Financial Risk Management - Edinburgh Business School
Financial RiskManagementSources of Financial Risk and RiskAssessmentPeter MolesFK-A3-engb 1/2016 (1011)
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Financial Risk ManagementDr Peter Moles MA, MBA, PhDPeter Moles is Senior Lecturer at the University of Edinburgh Business School. He is an experiencedfinancial professional with both practical experience of financial markets and technical knowledgedeveloped in an academic and work environment.Prior to taking up his post he worked in the City of London for international and money-centre banks.During the course of his career in the international capital markets he was involved in trading, riskmanagement, origination and research. He has experience of both the Eurobond and Euro moneymarkets. His main research interests are in financial risk management, the management of financialdistress and in how management decisions are made and the difficulties associated with managing complexproblems. He is author of the Handbook of International Financial Terms (with Nicholas Terry, published byOxford University Press) and Corporate Finance (published by John Wiley & Sons). He is a contributingauthor for The Split Capital Investment Trust Crisis (published by Wiley Finance) and has written a numberof articles on the problems of currency exposure in industrial and commercial firms.
First Published in Great Britain in 1998. Peter Moles 1998, 2001, 2004, 2013.The rights of Peter Moles to be identified as Author of this Work has been asserted in accordance withthe Copyright, Designs and Patents Act 1988.All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwisewithout the prior written permission of the Publishers. This book may not be lent, resold, hired out orotherwise disposed of by way of trade in any form of binding or cover other than that in which it ispublished, without the prior consent of the Publishers.
ContentsIntroductionxixixiixiiiArrangement of the CourseApproach and Key ConceptsAssessmentAcknowledgementsxvPART 1INTRODUCTIONModule 1Introduction1/11.1Introduction1.2What Is Risk?1.3What Is Financial Risk?1.4Steps to Risk Identification1.5Top-Down and Building-Block Approaches to Risk ManagementLearning SummaryAppendix to Module 1: What Risks Are We Taking?Review QuestionsCase Study 1.1: Attitudes to RiskModule 21/21/161/331/361/411/421/431/441/50Risk and the Management of the Firm2/12.1Introduction2.2The Pervasiveness of Risk2.3Why Manage Risk?2.4Taxes2.5Agency and Other Costs2.6Business Performance2.7Financial Risk and Financial Distress2.8The Costs of Risk ManagementLearning SummaryReview QuestionsCase Study 2.1: Laker 5PART 2THE MARKETSModule 3Market Mechanisms and Efficiency3/13.13.23/23/8vIntroductionMarket EfficiencyEdinburgh Business School Financial Risk Management
Contents3.3Market Liquidity3.4The Role of Financial Intermediaries3.5Systematic Risk and Non-Systematic Risk3.6Managing Market Risks3.7Effect of Credit RiskLearning SummaryReview QuestionsCase Study 3.1: Omega CorporationModule 4Interest Rate Risk4/14.1Introduction4.2Interest Rate Risk4.3The Term Structure of Interest Rates4.4Analysing Yield Curve Behaviour4.5The Money Markets4.6Term InstrumentsLearning SummaryAppendix 1 to Module 4: A Note on Early RedemptionAppendix 2 to Module 4: Relationship of Spot Rates and Par YieldsReview QuestionsCase Study 4.1: Panthos FinanceModule 5Currency Riskvi5/15/35/155/305/315/37Equity and Commodity Price Risk6.1Equity Market Risks6.2Commodity Price RiskLearning SummaryReview QuestionsCase Study 6.1: BankingCase Study 6.2: 15.1Introduction5.2Foreign Exchange Rate Risk5.3Foreign Exchange ExposureLearning SummaryReview QuestionsCase Study 5.1: Airbus IndustriesModule 76/216/21Edinburgh Business School Financial Risk Management
ContentsModule 7The Behaviour of Asset Prices7.1Introduction7.2The Price-Generating Process for Financial Assets7.3Understanding Volatility7.4Describing the Price-Generating ProcessLearning SummaryAppendix to Module 7: Statistical Measures of a Probability DistributionReview QuestionsCase Study 7.1: Diffusion TreesPART 3RISK ASSESSMENTModule 8Controlling Risk8.1Introduction8.2The Top-Down Approach to Risk Assessment8.3The Building-Block Approach to Risk Assessment8.4Reporting and Controlling Risk8.5A Note of WarningLearning SummaryReview QuestionsCase Study 8.1: Georgetown IndustriesModule 9Quantifying Financial Risks9.1Introduction9.2Statistical Analysis of Financial Risk9.3The Significance of the Normal Distribution9.4Understanding the Risk Measures9.5Measuring the Relationship between Assets9.6Portfolio Expected Return and Risk9.7Practical Considerations in Measuring Risk9.8Estimating Portfolio Value at RiskLearning SummaryAppendix to Module 9: Example of the Statistical Analysis of RiskReview QuestionsCase Study 9.1: Calculating the Risk Factors for Two CommoditiesCase Study 9.2: Portfolio RiskFinancial Risk Management Edinburgh Business 19/319/349/359/389/439/44vii
ContentsModule 10Financial Methods for Measuring Risk10/110.1 Introduction10/110.2 Using the Present-Value Approach to Determine Risk10/310.3 Calculating Spot Discount Rates for Specific Maturities10/510.4 The Term-Structure Approach to Risk Measurement10/1510.5 Simulation10/20Learning Summary10/33Appendix to Module 10: Bootstrapping Zero-Coupon Rates from the Par YieldCurve10/34Review Questions10/37Case Study 10.1: The Jabberwocky Company10/42Module 11Appendix 1Qualitative Approaches to Risk Assessment11/111.1 Introduction11.2 Qualitative Forecasting Methods11.3 Qualitative Forecasts11.4 A Practical Example of a Forecast11.5 Assessing Qualitative AccuracyLearning SummaryReview QuestionsCase Study 11.1: Bloomberg Minerals ice Final Examinations and SolutionsA1/1Examination OneExamination TwoExamination Answers1/21/121/23Appendix 2Statistical TablesA2/1Appendix 3Formula Sheet for Financial Risk ManagementA3/11. Compounding and Discounting2. Expected Value3. Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT)4. Currency Relationships5. Statistical Measures6. Portfolio Model7. Measures of Forecasting Accuracyviii3/13/23/23/33/33/43/4Edinburgh Business School Financial Risk Management
