Hull Book

PREFACE

Risk management practices and the regulation of financial institutions have

continuing to evolve in the last three years. "Risk management and institutions"
"financial" has been expanded and updated to reflect this. Just like my other
popular text options, Futures and Other Derivatives, the book is designed to be helpful
for current managers as well as university students. Those who study
For the GARP and PRMIA qualifications, you will find the book particularly useful.

The book is suitable for university courses in risk management or institutions.

financial. It is not necessary for students to take a course on options and markets
about futures before taking a course based on this book. But if they have taken such a course, part
The material in the first nine chapters does not need to be covered.

The level of mathematical sophistication and the way the material is presented has been
handled with care so that the book is accessible to the widest possible audience.

For example, when I cover copulas in Chapter 11, I present the intuition followed by a
detailed numerical example; when covering the maximum likelihood methods in Chapter
10 and the extreme value theory in Chapter 13, I provide numerical examples and
sufficient details for readers to develop their own Excel spreadsheets.
I also provided my own Excel spreadsheets for many applications in my
website:

[Link]/∼hull

This is a book about risk management, so there is very little material on valuation.
of derivatives. (This is the main focus of my other two books, Options, Futures and Others)
Derivatives and Fundamentals of Futures and Options Markets.

The appendices at the end of the book include material that summarizes some of the key findings.
of evaluation that are important in risk management, and DerivaGem the software is
you can download from my website.
Chapter 1 - Introduction

Imagine that you are the Chief Risk Officer (CRO) of a major corporation. The Director
The CEO wants your opinion on a new major company. You have been
flooded with reports showing that the new company has a net present value
positive and will improve shareholder value. What kind of analysis and ideas does the CEO have?
looking for you?

As CRO, it is your job to consider how the new company fits into the portfolio of the
company. What is the correlation of the new company's performance with the rest of the
business of the company? When the rest of the business is struggling, does the new company
it will also provide poor returns, or will have the cushioning effect of the
ups and downs in the rest of the business?

Companies must take risks if they want to survive and thrive. Main function of the
risk management is understanding the portfolio of risks that the company is taking and the
risks he plans to take in the future. He must decide whether the risks are acceptable and, if they are not
acceptable, what measures should be taken.

Most of this book deals with how banks manage risks and
other financial institutions, but many of the ideas and approaches we will discuss are
equally applicable to non-financial corporations. Risk management has
progressively becoming more important for all corporations in recent times
decades.
Financial institutions in particular are discovering that they must increase the
resources dedicated to risk management. Big losses from 'dishonest traffickers'
like those of Barings Bank in 1995, Allied Irish Bank in 2002, Société Générale in 2007 and
UBS in 2011 has been avoided if the procedures used by banks to collect
data about the negotiation the positions had been developed more carefully.

Huge high-risk losses at banks like Citigroup, UBS, and Merrill Lynch would have been
less severe if the risk management groups had been able to convince the leadership
indicating that the risks taken were unacceptable.

This opening chapter sets the scene. It begins by reviewing classical arguments.
about the risk-return concessions that an investor faces when choosing a portfolio
of stocks and bonds. Then consider if the same arguments can be used by
a company to choose new projects and manage its exposure to risk.

The chapter concludes that there are reasons why companies - particularly
financial institutions should be concerned about the total risk they face, not just
due to the risk from the perspective of a well-diversified shareholder.
1.1 RISK VS. RETURN FOR INVESTORS

As all fund managers know, there is a compensation relationship

between risk and return when money is invested The greater the
the greater the risks taken, the higher the performance that can be achieved.

The compensation is actually between risk and expected return, not between risk and
real yield. The term 'expected return' sometimes causes confusion. In the language
In everyday life, a result is considered 'expected' if it is highly likely to occur.
However, statisticians define the expected value of a variable as its value
average (or mean).

The expected return is therefore a weighted average of the possible outcomes.

yields, where the weight applied to a particular yield is equal to the probability
that this return occurs.

Possible returns and their probabilities can be estimated from data.

historical or subjectively assessed.

Let's assume, for example, that you have $100,000 to invest for a year. Let's also assume,
Treasury bonds yield 5%.1One alternative is to buy Treasury bills. There then
there is no risk and the expected return is 5%. Another alternative is to invest the $100,000
in an action. To simplify things, we assume that the possible outcomes of this
Investment is shown in Table 1.1. There is a probability of 0.05 that the return will be +
50%; there is a 0.25 probability that the return will be +30%; and so on.

1This is close to the historical average, but quite higher than Treasury yields.
seen in the years following 2008 in many countries.
Expressing the returns in decimal form, the expected return per year is:

0.05 × 0.50 + 0.25 × 0.30 + 0.40 × 0.10 + 0.25 × (-0.10) + 0.05 × (-0.30) = 0.10

This shows that in exchange for taking some risk, you can increase your expected return.
annual 5% offered by the Treasury bonds at 10%. If things go well, your
Annual returns can reach 50%. But the worst-case scenario results in a return
-30% or a loss of $30,000.

