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Financial Risk Management

Prof. Dr. Jörg Prokop

Winter Term 2014/15

Course Contents
• Concept of risk management
• Mechanics of financial markets, in particular derivatives
markets
• Applications and limitations of financial derivatives in risk
management

Financial Risk Management

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Preliminary Course Outline
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.

What Is Risk?
Introduction to Derivatives
Mechanics of Futures Markets
Hedging Strategies Using Futures
Interest Rates
Determination of Forward and Futures Prices
Swaps
Properties of Options
Binomial Trees
The Black-Scholes-Merton Model
Conclusion

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Recommended Readings
• Hull, John C. Options, Futures, and Other Derivatives, 8th ed.,
Pearson 2012 [OFD]
main textbook (note: the older editions 6 or 7 will do as well)
• Hull, John C. Solutions Manual for Options, Futures, and Other
Derivatives, 8th ed., Pearson 2012
• Damodaran, Strategic Risk Taking: A Framework For Risk
Management, Pearson 2008 [SRT] (draft version: http://pages.stern.
nyu.edu/~adamodar/New_Home_Page/valrisk/book.htm)
• Hull, John C. Fundamentals of Futures and Options Markets, 7th ed.,
Pearson 2011
alternative textbook
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Preliminary Schedule
Date

Time

Room

Topic

Chapter

17 Sep

14.00-17.00

BC-207

• What Is Risk?
• Introduction to Derivatives

• SRT 1, 2, 4
• OFD 1

18 Sep

14.00-17.00

BC-208

• Mechanics of futures
markets
• Hedging strategies using
futures

• OFD 2
• OFD 3

19 Sep

09.00-12.00
14.00-17.00

BC-208
BC-208







30 Sep

10.00-13.00
14.00-17.00

BC-207
BC-208

• Binomial trees
• The Black-Scholes-Merton
model
• Conclusion / recap session

Interest rates
Forward and futures prices
Swaps
Properties of Options

OFD 4
OFD 5
OFD 7
OFD 9, 10

• OFD 12
• OFD 13,
14
• OFD 35

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Course Organization
• Assessment:
– Written examination, date tba
– The exam will be closed book. However, you will be
permitted a hand-written two-sided “cheat sheet” with
notes and / or formulae.
• Slides & course announcements
=> Moodle
• Best way to contact me:
finance.banking@t-online.de
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Defining Risk. 2. No. Free Lunch. 60. p. London 1988.“ (Hessen. Vol. Financial Analysts Journal. Volume II. ch. 6. 19-25 Basic Principle „There’s no such thing as a free lunch. 2004. 1. pp. 450) How does that relate to Finance and Economics? Financial Risk Management 8 . in: Eatwell/Milgate/Newman: The New Palgrave: A Dictionary of Economics.Financial Risk Management: What Is Risk? Suggested Reading: • SRT. 4 • Holton.

Holton. 2004) …? Financial Risk Management 9 What Is Uncertainty? Being uncertain about a proposition means: – that you do not know wether it is true or false (perceived uncertainty) or – that you are not aware of the proposition. Financial Risk Management 10 .g. Knight.g. 1921) Risk Uncertainty + exposure? (e...What Is Risk? Measurable uncertainty? (e.

g.. Financial Risk Management 11 Taking Risk Some situations that involve risk: • Trading natural gas. • asking for a pay raise. • military adventures. and • romance. Do organizations (e. • launching a new business. companies) take risk? Who does? Financial Risk Management 12 .What Is Exposure? Having exposure to a proposition means: • that you care whether it is true or false or • that you would care whether it is true or false if you were aware of the proposition. • sky diving.

Bernoulli in St. you may flip it again. If it comes up tails. we would be willing to pay a very (or even infinitely) high amount of cash to participate • However. = ∑ = ∞ 2 2 2 2 i =1 2 • Expected value: E = • Judging only on the basis of the game‘s expected value. If it comes up tails again. 1738) Financial Risk Management 14 .. and you receive your accumulated gains. Petersburg Paradox 1 1 1 1 ⋅1 + ⋅ 2 + ⋅ 4 + ⋅ 8 + .. In this case. 16 8 4 2 ∞ 1 1 1 1 1 = + + + + . – If it comes up heads. – You may continue the game to double your winnings as long as the coin does not come up heads. Petersburg Academy Proceedings. you receive one dollar. the experiment ends.. in reality most people would pay only a few $ St. Petersburg Paradox (first published by D..Why Do We Care About Risk? The St. • How much would you pay to participate in this game? Financial Risk Management 13 Why Do We Care About Risk? The St. Petersburg Paradox • Try the following: – Flip a coin. your winnings will be doubled.

