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Risk Management Cheat Sheet

Risk Management (Royal Melbourne Institute of Technology)

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Chapter 1 Intro: Risk is the chance (or probability) of a deviation from an anticipated outcome. Hazard: Hazard is another term common in insurance. It is a condition or action of
the insured party that increases the likelihood or likely magnitude of a loss Physical Hazard: The condition of the insured property, person or operations that has the effect of
increasing the likelihood and/or severity of the loss Moral Hazard (snowboarder doing more crazy tricks once insured): A condition where the insured intentionally seeks to
take advantage of insurance cover either by deliberately causing an accident or by inflating the value of a loss. Morale Hazard (unconscious change): Actions taken by the
insured party that increases the likelihood and/or severity of a loss. Morale hazard arises because the consequences of the action are borne by the insurer rather than the
insured. For instance, car owners with fully comprehensive theft insurance are less likely to lock their cars when they leave them. Two approaches to modifying the level of risk:
Risk pooling (sharing) or risk transfer - Hedging – Elimination of Risk Via forward, future or swap which represents an agreement to sell the risk in the future – Diversification-
Insurance Risk = Probability of loss - Exposure =possibility of loss. RISK Cash Flows: Type 1: Amount & Timing known, with certainty Type 2: A. known with certainty T = U Type 3:
T = Known, A = UnC Type 4: T & A = UnCertain Accounting Definition:Transaction Exposure – ForEx rate risk Translation of foreign currency. Risk Management Process: S1:
Ident. Source of risk exposure S2: Quantify a/o assesss the exposure S3: Assess the impact of the exposure on the business & fin strategy. Determine the degree of risk
adjustment required (Cost/Benefit analysis) S4: Ass. The firm’s capabilities, competencies a/o capacity to undertake its own hedging and insurance program S5: Choose risk
management product & mix. Includes both op. hedging & the use of external risk man. Prods. – insurance derivatives & risk pooling S6: keep the risk management process under
rev. Chapter 2 Fixed Income Securities: Interest Rate Sensitivity of Bonds. 1.Bond price & Yields are inversely related: Yield Increases, Bond Price Falls. 2.Bond Prices are convex
functions of yields: An increase in bond’s YTM results in a smaller price decline than the price gain assoc. with a decrease of equal magnitude in yield. 3.Long term bonds more
sensitive to interest rate changes. 4. Sens. of bond p. changes in yields increases at a decreasing rate as maturity increases. 5.IRR Is inversely related to the bond’s coupon rate.
6.The sensitivity in a bond’s price to change in its yield is inversely related to the yield to maturity at which the bond is currently selling. Basis Points. 1BP = 0.0001, 50 Basis
Points = 0.005 Duration Gap (DGAP) measures the comparative price sensitivity of a bank’s assets with the price sensitivity of its liabilities when the target measure of
performance is the market value of stockholders’ equity (MVE). Reduce DGAP to zero, 1. reduce the duration of assets 2. Increase the duration of debts; or 3. Changing the levier
effect k.To increase DGAP; do the opposite. Chapter 3: Credit Risk Management: Risk of default on a debt that may arise from a borrower failing to make required payments.
Includes lost principal and interest, disruption to cash flows, increased collection costs. Financial institutions help mitigate CR in form of collateral. Initial Margins – imposed
because you want buy instruments or may lose money in future. Profits and Losses are added to equity based on closing price. If losses are extensive Margin Call may happen.
OTC derivatives are usually traded bilaterally, not on exchanges. Clearing houses are highly credit worthy, participants post initial margin, mark to market debts settled daily – if
too low Margin Call. Bilateral Clearing – parties make arrangements to reduce exposure to each other’s default. Central Counterparty – CCP step into agreements and act like
clearing house, buyer of every seller and seller of every buyer, still default risk in CCP, they have high creditworthiness (they collect initial margin, variation margin [margin call]),
mutualised default fund, fund by all ccp participants to ensure ccp can meet obligations to parties. Netting – (International Swaps and Derivates Association ISDA) – in default all
transactions are considered a single trans. Stop counterparties from keeping profitable trades, reduces CR exposure. Estimating Default Probabilities – conditional default
probabilities are also known as hazard rates and default intensities. Credit Spread – incremental rate of interest required by investors for bearing CR – Bond Yield Spread
(difference between RFR and corp bond) and Credit Default Swap (insurance on bond if it fails). Asset Swap – fixed investment (bond) swapped for floating investment like an
index. Chapter 4: Swaps Swap is an agreement between 2 parties to swap 2 future streams of cash flows – Credit Risk; every swap transaction has credit risk for both parties.
Interest rate swaps is simply a contract to exchange only interest payments. Valuation; marked to market by calc PV. If LT rates increase, swaps value decreases, if LT rates
decrease, swap value increases. Parallell shift upward of the yield curve, swap val decreases; par shift down, swap value increases. Int Rate Swap: Perspective float-rate payer:
Vswap=B fix - B fl
V =B - B
: Perspective fixed rate payer swap fl fix Cross Currency Swap: Inv exchange of fixed interest rates in different currencies. Principal may or may not be exchanged.
Cross-currency interest rate swap involves the exchange of fixed and floating payments, as well as payments in different currencies. Valuation CCS: Foreign currency paid,
V =B - S B V =S B - B
domestic received swap D 0 F , Foreign currency received, domestic is paid swap 0 F D - BF = foreign, BD = domestic, S0 = spot exchange rate. Chapter 5: Futures and
Forwards: Futures contract is between two parties to exchange assets or services at a specified time in the future at a price agreed upon at the time. Futures vs. Forwards:
Futures are market traded, Forwards are OTC; Futures are marked to market, forwards are not; Futures are standardized contracts, forwards can be agreed on any asset. Long
VS. Short; Long position commits to purchasing the commodity on the delivered date. Short position commits to delivering the commodity at contract maturity. Profit to long =
Spot price at maturity – original futures price. Profit to short = Original futures price – spot price at maturity. Perfect Hedge eliminates all the risk. Short Hedge involves short
pos. in futures contracts. Appropriate when hedger already owns an asset and expects to sell it at some time in the future. Long Hedge long pos in futures contract. Appropriate