One of the first attempts to understand the balance between risk and return
expected was by Markowitz (1952). Later, Sharpe (1964) and others took the analysis of
Markowitz a step further through the development of what is known as the Model
of Valuation of Financial Assets - CAPM. This is a relationship between the
expected return and what is called 'systematic risk'. In 1976, Ross developed
the arbitration price theory that can be seen as an extension of the CAPM model
to the situation where, as all fund managers know, there are several sources of
systematic risk. The key ideas of these researchers have a profound effect on the
the way portfolio managers think and analyze compensations of
risk-return they face. In this section, we review these ideas.

Quantifying the risk

How is the risk you are taking when choosing an investment quantified? One measure
A commonly used measure is the standard deviation of the return over a year.
This is

where R is the return per year. The symbol E indicates the expected value, so E(R)
it is the expected yield per year.

In Table 1.1, as we have shown, E(R) = 0.10. To calculate E(R2we must weigh the
alternative squared returns by their probabilities:

The standard deviation of the annual return is therefore

18.97%
Investment opportunities

Let's suppose we choose to characterize each investment opportunity by its

expected return and standard deviation of return. We can plot investments
risky available in a graph like Figure 1.1 where the horizontal axis is the
standard deviation of return and the vertical axis is the expected return.

Once we have identified the expected return and the standard deviation of the
return for individual investments, it is natural to think about what happens when combining
investments to form a portfolio. Consider two investments with returns R1 and R2. The
return of putting a proportion w1 of our money in the first investment and a
proportion w2 = 1 - w1 in the second investment is w1R1 + w2R2

The expected return of the portfolio is

μP = w1μ1 + w2μ2 (1.1)

where μ1 is the expected return of the first investment and μ2 is the return
expected from the second investment. The standard deviation of the portfolio's return is
given by
 (1.2)

where σ1 and σ2 are the standard deviations of R1 and R2 and ρ is the correlation coefficient
between the two.

Let's assume that μ1 is 10% per year and σ1 is 16% per year, while μ2 is 15% per year and
σ2 is 24% per year. Let's also assume that the correlation coefficient ρ, between the
yields are 0.2 or 20%. Table 1.2 shows the values of μP and σP for a number of
different values of w1 and w2. The calculations show that by putting part of your money in the
first investment and part in the second investment of a wide range of combinations
risk-return can be achieved. These are plotted in Figure 1.2.

Most investors are risk-averse. They want to increase returns.

expected while they reduce the standard deviation of the return. This means they want
move as far as they can in a 'northwest' direction in Figures 1.1 and 1.2.

Figure 1.2 shows that forming a portfolio of the two investments we have been
considering helps you do this. For example, by putting 60% in the first investment and
a 40% in the second, a portfolio with an expected return of 12% and a deviation
a performance standard of 14.87% is obtained. This is an improvement over the ratio of
risk-return for the first investment. (The expected return is 2% higher and the
the standard deviation of the yield is 1.13% lower.

The expected returns on investments are 10% and 15%; the standard deviation of
The returns are 16% and 24%; and the correlation between the returns is 0.2.
 FIGURE 1.2 Alternative risk-return combinations of two investments
(as calculated in Table 1.2)

1.2. THE EFFICIENT BORDER

We are now going to bring a third investment into our analysis. The third investment can be
combined with any combination of the first two investments to produce a
new risk-return combination. This allows us to advance even further in the direction
northwest.

We can add a fourth investment. This can be combined with any

combination of the first three investments to produce even more opportunities for
investment. As we continue this process, considering all the portfolios
possibilities of available risky investments, we obtain what is known as a
efficient border.

This represents the limit of how far we can move northwest so far and
is illustrated in Figure 1.3.
There is no investment that dominates a point on the efficient frontier in the sense that it has
both a higher expected return and a lower standard deviation of
performance. The southeast area of the efficient frontier represents the set of all
investments that are possible.

For any point in this area that is not on the efficient frontier, there is a
point on the efficient frontier that has a higher expected return and a deviation
lowest return standard.

In Figure 1.3, we have only considered risky investments. What does the frontier look like?
efficient of all possible investments? Specifically, what happens when we include
the risk-free investment? Let’s suppose that the risk-free investment generates a return
of RF. In Figure 1.4, we have indicated the risk-free investment by point F and it was drawn
a tangent from point F to the efficient frontier of risky investments that
developed in Figure 1.3. M is the point of tangency. As we will show now, the line FJ
it is our efficient new frontier.

Consider what happens when we form an investment I by placing βI of the funds that
we have available to invest in the risky portfolio, M, and 1 - βI in the risk-free investment
risk F (0 <βI <1). From equation (1.1) the expected return on investment, E (RI), comes
given by

and from equation (1.2), because the risk-free investment has a standard deviation of zero,
the return RI has a standard deviation
βIσM
where σM is the standard deviation of the return for portfolio M. This combination of
risk-return corresponds to the point labeled I in Figure 1.4. From the perspective of
expected return and the standard deviation of the return, point I is βI of the path from F to M.

All the points on the line FM can be obtained by choosing an appropriate combination of
the investment represented by point F and the investment represented by point M. The
points on this line dominate all points on the previous efficient frontier because they provide
a better risk-return combination. The FM straight line is therefore part of the
new efficient frontier.

