2014 Risk Management - Part 1

Financial Risk Management
Prof. Dr. Jrg Prokop
Winter Term 2014/15
Course Contents
Concept of risk management
Mechanics of financial markets, in particular derivatives
markets
Applications and limitations of financial derivatives in risk
management
Preliminary Course Outline

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
What Is Risk?
Introduction to Derivatives
Mechanics of Futures Markets
Hedging Strategies Using Futures
Interest Rates
Determination of Forward and Futures Prices
Swaps
Properties of Options
Binomial Trees
The Black-Scholes-Merton Model
Conclusion
Recommended Readings
Hull, John C. Options, Futures, and Other Derivatives, 8th ed.,
Pearson 2012 [OFD]
main textbook (note: the older editions 6 or 7 will do as well)
Hull, John C. Solutions Manual for Options, Futures, and Other
Derivatives, 8th ed., Pearson 2012
Damodaran, Strategic Risk Taking: A Framework For Risk
Management, Pearson 2008 [SRT] (draft version: http://pages.stern.
nyu.edu/~adamodar/New_Home_Page/valrisk/book.htm)
Hull, John C. Fundamentals of Futures and Options Markets, 7th ed.,
Pearson 2011
alternative textbook
Preliminary Schedule
Date
Time
Room
Topic
Chapter
17 Sep
14.00-17.00
BC-207
What Is Risk?
SRT 1, 2, 4
OFD 1
18 Sep
14.00-17.00
BC-208
Mechanics of futures
markets
Hedging strategies using
futures
OFD 2
OFD 3
19 Sep
09.00-12.00
14.00-17.00
BC-208
BC-208
30 Sep
10.00-13.00
14.00-17.00
BC-207
BC-208
Binomial trees
The Black-Scholes-Merton
model
Conclusion / recap session
Interest rates
Forward and futures prices
Swaps
Properties of Options
OFD 4
OFD 5
OFD 7
OFD 9, 10
OFD 12
OFD 13,
14
OFD 35
Course Organization
Assessment:
Written examination, date tba
The exam will be closed book. However, you will be
permitted a hand-written two-sided cheat sheet with
notes and / or formulae.
Slides & course announcements
=> Moodle
Best way to contact me:
finance.banking@t-online.de
Financial Risk Management:

What Is Risk?
Suggested Reading:
SRT, ch. 1, 2, 4
Holton, Defining Risk, Financial Analysts
Journal, 2004, Vol. 60, No. 6, pp. 19-25
Basic Principle
Theres no such thing as a free lunch.

(Hessen, Free Lunch, in: Eatwell/Milgate/Newman: The New Palgrave:
A Dictionary of Economics, Volume II, London 1988, p. 450)
How does that relate to Finance and Economics?
What Is Risk?
Measurable uncertainty?
(e.g., Knight, 1921)
Risk
Uncertainty + exposure?
(e.g., Holton, 2004)
What Is Uncertainty?
Being uncertain about a
proposition means:
that you do not know wether
it is true or false (perceived
uncertainty)
or
that you are not aware of
the proposition.
10
What Is Exposure?
Having exposure to a
proposition means:
that you care whether
it is true or false
or
that you would care
whether it is true or
false if you were aware
of the proposition.
11
Taking Risk
Some situations that involve risk:
Trading natural gas,
launching a new business,
military adventures,
asking for a pay raise,
sky diving, and
romance.
Do organizations (e.g., companies) take risk? Who does?
12
Why Do We Care About Risk?

The St. Petersburg Paradox
Try the following:
Flip a coin. If it comes up tails, you receive one dollar.
In this case, you may flip it again. If it comes up tails
again, your winnings will be doubled.
You may continue the game to double your winnings as
long as the coin does not come up heads.
If it comes up heads, the experiment ends, and you
receive your accumulated gains.
How much would you pay to participate in this game?
13
Why Do We Care About Risk?

