MEASURING RISK: ADVANCE TOPICS

BY:- RITIKA JAIN

ROLL NO. 180/09
ROYAL SCHOOL OF BUYSINESS
 CONTENTS
1. MEASURING EXPOSURE TO PRICE RISK
2. MANAGING RISK
3. INSURANCE
4. ASSETR/LIABILITY MANAGEMENT
5. HEDGING
6. SIZE OF HEDGE
7. MEASURING HEDGE EFFECTIVENESS
8. COST OF A HEDGE

1. MEASURING EXPOSURE TO PRICE RISK :-

Having knowledge of the existence of price risk is not enough to manage it. The risk
manager also needs to know the degree of exposure to the price risk. Two firms can have
an exposure to the same price risk but the extent of exposure can be quite different.

The first step after measuring the volatility of a price is then to measure the firm’s
exposure. This is done by constructing separate risk profiles for each price risk to which
firm is exposed. A risk profile is specification of the relationship between a performance
measure and price. Sometimes we find it convenient to use price changes from the current
price level instead of the price. Performance is usually plotted on the vertical axis and price
or price change on the horizontal axis. These alternative forms of risk profiles are
presented below:-

Performance performance

Price price change from current level

Current
price

PANEL A PANEL B

PERFORMANCE VS PRICE PERFORMANCE VS PRICE CHANGE

The performance measure most often used in developing risk profiles is a change in the present
value of the firms’ cash flows. The change in the value measure is particularly useful when the
goal of exposure measurement is to neutralize the risk.

EXAMPLE:- A U.S. financial corporation has just acquired $ 12 million for 5 yrs fixed-rate asset
loans paying a semiannual rate of 10%. It has financed these assets with floating-rate liabilities.
Specifically, the liabilities take the form of 6-months for 5 yr. this paper will be rolled over every
6months for 5 yr. the first paper issue required a paper rate of 7 % and the firm expects that a
this is a good estimate of future paper rates.
The difference between the payments the firm will receive at 10% and the payments the firm
will make at 7% represents a cash flow stream from the firms’ business. Under current
expectations and a semiannual discount rate of 10%, the firm concludes that the cash flow
stream has a present value of $1,389,913. The calculation is shown below:-

TABLE: - Calculating the present value of an expected cash flow stream

PERIOD KNOWN CASH IN EXPECTED CASH NET CASH FLOW DISCOUNTED

OUT VALUE (AT 10%)
1 600000 420000 180000 171429
2 600000 420000 180000 163265
3 600000 420000 180000 155491
4 600000 420000 180000 148087
5 600000 420000 180000 141035
6 600000 420000 180000 134319
7 600000 420000 180000 127923
8 600000 420000 180000 121831
9 600000 420000 180000 116030
10 600000 420000 180000 110504
TOTAL VALUE 1,389,913

Now consider how the value of the firm would change if the commercial paper rates suddenly
increase by 1%.

1) Firms’ initial net cash flow (period 1) would not change since the rate on the firm’s asset
is fixed at 10% and the cost of its commercial paper financing is fixed at 7% for the first 6
months.
2) It is the refunding rate 6 month out that rises to 8%, with each subsequent refunding
now expected to cost 8%
3) The expected cash flow for periods 2 through 10 therefore declines to $120000.
4) Discounting all the net cash flows at the same 10% we find that the value of the firms’s
cash flow declines to $983,751.
5) Thus, a 1% rise in commercial paper rates result in a $406,162 decrease in that portion
of the firms value

We can repeat these calculations for all new levels of interest rates and plot the value
changes against the rate changes to get the firms risk profile

RISK PROFLIE-PAPER RATE

CHANGE IN VALUE FROM EXPECTED VALUE 1.0 (MILLION)

0.5

RISK PROFILE

-2% -1% 0 1% 2%

CHANGE IN PAPER RATES

0.5

-1.0

This profile is downward sloping because an increase in rates leads to a decrease in value and
vice-versa.

Risk profiles, like the one above can be drawn for any price exposure. This can be an exposure
to interest rates, exchange rates, any hundreds of commodity prices, and even stock prices.

Risk profiles are useful for several reasons. Some are:-

1) The very act of developing risk profiles forces those exposed to give serious thought to
the existence of the exposures.
2) Without a serious effort to measure the exposures, it is impossible to efficiently manage
them.
3) The nature of the exposures and the shape of the risk profiles might suggest appropriate
risk management techniques.
2. Managing risks

There are three different, but related, ways to manage financial risks. They are :-
i) Insurance
ii) Asset/liability management
iii) Hedging

3. Insurance

An insurable risk is a risk to which many firms (or individuals) are exposed, for which
manifestations of the risk are not highly correlated among those exposed, and for which the
probability of a manifestations of the risk is known with a high degree of certainty. Insurable
risks include such risks as death, loss from fire, loss from theft, liability and medical expense.
Consider the case of fire. Damage from fire results in financial loss and the risk of fire is
therefore a financial risk.

For the insured firms, the payments of the insurance premium even if in excess of the amount
of the exposure, may be money well spend.

