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Risk Management
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Objectives
Is
Risk is symbol of Danger
Or
Symbol of Opportunity ?
It is
symbol of both
Danger & Opportunity
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………….. Uncertainty !
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Risk Management
Meaning:
“Risk can be defined as the possibility of loss
arising because of uncertainty of outcome of
particular transaction”.
“Risk refers to variability of the actual returns
from the expected returns in terms of cash
flows”.
“Risk management seeks to mitigate
variability and expected losses and increase
welfare”.
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Nature of risk
Important nature of risk is uncertainty. One
cannot predict risk when it will occur. Its
period of occurrence is not known.
It relates to theory of probability and it
standards more on guess work rather than
actual.
Risk exists in any activities when the
decision maker is in a position to assign
probabilities to various outcomes.
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Risk Management
Increased
Insurance
precautions
Hedging
Other contractual
risk transfers
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Objectives
The overall objectives of risk management is
to minimize the cost of risk.
Risk mgmt. seeks to mitigate variability and
expected losses and increase welfare.
Cost of risk:
Components of the cost of risk include;
1. the expected cost of loss,
Risk Management
Derivatives allow firms to:
Separate out the financial risks that they face.
Remove or neutralize the risk exposures they do
not want.
Retain or possibly increase the risk exposures
they want.
Risk Management
The proliferation of derivatives
allows firms to:
Efficiently manage a great variety of
risks.
To manage those risks in a variety
of different ways.
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Example
Consider a Indian fund manager with a
portfolio of U.S. equities.
Example
He is bearish about:
The dollar’s medium-term
prospects.
The overall U.S. stock market.
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Example
To hedge the currency risk, he could
sell dollars under the terms of a
forward contract.
To hedge the market risk, he could
short futures contracts on the S&P 500
index.
He would be left with exposure to
IBM’s share price only.
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Example
Preferred derivatives
Barings Bank
Long-Term Capital Management
Bank of Montreal
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Barings Bank
British investment bank, founded in 1763.
1803: Negotiated the purchase of Louisiana by
the U.S. from Napoleon.
Queen of England was a client.
( y I yG )
( y D yG )
Bank of Montreal
May 2007: Reported losses of $680 million
betting on the natural gas market.
BMO reported:
Its commodity trading team “did not operate
according to standard BMO business practices”.
“In the future in the (commodity) portfolio we will
only engage in the amount of market-making
activity required to support the hedging needs of our
oil and gas producing clients.”
“the bank has revised its risk management
procedures.”
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Basic principles
The object of the exercise to to take a
position that neutralizes risk as far as
possible.
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Hedging
Two counterparties with offsetting
risks can eliminate risk.
For example, if a wheat farmer and a flour mill
enter into a forward contract, they can
eliminate the risk each other faces regarding
the future price of wheat.
Hedgers can also transfer price risk to
speculators and speculators absorb
price risk from hedgers.
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Basis risk
It may be difficult to find a forward
contract on the asset that you are trying to
hedge.
Basis Risk
Futures
Price Spot Price
Time Time
(a) (b)
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Long Hedge
Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
You hedge the future purchase of an asset
by entering into a long futures contract
Cost of Asset=S2 –(F2 – F1) = F1 + Basis
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Short Hedge
Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
You hedge the future sale of an asset
by entering into a short futures
contract
Price Realized=S2+ (F1 –F2) = F1 +
Basis
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Choice of Contract
Choose a delivery month that is as close
as possible to, but later than, the end of
the life of the hedge
Notation
NA
N h
QF
where
NA size of the position being hedged (units),
QF size of one futures contract (units),
N* Optimal number of futures contracts
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What is it?
Financial Distress
Risk worth managing is that which may
have material impact on the value of the
firm’s periodic cash flows
Financial Distress
Risk Aversion Loss Aversion
Requires corporations Recognizes risk is
give up the chance for concern because of
upside foreign the downside losses
exchange gains to rather than the
protect themselves upside gains
from possible
downside foreign
exchange losses
Fear of Bankruptcy
Hedging with options
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Last Thought
Risk management adds value because
it helps ensure that a corporation has
sufficient internal funds available to
take advantage of profitable
investment opportunities. Risk
management helps the firm avoid
short-run and intermediate-run capital
constraints to survive in the long run
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Sources of Risk
Transaction Exposure: The risk that the
domestic cost or proceeds of a transaction
may change.
Translation Exposure: The risk that the
translation of value of foreign-currency-
denominated assets is affect by exchange
rate changes.
Economic Exposure: The risk that exchange
rate changes may affect the present value of
future income streams.
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Interest Rate
Market
Financial Liquidity
Risks
Operational
Foreign Exchange
Other Risks, Country Risk,
Settlement risk,
performance risk
Business Poles Business Lines
Commercial
Retail Financial Services
Lending & Collecting Deposits and
Advisory Services
Mergers & Acquisition
LBO
Investment Banks & Financial Firms ‘Structured Finance’
Banking Asset Financing
Commodities
Securitisation
Derivatives
Trading Equity Traded Instruments
Fixed Income
Others Custody
sartaj.hussain
Schematic classification of some major Financial
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Risks
Financial Risks
Credit Risk Liquidity Risk Interest Rate Risk Market Risk Forex Operational
Risk
Funding Risk
Market Liquidity Risk
Asset Liquidity Risk
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Default Risk.
Prolonged Delinquency.
Deterioration in the credit standing of
borrower
Restructuring of debt obligations.
Bankruptcies.
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Funding Risk.
Funding Risk
Inability to raise funds at normal cost.
Exotic products.
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Depositors runs.
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