risk management-class 2

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Financial Risk Management

Prof. M. Pandey



Risk Management

Risk management is a structured approach to

managing undesirable outcomes arising from a

transaction, deal or a project, which can adversely

impact a firm.

The risk management strategies include transferring

the risk to another party, avoiding the risk, reducing

the negative effect of the risk, and accepting some or

all of the consequences of a particular risk.



Risk Management

In ideal risk management, a prioritization process isfollowed whereby the risks with the greatest loss andthe highest probability of occurring are handled first,and risks with lower probability of occurrence andlower loss are handled in descending order.

This is the idea of opportunity cost. Resources spenton risk management could have been spent on moreprofitable activities. Again, ideal risk managementminimizes spending while maximizing the reductionof the negative effects of risks.



Risk management Approaches

Risk Avoidance: Not performing an activity that

could carry risk. Avoidance may seem the answer to

all risks, but avoiding risks also means losing out on

the potential gain that accepting (retaining) the riskmay have allowed. Not entering a business to avoid

the risk of loss also avoids the possibility of earning

profits.




Risk reduction: Involves methods that reduce the

severity of the loss or the likelihood of the loss from

occurring.

There are various methods of Risk reduction,followed by firms.

a) Statistical controls

b) DR techniquesc) Outsourcing




Risk retention: It Involves accepting the loss when it

occurs.

Risk retention is a viable strategy for small risks

where the cost of insuring against the risk would begreater over time than the total losses sustained.

All risks that are not avoided or transferred are

retained by default.




Risk Transference: This method involves

transferring the risk to the third party, who is

willing to assume the risk for certain price.

a) Insurance

b) Use of Derivatives



Risk Management styles

Control Focused: Respond to requests by

regulators

More compliance focused.

Risk Management performsa purely monitoring role

Monitoring of positions andrisks against limits

Strategic: Risk Management partners

with the business indecision-making

It works towardsdevelopment of newmodels.

The approach is to improverisk management process

Development and analysisof risk-adjusted returns



Risk management process

Identify Risk

Qualify the risk

Quantify the risk Formulate the treasury policy

Manage the risk

Policy review & improve



Identify Risk

Identify Risk Identify all the direct risks

first, along the firm value

chain.

Second also identify indirect

risks.



Q ualifying Risk

Q ualify the risk on 2

parameters.

Classify the qualified risks

under appropriate class.

High monetary impact

High probability of

occurrence

Commodity Price

risk,FX,Interest rate,

Credit,etc



Q uantify Risk

Q uantify risk: Scenario analysis

Based on historical

records & data.



Formulate treasury Policy

Formulate Policy Owner/Board Approval

Clearly define its risk

appetite and policy

objectives Specific parameters

defining hedging activity

Approved risk management

instruments

Identify who is authorised

to deal on behalf of

company



Manage Risk

Manage risk Introduce the concept

of hedging

Hedging acts as an

insurance technique

Hedging is different

from speculation.

Hedging does involvecost.



Review & improve

Review & improve Regular review of Treasury Policy

Regular performance

evaluations andexamination of management decisions

Simple analysis to

understand the actualcost incurred from

current strategies



Long & Short HedgesLong & Short Hedges

A long hedge is appropriate when you have

exposure to rise in price.

A short hedge is appropriate when you have anexposure to falling prices.



Arguments in Favor of HedgingArguments in Favor of Hedging

Companies should focus on the main business

they are in and take steps to minimize risks

arising from interest rates, exchange rates,

and other market variables



Arguments against HedgingArguments against Hedging

Shareholders are usually well diversified and can

make their own hedging decisions

It may increase risk to hedge when competitors do

not

Explaining a situation where there is a loss on the

hedge and a gain on the underlying can be difficult



Hedging ToolsHedging Tools

Forwards

Futures

Options

Swaps

Structured products



An Airline using options to hedge its Jet fuel

purchases

Airline purchases 100,000 bbl of Jet fuel every monthat price linked to Platts published monthly prices.

Airline decides to protect itself against increase in jet

fuel prices. They have decided to hedge 100,000 barrels per

month by buying a OTC call option from a Bank ata strike price of $16.00/bbl and premium of $0.25.



Airlines hedge position

Monthly Avg price $18.00/bbl $13.50/bbl

Cash market cost of

100,000 bbl.

