Financial Risk Management
Nguyen Thi Tuyet Mai, MSc International Finance Department Faculty of Banking and Finance Email: [Link]@[Link]
Module Outline
Chapter 1: Introduction to Financial risk management Chapter 2: Future and Forward Contract Chapter 3: Option Contract Chapter 4: Swap Contract
Textbook
Options, Futures and other derivatives
by John Hull
Investment by Bodie, Kane and Marcus
Assessment
Attendance: Comprises of 10% of Final
mark: assessed by in-class exercise. Mid-term test: Comprises of 30% of Final mark: assessed by Exercise Final exam: Comprises of 60% of Final mark
Chapter 1: Introduction to Financial risk management
Outline:
Real assets vs. financial assets Risk and return of financial assets Objectives of financial risk management Financial risk management instruments
1. Real assets and financial assets
The material wealth of a society is determined ultimately by
the productive capacity of its economy a function of the real assets of the economy. In contrast, financial assets (such as bonds, stocks) contribute to the productive capacity indirectly by allowing for separation of the ownership and management of the firm and facilitating the transfer of funds to enterprise. Financial assets are claims to the income generated by real assets or income from the government.
1. Real assets and financial assets
Real assets always appear on the asset side of the firms
balance sheet whereas, financial assets can appear on both side of the balance sheet. Financial assets will cancel out, leaving only the sum real assets as the net wealth of the aggregate economy. => Financial risk management FOCUS on financial assets
Questions
Are the following real assets or financial assets?
[Link] [Link] obligations [Link] goodwill 4.A college education 5.A $100 T-bill
2. Rate of return and risks
Rate of return of an investment/ a financial asset, is also
called Holding-period return, is the percentage gain or loss of an investment over a period of time. HPR will depend on the price you expect to prevail one year from now and associated cash flows during the holding period. Risk means uncertainty about future rate of return => Risk and return are two important criteria to measure the efficiency of an investment
2.1 Rate of return
Holding-period return (HPR) is defined as the capital gain
income plus dividend income per dollar invested in the stock at the start of the period:
HPR= Ending price of share beginning price + cash
dividend Beginning price of share
Example
You are considering investing in a stock with the current
price is $100. At the moment, the current dividend yield is 4%, which means you may receive $4 as dividend at the end of the holding period. The expected price of this stock after 6 months is $110. Calculate the HPR of the stock?
2.1 Rate of return
The rate of return comes from 2 sources of income:
- Capital gain - Income gain (dividend income or interest income) The above HPR is calculated based on the exact holding period. To compare HPR with current interest rate, we need to adjust HPR to express the return in a specific period.
2.1 Rate of return
Equivalent compounding rate of return in 1 year:
(1 + ra ) compounding annual rate of 1 = HPR Where: Ra: equivalent
return
n = T/12 or T/360 T: Holding period
o
2.1 Rate of return
Equivalent compounding rate of return in a specific
period of time m (in 1 month, 1 quarter ):
m Where: Rm: equivalent compounding rate of return
(1 + r ) 1 = HPR
t
t = T/m T: Holding period
2.1 Rate of return
Equivalent continuously compounding rate of return
during the holding period:
Or
e = HPR + 1
r
r = ln(1 + HPR )
2.1 Rate of return
Convert from compounding rate of return and
continuous rate of return:
=>
rm rc 1 + = e m
rm rc = m ln1 + m
rm = m(e
rc / m
1)
Example 1
Investor A purchased stock STB in January 2010 at the
price of 16,000 VND. In June 2010, he received a cash dividend of 2,000 VND. At the moment, he expects that by September 2011, the stock price will increase to 20,000 VND. Calculate the holding period return of this investment? Calculate equivalent annually compounding rate of return, monthly compounding rate of return, continuously compounding rate of return?
Example 2
David is considering investing in stock VNM. The stock
current price (on 18/8/2011) is 120,000 VND. He expects the the dividend yield of VNM would be 5% and the stock price on 20/2/2012 will be 128,000 VND. Calculate the holding period return of VNM Calculate the annually, monthly and continuously compounding rate of return
Example 3
Compare the two above investment
opportunities. Which stock will you choose to invest?
