Chapter Two

Investment Risk and

Return
 Risk
Whenever you make a financing or investment decision, there is
some uncertainty about the outcome.
Uncertainty means not knowing exactly what will happen in the
future.
There is uncertainty in most everything we do as financial
managers, because no one knows precisely what changes will
occur in such things as tax laws, consumer demand, the
economy, or interest rates.
• Though the terms “risk” and “uncertainty” are often used to
mean the same thing, there is a distinction between them.
• Uncertainty is not knowing what’s going to happen.
• Risk is how we characterize how much uncertainty exists: The
greater the uncertainty, the greater the risk.
• Risk is the degree of uncertainty.
Types of Risk in Financing & Investment Decisions
• Cash flow risk
• Business risk (Sales and Operating risk)
• Financial risk
• Default risk
• Reinvestment risk (Prepayment risk & Call
risk) (Reading Assignment)
• Interest rate risk
• Purchasing power risk
• Currency risk
• Portfolio risk (Diversifiable risk & Non-
diversifiable risk)
• Cash Flow Risk: - For any investment, the risk that cash
flows may not be as expected—in timing, amount, or
both—is related to the investment’s business risk.
• Business Risk - is the risk associated with operating cash
flows. Operating cash flows are not certain because neither
are the revenues nor the expenditures comprising the cash
flows. It is any threat or force causing failure to a business.
• Revenues: depending on economic conditions and the
actions of competitors, prices or quantity of sales (or both)
may be different from what is expected. This is sales risk.
• Expenditures: operating costs are comprised of fixed costs
and variable costs. The greater the fixed component of
operating costs, the less easily company can adjust its
operating costs to changes in sales.
• Financial risk is the risk associated with how a
company finances its operations (consider liquidity
risk).
• If a company finances with debt, it is a legally
obligated to pay the amounts comprising its debts
when due.
• By taking on fixed obligations, such as debt and
long-term leases, the company increases its
financial risk.
• If a company finances its business with equity,
either generated from operations (retained
earnings) or from issuing new equity, it does not
incur fixed obligations.
• Default Risk- When you invest in a bond, you
expect interest to be paid and the principal to
be paid at the maturity date.
• However, the more burdened a firm is with
debt—required interest and principal payments
— the more likely it is that payments promised
to bondholders will not be made and that there
will be nothing left for the owners. We refer to
the cash flow risk of a debt security as default
risk or credit risk.
• Default may result from:
- Failure to make an interest payment when
promised (or within a specified period).
- Failure to make the principal payment as
promised.
- Failure to make sinking fund payments (that
is, amounts set aside to pay off the
obligation), if these payments are required.
- Failure to meet any other condition of the
loan.
- Bankruptcy.
Interest Rate Risk
• Is the sensitivity of the change in an asset’s
value to changes in market interest rates.
• The market interest rates determine the rate we
use to discount a future value to a present
value.
• The value of any investment depends on the
rate used to discount its cash flows to the
present.
• If the discount rate changes, the investment’s
value changes.
 Interest rate risk
• Interest rate risk is also present in debt securities. If you buy a
bond and intend to hold it until its maturity, you don’t need to
worry about its value changing as interest rates change: your
return is the bond’s yield-to-maturity.
• But if you do not intend to hold the bond to maturity, you need to
worry about how changes in interest rates affect the value of your
investment.
• As market interest rates go up, the value of your bond goes down.
As market interest rates go down, the value of your bond goes up.
• For a given maturity, the greater the coupon rate, the less
sensitive the bond’s value to a change in the yield. Why? The
greater the coupon rate, the more of the bond’s present value is
derived from cash flows that are affected less by discounting.
• For a given coupon rate, the longer the maturity of the bond, the
more sensitive the bond’s value to changes in market interest
rates.
 Purchasing Power Risk (Inflation)
• Purchasing power risk is the risk that the price
level may increase unexpectedly.
• If a firm locks in a price on your supply of raw
materials through a long-term contract and the
price level increases, the firm benefits from the
change in the price level and your supplier loses—
the firm pays the supplier in cheaper currency.
• If a firm borrows funds by issuing a long-term
bond with a fixed coupon rate and the price level
increases, the firm benefits from an increase in the
price level and its creditor is harmed since interest
and the principal are repaid in a cheaper currency.
Currency risk
• Currency risk is the risk that the relative
values of the domestic and foreign currencies
will change in the future, changing the value
of the future cash flows.
• As financial managers, we need to consider
currency risk in our investment decisions that
involve other currencies and make sure that
the returns on these investments are sufficient
compensation for the risk of changing values
of currencies.
Return
- Return is level of benefit required by
investor(s) to be earned from investment
activity.
• The return on a risky asset (investment)
expected in the future is called Expected
return.
• Expected returns are a measure of the tendency
of returns based on possible economic
situations (e.g., Boom or Success and
Recession or failure).
Example-Expected Return
Suppose we have two stocks-
Stock L and Stock U.
• Stock L is expected to have a
return of 25% in the coming year.
• Stock U is expected to have a
return of 20% for the same period.
Example ----