chapter 10 Financial Risk Management 16 .” (Bernoulli. 1738.. 1954. Thus there is no doubt that a gain of one thousand ducats is more significant to a pauper than to a rich man though both gain the same amount. is dependent on the particular circumstances of the person making the estimate. 24]) How can we turn this idea into a decision model? Financial Risk Management 15 Expected Utility Theory • Bernoulli‘s approach: Utility functions Step 1: Assign a subjective utility value U (W ) to every potential outcome of the uncertain ~ target variable W [ ( )] ~ Step 2: Calculate the expectation value E U W of the distribution of uncertain utility values from step 1 Expected Utility Theory NB: The following discussion of Expected Utility Theory is partly based on Elton / Gruber / Brown / Goetzman: Modern Portfolio Theory and Investment Analysis. the utility. 6th ed. but rather on the utility it yields. Hoboken 2003. however. p.Expected Utility Theory “The determination of the value of an item must not be based on its price. The price of the item is dependent only on the thing itself and is equal for everyone. [cited in Econometrica 22(1).

9*1/5+30*2/5.4*1/4.(1/10)W2 Investment A: U(20) = 4*20 .(1/10)*182 = 39.6*1/4+38..4 etc.. = 26. = 34. Financial Risk Management 17 Example: Bernoulli-Principle • Probability distributions and utility profiles: Expected utility: E[U(WA)] = 40*3/15+39...(1/10)*142 = 36.98 E[U(WC)] = 39.3 E[U(WB)] = 39.6 U(14) = 4*14 . = 36.(1/10)*202 = 40 U(18) = 4*18 ..4 Resulting preference relation: W A f WC f WB Financial Risk Management 18 .6*5/15.Example: Bernoulli-Principle • Probability distributions of three investments: • Given utility function: U(W) = 4W ..

Characteristics of Utility Functions Example: „Fair gamble“ The investor‘s options: Financial Risk Management 19 Characteristics of Utility Functions (strictly) concave linear (strictly) convex Utility functions given: (1) Risk preference (e.. U(W) = W2) (2) Risk neutrality (e.g..g. U(W) = W0..5) Financial Risk Management 20 .g. U(W) = W) (3) Risk aversion (e.

sciencecartoonsplus.sciencecartoonsplus.php 22 .Risk Management Financial Risk Management http://www.com/gallery/risk/index.com/gallery/risk/index.php 21 Risk Management • Potential risk management actions: – Reduce risk exposure – Maintain current level of risk exposure – Increase risk exposure • Let’s focus on the first one: How can we reduce risk exposure? Financial Risk Management http://www.

2005. p. The Balanced Scorecard: Translating Strategy Into Action. 1996.) Financial Risk Management 23 Risk Management • Is the above definition „risk = uncertainty + exposure“ operational? „If you can‘t measure it..Risk Hedging Alternatives Natural Hedges • Borrow in the same currency that your asset risk is denominated in • Engineer flexibility into operations • Diversify • Improve forecasting • Match operating costs and revenues in the same currency • Optimize insurance policy • Share risks: joint ventures. you can‘t manage it!“ (Kaplan/Norton. Financial Theory and Corporate Policy. we need some adequate risk metrics Financial Risk Management 24 .e. 4th ed. sales agreements Financial Hedges • • • • Forwards Futures Options Swaps From Copeland/Weston/Shastri. 21) I.. 724 (mod. p.

inflation. or by their correlation coefficient (ρij): n σ ij ρij = σ ij = ∑ wk (~ rik − µi ) ⋅ (~ rjk − µ j ) σ i ⋅σ j k =1 Financial Risk Management 25 Systematic vs Non-Systematic Risk • Nonsystematic risk – Results from uncontrollable or random events that are firm-specific – Examples: labor strikes. j − µi ) 2 • The relationship between two investments’ return data can be described by their covariance (σij). the higher the expected return • We can characterize investments by their expected return (µi) and standard deviation of returns (σi): n µi = E[~ ri ] = ∑ w j ⋅ ~ ri .Risk vs Return • There is a trade off between risk and expected return • The higher the risk. lawsuits • Systematic risk – Attributable to forces that affect all similar investments – Examples: war. j σ i = σ i2 = j =1 ∑ w ⋅ (~r n j =1 j i. political events Financial Risk Management 26 .

