Course Organization
Each instructor is likely to have his or her own preference for the way in which a course
based on ”Risk Management and Financial Institutions” is organized. An abbreviated
sample outline is in RMFI2eSampleOutline.doc. The problems that are assigned in this
outline are from the ends of chapters and are not mathematically difficult. Instructors
who are teaching on math finance or similar courses may want to use more challenging
assignment questions.
My final exam is a two-hour closed book exam. Students are allowed to bring into the
exam two pages of material, consisting of formulas and other material they think will be of
use. Copies of the normal distribution tables (pages 540–41) are supplied when necessary.
Roughly half the exam involves numerical questions that are similar to the end-of-
chapter problems. The other half consists of non-numerical questions such as:
1. (a) Explain why long-term rates are higher than short-term rates most of the time
(b) Under what circumstances would you expect long-term rates to be less than short-
term rates
2. Describe alternative ways to estimate the probability of company defaulting on its
obligations over the next three years. Explain the difference between real-world and
risk-neutral estimates. Explain which is greater and why. When are each used?
3. Outline the main changes in bank regulation over the last 20 years. In particular,
explain in some detail Basel I, the 1996 amendment, and Basel II.
4. (a) Explain the difference between risk aggregation and risk decomposition
(b) Outline how the historical simulation and model building approaches to calculating
VaR work
(c) What are the pros and cons of the historical simulation and model building ap-
proaches to calculating VaR.
5. Explain how capital is calculated for credit risk under the IRB approach. Your answer
should explain the framework and specifically address the following questions
What losses at what confidence level is the capital is designed to cover?
What is the credit correlation model being assumed?
6. (a) How does a downgrade trigger work?
(b) Explain how the existence of downgrade trggiers can increase the probability of
default
46
,Instructor Notes
Risk Management and Financial
Institutions
Second Edition
John C. Hull
,Chapter 1: Introduction
I generally spend about 1 to 1.5 hours on the material in this chapter. The purpose
of most of the chapter is to link concepts in the rest of the book to concepts learned in
courses on corporate finance and investments. If students have not previously been exposed
to these concepts rather more time is likely to be necessary to cover the material in the
chapter.
Sections 1.1 to 1.4 review results on risk-return trade-offs and the distinction between
systematic (nondiversifiable) and non-systematic (diversifiable) risks. In most instances
students will already have been exposed to this material in their first corporate finance
class and classroom time can be used to refresh their memories. The second edition contains
material on alpha (Section 1.3).
Section 1.5 considers why companies are concerned with more than just systematic
risk and why they hedge. The bankruptcy costs argument (which most students will have
already met in the context of capital structure decisions) is discussed. Business Snapshot
1.1 describes a typical sequence of events that leads to the value of a company being
reduced because it is forced to declare bankruptcy.
Section 1.6 introduces students to the way risk are managed by financial institutions,
distinguishing between “risk decomposition” where risks are managed one by one and risk
aggregation where risks are combined and risk diversification is taken into account.
The material on bank capital in the first edition, where a simple balance sheet and
income statement for a bank is examined, has been moved to Chapter 2. The material
on the management of net interest income has been moved to Chapter 7. These changes
make Chapter 1 less “bitty.”
The Further Questions can be used either for class discussion or as assignment ques-
tions. Problem 1.17 provides an introduction to capital adequacy concepts.
Chapter 2: Banks
This is the first of three new chapters that describe the activities of different types
of financial institutions. The chapters provide important background material for the
discussion of risk management and regulation later in the book.
Chapter 2 explains the activities of commercial and investment banks. As students
are likely to be aware, the year 2008 saw the disappearance of large institutions that
were exclusively focused on investment banking. Lehman Brothers went bankrupt; Bear
Stearns was taken over by J. P. Morgan; Merrill Lynch was taken over by Bank of America;
Goldman Sachs and Morgan Stanley became bank holding companies with both commercial
and investment banking interests.
The parts of the chapter that I choose to spend most time on in class are a) Section 2.2
(the capital requirements of a small commercial bank) and b) IPOs and the Dutch auction
approach (in Section 2.4) and c) conflicts of interest in banks (Section 2.6). Section 2.2 is
an introduction to capital adequacy material that comes later in the book. I find it useful
to get students to think about what the balance sheet and income statement for a simple
bank look like. Students enjoy the discussion of the Dutch auction approach and Google’s
IPO (see Business Snapshot 2.1). The conflicts of interest section gets students thinking
about important issues that they may not have addressed in other courses.
1
, The Further Questions are straightforward and can be used in a number of differ-
ent ways. For example, Problem 2.15 can be discussed in conjunction with Section 2.2.
Problem 2.17 can be discussed when Dutch auctions are covered.