If we make the simplifying assumption that we can take loans at a free rate
of RF risk, as well as investing at that rate, we can create investments that are in the
continuation of FM beyond M. Let ’s suppose, for example, that we want to create the
investment represented by point J in Figure 1.4 where the distance from J to F is βJ
Sometimes the distance from M to F (βJ > 1). We borrow βJ - 1 from the amount that
we have available for investment at a RF rate and then invest everything (the original funds
and the borrowed funds) in the investment represented by point M. After allowing for the
interest paid, the new investment has an expected return, E (RJ) given by

and the standard deviation of the return is

This shows that the combination of risk and expected return corresponds to point J.
(Please note that the formulas for expected return and standard deviation
The return in terms of beta is the same whether beta is greater than or less than 1.

The argument we have presented shows that, when the risk-free investment is
Consider that the efficient border must be a straight line. To put this another way
there should be a linear compensation between expected return and deviation
standard of returns, as indicated in Figure 1.4.

All investors must choose the same portfolio of risky assets. This is the
portfolio represented by M. Then they should reflect their risk appetite.
combining this risky investment with loans or loans at the risk-free rate.

It is one step away from arguing that the portfolio of risky investments represented
M must be the portfolio of all risky investments. Let's suppose that a
investment is not in the portfolio. No investor would hold it and its price has to
lower so that its expected performance increases and becomes part of portfolio M.

In fact, we can go beyond this. To ensure a balance between supply and

demand for each investment, the price of each risky investment must be adjusted from
so that the amount of that investment in portfolio M is proportional to the amount of that
investment available in the economy. Therefore, the investment represented by point M
It is generally known as a market portfolio.
FIGURE 1.4 The efficient frontier of all investments
Point I is achieved by investing a percentage βI of the available funds in portfolio M.
and the rest in a risk-free investment. Point J is obtained by borrowing βJ - 1 from
funds available at the risk-free rate and investing everything in portfolio M.

1.3. ASSET PRICING MODEL - CAPM

How do investors decide on the expected returns they require for the
individual investments?

Based on the analysis we have presented, the market portfolio must play a role.
key. The expected required return on an investment must reflect the degree to which the
investment contributes to the risks of the market portfolio.

A common procedure is to use historical data and regression analysis to determine

a more suitable linear relationship between investment return and yield
of the market portfolio. This relationship takes the form:
where R is the return on investment, RMit is the market portfolio's performance,
a and β are constants, and ε is a random variable equal to the regression error.

Equation (1.3) shows that there are two uncertain components of the risk in the return of the
investment

1. A component βRM, which is a multiple of the market portfolio's return.

2. A component ε, which is not related to the performance of the market portfolio.
The first component is known as systematic risk. The second component is
it refers to a non-systematic risk.

First, consider the unsystematic risk. If we assume that the variables ε for different
investments are independent of each other, unsystematic risk is almost diversified by
complete in a large portfolio. Therefore, an investor should not worry about the
unsystematic risk and should not demand an additional return above the rate
risk-free to support unsystematic risk.

The component of systematic risk is what should matter to an investor. When you
it maintains a well-diversified portfolio, the systematic risk represented by βR Mno
disappears. An investor must demand an expected return to compensate for this risk.
systematic.

We know how investors negotiate systematic risk and expected return of the
Figure 1.4. When β = 0, there is no systematic risk and the expected return is RF. When
β = 1, we have the same systematic risk as the market portfolio, which is
represented by point M, and the expected return should be E (RMIn general
This is the capital asset pricing model. The expected return on
excess over the required risk-free rate for the investment β multiplied by the
expected excess return on the market portfolio. This relationship is plotted in the
Figure 1.5. The parameter β is the beta of the investment.

EXAMPLE 1.1
Let's assume that the risk-free rate is 5% and the portfolio return of
the market is 10%.
An investment with a beta of 0 should have an expected return of 5%. This is
because all investment risk can be diversified. An investment with a beta
0.5 should have an expected return of

0.05 + 0.5 × (0.1 - 0.05) = 0.075

7.5%

An investment with a beta of 1.2 should have an expected return of

0.05 + 1.2 × (0.1 - 0.05) = 0.11
to 11%.
The parameter, β, is equal to where ρ is the correlation between the return of the
investment and the market portfolio return, σ is the standard deviation of the
investment return, and σMonth the standard deviation of the portfolio return
market. Beta measures the sensitivity of investment return to portfolio performance
from the market. We can define the beta of any investment portfolio as in the
equation (1.3) when regressing its returns against the returns of the market portfolio. The
The CAPM model in equation (1.4) should then be applied with the return R defined.
like the performance of the portfolio. In Figure 1.4, the market portfolio represented
por M has a beta of 1.0 and the risk-free portfolio represented by F has a beta of
Zero. The portfolios represented by points I and J have betas equal to βI and βJ,
respectively.

Assumptions

The analysis we have presented leads to the surprising conclusion that all the
investors wish to maintain the same asset portfolios (the portfolio represented by
M in figure 1.4.) This is clearly not true. In fact, if it were true, the markets would not...
they would not work at all well because investors would not want to trade among themselves! In the
In practice, different investors have different viewpoints on the attractiveness of the
stocks and other investment opportunities risks. This is what makes them trade among
Yes, and it is this negotiation that leads to the formation of prices in the markets.

