Unit 2

Introduction to
Risks II

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Unit 2 Topics
1. Risk vs Return dynamics
2. Identifying Risk Exposure
3. How to define Returns and measure
4. How to measure risks – Standard Deviation, Covariance and Probability
5. Enterprise Risk Management
6. Risk Based Supervision
7. FRM through Options, futures and derivative securities
8. Assessment of financial
1. Asset Risk
2. Interest Rate
3. Debt Securities
4. Value At Risk

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Risk vs Return
Risk vs. Return Dynamics refers to the fundamental investment principle that higher
potential returns generally come with higher risk, and lower risk typically comes with
lower expected returns .
The Risk-Return Trade-off
Risk: The chance that an investment's actual return will differ from the expected return. This
includes the possibility of losing some or all of the original investment.
Return: The gain or loss made on an investment, usually expressed as a percentage.
Risk vs Return Decision Factors
● Investor’s risk tolerance: Conservative vs. aggressive investor.
● Time horizon: Longer timeframes usually allow for more risk.
● Investment goals: Retirement, wealth preservation, income, etc.
● Diversification: Spreads risk and can improve the risk-return ratio.
How to Manage Risk
● Diversify across assets/sectors/regions.
● Use hedging tools (options, stop-loss).
● Rebalance portfolios regularly.
● Invest according to your goals and risk profile.

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Identifying Risk Exposure
Risk exposure refers to the potential for loss or harm due to uncertain events. It is typically
measured in terms of:
Likelihood (probability of occurrence)
Impact (magnitude of consequence)
Steps to Identify Risk Exposure
1. Understand the Context
Define goals, assets, and operations
Determine what’s critical to success or survival
2. Identify Potential Risks
Use methods like:
Brainstorming
SWOT analysis (Strengths, Weaknesses, Opportunities, Threats)
Risk checklists
Interviews with stakeholders
Historical data or industry benchmarks
3. Categorize Risks
Common risk categories include: Strategic/Financial/Operational/Compliance etc..

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Identifying Risk Exposure
4. Assess Likelihood and Impact
Use qualitative scales (e.g., high/medium/low)
Or quantitative models (e.g., expected loss = probability × impact)
5. Determine Risk Exposure
Map risks on a risk matrix (likelihood vs. impact)
Prioritize based on highest exposure
Tools & Techniques
● Risk Register – A document listing all identified risks and details
● Heat Maps – Visual representation of risk severity
● Scenario Analysis – Evaluate exposure under different future scenarios
● Monte Carlo Simulation – For complex quantitative risk modelling
Next Steps After Identification
● Evaluate the risk tolerance
● Implement mitigation strategies (avoid, transfer, reduce, accept)
● Monitor and review regularly

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Risk and Return: Lessons from Market History
Key Concepts and Skills
Know how to calculate the return on an investment
Know how to calculate the standard deviation of an
investment’s returns
Understand the historical returns and risks on various
types of investments
Understand the importance of the normal distribution
Understand the difference between arithmetic and
geometric average returns

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10-7
Chapter Outline
10.1 Returns
10.2 Holding-Period Returns
10.3 Return Statistics
10.4 Average Stock Returns and Risk-Free
Returns
10.5 Risk Statistics
10.6 More on Average Returns
10.7 The U.S. Equity Risk Premium: Historical and
International Perspectives
10.8 2008: A Year of Financial Crisis

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10-8
10.1 Returns
Dollar Returns
the sum of the cash received and Dividends
the change in value of the asset,
in dollars. Ending market
value

Time 0 1
Percentage Returns
–the sum of the cash received and the
Initial change in value of the asset, divided
investment by the initial investment.

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10-9
Returns
Dollar Return = Dividend + Change in Market Value

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10-10
Returns: Example
Suppose you bought 100 shares of XYZ Co. one
year ago today at $45. Over the last year, you
received $27 in dividends (27 cents per share × 100
shares). At the end of the year, the stock sells for
$48. How did you do?
You invested $45 × 100 = $4,500. At the end of the
year, you have stock worth $4,800 and cash
dividends of $27. Your dollar gain was $327 = $27
+ ($4,800 – $4,500).
Your percentage gain for the year is:
$327
7.3% =
$4,500
10-11
Returns: Example

Dollar Return:
$27
$327 gain
$300

Time 0 1
Percentage Return:
$327
-$4,500 7.3% =
$4,500

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10-12
10.2 Holding Period Return
The holding period return is the return that an
investor would get when holding an investment over
a period of T years, when the return during year i is
given as Ri:

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10-13
Holding Period Return: Example
Suppose your investment provides the following
returns over a four-year period:

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10-14
Historical Returns
A famous set of studies dealing with rates of returns on
common stocks, bonds, and Treasury bills was conducted
by Roger Ibbotson and Rex Sinquefield.
They present year-by-year historical rates of return
starting in 1926 for the following five important types of
financial instruments in the United States:
◦ Large-company Common Stocks
◦ Small-company Common Stocks
◦ Long-term Corporate Bonds
◦ Long-term U.S. Government Bonds
◦ U.S. Treasury Bills

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10-15
10.3 Return Statistics
The history of capital market returns can be
summarized by describing the:
◦ average return

◦ the standard deviation of those returns

◦ the frequency distribution of the returns

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10-16
Historical Returns, 1926-2014
Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 12.1% 20.1%

Small Company Stocks 16.7 32.1

Long-Term Corporate Bonds 6.4 8.4

Long-Term Government Bonds 6.1 10.0

U.S. Treasury Bills 3.5 3.1

Inflation 3.0 4.1

– 90% 0% + 90%

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10-17
10.4 Average Stock Returns and
Risk-Free Returns
The Risk Premium is the added return (over and above the
risk-free rate) resulting from bearing risk.
One of the most significant observations of stock market data
is the long-run excess of stock return over the risk-free return.
◦ The average excess return from large company common stocks for
the period 1926 through 2014 was:
8.6% = 12.1% – 3.5%
◦ The average excess return from small company common stocks for
the period 1926 through 2014 was:
13.2% = 16.7% – 3.5%
◦ The average excess return from long-term corporate bonds for the
period 1926 through 2014 was:
2.6% = 6.1% – 3.5%

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10-18
Risk Premiums
Suppose that The Wall Street Journal announced that
the current rate for one-year Treasury bills is 2%.
What is the expected return on the market of
small-company stocks?
Recall that the average excess return on small
company common stocks for the period 1926 through
2014 was 13.2%.
Given a risk-free rate of 2%, we have an expected
return on the market of small-company stocks of
15.2% = 13.2% + 2%

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10-19
The Risk-Return Tradeoff

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10-20
10.5 Risk Statistics
There is no universally agreed-upon definition of
risk.
The measures of risk that we discuss are variance and
standard deviation.
◦ The standard deviation is the standard statistical measure of
the spread of a sample, and it will be the measure we use
most of this time.
◦ Its interpretation is facilitated by a discussion of the normal
distribution.

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10-21
Normal Distribution
A large enough sample drawn from a normal
distribution looks like a bell-shaped curve.
Probability

The probability that a yearly return

will fall within 20.1 percent of the
mean of 12.1 percent will be
approximately 2/3.

– 3σ – 2σ – 1σ 0 + 1σ + 2σ + 3σ
– 48.2% – 28.1% – 8.0% 12.1% 32.2% 52.3% 72.4% Return on
large company common
68.26% stocks
95.44%

99.74%
10-22
Normal Distribution
The 20.1% standard deviation we found for large
stock returns from 1926 through 2014 can now be
interpreted in the following way:
◦ If stock returns are approximately normally distributed, the
probability that a yearly return will fall within 20.1 percent
of the mean of 12.1% will be approximately 2/3.

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10-23
Example – Return and Variance
Year Actual Average Deviation from the Squared Deviation
Return Return Mean
1 .15 .105 .045 .002025

2 .09 .105 -.015 .000225

3 .06 .105 -.045 .002025

4 .12 .105 .015 .000225

Totals .00 .0045

Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

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10-24
10.6 More on Average Returns
Arithmetic average – return earned in an average period
over multiple periods
Geometric average – average compound return per period
over multiple periods
The geometric average will be less than the arithmetic
average unless all the returns are equal.
Which is better?
◦ The arithmetic average is overly optimistic for long
horizons.
◦ The geometric average is overly pessimistic for short
horizons.

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10-25
Geometric Return: Example
Recall our earlier example:

So, our investor made an average of 9.58% per year, realizing a

holding period return of 44.21%.

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10-26
Geometric Return: Example
Note that the geometric average is not the same as the
arithmetic average:

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10-27
10.7 The U.S. Equity Risk Premium

Over 1926-2014, the U.S. equity risk premium has been

quite large:
◦ Earlier years (beginning in 1802) provide a smaller estimate
at 5.4%
◦ Comparable data for 1900 to 2010 put the international equity
risk premium at an average of 6.9%, versus 7.2% in the U.S.
Going forward, an estimate of 7% seems reasonable,
although somewhat higher or lower numbers could also be
considered rational

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10-28
Quick Quiz
Which of the investments discussed has had the
highest average return and risk premium?
Which of the investments discussed has had the
highest standard deviation?
Why is the normal distribution informative?
What is the difference between arithmetic and
geometric averages?

