Financial institutions management a risk management approach 8th edition pdf

financial institutions management a risk management approach and also the chapter 15 financial risk management techniques and applications
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Financial Risk Management Sources of Financial Risk and Risk Assessment Peter Moles FK-A3-engb 1/2016 (1011) This course text is part of the learning content for this Edinburgh Business School course. In addition to this printed course text, you should also have access to the course website in this subject, which will provide you with more learning content, the Profiler software and past examination questions and answers. The content of this course text is updated from time to time, and all changes are reflected in the version of the text that appears on the accompanying website at Most updates are minor, and examination questions will avoid any new or significantly altered material for two years following publication of the relevant material on the website. You can check the version of the course text via the version release number to be found on the front page of the text, and compare this to the version number of the latest PDF version of the text on the website. If you are studying this course as part of a tutored programme, you should contact your Centre for further information on any changes. Full terms and conditions that apply to students on any of the Edinburgh Business School courses are available on the website, and should have been notified to you either by Edinburgh Business School or by the centre or regional partner through whom you purchased your course. If this is not the case, please contact Edinburgh Business School at the address below: Edinburgh Business School Heriot-Watt University Edinburgh EH14 4AS United Kingdom Tel + 44 (0) 131 451 3090 Fax + 44 (0) 131 451 3002 Email Website The courses are updated on a regular basis to take account of errors, omissions and recent developments. If you'd like to suggest a change to this course, please contact us: Financial Risk Management Dr Peter Moles MA, MBA, PhD Peter Moles is Senior Lecturer at the University of Edinburgh Business School. He is an experienced financial professional with both practical experience of financial markets and technical knowledge developed 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, risk management, origination and research. He has experience of both the Eurobond and Euro money markets. His main research interests are in financial risk management, the management of financial distress and in how management decisions are made and the difficulties associated with managing complex problems. He is author of the Handbook of International Financial Terms (with Nicholas Terry, published by Oxford University Press) and Corporate Finance (published by John Wiley & Sons). He is a contributing author for The Split Capital Investment Trust Crisis (published by Wiley Finance) and has written a number of 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 with the Copyright, Designs and Patents Act 1988. All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publishers. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers. Contents Introduction xi Arrangement of the Course xi Approach and Key Concepts xii Assessment xiii Acknowledgements xv PART 1 INTRODUCTION Module 1 Introduction 1/1  1.1 Introduction 1/2 1.2 What Is Risk? 1/16 1.3 What Is Financial Risk? 1/33 1.4 Steps to Risk Identification 1/36 1.5 Top-Down and Building-Block Approaches to Risk Management 1/41 Learning Summary 1/42 Appendix to Module 1: What Risks Are We Taking? 1/43 Review Questions 1/44 Case Study 1.1: Attitudes to Risk 1/50 Module 2 Risk and the Management of the Firm 2/1  2.1 Introduction 2/2 2.2 The Pervasiveness of Risk 2/10 2.3 Why Manage Risk? 2/10 2.4 Taxes 2/13 2.5 Agency and Other Costs 2/15 2.6 Business Performance 2/19 2.7 Financial Risk and Financial Distress 2/23 2.8 The Costs of Risk Management 2/25 Learning Summary 2/28 Review Questions 2/29 Case Study 2.1: Laker Airlines 2/35 PART 2 THE MARKETS Module 3 Market Mechanisms and Efficiency 3/1  3.1 Introduction 3/2 3.2 Market Efficiency 3/8 v Edinburgh Business School Financial Risk ManagementContents 3.3 Market Liquidity 3/11 3.4 The Role of Financial Intermediaries 3/13 3.5 Systematic Risk and Non-Systematic Risk 3/18 3.6 Managing Market Risks 3/21 3.7 Effect of Credit Risk 3/23 Learning Summary 3/27 Review Questions 3/28 Case Study 3.1: Omega Corporation 3/34 Module 4 Interest Rate Risk 4/1  4.1 Introduction 4/2 4.2 Interest Rate Risk 4/5 4.3 The Term Structure of Interest Rates 4/19 4.4 Analysing Yield Curve Behaviour 4/31 4.5 The Money Markets 4/36 4.6 Term Instruments 4/37 Learning Summary 4/40 Appendix 1 to Module 4: A Note on Early Redemption 4/41 Appendix 2 to Module 4: Relationship of Spot Rates and Par Yields 4/43 Review Questions 4/45 Case Study 4.1: Panthos Finance 4/55 Module 5 Currency Risk 5/1  5.1 Introduction 5/1 5.2 Foreign Exchange Rate Risk 5/3 5.3 Foreign Exchange Exposure 5/15 Learning Summary 5/30 Review Questions 5/31 Case Study 5.1: Airbus Industries 5/37 Module 6 Equity and Commodity Price Risk 6/1  6.1  Equity Market Risks 6/1 6.2 Commodity Price Risk 6/11 Learning Summary 6/16 Review Questions 6/17 Case Study 6.1: Banking 6/21 Case Study 6.2: Copper 6/21 vi Edinburgh Business School Financial Risk Management Contents Module 7 The Behaviour of Asset Prices 7/1  7.1 Introduction 7/1 7.2 The Price-Generating