The reason why the analysis leads to conclusions that do not correspond with the
the reality of the markets is that, when presenting the arguments, we implicitly made a
number of assumptions. In particular:

1. We assume that investors only care about expected return and deviation.
standard of their portfolio performance. Another way to say this is that investors
they only look at the first two moments of the return distribution. If the returns are
they normally distribute, it is reasonable for investors to do this. However, the
Returns of many assets are not normal. They have skewness and excess kurtosis.

The skewness is related to the third moment of the distribution and excess kurtosis is
related to the fourth moment. In the case of positive asymmetry, very high returns
high yields are more likely and very low yields are less likely than the
normal distribution would predict; in the case of negative skewness, very returns
Low yields are more likely and very high yields are less likely than what
I would predict the normal distribution.

Excess kurtosis leads to a distribution where returns are very high and
very low values are more likely than what the normal distribution would predict. Most of the
Investors are concerned about the possibility of extremely negative results.
They are likely to want a higher expected return on investments with asymmetry.
negative or excess kurtosis.

2. We assume that the variables ε for different investments in equation (1.3) are
independent.
Equivalently, we assume that the returns on investments are correlated.
between themselves only by their correlation with the market portfolio. This is clearly not true
Ford and General Motors are both in the automotive sector.
There is likely some correlation between their returns that does not arise from their correlation.
with the stock market in general. This means that the ε for Ford and the ε for General
Motors are probably not independent of each other.

3. We assume that investors focus on returns in a single period and the

the duration of this period is the same for all investors. This is also not true.
Some investors, like pension funds, have very long time horizons.
Others, like day traders, have very short time horizons.

4. We assume that investors can borrow and lend at the same risk-free rate.
of risk. This is approximately true under normal market conditions for a
a great financial institution that has a good credit rating. But it is not
exactly true for such a financial institution and not true for small ones
investors

5. We do not consider taxes. In some jurisdictions, capital gains are taxed.

differently the dividends and other sources of income. Some investments
they receive special tax treatment and not all investors are subject to the
same tax rate. In practice, tax considerations play a role that
play in the decisions of an investor. An appropriate investment for a pension fund
that does not pay taxes could be inappropriate for a taxpayer with a marginal rate
high that lives in New York, and vice versa.

Finally, we assumed that all investors make the same estimates of the
expected returns, the standard deviations of returns and the correlations
among the returns of available investments. In other words,
we assume that investors have homogeneous expectations. This is clearly not
true. In fact, as mentioned earlier, if we lived in a world of
homogeneous expectations that there would be no trade.

Despite all this, the Capital Asset Pricing Model (CAPM) has proven to be
a useful tool for portfolio managers. The estimates of the betas
of the actions are available and the expected return of a portfolio estimated by the
The capital asset pricing model (CAPM) is a benchmark.
commonly used to evaluate the performance of the portfolio manager, such as
we will explain now.
Alfa
When we observe a return of RMin the market, what do we expect it to be
performance of a portfolio with beta of β? The capital asset pricing model -
CAPM relates the expected return of a portfolio to the expected return on the
market. But it can also be used to relate the expected performance of a
portfolio with real market performance:

where RFit is the risk-free rate and RPit is the portfolio performance.

EXAMPLE 1.2

Consider a portfolio with a beta of 0.6 when the risk-free interest rate is
4%. When the market return is 20%, the expected return of the portfolio is
0.04 + 0.6 × (0.2 - 0.04) = 0.136
13.6%.

When the market return is 10%, the expected return of the portfolio is
0.04 + 0.6 × (0.1 - 0.04) = 0.076
7.6%.

When the market return is -10%, the expected return of the portfolio is
-0.044
-4.4%
The relationship between the expected portfolio return and the market return is
shown in Figure 1.6.
FIGURE 1.6 Relationship between the expected return of the portfolio and the actual return in
the market when the portfolio beta is 0.6 and the risk-free rate is 4%

Let's assume that the actual return of the portfolio is greater than the expected return.

The portfolio manager has produced superior returns for the amount of
systematic risk being taken. The extra return is:

This is commonly known as the alpha created by the portfolio manager.2.2

A portfolio manager has a portfolio with a beta of 0.8. The risk-free rate
a year of interest is 5%, the market return during the year is 7%, and
the portfolio manager's performance is 9%. The manager's alpha is

α = 0.09 - 0.05 - 0.8 × (0.07 - 0.05) = 0.024 or 2.4%.

2Sometimes it is known as Jensen's alpha because it was first used by Michael

Jensen when evaluating the performance of mutual funds. See Section 4.1.
Portfolio managers are continually looking for ways to produce a
positive alpha. One way is to try to choose stocks that outperform the market. Another is
for themarket [Link] implies trying to anticipate movements in the market in
general and move the funds from safe investments, such as Treasury bonds, to the market
stock market when a rebound is anticipated, and in the other direction when a downturn is anticipated
deceleration. Chapter 4 explains other strategies used by hedge funds
to try to create positive Alpha.

