Lecture 1 PDF

Lecture 1.
Introduction to Financial Risk Management

Subject Information
Lecturer Ms Eelin Goh

eelin.goh@jcu.edu.au
Online lecture Wednesday
14:00 – 15:50
9-11 Pm C03-04
Online Tutorial Thursday
Wednesday
2-4 Pm 16:00
12-2 –Pm
17:50
‚(B03-02)
Assessments
Assessment 1: [Quizzes] [30%] Quiz1: Due 22/08 – 26/08/2021 11:59 pm

5-9.12.22
(SG time)
Quiz2: Due 19/09 – 23/09/2021 11:59 pm
16-20.01.23
(SG time)
Assessment 2: [Group Assignment] [30%] Due 11:59 pm13.01.23

23/09/2021 (SG time)
Assessment 3: [Final Exam] [40%] Due: Examination Period

What is • Financial risk management is the process by
Financial Risk which financial risks are identified, assessed,
Management? measured, and managed in order to create
economic value.
• Financial Risk Manager

The function of the risk manager is to
evaluate financial risks using both
quantitative tools and judgment
• Investors cannot avoid risk in the

investments. Risk will repeat and never
disappears.
Evolution of Financial Innovations
1979 Over-the-
1970 Mortgage- 1971 Equity index 1972 Foreign
Commodity futures 1973 Stock options 1977 Put options counter currency
backed securities funds currency futures
options
Collateralized
1980 Currency 1981 Interest rate 1982 Equity index 1983 Equity index Interest rate
mortgage 1985 Swaptions
swaps swaps futures options caps/floors
obligations
1987 Path-
1992 Catastrophe
Asset-backed dependent options Collateralized debt 1993 Exchange-traded 1994 Credit default
insurance futures
securities (Asian, look-back, obligations Captions/floortions funds swaps
and options
etc.)
1996 Electricity 1997 Weather 2004 Volatility 2006 Leveraged 2009 Crypto
2008 Green bonds
futures derivatives index futures and inverse ETFs currencies
Lessons from Crises in Last 4 decades
2001 – Internet 1998 – Long-Term

2008 – Global
2020 – COVID-19 2003 – SARS Bubble, Corporate Capital
Financial Crisis
Pandemic (H1N1) Scandals & Management
(Subprime Crisis)
September 11 (LTCM)
1990 – Japan 1987 – US Stock

1997 – Asian
Prolonged Market Crash 1980 – Oil Crisis
Financial Crisis
Recession (Black Monday)
Definition of
Risk
• All investments or assets are risky.
Risk & Return
• Trade-off between risk and return when money is
invested.
• The greater the risks taken, the higher the return

that can be realized.
• Capital Asset Pricing Model (CAPM) is first and

classical asset pricing model which shows the
relationship between expected return of risky
asset and the market risk (systematic risk).
• Risk that can be measured or quantified can be
Risk managed better.
Measurement
• Investors assume risk only because they expect to
be compensated for it in the form of higher
return.
• To decide how to balance risk and return requires

risk measurement.
• Centralized risk management tools such as Value-

at-Risk (VAR) is developed in early 1990s.
• Risk measured at the diversified portfolio level.
• Risk should be measured on a forward-looking basis
using the current positions.
• The first step in risk management is the
Risk measurement of risk.
Measurement
VAR is the cut-off point such that there is • The vertical axis represents the frequency, or probability,
a low probability of greater loss.
This is also the percentile of the
of a gain or loss of a size indicated on the horizontal axis.
distribution.
The entire area under the curve covers all of the possible
Using 99% confidence level, for example,
realizations, so should add up to a total probability of 1.
VAR is 14.4%
• Absolute risk is measured in terms of shortfall
Absolute vs. relative to the initial value of the investment or
investment in cash. Using standard deviation as
Relative Risk the risk measure, absolute risk in dollar terms is
• Relative risk is measured relative to benchmark

index B. The deviation is 𝑒𝑒 = 𝑅𝑅𝑃𝑃 − 𝑅𝑅𝐵𝐵 .
• In dollar terms, the relative risk is measured as

𝑒𝑒 × 𝑃𝑃. Thus, the risk is
Where, 𝜔𝜔 is tracking error volatility.

Example
Answer: C
Interest rate
Types of risk
Market risk Credit risk
Financial Risks
Operational Counterparty
Liquidity risk
risk risk
Insolvency Off-balance Foreign

risk sheet risk exchange risk
Country or Technology Unknown

sovereign risk risk unknowns
• Known Knowns
• Risk can be properly identified and measured. Losses
Risk Categories due to portfolio selections.
• Back-testing can detect this problem.
• Known Unknowns
• Model weaknesses that are known or should be
known to exist but are not properly measured.
• It is called model risk.
• Stress-testing can detect this problem.
• Unknown Unknowns
• Abnormal events which models do not capture its risk.
• Example: regulatory risk due to government policies,
counterparty risk which is not easy to measure.
• Global financial crisis, COVID-19, etc.
• Central bank as the last resort for this problem.
Risk Manager
• Identifying all risks faced by the firm

Risk
Management • Assessing and monitoring those risk
Process
• Managing those risks if given the authority to do
so
• Communicating those risks to the decision makers
• Failing to meet any of the above-mentioned tasks,

risk management fails or is ineffective
Portfolio Setting
• High risk high return shown in Table 1.1. Trade-off

between risk and return by allocating investment
in equities and LT bonds.
• Asset allocation is difficult without proper risk

measures.
• Risk-adjusted portfolio performance measures, i.e.
Portfolio excess return per unit of risk.
Performance
• Sharpe Ratio (SR)
Total risk measured by

• Information Ratio (IR) Standard deviation.
Tracking error volatility.

