Chapter 1: Overview of Financial Risk Managment

Chapter 1: Overview of
Financial Risk Management

Nguyen Thi Ngoc Lan, Msc
Banking and Finance Faculty
Foreign Trade University
1
Nguyen 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
3
References
Options, Futures and Other Derivatives
by John C. Hull , Eighth Edition
4
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?
5
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
6
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
7
Variance and standard deviation
Average return
Variance
8
Slide 9
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:
Avoid
Transfer
reduce
Maintain
Efficiency
evaluation
Assessing efficiency and costs
Measuring results of risks
Assessing influences of risks
But it is not
simple
Objectives of financial risk
management
Financial risk management aims to use financial
instruments to manage risks including mainly market
risk and credit risk.
Like other risk management activities, financial risk
management consists of identifying risk, measuring and
evaluating risk, planning, implementing and evaluating
performance.
The objective of financial risk management is to reduce
the volatility of expected cash flow in order to maintain
the financial stability for enterprises.
Mathematically, financial risk management aims to
reduce standard divination of return or cash flow.
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Objective financial risk management
Impact of Financial Risk Management
on Cash Flow Volatility
Cash Flow
L
i
k
e
l
i
h
o
o
d
Trc FRM
Sau FRM
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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
12
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/future
contract assumes a long position and agrees to buy the underlying asset on
a certain specified future date for a certain specified price. The other party
assumes a short position and agrees to sell the asset on the same date for
the same price.
A forward contract is traded in the over-the-counter marketusually
between two financial institutions or between a financial institution and one
of its clients while future contracts are standardized in term of underlying
assets, volume, payment method, term) and listed in securities
exchanges.
Future payments are set daily (market to market daily settlement
meanwhile forward payments are settled at the maturity date)
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Forwards and Futures

F
Profit

Price
Short
Futures/Forwards

F
Profit

Price
Long
Futures/Forwards
14
Options
An option is an agreement between two parties which gives
the holder the right to buy or sell the underlying asset by a
certain date for a certain price. The price in the contract is
known as the exercise price or strike price; the date in the
contract is known as the expiration date or maturity.
A c a l l option gives the holder the right to buy the underlying
asset by a certain date for a certain price. A put option gives
the holder the right to sell the underlying asset by a certain
date for a certain price.
American options can be exercised at any time up to the
expiration date. European options can be exercised only on
the expiration date itself
15
CALL Options

-C
t

E
profit

Price
Long Call
F

C
t

E
Profit

Price
Short Call
F

C
t

-C
t

E
Profit

Price
Short + Long

C
t

-C
t

E
Profit

Price
Broker

C
t

-C
t

E
Profit

Price
Transaction cost
16
PUT Options

-C
t

Profit

Price
Long Put
E F

C
t

E
Profit

Price
Short Put
F

C
t

-C
t

E
Profit

Price
Short + Long
17
Swaps
A sw a p is an over-the-counter agreement between two
companies to exchange cash flows in the future. The
agreement defines the dates when the cash flows are to
be paid and the way in which they are to be calculated.
Usually the calculation of the cash flows involves the
future value of an interest rate, an exchange rate, or
other market variable. One of the most common SWAP
is to exchange fixed cash flow for floating cash flow
Example: Microsoft agrees to receive 6 month LIBOR
and pay every 06 month 5%/year during the period of 3
years with the notional principal of 100 million USD.
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---------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
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Types of traders
Hedgers
- U sing forward contracts: On 24
th
, May, 2010 ExportCo exports goods to
UK. The company would receive 30 million GBP in 3 months. The 3
month forward bid exchange rate is 1 GBP=1.4410 USD and the 3 month
forward ask exchange rate is 1.4415. What does ExportCo can do to hedge
for exchange rate fluctuation? Suppose that on 24
th
, August, the spot rate
(GBP/USD) is 1.3000 and 1.5000, evaluate the performance of the
hedging strategy?
- U sing options: Now it is May, an investor holds 1000 Microsoft shares at
the price of 28 USD/share. He predicts that the stock price will fall in the
next 2 months and wants to hedge this exposure. He takes the long position
of 10 July put option contracts on Microsoft with a strike price of 27.7$.
The option price is $1. Explain this hedging strategy?
- Explain the difference between hedging using forward and hedging using
option?
- Hedge funds? (your homework!!!)
20
Khoa TCNH-i Hc Ngoi Thng
Types of traders
Value of Microsoft holding in 2 months with and without hedging.
21
Types of Traders
Speculators
Using futures: Now it is February, an USA
speculator predicts that GBP will strengthen relative
to USD in next two months. He wants to speculate
with an amount of 250,000 GBP. There are two ways
to make this investment. The first is to purchase
250,000 GBP in Feb at the spot rate and sell later at
the expected higher rate in April. The second is to
take the long position of 4 April future contracts on
GBP (each contract is for purchase of 62,500 GBP
and initial margin requirement is 5,000$/contract).
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Types of Traders
Speculating 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$
23
Types of Traders
Speculators
- Using option contracts: Now is October, an
investor predict the the stock price of A will
increase in the next two months. The current stock
price is 20$, a two month call option on stock A
with strike price of 22.5$ is sold at 1$. The
investor is willing to invest 2000$. Compare two
speculating strategies: A, buy 100 stocks A; B:
long 2,000 call option on stock A.
24
Types of traders
Price 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
25
Types of traders
Arbitrage involves locking in a riskless profit by
simultaneously entering into transactions in two or
more markets
Example: A stock is listed on both New York exchange
and London exchange. Suppose that the stock price is
140$ in New York and 100 in London. The spot
exchange rate is 1.4300 USD per GBP. Arbitrageur
will simultaneously buy 100 shares in NY and sell them
in LD in order to gain a riskless profit of 100*
[(1.43*100)-$140]=300$ (no transaction cost).
Arbitrage opportunities cannot last for long. As
arbitrageurs buy the stock in New York, the forces of
supply and demand will cause the dollar price increase
26
Derivative markets
Derivative securities can be traded on exchanges
or over the counter market.
A derivatives exchange is a market where
individuals trade standardized contracts (options
and futures). Clearing house and deposit
mechanic helps to eliminate credit risk .
OTC transactions are made on an agreement
between two parties and securities are not
standardized. They are not guaranteed by the
clearing house therefore credit risk is high.
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Market size
Source: Bank for International Settlements. Chart shows total principal amounts
for OTC market and value of underlying assets for exchange market
1.28
Exercises
1, What is the difference between entering into a long forward
contract when the forward price is $50 and taking a long
position in a call option with a strike price of $50?
2, A trader enters into a short cotton futures contract when the
futures price is 50 cents per pound. The contract is for the
delivery of 50,000 pounds. How much does the trader gain
or 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 certain
stock. The current stock price is $29 and a 3-month call
with a strike price of $30 costs $2.90. You have $5,800 to
invest. Identify two alternative investment strategies, one in
the stock and the other in an option on the stock. What are
the potential gains and losses from each?
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Exercises
4, It is May and a trader writes a September call
option with a strike price of $20. The stock price
is $18 and the option price is $2. Describe the
traders cash flows if the option is held until
September and the stock price is $25 at that time.
5 A trader enters into a short forward contract on
100 million yen. The forward exchange rate is
$0.0080 per yen. How much does the trader gain
or lose if the exchange rate at the end of the
contract is (a) $0.0074 per yen and (b) $0.0091
per yen?
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