Although the capital asset pricing model is not realistic in some aspects,
the alpha and beta parameters that come from the model are widely used for
characterize investments. Beta describes the amount of systematic risk. The greater it is
the value of beta, the greater the systematic risk and the greater the extent to which the
Returns depend on market performance. Alpha represents the return
extra obtained from a management of a superior portfolio (or maybe just good luck). An investor
You can create a positive alpha only at the expense of other investors who are generating an alpha.
negative. The weighted alpha average of all investors must be zero.

1.4 ARBITRAGE PRICING THEORY

Arbitrage pricing theory can be seen as an extension of the CAPM model. In the
capital asset pricing model - CAPM, the return of an asset
it depends on a single factor.

In the arbitrage pricing theory, the yield depends on various factors. (These
factors could involve variables such as gross national product, the rate of
domestic interest, and the inflation rate.) When exploring ways in which investors
they can form portfolios that eliminate exposure to factors, the pricing theory of
Arbitrage shows that the expected return of an investment depends linearly on the
factors

The assumption that the ε variables for different investments are independent in the
equation (1.3) assures that there is only one factor that drives expected returns (and by
so, a source of systematic risk) in the CAPM model. This is the return of the portfolio
of the market. In arbitrage pricing theory, there are several factors that affect the
return on investment. Each factor is a separate source of systematic risk. The
unsystematic risk (that is, diversifiable) in the arbitrage pricing theory is the risk
that is not related to all the factors.

1.5 RISK VS. RETURN BY COMPANIES

Now we turn to consider the trade-offs between risk and return of a
company. How should a company decide if the expected performance of a new
Is the investment project a sufficient compensation for its risks?
The ultimate owners of a company are its shareholders, and a company must be
managed in the best interest of its shareholders. Therefore, it is natural to discuss that a
The new project undertaken by the company should be seen as an addition to the portfolio of
its shareholders. The company must calculate the project investment beta and its return.
expected. If the expected return is greater than that provided by the CAPM model, it is a
good business for shareholders and the investment must be accepted. Otherwise, it must be
rejected.

The argument we have just presented suggests that unsystematic risks should not
to be considered when accepting or rejecting decisions about new projects. In the
in practice, companies are concerned about unsystematic and systematic risks. For
for example, most companies insure against the risk of their buildings being
burned, even though this risk is completely unsystematic and can be
diversified by its shareholders. They try to avoid taking high risks and often hedge
their exposures to exchange rates, interest rates, product prices
basics and other market variables.

The stability of earnings and the survival of the company are often objectives.
important. Companies try and ensure that their expected profits in new
Companies should be consistent with the risk-return compensation of their shareholders.
But there is a primary restriction that the total risks taken should not be
too big.

Many investors are also concerned about the overall risk of companies in the
that invest. They do not like surprises and prefer to invest in companies that show
solid growth and meet earnings forecasts. They like that companies
they manage risks carefully and limit the total amount of risk, both systematic
like in the systematic way that they are taking.

The theoretical arguments that we present in Sections 1.1 to 1.4 suggest that the
Investors should not behave this way. They must have a well-balanced portfolio.
diversified and encourage the companies they invest in to make high investments
risk when the combination of expected return and systematic risk is favorable.

Some of the companies in the shareholders' portfolio will go bankrupt, but others
They will do very well. The result should be a satisfactory overall return to the shareholder.
Are investors behaving suboptimally? Would their interests be better off?
Were they attended to if companies took on more unsystematic risks? There is an argument.
important to suggest that this is not necessarily the case. This argument
It is generally known as the 'bankruptcy cost' argument. It is often used
to explain why a company should limit the amount of debt it takes on, but
it can be expanded to apply to a wider range of risk management decisions
What is this.
Bankruptcy costs
In a perfect world, bankruptcy would be a quick matter where the assets of the
company (tangible and intangible) are sold at their fair market value and the income is
distributed to the company's creditors using well-defined rules. If we lived in
In a perfect world, the bankruptcy process itself would not destroy value for the
stakeholders.

Unfortunately, the real world is far from perfect. By the time a company
reaches the breaking point, it is likely that its assets have lost some value. The
the bankruptcy process invariably further reduces the value of its assets. This
additional reduction in value is known as bankruptcy costs.

What is the nature of bankruptcy costs? Once a bankruptcy has occurred,

customers and suppliers are less inclined to do business with the company; goods to
Sometimes they have to be sold quickly at prices well below what would be realized.
in an orderly sale; the value of important intangible assets, such as brands and their
market reputation is often destroyed; the company no longer operates in the
best interests of the shareholders; large commissions are often paid to
accountants and lawyers; and so forth. The story in 'Business Overview' 1.1 is representative.
of what often happens in practice. It illustrates how, when a high-risk decision
It works badly, there can be disastrous bankruptcy costs.

