Financial Risk Management Text Edinburgh Business School

Financial Risk
Management
Sources of Financial Risk and Risk
Assessment
Peter Moles
FK-A3-engb 1/2018 (1011)

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Financial Risk Management
Dr Peter Moles MA, MBA, PhD
Peter Moles is Senior Lecturer at the University of Edinburgh Business School. He is an experienced
financial professional with both practical experience of financial markets and technical knowledge
developed in an academic and work environment.
Prior to taking up his post he worked in the City of London for international and money-centre banks.
During the course of his career in the international capital markets he was involved in trading, risk
management, origination and research. He has experience of both the Eurobond and Euro money
markets. His main research interests are in financial risk management, the management of financial
distress and in how management decisions are made and the difficulties associated with managing complex
problems. He is author of the Handbook of International Financial Terms (with Nicholas Terry, published by
Oxford University Press) and Corporate Finance (published by John Wiley & Sons). He is a contributing
author for The Split Capital Investment Trust Crisis (published by Wiley Finance) and has written a number
of articles on the problems of currency exposure in industrial and commercial firms.
First Published in Great Britain in 1998.
© Peter Moles 1998, 2001, 2004, 2013.
The rights of Peter Moles to be identified as Author of this Work has been asserted in accordance with
the Copyright, Designs and Patents Act 1988.
All rights reserved; students may print and download these materials for their own private study only and
not for commercial use. Except for this permitted use, no materials may be used, copied, shared, lent,
hired or resold in any way, without the prior consent of Edinburgh Business School.
Contents
Introduction xi
Arrangement of the Course xi
Approach and Key Concepts xii
Assessment xiii
Acknowledgements xv
PART 1 INTRODUCTION
Module 1 Introduction 1/1
1.1 Introduction 1/2

1.2 What Is Risk? 1/16
1.3 What Is Financial Risk? 1/33
1.4 Steps to Risk Identification 1/36
1.5 Top-Down and Building-Block Approaches to Risk Management 1/41
Learning Summary 1/42
Appendix to Module 1: What Risks Are We Taking? 1/43
Review Questions 1/44
Case Study 1.1: Attitudes to Risk 1/50
Module 2 Risk and the Management of the Firm 2/1

2.2 The Pervasiveness of Risk 2/10
2.3 Why Manage Risk? 2/10
2.4 Taxes 2/13
2.5 Agency and Other Costs 2/15
2.6 Business Performance 2/19
2.7 Financial Risk and Financial Distress 2/23
2.8 The Costs of Risk Management 2/25
Case Study 2.1: Laker Airlines 2/35
PART 2 THE MARKETS

Module 3 Market Mechanisms and Efficiency 3/1

3.2 Market Efficiency 3/8
Financial Risk Management Edinburgh Business School v

Contents
3.3 Market Liquidity 3/11

3.4 The Role of Financial Intermediaries 3/13
3.5 Systematic Risk and Non-Systematic Risk 3/18
3.6 Managing Market Risks 3/21
3.7 Effect of Credit Risk 3/23
Case Study 3.1: Omega Corporation 3/34
Module 4 Interest Rate Risk 4/1

4.2 Interest Rate Risk 4/5
4.3 The Term Structure of Interest Rates 4/19
4.4 Analysing Yield Curve Behaviour 4/31
4.5 The Money Markets 4/36
4.6 Term Instruments 4/37
Appendix 1 to Module 4: A Note on Early Redemption 4/41
Appendix 2 to Module 4: Relationship of Spot Rates and Par Yields 4/43
Case Study 4.1: Panthos Finance 4/55
Module 5 Currency Risk 5/1

5.2 Foreign Exchange Rate Risk 5/3
5.3 Foreign Exchange Exposure 5/15
Case Study 5.1: Airbus Industries 5/37
Module 6 Equity and Commodity Price Risk 6/1
6.1 Equity Market Risks 6/1

6.2 Commodity Price Risk 6/11
Case Study 6.1: Banking 6/21
Case Study 6.2: Copper 6/21
vi Edinburgh Business School Financial Risk Management

Contents
Module 7 The Behaviour of Asset Prices 7/1

7.2 The Price-Generating Process for Financial Assets 7/2
7.3 Understanding Volatility 7/18
7.4 Describing the Price-Generating Process 7/28
Appendix to Module 7: Statistical Measures of a Probability Distribution 7/37
Case Study 7.1: Diffusion Trees 7/42
PART 3 RISK ASSESSMENT

Module 8 Controlling Risk 8/1

8.2 The Top-Down Approach to Risk Assessment 8/13
8.3 The Building-Block Approach to Risk Assessment 8/16
8.4 Reporting and Controlling Risk 8/19
8.5 A Note of Warning 8/38
Case Study 8.1: Georgetown Industries 8/47
Module 9 Quantifying Financial Risks 9/1

9.2 Statistical Analysis of Financial Risk 9/4
9.3 The Significance of the Normal Distribution 9/9
9.4 Understanding the Risk Measures 9/11
9.5 Measuring the Relationship between Assets 9/16
9.6 Portfolio Expected Return and Risk 9/21
9.7 Practical Considerations in Measuring Risk 9/31
9.8 Estimating Portfolio Value at Risk 9/31
Appendix to Module 9: Example of the Statistical Analysis of Risk 9/35
Case Study 9.1: Calculating the Risk Factors for Two Commodities 9/43
Case Study 9.2: Portfolio Risk 9/44
Financial Risk Management Edinburgh Business School vii

Contents
Module 10 Financial Methods for Measuring Risk 10/1

10.2 Using the Present-Value Approach to Determine Risk 10/3
10.3 Calculating Spot Discount Rates for Specific Maturities 10/5
10.4 The Term-Structure Approach to Risk Measurement 10/15
10.5 Simulation 10/20
Appendix to Module 10: Bootstrapping Zero-Coupon Rates from the
Par Yield Curve 10/34
Case Study 10.1: The Jabberwocky Company 10/42
Module 11 Qualitative Approaches to Risk Assessment 11/1

11.2 Qualitative Forecasting Methods 11/3
11.3 Qualitative Forecasts 11/7
11.4 A Practical Example of a Forecast 11/9
11.5 Assessing Qualitative Accuracy 11/12
Case Study 11.1: Bloomberg Minerals Economics 11/23
Appendix 1 Practice Final Examinations and Solutions A1/1

Examination One 1/2
Examination Two 1/12
Examination Answers 1/23
Appendix 2 Statistical Tables A2/1

Appendix 3 Formula Sheet for Financial Risk Management A3/1
1. Compounding and Discounting 3/1
2. Expected Value 3/2
3. Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) 3/2
4. Currency Relationships 3/3
5. Statistical Measures 3/3
6. Portfolio Model 3/4
7. Measures of Forecasting Accuracy 3/4
viii Edinburgh Business School Financial Risk Management

Contents
Appendix 4 Answers to Review Questions A4/1

Module 1 4/1
Module 2 4/5
Module 3 4/11
Module 4 4/17
Module 5 4/28
Module 6 4/33
Module 7 4/38
Module 8 4/45
Module 9 4/52
Module 10 4/62
Module 11 4/70
Glossary G/1
Index I/1
Financial Risk Management Edinburgh Business School ix

Introduction
This elective course covers one of the core functions of finance, namely risk
management.* A large part of the role of finance – the actions of the financial
specialist and the operations of the financial department within firms – is devoted to
handling, controlling and profiting from risk. This text sets out to show why and
how firms manage their financial risks.
For most kinds of activity, risk is unavoidable as long as the outcome is uncer-
tain. Therefore, taking on risk and handling it is a core management discipline. All
major corporate decisions involve choices as to how much risk to take and how best
to manage these risks. At its simplest, risk management involves procedures for
becoming aware of risks and the methods used to analyse risks, assess their impact
and respond accordingly.
Financial risk management is the activity of monitoring financial risks and man-
aging their impact. It is a sub-discipline of the wider task of managing risk and also a
practical application of modern finance theories, models and methods. The tradi-
tional role of finance within the firm has been in terms of reporting and control.
The modern approach is to see the financial function as actively formulating policy
and directly involved in the subsequent decisions. Financial risk management
involves handling those business decisions resulting from financial exposures.
As a subject financial risk management draws on the disciplines of accountancy,
economics, management science, decision theory, statistics and psychology as well
as the key principles and methodologies to be found in finance. Before starting, the
student is expected to have some prior knowledge of the fundamentals of finance,
and, in particular, time value of money methods, and a basic understanding of
statistical concepts. The level of knowledge required is that which is necessary in
order to successfully complete a course in finance.
Arrangement of the Course

The modules that go to make up Financial Risk Management fall into the following
topic areas:
* The other key functions are valuation and the optimisation of resources across time.
Financial Risk Management Edinburgh Business School xi

Introduction
Topic area Modules

One Introduction 1 and 2
The background and basics of risk management
Two The Markets 3 to 7
Sources of financial risk from interest rates, currencies,
equities and commodities; the nature and structure of financial
markets; the asset price generating process
Three Risk Assessment 8 to 11
The techniques used to assess, model, manage and control
risks
The course starts with an overview of the financial risk management process and
its historical development (Part 1). A rationale for such activity is proposed based
on current financial theories about firms and markets. It then proceeds to an
examination of the principal financial risks that arise from interest rates, currencies,
equities and commodities markets (Part 2).
The text next goes on to examine methods used to identify, measure and reduce
these risks (Part 3). In implementing risk management policies, firms seek to
quantify the risks they face and the resultant impact on their profits or cash flows.
Two separate approaches are covered – the use of quantitative models and qualita-
tive scenario building – and the link between the two is discussed.
In presenting the text in this way, the aim is to provide a comprehensive and
logical approach to what is a complex subject.
Approach and Key Concepts

Financial risk management is a holistic subject. The order in which the text is
presented follows what may be called the standard risk management model. While
this is useful in developing a good understanding of how risk arises and how it is
handled, it does have some disadvantages in that material on one subject (for
instance, interest rate risk) is presented in modules that do not follow each other. As
a result, we would encourage students to look at alternative ways to approach the
text.
A basic premise of the text is that it is orientated at the industrial and commercial
firm. If anything, the typical firm is taken to be a manufacturer with cross-border
transactions of various kinds. That said, some sections provide methods that are
more suited to financial firms. On the whole the applicability of a technique to a
particular type of firm will be self-evident.
As a course, it is largely technique based and emphasises the financial, scientific
or engineering approach to risk management. While this is more appropriate to a
course on managing financial risks, the student should be aware that there is an
alternative, behaviourist approach to risk. In most cases, this social science approach
provides complementary insights into the sources and treatment of risk by individu-
als and organisations.
xii Edinburgh Business School Financial Risk Management

Introduction
Also financial risk management uses many ideas that are central to finance. For
instance, the key idea behind portfolio theory, the mean-variance framework is the
main approach to assessing the aggregate risk in an organisation. To use the
portfolio approach requires us to know the expected return on an asset, the asset’s
variance or standard deviation (that is, the dispersion from its expected return) and
the correlation to other assets in the portfolio. It is the same methodology used in
portfolio selection but applied to a different purpose. In risk management it is as if
we were running the ideas of portfolio selection in reverse, starting with a given set
of assets and determining their risk, rather than – in traditional portfolio selection –
starting with a risk/return objective and finding the appropriate set of assets. Even
so, optimising the risks in a firm is still an objective.
A key idea to understanding risk is the dispersion or the variance of return.† At its
simplest, the stochastic process that underlies future asset prices can be seen in the
binomial model where, for the next period, the asset price can take one of only two
states: an increase or decrease. Extending this approach allows one to understand
the price-generating process for financial assets as well as how derivatives on these
assets are priced.‡
Once the text has been read and assimilated, one of the key approaches to as-
sessing risk will become evident, namely the measurement of the position sensitivity
to the risk factor (usually the market factor). Sensitivity is a key concept in risk
management. Knowing the degree of responsiveness to the source of risk (coupled
to its impact) is essential in order to manage the risk. If one might use a medical
analogy to help bring home the point, people have different tolerances to outside
hazards: sunlight, alcohol, infections, pollutants, irritants and so forth. Knowing
how susceptible one is to chemical irritants is useful when determining the amount
of exposure one may take and the kinds of precautions that might be in order – for
instance, the need to wear rubber gloves.
To manage risk it is necessary to measure it – accurately. An advertising cam-
paign run by the Union Bank of Switzerland (UBS) some time ago promoted its
expertise in this area with the slogan: ‘Master the detail – manage the risks.’ A
similar approach is used here. Much of the material presented in the course covers
the different approaches used to master the detail of financial risk management. The
text introduces ideas at an early stage – for instance, much of the conceptual
foundation for risk management is given in Module 1 (Introduction) – that are then
taken apart and examined in detail in subsequent modules. In particular, all of Part 3
is devoted to examining different analytical approaches to financial risk manage-
ment.
Assessment
As is customary with this programme, you will find self-test questions and cases at
the end of each module. Also provided are two pro-forma exams of the type it is
† This dispersion is often referred to as ‘volatility’ by market participants.

‡ These are the subjects of the Derivatives course.
Financial Risk Management Edinburgh Business School xiii

Introduction
necessary to pass in order to gain credit from this course. The exam assessment is
based on the following criteria:
Section Number of Marks obtainable Total marks

questions per question for the
section
Multiple choice questions 30 2 60
Cases 3 40 120
180
xiv Edinburgh Business School Financial Risk Management

Acknowledgements
I would like to thank Financial Times Ltd and The Scotsman for permission to
reproduce items from their publications as background material to this course. Also
JP Morgan for the right to reproduce material from its RiskMetrics™ system.
Thanks are also in order to the production team at Edinburgh Business School
and an anonymous reviewer of an early draft of some of the text who provided
valuable comment on the evolving material. As is usual in these matters, all errors
remain the author’s responsibility.
Financial Risk Management Edinburgh Business School xv

PART 1
Introduction
Module 1 Introduction
Module 2 Risk and the Management of the Firm
Financial Risk Management Edinburgh Business School

Module 1
Introduction
Contents
1.1 Introduction.............................................................................................1/2
1.2 What Is Risk? ........................................................................................ 1/16
1.3 What Is Financial Risk? ........................................................................ 1/33
1.4 Steps to Risk Identification ................................................................. 1/36
1.5 Top-Down and Building-Block Approaches to Risk Management . 1/41
Learning Summary ......................................................................................... 1/42
Appendix to Module 1: What Risks Are We Taking? ................................. 1/43
Review Questions ........................................................................................... 1/44
Learning Objectives
This module introduces the sources of risk, together with the methods used to
measure it. It starts by looking at the historical background before going on to
define risk. It then examines the basic approaches used to identify, measure and
reduce risks. Managing risk is a key activity for firms, and a range of different
approaches is outlined. Firms may seek either to examine the totality of the risks
they face in the aggregate, an approach known as ‘top-down’, or to build up their
exposures from the individual risks, a procedure referred to as ‘ground-up’. In
practice, many firms use both methods.
The function of risk management is to control the effects of uncertain and gener-
ally adverse external developments (or events) on firms’ activities and projects.
Financial risk management is a more specific activity that seeks to limit the effects of
changes in financial variables such as interest rates, currencies and commodity
prices.
After reading this module, you should be able to understand:
 what financial risk management is designed to achieve;
 the difference between uncertainty and risk;
 the multidimensionality of risk;
 how different attitudes to risk lead to different decisions as to what amount of
risk is acceptable;
 the basic approaches used to manage risk;
 the basic nature of the financial risks facing the firm;
 the three key steps used in risk management: risk awareness, risk measurement
and risk adjustment.
Financial Risk Management Edinburgh Business School 1/1

Module 1 / Introduction
1.1 Introduction
My introduction to the dangers of financial risk arose in the early 1970s when I
had occasion to travel to Germany and, in order to have money available, was
advised by my bank to take traveller’s cheques. At the time, there was little choice of
currency for these, and I was persuaded to take US dollar-denominated ones on the
grounds that they were the most negotiable. When I got to Germany, I found that
each time I cashed my cheques I received fewer and fewer Deutschmarks for my
dollars. I was a victim of adverse movements in the exchange rate. I had, unknow-
ingly at the time, been exposed to currency risk. In reality I had taken on
considerably more risk than I need have, since not only was I exposed to move-
ments in the Deutschmark against the US dollar, but I had also exposed myself to
the exchange rate risk between British pounds (known as sterling) and the dollar, a
fact I discovered on my return to the UK when I sought to cash in my surplus
cheques!§ My experience, as we will discuss below, mirrors that of the modern
development of financial risk management, which has its origins in the global
financial dislocations that followed the collapse of the post-war global structure
called the Bretton Woods Agreement.
This module introduces the basic concepts of risk management and the justifica-
tion for this process. Managing risk is part of any organisation’s strategic and
operational activities, and analysing risks is an important aspect of a manager’s job.
Risk management is the process of monitoring risks and taking steps to minimise
their impact. Financial risk management is the task of monitoring financial risks
and managing their impact. It is a sub-discipline of the wider function of risk
management and an application of modern financial theory and practice. Financial
risk management falls within the financial function of an organisation and is a
reflection of the changing nature of this function over time. Traditionally, the
financial function has been seen in terms of financial reporting and control. The
modern approach is to consider the financial function in terms of financial policy
and financial decision making. This includes the management of the firm’s opera-
tional, business and economic risks.
Risk is pervasive. In fact, we experience it in our everyday lives, as it is a constant
of the human condition. Everything we do in our lives has a degree of risk attached
to it. In living with risk, however, certain potentially high-risk exposures or potential
events require us to take corrective action, for instance avoiding violent situations or
insuring one’s life, home and other possessions. In the terminology of risk manage-
ment, we would be adjusting the risk; that is, reducing the risk to acceptable
proportions by hedging, offsetting or possibly eliminating it, depending on the
courses of action that were available. The reason we make such adjustments is that
the particular risks are too great for an individual to bear. We may transfer part or all
of these risks to those better able to accept them, either by sharing the risk via
insurance (as with home and life assurance policies) or, in some cases, by finding
others who have the opposite risk and agreeing with them to exchange positions.
§ A more detailed discussion of this issue is given in the appendix to this module.
1/2 Edinburgh Business School Financial Risk Management

An example of risk management is the case of a commodity producer who is

concerned about investing in production. To protect against adverse movements in
the price of the commodity before it can be sold, the producer may seek out a buyer
and agree to a fixed price before committing to produce. On the other side, the
buyer has an equal incentive to agree to a fixed price, as he will be concerned that
the price might increase in the future. In the parlance of financial markets, the buyer
is locking in a fixed forward price for the commodity, in anticipation of its being
needed in the future. Taking such a step will eliminate the risk to the producer that
the price may decline, and to the consumer that the price may rise before the
purchase.** Alternatively, we may change our behaviour to reduce the risk. For
instance, one (but not the only) reason that companies establish overseas manufac-
turing subsidiaries in foreign markets is to eliminate currency risk on exports.
Because certain types of risk are unacceptable, a market for exchanging or offset-
ting risks has developed. This market in risk includes the insurance markets, capital
markets and specialised financial instruments, such as a variety of derivatives. While
it is possible to mitigate or transfer a great many types of risk in this way, the key to
the risk management process is choosing those risks to accept, not seeking
to avoid all risks. The latter is impossible.
1.1.1 Historical Background

There is evidence of risk management activity going back to the dawn of time.††
There are indications of forward dealing taking place in India as early as 2000 BC; a
forward market in grain is said to have existed in Ancient Rome; and certainly by the
Middle Ages risk sharing was widely used. Merchants spread their risks through
collective ventures by pooling capital to finance trading expeditions, thus allowing
them to diversify their investments. Agreements allowing parties with opposite risks
to exchange positions were also becoming common practice. For instance, a
forward market in currencies was well established in Antwerp by the close of the
fifteenth century. The Antwerp exchange was the original model for Thomas
Gresham’s Bourse, which was set up in 1571 in London, later to be known as the
Royal Exchange. By the eighteenth century in England thriving risk exchange
activity was taking place, with buyers and sellers willing to contract forward to
eliminate price and delivery risk on basic commodities. Since much of the uncertain-
ty arose in relation to imported products, these markets were located at terminal
points such as dockyards. It was at this time that life assurance was first introduced
as a product and that insurance companies were established. The above evidence is
testimony to the ongoing nature of the problem presented by risk in human affairs
** Of course, by buying forward, the buyer forgoes the opportunity to purchase the commodity at a lower
price, were it to fall in the meantime. The decision to ‘buy forward’ – or to hedge – will depend on
many factors: the consumer’s tolerance of risk, expectations about future price changes, the supply
outlook and how much prior price variability (generally known as volatility) there has been or is
expected in the future. The same considerations apply to the producer’s or seller’s decision as to
whether to ‘sell forward’ (that is, hedge the exposure to future price movements).
†† A good discussion of the history of risk management is to be found in Bernstein (1996).

and the willingness of individuals to create arrangements to mitigate its worst

effects.
In the nineteenth century, the development of modern risk management tech-
niques took a step forward with the formation of organised terminal or futures
exchanges to allow participants to exchange risks on a wide range of agricultural
commodities. The United States, because of the economic importance of its large
agricultural base, led the way with the establishment of commodity exchanges in
New York and Chicago. Soon after, similar terminal exchanges were established in
other major trading centres, such as London and Paris.
Financial risk management has always been implicit in the management of the
firm. Its recent development as a major management responsibility, however, is the
result of two major post-war developments. The first was the collapse of the
Bretton Woods Agreement following the decision by the US on 15 August 1971 to
stop exchanging dollars for gold at the fixed price of $35 per oz. From that moment
on, foreign exchange markets became more volatile, a factor that directly affected
interest rates and, indirectly, other assets such as commodities, many of which are
priced and traded in dollars.‡‡ The collapse of the fixed exchange rate system was
shortly followed by the first oil shock, when the price of oil quadrupled in the
winter of 1973–4. These two events led directly to a demand for instruments to
manage these risks.
The increased price uncertainty or volatility that has been seen since the early
1970s has been one of the main driving forces behind changes in financial risk
management tools and techniques and the increased choice available to practition-
ers. Another development encompassed the fundamental changes that took place in
the behaviour of economic variables from the mid-1960s. With the collapse of the
Bretton Woods Agreement, individual countries were able to pursue divergent
economic policies, the impact of which was now transmitted through the free-
floating exchange rate. To combat inflation and to prevent excessive currency
depreciation, countries needed to have a more aggressive approach to managing
interest rates, which in some cases were raised to unprecedented levels.
1.1.2 Increased Volatility in Foreign Exchange Rates

Figure 1.1 and Figure 1.2 show changes in the exchange rate of the British pound
against the US dollar. Apart from the occasional currency devaluation, prior to the
breakdown of the Bretton Woods Agreement there was relative stability month on
month. After the agreement collapsed, increased volatility is clearly evident. Before
the collapse of managed exchange rates, exporters and importers could be relatively
confident of the prices they would get or have to pay; afterwards, the rules had
changed. With a free-floating exchange rate, both exporters and importers had
significant currency risk. Exporters sought to protect themselves by pricing in their
domestic currency; importers sought to do the same. By accepting foreign currency
prices, one or other party stood to suffer a potential loss if the exchange rate moved
‡‡ This was the time I experienced my lesson in the vagaries of currency movements, as detailed in the
first paragraph of Section 1.1.

significantly between the time when the agreement was reached and that when the
payment was made.
$3.5
$3.0
$2.5
$/£ exchange rate
$2.0 1967
devaluation
$1.5
Collapse of
Bretton Woods
$1.0
$0.5 Fixed exchange rate Floating exchange rate
$0.0
11
Ja 7
Ja 0
Ja 3
Ja 6
Ja 9
Ja 2
Ja 5
Ja 8
Ja 1
Ja 4
Ja 7
Ja 0
Ja 3
Ja 6
Ja 9
Ja 2
Ja 5
Ja 8
5
0
n
n
n
Ja
Figure 1.1 British pound–US dollar monthly changes in exchange rates
Fixed exchange rate Floating exchange rate

$0.2
$0.1
$/£ exchange rate
$0.0
–$0.1
–$0.2
–$0.3
–$0.4
Ja 8
Ja 0
Ja 3
Ja 6
Ja 9
Ja 2
Ja 5
Ja 8
Ja 1
Ja 4
Ja 7
Ja 0
Ja 3
Ja 6
Ja 9
Ja 2
Ja 5
57
11
0
6
0
n
n
n
n
Ja
Ja
Figure 1.2 British pound–US dollar monthly volatility

Note: The data show month by month first differences in exchange rates.

Post-1997:
period of
continued
British pound strength
120
115 ERM period
110
16 Sept. 1992:
British pound leaves
the ERM
105
1996/7
British pounds appreciation
100
95
90
85
80
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Figure 1.3 British pound trade-weighted index from 1990 to 2001

Currency volatility also affects domestic producers and increases their risks. Me-
dium- to long-term changes in exchange rates affecting a country’s terms of trade
can make foreign producers more competitive relative to domestic ones, thus
allowing import penetration. The UK suffered such a change in the 1980s when the
exploitation of North Sea oil led to a significant increase in the value of the British
pound. Many parts of British industry found it very difficult to compete with
imports because of the overvaluation of the currency, and suffered long-term
damage as a result.
The situation changed again in the late 1980s and the 1990s as the impact of the
oil industry on the British pound diminished (partly as a result of the dramatic
decline in oil prices) and the pound fell to a more competitive level. But the 1990s
saw the British pound continue to show short-term and longer-term swings in its
external value. During the first decade of the twenty-first century, the pound
continued to enjoy periods of relative undervaluation and overvaluation as senti-
ment about the prospects for the British economy and interest rates changed from
positive to negative and back again. An indication of the problems for exporters and
importers is given by Figure 1.3, which shows the trade-weighted index. This has
indicated periods of overvaluation for the currency against economic fundamentals
matched by other periods of undervaluation. This has created real dilemmas for
firms and emphasised the importance of having a sound risk management strategy.
Even if countries manage the exchange rate, this does not always lead to success-
ful outcomes. In 2011, Brazil faced influxes of foreign money as interest rates, set
for domestic purposes, made foreign investment particularly attractive. China, by
pegging its currency to the US dollar, has maintained an artificially low exchange
rate that has greatly benefited its exports and domestic growth, but at the expense of
domestic consumption – and the country seems to suffer from chronic inflation. In
addition, currency surpluses have had to be recycled, leading to a build-up of
dangerous imbalances.
What is clear is that, looking ahead, currencies are likely to experience periods of
appreciation and depreciation, and this emphasises the need for organisations to
understand and manage these effects.
A Real Problem for Brazil ___________________________________
In 2011, the appreciation of the Brazilian real against foreign currencies became
a huge problem for the country and its domestic firms. The rising exchange rate,
which had increased by 8 per cent in the first half of the year and hit a 12-year
high against the dollar at the start of July 2011, made local producers increasing-
ly uncompetitive against Asian countries. This problem arose because countries
such as China, Vietnam and the Philippines had currencies that were linked to
the US dollar. As Figure 1.4 shows, the Brazilian real appreciated against the US
dollar, making Asian imports correspondingly cheaper in local currency terms.
This had a devastating impact on local firms, leading to President Dilma Rousseff
declaring: ‘We must protect our economy, our manufacturing efforts and our
jobs.’

The problem arose during the spring of 2011 because nominal interest rates in
Brazil were significantly higher than elsewhere in the world, and hence foreign
capital flooded into the country, pushing up the exchange rate. In 2011, Brazilian
bonds offered some of the highest yields in the world (around 12 per cent at
the time). Consequently, Brazilian assets were the fourth-largest foreign
holdings by Japanese investors. As a result of Brazil’s new-found status, underly-
ing economic strength and stability, foreign investors had been attracted to
Brazil and assets denominated in Brazilian reals.§§ The currency appreciation
problem was made worse by government policy that had created a stable
exchange rate against the US dollar, coupled to intervention in the currency
market to maintain its value and complex foreign exchange controls.
If the currency continued to increase or stayed at the high levels seen in the first
half of 2011, local manufacturers would ultimately go out of business. This was
due to the fact that foreign producers could undercut locally produced goods of
similar quality. Looking at the situation, local firms needed to consider how best
to manage this problem. This example is not untypical of the issues that have to
be addressed in financial risk management.
1.95
1.90
1.85
$/Brazilian real exchange rate
1.80
1.75
1.70
1.65
1.60
1.55
1.50
10
11
11
12
10
11
10
10
11
1
11
0
10
l1
l1
ov
n
ay
ar
ar
n
p
n
ov
ay
Ju
Ju
Se
Ja
Ja
Se
Ja
M
M
N
M
N
M
Figure 1.4 Brazil real versus the US dollar

__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
§§ Brazil was part of what is known as the BRICs – Brazil, Russia, India and China – large emerging
market countries with demonstrable high growth. The Brazilian economy grew 7.5 per cent in 2010, at
a time when most developed countries struggled in the aftermath of the 2008–9 credit crunch.

1.1.3 Increased Volatility in Interest Rates

As with currencies, interest rate volatility also increased as a result of the ending of
fixed exchange rates. At first, it was thought that countries would be able to pursue
divergent economic policies based on domestic criteria, including monetary condi-
tions and interest rates. However, rising inflation, partly caused by currency
depreciation, meant that, after some delay, interest rates too became more volatile.
This is shown in Figure 1.5, which plots the short-term interest rates in the UK, and
Figure 1.6, which plots short-term interest rate volatility.
40
35
30
25
Change in price
20
15
10
0
Ja 5
Ja 7
Ja 9
Ja 81
Ja 3
Ja 5
Ja 7
Ja 9
Ja 1
Ja 3
Ja 5
Ja 7
Ja 9
Ja 1
Ja 3
Ja 5
Ja 7
Ja 09
11
7
8
8
9
9
9
9
0
0
0
n
n
n
n
n
n
n
n
n
n
n
n
n
n
Ja
Figure 1.5 British pound short-term interest rates

25
20
15
10
5
Gold price, $/oz
–5
–10
–15
–20
–25
Ja 5
Ja 7
Ja 9
Ja 1
Ja 3
Ja 5
Ja 7
Ja 9
Ja 1
Ja 3
Ja 5
Ja 7
Ja 9
Ja 1
Ja 3
Ja 5
Ja 7
Ja 9
11
7
0
n
n
Ja
Figure 1.6 British pound short-term interest rate volatility

The increased risk had several effects. The fact that borrowing costs, lending
rates, bond prices and yields were unpredictable meant that financial institutions
were unwilling to enter into long-term fixed-rate commitments. In response, firms
increased hurdle rates on investments, required faster payback and sought better
ways to manage the risk.
1.1.4 Increased Volatility in Commodity Prices

The same increased volatility can be seen in commodity prices. The price of gold,
following the US Treasury’s decision to sever the link to the dollar, also changed
dramatically, as can be seen in Figure 1.7. The volatility picture in Figure 1.8 is even
more dramatic, as the price changes month by month suddenly become very
significant.

Gold price $/oz
$2100
$1800
$1500
$1200
$900
$600
$300
$0
71
68
74
77
80
83
86
89
92
95
98
01
04
07
10
n
n
n
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Figure 1.7 The behaviour of the gold price
Controlled period
when US dollar was
exchangeable for
$250
gold at $35/oz
$200
$150
$100
$50
$0
–$50
–$100
–$150
–$200
–$250
Ja 68
Ja 70
Ja 72
Ja 74
Ja 76
Ja 78
Ja 80
Ja 82
Ja 84
Ja 86
Ja 88
Ja 90
Ja 92
Ja 94
Ja 96
Ja 98
Ja 00
Ja 02
Ja 04
Ja 06
Ja 08
10
n
n
n
n
n
n
n
n
n
n
n
n
n
n
n
n
n
n
n
n
n
n
Ja
Figure 1.8 Gold price volatility

Since the 1970s there have been a number of ‘oil shocks’, when the crude oil
price has risen dramatically and subsequently fallen again, as shown in Figure 1.9
and Figure 1.10. The oil price has also been a very volatile series, with periods of
extreme price movements. This has made life difficult for oil producers and
consumers and increased the demand for risk management to handle this problem.
Fluctuations in the price of oil or, more particularly, jet fuel have been a major issue
for airlines. They need to show consistent pricing and, in many instances, set prices
well ahead of the point where they provide the service. Hence they have sought
various means to manage these price risks; these include extensive operational
hedging and financial instruments.

$160
$140
$120
$100
$80
$60
$40
$20
$0
86
88
90
92
94
96
98
00
02
04
06
08
10
12
n
n
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Figure 1.9 Crude oil price
$20
$10
$0
–$10
–$20
–$30
–$40
10
86
88
90
92
94
96
98
00
02
04
06
08
n
n
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Figure 1.10 Crude oil volatility
1.1.5 Increased Availability of Financial Risk Management Products

Another technical development that was to lead to the modern approach to
financial risk management was the introduction in the US by the Chicago Board
Options Exchange (CBOE) of exchange-traded options on common stocks (or
ordinary shares, as they are known in the UK). At the same time the Chicago
Mercantile Exchange (CME) started trading financial futures contracts on both
currencies and interest rates. While over-the-counter options and forward contracts

had long existed, they had many disadvantages; exchange-traded instruments

promised much greater liquidity, since the risk of default by one of the parties to a
transaction was negligible. Because of the methods used to manage trading on these
exchanges, these markets are open to all parties, with both firms and individuals able
to transact. In addition, exchanges, with their large number of competing bids and
offers, established robust trading mechanisms. Equally, immediate price dissemina-
tion provides transparent and efficient pricing.***
An unrelated but equally important development that was occurring at the same
time was the seminal work by Fisher Black and Myron Scholes (1972) on providing
a model for option pricing.††† Their work and that of others in this area has provid-
ed practitioners with accurate analytical models for pricing complex, probabilistic
products.‡‡‡
The combination of increased market volatility and the availability of financial
instruments for hedging purposes (latterly called derivatives) has led to the devel-
opment of modern financial risk management techniques. A related development
has been the proliferation of new financial instruments, many incorporating one, or
more than one, derivative to alter the pattern of the return offered. The long-
established instruments, namely traditional bonds and ordinary shares, have some
drawbacks, and structured products, as these new instruments are called, aim to
address these. Some of the new structured securities have been ‘seven-day wonders’;
others have created new possibilities for asset and liability managers. The process of
building new financial instruments continues, although there is some evidence that
the spurt in financial innovation that took place in the 1970s and particularly the
1980s has abated somewhat.§§§ Nevertheless, securities that have special features can
be an important way to manage certain risks. Even governments recognise this. For
instance, while the UK has had inflation-protected government bonds for a long
time, the US has not. Yet in the late 1990s the US introduced similar securities, and
other countries, such as France, have also in recent years begun to issue similar
securities. Other securities offer exposure or protection to currencies, commodities
and even equities.
As a consequence of the increased volatility and uncertainty, industrial and com-
mercial firms have responded to the increased financial risks by seeking better
methods to manage their risks. At the same time, reacting to the increased demand
for risk management instruments, financial intermediaries have sought better ways
of helping their clients to reduce or eliminate such risks. It is an ongoing dynamic
*** Forwards and futures, as part of the risk management product set, are examined in detail in the
Derivatives course.
††† See also Black and Scholes (1973). The Black–Scholes equation has been described as ‘the theoretical
workhorse of the financial industry’.
‡‡‡ Options are discussed in the Derivatives course text.
§§§ A good review of the process is found in Miller (1991). He lists four factors that have increased
financial innovation:
i. the move towards floating exchange rates;
ii. information technology and the developing power of the computer;
iii. world economic growth; and
iv. regulation and deregulation as contributory factors to the spurt of innovation in the last 20 years.

and interactive process where participants’ understanding of risk has led to the
evolution of new, more specific hedging methods. Over time, increased technical
expertise and experience have allowed financial engineers to more fully understand
these risks and develop ways of breaking them down into their constituent parts.
Complex exposures can then be reassembled with the undesirable or unacceptable
elements removed. As mentioned earlier, airlines face a range of risks in their
business: fuel prices, interest rates, currency movements, passenger load factors and
political events. Some or all of these risks need to be managed. In response,
financial intermediaries put together special hedge programmes, such as jet fuel
swaps or currency swaps, to provide tailor-made solutions to these and other
uncertainties.
1.1.6 New Developments in Technology

In the mid-1960s, International Business Machines (IBM) introduced its 360 series
of computers, heralding increased computing power and greater ease of use. Many
data-processing tasks that hitherto had to be handled manually were now automat-
ed. In 2001, Microsoft, along with computer manufacturers and other software
firms, celebrated the twenty-fifth anniversary of the introduction of the PC. New
developments in information technology (IT) have occurred hand in hand with the
need for more extensive risk management activity. Many of the developments in
financial methodology are dependent on the availability of cheap and fast processing
power. Pricing many kinds of derivatives requires the high-speed ability of comput-
ers to crunch the numbers. This applies to virtually all aspects of financial
intermediaries’ ability to deliver risk management products. Even an established
financial derivative like a foreign exchange forward contract cannot be managed
without the support of IT systems. More exotic derivatives require computers to
perform iterative simulation or optimisation in deriving a price or the instrument’s
risk characteristics. A side product to the availability of IT systems has been the
collection of enormous quantities of financial data with which to test the new
instruments and develop quantified risk estimates for the sources of risk.
The Effects of Financial Risk _________________________________
As we shall see, companies are vulnerable to changes in macroeconomic factors.
The following examples show how changes in economic factors are affecting
corporate performance.****
 Polish companies in bad bets against the zloty
In 2009, the Polish government stepped in to help companies such as Elwo,
which had undertaken extensive transactions in anticipation of a rise in the
zloty against the US dollar and the euro only to find the zloty suddenly fall
against these currencies in the wake of developing problems in Eastern Eu-
rope in the aftermath of the credit crunch. The US dollar gained 70 per cent
and the euro 40 per cent as investors fled problematic currencies. Com-
**** A fuller discussion of the issue of why firms, their managers and investors might be concerned about
these effects is deferred to Module 2.

menting on the problems facing companies such as Elwo, the Financial Super-
vision Authority estimated that Polish companies had lost 5.5 billion zlotys
($1.6 billion; €1.2 billion; £1.1 billion) from similar transactions. After the
bankruptcy filing by Elwo, the chief executive of its parent company stated:
‘In retrospect I can only say we chose bad instruments.’
 Cargill profits decline 66 per cent
Cargill, the world’s largest agricultural commodity trader, reported a 66 per
cent decline in first-quarter profits. It made a profit of $236 million in the
first three months of 2011, compared to $693 million in the first three
months of 2010. At the same time, revenues rose by 34 per cent to $34.6
billion, which, when combined with the fall in profits, meant that Cargill suf-
fered a significant reduction in its profit margins. The company indicated that
the significant volatility in financial and commodity markets and in particular
its results reflected the ‘stress in financial markets caused by growing eco-
nomic, fiscal and political concerns on both sides of the Atlantic’ (the US and
Europe).
 Allied Irish Banks suffers from low interest rates
The 1998 profitability of Allied Irish Banks (AIB) was adversely squeezed,
despite a 15 per cent increase in pre-tax profits to Irish punts (IR£)826 mil-
lion, up from IR£718 million in 1997, as a result of low interest rates
squeezing its net interest margin (the net difference between the rates at
which it lends and borrows funds). This fell by 33 basis points (a basis point is
one-hundredth of 1 per cent) to 3.33 per cent in 1998. AIB further indicated
that, as a result of the introduction of a common interest rate in countries
participating in the European Monetary Union, a further reduction in margin
was to be expected in 1999.
 General Mills and ConAgra
The US food company General Mills saw increased sales in the first quarter
of 2011, rising 9 per cent year on year. However, at the same time, profit
margins suffered and net earnings fell to $405.6 million from $472.1 million
for the same period the previous year, a decline of 14.1 per cent. The com-
pany indicated that it expected its raw material costs, mostly agricultural
commodities, to increase by 11 per cent over the forthcoming year. The
performance of General Mills has to be contrasted with that of its rival
ConAgra, which reported a 42 per cent year-on-year drop in net income as
a result of rising input costs. Its net income dropped to $85.3 million, down
from $146.4 million.
This example indicates how active risk management can help to overcome the
problems of economic factors:
 Japanese government provides aid to help exporters
In August 2011, the rapid rise in the Japanese yen (JPY) against the US dollar
and the euro prompted the Japanese government to offer short-term finan-
cial support to exporters hurt by the yen’s strength. Over the previous year,
the JPY had risen from JPY95 to the US dollar to JPY76 to the US dollar – a

post-war record – and a currency appreciation of 25 per cent. The loss of

international competitiveness in the American and European markets for
Japanese exports and the poor outlook for the global economy prompted
policy makers to turn to inventive policies to help Japanese export industries.
These policy initiatives followed two failed currency interventions by the
Bank of Japan designed to drive down the exchange rate.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
1.2 What Is Risk?

1.2.1 Definitions of Risk and Risk Management
A single definition of risk will not serve all risk management purposes. Risk manage-
ment is carried out in such diverse areas as transport, health and safety, finance, and
insurance. In mathematics, there is no single definition for the idea of a number; a
similar situation arises in risk management when it comes to defining risk and risk
management. Each of the disciplines above makes use of the idea of risk in the
context of its particular objectives. So, for transport, risk is taken to be an accident or
damage; for health, it is taken to be illness, injury or loss of life.
The term risk originates from the Italian riskare, which means ‘to dare’. The dic-
tionary lists risk as both a noun and a verb. When used as a noun it has the
connotation of danger, hazard, the chance of loss, an enterprise that can lead to
profit or loss, the amount of a loss (hence the ‘sum at risk’), a gamble or a bet.
When used as a verb, risk means to expose oneself to the potential for loss, to make
a bet or a wager, to gamble, to undertake an uncertain enterprise or venture. Both
uses imply that there is the possibility of gains as well as losses.
There is also a psychological meaning to risk: it is that state of uncertainty or
doubt in the face of a situation with beneficial and adverse consequences (gains and
losses).††††
A simple definition of risk that includes the meanings above is:
The chance (or probability) of a deviation from an anticipated outcome.
The implications of this definition are given below.

 We can attach probabilities to risk. Therefore, it can be measured, estimated or
calculated in some way. Risk can therefore be quantified and expressed as a pa-
rameter, number or value.
 Risk is concerned not just with the extent or probabilities of potential losses but
with deviations from the expected outcome. It is the extent to which the
actual result may deviate from the expected result that makes a situation risky.
 Risk is a function of objectives. It is the consequences of the actual result
deviating from the expected result that leads to risk. Without an objective or
intended outcome, there is only uncertainty. A rider to this is that risk arises only
†††† For a review of the behavioural aspects of risk, see Fischhoff (2012).

where the deviation from the objective matters; that is, if it affects individuals or
firms financially, or entails some other adverse consequence. It can also provide
an opportunity.
Within the discipline of risk management, of which financial risk management
forms a sub-element, the following additional concepts for risk are in use:
Possibility of a gain or loss

Where there is a possibility of a gain or loss, this is often referred to as a
risk. Note that this usage does not necessarily attempt to quantify the degree
of loss.
Probability of a gain or loss
This defines risk as the chance or probability of a gain or loss. In terms of
risk theory, the probability of an event occurring takes a value that can range
from zero to one. An event is impossible if it has a probability of zero; an
event is certain if it has a probability of one. Risk will be greatest if the gain-
or loss-making event has a probability of one; that is, it is certain to occur.
In practice, the probability of loss (ρ) will lie above zero and be less than
one, i.e. 0 < ρ < 1.0. Often people will talk of the odds of gains and losses.
This is the ratio of unfavourable to favourable outcomes. So, if the probabil-
ity of gain is 0.25, the odds are 0.75:0.25, which are more often expressed as
3 to 1. Hence we would say that the odds are 3 to 1 against success.
Cause of loss or peril
Peril is a term used in the insurance industry for the source of a risk. It is the
cause of a loss. For instance, fires, floods, explosions, accidents, death and
so on are all perils. In finance, the more common term is risk factor.
Hazard
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.
There are three common types of hazard:
 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: 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: actions taken by the insured party that increase the likeli-
hood and/or severity of a loss. Morale hazard arises because the
consequences of the action are borne by the insurer rather than the in-
sured. For instance, car owners with fully comprehensive theft insurance
are less likely to lock their cars when they leave them. Such persons are
likely to own more expensive vehicles and experience higher theft rates
than individuals who are not similarly insured.
(Note that these last two concepts bring in the behavioural aspect of risk.)

Potential gain or loss

The exposure or potential for gain or loss is also referred to as a risk.
Practitioners may use the term ‘risk’ to refer to the values that are exposed
to gains and losses. An example is the financial services industry’s ‘value-at-
risk’ metrics used to quantify the extent of an expected future loss within a
given confidence limit.
Range and variability of outcomes
The actual range of potential outcomes, or a measure of that range (for
instance, the variance of a particular set of outcomes), is used to define a
particular risk. A more sophisticated approach may specify the exact nature
of the probability distribution (such as the normal or Gaussian distribution).
Finance professionals will often refer to markets as being ‘highly volatile’.
The term volatility comes from the derivatives markets and is the standard
deviation of continuously compounded returns. The intellectual foundation
is the mean-variance approach derived from modern portfolio theory and
option pricing.
Risk management
Risk management is the identification, assessment and decisions made
regarding the treatment by an organisation (or an individual) of particular
risks faced by the organisation (or the individual). It can be a formal process
involving procedures, quantitative and qualitative assessments leading to
review and minuted decision, or it can be informal.
The Three Dimensions of Risk Management __________________
At the level of the economy, risk management makes use of basically two
approaches to modifying the level of risk, either risk pooling (sharing) or risk
transfer. At the aggregate level the total amount of risk in the economy cannot
be reduced, but its economic consequences can be modified through sharing its
consequences or transferring the risk to another party better able to accept the
consequences of the risk. With risk pooling, or risk sharing, the effects of risks
are spread among all market participants. Insurance is an example where losses
are shared among the pool of insured parties. Risk transfer involves reassigning
the risk to another party for a fee. For instance, many industrial and commercial
firms transfer their foreign exchange exposures to banks by buying forward
foreign exchange contracts. The bank then manages the resultant risks.
In addition, while the process of financial risk management activities may seem
complex – and this often serves to mask the inherent benefits from undertaking
the process – this same apparent complexity also hides the fact that the risk
management process has three generic approaches, namely hedging, diversifica-
tion and insurance.
Hedging leads to the elimination of risk through its sale in the market, either
through cash or spot market transactions or through a transaction, such as a
forward, future or swap, that represents an agreement to sell the risk in the
future. For instance, the UK-domiciled exporter being paid in euros when the
goods are delivered at some date in the future can hedge this exchange rate risk

by entering into a forward exchange agreement (with a bank) to sell the euros it
will receive at a fixed price and receive a known amount of British pounds
rather than leave the result to unknown fluctuations in the exchange rate.
Diversification reduces risk by combining less than perfectly correlated risks
into portfolios. For instance, while individual borrowers from a bank each
represent a significant element of credit risk, for the depositors at the average
bank there are virtually no concerns about credit risk.‡‡‡‡
Insurance involves paying a fee to limit risk in exchange for a premium. For
example, one has only to consider the benefits to be derived from paying a fixed
premium to protect against property damage or loss, or for life assurance, in
the traditional insurance contract. In doing so, the insurer, usually an insurance
company, takes on the risk of unknown future losses.
Figure 1.11 illustrates how the relationship between risk modification (through
risk pooling and risk transfer) and the generic risk management approaches
might work. Any risk management transaction can be mapped onto this tem-
plate.
Risk pooling Risk transfer
Risks are not pooled as such, Risks are exchanged

but transactions undertaken (transferred) from one
Hedging which have the economic party to another
effect of selling (or transferring)
the risk
Risks are placed into portfolios No risks are transferred:

and the aggregated risk is less risk reduction is obtained
Diversification than the sum of the individual through portfolio effects
risks
Assumed risks, as in the case Risks are sold (transferred)

of insurance, may be pooled from the buyer to the seller.
Insurance at the aggregate level and Seller assumes all future
hence risk taker may get uncertainty about value
benefits of diversification
Figure 1.11 Relationship between risk processes and generic risk

management approaches
_________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
All definitions of risk share two common factors: the indeterminacy of the out-
come and the chance of loss. That the result is not a foregone conclusion is implicit
in any concept of risk: the outcome must be in question. For a risk to exist, there must
‡‡‡‡ This is to simplify. Of course, depositors may be concerned about the financial stability of a bank given
other factors such as the competence of its management, lending policy and the level of defaults. Past
experience shows that banks can – and do – fail. It is for this and other public policy reasons that
banks are regulated and in some countries deposit insurance is provided. But banks thrived prior to
regulation.

be at least two possible outcomes. If we were to know for sure that a loss was the
result, there would be no risk; we would avoid the situation or accept the consequenc-
es. For instance, when we buy a new car, we know that the value of the car will
depreciate with age and use: here the outcome is (more or less) certain, and there is no
risk. The other element of risk is that at least one outcome is unexpected and undesir-
able. This is a loss in the sense that something of value is lost or that the gain in value
is less than what it was possible to achieve. For instance, an asset whose return – or
appreciation in value – is less than an alternative would result in an opportunity loss.
That is why the depreciation you experience when you own a car is not a risk. While it
is undesirable, it is not unexpected. It follows from knowing that the asset, a car in this
case, will lose value over time as it wears out.
Bryan Wynne (1992) proposes a four-level stratification:
1. risk, where probabilities are known;
2. uncertainty, where the main parameters are known but quantification is suspect;
3. indeterminacy, where the causation or risk interactions are unknown.
4. ignorance, where we don’t know what we don’t know. This refers to the risks
that have, so far, escaped detection or have not manifested themselves.
We can define risk as the set of outcomes for a given decision to the occurrence
of which outcomes we may assign a probability. Uncertainty implies that it is not
possible to quantify the extent of the hazard. It follows, therefore, that with risk the
outcome is unknown but we can somehow define the boundaries of the possible set
of outcomes. Risk can be quantified, whereas uncertainty cannot. While we can
make great play of the difference between risk and uncertainty, the two are often
used interchangeably. In so far as certain unexpected outcomes cannot be easily
quantified, they are uncertain rather than ‘risky’ under this definition. This is clear
when we consider the relationship between risk and exposure, two terms that are
often used interchangeably.
Risk is the probability of a loss; exposure is the possibility of loss. While the two
terms are often used interchangeably, risk arises from an exposure. Hence, as shown
by the example companies given in Section 1.1.6, a firm’s line of business creates
exposures that are risky and therefore need to be managed.
We can further refine our thinking by considering events that are common but
lead to small losses and events that are infrequent but lead to high losses. This latter
category is often the most troublesome, since occurrences are infrequent and
difficult to anticipate. We can hence categorise risk and frequency as shown in
Figure 1.12.

Probability
High Low
Frequent, low economic Infrequent, low economic
effect events effect events
e.g. processing errors; e.g. machine breakdowns
short delays in deliveries and outages
Small Impact: minor Impact: negligible
Firms can anticipate these Firms can easily recover
Size of economic effect

and allow for them in from such events
operations, etc.
Frequent, high economic Infrequent, high economic

effect events effect events
e.g. changes in exchange e.g. earthquakes, civil
rates, interest rates, unrest, economic
commodity prices depression
Large
Impact: major Impact: catastrophic
Firms anticipate such Firms are often caught
events and undertake risk unawares by such events
management to control and suffer significant
potential economic losses economic losses
Figure 1.12 Relationship between economic effect and the frequency of

occurrences
To be able to assess risks involves breaking the overall risk down into its compo-
nent parts. The basic risk paradigm, as shown in Figure 1.13, based on
MacCrimmon and Wehrung (1986), is a decision problem where there is a choice
between only two outcomes: a certain outcome (X: often but not exclusively the
status quo) and an uncertain outcome that is the result of two possible events, each
of which has a certain chance or probability of occurring, where one outcome
produces a gain (G) and the other a loss (L). The financial equivalents to this risk
model are the Sharpe–Lintner Capital Asset Pricing Model (CAPM), as developed
by Sharpe (1964), Lintner (1965) and others, and Arbitrage Pricing Theory (APT), as
proposed by Ross (1976).
As the risk paradigm shows, we face the problem of deciding whether it is advis-
able to take on a particular risk. This requires us to calculate the benefits of bearing
the risk. As a decision problem, this requires us to balance the possibility of a gain
against the possibility of a loss. When deciding on the appropriate course of action,
the risk paradigm also requires us to establish our attitude to the possibility of a loss
if the risky course of action is decided upon. Resolving the problem is a complicated
task that often depends on the situation, its context and the knowledge and attitudes
of the person or group making the decision. This is because the risk capacity of
individuals and groups varies enormously. Hence, developing an understanding of
an organisation’s risk tolerance or risk appetite is part of the process, since what is
acceptable to one individual or organisation may be unacceptable to another.
Factors such as the size, effect and potential consequences will need to be factored
in to the decision.

