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Summary Financial risk management - lecture notes
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Lecture notes on the lessons of financial risk management of Luc Keuleneer
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FINANCIAL RISKMANAGEMENT
Lecture 1 – Framework and Derivatives: Swaps
A. FRAMEWORK
You need a framework (chapter 2) if you want to discuss financial risk management.
The CEO’s primary task is risk management (the strategy of the company is based on it).
1. IDENTIFICATION
= identification of the different risks within the framework
à Operational/non-financial risks: The most dangerous operational risk: at the top of the
organisations: bad governance: making stupid decisions at the top. We are not going to focus
on those, but on the financial risks
à Financial risks:
o Market risks
§ Price risk
§ Interest rate risk
§ Currency rate risk
v Transactional currency rate risk: based on specific
transactions. You sell today to client in the states, but he’s
going to pay you one year from now. This can be a
completely different currency rate than the one today
v Economic currency rate risk: today you sell client in US, but
main competitor is in Japan; your cost is in €, but the
competitor cost is in yen àyou are compared to your
competitor based on the currency rate in $ (so euro in dollar
en yen in dollar): based on the current exchange rate, you
are cheaper than your Japanese competitor. But if there’s a
change in the € - $ rate, you may be more expensive than
Japanese competitor, but the costs haven’t change. So
change in € -$ rate is going to influence your competitive
position.
v Accounting or translation currency rate risk: if you do
business in another currency, this can influence your number
of the FS’s. You need to state the FS’s in different currencies,
which could change your result.
o Credit Risk
o Liquidity risk
Lotte Vermaerke – Financial Risk Management 1
,• What is the most dangerous financial risk?
à Liquidity risk: if there’s no liquidity anymore, then bankruptcy is very close by
• What is very bad financial risk management?
à If you want to manage the interest rate risk, you use an instrument or a technique, but by
using that instrument you create a new, more dangerous risk (vb liquidity risk), you will be in
trouble à you want to solve problems, not create new ones!
2. MEASUREMENT
• Credit risk
o Measured by credit rating. There are different credit rating agencies (Moody’s etc.)
• Interest rate risk
o Measured by duration
§ Difference between time to maturity and duration: Why can’t you just use time
to maturity (TTM) as a measure for interest rate risk?
à In general, the longer time to maturity the higher the interest sensitivity à
Only correct if there are no intermediate payments. If there are no intermediate
payments, TTM is the same as duration. But if there are, you need to correct the
TTM for those intermediate payments, then you have duration.
• RARORAC
o = Risk adjusted return on risk adjusted capital
o Risk management related to the Basel rules (= What is the minimum level of equity a
bank needs?)
• Value at risk (VaR)
o = Maximum loss that you can make on a portfolio during a certain period with a certain
probability.
o The portfolio theory à the Noble prize winner behind the portfolio theory is Markowitz:
if you know portfolio theory then it’s easy to understand VaR
§ Risk of a financial instrument: risk is volatility; and volatility is measured by the
standard deviation
§ Risk of a portfolio: portfolio is different financial instruments together à not just
add the different stand dev, but also incorporate the correlation between the
financial istruments à the risk of a portfolio can be less than de sum of the
different stad dev à it’s all about diversification: if you have a portfolio you are
diversifying your risk.
o What is now the link between portfolio theory and VaR?
§ Example: 1 000 000 shares of KBC bank. Stand dev on a weekly basis = 2%
à What is the 1 week value at risk for this portfolio with a 97.72% probability?
You take 100 weeks, and you always look at the result of each of those weeks,
what is then in 98 out of 100 the maximum loss you can make on this portfolio?
à Where is the 97,72% coming from? Zie tekening!
Lotte Vermaerke – Financial Risk Management 2
, If you have the normaal-curve, if you go 2std dev to the left/right, the probability
that you are in that range is 95,44%. The probability that you are outside the
range, is 2,28% on both sides. If you have a positive result on your portfolio,
that’s not a problem. The probability that you have a positive result, or a
negative result that does not exceed the red line is 97,72%. The probability that
you are in that range is 97,72%.
à you need to take 2 standard dev, so 2* 2% = 4% x 1 000 000 = 40 000 EUR.
Here we are using the first part of the Markowitz portfolio theory (risk is
measured by stad dev).
(if you want a larger probability, you will need more than 2 stad dev)
à Which risk are you measuring in this example? The price risk. Why is value at
risk a popular tool for risk management? Now we can do a 2nd step: in the
example we assumed that we were an euro investor. But if we are an American
pension fund wanting to invest in KBC, we don’t only have a price risk but also a
currency risk.
à you need to recalculate the stad dev on a weekly basis, for the portfolio,
where we both incorporate the price risk and the currency rate risk. For this you
need the stad dev of the share price, the stad dev of the currency rate, and the
correlation
o Why is VaR so popular?
§ 1st advantage is not AAA or ‘9 months’, but result is in monetary terms (zie vb, 40
000 EUR). Easier to communicate and understand for the board of directors etc.
§ With duration or credit risk, it is always for a specific risk. With VaR, you can
include different types of risks; you can summarize different risks in one specific
amount of EUR, $,...
§ But, disadvantage: the problem is people are starting to mixing things up. Big
problem with VaR: before we said if you understand Markowitz, you can
understand VaR; BUT what is the key issue?
à Your statistical distribution has to be correct; for price and currency rate risk
normal distribution is acceptable, but NOT for credit risk! So if you also include credit
risk and you make your calculations based on ‘okay so I need to take 2 stad dev to
have a probability of 97,72% and then we have 40 000 EUR’, your conclusion will be
completely wrong!
à So key issue is the underlying statistical distribution of the different types of risk
you include.
3. FINANCIAL RISK STRATEGY & CONTROL
• Which risks are acceptable, and what is the level that is acceptable? (= risk tolerance)
• Cost or profit center: if you hire very specialize people and you pay them a lot of money, then it
is not reasonable that you put them into a cost center.
• Centralized/decentralized
o If you are just looking at efficiency, you would expect a centralized structure. Vb for the
currency rate risk, if the structure is decentralized, the different companies in your group
are going to decide for themselves whether or not to hedge the dollar etc, will be more
expensive and complex to work with different banks in different companies.
Lotte Vermaerke – Financial Risk Management 3
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