Transcript Risk Management

Introduction to
Risk Management
Risk Management
Prof. Ali Nejadmalayeri,
a.k.a. “Dr N”
Origin of Risk Management
• Mankind has always fear forces of nature
and attempted to be in their “good” side
– Natural deities sun, moon, water, etc. were
thought of controlling entities of these forces
• As man evolved, so did his methods of
harnessing and controlling nature
– Probability and statistics invented to deal with
gambling and actuarial challenges
• Modern financial theories and instruments
are latest inventions to deal with risk!
– Must read: Against the Gods: The Remarkable
Story of Risk By Peter L. Bernstein
Basic Concepts
• Imagine you want to make a car noise-free.
What would you do?
– Find out what “the noise” looks like
– Design a wave with exact shape but opposite
cycles to cancel the noise
– Walla! You have a noise-free car!
• Now imagine fluctuations in wealth, cash
flows, values, prices, etc. How can you
make them less volatile? Any ideas?
Heuristically Speaking
Original Wave
Imagine the fluctuations
in value looks like this
Heuristically Speaking
Original Wave
Canceling Wave
Now imagine that is
financial instrument
which its fluctuations
in value looks like
this, so if we add this
instrument to the mix
Heuristically Speaking
Original Wave
Canceling Wave
Resulting Wave
Then the resulting
fluctuations should be
a average of the two,
much less volatile
Risk Management 101
• Indentify the nature of risk
– Price risk or quantity risk
• For quantity risk, design insurance
• For price risk, represent risk using:
– Fluctuations of value, cash flows, etc.
– Payoff of contractual agreements
• Indentify the building blocks
– Replicate the payoffs and fluctuations using
other financial instruments
– Construct a derivative with payoff replica
Quantity Risk
• Early insurance companies like Lloyds of
London wanted to offer a solution to an ageold problem:
– If my shipments got lost in the high seas, how
can my shipping business still survive?
• Without insurance, pretty much no way!
• Insurance, however, guarantees
compensation of replacement cost for goods
lost; solving quantity risk
Price Risk
• Even if you still own 100% of goods,
there’s no guarantee that value of these
goods would stay same over time
– Unless someone or something pays for losses of
value due to natural fluctuation, you ought to
live with risk
• What if someone is willing to offer an “offsetting”
payoff, maybe because they disagree with you on
what is most likely next price movement?
• Imagine you’re corn farmer and fear price of corn
may drop drastically by the harvest time. What if
another person thinks it would actually go up by
then? You could strike a deal to sell him the corn!
Forward & Futures
• In ancient India and Mesopotamia, farmers
presold their crop for a price to speculators
and merchants who were willing to take
risk. These are known as forward contracts.
• In late 18th century, Chicago merchants
offered “standardized” forward contracts for
agricultural products. These are futures.
– Today there multiple futures markets around the
globe. To name a few, CME, CBOT, ICE,
NYMEX, etc. Offerings ranges from wheat and
corn to T-bills and Fed Fund to Weather!
Futures
• Contract to deliver pre-specified assets
(commodities, financials, etc.) at a certain
date at a pre-agreed price
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Underlying asset are well defined
Maturity is well known in advance
Futures price is set at the beginning
No cash exchange initially
• Initial and maintenance margins are required
– Profit and losses are settled daily
• positions are “Marked to Market”
Futures Payoff
• Imagine you manage an index fund and want to protect the
value for the next year. You are long in the index, so
wherever index goes, you go the same way:
Future Portfolio Value
Fund Payoff
Future
Index
Value
Current
Value
Futures Payoff
• Now if you sell some futures contracts, let’s see what happens. When
your portfolio value drops, the buyer needs to bring pre-agreed value,
current value of the index. So you cover the difference!
Future Portfolio Value
Fund Payoff
Gains from
Futures
Position
Future
Index
Value
Losses
Current
Value
Future
Payoff
Derivatives
• Forward and futures are examples of
derivatives; instruments that derive their
value from some primitive like
commodities, stocks, bonds, etc.
• Major derivatives are:
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Forward and Futures
Options
Swaps and Swaptions
Compound and Exotic Options
More advanced derivatives
Options
• Bets on directional moves, up or down
– Romans and Phoenicians traded options
– Tulip mania in Holland was frothed with options,
mostly “call” or right to buy
– Early American options were called “privileges” and
come under scrutiny after Great Crash of 1929
• In 1973 two financial economists, Fischer Black
and Myron Scholes devised a formula for pricing
options. Shortly after CBOE was born.
– Today CBOE and other regional option markets handle
multi million dollar transaction of a variety of sorts.
Option Payoff
• Imagine again you manage an index fund and want to
protect the value for the next year. You are long in the
index, so wherever index goes, you go the same way:
Future Portfolio Value
Fund Payoff
Future
Index
Value
Current
Value
Option Payoff
• Now if you buy some put options, let’s see what happens. When your
portfolio value drops, the put pays the strike price, say current value of
the index. So you cover the difference again minus initial cost, of
course!
Future Portfolio Value
Fund Payoff
Gains from
Option
Position
Put
Option
Payoff
Losses
Current
Value
Future
Index
Value
Hedging
• The process of eliminating or reducing the
net impact of price fluctuation is called
“hedging”.
– Similar to “hedging” you bets so your losses
are not devastatingly large!
• A “perfect hedge” removes all volatilities!
– Difficult and very expensive to implement
• A practical hedge then can be an alternative.
This is an attempt to reduce major swings
while tolerating some fluctuation.
Hedge & Hedge Ratio
• Steps toward a hedge:
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Understanding distribution of value/cash flow
Defining tolerable level of short fall
Measure probability of short fall
Evaluating impact of derivatives
• Evaluating what kind of contract is available
• Measuring what kind of position needed
• Determining how many contracts are needed
– This is the Hedge Ratio, i.e., the number of
contracts needed for every share (unit) of the
underlying asset