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10-29
Return and Risk: The Capital Asset Pricing
Model (CAPM)
Key Concepts and Skills
Know how to calculate expected returns
Know how to calculate covariances, correlations, and
betas
Understand the impact of diversification
Understand the systematic risk principle
Understand the security market line
Understand the risk-return tradeoff
Be able to use the Capital Asset Pricing Model

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10-31
Chapter Outline
11.1 Individual Securities
11.2 Expected Return, Variance, and Covariance
11.3 The Return and Risk for Portfolios
11.4 The Efficient Set for Two Assets
11.5 The Efficient Set for Many Assets
11.6 Diversification
11.7 Riskless Borrowing and Lending
11.8 Market Equilibrium
11.9 Relationship between Risk and Expected Return
(CAPM)

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10-32
11.1 Individual Securities
The characteristics of individual securities that are of
interest are the:
◦ Expected Return
◦ Variance and Standard Deviation
◦ Covariance and Correlation (to another security or index)

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10-33
11.2 Expected Return, Variance, and
Covariance
Consider the following two risky asset world. There
is a 1/3 chance of each state of the economy, and
the only assets are a stock fund and a bond fund.

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10-34
Expected Return

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10-35
Expected Return

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10-36
Variance

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10-37
Variance

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10-38
Standard Deviation

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10-39
Covariance

“Deviation” compares return in each state to the expected return.

“Weighted” takes the product of the deviations multiplied by the
probability of that state.

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10-40
Correlation

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10-41
11.3 The Return and Risk for
Portfolios

Note that stocks have a higher expected return than bonds

and higher risk. Let us turn now to the risk-return tradeoff
of a portfolio that is 50% invested in bonds and 50%
invested in stocks.

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10-42
Portfolios

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:

10-43
Portfolios

The expected rate of return on the portfolio is a weighted

average of the expected returns on the securities in the
portfolio.

10-44
Portfolios

The variance of the rate of return on the two risky assets

portfolio is

where ρBS is the correlation coefficient between the returns

on the stock and bond funds.

10-45
Portfolios

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than either stocks or bonds held
in isolation. This is not always the case.

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10-46
11.4 The Efficient Set for Two
Assets

100%
stocks

100%
bonds

We can consider other

portfolio weights besides
50% in stocks and 50% in
bonds.
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10-47
The Efficient Set for Two Assets

100%
stocks

100%
bonds

Note that some portfolios are

“better” than others. They have
higher returns for the same level of
risk or less.
10-48
Portfolios with Various Correlations
retur

100%
ρ = -1.0 stocks
n

ρ = 1.0
100%
ρ = 0.2
bonds

Relationship depends on σcorrelation coefficient

-1.0 < ρ < +1.0
If ρ = +1.0, no risk reduction is possible
If ρ = –1.0, complete risk reduction is possible

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10-49
11.5 The Efficient Set for Many
Securities

return

Individual
Assets

σP
Consider a world with many risky assets; we can still identify
the opportunity set of risk-return combinations of various
portfolios.

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10-50
The Efficient Set for Many Securities

return
tie r
f r o n
nt
cie
effi
minimum
variance
portfolio

Individual Assets

σP

The section of the opportunity set above the minimum

variance portfolio is the efficient frontier.

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10-51
Announcements, Surprises, and
Expected Returns
The return on any security consists of two parts.
◦ First, the expected returns
◦ Second, the unexpected or risky returns
A way to write the return on a stock in the coming month
is:

10-52
Announcements, Surprises, and
Expected Returns
Any announcement can be broken down into two parts,
the anticipated (or expected) part and the surprise (or
innovation):
◦ Announcement = Expected part + Surprise.
□ The expected part of any announcement is the part of the
information the market uses to form the expectation, R, of the
return on the stock.
□ The surprise is the news that influences the unanticipated return
on the stock, U.

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10-53
Diversification and Portfolio Risk
Diversification can substantially reduce the variability
of returns without an equivalent reduction in expected
returns.
This reduction in risk arises because worse than
expected returns from one asset are offset by better
than expected returns from another.
However, there is a minimum level of risk that cannot
be diversified away, and that is the systematic
portion.

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10-54
Portfolio Risk and Number of Stocks

In a large portfolio the variance terms are

σ effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
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10-55
Risk: Systematic and Unsystematic
A systematic risk is any risk that affects a large number of
assets, each to a greater or lesser degree.
An unsystematic risk is a risk that specifically affects a single
asset or small group of assets.
Unsystematic risk can be diversified away.
Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
On the other hand, announcements specific to a single
company are examples of unsystematic risk.

