Course Title: Financial Risk

Management

LECTURE 2
 LECTURE CONTENTS
• Risk
• Risk Catagories
Financial Markets and Their Role
in the Global Economic System
• The financial system produces and distributes financial
services to the public.
• Among its most important services is a supply of credit which
allows businesses, households, and governments to invest
and acquire assets they need for daily economic activity.
• Another key role played by markets operating within the
financial system is to stimulate an adequate volume of savings
(i.e., funds left over after current consumption spending by
households and earnings retained by businesses) and to
transform those savings into an adequate volume of
investment (i.e., the purchase of capital goods and the buildup
of inventories of goods to sell).
• In turn, investment generates new products and services and
creates new jobs and new businesses, resulting in faster
economic growth and a higher standard of living.
• One important way to view the financial system of money and
capital markets is by examining its seven key functions or roles
in meeting the financial needs of individuals and institutions,
including generating and allocating savings, stimulating the
accumulation of wealth, providing liquidity for spending,
providing a mechanism for making payments, supplying credit
to aid in the purchase of goods and services, providing risk
protection services, and supplying a channel for government
policy in helping achieve the nation’s economic goals
(including maximum employment, low inflation, and
sustainable economic growth).
RISK
• Risk refers to the probability of loss, while exposure
is the possibility of loss, although they are often used
interchangeably.
• Risk arises as a result of exposure.
• There are three main sources of financial risk:
– Financial risks arising from an organization’s exposure to
changes in market prices, such as interest rates, exchange
rates, and commodity prices
– Financial risks arising from the actions of, and transactions
with, other organizations such as vendors, customers, and
counterparties in derivatives transactions
– Financial risks resulting from internal actions or failures of
the organization, particularly people, processes, and
systems
RISK AND RETURN
RELATIONSHIP
 RISK AND RETURN RELATIONSHIP
• There is always a trade-off b/w risk and return.
• The greater the risk the higher the return.
• But! The trade off is b/w risk and expected return not actual
return.
• Expected return is the weighted average of the possible
returns where the weight applied to a particular return equals
the probability of that return occuring.
Example:
You invest $100,000 for 1 year.
Alternatives
1. Buy T-bills yielding 5% pa. (0 risk and return of 5%)
2. Invest $100,000 in stock.
Below is the table for return in one year for investing in Equity
Probability return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 -10%
0.05 -30%

So expected return per year is

(0.05x0.50)+(0.25x0.30)+(0.40x0.10)+(0.25x(-0.10))+(0.05x(-0.3)) =0.10
• Modern Portfolio Theory (MPT)
• Modern Portfolio Theory (MPT), a hypothesis put forth by Harry Markowitz in his
paper "Portfolio Selection," (published in 1952 by the Journal of Finance) is an
investment theory based on the idea that risk-averse investors can
construct portfolio to optimize or maximize expected return based on a given level of
market risk, emphasizing that risk is an inherent part of higher reward. It is one of the
most important and influential economic theories dealing with finance and
investment.

•MPT is also called “Portfolio Theory”, or “Portfolio Management Theory”. MPT

suggests that it is possible to construct an "efficient frontier" of optimal portfolios,
offering the maximum possible expected return for a given level of risk. It suggests
that it is not enough to look at the expected risk and return of one particular stock. By
investing in more than one stock, an investor can reap the benefits of diversification,
particularly a reduction in the riskiness of the portfolio. MPT quantifies the benefits of
diversification, also known as not putting all of your eggs in one basket.

Professor Harry Markowitz (1952): “Don’t put all your eggs in one basket”.
• There are two main concepts in Modern Portfolio Theory, which are;
– Any investor's goal is to maximize Return for any level of Risk
– Risk can be reduced by creating a diversified portfolio of unrelated assets
• Quantifying Risk
A convenient Measure is Standard Deviation of
Return over one year
E(R2) – [E(R)]2
• Efficient Frontier
DERIVATIVE MARKETS
 DERIVATIVE MARKETS
• A derivative is a financial instrument that offers a return
based on the return of some other underlying asset.
• It trades in a market in which buyers and sellers meet and
decide on a price; the seller then delivers the asset to the
buyer and receives payment.
• The price for immediate purchase of the underlying asset is
called the cash price or spot price.
• A derivative also has a defined and limited life:
– A derivative contract initiates on a certain date and terminates on a
later date. Often the derivative's payoff is determined and/or made on
the expiration date, although that is not always the case
 TYPES OF DERIVATIVES
• Derivative contracts are created on and traded in two distinct but related types of
markets: exchange traded and over the counter.
• Exchange-traded contracts have standard terms and features and are traded on an
organized derivatives trading facility, usually referred to as a futures exchange or
an options exchange.
• Over-the-counter contracts are any transactions created by two parties anywhere
else.
• Derivative contracts can be classified into two general categories:
– forward commitments and
– contingent claims.
• forward commitments, two major classifications exist:
– exchanged-traded contracts, specifically futures,
– and over-the-counter contracts, which consist of forward contracts and swaps.
 TYPES OF DERIVATIVES –
FORWARD COMMITMENTS
• The forward contract is an agreement between two parties in which one
party, the buyer agrees to buy from the other party, the seller, an
underlying asset at a future date at a price established at the start.
• The contract is customized in a sense that the parties to the transaction
specify the forward contract's terms and conditions, such as when and
where delivery will take place and the precise identity of the underlying.
• Each party is subject to the possibility that the other party will default.
• Forward contracts in the financial world take place in a large and private
market consisting of banks, investment banking firms, governments, and
corporations.
• The underlying asset could be a security (i.e., a stock or bond), a foreign
currency, a commodity, or combinations thereof, or sometimes an interest
rate. (In case of Interest Rates, the contract is not on a bond from which
the interest rate is derived but rather on the interest rate itself)
• The forward market is a private and largely unregulated market.
Futures Contracts
• A futures contract is a variation of a forward contract that has
essentially the same basic definition but some additional
features that clearly distinguish it from a forward contract.
• a futures contract is not a private and customized transaction.
• It is a public, standardized transaction that takes place on a
futures exchange.
• A futures exchange, like a stock exchange, is an organization
that provides a facility for engaging in futures transactions
and establishes a mechanism through which parties can buy
and sell these contracts.
• The contracts are standardized, which means that the
exchange determines the expiration dates, the underlying,
how many units of the underlying are included in one
contract, and various other terms and conditions.
 Comparison of the Forward & Futures Markets
Forward Markets Futures Markets