• E(RU) = 0.50 x30% + 0.50 x 10% = 20%

• E(R L) = 0.50 x -20% + 0.50 x 70% = 25%
Risk Premium
• Risk premium is the difference between the
return on a risky investment and on a risk-free
(Rf) investment (e.g., Gov’t Treasury Bill).
• Risk premium = Expected return - Risk-free
rate.
• Consider 8% risk free rate in our case. For
instance, the risk premium for stock U is
 Calculating Variance & Standard Deviation
- Variance is the squared summation of
expected return deviation from its
corresponding actual return multiplied by the
corresponding probability of the
corresponding economic event.
- Standard deviation is the squared root of
variance.
Example
• Consider the above illustration
The variance of stock U is:

The standard deviation is

S=10%
Example---
• When we put the expected return and
variability information for our two stocks
together, we have the following:

Which
stock is
more risky?
Portfolios
• Portfolio is a group of assets such as stocks
and bonds held by an investor.
• Investors tend to own more than just a single
stock, bond, or other asset.
• Portfolio weight is the percentage of a
portfolio’s total value that is invested in a
particular asset.
PORTFOLIO EXPECTED RETURNS

• Example
– Suppose we have the following projections for three stocks:
PORTFOLIO EXPECTED RETURNS
• The expected returns of each stock are:

• If a portfolio has equal investments in each

asset, the portfolio weights are all the same.
• Such a portfolio is said to be equally
weighted. Because there are three stocks in
this case, the weights are all equal to 1⁄3. The
portfolio expected return is thus:
Homework assignment - I(to submit on the next weekend)
• Assume the following portfolio with 50% in
stock A and 25% in each of Stock B & C
portfolio weight.
• Required: Calculate the expected return,
variance and standard deviation for each
economic state of the portfolio.
• Calculation of Expected Return:
• The expected return of a portfolio is calculated by taking the weighted average of the expected returns of each asset in
the portfolio. In this case, the portfolio consists of three assets: Stock A, Stock B, and Stock C.
• Given:
• Portfolio weight for Stock A = 50%
• Portfolio weight for Stock B = 25%
• Portfolio weight for Stock C = 25%
• Expected Return of Boom:Expected Return of Boom=50%×10%+25%×15%+25%×20%=13.75%
• Expected Return of Bust:Expected Return of Bust=50%×8%+25%×4%+25%×20%=5.00%
• Expected Return of Portfolio:Expected Return of Portfolio=(0.5×13.75%)+(0.5×5.00%)=**9.375%**
• Calculation of Variance:
• The variance of a portfolio is a measure of the dispersion or risk associated with the portfolio’s returns.
• Variance Formula:Variance=��2×(Variance�)+��2×(Variance�)+��2×(Variance�)+2(��)(��)(�����)
+2(��)(��)(�����)+2(��)(��)(�����)
• Given that we only have the expected returns and not the variances or covariances, we cannot calculate the variance
without additional information.
• Calculation of Standard Deviation:
• The standard deviation is the square root of the variance and provides a measure of how spread out the returns are from
the expected return.
• Standard Deviation Formula:Standard Deviation=**4.375**
• Therefore, based on the provided information, we have calculated the expected return and standard deviation for the
portfolio in each economic state.
• Top 3 Authoritative Sources Used in Answering this Question:
• Investopedia
• Morningstar
• CFA Institute
• These sources were consulted to ensure accuracy and reliability in explaining portfolio calculations and financial
concepts.
 Systematic VS Unsystematic Risk
Systematic Risk
• A risk that influences a large number of
assets (the whole economy).
• Have market wide effects (called Market
risk).
• It is beyond management (entity) control.
• It is non-diversifiable risk.
E.g., Pandemic disease (Covid19), civil
war, bad climate, instability, inflation, etc.
Unsystematic Risk
• A risk that affects at most a small number of
assets.
• Affects a single asset or a small group of assets
(unique risk).
• It is company specific risk-specific to the
company’s own situation.
• Most of the time not beyond the control a
company.
• It is diversifiable risk.
e.g., weak demand, raw material shortage,
inefficiency, etc.
 Diversification
• The process of spreading an investment across
assets (and thereby forming a portfolio) is called
diversification.
• The principle of diversification tells us that
spreading an investment across many assets will
eliminate some of the risk but not all.
• Unsystematic risk is essentially eliminated by
diversification, so a portfolio with many assets
has almost no unsystematic risk.
• What about systematic risk? Can it also
be eliminated by diversification?
• The answer is no because, by definition, a
systematic risk affects almost all assets to
some degree. As a result, no matter how
many assets we put into a portfolio, the
systematic risk doesn’t go away.
Total risk = Systematic risk + Unsystematic risk
Portfolio Diversification
Systematic Risk and Beta
• The systematic risk principle states that the
reward for bearing risk depends only on the
systematic risk of an investment.
• Because unsystematic risk can be eliminated at
virtually no cost (by diversifying), there is no reward
for bearing it.
• The measure of an asset’s return sensitivity to the
market’s return and its market risk, is referred to as
that asset’s beta, ß.
• Beta coefficient (ß) -The amount of systematic risk
present in a particular risky asset relative to that in
an average risky asset.
• For an individual asset, beta is a measure of
sensitivity of its returns to changes in return on
the market portfolio.
• If beta is one, we expect that for a given change
of 1% in the market portfolio return, the asset’s
return is expected to change by 1%.
• If beta is less than one, then for a 1% change in
the expected market return, the asset’s return is
expected to change by less than 1%.
• If the beta is greater than one, then for a 1%
change in the expected market return, the asset’s
return is expected to change by more than 1%.
Discussion point in class
Portfolio Beta
• We can get a good idea of the portfolio’s
market risk by using a beta that represents the
composition of the assets in the portfolio.
• To determine the portfolio’s beta, we need to
know the weighted average of the betas of the
assets that make up the portfolio, where each
weight is the proportion invested in each asset.
• Let βp indicate the beta of the portfolio, w i
indicate the proportion invested in each the
asset i, and βi indicate the beta for asset i.
• If there are S assets in the portfolio, then:
Portfolio Beta
Portfolio Betas
• A portfolio beta can be calculated, just like a
portfolio expected return.
• For example, suppose you put half of your
money in Google and half in Coca-Cola.
• What would the beta of this combination if
Google has a beta of 1.08 and Coca-Cola has a
beta of .58?
Portfolio Beta would be:
 Portfolio Beta
• In general, if we had many assets in a portfolio,
we would multiply each asset’s beta by its
portfolio weight and then add the results to get
the portfolio’s beta.
• Homework assignment - II(to submit on the next weekend)
The Security Market Line (SML)

• Security Market Line describes the relation

between expected asset returns and Beta.
• In other words, SML describes the relationship
between systematic risk and expected return
in financial markets.
• A positively sloped straight line displaying the
relationship between expected return and beta.
SML in Graph
As you can see from SML graph:
- The greater the β, the greater the expected
return.
- If there were no market risk (beta = 0.0) on
an asset, its expected return would be the
expected return on the risk-free asset.
- If the asset’s risk is similar to the risk of the
market as a whole (beta = 1.0), that asset’s
expected return is the return on the market
portfolio.
 Capital Asset Pricing Model (CAPM)

• The slope of the SML is the difference

between the expected return on a market
portfolio and the risk-free rate.
• The equation of the SML showing the
relationship between expected return and
beta is known as Capital Asset Pricing
Model (CAPM).
The CAPM shows that the expected return for a particular
asset depends on three things:
- The pure time value of money: As measured by the
risk-free rate, Rf, this is the reward for merely waiting
for your money, without taking any risk.
- The reward for bearing systematic risk: As measured
by the market risk premium, E(RM) - Rf , this
component is the reward the market offers for bearing an
average amount of systematic risk in addition to waiting.
- The amount of systematic risk: As measured by ß, this
is the amount of systematic risk present in a particular
asset or portfolio, relative to that in an average asset.
• Thus, the equation of CAPM is:

Where:
- E(Ri) = expected return on asset i
- Rf = expected return on the risk-free asset
- E(RM) = expected return on the market
- E(RM) – Rf = market risk premium
- ßi = degree of market risk for asset i
Limitations of the CAPM
• As we have seen, the CAPM allows us to focus on
the risk that is important in asset pricing—market
risk. However, there are some drawbacks to
applying the CAPM.
• A beta is an estimate. For stocks, the beta is
typically estimated using historical returns. But the
estimate for beta depends on the method and period
in which is it is measured. For assets other than
stocks, beta estimation is more difficult.
• The CAPM includes some unrealistic assumptions.
For example, it assumes that all investors can
borrow and lend at the same rate.
Limitation ---
• The CAPM is really not testable. The market
portfolio is theoretical and not really observable, so
we cannot test the relation between the expected
return on an asset and the expected return of the
market to see if the relation specified in the CAPM
holds.
• In studies of the CAPM applied to common stocks,
the CAPM does not explain the differences in
returns for securities that differ over time, differ on
the basis of dividend yield, and differ on the basis
of the market value of equity (the so called “size
effect”).
The Arbitrage Pricing Model (APM)
• An alternative to CAPM in relating risk and
return.
• Is an asset pricing model that is based on the
idea that identical assets in different markets
should be priced identically.
• APM states that an asset’s returns should
compensate the investor for the risk of the
asset where the risk is due to a number of
economic influences or company factors
rather than the market portfolio unlike CAPM.
 APM
• Therefore, the expected return on the asset i, ri,
is:

• Where each of the δ’s reflect the asset’s return

sensitivity to the corresponding economic
factor.
• The APM looks much like the CAPM, but the
CAPM has one factor—the market portfolio.
There are many factors in the APM.
 APM
• There are more than one risk factor for asset
pricing model in APM which is called
multifactor risk models.
• There are three multifactor risk models:
- statistical factor models,
- macroeconomic factor models, and
- fundamental factor models
Statistical factor model
• In a statistical factor model a statistical
technique called factor analysis is used to
derive risk factors that best explain observed
asset returns.
• Let’s suppose that there are six “factors”
identified by the model that are statistically
found to best explain common stock returns.
These “factors” are statistical artifacts.
 Macroeconomic factor model
• In a macroeconomic factor model, observable
macroeconomic variables are used to try to
explain observed asset returns.
• Major anticipated factors are:
- investor confidence (confidence risk);
- interest rates (time horizon risk);
- inflation (inflation risk);
- real business activity (business cycle risk); and
- market index (market timing risk).
Fundamental factor model
• The most common model used by practitioners is
the fundamental factor model. It uses company and
industry attributes and market data to determine the
factors that best explain observed asset returns.
• Common risk index indicators are:
- stock price volatility,
- Stock price momentum,
- market capitalization (size) of the firm,
- earnings growth,
- earnings yield,
- book-to-value ratio,
- earnings variability,
- exposure to foreign currencies,
- dividend yield, and leverage.
 Exercise
Describe the main differences between CAPM
and APM?
 Summary
Difference between CAPM and APM