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10-56
Total Risk
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure of total
risk.
For well-diversified portfolios, unsystematic risk is
very small.
Consequently, the total risk for a diversified portfolio
is essentially equivalent to the systematic risk.

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10-57
Optimal Portfolio with a Risk-Free
Asset
return 100%
stocks

rf
100%
bonds

σ
In addition to stocks and bonds, consider a world that also
has risk-free securities like T-bills.

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10-58
11.7 Riskless Borrowing and
Lending

return
L
CM 100%
stocks
Balanced
fund

rf
100%
bonds
σ
Now investors can allocate their money across the
T-bills and a balanced mutual fund.

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10-59
Riskless Borrowing and Lending

return
L
CM efficient frontier

rf
σP

With a risk-free asset available and the efficient frontier

identified, we choose the capital allocation line with the
steepest slope.
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10-60
11.8 Market Equilibrium

return
L
CM efficient frontier

rf

σP
With the capital allocation line identified, all investors choose a point
along the line—some combination of the risk-free asset and the market
portfolio M. In a world with homogeneous expectations, M is the same
for all investors.
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10-61
Market Equilibrium

return L
CM 100%
stocks
Balanced
fund

rf
100%
bonds

σ
Where the investor chooses along the Capital Market Line depends
on her risk tolerance. The big point is that all investors have the
same CML.
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10-62
Risk When Holding the Market
Portfolio
Researchers have shown that the best measure of the
risk of a security in a large portfolio is the beta (β) of
the security.
Beta measures the responsiveness of a security to
movements in the market portfolio (i.e., systematic
risk).

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10-63
Estimating β with Regression

Security Returns
i ne
L
s t ic
te ri
a c
a r
h
C Slope = βi
Return on
market %

Ri = α i + β i Rm + e i

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10-64
The Formula for Beta

Clearly, your estimate of beta will depend

upon your choice of a proxy for the market
portfolio.

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10-65
11.9 Relationship between Risk
and Expected Return (CAPM)

Expected Return on the Market:

• Expected return on an individual security:

Market Risk Premium

This applies to individual securities held within
well-diversified portfolios.
10-66
Expected Return on a Security
This formula is called the Capital Asset Pricing
Model (CAPM):

Expected
Risk-fre Beta of the Market risk
return on = + ×
e rate security premium
a security

• Assume βi = 0, then the expected return is RF.

• Assume βi = 1, then

10-67
Relationship Between Risk &
Return
Expected return

1.0 β

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10-68
Relationship Between Risk &
Return
Expected
return

1.5 β

10-69
Quick Quiz
How do you compute the expected return and
standard deviation for an individual asset? For a
portfolio?
What is the difference between systematic and
unsystematic risk?
What type of risk is relevant for determining the
expected return?
Consider an asset with a beta of 1.2, a risk-free rate of
5%, and a market return of 13%.
◦ What is the expected return on the asset?

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10-70
Enterprise Risk Management
Enterprise Risk Management (ERM) is a structured, comprehensive approach to identifying, assessing, managing,
and monitoring risks across an organization to maximize value and achieve strategic objectives.
ERM is defined by COSO (Committee of Sponsoring Organizations of the Treadway Commission) as:
"The culture, capabilities, and practices, integrated with strategy-setting and performance, that organizations rely on to
manage risk in creating, preserving, and realizing value."
According to the COSO ERM Framework, the core components are:
1. Governance and Culture
● Tone at the top
● Risk governance and oversight
● Organizational culture and values
2. Strategy and Objective-Setting
● Risk appetite alignment
● Strategic planning integrated with risk consideration
3. Performance
● Identifying and assessing risks that impact performance
● Risk response strategies
● Monitoring performance and risk tolerance
4. Review and Revision
● Monitoring for changes in internal and external environments
● Continuous improvement in risk practices
5. Information, Communication, and Reporting
● Timely and relevant risk data
● Transparent reporting to stakeholders

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Enterprise Risk Management
Goals of ERM
● Identify and assess risk proactively
● Align risk appetite with strategy
● Improve decision-making and performance
● Enhance resilience to disruptions
● Protect and create value for stakeholders

Benefits of ERM
● Better strategic alignment
● Stronger corporate governance
● Enhanced regulatory compliance
● Improved operational efficiency
● Reduced losses and surprises

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Risk Based Supervision
Risk-Based Supervision (RBS) is a supervisory approach used by regulators (especially in financial sectors like
banking and insurance) to allocate supervisory resources based on the risk profile and systemic importance of
institutions. Instead of applying uniform oversight to all entities, RBS focuses more on entities that pose greater risks to
the system.

