Tag Archives | risk

Backwardation Definition

See Also:
Contango
Interest Rate
Efficient Market Theory
Market Dynamics
Arbitrage

Backwardation Definition

Backwardation is a term used to describe a commodities market when the spot rates are higher than the future price of that certain commodity. In other words there is a downward sloping forward curve relative to the spot rate set for maturity of the commodity. This is the opposite of a market that is in Contango.

Backwardation Explained

Backwardation has been seen in commodities like corn, wheat, or oil. A backwardation market usually occurs because farmers and other commodity producers would like to lock in a price so that they do not have to accept the risk of the fluctuations in the market. Many of these farmers will accept a current rate to mark a guaranteed price. The investors on the other hand will need to expect that the spot rate is actually higher so that they can lock in the current future price and make a profit.

Backwardation Example

Hal, a corn farmer in Nebraska, has been observing prices as of late to decide what he should do about his crop that is about to mature. Hal calculates that the future price of corn is around $6 per bushel. The spot rate at maturity is $8. However, Hal knows that this is never for sure. The market has been known to fluctuate the same amount the other way to $4 per bushel. Hal talks to some of his customers and locks in the future price of $6 to be sold when the crop matures. Because the customers believe the future spot rate to be correct they are happy to accept the $6 price. This way when they go to sell in the market they expect to make a profit of $2 per bushel.

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Call Option

See Also:
Put Option
Synthetic Stock
Future Value
Warrants
Intrinsic Value – Stock Options

Call Option Definition

The call option definition is a right by an investor to buy an asset at a pre-determined price on or before a certain date known as the call option expiration.

Call Option Explained

The call option gives an investor or holder several benefits by obtaining one of these contracts. One of the benefits is that the holder can watch the company and its stock on the market risk free because the holder does not have to exercise the call option. If the stock goes down then the call option holder simply lets the option expire. Once there has been a call option expiration then the call option has become useless to the holder. If the price were to go up above the exercise or strike price then the holder could exercise the call option and make an instant profit in the market.

Call Option Example

Jim has just received an option to buy 100 shares of Wawadoo Inc. at a price of $32 in January. The call option expiration date is set for December 31st. The price of the stock in January is $28. In November, the stock price of Wawadoo has risen to $35. Jim decides that the stock will not drop again and exercises his call option. Upon calling Jim has made a profit of $300 (($35*100) – ($32*100)). It should be noted that this is just one call option, often times people will receive several call options usually as compensation for business or for work done as an employee. If the price never surpassed the price of $32 by December, Jim would have just let his option expire meaning he would lose nothing and gain nothing.

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Business Risk

See Also:
Hedging Risk
Controller Definition
Risk Premium
Commercial Risk
Transfer Risk
Moral Hazard

Business Risk Definition

The business risk definition is the various risks a company copes with while doing business. It is a very broad concept. It generally includes the entire spectrum of risks which a company encounters.

Business Risk Explanation

Explained as the risk which causes many businesses to fail, business risk should not be taken lightly. Business risk exposure can come from a variety of situations: risk of competition, risk of change in market dynamics, risk of change in supply lines, buyer behavior, the legislative environment surrounding the business, and more. With an ever changing environment surrounding the business threats may arise which could cause one part or even the entire business to fail. Due to this fact, the prudent business owner must keep abreast with changes through constant research. This research puts the overall environment of the business in check.

Business owners also like to keep extra cash to deal with risk. This extra cash allows for unexpected expenses like lawsuits, legislative changes, changes which require more marketing, and more. Cash can protect a business from staying stagnant in the market positioning it takes.

Business Risk Example

Look at the following business risk example. Lee is the owner of a small Gelato store. His business, small and discretionary, has to face many business risks. As a result, Lee survives off of his gumption and perseverance.

Recently, Lee had to perform a major business risk evaluation. Lee just noticed another gelato store opening across the street. This risk, the threat of competitors, could mean the failure of Lee’s business. He has to act fast.

To deal with this, Lee takes a more focused marketing approach. He begins to contact community organizations. He provides a unique offer: 25% off gelato and free room to meet in his store. This has 2 benefits: increasing sales while getting the word out to the customer. After 2 months, it is clear that Lee’s plan was a success: his business is growing. It seems that people who come for a meeting have returned because they like the product.

Lee resolves to keep cash on hand and begin to find other routes for marketing. He knows that if he sticks with his business, then he can achieve great things.

Download your free External Analysis whitepaper that guides you through overcoming obstacles and preparing how your company is going to react to external factors.

business risk

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Arbitrage Pricing Theory

See Also:
Cost of Capital
Cost of Capital Funding
Capital Asset Pricing Model
APV Valuation
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return

Arbitrage Pricing Theory Definition

The arbitrage pricing theory (APT) is a multifactor mathematical model used to describe the relation between the risk and expected return of securities in financial markets. It computes the expected return on a security based on the security’s sensitivity to movements in macroeconomic factors. Then use the resultant expected return to price the security.