X
A
r
G
B
1–r
L
Figure 1.13 Basic risk paradigm

Source: MacCrimmon and Wehrung (1986).
In order to resolve the decision problem, the evaluation often takes the form of
some cost–benefit or risk–reward analysis where the various outcomes, their
costs (in terms of losses, etc.) and benefits (in terms of gains) are weighed up in an
appropriate way, taking into account the risk appetite or risk tolerance of the
decision maker.
To do this, we would require an estimate of the probability (ρ), which forms one
part of the resolution to the problem. A high probability of success is more likely to
make the risky decision seem the appropriate one. The risk of a loss, if it is small,
might make the risky alternative seem the best choice. However, these probabilities
are not sufficient alone and have to be integrated into the overall analysis to allow a
decision to be made. The expected value or certainty equivalent approach, as
proposed by decision theory, can be used to derive a probabilistically weighted
average value for the risky course of action. In the case of the risk paradigm above,
the course of action B would have an expected value (EV) of:
EV B 1
A more general outcome with n mutually exclusive possibilities would be:
E V ∑
where ρi is the probability or likelihood of the ith outcome and vi is its value. Note
that the various probabilities sum to 1 (that is, all possible outcomes are catered for):
∑ 1.0
The expected value (E(V)) is the average value of the payoffs from the possible
outcomes weighted by their probability. Once we have this average value, we can
calculate the dispersion or variability of the range of outcomes as a measure of the
risk we take. Again using the basic risk paradigm example, the variance in possible
outcomes from taking the risk would be:
VAR B 1
A situation where there is greater deviation from the expected outcome has a
higher risk than one where the deviation is smaller. We will look at how this
deviation (or variance) can be defined and measured in Module 7. In practice, and
because it is easier to interpret, we tend to use the square root of the variance of a

distribution, which is the standard deviation. In finance, the standard deviation of

the return for a financial asset is called volatility. This is a very important measure
of risk, and we will be calculating it and using it later on in this course.
Calculating Risk ____________________________________________
To see how we might estimate risk, think of the situation when we throw two
dice with the normal 1 through 6 on each of the faces. There are 36 possible
combinations with values ranging from 2 (snake eyes, or double 1) through to
12 (double 6). The likelihood of any number on a given dice is 1/6. But a little
thought will show that the likelihood of both dice giving a 1, for instance, is 1/6
× 1/6 or 1/36. So extreme values of 2 and 12 are unlikely. A number such as 7
(which is also the expected outcome) has a much higher likelihood, since a
number of different combinations of values can add up to 7: 1 + 6; 2 + 5; 4 + 3
(this can occur in six different combinations when we throw two standard dice).
The likelihood of obtaining a value for the two dice of 7 is in fact 6/36 or 1/6.
For risk management purposes, to determine just how much risk there is
involved, we want to know the possible deviation from the expected outcome.
To know this, we need to know the distribution of the outcomes. A histogram
of the possible values of the two dice and their frequency is given in Figure 1.14.
4,3
6
3,3 3,4 4,4
5
2,3 2,4 2,5 3,5 4,5
4
2,2 3,2 4,2 5,2 5,3 5,4 5,5

3
2,1 3,1 4,1 5,1 6,1 6,2 6,3 6,4 6,5

2
1,1 1,2 1,3 1,4 1,5 1,6 2,6 3,6 4,6 5,6 6,6
1
2 3 4 5 6 7 8 9 10 11 12
· · · · · · ···
· · ·
· · · · · · ···
Figure 1.14 Histogram of outcomes for two six-sided dice with faces with
values of 1 through 6
A spreadsheet version of this figure is available on the EBS course website.
In quantifying the risk, we can first calculate the expected value of the two dice.
This is 7. Given this, we can now calculate the variance and standard deviation
using the quantification formula:

Variance ∑
This gives a value for the variance of 5.83, and for the standard deviation, which
is the square root of the variance (√5.83), of 2.42.
Now let us look at another example of dice similar to the one above, except in
this case the dice are what are known as average dice. These dice have values
that are closer to the average of a normal dice (which is 3.5) and have faces
numbered 2, 3, 3, 4, 4 and 5.
The histogram of outcomes is given in Figure 1.15. A comparison of Figure 1.14,
for the normal two dice outcomes, and that of Figure 1.15, for two average dice
outcomes, shows that the spread of possible outcomes and their likelihood is
very different. Whereas with the normal two dice the average value, 7, is
expected in 6/36 cases, with the average dice it occurs in 10/36 cases. Also, the
likelihood of getting outcomes close to the average (namely 6 or 8) is much
higher in the case of the average dice.
3,4
10
3,4
9
2,4 4,3 4,4
8
4,2 4,3 4,4
7
3,3 3,4 4,4
6
3,3 3,4 4,4
5
2,3 2,4 4,3 3,5 4,5
4
3,2 4,2 4,3 3,5 5,4
3
3,2 3,3 2,5 5,3 4,5
2
2,2 2,3 3,3 5,2 5,3 5,4 5,5
1
2 3 4 5 6 7 8 9 10 11 12
· · · · · · · · ·
· · ·
· · · · · · · · ·
Figure 1.15 Histogram of outcomes from two average dice with faces
with values of 2, 3, 3, 4, 4 and 5
A spreadsheet version of this figure is available on the EBS course website.

As with the normal dice, we can calculate the spread using the variance equa-
tion. This gives 1.83 for the average dice variance and 1.35 for its standard
deviation. Hence, the dice are missing the extreme values of 1 and 6. In the
language of risk management, we would say that an average dice is less risky
than a conventional one, since the dispersion of values is smaller. The maximum
range for a standard six-sided dice is 1 to 6, or a variance of 5 between the
extreme outcomes. For the average dice, the range is 2 to 5, or a range of 3.
Both dice have the same expected value. Hence, following our definition of risk,
the standard dice is the riskier.
What the two statistics do is to provide us with a metric for measuring the
relative riskiness of the two situations. A glance at the two histograms will
immediately show there is a greater chance of significantly divergent outcomes
for the normal dice. For instance, the probability of getting an outcome more
than two values away from the mean (in either direction) – i.e. values that are
less than 5 (4, 3, 2) and more than 9 (10, 11, 12) – for the two cases is:
Normal dice: 0.33
Average dice: 0.06
We can use the variance or standard deviation statistic, therefore, as an objec-
tive measure of risk for comparison purposes.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
In practice we are more concerned with negative outcomes than positive out-
comes (that is, we concentrate on the downside element of risk in any given
situation). However, risk taking is as much about opportunity as it is about loss,
although such risk taking is often equated with gambling or speculation. It is thus
correct to consider the risk/reward of a situation. This is the trade-off between the
risk being taken and the expectation of reward. This makes risk a more neutral
concept and is in line with the way many financial market practitioners consider risk.
As in practice, to purely focus on risk elimination is to miss the fact that risks
provide opportunities as well as problems.
Risk is multidimensional. Any given situation may involve a number of differ-
ent risks, some of which may be related. Typically, in financial markets, we
concentrate on price risk – that is, the risk that prices may change – but other
related risks exist, for instance liquidity risk.§§§§ Liquidity risk arises from the
problem that there may not be a willing buyer (or seller) on the other side of a given
transaction at a price close to the previous recorded transaction within a reasonable
time frame.***** Although price risk and liquidity risk are distinct, they may interact:
there will be more price risk in an illiquid market since the time required to execute
a transaction may be greater and the market price may shift significantly in the
meantime. When dealing in financial markets, practitioners talk about marketabil-
ity, which is the ease with which an asset, such as a financial security or instrument,
§§§§ Price risk is also known as market risk.

***** Note that, as with most financial terminology, the term is somewhat imprecise. Liquidity risk has other
meanings, like the ability of a company to meet maturing obligations from available (liquid) assets, or
for a company to raise funds when required.

can be sold. Liquidity is an allied term that implies that, when selling an asset, it can
be sold quickly without loss of value.
We will use the term risk factor to describe any single particular risk.††††† A given
risk will thus be made up of one or more risk factors, the sum of which is the total
risk. Given that risks are complex, some of these risk factors might actually be
mutually offsetting. For instance, inflation and interest rates are highly correlated –
that is, they tend to move together. Thus a combination of increases in both factors
may not be the sum of the two risks in a given situation. An organisation, for
instance, may be able to benefit from inflation by increasing prices, which will, to
some extent, counteract the effects of higher interest rates. Whether the combined
risk benefits a particular organisation will depend on how the two factors interact.
Module 9 looks at how we can integrate the different risk factors or exposures
mathematically using modern portfolio theory.
One way of understanding the effects of a risk is to establish the risk profile of a
given exposure. The risk profile is the size and direction of the payoffs that can be
expected in the future, given the risk, as shown in Figure 1.16. It will also show us,
as with a payoff diagram, the relationship between the risk and the gains and losses
from the risk factor (which are our exposures to risk). The slope of this relationship
shows the sensitivity of the position to the underlying risk – an idea we will return
to frequently (see the slope in Figure 1.16). Equally, when undertaking quantitative
analysis we can also determine how well the exposure correlates to the underlying
risk factor.
+ Gains from the risk

Change in
exposure
due to the risk
Slope gives
sensitivity of
exposure to
the risk factor
– +
Change in
risk factor
Losses from the risk
Figure 1.16 Risk profile and sensitivity of an exposure to a risk factor

We need to broaden our understanding somewhat when considering risk and
exposure. We may face risks, but in practice organisations manage their exposures.
To understand the difference, we need to introduce the concept of materiality.
††††† This is a standard term that is in common usage in risk management.

There may be very great risks in certain circumstances, but if they are immaterial to
the specific organisation – that is, insignificant economically – our attitude to such
risks will be different from what it would be if they were likely to have a serious
impact on the organisation. For instance, an organisation with a £100 million
turnover and a foreign exchange transaction exposure of £100 000 is not likely
actively to manage this risk, since in the overall context of its business such a sum is
not important. It hardly warrants much management time devoted to the problem.
Managers will therefore weight risks by their materiality to derive a firm’s exposure
to a particular risk. The analysis in Table 1.1 illustrates the process of evaluating
risks to obtain exposures.
Table 1.1 Risk and exposure
Potential degree of Amount of the Value at risk
change in variable variable exposed
(risk) (total amount at risk)
(i) (ii) (i) × (ii)
−5% 1 000 000 50 000
−5% 25 000 1 250
Note: Value at risk is a measure of the value loss or gain that arises from the potential
change in the risk based on the exposed amount.
The organisation will want to manage the large exposure, which has a 50 000
value at risk, but will devote only minimal time to the small exposure. To do
otherwise is to misuse management time and effort. Material is, in this context, of
course, a relative term. When deciding which exposures are significant and hence
need action, organisations should manage the absolute values at risk in relation to
their size and the organisation’s overall objectives.
Thus material exposures, which we do want to manage, are the risk factors times
the total amount at risk in relation to the whole. A further examination of Table 1.1
shows that, if the potential degree of change in the variable had been only 0.5 per
cent, then the amount at risk would have been 5000. It is the combination of change
in the risk factor and the amount of the exposure that creates materiality. Of course,
we can argue about what is material in a given context. For an individual, the orders
of magnitude are much smaller: 500 might be a large loss to an individual and
consequently quite material. So it is beyond this course to set fixed criteria on
materiality and what risks organisations and, indeed, individuals should actively
manage.
One of the decisions to be made by a particular organisation is what constitutes
materiality in the context of the business, given that any time devoted to managing
such an exposure will involve a cost. Remember that the risk paradigm is a cost–
benefit analysis. Different organisations will arrive at different decisions in this
regard depending on their attitude to risk. A key policy decision facing any
organisation is how great an exposure it is prepared to assume. Economists general-
ly define individuals’ and organisations’ attitudes to risk as risk averse, risk neutral
or risk seeking (risk taking). Generally, an individual’s or organisation’s risk
tolerance or risk appetite is an important determinant of how risks are managed.

The kind of risks taken by, say, an oil exploration company may be very different
from those that a retailer is willing to take. The former will be taking very large bets
on finding oil, the latter very small bets on new products and the quantities of
existing products to order. The risk appetites, and consequently the risks they are
taking, are very different.
In determining the amount of risk being assumed, we may also be helped by the
lack of correlation between the different types of risk. As with a portfolio, the
benefits of diversification come to our rescue, with bad and beneficial consequences
cancelling each other out in most instances. The organisation’s ‘portfolio of risks’ is
likely to be, in the main, self-hedging. However, an organisation’s risk manager
would nevertheless want to check that this is the case. In the main, it is the excess of
the risks in the portfolio that needs to be managed. That is, it is the risks over and
above a certain threshold, determined by the organisation’s risk appetite, that will be
managed.
We must also distinguish between risk, which is manageable, and uncertainty,
which is not. Just to confuse matters, financial literature sometimes uses uncertainty
to mean the same thing as risk! Risk is the impact of events the occurrence of which
is predictable but the exact form of which is unpredictable. For example, with risk
we can predict a range of potential outcomes within which the actual outcome will
occur. Uncertainty is the impact of completely unpredictable events. In an uncertain
situation, we cannot make forecasts about the range of outcomes. Although
uncertainty is not amenable to quantifiable forecasts, it can be handled within a
generalised risk management framework. Risk managers will seek to build flexibil-
ity, resilience and redundancy into an organisation to cope with these events.
Such forward planning involves qualitative forecasts, scenario building and other
similar methods to ascertain the nature and scope of the impact of future, uncertain
developments. An example of such planning is the requirement for banks to have
duplicated data-processing facilities that can be brought online in the event of a
disruption of the main installation. As a general precaution, organisations routinely
prepare contingency plans for unpredictable events such as product tampering or
contamination, or systems failure. Equally, at the macro level, situations like the
outbreak of war or civil strife are foreseeable but impossible to predict.‡‡‡‡‡
The principal point is that, as we move from frequently occurring events to the
less common ones, there is a gradual reduction in our ability to calculate accurately
the chances of different events taking place. Since we largely base the future
probability of such events on their past occurrences (making any reasonable
adjustments for the future), we need a database of such occurrences on which to
build our analysis. We can rely on statistical assessment methods for events that
occur very frequently, but we will need to use alternative methods for events that
occur less frequently or potential discontinuities between the past and the future.
These are the high-impact but low-probability events shown in Figure 1.12.
‡‡‡‡‡ These fall within the category of risks or uncertainties that we know exist but are impossible
to quantify.

It may be argued that there is plenty of evidence that war, for instance, is a fairly
common event. We are aware that such a risk exists, but, due to the complexity and
variability of the factors that are likely to lead to the breakout of a war, we cannot
predict such an event with any degree of confidence. It is inherently uncertain. On
the other hand, we can predict with a great deal of confidence that about 3000
people will be killed in road accidents in the UK in the next 12 months. This is risk.
That said, it is a remarkable fact that many low-frequency events are amenable to
quantification through sophisticated statistical inference techniques, even if the
estimate itself should be subject to considerable uncertainty. An example of such
calculations is the safety estimates for nuclear power stations. However, in analyses
of these rare events, the process by which the result is achieved is often more
informative than the numerical estimate. In addition, there is strong research
evidence that people, in considering and analysing risks, tend to disregard undesira-
ble low-probability outcomes and, likewise, overestimate desirable ones (as with
gambling, where people inflate the odds of winning long-odds outcomes).
Analytic techniques that are useful for high-frequency events may not be suitable
for examining rare occurrences. This is a point that will be taken up later. Risk
management does not, therefore, restrict itself to a single analytical approach; rather
it makes use of a wide variety of techniques from finance, statistics and the man-
agement sciences. Therefore, it would be wrong to see financial risk management as
embodying one particular methodology, although, as we will see, there is a logical
approach to risk management that is widely used by risk managers whether in
finance, industry, commerce or government.
1.2.2 The Risk Landscape

As previously stated, the risk landscape is multidimensional. Different management
and administrative disciplines have to confront the problems of risk: health and
safety, transportation, public policy, the environment, technology, science and many
other areas are involved. There are a number of different ways of laying out the
different risks facing an organisation. One such way of looking at risks is shown in
Figure 1.17.§§§§§ Two important conclusions can be drawn from this approach.
The first is that financial risk management is only one aspect of risk. Although
this course concentrates on financial risk management, the approaches used to
manage financial risk may be applied to other aspects of an organisation’s activities.
The second is that, although the material covers the top right-hand quadrant, the
other quadrants impact on financial risks. Ultimately, every part connects with
everything else. The objective of risk management is to control risks in such a way
as to allow the effective operation of the organisation within its capabilities and
resource constraints.
§§§§§ Other modules will show other ways to categorise risks.

Financial/
Operational/ Markets
Legal Global Political Risks
International environment
Domestic environment
Political
Nuclear Regulation Commodities division
proliferation Legal Interest rates
Reputation Currencies
Settlement Credit War
Fraud
Economic
Technical
Systems Terrorism
The Firm
Products/ Fashion
Climate services Fads
change Production & Sentiment
technology Demand
Population
Disease growth
Social Religious
Business discord Economic/
Markets
Figure 1.17 A topography of corporate risk
1.2.3 Risk Management

Organisations have no choice in managing risks. If an organisation has a sensitivity
to a particular kind of risk due to the activities it pursues, then changes in this risk
factor will change the current and future cash flows of the organisation. As previ-
ously discussed, organisations have to choose what objectives to pursue in handling
these exposures. The basic risk management premise is to have more of the good
and less of the bad. The key management task is to balance the desirable objective
of risk reduction with the costs of so doing (the cost–benefit analysis discussed
earlier). We will examine why organisations manage risks and what these risks are in
detail in the next module. Typically, the organisation will want to be confident that
changes in the external environment do not affect its objectives. As the next section
indicates, the organisation is likely to have a multiple set of objectives that it will
seek to pursue in handling its various exposures.
Objectives of Risk Management ______________________________
In seeking to manage risk, individuals and organisations need to define an
objective or a set of objectives in deciding how and when to manage and what
to do about risk. A common goal for firms is to increase shareholder value. For

individuals it may be their wealth, or what economists call ‘utility’. That is, the
object is to increase the value of the firm through increasing the present value
of its future expected cash flows. In normal circumstances, in pursuing the goal
of increased shareholder value, firms are likely to evaluate risk management
decisions on the basis of two criteria: the cost of reducing risk and the cost
of setting risk levels at an acceptable level – that is, in line with the
particular firm’s risk appetite or risk tolerance. In essence, firms will be evaluat-
ing risk on the basis of cost–benefit criteria. The cost of risk management
relates to the price to be paid for risk control, be it via insurance, management
time or lost opportunities from hedging. Firms will want to economise on these
incidental expenses of being in business. In doing so, firms will want to arrive at
an acceptable level of exposure in order to allow managers to focus on the core
activity of value creation and not be preoccupied by the nature, extent and
consequences of the risks in the business to the exclusion of its value-enhancing
objective.
The situation is different once a major loss has occurred. At this point, the
objectives of risk management change. The overriding objective becomes
survival. In such a situation, the results of excessive risk taking are likely to
significantly jeopardise the firm’s survival. Firms will be looking to create a stable
set of earnings and, where the loss has been a physical one, such as a fire or
damage to plant and equipment, the ability to continue operations. Lastly, the
firm will be concerned about its future growth prospects and development. The
objectives of risk management are thus different depending on the firm’s
development and recent history.
Hence, since the nature of the firm’s objectives is changed by a major loss, to
the possible detriment of its fundamental objective, avoiding the loss becomes,
in itself, a desirable objective.
Of course, concerns such as satisfying externally imposed obligations, for
example health and safety regulations, employment law and so on, as well as
meeting issues of good corporate citizenship, will be applicable both before and
after any serious loss.

Summary of Pre- and Post-Loss Corporate Objectives _________
Pre-loss Post-loss
Enhancing shareholder value Survival
Objective is achieved by: Objective is achieved by:
 Cost–benefit analysis with  Maintaining earnings stability
emphasis on costs of reducing  Restarting and maintaining
risks operations
 An acceptable level of worry and  Continued future growth
anxiety so as not to distract from
core objective
Social responsibility
Satisfying externally imposed obligations
 Enhancing shareholder value: a criterion for decisions about future

courses of action that recognises the value-maximisation objective for the
firm’s managers. The goal of the firm’s managers is to increase the value of
the firm to benefit its owners;
 Survival: the ability of the firm to continue in operation in spite of sustaining
a loss;
 Cost–benefit analysis: evaluative technique that seeks to balance the
benefits of risk management against the costs;
 Acceptable level of worry and anxiety: corporate attitudes to risk
taking such that the risks being accepted do not detract from the pursuit of
the overall business objective. This objective includes the firm’s strategy for
delivering value and ensuring the well-being of its employees, customers,
society and so on;
 Earnings stability: keeping earnings within acceptable bounds;
 Maintaining operations: restoring normal operations with the minimum
of delay after a loss;
 Continued growth: ability to take advantage of growth opportunities;
 Social responsibility: the firm will be a good citizen;
 Satisfying externally imposed obligations: to comply with existing laws
and regulations.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
We may want to distinguish between two aspects of individual and corporate

behaviour. The first is the idea of speculation; the second is hedging. With
speculation, risk is deliberately taken on with the direct intention of producing a
gain. The change in value or impact of the risk will be beneficial. On the other hand,
hedging (which can include risk transfer or buying insurance) is a defensive action
aimed at protecting against the effects of uncertainty. Hedging involves giving up
the ‘upside’ in return for protection against the ‘downside’. Insurance provides
cover against potential adverse developments; that is, providing compensation for
the ‘downside’ while retaining the benefits of the ‘upside’. While, as we will see in

the next module, companies will want to choose the mix of risks they assume, firms
that decide not to hedge are, in effect, speculating. In the face of risks, deferring a
course of action is as much a ‘decision’ as buying insurance or putting on a hedge.
1.3 What Is Financial Risk?

There are several ways in which we may define financial risk. In understanding the
impact of financial risk on the organisation, the nature of the cash flows or transac-
tional exposures needs to be understood. The risk is in both the amount involved
and its timing. The most obvious way to understand such risks is in terms of the
impact of changes in the risk factors on the organisation’s accounting numbers.
Changes in the reported earnings will be indicative of the different outcomes
experienced by the organisation. However, as mentioned earlier, financial risk will
extend to contingent exposures; that is, expected future transactions. But there is a
further, more general type of financial risk, known as economic exposure, that
comes from the interaction between changes in macroeconomic variables and an
organisation’s overall competitive position. Note that all of these ultimately relate to
the value of the firm, and – in financial terms – this can be considered as the present
value of the future cash flows that the firm will generate.
1.3.1 The Nature of Cash Flows

We can define the nature of financial risk to cash flows in two ways: first, whether
the amount of the cash flows is known and, second, whether the timing is known.
We therefore have four different types of cash flow, as shown in Figure 1.18.
Financial risks involve contractual or potential contracted payments where the
cash flows either are known for certain or are conditional. A conditional cash flow
requires some event to make it take place. For instance, an insurance company may
expect to make claims on policies, but it will not know the exact amount until a
claim is made. The timing of these cash flows is also either certain or conditional.
Conditional timing is where the exact date that the cash flow will occur is not
known for certain ahead of time, although it might be expected. Payments firms
receive for goods sold on trade credit fall into this category. These lead to the four
types of risk given in Figure 1.18.

Timing of cash flows
Known Unknown
1 2
Amount and timing Amount of cash flows
Amount of future cash flows

Known of future cash flows is known with
are known with certainty but the
certainty timing is uncertain
3 4
The timing of cash Both the timing and
Unknown flows is known with the amount of the
certainty but the future cash flows
amount is uncertain are uncertain
Figure 1.18 The nature of financial assets and liabilities (cash flows)
Type 1 cash flows are contracted payments that it is known will have to be met
in the future. Examples of such known cash flows include the fixed-rate term
deposits made with a bank and the coupon and principal payments on a fixed-rate
bond. Both the cash flows and their timing are known with certainty. The deposit
will mature at a given date, and both the amount deposited and the set interest
thereon will be paid to the depositor. With a bond, the issuer will pay periodic
coupon payments as defined by the bond terms on set dates. The holder knows in
advance when these will take place.
Type 2 cash flows are contracted payments where the amount due is known but
where the actual timing is undetermined. These include, for instance, the payments
from customers when trade credit is given by the seller. The payment amount is
known, but the exact date on which payments will be received is not known for
certain. Uncertainty about the payment date also applies to various types of condi-
tional financial contracts, such as life insurance, where the payout is known, since it
is contracted, but the timing is unknown, since it depends on an uncertain event: the
death of the insured.
Note that indeterminate does not mean that estimation is not feasible. Estimation
is possible, often with a fair degree of accuracy. When a large number of transac-
tions are involved, the statistical properties of the event come into play and, in
particular, the law of large numbers applies. As we will see in later sections, the risk
manager will make use of data from past cases as a predictor for outcomes in the
future.
Type 3 cash flows have fixed timing but unknown amounts. These can arise, for
instance, when money is borrowed at a floating rate over a given period. In this
case, the contracted interest payments are not known for certain, since these will be
set in line with future, unknown market conditions for each of the interest periods.
For example, on a five-year bank loan that has the interest set every six months the

timing of the interest payments is known, but the amount will not be known until
the actual interest rate is set in accordance with the terms of the borrowing. Note
that, once this happens, the cash flow then becomes a Type 1 cash flow.
Type 4 cash flows have neither fixed timing nor known amounts. These are
typically various contingent contracts or obligations where the cash flow crystallises
only when a specific event occurs. These include many types of insurance contract
that require payments if a loss is incurred by the insured party and where the extent
of the loss becomes known only when the event happens. Type 4 cash flows also
include situations such as tenders for contracts, where the future cash flows are
conditional on success in the bidding process.
The different nature of these cash flows is captured in most organisations
through internal management information, often of an accounting or transactional
nature.
1.3.2 Accounting Definition

Various risks will affect an organisation’s reported accounting numbers. The most
common type of exposure is transaction exposure, which is based on contracted
transactions. This is most evident in terms of foreign exchange rate risk where the
value of payables and receivables in a foreign currency will vary directly with
changes in the foreign exchange rate. There is, therefore, a risk of an actual cash
loss if the position is not managed or completely hedged.
The second kind of accounting exposure arises from the translation of foreign
currency items into the reporting currency (and hence it is also known as accounting
exposure). Although no cash transactions arise, since the organisation is merely
consolidating different sets of accounting numbers, changes in the rate used to
convert currencies between one reporting date and another will create bookkeeping
losses or gains. The translation problem arises because of two different effects.
Accounting numbers are a combination of historic and current activities, and one
view holds that it is the inherent contradictions within accounting conventions for
creating sets of financial statements that create the problem.
1.3.3 Contingent Exposures

Contingent exposures are those created by expected but not, as yet, contracted
transactions. Typically an organisation will have some expectation of sales to be
made or costs to be incurred in the future on its recurring business. Although these
revenues and expenses are not yet binding, there is a high probability that some or
all of the anticipated cash flows will materialise. If such cash flows are denominated
in a foreign currency or sensitive to changes in commodity prices or interest rates,
then the value or magnitude of such expected cash flows may change in line with
changes in these risk factors. A typical example would be an organisation bidding
for a project or contract in a foreign currency where the value will fluctuate in line
with changes in currency rates, adding a large undesirable element of unpredictabil-
ity to the profitability of the contract.

1.3.4 Economic or Competitive Exposure

Economic or competitive exposure arises from changes in foreign exchange rates,
interest rates and commodity prices, which have an impact on the organisation’s
profitability. It can be seen as the extent to which an unexpected change in a risk
factor changes the value of the organisation’s future expected cash flows and
ultimately its profitability. The change in expected cash flows depends on the effect
of changes in the variables affecting future sales volumes, prices and costs and
hence competitiveness. It has second-, third- and higher-order effects since an
organisation will be looking not only at how changes in the risk factors affect its
suppliers and competitors but also at the effects on suppliers to the organisation’s
competitors and their competitors and so on.
Codelco Savaged by Poor Copper Price ______________________
An example of how economic factors affect firms’ cash flows and profitability is
the case of Codelco, the world’s largest copper producer. In 1999, the half-year
profits at the company were nearly halved to US$122 million as a result of low
copper prices. Over the first half of the year, the copper price had averaged just
$66.47/lb, one of the lowest in the twentieth century. At the time, the state-
owned mining concern accounted for 15 per cent of world output, producing
some 725 000 tons of fine copper annually, and had first-half sales of $1.27
billion, a fall of 7 per cent compared with the previous six months, even though
sales volumes had risen by 5.5 per cent over the same six-month period in the
previous year.
The situation would have been even worse had not managers at Codelco
embarked on a radical cost-cutting plan that involved job cuts and pay freezes at
the concern’s five mines. As a result, direct production costs had been pared
down from 44.3 cents/lb to 41.3 cents/lb.
Note the exposure that the company had to the copper price and its operation-
al response to the low copper price, which involved cutting production costs
and overheads – these are typical operational risk management decisions.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
1.4 Steps to Risk Identification

Risk management, financial or otherwise, follows a logical process. At its simplest it
involves three steps: an awareness of the risks being taken by the firm, organisation
or individual; measurement of the risks to determine their impact and materiali-
ty; and risk adjustment through the adoption of policies or a course of action to
manage or reduce the risks.
1.4.1 Risk Awareness

It is not obvious how we may become aware of or identify risks. Some risks will be
well known since they have long been identified; other risks will emerge as a result
of changing conditions. Management may have a prior awareness, or there may be a
specific experience of certain risks. Other methods of becoming aware of risks

include standard analytic methods such as fault tracing; the use of experts (for
instance Delphi forecasting); scenario building (via an investigation of Murphy’s law
– that is, what can go wrong will go wrong); brainstorming; and other similar
approaches used to identify the factors in a particular industry, economic environ-
ment or within the firm. Careful examination of accidents that happen to others is
also useful in creating awareness.*
Being aware of risks is an ongoing discovery exercise that needs to be repeated at
frequent intervals to capture changed conditions. As human beings, we also have
the problem that we may not either perceive the risk or be able to assess its signifi-
cance due to our interpreting data through our own ‘world view’. In addition,
different financial markets have varying degrees of efficiency, market transparency
and development. Dominic Casserley (1993) suggests three levels of risk awareness.
1. Risks that are unknown and unmeasurable (that is, they have not manifested
themselves or have not been perceived). An example would be global interlink-
ages that affected banks and other financial institutions in the wake of the
collapse of the US housing market. The contagion effect from the global holding
of various kinds of collateral debt obligations (CDOs) was unexpected, especially
since CDOs were supposed to diversify risk rather than enhance it. While a few
commentators had questioned the suitability of CDOs as financial instruments,
no one had understood the systemic risk that the wide dissemination of these
instruments had created. Banks in virtually every single major country were ad-
versely affected by the collapse in the CDO market and in a number of countries
required government support. Fear that some banks were holding large quanti-
ties of CDOs and other such ‘toxic assets’ caused a virtual collapse of the world
financial system in 2008, and only intervention by governments, regulators and
central banks prevented the system from totally failing.
2. Risks that are known but still unmeasurable (where, although the risk is
known, there are insufficient data on which to base an evaluation of the likely
consequences or to quantify the exposure). The Greek crisis started in late 2009,
when Greece announced that, far from having a manageable budget deficit as
previously forecast of 3.7 per cent of GDP, this was an unsustainable 12.7 per
cent. A few months later, in May 2010, the country was given a bailout by the
European Union and the International Monetary Fund. While the risk of a coun-
try defaulting is known, it is hard to measure, since there are relatively few
countries and few incidences of default. In addition, there are individual factors
that make each country’s case unique. Ireland and then Portugal were also given
European Union assistance later on. There are common factors that affect all
three countries, but, equally, the causes of their need for bailouts to prevent
default are also country specific.
3. Risks that are both known and measurable. (In such cases, there are many
observations on which to build a statistical model in order to predict future be-
haviour.) This is the situation with which risk management typically has to deal,
when organisations seek to measure their exposure to the principal financial risk
* The airline industry is a good example here: accident reports are widely circulated within the
industry.

factors. As discussed earlier, we have historical data on currency exchange rates,

commodity prices and interest rates that show how these have fluctuated consid-
erably over time.
1.4.2 Risk Measurement

Risk measurement transforms that which is difficult to measure into quantifiable
risks. The principal task initially is to model risk in order to measure its impact.
Once the extent of the exposure has been determined, decisions about the appro-
priate course of action can be made. Typically, the procedure is to evaluate these
risks using a cost–benefit approach (or, alternatively, the risk–reward trade-off)
according to predetermined criteria. In principle the decision will depend on the
costs and benefits involved in the different courses of action. There will be a trade-
off between the benefits of risk reduction and the costs to be incurred. Normally
the risks are contingent, while the costs involve actual cash outlays (for instance,
insurance premiums against damage to property from fire, floods, etc. that may
never occur). Also, many risk-reducing measures may involve opportunity costs –
eliminating the potential for loss may also eliminate the potential for gain. In
practice, organisations will also have different views about the level and types of risk
that are acceptable. Consequently, there is no hard and fast rule governing any
particular course of action. Indeed, one aspect of risk measurement involves
determining the organisation’s own risk-taking approach.
1.4.3 Risk Adjustment

Risk adjustment involves changing the nature of the risk from an undesirable level
to an acceptable one. Three different approaches exist that include elements of risk
pooling and risk transfer. The first involves insurance, where the risk is transferred
to another party better able to accept the risk. Many kinds of standard risk can be
insured at a price (known as a premium). The problem is that, as the risk to be
insured becomes more specific to a particular organisation, insurers have the same
problem as the insured! They will have the same difficulty quantifying the risk, and
the price of such insurance will rise to reflect this uncertainty.
The second approach uses hedging. This is the principle of offsetting one risk
with an opposite position in the same or similar risk. If the hedge works, the two
risks should be self-cancelling. A decision can be made about how much of the total
risk is to be hedged.
Organisations can undertake two different kinds of hedging. There is operational
hedging (which shares some of the characteristics of the third approach discussed
below), which involves the firm in changing sources of supply, the location of
manufacturing and so on in order to reduce the impact of economic factors. The
firm will also seek to match inflows and outflows in foreign currencies so as to
become self-hedging.

The alternative is via financial hedging, which uses both on-balance-sheet and
off-balance-sheet instruments.* Organisations using foreign-currency-denominated
borrowings, for instance, seek to eliminate foreign exchange rate risk by using
foreign currency income to service the foreign currency loan. This has the effect of
creating new liabilities and hence increasing the size of the balance sheet. On the
other hand, the great expansion in what were formerly off-balance-sheet instru-
ments (largely through the use of derivatives) used to manage financial risk has
greatly increased the organisation’s scope for such financial engineering. The
advantage of these specialised instruments is that they are relatively low cost but can
be rapidly adjusted to take account of changing economic circumstances. On-
balance-sheet hedging is less flexible in this regard and becomes very inflexible
when real assets, such as property and plant, are involved.
The third approach involves accepting the risk but reducing some of the more
undesirable aspects by changing behaviour. This typically involves strategic
decisions by organisations that seek to minimise undesirable risks. For instance, in
certain areas of the world, there is considerable country and political risk. To cope
with such a position, firms might form consortia, to spread the risks, or joint
ventures with local firms better able to understand local conditions. Another
alternative involves breaking down and separating the component risks in any given
situation and assuming only the acceptable risks. Such ‘cherry picking’ of risks is
typically seen in certain kinds of capital or venture-type projects and is the normal
practice in project finance, where the different parties connected with the undertak-
ing accept different parts of the overall risks involved.
Although the above suggests a sequential approach, risk analysis and manage-
ment is in fact a dynamic situation, as the perception of risks evolves over time. As
with so many management tasks, risk assessment has to be kept under constant
review as circumstances change. In addition, as organisations become more familiar
with different risks, they are better able to assess these and to handle the conse-
quences.
The Step-By-Step Risk Management Process _________________
The risk management literature often adopts a stages model from the project
management and decision theory literature. A typical set of steps is given below:
1. Identify the source of the risk exposure.
2. Quantify and/or assess the exposure.
3. Assess the impact of the exposure on the firm’s business and financial
strategy. Determine the degree of risk adjustment required against prede-
termined criteria. This often takes the form of a cost–benefit analysis.
4. Assess the firm’s capabilities, competencies and/or capacity to undertake its
own hedging and insurance programme.
* Under current International Financial Reporting Standards (IFRS), the accounting distinction between
what is reported on the balance sheet and transactions that were once not so reported and hence are
‘off balance sheet’ has largely vanished. Nevertheless, it is useful to maintain the distinction since items
once considered off balance sheet do not require significant new operational assets or liabilities.

5. Select the appropriate risk management product and mix. This will typically
include both operational hedging and the use of external risk management
products such as insurance contracts, derivatives and risk pooling.
6. Keep the risk management process under review.
In their discussion of how financial risk exposure can be applied in practice,
Bauman et al. (1994) also provide a logical series of steps, together with the
required analysis, policy formulation and operational procedures that are
required in order to properly manage and control the ongoing risks in the firm.
This generic model, with its five steps, is shown in Figure 1.19. In their ap-
proach, the formulation and execution of the risk management strategy is
deemed to be simultaneously taking place at different levels within the firm,
within different functions and business units, and also over time.
[1]
Identification of exposures
profile of business risks

classification of exposures
materiality ranking
Formulation of management
Ongoing review
planning and policy
reassessment in light of integration of strategic goals
– performance organisational structure
– changing environment establishment of responsibility
– changing business and accountability
[5] [2]
Control and evaluation Policy implementation

reporting of exposures exposure management
evaluation of performance methods
audit transaction execution
reporting and documentation
[4] [3]
Figure 1.19 The stages in strategic risk management

The dynamic element leads to a continual process of review and modification. In
Figure 1.19, the identification of exposures [1] leads to the formulation of an
appropriate managerial response [2]. This is then implemented at the business
unit and functional levels, with the appropriate set of controls and evaluation
criteria [3] to determine the policy’s effectiveness [4]. The results of the
implementation stage are then reviewed in the light of the firm’s overall corpo-
rate performance [5], changes in strategic objectives, and the changing business
environment, which in turn restarts the evaluation process, leading to changes in
policy [1]. The process is continuous as in step 6 in our decision approach the
risks are kept under constant review. This is because the nature of the firm
changes over time, as do the risks it faces.

The risk management process is, therefore, a continual adjustment of the firm’s
exposures in the light of changing conditions, the firm’s own capacity to operate
its hedging and insurance programme, and the cost–benefit trade-offs involved.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
1.5 Top-Down and Building-Block Approaches to Risk

Management
The senior management of an organisation will view the risk management process
by looking at the overall risk from all sources. It is their responsibility to put in place
a policy that will govern how much risk is acceptable. Indeed, in countries such as
the United Kingdom companies are legally obliged to undertake a risk review and
publish this in the annual report.
Within an organisation, the amount of risk that the firm considers acceptable will
be translated into a hierarchy of risk limits. A commonly accepted criterion is for
firms to seek to ‘maximise shareholder value’. This would suggest concentrating on
the impact of risk on a firm’s market value or equity value.*
Senior management may also decide on the overall exposures and the anticipated
movements in the risk factors. For instance, concerns about the likely direction of
changes in interest rates and their impact on profitability may lead to decisions
about the type and maturity of debt in the balance sheet. However, because senior
management may experience difficulties in reacting to changes within an appropriate
timescale, such decisions are normally delegated to a specialist committee or
individual. For instance, a common approach in banks is to delegate decisions about
the right level of sensitivity to interest rates and choices about funding to an Asset
Liability Management Committee (ALMAC). Given the objectives of a particular
firm, senior management will have to decide to what level to delegate responsibility.
There are three distinct approaches that can be adopted; these will be discussed
in the later modules on the techniques for modelling and measuring risk. They can
be termed an equity–value approach, an asset–liability approach and a transac-
tional or cash flow approach. The different methods provide different insights and
require differing amounts of information about the firm and its operations.
1.5.1 Equity Value

It is a tenet of finance that liquid capital markets are information efficient; that is,
the price of financial instruments reflects known facts about the issuer. The market
price of a security is a reflection of the consensus view on the worth of the asset. As
new information arrives, market participants revise their assessment on the basis of
the new information and act accordingly. This will cause prices to move; that is, to
reflect the impact of the new information on the firm or the security’s cash flows.
We can use this fact (even without being certain about the degree of market
efficiency – a subject still very much debated by financial economists) to measure
the effects of changes to equity values from our risk factors using standard statistical
* This section draws on the insights from Rawls and Smithson (1990) and Smith et al. (1995).

techniques (in this case multiple regression). The greater the price movement (or
sensitivity) for a given change in the risk factor, the greater the market’s estimate of
the firm’s exposure to the particular risk. Of course, such estimates are historical
since they measure the impact after the fact.
1.5.2 Asset–Liability Management

Organisations have access to information that is not generally available to outsiders.
This can be used for assessing their financial risks. The degree of sophistication used
in measuring exposure in this way will depend on the availability, quality and cost of
suitable data. The traditional approach is to focus on the accounting numbers
through the budgeting and reporting process, although for risk management
purposes this type of information may not be sufficiently timely, detailed or accurate
to give exact measurements. Organisations can and do collect other data that is not
strictly accounting information but that forms part of the information that these
organisations collect on their operations and related outside parties, such as suppli-
ers and customers.
Accounting methods have tended to involve scenario-building or maturity-gap
and funding-gap type analyses based on accounting entries. Maturity- and funding-
gap methods break up future assets and liabilities into discrete time intervals (for
instance, by quarter years), and the mismatch between receipts and payments is used
to determine the net amount of risk in any single period. This method is relatively
simple to apply since it is often easier for firms to collect information on their assets
and liabilities, which only change relatively slowly over time, than to have accurate
forecasts of their future transactions or cash flows. Various measures of risk, for
instance payback measures and so forth, can then be applied to the result to
determine the firm’s sensitivity to changes in risk factors. For some kinds of
organisations, non-accounting data are more useful than those present in the
financial statements. Take an insurance company: the history of past claims and the
characteristics of those insured provide the raw data for pricing insurance policies
and setting premiums.
1.5.3 Transactions and the Cash Flow Approach

The standard textbook finance approach focuses on changes to cash flows as the
key sensitivity measure. A transactions-based approach usually starts at the level of
the single transaction, building up individual exposures and netting the differences
where applicable in order to build an overall (net) position to be managed from the
ground up. This is often done in large organisations, for instance in foreign ex-
change management, through factoring arrangements between subsidiaries in
different countries. The different currency exposures are pooled, and only the net
residual difference has to be hedged. Using this method to manage contingent and
economic risks has the disadvantage that it requires knowledge of the future cash
flows from the business. In most instances, this will be impossible to determine
since such cash flows will not be known with certainty. Organisations could find
themselves overhedging their risks.

Learning Summary
This module has introduced the concept of risk as an unavoidable consequence of
human activity. The increased risks facing firms from changes in economic variables
have meant a greater focus on risk management activities.
Risk can be variously defined, no two definitions being identical. Generally, we
can define risk as the variability of future outcomes. This variability is in some way
measurable, rather than being pure uncertainty, where measurement is not possible
or is inaccurate. Financial risk is that part of a wider risk management process
concerned with managing changes in, among other areas, the business, social,
economic, political, technological and legal environment.
Corporate risk management is a natural response to an uncertain future. These
risks can be measured in different ways: using accounting information, future cash
flows, contingent and economic exposures. The risk management process is simple
to define, and it follows a series of simple steps that involve the firm in (a) becom-
ing aware of the risks; (b) measuring the risks; and (c) adjusting the risk, if necessary.
There are a number of different approaches that can be used to measure risk,
either taking an equity view or building up the relevant exposures from the basic
unit level. Risk can also be related to the asset and liability obligations of the
organisation. In practice, organisations tend to use a combination of methods
depending on the quality and timeliness of the information available.
Appendix to Module 1: What Risks Are We Taking?

The story in Section 1.1 about converting the British pound into US dollar travel-
ler’s cheques raises some issues about whether, in doing so, more risk has been
assumed than is necessary. Reviewers of this module described the example as
‘flawed’. They took the view that there was cross-rate parity; that is, that the risk of a
DM/£ fluctuation equals the combined risk of a $/£ fluctuation plus a DM/$
fluctuation. They also made the point that the DM/$ risk may be higher than the
DM/£ risk. Once you have exchanged pounds for dollars, you will no longer have
any $/£ risk, unless of course you have some money left over in dollars that you
want to take back and reconvert to British pounds.
In the earlier analysis, the decision to buy dollars for use in Germany may have
been motivated by a view that the dollar was likely to appreciate against the
Deutschmark in the immediate future (although at the time this was not the case).
As a transaction, buying US dollar traveller’s cheques is equivalent to a two-leg
transaction in foreign exchange. In making this transaction, I may have expected the
DM to depreciate relative to the dollar. I therefore sold pounds for dollars. In terms
of what is happening, the future relationship of the three currencies and their
exchange rates can be expressed as follows.
DM/$
DM/£
$/£
where FV is future value of the money, expressed as the ratio of the two currencies.
This synthetic position will be profitable if:

 both the British pound and the US dollar appreciate relative to the DM, but the
US dollar appreciates more; or
 the British pound and the US dollar depreciate relative to the DM, but the
British pound depreciates more; or
 the British pound depreciates against the DM, but the US dollar appreciates.
If the opposite result occurs, the transaction will lead to losses.
As a transaction, this trade will make most sense if the prognosis is that the dollar
will appreciate relative to the DM, while the British pound loses ground relative to
the DM. From a risk management perspective, I now have to forecast not just the
DM/£ exchange rate but also the DM/$ rate. If my ability to forecast currency
movements is 50:50, then adding another currency leg requires success on two
fronts!
Although, as the reviewers consider, I may have eliminated my British pound
currency risk, instead of just the DM/£ cross-rate, the denomination of my travel-
ler’s cheques in US dollars does increase the potential for risk, especially as my base
currency was British pounds – and not the dollar.
What do you think?
Review Questions
Multiple Choice Questions
1.1 Risk is:

I. the natural consequence of change in the world.
II. the interaction of unpredictable events upon one another.
III. the interaction of events upon one another that we can anticipate but not predict.
IV. the unexpected.
Which of the following is correct?
A. I and II.
B. I and III.
C. II and III.
D. III and IV.
1.2 For a firm, risk management is the responsibility of which of the following executives?
A. The managing director.
B. The financial function of the firm.
C. The firm’s advisers.
D. The firm as a whole.
1.3 Which of the following is correct? The task for risk management is to:
A. eliminate all risks.
B. reduce risks to an acceptable level.
C. eliminate unacceptable risks.
D. monitor risks and take action as required.

1.4 Which of the following is correct? A key factor in the modern development and practice
of risk management is:
A. the breakdown of the Bretton Woods Agreement.
B. the development of financial markets where risks can be exchanged.
C. an increasingly uncertain future.
D. all of A, B and C.
1.5 What effect does a change in the external value of the currency have on exporters?
A. It increases the price of their products and services in foreign terms.
B. It decreases the price of their products and services in foreign terms.
C. Neither A nor B.
D. No effect.
1.6 Which of the following are the consequences of significant swings in interest rates?
A. On average, the cost of borrowing has been higher.
B. Lenders have refused to make long-term fixed lending commitments.
C. Savers have benefited from higher interest rates.
D. Volatility has increased.
1.7 Firms react to uncertainty about future interest rates by which of the following?
A. They increase the required rate of return, or hurdle rates, on investments.
B. They shorten the payback period.
C. They devote more resources to managing interest rate risk.
D. All of A, B and C.
1.8 The introduction by exchanges in the early 1970s, such as the Chicago Mercantile
Exchange (CME), of financial instruments to manage risk addressed the following issues:
I. Problems of liquidity with over-the-counter (OTC) contracts.
II. The need for new instruments to manage financial risks.
III. The need to open the market in financial risk management products to all users.
IV. A requirement to trade risk management products on an exchange.
A. I and III.
B. I and II.
C. II and IV.
D. II and III.
1.9 The financial engineer seeks to help firms to manage their risk by which of the following
methods?
A. Selling the user a forward, future, swap or option.
B. Designing new securities for sale to investors.
C. Splitting risks into their constituent parts.
D. Designing special hedge programmes.

1.10 Which of the following is correct? A fair definition of ‘risk’ is:

A. a situation where we are likely to be disappointed by an uncertain outcome.
B. an unexpected or unintended outcome.
C. a measure of the deviation from an anticipated or expected result.
1.11 Which of the following is correct? The difference between risk and uncertainty is that:
A. there is no difference and the two terms are used interchangeably for the same
thing.
B. one can measure risks but only establish conditions of uncertainty.
C. uncertainty is a product of the human condition while risk is our perception of
man-made and natural hazards.
D. risk is objective in that it measures the range of outcomes in a given situation
whereas uncertainty is the result of the decision maker’s inability to choose a
course of action.
1.12 Which of the following is correct? The difference between uncertainty and
indeterminacy is:
A. that with an uncertain outcome the main parameters are known but not
measurable, whereas with indeterminacy the causation is unknown.
B. that uncertainty is another term for risk whereas indeterminacy means that
causal factors are unknown.
C. that uncertainty is another term for risk whereas indeterminacy means that the
range of the outcomes is unknown.
D. that with an uncertain outcome the risk taker knows the direction but not the
magnitude of the outcomes, whereas with indeterminacy the direction is
unknown but not the magnitude.
1.13 Which of the following is correct? A cost–benefit approach to risk proposes that:
A. the benefit of not analysing risk is measured against the cost of risk analysis
before a decision is made as to whether to assume the risk.
B. the benefit of analysing risk is measured against the cost of risk analysis before
a decision is made as to whether to assume the risk.
C. the benefits of not assuming the risk are weighed against the potential losses
according to predetermined criteria before a decision is made as to whether to
assume the risk.
D. the benefits of assuming the risk are weighed against the potential losses
assume the risk.

1.14 In analysing risk, the decision maker is often more concerned with the capacity for
losses or the downside than potential gains. Which of the following explains this
phenomenon?
A. Individuals and firms are risk averse and feel losses more than possible gains
from assuming risks.
B. Methodologies for analysing risk are better suited to measuring losses than
potential gains.
C. Losses arise before gains in any given situation.
1.15 Which of the following is correct? Price risk is:

A. the risk that the market price of an asset, security, etc. will change over time.
B. the risk that the price required to be paid by buyers will change over time.
C. the risk that the price required to be paid by sellers will change over time.
1.16 Which of the following is correct? Liquidity risk is:

A. the risk that market trading will be interrupted by the breakdown of market
systems, such as computer malfunction, power failures and other parts of the
mechanics of trading.
B. the difficulty a seller has in finding a buyer.
C. the problem of market price movements between a decision to buy or sell and
being able to carry out the transaction.
D. problems companies have in buying and selling currencies of some Central
African states.
1.17 Which of the following is correct? The risk profile is defined as:
A. the total risk of a given situation; that is, the sum of all the individual compo-
nent risks.
B. the analysis of a given situation by risk types, so that each risk is then catego-
rised, the total of these being known as the risk profile.
C. the amount of a particular risk in a given situation. Thus it is the individual
element of the total risk.
D. the sequence and payoffs from a given risk in a situation.
1.18 Exposure is:

I. the risk times the amount at risk.
II. the value at risk.
III. the sum of all the individual risks.
IV. the sensitivity times the amount at risk.
The correct definition includes which of the following?
A. I and II.
B. I and III.
C. II and III.
D. II and IV.

1.19 Which of the following is correct? Speculation is:

A. taking actions designed to make a profit from reducing risks.
B. taking actions designed to make a profit from increased risks.
C. structured risk management actions designed to benefit from reducing risks.
D. structured risk management actions designed to benefit from increasing risks.
1.20 We can adjust risk in which of the following ways? We can:

A. sell the risk to another party.
B. enter into transactions that have the opposite risk to the current risk.
C. follow policies that seek to take risks into account.
D. do all of A, B and C.
1.21 Transaction exposure arises from which of the following?

A. Companies undertaking purchases and sales of products and services for
immediate payment.
B. Companies reporting purchases and sales in their accounting books and
ledgers.
C. Companies reporting purchases and sales in their income statement and
balance sheet.
D. Companies undertaking to buy and sell products and services for deferred
payment.
1.22 Which of the following is correct? Contingent exposures arise from:

A. non-contractual agreements that cannot be enforced in law.
B. various expected but not guaranteed future receipts and payments.
C. any bids or tenders where the company is not sure it will get the business.
1.23 We can say the following about ‘economic exposure’:

I. It arises from changes in the balance sheet and income statement in a company.
II. It is the result of management decisions about the nature and type of business
activities pursued by the firm.
III. It arises from changes in exchange rates, interest rates and commodity prices.
IV. It is the result of management decisions about the nature and type of business
activities pursued by competing firms.
A. I, II and III.
B. I, II and IV.
C. I, III and IV.
D. II, III and IV.
1.24 Which of the following is correct? The insurance approach to risk management involves:
A. transferring a risk to another party better able to accept the risk.
B. entering into transactions that have offsetting characteristics to the risk.
C. changing the nature of a firm’s operations to reduce the risk.

1.25 Which of the following is correct? Operational hedging is the term given to:
A. how a risk manager carries out his duties.
B. transactions using financial instruments, such as forwards, futures, swaps and
options.
C. transactions that change the firm’s balance sheet, such as foreign currency debt.
D. how the financial function within a firm reports its risk management transac-
tions.
1.26 Firms seek to manage their risks by looking at the risks in the firm’s:
I. assets.
II. liabilities.
III. balance sheet.
IV. income statement.
V. cash flows.
A. I and II.
B. III and IV.
C. IV and V.
D. All of I, II, III, IV and V.
1.27 The risk management task follows a series of logical steps that are undertaken to carry
out the process. These involve initially identifying the risks facing the firm. Which of the
following represents the major difficulty that arises in this identification process?
A. There are insufficient data for the analysis.
B. Risks are ignored because they are seen as unimportant.
C. There is no consensus over which risks are to be included.
D. Some factors are included that are not risks.
1.28 There are many dimensions to risk. A firm will seek to manage some or all of these, and
the most appropriate combination of methods will be to:
I. manage each risk separately.
II. manage the sum of all the risks.
III. manage those risks that are considered important.
IV. manage those risks that exceed a given exposure.
A. I and III.
B. I and IV.
C. II and III.
D. II and IV.

