Lecture 1 (Chapter 1): Introduction
Definition of Risk (Management):
Risk: A possible future event which if it occurs will lead to an undesirable outcome; Risk is the
possibility of suffering loss
Risk Management: any set of actions taken by individuals or corporations in an effort to alter
the risk arising from their primary line(s) of business
Risk Management and Hedging
Hedge: a financial position – often a derivative - put on to reduce the impact of a risk one is
exposed to
Hedging: putting on a hedge
Is risk always bad? “ There is no such thing as free lunch ”
→ Some risks are worth taking because the possible benefit exceeds the possible
costs (ex ante)
→ One should avoid risk you do not know about.
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.
[1] Potential risk factors: political, operational, credit, commodity price, equity price,
interest rate, exchange rate risk & other (weather…) → Firm risk
Approaches to RM:
Tactical Risk Management: Involves the hedging of contracts or other explicit future
commitments of the firm such as exchange rate risk. The treasurer of the firm typically executes
such tactical currency hedging without consideration of other hedging or insurance activities
carried out in the firm, even when the risks across units are significantly correlated.
‘Strategic’ Risk Management (‘Integrated Risk Management’): Involves the identification and
assessment of the collective risks that affect firm value and the implementation of a firm-wide
strategy to manage those risks. How do exchange rate fluctuations affect the value of the entire
firm as well as the firm’s competitive environment, including the pricing of its products, the
quantity sold, the costs of its inputs, and the response of other firms within the same industry.
[2] Uncertainty in Risk Factors:
Future values of these risk factors are unpredictable. Based upon historical data, we can
construct though a probability density function (PDF).
Example: exchange rate US$/Dutch Guilder (Euro). Best prediction for tomorrow’s rate is its
current rate. (‘random walk hypothesis’) Annualized volatility over period 1986-2005: 11%.
Suppose exchange rate returns follow normal distribution with mean = 0 and volatility = 11%.
Risk factor: whenever cash flow or wealth depend on a variable - price or quantity - that can
change unexpectedly for reasons not under our control we call this a risk factor
Exposure: sensitivity of cash flow or wealth to a risk factor
, → For a given exposure, a change in the risk factor increases cash flow
approximately by the change in the risk factor times the exposure
→ Identifying the important risk factors for a firm and estimating the exposure of the
firm’s cash flow or of the firm’s value to these risk factors is critical to the success of
a risk management program
[3] Assessing potential impact + actions:
Estimate the impact of adverse movements in those risk factors on the strategic plan:
→ One risk may strengthen/eliminate other risks
→ Various tools: value-at-risk or cash-flow at risk
[4] Hedging:
Financial hedge: a financial position that decreases the risk resulting from the exposure to a
risk factor; financial position put on to reduce the impact of a risk one is exposed to
→ Sometimes it makes sense for a firm to choose derivatives positions that
increases risks the firm is exposed to
Perfect hedge: eliminates all the risk so that the hedged position, defined as the cash position
plus the hedge, has no exposure to the risk factor.
Important considerations:
[1] Through a financial transaction all risk can be eliminated without spending any cash to do so
[2] The firm cannot consider the gains and losses of derivatives positions independently from
the rest of the firm, when firm uses derivatives to hedge, only firm value matters. To eliminate
the risk of the hedged position, one has to be willing to make losses on derivatives positions; It
therefore makes no sense whatsoever to consider separately the gains and losses of
derivatives positions from the rest of the firm when firms use derivatives to hedge. What matters
are the total gain and loss of the firm.
[3] The forward price must be such that the forward contract has no value at origination, when
the contract is entered into both parties agree to sell/buy the asset at forward price. No money
changes hands except for the agreed upon exchange; if the forward contract has value at
inception for the exporter in that she could sell the forward contract and make money, it has to
have negative value for the counterparty. In this case, the counterparty would be better off not to
enter the contract. Consequently, for the forward contract to exist, it has to be that it has no
value when entered into. The forward price must therefore be the price that insures that the
forward contract has no value at inception.
[4] Risk exposure can be decreased by using different financial instruments
[5] How to reduce risk exposure:
Example: How could a firm solely engaged in copper extraction reduce its exposure to (large)
drops in copper prices?
