Foundation of Risk Management

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© EduPristine FRM – I \Foundation of Risk Management
 Foundation of Risk Management

Risk Security market APT and

Tools for Risk Capital Market Performance
Sources of Risk Management & Beta line (SML) & multifactor ERM
Management Line (CML) Measurement
value creation CAPM model

© EduPristine FRM – I \Foundation of Risk Management 2

 Foundation of Risk Management

Risk Security market APT and

Tools for Risk Capital Market Performance
Sources of Risk Management & Beta line (SML) & multifactor ERM
Management Line (CML) Measurement
value creation CAPM model

Business risk: Specific for the Financial Risk: result of a firm's

business house. Ex: Increase in financial market activities; volatility
the prices of cement for a in various market related
construction company instruments
Ex: Depreciation of dollar effecting
company's foreign currency assets

Types of Financial Risk

Market Risk: risk of value
decrease due to change in prices
of assets in the market.
Liquidity Risk: risk of not being
able to quickly liquidate a position
at a fair price.
• Asset Liquidity: Large positions
affecting asset prices.
• Funding liquidity: Inability to
honor margin calls, capital
withdrawals. Ex: Lehman.
Credit risk: risk of loss due to
counterparty default.
• Sovereign Risk: Willingness and
ability to repay.
• Settlement Risk: Failure of
counterparty to deliver its
obligation
• Exposure & recovery rate:
Calculated on the happening of
a credit event.
Operation risk: risk due to
inadequate monitoring, systems
failure, management failure,
human error.
• Model risk, people risk, legal
and compliance risk

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 Foundation of Risk Management

Risk Security market APT and

Tools for Risk Capital Market Performance
Sources of Risk Management & Beta line (SML) & multifactor ERM
Management Line (CML) Measurement
value creation CAPM model

Derivatives is the most popular tool used by Risk Managers for RM.
Other tools include:
• Stop-loss Limit: Limit on the amount of losses in a position.
• Notional Limit: Maximum amount to be invested in a asset.
• Exposure Limit: Exposure to risk factors like duration for debt instruments & Beta for Equity
Investments.
• VaR: maximum loss at given confidence level.

Q.
PV (Before edging) ………….……….Probability
$200 0.10
$300 0.20
$400 0.30
$500 0.40
Debt $300
Bankruptcy Cost $75
PV (after hedging) Prob
$200 0.00
$300 0.25
$400 0.30
$500 0.45
Ans.
• Debt value = probability*expected payment to debt i.e. 10% * 125 + 90% *300 = 282.5
Equity value = probability * expected payment to equity i.e. 30% * 100 + 40%*200 = 110, Thus EV = 392.5
• If Hedging cost is 10 & after hedging PV are also shown as above
Debt value = probability * expected payment to debt i.e. 100% *300 = 300
Equity value = probability *expected payment to equity i.e. 0.30%*100 + 45%* 200 =120, Thus EV = 420 – 10 = 410
• Incremental benefit = 410 - 392.5 = 17.5

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 Foundation of Risk Management

Risk Security market APT and

Tools for Risk Capital Market Performance
Sources of Risk Management & Beta line (SML) & multifactor ERM
Management Line (CML) Measurement
value creation CAPM model

By handling bankruptcy costs:
Δ (Expected Value of firm) = Δ
(Present Value of firm) + Δ (PV
of bankruptcy costs) – Risk
management cost.
Firms can use risk
management to move their
income across time horizon
and reduce tax burden.
Reducing WACC: Also we can
reduce the tax outgo by
increasing interest outgo, but
expected financial distress /
bankruptcy costs because of
leverage hamper the firm value
beyond a level.
By Reducing The Probability of
Debt Overhang: Debt
Overhang refers to situation
where the amt of debt the firm
is carrying prevents the
shareholders from investing in
+ive NPV projects
By Reducing The Problem of
Information Asymmetry:
Information Asymmetry results
in two problems:
• Investors have to rely on
mgmt estimates for
profitability of new projects
• Extent to which the
performance is due to
management decisions or
external factors

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 Foundation of Risk Management

Risk Security market APT and

Tools for Risk Capital Market Performance
Sources of Risk Management & Beta line (SML) & multifactor ERM
Management Line (CML) Measurement
value creation CAPM model

• Systematic risk (non-diversifiable risk or beta): CML: When a risky portfolio is combined with
individual security's risk that arises because of the some allocation to a risk free asset, the
positive covariance of the security's return with resulting risk- return combinations will lie on a
overall market return's. Beta (βa ) = Cov (ra, straight CML. All points along the CML have
rp)/Var(rp) superior risk-return profiles to any portfolio on
• Unsystematic risk (diversifiable risk): part of the the Efficient Frontier
volatility of a single security's return that is
uncorrelated with the volatility of the market
portfolio.
CML
Return
Pe
Efficient
Frontier

Volatility

Fama And French Three Factor Model:

• A factor model that expands on the capital
asset pricing model (CAPM) by adding size &
value factors in addition to the market risk
factor in CAPM.
• This model considers the fact that value and
small cap stocks outperform markets on a
regular basis.
r = Rf + beta3 x ( Km - Rf ) + bs x SMB + bv x
HML + alpha

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 Foundation of Risk Management

Risk Security market APT and

Tools for Risk Capital Market Performance
Sources of Risk Management & Beta line (SML) & multifactor ERM
Management Line (CML) Measurement
value creation CAPM model

• Investors will only be compensated

systematic risk since Unsystematic risk can
be diversified.
• SML: indicates a return an investor should
earn in the market for any level of Beta risk.
• The equation of the SML is CAPM (return &
Code of Conduct systematic risk equilibrium relationship
• CAPM: E(Ri)=RF+βi[E(Rmkt)-RF]
• [E(Rmkt)-RF] is the risk premium

Principals Professional Standards

Efficient-market hypothesis: it is impossible to

1. Fundamental consistently outperform the market by using Asset
1. Professional Integrity Responsibilities any information that the market already return

Required return %
and Ethical Conduct 2. Adherence to knows SML
2. Conflicts of Interest generally accepted The three forms of market efficiency
3. Confidentiality practices of risk • Weak-form efficiency: future prices cannot
be predicted by analyzing price from the Risk-free
management past rate of
• Semi-strong-form efficiency: prices adjust return
to publicly available new information very
rapidly and in an unbiased fashion Beta
• Strong-form efficiency: prices reflect all
information, public and private, and no one
can earn excess returns

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 Foundation of Risk Management

Risk Security market APT and

Tools for Risk Capital Market Performance
Sources of Risk Management & Beta line (SML) & multifactor ERM
Management Line (CML) Measurement
value creation CAPM model

Single factor risk model:

• Risk appetite - is the amount of risk,
on a broad level, an entity is willing
to accept in pursuit of value. It
reflects he entity’s risk management
Multifactor model
philosophy, and in turn influences
the entity’s culture and operating
style.
Multifactor SML
• Factors affecting risk appetite:
E(r) = rf + βGDP(RPGDP) + βIR(RPIR)
existing risk profile; risk capacity;
risk tolerance; and attitude towards
• APT model – prices of portfolios are restored to
risk
equilibrium due to arbitrage activities
• Adopting risk appetite, steps –
• APT does not have restrictive assumption of
Develop risk appetite, communicate
CAPM
risk appetite (risk appetite
statement); and monitor

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 Foundation of Risk Management

Risk Security market APT and

Tools for Risk Capital Market Performance
Sources of Risk Management & Beta line (SML) & multifactor ERM
Management Line (CML) Measurement
value creation CAPM model

Treynor Ratio: Sharpe Ratio: Is Sortino Ratio (SR): Alpha: measure of Tracking error (TE): Relative Risk Q. Q.
Is the excess return the excess return Excess return assessing an active TE = σEp (Std. dev. W= ω *P Last 4 years, the Value of portfolio
divided by per unit divided by per unit divided by Semi manager's of portfolio's Information ratio: returns on a =100,
of market risk of total risk in an standard performance as it excess return over is defined as excess portfolio were 6%, Portfolio return σp
(Beta) in an investment asset: deviation(SSD) is the return in Benchmark index); return divided by 9%, 4%, & 12%. The = 25%
investment asset [E(RP)-RF]/σp, which considers excess of a Where Ep = Rp – TE. returns of the Portfolio
[E(RP)-RF]/βp where only data points benchmark index. Rb;Rp = portfolio E(RP)-E(Rb)/TE benchmark were benchmark σB =
Rp = portfolio that represent a • αi < rf: the return, Rb = 7%, 10%, 4%, & 20%
return, Rf = risk loss. More relevant manager has benchmark return 10%. The minimum Correlation, ρPB
free return when the destroyed value • Lower the acceptable return =0.961
distribution is • αi = rf: the tracking error is 7%. What is the Calculate TEV
more skewed to manager has lesser the risk portfolio's SR? Ans. ω = √(0.252 +
the left. (Rp – MAR) neither created differential 0.4743 0.202-2*0.961*
/ SSD, MAR is nor destroyed between 0.25* 0.20) = 8%
minimum accepted value portfolio and the Relative risk =
return, Higher the benchmark 8%*100 =8
• αi > rf: the
index
SR, lower is the risk manager has TE Volatility(TEV)
of large losses created value = ω = √(σA2 - 2*
• The difference ρAB* σA* σB+ σB2)
αi − rf is called
Jensen's alpha
Jensen's α excess
return of a stock,
over its required
rate of return as
determined by
CAPM: α = Rp – Rc;
where Rp =
portfolio return,
Rc = return
predicted by CAPM

