EFB344

Risk Management and Derivatives

Week 1
Introduction to Risk, Risk
Management and Derivatives
1

Week Outline
Administration:
Unit Rationale, Aim, Objectives, Content, Assessment,
Resources

Risk:
Definition, Classifications, Measurement

Risk Management:
Definition, Irrelevance Proposition, Relevance

Derivatives:
Definition, Forward/Futures, Options, Swaps

Readings:
Stulz (2003) Risk Management and Derivatives, pp. 30-75.
Hull et al. (2013) Fundamentals of Futures and Options, Ch. 1.
RiskMetrics (1996) Technical Document, pp. 5-7.
2

Unit Rationale
Sound financial management and oversight requires
an understanding of the risks that arise through
financial exposures and how these risks can be
managed. Building on the introductory finance units,
and with a focus on the risk associated with
movements in market prices (market risk), this subject
introduces students to specialised knowledge and
skills for identifying, measuring, managing and
hedging risk. As derivative securities are an important
tool in risk management, this unit introduces a wide
range of derivatives securities and examines their
pricing and use in managing and hedging risk.

Unit Aim
This unit develops knowledge and skills required to
identify, measure and hedge the risks associated with
an exposure to financial securities. It also develops
knowledge of a variety of derivative contracts with a
specific focus on how these securities are priced and
how they are used to manage and hedge risk.
Additionally, students will develop their self reflection
skills in considering their application of financial
knowledge and reasoning, and in exercising
responsibility and accountability for their own
learning.

Unit Objectives
Upon completion of this unit, you should be able to:
1. Demonstrate and apply knowledge of financial
derivatives, markets, pricing methodologies and
evaluate their use in risk management
2. Demonstrate, analyse and apply knowledge of risk
management measures and practices
3. Apply knowledge, judgement, technical and
technological skills to solve problems related to the risk
management of diverse portfolios
4. Exercise self-reflection, responsibility and
accountability in relation to own learning and
professional practice

The specific course learning goals and unit objectives

Unit Content
Week 1: Introduction to Risk, Risk Management and
Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures: commodity and equity
Week 7: Forwards and Futures: interest rates
Week 8: Mid-Semester Exam and Reflective Practices
Week 9: Swaps: interest rate
Week 10: Options: introduction and pricing with the binomial model
Week 11: Options: pricing with the Black-Scholes model
Week 12: Options: trading strategies and risk management
Week 13: Derivative Disasters
Week 14: Revision
6

Unit Assessment
Assignment (30%)
Part A (week 6) covers risk management
Part B (week 12) covers derivative pricing and hedging, and
reflective practices

Mid-Semester Exam (20%)

Multiple Choice, 1 hour + 15 minutes perusal
Topics 1-5
Approx. Week 8 in lecture time

Final Exam (50%)

Short Answer, 2 hours + 10 minutes perusal
Topics 1-12 but will have greater focus on Topics 6-12
Central Exam Period
7

Unit Resources
Required References
Hull, J., Treepongkaruna, S., Heaney, R., Pitt, D. and Colwell,
D. (2014). Fundamentals of Futures and Options Markets.
Frenchs Forest, NSW: Pearson.
RiskMetrics (1996). Technical Document 4ed. New York, NY:
J.P.Morgan/Reuters. http://
www.msci.com/resources/research_papers/technical_doc/19
96_riskmetrics_technical_document.html

Other References
Stulz, R. (2003). Risk Management and Derivatives. Mason,
OH: Thomson.
Chance, D. and Brooks R. (2010), Derivatives and Risk
Management (8th ed.). Mason, OH: South-Western.
8

Risk
Defined
We define risk as the degree of uncertainty of future
net returns (RiskMetrics, 1996, p. 5).
The chance that an investments actual return will be
different than expected, (Investopedia, http://
www.investopedia.com/terms/r/risk.asp)
It is the absence of certainty.

Risk
Classifying risk in finance

Credit Risk: loss due to default

Operational Risk: loss due to human or system errors
Liquidity Risk: loss due to inability to access funds
Market Risk: loss due to changes in market factor (e.g.
price or yield)

Note that I have used the word loss here while the earlier
definitions simply refer to deviations from expectations.
There is some debate about what constitutes risk. The point
here is that risk is generally associated with the downside
but can be thought of as downside and upside. If the
distribution of returns is symmetric, the deviations on the
downside are the same as the deviations on the upside.
10