Key Principles of Risk-Based Supervision

● Risk Focus
Prioritizes supervisory attention on areas where the risks are greatest.
● Proportionality
Supervision is scaled to the size, complexity, and risk exposure of the entity.
● Forward-looking
Identifies emerging and potential risks before they become problems.
● Judgment-based
Involves qualitative assessments and the professional judgment of supervisors.
Core Components of RBS
● Risk Identification: Understanding the internal and external risks faced by an institution (e.g., credit risk, market
risk, operational risk).
● Risk Assessment
● Evaluating the severity and likelihood of identified risks.
● Often includes reviewing the institution’s governance, internal controls, and capital adequacy.
● Supervisory Planning: Based on the risk assessment, regulators decide the level of supervisory intensity and the
frequency of reviews.
● Monitoring and Intervention: Ongoing surveillance and timely interventions to mitigate risk escalation.

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Risk Based Supervision
Applications in Sectors
Sector Application of RBS
Basel II/III frameworks encourage RBS by requiring banks
Banking
to assess and hold capital against their risks.
Solvency II in the EU adopts RBS to ensure insurers
Insurance
manage their risks effectively.
Supervisory attention is given to funds that are
Pensions
underfunded or have weak governance.

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Risk Based Supervision
Benefits of RBS
● Efficient allocation of supervisory resources.
● Encourages better risk management in firms.
● Enables early detection and mitigation of systemic risks.
● More flexible and adaptable to changes in the financial landscape.

Challenges of RBS
● Requires skilled supervisors capable of making informed judgments.
● Relies heavily on the availability and quality of data.
● Potential for regulatory capture or inconsistent assessments.
● Dynamic and Emerging Risks Are Hard to Capture - Emerging risks like cyber threats,
climate risk, or fintech innovations evolve rapidly and may not be captured in traditional
RBS frameworks.

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FRM through Options/Futures/Derivative
Securities
Financial risk management involves identifying, analyzing, and mitigating uncertainty in investment
decisions. Derivative securities such as options, futures, forwards, and swaps play a central role in
this process.

Derivatives are financial instruments whose value is derived from an underlying asset (e.g., stocks,
bonds, commodities, currencies, interest rates).
Main Types of Derivatives:
● Options: Contracts that give the right, but not the obligation, to buy/sell an asset at a specific
price before a certain date.
● Futures: Standardized contracts to buy/sell an asset at a future date at a predetermined price.
● Forwards: Similar to futures but customized and traded over-the-counter (OTC).
● Swaps: Agreements to exchange cash flows or financial instruments (e.g., interest rate swaps).

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FRM through Options/Futures/Derivative
Securities
OPTIONS
Options are contracts that give the buyer the right, but not the obligation, to buy or sell an asset at a predetermined
price (called the strike price) before or at a specific date (expiration date).
Call Option: Right to buy the underlying asset.
Put Option: Right to sell the underlying asset.
Long Position: Expectation that Stock value will rise in future. A long position means an investor has bought and owns
shares of stock. You buy an asset (stock, option, etc.) expecting its price to rise. Think: “Buy low, sell high.”
Short Position: Expectation that Stock value will decrease in future. You sell an asset (usually borrowed) expecting its
price to fall, so you can buy it back cheaper later. Think: “Sell high, buy low.”

Key Concepts in Options

Term Meaning
The agreed-upon price at which the asset can be
Strike Price
bought or sold.
Premium The price paid for the option.
Expiration Date The date the option expires.
In-the-Money An option that would be profitable if exercised now.

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FRM through Options/Futures/Derivative
Securities
Real-Time Example – Stock Option (Call)
Scenario: Reliance Industries (RIL)
● Current stock price: ₹2,800
● You buy a Call Option with:
● Strike Price: ₹2,900
● Premium: ₹20
● Expiry: 1 month
Case 1: Stock goes up to ₹3,000
● You exercise the option: Buy at ₹2,900 and sell at ₹3,000
● Profit = ₹100 - ₹20 (premium) = ₹80 per share
Case 2: Stock stays at ₹2,800
● You don’t exercise (buying at ₹2,900 is costlier)
● You lose the premium: ₹20 per share
Scenario: TCS Ltd.
● Current stock price: ₹3,600
● You buy a Put Option with:
● Strike Price: ₹3,500
● Premium: ₹25
Case 1: Stock falls to ₹3,300
● You sell at ₹3,500 and buy back at ₹3,300
● Profit = ₹200 - ₹25 = ₹175 per share
Case 2: Stock rises to ₹3,700
● You let the option expire
● Loss = Premium paid = ₹25

