Risk Hedging and Risk Abitrage (types of risks) PDF

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Types of risks associated and how to tackle the risks with detail...

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RISK HEDGING AND ABITRAGE Risk hedging it is a strategy for reducing exposure to investment risk .An investor can hedge the risk of one investment by taking an offsetting position in other investments. Risk arbitrage it is an investment strategy to profit from the narrowing of a gap of the trading price of target`s stock and the acquirers valuation of that stock in an intended takeover deal. TRIANGULAR ABITRAGE It results from discrepancy between three foreign currencies that occurs when the currency`s exchange rates do not exactly match up. These are rare opportunities and traders who take advantage of them usually have advanced computer equipments or programs automate the process. A trader employing triangular arbitrage would exchange an amount at one rate ( EUR/USD), convert it again (EUR/GBP) and then convert it finally back to the original (USD/GBP) assuming low transaction cost. Example Suppose you have 1 million and you are provided with the following exchange rates :EUR/USD=0.8631, EUR /GBP=1.4600 AND USD/GBP=1.6939 With these exchange rates there is an abitrager opportunity 1. sell dollars for euros :$1m *0.8631= euro863,100 2. sell euros for pounds :euro863.100/1.4600=pounds 591 164,40 3. sell pounds for dollars : pounds 591 164,40*1.6939=$1 001 373 4.subtract the initial investment from the final amount: $ 1 001 373-$1 000 000=$ 1 373 From these transactions you would receive an arbitrage profit of $ 1 373 (assuming no transactional cost and taxes)

LOCATIONAL AND COVERED INTEREST ABITRAGE This is when a trader tries to benefit from the discrepancies in the exchange rates between two banks for the same currency. These differences in exchange rates last only for a short period of time, so the traders need to act fast to benefit from such an opportunity. If there are any corrections in the exchange rate before a trader executes a transaction, then the trader could incur heavy loses . A primary reason why such a discrepancy in the exchange rate even exists is that there is no centralisation of the currency market. They do not face regulations since transactions are done Over The Counter (OTC) Example of locational arbitrage There are two banks X and Z we will be ignoring bid \ask spreads in this case bank X has USD/GBP of $1.50 , While bank Z has a USD /GBP rate of $1.40 to benefit from this

discrepancy the trader will simultaneously buy GBP from Z bank and sell the same to X bank . In this trade the trader ,would make a $0.10 for every GBP. In another example with a bid /ask spread. Suppose bank X offers a UDS/GBP rate of 1.50/1.55 and bank Z offers a USD/GBP rate of 1.56/1.58 .In this case there is an arbitrage opportunity if a trader buys 1 GBP from bank X for $1.55 and then sells the same to bank Z for $1.56 . In the transaction a trader would make $0.01 per GBP If we change the rates that bank Z offer to 1.54 /1.58 ,does the arbitrage opportunity still exist ? No, there is no arbitrage opportunity even if a trader buys GBP from bank X at $1.55, but the rate at bank Z is offering $1.54. So, the trader will lose $0.01 per GBP Covered interest rate arbitrage It is the use of a forward contract to hedge the exchange rate risk .In this an investor tries to benefit from the difference in interest rates between two markets and then use a forward contract to lower the exchange rate risk....