1966) μ µM µ j = RF + β j (µ M − RF ) RF 1.Portfolio Selection: Combining Risky Investments (Markowitz. 1965 / Mossin. 1964 / Lintner. Journal of Finance 1952) can be eliminated through diversification cannot be eliminated through diversification Financial Risk Management 27 Expected Returns: The Capital Asset Pricing Model (Sharpe.0 β Risk-free  Required return Beta for  Market ×  − = Risk-free rate +   return rate   on investment j  investment j Financial Risk Management 28 .

Financial Risk Management 30 .Alpha • Alpha = extra return on a portfolio in excess of that predicted by CAPM so that µ P = RF + β P (µ M − RF ) α = µ P − RF − β P ( µ M − RF ) Financial Risk Management 29 Key Assumptions Underlying the CAPM • Investors are risk averse • Investors care only about an investment’s risk (σ) and expected return (µ) Implies either normally distributed returns or quadratic utility function • Unsystematic risks of different assets are independent • Investors focus on returns over one period • All investors can borrow or lend at the same risk-free rate • Tax does not influence investment decisions • All investors make the same estimates of µ’s. σ’s and ρ’s.

Journal of Economic Theory... pp. 1976. 341-360) • Assumptions: – Returns depend on several factors – Arbitrage-free markets (law of one price) • Expected return is linearly dependent on the realization of the factors µ i = α i + β i1 ⋅ µ I 1 + β i 2 ⋅ µ I 2 + . + β il ⋅ µ Il • Each factor is a separate source of systematic risk • Unsystematic risk is the proportion of total risk that is unrelated to all the factors Financial Risk Management 32 .Critique Regarding the µ-σ Framework • Quadratic utility function: – Implies negative marginal utility for certain (high) ranges of wealth – Implies increasing absolute risk aversion – Implies that investors are equally averse to good and to bad outcomes of the same absolute amount • Normal distribution of returns: – Skewness? – Kurtosis? – Jumps? Financial Risk Management 31 Digression: Arbitrage Pricing Theory (Ross.

and momentum arbitrage portfolios respectively. high minus low B/M.Digression: The Carhart (1997) Model E ( RS ) = RF + β SMkt ( E ( RMkt ) − RF ) + β SSMB E ( RSMB ) + β SHML E ( RHML ) + β SPR1YR E ( RPR1YR ) • In the Carhart (1997) model. Financial Risk Management 33 Approaches to Risk Reduction • Risk aggregation Aims to get rid of non-systematic risks with diversification • Risk decomposition Tackles risks one by one • In practice companies use both approaches Financial Risk Management 34 . small minus big. there are four factors representing the market risk premium. • The Fama-French (1993) three factor model is simply the four factor model without the momentum factor.

Applied Corporate Finance. In decision theory.. Petersburg Paradox? 2.Reducing Risk With Diversification Financial Risk Management Damodaran. 68 35 Recap Questions 1. p. Do you think this particular risk should be handled by risk decomposition or risk aggregation? Financial Risk Management 36 . What is the difference between systematic and nonsystematic risk? Which is more important to an equity investor? Which can lead to the bankruptcy of a corporation? 4. 3rd ed. How would you estimate the respective variables in practice? 5. What is the St. 2010. A company’s operational risk includes the risk of a very large loss due to employee fraud. what is considered a „fair gamble“? How does an investor‘s risk preference relate to her willingness to participate in a fair gamble? 3. Explain the CAPM formula.

Financial Risk Management: Introduction to Derivatives Suggested Reading: • OFD 2012. BIS Quarterly Review.000 600. ch.000 400.000 100. 1 Size of OTC and Exchange-Traded Derivatives Markets 700.000 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Over-the-counter Exchange-traded Source: Bank for International Settlements.000 200.335 billion US$ Financial Risk Management 38 . Amounts outstanding. in billions of US dollars Size of OTC and exchange-traded derivatives markets German GDP 2011: about 3.000 500.000 300. June 2012.

p.. 38. 193 Study on Derivatives Usage by NonFinancial Firms (2000/01) Financial Risk Management 39 Ways Derivatives are Used • To hedge risks • To speculate (take a view on the future direction of the market) • To lock in an arbitrage profit • To change the nature of a liability • To change the nature of an investment without incurring the costs of selling one portfolio and buying another Financial Risk Management 40 . Spring 2009. 1. Vol. Financial Management.Bartram et al. No.

