Lecture – 2 Risk Quantification

(Basic Concepts)
Financial Risk Management
 Learning Outcomes
• Introduction to risk and risk exposure.
• Over the counter and Exchange Market
• Hedging
• Long and Short Position
• Derivatives
• Forward Contracts and Future Contracts
• Operation of Margin
• Examples
 Risk
• Degree of Uncertainty, How uncertain is my profit.
• How uncertain is my share prices?
• What is the probability that the borrower will default on his obligations?
• How uncertain is that I will not receive repayments on my debt investment?
• How uncertain are my future cash flows?
• How uncertain is the exchange rate?
• What is my maximum loss for tomorrow under the highest level of
confidence?
• To what degree my future cash inflows are uncertain?
• To what degree exchange rate fluctuation will effect savings in US dollars?

• Mean
• Standard Deviation
– is a measure of the dispersion / deviation of a set of data from its mean.

• Risk Exposure
– The amount of risk an investor has taken or to take on in a particular
investment 
• Assignment 1
 Risk Exposure
• Type of exposure
– If the investment concerns buying a share,
the future value of this investment can be
quantified from the expected value these
share prices in the future
– Investment through bonds

• Degree of Risk Exposure

– Standard deviation of the share price
– The probability of Default
 Risk Exposure
• On the other hand, if future purchase rights
on a share are being acquired, both the future
value and the risk of these rights must be
quantified using the expected value and
standard deviation of the possible outcomes
caused by these rights. This quantification is
much more complicated, as different
scenarios must be taken into consideration.

• Similarly the degree of uncertainty of cash

flows from any investment
 Risk Exposure (Exchange rate)
• Transaction exposure: This arises from the
effect that exchange rate fluctuations have on
a company’s obligations to make or receive
payments denominated in foreign currency in
future.

• Translation exposure: This exposure arises

from the effect of currency fluctuations on a
company’s consolidated financial statements,
particularly when it has foreign subsidiaries
• Quantification through Standard deviation in
the exchange rate etc.
 Credit Exposure
• Credit exposure is the total amount of credit
extended to a borrower by a lender. The magnitude
of credit exposure indicates the extent to which
the lender is exposed to the risk of loss in the event
of the borrower's default.
• Default risk: When the borrower is unable to pay

• Quantification
– The probability of default measures how likely it is
the borrower is unable or unwilling to repay the
debt
 Liquidity Risk
• What is 'Liquidity Risk'
– Liquidity risk is the risk stemming from the lack of
marketability of an investment that cannot be
bought or sold quickly enough to prevent or
minimize a loss.

• Liquidity Risk in Companies

• Liquidity Risk in Financial Institutions

• Liquidity Risk for Individual Investors

 Market Risk Exposure
• What is 'Market Risk'
• Market risk is the possibility for an investor to experience losses due to factors
that affect the overall performance of the financial markets in which he is
involved. Market risk, also called "systematic risk," cannot be eliminated
through diversification, though it can be hedged against.

• Various Approaches to measure market risk

• CAPM

• Value at Risk

• To measure market risk, investors and analysts use the value at risk method.
The value at risk method is a well known and established risk management
method, but it comes with some assumptions that limit its correctness.
• Same Portfolio for Longer Period
 Over the Counter Market
• Over-the-counter (OTC) or off-exchange trading
is done directly between two parties, without the
supervision of an exchange.
• Characteristics
• Contracts outside an organized exchange are
traded in over the counter market
• In over the counter market, there is no
standardization, the parties themselves agree on
different aspects of the contract
• Contracts in OTC are flexible, but not liquid
• Chances of default are comparatively higher in OTC
as contracts are not marked-to-the-market
• The aggrieved party can go to court against the
defaulting party
 Exchange Market
• An exchange market
• A market where individuals trade standardized
contracts that have been defined by the exchange
• Exchange standardizes contracts with regard to:
• Number of units in one contract (quantity)
• Maturity (usually at the end of a month)
• Quality/ grade
• Delivery place
• Standardization increases liquidity but reduce
flexibility
• Contracts on exchange are marked-to-market on
daily basis
• Margin requirements (usually 5%)
• Margin call if margin falls due to losses
 Hedging
• Hedging is to reduce the risk of adverse price
movements in an asset. Normally, a hedge
consists of taking an offsetting position in a
related security, such as a futures contract.