Business Overview 1.1

The hidden costs of bankruptcy

Several years ago, a company had a market capitalization of $2 billion and

$500 million in debt. The CEO decided to acquire a company in a related industry.
for $1 billion in cash. The cash was raised using a combination of debt
banking and bond issuances. The price paid by the company was justified on the basis of
possible synergies, but the main threats to the company's profitability were passed
high. Many of the anticipated synergies did not materialize. Furthermore, the company that
acquired was not profitable and turned out to be a cash drain for the company
matrix. After three years, the CEO resigned. The new CEO sold the acquisition for $100.
millions (10% of the price paid) and announced that the company would focus on its business
original principal. However, by then the company was highly leveraged. A
The temporary economic recession made it impossible for the company to pay its debt and it
declared bankruptcy.
The company's offices soon filled with accountants and lawyers representing the
interests of the various parties (banks, different categories of bondholders, shareholders, the
company and the board of directors.
These people billed the company directly or indirectly about $10.
millions per month in fees. The company lost sales it would normally have made.
because nobody wants to do business with a bankrupt company. Key executives are
they were. The company experienced a dramatic reduction in its market share.
After two years and three attempts at reorganization, an agreement was reached between the
various parts and a new company was incorporated with a market capitalization of $
700,000 to continue the remaining profitable parts of the business. The shares of the new
The company was the exclusive property of the banks and the bondholders. The shareholders
they didn't get anything.

The largest bankruptcy in the history of the United States was that of Lehman Brothers in
September 15, 2008. Two years later, on September 14, 2010, the Financial Times
it reported that legal and accounting fees in the United States and Europe related
The bankruptcy of all the subsidiaries of the holding Lehman approached nearly $2 billion.
Despite the fact that some of the services had been provided at discounted rates.

We mentioned earlier that corporate survival is a managerial objective.

important and that shareholders like companies to avoid excessive risks.

Now we understand one of the reasons why this is so. The bankruptcy laws.
vary widely from one country to another, but they all have the effect of destroying value
when lenders and other creditors compete with each other to receive payment. If a
company chooses projects with very high risks (but the expected returns do)
high enough to be above the efficient frontier in Figure 1.4
the probability of bankruptcy will be quite high. Lenders will recognize that the costs
expected bankruptcies are high and they charge very high interest rates. Therefore, the
shareholders will have the expected bankruptcy costs in the form of higher charges for
interests. To limit the scope of this, managers try to keep it low.
probability of bankruptcy.

When contemplating a new significant investment, it is important to consider

how well it fits with other risks taken by the company. The investments
relatively small often can have the effect of reducing overall risks
taken due to their diversification benefits. However, a large investment can
dramatically increase these risks. Many spectacular corporate failures
(like the one in "Business Overview" 1.1) can be traced back to CEOs who conducted
big acquisitions (often highly leveraged) that did not work.

Financial institutions
One can discuss the importance of bankruptcy costs for decision-making.
from a non-financial company, but there is no doubt that it is of vital importance for a
financial institution like a bank to keep its probability of bankruptcy very low.
Large banks rely on deposits and wholesale instruments, such as bonds.
commercials for their financing. Trust is the key to their survival. If the
The market perceives that the risk of default is different from very low, there will be a lack
Trust and funding sources will be depleted. The bank will be forced into liquidation.
even if it is solvent in the sense of having positive equity. Lehman Brothers was the
largest bankruptcy in the history of the United States. Northern Rock was a major
failure of a financial institution in the United Kingdom. In both cases, the failure was because
there was a lack of confidence and traditional sources of financing had dried up.

Regulation
Even if, despite the arguments we just made, the managers of a bank
they wanted to take big risks, they would not be allowed to do so. Unlike others
companies, many financial institutions are heavily regulated. Governments in
everyone wants a stable financial sector. It is important that companies and the
Individuals have confidence in banks and insurance companies when they make
business transactions. The regulations are designed to ensure that the
probability of a large bank or an insurance company experiencing difficulties
Severe financial crises are low. The rescues of financial institutions in 2008 during the
subprime crisis illustrates the reluctance of governments to allow large
failed financial institutions. Regulated financial institutions are required to
consider the total risks (systematic plus non-systematic).

Bankruptcy often arises from incurred losses. Regulators try to ensure

that the capital in the hands of a bank is sufficient to provide a cushion for
absorb the losses with a high probability. Let's assume, for example, that
it is considered that there is only a 0.1% probability that a financial institution will experience
a loss of $2 billion or more in a year. Regulators may require that the
the bank has a share capital of $2 billion.
This would guarantee that there is a 99.9% probability that the share capital is sufficient.
to absorb the losses. The models used by the regulators are discussed in more detail.
detail in later chapters.

The key point here is that regulators are concerned with total risks, not just
Systematic risks aim to make bankruptcy a highly unlikely event.

1.6 RISK MANAGEMENT BY FINANCIAL INSTITUTIONS

There are two broad risk management strategies available for a financial institution.
(or any other organization). One approach is to identify the risks one by one and
handle them each separately. This is sometimes known as risk decomposition.
The other is to reduce risks by being well diversified. This is sometimes referred to as aggregation of
risks.
Both approaches are typically used by financial institutions.

