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Chapter 1

Introduction

Event Risk
An unforeseen event can affect revenue and costs Increased fuel prices in 1973 in the USA caused

American automakers to suffer as they concentrated on building larger cars


Foresight and appropriate strategy can help manage

these risks

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Price Risk
Arises when future cash flows are affected by

changing prices of inputs and outputs:


Changes in price of commodities Changes in price of financial instruments Changes in price of money or interest rates Changes in price of currency or exchange rate

changes

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Credit Risk
Arises when customers credit rating falls

When this occurs, the probability of default and

bankruptcy increase

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Risk Management
Risk is unavoidable Operating and business, and event risk, can be

management only by formulating appropriate strategies based on anticipation Price risk, which occurs on a regular basis, can be managed using derivative securities Credit risk can be managed through derivative securities

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Hedging
Hedging is undertaken to reduce the risk of unknown

future prices
Hedging is done using derivative securities

Derivatives used are:


Forward contracts Futures contracts Options contracts Swap contracts

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Forward Contracts
Provide the holder of contracts with the right to buy or

sell the underlying asset at a future time at a price that is agreed upon at the time of entering into the contract Both parties obligated to fulfill the contract Short-term, non-negotiable Typically over-the-counter

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Futures Contracts
Provide the holder of the contract with the right to buy

or sell the underlying asset at a future time at a price agreed upon at the time of entering into the contract
Both parties obligated to fulfill the contract

Can be short- or long-term


Negotiable Traded on futures exchanges

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Upside and Downside Risk


When prices move in favour of a company, increased

cash flow will be produced and the company will face upside risk
When prices move against a company, decreased

cash flow will result and the company will face downside risk
When hedging, attention is placed on downside risk

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Options Contracts
An option buyer has the right to either buy or sell the

underlying asset at a fixed price, at a future time Option buyers have no obligation to fulfill contracts, whereas the writers have to fulfill the obligations if called upon to do so Options provide protection against downside risk, while preserving upside potential; under forwards and futures, upside potential is foregone Options can be either over-the-counter or traded in exchanges

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Commodity Price Risk


Commodity price risk arises when future prices of

inputs and outputs are uncertain

Major determinants of price risk are:


Volatility of movement of prices Liquidity of the market

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Interest Rate Risk


Interest rate risk arises when future interest rates are

not known
Investors in fixed-income securities face interest rate

riskthe value of fixed-income securities are directly related to interest rate movements
Borrowers and lenders face interest rate risk, as

interest rate on loans depend on interest rates in the market

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Deregulation and Central Bank Intervention


Until the 1970s, interest rates were regulated with

ceilings on interest rates on deposits and loans


With deregulation, banks can offer competitive rates

The Central Bank can use interest rates as monetary

tools to determine money supply in the economy

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Floating-rate Loans
Floating-rate loans are loans where interest rates are

not fixed for the whole term of the loan, and are set at periodic intervals during the loan period based on basic interest rates in the economy
Example: 6-month MIBOR + 200 points Interest rates on loans will be reset every 6 months. Interest rates will be 2% above the 6-month MIBOR

at that time

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Floating Rate Loan: Example (1)


Date loan taken Loan amount Interest reset Loan maturity Base rate January 1, 2011 INR 1 million Every 6 months 2 years 6-month MIBOR

Premium
January 1, 2011 July 1, 2011 January 1, 2012 July 1, 2012
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100 basis points (1%)


Actual MIBOR Loan Rate 8% 8.6% 9% 8.5% 9% 9.6% 10% 9.5%

Floating Rate Loan: Example (2)


Amount of interest to be paid
Date of Interest Payment June 30, 2011 Dec 31, 2011 June 30, 2011 Dec 31, 2011 Interest Rate Amount of Interest INR 45,000 INR 48,000 INR 50,000 INR 47,500

9% 9.6% 10% 9.5%

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Interest Rates and Inflation


Relationship provided by Irving Fisher Nominal interest rate = (1 + real interest rate) * (1 +

expected inflation rate) 1


Nominal interest rate = real rate + expected inflation

rate

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Components of Interest Rate Risk


Interest rate risk has two effects: Risk of changes the price of securities is called

price risk
Risk of changes in the rate at which cash flows

received from investment can be reinvested is called reinvestment rate risk

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Currency Risk
Currency risk, or exchange rate risk, arises when

cash flows are denominated in a foreign currency


Examples of currency risk include:

Exporter receiving foreign currency


Importer needing to pay foreign currency Investors in foreign currency securities Borrowers of foreign currency loans

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Approaches to Risk Management


Do nothing

Cover everything

Selective hedging

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Risks in Derivative Trading


Hedging using derivatives has its own risks Using futures and forwards to hedge: The hedger benefits only if the price moves against

the hedger (downside risk) The hedger could face huge losses if the price moves against them (upside risk) Speculators can lose a large amount if prices move against their expectations Options can also result in losses even though they provide upside potential due to the cost of options as one needs to pay for buying the options Exotic derivatives and credit derivatives result in losses due to not understanding the nature of products
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