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Financial Risk Management (Definition of risk (Sub-elements of risk…
Financial Risk Management
Definition of risk
Probabilities
deviations from the expected outcome
Risk is a function of objectives
Sub-elements of risk
possibility of a gain or loss
probability of a gain or loss
Cause of loss or peril
Hazard
Potential gain or loss
Range and variability of outcomes
Risk management
Risk management
Risk pooling
Insurance
Diversification
Risk transfer
Hedging
Insurance
Common factors of risk
Indeterminacy of the outcome
Chance of loss
Four-level stratification
Risk
Uncertainty
Indeterminacy
Ignorace
Multidimensional 'risk landscape'
Price risk
Liquidity risk
Risk factors (the sum of these is total risk)
Risk profile
Size and direction of the expected future payoffs
The exposures to risk
The slope
Other
Concept of materiality
Attitudes of risk
Risk averse
Risk neutral
Risk seeking
Financial Risk
4 types of risk
Amount and timing of future cashflow are known with certainty
Amount of cashflows is known with certainty but the timing is uncertain
The timing of cashflows is known with certainty but the amount is uncertain
Both the timing and the amount of the future cashflows are uncertain
Risk Management
Logical process
Step 1: Awareness of the risk being taken
3 levels of risk awareness
Risks that are unknown and unmeasurable
Risks that are known but still unmeasurable
Risks that are known and measurable
Step 2: Measure of the risks to determine their impact and materiality
Cost-benefit analysis
Step 3: Risk adjustment through adoption of policies or a course of action to reduce risks
Insurance
Hedging
Accepting risk, but reduce some of the undesirble aspects by changing behavior
Approaches
Top-down
Building-block
Why?
Firm has more information than investors
Firm can undertake risk management more efficiently than individuals
KEY: Increas the expected value of the firm
Taxes
tax shields
progressive corporate tax rates
Information assymetries between managers and providers of funds
underinvestment problem
asymmetric information
ill-diversified owners
Problems arising from firms getting into financial difficulties
Costs
Direct costs of hedging
Indirect costs of hedging
Markets
Capital markets
Market for equity
Market for debt claims
Money market (short-term)
Bond market (long-term)
Foreign exchange markets
Commodities markets
RISKS
Liquidity risk
Credit risk
credit downgrade
default risk
Counterparty risk
Legal risk
Regulatory risk
Accounting risk
Tax risk
Settlement risk
Price risk
Timing risk
Execution risk
Board-Market Risks
Interest rates
Foreign exchange rates (currencies)
Commodity price risk
Equity price risk
M4: Interest rate risk
Reinvestment risk
Price (market) risk
Prepayment risk
Immunisation
Extension risk
term structure of interest rates
Shapes
upward sloping
downward sloping
flat
humped
Theories
Expectations theory of interest rates
Preferred habitat or market segmentation theory
liquidity preference theory
Modern theories of the term structure
M5: Foreign Exchange Rate Risk
Country risk
Transfer risk
Theories
Interest rate parity
covered interest arbitrage
Purchasing Power Parity
absolute purchasing power parity
relative purchasing power parity
The expectation theory
international fisher effect
transaction exposure
solution: hedge with forward contract, insurance or currency option
translation exposure
economic exposure
direct economic exposure
indirect economic exposure
M6: Equity risk
specific risk (operational decisions)
systematic risk
macroeconomic risks
political risks
operational leverage
financial leverage
M6: Commodity risk
Efficient Markets Hypothesis (EMH)
weak-form
semi-strong form
strong-form
M7: Asset Prices
Geometric brownian motion (random walk)
Markov process
Weiner process
Ito process
Boundaries: Lower side: zero Upward potential: unlimited
Volatility's effect on asset prices
Range of values that can be assumed at the end of the tree
The probabilities attached to this range
The
expected
distribution of price changes:
Estimates of volatility
Historical volatility
Future volatility
Expected volatility
Implied volatility
Risks
tail risk
Risk Assesment
Risk control
limits (contemporaneous)
value-at-risk (best practice method/predictive)
historical
stress test
Analysing and controlling risk
Top-down
Building-block
Objectives in measuring risk
awareness of
which risks are to be managed
over what time frame
A RISK MANAGEMENT FRAMEWORK
Awareness
Assessment
Management
approaches
change operations for matching principle
or use financial markets to modify exposure
TOP-DOWN APPROACH
BUILDING-BLOCK APPROACH
M11: The Qualitative Model
4 Methods
Polling
Expert opinion
Delphi forecast
Surveys
M10: Financial Methods for Measuring Risk