The St. Petersburg Paradox
1
1
1
1
1 + 2 + 4 + 8 + ...
16
8
4
2
1
1 1 1 1
= + + + + ... = =
2 2 2 2
i =1 2
Expected value: E =
Judging only on the basis of the games expected value,

we would be willing to pay a very (or even infinitely) high
amount of cash to participate
However, in reality most people would pay only a few $
St. Petersburg Paradox (first published by D. Bernoulli in St.
Petersburg Academy Proceedings, 1738)
14
Expected Utility Theory

The determination of the value of an item must not be based
on its price, but rather on the utility it yields. The price of the
item is dependent only on the thing itself and is equal for
everyone; the utility, however, is dependent on the particular
circumstances of the person making the estimate. Thus there
is no doubt that a gain of one thousand ducats is more
significant to a pauper than to a rich man though both gain
the same amount.
(Bernoulli, 1738, [cited in Econometrica 22(1), 1954, p. 24])
How can we turn this idea into a decision model?

15

Bernoullis approach: Utility functions
Step 1: Assign a subjective utility value U (W ) to
every potential outcome
of the uncertain
~
target variable W
[ ( )]
~
Step 2: Calculate the expectation value E U W
of the distribution of uncertain utility values
from step 1
NB: The following discussion of Expected Utility Theory is partly based on Elton / Gruber / Brown /
Goetzman: Modern Portfolio Theory and Investment Analysis, 6th ed., Hoboken 2003, chapter 10
16
Example: Bernoulli-Principle
Probability distributions of three investments:
Given utility function: U(W) = 4W - (1/10)W2

Investment A: U(20) = 4*20 - (1/10)*202 = 40
U(18) = 4*18 - (1/10)*182 = 39,6
U(14) = 4*14 - (1/10)*142 = 36,4
etc.
17
Example: Bernoulli-Principle
Probability distributions and utility profiles:
Expected utility: E[U(WA)] = 40*3/15+39,6*5/15... = 36,3

E[U(WB)] = 39,9*1/5+30*2/5... = 26,98
E[U(WC)] = 39,6*1/4+38,4*1/4... = 34,4
Resulting preference relation: W A f WC f WB
18
Characteristics of Utility Functions

Example: Fair gamble
The investors options:
19
Characteristics of Utility Functions

(strictly)
concave
linear
(strictly)
convex
Utility functions given:

(1) Risk preference (e.g., U(W) = W2)
(2) Risk neutrality (e.g., U(W) = W)
(3) Risk aversion
(e.g., U(W) = W0,5)
20
Risk Management
http://www.sciencecartoonsplus.com/gallery/risk/index.php
21
Risk Management
Potential risk management actions:
Reduce risk exposure
Maintain current level of
risk exposure
Increase risk exposure
Lets focus on the first one:
How can we reduce risk
exposure?
http://www.sciencecartoonsplus.com/gallery/risk/index.php
22
Risk Hedging Alternatives
Natural Hedges
Borrow in the same currency that
your asset risk is denominated in
Engineer flexibility into operations
Diversify
Improve forecasting
Match operating costs and revenues
in the same currency
Optimize insurance policy
Share risks: joint ventures, sales
agreements
Financial Hedges
Forwards
Futures
Options
Swaps
From Copeland/Weston/Shastri, Financial Theory

and Corporate Policy, 4th ed., 2005, p. 724 (mod.)
23
Risk Management
Is the above definition risk = uncertainty + exposure
operational?
If you cant measure it, you cant manage it!
(Kaplan/Norton, The Balanced Scorecard: Translating Strategy Into Action,
1996, p. 21)
I.e., we need some adequate risk metrics
24
Risk vs Return
There is a trade off between risk and expected return
The higher the risk, the higher the expected return
We can characterize investments by their expected return
(i) and standard deviation of returns (i):
n
i = E[~
ri ] = w j ~
ri , j
i = i2 =
j =1
w (~r
n
j =1
i, j
i )
The relationship between two investments return data can

be described by their covariance (ij), or by their
correlation coefficient (ij):
n
ij
ij =
ij = wk (~
rik i ) (~
rjk j )
i j
k =1
25
Systematic vs Non-Systematic Risk