1) The risk-averse nature of both the firms’ owner and managers suggest that they will be
willing to pay, up to a point, for the removal of the risk
2) The firms’ creditors will view the firms as more creditworthy if they minimize their risks.

4. Asset/Liability Management

Asset/liability management is an effort to minimize exposure to price risk by holding the

appropriate combinations of assets and liabilities so as to meet the firm’s objectives and
simultaneously minimize the firm’s risk. The key to this form of risk management is holding the
right combinations of on-balance sheet assets and on-balance sheet liabilities

Asset/liability management is most highly developed for managing interest-rate risk. But ALM
can be used and is often used in the management of exchange-rate risk, commodity-price risk,
and stock-price risk.

Ideally, ALM should strike to match the timing and the amount of cash inflows and cash
outflows from assets with the timing and the amount of cash outflows on liabilities. An asset
portfolio constructed to precisely match cash flows is called a dedicated portfolio.
5. Hedging:-

Although closely related to ALM and often used in conjunction with ALM, hedging is a distinct
activity. A hedge is a position that is taken as a temporary substitute for a later position in
another asset (liability) or to protect the value of an existing position in an asset (liability) until
the position can be liquidated. Most hedging is done in off-balance sheet instruments. The
instruments most often used for hedging are futures, forwards, options, and swaps. A hedge
can take of an on-balance sheet positions as well.

EXAMPLE:-

Lets us consider a West German firm’s exposure to exchange rate risk. This firm’s long position
in dollars stems from a $500,000 T-bill it owns that matures in 30 days. This risk profile
appears:-

Risk profile- exchange rates

Profits

150

100

50 dollar weakening

-50 dollar strengthening

-100

-150

1.75 1.8 1.85 1.9 1.95 2 2.05 2.1 2.15 2.2 2.25

Expected value DEM/USD EXCHANGE RISK

Note the value change, which, for consistency, we will henceforth call “profit”, is on the vertical
axis and price, in this case the DEM/USD 30- days forward exchange rate, is on the horizontal
axis.
The upward sloping nature of this risk profile suggests that the German firms exposure stems
from a long position in dollars i.e. an increase in the DEM/USD 30-day forward rate represents a
strengthening of the dollar vis-à-vis deutschemark.

6. Size of the hedge

The number of units of the hedging instruments necessary to fully hedge one units of the cash
position is called hedge ratio. For example, if on average it takes two units of 5 yr T-notes
futures to offset the risk exposure from one units of corporate debt, then the hedge ratio 2:1.

7. Measuring hedge effectiveness

The degree of correlation between two prices represents the closeness with which their
movements track one another. Assuming that the appropriate hedge ratio is employed, the risk
that remains after a hedge is placed is called basic risk. The relationship between basic risk and
price risk is given by :-

Basic risk = (1- 2) *price risk

This squared value is called the coefficient of determination.

Basic risk exists because the cash price and the price of the hedging instruments are not
perfectly correlated. This is so because the demand and supply conditions in the cash market
may evolve somewhat differently than the demand and supply conditions in the market for the
hedging instruments

Consider for e.g., a corporate investor efforts to hedge his or her planned 3-month commercial
paper issue 3-month T-bill futures contracts. The bills and the paper have the same maturity
and their rates tend to track each other fairly closely – although paper rates are always at a
premium to bill rates. The tracking isn’t perfect and so the firm that hedges its planned paper
issues in bill futures will bear some basic risk.

8. Cost of a hedge

There is a great deal of literature on the subject of the cost of hedging. The general consensus is
that hedging is relatively cheap but not free. There are two good reasons not to expect hedging
to be costless:-

i) The risk that hedgers seek to send when they take on a hedge must be borne by the
counterparty to the hedge contract. If the counterparty is another hedger with a
mirror image exposure, then both hedgers enjoy some benefits and we would not
expect either to have to compensate the other. But, more often, the counterparty to
the contract is a speculator – particularly when the hedging instruments are a
 futures contract. The speculator is taking a position in order to earn a speculative
profit. If speculation is privately costly to the speculator and if the speculators are
risk averse, then we would expect speculator to require compensation for their risk
bearing services. To the extent that speculators are compensating for risk bearing,
hedgers must bear the cost.
ii) There are transactions costs involved. Every trade involves some transaction costs in
form of a commission, a bid-ask spread, or both.

Although hedging is not costless, not all hedges will be equally costly. It may be, due to
inefficiencies in the market, that one type of hedge is less costly than another. Furthermore,
the relative costs may change from one day to next so that the cheaper hedge today might
not be cheaper tomorrow.

The upshot of these closing remarks is that the hedge must consider both the effectiveness
of the hedge and the cost of the hedge. Together, these factors determine the efficiency of
the hedge. Efficient hedges are those that provide maximum risk reduction per unit of cost.
From among the set of available efficient hedges, the hedger must select the optimal one.
The optimal hedge is that which maximizes the hedger’s utility – as this term is used in
economics.

REFERENCE: - FINANCIAL ENGINEERING BYJAOHN F. MARSHALL AND VIPUL K.

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