.Forward Price • The forward price for a contract is the delivery price that would be applicable to the contract if it were negotiated today (i.e. it is the delivery price that would make the contract worth exactly zero) • The forward price may be different for contracts of different maturities Financial Risk Management 41 Terminology • The party that has agreed to buy has what is termed a long position • The party that has agreed to sell has what is termed a short position Financial Risk Management 42 .

Example • On July 20. 2008 • What are the possible outcomes? Financial Risk Management 43 Profit from a Long Forward Position Profit Price of Underlying at Maturity. 2007 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 2.900 for £1 million on January 20. ST K Financial Risk Management 44 .048.0489 • This obligates the corporation to pay $2.

Profit from a Short Forward Position Profit Price of Underlying at Maturity. a futures contract is traded on an exchange Financial Risk Management 46 . ST K Financial Risk Management 45 Futures Contracts • Agreement to buy or sell an asset for a certain price at a certain time • Similar to forward contract • Whereas a forward contract is traded OTC.

500 @ 2. of oil @ US$120/bbl.0500 US$/£ in March (CME) – Sell 1. Gold: An Arbitrage Opportunity? • Suppose that: – The spot price of gold is US$900 – The 1-year forward price of gold is US$1. of gold @ US$900/oz. in April (NYMEX) Financial Risk Management 47 1.020 – The 1-year US$ interest rate is 5% per annum • Is there an arbitrage opportunity? Financial Risk Management 48 .000 bbl. in December (NYMEX) – Sell £62.Examples of Futures Contracts • Agreement to: – Buy 100 oz.

Gold: Another Arbitrage Opportunity? • Suppose that: – The spot price of gold is US$900 – The 1-year forward price of gold is US$900 – The 1-year US$ interest rate is 5% per annum • Is there an arbitrage opportunity? Financial Risk Management 49 The Forward Price of Gold If the spot price of gold is S and the forward price for a contract deliverable in T years is F. In our examples.05) = 945 Financial Risk Management 50 . and r =0.2. T = 1. then F = S (1+r )T where r is the 1-year (domestic currency) risk-free rate of interest. S = 900.05 so that F = 900(1+0.

1. Oil: Another Arbitrage Opportunity? • Suppose that: – The spot price of oil is US$95 – The quoted 1-year futures price of oil is US$80 – The 1-year US$ interest rate is 5% per annum – The storage costs of oil are 2% per annum • Is there an arbitrage opportunity? Financial Risk Management 52 . Oil: An Arbitrage Opportunity? • Suppose that: – The spot price of oil is US$95 – The quoted 1-year futures price of oil is US$125 – The 1-year US$ interest rate is 5% per annum – The storage costs of oil are 2% per annum • Is there an arbitrage opportunity? Financial Risk Management 51 2.

Options • A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) • A put option is an option to sell a certain asset by a certain date for a certain price (the strike price) Financial Risk Management 53 American vs European Options • An American option can be exercised at any time during its life • A European option can be exercised only at maturity Financial Risk Management 54 .

150 0.025 0.275 5.56) Strike Price Oct Call Jan Call Apr Call Oct Put Jan Put Apr Put 15.650 4.450 • American Options • Contract size: 100 shares Financial Risk Management 55 Net Profit of a Call Strategy at Maturity (Strike $20) 2000 1500 Profit ($) 1000 500 0 0 5 -500 Financial Risk Management 10 15 20 25 30 35 40 Stock price ($) 56 .300 25.375 0.00 4.CBOE Intel Option Prices.100 3.950 5.450 5.875 1.375 1.700 22.50 2. 2006 (Stock Price: 19.650 0.125 0.575 1.50 0.00 0.025 0.125 0.450 5.775 3.725 2.275 17.150 0. Sept 12.725 20.075 0.150 0.175 1.00 0.475 0.300 2.950 3.

5) 2000 1500 Profit ($) 1000 500 0 0 5 -500 10 15 20 25 30 35 40 Stock price ($) Financial Risk Management 57 Options vs Futures/Forwards • A futures/forward contract gives the holder the obligation to buy or sell at a certain price • An option gives the holder the right to buy or sell at a certain price Financial Risk Management 58 .Net Profit of a Put Strategy at Maturity (Strike $17.