Consider, for example, the market risks incurred by the trading floor of a
bank.
These risks depend on future movements in a multitude of variables.
market (exchange rates, interest rates, stock prices, etc.). To implement the
risk decomposition approach, the negotiation room is organized in such a way that
an operator is responsible for operations related to a single variable of
market. (or perhaps a small group of market variables. For example, there could be
a trader who is responsible for all operations involving the rate of
dollar-yen exchange rate. At the end of each day, the trader must ensure that certain measures of
risk remains within the limits specified by the bank. If the end approaches
of the day and it seems that one or more of the risk measures will be out of limits
specified, the trader must obtain special permission to maintain the position o
execute new hedge operations so that the limits are met. (The measures of
risk and the way it is used are discussed in Chapter 8.)

Risk managers, who work in what is called a bank's headquarters,

they implement the risk aggregation approach for the market risks that are being
taking. This involves calculating at the end of each day the total risk faced by the bank
due to movements in all market variables Hopefully, the bank is doing well
diversified, so its global exposure to market movements is quite
small. If the risks are unacceptably high, then the must be determined
reasons and take corrective measures. The models used for risk aggregation
Market trends are presented in Chapters 12, 13, and 14.

The aggregation of risks is a key tool for insurance companies. It considers

the car insurance. The payment of the insurance company for an insurance policy of
The specific automobile is quite uncertain.. However, the payment of 100,000 policies of
Similar insurance can be predicted with reasonable accuracy.

Credit risks are also traditionally managed through aggregation of

risks. It is important for a financial institution to be well diversified.. Yes, for
example, a bank lends 40% of its available funds to a single borrower, it is not
well diversified and probably subject to unacceptable risks. If the borrower
facing financial difficulties and cannot make interest and principal payments,
the bank could declare itself insolvent.

If the bank adopts a more diversified strategy of lending 0.01% of its availability
funds for each of the 10,000 different borrowers are in a position
much safer. Suppose that the probability that any of the borrowers
defaulting is 1%. We can expect that about 100 borrowers will default in the
year and the losses in these borrowers will be more than compensated by the gains
obtained in 99% of loans that perform well. To maximize the
benefits of diversification, borrowers must be in different regions
geographical areas and different industries. It is likely that a large international bank with
different types of borrowers around the world are much more diversified than a
small bank in Texas that lends entirely to oil companies.

However, no matter how well diversified a bank is, it is still exposed to systematic risk, which
create variations in the default probability for all borrowers of a year
to another.
Let's suppose that the probability of default for borrowers in a year
the average is 1%. When the economy is doing well, the probability of
non-compliance is less than this and when there is an economic recession, it is likely that
It is considerably more than this. The models to capture this exposure are
discussed in later chapters.

Since the late 1990s, we have seen the emergence of an active market for
credit derivatives. Credit derivatives allow banks to manage risks of
one-by-one credit (risk decomposition) instead of relying solely on the
risk diversification. They also allow banks to purchase protection against the
general level of non-compliance in the economy. However, for each buyer of
credit protection must have a seller. Many credit protection sellers,
whether in individual companies or in company portfolios, they suffered enormous
losses during the credit crisis that began in 2007. The credit crisis is discussed
later in Chapter 6.

1.7 CREDIT RATINGS

Credit ratings provide information that is widely used by the
market participants for credit risk management. A rating
Credit quality is a measure of the creditworthiness of a debt instrument, such as a bond.
However, it is often assumed that the rating of a corporate or sovereign bond is
an attribute of the bond issuer instead of a bond itself. Therefore, if the bonds
issued by a company have a rating of AAA, it is often said that the
the company has a rating of AAA.

The three main credit rating agencies are Moody's, S&P, and Fitch. The best
the rating assigned by Moody's is Aaa. Bonds with this rating are considered
they have almost no possibility of default. The next best rating is Aa.
After that come A, Baa, Ba, B, Caa, Ca, and C. The corresponding S & P ratings for
Moody's Aaa, Aa, A, Baa, Ba, B, Caa, Ca and C are AAA, AA, A, BBB, BB, B, CCC, CC and C.
respectively. To create finer rating measures, Moody's divides the category
of rating Aa into Aa1, Aa2, and Aa3; divides A into A1, A2, and A3; and so on. Similarly, S&P
divide its rating category AA into AA+, AA, and AA-; divide its rating category A
in A +, A and A-; and so on. Moody's Aaa rating and S & P AAA rating do not
are subdivided, nor are they usually the two lowest grading categories. The categories
Fitch's ratings are similar to those of S&P.

It is generally assumed that there is an equivalence between the meanings of the

ratings assigned by different agencies. For example, a BBB + rating from S
& P is considered equivalent to a Baa1 rating from Moody's. Those with
Ratings below BBB- (Baa3) are referred to as non-investment grade or junk bonds.
speculative or junk bonds. (In August 2012, S & P caused a stir by downgrading the debt
from the U.S. government from AAA to AA+.
We will learn much more about credit ratings in later chapters of this.
book. For example, Chapter 6 discusses the role of ratings in the credit crisis.
that began in 2007. Chapters 15 and 16 provide information on how it
they use grades in regulation.

Chapter 19 provides statistics on business default rates

with different credit ratings. Chapter 21 examines the extent to which the
Credit ratings of companies change over time.