Case Study 1.1: Attitudes to Risk

A family reunion has brought together three generations of a family. At this gathering
are the grandparents, the parents and their children. It is a cold winter’s day and, after
lunch, they decide to go for a walk. As they progress along they find that the route they
wish to take is thickly covered over a considerable area by ice from a broken water
pipe.
1 Consider the attitudes that the different members of this family might have towards the
idea of crossing the ice.
References
Bauman, J., Saratore, S. and Liddle, W. (1994) ‘A Practical Framework for Corporate
Exposure Management’, Journal of Applied Corporate Finance, 7 (3), 66–72.
Bernstein, P.L. (1996) Against the Gods: The Remarkable Story of Risk. New York: John Wiley &
Sons.
Black, F. and Scholes, M. (1972) ‘The Valuation of Option Contracts and a Test of Market
Efficiency’, Journal of Finance, 27 (May), 399–418.
Black, F. and Scholes, M. (1973) ‘The Pricing of Options and Corporate Liabilities’, Journal of
Political Economy, 81 (May–June), 637–54.
Casserley, D. (1993) Facing up to the Risks. New York: John Wiley & Sons.
Fischhoff, B. (2012) Risk Analysis and Human Behaviour. New York: Routledge.
Lintner, J. (1965) ‘The Valuation of Risky Assets and the Selection of Risky Investments in
Stock Portfolios and Capital Budgets’, Review of Economics and Statistics, 47 (February), 13–
37.
MacCrimmon, K.R. and Wehrung, D.A. (1986) Taking Risks: The Management of Uncertainty.
London: Collier Macmillan.
Miller, M. (1991) Financial Innovation and Market Volatility. Oxford: Blackwell.
Rawls, S.W. III and Smithson, C. (1990) ‘Strategic Risk Management’, Journal of Applied
Corporate Finance, 2 (4), 6–18.
Ross, S. (1976) ‘The Arbitrage Theory of Capital Asset Pricing’, Journal of Economic Theory, 13
(December), 341–60.
Sharpe, W. (1964) ‘Capital Asset Prices: A Theory of Market Equilibrium Under Conditions
of Risk’, Journal of Finance, 19 (September), 425–42.
Smith, C. Jr, Smithson, C. and Wilford, D.S. (1995) Managing Financial Risk: A Guide to
Derivative Products, Financial Engineering and Value Maximization. Chicago: Irwin Profession-
al Publishing.
Wynne, B. (1992) ‘Science and Social Responsibility’, in Ansell, J. and Wharton, F. (eds) Risk:
Analysis, Assessment and Management. Chichester: John Wiley & Sons.

Module 2
Risk and the Management of the Firm

Contents
2.1 Introduction.............................................................................................2/2
2.2 The Pervasiveness of Risk ................................................................... 2/10
2.3 Why Manage Risk? ............................................................................... 2/10
2.4 Taxes ..................................................................................................... 2/13
2.5 Agency and Other Costs ..................................................................... 2/15
2.6 Business Performance ......................................................................... 2/19
2.7 Financial Risk and Financial Distress ................................................. 2/23
2.8 The Costs of Risk Management.......................................................... 2/25
Learning Objectives
This module explains why firms are willing to devote resources to risk management.
As a general rule, firms will be risk takers in areas where they have unique or
specialised expertise, but seek to hedge or eliminate those risks that do not form
part of the firm’s core competencies.
There are a number of different reasons why managing risk is desirable. The two
principal reasons are that, first, firms have more information about the risks they
face than do investors and, second, firms can undertake risk management more
efficiently than individuals. An added reason is that, for some types of firm, financial
difficulties can jeopardise survival and, at the same time, lead to considerable loss of
value due to the nature of the firm’s business.
After studying this module, you should be able to understand the impact of:
 firm-specific factors on the decision as to whether to hedge a risk or to leave it
unhedged;
 asymmetric information on the risk management decision;
 the interaction of financing and investment decisions;
 the impact of agency and other costs on the risk management decision;
 the problem presented by financial distress;
 the effect of taxation;
 firm-specific risks and the undiversified investor in the firm.

Module 2 / Risk and the Management of the Firm
2.1 Introduction
In terms of the risk management process, firms will avoid risks in some areas while
taking additional risks in others. Typically a firm will take risks in areas where it has
expertise or in its core activities; that is, in its main business it will seek to adjust the
risk–reward equation in its favour. Hence a firm such as the Ford Motor Company,
in the business of making and selling motor cars, vans and trucks, will develop new,
untried motor vehicles. It will research the market and take a risk on product
development, consumer tastes and so forth. In fact, Ford would argue that it has
unique capabilities in evaluating these types of risk. In the language of finance, Ford
would have alphas in these areas; that is, it is able to generate an above-average
return for a given level of systematic risk.*
However, a firm will seek to avoid risks in areas of ignorance or non-core activi-
ties.† To use the Ford Motor Company example again, Ford will not take risks with
foreign exchange, interest rates, commodity prices and so on. These are areas where
Ford has no business-specific or unique expertise, and it would be unwise for the
firm to take any speculative risks in these areas. They are also not core activities of
the firm.
There is a qualitative difference between a firm’s core business risks – that is,
decisions that a firm makes about its business, for example production levels, labour
or capital input – and economic risks or exposures, such as unanticipated changes in
economic variables like interest rates, inflation, currencies and so on. These eco-
nomic exposures or risks arise out of decisions made by a firm, for instance to
develop export markets. Thus, extending our Ford example further, if the company
sees a commercial opportunity to sell to German customers a variant of its four-
wheel-drive off-road vehicles that are manufactured in the US, it will face exchange
* This statement rests on the idea that an asset’s (business’s) return is related to risk in the following
fashion:
In the equation ra is the return on an asset, rf is the pure risk-free interest rate, β is the asset’s
systematic risk and (rm rf) is the market risk premium. If superior (systematic) risk-adjusted
performance is in evidence, alpha (α) has a positive value.
We can also think of it as a firm’s ability to generate net present value projects. The standard
presentation implies a value to a project above the appropriate (risk-adjusted) rate of return:
NPV ∑
where I0 is the initial investment, E(NCFt) are the expected net cash flows after costs and rrr is the
required rate of return. A surplus of future benefits (gains) to cost at the appropriate risk-adjusted
required rate of return is an attractive, value-enhancing investment project.
† These may include taking out insurance against specific events, such as losses resulting from fire and
disaster to its factory, plant and machinery, key personnel and so on. These are corporate risk
management issues that are important but fall outside the scope of financial risk management.
However, the techniques used to assess financial risk can also be applied to such hazards.

rate risk in the process.‡ The decision to develop and sell such vehicles for the
German market is therefore a package of bets.§
Ford is betting on the commercial acceptability of the vehicles in the market.
However, at the same time, it is betting on the future movements in the euro against
the US dollar. It is, in a competitive motor vehicle market, also betting on relative
changes between the euro and the currencies in which Ford’s competitors in this
market (for instance Japanese and Korean manufacturers) operate. Given its
experience in the motor industry, the company is willing to back its judgement on
the German market’s potential for such four-wheel-drive vehicles. However, it may
be less optimistic about the currency, but this will have a large impact on the
resultant profitability – or lack thereof – of the new venture. The solution is for the
company to split these two elements: to take the commercial bet where it thinks the
odds are attractive and where it considers it has a competitive advantage, but to
insure or hedge the undesirable foreign exchange risk. Remember that for the firm
not to manage its currency risk is equal to the firm speculating in the foreign
exchange market, where it is unlikely to have a comparative advantage.
Figure 2.1 shows the external and internal factors that dictate the value of the
firm. A firm can control its core business risks that are generated internally, such as
the lines of business it offers, how the firm is financed and so on, but changes in
economic variables, such as natural disasters, the state of the economy or commodi-
ty prices, are outside its control.
‡ In saying this, we assume that the vehicles are produced in the United States and are then shipped to
Germany. The production currency is then US dollars and the revenue currency is euros, the currency
in use in Germany. It makes no difference if the company asked German consumers for US dollars
rather than euros; this would simply shift the risk from the producer (Ford) to the consumer. Most
consumers would be greatly deterred by having to pay in US dollars as it would be costly for them and
very inconvenient. So Ford has to assume the currency risk.
§ Of course, in some circumstances Ford (or another company) could indulge in opportunistic selling
behaviour. But even if there were no upfront costs in adapting the vehicle for the German market, the
company would be concerned about customer perception of its commitment to supporting a particular
model. For many types of goods, part of the value lies in the perceived ability of sales agents to provide
repair, replacement and service facilities for the product. All these have a cost. Where these features are
low, as with many generic commodities, opportunistic behaviour has little consequence. Where a
reputation is at stake, the actions of firms count. Taking steps to eliminate certain kinds of risk
therefore allows the firm to develop the long-term potential of the market.

External factors Value of the firm Internal factors
Expected cash flows

– magnitude
– timing
– risk
The economy The firm
– level of economic activity – lines of business
– interest rates – financial management
– commodity prices – capital budgeting
– exchange rates – financing
– product specifications,
Economic shocks quality and cost
– natural disasters – marketing, sales and
– wars and civil unrest promotion
– research and development
Business environment
– competition laws and regulations
– environmental laws and regulations
– health and safety laws and regulations
– taxes and tariffs
Figure 2.1 The major internal and external factors that affect the value
of a firm
Firms may seek to eliminate those risks that originate outside the firm and over
which they have little control, such as the cost of raw materials, during the produc-
tion cycle or budgeting period to facilitate planning, production, marketing and
sales. Firms therefore seek to limit their economic exposures through risk-reducing
corporate decisions involving operational or financial hedging. Operational hedging
involves using the inherent cash flow characteristics, by type, maturity, currency and
so forth, of the firm’s assets and liabilities. Financial hedging makes use of external
financial instruments (such as forward contracts, futures, swaps and options) to
adjust a firm’s exposure to particular pervasive risks.
Remember that, as proposed in Module 1, risk is the likelihood of an outcome
other than that intended; an exposure is the risk of an outcome multiplied by the
amount that is at risk. It is sometimes useful to think of risk in terms of a set of
outcomes; at other times in terms of the amount that is at risk, or exposed.
In order to understand why firms manage their risks, a convenient starting point
is to consider that a firm is a package of assets (contracts, projects or whatever) that
are funded via a set of liabilities (debt and equity in most cases). Conceptually, we
can think of this in terms of a balance sheet, as laid out in Table 2.1.
Table 2.1 Economic balance sheet for the firm

Assets (A) Liabilities (L)
≈ ≈
Income (I) Expenditure (E)
The assets generate the income, which is then used to service and reward the
liabilities (the source of funds used to buy the income-generating assets).

In economic terms, the value of the assets (A) is the same as that of the liabilities
(L). This is one of the outcomes of the Modigliani and Miller (1958) proposition
concerning the irrelevancy of capital structure.** These liabilities will consist of fixed
charges (or debt) and equity (or risk capital). Thus, conceptually, every type of
business can be seen as a similar package. In Table 2.2 we have a simplified repre-
sentation of the assets and liabilities of a gold-mining company, while Table 2.3
presents those of a bank. In the case of a gold company, they comprise the gold
reserves (plus, obviously, the extraction capacity); for the bank they are its portfolio
of loans.
Table 2.2 Schematic economic balance sheet of a gold-mining company

Gold reserves Equity
Debt
Table 2.3 Schematic economic balance sheet of a bank

Loans Equity
Debt
Given the economic identity of the firm’s assets to liabilities, we can see that
changes in the operating income (or the realisable value of the assets) in relation to
the fixed liabilities will change the firm’s cash flow and hence the value placed on its
liabilities (which, remember, cannot exceed its assets). A simple example will
illustrate this. If the present value of the gold reserves is 100 and the gold-mining
company has 60 in debt and 40 in equity, a change in the value of the gold reserves
will increase or decrease the value of the firm’s liabilities. As the debt obligation is
contractually fixed, most of the change will be in the value of the firm’s equity (the
risk capital). So, if the value of the gold reserves falls to 90 and the debt value is
unaffected, the equity value will be reduced to 30.††
Equally, we can think of the assets in terms of a stock value (the present value of
future cash flows) or in terms of the flow of funds. Consequently, changes in the
flow of income will (potentially) make the difference between a profit and a loss in
any given reporting period. To understand how the various risks affect the value or
cash flows that the firm has, we can show the relation of changes in the risk factor,
which affects the value of the firm’s assets (or its liabilities) in terms of a risk
profile. This is shown in Figure 2.2. In this case, the firm’s value is negatively
** The capital structure will not be quite as irrelevant if taxes are included in the analysis – a point
discussed later – as there are some tax advantages attached to debt finance. In the context of the
discussion, the benefit of the debt known as the tax shield can be seen as an asset.
†† The value of the firm (V) equals the value of the debt (D) and equity (E), so V – D = E. Note, in this
sense, the equity in the business (put in by the owners) is a residual claim on the firm’s cash flows once
debt is added. This helps us to understand why managing the firm for the benefit of the firm’s owners
(its shareholders) is considered the appropriate management objective.

correlated to increases in the risk factor. This risk factor can be exchange rates,
interest rates, the factors of production, commodity prices and so on.
+ D Value of the firm
– +
D Risk factor (factor of production)
Risk profile
of the firm
Figure 2.2 Risk profile of a firm exposed to an increase in the cost of

factors of production
The initial stage of risk analysis will seek to determine both the direction of the
slope and its sensitivity (or gradient) to changes in the risk factor. The extent to
which a firm responds to changes in the risk factor will be an important part of the
risk analysis process, since the degree of exposure will depend to a large extent on
how much the risk affects the firm’s value. If, in Figure 2.2, the line were relatively
flat to the underlying risk, large changes in the risk factor would lead only to small
changes in the firm’s value (that is, the company would be relatively insensitive to
the particular source of risk and how it affected the firm’s cash flows). If the
opposite was true, then small changes in the risk would lead to large changes in the
value of the company (that is, the company would then be relatively sensitive to the
risk). In the second case, more attention would need to be given to controlling the
risk.
The above would suggest a potential need to hedge assets and liabilities separate-
ly, but what about interactive effects between the two sides of the balance sheet?
There may well be offsetting effects that need to be taken into account. Most firms
will seek to match, whenever possible, the characteristics of assets and liabilities in
terms of their cash flows, maturity and sensitivity to economic factors. Firms will
look for ways to set such operational hedges first and then hedge any residual
exposures using financial hedging. For example, an electricity company that has a
large amount of investment non-current assets in the form of plant and equipment
is likely to seek to borrow long-term debt, as the cash flow characteristics of the
assets (income from generating electricity) are matched to the cash flow characteris-
tics of debt. Returning to our Ford Motor Company example discussed earlier,

Ford, in selling its vehicles to Germany, would generate revenues in euros but have
expenses in US dollars. It could, if it wanted, borrow in euros and use the money it
received from German customers to service this loan. In this way, the characteristics
of the assets (income in euros from German consumers) more closely match the
liabilities (financing of productive assets in the US) in terms of currency mix.‡‡
Operational and Financial Hedging __________________________
When confronted with a particular risk, firms can respond in a number of
different ways. One obvious approach is to modify their operations and liability
management practices in such a way as to mitigate the effects. Operational
hedging, which is also known as strategic risk management, aims to modify
the firm’s business exposure to these risks. The approach involves strategic
decisions such as flexible sourcing, diversification of the product range, diversify-
ing production and markets geographically, making acquisitions and disposals of
particular business lines and so forth. On the liabilities side, it typically involves
borrowing in currencies where there is a surplus of revenues to expenditures.
The intention is to ‘match’ the cash flows and hence hedge the firm’s sensitivity
to the risk. Such operational hedges are generally ‘on balance sheet’ in that they
involve actual asset and liability decisions and generally lead to the acquisition of
operational assets and/or funding. In this, operational hedges differ from many
financial instruments that are specifically designed to manage specific risks.
Although firms pursue operational hedging as part of a risk control strategy,
there are many problems in firms relying on the method. Changing suppliers
disturbs existing business relationships, may lead to production and/or quality
control problems and is slow to implement. Existing and projected production
systems are likely to benefit from significant economies of scale and other
elements of comparative advantage. In addition, many modern management
techniques now also involve suppliers as business partners. It may be difficult to
get suppliers to commit resources if such relationships are to be lightly over-
thrown. Equally, there are similar major problems in adjusting other business
decisions in order to provide internal hedging. Most operational business
decisions involve considerable long-term investment, which, in addition, proba-
bly has a significant ‘exit cost’ element. A decision to jettison a business strategy
(such as developing a particular export market) is unlikely to be favoured in the
face of short-term, unpredictable, adverse currency movements that might
quickly change in the firm’s favour. Firms therefore face considerable costs in
altering operational procedures as a risk management tool and are generally
disinclined to use strategic risk management as their primary means of control-
ling their macroeconomic exposures.
‡‡ Similar examples are not uncommon among large international companies that are able to borrow at
reasonable rates in different currencies.

Consequently, firms prefer to resort to financial hedging. This is financial

instruments or securities, such as derivatives or contingent claims, that mimic or
alter the buyer’s (or seller’s) exposure without adding in a significant way to the
firm’s operational assets or funding.§§ They have four significant advantages over
operational hedging:
 They do not disturb existing business relationships.
 They are quick to implement.
 Transaction costs are quite low.
 The hedge can be cheaply reversed if no longer appropriate.
A survey carried out by the Wells Fargo Bank in 2011 on currency risk man-
agement found that, of the companies that responded to the survey, the two
most highly indicated reasons for managing exchange rate risk were to eliminate
foreign exchange gains and losses and to minimise earnings volatility. The third
cited reason was to optimise the firm’s home currency cash flow. Only 6 per
cent of respondents ranked maintaining competitive advantage as the most
important risk management objective. The results were broadly similar when
respondents were split into whether they were public companies, with direct
access to the capital markets, or private companies. However, public companies
ranked minimising earnings volatility first, whereas for private companies it was
eliminating foreign exchange gains and losses that came top.
Additional questions in the survey found that 80 per cent of public companies
and 42 per cent of private companies had a formal written foreign exchange risk
management policy and that larger companies with revenues greater than
$500 million (presumably because they had more international operations) were
more than twice as likely to have such a policy compared to smaller firms.
The survey revealed that most hedging is short term, with only 20 per cent of
firms indicating that their balance sheet hedges had a maturity in excess of six
months, while 27 per cent indicated the maturity was one month or less. Thirty
per cent of firms hedged less than 25 per cent of balance sheet positions, while
about the same proportion hedged more than 75 per cent of positions. No
firms were in favour either of not hedging or of hedging the whole exposure.
Nearly all firms (96 per cent) used foreign exchange forward contracts for
hedging purposes, although a third also indicated a wide range of financial
instruments, including cross-currency swaps, purchased options and option
collars.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Fielder (1992) sums up the major impediment to firms significantly altering their
operational policies in response to currency risk as follows:
§§ Note that under International Financial Reporting Standards (IFRS) these financial hedging
instruments are reported on the balance sheet. In the past companies were not required to do this,
although they did disclose such transactions elsewhere in the financial statements. Hence, such
financial transactions were often referred to as ‘off balance sheet’.

Strategic exchange risk is an integral part of a business and inseparable from

other strategic business issues. For example, decisions to change where raw
materials are sourced, where to manufacture, what markets to serve, etc., all
will change the nature of the risk embedded in the business.
For example, in the case of the gold-mining company, increased costs may occur
at the same time as a rise in the value of the gold that the firm is producing. The two
effects mutually offset each other, providing a degree of internal protection. With a
commercial firm, there may be no such internal offsets that mitigate the effects of
one variable, although there may be benefits to the liabilities side of the balance
sheet. For instance, a food company is unlikely to be able to internally offset a rise
in the input prices for its raw materials, namely agricultural products, since it will
face pressure on its margins as it seeks to raise prices in response to an increase in
its factor costs. Generally, gains and losses will not exactly offset each other, and the
firm will have a residual net risk position. One of the key tasks of any risk manager
will be to identify the net effects of the different factors. This requires a portfolio
approach.
In terms of financial risk management, it is changes in the major risk factors such
as interest rates, foreign exchange rates, commodity prices and so forth that
will be the principal focus in establishing the firm’s exposure. On the whole it will
be the downside or adverse consequences of changes in the risk factors that concern
management. In Figure 2.3, the area of concern will be that zone where the value of
the firm declines. The figure shows a negative relationship of the risk factor and
firm value. In this case, an increase in the risk factor (for instance interest rates and
the cost of borrowing) leads to a decline in the firm value (or, equivalently, the
present value of future cash flows).
+ D Value of the firm
Risk profile
of the firm
D Risk factor (factor of production)
– +
Area of
concern
Figure 2.3 Risk profile of the firm and the area of concern

2.2 The Pervasiveness of Risk

Risk to value or cash flows arising from existing transactions is known as transac-
tion risk. The risk to value or cash flows of future business activity is called
economic or business risk. As the Wells Fargo survey indicates, firms generally
manage existing and, to some extent, anticipated transactions, since these are well-
known risks and it is relatively easy to quantify the exposure. In addition, established
procedures exist for coping with existing transactions and the risks they create.
Economic risk is more problematical since it involves the interaction of the firm’s
value with its environment and may well create different sensitivities depending on the
time horizon, the type of risk involved and so on. Furthermore, firms can have
economic risk without any transactions exposure. Hence, analysing and managing the
exposures created by economic risk may well require strategic decisions by the firm. A
firm will have economic risk to the extent that changes in economic variables affect
the firm’s market value; that is, the degree to which the present value (PV) of the
expected future cash flows of the firm is exposed to changes in these variables.
2.3 Why Manage Risk?

Firms will be concerned about that area where changes in the risk factor cause
losses, impair corporate strategies and may even put the survival of the firm into
jeopardy. They are in the same situation as Charles Dickens’s Mr Micawber: ‘Income
20/–; expenditure 19/6; result happiness. Income 20/–; expenditure 21/–; result
misery.’*** The value of the firm may be sensitive to changes in, for example, interest
rates, foreign exchange rates, energy costs and other input and output prices. The
key rationale is that the firm’s value will be increased if such risks (exposures) are
managed; that is, risk management increases the expected value of the firm. A
standard financial approach to value equates the present value of the asset (the firm)
to the future cash flows. Thus the value of the firm will be the present value of the
sum of the future expected net cash flows generated by its operations, as shown in
Equation 2.1:
NCF ﴾2.1﴿
V ∑
1
where E(NCFt) is the expected net cash flows of the firm in future periods and r is
the firm’s cost of capital.
There are three separate arguments as to why financial risk management may
have a positive impact on the value of the firm, namely taxes, information asymme-
tries between managers and providers of funds, and the problems arising from firms
getting into financial difficulties. These arguments relate to real-world corporate
*** Charles Dickens was a popular nineteenth-century writer, probably best known for his novel Oliver
Twist. At the time he wrote, the British currency was denominated in British pounds, shillings and
pence. Hence 20/– in the above refers to 20 shillings and 19/6 is 19 shillings and sixpence. So here the
income is greater than the expenditure. When the expenditure is 21/–, it is greater than the income:
misery.

finance problems in the structure and management of firms. As mentioned earlier,

following the Modigliani and Miller (M & M) proposition discussed in Section 2.1,
manipulating liabilities should have no economic impact on the value of the firm.
However, M & M’s theory assumed a world with no transaction costs, taxes or other
frictions or impediments. In fact, a commonly accepted financial model of the
market value of the firm’s liabilities suggests that it will depend on:
Value of firm Value of all equity finance PV of tax shield PV of costs of
financial distress PV of agency costs
The equation states that the value of the firm is the present value of the cash
flows when the firm is financed by equity. By adding debt, which has tax-deductible
interest payments, this allows firms to use less equity by substituting debt finance
and reducing the amount of taxes a firm pays on its operations. These are known as
‘tax shields’. However, debt is a fixed contractual obligation where the interest
payments and sum borrowed have to be repaid as stated. When firms find it difficult
to repay debt or service other creditors, this creates a condition called ‘financial
distress’. This has a negative impact on the firm’s value, since financial distress is
costly. The last element is the costs of separating the ownership of the firm and its
management. In corporate finance these are agency costs and will reduce the value
of the firm. As the equation shows, using debt is value enhancing; financial distress
and agency are value destroying. Hence, actions by firms that allow the use of more
debt to finance the operations and reduce financial distress and agency costs will
raise the value of the firm.
Once the benefits of tax shields and transaction costs are introduced, then risk
management activity makes sense if firms can reduce transaction costs, expected
taxes or other problems associated with external sources of funding.††† Active
management of problems of this type suggests two ways in which the value of the
firm given in Equation 2.1 may be altered:
 through changing the expected cash flows (E(NCF));
 by decreasing the return required by investors (r), by reducing the firm’s risk.‡‡‡
Before turning to how these might operate, it is important to address the prob-
lem presented by modern portfolio theory. To paraphrase the argument, current
theories suggest that, at the level of the firm, management of those risks with an
unsystematic element, which can be diversified away at the shareholder portfolio
level, represents an undesirable duplication and waste of effort. Since investors are
in a position to diversify portfolios efficiently and at less cost than firms, undertak-
ing such activity at the level of the firm is economically inefficient. This is because
investors can diversify unsystematic risks at low cost and therefore do not require a
risk premium from firm-specific risk. Pragmatic attempts to manage unsystematic
††† Problems raised by external funding and its impact on capital structure are discussed in Myers (1984)
and Myers and Majluf (1984). The problems of raising external debt and the (possible) adverse signals
conveyed would lead managements to reduce the variance of future expected cash flows in order to
reduce their potential dependence on outside funding. Reluctance to depend on outside sources would
also help to explain firms’ cash holdings and other observed risk-reducing activities.
‡‡‡ In this context, r is the risk-adjusted (required rate of) return that investors require for taking on the
risk.

financial risks will not change investors’ required rate of return and thus will not
reduce the firm’s cost of capital. Even if the risks are systematic, investors can
achieve their desired exposures by constructing suitable portfolios with various
degrees of systematic risk. As a result, attempting to manage such financial risks at
the level of the firm is at best redundant and at worst wasteful.
Let us now turn to the reasons why, in a less than perfect world, corporate risk
management may be beneficial.
There is a corollary to the above. For risk management to make sense at the firm
level, it must change the firm’s cash flows in ways that shareholders value and
cannot easily replicate themselves. Furthermore, the benefit obtained from such
activity at the firm level must outweigh the costs involved. In addition, corporate
risk management by the firm must be the lowest-cost means of achieving this
beneficial change in risk. This means the corporation must be at least as efficient at
risk management as are shareholders themselves. But, of course, shareholders have
the ability to diversify and eliminate specific risk. However, there are two particular
cases where shareholders might find it difficult to engage in efficient risk manage-
ment. Ill-diversified investors – that is, owner-managers and entrepreneurs – may be
required to hold more equity in their firms than is desirable from a portfolio risk
perspective. As a result they take on a lot of firm-specific risk. In this case, the ill-
diversified shareholder might want the corporate hedging programme to protect the
ill-diversified wealth of this major investor. Note this may not be attractive to those
shareholders in the firm who are in a position to diversify efficiently. The second
case relates to closely held private firms, where, as with the dominant shareholder
situation, the owners may not be able to modify their portfolios to eliminate the
firm-specific risk.
Risk Management and Value Maximisation ___________________
Equation 2.1 indicates that the firm’s current value is the present value of its
future earnings discounted at the appropriate risk-adjusted return (known in
corporate finance as the firm’s cost of capital). In deciding to manage risks, the
firm’s managers will apply a cost–benefit approach to assessing the benefit of
risk management and how to maximise the value of the firm. The net cost of
reducing risk will be the premium for any risk reduction paid less any expected
losses. The benefit of risk reduction will be a lower required rate of return (or
discount factor) that the market applies to the stream of future earnings. The
net benefit of risk reduction will be the combined effect of the cost and benefit.
This is best illustrated with an example:
Before risk management: The firm has a $500 million annual income that is
expected to continue over a 30-year horizon at a required rate of return (cost
of capital) of 9 per cent. The present value of this is $5.14 billion.
After risk management: The firm has a $485 million annual income that is
now discounted at 8.5 per cent. The present value of this is $5.21 billion. As
with most risk management decisions, there is a cost. Before risk management,
the firm earns $500 million and afterwards only $485 million, a cost of risk
management of $15 million per year.

However, by changing the risk of the firm, financial providers are willing to
accept a lower return. This translates into an increase in the present value of
the firm of $754 million.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
2.4 Taxes
In a world where taxes exist, saving on such payments is a real gain as taxes are a
cost of being in business. Savings from undertaking corporate management of the
firm’s future taxes can come from two distinct sources: tax shields and progres-
sive corporate tax rates. This latter point may not really be a major consideration
in the UK, with its unitary approach to corporation tax, except for very small
companies. Nevertheless, the complex operation of the tax rules may make tax-
based risk management activity attractive if it can defer the crystallisation of a tax
liability.§§§
The ability to postpone the payment of tax that can arise as a result of risk man-
agement activities will be valuable since it can postpone the liability into the future
and will be beneficial, simply on the basis of the ‘time value of money’ principle.
This ability to provide a ‘tax shield’, as it is known in financial literature, provides a
real incentive for firms to manage their expected cash flows in such a way as to
postpone tax liabilities.
In addition, if the firm faces progressive tax rates – that is, the higher the profits
it reports, the relatively greater is the tax burden – reducing the variability of
expected profits will reduce taxes. We will use an example to illustrate how risk
management by the firm can affect the amount of taxes the firm is expected to pay.
Note, as previously discussed, that, since taxes are paid by the firm, shareholders
cannot obtain this benefit for themselves. Hence managing the firm’s taxes is an
area where the argument favours such actions at the firm level.
If the firm expects one of two possible outcomes, as shown in Figure 2.4, then it
will have a different tax liability depending on whether pre-tax income PTI1 or PTI2
is the outcome. Either outcome is equally likely.
§§§ There is a considerable army of tax planners who advise firms on such tax-avoidance strategies.

1.0
Probability
0.5
PTI1 PTI2
Pre-tax income
Figure 2.4
The firm, if it has profits of PTI1, will pay tax T1, and, if PTI2, then tax T2. That is,
there is a degree of tax progression with higher taxes for the larger profit. Without
risk management, the expected tax burden will be [(0.5 × T1) + (0.5 × T2)]. If the
firm then decides to hedge its income, the variance in the outcomes will move
towards the mid-point of Figure 2.4. If hedging, for illustrative purposes, can
eliminate the variance, then the firm will have a known profit of PTImean. This is
shown in Figure 2.5.
1.0
Probability
0.5
PTI1 PTImean PTI2

Pre-tax income
Figure 2.5
The firm will then pay tax at the rate Tmean, which, if the tax function is progres-
sive and convex, is less than the expected tax without hedging. The effect is
illustrated in Figure 2.6.
The more convex the tax function and the more volatile the firm’s expected
income, the greater the tax benefits from hedging. If we substitute losses for PTI1
(which are subject to tax relief), the argument ties in with ‘time value of money’
considerations, since most tax concessions involve loss carryforwards rather than
carrybacks. That is, past losses cannot be used to recover taxes already paid but only
to be set against profits earned in future years. The argument could also be extended

to the effects of tax concessions such as tax depreciation (or capital allowances) or
write-downs on investments.
To conclude, it is worth noting that, even in the absence of an explicit convex tax
function, taxes may favour risk management if losses cannot be carried forward, as
is the case of a company that has already accumulated significant losses, or when
discount rates are very high. These arguments work in most countries regardless of
the detail of the corporate tax code.
Tax
T2
Convex
tax schedule
E(T)
Tmean
T1
PTI1 PTImean PTI2 Pre-tax income
Figure 2.6 The value of hedging with a progressive, convex tax function
2.5 Agency and Other Costs

One way to view a firm is as a set of contractual relationships between different
parties.**** In this firm, managers are employed, and delegated with the responsibility
of decision making, by the firm’s owners (shareholders). Agency costs arise
because the interests of the owners (known as principals) diverge from those of
their agent(s) and it is costly to ensure that the agent always acts in the best interest
of the principal. Such problems lead to principals monitoring and putting controls
or restrictions on the activities of their agents. Such controls include requirements
such as audits, formal reviews, limits to authority and so on. One method of
reducing the agency problems of delegated management is to seek to align the
interests of managers and owners through incentive schemes, such as profit sharing
or performance-related bonuses.
There are also contracting problems between the different classes of the firm’s
securities and between the providers of finance and the firm. It is possible to see
debtholders (that is, fixed-claim holders) as having written (that is, having sold) a
put option with the shareholders on the future value of the firm. This leads share-
holders to have an interest in borrowing more to invest in riskier projects. If the
investments turn out favourably, the shareholders benefit, since in most cases
debtholders do not participate in any gains above the contracted interest and
principal payments. In a situation where the firm can engage in two different
**** The classic work on agency problems in finance is Jensen and Meckling (1976); see also Fama (1980).

projects, both with the same cost and each with the same expected return, but with
one having a higher dispersion or variance of outcomes, shareholders have an
incentive to choose the higher-variance (that is, the riskier) project. This higher-risk
project provides them with a higher expected return since fixed-claim holders will
bear some of the loss if the project does not work out favourably. The problem that
then arises is finding ways of preventing shareholders from gambling on a favoura-
ble outcome once lenders have provided their money. This is a problem that
becomes more acute with higher levels of financial gearing or leverage (that is, when
the capital structure comprises mostly debt, and shareholders contribute relatively
little of the total funding) and in circumstances such as financial distress (that is,
situations where the firm has a high probability of becoming insolvent or bankrupt).
Value of claims
on the firm Panel A:
Probability distribution Low-risk firm
of future values for the
firm
Value of equity
Impaired debt value VE=VF–VD
when VF<VD
VD
Value of debt when VF>VD
0 VF=VD Value of the firm (VF)

E(VF)
Value of claims
on the firm Panel B:
Probability distribution High-risk firm
of future values for the
firm Value of equity
VE=VF–VD
Impaired debt value
when VF<VD
VD
Value of debt when VF>VD
VF=VD E(VF) Value of the firm (VF)
Figure 2.7 Effect of risk on value of firm’s equity and debt

Let us illustrate the contracting problems using a simple example. It is important
to understand that the only value that can be paid out to the owners of the firm’s
liabilities is the value of the firm. If the value of the firm is greater than the value of
the debt (VF > VD), the equity holders as residual claimants get what is left over
after the debtholders have been paid (VE = VF – VD). Figure 2.7 shows two possible
situations. In Panel A, a company has borrowed a certain amount of debt to finance
a relatively safe outcome. There is a possible range of future values for the firm’s

assets given by the histogram. With the low-risk project, there is virtually no future
possible outcome in which the firm value is not sufficient to pay back the debt.
Note that, as previously discussed, the value of the equity (E) is simply the value of
the firm (V) less the value of the debt (D). Panel B, in contrast, shows the same
amount of debt but a higher-risk business. In this case, the range of outcomes is
greater, and in some adverse conditions the value of the firm is so low that it affects
the value of the debt. There are circumstances where the firm value is less than the
value of the debt to be repaid.
Let us illustrate how this works. While we know that the future value of the firm
is a continuous distribution similar to those shown for the firm’s value in Figure 2.7,
for illustrative purposes we will assume that there are only two possible future
values to the firm: a high value (H) and a low value (L), which have equal probability
(0.50).
In the low-risk case, the values for the firm are 80 and 120; in the high-risk case,
the values for the firm are 40 and 160. The company has 60 in debt that has to be
repaid in one year. The expected value (EV) of the debt and equity, given the value
of the firm for the low-risk and high-risk cases, is given in Table 2.4.
Table 2.4 Expected values for the low- and high-risk firm
Probability Low-risk Value of Value of E(Vfirm) E(Vdebt) E(Vequity)
firm debt equity
Low value 0.5 80 60 20 40 30 10
High value 0.5 120 60 60 60 30 30
w.a. 100 60 40
High-risk
firm
Low value 0.5 40 40 0 20 20 0
High value 0.5 160 60 100 80 30 50
w.a. 100 50 50
Although the expected value for the firm is unchanged in the higher-risk case, the
higher-risk firm has seen a shift in the expected value of the liabilities. In the low-
risk case, even when the firm’s future value is low and the firm value will be
sufficient to pay back the debt, then the debt is, in this sense, risk free and will be
worth its full value of 60. When the firm’s risk is increased, the expected value of
the firm debt is now only 50, since, if the future value of the firm is low, debthold-
ers get back only 40, the total value of the firm in this adverse state and less than the
60 they are due. Since the expected value of the firm is unchanged at 100, and we
know that the combined value of the debt and equity must equal the value of the
firm (V = D + E), the fall in value of the debt must be compensated for by a rise in
the value of the equity. Examining the payoffs, you will notice that the value of the
debt is dependent on the firm having a high value in the riskier case. If the firm has
a low value, there is a shortage of 20 in the firm to repay debtholders. Since the
liability of shareholders is truncated at zero and they do not have to compensate

lenders for any losses if things go wrong, the payoff for both debt and equity is
asymmetrical. The debtholders, in effect, contribute to the losses if the firm ends up
in the future having a low value, as they will not be repaid in full. Given the above, it
is easy to see why shareholders would want the firm’s management to undertake the
higher-risk project. They have gained value from the increased risk within the firm.
The bondholders have lost out.
There is a corollary to the above, namely that managers are generally better in-
formed about the problems and prospects of their firms than are shareholders and
lenders. The existence of asymmetric information, as it is known in the financial
literature, means that in practice how a firm organises its financing will affect the
firm’s market value (that is, the sum of the debt and equity claims) (Diamond,
1984).†††† There may also be a tangible value to a firm’s credit reputation (that is, the
perceived financial soundness of the firm) and the way the firm behaves. Imperfect-
ly informed outside investors, such as bondholders, might see a high element of
variance in the firm’s cash flows or profits as a reflection of the firm’s poor credit
quality.‡‡‡‡ Cyclicality and the perceived quality of earnings are certainly two factors
taken into consideration by credit rating agencies. In such a situation, owner-
managers may be required to signal their firm’s good quality and prospects by
holding large (and hence undiversified) proportions of their wealth in their firms.§§§§
Such ill-diversified investors are then potentially overexposed if the firm should
encounter financial problems.
Given the above, to the extent that such behaviour is expected, debtholders will
increase their required rate of return to compensate them for the risk of losses. In so
doing, they lower the present value of the claims on the firm. As previously dis-
cussed, there is also the potential for this redistribution of wealth from fixed-claim
holders to shareholders when the firm’s risk is increased. Changes in the firm’s risk
can happen as a result of (a) changes in the risks of the firm’s investments or assets
and (b) the firm’s changing its capital structure by adding more debt. When the firm
repays debt, the remaining debt becomes less risky; when the firm adds debt, it
increases the risks to debtholders. This takes place when, for instance, the firm’s
indebtedness is raised substantially, as with a leveraged buyout (LBO) situation. In
an LBO, a firm will significantly increase the amount of debt financing used. Hence,
the risk of any existing debt will rise substantially and will decline in value. To fully
or partially counter this effect, outsider investors can be reassured by evidence of
risk reduction activity (hedging). In situations where there is asymmetric infor-
mation, such visible and credible actions by the firm can then be seen as a signal to
†††† Monitoring involves the outside lender in reviewing the activities of the firm and, potentially, in
ensuring that it maintains its creditworthiness. There is an added factor in that monitoring controls for
moral hazard.
‡‡‡‡ Credit rating agencies certainly examine the cyclicality of a firm’s operating income when assigning a
rating. The Wells Fargo report cited earlier also suggests that public firms in particular are concerned
about earnings volatility.
§§§§ For example, entrepreneur-owned firms that are floated via an initial public offering on a stock
exchange often have a large portion of the shares still held by the original founder(s). Bill Gates still has
a large portion of his wealth tied up in Microsoft stock, despite the fact the company he founded is a
very large publicly quoted company.

outside claim holders as to the policies that are being pursued by the firm and that
will protect the value of their investments in the firm. Signalling involves the notion
that actions (in this case, evidence of risk management activity) convey infor-
mation.***** Furthermore, it can be made a prerequisite for lending purposes as a way
of constraining management and preventing the kind of risk switch at the expense
of lenders described earlier.
Another major difficulty in contractual relationships is designing a contract that
will cover all eventualities. The problem can be partly overcome by requiring the
firm to take certain actions (known as covenanting) in its relations with outside
providers of finance. One way of addressing this problem that also reduces the cost
of finance to the firm is to put in place risk-reducing measures so as to reduce the
probability of non-performance. This is discussed in the next section.
2.6 Business Performance

Let us assume that a firm faces the following possible outcomes in the next year. If
everything works out, the firm will have a net cash flow of 200; if things go badly,
the cash flow will be 50. The firm can hedge the situation, if it should choose to do
so, in such a way that it is guaranteed to get 120. This relationship is shown in
Figure 2.8. The firm has an incentive to hedge if it needs to have 120 for planned
investment purposes; otherwise it may have to borrow up to 70 if there is an
adverse variance in the cash flows. To complete the investment when the cash flow
is only 50 requires the firm to raise external finance for the shortfall of 70 (120 –
50). Given imperfections in the capital market and the agency and other costs
discussed above, the firm has a strong incentive to hedge, since the need to borrow
– or raise equity – to cover any deficit would be sending the wrong kind of signal to
the market.†††††
Thus, hedging allows the firm to lock in a set of cash flows to be used for new
projects. In this context, the decision to proceed with a project can be seen as a
liability. The firm faces a real cost if it is not able to finance subsequent periods
from internal cash flow or if it seeks to minimise the use of external funding. In
particular, there are significant problems for outsiders to know the value of such
projects: payoffs are distant and uncertain, and therefore hedging eliminates a
particularly difficult risk. It should be added that raising external finance when
economic conditions and financial markets are unresponsive can be difficult and
costly. This happened in 2008, when the credit crunch affected firms’ ability to
borrow from banks, and again in 2011, when volatility in the world’s stock markets
made a number of firms defer or cancel the issuance of new equity.
***** For
a detailed exposition of how signalling works in a financial context, see Ross (1977).
††††† Under the pecking order hypothesis of capital structure, external finance is generally seen as a negative
signal. Also there is what is known as a ‘signal extraction problem’. Providers of funds would not know
whether the requirement arises from simple bad luck or poor managerial judgement.

Investment next period
Planned investment
Exposure
200
Hedge
120
50 Shortfall
from
adverse
movements
50 120 200 Cash flow next period

Adverse Expected Beneficial
movements cash flow movements
Figure 2.8 Effect of cash flow variability on funds for investment

Another sphere in which hedging can be helpful is in the problem of underin-
vestment. Firms may pass up the opportunity to invest in positive NPV projects
due to conflicts between debtholders and shareholders. Let us consider an example.
A firm has an ongoing investment project in the current period (Period 0) that has
an expected value of 100 but that will not be realised until Period 2. In Period 1, the
firm has the opportunity to invest in another project, costing 100, which has
positive NPV with an expected payoff of 120 in Period 2. The payoffs from the two
projects are shown in Figure 2.9.
Period 0 Period 1 Period 2
+150
r = 0.5
E(V) = 100
r = 0.5 +50
+150
r = 0.5
E(V) = 120
r = 0.5 +90
Figure 2.9 Firm with two projects

The firm can borrow the 100 to finance the project in Period 1 at a rate of 10 per
cent. Note that issuing equity is also possible – but, given the costs involved, this
reduces the NPV of the project to zero. So the firm would not proceed with the
second project if it can only raise equity. The firm’s value at the end of the second

period, depending on the outcomes of the two projects, is shown in Table 2.5. If
both projects do well, the total firm value will be 300 (150 from the project under-
taken at t0 and 150 from the project undertaken at t1. The other payoffs are found in
a similar way: in the case where the project is only worth 50 and the second 150, the
firm value will be 200.
Table 2.5 Terminal value of the firm if the two projects in Figure 2.9
are undertaken
Firm’s value P0 project
+150 +50
P1 project +150 300 200
+90 240 140
The value of the firm to shareholders, once the interest and debt have been met
from the firm’s value, will be as shown in Table 2.6. At the end of the year, the 100
debt will have interest of 10 per cent, so the firm is contractually obliged to pay back
110. So, in the case where both projects have a high value and the firm is worth 300,
the amount of the firm’s value attributable to shareholders is 190 (300 110).
If the two projects both perform badly, shareholders, who stood to gain a mini-
mum of 50 if they had undertaken only the project in Period 0, stand to receive only
30 if the second project is undertaken and they do both poorly. They are potentially
worse off, since some of the gains they would have had to be used to meet the
debtholders’ claim. As a result, shareholders may decide not to undertake the project
at t1, despite the fact that it has a positive expected NPV, since there is a significant
risk – a 25 per cent chance – that they will be worse off as a consequence (the
probability that Project 1 and Project 2 perform badly = 0.5 × 0.5).
Table 2.6 Value of the firm to the shareholders based on Figure 2.9
once interest and principal of 110 used to fund the project in
Period 1 have been met
Value of the equity P0 project
+ −
P1 project + 190 90
− 130 30
One solution that will make the project acceptable to shareholders is if the ad-
verse consequences of a poor outcome on the second project leave the shareholders
no worse off than if they had not undertaken it. If the variance in the outcome of
Project 2 can be hedged in such a way that the expected good and bad outcomes are
now less risky, as shown in column 3 of Table 2.7, the firm still has an incentive to
undertake the project, since shareholders will now be better off in all circumstances.

Table 2.7 New project outcomes with and without hedging being
undertaken
Project outcomes Unhedged project Hedged project
+ (ρ = 0.5) 150 120
− (ρ = 0.5) 90 110
Expected value 115 115
The possible range of the firm’s values if the variance in the cash flows from the
project undertaken at t1 is hedged, using the values of column 3 of Table 2.7, is now
given in Table 2.8.
Table 2.8 Terminal firm’s value if the two projects in Figure 2.9 are
undertaken, but the Period 1 project is hedged so that the
outcomes conform to column 3 of Table 2.7
Firm’s value P0 project
+ −
P1 project + 270 170
− 260 160
The terminal value of the firm’s equity, once the debt claim of 110 has been met,
is now as shown in Table 2.9.
Table 2.9 Value of the firm to the shareholders based on Figure 2.9, but
the Period 1 project has been hedged so that the outcomes
conform to column 3 of Table 2.7 and once interest and prin-
cipal of 110 used to fund the project in Period 1 has been paid
off
Value of the equity P0 project
+ −
P1 project + 160 60
− 150 50
Now shareholders might still have only a terminal value of the equity that is equal
to the lower outcome of 50 from their initial project in Period 0, but the chance is
now reduced to 25 per cent and their expected value has risen to 105. By hedging,
the firm is able to ensure that it is in a position to undertake the positive NPV
project at the end of t1 without adversely affecting the position of its shareholders.
Note that there is an additional benefit to hedging the t1 project, namely that the
minimum payoff is now equal to the value of the debt plus interest. As mentioned
earlier, this is a factor likely to reassure the lenders that the firm can meet its
commitments on its borrowings. Notice too that some of the expected value of the
project has been surrendered through hedging: the expected value without hedging
was 120; this becomes 115 when hedging is undertaken. Hence the reduction in the

value of the project is due to the cost of hedging (or, equivalently, to risk manage-
ment).
2.7 Financial Risk and Financial Distress

There is another serious problem that will incline firms towards managing risks,
namely the direct and opportunity costs involved if a firm should become financially
distressed.‡‡‡‡‡ Financial distress is a situation where a firm is unable to meet its
fixed-claim liabilities or has difficulty in doing so.§§§§§ The main problem with
financial distress is that it destroys the value of the firm.
Financial distress is likely to be costly in cases where the company uses firm-
specific assets and makes specific investments that cannot be fully recovered if the
firm ceases to trade. Examples of such situations are as follows.
 The firm acquires specialised plant and equipment that is dedicated to its production process.
The realisable or scrap value of such plant and equipment is likely to be far less
than the price paid for the equipment when purchased. The greater the degree of
such asset specificity, the more the firm’s value will be impaired if it gets into
financial distress.
 The firm produces a credence good. For example, in the case of airline travel, passen-
gers are likely to be concerned about the ability of the airline to fly them back at
a later date and the value of the return ticket they have purchased.
 The firm provides warranties or service agreements. The possibility that the firm will
cease to be in existence to honour its warranties, or continue to provide servicing
facilities, means that it is less likely to win business.
 The firm uses specialised labour or specialised training (skills) for employees or has other
sunk costs, the intangible ‘going concern’ value of corporate existence that will
be lost if the firm ceases to operate.
 Where the firm requires customised service from suppliers, or has few suppliers.
There are both direct costs – that is, advisory and other fees involved in restruc-
turing the firm – and indirect costs (including ex ante contracting costs as discussed
in the previous section). In the early 1990s the British company Brent Walker plc
ran up direct costs in excess of £60 million as a result of financial distress, and this
was just the billed items! Value was also lost as a result of management being
diverted onto the problems of restructuring, rather than developing the business.
Research suggests the indirect costs of financial distress are significantly larger than
the direct costs. Indirect costs include management time and resources diverted into
restructuring, loss of sales as the value of explicit and implicit warranties and service
agreements become questionable, loss of ambitious and talented employees and the
inability of the firm to engage in proper maintenance and replacement of its assets.
‡‡‡‡‡ This
section draws on Rawls and Smithson (1990).
§§§§§ Brealey
et al. (2008) liken the situation to that of ‘skating on thin ice’. Financial distress is a business
condition, not a legal one. When firms enter into insolvency proceedings, this is only one path out of
the condition; it is quite possible, and also fairly common, for firms to resort to informal restructuring
or ‘workouts’ rather than the legal process.

For a typical firm, the direct costs are probably around 5–8 per cent of the firm
value. The research evidence indicates that the indirect costs for firms that meet the
criteria given above range from 25 to 40 per cent of firm value. In a few cases, such
as an advertising agency, these can exceed 60 per cent of firm value.
Two factors will influence the likelihood that a firm may experience financial
distress. The first is the level of fixed claims in the firm’s capital structure. The
second element is the degree of income volatility; that is, the amount of variation in
the expected net cash flows (E(NCF)) in our model of the firm’s value.
Any ability to increase the firm’s value by managing risk will depend on (a) the
probability of financial distress if the firm does not hedge; and (b) the expected
costs that go with the problem. Hedging is a risk-reducing activity that will, if
properly applied, reduce the variance of expected cash flows. This is depicted in
Figure 2.10, where the inherent distribution before and the (reduced variance)
distribution after hedging activity show that the probability distribution of expected
pre-tax cash flows or the value of the firm is compressed towards the expected or
mean result.
Distribution after
risk management
Probability
Inherent
distribution
Value of firm or pre-tax cash flows
Figure 2.10 Hedging reduces the variance in the expected value of the
firm (or cash flows)
There may be some point on the left-hand side of the distribution where the pre-
tax cash flows or firm’s value (P1) are such that the firm may experience financial
distress as it has insufficient value or cash flow to meet its contractual obligations.
By managing the future risk of its cash flows in such a way as to reduce the variance
of future expected cash flows or the firm’s value, it can reduce the likelihood of the
firm not being able to meet its debt. In Figure 2.11, this has the effect of reducing
the probability of becoming financially distressed from P1 down to P2.

