# AFF9260 Australian capital markets WEEK 5 –Tutorial Questions: Risk and Uncertainty

1. The table below shows the probability distribution of shares prices for Company . !a" Calculate the e#pected \$alue of this share price !b" Assume that Company shares ha\$e a lon%&term standard de\$iation of returns of 0.'(. )f the shares of Company * ha\$e an e#pected return of 9.1(+ and a standard de\$iation of 0.'2, which company-s shares would be selected by a risk a\$erse in\$estor and why. Share return (%) Pro a ility

7.95 7.49 8.12 8.42 8.96 9.12 9.25 9.36 9.75 8.75 7.85
2.

0.08 0.06 0.04 0.07 0.08 0.18 0.16 0.12 0.07 0.09 0.05

A risk neutral in\$estor is plannin% to in\$est his money for one year. )f there is /ero inflation he would be willin% to in\$est at 10+ per annum. )n fact he e#pects that the inflation rate o\$er the comin% year will be '+ per annum & what is the minimum interest rate he would accept in this case. 0ohn approaches a bank for a loan for one year. The risk a\$erse bank has assessed the credit risk of 0ohn, and has decided that 0ohn is a risky borrower with an e#pected default rate of 0.01+. The bank is willin% to lend to 0ohn, pro\$ided he pays an interest rate which yields the bank an e#pected return of 11+ per annum. 2hat interest rate would they char%e. !Assume /ero inflation"

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*riefly e#plain !1&2 sentences" what is \$olatility, e#cess return, and hed%in%.
3olatiliy 4 refers to the amount of uncertainty or risk about the si/e of chan%es in a security5s \$alue. 6#cess return 4 )n\$estment returns from a security or portfolio that e#ceed a benchmark or inde# with a similar le\$el of risk.! total return of an asset or security portfolio less the risk&free return" 7ed%in% 4 8the practice of mana%in% risk e#posure, usually by takin% contracts !such as deri\$ati\$es" that ha\$e an offsettin% e#posure- and 8a process of establishin% a second position to counterbalance an e#posed e#istin% position-.

1.

6#plain the concept of a risk&return trade&off.

The risk9return tradeoff is the balance between the desire for the lowest possible risk and the hi%hest possible return. 6. :isk mana%ement is important to the lon%&term sur\$i\$al of a corporation !a" ;efine and e#plain the nature of risk. &:isk is the possibility or probability that somethin% may occur that is une#pected, not anticipated. &:isk adds uncertainty to the business mana%ement and forecastin% processes. &A business is e#posed to both operational risks and financial risks.

Ei\$en a decision to mana%e a risk. The company approaches Je%a *ank Gimited to establish an intermediated \$anilla swap. the **I2 is 6. e#tent and scope of risk e#posures will \$ary dependin% on the business operationB for e#ample. !a" 2hat is an intermediated \$anilla swap. measured. The board of directors of an or%anisation is responsible for the determination and documentation of all risk mana%ement ob=ecti\$es. *efore an or%anisation can be%in to mana%e risk e#posures it needs to know what those e#posures areB therefore it is necessary to identify all potential risk e#posures relatin% to all financial and operational components of a business. . 3iney > ?hillips 1@ A '. or if. 7ow much is the payment. how the risk mana%ement ob=ecti\$es will be implemented. <F :esources Gimited has recently issued H10 million in floatin% rate notes in order to fund the ne#t sta%e of an e#ploration pro=ect. the risk is to be mana%ed.C1 per cent per annum. calculate the a\$era%e returns and the standard de\$iations for shares X and Y.iscuss who is responsible for the establishment of risk mana%ement ob=ecti\$es. 609. @. . !b" 2hat is the purpose of risk mana%ement.iscuss the lo%ic and reasons behind the contention that risk must be identified. 3iney > ?hillips 1@ A 1'. The notes pay an annual coupon of **I2 plus 210 basis points. p. &To miti%ate potential ne%ati\$e operational and financial impacts of risk. &To establish robust risk mana%ement ob=ecti\$es. measured and mana%ed. p. )t is often ar%ued in the risk mana%ement literature that risk must be identified. &To protect personnel.10 per cent per annum and a reference rate of the 12 month **I2. p. *ased on this Duantitati\$e analysis. Kse the followin% returns.strate%ies and reportin% structures. &Financial risks affect business cash flows and the \$alue of balance sheet assets and liabilities. The chief e#ecuti\$e officer and e#ecuti\$e mana%ement will establish risk mana%ement procedures. procedures and strate%ies that result in all risk e#posures bein% identified. a minin% company will be e#posed to a different ran%e of risks than would a financial institution or a hotel chain. !c" . &To ensure an or%anisation is aware of the risks associated with all aspects of its business operations. 9. The swap contrast sets a fi#ed rate of 6. . 609. procedures and strate%ies in a corporation. and mana%ed. %i\$en a ran%e of scenarios. it will determine related risk mana%ement policiesB that is. &To ensure personnel consider the risk outcomes that deri\$e from their business decisions. The procedures and strate%ies are de\$eloped within the constraints of the risk mana%ement ob=ecti\$es and policies set by the board.raw and fully label a dia%ram showin% all the applicable interest rates at that date. C. policies. <nce a risk e#posure is identified it is necessary to measure the potential operational and financial impacts of the e#posure. 3iney > ?hillips 1@ A 1. 2hy don-t both parties need to make a payment. the or%anisation will determine alternati\$e strate%ies that may be appropriate to mana%e the risk determine the most suitable strate%y and put procedures in place to implement the strate%y. !b" At the first interest payment date. 610. The number. policies. !c" 2hich party to the swap contract is reDuired to make the first payment.AFF9260 Australian capital markets &<perational risks impact upon the normal day&to&day functions of a business. <nce the board has determined the ob=ecti\$es !which risks must be mana%ed". an or%anisation will decide how. measured and mana%ed.

21 0.11 0.17 0.14 0.08 0.08 0.18 0.06 0.27 0.12 0.21 0.19 0.06 Y .24 X 0.08 0.06 0.AFF9260 Australian capital markets Returns 1 2 3 4 5 6 7 8 year 0.