Nonsystematic risk
Results from uncontrollable or random events that are
firm-specific
Examples: labor strikes, lawsuits
Systematic risk
Attributable to forces that affect all similar investments
Examples: war, inflation, political events
26
Portfolio Selection: Combining Risky Investments

(Markowitz, Journal of Finance 1952)
can be eliminated
through diversification
cannot be eliminated
through diversification
27
Expected Returns: The Capital Asset Pricing Model

(Sharpe, 1964 / Lintner, 1965 / Mossin, 1966)
j = RF + j ( M RF )
RF
1.0
Risk-free
Required return
Beta for
Market

= Risk-free rate +
return
rate
on investment j
investment j
28
Alpha
Alpha = extra return on a portfolio in excess of that
predicted by CAPM
so that
P = RF + P ( M RF )
= P RF P ( M RF )
29
Key Assumptions Underlying the CAPM

Investors are risk averse
Investors care only about an investments risk () and
expected return () Implies either normally distributed
returns or quadratic utility function
Unsystematic risks of different assets are independent
Investors focus on returns over one period
All investors can borrow or lend at the same risk-free rate
Tax does not influence investment decisions
All investors make the same estimates of s, s and s.
30
Critique Regarding the - Framework

Quadratic utility function:
Implies negative marginal utility for certain (high) ranges
of wealth
Implies increasing absolute risk aversion
Implies that investors are equally averse to good and to
bad outcomes of the same absolute amount
Normal distribution of returns:
Skewness?
Kurtosis?
Jumps?
31
Digression: Arbitrage Pricing Theory

(Ross, Journal of Economic Theory, 1976, pp. 341-360)
Assumptions:
Returns depend on several factors
Arbitrage-free markets (law of one price)
Expected return is linearly dependent on the realization of
the factors i = i + i1 I 1 + i 2 I 2 + ... + il Il
Each factor is a separate source of systematic risk
Unsystematic risk is the proportion of total risk that is
unrelated to all the factors
32
Digression: The Carhart (1997) Model
E ( RS ) = RF + SMkt ( E ( RMkt ) RF ) + SSMB E ( RSMB )

+ SHML E ( RHML ) + SPR1YR E ( RPR1YR )
In the Carhart (1997) model, there are four factors
representing the market risk premium, high minus low B/M,
small minus big, and momentum arbitrage portfolios
respectively.
The Fama-French (1993) three factor model is simply the
four factor model without the momentum factor.
33
Approaches to Risk Reduction

Risk aggregation
Aims to get rid of non-systematic risks with
diversification
Risk decomposition
Tackles risks one by one
In practice companies use both approaches
34
Reducing Risk With Diversification
Damodaran, Applied Corporate Finance, 3rd ed., 2010, p. 68

35
Recap Questions
1. What is the St. Petersburg Paradox?
2. In decision theory, what is considered a fair gamble? How does an
investors risk preference relate to her willingness to participate in a
fair gamble?
3. What is the difference between systematic and nonsystematic risk?
Which is more important to an equity investor? Which can lead to the
bankruptcy of a corporation?
4. Explain the CAPM formula. How would you estimate the respective
variables in practice?
5. A companys operational risk includes the risk of a very large loss due
to employee fraud. Do you think this particular risk should be handled
by risk decomposition or risk aggregation?
36
Financial Risk Management:

Suggested Reading:
OFD 2012, ch. 1
Size of OTC and Exchange-Traded

Derivatives Markets
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Over-the-counter
Exchange-traded
Source: Bank for International Settlements,

BIS Quarterly Review, June 2012.
Amounts outstanding, in billions of US dollars
Size of OTC and exchange-traded derivatives markets
German GDP 2011: about 3,335 billion US$

