Chapter 1: Overview of financial risk managment

Chapter 1: Overview of Financial Risk Management

Nguyen Thi Ngoc Lan, MscBanking and Finance Faculty

Foreign Trade University

1Nguyen Thi Ngoc Lan Banking and Finance Faculty-FTU

Content Chapter 1: Overview of financial risk management

Risk and return relationship Objectives of financial risk management Evaluating risk of an asset (VAR) Tools of financial risk management Markets for financial risk management products

Chapter 2: Forward and Future contracts Forward versus future Operating mechanism of future market Determining the value of forward and future price contracts Using future contracts for herding

THS. Nguyn Th Ngc Lan Khoa TCNH-i Hc Ngoi Thng 2

Content Chapter 3: Option contracts

Operating mechanism of option market Characteristics of option contract Hedging strategy with options Determining the value of an option with binominal tree

model Chapter 4: SWAP

Interest rate SWAP Currency SWAP Determining the value of an SWAP

3THS. Nguyn Th Ngc Lan Khoa TCNH-i Hc Ngoi Thng

References

Options, Futures and Other Derivatives by John C. Hull , Eighth Edition


Questions on financial risk management

How can we identify risks? The relationship between risk and capital? How can we identify the amount of capital

needed? Do you understand your companys strategy and

the possible risks? Do other related parties influence on the level of

risk that the company bear? Do we include risk in our strategy? Why risk considerations are important with us?


Risk and return

Return and risk are the most important determinants in evaluating risk. The higher level of risk and higher return.

Investors prefer an opportunity with lower return given a constant level of risk.

Investors prefer an opportunity with lower level of risk given a constant level of return.

In the market, opportunities with high return will bear high risk and vice versa


The relationship between risk and return

High risk , high return For example, small cap stocks have the highest

long term return but its short-term return volatility is largest

Short-term bills have lowest long term return but its short-term return volatility is smallest

Variance and standard deviation are used to measure risk. Standard deviation is the squared root of variance


Variance and standard deviation Average return

Variance


Risk management process

*Crouhy, Galai, Mark, The Essentials of Risk Management (McGraw-Hill, NY 2006) p2

Identify risks

Finding approaches to transfer risks

Risk management strategy:

AvoidTransferreduceMaintain

Efficiency evaluation

Assessing efficiency and costs

Measuring results of risks

Assessing influences of risks

But it is not simple

THS. Nguyn Th Ngc Lan Khoa TCNH-i Hc Ngoi Thng

Objectives of financial risk management

Financial risk management aims to use financialinstruments to manage risks including mainly marketrisk and credit risk.

Like other risk management activities, financial riskmanagement consists of identifying risk, measuring andevaluating risk, planning, implementing and evaluatingperformance.

The objective of financial risk management is to reducethe volatility of expected cash flow in order to maintainthe financial stability for enterprises.

Mathematically, financial risk management aims toreduce standard divination of return or cash flow.


Objective financial risk managementImpact of Financial Risk Management

on Cash Flow Volatility

Cash Flow

Like

lihoo

d

Trc FRM

Sau FRM


Financial risk management instruments

Definition: A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables (underlying assets)

Underlying assets include: Stocks Bonds Interest rate Currencies Equity index


Financial risk management instruments Forwards and Futures Basically, a forward/future is an agreement to buy or sell an asset at a

certain future time for a certain price. One of the parties to a forward/futurecontract assumes a long position and agrees to buy the underlying asset ona certain specified future date for a certain specified price. The other partyassumes a short position and agrees to sell the asset on the same date forthe same price.

A forward contract is traded in the over-the-counter marketusuallybetween two financial institutions or between a financial institution and oneof its clients while future contracts are standardized in term of underlyingassets, volume, payment method, term) and listed in securitiesexchanges.

Future payments are set daily (market to market daily settlementmeanwhile forward payments are settled at the maturity date)


Forwards and Futures

F

Profit

Price

Short Futures/Forwards

F

Profit

Price

Long Futures/Forwards


Options An option is an agreement between two parties which gives

the holder the right to buy or sell the underlying asset by acertain date for a certain price. The price in the contract isknown as the exercise price or strike price; the date in thecontract is known as the expiration date or maturity.

A call option gives the holder the right to buy the underlyingasset by a certain date for a certain price. A put option givesthe holder the right to sell the underlying asset by a certaindate for a certain price.

American options can be exercised at any time up to theexpiration date. European options can be exercised only onthe expiration date itself


CALL Options

-Ct

E

profit

Price

Long Call

F

Ct

E

Profit

Price

Short Call

F

Ct

-Ct E

Profit

Price

Short + Long

Ct

-Ct E

Profit

Price

Broker

Ct

-Ct E

Profit

Price

Transaction cost


PUT Options

-Ct

Profit

Price

Long Put

E F

Ct

E

Profit

Price

Short Put

F

Ct

-Ct E

Profit

Price

Short + Long


Swaps A swap is an over-the-counter agreement between two

companies to exchange cash flows in the future. Theagreement defines the dates when the cash flows are tobe paid and the way in which they are to be calculated.Usually the calculation of the cash flows involves thefuture value of an interest rate, an exchange rate, orother market variable. One of the most common SWAPis to exchange fixed cash flow for floating cash flow

Example: Microsoft agrees to receive 6 month LIBORand pay every 06 month 5%/year during the period of 3years with the notional principal of 100 million USD.