[1] Diversify product line (extract silver, if silver and copper prices are not perfectly correlated)
[2] Manage expenditure (increase variable relative to fixed costs)
[3] Reduce leverage (reduce debt relative to equity)
[4] Use derivatives → cheapest and most flexible
Derivatives:
Derivative: a financial instrument with promised payoffs derived from the value of one or
several contractually specified underlyings
Definition of Risk (Management):
Risk: A possible future event which if it occurs will lead to an undesirable outcome; Risk is the
possibility of suffering loss
Risk Management: any set of actions taken by individuals or corporations in an effort to alter
the risk arising from their primary line(s) of business
Risk Management and Hedging
Hedge: a financial position – often a derivative - put on to reduce the impact of a risk one is
exposed to
Hedging: putting on a hedge
Is risk always bad? “ There is no such thing as free lunch ”
→ Some risks are worth taking because the possible benefit exceeds the possible
costs (ex ante)
→ One should avoid risk you do not know about.
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.
[1] Potential risk factors: political, operational, credit, commodity price, equity price,
interest rate, exchange rate risk & other (weather…) → Firm risk
Approaches to RM:
Tactical Risk Management: Involves the hedging of contracts or other explicit future
commitments of the firm such as exchange rate risk. The treasurer of the firm typically executes
such tactical currency hedging without consideration of other hedging or insurance activities
carried out in the firm, even when the risks across units are significantly correlated.
‘Strategic’ Risk Management (‘Integrated Risk Management’): Involves the identification and
assessment of the collective risks that affect firm value and the implementation of a firm-wide
strategy to manage those risks. How do exchange rate fluctuations affect the value of the entire
firm as well as the firm’s competitive environment, including the pricing of its products, the
quantity sold, the costs of its inputs, and the response of other firms within the same industry.
[2] Uncertainty in Risk Factors:
Future values of these risk factors are unpredictable. Based upon historical data, we can
construct though a probability density function (PDF).
Example: exchange rate US$/Dutch Guilder (Euro). Best prediction for tomorrow’s rate is its
current rate. (‘random walk hypothesis’) Annualized volatility over period 1986-2005: 11%.
Suppose exchange rate returns follow normal distribution with mean = 0 and volatility = 11%.
Risk factor: whenever cash flow or wealth depend on a variable - price or quantity - that can
change unexpectedly for reasons not under our control we call this a risk factor
Exposure: sensitivity of cash flow or wealth to a risk factor
, → For a given exposure, a change in the risk factor increases cash flow
approximately by the change in the risk factor times the exposure
→ Identifying the important risk factors for a firm and estimating the exposure of the
firm’s cash flow or of the firm’s value to these risk factors is critical to the success of
a risk management program
[3] Assessing potential impact + actions:
Estimate the impact of adverse movements in those risk factors on the strategic plan:
→ One risk may strengthen/eliminate other risks
→ Various tools: value-at-risk or cash-flow at risk
[4] Hedging:
Financial hedge: a financial position that decreases the risk resulting from the exposure to a
risk factor; financial position put on to reduce the impact of a risk one is exposed to
→ Sometimes it makes sense for a firm to choose derivatives positions that
increases risks the firm is exposed to
Perfect hedge: eliminates all the risk so that the hedged position, defined as the cash position
plus the hedge, has no exposure to the risk factor.
Important considerations:
[1] Through a financial transaction all risk can be eliminated without spending any cash to do so
[2] The firm cannot consider the gains and losses of derivatives positions independently from
the rest of the firm, when firm uses derivatives to hedge, only firm value matters. To eliminate
the risk of the hedged position, one has to be willing to make losses on derivatives positions; It
therefore makes no sense whatsoever to consider separately the gains and losses of
derivatives positions from the rest of the firm when firms use derivatives to hedge. What matters
are the total gain and loss of the firm.
[3] The forward price must be such that the forward contract has no value at origination, when
the contract is entered into both parties agree to sell/buy the asset at forward price. No money
changes hands except for the agreed upon exchange; if the forward contract has value at
inception for the exporter in that she could sell the forward contract and make money, it has to
have negative value for the counterparty. In this case, the counterparty would be better off not to
enter the contract. Consequently, for the forward contract to exist, it has to be that it has no
value when entered into. The forward price must therefore be the price that insures that the
forward contract has no value at inception.
[4] Risk exposure can be decreased by using different financial instruments
[5] How to reduce risk exposure:
Example: How could a firm solely engaged in copper extraction reduce its exposure to (large)
drops in copper prices?
[1] Diversify product line (extract silver, if silver and copper prices are not perfectly correlated)
[2] Manage expenditure (increase variable relative to fixed costs)
[3] Reduce leverage (reduce debt relative to equity)
[4] Use derivatives → cheapest and most flexible
Derivatives:
Derivative: a financial instrument with promised payoffs derived from the value of one or
several contractually specified underlyings
