Académique Documents
Professionnel Documents
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Course Contents
Concept of risk management
Mechanics of financial markets, in particular derivatives
markets
Applications and limitations of financial derivatives in risk
management
What Is Risk?
Introduction to Derivatives
Mechanics of Futures Markets
Hedging Strategies Using Futures
Interest Rates
Determination of Forward and Futures Prices
Swaps
Properties of Options
Binomial Trees
The Black-Scholes-Merton Model
Conclusion
Recommended Readings
Hull, John C. Options, Futures, and Other Derivatives, 8th ed.,
Pearson 2012 [OFD]
main textbook (note: the older editions 6 or 7 will do as well)
Hull, John C. Solutions Manual for Options, Futures, and Other
Derivatives, 8th ed., Pearson 2012
Damodaran, Strategic Risk Taking: A Framework For Risk
Management, Pearson 2008 [SRT] (draft version: http://pages.stern.
nyu.edu/~adamodar/New_Home_Page/valrisk/book.htm)
Hull, John C. Fundamentals of Futures and Options Markets, 7th ed.,
Pearson 2011
alternative textbook
Financial Risk Management
Preliminary Schedule
Date
Time
Room
Topic
Chapter
17 Sep
14.00-17.00
BC-207
What Is Risk?
Introduction to Derivatives
SRT 1, 2, 4
OFD 1
18 Sep
14.00-17.00
BC-208
Mechanics of futures
markets
Hedging strategies using
futures
OFD 2
OFD 3
19 Sep
09.00-12.00
14.00-17.00
BC-208
BC-208
30 Sep
10.00-13.00
14.00-17.00
BC-207
BC-208
Binomial trees
The Black-Scholes-Merton
model
Conclusion / recap session
Interest rates
Forward and futures prices
Swaps
Properties of Options
OFD 4
OFD 5
OFD 7
OFD 9, 10
OFD 12
OFD 13,
14
OFD 35
Course Organization
Assessment:
Written examination, date tba
The exam will be closed book. However, you will be
permitted a hand-written two-sided cheat sheet with
notes and / or formulae.
Slides & course announcements
=> Moodle
Best way to contact me:
finance.banking@t-online.de
Financial Risk Management
Basic Principle
What Is Risk?
Measurable uncertainty?
(e.g., Knight, 1921)
Risk
Uncertainty + exposure?
(e.g., Holton, 2004)
What Is Uncertainty?
Being uncertain about a
proposition means:
that you do not know wether
it is true or false (perceived
uncertainty)
or
that you are not aware of
the proposition.
10
What Is Exposure?
Having exposure to a
proposition means:
that you care whether
it is true or false
or
that you would care
whether it is true or
false if you were aware
of the proposition.
Financial Risk Management
11
Taking Risk
Some situations that involve risk:
Trading natural gas,
launching a new business,
military adventures,
asking for a pay raise,
sky diving, and
romance.
12
13
1
1
1
1
1 + 2 + 4 + 8 + ...
16
8
4
2
1
1 1 1 1
= + + + + ... = =
2 2 2 2
i =1 2
Expected value: E =
14
15
[ ( )]
~
Step 2: Calculate the expectation value E U W
of the distribution of uncertain utility values
from step 1
Expected Utility Theory
NB: The following discussion of Expected Utility Theory is partly based on Elton / Gruber / Brown /
Goetzman: Modern Portfolio Theory and Investment Analysis, 6th ed., Hoboken 2003, chapter 10
Financial Risk Management
16
Example: Bernoulli-Principle
Probability distributions of three investments:
17
Example: Bernoulli-Principle
Probability distributions and utility profiles:
18
19
linear
(strictly)
convex
20
Risk Management
http://www.sciencecartoonsplus.com/gallery/risk/index.php
21
Risk Management
Potential risk management actions:
Reduce risk exposure
Maintain current level of
risk exposure
Increase risk exposure
Lets focus on the first one:
How can we reduce risk
exposure?
Financial Risk Management
http://www.sciencecartoonsplus.com/gallery/risk/index.php
22
Natural Hedges
Borrow in the same currency that
your asset risk is denominated in
Engineer flexibility into operations
Diversify
Improve forecasting
Match operating costs and revenues
in the same currency
Optimize insurance policy
Share risks: joint ventures, sales
agreements
Financial Hedges
Forwards
Futures
Options
Swaps
23
Risk Management
Is the above definition risk = uncertainty + exposure
operational?
If you cant measure it, you cant manage it!
(Kaplan/Norton, The Balanced Scorecard: Translating Strategy Into Action,
1996, p. 21)
24
Risk vs Return
There is a trade off between risk and expected return
The higher the risk, the higher the expected return
We can characterize investments by their expected return
(i) and standard deviation of returns (i):
n
i = E[~
ri ] = w j ~
ri , j
i = i2 =
j =1
w (~r
n
j =1
i, j
i )
25
26
can be eliminated
through diversification
cannot be eliminated
through diversification
27
j = RF + j ( M RF )
RF
1.0
Risk-free
Required return
Beta for
Market
= Risk-free rate +
return
rate
on investment j
investment j
28
Alpha
Alpha = extra return on a portfolio in excess of that
predicted by CAPM
so that
P = RF + P ( M RF )
= P RF P ( M RF )
29
30
31
Assumptions:
Returns depend on several factors
Arbitrage-free markets (law of one price)
Expected return is linearly dependent on the realization of
the factors i = i + i1 I 1 + i 2 I 2 + ... + il Il
Each factor is a separate source of systematic risk
Unsystematic risk is the proportion of total risk that is
unrelated to all the factors
Financial Risk Management
32
33
34
Recap Questions
1. What is the St. Petersburg Paradox?
2. In decision theory, what is considered a fair gamble? How does an
investors risk preference relate to her willingness to participate in a
fair gamble?
