chapter 15: financial risk management: concepts, practice, & benefits

Chance/BrooksAn Introduction to Derivatives and Risk Management, 7th ed. Ch. 15: 1

Chapter 15: Financial Risk Management: Concepts, Practice,

& Benefits

Financial risk management is not about Financial risk management is not about avoiding risk. Rather, it is about understanding avoiding risk. Rather, it is about understanding and communicating risk, so that risk can be and communicating risk, so that risk can be taken more confidently and in a better way.taken more confidently and in a better way.

David R. KoenigDavid R. KoenigThe Professional Risk The Professional Risk

Managers’ Handbook, p. xxiv, 2004Managers’ Handbook, p. xxiv, 2004


Important Concepts in Chapter 15 The concept and practice of risk The concept and practice of risk

managementmanagement The benefits of risk managementThe benefits of risk management The difference between market and The difference between market and

credit riskcredit risk

Chance/BrooksAn Introduction to Derivatives and Risk Management, 7th ed.Ch. 15: 3

Definition of risk management: Definition of risk management: The practice of defining the risk The practice of defining the risk

level a firm desires, identifying the level a firm desires, identifying the risk level it currently has, and using risk level it currently has, and using derivatives or other financial derivatives or other financial instruments to adjust the actual risk instruments to adjust the actual risk level to the desired risk level.level to the desired risk level.


Why Practice Risk Management? The Impetus for Risk ManagementThe Impetus for Risk Management

Firms practice risk management for several Firms practice risk management for several reasons:reasons: Interest rates, exchange rates and stock Interest rates, exchange rates and stock

prices are more volatile today than in the prices are more volatile today than in the past. past.

Significant losses incurred by firms that did Significant losses incurred by firms that did not practice risk managementnot practice risk management

Improvements in information technologyImprovements in information technology Favorable regulatory environmentFavorable regulatory environment

Sometimes we call this activity financial risk Sometimes we call this activity financial risk management.management.


Why Practice Risk Management? (continued)

The Benefits of Risk ManagementThe Benefits of Risk Management Firms can practice risk management more Firms can practice risk management more

effectively.effectively. There may tax advantages from the There may tax advantages from the

progressive tax system.progressive tax system. Risk management reduces bankruptcy costs. Risk management reduces bankruptcy costs. Managers are trying to reduce their own risk.Managers are trying to reduce their own risk. By protecting a firm’s cash flow, it increases By protecting a firm’s cash flow, it increases

the likelihood that the firm will generate the likelihood that the firm will generate enough cash to allow it to engage in enough cash to allow it to engage in profitable investments.profitable investments.


Why Practice Risk Management? (continued) The arguments on Risk ManagementThe arguments on Risk Management

Modigliani-Miller principle argue that corporate Modigliani-Miller principle argue that corporate financial decisions provide no value because financial decisions provide no value because shareholders can execute these transactions shareholders can execute these transactions themselves?themselves?

Some firms use risk management as an excuse to Some firms use risk management as an excuse to speculate.speculate.

Some firms believe that there are arbitrage Some firms believe that there are arbitrage opportunities in the financial markets.opportunities in the financial markets.

Note: The desire to lower risk is not a sufficient Note: The desire to lower risk is not a sufficient reason to practice risk management.reason to practice risk management.


Managing Market Risk Market risk: the risk that the value of an Market risk: the risk that the value of an

investment will decrease due to moves in investment will decrease due to moves in market factors. The four standard market risk market factors. The four standard market risk factors are:factors are: Equity Risk-the risk that stock prices will Equity Risk-the risk that stock prices will

change.change. Interest Rate Risk-the risk that interest rates Interest Rate Risk-the risk that interest rates

will change.will change. Currency Risk-the risk that foreign exchange Currency Risk-the risk that foreign exchange

rates will change.rates will change. Commodity Risk-the risk that commodity Commodity Risk-the risk that commodity

prices (i.e. grains, metals, etc.) will change.prices (i.e. grains, metals, etc.) will change.