when company knows it will have to purchase a certain asset in the future and wants to lock in a price now. Basis Risk: Risk that the value of futures contract (or OTC Hedge) will
not move in line with that of the underlying exposure. Locational, Product, Time or Calendar basis risk. Pricing of Futures: Expectations Hypothesis: Futures price = the expected
value of the future spot price of the asset. Expected profit to either position of a futures contract would be 0. Normal Backwardation: Most commodities. there are natural
hedgers who desire to shed risk. Futures price will be bid down (in the market) to a level below the expected spot price and will rise over the life of the contract until the
maturity date. Normal Contango: Long hedgers agree to pay high futures prices to shed risk; speculators must be paid a premium to enter in short position; the contango theory
holds that the futures price must exceed the expected spot price. Perishable Commodities: No arbitrage argument is no available; if S is expected to increase before the
exspiration of the futures, F>S; if S expected to decrease, F < S; Futures = Spot Price – Expected Risk Premium. Storable Commodities: Strategy 1: Buy the futures contract. Take
delivery at expiration; Pay F; Strategy 2: Borrow spot price (S) of the commodity and buy the commodity. Pay the additional costs. Stock Index Futures: Strategy 1: Sell short on
the stocks in the index for the duration of the index futures contract. Invest the proceeds at the risk-free rate. This strategy requires that the owners of the index be
compensated for the dividends they would have received on the stocks. Strategy 2: Sell the index futures contract. Both strategies require the same initial invest, have the same
risks and should provide the same proceeds. Currency Futures: Holding Foreign Cur, enables investor to earn the risk-free int. rate prevailing in that country while the domestic
curr. Earn the dom. Risk free rate; Interest rate parity relates to the differential between futures and spot prices to interest rates in the domestic and foreign market; Triple
Witching Hour; this is the last hour of the stock market trading session (3:00-4:00pm) New York City Local Time on the 3rd Fri of every Mar, Jun, Sep & Dec. Stock market index
futures, stock market index options and stock options expire. These simultaneous expirations generally increases the trading volume of options, futures and the underlying
stocks, and occasionally increases volatility of prices of the related securities. Delivery Option and the Wild Card Play; This feature of treasury bond futures, that any treasury
bond can be delivered to fulfil the obligation on the bond, provides an advantage to the seller of a futures contract. The cheapest bond, after adjusting the conversion factor will
be delivered. This delivery option has to be priced into the futures contract. There is an additional option embedded in treasure bond futures contracts that arises as T.Bond
futures market closes at 2PM. Whilst the bonds continue trading until 4pm. The seller does not have to notify the clearing house until 8PM about his intention to deliver. If bond
prices decline after 2PM the seller can notify the clearing house of intention to deliver the cheapest bond that day. If not, the seller can wait for the next day. This option is called
the wild card play. Chapter 6: Options: An agreement between two parties in which one party grants another the right but not the obligation to buy or sell an asset for an agreed
price at an agreed future time. Exchange traded options: Margining applies to seller (writer) only (managed by clearing house); Standardised like futures OTC Options; no
margining, customised, majority of options in FX and Money Markets. Valuing Options; Premium includes two components – “Intrinsic Value” and “Time Value”; Intrinsic value is
determined by “Moneyness” determined by the relationship between spot price (S) and exercise price (X);Time Value of an option is the premium a rational investor would pay
over its current exercise value (intrinsic value), based on the probability it will increase in value before expiry. Tim Value measures the benefit of having an option with time
remaining until maturity and is determined by subtracting intrinsic value from the option premium Time Value = Option Value – Intrinsic Values; Sensitivity to inputs – Calls;
Value of a call option; increases as share price increases; decreases as strike price increases; increases with time to maturity. Sens. To In. Puts: Value of put option; decreases as
share price increases; increases as strike price increases; increases with time to maturity; increases as variance increases; decreases as interest rates increase. Put-Call Parity:
This states that simultaneously holding a short Euro put; and long euro call; of the same class will deliver the same return as holding 1 forward contract on the same underlying
asset, with the same expiration and forward price = to the option’s strike price Dynamic Delta Hedging: Delta of an option is the sensitivity of an option price relative to changes
in the price of the underlying asset; it tells option traders how fast the price of the option will change as the underlying stock/future moves. Delta hedging means to structure
trading activities such that the PF’s overall delta is 0 (or neutral) Options as Insurance; Writing covered calls; when you do not own the underlying stock is a high-risk investment;
when you do own the stock, all you risk is the loss of appreciation beyond your strike price. Equity Collar: A covered call can usually be combined with a protective put,
establishing at reasonable cost an acceptable range within which the investor is willing to part with a holding.Chapter 7 Value At Risk: VaR measures the worst expected loss
under normal market conditions over a specific time interval at a given confidence level. VaR answers the questions: how much can I lose with a x% probability over a pre-set
horizon.USED to facilitate risk reporting and control decisioning; greatly facilitates dealers’ reporting of risks; used by nonfinancial corps; pension plans; mutual funds; clearing
orgs; brokers and futures commission merchs & insurers. Defining VaR; (1) The holding period under consideration; (2) The desired statistical confidence interval. Calculating
VaR: 1. Variance-covariance approach; 2. Historical simulation; 3. Monte Carlo Simulation. Comparison of the Three Models; Distribution of risk factors; possibility of extreme
events happening; implementation ease; communicability. Issues with VaR; Subadditivity in VaR: This implies that the risk of a portfolio must be less than the sum of risks for
portfolio components. The VaR measures fails to satisfy the subadditivity problem. Problem of Tail Risk VaR does misleads about the loss beyond the VaR threshold; Alternatives
to Var; Cash Flow Risk; Risk-Based Capital Allocation; Shortfall Risk