3. What is the difference between systematic and nonsystematic risk?
Which is more important to an equity investor? Which can lead to the
bankruptcy of a corporation?
4. Explain the CAPM formula. How would you estimate the respective
variables in practice?
5. A companys operational risk includes the risk of a very large loss due
to employee fraud. Do you think this particular risk should be handled
by risk decomposition or risk aggregation?
Financial Risk Management
36
Exchange-traded
38
39
40
Forward Price
The forward price for a contract is the delivery price that
would be applicable to the contract if it were negotiated
today (i.e., it is the delivery price that would make the
contract worth exactly zero)
The forward price may be different for contracts of
different maturities
41
Terminology
The party that has agreed to buy has what is termed a
long position
The party that has agreed to sell has what is termed a
short position
42
Example
On July 20, 2007 the treasurer of a corporation enters into
a long forward contract to buy 1 million in six months at
an exchange rate of 2.0489
This obligates the corporation to pay $2,048,900 for 1
million on January 20, 2008
What are the possible outcomes?
43
Profit from a
Long Forward Position
Profit
Price of Underlying
at Maturity, ST
K
44
Profit from a
Short Forward Position
Profit
Price of Underlying
at Maturity, ST
K
45
Futures Contracts
Agreement to buy or sell an asset for a certain price at a
certain time
Similar to forward contract
Whereas a forward contract is traded OTC, a futures
contract is traded on an exchange
46
47
48
49
50
51
52
Options
A call option is an option to buy a certain asset by a certain
date for a certain price (the strike price)
A put option is an option to sell a certain asset by a certain
date for a certain price (the strike price)
53
54
Oct
Call
Jan
Call
Apr
Call
Oct
Put
Jan
Put
Apr
Put
15.00
4.650
4.950
5.150
0.025
0.150
0.275
17.50
2.300
2.775
3.150
0.125
0.475
0.725
20.00
0.575
1.175
1.650
0.875
1.375
1.700
22.50
0.075
0.375
0.725
2.950
3.100
3.300
25.00
0.025
0.125
0.275
5.450
5.450
5.450
American Options
Contract size: 100 shares
Financial Risk Management
55
1500
Profit ($)
1000
500
0
0
-500
10
15
20
25
30
35
40
1500
Profit ($)
1000
500
0
0
-500
10
15
20
25
30
35
40
57
Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation to
buy or sell at a certain price
An option gives the holder the right to buy or sell at a
certain price
58
Types of Traders
Hedgers
Speculators
Arbitrageurs
N.B.: Some of the largest trading losses in derivatives have occurred because
individuals who had a mandate to be hedgers or arbitrageurs switched
to being speculators (see for example Barings Bank, Business Snapshot
1.2, OFD p. 15)
59
Hedging Examples
A US company will pay 10 million for imports from Britain
in 3 months and decides to hedge using a long position in
a forward contract
An investor owns 1,000 Microsoft shares currently worth
$28 per share. A two-month put with a strike price of
$27.50 costs $1. The investor decides to hedge by buying
10 contracts
60
61
Speculation Example
An investor with $2,000 to invest feels that a stock price
will increase over the next 2 months. The current stock
price is $20 and the price of a 2-month call option with a
strike of $22.50 is $1
What are the alternative strategies?
62
Arbitrage Example
A stock price is quoted as 100 in London and $200 in
New York
The current exchange rate is 2.0300 $/
What is the arbitrage opportunity?
63
64
65
66
67
68
Recap Questions
1.
2.
Explain carefully the difference between selling a call option and buying a put
option.
3.
A trader enters into a short cotton futures contract when the futures price is
50 cents per pound. The contract is for the delivery of 50,000 pounds. How
much does the trader gain or lose if the cotton price at the end of the contract
is (a) 48.20 cents per pound and (b) 51.30 cents per pound?
4.
What is the difference between the over-the-counter market an the exchangetraded market? What are the bid and offer quotes of a market maker in the
over-the-counter market?
69
Recap Questions
6.
Suppose that a June put option to sell a share for $60 costs $4 and is held
until June. Under what circumstances will the seller of the option (i.e., the
party with the short position) make a profit? Under what circumstances will
the option be exercised? Draw a diagram illustrating how the profit from a
short position in the option depends on the stock price at maturity of the
option.
7.
Describe the profit from the following portfolio: a long forward contract on an
asset and a long European put option on the asset with the same maturity as
the forward contract and a strike price that is equal to the forward price of the
asset at the time the portfolio is set up.
8.
What are the main ideas underlying the accounting treatment of derivatives
according to IAS 39? What does the term hedge accounting mean in this
context?
70