Distribution after
risk management
Probability
Inherent
distribution
P1
P2
VFD Value of firm or pre-tax cash flows
Figure 2.11 Hedging reduces the probability of financial distress. VFD is

the value of the firm (cash flow) below which financial dis-
tress is encountered. Risk management reduces the
probability from P1 to P2
Such a reduction in the probability of financial distress is particularly useful for
ill-diversified investors, such as owner-managers, who hold a large proportion of
their wealth in their businesses. It also reduces the ex ante cost of borrowing, since
lenders will require a lower risk premium in this case. In addition, if the firm has
high financial distress costs, as previously described, it will lower the negative effect
of this on the firm’s value, as per Equation 2.1.
2.8 The Costs of Risk Management

Although in the discussion so far corporate risk management and hedging have
been seen as providing significant advantages, they do entail some costs. These are
both direct, in the form of transaction costs, overhead and establishment costs,
management time, diversion of resources and so forth, and indirect costs. On the
whole, direct costs are relatively small: a few percentage points of the total expo-
sures being managed. That said, firms should not be complacent about the
expenditures involved, and the costs incurred from their risk management pro-
gramme should be kept constantly under review.
Indirect costs are of a different order. When a firm hedges, it may have surren-
dered the opportunity of a windfall gain if the outcome turns out to have been
favourable. Of course, hedging is designed to reduce the downside or potential
losses. In doing so, the firm therefore eliminates the opportunities for gains, if
things go well. For instance, a company concerned about the exchange rate at which

it purchases foreign inputs hedges the exposure. If the forecast is correct and the
exchange rate in the future behaves as expected, the company is better off. On the
other hand, the company will be worse off if the exchange rate unexpectedly
improves. In this situation, the company faces an opportunity cost. It could – by not
hedging – have purchased the inputs at the future, better exchange rate. In most
cases, the benefits of hedging outweigh the costs.
There is an alternative, in that the firm could buy insurance. Contracts such as
financial options give the firm the opportunity to benefit from favourable outcomes,
but, of course, this entails a significant upfront expense in the form of premiums.
Perhaps of greatest concern when considering the costs of risk management are
potential competitive disadvantages that might arise if the firm hedges while its
competitors do not. A speculative firm can seek to benefit from favourable move-
ments. This can seriously disadvantage the more cautious firm that hedges and finds
the price then moves in a desirable fashion. The cautious firm, having hedged and
locked in the price, is less competitive than the speculative firm.
This brings us back to the discussion at the start of this module. Firms need to
consider where they have a competitive advantage and seek to exploit this and
ensure that extraneous factors do not adversely affect the business strategy. In the
vast majority of cases, it means that risk management is advantageous rather than a
source of competitive disadvantage.
Another problem with risk management is that, equally, by adding complexity
and the use of financial hedging instruments, the firm increases the potential for
costly errors as well as the potential for unintended or unanticipated speculation.
Given the very high gearing or leverage of the financial instruments used to manage
financial risks, the consequences can be quite devastating. Some of the ‘risk man-
agement disasters’ reported in the press suggest that firms made errors or allowed
executives to speculate rather than act in accordance with corporate policies. Well-
known examples include Codelco, the Chilean copper producer, with commodity
hedging; Showa Shell and Kashima Oil of Japan in foreign exchange management;
Sumitomo Corporation in copper trading; Procter & Gamble and Gibson Greetings
with interest rates; Metallgesellschaft with energy products; and Ashanti Mines in
gold hedging. While not new, the closing illustration below highlights how, through
the best of intentions, firms can manage to ‘get it wrong’.
It is therefore evident that in some circumstances the benefits of risk manage-
ment activity, or lack thereof, are not clear-cut. In the gold-mining industry, for
instance, until the recent run-up in the gold price, firms seemed equally divided as to
whether hedging adds value and whether it is in the best interests of shareholders.
On the one hand, some firms argued that they have an obligation to protect the
value of their output. Others equally vehemently suggested that the reason for
holding gold-mining shares is to benefit from changes in the gold price. During the
1980s and into the 1990s, the industry remained polarised between firms that
hedged and those that did not. Some firms, such as Barrick Gold, were active and
successful in hedging their output. Others, such as Ashanti Mines, experienced
difficulties as a result of poor hedging strategies. On the other side, some firms
made it a policy to remain unhedged. By 2011, the price of gold had risen to a point

where hedging was not being undertaken by gold producers. If the price were
subsequently to collapse, we would be likely to see the re-emergence of the debate.
PacifiCorp Reports Currency Management Loss ______________
In August 1997, PacifiCorp, the Oregon-based multinational energy utility
company, reported an after-tax loss in the third quarter of nearly $65 million.
This was the result of losses on its currency hedge transactions that arose in
connection with its tender offer for the UK-based Energy Group.
The primary reason given by the company for the loss was a delay in the UK
giving regulatory clearance for the takeover. This, according to PacifiCorp,
required the company to close out currency options positions at a loss. It had
used options to hedge its currency risk since it was borrowing in US dollars and
was paying for the Energy Group in British pounds.
The company launched its tender offer in June 1997, at which time it expected
its currency exchange costs would amount to approximately $27 million after
tax. In order to be able to proceed with its bid, the company had to show under
the UK’s takeover code that it had sufficient funds in British pounds to pay for
the Energy Group. For prudential reasons, it wanted to eliminate the exchange
rate risk between the time it bid and when it expected to close the offer. In
addition, under internal PacifiCorp policies it was required to hedge all foreign
currency exposures.
To achieve this, PacifiCorp purchased currency options to buy about
£1.45 billion of British pounds at an effective exchange rate of $1.64 (that is,
$2.37 billion). Because of the significant cost involved, the options were subse-
quently converted to foreign exchange forward contracts and part of the
premium was rebated back to the company. This was done in order to minimise
the upfront cost of the hedge transaction from using options.
However, on 1 August 1997 the then Trade and Industry Secretary, Mrs
Margaret Beckett, referred the takeover to the Monopolies and Mergers
Commission for investigation. This had the effect of delaying the completion of
the bid for several months. Under the terms of PacifiCorp’s offer, referral to the
competition authorities meant its bid automatically lapsed.
As a result of the termination of its tender offer, PacifiCorp’s financial policies
meant it had to close out its forward currency positions, since they were no
longer providing a hedge for an expected transaction. They were, in terms of its
policies, speculative.

In announcing the subsequent loss, PacifiCorp said that the US dollar–British

pound exchange rate was $1.63 when it started to close out its currency
positions. However, by the time the positions were finally closed, the exchange
rate had slipped to $1.58. That is, in closing out its foreign exchange forward
positions, the fall in the US dollar meant it incurred a loss. This resulted in the
company incurring an after-tax loss of almost $56 million. In addition to the
losses from the forward contracts, the company had to pay a further $9 million
after tax for the initial options.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Learning Summary
The rationale behind firms engaging in risk management activity is that it adds value
to the firm in ways that investors in the firm cannot do for themselves. In particular,
it addresses contracting problems between a well-informed insider management and
less well-informed providers of capital. It also allows investors to capture some, or
all, of the internal benefits of firm-specific assets, such as tax shields and positive
net present value investments, or to reduce contingent liabilities, such as the direct
and indirect costs of financial distress.
To summarise, maximum risk levels in the firm will be determined by:
 investor appetite for volatility of equity value. Investor appetite for risky cash
flows is likely to be low if the firm is owned by ill-diversified investors such as
owner-managers; this is most likely in the case of private or closely held firms;
 the threat of bankruptcy or other restructuring costs. These can arise
because of high financial gearing and/or volatile net cash flows (income);
 a significantly higher probability of a costly financial distress (or bankrupt-
cy) situation. Businesses with firm-specific assets that offer services, provide
warranties, require specialised staff and purchase customised inputs are particu-
larly exposed to significant financial distress costs and benefit most from
corporate risk management;
 management preferences as to the amount of risk they are willing to assume.
As managers have a significant proportion of their wealth in the businesses they
manage, they are generally risk averse;
 the potential and/or actual conflicts between different classes of securi-
ties, in particular those between shareholders and debtholders. These tend to be
most severe when there is high indebtedness and when there is a wide range of
investment (growth) opportunities available to the firm;
 the nature of underlying assets or business activity. The greater the volatility
of the underlying cash flow, the greater the benefits from risk management, as it
helps mitigate underinvestment, agency costs and financial distress;
 tax effects such as the ability to defer tax liabilities and the tax rate being related
to profits. Risk management can reduce the amount the firm pays in corporate
taxes. This applies even if corporate tax rates are not progressive;

 the opportunities available to the firm to invest in positive net present

value projects. The greater the investment opportunities available to the firm,
the greater the incentive to undertake the risk management.
Review Questions
2.1 Which of the following statements is true?

A. Firms use risk management to enhance their core business activities.
B. Firms use risk management to eliminate the risks from peripheral activities.
C. Firms use risk management to gain strategic advantage.
2.2 In financial terms, the economic value of the liabilities of a business depends upon which
of the following?
A. The market value of the firm’s liabilities.
B. The economic value of the firm’s assets.
C. The value given in the firm’s accounts for its liabilities.
D. The value given in the firm’s accounts for its assets.
2.3 The objective of financial risk management is to:

I. correct discrepancies in the firm’s reported income statement and balance sheet.
II. arrive at a sensitivity of the firm’s exposure to risk that is acceptable to management.
III. reduce the firm’s exposure to risk.
IV. guarantee profits in the future.
A. I.
B. II.
C. II and III.
D. All of I, II, III and IV.
2.4 Which of the following is correct? Financial risk is that part of a firm’s activity that is
concerned with:
A. evaluating the firm’s financial statements for errors and omissions.
B. evaluating the firm’s financial statements for differences between the current
and past reporting periods.
C. assessing the validity of the firm’s future cash flows.
D. assessing the variability of the firm’s future cash flows.
2.5 Which of the following is correct? When we talk of a ‘risk profile’, we mean:
A. the nature of a particular risk; that is, whether it is major, minor or insignifi-
cant.
B. the relationship between an exposure and its value at risk.
C. the relationship of a position to its underlying risk.
D. the sensitivity of one risk to other types of risk.

2.6 Which of the following is not an ‘operational hedge’?

A. Borrowing in a foreign currency.
B. Sourcing raw materials and semi-processed goods in foreign markets.
C. Diversifying the range of products and services on offer.
D. Buying options.
2.7 Which of the following is correct? Strategic risk management involves the firm in:
A. being flexible in its sourcing policy.
B. diversifying its production and markets by region and type.
C. pursuing an active programme of product innovation and diversification.
2.8 Which of the following is correct? In risk management terms, when we consider a firm’s
assets and liabilities to be ‘mutually offsetting’, we:
A. expect risks that affect the value of a firm’s assets not to affect the value of the
firm’s liabilities.
B. expect risks that affect the value of a firm’s liabilities not to affect the value of
the firm’s assets.
C. expect risks that affect the value of a firm’s liabilities to have the opposite effect
on the value of the firm’s assets.
D. expect risks that affect the value of a firm’s assets to have the same effect on
the value of the firm’s liabilities.
2.9 Which of the following is correct? Transaction risk is:

A. the risk that arises from the firm’s daily business activities.
B. the risk that arises when the firm wishes to raise money.
C. the risk that arises when a firm has future receivables and payables.
D. the risk that arises when a firm is seeking to get new business.
2.10 Which of the following refers to the market value of the firm?
A. The value at which the firm can be bought and sold in the market for such
firms.
B. The present value of the future cash flows of the firm’s assets.
C. The market value of the firm’s debt and equity.
2.11 Which of the following is not a reason for firms to manage their financial risks?
A. Differences between managers and shareholders as to the appropriate strategy
for the firm.
B. That, without managing their risks, firms have to pay more in taxes.
C. That, without managing their risks, firms are more likely to go bankrupt.
D. That managers have more information about the future prospects of the firm
than outside providers of finance.

2.12 If risk management is to ‘add value’ to a firm, it must transform the way the firm is
valued. Which of the following is not one of the ways by which risk management adds
value?
A. By increasing expected future cash flows.
B. By changing the required rate of return demanded by investors in the firm’s
liabilities.
C. By modifying and eliminating risks within the firm.
D. By reducing unsystematic risks.
2.13 Which of the following is correct? The arguments for tax-based risk management
practices suggest that:
A. because tax shield benefits and progressive tax rates exist, managing exposures
to minimise losses reduces taxes.
B. because losses can only be offset against future taxes, limiting losses reduces
taxes.
C. because firms pay more tax the greater their profits, managing exposures so as
to limit profits also limits taxes.
D. because tax shield benefits and progressive tax rates exist, managing the timing
and size of profits reduces taxes.
2.14 Managing risk in a firm helps to address problems of agency costs for which of the
following reasons?
A. It aligns the interests of managers and shareholders.
B. It reduces the tendency of managers to exploit lenders by taking on too much
risk.
C. It helps avoid disputes between shareholders and lenders.
2.15 If a firm has a lot of debt in its balance sheet, it may lead shareholders to prefer riskier
projects, since, in the case of an adverse outcome, lenders will bear some of the loss but
not participate in the gains if the outcome is favourable. To try to prevent this, lenders
will:
I. not lend to such companies.
II. require a higher return for taking on the risk that shareholders may behave in this
way.
III. require firms to undertake lower-risk projects.
IV. require firms to undertake risk management and other specific actions.
A. I, II and III.
B. I, II and IV.
C. II, III and IV.

2.16 In managing and fixing future cash flows over a given budgetary horizon, the argument
put forward as to why firms might choose to do this is based on:
I. the difficulty faced by firms in raising finance if the business’s cash flows are less than
expected.
II. allowing firms to plan ahead within a production cycle, knowing what their costs and
revenues will be over the hedging period.
III. separating the decision on undertaking new projects from the financing decision to
raise new money.
IV. avoiding excessive fluctuations in the firm’s profitability and sending the wrong signal
to financial markets about the firm’s quality.
The correct answer is which of the following?
A. I, II and III.
B. I, III and IV.
C. II, III and IV.
2.17 In which of the following ways can a firm adjust risk?

A. Sell the risk to another party.
B. Enter into transactions that have the opposite sensitivity to the current risk.
C. Follow operational policies that seek to take risks into account.
2.18 A firm’s risk policy will be decided by which of the following?

A. The firm’s auditors.
B. The firm’s board of directors.
C. The firm’s chief executive officer.
D. The firm’s chief financial officer.
2.19 Which of the following is correct? Firms will take risks in a particular area because:
A. they have no choice.
B. they can manage the risks they are taking.
C. they have experience of the particular type of risk.
D. they have been advised to by their shareholders.

2.20 Financial distress – that is, the business condition where firms have great difficulty in
meeting their contractual liabilities – is likely to be more costly if:
I. the firm produces goods and services that depend on the continued existence of the
firm.
II. the firm is small.
III. the firm has many assets for which there is an alternative use.
IV. the firm has developed unique processes for its products.
V. the firm uses skilled workers in its production processes.
VI. the firm has few customers and few suppliers.
A. I, II, V and VI.
B. I, IV, V and VI.
C. II, III, IV and V.
D. III, IV, V and VI.
2.21 Which of the following is correct? Financial risk management reduces the danger of
financial distress by:
A. seeking to ensure future cash flows are above the level that will trigger
financially distressed conditions.
B. seeking to ensure there is always a minimum level of profit made by the firm.
C. reducing incidental costs of the business, such as taxes and the cost of outside
finance.
D. reducing the probability that future cash flows are below the level that will
trigger financially distressed conditions.
2.22 Reasons why firms may engage in financial risk management are:
I. the firm will risk becoming financially distressed otherwise.
II. the firm will gain value through being able to deduct interest before paying taxes.
III. the firm will have a higher credit standing with investors.
IV. the firm’s management will be rewarded by higher salaries.
V. lenders will require the firm to pay more for funds.
A. I, II and III.
B. I, II and V.
C. I, IV and V.
D. II, III and IV.
2.23 One of the benefits of financial risk management is to:

I. increase the future expected cash flows of the firm.
II. increase the firm’s reported profits.
III. reduce the future variability of the firm’s cash flows.
IV. increase investor interest in the firm.
A. All of the above.
B. I and III.
C. II and IV.
D. None of I, II, III and IV.

2.24 Which of the following is correct? The costs of financial risk management to firms are:
A. forgone opportunities to benefit from favourable changes in economic risk
factors.
B. large outlays to purchase risk insurance products and services.
C. loss of competitive advantage.
2.25 Which of the following is correct? When ‘strategic risk management’ is applied, its
drawback is that:
A. it is quick to implement in response to rapidly changing economic conditions.
B. it is slow to implement in response to rapidly changing economic conditions.
C. it requires a firm to change the nature of its business.
D. it requires a firm to change the nature of its liabilities.
2.26 Which of the following is the reason for ill-diversified owner-managers to be more
active in managing the financial risks of their firms?
A. Because they have a large proportion of their wealth invested in the capital
market.
B. Because they have a large proportion of their wealth invested in the firm.
C. Outside providers of finance require them to do so.
D. They are insiders and have the best information on which to base decisions.
2.27 Which of the following is correct? Risk management is used by firms to:
A. gain competitive advantage.
B. select the risks in which they have special advantages.
C. fix budgeted costs and revenues.
2.28 Which of the following is correct? In financial risk management, when we use the term
‘risk factor’ we mean:
A. the degree of sensitivity of a position to changes in the underlying risk.
B. a particular type of risk with a single characteristic.
C. a grouping of particular risks that have common characteristics.
2.29 Which of the following is not a ‘financial hedge’?

A. Borrowing in a foreign currency.
B. Buying an option.
C. Buying a forward contract.
D. Entering into a cross-currency swap agreement.

2.30 Which of the following is correct? Another term for ‘economic risk’ is:
A. strategic risk.
B. business risk.
C. competitive risk.
Case Study 2.1: Laker Airlines******

In the late 1970s, Laker Airlines was developing strongly as a UK provider of package tour
holidays and also flights for other tour operators. The company had grown significantly under
the direction of Freddie Laker, an ebullient entrepreneur who had a vision of mass travel and
sought to develop cheap foreign holidays as part of the British way of life. The bulk of Laker
Airlines activity involved flying UK holidaymakers to foreign destinations in Europe, North
Africa and North America.
Laker’s success was phenomenal, and as a result the existing fleet of aircraft was no longer
adequate to meet the booming business. New aircraft were needed, and Sir Freddie, as he was
known following receipt of a knighthood, had to decide what to do. The US-based aerospace
manufacturer McDonnell Douglas was busy looking for buyers for its new wide-bodied jet, the
DC10, and was willing to let Laker Airways have five on attractive credit terms. This involved
Laker Airlines financing their purchase by taking out a low-cost loan in US dollars.
The airline decided to purchase the planes using the buyer finance made available by
McDonnell Douglas. But what were the consequences from a financial risk management
perspective?
1 Using the insights gained from Module 1 and this module, undertake a qualitative risk
assessment exercise on the situation that Laker Airlines had got itself into. You are not
required to quantify the results.
You may find that using a diagram is helpful. You should aim to break down the risks
into their individual risk factors and where possible group them into risk hierarchies and
also try to determine the possible interactions between the various individual risks.
****** Based on an article in Business Week (February 1982) and other sources. An abbreviated
account is given in Rawls and Smithson (1990).

References
Brealey, R., Myers, S. and Franklin, A. (2008) Principles of Corporate Finance. 9th edn. New
York: McGraw-Hill.
Diamond, D. (1984) ‘Financial Intermediation and Delegated Monitoring’, Review of Economic
Studies, 51, 393–414.
Fama, E. (1980) ‘Agency Problems and the Theory of the Firm’, Journal of Political Economy
(April), 288–307.
Fielder, D. (1992) ‘The Management of Exchange Risk’, The Treasurer (March), 20–3.
Jensen, M. and Meckling, W. (1976) ‘Theory of the Firm: Managerial Behavior, Agency Costs
and Ownership Structure’, Journal of Financial Economics, 3, 305–60.
Modigliani, F. and Miller, M. (1958) ‘The Cost of Capital, Corporation Finance and the
Theory of Investment’, American Economic Review, 48 (June), 261–97.
Myers, S. (1984) ‘The Capital Structure Puzzle’, Journal of Finance, 39 (July), 575–92.
Myers, S. and Majluf, N. (1984) ‘Corporate Finance and Investment Decisions when Firms
Have Information that Investors do not Have’, Journal of Financial Economics, 13, 187–221.
Rawls, S.W. III and Smithson, C. (1990) ‘Strategic Risk Management’, Journal of Applied
Corporate Finance, 2 (4), 6–18.
Ross, S. (1977) ‘The Determination of Financial Structure: The Incentive-Signalling
Approach’, Bell Journal of Economic Studies, 8 (Spring), 23–40.
Wells Fargo Bank (2011) Foreign Exchange Risk Management Practices Survey. [Online] Available
at: www.wellsfargo.com [Accessed January 2012].

PART 2
The Markets
Module 3 Market Mechanisms and Efficiency
Module 4 Interest Rate Risk
Module 5 Currency Risk
Module 6 Equity and Commodity Price Risk
Module 7 The Behaviour of Asset Prices

Module 3
Market Mechanisms and Efficiency

Contents
3.1 Introduction.............................................................................................3/2
3.2 Market Efficiency ....................................................................................3/8
3.3 Market Liquidity ................................................................................... 3/11
3.4 The Role of Financial Intermediaries ................................................ 3/13
3.5 Systematic Risk and Non-Systematic Risk ........................................ 3/18
3.6 Managing Market Risks........................................................................ 3/21
3.7 Effect of Credit Risk ............................................................................. 3/23
Learning Objectives
The key learning objective of this module is to provide an understanding of the
three main risk factors – market risk, specific risk and credit risk – that make up the
principal source of risk for financial instruments. Other risks, for instance liquidity
risk, are also discussed. The module ends with a brief overview of the role of
intermediaries in the transaction process.
The module starts with some general observations on markets and how they
operate. The competitiveness of markets, namely the degree of transparency or
ability of market participants to see how the market is operating and how well the
market absorbs new information, is discussed. This will be critical if the risk
management process is to use market information for measuring and modelling the
different risk factors.
Current financial theories about the nature and behaviour of risk are briefly cov-
ered, namely interest rate risk, currency risk, equity risk and commodity price risk,
and this forms a prelude to later modules that look in detail at these major asset
types of financial risk.
After reading this module, you should understand:
 the diverse risks facing the firm;
 the concept of risk sensitivity;
 the nature of the different market mechanisms that underpin financial markets;
 the theoretical basis for risk as proposed by the capital asset pricing model and
the arbitrage pricing theory;
 the source of major financial risks arising from changes in interest rates, currency
values, commodity prices and equity values;
 the effect of credit risk on value;
 the role of financial intermediaries in facilitating transactions in financial markets.

Module 3 / Market Mechanisms and Efficiency
3.1 Introduction
In order to undertake a business activity, firms invest in assets. These may be
tangible assets, such as land, property, plant and machinery, or intangible assets,
such as patents, trademarks or other intellectual property rights. Accounts distin-
guish between those assets that form part of the production cycle, which are current
assets, such as accounts receivable, inventories and work in progress, and non-
current assets (which used to be called fixed assets), which are assets of a longer-
lasting nature that form part of the production process or help support the business
operations. These include the buildings and productive equipment used by the firm.
In addition, financial statements also report a variety of other items, including
financial assets and cash and marketable securities held by the firm.
Accounts separate the liabilities side of the balance sheet to show those liabilities
that belong to the firm’s owners (owners’ equity), which includes paid-in capital and
reserves and those liabilities, such as loans, with contractual obligations that have to
be met.
To finance their activities, firms issue liabilities in the form of risk capital, or
equity and debt, either in negotiable form as securities or via loans from finance
companies. Some firms, for instance banks and investment companies, are them-
selves intermediaries in this process. Their assets are claims on other firms rather
than the real assets held by industrial and commercial firms. The claims held by
financial intermediaries are termed financial assets and are traded in the financial
markets. This module looks at some of the key characteristics of the markets in
which these financial assets are traded from a risk management perspective. In
subsequent modules we will examine in detail other sources of financial risk that
arise from the different types of financial and commodity markets.
There are three major categories of markets: the capital markets exist to bring
together borrowers and lenders, the foreign exchange markets to allow currencies
to be exchanged and the commodities markets to link producers and consumers.
The capital markets are themselves divided into two categories: the market for
equity and that for debt claims, which itself is subdivided into a short-term or
money market and a long-term or bond market. These are shown in Figure 3.1.
The arrows represent the exchanges that the firm makes with these different
financial markets. For example, the need to buy and sell currencies when undertak-
ing international trade and investment creates foreign exchange rate risk.
The purpose of markets is to bring buyers and sellers together. They are places
where firms and individuals can conveniently swap different types of asset as and
when required. At its simplest, this involves transactions where one party agrees to
buy and the other to sell an item, be it wheat, gold or financial instruments, for
money. However, markets, by their nature, also provide signals to the parties
involved: if prices are rising, it is because demand is outstripping supply; if falling,
the opposite is happening. Thus markets reflect supply and demand, with prices
constantly adjusting to new information and hence participants’ expectations about
values. The ability and speed with which markets react to news is an indication of
their efficiency. Different markets have different degrees of informational efficien-
cy. This can have a bearing on risk management activity. The continued reappraisal

and change in the values at which willing buyers and sellers will undertake transac-
tions are what make financial markets ‘risky’, since it is impossible to predict the
direction of such price fluctuations. The greater the range or dispersion of such
price changes, the greater the risk involved. This risk of changes in transaction
prices is known variously as market risk, price risk or rate risk (for interest rates
and foreign exchange).
Producer/ Foreign
Consumer trade and
investment
es
C
iti
ur
od
re
Currency
m
Factor
nc
om
ie
markets The firm markets
s
C
Capital markets
Debt Equity
Bonds Money markets
Figure 3.1 The financial risk environment for the firm

Note: The arrows are the exchanges or transactions that take place in these markets and
that create financial risks. The firm might be a buyer or a seller or both in these
different markets. These exchanges or transactions lead to various risks: price, credit,
liquidity and so forth.
The simple characterisation of markets immediately leads to another type of risk:
the availability of another party (the counterparty) willing to buy or sell that which
the first party wishes to sell or buy. The degree to which markets provide rapid
access to counterparties is known as liquidity; liquidity risk therefore arises because
there are no counterparties readily available.†††††† Lack of liquidity creates transaction
costs. It may take some time and effort to find the other side of a proposed transac-
tion, increasing the degree of price risk. Hence, in addition to being slow to locate,
the values at which counterparties may be willing to transact may be significantly
different from the prices of earlier transactions. The ease with which an asset can be
sold is known as its marketability. The less marketable an asset (think of the time
and expense involved in selling a house), the greater its liquidity risk. Having a ready
market increases the marketability of assets and reduces the costs involved in buying
and selling assets.
The costs of searching out willing counterparties provide one reason for the
development of financial intermediation, where middlemen are prepared to buy
or sell not because they want the asset as an end user but with the intention of
repurchasing or reselling it at a profit. Financial intermediation helps address the
†††††† Liquidity risk is a term with multiple uses: one definition applies to the ability of a firm to
meet maturing obligations, another to the ease with which one can trade specific financial instruments.
Therefore one talks of ‘corporate liquidity’ and ‘market liquidity’.

marketability problem and liquidity risk. So banks act to collect depositors’ money,
which they can withdraw at any point in time, and invest it in loans that are illiquid.
A broker-dealer will buy securities from a seller knowing that, in the near future,
these securities can be sold on to a buyer at a higher price.
Extending the analysis further, there is also a potential doubt about the quality
and hence value of the asset on offer. In the case of financial assets, these are issued
by a wide range of borrowers, some of whom in the course of time may be unable
to repay the obligation. When borrowers default, lenders lose some or even all their
investment. This risk is known as credit risk. It can take two forms. In the first
instance, the evaluation that others place on the future potential payoffs from the
asset may change, resulting in a reduction in the price they are willing to pay for this
as compared to other similar assets. This is known as a credit downgrade. To take
a simple example, suppose you have a bond that is contracted to pay investors 100
in one year’s time. However, economic conditions change and now there is a small
chance (say, 1 per cent) that the company will be unable to pay back the obligation
when due. If this happens, you get nothing. Now, investors will not be willing to
pay the same for something where the expected amount is now 99 (100 × 0.99 + 0
× 0.01) rather than 100 in one year’s time. Rational investors will pay more for the
case when a payment of 100 is expected rather than an expected payment of 99. As
economic conditions change, the ability of firms to service their contractual obliga-
tions also changes, leading to changes in the probability that firms will make the
necessary payments and/or the amounts they will eventually repay.
The other part of credit risk is default risk, which arises when the debtor does
not honour the contractual obligation. Credit risk and default risk are often used
interchangeably, and to some extent they are interchangeable, but default risk is
more specific in that it is the probability that the obligor is unable to make the
required payment.
There is a further, but distinct, risk along the same lines in that transactions in-
volve having to deal with another party. For example, when a buyer or seller uses a
market maker to make a transaction, the dealer is acting as a principal even though
the intention of the dealer is to sell or buy from a third party. During the course of
the transaction, there is a credit risk to the dealer until the asset or cash is received.
Thus counterparty risk (also sometimes called ‘counterparty credit risk’) arises
because of the need to have the other party, either as buyer or seller, honour their
obligations. In some kinds of transactions involving the simple purchase or sale of
an asset, the risk is a short-term problem, since, once the transaction is settled, there
is no more risk. But for other types of transaction, as with many derivatives, the risk
that other parties may not perform their obligation remains to the end of the
contract. Some contracts can have maturities measured in years rather than days, so
there are naturally concerns about the long-term ability of the counterparty to
perform. These contractual issues are important considerations in the way partici-
pants both perceive market values and structure transactions. Mechanisms to reduce
these problems form an integral part of most markets.
Because market transactions involve contracts, there are risks attached to these:
legal risk may arise if the contract is termed null and void; there may be regulatory

risk arising from the supervision of the financial markets or participants; or, if the
transaction is dependent on favourable accounting or tax treatment, this can lead to
accounting risk or tax risk.
Once a transaction is entered into, it has to be settled with a legally binding trans-
fer of ownership through the provision of documents and receipts or payments on
the other side. Failure to provide timely delivery of any part of the transaction can
lead to potentially costly delays. Or the settlement system itself may break down;
hence the existence of settlement risk. Note that, in principle, settlement risk
should include an element of counterparty risk.‡‡‡‡‡‡
The above shows that there are many risks involved in even the simplest transac-
tion. The risks involved are multidimensional and can arise from many causes and
at different stages of a transaction. To complicate matters, these risks are not
distinct but may interact on each other, as liquidity risk does on price risk, for
example. An illiquid market, where selling is difficult, is likely to have greater price
risk since it may take some time to realise the sale and the price may have shifted
significantly in the interim. One of the reasons why the 2008 credit crunch was so
severe and greatly affected the way markets operated during this period was that
various risks – counterparty risk, credit risk and market risk – all interacted and led
many market participants to stop doing business with each other out of fear. As a
result, central banks and governments had to step in, for instance to provide
funding to banks and other financial institutions in order to prevent the financial
system ceasing to operate as a chain reaction of defaults fed through the system.
Owning a security or an asset means that there is a positive sensitivity or relation-
ship between the gains and losses to changes in its market value. If we buy an asset
for 100 and the market price of such assets goes up (down), we gain (lose) as the
price we can subsequently sell goes up (down). When we own assets, in financial
parlance we have a long position, or are ‘long’. The opposite holds if we do not
own the asset and we need to buy the asset at a future date: we have a short
position, or are ‘short’. For instance, a steel mill that needs to buy iron ore in the
future would be said to be ‘short iron ore’ in the market (for iron ore). Depending
on which side of the market we are on (that is, we either own the asset or need to
own the asset), we will have a risk profile that gains from price or rate increases
(that is, we are long), or one where we lose (short). A price increase in iron ore
before the steel mill purchases its raw materials will mean that the steel mill will pay
more for this input. In having to pay the new, higher, price, the mill will be paying
more compared with the price before the increase for the same quantity of ore. So
long and short refer to the different sensitivities to changes in the market price.
Note that a firm or individual with a long position will own the asset and be
seeking to sell it in the future; a firm or individual with a short position will currently
not own the asset but will be seeking to buy it in the future. This works for produc-
ers and consumers too: a mining company that owns iron ore would be long iron
ore; the steel mill that consumes iron ore would be short iron ore.
‡‡‡‡‡‡ Once again here we see how risks interconnect.

The two basic sensitivities are shown in Figure 3.2. The short position (that is, a
future buyer) gains if the price falls before the purchase is made. The long position
(that is, a future seller) gains if the price rises before the sale is made.
The effect of the different sensitivities is summarised in Table 3.1, showing the
nature of the exposure to changes in the market value over time. Given these
sensitivities, if we expected the price to decline, we would want to have a short
position, or go short the asset. If the expected price decline occurred, we could then
buy the asset at a lower price.§§§§§§ That is, given a view on how the price will
change, we want to have the correct exposure to the risk.
+ +
Buyer gains Seller gains

if price falls if price rises
Risk profile
Asset Asset
price – + price
– +
Risk profile
– –
Short position Long position
Figure 3.2 Payoff diagrams for a short asset position and a long asset
position showing their respective risk profiles
Table 3.1 Sensitivity and exposure to market movements

Sensitivity to market Nature of Exposure
movements positions
Positive Long Gain if market prices rise
Lose if market prices fall
Negative Short Gain if market prices fall

Lose if market prices rise
A Simple Topography of Risks _______________________________

We can arrange the significance and interconnection of different risks in a
number of ways. Figure 3.3 shows a simple topography of market and market-
§§§§§§ The terminology here implies that ‘being short’ involves repurchasing something that has
been previously sold. This is not necessarily the case: if you know you are going to need to buy copper
in the future, this would be termed a short (future) copper position. When the time came, the purchase
would take place. The idea of long and short in this context refers to the nature of the price exposure:
a short gains from price falls, a long from price gains.

related risks. It is, of course, not the only way they can be presented, but it
helps us to understand the way risks are linked.
To show how risks interconnect, there are lines connecting credit risk to the
various aspects of market risk in interest rates, currencies, equities and com-
modities. Credit risk runs through the valuation of all assets, and the credit
implications can manifest themselves both as a change in market values and via
changes in market credit spreads. Market risk is also affected by changes in
liquidity. The connection may also be in the opposite direction. For example,
unfavourable changes in interest rates can adversely affect the liquidity or credit
position of a particular counterparty.
Market Risk
Interest Rate Risk Equity Risk
Interest rate Equity price

Interest rate volatility Equity price volatility
Yield curve risk Implied volatility risk
Interest rate basis risk Equity basis risk
Spread risk Dividend risk
Prepayment risk Forward price risk
Currency Risk Commodity Risk
Exchange rate Commodity price risk

Exchange rate volatility Commodity price volatility
Transaction risk Forward price risk
Commodity basis risk
Commodity spread risk
Credit Risk
Market Liquidity Risk

Liquidity Risk
Solvency Risk (Prudential Liquidity Risk)
Figure 3.3 Topography of risks showing how liquidity risk is linked to

market or position risk
The risks listed in Figure 3.3 are explained in detail in this and the subsequent
modules, which look at the source of market-related risks. Module 4 looks
at the detail of how risks arise in interest rates, Module 5 will then examine
currency risk and Module 6 will deal with both equity risk and commodity price
risk. Module 7 looks at the price-generating mechanism and at volatility in
particular. The more specific risks given in Figure 3.3 are not covered in this
course but are addressed in the Derivatives course. Basis risk and forward

price risk are covered in the relevant modules of that elective on the deriva-
tive risk management product set: Module 3 on forwards, and Module 4
and parts of Module 11 on hedging for futures and basis risk. The division of
the coverage of the material is due to the fact that basis risk arises mainly from
the problems in hedging with futures, which is a type of derivative. Neverthe-
less, it is useful to include these elements here in Figure 3.3 as it shows that
even for the simplest of transactions individuals and firms face a multiplicity of
interconnecting risks, not all of which are often considered. This became
apparent in the global credit crunch and, in particular, in the very stressed
market conditions that occurred in the autumn of 2008 following the bankrupt-
cy of Lehman Brothers, the US investment bank.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
3.2 Market Efficiency

The degree to which market prices reflect new information about the value of
assets, and the speed with which they do so, dictates their informational efficien-
cy.******* The informational efficiency of a market refers to the fact that the analysis
of past movements in prices and the information used to set asset prices will not
allow investors to earn superior returns by consistently predicting winners. The
reason is that, since all market participants engage in such activity, it ends up being
self-defeating; any profitable patterns or information being acted on by all partici-
pants so that all predictability disappears. Thus market price behaviour becomes
effectively random in nature. In fact, such behaviour is often characterised as being
‘a random walk’. We will examine the characteristics of price behaviour later on, in
Module 7. Note that, while in the short term prices appear unpredictable, over the
longer term and in retrospect prices can be related to predictable variables, such as
economic growth and so on.
The efficient markets theory suggests that forecasts are elaborate guesswork,
which, on average, is unlikely to be accurate. All an investor can expect is to earn a
fair return, given the risk taken. Note too that the theory does not suggest that price
randomness is senseless; rather, it is the logical result of competition between
rational investors seeking superior returns. This competition is in terms of invest-
ment objectives, yields and availability of information. The efficient markets model
stresses the role of information, maintaining that prices change only when new
information becomes available and current prices reflect all that is known about a
particular market, sector or security at that point in time. New information will
change the value; it is just not possible to tell in advance what that information is
and when it will be revealed.
The efficient markets hypothesis (EMH) postulates three possible degrees of
market efficiency: weak-form, semi-strong-form and strong-form efficiency.
******* There is another type of market efficiency, operational efficiency, which relates to the way
transactions are undertaken and the cost of trading. Operational efficiency has no bearing on
informational efficiency – and the opposite is true, although trading costs will put a limit on the ability
of market participants to exploit information.

The three forms of the model state that:

 a market is weak-form efficient when market prices reflect all previous price
behaviour and market participants cannot make abnormal returns from analysing
past prices to predict future prices;
 the semi-strong-form efficient market includes the conditions of weak-form
efficiency but extends the information set priced in the market to include all
publicly available information;
 the strong-form efficient market includes the semi-strong-form efficient
market model but includes in addition all available information, whether availa-
ble publicly or not. Hence, this strong-form version of the model would include
private information that is not generally available to all market participants.
The implication of market efficiency for risk management lies in the value of
market prices and the behaviour of prices over time. For instance, if prices are
predictable, then such analysis is worthwhile since it will provide an opportunity to
generate superior returns.
Early researchers found strong evidence for market efficiency certainly for the
first two forms, the weak and semi-strong formulations, and, while no conclusive
evidence was found, were generally supportive of strong-form efficiency. More
recent research on securities price behaviour suggests the existence of a number of
different anomalies in market behaviour. These are interesting in their own right
but do not fundamentally affect how market risks might be managed. There is a
strand of finance research that focuses on behavioural finance. This is quite critical
of the efficiency arguments as researchers in this area tend to argue that market
prices can be greatly influenced by market sentiment. That is, the attitudes and
emotions of investors can affect the prices at which transactions take place. There is
currently a great deal of debate about this between academic researchers, and the
verdict is out. What is clear is that the early idea of markets as conforming to the
efficient market model, in whatever form, overstates the case. Markets are mostly
efficient in that it is very difficult to earn superior returns based on information, but
they can also be irrational, as evidenced by well-documented ‘asset bubbles’ such as
the dotcom bubble at the turn of the millennium and other situations where prices
have deviated a long way from fundamental values. The problem for the risk
manager is that identifying asset bubbles is very difficult while they are occurring.
On the other hand, a bubble is obvious in retrospect.
In addition to market efficiency, there is also a question of the transparency
with which markets or institutions within markets operate. A market is transparent
when it is possible to observe the behaviour of other participants: for instance, the
buying and selling activity of brokers on a futures exchange is easily observed.
Opaque markets, on the other hand, are hard to penetrate where pricing is not
observable and is a matter of conjecture. Figure 3.4 shows different markets and
institutions in terms of how transparent their actions are. At one end, government
bond markets are generally very transparent to both participants and outsiders; at
the other extreme, the actions of deposit-taking institutions are generally opaque to
outsiders. In this case, it is not possible to understand the market for bank loans, if
not directly involved.

Generally, as Figure 3.4 shows, transparency and liquidity go together. Traded

markets where transactions take place between many market participants require
trust that the prices at which buyers transact are those prevailing in the market. Thus
price transparency and liquidity go together. At the other extreme, where there is no
price transparency, there is very little trading activity, since it is difficult to know
whether the price being offered is a fair one.†††††††
The important lesson from market efficiency is that the extent to which the mar-
ket incorporates the information (used to generate asset prices), and the speed with
which it uses that information, have a bearing on the value of those prices for
decision making. The degree to which markets or institutional prices are transparent
– that is, the nature of the institutional structure of the market – will form part of
that process. These factors have implications for market liquidity.‡‡‡‡‡‡‡
††††††† That said, there is a market in bank loans between banks, and between banks and other
investing institutions. Some parts of this market proxy the behaviour of traded markets, for instance
when banks sell short-dated (up to one-year) loans from commercial borrowers on terms that are not
dissimilar from those being offered in the commercial paper market. Hence participants can rely on the
prices from the commercial paper market, with its publicly available traded prices, to ascertain the
value of what they are being offered. In other areas of such loan trading, however, such as the market
in distressed loans or loans from emerging markets, it is very difficult for the buyer to know whether
the price is a fair one and at what price other transactions were executed.
‡‡‡‡‡‡‡ Complex financial instruments for which there are no comparable examples can also create
difficulties. One of the major issues in the credit crunch was collateralised debt obligations (CDOs),
where investors were unable to ascertain the underlying risks. Once their value was thrown into doubt,
trading in these instruments collapsed as there was a near total absence of buyers. Hence, acute
information asymmetries can prevent a market operating efficiently.

High
Government Futures
bond markets & options
markets
Unitised trusts
Corporate bond markets
Price transparency
Mutual funds
Pension
funds
Finance
companies
Hedge funds
Insurance
companies
Commercial
banks
Low
Low High
Liquidity
Figure 3.4 Classification of financial structures according to the degree

of trading, price and liquidity
3.3 Market Liquidity

We may differentiate between two extreme models of the way markets operate: the
intermediated market and the direct search market. The intermediated market is
characterised by a predominance of market makers whose main function is to
provide liquidity and a relative degree of homogeneity in the assets being traded.
Typically, those markets that are volatile and subject to a high degree of price risk
tend to be intermediated markets. An example is a stock market such as the London
Stock Exchange, which has a large number of members committed to making a
market in the securities listed on the exchange. Most of the securities traded on the
London Stock Exchange are equities. Equity values or the price of shares are known
to change significantly over a short period of time.
In the direct search market, buyers and sellers seek each other out to make trans-
actions. Asset categories that have unique characteristics, such as property, tend to
be direct search markets.
At any time, market participants may wish to change the composition of their
portfolios, either adding to or reducing the amounts held in risky assets. This
requirement is not always the same across the whole market; if it were to be so, the
net of buyers and sellers would always sum to zero. It takes both a buyer and a seller

to make a market. In practice, frictions and imperfections may mean that demand
and supply do not immediately coincide. Without an immediate counterparty, the
holder of the asset and the prospective buyer face two risks: timing risk, in that the
adjustment to the portfolio does not take place at the required time, and price risk,
in that the market value of the asset may have changed unfavourably before the
transaction can be executed. It should be noted that, although timing risk and price
risk in one market are related, timing risk may also extend across markets or
instruments. That is, disinvestment from one asset to reinvest in another is subject
to potential delay both in the sale (timing risk) and in adverse price movements
(asset selling price risk). In addition, the funds obtained from the disposal and
reallocated to other risky assets are subject to uncertainty (asset purchasing price
risk). The balance of risks will therefore depend not only on some measure of the
particular market’s asset risk but also on the purpose of the transaction. Thus, to sell
one share in order to buy another may be particularly costly if the sale is delayed,
since the price of the share to be sold may fall in value and that of the share to be
bought may increase, a problem known as execution risk. If we also include the
proposition discussed earlier that markets and the values of assets change in
response to new information, then speed of execution becomes important.
Moreover, the matching principle may be applicable at this point. If the trans-
action is part of some intended portfolio effect, where the acquired asset and the
sold asset act in some way to offset risks (as would be the case if the transaction was
designed as a hedge), then the requirement to match also makes timing a critical
issue. For markets to operate efficiently, this timing problem has to be resolved. The
solution is to pay someone to accept the timing risk.
Where timing risks are high, market participants face a dilemma as to whether to
accept lower bids or higher offers than would otherwise be the case in a normal
demand and supply equilibrium, or to wait until the demand for (or supply of) the
asset increases and sell at the new equilibrium price. An intermediary that is pre-
pared to act in a countervailing role can play the supplier or demander of liquidity
and accept the timing risk. The return intermediaries earn from taking on this risk
will be offset by income from supplying the service and from capturing the oppor-
tunity costs of supplying immediacy to other market participants.
In an intermediated market, a buy or sell instruction is given to the intermediary.
The intermediary then assumes the execution risk. This market maker then has to
search out possible counterparties willing to enter into the opposing transaction.
Part of the market maker’s remuneration is the ‘bid–offer’ spread, or turn between
the two parties.§§§§§§§ Since the availability of an opposing transaction is a function of
market activity, or liquidity, this turn is a convenient measure of market liquidity.
Markets with high liquidity can be expected to have a small bid–offer spread;
markets with less liquidity will have a higher spread. Note that intermediating firms
providing immediacy do not hold or sell assets they do not currently possess in their
own right but in order to provide liquidity services to market participants.
§§§§§§§ The bid–offer spread is also called the ‘bid–ask spread’.

3.4 The Role of Financial Intermediaries

This module has looked at the structure of markets and introduced certain kinds of
risk that are the concern of financial risk managers. These assets are traded in a
variety of markets, either directly between participants via over-the-counter (OTC)
markets or through organised exchanges with formal rules and regulations. One
characteristic of markets is that, in addition to producers and end users, there is a
group of participants whose sole function is to act as intermediaries and who are
rewarded for providing liquidity or otherwise assisting transactions. These interme-
diating institutions buy from producers and sell to end users acting as either an
agent or broker, putting buyers and sellers in contact with each other, or as
principal, buying and selling on their own account from an inventory held for that
purpose (then known as a market maker, a broker-dealer or simply a dealer). They
may also endorse the transactions of others in order to make them more marketa-
ble, as with banks’ accepting bills of exchange (documentary credits) and attaching
their name and credit to the instrument.
3.4.1 Exchange-Traded and Over-the-Counter Markets

Transactions in financial markets can either be channelled through an organised
exchange or bourse (and hence are known as exchange traded) or be undertaken in
an informal market directly between market participants, including brokers, broker-
dealers and informal market makers who act to facilitate transactions. Such informal,
party-to-party markets are known as ‘over-the-counter’ markets and are less well
regulated and more opaque than organised exchanges.
The benefits of an organised exchange arise from the fact that they reduce the
search costs of finding a suitable counterparty to enter into the opposite side of the
transaction. Exchanges also provide a set of rules that govern the way in which
transactions are carried out, for instance setting rules on how transactions are given
preference in the market by size, type and time, establishing disclosure requirements
and so on. Such controls are probably mandatory for auction markets to function
smoothly. Exchanges may also disseminate information about market conditions,
such as price and other relevant information that is required to establish a fair
transaction price. In addition, they can also provide verification of the status of
members, thus reducing some aspects of counterparty risk. For instance, exchanges
or their regulator often insist that mutual insurance is provided to ensure that the
exchange’s reputation is not jeopardised if a member should fail to honour its
obligations. Exchanges may also limit the range of assets that may be traded. The
London Stock Exchange, for example, requires that all companies that wish to have
their shares transacted on the exchange go through a formal listing procedure,
which includes disclosing relevant financial information to potential investors.
Limiting the number of assets that may be traded also has a beneficial effect in that
trading will be concentrated in a few ‘benchmark’ assets. This is particularly true of
exchanges specialising in derivatives. The loss of specificity is more than made up
for by the increased activity in these assets, the size of the market providing more
liquidity, economies of scale and reduced transaction costs. The disadvantage is that,
for hedging purposes, using these benchmark assets creates a potential mismatch

between the two sides. As this mismatch (or basis risk or spread risk, as it is
known) increases, new benchmarks are required that more closely match the
behaviour of a particular set of assets.
3.4.2 Methods of Intermediation

Financial intermediaries provide a number of services for which they either earn a
commission, or fee, or make a profit from buying at one price and selling at a
(slightly) higher one, known as a bid–offer spread or turn. There are three types of
function performed by a financial intermediary in this context:
1. acceptance, which is carrying out a transaction for a client and also guarantee-
ing that the client will perform under the terms of the agreement. For instance,
this arises in the case of banks where documentary credits are guaranteed by the
bank. In effect, the bank is substituting its reputation and creditworthiness for
that of the two parties that are carrying out the underlying transaction. This
makes sense in, for instance, an international context where the bank that pro-
vides the documentary credit will be known to the recipient bank in the foreign
country, and therefore this latter institution will have more assurance in the con-
tract being eventually honoured;
2. broking, which involves providing the client with advice on the best way of
making the transaction and seeking out suitable counterparties. Brokers act as
agents for the client in searching out the other side of the proposed transaction.
Since there are both economies of scale in such activities and efficiency gains
from concentrating on a specific activity, although there is a fee paid to the bro-
ker, this is less than the costs that would have been incurred by the customer if
they had not used one;
3. dealing: acting as a market maker or principal and being willing to act as
counterparty for a client either as buyer and seller. Because the market maker’s
activity is to job between buyers and sellers by selling to buyers and buying from
sellers, the client is assured of almost immediate execution of the transaction in
most circumstances. Dealers are willing to sell from their inventory of securities
held for this purpose and even to sell securities they do not currently own in the
expectation that they will subsequently be able to purchase these.
Intermediaries therefore act to reduce transaction costs in markets in a variety of
ways, providing information, a centralised marketplace, greater diversification,
convenience and immediacy, and a reduction in default risk.
3.4.3 The Role of Market Makers

Market makers fulfil a number of important functions in financial markets:
 They act as auctioneers: they stand ready to transact in the financial markets,
organise transactions, handle the flow of orders and otherwise facilitate transac-
tions.
 They act to stabilise prices, either by virtue of their role by ‘selling high’ and
‘buying low’, or, as imposed by some exchanges, such as the New York Stock
Exchange (NYSE), they are charged with an active duty to stabilise prices and

the rules may prevent them selling into a falling market or buying into a rising
one. As they are buying when others are selling and vice versa, their actions tend
to reduce the swings in prices that would otherwise occur due to imbalances
between supply and demand.
 They are processors of information. Recall the idea, discussed earlier, that
markets reflect available information. Therefore, the prices at which market
makers are willing to transact at any particular time will reflect all the information
known to them at that time, including the flow of buy and sell orders. Thus the
prices at which market makers are prepared to transact embody the information
about the value of assets and help establish the assets’ equilibrium price.
 From a user’s perspective, perhaps the most important function of market
makers is that they provide immediacy of execution. That is, they address the
problems users of the financial markets have in executing transactions due to
lack of liquidity.
A simple model can be used to show how market makers facilitate transactions.
Figure 3.5 shows the relationship between the quantity of assets traded in a given
period and their price.
Price
S mm
D
D mm S
Pa
Pe
Pb
S mm D
S
D mm
Quantity traded per period
Figure 3.5 The effect on the price–quantity relationship per period when
a financial intermediary acts as a market maker
In Figure 3.5, the lines D and S represent the market’s demand and supply for the
asset in question and the equilibrium point (Pe) where demand and supply are in
balance. However, this price is only obtained if both buy and sell orders are present
in the market at the same time. The other lines, Dmm and Smm, are the market maker’s
demand and supply curves for the asset.* The position of the lines shows that
* Remember that the market maker is buying as a service to market users, not as a goal in
itself: the acquisition of the asset is intended purely to facilitate a seller’s immediate requirement to
dispose of the asset. The market maker will want to sell the asset as soon as practicable thereafter.

the market maker is willing to buy (or sell) at a price that is fractionally lower (or
higher) than those at which market participants are willing to transact. This differ-
ence is part of the bid–offer spread that market makers earn from acting as
intermediaries. The point of intersection between the market maker’s selling curve
(Smm) and the market’s demand curve (D) will be the price at which the market
maker is willing to sell to market users. This gives the market maker’s offer price (or
asked-for price): the price at which, if asked, he will always immediately sell the
asset. In the same way, the point of intersection between the market’s selling curve
(S) and the market maker’s demand curve (Dmm) will be the price at which the
market maker is willing to buy. This gives the market maker’s bid-for price (or bid
price): the price at which the market maker would, if asked, agree to buy the asset.
The price differential Pa and Pb is the market maker’s quoted spread. This is the
turn (or bid–offer or bid–ask spread) that represents the gross return from provid-
ing liquidity and immediacy to market users. Hence, from a market user’s
perspective, the price difference Pa and Pb can be considered the cost of being able
to execute a transaction immediately in a given period.
In buying securities when a market user sells and also in the opposite situation of
selling securities when a market user buys, the market maker is bearing risk for his
account. A purchase by a market user and hence a sale from the dealer’s perspective
means that the market maker now holds less inventory than is optimally desirable
and the market maker will correct this by offering a higher price to sellers (that is,
the market maker will raise the bid price he is quoting to the market). At the same
time, in order to preserve the bid–offer spread, the market maker will also raise the
offered (or ask) price. By acting in this way – raising the bid and offer prices when
securities are sold from his inventory and lowering the bid and offer prices when
securities are purchased into his inventory – the market maker will realise an actual
spread that will be less than the quoted spread. When a buyer concludes a transac-
tion with the market maker at time t1, assets are sold, and if a seller transacts at time
t2 the market maker buys. Hence, the actual spread made in this case is:
, , , , ﴾3.1﴿
which is less than the quoted spread. In a situation when a seller transacts at time t1
followed by a buyer at time t2:
, , , , ﴾3.2﴿
which, again, is less than the quoted spread.
Let us look at an example that will make the process clear. In the case of a securi-
ty where the market maker’s quoted price is, say, 100–102, the quoted bid–offer
spread is 2, which is simply the offer price less the bid price (102 – 100). The market
user at time t1 buys at 102 and sells at 100. Now the dealer-broker is approached
and sells to a market user at the offer price of 102. Now the dealer is short of
inventory, so needs to find a seller in the market to replenish the just-sold securities.
As described above, to do this the dealer will raise the price at which he is willing to
buy (bid for) securities. If the price now moves to 100.50–102.50 as a result of the
sale (i.e. the broker raises his price to ‘flush out’ a seller), then the bid price is now

100.50. If the market maker can find a seller at 100.50, then the required inventory
level is now restored. Note the result: the dealer-broker has made an actual spread
of 1.50, which is less than the quoted spread of 2. The same logic applies when the
dealer buys (that is, the customer sells) with prices in t2 of 99.50–101.50.
A key issue is how the bid–offer spread is determined by the dealer. We can
break this down into four elements: business costs, a reward for bearing risk, the
cost of being wrong and competition between market makers. These are explained
below:
1. The costs of being in business; that is, the fixed and variable costs of being a
market maker. The variable will be directly linked to the number of transactions
undertaken, such as confirmation, settlement and transfer fees, together with any
taxes that might be paid. The fixed costs will be staff costs, office space, mem-
bership fees to exchanges, compliance, equipment costs and so forth. These are
business costs that any firm has to cover if it wants to undertake a line of busi-
ness, and while there are components specific to being a dealer-broker, these are
not directly related to market making.
2. The cost of assuming risk. Finance theory says that risk must be rewarded.
The earlier discussion shows that the dealer could lose money if between making
sales and purchases prices move sufficiently. Factors such as the volatility of the
asset(s), the size of transactions, the amount of capital committed by the market
maker and the market maker’s risk tolerance all have a bearing on the cost of
assuming risk. Hence part of the bid–offer spread relates to the dealer’s reward
for bearing risk.
3. The cost of being wrong. As shown in Equation 3.1 and Equation 3.2, the
market maker will earn less than the quoted bid–offer spread. Whether the mar-
ket maker even earns this reduced spread will depend on the frequency with
which a sale is followed by a purchase – and vice versa – at prices not too differ-
ent from those at which earlier transactions took place. In the cases where a sale
is followed by another sale, or a purchase by another purchase, market makers
may have to purchase inventory or sell from inventory at prices outside their
quoted spread and hence at a loss. While this is partly addressed in the reward
for bearing risk, this is nevertheless a specific risk for dealer-brokers, and hence
they need to be compensated for this. As mentioned earlier, while markets are
highly informationally efficient, they are not perfectly efficient. Consequently, a
market maker is always vulnerable to being exploited by better-informed market
participants who are trading on superior information.
4. The degree of competition between market makers. If unchecked, a market
maker not subject to competition will seek to widen the bid–offer spread to
maximise profitability, being subject only to the constraint that the demand func-
tion for intermediation is downward sloping. Hence, we expect to see wider
spreads in those markets and securities where there are fewer market makers.
Market makers may benefit also from economies of scale in their activities. Evi-
dence on bid–offer spreads (Demsetz, 1968) suggests that there is a negative
relationship between turnover and spreads in individual securities. That is, securities
with larger trading volumes have narrower spreads. There are two reasons why this
may occur. At the level of the individual market maker, larger volumes may allow a

wider spread of fixed costs across a greater number of transactions. However, the
existence of several market makers for a given security suggests that such benefits
are limited and do not create significant barriers to entry. At the level of the market,
larger markets typically have a greater flow of information. This should allow market
makers to set their bid–offer prices nearer to the equilibrium clearing price. Also,
when more market makers trade the same securities, there are more opportunities
for transactions between market makers to lay off risks; that is, dealers can trade
between each other to acquire the necessary securities or dispose of unwanted
inventory. In such a situation, the liquidity of the market tends to be higher, as
measured by the effective bid–offer spread between the best bid and the best offer
available to market users (what is known as the inside spread or ‘touch’). There is
considerable evidence that trading between dealers takes place and is used to
manage inventory risk (see Viswanathan and Wang, 2004).
Note that the above external benefits suggest that there may be a tendency to-
wards monopoly conditions applying at the level of the marketplace itself. Evidence
that there is little real competition between exchanges for the same assets supports
this contention.*
A key issue for risk managers and one clearly demonstrated during the credit
crunch is that, since market makers provide liquidity to a market, any market
conditions during which the factors that impinge on the spread and the ability of
market makers to provide immediacy are adversely affected will also adversely affect
market liquidity. Any risk management transaction or programme that relies on
markets needs to be aware of the potential disruption that conditions such as those
experienced in the autumn of 2008 can bring about to trading and market liquidity.
3.5 Systematic Risk and Non-Systematic Risk

It is a feature of the behaviour of different assets that they have a tendency to
change in value in similar ways. Thus interest rates, share prices and commodity
prices all tend to move together, either increasing or decreasing together. The
reason for this similarity of behaviour is that these assets are affected by a common
source of risk. Interest rates tend to follow the economic cycle, rising when an
economy is booming and falling when an economy goes into recession. Share prices
that depend on firms’ cash flows and dividends tend to do the same, rising in
periods of economic expansion and falling in periods of economic contraction. The
demand for commodities is also very pro-cyclical. When an economy is booming,
output increases and the demand for commodities as inputs rises, pushing up the
price.
* The battle between what was then the London International Financial Futures and Options Exchange
(LIFFE) and the Deutsche Terminbörse (DTB) for short-term interest rate (STIR) futures on German
interest rates has led to LIFFE contracts dominating the market to the exclusion of DTB’s own
version. In STIR futures on US dollar deposits, LIFFE initially offered its own Eurodollar contracts,
which competed with those offered by the Chicago Mercantile Exchange, but gave up trading these
when most of the business went to Chicago. (LIFFE later merged with the Euronext exchange to form
Euronext-LIFFE.)