Managing Credit Risk

Credit risk or default risk is the risk Credit risk or default risk is the risk that the counterparty will not pay off in that the counterparty will not pay off in a financial transaction.a financial transaction.

Credit ratings are widely used to assess Credit ratings are widely used to assess credit risk.credit risk.


Managing Credit Risk (continued) The Credit Risk of DerivativesThe Credit Risk of Derivatives

Current credit risk is the risk to one party Current credit risk is the risk to one party that the other will be unable to make that the other will be unable to make payments that are currently due.payments that are currently due.

Potential credit risk is the risk to one party Potential credit risk is the risk to one party that the counterparty will default in the that the counterparty will default in the future.future.

In options, only the buyer faces credit risk.In options, only the buyer faces credit risk.

Managing Credit Risk (continued) The Credit Risk of Derivatives (continued)The Credit Risk of Derivatives (continued)

Forward Rate Agreements (FRAs)* and swaps Forward Rate Agreements (FRAs)* and swaps have two-way credit risk but at a given point have two-way credit risk but at a given point in time, the risk is faced by only one of the in time, the risk is faced by only one of the two parties.two parties. FRAs : a transaction similar to a forward FRAs : a transaction similar to a forward

contract in which, one party agrees to contract in which, one party agrees to make a future interest payment based on make a future interest payment based on an agreed-upon fixed rate of interest and an agreed-upon fixed rate of interest and receives a future interest payment based receives a future interest payment based on a floating rate, such as LIBOR on a floating rate, such as LIBOR (The LIBOR [London Interbank Offered Rate] is the average interest rate that leading banks in London charge when lending to other banks)



Managing Credit Risk (continued) The Credit Risk of Derivatives (continued)The Credit Risk of Derivatives (continued)

Potential credit risk is largest during the middle of an Potential credit risk is largest during the middle of an interest rate swap’s life but due to principal interest rate swap’s life but due to principal repayment, potential credit risk is largest during the repayment, potential credit risk is largest during the latter part of a currency swap’s life.latter part of a currency swap’s life.

Typically all parties pay the same price on a Typically all parties pay the same price on a derivative, regardless of their credit standing. Credit derivative, regardless of their credit standing. Credit risk is managed throughrisk is managed through limiting exposure to any one party (primary limiting exposure to any one party (primary

method)method) Collateral-Any type of cash or security set aside as Collateral-Any type of cash or security set aside as

protection for the lender in a loan. Also, used as a protection for the lender in a loan. Also, used as a credit enhancement in a derivative transaction.credit enhancement in a derivative transaction.

periodic marking-to-marketperiodic marking-to-market (by dealers) captive derivatives subsidiaries(by dealers) captive derivatives subsidiaries netting netting


Managing Credit Risk (continued) NettingNetting

Netting: several similar processes in which the amount Netting: several similar processes in which the amount of cash owed by one party to the other is reduced by of cash owed by one party to the other is reduced by the amount owed by the latter to the former.the amount owed by the latter to the former. Bilateral netting: netting between two parties. Bilateral netting: netting between two parties. Multilateral netting: netting between more than two Multilateral netting: netting between more than two

parties; essentially the same as a clearinghouse.parties; essentially the same as a clearinghouse. Payment netting: Only the net amount of a payment Payment netting: Only the net amount of a payment

owed from one party to the other is paid.owed from one party to the other is paid. Cross-product netting: payments from one type of Cross-product netting: payments from one type of

transaction are netted against payments for another transaction are netted against payments for another type of transaction.type of transaction.


Managing Credit Risk (continued) Netting (continued)Netting (continued)

Netting by novation: net value of two parties’ Netting by novation: net value of two parties’ mutual obligations is replaced by a single mutual obligations is replaced by a single transaction; often used in FOREX markets.transaction; often used in FOREX markets.