Process for Financial Assets 7/2 7.3 Understanding Volatility 7/18 7.4 Describing the Price-Generating Process 7/28 Learning Summary 7/36 Appendix to Module 7: Statistical Measures of a Probability Distribution 7/37 Review Questions 7/38 Case Study 7.1: Diffusion Trees 7/42 PART 3 RISK ASSESSMENT Module 8 Controlling Risk 8/1  8.1 Introduction 8/2 8.2 The Top-Down Approach to Risk Assessment 8/13 8.3 The Building-Block Approach to Risk Assessment 8/16 8.4 Reporting and Controlling Risk 8/19 8.5 A Note of Warning 8/38 Learning Summary 8/40 Review Questions 8/41 Case Study 8.1: Georgetown Industries 8/47 Module 9 Quantifying Financial Risks 9/1  9.1 Introduction 9/2 9.2 Statistical Analysis of Financial Risk 9/4 9.3 The Significance of the Normal Distribution 9/9 9.4 Understanding the Risk Measures 9/11 9.5 Measuring the Relationship between Assets 9/16 9.6 Portfolio Expected Return and Risk 9/21 9.7 Practical Considerations in Measuring Risk 9/31 9.8 Estimating Portfolio Value at Risk 9/31 Learning Summary 9/34 Appendix to Module 9: Example of the Statistical Analysis of Risk 9/35 Review Questions 9/38 Case Study 9.1: Calculating the Risk Factors for Two Commodities 9/43 Case Study 9.2: Portfolio Risk 9/44 vii Financial Risk Management Edinburgh Business School Contents Module 10 Financial Methods for Measuring Risk 10/1  10.1 Introduction 10/1 10.2 Using the Present-Value Approach to Determine Risk 10/3 10.3 Calculating Spot Discount Rates for Specific Maturities 10/5 10.4 The Term-Structure Approach to Risk Measurement 10/15 10.5 Simulation 10/20 Learning Summary 10/33 Appendix to Module 10: Bootstrapping Zero-Coupon Rates from the Par Yield Curve 10/34 Review Questions 10/37 Case Study 10.1: The Jabberwocky Company 10/42 Module 11 Qualitative Approaches to Risk Assessment 11/1  11.1 Introduction 11/1 11.2 Qualitative Forecasting Methods 11/3 11.3 Qualitative Forecasts 11/7 11.4 A Practical Example of a Forecast 11/9 11.5 Assessing Qualitative Accuracy 11/12 Learning Summary 11/19 Review Questions 11/20 Case Study 11.1: Bloomberg Minerals Economics 11/23 Appendix 1 Practice Final Examinations and Solutions A1/1 Examination One 1/2 Examination Two 1/12 Examination Answers 1/23 Appendix 2 Statistical Tables A2/1 Appendix 3 Formula Sheet for Financial Risk Management A3/1 1. Compounding and Discounting 3/1 2. Expected Value 3/2 3. Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) 3/2 4. Currency Relationships 3/3 5. Statistical Measures 3/3 6. Portfolio Model 3/4 7. Measures of Forecasting Accuracy 3/4 viii Edinburgh Business School Financial Risk Management Contents Appendix 4 Answers to Review Questions A4/1 Module 1 4/1 Module 2 4/5 Module 3 4/11 Module 4 4/17 Module 5 4/28 Module 6 4/33 Module 7 4/38 Module 8 4/45 Module 9 4/52 Module 10 4/61 Module 11 4/69 G/1 Glossary I/1 Index ix Financial Risk Management Edinburgh Business School Introduction This elective course covers one of the core functions of finance, namely risk management. A large part of the role of finance – the actions of the financial specialist and the operations of the financial department within firms – is devoted to handling, controlling and profiting from risk. This text sets out to show why and how firms manage their financial risks. For most kinds of activity, risk is unavoidable as long as the outcome is uncer- tain. Therefore, taking on risk and handling it is a core management discipline. All major corporate decisions involve choices as to how much risk to take and how best to manage these risks. At its simplest, risk management involves procedures for becoming aware of risks and the methods used to analyse risks, assess their impact and respond accordingly. 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 formulating policy and directly involved in the subsequent decisions. Financial risk management involves 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 well as the key principles and methodologies to be found in finance. Before starting, the student is expected to have some prior knowledge of the fundamentals of finance, and, in particular, time value of money methods, and a basic understanding of statistical concepts. The level of knowledge required is that which is necessary in order to successfully complete a course in finance. Arrangement of the Course The modules that go to make up Financial Risk Management fall into the following topic areas: The other key functions are valuation and the optimisation of resources across time. xi Edinburgh Business School Financial Risk ManagementIntroduction Topic area Modules One Introduction 1 and 2 The background and basics of risk management Two The Markets 3 to 7 Sources of financial risk from interest rates, currencies, equities and commodities; the nature and structure of financial markets; the asset price generating process Three Risk Assessment 8 to 11 The techniques used to assess, model, manage and control risks The course starts with an overview of the financial risk management process and its historical development (Part 1). A rationale for such activity is proposed based on current financial theories about firms and markets. It then proceeds to an examination 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 reduce these risks (Part 3). In implementing risk management policies, firms seek to quantify 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 qualita- tive scenario building – and the link between the two is discussed. In presenting the text in this way, the aim is to