---------Millions of Dollars---------

LIBOR FLOATING FIXED Net

Date Rate Cash Flow Cash Flow Cash Flow

Mar.5, 2004 4.2%

Sept. 5, 2004 4.8% +2.10 2.50 0.40

Mar.5, 2005 5.3% +2.40 2.50 0.10

Sept. 5, 2005 5.5% +2.65 2.50 +0.15

Mar.5, 2006 5.6% +2.75 2.50 +0.25

Sept. 5, 2006 5.9% +2.80 2.50 +0.30

Mar.5, 2007 6.4% +2.95 2.50 +0.45

Cash flow of Microsoft


Types of tradersHedgers- Using forward contracts: On 24th, May, 2010 ExportCo exports goods to

UK. The company would receive 30 million GBP in 3 months. The 3month forward bid exchange rate is 1 GBP=1.4410 USD and the 3 monthforward ask exchange rate is 1.4415. What does ExportCo can do to hedgefor exchange rate fluctuation? Suppose that on 24th , August, the spot rate(GBP/USD) is 1.3000 and 1.5000, evaluate the performance of thehedging strategy?

- Using options: Now it is May, an investor holds 1000 Microsoft shares atthe price of 28 USD/share. He predicts that the stock price will fall in thenext 2 months and wants to hedge this exposure. He takes the long positionof 10 July put option contracts on Microsoft with a strike price of 27.7$.The option price is $1. Explain this hedging strategy?

- Explain the difference between hedging using forward and hedging using option?

- Hedge funds? (your homework!!!)

20Khoa TCNH-i Hc Ngoi Thng

Types of tradersValue of Microsoft holding in 2 months with and without hedging.


Types of Traders

Speculators Using futures: Now it is February, an USA

speculator predicts that GBP will strengthen relativeto USD in next two months. He wants to speculatewith an amount of 250,000 GBP. There are two waysto make this investment. The first is to purchase250,000 GBP in Feb at the spot rate and sell later atthe expected higher rate in April. The second is totake the long position of 4 April future contracts onGBP (each contract is for purchase of 62,500 GBPand initial margin requirement is 5,000$/contract).


Types of TradersSpeculating strategies

Buy 250.000 At the spot price of 1.4470 USD per GBP

Long 4 futures at the future price of 1.4410 USD per GBP

Total investment 250,000*1,4470=361,750$ 4*5000$=20,000$Profit/loss if GBP/USD 1.5000 in April

(1.5000-1.4470)*250,000=13,250$

(1.5000-1.4410)*250,000=14,750$

Profit/loss if GBP/USD is 1.4000 in April

(1.4000-1.4470)*250,000= -11,750$

(1.4000-1.4410)x 250,000=-10,250$


Types of Traders

Speculators- Using option contracts: Now is October, an

investor predict the the stock price of A willincrease in the next two months. The current stockprice is 20$, a two month call option on stock Awith strike price of 22.5$ is sold at 1$. Theinvestor is willing to invest 2000$. Compare twospeculating strategies: A, buy 100 stocks A; B:long 2,000 call option on stock A.


Types of tradersPrice of A on December

Strategies 15$ 27$Buy 100 shares (15-20)*100=-500$ (27-20)*100=700$Long 2000 call options -2000 (27-22.5)*2000-

2000=7000$

Payoff diagram of the two strategies


Types of traders

Arbitrage involves locking in a riskless profit bysimultaneously entering into transactions in two ormore markets

Example: A stock is listed on both New York exchangeand London exchange. Suppose that the stock price is140$ in New York and 100 in London. The spotexchange rate is 1.4300 USD per GBP. Arbitrageurwill simultaneously buy 100 shares in NY and sell themin LD in order to gain a riskless profit of 100*[(1.43*100)-$140]=300$ (no transaction cost).Arbitrage opportunities cannot last for long. Asarbitrageurs buy the stock in New York, the forces ofsupply and demand will cause the dollar price increase


Derivative markets

Derivative securities can be traded on exchangesor over the counter market.

A derivatives exchange is a market whereindividuals trade standardized contracts (optionsand futures). Clearing house and depositmechanic helps to eliminate credit risk .

OTC transactions are made on an agreementbetween two parties and securities are notstandardized. They are not guaranteed by theclearing house therefore credit risk is high.


Market size

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

1.28THS. Nguyn Th Ngc Lan Khoa TCNH-i Hc Ngoi Thng

Exercises1, What is the difference between entering into a long forward

contract when the forward price is $50 and taking a longposition in a call option with a strike price of $50?

2, A trader enters into a short cotton futures contract when thefutures price is 50 cents per pound. The contract is for thedelivery of 50,000 pounds. How much does the trader gainor 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?

3, You would like to speculate on a rise in the price of a certainstock. The current stock price is $29 and a 3-month callwith a strike price of $30 costs $2.90. You have $5,800 toinvest. Identify two alternative investment strategies, one inthe stock and the other in an option on the stock. What arethe potential gains and losses from each?


Exercises

4, It is May and a trader writes a September calloption with a strike price of $20. The stock priceis $18 and the option price is $2. Describe thetraders cash flows if the option is held untilSeptember and the stock price is $25 at that time.

5 A trader enters into a short forward contract on100 million yen. The forward exchange rate is$0.0080 per yen. How much does the trader gainor lose if the exchange rate at the end of thecontract is (a) $0.0074 per yen and (b) $0.0091per yen?


Chapter 1: Overview of financial risk managment

Documents

Transcript of Chapter 1: Overview of financial risk managment