$1800,000 $1350,000

Option

Gain/loss Gain $175,000 Loss$25,000

Effective total cost $1625,000 $1375,000



DerivativesDerivatives

Derivatives are contracts, financial instruments,which derive their value from that of anunderlying asset. The asset that underlies aderivative can be a physical commodity, foreigncurrencies, treasury bonds, company stock, etc.

It is legally binding contract.

Derivatives are of 2 types

1)Exchange traded2)OTC

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Ways Derivatives are UsedWays Derivatives are Used

To hedge risks

To speculate (take a view on the futuredirection of the market)

To lock in an arbitrage profit

To generate income

Financial engineering

To change the nature of a liability

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Forward ContractForward Contract

It is an agreement to buy or sell an asset on

a future date at a certain price.

The forward price for a contract is the

delivery price that would be applicable tothe contract, negotiated today.

The forward price may be different for

contracts of different maturities

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TerminologyTerminology

The party that has agreed to buy has what

is termed a long position

The party that has agreed to sell has whatis termed a short position

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Foreign Exchange Q uotes for GBP, July 20,Foreign Exchange Q uotes for GBP, July 20,

20072007

Bid Offer

Spot 2.0558 2.0562

1-month forward 2.0547 2.0552



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ExampleExample

On July 20, 2007 the treasurer of a corporation

enters into a long forward contract to buy £1 million

in six months at an exchange rate of 2.0489

This obligates the corporation to pay $2,048,900 for£1 million on January 20, 2008

The bank has a short position on GBP.

Both corporation & Bank have made a bindingcommitment.

What are the possible outcomes?

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ExampleExample

What are the possible outcomes?

If the spot exchange rate rose to say, 2.1000 at the

end of six months.

It would enable the corporation to purchase 1

million pound at contracted rate of 2.0489, rather

than 2.1000. Thus corporation gains $51,100

(2100,00-2048,900).

If spot rate fell to 1.9000 at the end of six months,

corporation would make a notional loss of $148,900.

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Payoff from aPayoff from a

Long Forward PositionLong Forward Position

Profit

Price of Underlying

at Maturity, S T

K

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Payoff from aPayoff from a

Short Forward PositionShort Forward Position

Profit

Price of Underlying

at Maturity, S T

K

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Determination of Forward and

Futures Prices



Arbitrage Opportunity?Arbitrage Opportunity?

Suppose that:

±The spot price of non dividend-paying

stock is $40

±The 3 month forward price is US$43

±The 3 month interest rate is 5% per

annum

Is there an arbitrage opportunity?

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Borrow $40 @5% for 3 months

Buy one unit of asset

Enter into forward contract to sell asset in3 months for $43.00

At end of 3 months

Payoff loan for $40.50

Sell asset for $43

Profit realised $2.50

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Suppose that:

±The spot price of non dividend-paying

stock is $40

±The 3 month forward price is US$39

±The 3 month interest rate is 5% per

annum

Is there an arbitrage opportunity?

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Short 1unit of asset to get$40

Invest $40 @5% for 3 months

Enter into forward contract to buy asset in 3

months for $39.00 At end of 3 months

Buy asset for $39.00

Close the short position

Receive $40.50 from investment Profit realised $1.50

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Gold: An ArbitrageGold: An Arbitrage

Opportunity?Opportunity?

Suppose that:

T

he spot price of gold is US$900The 1-year forward price of gold is

US$1,020

The 1-year US$ interest rate is 5% per

annumIs there an arbitrage opportunity?

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Consumption vs Investment Assets

Investment assets are assets held by

significant numbers of people purely for

investment purposes (Examples: Stocks,gold,

silver)

Consumption assets are assets held primarily

for consumption (Examples: copper, oil)

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Notation

S 0: Spot price today

F 0: Futures or forward price today

T : Time until delivery date

r : Risk-free interest rate for

maturity T

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When Interest Rates are Measured with

Continuous Compounding

F 0 = S 0erT

This equation relates the forward price and

the spot price for any investment asset that

provides no income and has no storagecosts

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The Cost of Carry

The cost of carry, c, is the storage cost plus the

interest costs less the income earned

For an investment asset F 0 = S 0ecT

For a consumption asset F 0 = S 0 e(c ± y )T

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