The arbitrage pricing theory is based on three assumptions. First, that a factor model can be used to describe the relation between the risk and return of a security. Then, idiosyncratic risk can be diversified away. Finally, efficient financial markets do not allow for persisting arbitrage opportunities.

In addition, the arbitrage pricing theory calculates the expected return for a security based on the security’s sensitivity to movements in multiple macroeconomic factors. Whereas the standard capital asset pricing model (CAPM) is a single factor model, incorporating the systematic and firm specific risk related to the overall market return, the arbitrage pricing theory is a multifactor model.

Then, set up the arbitrage pricing theory to consider several risk factors, such as the business cycle, interest rates, inflation rates, and energy prices. The model distinguishes between both systematic risk and firm-specific risk. It also incorporates both types of risk into the model for each given factor.

Arbitrage Pricing Theory Formula

The formula includes a variable for each factor, and then a factor beta for each factor, representing the security’s sensitivity to movements in that factor. Because it includes more factors, consider the arbitrage pricing theory more nuanced – if not more accurate, than the capital asset pricing model.

A two-factor version of the arbitrage pricing theory formula is as follows:

r = E(r) + B1F1 + B2F2 + e 

r = return on the security
E(r) = expected return on the security
F1 = the first factor
B1 = the security’s sensitivity to movements in the first factor
F2 = the second factor
B2 = the security’s sensitivity to movements in the second factor
e = the idiosyncratic component of the security’s return

If you want to improve your pricing and your profits, then download the free Pricing for Profit Inspection Guide.

arbitrage pricing theory

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supplier power analysis

 

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Economic Reset

I just returned from the Microsoft Worldwide Partner Conference 2009 in New Orleans. At the conference I heard Steve Ballmer discuss the direction of the economy over the next several years. He believes that the world economy is going through an “economic reset”.

Economic Reset

According to Ballmer ,the world economy becomes overheated every twenty-five to thirty years. Credit expands until the economy becomes so heated that risk is priced out of the market. In other words, there is so much money chasing too few good deals. Ballmer pointed out that total debt reached 350% of GDP in the United States at the height of the most recent boom. Prior to the Great Depression, that figure was only 150% of GDP. He believes that the economy won’t resume growing until that figure comes down significantly.

He contends that every 25 to 30 years the economy “resets” itself at a lower level thereby flushing out the high leverage and poor investments. Because this process takes time, he believes that the recovery will not be the quick rebound many predict.

Consequently, companies should be prepared to restructure their businesses to survive at a lower economic level. It will be difficult, if not impossible, to grow revenue in this environment. Instead he suggests that companies should focus on increasing market share.

Economic Growth

Finally, when economic growth does resume it will not be fueled by debt. The growth will need to come from increased productivity. Because IT continues to change and most companies are stretching the life of their IT infrastructure there will be pent up demand once the economy grows.

So what should you or your company do to survive in these tough economic times? First, evaluate the effectiveness of your marketing dollars. For those marketing initiatives that work, you should increase your spending.

Second, invest in processes, tools, and training to improve your productivity, both personally and as a company. Acquire new skills and capabilities to prepare for when the economy does start growing again.

If you want to further develop your financial leadership skills, then click below.

Economic Reset

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If They Will Buy, Then I Will Sell!

If they will buy, then I will sell! Or stated another way, if I can sell it then buyer beware! That seems to have been the motto for the sub prime mortgage industry. Over the past five years a looming crisis has been in the making. Mortgage brokers would originate the loan then immediately pass on the risk to the investors. Few would keep the loans for a month let alone ninety days. Consequently, they were assuming little risk and had no incentive to police the quality of the loan.

If They Will Buy, Then I Will Sell!

Some people are questioning whose responsibility it was to police the market. At some point in the cycle someone needed to say no to the level of risk being assumed. Some say we should have government oversight. I say it is the job of Mr. Market!

The only thing that keeps people from taking stupid risks is the fear of loss. Until recently we haven’t had that in the past five years. During this time period we have experienced low cost of capital, high liquidity and increasing productivity of employees. Now the market forces (i.e. losses) are policing the sub prime markets.

Other Markets in the Economy

The real question is what other markets in the economy are in line to be disciplined? The economy is beginning to look like a slow moving train wreck. This scenario is not unlike the dot com bust where few of us were directly in the business but all of us were effected. Now is the time for entrepreneurs and their CFOs to take action to weather any possible storm. Download the External Analysis to gear up your business for change.

If They Will Buy, Then I Will Sell!

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If They Will Buy, Then I Will Sell!

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