Final summary - Lecture 1 -
Introduction to Risk Management
Course Risk management
Status Done
Tags
Semester Semester 5
Type Lecture
Files
Definitions
Risk = possible future event which, if it occurs, will lead to an undesirable outcome
(possibility of suffering a loss). It is the uncertainty that individuals, investors and
corporations do not like.
When driving a car, you may have an accident
Risk management = Any set of actions taken by individuals, investors or
corporations to alter the risk arising from their primary line(s) of business
You can limit the probability of an accident by adapting driving style, driving
sober, avoiding bad weather conditions
Hedge = a financial position - often a derivative - used to reduce the impact of a risk
one is exposed to (hedging means putting on a hedge).
Hedge would be car insurance (receive financial compensation if an accident
occurs)
Basis risk = the hedge is imperfect: the insurance may not fully cover the
financial (as well as physical and emotional) damage of the accident
Final summary - Lecture 1 - Introduction to Risk Management 1
, Some risks are worth taking, as possible benefits exceed possible costs
E.g. taking a plane to a favorite destination, which is a small risk but has a big
payoff
Risk management process
Identify relevant risk factors
Example: the company building highways, there can be lots of things that play a role;
Price of petroleum, interest rates, exchange rates, business conditions, etc.
When demand for roads is high (business conditions), firm will need to borrow
more and this borrowing tends to be expensive (higher interest rates). This
correlation decreases risk.
However, petroleum prices tend to be lower in a boom. This correlation
increases risk.
Example with Adidas based in the EU
Final summary - Lecture 1 - Introduction to Risk Management 2
, Volatility index = measures short-term expected volatility in the S&P500 (measure of
risk: how big are movements going to be, but does not tell you the direction)
Best prediction of tomorrow’s rate is its current rate (random walk
theory)
Final summary - Lecture 1 - Introduction to Risk Management 3
, With mean = 0% and volatility = 11%
Derivatives
It is a financial instrument with promised payoffs derived from the value of one or
several contractually specific underlying’s.
Underlying’s are risks to which economic agents (individuals and corporations) are
exposed
Can be anything, hours of sun in Kansas, snow in cm in NY state, total number
or bankruptcies in a year, Bitcoin, elections, number of houses destroyed in
hurricane, etc.
Most liquid (cheaper and easier to access) are on those underlying’s to which many
agents are exposed, such as: stock prices, exchange rates, interest rates,
commodity prices
2 flavors
Plain vanilla (more common): forwards and futures (& swaps, a portfolio of them)
and options
Exotic derivatives (more complex)
Traded on exchanges or OTC (2 parties agree, customized, contract, more expensive,
most is OTC)
Final summary - Lecture 1 - Introduction to Risk Management 4
