Risk Management
Chapter 1: Introductory Lecture
What is Risk
A possible future event which if it occurs will lead to
an undesirable outcome.
The possibility of suffering loss
What is 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
Hedge: a financial position (derivative) put on to reduce the impact of a risk one is exposed to.
(hedging = putting on a hedge)
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 correlate
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
Example Appreciation/Depreciation in a Production firm
- IMPUT -> CD appreciates with respect to the USD
o Canadian Dollar worth more, stronger CD
o Need more USD to pay the imput
- Output -> CD depreciates with respect to the USD
o Asset is in CD -> get less CD
o So eventually also less USD
Low Interest -> implies slow growth & implies chance on deflation (stagnation economy)
How could a firm reduce the risk exposure?
1. Diversify product line
- Most of time with negative correlated activities (requires
investments/uncertainty/time-consuming)
2. Manage the expenditures
- Increase variable relative to fixed cost (difficult with machines).
- If sales drop -> cost will drop, overhead doesn’t change
- More temporal contracts.
3. Reduce leverage
- Reduce debt relative to equity
- The less debt you got -> less the cash flow requirements will be (and also bankruptcy
costs/financial distress.
4. Use of derivatives
- Often cheapest and most flexible
,What is a derivative?
- “A derivative is a financial instrument with promised payoffs derived from the value
of one or several contractually specific underlyings.
- A financial instrument which end value is DERIVED from the underlyings
- Underlyings can be “anything”.
Derivatives come in two flavours:
1. Plain vanilla
- Forwards
- Futures
- Options
2. Exotic -> derivative whose payoff cannot be replicated by a combination of options and
futures
- Exotic swap
- Binary option
Way of trading derivatives
- Exchange (CME)
- Over-the-counter
i. Two parties agree on a trade without meeting through an organized
exchange. (mostly with a bank)
Mostly common underlying: Interest rate -> Banks (mostly with swaps) hedge their own risk, e.g. for
asset/liability management.
Note: If not well understood, trading in derivatives can lead to large losses that often endanger the
financial health of corporations and another derivative trader.
Windfall: what you get relatively to what you expect.
Main types of Derivatives
1. Options
- Call Option: a security which gives the right to BUY a specified
quantity of an underlying assed at a contractually agreed price
at OR BEFORE a fixed date
i. MAX (0, St – X)
- Put Option: a security which gives the right to SELL a specified
quantity of an underlying assed at a contractually agreed price
at OR BEFORE a fixed date
i. MAX (0, X – St)
TERMS
- Exercise price/ Strike Price (X)
- Maturity
- Option buyer / seller (writer
- Option premium
-> “Fee” for protecting downside/upside and gaining up/down potential
- European vs American -> when to exercise.
Option: upside potential + downside protection -> pay a premium
Forward: pay for downside protection
Implicitly: pay for the downside protection by giving up the upside potential
,2. Forward contracts: an agreement between 2 parties to buy (sell)
a well-defined asset at a pre specified prices AT a well-defined
future point in time
- Long: Obligation to BUY
- Short: Obligation to sell -> PICTURE
- Difference with futures
i. Not traded on exchange =(not standardized) -> Over-The-Counter
ii. Tailor-made -> amount and maturity
3. Futures contracts (similar to Forwards but see difference and more details later in course)
- Société Generale (Jérôme Kerviel)
Long position to buy DAX-stocks at 8000 on ...time… -> DAX
start falling -> huge future loss
4. Swaps: a contract between two parties who engage themselves to swap casflows at pre-
specified future moments according to a pre-specified formula
- Interest Rate Swaps: At the coupon days, B pays a fixed interest rate on a notional
amount to A. A pays B on the same amount a floating rate
i. Fixed for floating (B is swapping his fixed for the
floating with A)
ii. Floating for fixed
- Currency Swaps: A fixed (variable) rate
currency swap involves counterparty A
exchanging fixed (variable) rate interest in
one currency with counterparty B in return
paying fixed (variable) interest in another
currency.
i. Useful in debt management!
Swaps are typically longer term for recurring
exposures!
, Chapter 2: Investors and Risk management
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.
Investors have tools to choose the optimal risk level of their portfolio through:
1) Asset Allocation
2) Diversification (portfolio mostly done)
3) (Derivative)
If investors can manage at portfolio level, do they still want firms to spend money on risk
management strategies?
- Need to know more information
1. Calculate (historical) Return. (without Divident =(New-Old)/Old)
2. Calculate (return) Variance Excel = Var(..)
- The variance of a random variable is a quantitative
measure of how the realizations of the random variable
are distributed around their expected value
- Momentum effect (ST): a stock performed well today, so
it will be likely to perform well tomorrow.
3. Volatility = the square root of the variance!!
- Need the average return
- Asset’s weekly return variance
4. Variance of Multi-period returns
- The square root of time rule! (Excel =SQRT(..)
Variance of returns grows linearly with time while
volatility grows by the square root of time
- Daily to weekly
VOL(weekly) = SQRT(Variance(daily)) *SQRT (7)
- Daily to Annualized
VOL(annualized) = SQRT(Variance(daily)) *SQRT (252)
- Weekly to Annualized
VOL(annualized) = SQRT(Variance(weekly)) *SQRT (52)
5. Probability distribution function: A probability distribution function provides a quantitative
measure of the likelihood of the possible outcomes or realizations of a random variable by
assigning probabilities to these outcome.
- Normal Distribution (PDF)
i. Entirely determined by mean and variance
ii. Symmetric
iii. “Bell-Shaped”
1) Provides a reasonable approximation for the true distribution of
stock returns
Chapter 1: Introductory Lecture
What is Risk
A possible future event which if it occurs will lead to
an undesirable outcome.
