Financial Risk Management

The following sections are included:

• Preface
• Contents
• Symbols Used in this Book
• About the Author

We begin this book with a fictionalized story. Bob Doyle has just been promoted to treasurer of a Fortune 1000 company. With Bob’s new salary, stock options, and bonus potential, he begins thinking that the sedan he drives is not quite the appropriate vehicle for a person of his new status. After all, Bob will now have his own parking space in the company lot. Bob’s wife Kathy agrees, and the two of them drive the sedan to a local upscale car dealership. After informing the salesman that they are looking for a new vehicle appropriate for a corporate executive, he proceeds to show them several models. The salesman, clearly interested in selling the Doyles the most expensive car he has, is pushing them toward a very nice and sophisticated sporty car. The following conversation ensues…

The study of finance and in fact much of the broader field of economics is frequently based on the assumption that people act consistently and rationally. Rational behavior leads to statements, models, and theories that describe how asset prices, interest rates, and exchange rates are generated in financial markets. Knowing how prices and rates are determined is instrumental and in fact critical to making effective financial decisions and practicing good financial risk management. But in reality, people often act inconsistently and irrationally. Such behavior is nearly always sub-optimal and frequently leads to poor performance over the long haul. In fact, there are investment managers whose central trading philosophy is based on the notion that many investors can be counted on to be consistently wrong and irrational and that it is possible to take advantage of the errors these investors make…

In the previous chapters we explored some basic concepts related to how people feel about risk, how they react to risk, and how they manage risk at a very fundamental level. Most of these ideas were examined in a broader or more societal context than that of a business or non-profit organization. Now it is time to gear up toward managing risk within the framework of an organization. As we shall see throughout this course, there are a variety of sources of risks, but the ones that occupy center stage for much of this book are market risks, i.e., those that arise from changes in interest rates, exchange rates, commodity prices, and stock prices. The examples we will begin to see, starting with this chapter, mostly represent risks derived from these sources of uncertainty. There are other sources of risk, and they will be covered in detail in Chapters 11 and 12…

This book examines how organizations manage risk. These organizations are primarily shareholder-oriented companies, but the principles are applicable in non-profits as well. Both types of entities are expected to be good stewards of the capital entrusted to them. Both must raise and allocate capital and do their best to, first, survive, and, second, achieve their objectives. Both types of entities reflect an appetite for risk and are damaged by adverse outcomes, while benefitting from favorable outcomes. While there can be considerable variation in the types of risks faced by organizations, the fundamental principles of risk management are common to all…

Before we begin to look at the details of how to manage financial risk, we need to set the story in its proper perspective. So let us next take a look at the environment in which risk management is practiced. Of course, that environment can be viewed as the entire global economy and in particular, the global financial and commodity markets. Inasmuch as the practice of risk management relies heavily on the use of derivatives, we need to examine the basic structure and special characteristics of the derivatives markets…

We have completed five chapters on the subject of risk management, but we have yet to ask a very important question: is risk management worth the effort? Specifically, does risk management add value? Does it do something for shareholders that they could not do for themselves? This question is not an easy one to answer. In fact, it is an extremely difficult one. There are many possible benefits of risk management, but not all of them necessarily make legitimate contributions to the welfare of the owners of the company. We did not raise this question until now because there were some things you needed to know about risk management before we got into this subject. Now that you have the foundations in place, let us dive into this issue…

We now start Part III, which deals with managing market risk. The unit consists of four chapters. This chapter is the first, of course and it provides an introduction to the tools used in measuring market risk. Recall that market risk is the risk arising from movements in interest rates, exchange rates, commodity prices, and stock prices. These types of risks are those that arise from the volatility of prices and rates in their respective markets. In measuring these risks, we will use a number of risk management models. Risk management models have much in common with many financial models, but they do have some important differences. Most financial models are designed to capture the relationship between expected return and risk and, in so doing, they help us determine a fair price for an asset. For that reason, they are often called pricing models. The primary objective of risk management models is not the pricing of assets, but the measurement and control of the risks arising from those assets. Also, pricing models typically assume that market participants act rationally and align their desired risks with their risk tolerances. Risk management models make no such assumptions. The desired risks and risk tolerances are exogenous factors determined by risk managers, CEOs, or whoever is responsible for determining the amount of risk taken by the entity. Risk management models provide guidance on how to measure and control risk, so that the risk taken can be aligned with the desired risk for a given market participant…