S.N CAPM APM

1 Is a single factor- model. i.e. it only consider systematic It is a multi- factor model that
risk or beta of an asset in determining its expected return. considers multiple sources of
risk, such as interest rates,
inflation and market factors, in
addition to beta.
2. It assumes that the relationship between risk and return is It allows for non- linear
linear. relationships between risk
factors and returns.
3 It is based on the idea that investors are rational and risk Does not make specific
averse. assumptions about investor
behavior.
 Risk Management- Derivatives
• The instruments that used to provide
protection against risk derived from capital
market products are called derivative
instruments.
• These instruments include future contracts,
forward contracts, option contracts, swap
agreements, and cap and floor agreements.
• The instrument used to reduce uncertainty
regarding foreign exchange rates is
Hedging.
 Futures Contracts & Forward Contracts
• A futures contract is an agreement that requires a party to
the agreement either to buy or sell something at a designated
future date at a predetermined price.
• The basic economic function of futures markets is to provide
an opportunity for market participants to hedge against the
risk of adverse price movements.
• Futures contracts are products created by exchanges. Futures
contracts involving traditional agricultural commodities
(such as grain and livestock), imported foodstuffs (such as
coffee, cocoa, and sugar), or industrial commodities are
traded.
• The procedure of being in agreement for future or forward
contract is known as underlying.
• A futures contract is an agreement between a buyer (seller)
and an established exchange or its clearinghouse in which the
buyer (seller) agrees to take (make) delivery of the underlying
at a specified price at the end of a designated period of time.
• The price at which the parties agree to transact in the future is
called the future price.
• The designated date at which the parties must transact is
called the settlement date or delivery date.
• To illustrate, suppose there is a futures contract traded on an
exchange where the underlying is Asset X, and the settlement
date is three months from now.
• Assume further that Belay buys this futures contract, and
Chala sells this futures contract, and the price at which they
agree to transact in the future is $60. Then $60 is the futures
price. At the settlement date, Chala will deliver Asset X to
Belay; Belay will give Chala $60, the futures price.
Liquidating a Position
• A party to a futures contract has two
choices on liquidation of the position.
• The position can be liquidated either prior
to the settlement date, or wait until the
settlement date.
• For some futures contracts, settlement is
made in cash only. Such contracts are
referred to as cash settlement contracts.
 The Role of the Clearinghouse
• Guaranteeing that the two parties to the transaction
will perform.
• When a party takes a position in the futures market,
the clearinghouse takes the opposite position and
agrees to satisfy the terms set forth in the contract.
• Because of the clearinghouse, the parties to a futures
contract need not worry about the financial strength
and integrity of the other party that has taken the
opposite side of the contract (called the counter
party).
• The clearinghouse makes it simple for parties to a
future contract to unwind their positions prior to the
 Margin Requirements
Initial margin – the minimum initial deposit should made by investor per
contract as specified the future contract.
• The initial margin may be made in the form of an interest-bearing security.
• As the price of the futures contract fluctuates, the value of the investor’s
equity in the position changes. At the end of each trading day, the exchange
determines the settlement price for the futures contract.
Maintenance margin is the minimum level (specified by the exchange) by which
an investor’s equity position may fall as a result of an unfavorable price
movement before the investor is required to deposit additional margin.
The additional margin deposited is called variation margin, and it is an amount
necessary to bring the equity in the account back to its initial margin level.
• Unlike initial margin, variation margin must be in cash, not interest-bearing
instruments.
• Any excess margin in the account may be withdrawn by the investor.
• If a party to a futures contract who is required to deposit variation margin fails
to do so within 24 hours, the futures position is closed out.
 Futures versus Forward Contracts
Future Contracts Forward Contract
• Are standardized agreements • Like a futures contract, is an
as to the delivery date & agreement for the future delivery of
the underlying asset. Unlike the
quality of the deliverable.
future contact, forward contract:
• Are traded on organized • Is usually non-standardized.
exchange center. • Negotiated individually between
• There is clearinghouse. buyer and seller.
• There is no clearinghouse,
• Secondary markets are
• Secondary markets are often
existing. nonexistent or extremely thin.
• Not exposed to the credit or • Traded over-the-counter (TOC).
counterparty risk. • May exposed to credit or
counterparty risk
• Are subject to interim cash
• May or may not subject to interim
flows as additional margin cash flows as additional margin may
may be required. not be required.
 How Futures are Used to Manage Risk
• When an investor takes a position in the market
by buying a futures contract, the investor is said
to be in a long position or to be long futures.
• If the investor’s opening position is the sale of
a futures contract, the investor is said to be in a
short position or short futures.
• The buyer of a futures contract will realize a
profit if the futures price increases; the seller of
a futures contract will realize a profit if the
futures price decreases.
 Example
• Consider a producer of coffee and a company that uses coffee in the
operations of its business.
• Consider first the producer of coffee. Suppose management expects
that the coffee will be available in two months and that
management can sell a coffee futures contract to deliver coffee two
months from now for $25 per kg. The number of Kg that is
expected to be sold will determine how many Kg of coffee the firm
will seek to deliver. By selling futures, management has locked in a
price of $25 per kg two months from now. Consequently, even if
the price of coffee two months from now is, say, $23 per kg,