This tendency is not perfect, since different types of asset and individual instru-
ments within an asset class may diverge from the overall trend. There are firm- and
asset-specific idiosyncratic factors that might make prices diverge from the overall
trend. For instance, the stock market and equity values generally might be falling,
but a particular firm that is subject to a takeover at a set price might well see its
share price increase rather than fall in line with the market. This is firm-specific or
asset-specific behaviour that is independent of the market as a whole. The reason is
that the price change in this case depends on the information affecting just the asset
in question (as with the takeover situation) rather than being economy wide.
The modern theory of finance calls the tendency of assets to show similar behav-
iour systematic risk, the individual differences specific risk. The risk of assets
thus has two components: a systematic element that is non-diversifiable and a non-
systematic element that is diversifiable. Diversification has the effect of eliminating
the specific risk element, since the gain in one asset from idiosyncratic factors is
compensated by losses on another asset from other specific factors. That is, the
specific risk effects of individual assets are uncorrelated or even offsetting. Thus,
changes in interest rates, inflation, currency rates and other, generally macroeco-
nomic, factors will have a systematic effect on asset prices.† Specific risks will be
those developments that affect the individual asset (or a group of assets), such as the
takeover mentioned earlier, management changes in a company, industrial action,
alterations to regulations, legal actions and so on.‡
The capital asset pricing model (CAPM), which is the standard valuation mod-
el used in finance, proposes that the return on an asset will be a function of the
degree to which the asset has systematic risk (which is also sometimes called market
risk).§ The model’s central equation proposes a linear relationship between systemat-
ic risk and return:
﴾3.3﴿
where E(ra) is the expected return on the asset, rf is a risk-free rate, E(rm) is the
expected return on the market factor and βa is the asset’s beta, or risk relative to the
market factor. The variable (E(rm) rf) is called the market risk premium. The beta
of an asset is a function of the covariance of the return on the asset and the market
factor divided by the variance of the market return:
Covariance ﴾3.4﴿
Variance
where ρa is the correlation between the return on the asset and the return on the
market factor, σa and σm are the standard deviation of returns on the asset and the
† Of course, not all assets will be affected to the same extent. Their systematic risks will thus be
different. Depending on their susceptibility to the underlying systematic factors, they will have greater
or lesser systematic risks.
‡ In many cases, the bad news in one company is probably the good news in one or more other
companies: its competitors (and vice versa)!
§ This is not quite the same definition as given earlier. Market risk in the CAPM is the systematic risk
element of an asset total risk; market risk, as used in financial risk management, is an asset’s price risk.

market factor respectively and is the variance of return on the market factor,
while εa is the specific risk element of the asset, which has an expected value of
zero. Note that, in the model, systematic risk is priced but asset-specific risk is not.
The important result from this formulation is that, as long as the correlation be-
tween the asset and market portfolio returns is less than perfect, there is an advantage
to diversification. A later module will look at how we can use diversification to reduce
risk.
An alternative approach, derived from a different premise, is the arbitrage pric-
ing theory (APT) model, which postulates that the equilibrium expected return on
the asset is the risk-free rate and the sum of a number of risk sensitivities to
economic factors:
⋯ ﴾3.5﴿
where fi is the ith risk factor, bi is the ith sensitivity of asset a to the factor i and εa is
a residual return element that has an expected value of zero.
The APT has attractions as a description of risk since it postulates a number of
factors that determine the return characteristics for assets. This conforms with our
earlier discussion on the nature of risks, where risks are broken down into underly-
ing factors. The disadvantage of the model is that, unlike the CAPM, there is no
specification as to what these risk factors are or how many there might be. A
number of likely candidates have been proposed, including, inter alia, changes in
industrial production, expected and unexpected inflation, default risk and the slope
of the yield curve. Note these are all what you might term ‘economic factors’. Again,
as with the CAPM, asset-specific risk can be diversified away and is not ‘priced’ in
the model.
In spite of the above difficulty, the APT model provides a theoretical justification
for empirical approaches to measuring risk that is based on econometric modelling
of asset price behaviour, using macroeconomic variables that can be shown to
influence price. It also fits in with the applied risk management approach that
unbundles a given exposure (or type of asset or position) into a set of specific risk
factors or fundamental elements.
In financial markets there are many different asset classes, and within each there
are thousands of different securities. Risk managers can make use of asset pricing
models, such as the CAPM or APT, to simplify the computation of a particular asset
risk or the risk of a portfolio of assets. For instance, if equities conform to the
model in Equation 3.3, rather than predict the price behaviour for each security in a
portfolio, we simply need to estimate the security’s systematic risk and the expected
return on the market. This greatly simplifies the estimation procedures.
Asset pricing models can also help us to assess risk. For instance, with interest-
rate-sensitive assets there is theoretically a different factor for each interest rate
period (t = 1, 2, …m). For a long-dated security, this can mean a large number of
factors. Computing these is both burdensome and less than efficient if these interest
rate factors can be reduced to a smaller number. By using an asset pricing model we

can reduce the number of factors considerably, without at the same time losing the
fundamental characteristics of the risks in the assets we seek to model.
3.6 Managing Market Risks

Financial risk management is concerned with managing the impact of economic and
financial variables on values. There are four broad market (or transactional) risk
types: interest rates, foreign exchange or currencies, commodities and equity.
The basic cash instruments and the related derivatives used for risk management
purposes are given in Table 3.2.
Table 3.2 Cash and derivative market instruments

Cash assets Derivative product set
Capital markets Forward contracts
Common stock or ordinary shares Commodities
Preferred stock or preference shares Currencies
Bonds Interest rates
Mortgages Equities
Asset-backed
Futures contracts
Money markets Soft commodities
Federal funds (US) Metals
Commercial paper Energy
Certificates of deposit Financial assets:
Treasury bills Interest rates
Bankers’ acceptances and bills of Stock indices
exchange Currencies
Bank deposits Equities
Interbank Miscellaneous
Currency markets (foreign Option contracts

exchange) Financial assets
Spot exchange Commodities
Insurance
Non-financial assets Common stocks or ordinary shares
Spot commodities Stock indices
Transport Currencies
Real estate and property Futures contracts
Collectables Bonds
Insurance Miscellaneous financial instruments
Miscellaneous

Cash assets Derivative product set
Swap contracts
Currency
Interest rates
Commodities
Equities
Miscellaneous
We refer to those instruments from Table 3.2 that relate to cash purchases as
being on balance sheet, since they add to the reported assets and liabilities of the
firm.** In this category, we need to include operational hedging procedures, such
as matching assets and liabilities in a particular currency by applying the matching
principle. When corporate strategic considerations allow, a firm will use such
operational matches to provide an internal hedge against economic exposures. For
instance, a company with a steady stream of receivables denominated in euros that
result from selling into Europe could offset the exchange rate effect of this inflow
by borrowing in euros. If the value of the euro falls, this will reduce the value of the
cash flow. At the same time, the value of the loan will also drop. But, more im-
portantly, the cash inflow stream in euros is matched by an equal and opposite cash
outflow on the borrowings. This matching thus eliminates the exchange rate risk
that the firm would otherwise have from its sales in Europe. Generally, operational
hedging will still leave a residual exposure. As a risk management tool, operational
hedging will form part of any strategic assessment and can, to some extent, be
adapted to maximise the matching principle, but usually not in the short term. Since
corrective action is required immediately, financial hedging is often the preferred
solution. This involves the use of financial risk management products, which are
mostly derivative instruments. Derivatives are contracts that address underlying
economic risk factors and are, in essence, contracts for differences and are therefore
unconnected to the operations of the firm.††
Note that, although derivatives are used to manage risk, they have the same eco-
nomic effect as if they were operational assets and liabilities, but the structure of the
contractual arrangements means that they provide magnified or geared (known as
leveraged in US parlance) exposures. This is because they are contracts for differ-
ences, based on the price or rate performance of a cash instrument or market, and
** Of course, under the International Financial Reporting Standards (IFRS) that are used in most
countries, firms are now required to report their financial instruments that were once considered ‘off
balance sheet’ to help provide users of financial statements with a more complete picture. So, while the
old distinction of what is reported on the balance sheet now no longer applies, it is still conceptually
useful to think of on-balance-sheet elements as having an asset and liability effect, while derivatives are
contingent contracts with payoffs conditional on future economic conditions.
†† This does not mean that they are ignored in financial reporting. The footnotes to financial statements
often include detailed disclosure as to the nature, size and maturity of such contracts. Such disclosure is
being increased in response to concern by the accounting profession, regulators and users that financial
statements should reflect the economic realities of the contracts entered into by the firm.

are usually nil or partly paid structures based on a notional principal amount of
the underlying asset. So a company could obtain protection against changes in the
copper price by entering into a copper futures contract. To do this, it is not required
to purchase copper (a cash outlay and hence use of cash by the firm) but only to
make a small goodwill deposit on the futures contract.‡‡ The cash flow occurs only
when the contract matures. Hence, the futures contract has a limited effect on the
firm’s operations when the contract is entered into. If the contract is used to hedge
a future copper purchase (that is, the firm is short copper), the contract has the
effect of determining the price today of the copper to be purchased at some point
of time in the future.
These financial markets operate in two basic ways: either through organised
exchanges, such as a stock exchange (like the London Stock Exchange), or via
informal over-the-counter (OTC) markets. For instance, foreign exchange, which is
the biggest financial market in the world, is an OTC market. Banks provide foreign
exchange services directly to their customers, rather than currencies being traded via
a centralised currency exchange. Although generally not a major risk factor, how a
market is structured has some implications in terms of certain risks that may arise.
On the whole, the OTC markets tend to have higher counterparty risk than
exchanges.§§
Exposure to market risks arises from firms engaging in economic activity: for
instance, the need to borrow or lend money in the case of interest rates; to make
transactions involving a foreign currency; being a commodity producer or consum-
er; and issuing or investing in equities. The risks inherent in each of the four major
classes are discussed in later modules, but it is important also to understand how
credit risk affects value and hence needs to be managed.***
3.7 Effect of Credit Risk

If we know what the future cash flows on an asset will be, we can use standard
financial techniques to derive its current value. This valuation will depend on the
size and timing of the cash flows and their risk, reflected in the interest rate used to
discount these cash flows. In normal circumstances, the interest rate is set within an
economy and for a particular period, as we will see in later modules. One added
complication of the valuation process placed on future cash flows relates to credit
risk. In a situation where, for a particular asset, instrument or security, there is a risk
that the issuer will not make timely repayment, the chance that the promised
‡‡ That said, futures can create cash flows prior to the maturity date if the contract is losing the firm
money, as futures exchanges, concerned about credit risk, require the goodwill deposit (variously called
margin or performance bond) to be increased if there are losses. The mechanism is explained in detail
in the Derivatives course.
§§ Because of this, there have been attempts to provide greater credit protection in the OTC markets and
clearing systems designed to minimise credit risks.
*** The elective Credit Risk Management examines in detail how credit risk is measured and managed. Only
the basics of credit risk are discussed at this point and later on in the module.

payment is not made will be incorporated in the market’s assessment of its current
value.
To illustrate how value may change with credit risk, we will assume that we have
a one-period asset where the issuer belongs to a particular class of firms where there
is a known probability of five in a thousand (0.005 or 5/1000) that such a company
may default in the next period. The market’s default-free rate of interest is 10 per
cent. We therefore have the following probable set of outcomes: a large probability
that the firm does not default and a small, but not insignificant, probability that it
does. The tree of the two possible outcomes is shown in Figure 3.6. This is simply
the lower part of the decision problem shown in Figure 1.13. The decision to own
the asset has been omitted in this case. If there is no default, the asset is worth 100
plus the 10 per cent interest, so the future cash flow in this case will be 110. If there
is default, we need to know what we will get back. The amount will depend on a
variety of factors, including the underlying economic value of the obligor, economic
conditions at the time and so on. For the purposes of this analysis, we will assume
that holders of the asset receive back 50 per cent of what they are due, which is 55
(110 × 0.50).
Present Probability of Future

outcome (r)
Firm does not default
0.995
110
55
0.005
Firm does default
Discount rate = 10%
Figure 3.6 Payoffs for a one-period risky asset subject to default

Note: It is assumed that, in the case of default, repayment will be 50 per cent of the non-
defaulted value. This is not an unreasonable assumption in most cases. It is based on the
fact that, for most kinds of assets, the holder receives some form of payment even after
default. This could be, in fact, the entire contractual value of the claim, but deferred to
some future date. So the value of 55 could be taken to be the discounted value of this
deferred payment at the expected repayment date. Such refinements do not alter the
basic analysis.
Following the expected value approach and solving for the values in Figure 3.6,
the valuation of the asset will be as follows:
99.75 0.995 110/1.1 0.005 55/1.1
If, however, the asset had been default free and the promised payment was com-
pletely without credit risk, then the valuation would have been:
100 110/1.1

In financial markets, this difference in valuation is normally expressed in terms of

the differences in the interest rates used to present value the cash flows; that is, as a
credit spread:
10.28% 110/99.75 1 100
10.00% 110/100 1 100
The 0.28 per cent reflects the reward for taking on (credit) risk. In financial mar-
kets, this would be called 28 basis points, where a basis point is one-hundredth of 1
per cent. We may rewrite the above as:
Return Market rate of return Default risk premium ﴾3.6﴿
that is, 10.28% = 10% + 0.28%. Note that this only applies in a pure expected value
(expectations) framework under risk neutrality. If the majority of investors are, in
fact, risk averse, there will be a further value discount reflecting a pure risk premi-
um. This additional discount (yield) represents the rate at which a safe cash flow
(safe, that is, in credit terms) is exchanged for an uncertain one. Thus, Equation 3.6
can be rewritten as:
Return Market rate of return Default discount Risk premium ﴾3.7﴿
So, if investors required a risk premium of say 0.10 per cent (10 basis points), and
the capital asset pricing model discussed earlier suggests this would be the case, the
required return on the asset would be 10.38% (10% + 0.28% + 0.10%). In this case,
the market value of the asset today would be 99.56 (110/(1 + 0.1038)), slightly less
than the value initially calculated.
In practice, there will be a wider range of factors that will affect the interest rate
spread: the type of issuer; the issuer’s perceived creditworthiness; the term or
maturity of the asset (longer maturity assets having greater risks); the expected
liquidity of the issue (a marketability discount); any special rights or conditions
allowing the issuer or investor the option to do something (this will raise or lower
the spread); and the tax effects.
Note too that most debt claims will have more than one cash flow and the prob-
ability of non-payment may be different for each of the periods. Thus the observed
credit risk premium for such a package of cash flows is a weighted average of the
occurrence of the different probabilities of default occurring over time. Observation
of market credit spreads indicates that these tend to rise with maturities, longer
maturity instruments having bigger spreads.
Credit risk adds a specific new risk variable since the change in valuation arising
from changing economic conditions may be increased or reduced by changes in the
probability of repayment. In fact, if the ability of the issuer is positively affected by
changes in market values, the two types of risk may be highly positively correlated.
This will alter the behaviour of such risky investments in relation to default-free
investments (such as government securities). Readers need to bear this in mind in
the analysis in subsequent modules of the specific financial markets.

Borrowers Default __________________________________________

The following table shows a number of companies that have, in some way,
defaulted on their obligations to investors. As the table shows for this selection,
defaults cover a number of countries, and what constitutes default (that is,
credit risk) differs.
Table 3.3 Companies that have defaulted

Company Country Industry Amount of Reason for default
default
(millions of
US dollars)
Confidential US Forest products 145 Chapter 11 (bankruptcy
Company proceedings)
Gulf Finance House Bahrain Financial 252 Distressed bond
services exchange
PT Arpeni Pratama Indonesia Aeronautical & 458 Missed interest payment
Ocean Line Tbk. automotive
TRUVO Subsidiary Belgium Leisure & media 1332 Missed interest payment
Corporation
Metrogas S.A. Argentina Utility 238 Bankruptcy
Titan Petrochemicals Hong Kong Transportation 106 Distressed bond exchange
Group Ltd
Angiotech Canada Healthcare 610 Missed interest payment
Pharmaceuticals Inc.
The Great Atlantic US Consumer 893 Chapter 11 (bankruptcy
& Pacific Tea Co. services proceedings)
Inc.
EnviroSolutions US Healthcare 210 Chapter 11 (bankruptcy
Holdings Inc. proceedings)
In the United States, firms that are unable to pay creditors enter a legal bank-
ruptcy and reorganisation process called Chapter 11. But investors in a
company’s debt can also lose out if the company has to reorganise the debt via a
distressed bond exchange that extends the maturity of the debt, reduces the
interest rate on the obligation and reduces the amount of principal (that is, the
amount borrowed). Another form of default is when a company, through lack of
cash on hand, misses an interest payment. Note that all of these ‘events of
default’ affect the payments promised to debtholders in the way described in
Section 3.7.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Learning Summary
This module has considered how markets work and some of the ways that market
mechanisms and efficiency affect the process of financial risk management. Risks in
financial markets can arise in a variety of ways, ranging from price risk, credit risk
and liquidity risk to more complex interconnection risks. The structure and behav-
iour of the market can also have a bearing on these risks based on how efficient and
transparent the market is. This module shows that the risk of a position in the
market is multidimensional. Any exposure to the market by being long or short is a
package of all the individual risk factors or elements that are in the asset and the way
it trades in the market.
The direction of the exposure will depend on the sensitivity, whether the asset is
owned (a long position) or is to be purchased (a short position). With a long
position, price increases lead to gains, price decreases to losses. For a short position,
the opposite applies.
The standard model used for valuation in finance, the capital asset pricing model,
suggests that risk should be broken down into at least two elements: the asset’s
systematic risk, which cannot be diversified, and its specific risk, which can. The
asset’s sensitivity to changes in the market can then be measured by its beta.
Another approach, arbitrage pricing theory, proposes that risk is a function of a
variety of macroeconomic and systematic factors. This latter theoretical model has
more relevance to the risk management approach that unbundles a particular
exposure into its constituent risk factors. However, the theory does not specify what
these factors should be.
The major financial risk categories are interest rates, foreign exchange rates,
commodity price risk and equity price risk. Each of these is subject to particular
kinds of risk:
 Market or price risk arises from changes in the demand and supply of an asset
over time, which changes the equilibrium price and hence the price of the asset
observed in the market.
 Liquidity risk arises from (a) a lack of available buyers at a specific point in time,
known as timing risk, and (b) changes in the market price owing to delays in
carrying out transactions; this can arise when assets have limited marketability.
Liquidity risk can be considered as either selling price risk or purchasing price
risk, or both if the transaction involves switching between two assets that are
illiquid.
 Credit risk arises from a potential default by the issuer of the asset or the
counterparty to a transaction.
 A range of other risks, such as legal risk, regulatory risk and tax risk may also
need to be considered.

Review Questions
3.1 Which of the following is correct? The function of financial markets is:
A. to equate supply and demand.
B. to provide pricing signals.
C. to bring together buyers and sellers.
3.2 Which of the following statements is untrue?

A. Firms use factor markets to exchange their production for capital.
B. Firms use foreign exchange markets to obtain and sell foreign currencies.
C. Firms use the capital markets to raise new funds.
D. Firms use the commodity markets to obtain the raw materials for their
production processes.
3.3 Which of the following is correct? Market risk can be defined as:
A. the difficulties sellers have in finding buyers in a market.
B. the likelihood that transaction prices will change unpredictably over time.
C. a lack of market makers willing to buy or sell in a given market.
D. the danger that counterparties will not honour their commitments when
entering transactions.
3.4 Which of the following is correct? Liquidity risk arises because:

A. there are more buyers than sellers in a market.
B. there are more sellers than buyers in a market.
C. there are few buyers and sellers.
D. there are many buyers and sellers.
3.5 Which of the following is correct? Credit risk is the risk that:
A. there are no funds available from lenders.
B. there are funds available from lenders.
C. borrowers have no funds to repay lenders.
D. borrowers have funds to repay lenders.
3.6 Which of the following is correct? Financial intermediation takes place when:
A. a firm places itself between producers and consumers.
B. a firm places itself between buyers and sellers of financial instruments.
C. a firm places itself between different types of assets.
D. a firm places itself between different types of credit risk.
3.7 Which of the following is correct? A ‘credit downgrade’ involves:

A. a reduction in the default risk of a particular debtor.
B. an increase in the default risk of a particular debtor.
C. an absence of default risk in a particular debtor.
D. none of A, B and C.

3.8 Which of the following best describes ‘settlement risk’?

A. The payment on a transaction is delayed.
B. The other party to a transaction cannot deliver the asset against the payment
to be made.
C. The other party to a transaction cannot deliver cash against the asset to be
delivered.
3.9 If we have a ‘long position’, we have which of the following?

A. More risky assets in a portfolio than is desirable.
B. Fewer risky assets in a portfolio than is desirable.
C. A positive exposure to a risk.
D. A negative exposure to a risk.
3.10 Which of the following is correct? An efficient market is:

A. a market where there are a large number of buyers and sellers.
B. a market where there are a large number of market makers.
C. a market where information about the true value of assets is incorporated in
their transaction price.
D. a market where rapid and effective settlement takes place between buyers and
sellers.
3.11 Which of the following is correct? A market is transparent if:

A. market users can observe how market prices are being determined.
B. market users cannot observe how market prices are being determined.
C. market users can determine the number of market makers who operate in the
market.
D. market users cannot determine the number of market makers who operate in
the market.
3.12 Which of the following is correct? In a direct search market, market users will:
A. employ the services of a market maker in undertaking transactions.
B. deal directly with counterparties who are buying and selling.
C. use an exchange to undertake transactions.
D. undertake all of A, B and C.

3.13 Execution risk arises because:

I. a market has too few market makers.
II. the purchase of one asset and the sale of another do not happen at the same time.
III. there are more buyers than sellers.
IV. there are more sellers than buyers.
A. I, III and IV.
B. II, III and IV.
C. III and IV.
3.14 Which of the following is correct? In financial markets, a broker will:

A. locate the other party to a transaction.
B. buy or sell on his own account.
C. add the broker’s name to the transaction.
D. stand ready to buy or sell as required.
3.15 Which of the following is correct? An over-the-counter market is one in which:

A. transactions take place on an exchange or bourse.
B. transactions take place directly between market participants.
C. transactions take place through market makers.
D. transactions take place only at recognised locations and times.
3.16 Which of the following is not an advantage of having financial instruments traded via an
organised exchange?
A. It minimises the search costs in finding counterparties to a transaction.
B. It reduces counterparty risk.
C. It reduces the mismatch risk for market users.
D. It helps disseminate information about market prices and conditions.
3.17 The following functions apply to market makers.

I. They stand ready to buy and sell in the market.
II. They stabilise prices in the market.
III. They assist in the smooth operation of markets.
IV. They help determine prices by their actions.
A. I, II and IV.
B. II, III and IV.
C. III and IV.

The following information is used for Questions 3.18 and 3.19.

The table gives the bid-offered (bid-asked) quotes available for a given security X by market
makers A, B and C.
Market maker A B C
Offer 1001/4 1003/8 1003/16
Bid 997/8 9915/16 9913/16
3.18 Which of the following is correct? The ‘inside spread’ for security X is therefore:
A. 5/16
B. 1/8
C. 3/8
D. 1/4
3.19 You have ascertained that the ‘fair value’ based on a pricing model for the security X is
100. Therefore the market makers most anxious to buy and sell are which of the
following?
A. A most wishes to buy, whereas C most wishes to sell.
B. B most wishes to buy, whereas C most wishes to sell.
C. B most wishes to buy, whereas A most wishes to sell.
D. C most wishes to buy, whereas B most wishes to sell.
3.20 Which of the following is correct? If we are making profits when prices rise, we would
say that:
A. we are ‘long the market’.
B. we are ‘short the market’.
C. we are ‘insensitive to the market’.
3.21 Which of the following is correct? The price change in an asset or security from
systematic risk arises when:
A. the asset price changes when market prices do not.
B. the asset price changes when credit risk changes.
C. the asset price changes when market prices change.
D. the asset price changes when assets are bought and sold.
3.22 The differences between the capital asset pricing model (CAPM) and the arbitrage
pricing theory (APT) as descriptions of asset pricing models are which of the following?
A. CAPM assumes only one systematic factor, whereas APT assumes a multiplicity
of factors.
B. CAPM is observable, whereas APT is not.
C. CAPM is based on a linear relationship of return to risk, whereas APT is not.

3.23 Which of the following is correct? An asset, instrument, security or contract is said to
be an operational asset when:
A. it forms part of the assets used by a firm in conducting its business activities.
B. it is referred to in a firm’s balance sheet.
C. it is owned by the firm.
D. it is a contingent asset of the firm.
3.24 Which of the following is correct? One of the major effects of financial instruments such
as derivatives is that:
A. they are agreements for exchanges to be made at some future date.
B. they offer a geared or leveraged exposure to an underlying economic risk.
C. they do not have to be reported on a firm’s balance sheet.
D. no payment is required to enter into such agreements.
3.25 Which of the following is correct? We would characterise a security or debt as ‘default
free’ if:
A. the borrower is almost certain to repay the debt.
B. the borrower is certain to repay the debt.
C. the borrower is almost certain not to repay the debt.
3.26 A debt instrument trades in the market at a lower price (that is, higher yield or
promised return to investors) than government debt. This observable spread on the
debt above the market rate of return is due to which of the following?
A. Concerns about future inflation.
B. Concerns about possible market disruption.
C. Concerns about the credit standing of the borrower.
D. The greater attractions of holding government debt.
3.27 Which of the following is correct? If we said the market was ‘semi-strong-form efficient’
it means that:
A. there are only a few market makers willing to buy and sell in the market.
B. the history of prices and publicly available information have been incorporated
in current market prices.
C. all information relating to the valuation of assets has been incorporated in
current market prices.
D. there are many market users willing to buy and sell in the market.
3.28 Which of the following is correct? Counterparty risk is a special form of credit risk that
arises because:
A. there are too few creditworthy other parties in a market.
B. the other party may delay the settlement of a transaction.
C. the other party may accelerate the settlement of a transaction.
D. the other party has to be able to carry out its obligation until the contract is
terminated.

3.29 Which of the following is correct? In a situation where we are ‘short’, we have:
A. too many risky assets in a portfolio.
B. too few risky assets in a portfolio.
C. a positive exposure to an underlying risk.
D. a negative exposure to an underlying risk.
3.30 Which of the following is correct? For a financial intermediary to endorse a transaction
involves:
A. locating the other party to a transaction.
B. buying or selling for the intermediary’s own account.
C. adding the intermediary’s name to the transaction.
D. standing ready to buy or sell as required.
3.31 Which of the following is correct? From a market user’s perspective, the ‘inside spread’
represents:
A. the gain from buying and selling assets.
B. the loss from buying and selling assets.
C. the effect of changes in market values on portfolio values.
D. the effect of changes in counterparty credit risk on portfolio values.
3.32 All else being equal, the spread on a security over the default-free interest rate will be
influenced by:
I. any special rights and conditions that may be applicable to the issue.
II. the maturity of the issue.
III. the liquidity of the issue.
IV. the number of market makers in the issue.
V. the name of the issuer.
VI. taxes.
A. All of I, II, III, IV, V and VI.
B. I, II, III, V and VI.
C. I, II, IV, V and VI.
D. II, III, V and VI.
3.33 Which of the following is not a form of market risk?

A. Commodity price risk.
B. Exchange rate risk.
C. Equity risk.
D. Counterparty risk.
3.34 The expected market return is 20 per cent, the risk-free interest rate is 6 per cent and
the debt’s beta is 0.5. There is a credit risk premium on the debt of 2 per cent. What is
the market’s required return on the debt?
A. 6 per cent.
B. 8 per cent.
C. 11 per cent.
D. 15 per cent.

Case Study 3.1: Omega Corporation

Omega Corporation has a series of outstanding zero-coupon bonds. Zero-coupon bonds pay
no interest and repay all the principal (and the implied interest) at maturity. They are also
called discount securities. The Omega Corporation bonds have the following maturities:
Maturity Market value per 100 nominal Current market rate of interest
(%)
1 year 90.70 10.10
2 years 81.90 10.25
5 years 55.74 11.50
8 years 35.06 13.00
1 What is the market’s assessment of the credit risk of Omega Corporation?

Note: In order to be able to answer this question, you have to know how a zero-coupon
bond is priced. Look at the calculations used in Section 3.7. A more detailed treatment
is given in Module 4 and Module 10.
One year later, the bonds now have one year less to maturity. In fact, the one-year
zero-coupon bond has matured and been repaid. At the same time, interest rates have
fallen and the new prices for the remaining bonds and the current market rate of
interest are as follows:
Maturity Market value per 100 Current market rate of

nominal interest (%)
1 year 92.50 8.00
4 years 70.58 8.50
7 years 52.30 9.00
2 What conclusions can you draw about Omega Corporation from this development?
References
Demsetz, H. (1968) ‘The Cost of Transacting’, Quarterly Journal of Economics, 82, 33–53.
Ross, S.A. (1989) ‘Institutional Markets, Financial Marketing and Financial Innovation’,
Journal of Finance, 44 (July), 541–56.
Viswanathan, S. and Wang, J. (2004) ‘Inter-dealer Trading in Financial Markets’, Journal of
Business, 77 (4), 987–1040.

Module 4
Interest Rate Risk

Contents
4.1 Introduction.............................................................................................4/2
4.2 Interest Rate Risk ...................................................................................4/5
4.3 The Term Structure of Interest Rates .............................................. 4/19
4.4 Analysing Yield Curve Behaviour....................................................... 4/31
4.5 The Money Markets ............................................................................. 4/36
4.6 Term Instruments ............................................................................... 4/37
Appendix 1 to Module 4: A Note on Early Redemption ............................ 4/41
Appendix 2 to Module 4: Relationship of Spot Rates and Par Yields ....... 4/43
Learning Objectives
Module 4 discusses the risks that arise from changes in interest rates. It looks at the
different theories that have been put forward to explain the behaviour of interest
rates. The nature, cause and effect of the key sources of interest rate risk are also
covered in detail. The similarities and differences in interest rate risks, as well as the
source and nature of the different risks, are brought out. Interest rate risk is a major
component of any financial risk. In particular, the value of (interest) rate-sensitive
assets depends directly, or indirectly, on the interest rate (or the discount rate) used
to present value the cash flows of these assets.
After studying this module, you should be able to understand:
 the sources of interest rate risk;
 the impact of the different types of interest rate risk on a given exposure;
 how interest rate price risk is inversely related to the level of interest rates and
the maturity of the set of fixed cash flows;
 how reinvestment risk is directly related to interest rates;
 the problems and attractions of the right to early repayment of a set of fixed cash
flows;
 the causation of extension risk in some fixed-interest securities;
 the nature of, and theories used to explain, the term structure of interest rates:
 expectations theory;
 liquidity preference theory;
 market segmentation theory;
 volatility theory of the term structure;

Module 4 / Interest Rate Risk
 how different securities are affected by the various components of interest rate
risk.
4.1 Introduction
Interest rates have a central role in finance. There is probably no part of the theory
and practice of finance that does not include somewhere an application of the time
value of money principle. From a theoretical and practical point of view, interest
rates are used to value future cash flows. (Note that the behaviour of interest rates
for different maturities is known as the term structure of interest rates.) Students of
finance will be familiar with how interest rates are used in compounding and
discounting; that is, to calculate the future- and present-value equivalents of money
today or in the future. It is changes in interest rates and how they affect future and
present values of these cash flows that make assets and liabilities that are interest
rate sensitive ‘risky’. As the discount rate (or capitalisation rate) used to give the
present value of a set of cash flows is changed, the present value will change. A cash
flow of £100 to be received in one year’s time discounted at 10 per cent will be
worth about £91 today.††† If the cash flow was to be received in five years’ time – at
the same discount rate of 10 per cent per year – we would value it at about £62
today. Now, if interest rates were to change by 1 per cent, to 11 per cent, the new
value for the one-year cash flow would be about £90, a change of −£1, but for the
five-year cash flow it would be worth only about £59, a change of −£3. This shows
that changes in interest rates affect values and lead to such assets – and liabilities –
having interest rate risk.
Changes in the interest rate or the capitalisation rate used to give the present
value of future cash flows change the current (or present) value of assets and
liabilities. The interest rate risk arises when the current value changes when the
interest rate used to present value the cash flows changes. Hence it is changes in
interest rates that make assets and liabilities that are interest rate sensitive ‘risky’.
Furthermore, as we will see, a change in interest rates can have a complex effect on
the value of multiple cash flows that are taking place at different points in time.
Equitable’s Interest Rate Risk Debacle _______________________
A classic case and one worth quoting here about a business that failed to
understand interest rate risk relates to Equitable Life, one of Britain’s oldest life
assurers and a long-established mutual company founded in 1762. In the late
1990s, the insurance company found itself facing considerable regulatory,
financial and reputational problems as a result of its guaranteed annuity rate
(GAR) pension product. These were interest-rate-sensitive products that the
company had successfully sold for many years. Remarkably, the management of
the company seemingly had failed to understand the risks the company was
assuming in selling these products.
††† The values used here are rounded. Obviously, if we apply the formula for present value we get
£100/(1.10) = £90.91, which when rounded gives £91. At 11 per cent, the value is £90.09, about £90.

The story began in 1957, when, as a result of both competitive pressures and
through a deliberate marketing strategy, Equitable (like other insurance compa-
nies) began to offer a minimum interest rate on the annuity that was created
when the pension contract came to maturity. Policyholders paid in premiums
over the life of the contract and, upon maturity, would receive regular payments
via an annuity thereafter.
At the time, with double-digit interest rates, little thought was given to the
implications of the minimum interest rate guarantees on the annuities. Under
the GAR structure, policyholders who then drew their pension were effectively
offered a minimum interest rate or ‘floor’ on the income to be derived from the
policy. To illustrate this, assuming a policy value at maturity of £100 000, a
remaining life of eight years and an interest rate of 8 per cent per year, the
minimum monthly payment a policyholder could expect would be £1400. At the
time, long-term interest rates were significantly above the 8 per cent level and,
to use the language of the options markets, the floor was significantly ‘out of the
money’ and not worth very much. Insurers, including Equitable, ceased offering
GARs in 1988 as a result of changes in pension legislation. However, the
institution was left with a long tail of existing GAR contracts, which it had sold
since first introducing the product in 1957. As these are long-dated contracts, it
is not until they start to mature and policyholders start to receive the annuity
payments that the insurer will then have to make payments on these GAR
products.
Unfortunately, by 1993, long-term interest rates had fallen significantly due to a
combination of sound UK fiscal and monetary policy and much reduced inflation
expectations, and annuity rates in the market fell below those offered on the
GAR contracts. Continuing the earlier illustration, assuming that the GAR was
for 8 per cent and current annuity interest rates were now 6 per cent, then the
value of the contributions would have had to be £107 500 to match the GAR
annuity payments.‡‡‡ That is, the pension provider had to make up a shortfall in
the present value of the funds in the policy of £7500. Equitable had two ways of
doing this. First, it could transfer funds out of reserves into the pension account
to cover the shortfall. Second, it could reduce the value of the GAR holders’
‡‡‡ We find the present value of the difference by taking the difference between the amount paid under an
annuity of 8 per cent per year, paid monthly, and an annuity of 6 per cent per year, also paid monthly.
The two annuity factors are:
. /
6% 76.09522
. /
. /
8% 70.73797
. /
The monthly payment at 8 per cent is £100 000/70.73797 = £1413.67, which we will round to £1400
(the balance, we assume, is an administration charge). Now we calculate the present value of this
payment stream (£1413.67) at 6 per cent interest for eight years, which gives £107 573 (again rounded
to £107 500). So to provide the guaranteed annuity rate of about £1400 per month on the policy,
Equitable would need not £100 000 but £107 500 in the policy; hence the shortfall of £7500 on this
policy. Note that the numbers in the text have been rounded.

fund through what is known as the discretionary bonus, effectively penalising the
GAR holders for the drop in interest rates. This would mean that the amount at
maturity that had been accumulated would be less, and hence the monthly
payments Equitable would have to make would also be lower. There was a
problem with the first approach: since the life insurance company was a mutual
institution, its reserves were technically policyholders’ money. But in addition
past practice had been to maintain a low level of reserves and Equitable did not
have sufficient excess capital to cover the emerging liability. Furthermore,
significant transfers of reserves would have also exposed the problem and
probably impaired its ability to do new business. Equally, there was a problem
with the second approach in that it would discriminate against policyholders
who had purchased GAR products.
In the event, Equitable opted for the second solution and, in January 1994,
started to cut the bonuses for GAR policyholders. At the same time, Equitable’s
management hoped the problem would go away. But long-term interest rates
continued to fall. The May 1997 election installed a Labour government, which,
in pursuit of sound monetary policy, gave the Bank of England operational
independence and in particular a mandate to reduce inflation. This had the effect
of further lowering long-term inflation expectations and, hence, the all-
important long-term interest rates that were used to price annuities. As a
result, long-term interest rates continued to fall, worsening Equitable’s position
in relation to its obligations on GAR pensions. By September 1998, a group of
disgruntled policyholders formed the Equitable Life Guaranteed Annuity Action
Group to pressure the insurance company for better treatment. A test case
brought before the High Court, however, upheld Equitable’s stance. But the
judgement was appealed, and in January 2000 the Court of Appeal ruled two to
one in GAR policyholders’ favour. Given the complexities of the case, leave was
then granted to Equitable to take the adverse judgement to the House of Lords,
then the UK’s highest court of law. In July 2000, the Law Lords upheld the
appellate court’s decision and dismissed the appeal.
Now forced to provide equal treatment to all policyholders and without the
reserves or ability to raise equity to meet the obligation to GAR holders,
Equitable Life immediately put itself up for sale. In December 2000, the insur-
ance company closed to new business, given the uncertainties over its future: no
other institution had come forward as a purchaser due to the large and uncap-
pable liabilities represented by the GAR policies. In February 2001, Equitable
did, however, manage to sell off its operational assets to Halifax, a UK building
society turned bank wanting to expand its bancassurance interests. Then, in
March, the senior managers at Equitable who had overseen the decision to go
to court to defend their decision to cut bonuses resigned. All this time, the life
fund bled withdrawals and redemptions as dissatisfied and concerned policy-
holders left the troubled insurance company. In July 2001, the new management,
faced with an uncertain future and the obligation to give equal treatment to all
life policyholders, whether benefiting from the GAR element or not, slashed the

value of pension funds by 16 per cent to reflect more cautious actuarial assump-
tions about the future. Estimates in August 2001 suggested that the GAR
contracts created a £2.6 billion liability in the £24 billion with-profits pension
fund; that is, just over 10 per cent. Somehow, the new managers would have to
square the circle of the conflicting interests of those with GAR protection and
those without in an economic environment where long-term interest rates
were likely to be significantly below those guaranteed to GAR holders. In the
meantime, the fund was leaking cash as anxious policyholders switched out of
the troubled insurance company.
It was not a happy outcome to a casual decision to enhance the marketability of
a major product by building in significant interest rate risk. And where did the
debacle leave Equitable’s pensioners going forward?
While interest rate risk brought down Equitable Life, many companies have to
deal with the problem of volatile interest rates and – using whatever methods
are appropriate – manage the risk.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
4.2 Interest Rate Risk

Interest rate risk is the risk arising from changes in the rate of interest and hence the
cash flows on borrowed or invested money. The simple example in Table 4.1 shows
the effect of interest rate exposure on a company’s cash flows.
Table 4.1 The effect on the profits (cash flows) of a company of a

change in interest rates
Balance sheet
Total assets £150m
Floating-rate loans (which are repriced; that is, the interest rate is £100m
reset) in line with interest rates on a periodic basis
Interest expense on floating-rate loans £10m
Income statement
Gross revenue £40m
Total expenses (including interest) £35m
Net profit £5m
The company, which has borrowed at a floating rate – where the interest is reset
periodically (or in financial jargon ‘repriced’) in line with the then prevailing market
interest rate – is exposed to changes in interest rates. The interest rate exposure of
the company will be:
Interest rate exposure Change in interest rate Amount of the loans ﴾4.1﴿
To illustrate this, the effects on the company’s profits of a 1 per cent change in
interest rates are given in Table 4.2.

Table 4.2 The effect of interest rate exposure on company profitability

Change in Interest Effect on Net profit Change in
interest charge cost of loan profit
rate
+ 1% £11m + £1m £4m −20%
0 £10m 0 £5m 0
−1% £9m −£1m £6m +20%
The simple example given in Table 4.2 shows that interest rate changes (interest
rate risk) can have a significant effect on the firm’s reported profit. The 1 per cent
change in interest rates translates into a 20 per cent change in profitability.
When one looks at interest rate exposure, there are a number of possible sources
of interest rate risk that depend on the contractual relationship and the nature of
the cash flows involved. These are price risk, reinvestment risk, prepayment risk and
extension risk.
Price risk and reinvestment risk are two interconnected effects of interest rate
risk that directly affect cash flows when interest rates change and affect the market
price and the future value of reinvested intermediate cash flows. The two effects are
shown in Figure 4.1.
CFt
FVt–x
t–x
FVt
(1 + rt–x)
t
PV (1 + rt)
Interest rate used to discount future

Price risk cash flows dictates their present value
Present Future
Interest rate used to compound cash

Reinvestment risk
flows dictates their future value
CFt–z CFt–y
y
PVt–y(1 + ry)
z
PVt–z(1 + rz) FV
Figure 4.1 Price risk and reinvestment risk

Note: Price risk relates to the interest rate used to give the present value of future cash
flows; reinvestment risk relates to the interest rate used to give the future value of, or
compound, cash flows into the future.
To understand how these effects work, consider that the cash flow involved is
short term – that is, generally less than one year – and has been borrowed or
invested for this short period of time. Then, at the maturity of the contract, both the
principal and interest are repaid. If at this point the money is either reinvested or

reborrowed, this will take place at the then prevailing market rate of interest. This
may be at a higher or lower interest rate depending on what has happened to the
market rate since the first transaction was entered into. If the rate has risen, more
interest will be earned or paid in the next borrowing or lending period; if the rate
has fallen, less interest will be earned or paid. This is known as reinvestment risk
and arises whenever maturing cash flows need to be recycled into new investments,
or new borrowings made. To illustrate this, suppose £100 000 is borrowed for one
year at 10 per cent interest. At the end of Year 1, the amount is now £110 000; there
is £10 000 of interest with the loan. If interest rates have fallen to 8 per cent, then
only £8000 will be earned on the initial investment and a further £800 on the
interest earned in the first year, giving a total amount of £118 800 at the end of Year
2. Contrast this with what would have happened had the interest rate risen to 11 per
cent after one year; the value would then be £122 100.
If, however, the maturity of the borrowing is longer term and greater than one year,
then there are intervening interest payments that will be made after one, two, three
years, etc.§§§ In this case, the situation is more complex, since the value of the claim at
any point prior to its maturity date will depend on the interest rate(s) used to derive
the valuation, a phenomenon known as price risk. Let us say, as with the credit
example in Section 3.7, that the future cash flow in one year is £110 and this repre-
sents £100 of principal (the amount initially borrowed or loaned) and £10 of interest.
If we discount this at 10 per cent, it is worth £100 (£110/1.10); if the rate is 9 per
cent, we would value it at £100.92 (£110/1.09); if it is 11 per cent, then we would
value it at only £99.10 (£110/1.11). We can see that, as interest rates fall, the present
value rises, and as interest rates rise, the present value falls. On the other hand, if we
start with £100 and invest for one year at 10 per cent, we get £110 (£100 × 1.10). If
we can only earn 9 per cent, we end up with less in the future £109 (£100 × 1.09); if
the interest rate is 11 per cent, we get more in the future: £111 (£100 × 1.11).
Depending on whether we are determining the value of future cash flows today
(discounting) or in the future (compounding), we have the relationships shown in
Table 4.3. A rise in the interest rate is good for reinvestment (taking money into the
future) since we are now earning more for the future (equally, we are having to pay
more to borrow money). It is bad for the asset’s price (its present value), since we are
now discounting the future cash flow(s) at a higher rate and they are worth less in
present-value terms.
Table 4.3 Relationship between reinvestment risk and market price

risk
Change in interest Effect on reinvestment Effect on the asset
rate return and borrowing price
costs
Rise Increases Falls
Fall Decreases Rises
§§§ For simplicity, we assume annual interest, but more frequent intervals are not uncommon, especially in
consumer finance.

So far we have illustrated these effects separately and for single cash flows. When
there are multiple cash flows, these effects interact in a complex fashion. We can
better understand how they do so if we look at these risks in terms of a £10 000
loan. We will assume that the loan is made for three years and that it is repaid on an
annuity basis; that is, the borrowed money is repaid in three equal amounts at the
end of Years 1, 2 and 3. We will also assume that the current market interest rate is
8 per cent per year over the three years. Thus the cash flows on such a loan would
be as shown in Table 4.4.
Table 4.4 Cash flows on a three-year fully amortising annuity loan at 8

per cent
Time 0 Year 1 Year 2 Year 3
£10 000 £3880 £3880 £3880
A spreadsheet version of this table is available on the EBS course website.
The payment per year on the amortising loan is determined by dividing the
amount of the loan by the three-year annuity factor for 8 per cent. This is 2.577, so
the payment is found by £10 000/2.577 = £3880.48. This is rounded to the nearest
unit in the table.
Price risk arises when we trade assets. The value of a loan to a buyer will be the
present value of the future cash flows, discounted at the appropriate interest rate.
Let us now assume that the lender decides at the end of the second year to sell the
loan to another institution. If the rate of interest is still 8 per cent, then the present
value (PV) of the remaining cash flow on the loan is £3593 (£3880/1.08). If,
however, interest rates have risen to 10 per cent, then at the end of Year 2 the loan
would be worth only £3527 (£3880/1.10); and if the rate had fallen to 6 per cent,
then it would be worth £3660 (£3880/1.06). These relationships are given in Table
4.5. This shows that the market value of the loan is inversely related to the
discount rate used to calculate the present value of the future cash flows.
That is, asset prices fall when interest rates rise and vice versa.
Table 4.5 Effect of different discount rates on the present value of a set
of fixed cash flows
Interest Value of remaining cash Value of remaining cash
rate flow due in Year 3 in Year 2 flow due in Year 3
present values
6% £3660 £3880
8% £3593 £3880
10% £3527 £3880
The situation is somewhat different if we now look at the effect on reinvested

income. Recall that this is the interest earned on the investment prior to its final
maturity. The lender expects to earn 8 per cent on the loan. If, at the end of Year 1,

the interest rate has fallen to 6 per cent, then the repayment of £3880 on the loan
can be reinvested to give a future value at the end of Year 2 of £4113 (£3880 ×
1.06). If the rate had risen to 10 per cent, then the value is £4268 (£3880 × 1.10). A
higher rate of interest is thus associated with a higher terminal value. Therefore, the
reinvestment value is directly related to the level of interest rates. Higher rates
are good for reinvested income since they become larger in the future.
Because of the contradictory nature of the two effects – interest rate rises reduc-
ing the market price and increasing the value of reinvestment income in the future –
they are to some extent offsetting, as is shown in Table 4.6, where the sale price for
the loan at the end of Year 2 and the reinvestment income at the different interest
rates are combined. So, in the 6 per cent scenario, as previously indicated, the
amount for which the loan can be sold at the end of Year 2 is greater than if interest
rates had remained unchanged. The lender will get £3880/1.06 for this, or £3660.
On the other hand, the cash flow reinvested income from Year 1 is £3880 × 1.06,
namely £4113. In addition, there is the Year 2 cash flow of £3880, so the total
amount that the lender has after selling the loan will be £4113 (Year 1 cash flow),
£3880 (Year 2 cash flow) and £3660 (Year 3 cash flow), or £11 653. The rate of
return – expressed, as is conventional, as an interest rate per year – is the square
root (£11 653 reflects the total return of two years) less 1 of £11 653/£10 000 =
√1.1653 – 1 = 7.96 per cent. Figure 4.2 shows the same calculations for the case
when interest rates are unchanged at 8 per cent.
Table 4.6 Effects of reinvestment rates and price risk on a set of cash
flows
Year 2 Year 3
(Loan sold) (Terminal value)
Initial loan value = £10 000 £3880 £3880
Constant interest rate (8%) £8070 + (PV £3880 = (FV £8717) + £3880
£3593)
ROR = 8% ROR = 8.0%
Rising interest rate £8148 + (PV £3880 = (FV £8964) + £3880

(10%) £3527)
ROR = 8.06% ROR = 8.7%
Falling interest rate (6%) £7993 + (PV £3880 = (FV £8473) + £3880
£3660)
ROR = 7.96% ROR = 7.3%
Note: ROR is the rate of return expressed as an annual rate.

t=1 t=2 t=3
£3 880 £3 880 £3 880

1.08 £4 190
PV x (1 + r) £8 070 –1
£3 593 £3 880 x (1.08)
£11 663 FV / (1.08)
What you will
receive if you What you will
invest the cash have if you sell
flow received in the cash flow
Year 1 due in Year 3 in
(compounding) Year 2
10 000 (discounting)
1/2
ROR = [(11 663/10 000) – 1] x 100
Figure 4.2 Calculating the rate of return

In the case where the loan is held to maturity, the amount earned through rein-
vestment (the terminal value) will only equal the interest rate on the loan when it is
made if interest rates remain unchanged throughout the three years. Note that this
return, based on lending cash flows today and receiving back future payments,
would have been fixed at 8 per cent without any reinvestment risk but for the
intervening cash flows, which have to be reinvested. If interest rates are different
from expected at the outset, this will not be the case.
If the loan is prior to maturity, for instance it is sold at the end of Year 2 (with
one more year to go), then the outcome depends on whether interest rates have
risen or fallen and on the distribution of the cash flows. The rate of return earned
for the two possible cases, selling the loan at the end of Year 2 or holding the loan
to its three-year maturity, will depend on the balance of the two risks – price risk
and reinvestment risk – that determine its value.
To see how this works, we can extend our analysis slightly and now look at a
four-year loan for £10 000, which has the same amortising characteristic as the
earlier example. The cash flows are as shown in Table 4.7. As with the three-year
loan, we can calculate the resale value of the loan plus reinvested interest for
different holding periods in the situation where the interest rate has changed.
Again the effect of reinvestment risk is offset against the market (price) risk of the
remaining cash flows to produce complicated value effects. These are shown in the
bottom half of Table 4.7.