Chapter 8 is the first of three chapters that get into the meat and bones of risk management. Specifically, we will take a careful look at the types of derivative contracts that are used to manage financial risk. This chapter deals with forwards and futures, while the next, Chapter 9, deals with swaps, and after that we have Chapter 10, which covers options. We have already introduced these instruments in Chapter 4, though we did not get too far into them. After a brief review of the definition and characteristics of forward and futures contract, we will dive into the process of determining the price and value of a contract. Then we will look at applications in risk management. We will follow these steps first for forwards and then for futures…

In Chapter 8 we examined forward and futures contracts. Recall that these derivatives are contracts in which two parties agree that one party will buy an asset from another at a future date at a price they agree on at the start. Forward and futures contracts are sometimes called forward commitments, because they are agreements that commit each party to a transaction in the future at a price they agree on when the transaction is initiated. Swaps extend the idea of a commitment made in advance for a single transaction to a commitment made in advance for a series of transactions at different dates. Thus, in some sense a swap can be viewed as a portfolio of forward or futures contracts, though we will illustrate this point in more detail later and show that there are some technical differences.

Chapter 10 is the final chapter of a pedagogical trilogy on the three principal types of instruments used in market risk management. Chapter 8 was on forwards and futures, and Chapter 9 was on swaps. Because they are slightly more complex than forwards, futures, and swaps, we have saved options for last, though the wait should be worth it. What makes options more complex is that they have non-linear payoffs, meaning that their payoffs are not related to the underlying in the same way over the full range of possible underlying values at the expiration or settlement dates. In contrast, forwards, futures, and swaps have linear payoffs, meaning that the payoffs are the same function of the underlying regardless of the level of the underlying. If this point is not clear, do not worry. We will cover it in detail, and it will become clear. So, let us get started with understanding just what an option is.

It is perhaps appropriate that the chapter on credit risk is Chapter 11 of this book. Normally in the financial world, when you say “Chapter 11,” you are referring to the section of the U.S. bankruptcy code that specifies the legal statute under which a company can file for protection from its creditors. Owing money to other entities in excess of the equity of a company or individual is what results in bankruptcy. When one party owes money to another party, there is always the possibility of bankruptcy. Credit risk management is a critical process by which an organization manages the risk that the counterparty will not pay what it owes…

Chapter 12 is the second of two chapters in Part III that deal with nonmarket risks. Chapter 11 covered credit risk, which is related to but distinct from market risk. Now in Chapter 12 we introduce several other types of non-market risks. Because there are so many non-market risks, we divide the chapter into two parts, one dealing with operational risk and the other with a very general classification of “other” risks. The risks covered in this chapter are quite different from what we have encountered before in that they are much harder to identify, quantify, and manage. Fortunately for most end users, these risks tend to be of smaller severity and lower frequency than they are for dealers, but that does not mean we can ignore them. They have the potential for causing severe damage to any entity. In addition, it is important for end users to know how banks deal with these types of risks. But before we get to the “other” risks, let us first start off with operational risk.

Part V of this book takes a different turn. Through Part IV, we have been studying types of risks and how they are managed. In Part V, we begin to look at how companies engage in the supporting activities that are necessary for practicing good risk management. In this chapter, we look at how companies account for and disclose their risk management strategies and transactions. In Chapter 14, we examine how an entity organizes the risk management function through the process of risk management governance. These chapters are quite different from most of the preceding chapters in that they do not address specific risks, but look more at risk management from a top-down perspective.

This final chapter in our journey through the practice of financial risk management by end users is an overview of the most important organizational and governance considerations in financial risk management. The terms organizational and governance refer to the structure of an entity’s risk management system and its oversight. For the first 12 chapters, we looked at how to practice financial risk management. In Chapter 13 we examined how to record and report the transactions and convey to the public what the organization is doing with respect to managing risk. None of that will matter, however, if the entity does not have an effective system to implement its risk management strategies within the organization and, most importantly, oversight by the people who are ultimately responsible…

The following sections are included:

• References
• Index