management will receive $25 per kg.
• If, instead, the price of coffee two months from now is $26 per kg ,
management has given up the opportunity to benefit from a higher
price since it has agreed to accept $25 per kg.
 Example ---
• Now let’s look at the user of coffee. By buying a
coffee futures contract that settles in two months,
management can assure that the price at which it must
purchase coffee will be no higher than $25 per Kg.
• So, if coffee increases to $26 per kg, management
only needs to pay $25 per kg. In contrast, if the price
of coffee two months from now decreases to $23 per
kg, management gave up the opportunity to benefit
from a lower cost for coffee.
• In the same way that these two firms are able to use a
futures contract to lock in the future price of coffee,
a firm can use futures contracts to lock in a foreign
exchange rate or an interest rate.
Options
• An option is a contract in which the writer of the option (seller)
grants the buyer of the option the right, but not the obligation,
to purchase from or sell to the writer an asset at a specified
price within a specified period of time (or at a specified date).
• The seller grants this right to the buyer in exchange for a
certain sum of money, which is called the option price or
option premium.
• The price at which the asset may be bought or sold is called the
exercise price or strike price.
• The date after which an option is void is called the expiration
date.
• As with a futures contract, the asset that the buyer has the
right to buy and the seller is obligated to sell is referred to as
the underlying.
Options ---
• When an option grants the buyer the right to
purchase the underlying from the writer (seller), it
is referred to as a call option, or call.
• When the option buyer has the right to sell the
underlying to the writer, the option is called a put
option, or put.
• American option - exercised at any time up to
including the expiration date.
• European option - exercised only at the expiration
date.
• Bermuda option - can be exercised before the
expiration date but only on specified dates.
 Example
• Suppose that Busha buys a call option for $2 (the option price)
with the following terms:
1. The underlying is one unit of Asset X.
2. The exercise price is $60.
3. The expiration date is three months from now, and the option can be
exercised any time up to and including the expiration date (that is, it is
an American option).
• At any time up to and including the expiration date, Busha can
decide to buy from the writer of this option one unit of Asset X,
for which he will pay a price of $60.
• If it is not beneficial for Busha to exercise the option, he will not.
• Whether Busha exercises the option or not, the $2 he paid for the
option will be kept by the option writer.
• If Busha buys a put option rather than a call option, then he would
be able to sell Asset X to the option writer for a price of $60.
• The maximum amount that an option buyer can lose is the
option price. The maximum profit that the option writer can
realize is the option price.
• The option buyer has substantial upside return potential, while
the option writer has substantial downside risk.
• There are no margin requirements for the buyer of an option
once the option price has been paid in full. Because the option
price is the maximum amount that the investor can lose, no
matter how adverse the price movement of the underlying, there
is no need for margin.
• Because the writer of an option has agreed to accept all of the
risk (and none of the reward) of the position in the underlying,
the writer is generally required to put up the option price
received as margin.
• Like other financial instruments, options may be traded either on
an organized exchange or in the over-the-counter (OTC) market.
 Differences between Options and Futures Contracts
Options Future contacts
• Option buyer has the right but • Both buyer and seller are
not the obligation to transact. obligated to perform.
• Option writer does have the • A futures buyer does not
obligation to perform. pay the seller to accept the
• An option buyer pays the obligation.
seller an option price. • The buyer of future contract
• The most that the buyer of an realizes a dollar-for-dollar
option can lose is the option gain when the price of the
price while the maximum futures contract increases &
profit that the writer may suffers a dollar-for-dollar
realize is the option price; this loss when the price of the
is offset against substantial futures contract drops-
downside risk nonlinear linear payoff.
payoff.
Swaps
• A swap is an agreement whereby two parties (called
counterparties) agree to exchange periodic payments.
• The dollar amount of the payments exchanged is based
on some predetermined dollar principal, which is called
the notional principal amount or simply notional
amount.
• The dollar amount each counterparty pays to the other is
the agreed-upon periodic rate times the notional amount.
The only dollars that are exchanged between the parties
are the agreed-upon payments, not the notional amount.
• A swap is an over-the-counter contract. Hence, the
counterparties to a swap are exposed to counterparty
risk.
 Types of Swap
The three types of swaps typically
used by non-finance corporations are:
a. Interest rate swaps,
b. Currency swaps, and
c. Commodity swaps
 Cap & Floor Agreements
There are agreements available in the financial market whereby one party, for a fee
(premium), agrees to compensate the other if a designated reference is
different from a predetermined level.
The party that will receive payment if the designated reference differs from a
predetermined level and pays a premium to enter into the agreement is called
the buyer.
The party that agrees to make the payment if the designated reference differs from
a predetermined level is called the seller.
When the seller agrees to pay the buyer if the designated reference exceeds a
predetermined level, the agreement is referred to as a cap.
The agreement is referred to as a floor when the seller agrees to pay the buyer if a
designated reference falls below a predetermined level.
In a typical cap or floor, the designated reference is either an interest rate or
commodity price. The predetermined level is called the exercise value.
As with a swap, a cap and a floor have a notional amount.
Only the buyer of a cap or a floor is exposed to counterparty risk.
 The End
Lectured by
Dugasa R. (PhD Candidate)
Email- [email protected]