Table 4.7 Effect of lengthening the number of fixed cash flows on

interest rate sensitivity and the ex post rate of return (ROR)
under different interest rates
Year 1 Year 2 Year 3 Year 4
Cash flow £3019 £3019 £3019 £3019
Interest rate Holding period return

Falling 6% 10.9% 8.4% 7.6% 7.3%
Constant 8% 8.0% 8.0% 8.0% 8.0%
Rising 10% 5.3% 7.6% 8.4% 8.8%
When the reinvestment rate falls to 6 per cent, the ex post return declines because
of the lower terminal value on the reinvested intermediate cash flows. Their rate of
increase has fallen, and hence the accumulated value at maturity. The opposite effect
is evident with a rise in interest rates. As each cash flow is received, it can be
reinvested to earn more, with the result that the terminal value is larger.
As the discussion above indicates, interest rate sensitivity increases with maturity.
The following illustrates the effects on long-dated maturity bonds. The example is
based on par bonds with 10-, 20- and 30-year original issue maturities and a 6 per
cent coupon rate (the amount of interest earned per year on the bonds). If after a
year interest rates change by 1 per cent to 5 per cent and 7 per cent, we have the
holding period rate of return as shown in Table 4.8.****
Table 4.8 One-year holding period return for 6 per cent par bonds with
original maturities of 10, 20 and 30 years
Yield falls to 5% Yield rises to 7%
Maturity Market Total Market Total
value return value return
10 years 107.108 13.11% 93.485 −0.52%
20 years 112.085 18.09% 89.664 −4.34%
30 years 115.141 21.14% 87.722 −6.28%
Note: The total return after one year (the holding period return) is the market value
after one year, plus the coupon payment less the original value divided by the initial
investment expressed as a percentage. Return = [(Value at end of year + Coupon) –
Value at start]/Value at start × 100%. Return for the 10-year bond at 5 per cent
= [(107.108 + 6.0) –100]/100 × 100% = 13.11%.
**** The pricing of the bonds is calculated as follows:
Price
where C is the coupon, y the interest rate (known as a yield) and m the maturity of the bond.

We should add one more significant effect on interest rate risk, and that is the
size of the cash flows in any given period. Let us now assume that the four-year loan
in Table 4.7 is all repaid at maturity, rather than in equal instalments (incidentally,
this is known as a ‘bullet’ loan). Recalculating the effects of price and reinvestment
risk for this type of loan, we have the results shown in Table 4.9.
Table 4.9 Interest rate sensitivity and the size of future fixed cash flows
(with the effect of reinvestment risk on holding period re-
turn)
Year 1 Year 2 Year 3 Year 4
Cash flow £800 £800 £800 £10 800
Interest rate Holding period return

Falling 6% 13.3% 9.6% 8.4% 7.78%
Constant 8% 8.0% 8.0% 8.0% 8.00%
Rising 10% 3.0% 6.5% 7.6% 8.21%
The results show that, because by far the largest cash flow on the loan (the prin-
cipal amount) is received at the end of Year 4, the sensitivity of the holding period
return is greatest to price risk. That is because the current valuation of the future
cash flows at the prevailing interest rate (that is, the asset’s market price), or the
value at which future cash flows are discounted, dominates over reinvested cash
flows. Taken to its extreme, in a loan where all the interest and principal are paid at
maturity, all the value sensitivity would be in the discount rate applied to this one
future cash flow. This is indeed the case for what is known as a zero-coupon bond,
which, of the instruments discussed, has the highest sensitivity to interest rates since
all its cash flows occur at the bond’s maturity.
Taking our long-dated securities example further, if the bonds had been zero-
coupon securities (that is, pure discount instruments), then the effect of discount
rate changes would have been as shown in Table 4.10.†††† In this case, the reduction
in interest rates leads to a very significant appreciation in the value of the securities.
The opposite occurs if the interest rate goes up.
†††† Zero-coupon instrument is priced as:

Price
where y is the interest rate (or yield) and m is the maturity of the bond.

Table 4.10 Price and return performance for long-dated zero-coupon bonds
Original Original price 5 per cent One-year 7 per cent One-
maturity (at 6 per cent yield return yield year
(years) yield) return
10 55.84 64.46 15.44% 54.39 –2.59%
20 31.18 39.57 26.92% 27.65 –11.32%
30 17.41 24.30 39.54% 14.06 –19.27%
Note: The original yield at issue is 6 per cent. After one year, the yield for valuation is
either 5 per cent or 7 per cent. The new price allows for the computation of the one-
year holding period return. Compare these returns with those in Table 4.8 for the
equivalent maturity par bonds, which pay annual coupon interest to bondholders.
Thus, to summarise, we have the following effects at work:

 Interest rate sensitivity increases with maturity.
 Market, price or value risk increases as the period and amount to be received
increases into the future.
 The future value of reinvested cash flows increases as interest rates increase.
It may have occurred already to some readers that there is a point where the two
effects of price and reinvestment risk are mutually offsetting, since changes in
interest rates have the opposite sensitivities on these two risks. Price risk is negative-
ly related to interest rates, and reinvestment risk is positively related to interest rates.
Hence, their risk profiles are the opposite. Hence, it should be possible to offset the
one risk with the other. The process of eliminating the effect of price risk and
reinvestment risk is known as immunisation. The question we want to address
now is why anyone should be interested in making a four-year loan rather than a
three-year or even shorter loan when it can be demonstrated that, for the same
variability in interest rates, a longer-term loan is more risky than a short-term one.
Before we do that, let us look at the other kinds of risk that arise in interest-rate-
sensitive assets.
Prepayment risk may arise if the borrower has a right to repay the debt prior to
the final contractual maturity date.‡‡‡‡ In such a situation, the party that can do this is
likely to exercise this right to prepay early if the opportunity arises for the borrower
to refinance at a lower cost. Thus prepayment risk rises as the interest rate falls. At
some given interest rate, the borrower will find it profitable to repay the existing
debt and borrow more money at the now lower interest rate available in the market.
To illustrate this, let us assume that, in the amortising case we used above, the
lender allows the borrower to prepay the principal on the loan together with the
interest due up to that point at the end of the second year (the exercise date of the
prepayment option). If the borrower exercises his right to prepay, the borrower has
to pay a penalty or early termination charge of £50. The question is therefore: at
what rate would the borrower take advantage of this opportunity? Well, from the
‡‡‡‡ This is also variously known as timing risk or call risk.

earlier discussion, we know this will occur if interest rates fall. The decision to
refinance will therefore be made at the interest rate at which it pays the borrower to
refinance the loan. Let us work through the calculations to find the point at which a
borrower will be just indifferent between retaining the old loan and refinancing (this
in corporate finance terms would be called a breakeven analysis). The amount of
payment due in Year 3 is £3880, but this includes the interest for the third year
contracted on the loan when it was originally made. In order to know how much of
the cash flow is principal, we need to discount the £3880 amount to the second
year, giving a value of £3593 for the principal amount.§§§§ We then need to add the
£50 to this sum to get the total repayment required: £3643. The breakeven interest
rate is thus the yield (or rate of interest) implied by the price relative £3880/£3643
= 1.065; that is, a yield or interest rate of 6.5 per cent ([£3880/£3643 – 1] × 100%).
Hence, interest rates need to fall by 1.5 per cent before it makes sense for the
borrower to refinance in the market. Note the redemption penalty is in effect
contingent interest to the lender and acts to reduce the rate at which refinancing
makes sense for the borrower. Without this contingent charge, any fall below the 8
per cent interest rate would lead the borrower to refinance in the market. For
instance, without the penalty and with a market interest rate of 7 per cent, the
borrower saves £36 in interest in Year 3 by refinancing.
What the analysis shows is that, even with an early redemption penalty for the
borrower, if one-year interest rates fall somewhere below 6.5 per cent, it would be
advantageous to repay the loan by borrowing elsewhere at the new market interest
rate. For the lender, this constitutes a form of interest rate risk, since the asset will
be annulled, the money repaid and the unexpected cash flow reinvested at the, now
lower, market rate. Note that, due to a number of reasons that do not relate directly
to optimal decision making, while the 6.5 per cent interest rate is the breakeven rate,
borrowers may not actually act to repay early and refinance until the interest rate is
well below this trigger point.
Let us now assume that the lender decides to sell on the loan with the early re-
demption clause after one year to another institution. The buyer of the loan knows
that if interest rates fall below 6.5 per cent the borrower will most likely repay the
loan and the new lender will forgo the opportunity to earn the higher interest in
Year 3, and again will have to reinvest the proceeds at the now lower interest rate
available in the market. From a valuation perspective, the market price of the loan
will be capped at the value the lender will receive in Year 2 from the early repay-
ment, if interest rates drop.
Therefore, the value of the loan to the buying institution will be the present value
of the two remaining cash flows (those due in Years 2 and 3: CF2 and CF3):
﴾4.2﴿
where PV1 is the present value at the end of Year 1 when there are two remaining
cash flows in Years 2 and 3. We assume here that the existing owners retain the cash
§§§§ This follows from the basic finance equation:

PV × (1 + r)t = FVt

flow of £3880 due on the loan at the end of the year. In the situation where interest
rates remain constant at 8 per cent, the value of the loan at the end of Year 1 will be:
£3880 £3880 ﴾4.3﴿
£6919.07
1.08 1.08
If at the end of the first year interest rates have fallen to 5 per cent, then, given a
breakeven rate of 5.6 per cent, we can anticipate that the expected prepayment at
the end of Year 2 will take place and the new owner of the loan will receive £3642
as a result. On this basis, the value of the loan will be:
£3880 £3642 ﴾4.4﴿
£7163.81
1.05
The new value for the loan is now £7163.81. This is based on discounting the
future cash flows, knowing that, as the rate is now 5 per cent, the borrower will be
able to refinance the expensive 8 per cent loan in the market at the lower cost of 5
per cent. The borrower will thus prepay the loan, plus any penalty at the next
opportunity, in this case the end of Year 2; and so the correct cash flow in Year 2
includes the early repayment of the cash flow from Year 3.
By contrast, if the loan had no early termination clause, and had therefore run to
maturity, the value would have been:
£3880 £3880 ﴾4.5﴿
£7214.51
1.05 1.05
The difference in the present value between the results of Equation 4.4 and
Equation 4.5 of £50.70 represents the loss of value by the lender from including the
right to early repayment. The likelihood that this early repayment will take place will
rise as interest rates fall, as the probability of the event rises towards certainty.*****
Modelling of the stochastic process underlying changes in interest rates might
provide a clue as to whether there was a high or low probability of interest rates
getting down to the (prepayment) danger zone.
Another way to view the price difference in the two situations is in terms of the
behaviour of the loan value in relation to changes in interest rates. This value/rate
modelling is called duration. The loan with the early termination clause would have
what is known as negative convexity. The risk arising from prepayment and other
embedded options that affect future cash flows is also referred to as volatility risk,
since the value will largely depend on volatility.†††††
Note that, in this case, the lender has lost out if interest rates fall below 6.5 per
cent, while the borrower will have gained. In the language of options, it is because
the lender has written an option with the borrower, who then has the choice
***** That is, when if im becomes positive, where if is the rate on the loan and im is the market rate. Note
that this is the market rate for the remaining period of the fixed-rate loan, not the original period, thus
im will be different for different periods to maturity.
††††† This is examined in detail in the Derivatives course text in the context of factors that influence option
prices.

whether to exercise this option if (and only if) it is to his advantage.‡‡‡‡‡ The
borrower would be said to have a put option on the loan. The £50 penalty (or
option premium) provides some compensation for this risk, but will not cover it
entirely.§§§§§ Valuation of such options is covered in the elective Derivatives. The
course discusses in detail the use of options as instruments to modify and reduce
financial risk. At this point it is sufficient to say that the way the lender could have
ensured protection from the above risk would have involved buying another option
that cancelled the effects of the option already granted.
The final kind of interest rate risk, known as extension risk, arises in certain
specialised kinds of securities where the borrower may modify the cash flows in
response to economic conditions. Extension risk arises, for instance, with mort-
gage-backed securities, which are bonds where the repayment of interest and
principal is supported by mortgages on property. Typically, mortgages allow the
borrower to prepay the loan, usually for some minor penalty, prior to the final
maturity date, as discussed above. For instance, prepayment may arise if the owner
of the property moves or changes job and so on. For a given pool of mortgages that
makes up an issue of mortgage-backed securities, a prepayment pattern might be
deduced from the historical prepayment behaviour of similar securities. Therefore
the expected average life of the securities can be found on the basis of anticipated
prepayments. However, the prepayments on mortgages are not contractual, and
changes in the property market may change actual experience in the future. For
instance, fewer people might move if house prices decline, job opportunities
become fewer and so on.******
If the mortgages are at a fixed rate, the prepayment pattern will also depend on
the attractions of refinancing opportunities. If borrowers can refinance at lower
rates, they are likely (but are not bound) to do so, as in the loan example discussed
earlier. Thus, such securities are likely to experience prepayment risk if interest rates
fall and it becomes attractive to refinance. The results of such changes are summa-
rised in Table 4.11.
‡‡‡‡‡ Optionsfor one or other party can be a feature of certain types of contractual arrangements – as here –
and are generally referred to as ‘embedded’ in that the option element cannot be unbundled and traded
separately. Option pricing methods can be used to value such embedded options – or embeddos. Thus
the ex ante value of the prepayment loan can be seen as:
Value of the loan with prepayment Value of the loan without prepayment Value of the option
§§§§§ The penalty is not quite the same as an option premium: it is only paid if it is exercised. The option to
prepay has what is known as a contingent premium option, a type of exotic option.
****** Note that extension risk can exist whether the mortgage-backed security is subject to interest
rate risk or not. A mortgage-backed floating-rate note where the interest payments are linked to current
market levels will have negligible interest rate risk. However, it may have significant extension risk, for
the reasons discussed.

Table 4.11 Interest rate environment and extension risk and prepay-
ment risk effects
Rising interest rate Neutral interest rate Falling interest rate
environment environment environment
1 Refinancing is unattractive 1 Expected cash flows likely 1 Refinancing is attractive,
individuals seek lower-cost
mortgages
2 The property market is 2 Refinancing is unattractive 2 The property market is
less active, individuals are more active, individuals
less likely to move are more likely to move
Extension risk increases Prepayment risk increases
It is worth adding at this point that default risk or credit risk is also present in
many such transactions. From the lender’s perspective, the ability of the borrower to
repay has to be a factor in the decision to advance funds. Also, the lender may, as in
our earlier example, wish to resell the loan, so liquidity risk may be another
dimension that has to be included. If the lender’s base currency is different from the
lending currency, there may also be currency risk. Then other kinds of risk, such as
political risk, legal risk, event risk and sector risk, also exist. Sector risk relates to
the tendency of securities of a given type to behave in a similar fashion. For
instance, mortgage-backed securities will tend to show common patterns in their
price changes in response to shared underlying price drivers. Also, since debt claims
are largely nominal instruments, repayments in a fixed amount of money are subject
to inflation risk.†††††† Inflation risk is discussed in Section 4.3 in the context of how
the term structure of interest rates is affected by economic factors.
Figure 3.3 in Module 3 also includes other interest rate risks that affect interest-
rate-sensitive assets and liabilities. Interest rate volatility risk is the risk arising
from changes in interest rates. This may be a risk if large and rapid changes of
interest rates lead to unexpected changes in the present value of cash flows. In terms
of the prepayment issues discussed earlier, if there are rapid changes in interest rates
this can lead to unanticipated prepayment behaviour by borrowers. At the same
time, it may adversely affect the prices that such assets fetch in the market. Consider
again the loan with the right to prepay that we discussed earlier. The prepayment
option does not matter too much if interest rates remain around 8 per cent. But, if
interest rates rapidly fell, then the price this loan could fetch would fall significantly,
as any buyer would need to factor in the strong likelihood that early repayment
would occur. Hence assets whose cash flows in size and timing depend on the level
of interest risk are particularly sensitive to changes in interest rates. Yield curve risk
is the risk that the shape of the yield curve may change over time. This is discussed
in Section 4.3. Interest rate basis risk arises when, for instance, a financial institu-
†††††† The modifier ‘largely’ is required since some countries, notably the UK and the US, have
‘index-linked’ securities issued by the government, which are inflation-risk-free debt claims since the
payments received by holders are adjusted for inflation by ‘indexing’ the nominal value of the payment
to a measure of inflation. For the UK, this is the retail price index (RPI), for the US, the consumer
price index (CPI). In the US, they are called treasury inflation-protected securities, or TIPS for short.

tion borrows in one market, say the interbank market, and lends in another market,
say the euromarket. While the interest rates in the two markets may be linked, there
may be small differences between the two (called the basis), which can lead to
unanticipated losses. Spread risk arises from relationships between different classes
of assets. High-grade government bonds, such as those issued by the German
government, are not subject to credit concerns or default, but corporate bonds,
where firms can default, are affected by these concerns. The differences in interest
rates (known as the spread) between government bonds and those used to value
corporate bonds may change due to the market’s view about credit factors that
affect the value of corporate bond issues but that do not affect government bonds.
Hence this leads to spread risk between the two.‡‡‡‡‡‡
4.2.1 Why Individuals and Firms Accept Interest Rate Risk

We asked earlier why a lender would want to make a four-year loan knowing that it
carried more interest rate risk than making a three-year loan. (And a three-year loan
would have more risk than a two-year loan and so forth.) We have also discussed
the idea that loans can be made in such a way that they are ‘repriced’ to the current
market rate; that is, the interest rate on the loan is reset in line with current interest
rates at the beginning of each interest payment period. By accepting to lend for long
maturities at a fixed rate, one is apparently assuming considerable interest rate risk.
Bonds with 10-year, 20-year or even longer maturities are issued by a wide range of
different borrowers and are purchased and held by investors.
One possible reason for accepting interest rate risk may be that there is no
choice. It could be that borrowers need to have money for four years and will
accept nothing else. Therefore, for commercial reasons, lenders have to go along
with that.
Equally, investors might want to lend for a long period in order to be certain of
getting a given cash flow. Borrowers then have to put up with that, even though
they might prefer to borrow for shorter periods.
Another reason is that the risk may not be as great as it appears when we look at
a single transaction in isolation. For example, a pension fund will, typically, be made
up of two kinds of members: those still working and building up contributions and
those who have retired and are receiving their pensions. In the case of the latter, the
payment stream to retirees drawing their pensions from the fund will be predictable
ahead of time. By holding long-dated fixed-rate claims, the fund is guaranteed that
the coupon interest it receives from its fixed-income portfolio will meet the cash
outflows to pensioners. Hence, the matching principle can be applied to these
bonds that, when examined in isolation, may appear to be very risky investments.
Risk, in such a context, is relative. There would be more risk for the fund in holding,
say, equities or short-dated money market instruments, since these will lead to a
‡‡‡‡‡‡ Note this largely arises when we are hedging – as discussed in the Derivatives course text –
where we are using government bonds to eliminate the interest rate risk on corporate bonds. It works
well most of the time but leaves the hedger exposed to spread effects. In this case, some protection,
albeit imperfect, is better than none at all, as in most cases the price effect of spread changes will be
less than that from changes in interest rates as a whole.

greater mismatch between the asset position (the investments held by the fund) and
the fund’s liabilities (its payments to existing and future retirees).
Another reason that interest rate risk is accepted is that it is also an opportunity.
Consider again the case of the four-year loan. If the lenders had correctly anticipated
that interest rates were going to fall over the life of the loan, then they will earn a
higher return from this long-term loan than if they had made a series of four
consecutive one-year loans each at the prevailing but falling interest rates.§§§§§§ So,
although there is risk, there is reward: it is a risk–reward trade-off. Hence, in the
context of extension risk, a lender may be willing to accept the risk that mortgages
will not be repaid when expected in exchange for a higher yield (that is, the interest
rate earned on the loan). Such an investment boils down to a judgement of whether
the higher interest received (reward) is justified by the risk (extension of the loan).
The interest rate, or price of money for a given time period, gives the trade-offs
to be had for borrowing and lending for different maturities. It is to explanations of
how these trade-offs are generated – that is, to theories of the term structure of
interest rates or, as practitioners prefer to call it, the yield curve – that we turn next.
4.3 The Term Structure of Interest Rates

The term structure of interest rates – the relationship between interest rates and
time – is often shown graphically in what is known as a yield curve. This presents in
graphical form the relationship between interest rates and the time to maturity or
repayment of financial instruments issued by a single entity or a comparable group
of entities at a given point in time. An example is shown in Figure 4.3.
§§§§§§ If the original loan is a bullet and the interest rate is 8 per cent, the cash flows are 800 in
Year 1, 800 in Year 2, 800 in Year 3 and 10 800 in Year 4. With loans starting at 8 per cent in Year 1,
we get 800 in Year 1; if interest rates are now 7 per cent and drop by 1 per cent again in Years 3 and 4,
we have 700 in Year 2, 600 in Year 3 and 10 500 in Year 4. The fixed loan offers greater cash flows. Of
course, the opposite applies if interest rates are going up: the fixed loan does worse than the short-term
loans.

Interest rate
i%
etc
*
* 3
* 2
1
* Securities
0
Maturity (years)
Figure 4.3 Graphical depiction of the yield curve or term structure of

interest rates
Note: Each issue, 1, 2, 3 and so on, is plotted on the basis of its yield to maturity
(internal rate of return) against its maturity or redemption date.
The same data can be given in tabular form. The relationship depicted in Figure
4.3 is given in Table 4.12.
Table 4.12 Tabular representation of the yield curve

Time (to maturity) Yield (internal rate of return)
1 8.20%
2 8.35%
3 8.39%
4 8.43%
etc.
Typically, yield curves are constructed for government debt issues or a compara-
ble class of issuer, such as a group of corporate issues of similar credit standing and
so on. The observed shape and form of the yield curve is not fixed over time; the
curve alters in response to new information and the changing views of market
participants. The yield curve is altered by current and expected changes in domestic
economic conditions, as well as changes in conditions in other countries. In a
situation where capital can move from one country to another, the relative attrac-
tions of different countries will also have an influence. The interrelationship
between interest rates and foreign exchange rates is discussed in Module 5.
The shape of the yield curve will change over time. The yield curve can take on a
number of different basic shapes, which can be summarised as:
1. upward sloping, or ascending, and often called the classic shape of the yield
curve. As maturities get longer, yields are higher, and longer-dated securities
offer higher prospective returns than shorter-dated ones. Such a shape is also
called a premium market or contango (see Figure 4.4);

2. downward sloping, or inverted. As maturities get longer, the yields on securities

get lower. This shape is also known as a discount market or backwardation
(see Figure 4.5);
3. flat. All maturities have the same yield (see Figure 4.6);
4. humped. This occurs when the yields initially rise with a longer maturity, reach a
high and then fall as the maturity becomes even longer (see Figure 4.7).
Before discussing how we should understand the yield curve, it is useful to un-
derstand how interest rates of different maturities behave. When we say, for
instance, that we are compounding an amount for four years at 8 per cent, we state
this formally using the fundamental financial equation:
1.08 ﴾4.6﴿
Now we can break out the compounding factor in Equation 4.6 as follows:
1.08 4 1.08 1.08 1.08 1.08
This shows that the four-year interest rate is simply four one-year interest rates
that are multiplied together. But there is no reason why the four interest rates
should all be the same. The four-year annualised interest rate is 8 per cent, but we
could have a situation where the underlying interest rates are all different. For
instance, 4.2 per cent, 7 per cent, 8 per cent and 13 per cent will give an ‘average’ for
the four-year interest rate of 8 per cent. The key point is that, observing 8 per cent
in the market for four years, we are assuming that investors expect the reinvestment
rate over the four years to average about 8 per cent per year. It is the rate at which
cash flows can be reinvested in Years 2, 3 and 4 that determines the fact that
investors expect 8 per cent over the four years. The interest rate from now to the
end of Year 1 is directly observable. The interest rates for Years 2, 3 and 4 are those
that investors expect to see in the market in the future. We call these forward rates.
The above analysis does not tell us whether the interest rates each year are ex-
pected to be higher or lower in the future. At any point in time, we can observe the
actual interest rates that relate to the different maturities. If, in our case, we saw that
the one-year interest rate was 4.2 per cent, the two-year interest rate was 6 per cent
and the three-year interest rate was 6.39 per cent, we would see an upward-sloping
yield curve and hence that investors and the market were expecting higher short
maturity interest rates in the future. The forward interest rates that the market is
expecting are embedded in the shape of the yield curve. These are called the implied
forward rates, since they are implied by the relationship of yields (interest rates) to
maturity. Hence the yield curve has a lot to tell us of the market’s future interest rate
expectations. In terms of these expectations, the different shapes of the yield curve
imply the (consensus) views given in Table 4.13.

Yield
Maturity
Figure 4.4 Premium market, with a rising yield curve; shape (1)
Yield
Maturity
Figure 4.5 Discount market, with a falling yield curve; shape (2)
Yield
Maturity
Figure 4.6 Flat market, with constant interest rates; shape (3)

Yield
Maturity
Figure 4.7 Humped market, with initially rising then falling interest
rates; shape (4)
Table 4.13 Summary of fundamental yield curve shapes and market expectations
Upward Downward Flat Humped
Implied forward Forward rates Forward rates are Forward rates Forward rates for
interest rates are higher than lower than are the same as some maturities are
current rates for current rates for current rates for higher than current
the same the same maturity the same rates for the same
maturity maturity maturity; but also
lower than some
current rates for
the same maturity
Expectations on Increasing Decreasing No change in Expectations on
changes in interest rates in interest rates in interest rates in interest rates
future interest the future the future the future depend on time,
rates rising at first and
then falling
Expected The exact The exact Transition period The exact expectation
change expectation for expectation for when the yield for changes in interest
higher rates will lower rates will curve is expected rates will depend on
depend on the depend on the to become neither the steepness of the
slope of the yield slope of the yield upward sloping nor humped shape
curve; the curve; the steeper downward sloping
steeper the the slope, the
slope, the higher lower the future
the future expected interest
expected interest rate
rate

Upward Downward Flat Humped

Investment A yield premium Reinvestment Reinvestment Initial rise in
implications*** required for rates are expected rates are interest rates
longer maturities to be lower in the expected to be expected, followed
to compensate future the same in the by a subsequent fall;
for expected future reinvestment rates
future rise in are expected to be
interest rates; higher, then lower
reinvestment
rates are
expected to be
higher in the
future
Economic policy Tightening of Loosening of Neutral policy Initial tightening of
implications policy expected; policy expected; view; this occurs
policy expected,
this is likely when this is likely when when policy is followed by later
inflation is rising inflation is falling shifting from relaxation. Initially,
and when there and when there expansionary tothe market is
are expansionary are contractionary contractionary expecting higher
economic economic or vice versa inflation due to
conditions conditions expansionary
conditions but with
subsequent contrac-
tionary conditions
to prevail
*** You might like to test these propositions by working out the implied forward rate (the methodology
for which is given in Module 10) for one year in one year’s time, if the current one-year rate is 10 per
cent:
 If the one-year rate is 10 per cent and the two-year rate 11 per cent, what is the
implied one-year forward rate (that is, the one-year interest rate in one year)?
 The answer is 12 per cent.
 If the one-year rate is 10 per cent and the two-year rate 9 per cent, what is the
implied one-year forward rate?
 If the one- and two-year rates are 10 per cent, what is the implied one-year
forward rate?
4.3.1 Traditional Theories of the Term Structure

There are three traditional theories that seek to explain the behaviour of the term
structure of interest rates: the expectations theory of interest rates, the preferred
habitat or market segmentation theory and the liquidity preference theory.

4.3.2 The Expectations Theory of the Term Structure of Interest Rates

The expectations theory of the term structure proposes that the shape of the yield
curve is determined by market participants’ views on the future course of short-term
interest rates and the demand for securities of a particular maturity. We can illustrate
this as follows. Let us assume there are two bonds outstanding in the market: a one-
year and a two-year bond. These are zero-coupon bonds that pay all their income at
maturity.******* They have the market or current prices, expressed as a percentage of
their face value (which is 100 per cent), as shown in Table 4.14.
Table 4.14
Maturity Bond price Yield equivalent to
One year 92.59 A one-year yield of 8%
Two years 84.17 An annual yield of 9%
Let us assume that investors wish to take advantage of the current yield curve.
Investors essentially have two choices: to buy the two-year bond or to buy the one-
year bond and reinvest the proceeds in one year’s time at the then prevailing one-
year rate. The implied one-year rate in one year can be found by calculating what the
value of the two-year bond will be one year hence, using the one-year rate of 8 per
cent, which gives a price of 90.90 (84.17 × 1.08).††††††† The expected return for the
second period is thus 100.00/90.90 –1% = 10.00%.
This shows that investors expect the one-year rate in one year’s time to be 10 per
cent. If investors do not believe that this is the case, they have two strategies that
would allow them to benefit from the current term structure. These strategies are
given in Table 4.15.
******* Zero-coupon bonds are also known as discount securities. Their market, current or present
value is found by the equation:
Present value
where y is the ‘yield’ on the bond. Alternatively, knowing the face value, the amount that is repaid at
maturity and the present value of the bond, we can find the bond’s yield.
††††††† We use the one-year interest rate (here 8 per cent) and not the bond’s yield to maturity to
work out the expected price in one year’s time as this is the appropriate interest rate for investments
that mature in one year and hence, to prevent arbitrage, is also the expected yield and price change for
the two-year bond over the first year.

Table 4.15 Actions under the expectations hypothesis of the term

structure of interest rates based on investors’ expectations of
the future course of interest rates
View on the one-year Action Effect
interest rate in one
year’s time
Less than expected Buy the two-year bond If the refinancing rate is
(< 10%) [1] yielding 9 per cent and below 10 per cent, the
borrow for one year at 8 investor will make a profit
per cent by issuing a one- on the difference between
year bond, then refinance the current expected one-
at the prevailing one-year year rate and actual cost of
rate in one year borrowing in Year 2
More than expected Borrow for two years at If the interest rate is above
(> 10%) [2] 9 per cent by issuing a 10 per cent, the investor
two-year bond and invest will make the difference
for one year at 8 per cent between the current
in the one-year bond, expected one-year rate on
then reinvest at prevailing the borrowing and the
one-year rate in one year actual one-year rate on the
investment
In order for the prices of the bonds to be in equilibrium, the two effects in Table
4.15 must cancel out; otherwise increased demand for issuing one-year or two-year
bonds and investing in two-year or one-year bonds will cause their prices to change
in the market. For instance, if most market participants believed that the one-year
rate in one year was going to fall to 9.75 per cent, they would be willing to pay up to
84.37 for the two-year bond in pursuit of Strategy [1] in Table 4.15, the additional
demand forcing an increase on the current price of 84.17. This is because investors
would expect to earn 8 per cent in Year 1 and 9.75 per cent in Year 2. So the two-
year bond should have a value of 91.12 (100/1.0975) at the end of year one and
84.37 today (91.12/1.08).
More formally, the expectations theory states that the expected return on a secu-
rity of whatever maturity is the same for the same holding period. That is, investors
expect to earn the same return from holding a two-year security for one year as
would be obtainable from holding a one-year security for one year. This is based on
the supply and demand argument given earlier in Table 4.15. If there is the possibil-
ity of earning a higher return by investing for one or two years and borrowing, then
market prices will adjust accordingly until this excess return opportunity is eliminat-
ed.
Another way to see the interest rates under the expectations theory is to say that
any long-term rate is the geometric average of the expected short-term rates that go
to make up the long-term rate:
1 1 1 1 … 1 ﴾4.7﴿

Thus, based on the theory (and our example), the price of the two-year bond
now would be the present value of the expected price of the two-year bond in one
year’s time:
﴾4.8﴿
1
where 0P2 is the current price of the two-year bond and E0 is the expected price of
the bond in the future at the present time. When the expected interest rate is 10 per
cent, this means the expected price E0(1r2) is 90.91 in one year’s time (100/1.10).
The value of the two-year bond in one year will depend on the expected one-year
rate in one year, E0(1r2). Similarly, the value of a three-year bond will depend on the
observed one-year rate and the expected one-year rates in Years 2 and 3 and so on.
In Module 10 we will show how these implied forward rates can be calculated from
the yield curve.
The expectations theory therefore postulates that long-term interest rates are
largely determined by the market’s expectations for future short-term interest rates.
The caveat ‘largely’ is required because if short-term interest rates are serially
correlated, as is observed empirically, then the product of the expectations will not
equal the expectation of the product. Where interest rates are correlated across time
– that is, observed high rates in one period tend to be followed by high rates in the
next and vice versa – the interest rate and hence the value for different maturity
investments will be different.
The expectations theory of the yield curve therefore predicates that long-term
interest rates are largely determined by short-term interest rates and the degree to
which short-term interest rates are correlated across time. It follows from this
theory that the observed shape of the yield curve largely, but not completely, reflects
market participants’ expectations for future short-term rates. A rising yield curve
indicates that participants expect short-term rates to rise, a falling yield curve that
future short-term rates will fall. The implications for the different shapes of the yield
curve in terms of expectations are given in Table 4.13.
4.3.3 The Liquidity Preference Theory of the Term Structure of Interest

Rates
The liquidity preference theory proposes that investors require a maturity risk
premium as compensation for holding longer maturity investments. As we have
seen earlier, the longer the maturity of a security, the greater the degree of price risk
attached to it. A one-year bond priced at a 10 per cent yield will have a price of
90.91 (100/1.10). A change in interest rates to 11 per cent will reduce the bond price
to 90.09 (100/1.11), a drop of 0.82, or 0.90 per cent. For a five-year bond, the
corresponding values are 62.09 (100/1.105) and 59.35, a drop of 2.74, or 4.41 per
cent.
Consequently, risk-averse investors concerned about changes in interest rates are
seen to have a preference for safe and easily realisable investments – that is, those
with the shortest maturity – and require an increased return (or yield) to compensate

them for investing in longer, less attractive maturities that have more price risk.
Hence investors require a risk premium or additional return for longer maturity
securities. Furthermore, the longer dated the security, the riskier the investment,
since there is more price uncertainty attached to it and hence the risk premium
required will rise with the term of the security. The term or liquidity premium is the
extra return required by the market to compensate for the additional risk involved.
If liquidity preference determines the shape of the yield curve, we can recast the
expectations model given in Equation 4.8 as:
1 1 1 1 … 1 ﴾4.9﴿
where the component:
﴾4.10﴿
now incorporates the expected yield (E(r)) and the liquidity premium (LP) for the
period n − 1 to n. The liquidity premium is an increasing function of maturity; that
is, the liquidity premium for the period n – 2 to n – 1 is less than the premium for
the period n – 1 to n. Thus the following inequalities hold:
0 ⋯ ﴾4.11﴿
If liquidity premiums exist and are an increasing function of maturity, this means
that the natural shape of the yield curve would be upward sloping. This means that
the implied forward rates derived from the yield curve under the liquidity premium
theory will overstate the expected short-term rate when the yield curve is upward
sloping and understate expected short forward rates when the yield curve is invert-
ed, or downward sloping. The impact of the existence of a liquidity premium on a
pure expectations yield curve is shown in Figure 4.8.
Yield
Expectations plus
liquidity premium
Liquidity premium
( LP )
Expectations only
Maturity
Figure 4.8 Effect of liquidity premium on the term structure of interest
rates
Is there a term liquidity premium? There is considerable empirical evidence that
there are term premiums in the observed yield curve. That said, there is ongoing
debate as to their size and behaviour over time. The key implication of the liquidity
premium theory of the term structure for risk management is that the implied

forward rate in the yield curve that we observe may be a biased predictor of the
future spot interest rate for that maturity, the bias increasing with maturity.
4.3.4 The Preferred Habitat or Market Segmentation Theory of the

Term Structure of Interest Rates
The preferred habitat or market segmentation theory proposes that market partici-
pants have a preferred maturity range or ‘habitat’ in which they like to borrow or
lend. The yield curve is therefore a series of maturity-segmented markets as illustrat-
ed in Figure 4.9.
Yield
Long
maturities
Medium
maturities
Short
maturities
0
Maturity
Figure 4.9 The term structure under the segmentation hypothesis

Note: The observed yield curve is, under this hypothesis, a composite structure made up
of a number of different segments, here shown as comprising three elements: short
maturities, medium maturities and long maturities.
Under this model, supply and demand factors in the market segments, which
include market participants’ expectations about the future course of interest rates,
will determine interest rates at different maturities. Thus borrowers, who may expect
interest rates to rise, would have an incentive to borrow for long maturities: lenders
would prefer shorter ones. The degree to which investors are willing to accept
maturity substitution will dictate how segmented the market is. The further from
their natural maturity habitat investors are taken, the less the substitution. Conse-
quently, for instance, there is probably a fair amount of substitution between
instruments with 3-month and 6-month maturities, but not between a 3-month
instrument and a 10-year one. Decreasing acceptance of substitution as market
participants move away from their preferred habitat arises because demand is driven
by the preference for maturities that match assets or liabilities. For example,
investing institutions would be looking for long-term investments to match long-
term liabilities; short-term savers would have a preference for short-dated securities.
The result of this preferred maturity requirement is that the market is ‘segmented’
by maturity. For each maturity there is an identifiable supply and demand function
that determines the interest rate. Under this model, changes in the yield curve are
therefore determined by changes in the supply and demand in a particular maturity

bracket, coupled to the extent market participants are prepared to seek opportuni-
ties outside their preferred habitat.
The result is that, under this theory, the yield curve is not uniform and may not
give as clear a signal of the market’s view on interest rates as under the expectations
theory. This is because the attitude of market participants to different securities will
depend on whether they are forced to move outside their investment horizon.
Leaving the preferred habitat will mean taking on increased risk. For an investor
with a 5-year horizon, holding securities with a 2-year or 10-year maturity is less
desirable since this creates reinvestment or price risk. If investors are risk averse,
they will demand a risk premium for moving outside their preferred habitat. As an
aside, on the basis of their own observations, many market participants believe that
investors’ behaviour supports this hypothesis. Investors set objectives in such a way
that they have a preferred habitat and are (generally) unwilling to invest outside their
preferred maturities.
4.3.5 Modern Theories of the Term Structure

Modern theories of the behaviour of interest rates depend on stochastic models to
explain the term structure. We will begin by discussing how short-term interest rates
behave under such stochastic models and then expand the exposition to longer
rates.
The stochastic process for short-term interest rates aims to describe how the rate
for short maturity changes through time. We can define the change from one period
to the next as:
﴾4.12﴿
where Δrt is the change in interest rates between period 0r1 and period 1r2, for
instance. The model defines the change in short-term interest rates as being charac-
terised by two components. The first component is a deterministic process that
brings the rate back to its central tendency at a given rate per period, while the
second component is a random variable taken from a normal distribution with a
mean of zero and a standard deviation of 1. The deterministic component is
required to account for the observed ‘mean reversion’ of interest rates; the stochas-
tic element provides for the unpredictable changes in rates. The formal definition of
the model provides the following behaviour for short-term interest rates:
√ ﴾4.13﴿
where r is the short-term interest rate; μ is the central tendency of the interest rate; K
is a coefficient determining how fast the interest rate reverts towards its mean rate;
and Z is a standardised, normal random variable taken from a normal distribution
with a mean of zero and a standard deviation of 1. This model was first formulated
by Cox, Ingersoll and Ross (and hence is frequently referred to as the CIR model) in
1985 (see Cox et al., 1985).
The attraction of this model of short-term interest rates is that it incorporates
two features that are consistent with the observed behaviour of short-term rates.

The first is a tendency for the interest rate to return to its central tendency μ; in
other words short-term rates revert to the mean. The second is that the interest rate
will always be positive.
At this point it is worth noting the implication of such behaviour for option-
pricing models used for pricing rate-sensitive assets, which are discussed in the
Derivatives course text. The basic option-pricing model assumes that the variance in
the stochastic process is an increasing function of time. Clearly this is not tenable
when pricing options on interest rates if the latter revert to the mean. In the CIR
model, the variance of interest will not increase with time. This point also applies to
the observation that long-term interest rates are less volatile than short-term rates. If
the stochastic process generating short-term rates reverts to the mean and if long-
term rates are made up of a series of short-term rates, the long-term rates will have a
lower observed volatility than the short-term rates.
It should be noted that there are a number of alternative two-factor models for
the term structure. One such model seeks to relate the behaviour of short-term and
long-term interest rates. In this formulation the behaviour of the short-term rate is
different from the CIR model in that it does not return to its mean (μ) but reverts to
the level of the long-term interest rate. The long-term rate itself behaves in very
much the same way as the one-factor model for the short-term interest rate given
above, in that it has both a deterministic and a random component. In this version
of the model, the deterministic component is related to both the short-term and the
long-term rate. This two-factor model in essence says that the long-term interest
rate is being set by a long-term central tendency that is being systematically influ-
enced by the short-term interest rate.
There is another version of the two-factor model where the two factors are the
short-term interest rate and its variance. Empirical tests of this model show that it
provides an acceptable description of the cross-sectional observed behaviour of the
term structure.
4.4 Analysing Yield Curve Behaviour

The spot rates or zero-coupon rates derived from the yield curve provide the
interest rates for valuing future cash flows.‡‡‡‡‡‡‡ The term structure is thus funda-
mental for deriving the market’s set of discount rates for each period, which are
used to present value future cash flows.
In managing risk, we want to understand the implications of changes in the yield
curve (or the term structure of interest rates) on the value of an asset or position.
We have already seen how changes in reinvestment rates can alter the returns
available on a financial instrument. We can anticipate that changes in the yield curve,
and hence the set of discount rates used to value an asset, will arise from changes in
economic and especially monetary conditions. For instance, if we have £10 000 due
in the following five years and the interest rate is 8 per cent, the present value of this
cash flow stream will be:
‡‡‡‡‡‡‡ How to derive these is shown in detail in Module 10 and so is not covered here.

£10 000 PVIFA8%,5y

where PVIFA is the present value of an interest factor for an annuity for five years
at 8 per cent. So the value of the cash flow stream will be £39 930
(£10 000 × 3.993).§§§§§§§ If interest rates rise to 9 per cent, then the cash stream will
be worth only £38 900 (£10 000 × 3.890). We want to understand, therefore, how
interest rates, which are the risk factor for cash flows to be paid or received in the
future, affect their present value.
The nominal interest rate can be decomposed into two elements, a real interest
rate and an inflation premium, as shown in Equation 4.14:
1 1 1 Expected inflation ﴾4.14﴿
where Rnominal is the nominal or observed interest rate and Rreal is the real interest
rate. Where there is no inflation, nominal rates will equal real rates. However, where
inflation is expected, the nominal rate will incorporate an expected inflation
premium. If investors expect to earn a real rate of 4 per cent and inflation is
anticipated to be 3 per cent over the period, we would expect the nominal rate to be
7.12 per cent:
1.0712 1.04 1.03 1 100 7.12% ﴾4.15﴿
Empirical evidence seems to suggest that the real interest rate is largely a constant
or that it changes only slowly over time. Under economic conditions that lead to the
yield curve having the traditional, upward-sloping characteristic as shown in Figure
4.4, the implication of such a slope is that the market expects short-term interest
rates to rise in the future. If the real return is constant, then the additional interest
cost is due to expectations of higher inflation in the future.******** Remember that
debt contracts and future cash flows are largely denominated in nominal (monetary)
terms: higher inflation will reduce the purchasing power of the cash flows received
from such instruments or cash flows.
The usual policy response to evidence of overheating in an economy and an
increased likelihood of higher inflation in the future is to tighten monetary condi-
tions by raising short-term interest rates. This will have a beneficial impact on
expected inflation in the future, and the inflation premium in nominal rates will
decline as future inflation expectations are reduced. As a result, we can expect the
term structure to move from being upward sloping to becoming, at first, flat, and
then downward sloping, as shown in Figure 4.10.
§§§§§§§ We can calculate the annuity factor as:

PVIFA%,
******** Although, as discussed earlier, if the market is driven by liquidity preference this may not be
a wholly valid statement: it will depend on the extent to which the curve steepens over and above the
required liquidity premium.

Yield
Tightening of Reduced
monetary conditions expectation
of inflation
Maturity
Figure 4.10 Changes in the yield curve shape as a result of a tightening in

monetary policy
While the above can be explained in terms of simple changes in inflation expecta-
tions, we can also envisage more complex scenarios for yield curve changes: one
such is given in Figure 4.11. In this case, changes in monetary policy combine with
changes in expectations to move different parts of the yield curve in different ways.
A general increase in yields arises from an upward change in inflationary expecta-
tions (1) and an increase in short-term rates due to monetary tightening (2), the
effects of which are partially offset by a longer-term decline in inflationary expecta-
tions (3), as monetary policy has the effect of reducing economic activity and the
source of future expected inflation.
(3)
Reduction in longer-term
Yield (2) inflationary expectations
Increase in short-term
rates due to tightening
of monetary policy
(1)
Increase due to
altered expectations
Maturity
Figure 4.11 Changes in the shape of the yield curve arising from com-
bined effects
Note: The changes in the shape are known as a ‘twisting’ of the yield curve.
We can characterise the change in shape of the yield curve as expectations about
inflation change in two basic ways: a parallel shift and a rotational shift. The parallel
shift causes all maturities to change by the same amount, as illustrated in Figure 4.12,
whereas a rotational shift will see the yield curve pivot around a particular maturity
point, as shown in Figure 4.13.

Yield
Maturity
Figure 4.12 The parallel shift in the yield curve. All maturities increase or
decrease by the same amount
Yield
Maturity
Figure 4.13 The rotational shift in the yield curve

Note: The yield curve pivots around a particular maturity, with the rates either side of
the pivot point rising (or falling) by a greater amount the further they are away from the
pivot.
Empirical analysis of the term structure of interest rates suggests that this is a
valid model for describing the term structure. A principal component analysis of the
US treasury yield curve by Litterman and Scheinkman (1988) of the US investment
bank Goldman Sachs found that three factors explained about 98 per cent of the
observed variance in US Treasuries. The first factor, which explained about 90 per
cent of the variance, was common to all maturities and was interpreted as a level
factor. The second, which accounted for an average 8.5 per cent, was interpreted as
a steepness factor, and the last, which explained about 2 per cent on average, was a
curvature factor. For different maturities, the relative importance of the factors
changed somewhat: the steepness factor reduced yields on short-term bonds with
maturities up to five years and increased that for bonds with longer maturities,
whereas the curvature factor was significant for bond yields with maturities of less
than 20 years.

Given changes in expectations, we are likely to see both parallel and rotational
shifts taking place in tandem; that is, changes in market participants’ expectations
will tend to cause complex changes in discount rates, of the type depicted in Figure
4.11. However, the largest component of such changes is likely to be made up of
parallel shifts, and first-order measures, such as duration, provide reasonably
accurate solutions. In order accurately to capture the complex movements of the
curve, a second element – the rotational factor – and even a third element – the
curvature of the term structure – need to be added.
For risk management purposes, a sensitivity model for the present value of future
cash flows can be constructed that takes into account the degree of risk attached to
both parallel and rotational changes. The interest-rate-based sensitivity analysis of
cash flows is discussed in detail in Module 10. Such sensitivity analysis can be
combined with a directional view on future interest rates. By anticipating the future
direction of interest rates, the risk manager can ensure that a position has the right
interest rate sensitivity or exposure to take advantage of the expected change in the
discount rates used to value future cash flows.
4.4.1 Forecasting Interest Rates

The ability to forecast future interest rates accurately will depend on the degree of
efficiency of the market. If the market is strong-form efficient, the gains from
investing in such endeavours should outweigh the alternatives on a risk-adjusted
basis. Various alternative approaches to forecasting interest rates can be used. These
range from qualitative assessments to fully fledged econometric models.†††††††† A
range of different models is in general use. One common method is to use auto-
regressive techniques, which assume that the current interest rate is based on some
function of observed past interest rates. Models of this kind might prescribe the
following process:
∑ ﴾4.16﴿
where lrt is the long-term interest rate observed at time t; α is a constant; srt 1 is the
t − 1th short-term interest rate and βi is the coefficient for the ith observation.
An alternative formulation based on the same relationship looks at the real inter-
est rate (which some economists have proposed is a constant) and the inflation rate.
Such a model might be formulated as:
Δ ﴾4.17﴿
where rt is the short-term interest rate observed at time t; ΔI is the change in the
observed current rate of inflation; α is a constant; and β1 and β2 are coefficients that
measure the relative significance of the nominal interest rate and the inflation rate in
the nominal interest rate at time t. The model therefore provides a prediction for
†††††††† Such an analysis will probably have to be based on a qualitative forecast. Module 11
discusses how such a forecast might be constructed.

future interest rates based on forecasts of the expected change in inflation and the
current level of interest rates.
Qualitative forecasts of interest rates can either score different economic data,
such as the unemployment rate, inflation, exchange rate and so on, or be a consid-
ered view of the likely development of economic conditions in the forecast period.
Some models use the consensus from other forecasts combined with interpretations
of the yield curve.
Regardless of the method used to derive the forecast, the interest rates derived
are then used to model the effect of the predicted change in interest rates on the
exposure or position being managed.
4.5 The Money Markets

The money markets are short-term markets, usually up to one year, for loan
instruments made between borrowers and lenders. Examples of such instruments
are bank deposits, interbank loans, commercial paper, certificates of deposit,
bankers’ acceptances, bills of exchange, promissory notes, documentary credits and
so on.
The cash flow character of such transactions is generally very simple, as depicted
in Figure 4.14. Money market instruments normally have only two cash flows: an
initial investment/receipt (PV) followed by the later repayment of the principal and
interest (FV). In practice, complications can arise from the exact computations used
to establish this future value since a number of different conventions exist, but, in
terms of explaining the interest rate risk inherent in money market instruments,
these can be ignored.‡‡‡‡‡‡‡‡
Lender’s cash flow for a money market instrument

+FV
t0
–PV
Borrower’s cash flow for a money market instrument

+PV
tm
t0
–FV
Figure 4.14 Cash flow of money market instruments. Interest is paid

either by discounting the future value or by adding it to the
present value and paying it at maturity
‡‡‡‡‡‡‡‡ Money markets use either ‘bank discount’ or ‘ordinary interest’ methods for calculating the
PV and FV amounts.

The attraction of short-term money market instruments is that the investment

horizon and the maturity of the instrument can be made the same. The cash flows
of money market instruments, as shown in Figure 4.14, have no price risk if held to
maturity (tm). However, investing with a holding period beyond the maturity of the
instrument will leave the investor with reinvestment risk. If the maturing funds are
reinvested, this will be at the new, then prevailing market rate.
Note that, even if short-term money market instruments are not held to maturity,
the generally short maturity, up to one year, means that the price risk is low. In
terms of exposure to interest rate risk, such instruments are seen as low risk. While
true, this is of course in relation to their objective in providing a short-term home
for surplus funds or short-term funding for borrowers. They would not be free of
interest rate risk if they were held as a long-term investment, as an investment
horizon beyond their maturity leaves the holder with reinvestment risk.
4.6 Term Instruments

Most debt instruments with maturities longer than one year, such as term loans,
bonds, notes and so on, have multiple cash flows. The borrower agrees to pay the
lender a fixed – or variable – interest payment, or coupon, for a specific period and
a final payment of interest together with the principal borrowed. Variations that
allow for a series of repayments of principal over time (or amortisation) exist. With
the annuity structure, from the first periodic payment, principal is being returned to
the lender. With a balloon arrangement, the start of repayment is deferred to some
time prior to the maturity. A bullet maturity means that all the principal is repaid at
the end.
Term instruments, on first inspection, look to be much more complicated than
money market instruments. However, this is true only if the instrument has a fixed
rate. A term loan, where the interest is paid periodically but reset in line with the
prevailing market rates (known as floating-rate or variable-rate interest), can be
seen as functionally equivalent to a series of individual short-term money-market-
type instruments that are simultaneously redeemed and then reissued.§§§§§§§§ In the
same way, a bond made up of a series of fixed cash flows can also be seen as a
package of simple money-market-type instruments but sold as a unit. The concept
is shown in Figure 4.15 where It is the interest element and P is the principal.
In fact, the idea of unbundling a term instrument into its component cash flows
and trading them separately, as shown in the second half of Figure 4.15, has been an
accepted procedure in the bond market for a number of years.*********
§§§§§§§§ While functionally equivalent, it will have more credit risk since the maturity is longer than
that on a money market instrument. The lender does not have the option not to advance further funds,
even if the interest is reset in line with the market rate periodically. Of course, a lender will charge
more for eliminating a borrower’s ‘funding risk’ by agreeing to a longer maturity.
********* These go by the name of strips. Each strip has a single maturity and is a zero-coupon
instrument with the same simple cash flows as a money market instrument: an initial invest-
ment/receipt (PV) and a single payment at maturity (FV) representing the principal and accrued
interest.

Lender’s cash flow

for a term, I1 I2 I3 I4 I + P5
interest-paying
instrument
PV
This is functionally I1
equivalent to:
PV1 I2
PV2 I3
PV3 I4
PV4 I + P5
PV5
Figure 4.15 The cash flows on a fixed-interest term security (bond) and
the functional equivalent
Note: A bond is a package of simple cash flows that are contractually sold as a unit.
Bond Calculations __________________________________________
Bond returns are normally expressed in terms of the security’s internal rate
of return or yield. For bonds without any optional element for early redemp-
tion, this is the yield to maturity of the instrument. It is found by solving for:
⋯
﴾4.18﴿
1 1 1 1
where C is the coupon payment, P is the principal and y is the constant discount
rate used to relate the present value (PV) or market price of the bond to its
future cash flows. Note that the value for y is found by iteration.
For a bond with an annual coupon, y is the effective annual interest rate (rE). For
a bond with a semi-annual coupon, then y is the quoted annual interest rate
divided by two ( ). Likewise the coupon payment is the quoted rate divided by
two. An example will make it clear. If we have a three-year 6 per cent annual-
pay bond where the yield-to-maturity used to value the bond is 7 per cent, the
present value or market price of the bond will be:
97.38
. . .