provide a comprehensive and logical approach to what is a complex subject. Approach and Key Concepts Financial risk management is a holistic subject. The order in which the text is presented follows what may be called the standard risk management model. While this is useful in developing a good understanding of how risk arises and how it is handled, it does have some disadvantages in that material on one subject (for instance, interest rate risk) is presented in modules that do not follow each other. As a result, we would encourage students to look at alternative ways to approach the text. A basic premise of the text is that it is orientated at the industrial and commercial firm. If anything, the typical firm is taken to be a manufacturer with cross-border transactions of various kinds. That said, some sections provide methods that are more suited to financial firms. On the whole the applicability of a technique to a particular type of firm will be self-evident. As a course, it is largely technique based and emphasises the financial, scientific or engineering approach to risk management. While this is more appropriate to a course on managing financial risks, the student should be aware that there is an alternative, behaviourist approach to risk. In most cases, this social science approach provides complementary insights into the sources and treatment of risk by individu- als and organisations. xii Edinburgh Business School Financial Risk Management Introduction Also financial risk management uses many ideas that are central to finance. For instance, the key idea behind portfolio theory, the mean-variance framework is the main approach to assessing the aggregate risk in an organisation. To use the portfolio approach requires us to know the expected return on an asset, the asset’s variance or standard deviation (that is, the dispersion from its expected return) and the correlation to other assets in the portfolio. It is the same methodology used in portfolio selection but applied to a different purpose. In risk management it is as if we were running the ideas of portfolio selection in reverse, starting with a given set of assets and determining their risk, rather than – in traditional portfolio selection – starting with a risk/return objective and finding the appropriate set of assets. Even so, 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 its simplest, the stochastic process that underlies future asset prices can be seen in the binomial model where, for the next period, the asset price can take one of only two states: an increase or decrease. Extending this approach allows one to understand the price-generating process for financial assets as well as how derivatives on these † assets are priced. Once the text has been read and assimilated, one of the key approaches to as- sessing risk will become evident, namely the measurement of the position sensitivity to the risk factor (usually the market factor). Sensitivity is a key concept in risk management. Knowing the degree of responsiveness to the source of risk (coupled to its impact) is essential in order to manage the risk. If one might use a medical analogy to help bring home the point, people have different tolerances to outside hazards: sunlight, alcohol, infections, pollutants, irritants and so forth. Knowing how susceptible one is to chemical irritants is useful when determining the amount of exposure one may take and the kinds of precautions that might be in order – for instance, the need to wear rubber gloves. To manage risk it is necessary to measure it – accurately. An advertising cam- paign run by the Union Bank of Switzerland (UBS) some time ago promoted its expertise in this area with the slogan: ‘Master the detail – manage the risks.’ A similar approach is used here. Much of the material presented in the course covers the different approaches used to master the detail of financial risk management. The text introduces ideas at an early stage – for instance, much of the conceptual foundation for risk management is given in Module 1 (Introduction) – that are then taken apart and examined in detail in subsequent modules. In particular, all of Part 3 is devoted to examining different analytical approaches to financial risk manage- ment. Assessment As is customary with this programme, you will find self-test questions and cases at the 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. xiii Financial Risk Management Edinburgh Business School Introduction necessary to pass in order to gain credit from this course. The exam assessment is based on the following criteria: Section Number of Marks obtainable Total marks questions per question for the section Multiple choice questions 30 2 60 Cases 3 40 120 180 xiv Edinburgh Business School Financial Risk Management Acknowledgements I would like to thank Financial Times Ltd and The Scotsman for permission to reproduce items from their publications as background material to this course. Also JP Morgan for the right to reproduce material from its RiskMetrics™ system. Thanks are also in order to the production team at Edinburgh Business School and an anonymous reviewer of an early draft of some of the text who provided valuable comment on the evolving material. As is usual in these matters, all errors remain the author’s responsibility. xv Financial Risk Management Edinburgh Business School PART 1 Introduction Module 1 Introduction Module 2 Risk and the Management of the Firm Financial Risk Management Edinburgh Business School Module 1 Introduction Contents 1.1  Introduction .............................................................................................1/2  1.2  What Is Risk? ........................................................................................ 