Risk
Order the following securities according to their risk

A 3-month Australia Government T-Bill

A 3-month U.S. Government T-Bill
A 1-year Australia Government Bond
A 10-year Australian Government Bond
A USD/AUD 6-month currency forward
An A class security for securitisation
The first-loss security for a securitisation
A Woolworths Stock
A BHP Stock
An Iron-ore Futures Contract
An Oil Futures Contract
An at-the-money BHP Call Option
A deep-out-of-the-money BHP Call Option
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Risk
Measuring risk
Credit Risk
credit rating (AAA, AA, )
probability of default and expected loss given default
Market Risk
duration and convexity: for bonds and interest rate
derivatives.
variance or beta: for stocks for equity derivatives
delta and gamma: for options
value-at-risk: for all securities
Liquidity Risk
liquidity ratio
Operational Risk
?
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Risk
Why risk matters
It affects value
Ultimately, there is a risk/return trade-off.
It informs and regulates decision makers
Does the investment generate sufficient return for its
risk?
Should the firm hedge?
What expected losses can occur?
How can value or price change and what exposures
should be held?
What is the probability of bankruptcy or default?
It affects behaviour
Are the managers incentives correctly aligned with the
risk appetite of the firm owners?
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Risk
What
is the assets value?

where:

is the expected cash flow at time

is the required rate of return of cash flows at time
is some finite amount of time in the future
is the production function that allows to vary through time

Expanded:

Note that there may be no risk in valuing this asset.

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Risk
Credit Risk. As credit
worthiness degrades,
yield increases.
BBB Corp.
A Corp.
AAA Corp.

AA QLD GOV

AA Corp.
AAA AUS GOV

Market Risk / Liquidity

Risk. Upwardly sloped
curves. Note that
slope of yield curves
includes the markets
expectations of future
rates. Hence, its
difficult to conclude on
the exact levels
expectations, market
risk and liquidity
components.
Refer to term structure
15
theories for more

Risk
Bond Price Sensitivity
Yield (y)

C = 0.1, T = 3

C = 0.1, T =
10

C = 0.0, T =
10

11%

97.556 (2.444%)

94.111
(5.889%)

35.218
(8.653%)

10%

100.000

100.000

38.554

102.531
42.241
where C =9%
annual coupon
percentage 106.418
and T = maturity
in years
(2.531%)

(6.418%)

(9.563%)

Note the following general rules to parallel shifts in yield:

Longer dated bonds are more sensitive to changes in yield
Bonds with higher coupons are less sensitive to
Up/Down
changes for a shift in yield are not the same
yield changes
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(theyre asymmetric)

Risk
Duration
defined

A measure of the average life of a bond. It is also an

approximation to the ratio of the proportional change in
the bond price to the absolute change in its yield (Hull
et al., 2013, p. 546).
Well do more with
duration in later weeks, but as a start

time weighted present value of cash flows

from this equation, the bond price change can be

approximated by

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Risk
Duration example
Yield

C = 0.1, T = 3

C = 0.1, T =
10

C = 0.0, T = 10

10%

100.000

100.000

38.554

2.736

6.759

10.000

9%

102.531

106.418

42.241

100.000 +
100.000 +
38.554 +
0.01 x 2.736 x
0.01 x 6.759 x
0.01 x 10.000 x
100
100
38.554
/ 1.10
/ 1.10
/ 1.10
Note the following: = 102.487
= 106.145
= 42.059
Longer dated bonds are more sensitive to changes in yield
Bonds with higher coupons are less sensitive to
changes
yield
Duration
only approximates price changes. It works best
when yield change is small. You need to measure
convexity
for greater
accuracy
Duration
is linearly
additive
useful in portfolio and risk
18
management

Risk

Capital Market Line (CML)

E[R
]

Security Market Line (SML)

E[R
]
M
P

Return
Risk
Rf

Rf

Risk
(STD)

Risk
(Beta)
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Risk

A stock has a monthly and monthly

Assuming normality the Value-at-Risk (VaR) is
There is a 2.5% probability to experience a loss of 6.91% or
more in the next month. Or, in dollar terms, for every $1,000,000
invested there is a 1 in 40 chance that youll lose $69,100 or
more in the next month
2 x STD
Based on the empirical rule of the
normal distribution, 5% of
observation lie two STDs or more
from the mean. As the normal
distribution is symmetric, area in
left tail below -0.0691 is 2.5%
-0.0691

0.0151

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Risk Management
Defined
Risk Management is the practice of defining the risk
level a firm desires, identifying the risk level the firm
currently has, and using derivatives and other financial
instruments to adjust the actual level of risk to the
desired level of risk. (Chance and Brooks, 2007, p. 519).
The process of identification, analysis and either
acceptance or mitigation of uncertainty in investment
decision-making. (Investopedia, http://
www.investopedia.com/terms/r/riskmanagement.asp)

21

Risk Management
Risk Management Irrelevance Proposition
a firm cannot create value by hedging risks when it costs the
same for the firm to bear the risks directly than to pay capital
markets to bear them (Stulz 2003, p. 45).

