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You are on page 1of 31

Week 1

Introduction to Risk, Risk

Management and Derivatives

1

Week Outline

Administration:

Unit Rationale, Aim, Objectives, Content, Assessment,

Resources

Risk:

Definition, Classifications, Measurement

Risk Management:

Definition, Irrelevance Proposition, Relevance

Derivatives:

Definition, Forward/Futures, Options, Swaps

Readings:

Stulz (2003) Risk Management and Derivatives, pp. 30-75.

Hull et al. (2013) Fundamentals of Futures and Options, Ch. 1.

RiskMetrics (1996) Technical Document, pp. 5-7.

2

Unit Rationale

Sound financial management and oversight requires

an understanding of the risks that arise through

financial exposures and how these risks can be

managed. Building on the introductory finance units,

and with a focus on the risk associated with

movements in market prices (market risk), this subject

introduces students to specialised knowledge and

skills for identifying, measuring, managing and

hedging risk. As derivative securities are an important

tool in risk management, this unit introduces a wide

range of derivatives securities and examines their

pricing and use in managing and hedging risk.

Unit Aim

This unit develops knowledge and skills required to

identify, measure and hedge the risks associated with

an exposure to financial securities. It also develops

knowledge of a variety of derivative contracts with a

specific focus on how these securities are priced and

how they are used to manage and hedge risk.

Additionally, students will develop their self reflection

skills in considering their application of financial

knowledge and reasoning, and in exercising

responsibility and accountability for their own

learning.

Unit Objectives

Upon completion of this unit, you should be able to:

1. Demonstrate and apply knowledge of financial

derivatives, markets, pricing methodologies and

evaluate their use in risk management

2. Demonstrate, analyse and apply knowledge of risk

management measures and practices

3. Apply knowledge, judgement, technical and

technological skills to solve problems related to the risk

management of diverse portfolios

4. Exercise self-reflection, responsibility and

accountability in relation to own learning and

professional practice

Unit Content

Week 1: Introduction to Risk, Risk Management and

Derivatives

Week 2: Financial Statistics

Week 3: Value-at-Risk 1

Week 4: No Classes Ekka Public Holiday

Week 5: Value-at-Risk 2

Week 6: Forwards and Futures: commodity and equity

Week 7: Forwards and Futures: interest rates

Week 8: Mid-Semester Exam and Reflective Practices

Week 9: Swaps: interest rate

Week 10: Options: introduction and pricing with the binomial model

Week 11: Options: pricing with the Black-Scholes model

Week 12: Options: trading strategies and risk management

Week 13: Derivative Disasters

Week 14: Revision

6

Unit Assessment

Assignment (30%)

Part A (week 6) covers risk management

Part B (week 12) covers derivative pricing and hedging, and

reflective practices

Multiple Choice, 1 hour + 15 minutes perusal

Topics 1-5

Approx. Week 8 in lecture time

Short Answer, 2 hours + 10 minutes perusal

Topics 1-12 but will have greater focus on Topics 6-12

Central Exam Period

7

Unit Resources

Required References

Hull, J., Treepongkaruna, S., Heaney, R., Pitt, D. and Colwell,

D. (2014). Fundamentals of Futures and Options Markets.

Frenchs Forest, NSW: Pearson.

RiskMetrics (1996). Technical Document 4ed. New York, NY:

J.P.Morgan/Reuters. http://

www.msci.com/resources/research_papers/technical_doc/19

96_riskmetrics_technical_document.html

Other References

Stulz, R. (2003). Risk Management and Derivatives. Mason,

OH: Thomson.

Chance, D. and Brooks R. (2010), Derivatives and Risk

Management (8th ed.). Mason, OH: South-Western.

8

Risk

Defined

We define risk as the degree of uncertainty of future

net returns (RiskMetrics, 1996, p. 5).

The chance that an investments actual return will be

different than expected, (Investopedia, http://

www.investopedia.com/terms/r/risk.asp)

It is the absence of certainty.

Risk

Classifying risk in finance

Operational Risk: loss due to human or system errors

Liquidity Risk: loss due to inability to access funds

Market Risk: loss due to changes in market factor (e.g.

price or yield)

Note that I have used the word loss here while the earlier

definitions simply refer to deviations from expectations.

There is some debate about what constitutes risk. The point

here is that risk is generally associated with the downside

but can be thought of as downside and upside. If the

distribution of returns is symmetric, the deviations on the

downside are the same as the deviations on the upside.