• Taking long and short position

 Long Position and Short Position
• Long Position
• A long position is the buying of a security such as a
stock, commodity or currency with the expectation
that the asset will rise in value.
• A Long position holder or buyer profits from the price
increase in the underlying asset

• In a future or forward contract a buyer will always

attain a long position with the expectation that the
price of the underlying asset or commodity will rise.

• South African Company constructing a football stadium

will go long for a cement forward or future contract
with Bestway cement by expecting that the price of
cement will increase in future
 What is Short Position
• The Short Position is a technique used when
an investor anticipates that the value of a
stock will decrease in the short term, perhaps
in the next few days or weeks.
• Or A short position is taken by a seller during
a forward or future contract because he
anticipates that the price of a particular asset
or commodity is going to decrease.

• It is called short because the underlying asset

is not yet produced or borrowed.
 Derivatives
• A derivative can be defined as a financial
instrument (simply, an agreement between
two people) whose value depends on (or
derives from) the values of an underlying
assets.
• When the firm reduces its risk exposure with
the use of derivatives, it is said to be hedging.
 Types of Derivatives
• Among many variations of derivative
contracts, following are the major types:
– Forward contracts
– Future Contract
– Swaps
– Options
 Forward Contract
• Definition: an agreement to buy or sell an
asset at a certain future time for a certain
price
• A forward contract is traded in the over-the-
counter market
• A party assuming to buy the underlying asset
is said to have assumed a long-position
• The other party assumes a short-position and
agrees to sell the asset
 Example
• Assume that you buy a book from a bookshop for
delivery in approximately 1 month. You commit to
pay the bookshop 10 rupees when the book is
delivered. You are buying forward and taking
delivery in a month from today. The bookseller is
selling you a forward since he promises to deliver
in a month at 10 rupees. The book is the
"deliverable asset." This forward position entails
a risk.
• Whichever way the price of the book moves, one
party has to suffers a loss. If the price of the book
drops to 6 rupees, the seller gains 4 rupees and
buyer ( long position) suffer a loss of 4 rupees. If
the price of the book rises to 15 rupees, then?
 A Real life example
• As you know next football world cup 2022 will be
played in Qatar. Qatar will need to construct
football stadiums, seating arrangements, parking
areas etc. which need heavy consumption of
cement. Qatar does not have the required amount
of cement, it will call many producers of cement to
send their quotations to Qatar. If from Pakistan,
Lucky cement company is short-listed and
approved for export of cement to Qatar at $10 a
bag, 500,000 bags by December 2011, it will be an
example of forward contract
• In the above contract, lucky cement has a short-
position
(sold cement now deliverable in future) and Qatar
government has a long position
 A Real life example
• The contract exposes lucky cement to few
risks.
– If the cost of raw material increases, it
cannot be passed on to the Qatar
government
– If the value of rupee against dollar
increases, Lucky cement will receive fewer
rupees per dollar
• To control these risks, lucky cement should
use forward/future contracts (HOW?)
 A real life Example
• Lucky cement should buy raw material (coal,
oil, chemicals) in advance through future
contracts (i.e going long)
• Lucky cement should sell dollars derivable in
December 2009 (when it will receive them
from Qatar government)
 Future Contracts
• The exchange provides a mechanism that
gives the two parties a guarantee that the
contract will be honored.
• Futures contracts are traded on organized
exchanges that standardize
– the size of the contract,
– the grade of the deliverable asset,
– the delivery month,
– and the delivery location.
• Traders negotiate only over the contract price.
• Standardization increases liquidity but reduce
flexibility. How?
 Future / Forward Contracts
• The time at which the contract settles is
called the expiration date.
• The asset or commodity on which the forward
contract is based is called the underlying
asset.
• Spot price is the market price for immediate
delivery of the asset.
 SPECIFICATION OF A FUTURES CONTRACT
• When developing a new contract, the exchange
must specify in some detail the exact nature of
the agreement between the two parties. In
particular, it must specify the asset, the contract
size (exactly how much of the asset will be
delivered under one contract), where delivery
will be made, and when delivery will be made.