Closeout netting: netting in the event of Closeout netting: netting in the event of default, where all transactions between two default, where all transactions between two parties are netted against each other; see parties are netted against each other; see example in text.example in text.

The OTC derivatives market has an excellent The OTC derivatives market has an excellent record of default. Note the Hammersmith and record of default. Note the Hammersmith and Fulham default where it was found that a town Fulham default where it was found that a town had no legal authority to engage in swaps. had no legal authority to engage in swaps. The town was able to get out of paying its The town was able to get out of paying its losses.losses.


Managing Credit Risk (continued) Credit Derivatives: Credit Derivatives:

A family of derivative instruments whose A family of derivative instruments whose payoff is largely determined by the credit of payoff is largely determined by the credit of another party.another party.

Used to separate market risk from credit Used to separate market risk from credit risk and permits the separate trading of risk and permits the separate trading of credit risk.credit risk.

Each transaction involves 3 parties: credit Each transaction involves 3 parties: credit buyer, credit seller, & the reference entity.buyer, credit seller, & the reference entity.

Managing Credit Risk (continued)

Credit Derivatives types include:Credit Derivatives types include: Total return swaps: See Total return swaps: See FigureFigure Figure 15.4, Figure 15.4,

p. 550. Credit derivative buyer purchases p. 550. Credit derivative buyer purchases swap from credit derivative seller in which swap from credit derivative seller in which it pays the total return on a specific bond. it pays the total return on a specific bond. If that return is reduced by some credit If that return is reduced by some credit event, this loss is passed through event, this loss is passed through automatically in the swap.automatically in the swap.



Managing Credit Risk (continued) Credit Derivatives types include (continued) :Credit Derivatives types include (continued) :

Credit default swap: A swap in which the Credit default swap: A swap in which the credit derivatives buyer pays a periodic fee credit derivatives buyer pays a periodic fee to the credit derivatives seller. If the to the credit derivatives seller. If the buyer sustains a credit loss from a third buyer sustains a credit loss from a third party (reference entity), it then receives party (reference entity), it then receives payments from the credit derivatives seller payments from the credit derivatives seller to compensate. to compensate. See Figure 15.5, p. 551. This is really more See Figure 15.5, p. 551. This is really more like an option.like an option.

Credit spread option: An option in which Credit spread option: An option in which the underlying is the yield spread on a the underlying is the yield spread on a bond. bond. See Figure 15.6, p. 552. See Figure 15.6, p. 552.


Managing Credit Risk (continued)

Credit Derivatives types include (continued) :Credit Derivatives types include (continued) : Credit linked security: This is a bond or Credit linked security: This is a bond or

note that pays off less than its face value if note that pays off less than its face value if a credit event occurs on a third party. a credit event occurs on a third party. Figure 15.7, p. 553. Figure 15.7, p. 553.

The credit derivatives market is small but The credit derivatives market is small but growing rapidly. The notional principal of growing rapidly. The notional principal of credit derivatives at U. S. banks was credit derivatives at U. S. banks was estimated at about $2.3 trillion in 2005.estimated at about $2.3 trillion in 2005.


Synthetic CDO (Collateralized Debt Obligation) Credit Derivatives types include (continued) :Credit Derivatives types include (continued) :

Cash CDOs – underlying is a portfolio of Cash CDOs – underlying is a portfolio of securitiessecurities

Synthetic CDOs – underlying is a portfolio Synthetic CDOs – underlying is a portfolio of credit derivativesof credit derivatives See Figure 15.8, p. 555. See Figure 15.8, p. 555.


Other Types of Risks operational risk (including inadequate controls)operational risk (including inadequate controls) model riskmodel risk liquidity riskliquidity risk accounting riskaccounting risk legal risklegal risk tax risktax risk regulatory riskregulatory risk settlement risksettlement risk systemic risksystemic risk


Summary

Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 15: 21

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chapter 15: financial risk management: concepts, practice, & benefits

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