10

Risk

Order the following securities according to their risk

A 3-month U.S. Government T-Bill

A 1-year Australia Government Bond

A 10-year Australian Government Bond

A USD/AUD 6-month currency forward

An A class security for securitisation

The first-loss security for a securitisation

A Woolworths Stock

A BHP Stock

An Iron-ore Futures Contract

An Oil Futures Contract

An at-the-money BHP Call Option

A deep-out-of-the-money BHP Call Option

11

Risk

Measuring risk

Credit Risk

credit rating (AAA, AA, )

probability of default and expected loss given default

Market Risk

duration and convexity: for bonds and interest rate

derivatives.

variance or beta: for stocks for equity derivatives

delta and gamma: for options

value-at-risk: for all securities

Liquidity Risk

liquidity ratio

Operational Risk

?

12

Risk

Why risk matters

It affects value

Ultimately, there is a risk/return trade-off.

It informs and regulates decision makers

Does the investment generate sufficient return for its

risk?

Should the firm hedge?

What expected losses can occur?

How can value or price change and what exposures

should be held?

What is the probability of bankruptcy or default?

It affects behaviour

Are the managers incentives correctly aligned with the

risk appetite of the firm owners?

13

Risk

What

is the assets value?

where:

is the required rate of return of cash flows at time

is some finite amount of time in the future

is the production function that allows to vary through time

Expanded:

14

Risk

Credit Risk. As credit

worthiness degrades,

yield increases.

BBB Corp.

A Corp.

AAA Corp.

AA QLD GOV

AA Corp.

AAA AUS GOV

Risk. Upwardly sloped

curves. Note that

slope of yield curves

includes the markets

expectations of future

rates. Hence, its

difficult to conclude on

the exact levels

expectations, market

risk and liquidity

components.

Refer to term structure

15

theories for more

Risk

Bond Price Sensitivity

Yield (y)

C = 0.1, T = 3

C = 0.1, T =

10

C = 0.0, T =

10

11%

97.556 (2.444%)

94.111

(5.889%)

35.218

(8.653%)

10%

100.000

100.000

38.554

102.531

42.241

where C =9%

annual coupon

percentage 106.418

and T = maturity

in years

(2.531%)

(6.418%)

(9.563%)

Longer dated bonds are more sensitive to changes in yield

Bonds with higher coupons are less sensitive to

Up/Down

changes for a shift in yield are not the same

yield changes

16

(theyre asymmetric)

Risk

Duration

defined

approximation to the ratio of the proportional change in

the bond price to the absolute change in its yield (Hull

et al., 2013, p. 546).

Well do more with

duration in later weeks, but as a start

approximated by

17

Risk

Duration example

Yield

C = 0.1, T = 3

C = 0.1, T =

10

C = 0.0, T = 10

10%

100.000

100.000

38.554

2.736

6.759

10.000

9%

102.531

106.418

42.241

100.000 +

100.000 +

38.554 +

0.01 x 2.736 x

0.01 x 6.759 x

0.01 x 10.000 x

100

100

38.554

/ 1.10

/ 1.10

/ 1.10

Note the following: = 102.487

= 106.145

= 42.059

Longer dated bonds are more sensitive to changes in yield

Bonds with higher coupons are less sensitive to

changes

yield

Duration

only approximates price changes. It works best

when yield change is small. You need to measure

convexity

for greater

accuracy

Duration

is linearly

additive

useful in portfolio and risk

18

management

Risk

E[R

]

E[R

]

M

P

Return

Risk

Rf

Rf

Risk

(STD)

Risk

(Beta)

19

Risk

Assuming normality the Value-at-Risk (VaR) is

There is a 2.5% probability to experience a loss of 6.91% or

more in the next month. Or, in dollar terms, for every $1,000,000

invested there is a 1 in 40 chance that youll lose $69,100 or

more in the next month

2 x STD

Based on the empirical rule of the

normal distribution, 5% of

observation lie two STDs or more

from the mean. As the normal

distribution is symmetric, area in

left tail below -0.0691 is 2.5%

-0.0691

0.0151

20

Risk Management

Defined

Risk Management is the practice of defining the risk

level a firm desires, identifying the risk level the firm

currently has, and using derivatives and other financial

instruments to adjust the actual level of risk to the

desired level of risk. (Chance and Brooks, 2007, p. 519).

The process of identification, analysis and either

acceptance or mitigation of uncertainty in investment

decision-making. (Investopedia, http://

www.investopedia.com/terms/r/riskmanagement.asp)

21

Risk Management

Risk Management Irrelevance Proposition

a firm cannot create value by hedging risks when it costs the

same for the firm to bear the risks directly than to pay capital

markets to bear them (Stulz 2003, p. 45).

Consider:

Diversifiable Risk: removing diversifiable risk does not change

the assets expected cash flows or required rate of return.

Furthermore, shareholders can perform this task themselves.