Chapter 3: Insurance Companies and Pension Funds
This chapter starts by discussing different types of life insurance contracts and annuity
contracts. It explains the investment component of life insurance contracts and the tax
deferral advantages of these contracts. Mortality tables enable students to calculate pre-
miums for simple life insurance contracts. (It can be pointed out that the calculations are
similar to those used to determine the spread for credit default swaps.) The chapter then
moves on to discuss property-casualty insurance, health insurance, moral hazard, adverse
selection, the balance sheets of insurance companies, and pension plans.
Students should understand the types of insurance contracts in the market and the
nature of the risks in life insurance, property-casualty insurance, and health insurance.
They should appreciate the nature of moral hazard and adverse selection. (It is interesting
that individuals who buy life insurance die earlier on average than individuals who buy
annuities.) They should understand why property-casualty companies need more capital.
I consider it important not to cover the pension fund material too quickly. Students
should understand the differences between the two types of pension plans and the risks they
pose for companies. Why are defined benefit pension plans 60% invested in equities when
their liabilities are “bond-like”? The answer appears to be that bonds do not provide a
high enough return for them to be able to meet their obligations. Another way of putting
this is that the only way pension plans can meet their obligations is if equity markets
perform well. To emphasize these points, I go through Problem 3.15 in class (because the
calculations are simple) and assign Problem 3.19.
Problems 3.16, 3.17, and 3.19 can be used for assignments. Problem 3.18 can be used
for class discussion.
Chapter 4: Mutual Funds and Hedge Funds
This chapter explains the differences between open-end mutual funds, closed-end mu-
tual funds, and ETFs. It reviews the evidence on the performance of mutual funds and
discusses the increasing popularity of index funds. It explains how hedge funds differ from
mutual funds. It considers the incentives of hedge fund managers, describes different hedge
fund strategies, and reviews their performance.
Some students are usually unwilling to accept that a) actively traded mutual funds
do not outperform stock indices and b) that the past performance of a mutual fund is
not a good guide to its future performance. I spend some time explaining Jensen’s classic
results and point out that many other studies conducted since Jensen have reached similar
conclusions. I discuss the growth of index funds. I also explain carefully how ETFs work
and why they have been voted the most innovative investment vehicle of the last two
decades. A discussion of late trading reinforces the fact that mutual funds trade only at
4pm each day. This distinguishes them from closed-end funds and ETFs.
Students usually enjoy learning about the strategies followed by hedge funds and the
fees earned by hedge fund managers. I explain that the hedge fund manager has a call
2
Each instructor is likely to have his or her own preference for the way in which a course
based on ”Risk Management and Financial Institutions” is organized. An abbreviated
sample outline is in RMFI2eSampleOutline.doc. The problems that are assigned in this
outline are from the ends of chapters and are not mathematically difficult. Instructors
who are teaching on math finance or similar courses may want to use more challenging
assignment questions.
My final exam is a two-hour closed book exam. Students are allowed to bring into the
exam two pages of material, consisting of formulas and other material they think will be of
use. Copies of the normal distribution tables (pages 540–41) are supplied when necessary.
Roughly half the exam involves numerical questions that are similar to the end-of-
chapter problems. The other half consists of non-numerical questions such as:
1. (a) Explain why long-term rates are higher than short-term rates most of the time
(b) Under what circumstances would you expect long-term rates to be less than short-
term rates
2. Describe alternative ways to estimate the probability of company defaulting on its
obligations over the next three years. Explain the difference between real-world and
risk-neutral estimates. Explain which is greater and why. When are each used?
3. Outline the main changes in bank regulation over the last 20 years. In particular,
explain in some detail Basel I, the 1996 amendment, and Basel II.
4. (a) Explain the difference between risk aggregation and risk decomposition
(b) Outline how the historical simulation and model building approaches to calculating
VaR work
(c) What are the pros and cons of the historical simulation and model building ap-
proaches to calculating VaR.
5. Explain how capital is calculated for credit risk under the IRB approach. Your answer
should explain the framework and specifically address the following questions
What losses at what confidence level is the capital is designed to cover?
What is the credit correlation model being assumed?
6. (a) How does a downgrade trigger work?
(b) Explain how the existence of downgrade trggiers can increase the probability of
default
46
,Instructor Notes
Risk Management and Financial
Institutions
Second Edition
John C. Hull
,Chapter 1: Introduction
I generally spend about 1 to 1.5 hours on the material in this chapter. The purpose
of most of the chapter is to link concepts in the rest of the book to concepts learned in
courses on corporate finance and investments. If students have not previously been exposed
to these concepts rather more time is likely to be necessary to cover the material in the
chapter.
Sections 1.1 to 1.4 review results on risk-return trade-offs and the distinction between
systematic (nondiversifiable) and non-systematic (diversifiable) risks. In most instances
students will already have been exposed to this material in their first corporate finance
class and classroom time can be used to refresh their memories. The second edition contains
material on alpha (Section 1.3).
