Measuring Risk: Advanced

Topics
Presented By :
Bandeep
Manka
Neha Gaur
Nidhi
Shikha
Shweta
Swati Aggarwal
Contents
Risk introduction
Price risk
Insurance
Asset liability management
Hedging
Risk
Risk concerns the deviation of one or more results of
one or more future events from their expected value.
The value of those results may be positive or
negative.
Types of Risks
 Systematic risk- Systematic risk, sometimes
called market risk, aggregate risk, or undiversifiable risk,
is the risk associated with aggregate market returns.

 Unsystematic Risk- Company or industry specific risk that

is inherent in each investment. The amount of
unsystematic risk can be reduced through appropriate
diversification. 
Price risk is a systematic risk. It further is of 4 types:
(i) Interest rate risk
(ii) Stock price risk (equity related risk)
(iii) Exchange rate risk
(iv) Commodity price risk

It is not possible to control these risks but

companies can hedge against them
Price Risk
 It is defined as the potential for a future price to deviate
from its expected value.

 Risk resulting from the possibility that the price of a

security or physical commodity may decline.

 Since price risk represents the potential for actual prices

to deviate from expectations, one can try to improve the
accuracy of the expectations.
Contd…
Price risk is measured with the aid of a statistic called
variance or its square root called standard deviation.
Risk Profile
A risk profile is a graphic depiction of the relationship
between the change in firm’s value and the changing
price.

It examines the nature of the threats faced by an

organization, the likelihood of adverse effects
occurring, and the level of disruption and costs
associated with each type of risk.
Importance of Risk Profile
 The act of developing risk profiles forces those exposed
to give serious thought to the existence of the exposures.

 Without a serious effort to measure the exposures, it is

impossible to efficiently manage them.

 The nature of the exposures and the shape of the risk

profiles might suggest appropriate risk management
techniques.
Managing Risk
 Insurance- Some financial risks can be managed by
the purchase of insurance.

 Asset/Liability Management- This involves careful

balancing of assets and liabilities so as to eliminate
net value changes.

 Hedging- It involves the taking of offsetting risk

positions.
Definition of Insurance
Insurance is the pooling of fortuitous losses by
transfer of such risks to insurers who agree to
indemnify for such losses to provide other pecuniary
benefits on their occurrence, or to render services
connected with the risk.
Basic Characteristics of Insurance
Pooling of Losses:
Pooling is the spreading of losses incurred by the few
over the entire group, so that in the process average
loss is substituted for actual loss.
For E.g.: 1000 households,
Each household worth = $100,000
$100($100,000/1000)
Pooling technique results in substitution of an average
loss of $100 for the actual loss of $100,000
Fortuitous Loss: It is the one that is unforeseen and
unexpected and occurs as a result of chance.
Risk Transfer: A pure risk is transferred from insured
to the insurer, who typically is in a stronger Financial
position to pay the loss that the insured.
Indemnification: The insured is restored to his/her
approximate financial position prior to the occurrence
of the loss.
Requirements of an Insurable Risk
Large Number of Exposure Units
Accidental and Unintentional Loss
Determinable and Measurable Loss: The loss
should be definite as to cause, time, place and amount.
Loss should not be Catastrophic: A Large
proportion of exposure units should not incur losses at
the same time.
Requirements of an Insurable Risk
Calculable Chance of Loss: The insurer must be able
to calculate the both the average frequency and the
average severity of future losses with some accuracy.
Economically Feasible Premium: The premium
paid is substantially less than the face value or the
amount of the policy.
Applications: The Risks of Fire and Unemployment
S.No. Requirements Does Risk of Does Risk of
Fire meet the Unemployment
Requirements? meet the
Requirements?

1. Large Number of Exposure Units Yes Not Completely

2. Accidental and Unintentional Yes No
Loss
3. Determinable and Measurable Yes Not Completely
Loss
4. No catastrophic Loss Yes No

5. Calculable Chance of Loss Yes No

6. Economically Feasible Premium Yes No

Insurable risk
Risk to which many firms are exposed
For which manifestations of the risk are not highly
correlated among those exposed
Probability of a manifestation of the risk is known
with a high degree of certainty through actuarial
studies
E.g.: risk of loss from fire, death, loss from theft,
medical expense, etc.
An example :
 Suppose there are 1000 identical firms each with net worth
(equity) of $2 million
 Each is subject to 2% probability of fire
 If a fire occurs, loss averages to $5 million (in terms of
replacement cost of assets and lost business)
 Not only owners of these firms are exposed to a financial risk
but also the firms’ creditors
The amount of exposure = 0.02* $5 million = $100,000
Supposing an insurance company offers to cover any
fire losses at any of the firms for an annual premium of
$120,000
Excess ($20,000) covers the administrative costs and
profit for the insurer
Why insurance?
Risk averse nature of both the firms’ owners and
managers
Perception of the firms by their creditors as more
creditworthy if they minimize their risks- this may
lower the cost of getting the credit
Individual risks of fire were not highly correlated
If zero correlation is assumed, the insurer’s per
firm risk is quite small
The more policies the insurer writes, the greater
the degree to which the premiums and policy
payouts are offsetting
Average per firm risk to the insurer:

PFR =

IFE: individual firm’s exposure

N: number of identical firms insured
The insurer’s risk when spread across a large policy
base (law of large numbers) is a small fraction of the
insured’s risk
 Insurer’s average risk exposure (per firm insured)
Average risk
1

0.8

0.6

0.4

0.2

0
0 10 20 30
Number of firms insured
Problems with removing risks by insurance:
Introduction of an intermediary ( the insurer) causes
the cost of insurance to exceed its expected monetary
value
Not all risks are insurable, specially price risks ( as the
financial performances of firms with an exposure to
the same price risk are not independent of one
another- are nearly perfectly positively correlated)
Insurance and Hedging Compared
First, an insurance transaction involves the transfer of
insurable risks.
Second, Insurance can reduce the objective risk of an
insurer by application of law of large numbers. In
contrast, hedging typically only involves risk transfer,
not risk reduction.
Asset Liability Management
ALM is an effort to minimize exposure to price risk by
holding the appropriate combination of assets and
liabilities so as to meet the firm’s objectives and
simultaneously minimize the firm’s risk
Foundation Concepts of ALM
Liquidity – ALM depends on the ease with which the
assets can be converted to cash
Term Structure – ALM strategy depends on the
expected relation between the bond maturity and the
yield
Interest-Rate Sensitivity – ALM depends on how the
price of an instrument changes with the changes in
market rate
Contd…
Maturity Composition – matching the maturity of
assets and liabilities
Default Risk – risk that the debtor will be unable to
pay back the loan
 Terminology
Net Interest Margin : the net difference between
interest earning assets (loans) and interest paying
liabilities (deposits)

Gap : The dollar difference between assets (loans)

maturing and liabilities (deposits) is known as the rate
sensitivity gap
Capital Allocation
A process of how businesses divide their financial
resources and other sources of capital to different
processes, people and projects. Overall, it is
management's goal to optimize capital allocation so
that it generates as much wealth as possible for its
shareholders.
Dedicated Portfolio
Ideally, asset/liability management should strive to
match the timing and amount of cash outflows and
inflows.
An asset portfolio constructed precisely to match cash
flows is called a dedicated portfolio.
Portfolio Immunization
The selection of assets so as to minimize the rate
sensitivity of the difference between asset and liability
values is called portfolio Immunization.
Concept of Duration
 Most widely used measure of interest-rate sensitivity.

 Developed in 1938 by Frederick Macaulay and is called Duration.

 It is calculated as a weighted average of the time to the instrument’s

maturity.

Where:
w(t) : present values of the individual cash flows/ present value of the
entire stream of cash flows
t/m : time at which cash flow will occur
t : the number of the cash flow
m : the number of cash flows per year
The duration value is often modified by dividing by 1 plus the instrument’s
yield(y) divided by the number of cash flows per year(m). The modified
Duration is given by:

D* = D/(1+y/m)
Relationship Between a Risk Profile and Duration
 An interesting property of duration is that the duration of a portfolio of
assets is a weighted average of the durations of the individual assets
included in the portfolio .

 Here the instruments’ weights are taken to be the market values of the
instruments divided by the entire market value of the portfolio. This
type of weighting is called Value Weighting.

 This duration property of asset and liability is the key to

Immunization Strategies.
 Example:

Suppose that the pension fund sells a new policy that commits
the fund to pay $100 each for the next 15 years . The cash
flows of the liability stream, together with their discounted
values(using a 10% discount rate) and their contributions to
duration(products) are depicted :
The Calculation of Modified Duration

Time Cash Flow Discounted Weight Product

value of Cash
Flow

1 100 90.909 0.120 0.120

2 100 82.645 0.109 0.217
3 100 75.131 0.099 0.296
. . . . .
. . . . .
. . . . .
15 100 23.939 0.031 0.472
Total 760.608 1.000 6.279

Modified Duration = 6.279/1.1 =5.708

 The problem for the fund is how to invest the $760.61 proceeds
from the sale of the policy to earn a return of at least 10% while
assuring itself that the assets in which the fund invests will have a
value at least equal that of its liabilities at each and every point in
time in the future.

Suppose now that the fund has two instruments in which it can
invest:
(i) A 30-year Treasury bond paying a coupon of 12% and selling at
par.
(ii) 6-month T-bills yielding 8%.

