RISK MANAGEMENT
Tilburg University
DR. LIEVEN BAELE
, Table of Contents
Lecture 1 Chapter 1: Introduction ..................................................................................................4
Lecture 2 Chapter 2: Calculations of volatility of portfolio ............................................................9
Lecture 3 Chapter 3: Creating value with risk management ....................................................... 11
Lecture 4 Chapter 4: A Firm-wide approach to Risk Management ............................................. 16
Lecture 5 + 6 Chapter 5: Forward and Futures Contracts ................................................................. 24
Lecture 6 + 7 Chapter 6: Hedging Exposures with Futures/Forwards ............................................... 34
Lecture 8 Chapter 7: Optimal Hedges for the Real World ........................................................... 40
Lecture 9 Chapter 9: Measuring and Managing Interest Rate Risks ........................................... 46
Lecture 10 SWAPS.......................................................................................................................... 54
Lecture 11 Chapter 10: Hedging with Options .............................................................................. 59
Lecture 12 Chapters 11 + 12: Option Pricing ................................................................................. 64
1
, What to Study?
Chapter 1 (Lecture 1)
Introduction
Chapter 2 (Lecture 2)
Important points of this chapter: Calculation of volatility of portfolio, effect of correlation on total
portfolio risk, capital asset pricing model, difference between systematic and idiosyncratic risk,
hedging irrelevance proposition.
Chapter 3 (Lecture 3)
This chapter explains in what circumstances hedging creates value for an organization. You should be
able to explain each of these reasons in half a page, where appropriate illustrated with a small graph.
If you only want to read one chapter in the book, it should be this one!
Chapter 4 (Lecture 4)
You should be able to clearly explain VaR and CaR, apply them in a small exercise, and understand in
what circumstances one is more appropriate than the other. Understand how VaR/CaR are related to
distress costs. What are differences with expected shortfall? How does VaR change when there is a
proportionate change in the asset weights (point that it is not the total but only the systematic risk of
the individual assets that matters is crucial)? How to adjust standard NPV calculation with a cost of
CaR measure.
Chapter 5 (Lecture 5 + 6)
This chapter develops the pricing methodology for forward and futures contracts. You should be able
to calculate the theoretical price of a forward on a Treasury bill, stock, or commodity, and to exploit
any potential mispricing by setting up an arbitrate strategy. Understand basic differences between
forward and futures, and in particular the effect the existence of a margin account may have on the
futures price (relative to a forward price).
Chapter 6 (Lecture 6 +7)
This chapter is the first chapter on how to hedge with forward and futures in practice. Understand
why tailing the hedge is necessary in case of futures. Understand what may cause ‘basis risk’, and
what the consequences are for the optimal hedge ratio. You should be able to derive an optimal
hedge ratio plus its quality from a regression output.
Chapter 7 (Lecture 8)
How to hedge in the long-term by rolling over short-term futures contracts. Effect of basis risk on
optimal hedge ratio. How to adjust optimal hedge ratio when hedging is costly (no derivation, but
understanding!). How to deal with multiple (correlated) exposures, or with cash flows occurring at
different dates.
Chapter 8
Not discussed, so I will also not ask questions about it. We discuss competitive risk and volume risk in
two separate case studies (see further)
2
, Chapter 9 (Lecture 9)
What are the different components of (corporate) interest rates? Understand inverse relationship
between interest rates and bond prices. How to use forward rate agreements to hedge interest rate
risk. Understand concept of duration, how to calculate it, and how to use it to predict bond price
after particular change in interest rates. Use of duration in Asset and Liability management.
Chapter 10 (Lecture 11)
Basic introduction to options. You should be able to set up a basic hedging strategy using
(combinations of) options, and understand in what situations options may be preferred over
forwards/futures. How to set up basic trading strategies (straddles, strangles, portfolio insurance,...).
Understand + apply put-call parity.
Chapter 11 (Lecture 12)
Understand Binomial option pricing model, and how replicating portfolio changes each period. Be
prepared to calculate an option price yourself!
Chapter 12 (Lecture 12)
Understand how the Black-Scholes formula is related to the replicating portfolio in the Binomial
option pricing formula. Basic understanding of the ‘greeks’(delta, vega, not rho/theta), and especially
the graphs plotted in the slides. Understand concepts and use of implied volatility. How to calculate
options on dividend-paying stocks, or on currencies.
Swaps (Lecture 10)
Understand why swaps are useful, in particular to hedge interest rate exposures. Be able to
understand and develop basic setup of an interest rate and currency swap.