38
Bartram et al., Financial Management,

Vol. 38, No. 1, Spring 2009, p. 193
Study on Derivatives Usage by NonFinancial Firms (2000/01)
39
Ways Derivatives are Used

To hedge risks
To speculate (take a view on the future direction of the
market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without incurring
the costs of selling one portfolio and buying another
40
Forward Price
The forward price for a contract is the delivery price that
would be applicable to the contract if it were negotiated
today (i.e., it is the delivery price that would make the
contract worth exactly zero)
The forward price may be different for contracts of
different maturities
41
Terminology
The party that has agreed to buy has what is termed a
long position
The party that has agreed to sell has what is termed a
short position
42
Example
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
What are the possible outcomes?
43
Profit from a
Long Forward Position
Profit
Price of Underlying
at Maturity, ST
K
44
Profit from a
Short Forward Position
Profit
Price of Underlying
at Maturity, ST
K
45
Futures Contracts
Agreement to buy or sell an asset for a certain price at a
certain time
Similar to forward contract
Whereas a forward contract is traded OTC, a futures
contract is traded on an exchange
46
Examples of Futures Contracts

Agreement to:
Buy 100 oz. of gold @ US$900/oz. in December
(NYMEX)
Sell 62,500 @ 2.0500 US$/ in March (CME)
Sell 1,000 bbl. of oil @ US$120/bbl. in April (NYMEX)
47
1. Gold: An Arbitrage Opportunity?

Suppose that:
The spot price of gold is US$900
The 1-year forward price of gold is US$1,020
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?
48
2. Gold: Another Arbitrage Opportunity?

Suppose that:
The spot price of gold is US$900
The 1-year forward price of gold is US$900
49
The Forward Price of Gold

If the spot price of gold is S and the forward price for a
contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-free rate of
interest.
In our examples, S = 900, T = 1, and r =0.05 so that
F = 900(1+0.05) = 945
50
1. Oil: An Arbitrage Opportunity?

Suppose that:
The spot price of oil is US$95
The quoted 1-year futures price of oil is US$125
The storage costs of oil are 2% per annum
51
2. Oil: Another Arbitrage Opportunity?

Suppose that:
The spot price of oil is US$95
The quoted 1-year futures price of oil is US$80
The storage costs of oil are 2% per annum
52
Options
A call option is an option to buy a certain asset by a certain
date for a certain price (the strike price)
A put option is an option to sell a certain asset by a certain
date for a certain price (the strike price)
53
American vs European Options

An American option can be exercised at any time during
its life
A European option can be exercised only at maturity
54
CBOE Intel Option Prices, Sept 12, 2006

(Stock Price: 19.56)
Strike
Price
Oct
Call
Jan
Call
Apr
Call
Oct
Put
Jan
Put
Apr
Put
15.00
4.650
4.950
5.150
0.025
0.150
0.275
17.50
2.300
2.775
3.150
0.125
0.475
0.725
20.00
0.575
1.175
1.650
0.875
1.375
1.700
22.50
0.075
0.375
0.725
2.950
3.100
3.300
25.00
0.025
0.125
0.275
5.450
5.450
5.450
American Options
Contract size: 100 shares
55
Net Profit of a Call Strategy at Maturity

(Strike $20)
2000
1500
Profit ($)
1000
500
0
0
-500
10
15
20
25
30
35
40
Stock price ($)

56
Net Profit of a Put Strategy at Maturity

(Strike $17.5)
2000
1500
Profit ($)
1000
500
0
0
-500
10
15
20
25
30
35
40
Stock price ($)
57
Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation to
buy or sell at a certain price
An option gives the holder the right to buy or sell at a
certain price
58
Types of Traders
Hedgers
Speculators
Arbitrageurs
N.B.: Some of the largest trading losses in derivatives have occurred because
individuals who had a mandate to be hedgers or arbitrageurs switched
to being speculators (see for example Barings Bank, Business Snapshot
1.2, OFD p. 15)
59
Hedging Examples
A US company will pay 10 million for imports from Britain
in 3 months and decides to hedge using a long position in
a forward contract
An investor owns 1,000 Microsoft shares currently worth
$28 per share. A two-month put with a strike price of
$27.50 costs $1. The investor decides to hedge by buying
10 contracts
60
Value of Microsoft Shares With and Without