The bond has a modified duration of 8.080 years and the bill has a
modified duration of 0.481
Now,
w1. D1 + w2. D2 = DL
w1 + w2 = 1
Substituting the values,
w1 . 8.080 + w2 . 0.481 = 5.708
w2 = 1- w1
We get
w1 (weight on the bond) = 68.79%
w2 (weight on the bill) = 31.21%
Hence investment of $ 523.23 in bonds and $237.38 in bills has
to be done.
Now if the yield curve move upwards by 10 basis points. Then
 Liabilities discounted by 10.1% instead of 10
 Bond is discounted by 12.1% instead of 12
 Bill is discounted at 8.1% instead of 8

Hence,
Pension 30-year Bond 6-Month Bill
Liabilities
Old value 760.61 523.23 237.38
New value 756.29 519.03 237.26
Change in value -4.32 -4.20 -0.12

-4.20 + - 0.12 = -4.32

Hence Immunization Strategy has successfully protected the fund from a

ten basis point change in asset and liability yields.
Problems associated with the immunization approach:

 The duration values are only reliable for short periods of time.

 Durations also change with changes in yields and these duration

changes are not necessarily the same for all the instruments.

 The third problem with the simple duration matching strategy

concerns the assumption that all movements of the yield curve take the
form of parallel shifts.
 The first two problems can be easily solved by recomputing the
durations frequently, recalculating the weights and adjusting the
portfolio accordingly.

 The solution to the third problem is to adjust the size of the asset
positions on the basis of the historical relationship between the yield
changes on the liabilities and yield changes on the assets. Statistical
procedure used for this purpose is Linear regression . It is given by :

YL = β . Y b
Where
YL : yield change on the liabilities
Yb: yield change on the bond
β : coefficient called Yield Beta
Management of exchange-rate risk
Balance sheet of a Global Bank
(All values in millions)

Assets Liabilities
Loans(sterling) 2.50 Demand Deposits(dollars)
3.51
Loans(lira) 1480.00 Cash Deposits( dollars) 11.48

Loans( dollars) 12.40 Other time deposits( dollars) 2.70

Total liabilities 17.69

Exchange Rates : USD/BPS = 1.6550

USD/ITL = 0.0007785
USD/USD = 1.0000
 This type of risk can be reduced by using a Currency- matching Strategy
i.e. the bank should borrow the same currency in which it wants to fund
loans.

 This strategy does not completely eliminate the bank’s exchange rate
exposure. It still bears the risk associated with the ultimate repatriation of
its profits from its global activities . However, it reduces the risk to a large
extent.

 Immunization and Currency matching strategies often require the sacrifice

of better, more profitable, opportunities. For this reason, hedging strategies
can sometimes prove superior.
Hedging :
A ‘hedge’ is a position that is taken as a temporary
substitute for a later position in another asset
(liability) or to protect the value of an existing position
in an asset (liability) until the position can be
liquidated.
The instruments most often used for hedging are
futures, forwards, options and swaps
The concept of hedging mechanism is to participate
in two markets where gains in one market are
basically offset by losses in the other
Concept of Hedging
Value of Asset
In Market 1

Value of Asset
In Market 2
Requirements for Hedging
Prices in both markets (cash and futures) will
respond to underlying forces of supply and demand
in such a way that they will tend to move together
and in the same direction
Cash and futures market prices will tend to converge
(become equal) as maturity of the futures contract
approaches. Otherwise “arbitrage” will occur
In most cash markets, convergence will be to a
predictable difference

APEC 5010
Illustration:
A west German firm’s exposure to exchange-rate risk.
The firm holds a long position in dollars at $500,000
T-bill that matures in 30 days.
The risk stems from this long forward position in
dollars. That is, an increase in the DEM/USD 30-day
forward rate represents a strengthening of the dollar
vis – a – vis the deutschemark. The German firm
benefits from any such strengthening. On the other
hand, the German firm will suffer financially from any
weakening of the dollar.
Given Mean is 2.0000 and a Standard Deviation is
0.0625.
 The 90% confidence interval
= 2.0000-(1.64*o.o625) to 2.0000+(1.64*0.0625)
• Confidence interval is a range of values symmetrically distributed around the
expected value that captures a specified probability for the actual outcome. The
probability is called the confidence level.
• The nice feature of this approach to assessing risk exposure is that the standard
deviation of the price change, for whatever price being considered is the same
for any and all firms.
• Also, firm’s profit risk = Size of Position in foreign currency *
Standard deviation of the exchange rate
• For this German firm, this is:
= USD 500,000 * 0.0625 DEM/USD
= DEM 31,250
 The German firm arranges for a 500,000 30-day forward dollars contract with a
German bank for a short(selling) position. The agreed price on this exchange is
2.0000 DEM/USD.
 In this way it is able to hedge its position against the foreign exchange exposure
risk. A hedge creates a second risk equal to , but opposite, that of the original
exposure. The two exposures are the offsetting and the end result is no net risk.
Hedge using Swaps
Swap refers to exchange of an agreed amount of a currency
for another currency at a specific future date. This is
equivalent to currency forward contract in a sophisticated
way.

