FINANCIAL RISK MANAGEMENT
Introduction ........................................................................................................................................................................... 2
Topic 1: Introduction to risk management ............................................................................................................................ 2
Topic 2: Interest rates ............................................................................................................................................................ 7
Topic 3: Risk measurement ................................................................................................................................................. 15
Topic 4: Risk management (1) ............................................................................................................................................. 25
Topic 5: Risk management (2) ............................................................................................................................................. 35
Topic 6: Hedging with options ............................................................................................................................................. 47
Topic 7: Pricing of options ................................................................................................................................................... 61
,Introduction
Key questions in the course:
- What is (financial) risk and how can we measure/manage it?
- What financial instruments are used to mitigate risk and how do they do so?
- How do we ‘value’ these financial instruments?
Topic 1: Introduction to risk management
Risk management
“There is no such thing as a return without risk”
- Risks are necessary to generate return
- True in business, in investing, when buying a house, ...
- Risk management
o Try to understand the risk involved in running a business
o Identify the amount of risk you are willing to take
§ The risk should align with your risk appetite
o Manage the risk
o Rely on a fixed process
§ Identify > measure > manage > monitor > report on risks
Risk management process
Risk Appetite framework
- Identify
- Measure
- Manage (mainly done by derivatives)
- Monitor
- Report
- E.g. ‘How comfortable am I if the share price drops by 20%?’
Identifying risks
Two types of risks: financial and non-financial
- Both can have financial consequences (losses, fines, …)
- Difference: nature of the risk
o Financial risk: comes from participation in financial markets
o Non-financial risk: everything else
Financial risk
- Comes from participating in financial markets: changes in prices and interest rates
o Market risk: risk of losses due to adverse movements in stock prices, interest rates, exchange rates,
commodity prices, ...
o Credit risk: risk of losses due to counterparty not being able to pay back
§ Main risk for banks
o Liquidity risk: risk of losses because you’re unable to buy or sell assets due to lack of market participants
Non-financial risk
- = Residual risk
o Can still have major financial consequences
o Because people/processes are imperfect
o Become more and more important
- Operational risk: risk of losses due to inadequate internal processes, people and systems, or from external
events
o Internal/external fraud
2
, o Cyber risk
o Legal risk
o Country risk
o Model risk
- Reputation risk: risk of losses due to damages in reputation
Financial risk
Market risk: S&P 500
- Changes in the market due to trade tariffs
o Financial markets don’t like any type of barrier to trade
o Markets are volatile and thus completely overreact to news
Credit risk: borrowing rate
- Country’s usually don’t default, but France’s risk of defaulting has gone up
o Result 1: lower rating for France
o Result 2: You have to pay more interest to borrow money, because of the lower rating
Liquidity risk: US treasuries for different maturities
- Bid-ask spread = difference between price for which you buy and sell
o This is how brokers make money
o Relatively low
§ Uncertainty in the market about who’s creditworthy resulted in higher bid-ask spreads
Non-financial risk (slide 20)
- Barings goes bust
- Fraud
- Cyber attacks
- Money laundering scandal Danske Bank
Identifying risks
From Deloitte Global Risk Management Survey
- ‘How many of you take these risks into account?’
o Cybersecurity isn’t taken into account enough
- Most financial institutions now have proper risk management frameworks
in place for financial risks
- Nonfinancial risks are becoming more important
Measuring financial risks
What exactly is risk?
- Risk means that the outcome is uncertain
- Not the same as uncertainty
- Donald Rumsfeld (former Secretary of Defense in the U.S.):
3
, “There are known knowns. These are things we know that we know. There are known unknowns. That is to say,
there are things that we know we don’t know. But there are also unknown unknowns. These are things we don’t
know we don’t know.”
o Risks (known unknowns) are put into the Rumsfeld matrix (combination of (un)known – (un)known)
Measuring financial risks
- Risks = known unknowns
o We know the probabilities and the different states that can happen
o Losses and profits are unknown à not entirely true
§ You can price risks
- Example:
o You own shares in AB-Inbev currently worth €49.94
o Tomorrow, there are two states of the world, each with 50% probability:
State Probability Share price
1 50% 30
2 50% 80
§ Expected value = (50% x 30 ) + (50% x 80) = 55
§ The risk in owning this share is that tomorrow it is worth either €30.00 or €80.00, and your
investment might lose value
Measuring risks
- Uncertainty = unknown unknown
o You don’t know how many states there are
o You don’t know their probability
o You don’t know their pay-off
o You just don’t know
o Much more severe than risks
- Or, as Frank Knight (UChicago) put it:
“Uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never
been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of
measurement, while at other times it is something distinctly not of this character; and there are far- reaching and
crucial differences in the bearings of the phenomena depending on which of the two is really present and
operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far
different from an unmeasurable one that it is not in effect an uncertainty at all.”