ContentsAppendix 4Answers to Review QuestionsModule 1Module 2Module 3Module 4Module 5Module 6Module 7Module 8Module 9Module 10Module 11GlossaryIndexFinancial Risk Management Edinburgh Business 69G/1I/1ix
IntroductionThis elective course covers one of the core functions of finance, namely riskmanagement.* A large part of the role of finance – the actions of the financialspecialist and the operations of the financial department within firms – is devoted tohandling, controlling and profiting from risk. This text sets out to show why andhow firms manage their financial risks.For most kinds of activity, risk is unavoidable as long as the outcome is uncertain. Therefore, taking on risk and handling it is a core management discipline. Allmajor corporate decisions involve choices as to how much risk to take and how bestto manage these risks. At its simplest, risk management involves procedures forbecoming aware of risks and the methods used to analyse risks, assess their impactand respond accordingly.Financial risk management is the activity of monitoring financial risks and managing their impact. It is a sub-discipline of the wider task of managing risk and also apractical application of modern finance theories, models and methods. The traditional role of finance within the firm has been in terms of reporting and control.The modern approach is to see the financial function as actively formulating policyand directly involved in the subsequent decisions. Financial risk managementinvolves handling those business decisions resulting from financial exposures.As a subject financial risk management draws on the disciplines of accountancy,economics, management science, decision theory, statistics and psychology as wellas the key principles and methodologies to be found in finance. Before starting, thestudent is expected to have some prior knowledge of the fundamentals of finance,and, in particular, time value of money methods, and a basic understanding ofstatistical concepts. The level of knowledge required is that which is necessary inorder to successfully complete a course in finance.Arrangement of the CourseThe modules that go to make up Financial Risk Management fall into the followingtopic areas:*xiThe other key functions are valuation and the optimisation of resources across time.Edinburgh Business School Financial Risk Management
IntroductionTopic areaOne IntroductionThe background and basics of risk managementTwo The MarketsSources of financial risk from interest rates, currencies,equities and commodities; the nature and structure of financialmarkets; the asset price generating processThree Risk AssessmentThe techniques used to assess, model, manage and controlrisksModules1 and 23 to 78 to 11The course starts with an overview of the financial risk management process andits historical development (Part 1). A rationale for such activity is proposed basedon current financial theories about firms and markets. It then proceeds to anexamination of the principal financial risks that arise from interest rates, currencies,equities and commodities markets (Part 2).The text next goes on to examine methods used to identify, measure and reducethese risks (Part 3). In implementing risk management policies, firms seek toquantify the risks they face and the resultant impact on their profits or cash flows.Two separate approaches are covered – the use of quantitative models and qualitative scenario building – and the link between the two is discussed.In presenting the text in this way, the aim is to provide a comprehensive andlogical approach to what is a complex subject.Approach and Key ConceptsFinancial risk management is a holistic subject. The order in which the text ispresented follows what may be called the standard risk management model. Whilethis is useful in developing a good understanding of how risk arises and how it ishandled, it does have some disadvantages in that material on one subject (forinstance, interest rate risk) is presented in modules that do not follow each other. Asa result, we would encourage students to look at alternative ways to approach thetext.A basic premise of the text is that it is orientated at the industrial and commercialfirm. If anything, the typical firm is taken to be a manufacturer with cross-bordertransactions of various kinds. That said, some sections provide methods that aremore suited to financial firms. On the whole the applicability of a technique to aparticular type of firm will be self-evident.As a course, it is largely technique based and emphasises the financial, scientificor engineering approach to risk management. While this is more appropriate to acourse on managing financial risks, the student should be aware that there is analternative, behaviourist approach to risk. In most cases, this social science approachprovides complementary insights into the sources and treatment of risk by individuals and organisations.xiiEdinburgh Business School Financial Risk Management