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FRM through Options/Futures/Derivative
Securities
Uses of Options in Risk Management
1. Hedging Price Risk
Options protect against adverse price movements while preserving upside potential.
Example:
An investor owns a stock and buys a put option.
If the stock falls, the put increases in value, offsetting the loss.
If the stock rises, the investor benefits from the appreciation.
2. Income Enhancement
Covered Call Strategy: Sell a call option on a stock you own to earn premium income. Reduces upside potential but provides
downside cushion.
3. Volatility Management
Use straddles or strangles to hedge against unexpected volatility in an asset’s price.
Useful when direction of the move is uncertain but volatility is expected. Straddle - Buy (or sell) a call and put with the same
strike price and same expiry. Strangle - Buy (or sell) a call and put with different strike prices (typically
out-of-the-money), same expiry.
4. Protecting Portfolios (Portfolio Insurance)
Buying index put options can act as insurance for large portfolios, especially during uncertain market conditions.
● Index put options are financial derivatives that give the buyer the right, but not the obligation, to sell a specific stock market
index (like the S&P 500, Nifty 50, Dow Jones) at a predetermined price (strike price) before a certain expiration date.
● In insurance and risk management, index put options are used as a hedge or protection against losses due to a
decline in the value of an investment portfolio that tracks that index. This is often called portfolio insurance.
What is an Index?
● An index is a number representing the overall performance of a group of stocks.
● Examples: S&P 500, Nifty 50, Dow Jones.
● You cannot physically buy or sell the index itself because it's just a calculated number, not a tangible asset.
5. Currency and Interest Rate Risk
Corporations use options on currencies or interest rates to hedge exposure from international operations or floating-rate debt.

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FRM through Options/Futures/Derivative
Securities
Advantages of Options in Risk Management
Asymmetry: Limited downside (premium) with unlimited upside (for call options).
Flexibility: Can create custom strategies for various market views.
Leverage: Control large positions with a small upfront investment.
Common Option-Based Hedging Strategies
Risks and Challenges
Premium Cost: Options can be expensive, especially in volatile markets.
Complexity: Strategies like straddles require expertise.
Time Decay: Options lose value as they approach expiration (theta risk).
Incorrect Hedging: Poorly structured options can increase risk.

Common Option-Based Hedging Strategies

Strategy Description Use Case

Protective Put Buy a put option on an asset you own Protect against price drops
Covered Call Sell a call on an asset you own Generate income
Buy a put and sell a call on the same
Collar Limit both downside and upside
asset
Long Straddle Buy both call and put at same strike Hedge against volatility (both sides)
Long Strangle Buy call and put at different strikes Similar to straddle, cheaper premiums

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FRM through Options/Futures/Derivative
Securities
Real-World Company Examples
Southwest Airlines – Fuel Hedging (Options on Oil)
Used oil call options to hedge against rising fuel prices.
Locked in lower prices during times of market volatility.
Saved hundreds of millions in costs during high oil price periods.
Apple Inc. – FX Hedging
Apple uses currency options to hedge against exchange rate fluctuations due to its international revenue streams.
For example, it uses put options on foreign currencies to protect USD earnings when foreign currencies weaken
Boeing – Risk Management with Options
Boeing uses options on interest rates and foreign currencies to protect revenue from plane sales in different
markets.
This smooths their income regardless of macroeconomic movements.

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FRM through Options/Futures/Derivative
Securities
Forward Contract:
A forward contract is a customized agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon
today. It’s a type of derivative, meaning its value is derived from the underlying asset.
Key Features:
Custom Terms: Unlike standardized futures, forward contracts are private agreements tailored to the specific needs of the buyer and seller.
No Initial Payment: Typically, no money changes hands when the contract is created.
Settlement at Maturity: The contract is settled at the end of the term, either through physical delivery or cash settlement.
Traded Over-the-Counter (OTC): Not traded on exchanges, which makes them more flexible but also exposes both parties to counterparty
risk.
Example:
Suppose a wheat farmer and a bread company agree today (in July) that the company will buy 1,000 bushels of wheat from the farmer at $5.00
per bushel in December.
If the market price in December is $4.50, the buyer (bread company) loses out by paying more.
If the market price is $5.50, the seller (farmer) misses out on a higher price.
But both sides benefit from price certainty.
Common Use Cases:
Hedging: Businesses use forward contracts to lock in prices and reduce exposure to price fluctuations (e.g., commodities, currencies, interest
rates).
Speculation: Investors may enter forward contracts to profit from expected price movements.

Pros and Cons:

Advantages:
Customizable (terms, amounts, delivery)
Hedging against future price uncertainty
No upfront cost
Disadvantages:
Counterparty risk - Counterparty risk is the risk that the other party in a financial contract will default — meaning they won’t fulfill their
side of the agreement.
Illiquidity (hard to transfer/sell)
No regulatory oversight (unlike futures)

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FRM through Options/Futures/Derivative
Securities
Futures:
Futures are standardized financial contracts that obligate the buyer to purchase (or the seller to sell) an asset at a predetermined price on a
specific future date.
They are traded on organized exchanges like the Chicago Mercantile Exchange (CME).