1/16  1.3  What Is Financial Risk? ........................................................................ 1/33  1.4  Steps to Risk Identification ................................................................. 1/36  1.5  Top-Down and Building-Block Approaches to Risk Management . 1/41  Learning Summary ......................................................................................... 1/42  Appendix to Module 1: What Risks Are We Taking? ................................. 1/43  Review Questions ........................................................................................... 1/44  Learning Objectives This module introduces the sources of risk, together with the methods used to measure it. It starts by looking at the historical background before going on to define risk. It then examines the basic approaches used to identify, measure and reduce risks. Managing risk is a key activity for firms, and a range of different approaches is outlined. Firms may seek either to examine the totality of the risks they face in the aggregate, an approach known as ‘top-down’, or to build up their exposures from the individual risks, a procedure referred to as ‘ground-up’. In practice, many firms use both methods. The function of risk management is to control the effects of uncertain and gener- ally adverse external developments (or events) on firms’ activities and projects. Financial risk management is a more specific activity that seeks to limit the effects of changes in financial variables such as interest rates, currencies and commodity prices. 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 of risk 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 measurement and risk adjustment. 1/1 Financial Risk Management Edinburgh Business School Module 1 / Introduction 1.1 Introduction My introduction to the dangers of financial risk arose in the early 1970s when I had occasion to travel to Germany and, in order to have money available, was advised by my bank to take traveller’s cheques. At the time, there was little choice of currency for these, and I was persuaded to take US dollar-denominated ones on the grounds that they were the most negotiable. When I got to Germany, I found that each time I cashed my cheques I received fewer and fewer Deutschmarks for my dollars. I was a victim of adverse movements in the exchange rate. I had, unknow- ingly at the time, been exposed to currency risk. In reality I had taken on considerably more risk than I need have, since not only was I exposed to move- ments in the Deutschmark against the US dollar, but I had also exposed myself to the exchange rate risk between British pounds (known as sterling) and the dollar, a fact I discovered on my return to the UK when I sought to cash in my surplus cheques My experience, as we will discuss below, mirrors that of the modern development of financial risk management, which has its origins in the global financial dislocations that followed the collapse of the post-war global structure called the Bretton Woods Agreement. This module introduces the basic concepts of risk management and the justifica- tion for this process. Managing risk is part of any organisation’s strategic and operational activities, and analysing risks is an important aspect of a manager’s job. Risk management is the process of monitoring risks and taking steps to minimise their impact. Financial risk management is the task of monitoring financial risks and managing their impact. It is a sub-discipline of the wider function of risk management and an application of modern financial theory and practice. Financial risk management falls within the financial function of an organisation and is a reflection of the changing nature of this function over time. Traditionally, the financial function has been seen in terms of financial reporting and control. The modern approach is to consider the financial function in terms of financial policy and financial decision making. This includes the management of the firm’s opera- tional, business and economic risks. Risk is pervasive. In fact, we experience it in our everyday lives, as it is a constant of the human condition. Everything we do in our lives has a degree of risk attached to it. In living with risk, however, certain potentially high-risk exposures or potential events require us to take corrective action, for instance avoiding violent situations or insuring one’s life, home and other possessions. In the terminology of risk manage- ment, we would be adjusting the risk; that is, reducing the risk to acceptable proportions by hedging, offsetting or possibly eliminating it, depending on the courses of action that were available. The reason we make such adjustments is that the particular risks are too great for an individual to bear. We may transfer part or all of these risks to those better able to accept them, either by sharing the risk via insurance (as with home and life assurance policies) or, in some cases, by finding others who have the opposite risk and agreeing with them to exchange positions. A more detailed discussion of this issue is given in the appendix to this module. 1/2 Edinburgh Business School Financial Risk Management

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