Hedging
61
Speculation Example
An investor with $2,000 to invest feels that a stock price
will increase over the next 2 months. The current stock
price is $20 and the price of a 2-month call option with a
strike of $22.50 is $1
What are the alternative strategies?
62
Arbitrage Example
A stock price is quoted as 100 in London and $200 in
New York
The current exchange rate is 2.0300 $/
What is the arbitrage opportunity?
63
Accounting for Derivatives

Ideally hedging profits (losses) should be recognized at the
same time as the losses (profits) on the item being hedged
Ideally profits and losses from speculation should be
recognized on a mark-to-market basis
Roughly speaking, this is what the accounting treatment of
futures under U.S. GAAP and IFRS (and many other
accounting frameworks) attempts to achieve
EU: IAS 39 (financial instruments: recognition and
measurement), to be superseded by IFRS 9 (issued Nov
2009, but not yet endorsed)
64
Derivatives: The IFRS Perspective (here: IAS 39.9)

A derivative is a financial instrument or other contract within the scope of
this standard (see paragraphs 2-7) with all three of the following
characteristics:
(a) its value changes in response to the change in a specified interest
rate, financial instrument price, commodity price, foreign exchange
rate, index of prices or rates, credit rating or credit index, or other
variable, provided in the case of a non-financial variable that the
variable is not specific to a party to the contract (sometimes called the
underlying);
(b) it requires no initial net investment or an initial net investment that is
smaller than would be required for other types of contracts that would
be expected to have a similar response to changes in market factors;
and
(c) it is settled at a future date.
65
How to Account for Derivatives (IAS 39.9)

A financial asset or financial liability at fair value through profit or loss is a
financial asset or financial liability that meets either of the following
conditions.
(a) It is classified as held for trading. A financial asset or financial liability
is classified as held for trading if it is:
(i) acquired or incurred principally for the purpose of selling or
repurchasing it in the near term;
(ii) part of a portfolio of identified financial instruments that are
managed together and for which there is evidence of a recent
actual pattern of short-term profit-taking; or
(iii) a derivative (except for a derivative that is a financial guarantee
contract or a designated and effective hedging instrument).
(b) (b) Upon initial recognition it is designated by the entity as at fair
value through profit or loss.
66
Hedge Accounting (IAS 39)

Hedge accounting recognises the offsetting effects on profit or loss of
changes in the fair values of the hedging instrument and the hedged
item. (IAS 39.85)
Definitions (IAS 39.9):
A hedging instrument is a designated derivative [] whose fair
value or cash flows are expected to offset changes in the fair value
or cash flows of a designated hedged item [].
A hedged item is an asset, liability, firm commitment, highly
probable forecast transaction or net investment in a foreign
operation that (a) exposes the entity to risk of changes in fair value
or future cash flows and (b) is designated as being hedged [].
Hedge effectiveness is the degree to which changes in the fair
value or cash flows of the hedged item that are attributable to a
hedged risk are offset by changes in the fair value or cash flows of
the hedging instrument [].
67
Embedded Derivatives (IAS 39.10 & 11)

