due to specific characteristics of the firm is removed. But of course, market risk, which is inherent in the portfolio, can never be fully eliminated because it is caused by the overall stock market and economic situation.
                 
Risk: Good or Bad?
Many investors wrongly perceive risk as bad for their portfolios. Yet at the same time, it is widely understood by investors that risk and return go hand in hand. In order to earn higher returns, we must assume higher risks. So, if we eliminate all risk, we will only earn risk-free returns, which is equivalent to risk-free rates. What all investors ultimately want is to preserve or enhance upside risk while minimising or eliminating downside risk.

Many investors also think that derivatives are financial instruments that are highly risky. They do not relish the idea of using derivatives to manage portfolio market risk. In actual fact, the development of financial derivatives instruments provides new ways of managing risk for investors!

Taking Advantage of Futures to Hedge Market Risk  
Futures are standard contracts being traded on the exchange. They are one of the most common derivatives used to manage equity market risk. Since most futures are based on broad indices, they can be used to manage the risk related to the indices that the futures are based on.
For example, if an investor is optimistic that the overall economy is heading towards recovery, but his current stock holdings are not big or diverse enough to resemble market exposure[1], he can consider buying futures contracts that are based on the broad market index. By doing this, when the market goes up, he will gain higher profits than his original portfolio. However, in the event that the market heads downwards, his losses will also be more than what he would lose in his original portfolio.

Now, assume an investor is currently holding a well-diversified portfolio, and based on his own observation, thinks the market may be heading downward. Instead of selling his current stock holdings, he can choose to hedge his portfolio by selling futures contracts. The amount of contracts to sell will depend on how much market risk the investor would like to hedge[2]. When the market actually drops, the investor will close his positions in the futures contracts and the profits earned can then be used to offset the drop in the value of his investment portfolio. However, if the market goes up, the losses in the futures contracts will also offset the increase in the value of this portfolio. By using futures to hedge his portfolio risk, he gets downside protection but at the same time foregoes upside potential.

In extreme cases, if the investor is very pessimistic about market conditions, he may choose to fully hedge his portfolio by selling the amount of futures contracts that is equivalent to the value of his investment portfolio. Effectively, the investor would be turning his investment profile from equity into a risk-free bond[3]:

 
Conclusion

Futures enable investors to change their risk and return profiles without changing their investment holdings. This is very important as oftentimes, ups and downs in the market are only temporary. If investors were to change their investment holdings to get broader market exposure, they would need more capital and incur a lot more transaction costs compared to using futures. Additionally, to change the stock holdings would mean investors need to do in-depth research before deciding what to sell or buy.

Ultimately, using futures to manage equity market risk gives the flexibility of altering your equity market risk profile without changing your stock holdings, making it a very viable market risk management solution for any investor.


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[1] The exposure of a portfolio to particular securities/markets/sectors must be considered when determining asset allocation since it can greatly increase returns or, if properly done, minimise losses. For example, a portfolio with both stocks and bonds holdings will typically have less risk than a portfolio with exposure only to stocks.

 

[2] To make an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

 

Endowment vs Whole Life Insurance       

Endowment and whole life insurance are two different types of permanent life insurance. In endowment insurance, the premium-paying period is shorter than whole life insurance and the insurance amount is paid out within a certain period (ten, fifteen or twenty years) or at a certain age (of the insured person) after which the policy matures. At the time of maturity, a lump sum is paid back.
Whole life insurance remains active throughout the life of the policy holders and premiums have to be paid every year. The insurance company guarantees a death benefit to the beneficiaries after the demise of the insured. Additional cash benefits can be availed by the policy holder during the life of the policy.

Comparison chart

                                   

Improve this chart	Endowment	Whole Life Insurance
If alive at the end of the policy/coverage term:	Guaranteed payout	Guaranteed payout
Factors to consider:	Benefit amount, premium, investment rate, coverage term	Payout, Premium, Policy cash value, participating/non-participating.
Definition:	Endowment is type of permanent life insurance in which the premium paying period is shorter than whole life insurance and the insurance amount is paid out within a certain period (10-20 yrs) or when the insured reaches a certain age.	A life Insurance plan with an unspecified period, under which the death benefits are paid on death whenever it may occur.
Payment:	Death benefits paid at the time of death or a lump sum paid on maturity.	Death benefits paid on death (in full) up to age 100 or 120.
Premium:	Cost or premiums every month is comparatively expensive and premium paid over a shorter period of time.	Higher premium as whole life insurance plans must always pay out eventually and builds a cash value
Types:	There are three different types of endowment policies: with-profit, unit-linked and low-cost endowments insurance.	Whole life insurances are of different types: non-participating, participating, limited pay, single premium.
Advantages:	Limited period to pay premium, which builds cash value faster. Also, it is possible get a lump sum of cash in case of illness or at the time of maturity.	Level premiums distributed throughout life of insured and more affordable.

