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8/8/2019 Risk Management-Class 2
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Financial Risk Management
Prof. M. Pandey
8/8/2019 Risk Management-Class 2
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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.
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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.
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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.
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Risk management Approaches
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
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Risk management Approaches
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.
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Risk management Approaches
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
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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
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Risk management process
Identify Risk
Qualify the risk
Quantify the risk Formulate the treasury policy
Manage the risk
Policy review & improve
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Identify Risk
Identify Risk Identify all the direct risks
first, along the firm value
chain.
Second also identify indirect
risks.
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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
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Q uantify Risk
Q uantify risk: Scenario analysis
Based on historical
records & data.
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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
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Manage Risk
Manage risk Introduce the concept
of hedging
Hedging acts as an
insurance technique
Hedging is different
from speculation.
Hedging does involvecost.
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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
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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.
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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
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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
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Hedging ToolsHedging Tools
Forwards
Futures
Options
Swaps
Structured products
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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.
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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
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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
3-month forward 2.0526 2.0531
6-month forward 2.0483 2.0489
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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
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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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Arbitrage Opportunity?Arbitrage Opportunity?
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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Arbitrage Opportunity?Arbitrage Opportunity?
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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Arbitrage Opportunity?Arbitrage Opportunity?
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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