For Example:
A US firm has receivable in Euro from a Belgian buyer; so it
is looking for euro denominated liability to hedge the
receivable.

On the other hand, a Belgian firm exports to USA and has
US$ denominated receivable; it needs US$ liability to hedge
receivables in US$.
Contd…
US firm borrows (say $100,000) at 11%
Belgian firm borrows($100,000/E0.6 per $) 166,667 Euros at
10%
US firm receives Euros from buyer and give it to the Belgian
firm so that it (Belgian) can repay euro denominated loan.
The Belgian firm receives US$ from buyer and give it to the
US firm so that it (US firm) can repay US$ denominated
loan.

Both firms lock in current spot rate for future payments

by swapping receivables.
Size of Hedge
Hedge Ratio:
Number of units of the hedging instruments
required to fully hedge one unit of the cash
position
Eg. 2 units of 5 year T-note futures(on an average)
are required to offset the risk from one unit of
corporate debt
Hedge Ratio = 2:1
 Measuring Hedge Effectiveness
Basis Risk: the risk that remains after a hedge is placed(assuming that appropriate hedge is
employed)
Basis Risk= (1-ρ2). Price Risk
ρ=correlation coefficient of two prices
ρ2 = coefficient of determination= measure of % of original risk
removed by hedge

Source of basis risk:

one gains better insight into how to construct better hedges

Basis risk exist

because the cash price and the price of the hedging instrument are
not perfectly correlated
(cause: demand & supply conditions in cash market may be a bit different than
demand & supply in market for hedging instruments)
 Cost of Hedge
General View:
Hedging is relatively cheaper but not free
Why…. Hedging is not costless?
 the risk that hedgers seek to shed must be borne by the counterparty
 if counterparty is another hedger…with a mirror image exposure
…both benefitted
…no one compensates
 But…usually counterparty is a speculator(particularly in future
contracts)
 Presence of transaction cost

Note: All hedges do not have equal costs…it varies as per the market
inefficiencies.
Efficiency of Hedge:
both effectiveness of market and cost of hedge
must be considered.

Optimal Hedge:
One that maximizes the hedger’s utility

Less effective and inefficient Hedges

Composite Hedge: a direct application of portfolio theory to hedging

Involves more than one hedging instrument. Such a hedge
reduces the basis risk otherwise associated with the simple hedge.
 Example:
Assume in June a farmer expects to harvest at least 10,000
bushels of soybeans during September. By hedging, he can lock
in a price for his soybeans in June and protect himself against the
possibility of falling prices.

Cash price for new-crop soybeans = $6

price of November bean futures = $6.25
delivery month of November is the harvest of new-crop soybeans.

The farmer short hedges his crop by selling two November 5,000 bushel
soybean futures contracts at $6.25.
(farmers do not hedge 100 percent of their expected production, as the
exact number of bushels produced is unknown until harvest. In this
scenario, the producer expects to produce more than 10,000 bushels of
soybeans.)
By the beginning of September, cash and futures prices have fallen.
When the farmer sells his cash beans to the local elevator for $5.72 a bushel
He lifts his hedge by purchasing November soybean futures at $5.95
30-cent gain in the futures market offsets the lower price he receives for his
soybeans to the cash market.

Cash Future
June Price for new crop soybeans at Sell 2 November soybean
$6.00/bushel contracts at $6.25/bushel
September Sell 10,000 bushels soybeans at Buy 2 November soybean
$5.72/bushel contracts at $5.95/bushel
Result Cash Sales Price $5.72/bushel
Future gain + 0.30/bushel
Net selling price $6.02/bushel

Had the farmer not hedged, he only would have received $5.72 a bushel for
his soybeans - 30 cents lower than the net selling price he received.
 A Quick Recap:
Measuring Risk: Price risk, degree of exposure to it, risk
profiles
Managing Risk: An overview
Insurable risk: for which the probability of manifestation
of the risk is known with high degree of certainty(death,
loss from fire, theft etc).
Asset liability Management: an effort to minimize
exposure to price risk by holding the appropriate
combination of assets and liabilities so as to meet the firm’s
objectives(earning target) and minimizing the firm’s risk.
Hedging: a position taken as a temporary substitute for a
later position in another asset(liability) or to protect the
value of an existing position until the position can be
liquidated.
Thank
You……