Two Case Studies (not involved in this document)
(1) Foreign Exchange Hedging Strategies at General Motors: Competitive Exposures: framework to
think about competitive risk, and how it differs from transactional and competitive risks.
Methodology to quantify competitive risk. What can you do about it?
(2) The Hedging Decision at AIFS: case on hedging with forwards versus options in case of volume
uncertainty.
3
, Lecture 1
Chapter 1: Introduction
This course is designed to train the participants in
1. Identifying financial risks
2. Measuring them
3. Removing risks that decrease shareholder value via the use of special financial instruments, i.e.
derivatives.
Part 1: Risk Management: What and Why? (Chapter 1-4)
- What is Risk management?
- Risk Management and Firm Value
- Quantifying Relevant Exposures
Part 2: Plain-Vanilla Hedging + Pricing Basics (Chapter 5-14)
- Pricing of/hedging with Forward and Futures Contracts
- Pricing of/hedging with Swaps
- Pricing of/hedging with Options Structure of the Course
Hedging = A hedge is a financial position – often a derivative - put on to reduce the impact of a risk
one is exposed to.
Plain vanilla hedging = Plain vanilla signifies the most basic or standard version of a financial
instrument, usually options, bonds, futures and swaps. Plain vanilla is the opposite of an exotic
instrument, which alters the components of a traditional financial instrument, resulting in a more
complex security.
Risk Management Process
1. Identify relevant risk factors.
2. Understand the distribution of those risk factors
3. Estimate the impact of adverse movements in those risk factors on the strategic plan.
4. Decide whether to hedge or not.
5. Choose the appropriate financial instrument.
6. Determine how much to hedge.
Suppose that the firm ABC builds pre-fabricated housing in the US. Canada is the major supplier of
lumber that is its most important input. Japan is a major consumer of its prefabricated housing
products. The housing sector is highly procyclical, while interest rates are also procyclical. Supply
shocks make energy prices counter-cyclical. ABC’s big competitors are Canadian and German
companies. ABC has little debt in its capital structure.
What are the major risk factors ABC faces? A partial list includes changes in:
a) Price of lumber
b) Price of alternatives to pre-fabricated housing
c) Interest rates
d) Oil prices
e) Canadian dollar/US dollar exchange rates
f) Japanese Yen/US dollar exchange rates
g) German Mark/US dollar exchange rates
h) Business conditions in US, Canada, Germany, and Japan
4
Tilburg University
DR. LIEVEN BAELE
, Table of Contents
Lecture 1 Chapter 1: Introduction ..................................................................................................4
Lecture 2 Chapter 2: Calculations of volatility of portfolio ............................................................9
Lecture 3 Chapter 3: Creating value with risk management ....................................................... 11
Lecture 4 Chapter 4: A Firm-wide approach to Risk Management ............................................. 16
Lecture 5 + 6 Chapter 5: Forward and Futures Contracts ................................................................. 24
Lecture 6 + 7 Chapter 6: Hedging Exposures with Futures/Forwards ............................................... 34
Lecture 8 Chapter 7: Optimal Hedges for the Real World ........................................................... 40
Lecture 9 Chapter 9: Measuring and Managing Interest Rate Risks ........................................... 46
Lecture 10 SWAPS.......................................................................................................................... 54
Lecture 11 Chapter 10: Hedging with Options .............................................................................. 59
Lecture 12 Chapters 11 + 12: Option Pricing ................................................................................. 64
1
, What to Study?
Chapter 1 (Lecture 1)
Introduction
Chapter 2 (Lecture 2)
Important points of this chapter: Calculation of volatility of portfolio, effect of correlation on total
portfolio risk, capital asset pricing model, difference between systematic and idiosyncratic risk,
hedging irrelevance proposition.
Chapter 3 (Lecture 3)
This chapter explains in what circumstances hedging creates value for an organization. You should be
able to explain each of these reasons in half a page, where appropriate illustrated with a small graph.
If you only want to read one chapter in the book, it should be this one!
Chapter 4 (Lecture 4)
You should be able to clearly explain VaR and CaR, apply them in a small exercise, and understand in
what circumstances one is more appropriate than the other. Understand how VaR/CaR are related to
distress costs. What are differences with expected shortfall? How does VaR change when there is a
proportionate change in the asset weights (point that it is not the total but only the systematic risk of
the individual assets that matters is crucial)? How to adjust standard NPV calculation with a cost of
CaR measure.
Chapter 5 (Lecture 5 + 6)
This chapter develops the pricing methodology for forward and futures contracts. You should be able
to calculate the theoretical price of a forward on a Treasury bill, stock, or commodity, and to exploit
any potential mispricing by setting up an arbitrate strategy. Understand basic differences between
forward and futures, and in particular the effect the existence of a margin account may have on the
futures price (relative to a forward price).
