Chapter 15: Financial Risk Management: Techniques and Applications

Chapter 15: Financial Risk Management:
Techniques and Applications
Risk managers need to be perceived like good goalkeepers,

always in the game and occasional at the heart of it, like in
a penalty shoot-out. .
Anonymous
"Confessions of a Risk Manager,” The Economist, 8/7/08
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 1
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Important Concepts in Chapter 15
 The concept and practice of risk management
 The benefits of risk management
 The difference between market and credit risk
 How market risk is managed using delta, gamma, vega,
and Value-at-Risk
 How credit risk is managed, including credit derivatives
 Risks other than market and credit risk
 Definition of risk management: the practice of defining the
risk level a firm desires, identifying the risk level it
currently has, and using derivatives or other financial
instruments to adjust the actual risk level to the desired
risk level.
Why Practice Risk Management?
 The Impetus for Risk Management
 Firms practice risk management for several reasons:
 Interest rates, exchange rates and stock prices are
more volatile today than in the past.

 Significant losses incurred by firms that did not
practice risk management

 Improvements in information technology
 Favorable regulatory environment
 Sometimes we call this activity financial risk

management.
Why Practice Risk Management? (continued)
 The Benefits of Risk Management
 What are the benefits of risk management, in light of
the Modigliani-Miller principle that corporate financial
decisions provide no value because shareholders can
execute these transactions themselves?
 Firms can practice risk management more
effectively.
 There may tax advantages from the progressive tax
system.
 Risk management reduces bankruptcy costs.
 Managers are trying to reduce their own risk.
Why Practice Risk Management? (continued)
 The Benefits of Risk Management (continued)
 By protecting a firm’s cash flow, it increases the
likelihood that the firm will generate enough cash to
allow it to engage in profitable investments.
 Some firms use risk management as an excuse to
speculate.
 Some firms believe that there are arbitrage
opportunities in the financial markets.
 Note: The desire to lower risk is not a sufficient reason
to practice risk management.
Managing Market Risk
 Market risk: the uncertainty associated with interest rates,
foreign exchange rates, stock prices, or commodity prices.
 Example: A dealer with the following positions:
 A four-year interest rate swap with $10 million
notional principal in which it pays a fixed rate and

receives a floating rate.
 A 3-year interest rate call with $8 million notional
principal. The dealer is short and the exercise rate is

12%.
 See Table 15.1 for current term structure and forward
rates. We obtain the call price as $73,745 and the swap
rate is 11.85%.
Managing Market Risk (continued)
 Delta Hedging
 We estimate the delta by repricing the swap and option
with a one basis point move in all spot rates and
average the price change.
 See Table 15.2 for estimated swap and option deltas.
• We are long the swap so we have a delta of

$2,130.5, round to $2,131.
• We are short the option so we have a delta of
-$244.
• Our overall delta is $1,887.
 Delta Hedging (continued)
 We need a Eurodollar futures position that gains $1,887
if rates move down and loses that amount if rates move
up. Thus, we require a long position of
$1,887/$25 = 75.48 contracts. Round to 75. Overall
delta:
 $2,131 (from swap)
 -$244 (from option)
 75(-$25) (from futures)
 = $12 (overall)
 Gamma Hedging
 Here we deal with the risk of large price moves, which
are not fully captured by the delta.
 See Table 15.3 for the estimation of swap and option
gammas. Swap gamma is -$12,500, and option gamma
is $5,000. Being short the option, the total gamma is -
$17,500.
 Eurodollar futures have zero gamma so we must add
another option position to offset the gamma. We
assume the availability of a one-year call with delta of
$43 and gamma of $2,500.
 Gamma Hedging (continued)
 We use x1 Eurodollar futures and x2 of the one-year
calls. The swap and option have a delta of $1,887 and
gamma of -$17,500. We solve the following equations:
 $1,887 + x (-$25) + x ($43) = $0 (zero delta)
1 2
 -$17,500 + x ($0) + x ($2,500) = $0 (zero gamma)
1 2
 Solving these gives x1 = 87.52 (go long 88
Eurodollar futures) and x2 = 7 (go long 7 times
$1,000,000 notional principal of one-year option)
 Vega Hedging
 Swaps, futures, and FRAs do not have vegas.
 We estimate the vegas of the options
 On our 3-year option, if volatility increases
(decreases) by .01, option will increase (decrease) by

