Unit -1 Risk Management

Session 3B – Types of Market Risk

Investment Banking
 Learning Objectives

At the end of the session, the participants

will be able to explain:

•Commodities Risk
•Equity Risk
•Foreign Exchange Risk
 Commodities Risk

• Volatility and risk create opportunities for profits.

• In losses laden with risk, the potential for losses are great, but
so are the possibilities for profit.
 Commodities Risk

• The main reason why commodities are a risky proposition is

that they trade on futures markets which offer a high degree of
leverage.

• A commodity trader normally only has to post 5 to 15 percent

of the contract value in futures margin value to control an
investment in the total contract value.
 Commodities Risk

• For example, if the price of crude oil is trading at $82 a barrel

and crude oil futures contract is for 1,000 barrels, the total
value of the futures contract is $82,000.

• A trader might only have to post about $5,100 to control

$82,000 worth of crude oil.

• For every $1 that crude oil moves, that trader could potentially
earn or lose $1,000 per contract held.
 Commodities Risk

• Crude oil can move more than $2 during a trading day. $2

higher or lower equates to a 40% move when compared to the
margin necessary to trade the crude oil futures contract.

• Therefore, the risk of commodity futures is what attracts some

and keeps others far away.
 Commodities Risk

• Commodity Trading Advisors (CTA’s) tend to achieve positive

returns because of their experience in the managed futures
arena.

• The Barclay CTA Index highlights that CTA’s earned an average

compound annual return of 11.56% for the period between 1980
and 2009.

• CTA's had three losing years, and the worst drawdown was –
1.19%.
Commodities Risk
 Commodities Risk
• Reward is a direct function of risky. In the world of
commodities, greater rewards come with a higher degree of
risk.

• Commodity futures are leveraged instruments; it takes a small

amount of margin to control a large amount of a commodity.

• Therefore, a trader or investor can make a lot of money, but

they can also lose a lot.
 Commodities Risk
• Commodities are the most volatile asset class. It is not unusual
for the price of a raw material to half or double, triple or more
over a very short time.

• Stocks, bonds, and currencies tend to have lower variance and

more liquidity than commodities.
 Commodities Risk
• For example, the daily volatility of a currency like the dollar
tends to be lower than 10% while the same metric for a
commodity like natural gas tends to be above 30%.

• Commodities are risky assets. Therefore, good judgement,

caution, and knowledge about the instruments that you are
trading or investing in are of particular importance in the
commodities futures arena.
 Commodities Risk
• In any market, the biggest risk is not having a complete
understanding of the business.

• Each business has risks.

• Credit risk, margin risk, market risk and volatility risk are just a
few of the many risks people face every day in commerce. In
the world of commodity futures markets, the leverage afforded
by margin makes price risk the danger on which most people
focus.
 Equity Risk

Equity risk is the risk one's investments will depreciate because of

stock market dynamics causing one to lose money.

Equity risk, at its most basic and fundamental level, is the financial
risk involved in holding equity in a particular investment.
 Equity Risk

Although investors can build equity in various ways, including

paying into real estate deals and building equity in properties,
equity risk as a general term most frequently refers to equity in
companies through the purchase of common or preferred stock.

Investors and traders consider equity risk in order to minimize

potential losses in their stock portfolios.
 Equity Risk

Although investors can build equity in various ways, including

paying into real estate deals and building equity in properties,
equity risk as a general term most frequently refers to equity in
companies through the purchase of common or preferred stock.

Investors and traders consider equity risk in order to minimize

potential losses in their stock portfolios.
Equity Risk
 Equity Risk

One basic way to limit equity risk is with diversification of stocks.

Many professionals encourage investors to hold several stocks in
order to provide diversification.

The idea is that, if one stock experiences a sudden and significant

decline, it will affect the portfolio less if additional stocks or equities
are involved.

Recently, some experts have been coming out with a more extreme
call for diversification, urging the average investor to own at least
30 or more stocks.
 Foreign Exchange Risk

Foreign exchange risk - also called FX risk, currency risk, or

exchange rate risk - is the financial risk of an investment's value
changing due to the changes in currency exchange rates.

This also refers to the risk an investor faces when he needs to close
out a long or short position in a foreign currency at a loss, due to an
adverse movement in exchange rates.
 Foreign Exchange Risk

Foreign exchange risk typically affects businesses that export

and/or import their products, services and supplies.

It also affects investors making international investments.

For example, if money must be converted to another currency to

make a certain investment, then any changes in the currency
exchange rate will cause that investment's value to either decrease
or increase when the investment is sold and converted back into
the original currency.
 Foreign Exchange Risk

A firm is exposed to foreign exchange risks if it has receivables and

payables whose values are directly affected by currency exchange
rates.

Contracts between two different firms with different domestic

currencies are set with specific rules.
 Foreign Exchange Risk

This contract provides exact prices for services and exact delivery
dates.

However, this contract faces the risk of exchange rates between the
involved currencies changing before the services are delivered or
before the transaction is settled.
 Foreign Exchange Risk

A firm faces foreign exchange risks due to economic exposure - also

referred to as forecast risk - if its market value is impacted by
unexpected currency rate volatility.

Currency rate fluctuations may affect the company's position

compared to its competitors, its value and its future cash flow.
These currency rate changes may also have good effects on firms.
 Foreign Exchange Risk

For example, a company from the United States with a milk supplier
from New Zealand will be able to cut costs if the U.S. dollar
strengthens against the New Zealand dollar.

In this light, economic exposure may be managed strategically

through arbitrage and outsourcing.
 Foreign Exchange Risk

All firms generally prepare financial statements.

These statements are created for reporting purposes.

They are provided for multinational partners, thus there’s a need

for the translation of important figures from the domestic currency
to another currency.
 Foreign Exchange Risk

These translations face foreign exchange risks, as there can be

changes in foreign exchange rates when the translation from the
domestic currency to another currency is performed.

Though translation exposure may not impact a firm's cash flow, it

can change the overall reported earnings of the firm, which affects
its stock price.
 Questions
• What is commodities risk?
• What is equity risk?
• What is foreign exchange risk?

Investment Banking
 Activity
• Find out news headlines related to the different types of market
risks. Analyzer the news.

Investment Banking
THANK YOU

Investment Banking