Chapter 6 (Lecture 6 +7)
This chapter is the first chapter on how to hedge with forward and futures in practice. Understand
why tailing the hedge is necessary in case of futures. Understand what may cause ‘basis risk’, and
what the consequences are for the optimal hedge ratio. You should be able to derive an optimal
hedge ratio plus its quality from a regression output.
Chapter 7 (Lecture 8)
How to hedge in the long-term by rolling over short-term futures contracts. Effect of basis risk on
optimal hedge ratio. How to adjust optimal hedge ratio when hedging is costly (no derivation, but
understanding!). How to deal with multiple (correlated) exposures, or with cash flows occurring at
different dates.
Chapter 8
Not discussed, so I will also not ask questions about it. We discuss competitive risk and volume risk in
two separate case studies (see further)
2
, Chapter 9 (Lecture 9)
What are the different components of (corporate) interest rates? Understand inverse relationship
between interest rates and bond prices. How to use forward rate agreements to hedge interest rate
risk. Understand concept of duration, how to calculate it, and how to use it to predict bond price
after particular change in interest rates. Use of duration in Asset and Liability management.
Chapter 10 (Lecture 11)
Basic introduction to options. You should be able to set up a basic hedging strategy using
(combinations of) options, and understand in what situations options may be preferred over
forwards/futures. How to set up basic trading strategies (straddles, strangles, portfolio insurance,...).
Understand + apply put-call parity.
Chapter 11 (Lecture 12)
Understand Binomial option pricing model, and how replicating portfolio changes each period. Be
prepared to calculate an option price yourself!
Chapter 12 (Lecture 12)
Understand how the Black-Scholes formula is related to the replicating portfolio in the Binomial
option pricing formula. Basic understanding of the ‘greeks’(delta, vega, not rho/theta), and especially
the graphs plotted in the slides. Understand concepts and use of implied volatility. How to calculate
options on dividend-paying stocks, or on currencies.
Swaps (Lecture 10)
Understand why swaps are useful, in particular to hedge interest rate exposures. Be able to
understand and develop basic setup of an interest rate and currency swap.
Two Case Studies (not involved in this document)
(1) Foreign Exchange Hedging Strategies at General Motors: Competitive Exposures: framework to
think about competitive risk, and how it differs from transactional and competitive risks.
Methodology to quantify competitive risk. What can you do about it?
(2) The Hedging Decision at AIFS: case on hedging with forwards versus options in case of volume
uncertainty.
3
, Lecture 1
Chapter 1: Introduction
This course is designed to train the participants in
1. Identifying financial risks
2. Measuring them
3. Removing risks that decrease shareholder value via the use of special financial instruments, i.e.
derivatives.
Part 1: Risk Management: What and Why? (Chapter 1-4)
- What is Risk management?
- Risk Management and Firm Value
- Quantifying Relevant Exposures
Part 2: Plain-Vanilla Hedging + Pricing Basics (Chapter 5-14)
- Pricing of/hedging with Forward and Futures Contracts
- Pricing of/hedging with Swaps
- Pricing of/hedging with Options Structure of the Course
Hedging = A hedge is a financial position – often a derivative - put on to reduce the impact of a risk
one is exposed to.
Plain vanilla hedging = Plain vanilla signifies the most basic or standard version of a financial
instrument, usually options, bonds, futures and swaps. Plain vanilla is the opposite of an exotic
instrument, which alters the components of a traditional financial instrument, resulting in a more
complex security.
Risk Management Process
1. Identify relevant risk factors.
2. Understand the distribution of those risk factors
3. Estimate the impact of adverse movements in those risk factors on the strategic plan.
4. Decide whether to hedge or not.
5. Choose the appropriate financial instrument.
6. Determine how much to hedge.
Suppose that the firm ABC builds pre-fabricated housing in the US. Canada is the major supplier of
lumber that is its most important input. Japan is a major consumer of its prefabricated housing
products. The housing sector is highly procyclical, while interest rates are also procyclical. Supply
shocks make energy prices counter-cyclical. ABC’s big competitors are Canadian and German
companies. ABC has little debt in its capital structure.
What are the major risk factors ABC faces? A partial list includes changes in:
a) Price of lumber
b) Price of alternatives to pre-fabricated housing
c) Interest rates
d) Oil prices
e) Canadian dollar/US dollar exchange rates
f) Japanese Yen/US dollar exchange rates
g) German Mark/US dollar exchange rates
h) Business conditions in US, Canada, Germany, and Japan
4