$42 (-$42). Average is $42. We are short this
option, so vega = -$42.
 One-year option has estimated vega of $3.50.
 Overall portfolio has vega of
($3.50)(7 million) - $42 = -$17.50.
 Vega Hedging (continued)
 We add a Eurodollar futures option, which has delta of
-$12.75, gamma of -$500, and vega of $2.50 per
$1MM.
 Solve the following equations
 $1,887 + x (-$25) + x ($43) + x (-$12.75) = 0
1 2 3
(delta)
 -$17,500 + x ($0) + x ($2,500) + x (-$500) = 0
1 2 3
(gamma)
 -$42 + x ($0) + x ($3.50) + x ($2.50) = 0 (vega)
1 2 3
 The coefficients are the multiples of $1,000,000
notional principal we need.
 Solutions are x1 = 86.61, x2 = 8.09375, x3 = 5.46875.
 Vega Hedging (continued)
 Any type of hedge (delta, delta-gamma, or delta-
gamma-vega) must be periodically adjusted.
 Virtually impossible to have a perfect hedge.
 Value-at-Risk (VAR)
 A dollar measure of the minimum loss that would be
expected over a given time with a given probability.
Example:
 VAR of $1 million for one day at 0.05 means that
the firm could expect to lose at least $1 million over

a one day period 5% of the time.
 Widely used by dealers and increasingly by end users.
 See Table 15.4 for example of discrete probability
distribution of change in value.
VAR at 5% is $3 million loss.
 See Figure 15.1 for continuous distribution.
 Value-at-Risk (VAR) (continued)
 VAR calculations require use of formulas for expected return and
standard deviation of a portfolio:
E(R p )  w1E(R1 )  w 2 E(R 2 )

2 2
σ p  w 1 σ12  w 2 σ 22  2w1w 2 σ1σ 2ρ
 where
 E(R ), E(R ) = expected returns of assets 1 and 2
1 2
  ,  = standard deviations of assets 1 and 2
1 2
  = correlation between assets 1 and 2
 w1, w2 = % of one’s wealth invested in asset 1 or 2
 Three methods of estimating VAR
 Analytical method: Uses knowledge of the parameters
(expected return and standard deviation) of the probability

distribution and assumes a normal distribution.
• Example: $20 million of S&P 500 with expected return
of 0.12 and volatility of 0.15 and $12 million of Nikkei
300 with expected return of 0.105 and volatility of 0.18.
Correlation is 0.55. Using the above formulas, the overall
portfolio expected return is 0.1144 and volatility is
0.1425.
 For a weekly VAR, convert these to weekly figures.
Expected return = 0.1144/52 = 0.0022

Volatility = 0.1425/52
0.1425/ = 0.0198.
 With a normal distribution, we have
VAR = 0.0022 - 1.65(0.0198) = -0.0305

 So the VAR is $32,000,000(0.0305) = $976,000.

 Example using options: 200 short 12-month calls on S&P 500,
which has volatility of 0.15 and price of $14.21. Total value of
$1,421,000.
 Based on monthly data, expected return is 0.0095 and
volatility is 0.0412.
 Upside 5 % is 0.0095 + 1.65(0.0412) = 0.0775, which is
720(1.0775) = 775.80.
 Option would be worth 775.80 - 720 = 55.80 so loss is
55.80 - 14.21= 41.59 per option.

 Total loss = 200(500)(41.59) = $4.159 million. This is the
VAR.
 One assumption often made is that the expected return
is zero. This is not likely to be true.
 Sometimes rather than use the precise option price from
a model, a delta is used to estimate the price. This
makes the analytical method be sometimes called the
delta-normal method.
 Volatility and correlation information is necessary. See
the web site www.riskmetrics.com, where data of this
sort are provided free.
 Historical method: Uses historical information on the
user’s portfolio to obtain the distribution.
 Example: See Figure 15.2. For portfolio of $15
million, VAR at 5% is approximately a loss of 10%

or $15,000,000(0.10) = -$1,500,000.
 Historical method is subject to limitation that the
past holdings of the portfolio may not have the same

distributional properties as the future holdings. It
also is limited by the results of the chosen time
period, which might not be representative of the
future.
 Monte Carlo Simulation method: Uses Monte Carlo
method, as described in Appendix 14, to generate
random outcomes on the portfolio’s components.
 A Comprehensive Calculation of VAR
 We do an example of a portfolio of $25 million in
the S&P 500. We want a 5% 1-day VAR using each

method. We collect a sample of daily returns on
the S&P 500 for the past year and obtain the
following parameter estimates: Average daily
return = 0.0457% and daily standard deviation =
1.3327%. These result in annual figures of
0.0457(253)  0.1156
1.3327 253  0.2120
 A Comprehensive Calculation of VAR (continued)
 Analytical method: We have 0.0457% − (1.65)1.3327%
= −2.1533%. So the VAR is