Example 4
VCB quote the interest rate for saving deposit 3 months
term is 14%. The interest rate for 1 month term is 13.5%. If you are customer, which term will you choose for your deposit? Calculate the equivalent continuous rate of return for these 2 investments
2.1 Rate of return
When investing in financial assets, investor must
consider the inflation rate effect on the rate of return => the real rate of return:
or
rn = (1 + rr )(1 + inf) 1
rn = rr + inf
2.2 Risk
When calculating HPR, we assume that the expectation of
investor will become true after the holding period. However, the fact is that there is considerable uncertainty about the price of stock at the end of holding period => financial risk: uncertainty about the value received at the end of investment interval.
2.2 Risk
To measure the risk, standard deviation is used. First, we calculate the average rate of return for the
defined period:
R = Ri / n
n
i= 1
R = Ri *Wi
2.2 Risk
Risk is the standard deviation of return from
the average rate of return:
i= 1 1 ( Ri R ) 2 ( N 1) N
Example
Calculate the average return and risk of the
following investment:
Month Rate of return
1 2 3 4 5 6
+0,8% +0,6% +1,8% -0,7% +0,3% -0,1%
2.3 Rate of return and risk of financial assets
For the bond:
- Price of bond: T 1 F PB = C + i T (1 + r ) i =1 (1 + r ) - Rate of return of the bond: is the YTM (r). - Risk of bond: measure by the duration
Example 1
Pricing the bond with the following
information: Par value: $100,000 Time to maturity: 10 years Coupon rate: 8%/annual, paid semiannual Current YTM: 6%
Calculate the duration of this bond
2.4 Expected rate of return and risk
In some situations, analysts may guess the price of
financial asset in terms of possible scenarios of the economy. Called p is the probability weighted average of the rate of return in each scenario and r is the HPR in each scenario, expected rate of return is:
E ( R) = p1 R1 + p 2 R2 + .... + p n Rn
2.4 Expected rate of return and risk
We may derive the expected rate of return
of financial asset using CAPM model:
E ( R ) = R f + ( E ( Rm ) R f )
Example
Consider the following investment estimate: Calculate expected return and risk?
2.4 Rate of return and risk of a portfolio
Rate of return of the portfolio with 2 financial
assets:
Risk of the portfolio:
2 p 2 A 2 A 2 B
R p = R AW A + RBWB
2 B
= W + W + 2WAWB A B AB
Example 1
Consider the following portfolio: No of assets: 2 financial assets A and B A has the rate of return is 15% and standard
deviation is 30% B has the rate of return is 12% and standard deviation is 20% Weight of A in the portfolio is 40%. The correlation coefficient between A and B is 0.6. Calculate the rate of return and risk of this portfolio?
2. Rate of return and risks
Risk and return can be considered as revenue and cost in
business, so as to achieve return, you must accept the risk. Most investors seek for opportunities which yield high return with low risk For risk-averse investors, for 2 opportunities with the same level of risk, they preferred the investment with higher return For 2 opportunities with the same level of return, they preferred the investment with lower risk
If you invest $1 in 1926
Real return of $1 in 1926
Rate of return of investment
-50 to -40 -40 to -30 -30 to -20 -20 to -10
13
-10 to 0
11
0 to 10 10 to 20 20 to 30 30 to 40
40 to 50 50 to 60
13 12 11 10 9 8 7 6 5 4 3 2 1 0
Rate of return distribution of stock market
1 4 13 12 13 3
3. Objectives of financial risk management
Main objective is to reduce the variation of
the firms future cash flow to stabilise financial activities Mathematically, risk management is to reduce the standard deviation of investments return or future cash flow. Risk management includes identification of risk, risk measurement, risk evaluation, planning the risk management strategies and implementation.
Impact of Financial Risk Management on Cash Flow Volatility
Likelihood
Ca sh Flow
4. Financial derivative markets
Financial derivative is a financial instrument
whose characteristic and value depend upon the characteristics and value of an underlying asset, typically a commodity bond, equity or currency Derivative instruments can be used to manage the risk associated with the underlying assets, to protect against fluctuations in value. Derivative instruments including: - Forward contract - Future contract - Option contract - Swap contract
4. Financial Derivative markets
Derivative markets can be divided into:
- Exchange market: Market where all the contracts are standardised based on the regulation of exchange center. - OTC market: Buyer and seller can negotiate directly about all the terms and conditions of the contract. => OTC market is more risky than exchange centre.
4. Financial Derivative markets
Trading on the exchange center almost
eliminate counter-party risk due to the utilization of margin account mechanism. An advantage of the exchange center is the continuity of trading so that investors or traders can timing the market at any time during the trading day.