The Financial Planning Process

THE FINANCIAL PLANNING PROCESS

Most people want to handle their finances so that they get full satisfaction from each available dollar. Typical financial goals include such things as a new car, a larger home, advanced career training, extended travel, and self-sufficiency during working and retirement years. To achieve these and other goals, people need to identify and set priorities. Financial and personal satisfaction are the result of an organized process that is commonly referred to as personal money management or personal financial planning. Personal financial planning is the process of managing your money to achieve personal economic satisfaction. This planning process allows you to control your financial situation. Every person, family, or household has a unique financial position, and any financial activity therefore must also be carefully planned to meet specific needs and goals. A comprehensive financial plan can enhance the quality of your life and increase your satisfaction by reducing uncertainty about your future needs and resources. The specific advantages of personal financial planning include Increased effectiveness in obtaining, using, and protecting your financial resources throughout your lifetime. Increased control of your financial affairs by avoiding excessive debt, bankruptcy, and dependence on others for economic security. Improved personal relationships resulting from well-planned and effectively communicated financial decisions. A sense of freedom from financial worries obtained by looking to the future, anticipating expenses, and achieving your personal economic goals. We all make hundreds of decisions each day. Most of these decisions are quite simple and have few consequences. Some are complex and have long-term effects on our personal and financial situations. The financial planning process is a logical, six-step procedure: (1) determining your current financial situation (2) developing financial goals (3) identifying alternative courses of action (4) evaluating alternatives (5) creating and implementing a financial action plan, and (6) reevaluating and revising the plan. Step 1: Determine Your Current Financial Situation In this first step of the financial planning process, you will determine your current financial situation with regard to income, savings, living expenses, and debts. Preparing a list of current asset and debt balances and amounts spent for various items gives you a foundation for financial planning activities. Step 2: Develop Financial Goals You should periodically analyze your financial values and goals. This involves identifying how you feel about money and why you feel that way. The purpose of this analysis is to differentiate your needs from your wants. Specific financial goals are vital to financial planning. Others can suggest financial goals for you; however, you must decide which goals to pursue. Your financial goals can range from spending all of your current income to developing an extensive savings and investment program for your future financial security. Step 3: Identify Alternative Courses of Action Developing alternatives is crucial for making good decisions. Although many factors will influence the available alternatives, possible courses of action usually fall into these categories: Continue the same course of action. Expand the current situation. Change the current situation. Take a new course of action. Not all of these categories will apply to every decision situation; however, they do represent possible courses of action. Creativity in decision making is vital to effective choices. Considering all of the possible alternatives will help you make more effective and satisfying decisions. Step 4: Evaluate Alternatives You need to evaluate possible courses of action, taking into consideration your life situation, personal values, and current economic conditions. Consequences of Choices. Every decision closes off alternatives. For example, a decision to invest in stock may mean you cannot take a vacation. A decision to go to school full time may mean you cannot work full time. Opportunity cost is what you give up by making a choice. This cost, commonly referred to as the trade-off of a decision, cannot always be measured in dollars. Decision making will be an ongoing part of your personal and financial situation. Thus, you will need to consider the lost opportunities that will result from your decisions. Evaluating Risk Uncertainty is a part of every decision. Selecting a college major and choosing a career field involve risk. What if you don’t like working in this field or cannot obtain employment in it? Other decisions involve a very low degree of risk, such as putting money in a savings account or purchasing items that cost only a few dollars. Your chances of losing something of great value are low in these situations. In many financial decisions, identifying and evaluating risk is difficult. The best way to consider risk is to gather information based on your experience and the experiences of others and to use financial planning information sources. Financial Planning Information Sources Relevant information is required at each stage of the decision-making process. Changing personal, social, and economic conditions will require that you continually supplement and update your knowledge. Step 5: Create and Implement a Financial Action Plan In this step of the financial planning process, you develop an action plan. This requires choosing ways to achieve your goals. As you achieve your immediate or short-term goals, the goals next in priority will come into focus. To implement your financial action plan, you may need assistance from others. For example, you may use the services of an insurance agent to purchase property insurance or the services of an investment broker to purchase stocks, bonds, or mutual funds. Step 6: Reevaluate and Revise Your Plan Financial planning is a dynamic process that does not end when you take a particular action. You need to regularly assess your financial decisions. Changing personal, social, and economic factors may require more frequent assessments. When life events affect your financial needs, this financial planning process will provide a vehicle for adapting to those changes. Regularly reviewing this decision-making process will help you make priority adjustments that will bring your financial goals and activities in line with your current life situation.