Portfolio • Treynor Ratio (TR) Excess returns
Performance
&
Asset Allocation
portfolio risk premeries % systemetrik Risk Beta assuming diversified
Risk= systemtric (Market Risk) Portfolio. Only systematic risk.
unsystemetric
Firm diver
• Statistical Asset Allocation

For example, maximizing Sharpe Ratio (SR) subject
to 𝑤𝑤𝑗𝑗 , the individual risky assets j, where
∑𝑁𝑁
𝑗𝑗=1 𝑤𝑤𝑗𝑗 = 1.
Portfolio • Portfolio expected rate of return
Expected Return 𝑁𝑁
& Standard
𝐸𝐸 𝑅𝑅𝑃𝑃𝑃𝑃 = � 𝑤𝑤𝑗𝑗 𝑅𝑅𝑗𝑗
Deviation
𝑗𝑗=1
• Portfolio standard deviation (two stocks: A & B)
Portfolio’s Beta 𝛽𝛽𝑃𝑃 𝜎𝜎𝑃𝑃𝑃𝑃 = 𝑤𝑤𝐴𝐴2 𝜎𝜎𝐴𝐴2 + 𝑤𝑤𝐵𝐵2 𝜎𝜎𝐵𝐵2 + 2𝑤𝑤𝐴𝐴 𝑤𝑤𝐵𝐵 𝜎𝜎𝐴𝐴 𝜎𝜎𝐵𝐵 𝜌𝜌𝐴𝐴𝐴𝐴
𝑁𝑁
where,
𝛽𝛽𝑃𝑃 = � 𝑤𝑤𝑗𝑗 𝛽𝛽𝑗𝑗
𝑗𝑗=1
𝜌𝜌𝐴𝐴𝐴𝐴 is the correlation between stocks A and B
taking the value between -1 and 1.
Thus, lower correlation leads to lower portfolio
standard deviation, vice versa.
Asset Pricing
Models: • Expected return of risky asset is priced by the risk
to compensate or reward the investors.
Risk & Return
• What risks are priced?
• Capital Asset Pricing Model (CAPM)

• Market Risk or Systematic Risk
• Arbitrage Pricing Theory (APT)

• Macroeconomic variables
• Fama & French 3-Factor Model (FF3)

• Systematic risk, Size and Growth
Example
Answer:
Example
Jensen’s alpha:
𝐸𝐸 𝑅𝑅𝑖𝑖𝑖𝑖 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽 𝑅𝑅𝑚𝑚 − 𝑅𝑅𝑓𝑓
𝐸𝐸 𝑅𝑅𝑖𝑖𝑖𝑖 − 𝑅𝑅𝑓𝑓 = 𝛼𝛼 + 𝛽𝛽 𝑅𝑅𝑚𝑚 − 𝑅𝑅𝑓𝑓
Abnormal or Excess Return

Answer:
• Risk Management Irrelevance
• Firms should focus on their business they are good at.
Value of Risk • According Modigliani & Miller Theory, investors can
Management diversify the risks of their investments (homemade
leverage) regardless to the firm’s financing decision
(D/E).
• Risk Management Relevance

• Hedging reduces the cost of financial distress resulting in
value creation.
• Stabilizing firm’s earnings reduces the average tax
payment over time, which hence increase firm value.
• Hedging helps reduce the external borrowing cost
mitigating the underinvestment problem, and hence
increase firm value.
• Hedging helps mitigate agency problem and reduces
agency cost and create firm value.
• Concentrated ownerships prefer firms with hedging
which lower the risk for the large shareholders.

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Lecture 1.

Introduction to Financial Risk Management

Lecturer Ms Eelin Goh

Assessment 1: [Quizzes] [30%] Quiz1: Due 22/08 – 26/08/2021 11:59 pm

Assessment 2: [Group Assignment] [30%] Due 11:59 pm13.01.23

Assessment 3: [Final Exam] [40%] Due: Examination Period

• Financial Risk Manager

• Investors cannot avoid risk in the

2001 – Internet 1998 – Long-Term

1990 – Japan 1987 – US Stock

• The greater the risks taken, the higher the return

• Capital Asset Pricing Model (CAPM) is first and

• To decide how to balance risk and return requires

• Centralized risk management tools such as Value-

• Relative risk is measured relative to benchmark

• In dollar terms, the relative risk is measured as

Where, 𝜔𝜔 is tracking error volatility.

Insolvency Off-balance Foreign

Country or Technology Unknown

• Identifying all risks faced by the firm

• Communicating those risks to the decision makers

• Failing to meet any of the above-mentioned tasks,

• High risk high return shown in Table 1.1. Trade-off

• Asset allocation is difficult without proper risk

Total risk measured by

Tracking error volatility.

• Statistical Asset Allocation

• Portfolio standard deviation (two stocks: A & B)

• Capital Asset Pricing Model (CAPM)

• Arbitrage Pricing Theory (APT)

• Fama & French 3-Factor Model (FF3)

Abnormal or Excess Return

• Risk Management Relevance

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