Consider:
Diversifiable Risk: removing diversifiable risk does not change
the assets expected cash flows or required rate of return.
Furthermore, shareholders can perform this task themselves.
Systematic Risk: reducing systematic risk reduces both the
expected cash flow and the required rate of return.
Furthermore, shareholders can perform this task themselves.
22

Risk Management
Risk Management Irrelevance Proposition
Relies on the assumption of perfect capital markets. That
is,
No transactions costs
No taxes
Equal access to information
Rational Investors
In this instance, the law-of-one price holds such that the
return to shareholders for bearing the risk is the same as
the cost to transfer the risk to capital markets. Hence, no
value added!

Therefore, for risk management to be relevant, we must

identify how it creates value.

23

Risk Management
Maybe not!
Risk Management is the practice of defining the risk level a firm desires,
identifying the risk level the firm currently has, and using derivatives and
other financial instruments to adjust the actual level of risk to the
desired level of risk. (Chance and Brooks 2007, p.519).
It does not mention value!

Back to value
For value to exist, the return for the firm bearing risk must differ from the
markets return.

Dead Weight Loss (costs and lost investment because of capital shortfall)
Bankruptcy and Financial Distress Costs (fees, management time, lost investment)
Homemade Hedging (costs, inability, information asymmetry)
Tax (changes, carrybacks and carryforwards, other tax shields)
Capital Structure (increases debt carrying capacity tax exists)
Stakeholders (relates to financial distress in terms of their willingness to invest.)
Debt Overhang (accept negative NPV investments and reject positive NPV investments)
24

Risk Management
Example:
Bankruptcy Costs from Stulz (2003,

pp. 57-58)
Gold mine
Output = 1,000,000 ounces

, where

Unhedged: =

Hedged:

Risk Management is irrelevant here but what about

bankruptcy?

25

Risk Management
Example:
Bankruptcy Costs from Stulz (2003,

pp. 57-58)
Gold mine
Output = 1,000,000 ounces,, , where
, gold spot price is normally distributed with mean of 0 and STD =
0.2

Unhedged:

Hedged:

=
=

Risk Management adds value, $1.46m in this example.

26

Risk Management
Example:
Debt Overhang from Stulz (2003, pp.

70-71)
Output = 1,000,000 ounces,, , , , where
, its +ve NPV

without project: + =
PV Debt =
309.52

with project:
PV Debt =
314.29

PV Equity = 23.81

+=
PV Equity = 28.57

However, PV Equity has only increased by $4.76m when $5m is

required.
Risk Management that reduces the probability of the debt overhang

27

Derivatives
Defined:
An instrument whose price depends on, or is derived from, the
price of another asset (Hull et al. 2013, p. 546).
Derivatives are financial instruments whose returns are derived
from those of other financial instruments. (Chance and Brooks
200X, p.1).

Written On:
Stocks, Bonds, Commodities, Currencies and Events

Major Types:

Forward: an obligation to buy or sell

Futures: an exchange traded forward that is marked-to-market daily
Swaps: a bundle of forwards
Options: the right but not the obligation to buy or sell

Uses and Users:

Derivatives offset an existing exposure or create an exposure
Hedgers, Portfolio Managers, Speculators and Arbitrageurs

28

Derivatives
Forward/Futures

Payoff

A forward is a contract made today to be performed at some set

time in the future at a set price for goods of a particular quality
delivered to a set location.
An futures contract is an agreement made today to exchange a
specified asset at a specified price at a specified date in the
future.
Trading, Pricing, Hedging, Risk Management, etc. discussed in
Where:
later weeks.
- F0,T is the forward price set at day 0 for
Exposure: Long (bought) Forwardforward that matures at T.
0
F0,T

ST

ST is the future spot price at T

Note:
- V0, which is the value of the forward
contract at 0, is 0; V0 = 0.
- However, Vt, which is the value of the
forward after 0 but only up to T, can b
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positive or negative.

Derivatives
Options

Payoff

Payoff

An option is the right (but not the obligation) to force a

transaction to occur at some time in the future on terms and
conditions agreed upon now.
Trading, Pricing, Hedging, Risk Management, etc. discussed in
later weeks.
Lots of jargon including, put, call, writer, American, intrinsic
Long Call
Long Put
value, etc.
Where:
Exposure:
- X is the exercise price

0
X

ST

Note:
- Call price (C) and Put price
(P) > 0

0
X

ST

30

Derivatives
Swap
A contract to exchange cash flows periodically for an agreed
period of time.
Trading, Pricing, Hedging, Risk Management, etc. discussed
in later weeks.
Major types are interest rate and cross-currency swaps
LIBOR + MarginInterest Rate Swap
Exposure: Fixed-for-Floating
Counterpar
ty
A

Fixed

Counterpar
ty
B

Where:
- LIBOR is a floating reference rate (London Inter-Bank Offer Rate) that resets
every 3 or 6 months.
Note:
- Generally, V0, which is the value of the swap contract at 0, is 0; V0 = 0. This
implies PV of floating payments equals the PV of fixed payment at inception.
- However, Vt, which is the value of the swap after 0 but only up to maturity,
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can be positive or negative.