What is Financial Planning?

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What is Financial Planning?

Financial Planning can mean many different things to many different people, typically as a person goes through their life they will be faced with many different stages of Financial Planning such as:

• Saving for a house deposit
• Mortgage Planning
• Saving for a Family
• Family Protection ensuring loves ones are looked after
• Saving for retirement, ensuring pension income will be sufficient
• Getting ready for retirement, choosing the right annuity
• Estate Planning & Tax planning

This is just a very broad example of how someone’s priorities may change throughout their life, now lets consider the process.

The Financial Planning Process

Financial planning is a process of setting objectives, assessing assets and resources, estimating future financial needs, and making plans to achieve monetary goals. Many elements may be involved in financial planning, including investing, asset allocation, and risk management. Tax, retirement, protection planning including life assurance and estate planning are typically included as well.
Financial planning plays a starring role in helping individuals get the most out of their money. Careful planning can help individuals and couples set priorities and work steadily towards long-term goals. It may also provide protection against the unexpected, by helping individuals prepare for things such as unexpected illness or loss of income.
As mentioned Financial planning may mean different things to different people. For one person, it may mean planning investments to provide security during retirement. For another, it may mean planning savings and investments to provide money for a dependent’s college education. Financial planning may even involve making career-related decisions or choosing the right insurance products.
Many individuals choose to use the services of financial planners to help them reach their goals. A financial planner is a professional who provides advice and guidance for a wide spectrum of financial planning issues. Financial planners may or may not be certified and offer varied levels of experience, it is important to make sure you choose a financial adviser that is right for your needs, care should be taken to make sure you research local advisers and prepare questions you want to ask them in advance.
Though a financial planner may make developing a financial plan easier, hiring one is not at all a necessity. There are many books, computer programs, and other resources available to help individuals with financial planning. Furthermore, there is a wealth of related information available on the Internet. The decision to hire a financial planner may depend on many things, including the financial worth of the individual, his or her goals for the future, and the amount of research the individual is willing to perform.
Their have been many changes put in place and are due to be put in place by the FSA, The Financial Services Authority. When it comes to choosing a Financial Planner must people consider an Independent Financial Adviser (Click this to see a full description of what an Independent Financial Adviser is) to be the must suitable to meet their Financial Planning needs, this is because they provide unbiased advice because they are not tied to a particular provide and so can recommend products as services from the whole of the market.
All too often, people delay planning for the future. They may feel such planning should take a back seat to staying financially afloat in the present. However, even those living from paycheck to paycheck can benefit from financial planning by creating a budget. A budget can be used to determine what is actually spent each month and find ways to trim or even eliminate unnecessary or out-of-control expenditures.
The right time to create a financial plan is right now. No matter what your income level or what your hopes for the future, you need a solid plan to achieve your goals. Drifting through life without carefully set goals and well-researched methods of achieving them is a recipe for disaster. To enable your money to offer you more of what you want out of life, start creating a financial plan today.

Retirement Planning: Why Plan For Retirement?

Filed Under » Bonds, Enron, Life Stage - Retirement, Options, Retirement Budgeting, Retirement Planning

Before we begin discussing how to plan a successful retirement, we need to understand why we need to take our retirement into our own hands in the first place. This may seem like a trivial question, but you might be surprised to learn that the key components of retirement planning run contrary to popular belief about the best way to save for the future. Further, proper implementation of those key components is essential in guaranteeing a financially secure retirement. This involves looking at each possible source of retirement income.

