Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 9

Managing Spot Risk

Spot trades are trades that involve an immediate exchange. This includes trades such as purchases of stock, purchases of gold, and exchanges of one currency for another. It excludes trades that involve a promise to deliver at some future time. Most of our study of risk involves future promises to deliver—unconditional promises constitute forward transactions, and promises whose payments are predicated on some future condition constitute options transactions.

The mathematical modeling and risk management of forwards and options are far more complex than the corresponding elements of spot transactions, and far more space in this book is devoted to forwards and options than to spot positions. However, positions in spot trades often constitute the largest portion of a firm's risk. Spot transactions are also the fundamental building blocks for valuing and risk managing forward and option positions. We can find the present value equivalent of a set of forward cash flows or the delta equivalent of an options position, but we then need to be able to value and risk manage these resulting spot positions. So a brief survey of the management of spot risk is in order.

9.1 OVERVIEW

All instruments traded by financial firms are commodities in the sense of not being individually identifiable. (If I borrow—that is, rent—a house from you, you expect me to return that exact same house, so houses are not a commodity; this is not true for dollar bills, bars of gold, barrels ...