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Types of Risk Management
LTCM
Failure
• Risk metrics failure. • LTCM was a hedge fund using highly
leveraged arbitrage trading activities
Ex: MRM & LTCM
in fixed income in addition to pairs
• Incorrect
trading. Before failing in 1998, it had
measurement of
given spectacular returns in 1995-97
known risks. Ex: MRM
periods (upto 40% post-fees). Post
& LTCM.
Russian default on its ruble
• Ineffective risk denominated debt, LTCM lost more
monitoring. Ex: than 4bn USD in 4 months.
Barrings & Sumitomo • LTCM used proprietary mathematical
• Ineffective risk models to engage in arbitrage trading
in U.S., Danish, Russian, European and
communication
Japanese Govt. bonds. In 1998, LTCM's
• Ignorance of
positions were highly leveraged (1:28)
significant known
with ~ USD 5: 130 billion of equity and
risks. Ex: MRM &
assets.
LTCM. • LTCM's model assumed maximum
• Unknown risk. volatility of 20% annually. Based on its
models, it was expected to losses
more than ~500 million USD in once in
20 months.
• It had its bet on convergence of
Russian & American G-sec yield, which
however diverged after Russian
default.. Its failure led to a huge
bailout by large commercial &
merchant banks under the guidance
of Federal Reserve
• It had various risk exposures ….such as
Model Risk, Funding liquidity risk,
Sovereign Risk, Market Risk.
© EduPristine FRM – I \Foundation of Risk Management
Foundation of Risk Management
(Case Studies)
Metallgesellschaft (MRM)
• Nick Lesson, trader at Baring PLC, took
• It used Stack and roll hedging strategy
• In 1991, it offered fixed price contract
for supplying gasoline for 5 to 10
years. In order to hedge MG took long
positions in near month futures and
rolled the stack into next near month
contract every time by decreasing the
• Lesson was solely responsible for back
trade size gradually so as to match the
stack with pending short position (in
long term supply contracts).
• MG bought futures on NYMEX to
offset its forward commitments
exposure with hedge ratio of one
• He kept on selling straddles on Nikkei
(every barrel was hedged).
• As these derivatives were short-term
thus MRM had to roll them forward
every month-end or term-end till 5-10
years or the contract's end.
• He kept on building his positions even
• Company was exposed on rising spot
prices. It eventually lost more than
USD 1.5bn in 1993.
• It had various risk exposures ….such as
Basis Risk, Market Risk, Funding
• It eventually led to the collapse of
Liquidity Risk.
• It had various risk exposures …such as
Q.
Which of the following reasons does
not help explain the problems of LTCM
in August and September 1998?
a. A spike in correlations
b. An increase in stock index volatilities
c. A drop in liquidity
d. An increase in interest rates on
on-the-run Treasuries
Ans.
D, An increase in interest rates on
on-the-run Treasuries
Baring Sumitomo
• Yasuo Hamanaka - copper trader at
concentrated positions Nikkei 225
Sumitomo manipulated copper prices
derivatives for bank in Singapore
on London Metal Exchange.
International Monetary Exchange
• Fall in copper prices in June 1996 after
(SIMEX). He took arbitrage positions
revelation of Hamanaka's unfair
on Nikkei derivatives on different
dealings led to ~2.6bn USD loss for
exchanges viz. Osaka, Tokyo & SIMEX.
Sumitomo
• Positions were so large that company
& front office operations of
could not liquidate them completely
Singapore. He used an error account
• Hamanaka used his independence to
hide his losses by fraudulently
trade in the market on behalf of the
transferring funds to & from his error
company and manipulated the copper
accounts
prices by buying physical copper in
large quantities and storing in the
futures with an assumption that
warehouse thereby creating lack of
Nikkei is under-priced. He took double
copper in the market
long exposure on the same index from
• He sold put options to collect the
different exchanges.
premiums as he thought he can push
the prices up & thus writing put
after Nikkei kept on falling, however
options was not risky for him
after Jan'95 earthquake, he could not
• Though, he never imagined that he
sustain his positions & failed to honor
could be susceptible to steep decline
the margin calls
of copper prices
• It had various risk exposures ….such
Barings bank, when it was sold to ING
as Operational Risk, Employee/
for mere $1.60 only
People Risk, Liquidity Funding Risk,
Market Risk
Operational Risk, Market risk,
Employee/People risk
10
 Foundation of Risk Management
(Case Studies)

Types of Risk Management

LTCM
Failure

UBS LTCM
Drysdale Chase Manhattan Bank

Investors
• Losses between 1.1 Bn and 1.4 Bn from 1997-8
• UBS held a large position in LTCM (40% direct, 60% Options)
Inexperienced Mangers: • Equity Derivatives team not scrutinized by Corporate Risk Team
Capital: $20 Mn
1. Thought they were just • Head of Analytics – compensation was in line with fund
Borrowed
middlemen performance
Debt Market: $300 Mn
2. Didn't realize contract • Equity Derivative Losses due to:
(Unsecured Loan)
indicated Chase taking full ― Change in British Tax Laws regarding valuation of long dated
responsibility of debt stock options
― Large position in Japanese Bank Warrants (were not
adequately hedged)
― Correlation assumptions on long dated equity options was
not in line with the rest of the market
― Modeling Deficiencies

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© EduPristine FRM – I \Foundation of Risk Management