39.10: An embedded derivative is a component of a hybrid (combined) instrument
that also includes a non-derivative host contract with the effect that
some of the cash flows of the combined instrument vary in a way similar to
a standalone derivative. []
39.11: An embedded derivative shall be separated from the host contract and
accounted for as a derivative under this standard if, and only if:
(a) the economic characteristics and risks of the embedded derivative are
not closely related to the economic characteristics and risks of the host
contract (see Appendix A paragraphs AG30 and AG33);
(b) a separate instrument with the same terms as the embedded derivative
would meet the definition of a derivative; and
(c) the hybrid (combined) instrument is not measured at fair value with
changes in fair value recognised in profit or loss (i.e. a derivative that is
embedded in a financial asset or financial liability at fair value through
profit or loss is not separated). []
68
Recap Questions
1.
Explain carefully the difference between hedging, speculation, and arbitrage.
2.
Explain carefully the difference between selling a call option and buying a put
option.
3.
A trader enters into a short cotton futures contract when the futures price is
50 cents per pound. The contract is for the delivery of 50,000 pounds. How
much does the trader gain or lose if the cotton price at the end of the contract
is (a) 48.20 cents per pound and (b) 51.30 cents per pound?
4.
What is the difference between the over-the-counter market an the exchangetraded market? What are the bid and offer quotes of a market maker in the
over-the-counter market?
69
Recap Questions
6.
Suppose that a June put option to sell a share for $60 costs $4 and is held
until June. Under what circumstances will the seller of the option (i.e., the
party with the short position) make a profit? Under what circumstances will
the option be exercised? Draw a diagram illustrating how the profit from a
short position in the option depends on the stock price at maturity of the
option.
7.
Describe the profit from the following portfolio: a long forward contract on an
asset and a long European put option on the asset with the same maturity as
the forward contract and a strike price that is equal to the forward price of the
asset at the time the portfolio is set up.
8.
What are the main ideas underlying the accounting treatment of derivatives
according to IAS 39? What does the term hedge accounting mean in this
context?
70

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Financial Risk Management

Prof. Dr. Jrg Prokop

Winter Term 2014/15

Financial Risk Management

Preliminary Course Outline

Financial Risk Management

Financial Risk Management

Financial Risk Management:

Theres no such thing as a free lunch.

How does that relate to Finance and Economics?

Financial Risk Management

Financial Risk Management

Financial Risk Management

Do organizations (e.g., companies) take risk? Who does?

Financial Risk Management

Why Do We Care About Risk?

Financial Risk Management

Why Do We Care About Risk?

Judging only on the basis of the games expected value,

Expected Utility Theory

How can we turn this idea into a decision model?

Expected Utility Theory

Given utility function: U(W) = 4W - (1/10)W2

Expected utility: E[U(WA)] = 40*3/15+39,6*5/15... = 36,3

Characteristics of Utility Functions

The investors options:

Financial Risk Management

Characteristics of Utility Functions

Utility functions given:

Financial Risk Management

Risk Hedging Alternatives

From Copeland/Weston/Shastri, Financial Theory

Financial Risk Management

I.e., we need some adequate risk metrics

Financial Risk Management

The relationship between two investments return data can

Systematic vs Non-Systematic Risk

Financial Risk Management

Portfolio Selection: Combining Risky Investments

Financial Risk Management

Expected Returns: The Capital Asset Pricing Model

Financial Risk Management

Financial Risk Management

Key Assumptions Underlying the CAPM

Financial Risk Management

Critique Regarding the - Framework

Digression: Arbitrage Pricing Theory

Digression: The Carhart (1997) Model

E ( RS ) = RF + SMkt ( E ( RMkt ) RF ) + SSMB E ( RSMB )

Financial Risk Management

Approaches to Risk Reduction

Financial Risk Management

Reducing Risk With Diversification

Financial Risk Management

Damodaran, Applied Corporate Finance, 3rd ed., 2010, p. 68

Financial Risk Management:

Size of OTC and Exchange-Traded

Source: Bank for International Settlements,

Amounts outstanding, in billions of US dollars

Size of OTC and exchange-traded derivatives markets

German GDP 2011: about 3,335 billion US$

Bartram et al., Financial Management,

Study on Derivatives Usage by NonFinancial Firms (2000/01)

Financial Risk Management

Expected utility: E[U(WA)] = 403/15+39,65/15... = 36,3