Uncertainty of Social Security and Pension BenefitsFirst off, we need to be up front about the prospects of government-sponsored retirement - they're not very good. As we all know, the developed world's populations are continuing to age, with fewer and fewer working-age people remaining to contribute to social security systems.

For instance, consider that according to a 2005 study by Stephen C. Goss, chief actuary of the Social Security Administration, the ratio of covered workers versus the number of beneficiaries under the U.S. Social Security program has been reduced significantly over the years. In 1940, there were 35.3 million workers paying into the system, with only 222,000 beneficiaries - a ratio of 159 to 1. In 2003, the number of workers increased to 154.3 million, with 46.8 million beneficiaries - a ratio of 3.3 to 1. (For related reading, see Introduction To Social Security and The Generation Gap.)

A similar pattern exists with other pension systems, including those in many European nations. At the same time, greater and greater burdens are being placed on the system, as more and more people retire and, due to advances in health care, are living longer than ever before.

This "double-whammy" effect holds the potential to put significant strains on the system and could leave governments with no other viable option but to reduce social security benefits or suspend them altogether for all but the poorest of the poor.

Private pension plans aren't immune to shortcomings either. Corporate collapses, such as the high-profile bankruptcy of Enron at the turn of the century, can result in your employer-sponsored stock holdings being wiped out in the blink of an eye. (To learn more about how this happens, read What Enron Taught Us About Retirement Plans.)

Defined-benefit pension plans, which are supposed to guarantee participants a specified monthly pension for the duration of their retirement years, actually do fail every now and again, sometimes requiring increased contributions from plan sponsors, benefit reductions, or both, in order to keep operating. (For more on this topic, check out The Demise Of The Defined-Benefit Plan.)

In addition, many employers who used to offer defined-benefit plans are now shifting to defined-contribution plans because of the increased liability and expenses that are associated with defined-benefit plans, thus increasing the uncertainty of a financially secure retirement for many.

These uncertainties have transferred the financing of retirement from employers and the government to individuals, leaving them with no choice but to take their retirement planning into their own hands.

Unforeseen Medical ExpensesWhile the failure of a social security system may not occur, planning your retirement on funds you don't control is certainly not the best option. Even with that risk aside, it's important to realize that social security benefits will never provide you with a financially adequate retirement. By definition, social security programs are intended to provide a basic safety net - a bare minimum standard of living for your old age.

Without your own savings to add to the mix, you'll find it difficult, if not impossible, to enjoy much beyond the minimum standard of living social security provides. This situation can quickly become alarming if your health takes a turn for the worse.

Old age typically brings medical problems and increased healthcare expenses. Without your own nest egg, living out your golden years in comfort while also covering your medical expenses may turn out to be a burden too large to bear - especially if your health (or that of your loved ones) starts to deteriorate. As such, to prevent any unforeseen illness from wiping out your retirement savings, you may want to consider obtaining insurance, such as medical and long-term care insurance (LTC), to finance any health care needs that may arise. (To learn more about providing for your medical expenses, read Medicaid Versus LTC Insurance, The Evolution Of LTC-Insurance Plans, Long-Term Care: More Than Just A Nursing Home and A New Approach To Long-Term Care Insurance.)



Estate PlanningSwitching to a more positive angle, let's consider your family and loved ones for a moment. Part of your retirement savings may help contribute to your children or grandchildren's lives, be it through financing their education, passing on a portion of your nest egg or simply keeping sentimental assets, such as land or real estate, within the family.

Without a well-planned retirement nest egg, you may be forced to liquidate your assets in order to cover your expenses during your retirement years. This could prevent you from leaving a financial legacy for your loved ones, or worse, cause you to become a financial burden on your family in your old age. (For more insight, read The Importance Of Estate And Contingency Planning.)

The Flexibility to Deal With ChangesAs we know, life tends to throw us a curve ball every now and then. Unforeseen illnesses, the financial needs of your dependents and the uncertainty of social security and pension systems are but a few of the factors at play.

Regardless of the challenges faced throughout your life, a secure nest egg will do wonders for helping you cope. Financial hiccups can be smoothed out over the long term, provided that they don't derail your financial plan in the short term, and there is much to be said for the peace of mind that a sizable nest egg can provide.

Read more: http://www.investopedia.com/university/retirement/retirement1.asp#ixzz2LJyCtQV6