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Macaulay Duration Convexity

FV $1000, Coupon Rate 5%, Coupon PMT = 1000 X 5% = $50, Maturity 4 Years FV = $100'000, Coupon Rate = 5%.Duration = 5 Years
PMT Discounted at Time X Time (1) Cash Flow (2) PV (3) t^2 +t (4) PV(t^2+1) = (2)x(3)
Years PMT YTM Weight of PMT Weight 1.00 5000.00 4761.90 2.00 9523.81
1.00 50.00 47.62 0.05 0.05 2.00 5000.00 4535.15 6.00 27210.88
2.00 50.00 45.35 0.05 0.09 3.00 5000.00 4319.19 12.00 51830.26
3.00 50.00 43.19 0.04 0.13 4.00 5000.00 4113.51 20.00 82270.25
4.00 1050.00 863.84 0.86 3.46 5.00 105000.00 82270.25 30.00 2468107.42
1000.00 1.00 3.72 100000.00 2638942.62
Duration:New Bondprice = Old Bondprice - DIntRate X (Time×Weight Total) ´PV of Bond 1
D Interest Rate Swap Convexity= ´2638942.62=23.94, from table
Modified Duration: Dm= mac, y=ytm,k=no# pmts 100'000 (1+0.05)2
1+y/k
Modified Duration
Basis Point Value = ´ Bondprice
100

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Storable Commodities
Simple Interest = P(1+rt)
Compounding Interest = P (1+rt)n
Discounting = P (1+i)- n
é ù
(1+r)n- 1ú
FVOA = PMTê
êë r úû
OPTIONS Calls Premium Puts
é - nù
1- (1+r)
Able to ú buy the Pays Able to sell the
PV OABuyer
= PMTê
êë underlying
r úû asset underlying asset at
é ù strike
at the the strike price
(1+r)n- 1ú
FV AD = PMTê price
(1+r)
êë r May úû
Seller be Receives May be obliged to
é
obligated to sell1) ù
- (n- buy the underlying
ê 1- (1+r) ú
PV AD = PMT+ PMT the
Treasury Bond Futures
êë underlying r úû asset at the strike
é asset at the ù price
1- (1+r) - (n- 1) FV
BONDPRICE=PMTê strike price ú +
MONEYNESS êë Callr úû (1+r)n Put Intrinsic Value
DGAP= DAssets- ( DLiabilities
ITM Spot > Exercise ´k) Spot < Exercise >0
ATM S=X S=X =0
Liabilities 8100 Black Scholes
k= = =0.4793
OTM
TotalAssets 16900 S < X S>X =0 Call Option = S X N(d1 )- N (d2 ) Xe- rt