Feature Description
Contract terms (quantity, quality, delivery date) are fixed by the
Standardized
exchange.
You only need to post a margin (a small percentage of the contract
Leverage
value), making it capital-efficient.
Can be physical (actual delivery of the asset) or cash-settled (just
Settlement
the difference in price).
Mark-to-Market Profits and losses are settled daily based on market price changes.

Example: Crude Oil Futures

A crude oil futures contract might represent 1,000 barrels.
If you buy it at $80/barrel, the contract value is $80,000.
If oil rises to $85, and you sell the contract, you've made a $5,000 gain (minus fees).
Who Uses Futures?
1. Hedgers
Use futures to protect against price changes.
Example: A wheat farmer locks in a selling price before harvest.
2. Speculators
Bet on the price going up or down to profit.
Don’t intend to take delivery — just want the price movement.
3. Arbitrageurs
Exploit price differences between markets to make risk-free profits.

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FRM through Options/Futures/Derivative
Securities
Risks in Futures Trading
● Leverage risk: High potential for both gains and losses.
● Liquidity risk: Not all contracts have deep markets.
● Basis risk: The futures price may not perfectly track the spot price.
● Margin calls: Daily losses may require additional funds.

Type Examples
Commodity Futures Oil, gold, wheat, coffee
Financial Futures S&P 500, bonds, interest rates
Currency Futures EUR/USD, JPY/USD, etc.
Volatility Futures VIX index

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Assessment of Asset Risk
Financial asset risk refers to the possibility that the value of a financial asset (such as stocks, bonds, real estate, or derivatives) may decrease
or fail to perform as expected, leading to a loss for the investor. There are various types of risks associated with financial assets, including:
Market Risk
Definition: The risk of losses due to changes in market prices.
Examples:
Equity risk: Changes in stock prices.
Interest rate risk: Changes in interest rates affecting bond values.
Currency risk: Impact of exchange rate fluctuations on international investments.
Commodity risk: Price changes in commodities like oil, gold, etc.
Credit Risk
Definition: The risk that a borrower will default on a loan or bond.
Example: A company fails to pay back bondholders.
Liquidity Risk
Definition: The risk that an asset can't be sold quickly enough in the market without a substantial price reduction.
Example: A real estate investment taking months to sell, possibly at a lower value.
Operational Risk
Definition: Risk of loss from failed internal processes, people, systems, or external events.
Example: Fraud, system failures, or mismanagement.
Inflation Risk
Definition: The risk that inflation will erode the purchasing power of returns.
Example: A fixed-income bond yielding 3% when inflation rises to 5% results in a negative real return.
Reinvestment Risk
Definition: The risk that future cash flows (like bond coupons) will be reinvested at lower interest rates. It’s the risk that when you get money
back from an investment, you won’t find another investment offering the same or better returns.
Example: A bond paying 6% matures and new bonds only offer 3%.
Political or Regulatory Risk
Definition: Risk arising from changes in laws, regulations, or political events.
Example: Government imposes capital controls or changes tax policies affecting investments.

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Assessment of Interest Rate Risk
Interest rate risk is the potential for investment losses that result from a change in interest rates. It's a key concern for
both individual investors and financial institutions, particularly those with fixed-income investments like bonds.
Types of Interest Rate Risk
● Price Risk: When interest rates rise, the market value of existing bonds falls. This happens because new bonds
offer higher yields, making older ones less attractive.
● Reinvestment Risk: When interest rates fall, the income from an investment (e.g., bond coupon payments) may
have to be reinvested at lower rates.
Who Faces Interest Rate Risk?
● Bondholders: Price of bonds falls when interest rates rise.
● Banks and Lenders: Interest rate changes can affect loan profitability.
● Insurance Companies and Pension Funds: Changes in rates can impact long-term liabilities and returns.
● Homeowners with Variable-Rate Mortgages: Payments may rise if interest rates increase.
Measurement Tools
● Duration: Estimates how much a bond’s price will change with a 1% change in interest rates.
● Convexity: Refines duration by accounting for the curvature in the price-yield relationship.
● Value at Risk (VaR): Estimates potential losses due to interest rate moves over a given time period.
Strategies to Manage Interest Rate Risk
● Diversification: Spread investments across different maturities and asset classes.
● Duration Matching: Match asset and liability durations to reduce exposure.
● Interest Rate Swaps: Exchange fixed-rate payments for floating-rate payments (or vice versa).
● Use of Derivatives: Futures, options, and swaps can help hedge risk.

