The New Risk ManagementThe Good, the Bad, and the UglyAuthor : Philip H. Dybvig, Pierre Jinghong Liang, and William J. Marshall

Presented By: Yiji Gu

New Risk Management

New VS. Old

Old Buy corporate insurance Avoid lawsuits and accidents Install safety equipment

New Use financial markets to hedge against interest rate

risk, currency fluctuations…etc

Tools for hedging

Options

Black-Scholes model

Matching beginning value and ending value

Losing money in good times and making money in bad times

Example

Naive Hedge

Unhedged Cash Flows

Fully Hedged

Example

Price Dynamics

Example-Dynamic Hedging

Reinvestment rate

Reinvested proceeds of the hedge + original cash flow is the same in every contingency

Four Questions to ask

Why should we hedge?

What risk should we hedge?

With what instrument should we hedge?

Support your investment banker

Why should we hedge

Reduce the volatility of the value received by shareholders

Avoid potential ancillary damage within the firm. i.e. bankruptcy, increase tax

A policy of smoothing earning

Give managers incentives to produce profits

What risks should we hedge

i.e. interest rate risk

Directly hedge the mismatch of existing assets and liabilities

Or hedge the full economic value that includes the value of future business

Hedge cash flows or value

Accounting issues

Hedge accounting treatment Fair value hedge VS Cash flow hedge Conditions Failure to qualify as a hedge often penalize true

economic hedging

Hedges that are economically equivalent may have very different accounting treatment

Cost

Transaction cost Liquid market Custom contracts

Marginal cost Spot market price

Risk Management Policy

Control system

Goals of hedging program

Ex post evaluation

Thank YouYiji Gu