• 0.021533($25,000,000) = $538,325
• The 0.21 standard deviation is historically a bit high. Re-
estimating with a standard deviation of 0.15 gives us a
daily standard deviation of 0.9430. Then we obtain
0.0474% − 1.65(0.9430) = −1.5086% and a VAR of
• 0.015086($25,000,000) = $377,150
• Are our data normally distributed? Observe Figure 15.3.
 Historical method: Here we rank the returns from
worst to best. For 253 returns we obtain the 5%

worst by observing the 0.05(253) = 12.65 worst
return. We shall make it the 13th worst. This would
be −2.0969%. Thus, the VAR is
• 0.020969($25,000,000) = $524,225
 Monte Carlo simulation method: We shall use an
expected return of 12%, a standard deviation of 15%

and a normal distribution.
• We generate 253 random returns (this number is
arbitrary and should actually be much larger) by
the following method:
Return  (Expected Return(1/253)
(Standard deviation) *  1/253
• where  is a standard normal random number.
 Monte Carlo simulation method (continued): We do
this 253 times, rank the returns from worst to best

and obtain the 13th worst return, which is
−1.3942%. Then the VAR is
0.013942($25,000,000) = $348,550
 So VAR is estimated to be either
• $538,325
• $377,150
• $524,225
• $348,550
 Key considerations: wide ranges such as this are
common, real-world portfolios are more

complicated than this, ex post evaluation should be
done
 Benefits and Criticisms of VAR
 Widely used
 Facilitates communication with senior management
 Acceptable in banking regulation
 Used to allocate capital within firms
 Used in performance evaluation
 Extensions of VAR
 Stress testing
 Conditional VAR: expected loss, given that loss exceeds VAR. In S&P
example, this is $719,450.

 Cash Flow at Risk (CAR or CFAR), which is more appropriate for firms
with assets that generate cash but for which a market value cannot easily
be assigned.
• Example: expected cash flow of $10 million with standard deviation
of $2 million. CAR at .05 would be 1.65($2 million) = $3.3 million
because
Prob[$10 million − $3.3 million > Actual Cash Flow]
= 0.05.
– Note: CAR is a shortfall measure.
 Earnings at Risk (EAR): measures earnings shortfall.
Managing Credit Risk
 Credit risk or default risk is the risk that the counterparty

will not pay off in a financial transaction.
 Credit ratings are widely used to assess credit risk.
Managing Credit Risk (continued)
 Option Pricing Theory and Credit Risk
 Here we use option pricing theory to understand the
nature of credit risk. Consider a firm with assets with
market value A0, and debt with face value of F due at T.
The market value of the debt is B0. The market value
of the stock is S0.
 See Table 15.5 for the payoffs to the suppliers of
capital. Note how the stock is like a call option on the
assets. Its payoff is
 Max(0,A – F)
T
 Using put-call parity, we have
 P = S – A + F(1 + r)-T
0 0 0
 Option Pricing Theory and Credit Risk (continued)
 This put is the value of limited liability to the stockholders.
Rearranging, we obtain S0 = A0 + P0 – F(1 + r)-T. But, by definition,
S0 = A0 – B0. Setting these equal, we obtain
 B = F(1 + r)-T – P .
0 0
 Thus, the bond subject to default risk is equivalent to a risk-free
bond and a put option written by the bondholders to the
stockholders.
 The Black-Scholes-Merton formula adapted to price the stock as a
call would be  rc T
S0  A 0 N(d1 )  Fe N(d 2 )
 Using B0 = A0 – S0, we can obtain the value of the bonds.
B0  Fe  rcT N(d 2 )  A 0 (1  N(d 2 ))
 Credit Risk of Derivatives
 Current credit risk is the risk to one party that the other
will be unable to make payments that are currently due.
 Potential credit risk is the risk to one party that the
counterparty will default in the future.
 In options, only the buyer faces credit risk.
 FRAs and swaps have two-way credit risk but at a
given point in time, the risk is faced by only one of the
two parties.
 The Credit Risk of Derivatives (continued)
 Potential credit risk is largest during the middle of an
interest rate swap’s life but due to principal repayment,
potential credit risk is largest during the latter part of a
currency swap’s life.
 Typically all parties pay the same price on a derivative,
regardless of their credit standing. Credit risk is
managed through
 limiting exposure to any one party (primary method)
 collateral
 periodic marking-to-market
 (by dealers) captive derivatives subsidiaries
 netting (see next)
 Netting
 Netting: several similar processes in which the amount of cash
owed by one party to the other is reduced by the amount owed by
the latter to the former.
 Bilateral netting: netting between two parties.
 Multilateral netting: netting between more than two parties;
essentially the same as a clearinghouse.