æ 5500 ö æ 3400 ö
DA=ç ×Duration(0)÷+ç ´3.828÷.......=2.8042 Put = N(-d2 ) Xe- r (T- t) - Spotprice´N (- d1 )
è 16900 ø è 16900 ø
s2 t
æ 3800 ö æ 3000 ö ln( S/X )+( r+ )
DL =ç ´0.25÷+ç ´1÷.......=1.5833 d1= 2 , d =d - s t
2 1
è 16900 ø è 16900 ø s t
8100
DGAP=2.8042- (1.5833´ )
16900 C = Call, P = Put, S = Spot Price, X = Exercise Price, r = Risk Free Rate, t = time to maturity, N() = Norm Distr., s Volatility
DGAP=2.0453
Net Wealth (Equity)
Maintenance Margin = Call Option: S = $42, X = $40, r = 10%,p.a. Vol = 20%, T = 6 months
Market Value
Q(t) is the prob. of default by time t
0.2 2 0.5
Q(t) = 1-e l (t)t;l =hazard rate ln( 42/40 )+( 0.1+
2
)
d1= ,=0.7693
0.20 0.50
The unconditional prob. of default during the period between t and t+1 is:
PD(t+1) = Q(t+1) - Q(t) d2 =0.7693- 0.20 0.50=0.6278

Hazard Rate is constant at 2% per year. Prob of defaulting the end of first year is:
Q(1) = 11-e(- 0.02´1) =0.0198 N ( d1 ) = N ( 0.7693)

Q(2) = 11-e(- 0.02´2) =0.0392

Prob Default (2)=0.0392- 0.0198=0.0194 N ( d1 )=N ( 0.76 )+( 0.93)[ N ( 0.77 )- N ( 0.76 )] - see norm distribution table

Forward Price = S ´ert

s [
N ( d1 )=0.774+0.93´0.7794- 0.7763]
Optimal Hedge Ratio: H*= P s ; p = correlation coeff; s s=s td.dev spot; s f =std. dev in futures
sf
N ( d1 )=0.7792 Put Option:
Q
Optimal No# of contracts required N*=H*× A ; Q A=Position being hedged; Q = Future contract size
QF F
N ( d2 )=N ( 0.6278) N (- d1 ) = N (- 0.7693)
é ù
Storable Commodities: F *=Sê (1+r)t+ktú;k= cost of storage
ë û
N ( d2 )=N ( 0.62 )+0.78[ N( 0.63)- N ( 0.62 )] N (- d1 )=N (- 0.76 )- ( 0.93)[ N (- 0.76 )- N (- 0.77 )] - see norm distribution table
Stock Index Futures: F *= S(1+r-y)t
Treasure Bond Futures: F *=(S- PVC)(1+r)t
F* futures price, S = spot price, PVC = Present value of coupons, R = Interest Rate, T = life of futures contract N ( d2 )=0.7324+0.78´[ 0.7357- 0.7324] [
N (- d1 )=0.2236- 0.93´0.2236- 0.2206]
1+r
Currency Futures; F*d, f =Sd, f ´ d N ( d2 )=0.7350 N (- d1 )=0.2208
1+rf
Intrinsic Value of a Call Option = P- Max(St- k,0)
Intrinsic Value of a Put Option = P- Max(K - St,0) Call = Spotprice X N(d1 )- N ( d2 ) Xe- rt N (- d2 )=N(- 0.6278 )

VaR = 95% Confidence level = 1.645

Single Asset VaR 95% =$115(stock)´0.20(stddeviation)´1.645=37.835 C=42´0.7792- 40 e- 0.10´0.50 ´0.7350 N (- d2 )=N(- 0.62 )+0.78[ N (- 0.62 )- N (- 0.63)]

Portfolio VaR = w12s 12 +w22s 22 +2 w1w2COV(1,2)

Call=$4.67 [
N (- d2 )=0.2676- 0.78´0.2676- 0.2643]
VaR = Portfolio value ´ s portfolio´Ztable- 95%=1.645

N (- d2 )=0.2650

Put = N(-d2 ) Xe- r (T- t) - Spotprice´N (- d1 )

Put = 0.2650´40 e- 10´0.50 - 42´0.2208

Put = $0.81

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