Chapter 15: Financial Risk Management: Concepts, Practice, & Benefits

Chapter 15: Financial Risk Management: Concepts, Practice, & Benefits Financial risk management is not about avoiding risk. Rather, it is about understanding and communicating risk, so that risk can be taken more confidently and in a better way. David R. Koenig The Professional Risk Managers’ Handbook, p. xxiv, 2004 An Introduction to Derivatives and Risk Management, 7th ed.

Important Concepts in Chapter 15 • The concept and practice of risk management • The benefits of risk management • The difference between market and credit risk An Introduction to Derivatives and Risk Management, 7th ed.

Definition of risk management: • The practice of defining the risk level a firm desires, identifying the risk level it currently has, and using derivatives or other financial instruments to adjust the actual risk level to the desired risk level. An Introduction to Derivatives and Risk Management, 7th ed.

Why Practice Risk Management? • The Impetus for Risk Management • Firms practice risk management for several reasons: • Interest rates, exchange rates and stock prices are more volatile today than in the past. • Significant losses incurred by firms that did not practice risk management • Improvements in information technology • Favorable regulatory environment • Sometimes we call this activity financial risk management. An Introduction to Derivatives and Risk Management, 7th ed.

Why Practice Risk Management? (continued) • The Benefits of Risk Management • Firms can practice risk management more effectively. • There may tax advantages from the progressive tax system. • Risk management reduces bankruptcy costs. • Managers are trying to reduce their own risk. • By protecting a firm’s cash flow, it increases the likelihood that the firm will generate enough cash to allow it to engage in profitable investments. An Introduction to Derivatives and Risk Management, 7th ed.

Why Practice Risk Management? (continued) • The arguments on Risk Management • Modigliani-Miller principle argue that corporate financial decisions provide no value because shareholders can execute these transactions themselves? • Some firms use risk management as an excuse to speculate. • Some firms believe that there are arbitrage opportunities in the financial markets. • Note: The desire to lower risk is not a sufficient reason to practice risk management. An Introduction to Derivatives and Risk Management, 7th ed.

Managing Market Risk • Market risk: the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are: • Equity Risk-the risk that stock prices will change. • Interest Rate Risk-the risk that interest rates will change. • Currency Risk-the risk that foreign exchange rates will change. • Commodity Risk-the risk that commodity prices (i.e. grains, metals, etc.) will change. An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk • Credit risk or default risk is the risk that the counterparty will not pay off in a financial transaction. • Credit ratings are widely used to assess credit risk. An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk (continued) • The Credit Risk of Derivatives • Current credit risk is the risk to one party that the other will be unable to make payments that are currently due. • Potential credit risk is the risk to one party that the counterparty will default in the future. • In options, only the buyer faces credit risk. An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk (continued) • The Credit Risk of Derivatives (continued) • Forward Rate Agreements (FRAs)* and swaps have two-way credit risk but at a given point in time, the risk is faced by only one of the two parties. • FRAs : a transaction similar to a forward contract in which, one party agrees to make a future interest payment based on an agreed-upon fixed rate of interest and receives a future interest payment based 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) An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk (continued) • The Credit Risk of Derivatives (continued) • Potential credit risk is largest during the middle of an interest rate swap’s life but due to principal repayment, potential credit risk is largest during the latter part of a currency swap’s life. • Typically all parties pay the same price on a derivative, regardless of their credit standing. Credit risk is managed through • limiting exposure to any one party (primary method) • Collateral-Any type of cash or security set aside as protection for the lender in a loan. Also, used as a credit enhancement in a derivative transaction. • periodic marking-to-market • (by dealers) captive derivatives subsidiaries • netting An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk (continued) • Netting • Netting: several similar processes in which the amount of cash owed by one party to the other is reduced by the amount owed by the latter to the former. • Bilateral netting: netting between two parties. • Multilateral netting: netting between more than two parties; essentially the same as a clearinghouse. • Payment netting: Only the net amount of a payment owed from one party to the other is paid. • Cross-product netting: payments from one type of transaction are netted against payments for another type of transaction. An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk (continued) • Netting (continued) • Netting by novation: net value of two parties’ mutual obligations is replaced by a single transaction; often used in FOREX markets. • Closeout netting: netting in the event of default, where all transactions between two parties are netted against each other; see example in text. • The OTC derivatives market has an excellent record of default. Note the Hammersmith and Fulham default where it was found that a town had no legal authority to engage in swaps. The town was able to get out of paying its losses. An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk (continued) • Credit Derivatives: • A family of derivative instruments whose payoff is largely determined by the credit of another party. • Used to separate market risk from credit risk and permits the separate trading of credit risk. • Each transaction involves 3 parties: credit buyer, credit seller, & the reference entity. An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk (continued) • Credit Derivatives types include: • Total return swaps: See FigureFigure 15.4, p. 550. Credit derivative buyer purchases swap from credit derivative seller in which it pays the total return on a specific bond. If that return is reduced by some credit event, this loss is passed through automatically in the swap. An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk (continued) • Credit Derivatives types include (continued) : • Credit default swap: A swap in which the credit derivatives buyer pays a periodic fee to the credit derivatives seller. If the buyer sustains a credit loss from a third party (reference entity), it then receives payments from the credit derivatives seller to compensate. See Figure 15.5, p. 551. This is really more like an option. • Credit spread option: An option in which the underlying is the yield spread on a bond. See Figure 15.6, p. 552. An Introduction to Derivatives and Risk Management, 7th ed.

Managing Credit Risk (continued) • Credit Derivatives types include (continued) : • Credit linked security: This is a bond or note that pays off less than its face value if a credit event occurs on a third party. Figure 15.7, p. 553. • The credit derivatives market is small but growing rapidly. The notional principal of credit derivatives at U. S. banks was estimated at about $2.3 trillion in 2005. An Introduction to Derivatives and Risk Management, 7th ed.

Synthetic CDO (Collateralized Debt Obligation) • Credit Derivatives types include (continued) : • Cash CDOs – underlying is a portfolio of securities • Synthetic CDOs – underlying is a portfolio of credit derivatives • See Figure 15.8, p. 555. An Introduction to Derivatives and Risk Management, 7th ed.

Other Types of Risks • operational risk (including inadequate controls) • model risk • liquidity risk • accounting risk • legal risk • tax risk • regulatory risk • settlement risk • systemic risk An Introduction to Derivatives and Risk Management, 7th ed.

Summary An Introduction to Derivatives and Risk Management, 7th ed.

(Return to text slide) An Introduction to Derivatives and Risk Management, 7th ed.

Chapter 15: Financial Risk Management: Concepts, Practice, & Benefits