Section 1.5 considers why companies are concerned with more than just systematic
risk and why they hedge. The bankruptcy costs argument (which most students will have
already met in the context of capital structure decisions) is discussed. Business Snapshot
1.1 describes a typical sequence of events that leads to the value of a company being
reduced because it is forced to declare bankruptcy.
Section 1.6 introduces students to the way risk are managed by financial institutions,
distinguishing between “risk decomposition” where risks are managed one by one and risk
aggregation where risks are combined and risk diversification is taken into account.
The material on bank capital in the first edition, where a simple balance sheet and
income statement for a bank is examined, has been moved to Chapter 2. The material
on the management of net interest income has been moved to Chapter 7. These changes
make Chapter 1 less “bitty.”
The Further Questions can be used either for class discussion or as assignment ques-
tions. Problem 1.17 provides an introduction to capital adequacy concepts.
Chapter 2: Banks
This is the first of three new chapters that describe the activities of different types
of financial institutions. The chapters provide important background material for the
discussion of risk management and regulation later in the book.
Chapter 2 explains the activities of commercial and investment banks. As students
are likely to be aware, the year 2008 saw the disappearance of large institutions that
were exclusively focused on investment banking. Lehman Brothers went bankrupt; Bear
Stearns was taken over by J. P. Morgan; Merrill Lynch was taken over by Bank of America;
Goldman Sachs and Morgan Stanley became bank holding companies with both commercial
and investment banking interests.
The parts of the chapter that I choose to spend most time on in class are a) Section 2.2
(the capital requirements of a small commercial bank) and b) IPOs and the Dutch auction
approach (in Section 2.4) and c) conflicts of interest in banks (Section 2.6). Section 2.2 is
an introduction to capital adequacy material that comes later in the book. I find it useful
to get students to think about what the balance sheet and income statement for a simple
bank look like. Students enjoy the discussion of the Dutch auction approach and Google’s
IPO (see Business Snapshot 2.1). The conflicts of interest section gets students thinking
about important issues that they may not have addressed in other courses.
1
, The Further Questions are straightforward and can be used in a number of differ-
ent ways. For example, Problem 2.15 can be discussed in conjunction with Section 2.2.
Problem 2.17 can be discussed when Dutch auctions are covered.
Chapter 3: Insurance Companies and Pension Funds
This chapter starts by discussing different types of life insurance contracts and annuity
contracts. It explains the investment component of life insurance contracts and the tax
deferral advantages of these contracts. Mortality tables enable students to calculate pre-
miums for simple life insurance contracts. (It can be pointed out that the calculations are
similar to those used to determine the spread for credit default swaps.) The chapter then
moves on to discuss property-casualty insurance, health insurance, moral hazard, adverse
selection, the balance sheets of insurance companies, and pension plans.
Students should understand the types of insurance contracts in the market and the
nature of the risks in life insurance, property-casualty insurance, and health insurance.
They should appreciate the nature of moral hazard and adverse selection. (It is interesting
that individuals who buy life insurance die earlier on average than individuals who buy
annuities.) They should understand why property-casualty companies need more capital.
I consider it important not to cover the pension fund material too quickly. Students
should understand the differences between the two types of pension plans and the risks they
pose for companies. Why are defined benefit pension plans 60% invested in equities when
their liabilities are “bond-like”? The answer appears to be that bonds do not provide a
high enough return for them to be able to meet their obligations. Another way of putting
this is that the only way pension plans can meet their obligations is if equity markets
perform well. To emphasize these points, I go through Problem 3.15 in class (because the
calculations are simple) and assign Problem 3.19.
Problems 3.16, 3.17, and 3.19 can be used for assignments. Problem 3.18 can be used
for class discussion.
Chapter 4: Mutual Funds and Hedge Funds
This chapter explains the differences between open-end mutual funds, closed-end mu-
tual funds, and ETFs. It reviews the evidence on the performance of mutual funds and
discusses the increasing popularity of index funds. It explains how hedge funds differ from
mutual funds. It considers the incentives of hedge fund managers, describes different hedge
fund strategies, and reviews their performance.
Some students are usually unwilling to accept that a) actively traded mutual funds
do not outperform stock indices and b) that the past performance of a mutual fund is
not a good guide to its future performance. I spend some time explaining Jensen’s classic
results and point out that many other studies conducted since Jensen have reached similar
conclusions. I discuss the growth of index funds. I also explain carefully how ETFs work
and why they have been voted the most innovative investment vehicle of the last two
decades. A discussion of late trading reinforces the fact that mutual funds trade only at
4pm each day. This distinguishes them from closed-end funds and ETFs.
Students usually enjoy learning about the strategies followed by hedge funds and the
fees earned by hedge fund managers. I explain that the hedge fund manager has a call
2