 Payment netting: Only the net amount of a payment owed
from one party to the other is paid.

 Cross-product netting: payments from one type of transaction
are netted against payments for another type of transaction.
 Netting (continued)
 Netting by novation: net value of two parties’
mutual obligations is replaced by a single

transaction; often used in FX markets.
 Closeout netting: netting in the event of default,
where all transactions between two parties are

netted against each other; see example in text.
 The OTC derivatives market has an excellent record
of default. Note the Hammersmith and Fulham

default where it was found that a town had no legal
authority to engage in swaps. The town was able to
get out of paying its losses.
 Credit Derivatives: A family of derivative instruments

that have payoffs contingent on the credit quality of a
particular party. Types include
 Total return swaps: See Figure 15.4. Credit derivative
buyer purchases swap from credit derivative seller in
which it pays the total return on a specific bond. If that
return is reduced by some credit event, this loss is
passed through automatically in the swap.
 Credit Derivatives (continued)

 Credit default swap: A swap in which the credit
derivatives buyer pays a periodic fee to the credit
derivatives seller. If the buyer sustains a credit loss
from a third party, it then receives payments from the
credit derivatives seller to compensate.
See Figure 15.5. This is really more like an option.
 Credit spread option: An option in which the
underlying is the yield spread on a bond.
See Figure 15.6.
 Credit Derivatives (continued)

 Credit linked security: This is a bond or note that pays
off less than its face value if a credit event occurs on a
third party. Figure 15.7.
 The credit derivatives market is large and growing
rapidly. The notional principal of credit derivatives at
U. S. banks was estimated at about $57.9 trillion in
2007.
Synthetic CDO
 Cash CDOs – underlying is a portfolio of securities

 Synthetic CDOs – underlying is a portfolio of credit
derivatives
 See Figure 15.8.
Other Types of Risks
 operational risk (including inadequate controls)
 model risk
 liquidity risk
 accounting risk
 legal risk
 tax risk
 regulatory risk
 settlement risk
 systemic risk
Summary
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Chapter 15: Financial Risk Management: Techniques and Applications

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Chapter 15: Financial Risk Management: Techniques and Applications

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Chapter 15: Financial Risk Management:

Techniques and Applications

Risk managers need to be perceived like good goalkeepers,

more volatile today than in the past.

practice risk management

 Favorable regulatory environment

 Sometimes we call this activity financial risk

 Managers are trying to reduce their own risk.

notional principal in which it pays a fixed rate and

principal. The dealer is short and the exercise rate is

• We are long the swap so we have a delta of

 -$244 (from option)

 75(-$25) (from futures)

(decreases) by .01, option will increase (decrease) by

 Overall portfolio has vega of

($3.50)(7 million) - $42 = -$17.50.

the firm could expect to lose at least $1 million over

E(R p )  w1E(R1 )  w 2 E(R 2 )

(expected return and standard deviation) of the probability

Expected return = 0.1144/52 = 0.0022

VAR = 0.0022 - 1.65(0.0198) = -0.0305

 Value-at-Risk (VAR) (continued)

55.80 - 14.21= 41.59 per option.

million, VAR at 5% is approximately a loss of 10%

past holdings of the portfolio may not have the same

the S&P 500. We want a 5% 1-day VAR using each

= −2.1533%. So the VAR is

worst to best. For 253 returns we obtain the 5%

expected return of 12%, a standard deviation of 15%

this 253 times, rank the returns from worst to best

common, real-world portfolios are more

 Facilitates communication with senior management

 Acceptable in banking regulation

 Used to allocate capital within firms

 Used in performance evaluation

example, this is $719,450.

 Credit risk or default risk is the risk that the counterparty

 (by dealers) captive derivatives subsidiaries

 netting (see next)

 Multilateral netting: netting between more than two parties;

essentially the same as a clearinghouse.

from one party to the other is paid.

are netted against payments for another type of transaction.

mutual obligations is replaced by a single

where all transactions between two parties are

of default. Note the Hammersmith and Fulham

 Credit Derivatives: A family of derivative instruments

 Credit Derivatives (continued)

 Credit Derivatives (continued)

 Cash CDOs – underlying is a portfolio of securities

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