Chapter 

4: Identify Major 
Financial Risks

Lecturer : Amadeus GABRIEL

Sup de Co La Rochelle
 Major financial risks

Foreign exchange risk

Interest rate risk

Commodity price risk

Equity price risk

Credit risk

Operational risk

Liquidity risk

Systemic risk
 Interest rate risk

Changes in the level of interest rates (absolute
interest rate risk)

Changes in the shape of the yield curve (yield
curve risk)

Mismatches between exposure and risk
management strategies (basis risk)
Absolute interest rate risk

Borrower: higher interest rates → higher project
costs

Lender: decline in interest rate → lower interest
income

The greater the duration, the greater the impact
of an interest rate change

Hedging tools in next chapter
 Yield curve risk

Changes in the relationship between short- and
long-term interest rates

Normally, upward-sloping → LT interest rates are
higher than ST rates due to higher risk for lender

Interest rate differential affects profitabilit

If there is a mismatch between assets and
liablities within a company → this risk should be
assessed

Basis risk → relationship between futures and
spot prices change, not in the same magnitude
as interest rates do
 Foreign exchange risk

More details in chapter 6

Companies that buy or sell in a foreign currency
have transaction exposure

Translation exposure → assets, liabilities, or
profits are translated from operating currency
into a reporting currency

Commodity prices → many commodities are
priced in USD
 Commodity risk

Commodity price risk → changes of price for
products that must be purchased

Commodity quantity risk

Commodity basis (difference between spot and
future price)

Special risks (physical aspects such as
transportation, spoilage, etc.)
 Credit Risk

Exposure to a counterparty

Default risk

Counterparty Pre-Settlement Risk (replacement
contract at less favorable prices)

Counterparty Settlement Risk (fails to settle a
payment)

Sovereign or country risk

Concentration risk (poorly diversified sectors)

Legal risk (Is the counterparty legally
authorized?)
 Operational risk

Human Error and Fraud

Procedural risk (inadequate controls)

Technology and Systems Risk
 Other risks

Equity risks: risks linked to equity prices

Liquidity risks: ability to sell or buy a security
on the market or insufficient liquidity within a
company

Systemic risk:
Affects the whole market (financial crisis), difficult
to mitigate
 Valuation and risk

Hedging via e.g. derivatives allow to
potentially reduce or eliminate financial risks

However, how do we determine valuations and
risk for the most common financial
instruments ?

Recall: bonds, stocks, etc. are common assets
for banks and insurances
 Valuation and risk

Again, the coefficient of variation is one
common measure to compare securities that
have different expected returns

Example: Which stock is riskier ?

Stock Stock B
A
Expected return 19 % 15 %
Standard Deviation 14,28 3,16 %
%
 Valuation and risk

Common risks which are associated with financial
and investment decisions:

Business risk (EBIT, variability in demand, leverage,
etc.)

Liquidity risk (can it be sold on short notice for its
market value ?)

Default risk (ability to pay back debt)

Market risk (asset prices are somewhat correlated
with market developments)

Interest rate risk (e.g. if interest rate rises, bond
prices fall)

Purchasing power risk (inflation risk)
 Portfolio risk

The risk of a portfolio ( p ) is not simply the
weighted average of the standard deviations of
the individual assets in the contribution

It is also dependent on the correlation
coefficient ρ (rho)
 Portfolio risk

Example:


Portfolio risk is then:
 Portfolio risk

If correlation is equal to 1 (perfect correlation between A
and B)


If correlation is equal to 0 (A and B are not correlated)


If correlation is equal to -1 (perfect negative correlation)
 Portfolio risk

Diversification can minimize portfolio risk.

Look at the following data

Year Security X Security Y Security Z

1 10 50 10

2 20 40 20

3 30 30 30

4 40 20 40

5 50 10 50

E(r) 30 30 30

σ 14,14 14,14 14,14

 Portfolio risk

Suppose 50/50 diversification

Year Security XY Security XZ

1 30 10

2 30 20

3 30 30

4 30 40

5 30 50

E(r) 30 30

σ 0 14,14
 CAPM

A security risk consists of two components – diversifiable
risk and nondiversifiable risk

Business, liquidity, default risk are diversifiable

Purchasing power, interest rate and market risk are
nondiversifiable

Systematic risk is measure by the beta coefficient
 CAPM

A security risk consists of two components – diversifiable
risk and nondiversifiable risk

Business, liquidity, default risk are diversifiable

Purchasing power, interest rate and market risk are
nondiversifiable

Systematic risk is measure by the beta coefficient
 Bond valuation

Three elements:
1.) amount of cash flows to be received
2.) the maturity date of the loan
3.) the investor's required rate of return
 Bond valuation

Example:Consider a bond, maturing in 10 years and having a
coupon rate of 8 percent. The par value is 1000. Investors
consider 10 percent to be an appropriate required rate of
return in view of the risk level associated with this bond.


V = 80 * PVIFA(10 %,10) [check table] + 1000/(1 + 0,1)^10 =
877,07

Required return on a bond is also called « Yield to maturity »

You can determine it by solving for r, where V is the market
price of the bond

Use trial and error or more sophisticated numerical solutions

Approximately,
 Interest rate risk of a debt
instrument

Macaulay's duration coefficent and interest elasticity

Example: Bond with 7 % coupon rate, 1000 face value, 3
years till maturity and YTM of 6 %

Year Cash flow PV factor PV of Cash PV as Weighted

at 6 % flow proportion duration
of price
1 70 1/1,06 = 66,04 0,0643 0,0643 *1 =
0,9434 0,0643
2 70 1/1,06² = 62,30 0,0607 0,0607 * 2=
0,89 0,1214
3 1070 1/1,06³ = 898,39 0,8750 2,6250
0,8396
1026,73 1 2,8107
 Interest rate risk of a debt
instrument

This 3-year bond’s duration is a little over 2.8 years.
Although duration is expressed in years, think of it as a
percentage change. Thus, 2.8 years means this particular
bond will gain (lose) 2.8 percent of its value for each 1
percentage drop (rise) in interest rates. Note, however,
that duration will not tell you anything about the credit
quality or yield of your bonds.

Interest rate elasticity = % change in bond price/ % change
in YTM

It will always be negative, thus (-1)E = D*(YTM/(1 + YTM))

In this example, (-1)2,8107*(0,06/1,06) = 15,91 %

Principal value for each 1 percentage point move in
interest will gain or lose 15,91 %