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Assessment of Debt Securities Risk
Debt Securities Risk refers to the potential for loss associated with investing in debt instruments such as bonds, notes, or debentures. While typically
considered lower risk than equities, debt securities are not risk-free. Here are the main types of risks associated with debt securities:
1. Credit Risk (Default Risk)
Definition: The risk that the issuer will fail to make interest payments or repay the principal.
Example: A corporate bond issued by a company with poor financial health may default.
2. Interest Rate Risk
Definition: The risk that rising interest rates will cause the market value of existing bonds to fall.
Example: If interest rates increase, newer bonds offer higher yields, making existing bonds with lower rates less attractive.
3. Reinvestment Risk
Definition: The risk that future cash flows (interest or principal) will have to be reinvested at lower interest rates.
Example: If interest rates fall, coupon payments may be reinvested at lower rates, reducing overall return.
4. Inflation Risk
Definition: The risk that inflation will erode the purchasing power of the bond’s future payments.
Example: A fixed-rate bond paying 3% annually may become unattractive if inflation rises to 5%.
5. Liquidity Risk
Definition: The risk that the investor may not be able to sell the debt security quickly without affecting its price.
Example: A municipal bond from a small issuer may not have an active secondary market.
6. Call Risk (Prepayment Risk)
Definition: The risk that a bond may be repaid (called) before maturity, especially when interest rates fall.
Example: Callable bonds may be redeemed early by the issuer to refinance at lower rates, reducing expected interest income.
7. Market Risk
Definition: The risk of bond price volatility due to overall market fluctuations.
Example: Economic downturns, geopolitical tensions, or investor sentiment shifts can impact bond prices.
8. Currency Risk (for international bonds)
Definition: The risk that changes in exchange rates will affect the value of bond payments when converted to your home currency.
Example: A U.S. investor holding a Japanese government bond may lose money if the yen weakens against the dollar.
Managing Debt Securities Risk:
● Diversify across issuers, sectors, and maturities.
● Use bond ratings (e.g., Moody’s, S&P) to gauge creditworthiness.
● Consider bond ladders to manage interest rate and reinvestment risk.
● Hedge currency exposure if investing internationally.

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Value At Risk
Value at Risk (VaR) is a risk management tool used to estimate the potential loss in value of an asset or portfolio over a defined period for a given confidence
interval. It's widely used by banks, investment firms, and corporations to measure and control financial risk.
Value at Risk (VaR) answers the question: "How much could I lose on this investment, in normal market conditions, over a set time period, with a certain level
of confidence?“
Key Components
● Time Horizon – The period over which the risk is assessed (e.g., 1 day, 10 days, or 1 month).
● Confidence Level – The probability that the loss will not exceed the VaR (e.g., 95% or 99%).
● Loss Amount – The estimated amount that could be lost.
Example
Let’s say a portfolio has a 1-day 95% VaR of $1 million.
This means:
There is a 5% chance the portfolio could lose more than $1 million in one day.
There is a 95% chance it will lose less than $1 million.
Methods to Calculate VaR
Historical Simulation
Uses actual past returns to simulate possible future losses.
Simple and does not assume normality.
Variance-Covariance (Parametric Method)
Assumes returns are normally distributed.
Uses the mean and standard deviation of returns.
VaR=Z⋅σ⋅t
where:
Z = Z-score for confidence level (e.g., 1.65 for 95%)
σ = standard deviation (volatility)
t = time horizon
Monte Carlo Simulation
Uses random sampling and probability distributions to simulate a wide range of possible outcomes.
Limitations of VaR
● Does not predict extreme losses (only tells you how bad things might get most of the time, not worst-case).
● Assumes normal market conditions.
● Not additive across portfolios in all cases (can misrepresent risk when aggregating).

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Value At Risk
Real-World Example: Equity Portfolio
● Let’s say an investment bank has a portfolio of ₹100 crore in Indian equities.
● The bank uses historical price data and risk models to estimate risk.
VaR Statement (Example):
"With 95% confidence, the bank could lose up to ₹5 crore in a single day.“
What This Means:
● There is a 95% chance that losses will not exceed ₹ 5 crore in a day
● There is a 5% chance that losses could exceed ₹5 crore
Suppose:
● Portfolio value: ₹100 crore
● Daily standard deviation of returns: 1.5%
● Confidence level: 95% (Z-score = 1.65)

VaR = Z × σ × Portfolio Value

● → VaR = 1.65 × 1.5% × ₹100 crore
→ VaR = ₹2.475 crore

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Capital adequacy risk – Will be Covered in Unit 3
Operational risks in banks – Will be Covered in Unit 4
Basel II committee recommendations – Will be Covered in Unit 3

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