Contract size Customized Standardized

Delivery date Customized Standardized
Participants Banks, brokers, Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.
Security Compensating Small security
deposit bank balances or deposit required.
credit lines needed.
Clearing Handled by Handled by
operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market prices.
 Comparison of the Forward & Futures Markets
Forward Markets Futures Markets
Marketplace Worldwide Central exchange
telephone floor with worldwide
network communications.

Regulation Self-regulating Commodity

Futures Trading
Commission,
National Futures
Association.
Liquidation Mostly settled by Mostly settled by
actual delivery. offset.
Transaction Bank’s bid/ask Negotiated
Costs spread. brokerage fees.
 Forward v/s Future Contracts
• the most important distinction between a futures contract
and a forward contract, however, lies in the default risk
associated with the contracts.
• In a forward contract, the risk of default is a concern.
• In a futures contract, however, the futures exchange
guarantees to each party that if the other fails to pay, the
exchange will pay.
• the exchange actually writes itself into the middle of
• the contract so that each party effectively has a contract with
the exchange and not with the other party. The exchange
collects payment from one party and disburses payment to
the other.
• The futures exchange implements this performance guarantee
through an organization called the clearinghouse.
• For some futures exchanges, the clearinghouse is a separate corporate
entity. For others, it is a division or subsidiary of the exchange. In either
case, however, the clearinghouse protects itself by requiring that the
parties settle their gains and losses to the exchange on a daily basis. This
process, referred to as the daily settlement or marking to market, is a
critical distinction between futures and forward contracts.
• With futures contracts, profits and losses are charged and credited to
participants' accounts each day. This practice prevents losses from
accumulating without being collected. For forward contracts, losses
accumulate until the end of the contract.‘
• Another important distinction between forward contracts and futures
contracts lies in the ability to engage in offsetting transactions. Forward
contracts are generally designed to be held until expiration.
– For example, a party might commit to purchase one million euros at a
future date at an exchange rate of $0.85/€. Suppose that later the euro
has a forward price of $0.90/€. The party might then choose to engage in
a new forward contract to sell the euro at the new price of $0.90/€. The
party then has a commitment to buy the euro at $0.85 and sell it at $0.90.
The risk associated with changes in exchange rates is eliminated, but both
transactions remain in place and are subject to default.'
SWAP CONTRACTS
• A swap is a variation of a forward contract that is essentially
equivalent to a series of forward contracts.
• a swap is an agreement between two parties to exchange a
series of future cash flows.
• one party agrees to pay the other a series of cash flows whose
value will be determined by the unknown future course of
some underlying factor, such as an interest rate, exchange
rate, stock price, or commodity price.
• The other party promises to make a series of payments that
could also be determined by a second unknown factor or,
alternatively, could be preset.
• A swap in which one party makes a single fixed payment and
the other makes a single floating payment amounts to a
forward contract. One party agrees to make known payments
to the other and receive something unknown in return.
• This type of contract is like an agreement to
buy at a future date, paying a fixed amount
and receiving something of unknown future
value. That the swap is a series of such
payments distinguishes it from a forward
contract, which is only a single payment.
 TYPES OF DERIVATIVES –
CONTINGENT CLAIMS
• Contingent claims are derivatives in which the payoffs occur if
a specific event happens.
• an option is a financial instrument that gives one party the
right, but not the obligation, to buy or sell an underlying asset
from or to another party at a fixed price over a specific period
of time.
• An option that gives the right to buy is referred to as a call; an
option that gives the right to sell is referred to as a put.
• The fixed price at which the underlying can be bought or sold
is called the exercise price, strike price, striking price, or
strike, and is determined at the outset of the transaction.
• In contrast to participating in a forward or futures contract,
which represents a commitment to buy or sell, owning an
option represents the right to buy or sell.
• To acquire this right, the buyer of the option must pay a price
at the start to the option seller. This price is called the option
premium or sometimes just the option price.
• For options, both types of contracts-over-the-counter
customized and exchange-listed standardized exist.
• In other words, the buyer and seller of an option can arrange
their own terms and create an option contract.
• A variety of other instruments contain options and thus are
forms of contingent claims.
– E.g. many corporations issue convertible bonds offering the holder an option,
Callable bonds are another example of a common financial instrument that
contains an option