Financial Markets and Instruments

Study Notes

If the return from investing in riskless instruments is more than the return from arbitrage trades, it makes sense to arbitrage, known as reverse-cash-and-carry arbitrage.
This arbitrage activity ensures that spot and futures prices stay in line with the cost-of-carry.
Exploiting arbitrage involves trading on the spot market.

Hedging is a risk mitigation mechanism.
A certain exposure in a security can be hedged by an equal and opposite transaction in the futures for the same security.
There are two types of risks: Unsystematic Risk (also known as Company Specific Risk or Diversifiable Risk) and Systematic Risk (also known as Market Risk or Non-diversifiable Risk).

Unsystematic risk is specific to a company and can be reduced through diversification.
Examples: change in government policy affecting the price of steel and company shares.

Systematic risk is associated with the overall market returns and cannot be reduced through diversification.
Examples: cultivating rice and missing out on high profits due to high demand for wheat, or vice versa.

The past two decades have seen exponential growth in international trade and business due to globalization and liberalization.
The demand for international money and financial instruments has increased significantly, leading to increased financial risk.
Derivatives have been developed to manage this risk and ensure commitments to prices for future dates.

A good index is a trade-off between diversification and liquidity.
Diversification reduces risk, but there are diminishing returns to diversification beyond a certain point.
Including illiquid stocks in an index can worsen the index due to contaminated information.
There are three computational methodologies for constructing stock market indices: Free Float Market Capitalization Weighted Index, Market Capitalization Weighted index, and Price Weighted Index.