SUMMARY
An important general principle in finance is that there is a trade-off between risk and
return. Generally, higher returns can only be achieved if you take on more risks.
elevated.

In theory, shareholders should not worry about risks that can be diversified.

The expected return they require should reflect only the amount of systematic (it is
to say, non-diversifiable risk that they are experiencing.

Companies, although sensitive to the risk-return concessions of their shareholders,

they are concerned about the total risks when managing risks. They do not ignore
the unsystematic risk that its shareholders may diversify. A valid reason for
this is the existence of bankruptcy costs, which are the costs for shareholders that
result from the bankruptcy process itself.

For financial institutions such as banks and insurance companies, there is another reason
important: regulation. Financial institution regulators are concerned
mainly to minimize the likelihood of failure of the regulating institutions. The
The probability of failure depends on the total risks taken, not just on the risks.
that cannot be diversified by the shareholders. As we will see later in this
book, regulators seek to ensure that financial institutions maintain
sufficient capital for the total risks they are taking.

Two general approaches to risk management are risk decomposition and

risk aggregation. Risk decomposition involves managing risks one by one.
one. Risk aggregation implies relying on the power of diversification to reduce the
risks. Banks use both approaches to manage market risks. The
credit risks have traditionally been managed with risk aggregation, but with the
arrival of credit derivatives the risk decomposition approach can be
used.
QUESTIONS AND PRACTICE PROBLEMS
(ANSWERS AT THE END OF THE BOOK)

1.1 An investment has probabilities 0.1, 0.2, 0.35, 0.25, and 0.1 of yielding equal returns.
40%, 30%, 15%, -5% and -15%. What is the expected return and the standard deviation
about the returns?

1.2 Suppose there are two investments with the same probability distribution of
returns as in problem 1.1. The correlation between the returns is 0.15. What is
the expected return and the standard deviation of a portfolio's return
where money is divided equally among the investments?

1.3 For the two investments considered in Figure 1.2 and Table 1.2, what are the
combinaciones alternativas de riesgo-retorno si la correlación es (a) 0.3, (b) 1.0 y (c) -
1.0?

1.4 What is the difference between systematic risk and unsystematic risk? Which one is greater?
important for a capital investor? Which can lead to bankruptcy of a
corporation?

1.5 Summarize the arguments that lead to the conclusion that all investors should
to choose the same risky investment portfolio. What are the key assumptions?

The expected return of the market portfolio is 12% and the risk-free rate
It is 6%. What is the expected return of an investment with a beta of (a) 0.2, (b)
0.5 y (c) 1.4?

1.7 The arbitrage pricing theory is an extension of the asset pricing model.
capital" Explain this statement.

1.8 "The decision on a company's capital structure is a trade-off between the

bankruptcy costs and the tax advantages of debt." Explain this statement.

1.9 What is meant by risk aggregation and risk decomposition? Which one requires
a deep understanding of individual risks? Which requires knowledge
detailed correlations between the risks?

1.10 The operational risk of a bank includes the risk of very large losses due to
employee fraud, natural disasters, litigation, etc. Do you think the risk
operational is better managed through risk decomposition or aggregation
risks? (Operational risk will be discussed in Chapter 23.)
1.11 The bank's profit next year will be normally distributed with an average of
0.6% of the assets and a standard deviation of 1.5% of the assets. The capital of
the bank is 4% of the assets. What is the probability that the bank has a
positive net worth at the end of the year? Ignore the taxes.

1.12 Why do you think banks are regulated to ensure that they do not take
too many risks, but most of the other companies (for example, those of
manufacturing and retail sale) right?

1.13 List the bankruptcy costs incurred by the company in 'Business Snapshot'.
1.1”.

1.14 The market return last year was 10% and the risk-free rate was
5%. A hedge fund manager with a beta of 0.6 has an alpha of 4%.
What performance did the hedge fund manager achieve?

MORE QUESTIONS

1.15 Let's assume that an investment has an average return of 8% and a

standard deviation of return of 14%. Another investment has an average return
of 12% and a standard deviation of the return of 20%. The correlation between the
Returns is 0.3. Produce a graph similar to Figure 1.2 that shows combinations.
risk-return alternatives of the two investments.

1.16 The expected return in the market is 12% and the risk-free rate is
7%. The standard deviation of market return is 15%. An investor creates
a portfolio on the efficient frontier with an expected return of 10%. Another creates
a portfolio on the efficient frontier with an expected return of 20%. What is the
standard deviation of the return in each of the two portfolios?

A bank estimates that its profits next year will be normally distributed with
an average of 0.8% of the assets and a standard deviation of 2% of the assets.
How much capital (as a percentage of assets) does the company need to be (a)
99% sure that it will have a positive capital at the end of the year and (b) 99.9% sure that
Will it have a positive capital in the market? Year-end? Ignore taxes.

1.18 A portfolio manager has maintained an actively managed portfolio.

with a beta of 0.2. During the last year, the risk-free rate was 5% and the
main stock indexes performed very poorly, providing
yields of approximately -30%. The portfolio manager produced a
a -10% performance and claims that, given the circumstances, it is good. Discuss this.
complaint.