• When the party with the short position is ready

to deliver, it files a notice of intention to
deliver with the exchange. This notice indicates
selections it has made with respect to the grade
of asset that will be delivered and the delivery
location.
 SPECIFICATION OF A FUTURES CONTRACT
• Underlying Asset
• When the asset is a commodity, there may be
quite a variation in the quality of what is
available in the marketplace. When the asset
is specified, it is therefore important that the
exchange stipulate the grade or grades of the
commodity that are acceptable.
 SPECIFICATION OF A FUTURES CONTRACT
• The Contract Size
• The contract size specifies the amount of the
asset that has to be delivered under one
contract. This is an important decision for the
exchange. If the contract size is too large,
many investors who wish to hedge relatively
small exposures or who wish to take relatively
small speculative positions will be unable to
use the exchange. On the other hand, if the
contract size is too small, trading may be
expensive as there is a cost associated with
each contract traded.
 SPECIFICATION OF A FUTURES CONTRACT
• Delivery Arrangements
• The place where delivery will be made must
be specified by the exchange. This is
particularly important for commodities that
involve significant transportation costs.
• When alternative delivery locations are
specified, the price received by the party with
the short position is sometimes adjusted
according to the location chosen by that party.
The price tends to be higher for delivery
locations that are relatively far from the main
sources of the commodity.
 SPECIFICATION OF A FUTURES CONTRACT
• Delivery Months
• A futures contract is referred to by its delivery
month. The exchange must specify the
precise period during the month when
delivery can be made. For many futures
contracts, the delivery period is the whole
month. The exchange specifies when trading
in a particular month’s contract will begin.
The exchange also specifies the last day on
which trading can take place for a given
contract. Trading generally ceases a few days
before the last day on which delivery can be
made.
 SPECIFICATION OF A FUTURES CONTRACT
• Price Quotes
– The exchange defines how prices will be quoted. For
example, in the US, crude oil futures prices are quoted
in dollars and cents.
• Price Limits and Position Limits
– For most contracts, daily price movement limits are
specified by the exchange. If in a day the price moves
down from the previous day’s close by an amount
equal to the daily price limit, the contract is said to be
limit down. If it moves up by the limit, it is said to be
limit up. A limit move is a move in either direction
equal to the daily price limit. Normally, trading ceases
for the day once the contract is limit up or limit down.
However, in some instances the exchange has the
authority to step in and change the limits.
 Position Limits

• Position limits are the maximum number of

contracts that a speculator may hold. The
purpose of these limits is to prevent
speculators from exercising undue influence
on the market.
Pakistan Mercantile Exchange Limited (PMEX)
• Pakistan Mercantile Exchange Limited (PMEX)
is Pakistan’s first and only multi-commodity
futures exchange, which is licensed and
regulated by the Securities & Exchange
Commission of Pakistan (SECP). Its
shareholders include National Bank of
Pakistan (NBP), Pakistan Stock Exchange
Limited (PSX), ISE Towers REIT Management
Company Limited, LSE Financial Services
Limited, Pak Brunei Investment Company
Limited, Zarai Taraqiati Bank Limited and Pak
Kuwait Investment Company Limited. The
Exchange offers a diverse range of domestic
and international commodities and financial
Pakistan Mercantile Exchange Limited (PMEX)
• There are 2 kinds of contracts offered at PMEX.

• 1. Deliverable Contract: This is a contract which is settled

through giving/taking the actual delivery of the underlying
commodity on final settlement after the expiry day. However
the investor/trader has the right to square off their open
positions at any time before expiry and booked their
profit/losses in term of cash

• 2. Cash Settled Contract: There is no obligation of

giving/taking deliveries of underlying commodities after the
expiry of contracts. The profit/loss transferred into the
respective traders accounts on final settlement day if their
positions remained open on expiry. However the investor/trader
has the right to square off their open positions at any time
before expiry and booked their profit/losses in term of cash.
Pakistan Mercantile Exchange Limited (PMEX)
• The commodities being offered for trade at
PMEX can be clubbed into four main
categories: precious metals (Gold & Silver),
agricultural (Wheat, Rice, Palm Oil, Cotton &
Sugar), energy (Crude Oil) and financial
futures (KIBOR).