Business Snapshot 1.Types of Traders • Hedgers • Speculators • Arbitrageurs N.2. 15) Financial Risk Management 59 Hedging Examples • A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract • An investor owns 1. A two-month put with a strike price of $27.: Some of the largest trading losses in derivatives have occurred because individuals who had a mandate to be hedgers or arbitrageurs switched to being speculators (see for example Barings Bank. The investor decides to hedge by buying 10 contracts Financial Risk Management 60 .000 Microsoft shares currently worth $28 per share.B.50 costs $1. OFD p.

The current stock price is $20 and the price of a 2-month call option with a strike of $22.50 is $1 • What are the alternative strategies? Financial Risk Management 62 .000 to invest feels that a stock price will increase over the next 2 months.Value of Microsoft Shares With and Without Hedging Financial Risk Management 61 Speculation Example • An investor with $2.

but not yet endorsed) Financial Risk Management 64 .Arbitrage Example • A stock price is quoted as £100 in London and $200 in New York • The current exchange rate is 2.0300 $/£ • What is the arbitrage opportunity? Financial Risk Management 63 Accounting for Derivatives • Ideally hedging profits (losses) should be recognized at the same time as the losses (profits) on the item being hedged • Ideally profits and losses from speculation should be recognized on a mark-to-market basis • Roughly speaking. GAAP and IFRS (and many other accounting frameworks) attempts to achieve • EU: IAS 39 (financial instruments: recognition and measurement). to be superseded by IFRS 9 (issued Nov 2009. this is what the accounting treatment of futures under U.S.

provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’). (ii) part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking. commodity price.9) A financial asset or financial liability at fair value through profit or loss is a financial asset or financial liability that meets either of the following conditions. financial instrument price. credit rating or credit index. (a) It is classified as held for trading. and (c) it is settled at a future date.Derivatives: The IFRS Perspective (here: IAS 39. Financial Risk Management 66 . or (iii) a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument). or other variable. foreign exchange rate.9) A derivative is a financial instrument or other contract within the scope of this standard (see paragraphs 2-7) with all three of the following characteristics: (a) its value changes in response to the change in a specified interest rate. (b) (b) Upon initial recognition it is designated by the entity as at fair value through profit or loss. (b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. Financial Risk Management 65 How to Account for Derivatives (IAS 39. A financial asset or financial liability is classified as held for trading if it is: (i) acquired or incurred principally for the purpose of selling or repurchasing it in the near term. index of prices or rates.

85) • Definitions (IAS 39.11: An embedded derivative shall be separated from the host contract and accounted for as a derivative under this standard if. and only if: (a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract (see Appendix A paragraphs AG30 and AG33). liability. (b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative. […] Financial Risk Management 68 .10 & 11) 39. – Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument […]. a derivative that is embedded in a financial asset or financial liability at fair value through profit or loss is not separated). (IAS 39.Hedge Accounting (IAS 39) • Hedge accounting recognises the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item. Financial Risk Management 67 Embedded Derivatives (IAS 39.10: An embedded derivative is a component of a hybrid (combined) instrument that also includes a non-derivative host contract — with the effect that some of the cash flows of the combined instrument vary in a way similar to a standalone derivative. highly probable forecast transaction or net investment in a foreign operation that (a) exposes the entity to risk of changes in fair value or future cash flows and (b) is designated as being hedged […]. and (c) the hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in profit or loss (i.e. firm commitment.9): – A hedging instrument is a designated derivative […] whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item […]. […] 39. – A hedged item is an asset.

Suppose that a June put option to sell a share for $60 costs $4 and is held until June.e. Explain carefully the difference between selling a call option and buying a put option.Recap Questions 1. speculation. Explain carefully the difference between hedging. Under what circumstances will the seller of the option (i..20 cents per pound and (b) 51. What are the main ideas underlying the accounting treatment of derivatives according to IAS 39? What does the term “hedge accounting” mean in this context? Financial Risk Management 70 . 2. 3. 8. 7.30 cents per pound? 4. A trader enters into a short cotton futures contract when the futures price is 50 cents per pound. and arbitrage. the party with the short position) make a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating how the profit from a short position in the option depends on the stock price at maturity of the option. How much does the trader gain or lose if the cotton price at the end of the contract is (a) 48. The contract is for the delivery of 50. Describe the profit from the following portfolio: a long forward contract on an asset and a long European put option on the asset with the same maturity as the forward contract and a strike price that is equal to the forward price of the asset at the time the portfolio is set up. What is the difference between the over-the-counter market an the exchangetraded market? What are the bid and offer quotes of a market maker in the over-the-counter market? Financial Risk Management 69 Recap Questions 6.000 pounds.