Risk measurement
- Risk is much easier to measure than uncertainty
- Shed some light on the unknown unknowns (= uncertainty), to potentially make them known unknowns (= risk)
- Quantify the known unknowns (= risk)
o Using statistical and econometric methods
Managing risks
Process
- Quantify financial risks
- Manage risks
Tools are necessary to manage risks: Derivative instruments
- Contracts whose value is derived from an underlying asset
- Futures, forwards, swaps, options, credit default swaps, etc.
4
, - Outstanding (notional) derivatives market is >730 trillion dollar, roughly 3 times larger than the bond (145
trillion dollar) and equity market (126 trillion dollar) combined!
- Mainly interest rate and foreign exchange rate derivatives
o Example: slide 28
- Banks are a large part of the derivatives market
o Banks use swaps to hedge interest rate risk
Monitor risks
Three lines of defense:
- Senior mgmt. sets the risk appetite that the company is comfortable with
- 1st line: front office à Person taking the risk
o Internal risk limits: Front office should know how much risk they are allowed to take
o Management controls
o Internal control measures
- 2nd line: risk management à ensures that total risk limit (set by senior management) is not overdone, by
looking at the different risks taken by the front office (traders, branches)
o Central risk controls
§ Financial control
§ Security
§ Risk management
§ Quality
§ Inspection
§ Conformité
- 3rd line: internal audits
o Ensures that whatever risk is
reported to senior
management is correct
o Reports to senior
management and governing
body
- External audit (big4)
- Regulator
Reporting risks
Monitoring and measuring of risks needs to be reported to the board of directors
- Most Financial Institutions have a Chief Risk Officer (CRO) in the board
- Dual purpose:
o Board of directors need a risk appetite framework in place before taking the risks
o Board of directors need to be informed on the current risks (and risk exceedances)
o Tools used to report to board of directors:
5
, Challenges
- Firms have become more skilled at managing financial risks
Challenges for risk management in the future
- Incorporating non-financial risks
- Hiring and developing talent
- New ‘uncertainties’ in the world
o Geopolitical risk
o Trade uncertainties
o Climate
o Changing business models, …
But there is always a trade-off between risk and return
Example Credit Suisse (slide 34)
- The bank became more commercial and just wanted to sell without taking into account the risks
- They took a series of bets and were left with a lot of losses
- They didn’t invest properly in risk management
o Reason: trade-off between risk and return
- There came a new CEO and CCO (Chief compliance officer)
- UBS (Credit Suisse’s longtime rival) bought Credit Suisse which went bankrupt
6
Introduction ........................................................................................................................................................................... 2
Topic 1: Introduction to risk management ............................................................................................................................ 2
Topic 2: Interest rates ............................................................................................................................................................ 7
Topic 3: Risk measurement ................................................................................................................................................. 15
Topic 4: Risk management (1) ............................................................................................................................................. 25
Topic 5: Risk management (2) ............................................................................................................................................. 35
Topic 6: Hedging with options ............................................................................................................................................. 47
Topic 7: Pricing of options ................................................................................................................................................... 61
,Introduction
Key questions in the course:
- What is (financial) risk and how can we measure/manage it?
- What financial instruments are used to mitigate risk and how do they do so?
- How do we ‘value’ these financial instruments?
Topic 1: Introduction to risk management
Risk management
“There is no such thing as a return without risk”
- Risks are necessary to generate return
- True in business, in investing, when buying a house, ...
- Risk management
o Try to understand the risk involved in running a business
o Identify the amount of risk you are willing to take
§ The risk should align with your risk appetite
o Manage the risk
o Rely on a fixed process
§ Identify > measure > manage > monitor > report on risks
Risk management process
Risk Appetite framework
- Identify
- Measure
- Manage (mainly done by derivatives)
- Monitor
- Report
- E.g. ‘How comfortable am I if the share price drops by 20%?’
Identifying risks
Two types of risks: financial and non-financial
- Both can have financial consequences (losses, fines, …)
- Difference: nature of the risk
o Financial risk: comes from participation in financial markets
o Non-financial risk: everything else
Financial risk
- Comes from participating in financial markets: changes in prices and interest rates
o Market risk: risk of losses due to adverse movements in stock prices, interest rates, exchange rates,
commodity prices, ...
o Credit risk: risk of losses due to counterparty not being able to pay back
§ Main risk for banks
o Liquidity risk: risk of losses because you’re unable to buy or sell assets due to lack of market participants
Non-financial risk
- = Residual risk
o Can still have major financial consequences
o Because people/processes are imperfect
o Become more and more important
- Operational risk: risk of losses due to inadequate internal processes, people and systems, or from external
events
o Internal/external fraud
2
, o Cyber risk
o Legal risk
o Country risk
o Model risk
- Reputation risk: risk of losses due to damages in reputation
Financial risk
Market risk: S&P 500
- Changes in the market due to trade tariffs
o Financial markets don’t like any type of barrier to trade
o Markets are volatile and thus completely overreact to news
Credit risk: borrowing rate
- Country’s usually don’t default, but France’s risk of defaulting has gone up
o Result 1: lower rating for France
o Result 2: You have to pay more interest to borrow money, because of the lower rating
Liquidity risk: US treasuries for different maturities
- Bid-ask spread = difference between price for which you buy and sell
o This is how brokers make money
o Relatively low
§ Uncertainty in the market about who’s creditworthy resulted in higher bid-ask spreads
Non-financial risk (slide 20)
- Barings goes bust
- Fraud
- Cyber attacks
- Money laundering scandal Danske Bank
Identifying risks
From Deloitte Global Risk Management Survey
- ‘How many of you take these risks into account?’