The same maturity bond with a semi-annual-pay coupon with the same yield to
maturity will pay 3 per 100 every six months and be discounted at 3.5 per cent
per (six-month) period. It will be worth:
97.34
. . . . . .
The semi-annual bond clearly shows that we can conceptually rethink the cash
flows of such a security as being equivalent to an annuity strip for three years
paying 3 per 100 every six months plus a terminal payment of 100. Given the
yield to maturity for valuing a bond, a simple rearranging and making use of the
annuity formula allows us to derive a computational equation for valuing the
bond, given the yield:
/
﴾4.19﴿
/ /
where m is the bond maturity in years, f is the frequency of payments (typically

either 1 or 2) and the other terms have already been defined.
For the semi-annual bond, Equation 4.19 would be:
. /
3
. / . /
Note this approach allows us to value bonds even between interest payment
dates. Assume the annual-pay three-year bond has two and a half years to
maturity. The yield to maturity is still 7 per cent. The price at three years was
computed as 97.38. We simply need to project this value forward for the six
months:
.
97.3757 1.07 100.73
This is the full price, or dirty price, as it is known in the bond markets, since it
includes the accrued interest on the bond. As the bond owner will be paid
interest of 6 per 100 at the end of the year, the price will rise as the interest is
reflected in the price. So we would expect the bond to change in price even if
the yield used to price it remains unchanged. To get around this problem, the
bond markets trade bonds at their clean price or net of accrued prices, so to
get the market price equivalent to the one at three years exactly (where there
is no accrued interest), we need to subtract the amount of coupon interest
earned.
Coupon interest is credited on a straight-line basis, so for the six-month period
we should subtract (6 × 0.5) from the above. This gives a net price (as would be
quoted in the market) of 97.73 (100.73 − 6 × 0.5).
Note that the price has risen slightly from the three-year price. This is to be
expected as the bond is standing at a discount to par and will therefore appreci-
ate in price as it moves towards maturity. With no change in the yield to
maturity, the price with two years to go will be 98.19, a rise of 0.82. Half this

value added to the three-year price gives us an approximation of what the two-
and-a-half-year clean price would be in the absence of any interest rate changes.
Bonds that have a yield to maturity that is above the coupon rate stand at a
discount and will increase in value as they move towards par. These bonds have
a price that is at a discount to their redemption value (the principal amount) and
therefore appreciate in value as they move towards maturity. This is called the
‘pull to par’. Bonds where the yield to maturity is below the coupon rate are at
a premium and will depreciate in value as they move towards maturity. Bonds
that are priced at their face value are called par bonds and have a yield to
maturity that is equal to their coupon rate. As we shall see in Module 10, par
bonds are very useful for determining the underlying zero-coupon or spot
interest rates that are embedded in the yield curve.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Learning Summary
This module has looked at the effects of interest rate risk on cash flows. There are a
number of different risks within the definition of interest rate risk, and these depend
on the exact nature of the cash flows:
 Price or market risk arises from changes to the present values of cash flows from
changes in the discount rates used to value these cash flows. This risk is inversely
related to the interest rate: higher interest rates will reduce the present value of
cash flows, and lower interest rates will increase the present value of cash flows.
 Reinvestment risk happens whenever maturing cash flows give rise to new
transactions in the market and the new borrowings or investments are made at a
rate different from that originally anticipated. This risk is directly linked to the
level of interest rates. Higher interest rates will increase the future value of rein-
vested cash flows; lower interest rates will reduce the future value of reinvested
cash flows.
 It is possible to balance price risk and reinvestment risk so that the two risks
offset each other through a process called immunisation.
 Prepayment risk arises when one party to a contract with a fixed set of cash
flows has the right to terminate the agreement early and pay back the money
involved on pre-agreed terms. This is a contingent risk and will occur only if the
market rate is below (or above) the rate at which the party that has the right to
terminate the contract can borrow (or lend) in the market. If interest rates drop,
borrowers can benefit from refinancing at a lower rate. If interest rates rise,
lenders can ask for repayment and reinvest at a higher (interest) rate.
 Extension risk happens if expected, but not contractually fixed, cash flows are
delayed. This occurs when there are non-contractual factors at work allowing
one party to defer terminating the agreement. Examples include mortgage securi-
ties where homeowners may move due to changes in jobs, which may or may
not be associated with rises and falls in interest rates.
The term structure of interest rates, or the yield curve, is a depiction of the rela-
tionship of interest rates to time. It embodies the market’s best guess as to what

interest rates are likely to be in the future. A number of different theories have been
put forward to explain the observed shapes of the yield curve. There are four
characteristic shapes: upward sloping, downward sloping, flat and humped.
We can analyse changes in the yield curve through two principal effects: a parallel
shift, when the rate for all maturities changes equally, and a rotational shift, when
the curve pivots around a particular maturity to either steepen or flatten. When
changes to the yield curve are observed, it is likely that both effects take place at the
same time, leading to twisting effects.
Financial instruments, whose values are directly related to interest rates, either
can be characterised by a simple pair of cash flows, consisting of an inflow, an
outflow and a short maturity, as is the case with the money markets, or are complex
bundles of simple cash flows, as are the instruments traded in the term debt
markets. The characteristics of the instruments’ cash flows will dictate their expo-
sure to the different types of interest rate risk.
Appendix 1 to Module 4: A Note on Early Redemption

Early redemption, or a call provision, allows the issuer to redeem the security at a
date prior to its final maturity. Equally, a put provision allows the holder to seek
redemption at a date prior to its final maturity. Some kinds of consumer finance
contracts, such as a bank loan or mortgage, also include early redemption clauses
allowing the borrower to repay the debt before its final maturity date.
Early redemption works as follows: a bond has a contractual maturity of M, but
is redeemable at time (M − k) such that the cash flows to be received by the holder
from k to M are cancelled in exchange for a predetermined amount at time k
(usually the par or face amount or some agreed amount close to the par or face
amount). The idea is illustrated in Figure 4.16.

Cash flows Early redemption Final maturity

(M – k)
[A] Present value of cash flows

to final maturity
[B] Present value of cash flows

to early redemption
Present value of cash flow difference between

final maturity and early redemption is
value of the ‘right’ to early termination
Figure 4.16 Schematic of the effect of early redemption on the value of the
cash flows
Putting some numbers to the idea, if the bond has a three-year maturity when the
yield used to value the bond is 6 per cent per year and the coupon rate is 3 per 100
nominal gives a bond value for the bond to final maturity [A] of 91.98.††††††††† If
there is an early redemption right to redeem the bond after two years at 100, then
the price of the bond to the early redemption date [B] is 94.50. The absolute
difference is 2.52 and represents the value of the opportunity to reinvest the
difference in the cash flows from Year 2 to Year 3 at the higher market rate of 6 per
cent. Bonds with call provisions will trade at lower prices than bonds without similar
provisions with the same maturity when their coupon rate is above the yield to
maturity. This is because the issuer of the bond is likely to call (redeem) the bond at
the earliest opportunity and refinance at the lower, prevailing, market yield. Bonds
with put provisions will trade at higher prices than bonds without similar provisions
with the same maturity when their coupon rate is below the yield to maturity. This is
because the holder or investor in the bond is likely to put (seek repayment on) the
bond at the earliest opportunity and reinvest at the higher, prevailing, market yield.
This shows that call provisions and put provisions are, in fact, two sides of the same
coin: call provisions advantage the issuer; put provisions advantage the bondholder.
In practice the value of the bond will trade somewhat above 94.50 since there is
an optional element attached to the right to redeem. The decision to put (obtain
repayment on) the bond back to the issuer does not have to be taken until Year 2,
thus preserving the flexibility of the holder. So such a bond will trade at, say, 95.25,
the 0.75 of additional value representing the value of such flexibility.‡‡‡‡‡‡‡‡‡
††††††††† Note, as the coupon rate is 3 per cent and the interest rate or yield used to present value the
bond is 6 per cent, the bond’s current value is less than its principal value and the bond is trading at a
discount to par.
‡‡‡‡‡‡‡‡‡ In option terminology, the 0.75 additional price effect is the time value of the option and
the 2.52 is the option’s intrinsic value.

Appendix 2 to Module 4: Relationship of Spot Rates and Par Yields

This section discusses the linkage between spot rates (also called zero-coupon rates)
and par rates and the arithmetic involved.
A par bond will have a value of 100, by definition, since it is trading at par.§§§§§§§§§
The valuation (V) will be based on the present value of the future cash flows to be
received discounted by the yield, namely:
V ⋯
where y is the yield to maturity of the bond, m is the maturity date, C is the coupon
and P the principal.
We have already said that cash flows for a given maturity are discounted using a
common interest rate for that maturity (the spot interest rate in point of fact) so that
the correct way of expressing the pricing of a bond – or any other financial instru-
ment – is not in terms of their yield but in terms of the underlying spot interest rates
(which we will denote by z, as in zero-coupon rates). The yield to maturity of a bond
is simply its internal rate of return and is derived by solving for the bond’s price (V)
using a common interest rate (y) to present value the cash flows. So we should
recast the pricing of the par bond using the following equation:
V ⋯
where zt is the spot or zero-coupon interest rate for time t. Note that now we may
have different interest rates for each period since there is no reason why the various
zero-coupon rates should be the same for each date.
We will illustrate how we can use the observable par interest rates to find the
underlying zero-coupon interest rates by using a two-period model. As a technique,
this is similar to the discussion in the text explaining the expectations theory of the
term structure of interest rates. In the following discussion we will look at the 6-
month interest rate (which is a money market interest rate) and the 12-month
interest rate. Hence, we will be looking at cash flows that occur every half year
(semi-annually).
There is a link between short-term interest rates for a given maturity, which are
par interest rates, and zero-coupon interest rates. Just as we can move from par
interest rates to zero-coupon interest rates, in the same way we can use the zero-
coupon rates to find out what the applicable par interest rates are. We demonstrate
that next.**********
Period 6 months 12 months

Zero-coupon interest rate (expressed as an annual rate) 5.5% 5.625%
§§§§§§§§§ Actual bonds are often in much larger denominations than 100, typically in units of 1000, 10
000 or even 100 000 for currencies such as the US dollar, the euro and the British pound.
********** The convention is to express the 6-month interest rate (par yield in this case) as an annual
rate. The 6-month rate is 2.25 per cent, so the annualised rate is simply twice this, namely 5.5 per cent
(2.25% × 2).

A semi-annual-pay bond with 6 months to maturity will have just one future cash
flow, the principal and final coupon. This will be the principal (P = 100) and a
coupon of . Coupon rates for bonds are always expressed as an annual payment, so
since the coupon is paid every half-year we divide the coupon payment into equal
payments that would be received after 6 months and then again after 12 months.
The 6-month rate is already known and is 5.5 per cent. The value of must corre-
spond to this; otherwise there is an arbitrage opportunity in the market.
To solve for , we proceed as follows:
. .
100 1 100 1
.
100 1 100
2.75
2 2.75
This gives us the annualised rate of 5.5 per cent as per our six-month rate in the
table. This is the coupon rate (for the semi-annual bond) that must be applicable in
order to prevent arbitrage between bond market prices and short-term interest rates.
With one year to maturity, we now have:
. . .
100 1 1 100 1
100
. . .
1 1 1
5.3963 1.90991
2.8120 2
This shows that a one-year par bond will have a coupon of 5.623 per cent.
If we know either the short-term rate or the par yield, we can compute the ap-
propriate other rate.
The general formula for calculating the spot rate or par rates is:
∑
1 1
where PV is the present value of the instrument, C is the coupon, f is the frequency
(usually one or two payments per year; that is, annual or semi-annual pay), and 0Zt is
the zero-coupon or spot rate corresponding to the maturity t.
The future value is computed:
1

where Zt is the spot rate (zero-coupon rate) for period t, PV represents the present
value of the investment, FV is the future value of the investment, f is the compound-
ing frequency, and t is the time index of cash flows (typically in years such that t =
0.5, 1, 1.5, 2, etc.).
We can rearrange the above equation to derive the appropriate spot rate for each
period:
From the spot rates (st) we can compute the forward rate Ft as follows:
1
1
1
For the first two periods, this can be computed as:

.
. 1
5.70%
Review Questions
4.1 Which of the following is the effect of an increase in the capitalisation rate on an asset’s
value? Assume there are no other changes, such as greater future cash flows on the
asset.
A. It has an indeterminate effect.
B. It will increase the asset’s value.
C. It will decrease the asset’s value.
D. It has no effect.
4.2 Which of the following is correct? Price risk for interest-rate-sensitive assets arises
because:
A. maturing cash flows have to be reinvested at lower interest rates.
B. future cash flows have to be reinvested at higher expected interest rates.
C. future cash flows are discounted at prevailing interest rates.
4.3 Which of the following is correct? Reinvestment risk in interest-rate-sensitive assets

arises when:
A. making an initial investment in interest-rate-sensitive assets.
B. intermediate cash flows on interest-rate-sensitive assets have to be reinvested.
C. an investment in interest-rate-sensitive assets matures.

4.4 In the following set of cash flows, which risk, price risk or reinvestment risk, is likely to
predominate?
Time t=1 t=2 t=3

Cash flow 10 10 110
A. Price risk.
B. Reinvestment risk.
C. They are equal.
D. There is insufficient information to determine which predominates.
4.5 Which of the following is correct? The holding period return on a debt instrument is
the return earned:
A. when the instrument is held to maturity.
B. when the instrument is held to a date before maturity.
C. when interest rates remain constant.
D. from taking on reinvestment risk.
4.6 Which of the following types of debt instrument, when they have the same maturity, is
likely to have the most price risk?
A. A fixed-rate annuity.
B. A loan where the interest rate is reset periodically in line with current market
rates.
C. A fixed-rate bond where the instrument pays a periodic fixed amount of
interest until maturity.
D. A zero-coupon bond where the instrument pays no interest.
4.7 Which of the following is correct? Prepayment risk is the risk that:
A. higher interest rates will lead borrowers to default on their obligation.
B. lower interest rates will reduce the investment’s terminal value.
C. lower interest rates will lead borrowers to repay their obligations.
D. higher interest rates will reduce the investment’s market value.
4.8 In accepting to make a fixed-rate loan with an early termination clause, the lender has:
I. increased the credit risk on the loan.
II. decreased the credit risk on the loan.
III. created prepayment risk on the loan.
IV. eliminated prepayment risk on the loan.
V. purchased an option on future interest rates.
VI. sold an option on future interest rates.
A. I and III.
B. II and V.
C. IV and V.
D. III and VI.

4.9 Which of the following is correct? The yield curve is a graphical representation of:
A. the differences in credit risk between different borrowers.
B. the relationship of buyers to sellers in the market for interest-rate-sensitive
instruments.
C. the prices at which interest-rate-sensitive instruments of various maturities are
exchanged between market participants.
4.10 In creating a yield curve, one would use the fixed-rate debt securities (bonds and notes)
of which of the following?
A. A single borrower.
B. All borrowers.
C. A random selection of borrowers.
D. None of A, B and C.
4.11 If we saw the yield curve depicted in the following diagram, we would describe it as:
Yield
(IRR)
Maturity
I. a contango yield curve.

II. a backwardated yield curve.
III. a flat yield curve.
IV. a humped yield curve.
V. a premium market.
VI. a discount market.
A. I, III, V and VI.
B. II and V.
C. II, IV and VI.
D. II and VI.

4.12 Which of the following does the yield curve shown in Question 4.11 imply about future
monetary policy and the implications for investment strategy?
A. Future monetary policy will be tightened and reinvestment rates will be
reduced.
B. Future monetary policy will be loosened and reinvestment rates will be
reduced.
C. Future monetary policy will be tightened and reinvestment rates will be raised.
D. Future monetary policy will be loosened and reinvestment rates will be raised.
4.13 Under the expectations theory of the term structure of interest rates, which of the
following is correct (assuming all investments are zero-coupon bonds and interest rates
do not change)?
A. A one-year investment reinvested for the second year is expected to give the
same return as directly making a two-year investment.
B. A one-year investment plus a forward contract for the second year made at the
same time will give the same return as directly making a two-year investment.
C. A one-year investment plus reinvesting in one year’s time in the two-year
investment (with one year to go) is expected to give the same return as
directly making a two-year investment.
4.14 Which of the following is correct? Under the liquidity preference theory of the term
structure of interest rates the implied future short-term interest rates derived from
observable market prices for securities will:
A. overstate the expected future short-term rate.
B. understate the expected future short-term rate.
C. both overstate and understate the expected future short-term rate.
D. be unbiased predictors of the expected future short-term rate.
4.15 Which of the following is correct? The market segmentation hypothesis of the term
structure of interest rates implies that:
A. investors will want to hold securities of one maturity only.
B. investors will want to hold securities within a narrow maturity range only.
C. investors will hold all securities at the market price.
D. investors will seek out price bargains regardless of maturity.
4.16 Which of the following is correct? Mean reversion in interest rates means that:
A. interest rates have a tendency to spread out over time.
B. interest rates have a tendency to bunch up over time.
C. the yield curve will have less divergence between the short and long ends.
D. the yield curve will have more divergence between the short and long ends.
4.17 Which of the following is correct? The real component of interest rates is found by:
A. multiplying 1 plus the nominal rate times 1 plus the rate of inflation, minus 1.
B. subtracting the rate of inflation from the nominal interest rate, minus 1.
C. dividing 1 plus the nominal rate by 1 plus the rate of inflation, minus 1.

4.18 Which of the following is correct? In a rotational shift of the yield curve, we would
expect the interest rates or yields of:
A. longer maturities to change by less than shorter ones.
B. longer maturities to change by more than shorter ones.
C. longer maturities to change by the same amount as shorter ones.
D. unpredictable changes to both longer maturities and shorter ones.
4.19 When we say the yield curve has twisted, it implies that:
I. interest rates for short maturities have changed more than those for long maturities.
II. interest rates for long maturities have changed more than those for short maturities.
III. interest rates for short maturities have risen while those for long maturities have
fallen.
IV. interest rates for short maturities have fallen while those for long maturities have
risen.
V. interest rates for all maturities have changed by a similar amount.
VI. none of I, II, III, IV and V.
A. I and III.
B. II and IV.
C. V.
D. VI.
4.20 Which of the following is correct? A money market instrument will have:
A. one cash flow.
B. two cash flows.
C. more than two cash flows that are known.
D. an indefinite number of cash flows.
4.21 A lender who agrees to make a five-year loan where the interest is reset in line with
current market rates every six months is:
I. making a loan that is equivalent to making 10 sequential semi-annual loans at the
then prevailing rate for such six-month loans.
II. taking on more risk than making a series of 10 sequential semi-annual loans.
III. taking on less risk than making a series of 10 sequential semi-annual loans.
IV. transforming the nature of the risk being taken from making 10 sequential semi-
annual loans.
A. I.
B. II.
C. II and IV.
D. III and IV.
4.22 Which of the following term instruments is identical to a money market instrument?
A. An annuity.
B. A fixed-rate loan.
C. A floating-rate loan.
D. A zero-coupon bond.

4.23 Under the expectations theory of the term structure of interest rates, what is likely to
happen to the value of bonds with a long maturity, if the term structure or yield curve is
expected to change from a positive, upward-sloping shape to a flat shape?
A. A rise in the price of such bonds.
B. No change in their price.
C. A fall in the price of such bonds.
D. Some long maturity bonds will rise in price while others will fall.
The following table is used for Questions 4.24, 4.25 and 4.26.
Year 1 2 3 4 5
A 100 100 100 100 100 (annuity)
B 20 20 20 20 120 (straight bond)
C 500 (zero-coupon bond)
D 250 150 100 50 50 (declining cash flows)
4.24 If interest rates fall, which of the following cash flows is likely to increase most in
present-value terms as a percentage?
A. Annuity.
B. Straight bond.
C. Zero-coupon bond.
D. Declining cash flows.
4.25 The zero-coupon yield curve is flat at 10 per cent. Which of the following is the current
market value (rounded to the nearest whole number) of instrument (D) with declining
cash flows?
A. 310
B. 546
C. 373
D. 492
4.26 The zero-coupon yield curve is flat at 10 per cent. Which of the following is the
interest-rate risk, in value terms (rounded to one decimal place) in the zero-coupon
bond (instrument C) if interest rates were to change by 0.10 per cent (10 basis points)?
A. 0.5
B. 3.1
C. 1.4
D. 5.0

4.27 Which of the following is correct? The effects of price risk and reinvestment risk on a
firm’s borrowing liability, where the interest costs are periodically revised in line with
current market rates (that is, it is at a floating rate) when interest rates increase, are
that:
A. price risk makes the liability price fall; reinvestment risk makes the liability cost
rise.
B. price risk makes the liability price rise; reinvestment risk makes the liability cost
fall.
C. price risk makes the liability price fall; reinvestment risk makes the liability cost
fall.
D. price risk makes the liability price rise; reinvestment risk makes the liability cost
rise.
4.28 In the following set of cash flows on an investment, which risk, price risk or
reinvestment risk, is likely to predominate?
Time t=1 t=2 t=3

Cash flow 100 10 10
Note that the current interest rate is 10 per cent.

A. Price risk.
B. Reinvestment risk.
C. It depends.
D. There is insufficient information to determine which predominates.
4.29 Which of the following types of debt instrument, when they have the same maturity, is
likely to have the least price risk?
A. A fixed-rate annuity.
B. A loan where the interest rate is reset periodically in line with current market
rates.
C. A fixed-rate bond where the instrument pays a periodic fixed amount of
D. A zero-coupon bond where the instrument pays no interest.
4.30 Which of the following is correct? If the yield curve or term structure of interest rates
is rising with maturity, we would expect that:
A. longer maturities have lower interest rate costs and higher implied short-term
future interest rates.
B. longer maturities have higher interest rate costs and lower implied short-term
C. longer maturities have lower interest rate costs and lower implied short-term
D. longer maturities have higher interest rate costs and higher implied short-term

4.31 Under the expectations hypothesis of the term structure of interest rates, which of the
following statements is true?
A. Investors who buy long-dated securities expect to earn higher returns than
they would if they bought a series of shorter-dated ones.
B. Investors who buy a series of short-dated securities expect to earn higher
returns than they would if they bought long-dated ones.
C. Investors who buy long-dated securities expect to earn the same returns as
they would if they bought a series of short-dated ones.
D. None of A, B or C.
Time Value of Money Calculations

These questions are included to refresh and test your abilities in interest rate
calculations. This, and the next section on advanced topics, you may prefer to
leave until you have studied Module 10.
4.32 Which of the following is the future value of a deposit of £1000 made at 6 per cent
when invested for 270 days?
A. £1044.05
B. £1044.67
C. £1044.38
D. £1043.75
4.33 You have an investment of £800 that will give you £897 back at the end of 15 months.
Which of the following is the interest rate you can earn on this opportunity?
A. 9.59 per cent.
B. 9.70 per cent.
C. 12.13 per cent.
D. 12.25 per cent.
4.34 We have the following three cash flows and the market rate of interest for the same
maturities.
Time Cash flow Market interest rate

1 100 6.00%
2 50 6.50%
3 75 6.75%
Which of the following is the present value of the cash flows?

A. 199.21
B. 200.00
C. 200.07
D. 201.81

4.35 If we have a consumer finance agreement where the interest is paid monthly and the
nominal interest rate is 18 per cent per year, what is the true interest rate that we are
paying expressed as an annual rate (that is, the loan’s effective annual percentage rate)?
A. 18 per cent.
B. 19.20 per cent.
C. 19.56 per cent.
D. 19.89 per cent.
4.36 A two-year fixed-rate loan pays interest at 6 per cent per year, with the interest paid
semi-annually. Assuming each period is an exact half-year, what would be the equivalent
interest rate if the interest were paid annually when the term structure interest rate
was flat at 5 per cent? (Hint: Consider the cash flows on the loan when the interest rate
is paid semi-annually and when it is paid annually.)
A. 5.06 per cent.
B. 6.07 per cent.
C. 6.09 per cent.
D. 6.16 per cent.
4.37 Which of the following is the monthly repayment on a loan you would have to make if
you borrowed £3000 over 2.5 years at 2 per cent per month, repaying in equal monthly
instalments?
A. £133.95
B. £144.25
C. £160.00
D. £181.14
4.38 If the discount factor for 184 days is 0.9608, which of the following is the interest rate
expressed as an annual rate?
A. 4.080 per cent.
B. 8.093 per cent.
C. 8.125 per cent.
D. 8.255 per cent.
4.39 Dorothy has decided to live in Oz and to buy a house that will cost Oz£115 000. The
Yellow Brick Road Bank is willing to advance her the money over 20 years and has
offered her three alternatives.
I. Alternative 1 is for Dorothy to repay the advance in 20 equal annual instalments of
Oz£15 396.
II. Alternative 2 involves equal quarterly repayments over the 20 years of Oz£3796.65.
III. Alternative 3 involves equal monthly repayments of Oz£1266.25 over 20 years.
Note that current interest rates in Oz are around 12 per cent per year.
Which alternative is best from Dorothy’s point of view?
A. I.
B. II.
C. III.
D. All the offers are the same.

Advanced Interest Rate Topics

You may wish to leave these questions until you have read and understood Module
10.
The following table of zero-coupon bond prices is used for Questions 4.40 to 4.43.
Term Price
1 94.33
2 88.16
3 81.63
4 76.00
4.40 Which of the following is the implied interest rate between Years 2 and 3?
A. 6.75 per cent.
B. 8.00 per cent.
C. 13.50 per cent.
D. 13.95 per cent.
4.41 Under the expectations hypothesis, if the four-year bond is held for two years, which of
the following is the return that can be expected?
A. 6.50 per cent.
B. 6.75 per cent.
C. 7.10 per cent.
D. There is not enough information to determine an answer.
4.42 Under the expectations hypothesis, if an investment is made for three years and then
rolled over for the last year, which of the following will be the yield – or interest rate –
earned in the fourth year?
A. 6.65 per cent.
B. 7.05 per cent.
C. 7.10 per cent.
D. 7.40 per cent.
4.43 If a forward contract to purchase the two-year bond in one year’s time is on offer at
92.57, which of the following is the appropriate arbitrage to undertake? (Assume there
is no bid and offer on purchasing and issuing bonds; a forward contract is a contract
entered into today to purchase and sell the bonds in the future at a pre-set and fixed
price agreed today.)
A. There is no arbitrage.
B. Issue the two-year bond, buy the one-year bond and sell the forward contract
and reinvest in the one-year bond in one year’s time.
C. Issue the one-year bond, buy the forward contract and buy the two-year bond
and reissue a one-year bond in one year’s time.
D. Issue the two-year bond, buy the one-year bond and buy the forward contract
and reinvest in the one-year bond in one year’s time.

Case Study 4.1: Panthos Finance

Panthos Finance, a consumer finance company, is in the business of providing finance to
individual and corporate purchasers of new cars. The company’s most popular product is a
five-year loan with a low fixed monthly payment and a final repayment at maturity when the
customer has sold the car. Since many car buyers wish to sell before the final maturity date of
five years, to be competitive Panthos has to offer an early repayment option. The company
charges one month’s interest on such early termination but waives the fee if a new loan is
agreed. An example of the terms and conditions for one of their ‘low-cost’ loans is given
below:
Borrower A.N. Other

Amount £10 000
Term 5 years
Payments Monthly, in arrears
Amount of monthly payment £150
Amount paid at the end £7165
Special terms and conditions The borrower may repay at any time
with one month’s penalty interest
The company will take a lien on the motor vehicle being purchased, but tracking down
those who default on payments, and gaining repossession, can be difficult and costly.
Currently the interest rate in the market is 10 per cent, at which Panthos Finance can
borrow. The company likes to make a 5 per cent spread between its borrowing costs and its
lending rate. The company raises wholesale finance from a variety of lenders, such as banks,
insurance companies, corporations and the like.
1 Consider the nature of the various risks (not just interest rate risks) that Panthos
Finance is taking in its consumer finance business.
2 Quantify the nature of the interest rate risk that Panthos has in its low-cost finance
package.
References
Cox, J., Ingersoll, J. and Ross, S. (1985) ‘A Theory of the Term Structure of Interest Rates’,
Econometrica, 53, 385–407.
Litterman, R. and Scheinkman, J. (1988) ‘Common Factors Affecting Bond Returns’,
Goldman Sachs Financial Strategies, as quoted in Jorion, P. and Khoury, S.J. (1996) Financial
Risk Management. Oxford: Blackwell Business.

Module 5
Currency Risk
Contents
5.1 Introduction.............................................................................................5/1
5.2 Foreign Exchange Rate Risk ..................................................................5/3
5.3 Foreign Exchange Exposure ............................................................... 5/15
Learning Objectives
This module looks at currency risk, one of the major types of financial risk, which is
also called foreign exchange risk, as it relates to changes in the price at which one
currency is exchanged for another. Currency risk can arise in a variety of different
ways: from undertaking transactions between currencies and through consolidating
financial statements in different currencies and the effects the exchange rate has on
competition. The module also looks at the different theories that have been ad-
vanced to explain the behaviour of currencies. The nature, cause and effect of the
key sources of currency risk are also detailed.
After completing this module, you should know:
 how foreign exchange rates are determined;
 the sources of currency risk:
 transaction exposure;
 translation exposure;
 economic exposure;
 the complexities involved in managing economic exposures arising from
currency movements;
 the role of interest rates in setting forward exchange rates;
 the different theories advanced to explain the behaviour of currencies.
5.1 Introduction
At one time, I was involved in treasury management consulting for the bank for
which I worked. We were looking at how a group of companies might improve their
foreign exchange operations. In particular, we were asked to look at the benefits of
centralising foreign exchange management. At one meeting, with the financial
director and treasurer of one of these companies, a discussion on the number and
nature of currency transactions developed into a discussion on its hedging policy.
The firm imported oil from the world market, refined it and sold the refined

Module 5 / Currency Risk
products on the domestic market. The question we debated at some length was: did
the company have any currency risk? The price of its products in local currency was
a direct translation of the US dollar price for oil-based products; this was a condi-
tion of its licence. This meant that, if the oil price was $50 and the exchange rate
between the local currency and the US dollar was Local2/$ (two local currency units
= $1), it would sell oil at Local2. If the exchange rate changed to Local2.2/$, it
would sell the oil at Local2.2. The firm consequently took the view that there was
no currency risk involved in acting as an importer and refiner of oil since the value
in local currency was always based on the US dollar price. We accepted what it said
but still maintained that the company was incorrect in asserting that there was no
currency exposure: the firm did operate in two different currencies and there was a
consequent mismatch. In fact, its behaviour, which involved the company in
forward currency transactions that set the price for future oil deliveries in the local
currency, supported our contention that, however defined, the company had an
element of currency risk.
The above illustrates that currency risk effects, particularly – as we shall see – at
the strategic and competitive level, are subtle and often hard to capture and can be
easily misunderstood. Simple currency risks, such as those created by foreign
currency purchases and sales, are relatively easy to measure and to manage. Howev-
er, the effects of competitive exposures are much harder to handle.
Understanding and managing currency risk is indispensable to a proper handling
of financial risks. The increasing internationalisation of business activity and the
growing integration of the world economy mean that firms are now more involved
in foreign currency transactions, both as inputs, as these are increasingly being
sourced from abroad and paid for in foreign currency, and as a result of developing
foreign markets for their products and services.†††††††††† In addition, firms make
direct investments in foreign countries as part of their competitive strategies. These
operational and strategic decisions result in various kinds of foreign exchange rate
risk. Historically, currency movements have shown very considerable swings and
volatilities have been very high, ever since the breakdown of the Bretton Woods
Agreement.
Chiquita’s Dollar Woes Add to Its Troubles __________________
Chiquita International, the second-largest US banana grower, announced dismal
fourth-quarter 2000 results, citing the strongest dollar in 14 years against the
euro. Other factors that contributed to a loss of $69 million were higher fuel
costs and weakening demand in North America.
Poor financial results were only the latest in a string of problems at the compa-
ny, which included trade difficulties arising from the European Union’s banana
import rules and the threat of insolvency. In January 2001 the company indicat-
ed it would not be able to meet payments of interest and repayment of principal
on its bonds. It asked bondholders to agree a $860 million debt-for-equity swap
to ease cash flow problems. The company indicated that bondholders’ failure to
†††††††††† A possible exception is the creation of the euro via the European Monetary Union, which
eliminated currency risks for those countries that have adopted the currency since 2001.

agree to such a reorganisation would mean the corporation would have to file
for protection from its creditors under Chapter 11 bankruptcy proceedings
when reorganisation would then be supervised by the commercial court.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Currency Losses Affect Electricidade de Portugal (EdP) _______

First-quarter 2001 net profits at the Portuguese electricity utility fell 31 per cent
to €118 million, partly as a result of currency losses at Bandeirante, a Brazilian
power company in which EdP held a 54 per cent stake. Foreign exchange losses
of €27.4 million were due to the impact of a 14 per cent devaluation of the
Brazilian real against the US dollar, the currency of issue of most of Bandei-
rante’s debt.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
5.2 Foreign Exchange Rate Risk

There are two different effects involved in foreign exchange rate risk:
1. changes in the spot rate;
2. changes in the rate for forward transactions.‡‡‡‡‡‡‡‡‡‡
The second is a complex risk since it combines changes in the spot rate with
changes in the relative interest rates between the two currencies.§§§§§§§§§§ We will
begin by describing how the spot rate is determined and then look at the implica-
tions for the forward rate.
The value, or exchange rate, of one currency in relation to another changes over
time in response to market forces. For example, the demand for and supply of
British pounds (the pound sterling or sterling exchange rate) against foreign
currencies comes from a variety of different sources, as given in Table 5.1.
‡‡‡‡‡‡‡‡‡‡ A spot transaction is undertaken for immediate delivery; a forward transaction has its
execution deferred to a future, agreed date.
§§§§§§§§§§ Derivatives looks in detail at how forward rates are determined. At its simplest, if the interest
rate in British pounds is 4 per cent and in US dollars it is 2 per cent, we would expect the one-year-
ahead forward exchange rate between the US dollar and British pounds to be about 2 per cent lower
than the spot rate. The actual calculation is:
$
where F1 is the one-year forward exchange rate today, S0 is the current spot exchange rate and r$ and
rGBP are the one-year interest rates in US dollars and British pounds respectively.

Table 5.1 The effect of market forces on the British pound exchange rate
Demand for the British pound Supply of the British pound
1 Foreign buyers of British goods paid for in 1 UK importers who need to pay for imported
British pounds goods in foreign currency
Demand is conditioned by: Supply is conditioned by:
• UK prices relative to foreign prices • foreign prices relative to UK prices
• foreign levels of income • UK levels of income
• any preferences for UK goods and services • any preferences for foreign goods and
services
2 Foreign investors who wish to acquire 2 UK investors who wish to acquire financial
financial or physical assets denominated or or physical assets denominated or paid for in
paid for in British pounds foreign currency
Demand depends on: Supply depends on:
• UK interest rates relative to foreign interest • foreign interest rates relative to UK interest
rates rates
• perceived risks of holding British pound- • perceived risks of holding assets denominat-
denominated assets ed in a foreign currency
3 Foreign currency earnings, profits and 3 British pound earnings, profits and remit-
remittances of UK-domiciled firms and tances of foreign-domiciled firms and
individuals individuals
4 Speculators who take the view that the 4 Speculators who take the view that the
British pound will appreciate relative to British pound will depreciate relative to
foreign currencies foreign currencies
5 Intervention by the Bank of England, the 5 Intervention by the Bank of England to
central bank, to support a particular value of support a particular value of the British
the British pound against foreign currencies pound against foreign currencies
Note: In most respects, demand and supply factors are mirror images of each other.
The exchange rate is also affected by economic and political conditions that
influence the supply of and demand for a particular currency. These macro condi-
tions can include differences in inflation rates and interest rates between countries,
trade policies being pursued by the government and the political stability of the
government and country.
High inflation in the country relative to other countries is likely to reduce the
value of the currency, whereas relatively high interest rates will tend to raise a
currency’s external value. Note that, although this is generally true, the market’s
expectations may accentuate or reduce these effects. For instance, in the mid-1980s,
expectations about US monetary policy meant that – at one point – a deteriorating
trade balance led to a fall in the US dollar; whereas later on the same economic
conditions pushed up the value of the dollar. The reason for this about-face by the
market was that the consensus expectation about the policy response had changed.
The rise in the dollar in the later period was predicated on an anticipated tightening
of monetary policy in the US (by increasing interest rates), which would be good for
the US dollar.

Government policies or regulations that limit imports or control the availability

of foreign exchange tend to reduce the supply of domestic currency available in the
foreign exchange market. The degree of political stability affects the risks of doing
business in the country and hence the demand for currency for investment purpos-
es. This country risk may include fears of expropriation of assets held in the
country or restrictions on the remittances from the country, a situation known as
transfer risk.
While the exchange rate for immediate cash conversion between one currency and
another (the spot rate) is subject to short-term supply and demand considerations and
the market’s view on a range of economic and political factors affecting the country,
there are important relationships between the spot rate, future exchange rates,
inflation and interest rates.
5.2.1 The Interest Rate Parity Model and Covered Interest Arbitrage
There exists a close relationship between the forward exchange rate of two
currencies and the interest rates in the two countries. A forward exchange rate
contract is an agreement to buy and sell a currency pair at an agreed date other than
immediately. So two parties may agree to buy and sell Brazilian reals against US
dollars one year ahead at a price or exchange rate agreed today. The forward
exchange rate (exchange rate forward price) is the price or quote at which this future
exchange will take place. Under the interest rate parity (IRP) model or theory, the
forward price or forward exchange rate (fD/F) at a time (t) between the domestic (D)
or base currency used in the foreign exchange quote and the foreign currency (F) –
that is, the quoted currency – will be equal to the interest rate differential between
the two currencies. The interest rate parity model therefore gives us the relation-
ships in Equation 5.1:
/ ﴾5.1﴿
/
We can rewrite Equation 5.1 to give us:
﴾5.2﴿
/ /
For example, if the spot exchange rate (SD/F) is $1.5000/£ ($1.5000 = £1: the US
dollar is the quoted currency and British pounds is the base currency in this curren-
cy pair) and the US dollar interest rate is 6 per cent and that for British pounds is 8
per cent, and the time is one year, we have:
1.06 ﴾5.3﴿
1.5000 1.4722
1.08
The forward rate (fD/F t ) for one year is therefore $1.4722/£. This is often ex-
pressed as forward points, which would be: 278 (1.4722 − 1.5000). Note that in the
currency markets the negative sign is often omitted in quotations as being under-
stood.

If interest rates were the same for all periods and the maturity of the forward
contract was two years, the two-year forward rate would be:
1.06 ﴾5.4﴿
1.5000 1.4450
1.08
The exchange rate forward price for two-year delivery will be $1.4450/£.
If the forward exchange rate for one year had been different from the one com-
puted in Equation 5.3, market participants would have been able to engage in
riskless arbitrage. Let us say the forward rate for one year was $1.4500/£ rather than
$1.4722/£ and, for convenience, both borrowing and lending rates are the same.
Note this latter simplification does not alter the argument; rather differential
borrowing and lending rates create an arbitrage-free channel, reflecting the differen-
tial between the bid and offer rates for the two currencies. A market participant
would be able to borrow British pounds for a year (at a cost of 8 per cent), invest
them in US dollars (at a gain of 6 per cent) and cover the foreign exchange rate risk
by entering into a forward contract at $1.4500/£. After one year, the US dollar
deposit is worth $1.59 ($1.5000 × 1.06); this is converted back to British pounds at
the agreed rate of $1.4500/£ to give £1.097, which is then used to pay off the
British pound borrowing of £1.08, leaving a net gain of £0.017.
In a freely operating market, the availability of such a riskless arbitrage would
quickly create excess demand for forward foreign exchange contracts to sell dollars
and buy British pounds in one year’s time, thus pushing the forward exchange rate
up towards its equilibrium no-arbitrage price of $1.4722/£. If, on the other hand,
the forward rate had been $1.4900/£, then market participants could have made a
gain by entering into the opposite transaction: seeking to sell British pounds and buy
dollars in the one-year forward contract, thus pushing the exchange rate down
towards its no-arbitrage value.*********** Exploiting such price discrepancies is known
as covered interest arbitrage. The ability of market participants to enter into the
simultaneous combination of borrowing and lending in the two currencies, a spot
exchange and the forward currency contract means that they can make a profit out
of nothing. In a competitive and efficient market, prices would swiftly adjust to
eliminate this opportunity for riskless gain.
In practice, dealers in the foreign exchange market set their forward rate or the
price at which they are willing to transact based on the interest rate differentials
between currencies, so as to prevent covered interest arbitrage.
Interest Rate Parity and Covered Interest Arbitrage __________
To make money from mispricing under the interest rate parity model involves
exploiting the differences between markets. To arbitrage the foreign exchange
markets involves four elements: (1) the spot exchange rate; (2) the forward
exchange rate; (3) the domestic interest rate for the same maturity as the
*********** To check this you need to recalculate the arbitrage transactions, this time doing the opposite
of what the example showed when the exchange rate was $1.4500/£.

forward exchange rate; and (4) the foreign interest rate. Mispricing (2), (3) or
(4) provides an arbitrage opportunity. Assume the following market conditions:
Table 5.2 Market conditions for exploiting mispricing between the

deposit markets and the currency markets
Interest rates US dollar/euro currency market
Spot Forward
US dollars (foreign) 5 $1.0000 $1.024
Euros (domestic) 2.5
The non-arbitrage forward exchange rate is $1.024 = (1.05/1.025) × $/€1.
The appropriate transactions for exploiting the mispricing are given in Table 5.3.
By borrowing euros, exchanging them for US dollars in the spot market and
investing the dollars, at the same time covering the foreign exchange risk by
buying US dollars in the forward market, the covered interest arbitrage yields a
no-invested funds profit of $4 per $10 000 of the arbitrage undertaken.
Table 5.3 Covered interest arbitrage between the US dollar and the
euro based on the information in Table 5.2
US$ Initial US$ Terminal
euros euros
Borrow € at 2.5% 10 000 (10 250)
Buy $ spot 10 000 (10 000)
Invest at 5% (10 000) 10 500
Buy € forward (10 496) 10 250
Net cash flows 0 0 4 0
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
5.2.2 Purchasing Power Parity

The purchasing power parity model of exchange rates extends the interest rate
parity model to include the traded goods and services of a country in determining
the exchange rate. In a situation where there are no impediments to international
trade, and if a product is manufactured in two countries, then under the law of one
price it should have the same value in both markets. If it does not, then arbitrageurs
could buy the product in one country and ship it to the other for sale and make a
profit. This activity will push prices towards equality in both countries. Economists
refer to this effect as absolute purchasing power parity.
A less restrictive form of the model is known as relative purchasing power
parity. This states that, in comparison to a period when the exchange rate between
two countries is in equilibrium, changes in the differential inflation rates of the two
countries will be offset by equal, but opposite, changes in the future spot exchange
rate, namely:

1 / ﴾5.5﴿
1 /
where E 1 + iF and E 1 + iD are the inflation rates in the foreign (F) and domestic
(D) countries and E SD/F is the expected spot price at time (t).
Example
If the inflation rate in the UK is 6 per cent and in the US it is 4 per cent, then the left-
hand side of Equation 5.5 becomes:
.
0.9811
.
Assuming an exchange rate of $1.60 = £1 (where the US dollar is the quoted currency
and the British pound is the base currency), the right-hand side of Equation 5.5 should
be:
$ .
0.9811
$ .
That is:
. $ . /
0.9811
. $ . /
The relationship is supported by market forces as follows: if one country has a higher
inflation rate (i) than another, its goods and services will become relatively more
expensive than those of the lower-inflation country, thus making its exports less price
competitive and its imports more competitive. The resulting foreign trade deficit will
place downward pressure on the currency of the higher inflationary country (recall
Table 5.1) until a new equilibrium rate is reached.
5.2.3 The Expectations Theory of Forward Foreign Exchange Rates

If the market for foreign exchange is efficient, the forward rate should reflect
participants’ expectations of what the future spot rate is likely to be. That is, the
expected spot foreign exchange rate (E SD/F t ) at a future time is the same as the
current forward foreign exchange rate for the same maturity (FD/F t ). The expecta-
tions theory of forward foreign exchange rates is based on the same rationale as the
expectations theory of the term structure of interest rates.††††††††††† This is not
surprising since, just as we can envisage the term structure as incorporating a whole
series of delayed-start short-term rates, the forward exchange rate incorporates a
whole series of future spot exchange rates and their corresponding observable
forward rates.
Under the expectations model, the current forward rate for time t is the best
estimate of the future spot rate at time t:
/ / ﴾5.6﴿
/ / / /
/ /
††††††††††† Recall that this was discussed in the previous module.

Let us illustrate the logic. If the forward exchange rate between British pounds
and the euro in one year was at €1.58, then the expected spot rate is the same. If
market participants thought that the future spot rate was in fact going to be higher,
then they would not want to buy British pounds forward; if they had the opposite
view, then they would want to sell British pounds forward. Consequently, transac-
tions would take place until the expectation of the future spot rate and the forward
rate were equal. Table 5.4 illustrates the effect of expectations on the forward
foreign exchange rate.
Table 5.4 The effect of expectations on the forward foreign exchange rate
If the expected forward rate is Action Result
E SD/F 1‐year > FD/F 1‐year Sell British pounds; buy Fewer € needed to close out £
euros side of the transaction
In one year’s time €/£ = €1.48 Gain = 10 pence
E SD/F 1‐year < FD/F 1‐year Buy British pounds; sell Fewer £ needed to close out €
euros side of the transaction
In one year’s time €/£ = €1.65 Gain = 4 pence
Note: The one-year forward rate is taken to be €1.58.
It is important to note that the expectations model for the exchange rate does
not require that the actual spot rate at time t be equal to the historical forward rate.
Market participants are not required to be perfect forecasters. All that is required is
that, on average, the forward rate should equal the future spot rate. Empirical
research on exchange rate behaviour finds that, as predicted under the expectations
theory, the average forward rate is an unbiased estimate of the future spot rate.
However, there is considerable variability between the forward rate and the actual
future spot rate. In addition, there is some evidence of market overshooting, which
occurs most often when the forward rate stands at a significant premium or
discount to the spot rate. In such cases, the actual movement in the spot rate is, on
average, less than the forward estimate.
If the expectations theory holds – and the evidence, although not conclusive,
suggests on average that it does – the value of the forward rate for risk management
purposes is that it provides an unbiased forecast of the future spot rate. This
consensus forecast can be fed into any decision-making process concerned with
managing exchange rate exposure alongside other forecasts.
The fact that forward rates and the expected spot rate are, on average, the same
also implies that using forward contracts to hedge currency exposure will, in the
long run, provide a neutral payoff. That said, the high degree of variability between
the forward rate and the ex post spot rate means that for individual outcomes the
equality is highly unlikely.
Quoting Foreign Exchange __________________________________
The quotation of currency pairs in the foreign exchange market involves one
currency being the base currency and the other the quoted currency. So,
for instance, when quoting British pounds against the US dollar, British pounds

(also called ‘pounds sterling’) is the base currency and the dollar is the quoted
currency. The quotation seen in the newspaper or from an information provider
will thus be one unit of sterling (that is, one British pound) against a variable
amount of US dollars. A typical quote will thus be $1.5425 to the British pound.
This is often written as $/£ for convenience ($ per £).
This quotation applies even if the transaction is a forward contract. The only
difference will be that the rate will be determined by the interest rate parity
(IRP) conditions between the two currencies. Taking our example above, if the
one-year interest rates are 3.25 per cent in dollars (the quoted currency) and
4.125 per cent in British pounds (the base currency), then the IRP values for the
two currencies will be:
$ . .
$1.5295
.
This rate is known as the forward outright exchange rate.

Since the spot currency value changes as transactions take place, it is easier for
foreign exchange traders to quote the forward rate not as an outright rate but
in terms of the interest rate differentials. In the above case, the interest rate
differential is (1.0325)/(1.04125) = 0.9916. But it is awkward to use this in
practice. What the currency markets do is quote this differential in terms of the
premium or discount of the exchange rate relative to the spot rate. In the above
case, this differential is $1.5425 – $1.5295 = 0.0130.
The currency markets make two further adjustments. Quoting fractions can
lead to mistakes, so the differentials are expressed in terms of foreign exchange
points by multiplying the differential by 10 000.‡‡‡‡‡‡‡‡‡‡‡ So the one-year would
be quoted as 130. In addition, the fact that the points need to be subtracted
from the spot quotation is often ignored as market participants would know the
interest rates in the currency pair and since there is a bid–offer (bid–asked)
spread, there will be two quotations: the bid for selling the quoted currency to
the market maker and the ask for buying the quoted currency from the market
maker.§§§§§§§§§§§ Whether the swap points are added or subtracted will be
obvious from the quotation. (Note that this information is given to you so you
will understand how quotations operate in the market. As this is complicated to
remember unless you are working in the currency markets or make frequent
foreign exchange transactions, for the purposes of this module there will be no
market maker’s spread and you will be given the forward outright rates or can
compute these from the interest rate differentials in any exercises.)
Let us see what happens if interest rates remain unchanged but the spot
changes. (Note short-term interest rate changes are far less frequent than
changes in the exchange rate.) Let us assume the spot rate goes from $1.5425
‡‡‡‡‡‡‡‡‡‡‡ This might differ in some currencies where the quotation is a multiple of a single unit, such
as the Japanese yen.
§§§§§§§§§§§ The market maker makes their profit from buying at the bid rate and selling at the (higher)
offer or ask rate.

to $1.5420, a change of 0.0005 or 5 points. The outright forward exchange rate

using the interest rate parity equation will be:
$ . .
$1.5290
.
The forward swap points will be $1.5420 – $1.5290 = $0.0130. This shows
there is no change in the swap points (which represent the interest rate
differentials) for small changes in the spot rate. Hence it is much easier to quote
the forward rate in terms of swap points rather than in terms of a forward
outright rate that is constantly changing in response to changes in the spot rate.
Just remember that the swap points represent the interest rate differential
between the currency pair.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
5.2.4 The International Fisher Effect

The international Fisher effect is an extension of Irwin Fisher’s analysis of the
behaviour of interest rates. Fisher (1930) proposed that lenders seek a real return on
their investment but due to inflation demand a nominal interest rate that includes
the expected inflation; that is, the interest rate they require is one that compensates
them for the effects of inflation and also allows them to earn a real rate of interest.
These two components of the interest rate were discussed in Module 4. The
international Fisher effect extends this analysis to foreign currencies. In the absence
of controls, the real rates of return across countries will be equal due to the possibil-
ity of arbitrage. If the real rate of interest in the UK is higher than that in the US,
capital will flow from the US to the UK until the real return is equalised. Note that
Fisher’s proposition ignored differences between countries in non-market risks and
attitudes towards risk. The extent of controls on capital movements and invest-
ments will also prevent real rates equalising across countries. The significant
liberalisation in international trade and investment since the Second World War and,
in particular, the removal of controls on the movement of capital in the major
economies, has led to a significant reduction of such barriers to exchange rate
equilibrium.
If the real interest rate is equal between different countries, it follows that the
differences in their observed rates must arise from differences in expected inflation.
The international Fisher effect incorporates these differences in inflation as predic-
tions on the future movements in the relative value of currencies. That is,
differences in the nominal interest rates in two countries should be offset by equal,
but opposite, changes in the future spot rate between the two countries. This is, in
essence, a form of the relative purchasing power model discussed earlier but applied
to interest rates rather than physical assets.
The model proposes that the differences in nominal interest rates must equal the
differences in the expected inflation rates, as presented in Equation 5.7:
﴾5.7﴿

So, if the nominal interest rate in British pounds is 6 per cent and in euros is 4
per cent, we expect an inflation differential of about 1.89 per cent between the two
currencies. So, if inflation in countries that use the euro is expected to be 1 per cent,
inflation in the UK is expected to be 2.95 per cent. To avoid the possibility of
arbitrage, changes in the spot rate between two currencies will be equal to the
differences in their nominal interest rates:
/ ﴾5.8﴿
/
We can also present the relationship in Equation 5.8 as follows:
/ / ﴾5.9﴿
/
For example, if the UK interest rate is 5 per cent, the eurozone rate is 3 per cent
and the spot rate is €1.50 per British pound, the spot rate in one year would be
expected to be, based on Equation 5.8:
€/£ . ﴾5.10﴿
€ . .
giving an expected spot rate in one year of €1.4714 per British pound.
5.2.5 An Integrated View of International Parity Relationships for Foreign

Exchange
The international parity relationships described in Section 5.2.1 to Section 5.2.4
provide an elegant set of equilibrium conditions between the price of traded goods
and services and interest rates and the spot and forward exchange rate. Although
they are abstract and theoretical models and depend on some unrealistic assump-
tions (such as perfect competition), they nevertheless provide a powerful theoretical
framework for understanding and explaining the underlying forces that determine
the exchange rate and why this varies over time. Table 5.5 shows the four models,
together with the Fisher effect for comparison purposes.