Systematic Risk: reducing systematic risk reduces both the

expected cash flow and the required rate of return.

Furthermore, shareholders can perform this task themselves.

22

Risk Management

Risk Management Irrelevance Proposition

Relies on the assumption of perfect capital markets. That

is,

No transactions costs

No taxes

Equal access to information

Rational Investors

In this instance, the law-of-one price holds such that the

return to shareholders for bearing the risk is the same as

the cost to transfer the risk to capital markets. Hence, no

value added!

identify how it creates value.

23

Risk Management

Maybe not!

Risk Management is the practice of defining the risk level a firm desires,

identifying the risk level the firm currently has, and using derivatives and

other financial instruments to adjust the actual level of risk to the

desired level of risk. (Chance and Brooks 2007, p.519).

It does not mention value!

Back to value

For value to exist, the return for the firm bearing risk must differ from the

markets return.

Dead Weight Loss (costs and lost investment because of capital shortfall)

Bankruptcy and Financial Distress Costs (fees, management time, lost investment)

Homemade Hedging (costs, inability, information asymmetry)

Tax (changes, carrybacks and carryforwards, other tax shields)

Capital Structure (increases debt carrying capacity tax exists)

Stakeholders (relates to financial distress in terms of their willingness to invest.)

Debt Overhang (accept negative NPV investments and reject positive NPV investments)

24

Risk Management

Example:

Bankruptcy Costs from Stulz (2003,

pp. 57-58)

Gold mine

Output = 1,000,000 ounces

, where

Unhedged: =

Hedged:

bankruptcy?

25

Risk Management

Example:

Bankruptcy Costs from Stulz (2003,

pp. 57-58)

Gold mine

Output = 1,000,000 ounces,, , where

, gold spot price is normally distributed with mean of 0 and STD =

0.2

Unhedged:

Hedged:

=

=

26

Risk Management

Example:

Debt Overhang from Stulz (2003, pp.

70-71)

Output = 1,000,000 ounces,, , , , where

, its +ve NPV

without project: + =

PV Debt =

309.52

with project:

PV Debt =

314.29

PV Equity = 23.81

+=

PV Equity = 28.57

required.

Risk Management that reduces the probability of the debt overhang

27

Derivatives

Defined:

An instrument whose price depends on, or is derived from, the

price of another asset (Hull et al. 2013, p. 546).

Derivatives are financial instruments whose returns are derived

from those of other financial instruments. (Chance and Brooks

200X, p.1).

Written On:

Stocks, Bonds, Commodities, Currencies and Events

Major Types:

Futures: an exchange traded forward that is marked-to-market daily

Swaps: a bundle of forwards

Options: the right but not the obligation to buy or sell

Derivatives offset an existing exposure or create an exposure

Hedgers, Portfolio Managers, Speculators and Arbitrageurs

28

Derivatives

Forward/Futures

Payoff

time in the future at a set price for goods of a particular quality

delivered to a set location.

An futures contract is an agreement made today to exchange a

specified asset at a specified price at a specified date in the

future.

Trading, Pricing, Hedging, Risk Management, etc. discussed in

Where:

later weeks.

- F0,T is the forward price set at day 0 for

Exposure: Long (bought) Forwardforward that matures at T.

0

F0,T

ST

Note:

- V0, which is the value of the forward

contract at 0, is 0; V0 = 0.

- However, Vt, which is the value of the

forward after 0 but only up to T, can b

29

positive or negative.

Derivatives

Options

Payoff

Payoff

transaction to occur at some time in the future on terms and

conditions agreed upon now.

Trading, Pricing, Hedging, Risk Management, etc. discussed in

later weeks.

Lots of jargon including, put, call, writer, American, intrinsic

Long Call

Long Put

value, etc.

Where:

Exposure:

- X is the exercise price

0

X

ST

Note:

- Call price (C) and Put price

(P) > 0

0

X

ST

30

Derivatives

Swap

A contract to exchange cash flows periodically for an agreed

period of time.

Trading, Pricing, Hedging, Risk Management, etc. discussed

in later weeks.

Major types are interest rate and cross-currency swaps

LIBOR + MarginInterest Rate Swap

Exposure: Fixed-for-Floating

Counterpar

ty

A

Fixed

Counterpar

ty

B

Where:

- LIBOR is a floating reference rate (London Inter-Bank Offer Rate) that resets

every 3 or 6 months.

Note:

- Generally, V0, which is the value of the swap contract at 0, is 0; V0 = 0. This

implies PV of floating payments equals the PV of fixed payment at inception.

- However, Vt, which is the value of the swap after 0 but only up to maturity,

31

can be positive or negative.

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