o Cybersecurity isn’t taken into account enough
- Most financial institutions now have proper risk management frameworks
in place for financial risks
- Nonfinancial risks are becoming more important
Measuring financial risks
What exactly is risk?
- Risk means that the outcome is uncertain
- Not the same as uncertainty
- Donald Rumsfeld (former Secretary of Defense in the U.S.):
3
, “There are known knowns. These are things we know that we know. There are known unknowns. That is to say,
there are things that we know we don’t know. But there are also unknown unknowns. These are things we don’t
know we don’t know.”
o Risks (known unknowns) are put into the Rumsfeld matrix (combination of (un)known – (un)known)
Measuring financial risks
- Risks = known unknowns
o We know the probabilities and the different states that can happen
o Losses and profits are unknown à not entirely true
§ You can price risks
- Example:
o You own shares in AB-Inbev currently worth €49.94
o Tomorrow, there are two states of the world, each with 50% probability:
State Probability Share price
1 50% 30
2 50% 80
§ Expected value = (50% x 30 ) + (50% x 80) = 55
§ The risk in owning this share is that tomorrow it is worth either €30.00 or €80.00, and your
investment might lose value
Measuring risks
- Uncertainty = unknown unknown
o You don’t know how many states there are
o You don’t know their probability
o You don’t know their pay-off
o You just don’t know
o Much more severe than risks
- Or, as Frank Knight (UChicago) put it:
“Uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never
been properly separated.... The essential fact is that 'risk' means in some cases a quantity susceptible of
measurement, while at other times it is something distinctly not of this character; and there are far- reaching and
crucial differences in the bearings of the phenomena depending on which of the two is really present and
operating.... It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far
different from an unmeasurable one that it is not in effect an uncertainty at all.”
Risk measurement
- Risk is much easier to measure than uncertainty
- Shed some light on the unknown unknowns (= uncertainty), to potentially make them known unknowns (= risk)
- Quantify the known unknowns (= risk)
o Using statistical and econometric methods
Managing risks
Process
- Quantify financial risks
- Manage risks
Tools are necessary to manage risks: Derivative instruments
- Contracts whose value is derived from an underlying asset
- Futures, forwards, swaps, options, credit default swaps, etc.
4
, - Outstanding (notional) derivatives market is >730 trillion dollar, roughly 3 times larger than the bond (145
trillion dollar) and equity market (126 trillion dollar) combined!
- Mainly interest rate and foreign exchange rate derivatives
o Example: slide 28
- Banks are a large part of the derivatives market
o Banks use swaps to hedge interest rate risk
Monitor risks
Three lines of defense:
- Senior mgmt. sets the risk appetite that the company is comfortable with
- 1st line: front office à Person taking the risk
o Internal risk limits: Front office should know how much risk they are allowed to take
o Management controls
o Internal control measures
- 2nd line: risk management à ensures that total risk limit (set by senior management) is not overdone, by
looking at the different risks taken by the front office (traders, branches)
o Central risk controls
§ Financial control
§ Security
§ Risk management
§ Quality
§ Inspection
§ Conformité
- 3rd line: internal audits
o Ensures that whatever risk is
reported to senior
management is correct
o Reports to senior
management and governing
body
- External audit (big4)
- Regulator
Reporting risks
Monitoring and measuring of risks needs to be reported to the board of directors
- Most Financial Institutions have a Chief Risk Officer (CRO) in the board
- Dual purpose:
o Board of directors need a risk appetite framework in place before taking the risks
o Board of directors need to be informed on the current risks (and risk exceedances)
o Tools used to report to board of directors:
5
, Challenges
- Firms have become more skilled at managing financial risks
Challenges for risk management in the future
- Incorporating non-financial risks
- Hiring and developing talent
- New ‘uncertainties’ in the world
o Geopolitical risk
o Trade uncertainties
o Climate
o Changing business models, …
But there is always a trade-off between risk and return
Example Credit Suisse (slide 34)
- The bank became more commercial and just wanted to sell without taking into account the risks
- They took a series of bets and were left with a lot of losses
- They didn’t invest properly in risk management
o Reason: trade-off between risk and return
- There came a new CEO and CCO (Chief compliance officer)
- UBS (Credit Suisse’s longtime rival) bought Credit Suisse which went bankrupt
6