• Within each commodity, the Exchange

provides different contracts in terms of
currency denomination, contract size and
tenor. Though the Exchange offers various
commodities for investment/trading, bulk of
the trade comes from gold, silver and crude
oil.
Pakistan Mercantile Exchange Limited (PMEX)
Future Contracts at KSE
 Operations of Margin
• Initial Margin
– The amount that must be deposited as a security at the time the contract is
entered into.
– The investor is entitled to withdraw any balance in the margin account in
excess of the initial margin
• Daily Settlement/Marking to Market
– At the end of each trading day, the margin account is adjusted to reflect the
investor’s gain or loss
• Maintenance Margin

– It is the amount below the initial margin. If the amount of initial margin drops
below the maintenance margin a marginal call is made

• Margin Call
– It is call which is made to either party whose margin is less than the
maintenance margin.

• Variation Margin: T
– he extra funds deposited after the margin call.
 Closing Out Positions
• The vast majority of futures contracts do not
lead to delivery. The reason is that most
traders choose to close out their positions
prior to the delivery period specified in the
contract.
 Example of Margin
• Consider an investor who contacts his or her
broker to buy two December gold futures
contracts New York Mercantile Exchange
(NYMEX). Suppose that the current futures
price is $1,250 per ounce. Contract size is 100
ounces, the investor has contracted to buy a
total of 200 ounces . The initial margin is
$6,000 per contract, or $12,000 in total; the
maintenance margin is $4,500 per contract,
or $9,000 in total. The contract is entered into
on Day 1 at $1,250 and closed out on Day 16
at $1226.90.
Example
 Example
• A trader buys two July futures contracts on
orange juice. Each contract is for the delivery
of 15,000 pounds. The current futures price is
160 cents per pound, the initial margin is
$6,000 per contract, and the maintenance
margin is $4,500 per contract. What price
change would lead to a margin call? Under
what circumstances could $2,000 be
withdrawn from the margin account?
 Example of future contracts:
• Assume you are a delivery company whose
expense are tied to fuel prices. You
anticipated that you use 90,000 gallons of
gasoline per month. It currently July 1st and
you want to hedge your next 3 months of fuel
cost using Gasoline future contract.
Information on these contract are as follows:
– Each contract is for 45,000 gallons
– The initial margin is $11,475 and the
maintenance margin is $8500
 Example of future contracts (Con’t)
• Q1. Should you buy(long) or Sell(short) the
futures to initiate your position?
• Q2. How many contract should you use per
month
• Q3. What is your initial margin
• Assume the price of gasoline is currently 3.5 a
gallon and the august future is 2.8974, Sept.
future is 2.8798 and October future is 2.7658.
• Q4. assume the average gas price for next 3
months are 3.25(August), 3.00(Sep) and
2.8(Oct) how much did your firm save
compared to current price(ignore the futures)?
 Solution of example
• Ans01: Price increase leads to increase in
expenses and then onward profit would
decrease, therefore long position
• Ans 02: 2 contract
• Ans 03 : 2*11475*3=
 Solution of example (Con’t)
• Ans 04:
• Fuel saving in July= 90,000*(3.5-
3.25)=22,500
• Fuel saving in Aug= 90,000*(3.5-
3.00)=45,000
• Fuel saving in Sept=90,000*(3.5-2.8)=63,000
 Example
• Suppose Arif Khan expects to have 120,000
kg of mutton to sell in 3 months. The mutton
futures contract traded by the PMEX is for the
delivery of 40,000 kg of mutton. How can the
farmer use the contract for hedging? From the
farmer’s viewpoint, what are the pros and
cons of hedging?
 Convergence of Future price to Spot price
• As the delivery period for a futures contract is
approached, the futures price converges to
the spot price of the underlying asset.
• If futures price is above the spot price during
the delivery period. Traders then have a clear
arbitrage (taking riskless profit because of
price differences) opportunity: How?
– Sell (i.e., short) a futures contract
– Buy the asset
Conversion of Future price to Spot price