IntroductionAlso financial risk management uses many ideas that are central to finance. Forinstance, the key idea behind portfolio theory, the mean-variance framework is themain approach to assessing the aggregate risk in an organisation. To use theportfolio approach requires us to know the expected return on an asset, the asset’svariance or standard deviation (that is, the dispersion from its expected return) andthe correlation to other assets in the portfolio. It is the same methodology used inportfolio selection but applied to a different purpose. In risk management it is as ifwe were running the ideas of portfolio selection in reverse, starting with a given setof assets and determining their risk, rather than – in traditional portfolio selection –starting with a risk/return objective and finding the appropriate set of assets. Evenso, optimising the risks in a firm is still an objective.A key idea to understanding risk is the dispersion or the variance of return.* At itssimplest, the stochastic process that underlies future asset prices can be seen in thebinomial model where, for the next period, the asset price can take one of only twostates: an increase or decrease. Extending this approach allows one to understandthe price-generating process for financial assets as well as how derivatives on theseassets are priced.†Once the text has been read and assimilated, one of the key approaches to assessing risk will become evident, namely the measurement of the position sensitivityto the risk factor (usually the market factor). Sensitivity is a key concept in riskmanagement. Knowing the degree of responsiveness to the source of risk (coupledto its impact) is essential in order to manage the risk. If one might use a medicalanalogy to help bring home the point, people have different tolerances to outsidehazards: sunlight, alcohol, infections, pollutants, irritants and so forth. Knowinghow susceptible one is to chemical irritants is useful when determining the amountof exposure one may take and the kinds of precautions that might be in order – forinstance, the need to wear rubber gloves.To manage risk it is necessary to measure it – accurately. An advertising campaign run by the Union Bank of Switzerland (UBS) some time ago promoted itsexpertise in this area with the slogan: ‘Master the detail – manage the risks.’ Asimilar approach is used here. Much of the material presented in the course coversthe different approaches used to master the detail of financial risk management. Thetext introduces ideas at an early stage – for instance, much of the conceptualfoundation for risk management is given in Module 1 (Introduction) – that are thentaken apart and examined in detail in subsequent modules. In particular, all of Part 3is devoted to examining different analytical approaches to financial risk management.AssessmentAs is customary with this programme, you will find self-test questions and cases atthe end of each module. Also provided are two pro-forma exams of the type it is*†This dispersion is often referred to as ‘volatility’ by market participants.These are the subjects of the Derivatives course.Financial Risk Management Edinburgh Business Schoolxiii
Introductionnecessary to pass in order to gain credit from this course. The exam assessment isbased on the following criteria:SectionMultiple choice questionsCasesxivNumber ofquestionsMarks obtainableper question303240Total marksfor thesection60120180Edinburgh Business School Financial Risk Management
AcknowledgementsI would like to thank Financial Times Ltd and The Scotsman for permission toreproduce items from their publications as background material to this course. AlsoJP Morgan for the right to reproduce material from its RiskMetrics system.Thanks are also in order to the production team at Edinburgh Business Schooland an anonymous reviewer of an early draft of some of the text who providedvaluable comment on the evolving material. As is usual in these matters, all errorsremain the author’s responsibility.Financial Risk Management Edinburgh Business Schoolxv
PART 1IntroductionModule 1 IntroductionModule 2 Risk and the Management of the FirmFinancial Risk Management Edinburgh Business School
Module 1IntroductionContents1.1Introduction.1/21.2What Is Risk? . 1/161.3What Is Financial Risk? . 1/331.4Steps to Risk Identification . 1/361.5Top-Down and Building-Block Approaches to Risk Management . 1/41Learning Summary . 1/42Appendix to Module 1: What Risks Are We Taking? . 1/43Review Questions . 1/44Learning ObjectivesThis module introduces the sources of risk, together with the methods used tomeasure it. It starts by looking at the historical background before going on todefine risk. It then examines the basic approaches used to identify, measure andreduce risks. Managing risk is a key activity for firms, and a range of differentapproaches is outlined. Firms may seek either to examine the totality of the risksthey face in the aggregate, an approach known as ‘top-down’, or to build up theirexposures from the individual risks, a procedure referred to as ‘ground-up’. Inpractice, many firms use both methods.The function of risk management is to control the effects of uncertain and generally adverse external developments (or events) on firms’ activities and projects.Financial risk management is a more specific activity that seeks to limit the effects ofchanges in financial variables such as interest rates, currencies and commodityprices.After reading this module, you should be able to understand: what financial risk management is designed to achieve;the difference between uncertainty and risk;the multidimensionality of risk;how different attitudes to risk lead to different decisions as to what amount ofrisk is acceptable; the basic approaches used to manage risk; the basic nature of the financial risks facing the firm; the three key steps used in risk management: risk awareness, risk measurementand risk adjustment.Financial Risk Management Edinburgh Business School1/1
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Financial risk management is the activity of monitoring financial risks and man-aging their impact. It is a sub-discipline of the wider task of managing risk and also a practical application of modern finance theories, models and methods. The tradi-tional role of finance within the firm has been in terms of reporting and control. The modern approach is to see the financial function as actively .
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