The possibility of suffering loss
What is 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
Hedge: a financial position (derivative) put on to reduce the impact of a risk one is exposed to.
(hedging = putting on a hedge)
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 correlate
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
Example Appreciation/Depreciation in a Production firm
- IMPUT -> CD appreciates with respect to the USD
o Canadian Dollar worth more, stronger CD
o Need more USD to pay the imput
- Output -> CD depreciates with respect to the USD
o Asset is in CD -> get less CD
o So eventually also less USD
Low Interest -> implies slow growth & implies chance on deflation (stagnation economy)
How could a firm reduce the risk exposure?
1. Diversify product line
- Most of time with negative correlated activities (requires
investments/uncertainty/time-consuming)
2. Manage the expenditures
- Increase variable relative to fixed cost (difficult with machines).
- If sales drop -> cost will drop, overhead doesn’t change
- More temporal contracts.
3. Reduce leverage
- Reduce debt relative to equity
- The less debt you got -> less the cash flow requirements will be (and also bankruptcy
costs/financial distress.
4. Use of derivatives
- Often cheapest and most flexible
,What is a derivative?
- “A derivative is a financial instrument with promised payoffs derived from the value
of one or several contractually specific underlyings.
- A financial instrument which end value is DERIVED from the underlyings
- Underlyings can be “anything”.
Derivatives come in two flavours:
1. Plain vanilla
- Forwards
- Futures
- Options
2. Exotic -> derivative whose payoff cannot be replicated by a combination of options and
futures
- Exotic swap
- Binary option
Way of trading derivatives
- Exchange (CME)
- Over-the-counter
i. Two parties agree on a trade without meeting through an organized
exchange. (mostly with a bank)
Mostly common underlying: Interest rate -> Banks (mostly with swaps) hedge their own risk, e.g. for
asset/liability management.
Note: If not well understood, trading in derivatives can lead to large losses that often endanger the
financial health of corporations and another derivative trader.
Windfall: what you get relatively to what you expect.
Main types of Derivatives
1. Options
- Call Option: a security which gives the right to BUY a specified
quantity of an underlying assed at a contractually agreed price
at OR BEFORE a fixed date
i. MAX (0, St – X)
- Put Option: a security which gives the right to SELL a specified
quantity of an underlying assed at a contractually agreed price
at OR BEFORE a fixed date
i. MAX (0, X – St)
TERMS
- Exercise price/ Strike Price (X)
- Maturity
- Option buyer / seller (writer
- Option premium
-> “Fee” for protecting downside/upside and gaining up/down potential
- European vs American -> when to exercise.
Option: upside potential + downside protection -> pay a premium
Forward: pay for downside protection
Implicitly: pay for the downside protection by giving up the upside potential
,2. Forward contracts: an agreement between 2 parties to buy (sell)
a well-defined asset at a pre specified prices AT a well-defined
future point in time
- Long: Obligation to BUY
- Short: Obligation to sell -> PICTURE
- Difference with futures
i. Not traded on exchange =(not standardized) -> Over-The-Counter
ii. Tailor-made -> amount and maturity
3. Futures contracts (similar to Forwards but see difference and more details later in course)
- Société Generale (Jérôme Kerviel)
Long position to buy DAX-stocks at 8000 on ...time… -> DAX
start falling -> huge future loss
4. Swaps: a contract between two parties who engage themselves to swap casflows at pre-
specified future moments according to a pre-specified formula
- Interest Rate Swaps: At the coupon days, B pays a fixed interest rate on a notional
amount to A. A pays B on the same amount a floating rate
i. Fixed for floating (B is swapping his fixed for the
floating with A)
ii. Floating for fixed
- Currency Swaps: A fixed (variable) rate
currency swap involves counterparty A
exchanging fixed (variable) rate interest in
one currency with counterparty B in return
paying fixed (variable) interest in another
currency.
i. Useful in debt management!
Swaps are typically longer term for recurring
exposures!
, Chapter 2: Investors and Risk management
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.
Investors have tools to choose the optimal risk level of their portfolio through:
1) Asset Allocation
2) Diversification (portfolio mostly done)
3) (Derivative)
If investors can manage at portfolio level, do they still want firms to spend money on risk
management strategies?
- Need to know more information
1. Calculate (historical) Return. (without Divident =(New-Old)/Old)
2. Calculate (return) Variance Excel = Var(..)
- The variance of a random variable is a quantitative
measure of how the realizations of the random variable
are distributed around their expected value
- Momentum effect (ST): a stock performed well today, so
it will be likely to perform well tomorrow.
3. Volatility = the square root of the variance!!
- Need the average return
- Asset’s weekly return variance
4. Variance of Multi-period returns
- The square root of time rule! (Excel =SQRT(..)
Variance of returns grows linearly with time while
volatility grows by the square root of time
- Daily to weekly
VOL(weekly) = SQRT(Variance(daily)) *SQRT (7)
- Daily to Annualized
VOL(annualized) = SQRT(Variance(daily)) *SQRT (252)
- Weekly to Annualized
VOL(annualized) = SQRT(Variance(weekly)) *SQRT (52)
5. Probability distribution function: A probability distribution function provides a quantitative
measure of the likelihood of the possible outcomes or realizations of a random variable by
assigning probabilities to these outcome.
- Normal Distribution (PDF)
i. Entirely determined by mean and variance
ii. Symmetric
iii. “Bell-Shaped”
1) Provides a reasonable approximation for the true distribution of
stock returns