Table 5.5 International parity relationships compared

[1] Fisher effect 1 1 1 1
[2] Interest rate parity /

/
[3] Purchasing power parity /

/
[4] Expectations theory / /
/ / / /
/ /
[5] International Fisher effect / /

/
There are some interesting relationships between the different models, based on
expected inflation and/or on nominal and real interest rates. How these relation-
ships are integrated is shown in Figure 5.1. The Fisher effect [1] postulates that the
real interest rate between two countries is constant and that the observed differ-
ence in nominal rates is due to differences in expected inflation. For example, if
the UK’s interest rate is 6 per cent and that for the US is 3 per cent, then the
implied difference in inflation between the two is approximately 3 per cent.************
The 3 per cent differential in inflation means that the spot rate in one year’s time
can be expected to change by this amount, with British pounds falling by 3 per cent
against the dollar. This is also the expected condition under purchasing power
parity, where the exchange rate adjusts for the change in relative purchasing power
between the two currencies [3]. Higher inflation in the UK will reduce the purchas-
ing power of British pounds relative to US dollars.
The 3 per cent interest rate differential also implies that, to avoid covered
interest arbitrage, the one-year forward exchange rate will be 3 per cent less for
British pounds relative to the dollar [2]. If the forward exchange rate is an
unbiased forecast of the future spot rate, then the expected spot rate in one year
would change, with British pounds 3 per cent weaker relative to the dollar [4].
The last relationship, that of the international Fisher effect [5], implies that, if
the nominal interest rates in British pounds are 3 per cent above those for the US
dollar, then the spot rate in one year’s time will have changed in such a way that
British pounds are 3 per cent weaker against the dollar.
************ Using the correct formula, we have 2.91 per cent. The discussion will round this to 3 per
cent, for simplicity.

E(SD/F(t)) = FD/F(t)
E(1 + iF(t)) E(SD/F(t)) Expected
= change in FD/F(t) – SD/F E(SD/F(t)) – SD/F
E(1 + iD(t)) SD/F =
the spot rate SD/F SD/F
[3] [4]
[5]
Differences Differences
in expected SD/F(t) – SD/F rF(t) – rD(t) between spot
=
inflation SD/F 1 + rD(t) and forward
exchange rates
[1] [2]
(1 + iD)(1 + rreal) = Differences 1 + rF(t) f (t)
= D/F
(1 + iF)(1 + rreal) in interest 1 + rD(t) SD/F
rates
Figure 5.1 Integrated view of the theories of exchange rate determina-

tion
Note: [1] Fisher effect; [2] interest rate parity; [3] purchasing power parity; [4] expecta-
tions theory; [5] international Fisher effect.
5.2.6 Forecasting Future Exchange Rates

The theoretical models provide a set of economic factors that influence the spot and
forward exchange rate and suggest a number of different approaches that might be
used to forecast future exchange rate movements. The first approach is a supply and
demand forecast model as suggested by the market forces determining the exchange
rate given in Table 5.1. From such an understanding, an estimate of the trend in the
excess demand or supply of a currency can be obtained qualitatively by scenario
building or by econometric modelling.
An alternative approach is the observation that the forward rate, and how it
changes, provides a consensus estimate of market participants’ view on the future
spot rate. This simple forecast can be expanded using additional information from
the term structure of interest rates and applying the equilibrium relationship from
the international Fisher effect. For instance, returning to our example of British
pounds against the euro, let us assume the following spot rates were observed over
the next 10 years using a generalisation of the formula:
€/£ ﴾5.11﴿
€/£
where n is 1–10 years. Using the known interest rates, from the term structure it is
possible to provide a forecast of the future exchange rate. Such an analysis is given
in Table 5.6, where the euro against British pounds exchange rate has been forecast,
based on the interest rate differential between the two currencies.

Table 5.6 Forecast future euro versus British pounds exchange rate
based on the term structure of interest rates in both curren-
cies
Time (years) £ interest rate € interest rate Forecast €
rD rF versus £ ex-
change rate
0 €1.6179
1 5.0 3.5 1.595
2 4.5 3.25 1.579
3 4.0 3.75 1.606
4 3.5 4.0 1.649
5 3.5 4.1 1.665
6 4.0 4.2 1.637
7 4.0 4.4 1.662
8 4.5 4.4 1.606
9 4.4 4.5 1.632
10 4.5 4.7 1.649
This approach to forecasting exchange rates makes use of the information em-
bedded in the yield curve about the future course of short-term interest rates, as
discussed in the previous module. Refinements to the forecasting process might
involve separating the real and nominal components in interest rates, incorporating
short-, medium- and long-term currency demand/supply factors, macroeconomic
models of the various economies, changes in competitiveness, productivity and
other aspects of the real economy and so on. These are all beyond the scope of this
module and the course and are not discussed further.
5.3 Foreign Exchange Exposure

As stated in the introduction to this module, foreign exchange rate exposure arises
principally from the requirement to convert a cash flow or amount in one currency
into another as the result of a transaction. As the value of two currencies change in
relation to each other, the value of a cash flow in terms of the other currency will
also change. This exchange rate risk is most obvious when there is a conversion of
an actual cash flow (this is known as transaction exposure). It also arises in
financial reporting when accounting items are converted from one currency to
another, which happens when foreign subsidiaries are consolidated with a parent
company whose reporting currency is different (this is called translation exposure).
Note that translation exposure is different from transaction exposure since there
may not be an actual cash flow involved. There is a third kind of currency risk
known as economic exposure, which arises when the value of a currency deviates
significantly from its purchasing power parity over time. This last kind is subtle in its
effects and difficult to manage. (The Scotsman article from 1997 reproduced below

highlights the problems that economic exposure can generate for firms. At the time,
the British pound was generally considered to be above its appropriate purchasing
power parity, and this meant that firms based in the UK faced difficult business
conditions, as explained in the article.)
Exporter facing ‘serious decisions’ ___________________________
The Scotsman (January 1997)††††††††††††
Brian Wiseman was yesterday at his desk in Clydebank – putting the final
touches to a four-page report on the sterling problem for his chiefs 6000 miles
away in Japan.
‘It is the number one topic of conversation around here and with our agents
abroad,’ said Mr Wiseman, who is the European chief executive of the Japanese
engineering firm Terasaki.
Terasaki’s Clydebank factory currently employs just over 200 people making
circuit-breakers and switchgear. Around 50 per cent of its output is destined for
markets outside the UK.
‘We have managed up until now, but there is no doubt that the strong pound is
just starting to hurt us and we are going to have to take some serious action,’
he said.
Mr Wiseman says the company is basically faced with two choices:
It can maintain its prices and lose market share to its competitors, which include
European giants such as ABB and Siemens. Or it can cut its prices and sacrifice
profit margin to retain sales overseas.
But it is the domestic market which is giving Mr Wiseman most cause for
concern.
‘Our biggest worry is that the weakness of other currencies is making our
foreign rivals more competitive in the UK, which remains our biggest market,’
Mr Wiseman says.
The recent rise in sterling has only confirmed Mr Wiseman’s support for a
single currency in Europe.‡‡‡‡‡‡‡‡‡‡‡‡
‘I have always been in favour, we sell to around 33 different countries and we
can lose an entire year’s profit in one on an adverse currency movement.
Anything that would stabilise the situation would be useful.’
– Paul Stokes
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
†††††††††††† While this is a relatively old case, dating as it does from 1997, it is perhaps one of the most
insightful newspaper reports on the problems presented in any public forum.
‡‡‡‡‡‡‡‡‡‡‡‡ As of the date of the article, the British pound had risen 14 per cent on a trade-weighted
basis in the previous four and a half months.

5.3.1 Transaction Exposure

Transaction exposure arises when a payable or receivable is due in a foreign
currency and the domestic or base currency has to be exchanged for the foreign
currency, or the foreign currency into the domestic currency. The exposure arises
typically from timing problems in international trade.§§§§§§§§§§§§ Firms agree contracts
to sell and purchase in foreign currencies that are not settled immediately; that is,
they are settled at some pre-agreed future date that is typically months but could be
years in the future. By providing trade credit to purchasers of the firm’s goods and
services, firms facilitate their business, but it means that the actual cash receipt or
payment may not occur until a month and sometimes several months or even years
after the contract terms are agreed. In that time, the value of the payment in the
contract in the domestic currency may have changed significantly if the exchange
rate has moved in the meantime.************* Given that currencies are quite volatile,
there is a significant risk that the actual amount will have materially increased or
decreased in the interim.
Thus an exporter who agrees to sell goods valued at £1 000 000 when the British
pounds/US dollar exchange rate is $1.40 and who is invoiced in US dollars would
be due to receive, say, $1 400 000 in three months’ time when the payment is due.
Changes in the exchange rate between the point at which the contract is agreed and
when the payment is received will mean that there is a potential loss (or gain) on the
exchange back into British pounds when payment is received. Some indication of
potential losses and gains are given in Table 5.7.
Table 5.7 Effect of exchange rate exposure on a foreign currency

transaction
Exchange US dollar British Change on Resultant
rate when ($) amount pounds (£) original effect on
funds are (as on amount position (£) the position
transferred invoice) for the
($/£) exporter
(i) (ii) (ii ÷ i)
1.30 $1 400 000 £1 076 923 +76 923 Gain
1.40 1 400 000 1 000 000 0 No change
1.50 1 400 000 933 333 −66 667 Loss
Note: The contract was originally negotiated at an exchange rate of $1.4000 per British
pound.
§§§§§§§§§§§§ It also arises for individuals, from similar timing effects: you recall my experiences described
at the start of Module 1. When one uses credit cards in an international environment, the translation
value (which is mentally converted or translated to one’s own currency) for a foreign bill and the
ultimate value that appears on one’s statement may differ significantly if there is a delay in processing
the transaction. In these cases, one is in the same position as the exporter/importer: trying to forecast
likely currency movements over the exposure period!
************* It makes no difference if the contract is denominated in the foreign currency, since it will
ultimately need to be exchanged back into the domestic currency.

The movement to an exchange rate of $1.30 per British pound has meant that the
dollar has strengthened against the British pound. A given number of dollars will
now buy more units of British pounds. Thus, the exporter who is due to receive a
fixed amount of US dollars can exchange these for a larger amount of British
pounds, making a windfall gain of £76 923 on the original expected British pounds
amount. The opposite happens if the dollar weakens against British pounds by
moving to $1.50 per British pound. In this case, the exporter is £66 667 worse off
than expected at the onset of the contract.
Note that, if this transaction had not involved an exporter due to receive dollars
but an importer buying from the US, then the gains and losses would have been
reversed, since the importer benefits from a rise in the exchange rate. The importer
gains if the domestic currency strengthens but loses if the domestic currency
weakens. The exporter gains if the foreign currency strengthens but loses if the
foreign currency weakens. Hence knowing the direction of the sensitivity to
currency effects is important.
The obvious solution for firms engaged in international trade that do not wish to
expose themselves to transaction risk is to hedge the risk. They can do this by
entering into a forward contract, by which the amount of British pounds for US
dollars is specified, at the same time as the sale with the foreign client is
agreed.††††††††††††† Alternatively, the exporter could have paid an insurance premium
in order to minimise the losses by buying a currency option but still benefit from
any favourable currency movements.‡‡‡‡‡‡‡‡‡‡‡‡‡
Foreign exchange transaction risk exists whenever contracts are denominated in a
currency other than the domestic or base currency of the firm involved.§§§§§§§§§§§§§
This means that firms engaged in international transactions have significant currency
risk, since exchange rates are often highly volatile. Unexpected changes in the
exchange rate at which currencies are bought and sold in the future may lead to
unanticipated losses (or windfall gains). To guard against the risk of losses, most
transactions are fully hedged by one means or another.**************
Roche Reports Lower Turnover in Swiss Francs _______________
The Roche Group, the Basel-based pharmaceutical company, reported reduced
sales when it announced its third-quarter 2011 results in its reporting currency,
Swiss francs. Sales in the first nine months of the fiscal year were down 13 per
cent to SFr31.49 billion. On the other hand, sales increased by 6 per cent when
††††††††††††† The pricing, characteristics and effects of forward contracts is discussed in more detail in the
Derivatives course.
‡‡‡‡‡‡‡‡‡‡‡‡‡ The use of options is discussed in Derivatives.
§§§§§§§§§§§§§ Requiring an importer to pay in the exporter’s currency or an exporter to pay in the
importer’s currency does not, of course, eliminate the risk: it merely passes it to the other party!
************** Survey evidence on corporate hedging practices suggests that almost all foreign currency
transactions are fully hedged. In addition, some firms will also hedge expected transactions within a
given time period. Financial directors responding to a survey following Allied Lyons’s problems with
currency options indicated that 100 per cent of foreign exposures were hedged! The reality is that, for
most well-run organisations, material exposures are hedged this way using a combination of forwards,
futures, swaps and options.

the results were expressed in US dollars. The results showed the significant
translation effects on Roche’s performance from a stronger Swiss franc over this
period.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
5.3.2 Translation Exposure

Translation exposure arises from the consolidation of financial statements of
subsidiaries where the reported accounting numbers are denominated in a foreign
currency and are converted back into the domestic currency of the parent firm. This
occurs so that financial statements can be produced for the group as a whole, in an
accounting process known as consolidation. Hence, for companies with operations
in foreign countries using different currencies, these firms’ reported financial
statements will include subsidiaries that reported their operations in a foreign
currency but which were ‘translated’ into the parent company’s operating currency.
With translation, or accounting exposure, it is the conversion of these accounting
items and not a cash flow item that leads to the currency exposure.
For example, a UK company (that reports in British pounds) has a French sub-
sidiary, which, at the start of the reporting period, has assets in euros of €4 billion.
The current exchange rate for Year 1 reporting purposes is €1.60 = £1, so the €4
billion of assets is worth €4000/€1.60 = £2500 in British pound terms. The
consolidated financial statement in Year 1 is given in Table 5.8.
Table 5.8 Consolidation of a French foreign subsidiary with its parent

UK company, Year 1; euro/British pounds exchange rate is
€1.6 = £1
Assets £ Liabilities £
British pounds assets 4000 Share capital 3000
European assets Translation gain (loss)
€4000/€1.6 2500 British pounds denominated debt 3500
6500 6500
In Year 2, the asset position of the group in local currency has not changed.
However, the exchange rate between British pounds and the euro has changed and
the British pound has appreciated against the euro, such that the exchange rate is
now €2 = £1. The new consolidation is now shown in Table 5.9.


UK company, Year 2; euro/British pounds exchange rate is
€2 = £1
European assets Translation gain (loss) (500)
€4000/€2 2000 British pounds denominated debt 3500
6000 6000
The value of the French subsidiary’s reported accounts in euros is unchanged. It

is only when the accounts are rendered into British pounds for reporting purposes
that an apparent change has taken place. On consolidation, the firm now has an
asset position in Year 2 that is £500 less than Year 1.
If, on the other hand, part of the firm’s liabilities had been in euro-denominated
debt, this would have had an offsetting effect. If, for instance, £1500 of the British
pounds loan had been in euros, then a fall in the euro against the British pound will
give the result shown in Table 5.10.

UK company with a foreign currency loan, Year 2;
euro/British pounds exchange rate is €2 = £1
European assets Translation gain (loss) (200)
€4000/€2 2000 British pounds denominated debt 2000
Euro denominated debt €2400/€2 1200
6000 6000
As a result of the foreign borrowing, the net translation effect has dropped from
a loss of £500 million to a translation loss of £200 million. This is because the loss
in value of the foreign currency loan (a liability) partially offsets the loss in value on
the foreign currency asset.
The above example illustrates that a firm’s accounting exposure may have differ-
ent sensitivities depending on whether it is net long or short in the foreign currency
assets and liabilities. A firm will have a positive (long) exposure if:
Net long positive exposure Exposed assets Exposed liabilities
Equally, it will have a negative (short) exposure if:
Net short negative exposure Exposed assets Exposed liabilities
The exposures are illustrated in Figure 5.2.

Assets Liabilities Assets Liabilities
Exposed
assets > Exposed
liabilities
Exposed
assets < Exposed
liabilities
Positive (long) exposure Negative (short) exposure
Foreign Foreign Foreign Foreign

currency currency currency currency
devalues revalues devalues revalues
(–) (+) (–) (+)
Translation Translation Translation Translation

loss gain gain loss
Figure 5.2 Translation sensitivity effects on foreign subsidiary consolida-

tion
The accounting methods used to translate statements have changed over time as
there were problems with how accountants treated foreign currency assets and
liabilities for consolidation purposes. Hence changes have been introduced to
address these issues. The initial approach was to use historical exchange rates, as
required for instance by the US’s standard-setting body, the Financial Accounting
Standards Board (FASB), in their Statement of Financial Accounting Standard
(SFAS) 18, and to make the appropriate adjustments to the reported income
statement. This was changed in 1982 with the introduction of SFAS 52, which
replaced SFAS 18 and which required companies to translate foreign currency gains
and losses using the then current exchange rate (taken to be the year-end exchange
rate). With this new standard, all assets and liabilities are translated at current
exchange rates, while income items use a weighted average of the exchange rate over
the reporting period. However, the equity investment in the foreign subsidiary is still
translated using historical rates, as with SFAS 18. Whereas, with SFAS 18, transla-
tion currency gains and losses were carried through the income statement, with
SFAS 52 translation differences are charged to a special equity account, thus not
directly having an impact on the income statement, unless realised. The similar UK
accounting standard, Statement of Standard Accounting Practice (SSAP) 20, issued
in 1983 and revised in 1994, operates in the same way as SFAS 52. The switch by
Britain and many other countries to International Financial Reporting Standards
(IFRS) means that International Accounting Standard (IAS) 21, issued in November
1993, is now the new standard for reporting currency effects. IAS 21 has not meant
major changes for UK companies in that it is similar to SSAP 20, the previous UK
GAAP standard. Under these rules at each balance sheet date:
 foreign currency monetary items shall be translated using the foreign exchange
rate at the balance sheet date;
 non-monetary items that are measured in terms of historical cost are translated
using the exchange rate at the date of the transaction; and

 non-monetary items that are measured at fair value shall be translated using the
exchange rates at the date when the fair value was determined.
Although translation effects do not involve cash flows, in the past considerable
management attention has been devoted to the problem. This was particularly true
in the period following the break-up of the Bretton Woods Agreement, when
companies first began to experience translation losses in their consolidated financial
statements. Highly volatile exchange rates have meant that the consolidated financial
statements of some companies have changed radically from reporting period to
reporting period. In addition, the accounting rules governing the treatment of
translation have also led to problems in that gains and losses have had to be, in
some instances, passed through the income statement, leading to significant swings
in reported earnings from period to period. This was the case with the standard
SFAS 18 used by the US until 1982 and the similar approach used in the UK. Under
these standards, the method separated items into current items, which were con-
verted at the current exchange rate, and non-current (that is, fixed) assets, which
used the exchange rate at the time they were entered into the accounts; that is, the
historical rate. This method has been superseded in the US’s SFAS 52 and in the
UK’s SSAP 20, both of which now require that a current rate is used for all items
except the equity account, this latter still being translated at the historical rate. This
is largely what happens under the IAS 21 rules, supplemented by IAS 39, which
governs the treatment of financial instruments.
Consequently, under current accounting practices it will be the nature and struc-
ture of the subsidiary’s accounts that will dictate whether there is a loss or gain to
the consolidated statement in the home currency of the parent. To the extent that
assets and liabilities match, the effect of currency changes will be offsetting.
Even though translation exposure is not a cash item, some firms have hedged the
exposure through various methods in order to smooth reported results from period
to period. That is, hedges are used to reduce the swing in reported items from
subsidiaries using foreign currencies. The reason is that companies were concerned
that financial markets would not understand the reasons for such swings.
Summary of International Accounting Standard 21: The Effects
of Changes in Foreign Exchange Rates _______________________
The discussion of translation risk is designed to simplify the accounting issues
involved. Obviously, the accounting process leads to a more complicated
situation in most cases, and hence what is given here is simply to illustrate the
effects of accounting rules on consolidated financial statements. For instance,
there is a difference between current revenue and expense items and long-term
investments in businesses and assets. The following summarises the key ele-
ments of IAS 21:
Foreign currency transactions
 Transactions should be translated on the date the transaction takes place.
Thus, items in the income statement are translated at the average exchange
rate over the reporting period.

Investments in foreign entities that are integral to the operations of

the parent
 Monetary balances should be translated at the closing exchange rate, and
non-monetary balances at the exchange rate that relates to the basis for
entering the value in the reported accounts. This means the exchange rate
on the acquisition date for non-monetary assets carried in the accounts on a
historical cost basis and the exchange rate at valuation date for revalued
non-monetary assets.
 Differences on monetary items should be credited or debited to the income
statement. The exception relates to those items that constitute a net in-
vestment in a foreign entity, in which case these are reported in the equity
element of the balance sheet until the asset or liability is disposed of.
 Financial statements of foreign operations that are integral to the operations
of the parent should be treated as above.
Investments in other foreign entities
 Financial statements of other entities in which the company holds invest-
ments should be translated using closing rates for balance sheet items and
transaction rates (or, in practice, average rates over the reporting period)
for revenue and expense items. Differences should be taken directly to equi-
ty.
Disclosures: Firms are required under IAS to:
 report translation differences in the net profit (net income);
 provide an analysis of translation differences in the equity element of the
balance sheet;
 provide changes in the relevant exchange rates after the balance sheet date;
 give details of their foreign exchange risk management policies.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
5.3.3 Economic Exposure

Unlike translation exposure, which is essentially historic, and transaction exposure,
which refers to current known activities, economic exposure is forward looking. It
is concerned with the extent to which unexpected movements in the exchange rate
change the value of expected cash flows in the future (see ‘Scotland’s 1997 Experi-
ence’, below.) This change in value arises from the effect that changes in the
exchange rate may have, directly, on future foreign and domestic sales, sales
volumes, prices and costs and, indirectly, from the impact of these effects on the
firm’s suppliers and their competitors and their suppliers and competitors and so
forth. Because of this effect, economic exposure is also sometimes referred to as
competitive or operating exposure.
Scotland’s 1997 Experience _________________________________
The Scottish Council for Development and Industry’s (SCDI’s) quarterly index
of export performance based on a panel of 26 companies that together account
for half of the country’s exports reported for the second quarter of 1997 that
exports fell by £400 million to £4.08 billion compared to the first quarter’s

£4.46 billion – a fall of 8.7 per cent. The total was up on 1996, when exports of
£3.8 billion were recorded. The results confirmed that ‘members [are] becom-
ing increasingly uncompetitive in many export markets’.
Note that over the 12-month period covered by the report, the British pound
had significantly appreciated against European currencies but less against the US
dollar. One point of interest was that the SCDI reported that the drop was not
uniform across all sectors. The large electronics sector, which makes up nearly
half of Scotland’s exports, suffered less severely. Prices for electronic products
are dollar based and hence less affected by the British pound’s 1996/7 apprecia-
tion than other industries. In the first quarter, the high pound made component
imports from East Asia cheaper in British pound terms.
A concurrent survey of SCDI members suggested that, rather than lose busi-
ness, firms were taking currency appreciation in the form of reduced profit
margins. Firms were also responding to the strong pound by ceasing to recruit,
with 30 per cent indicating they had cut jobs as a result. About a third of
companies had stepped up their marketing spend in affected export mar-
kets.††††††††††††††
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
There are two elements to economic exposure: direct economic exposure and
indirect economic exposure. Direct exposure is the impact of changes in the
exchange rate that directly affect the firm. Indirect exposure is the impact of
changes in the exchange rate on competitors, suppliers, their competitors and
suppliers and so on, and which, in turn, affect the firm through indirect effects.
These indirect exposures arise from actions within the firm (for instance, choices
made on sourcing inputs) and from actions outside the firm, which, although they
do not have a direct effect on expected future cash flows, do have an indirect effect
through competitive effects. Table 5.11 summarises the effects of currency apprecia-
tion and depreciation and their effects on a company both in terms of the direct
effects and of the indirect effects.
Table 5.11 Sources of direct and indirect economic exposure

Home currency rises Home currency falls
against foreign currency against foreign currency
Direct economic exposure effects on:
Foreign currency revenues Fall in home currency Rise in home currency
terms: Value of revenue terms: Value of revenue
stream is reduced in home stream is increased
currency terms Effect: Cash inflows are
Effect: Cash inflows are increased in home currency
reduced in home currency
†††††††††††††† You should read this in conjunction with the earlier article about Terasaki, as reported in The
Scotsman.

Home currency rises Home currency falls

against foreign currency against foreign currency
Foreign currency costs Fall in home currency Rise in home currency
terms: Costs of foreign terms: Costs of foreign
purchases are reduced in purchases increased in home
home currency terms currency terms
Effect: Cash outflows are Effect: Cash outflows are
reduced in home currency increased in home currency
Earnings in foreign currencies Fall in home currency Rise in home currency
terms: Home currency terms: Home currency value
value of foreign earnings is of foreign earnings is in-
reduced creased
Effect: Cash inflows/ Effect: Cash inflows/
translation are reduced in translation are increased in
home currency home currency
Indirect economic exposure effects on:

Competition where inputs are Rise in home currency Fall in home currency
denominated in foreign currencies terms: Allows competitors terms: Leads competitors to
and/or foreign domiciled suppliers to improve margins and/or reduce margins and/or
reduce prices and improve increase prices and weaken
their competitive position their competitive position
Effect: Negative on cash Effect: Positive on cash flows
flows
Suppliers who source in foreign Fall in home currency Rise in home currency
currencies and/or foreign domi- terms: Local suppliers terms: Local suppliers buying
ciled suppliers buying abroad see an abroad see a reduction in
improvement in margins margins
Effect: Positive on cash Effect: Negative on cash
flows flows
Customer making sales in foreign Rise in home currency Fall in home currency
currencies terms: Leads customers to terms: Allows customers to
reduce margins and/or improve margins and/or
increase prices and weaken reduce prices and improve
Effect: Negative on cash Effect: Positive on cash flows
flows
Customer where inputs are Fall in home currency Rise in home currency
denominated in foreign currencies terms: Allows customers terms: Leads customers to
and/or use foreign domiciled to improve margins and/or reduce margins and/or
suppliers reduce prices and improve increase prices and weaken
Effect: Positive on cash Effect: Negative on cash
flows flows

The following example illustrates how direct economic exposure can affect a
firm’s competitive position. British manufacturers are competing for business with
domestic US manufacturers. The US unit cost is $1.50 in both countries. The initial
position is:
Situation 1: the exchange rate is $1.50 = £1.00. The UK unit cost is £1.00 per
unit. The US dollar equivalent is $1.50.
Situation 2: the exchange rate moves to $1.25 = £1.00; that is, there has been a
depreciation in the British pound against the US dollar. The UK unit cost re-
mains unchanged at £1.00 per unit. The US dollar equivalent has now dropped
to $1.25, providing a 25-cents competitive advantage against US domestic cus-
tomers. In this case British firms can maintain their current margins or even
improve them somewhat and still undercut US competitors.‡‡‡‡‡‡‡‡‡‡‡‡‡‡
A situation such as that in the example above arises if the exchange rate does not
fully adjust for changes in purchasing power parity or overshoots its equilibrium
level. Economic exposure is essentially the result of the exchange rate deviating
from a competitive equilibrium. In the example above, if the cost to UK manufac-
turers had risen to £1.20, no competitive advantage would have arisen from the
British pounds depreciation/US dollar appreciation.
Although the above example is straightforward, identifying the direction and
magnitude of such exposures in practice is not. The following examples illustrate
that economic exposure is diffuse and can occur even if all future expected cash
flows are denominated in the home currency:
 The impact of a real appreciation or depreciation in British pounds on a Lon-
don-based hotel. Although all the cash flows are British pound denominated, the
economic impact of a change in the real exchange rate will either increase or
decrease the competitiveness of London as a discretionary location for holidays,
conferences and so on relative to competing destinations.
 The decision to source intermediate factors of production for finished products
sold into the European Union from a Pacific Rim country that has its currency
(and domestic costs) tied to the US dollar. An unexpected change in the real
value of the US dollar will change the costs of the inputs, even though the firm
has no direct US dollar cash flows.
 The change in competitiveness of Jaguar cars, built in the UK and sold in the
United States where the main competitors are euro-based producers such as
BMW or Mercedes-Benz, or yen-based firms such as Honda and Toyota.
 The willingness of supermarket chains to buy abroad, rendering domestic food
manufacturers vulnerable to shifts in the exchange rate.
‡‡‡‡‡‡‡‡‡‡‡‡‡‡ Note that under purchasing power parity, we would expect British costs to rise in the future
to largely eliminate this economic advantage. But these kinds of adjustments may take some years to be
fully reflected in costs and prices, giving British companies a competitive advantage due to the weaker
pound against the US dollar.

Corus and Imported Steel __________________________________

In November 2001, the UK Steel Association, whose leading member at that
time was Corus, reported that steel imports into the UK in 2001 were likely to
top 8.2 million tons, an increase of 6.5 per cent from the previous year – and a
record quantity. The increase was due to non-European Union sources, which
were due to reach 2.8 million tons, double what was imported in 1997, the first
year that the British pound rose substantially against other currencies (see
discussion of the recent behaviour of British pounds against other currencies in
Module 1). Imports were likely to exceed domestically produced steel for the
first time since 1980, when domestic output was severely disrupted by industrial
action.
With UK steel demand flat in 2001, increased import penetration meant that
domestic producers and Corus (formerly British Steel), which accounted for
85 per cent of the 32 000 people employed in the industry, were suffering.
Corus had been severely hit by the reduction in competitiveness at its UK
plants (the others being in the Netherlands) due to the strength of the British
pound against the euro. In the previous year, it had announced the closure of its
South Wales steel-making mills with the loss of 10 000 jobs. In its 2000 results it
had reported a loss of £1.1 billion.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
UK Japanese Car Manufacturers Suffer from Strength of the

British Pound ______________________________________________
The dismal financial performance in 2000 of Nissan and Toyota, two major
Japanese car manufacturers, owed much to the strength of the British pound
against the euro. Both companies had made their UK plants the hub of their
European manufacturing operations with the bulk of their output exported. In
spite of highly productive plants, the high exchange rate meant that the compa-
nies’ competitiveness was adversely affected by currency volatility.
Toyota UK reported pre-tax losses of £130.2 million, more than double the
£52 million loss of 1999, on sales down 6 per cent to £1.23 billion. The carmak-
er, which exports four out of five cars produced in Britain, indicated that in
addition to the woes of the British pound it faced very severe competition in its
major markets.
Nissan Motor Manufacturing (UK) revealed losses of £17.7 million for 2000,
having shown a small profit of £19.8 million the previous year despite increasing
sales by 14 per cent to £2.07 billion. The company blamed the continued
strength of the British pound against continental currencies for its poor perfor-
mance despite having instituted cost reduction activities and the high
productivity of its Sunderland plant (rated the most productive in Europe).
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Different types of firms will have different types and degrees of economic expo-
sure, depending on what aspects of their future cash flows are affected by changes
in the exchange rate. There are four broad categories of firms grouped according to

whether they have high or low sensitivity on revenues and/or on factor costs to
changes in the exchange rate. The types of firms are shown in Table 5.12.
Table 5.12 Classifying firms according to their sensitivity to economic

exposure
Exchange Local firms Exporters Importers Global
rate firms
Input prices Local Local Foreign Foreign
and quantities currency currency currency currency
(costs) denominated denominated denominated denominated
Output prices Local Foreign Local Foreign
and quantities currency currency currency currency
(revenues) denominated denominated denominated denominated
Net sensitivity Low High High Low
to exchange rate
effects
Both costs and Costs are in Costs are in Both costs
revenues are local currency foreign and revenues
denominated in but revenues currencies are denomi-
local currency are in foreign but revenues nated in
currencies are in local foreign
currency currencies
The definitions of the types of firms are:
Local firms Those firms that source and sell in local markets only. This would
include most local services, those firms protected from foreign
competition by geography (for instance, it is prohibitive to move
cement any considerable distance, other than by ship), by line of
business (those firms, such as retailers, providing a positional
good), local monopolies and so on.
Exporters Those firms that source their factors of production in local
markets but sell in competitive world markets. The group of
high-revenue sensitivity/low-factor cost sensitivity also includes
those firms that, although they sell locally, are competing in world
markets.
Importers Those firms that source their factors of production in world
markets but sell locally.
Global firms Those firms that have both high revenue sensitivity and high
factor cost sensitivity. As long as the two sensitivities are partially
or largely mutually offsetting, then the sum of their exposures is
low. This group also includes those types of importers, such as
various commodity suppliers, where competitors have similar
sensitivities to currency movements; for instance, coffee and tea
importers.

In addition to the degree of sensitivity of cash flows to changes in currencies, the

movements in exchange rates have time horizon effects. In the immediate term –
that is, within a budget or price list cycle – it is difficult to adjust prices and/or
factor costs. To some extent anticipatory hedging activity can reduce the scale of the
risk. However, sudden changes in exchange rates will mean that realised cash flows
will differ from those anticipated in the budgeting process.
Over the medium term – that is, within a two- to five-year period – the effect
will depend on whether the exchange rate moves back to its purchasing power
equilibrium or remains in disequilibrium. If the exchange rate returns to equilibrium,
prices and costs should adjust to maintain the value of real cash flows. That might
have been the case in the earlier example when the British pound depreciated
against the dollar if the UK manufacturers’ costs had risen in response to the
depreciation. In the disequilibrium case, the exchange rate takes an extended
departure from purchasing power parity conditions. This situation occurred in
Brazil, for instance, in 2011 as a result of its domestic monetary policy and the rapid
growth and internationalism of its economy.§§§§§§§§§§§§§§ In this instance, prices and
costs do not adjust to reflect the new competitive situation and there are significant
gains and losses for firms’ competitive positions depending on the sensitivity of
their cash flows to exchange rate effects. Firms with strong barriers to market entry
or selling a unique product are better placed to cope with such a situation. Providers
of commodity products, or those susceptible to market penetration from external
suppliers or competitors, suffer the most.
The effects of economic exposure are subtle and difficult to quantify. In addition,
some approaches to analysing economic exposure make the distinction between
changes in relative prices (that is, competitiveness) and deviations from the equilib-
rium exchange rate (that is, disequilibrium in the purchasing power parity
relationship) when seeking to define economic exposure. Understanding how a
particular product, source of supply or a firm is affected by such issues is a key risk
management task.
5.3.4 Managing Foreign Exchange Risk

Firms adopt a range of strategies to manage foreign exchange rate risks. In seeking
to avoid the effects, firms can adapt their operations to take account of currency
effects. At its simplest, this is an application of asset-liability management tech-
niques in that inflows and outflows are matched by currency. Some of the
techniques are operational and hence fall under the scope of operational hedging;
others are financial and hence are financial hedging. The range of techniques used
by firms that have been identified includes:
 location of the firm’s production facilities;
 markets in which the firm purchases its inputs;
 nature of the products sold by the company (in particular, the degree to which
they are differentiated; that is, price inelastic);
§§§§§§§§§§§§§§ This was such a problem for Brazilian industry that the government sought unorthodox
ways to reduce the appreciation of the Brazilian real against the US dollar.

 selection of markets in which the firm sells its products;

 strategic financial decisions such as the currency denomination of debt;
 the degree of diversification in sourcing its inputs and selling its outputs (to take
advantage of portfolio effects);
 the extent to which cash flows in various currencies can be matched;
 policies on pricing, firm capabilities and the degree of flexibility in response to
changes in the economic environment.
Actions can involve smoothing (for instance, mixing currencies), netting (making
use of offsets in different currencies), leading and lagging payments (that is, reduc-
ing the time lag for currencies that are expected to appreciate if buying, and delaying
the transaction if selling), having receivables in the domestic currency (although this
only shifts the risk to the foreign product buyer).
Another complementary way of handling foreign exchange risk is through finan-
cial instruments. This involves the risk management product set of forward
contracts, futures contracts, interest rate and cross-currency swaps, options, and a
variety of hybrid instruments. Many financial contracts exist to assist firms in
managing their currency risk and go by a bewildering variety of names: currency
cylinders, caps, floors, participating forwards, zero-cost collars, breakforwards,
synthetic currency debt and the like. The essential element of these financial
instruments is that they are designed to modify the risks of future cash flows in
desirable ways. For example, a simple forward contract converts at today’s exchange
rate a foreign currency receivable or payable that is not due until sometime in the
future, thus eliminating uncertainty as to its value.***************
The principal attraction of financial risk management, as opposed to operational
risk management, is that it allows risk management decisions to be divorced from
operational decisions. Most operational decisions are long term, and reversing these
disturbs client and supplier relationships as well as leading to sunk costs. On the
other hand, financial instruments are readily bought and sold, so that decisions
made to use these instruments are not binding and can be relatively easily unwound.
In addition, the instruments are generally low cost and their effects can be rapidly
sold without affecting the underlying business. For these reasons, firms use these
instruments extensively to manage financial risks.
Learning Summary
The changes in the value of currencies over time are a major source of risk. Foreign
exchange rate risk arises whenever the value of one currency against another
changes in an unexpected way. In a world of floating exchange rates, market forces
and participants’ expectations determine the value of one currency against another.
*************** The rate agreed today on a foreign exchange forward contract, the delivery price or rate will
reflect the time value of money and will be priced according to interest rate parity relationships, which
were discussed earlier. A full discussion of these and the other instruments mentioned here is provided
in the Derivatives course.

A number of different theories have been advanced to explain the relationship of

the current market rate for a currency and the forward exchange rate. These models
– purchasing power parity, interest rate parity, expectations and the international
Fisher effect – are based on economic or arbitrage arguments. These theories
provide alternative explanations for the paths that currencies may pursue over time.
The fact that a number of theories exist indicates that we do not really understand
how exchange rates are determined at any time.
There are three major sources of exchange rate risk for most organisations:
 transaction risk, when a cash flow in one currency has to be converted at the
prevailing market rate into another currency;
 translation risk or accounting risk, when a reported accounting item in one
currency is converted into another currency for financial reporting purposes;
 economic or competitive risk, when changes in the value of a currency against
other currencies lead to increased or decreased competitiveness of the firm and
alter the future cash flows from its operations. This form of exchange rate risk is
both direct, as it affects the firm itself and its subsidiaries, and indirect, when it
affects the position of its competitors and domestic and foreign suppliers.
Review Questions
5.1 Which of the following is correct? Foreign exchange rate risk arises from:
A. buying goods and services denominated in foreign currency.
B. selling goods and services denominated in foreign currency.
C. investing in foreign currency assets.
5.2 Which of the following is not a direct source of foreign exchange rate risk?
A. Changes in factor prices and product/services prices.
B. Changes in the external value of a currency.
C. Changes in domestic interest rates.
D. Changes in foreign interest rates.

5.3 Some or all of the following may influence the exchange rate between currencies:
I. Domestic producer’s prices.
II. The climate for inward investment.
III. Central bank operations in the money markets.
IV. Government policy.
V. Previous currency appreciation or depreciation.
A. I, II and V.
B. I, IV and V.
C. II, III and V.
5.4 Which of the following is correct? Country risk is a sub-element of currency risk
because:
A. some countries place restrictions on purchases and sales of their currencies.
B. some foreign countries have, from time to time, expropriated foreign invest-
ments.
C. governments and their policies might change in the future.
5.5 If interest rates in currency A are a constant 12 per cent and those in currency B are a
constant 9 per cent and the exchange rate is currently A200 for B1, the six-month
forward exchange rate value of the two currencies will be which of the following?
A. 202.73
B. 203.00
C. 205.51
D. 206.00
5.6 If, in Question 5.5, immediately after completing the contract, the interest rate on
currency B rises to 10 per cent, how much will a user of the forward contract lose if he
has agreed to sell currency B and buy currency A?
A. Nothing.
B. 0.52
C. 1.81
D. 1.87
5.7 Which of the following is correct? Under the interest rate parity theory of foreign
exchange, the forward rate will be:
A. the same as the spot rate.
B. based on the domestic interest rate less the foreign one.
C. based on the domestic interest rate plus the foreign one.
D. the product of the differentials of the domestic interest rate and the foreign
one.

5.8 For purchasing power parity to hold between currencies, which of the following has to
take place?
A. Traded goods and services in the currency with the higher inflation rate have to
become more competitive in international markets.
B. The exchange rate of the higher inflating country has to depreciate to compen-
sate for the differences in inflation.
C. Arbitrageurs must be willing to act to bring discrepancies in prices into line.
5.9 Which of the following is correct? Under the expectations theory of foreign exchange,
the forward exchange rate is:
A. based on the interest rate differentials between the two currencies.
B. the best current estimate of the future spot rate.
C. the market consensus as to what the future spot rate will be.
5.10 Which of the following is correct? The international Fisher effect postulates that the
future exchange rate between two currencies will:
A. remain the same when the two currencies have the same nominal interest rates
and current inflation rates.
B. remain the same when the two currencies have different nominal interest rates
and current inflation rates.
C. change to take account of different nominal interest rates and current inflation.
D. change to take account of different nominal interest rates and expected
inflation.
5.11 A firm’s currency translation exposure (risk) arises:

I. from selling abroad.
II. from buying abroad.
III. from having subsidiaries in foreign currencies.
A. I only.
B. II only.
C. I and II.
D. III only.
5.12 Foreign exchange risk arises from:

I. buying and selling goods and services denominated in foreign currencies.
II. investing in foreign currency assets.
III. buying and selling goods and services from foreign providers and to foreign markets
but denominated in the home currency.
A. I.
B. II.
C. I and II.
D. All of I, II and III.

5.13 In an efficient currency market, which of the following should market participants not be
able to do when undertaking a covered interest arbitrage transaction?
A. Borrow the domestic currency, invest spot in the foreign currency, sell the
foreign currency forward and make a risk-free profit.
B. Borrow the foreign currency, invest spot in the domestic currency, buy the
foreign currency forward and make a risk-free profit.
C. Buy and sell the foreign currency spot and forward and deposit the difference.
The following information is used for Questions 5.14 to 5.16.
The conditions for currencies X and Y:
Interest rate Currency X Currency Y

3 months 6.0% 4.0%
6 months 6.5% 3.5%
12 months 7.0% 3.5%
The current exchange rate between the two currencies is X400 = Y1.
5.14 Which of the following will be the value of a forward foreign exchange contract
between the two currencies in three months’ time?
A. 386.92
B. 398.10
C. 401.91
D. 408.00
5.15 Which of the following will the user of the forward contract with a three-month
maturity, who has agreed to buy currency Y and sell currency X, lose if, just after
completing the contract, the interest rate on currency Y rises to 5 per cent?
A. Nothing.
B. 0.91
C. 0.96
D. The user makes a profit.
5.16 The forward contract for 12 months between the pair of currencies X and Y is being
offered in the market at 412.25. Which of the following is the arbitrage that market
users can make to take advantage of this fact?
A. There is no arbitrage opportunity.
B. Borrow currency X, exchange this for Y at the spot rate and invest for one
year and hedge the currency risk by selling X forward at 412.25.
C. Borrow currency Y, exchange this for X at the spot rate and invest for one
year and hedge the currency risk by buying Y forward at 412.25.
D. Do either B or C.

5.17 The price of a Big Mac at the McDonald’s hamburger chain on sale in different countries
when converted to a common price shows wide variations in price. Which of the
following is the reason for this?
A. Exchange rates can be out of equilibrium.
B. Relative purchasing power parity does not hold.
C. Absolute purchasing power parity does not hold.
5.18 Transaction exposure arises when:

I. a product or service is sold to another country using a different currency.
II. a product or service is purchased from another country using a different currency.
III. foreign corporate profits are consolidated with those of its parent.
IV. competitors’ prices are adjusted to take account of changes in the value of the
currency.
A. I and II.
B. I, II and III.
C. I, II and IV.
D. III and IV.
5.19 Which of the following is correct? The gains and losses from translation exposure are
taken:
A. in the income statement.
B. in the balance sheet.
C. in both the income statement and the balance sheet.
D. the company can choose whether to take them in the income statement or in
the balance sheet.
5.20 Which of the following is correct? The cause of transaction exposure is:
A. changes in the prices at which currencies are exchanged.
B. delays between contracting to buy and sell and the actual payment.
C. agreeing contracts in a foreign currency.
5.21 The case for managing translation exposure depends on which of the following?
A. There is no case for managing translation exposure.
B. The fact that it leads to wide swings in reported corporate performance
unrelated to the firm’s fundamentals.
C. The availability of hedging instruments.
D. The growth of international commerce.

5.22 A firm will have economic exposure if:

I. it has many foreign competitors.
II. it has many domestic competitors.
III. it has many foreign suppliers.
IV. it has many domestic suppliers.
A. I.
B. I and III.
C. II and IV.
5.23 Some combination of the following indirect effects of economic exposure arises when a
company’s base currency appreciates.
I. Foreign competitors gain economic advantage.
II. Domestic competitors with domestic supplies lose economic advantage.
III. Suppliers that source in a foreign currency become more competitive.
IV. Suppliers that source in a foreign currency become less competitive.
V. Customers that source in a foreign currency become more competitive.
VI. Customers that source in a foreign currency become less competitive.
A. I, III and V.
B. II, IV and VI.
C. III and V.
D. IV and VI.
5.24 Firms would be classified as having high economic exposure sensitivity if:
I. inputs, but not outputs, are sensitive to changes in the exchange rate whereas those
of competitors are not.
II. outputs, but not inputs, are sensitive to changes in the exchange rate whereas those
of competitors are not.
III. both inputs and outputs are sensitive to changes in the exchange rate as are those of
competitors.
IV. some inputs and some outputs are sensitive to changes in the exchange rate, as are
those of competitors.
A. I and II.
B. I and III.
C. II and III.
D. III and IV.

5.25 Which of the following is correct? In the equilibrium case for economic exposure, in the
medium term, we can expect that:
A. prices and costs do not adjust to reflect the new competitive situation and a
firm’s competitive position depends on the sensitivity of its cash flows to
exchange rate effects.
B. prices and costs do adjust to reflect the new competitive situation and a firm’s
competitive position depends on the sensitivity of its cash flows to exchange
rate effects.
C. prices and costs do not adjust to reflect the new competitive situation but a
firm’s competitive position is independent of the sensitivity of its cash flows to
D. prices and costs do adjust to reflect the new competitive situation but a firm’s
competitive position is independent of the sensitivity of its cash flows to
Case Study 5.1: Airbus Industries

Airbus Industries is a subsidiary of EADS, the pan-European aerospace conglomerate, and is
best known for its range of airliners and, in particular, for the Superjumbo A380, the world’s
first twin-deck, twin-aisle passenger jet, capable of carrying more than 500 passengers on
international flights. The unveiling of this aircraft in 2010 was the culmination of 15 years’
work, starting with the initial ideas and creation of the Large Aircraft Division in 1996.
Airbus manufactures its jets in Europe; following the introduction of the European Mone-
tary Union (EMU) and the launch of the euro in 2000, this is the company’s domestic currency
and the currency in which it has most of its costs. The group has a number of manufacturing
and assembly units across Europe, notably in Germany, France and Spain, and contracts with a
large number of highly specialised technological sophisticated suppliers within the eurozone,
elsewhere within Europe, such as the UK, and further afield, such as the US and Japan. The
production of a jetliner is a complex and time-consuming business, and it may be several years
before a particular aircraft order is delivered. Because its airframe assembly is in Europe, most
of the group’s costs are in euros, although some payments go to British firms and hence their
costs are in British pounds, although they sell to Airbus in euros. For instance, Rolls-Royce is a
major provider of engines for the Airbus range. Firms outside Europe are paid mostly in US
dollars as this is the international currency for the aerospace industry. Engines that power
certain Airbus models are provided by General Electric and Pratt & Whitney, which are both
based in the US.
The world market for airliners is dominated by Boeing Inc., the US company, and Airbus,
but there are significant niche players in Canada, Brazil, Russia and Japan. In recent years,
China has sought to develop a commercial jet export business. In the major classes of aircraft,
such as the Boeing B737 and the Airbus A320, the two companies compete head to head for
orders, as these are the two aircraft of choice for airlines in this size and specification range.
The two companies have been and continue to be intense rivals for commercial airlines, with
neither company being able to outcompete the other, as the following table of orders for the
two companies shows:
2011 2010 2009 2008 2007 2006 2005 2004 2003 2002
Airbus 1038 574 271 777 1341 790 1055 370 284 300
Boeing 426 530 142 662 1413 1044 1002 272 239 251

However, competition in certain market segments, such as that for the B737/A320 is likely
to increase as rival manufacturers, such as China’s Comac, introduce similar products, such as
its C919, developed partly in partnership with Western low-cost airlines. The Brazilian aircraft
manufacturer Embraer has a similar, if somewhat smaller, competitor in the E195 jetliner, as
does Bombardier of Canada with its CSeries. Longer term, Russia, which in its Soviet Union
days had a thriving civil aircraft industry, could also become a major supplier. Buyers can be
very price sensitive, as a commercial jet is a large capital item costing upwards of $65 million
for the smallest aircraft in the A320 range to $380 million for the largest specification A380
superjumbo.
It is only with its very largest aircraft, the A380, that Airbus does not face direct competi-
tion from rivals.
Given its international nature, the price of commercial jets is determined in US dollars so
that for a company such as Boeing its production costs and revenues are both denominated in
the same currency, US dollars. For Airbus, most of its production costs are in euros. Boeing
offers its range only in US dollars, but Airbus, to be flexible, has agreed to make sales, mostly
to the Middle East and Asia, in a range of currencies.
Demand for new jets is driven by the expansion of air travel and the ability of airlines to
replace older aircraft with newer, more efficient and quieter jets.
1 Consider the environment within which Airbus operates and determine what might be
the major sources of risk.
2 What are the key issues facing the firm in managing its currency risk?
References
Fisher, I. (1930) The Theory of Interest. New York: Augustus M. Kelly (1965 reprint of the 1930
edition).

Module 6
Equity and Commodity Price Risk

Contents
6.1 Equity Market Risks ................................................................................6/1
6.2 Commodity Price Risk ........................................................................ 6/11
Learning Objectives
This module covers equities and commodities and continues and concludes the
analysis of risk in the main financial asset classes.
The overall objective of this module is to provide an understanding of the three
main risk factors – market risk, specific risk and credit risk – that make up the
principal sources of risk for financial instruments.
Equity risk is, in effect, the risks from asset ownership, since the equity holder
has a residual claim on the firm’s cash flows and by implication the value of the
firm’s assets after prior charges have been met. Ownership brings both gains and
losses. The risks inherent in equities can be either market-wide, which affect all
equities to a greater or lesser extent, or firm-specific factors.
The second section looks at commodities. These are both consumption assets, in
that firms use commodities as the raw material for their processes (e.g. agricultural
commodities are eaten), and used for investment purposes. As a result, commodity
price risk is a significant problem for firms if the commodity is used in the manufac-
turing process and for consumers of products in general.
After completing this module, you should understand:
 the sources and types of risk relating to equities;
 problems in analysing future cash flows relating to equity;
 the difference between systematic and stock-specific risks;
 the difference between commodities, which are consumption assets, and other
financial assets, which are held for investment purposes;
 the factors that determine commodity prices, including the existence of a
convenience yield for commodities.
6.1 Equity Market Risks

I once attended a meeting in which various managers from an investment bank
discussed with new graduates their departments and what was required of new

Module 6 / Equity and Commodity Price Risk
recruits. When it came to the turn of the head of equity, he started by pointing out
that, unlike the fixed-income side, they were interested in more than the numbers.
Dealing in equities was too complex, he asserted, for it to be reduced to numbers;
and he went on to discuss the story of how an analyst got wind of upcoming
problems in the construction sector. The analyst, we were told, passed a large
number of building sites on his way home. Passing the same sites daily, he became
aware, over a number of weeks, that on most of the sites the speed with which the
buildings were going up had slowed down. He realised that construction firms were
under less pressure to finish and deduced, correctly, that they had less new work in
the pipeline than hitherto. He therefore issued a circular to the bank’s clients
recommending they disinvest from the industry. Shortly afterwards the whole
construction sector was downrated as the cyclical downturn in the construction
business became public knowledge. The market’s valuation on construction firms
had been changed. The price of shares in building companies fell.
Equity (plural: equities) is the risk-taking element in a firm’s capital structure.
The attraction of equity is that it provides a real claim on the firm’s underlying cash
flows. Equity holders are the firm’s owners and share in the risks and rewards of
ownership.††††††††††††††† Debt instruments are, in most cases, denominated in nominal
terms. They provide the holder with a fixed claim on the future cash flows of the
issuer that is largely predetermined when the security is issued. The choice between
different types of debt claim will depend very much on choices about potential
default risks. Risk-averse investors will hold default-free claims issued by govern-
ments and, perhaps, the best-rated corporations and financial institutions. More
adventurous investors might hold lesser corporates and some speculative invest-
ments. Nevertheless, whatever the degree of credit risk, the future claims of
debtholders are usually contractually predetermined and investors largely know what
cash flows they will receive.
Equities provide holders with all the benefits and disadvantages of holding real
assets. The residual value of the firm and its cash flows accrue to equity holders
once all debt claims are satisfied (hence they are often called a residual claim). The
risk in holding equities therefore relates to the ability of the individual firm to
maintain and increase these cash flows in real terms (that is, the economic value of
the firm’s assets). The value, or price performance, of an individual share will
depend on how well the firm can achieve this objective.‡‡‡‡‡‡‡‡‡‡‡‡‡‡‡
In law, the equity holders are the owners of the firm and are entitled to any sur-
plus in the event of the firm being wound up or otherwise liquidated. With a limited
company, the owners’ liability is limited to the invested amount, this being divided
up into shares, each of which constitutes a proportional claim to ownership.
Shareholders also have a say in how the firm is managed, through electing the board
of directors and being given voting rights for major decisions concerning the
management of the corporation, as well as being supplied with a limited amount of
††††††††††††††† Equity securities are generally referred to as common stocks (US) or ordinary shares (UK),
although, technically, preferred stocks (US) and preference shares are also equity. There exist also a
variety of hybrid instruments such as convertible bonds, which have equity characteristics.
‡‡‡‡‡‡‡‡‡‡‡‡‡‡‡ Note that this is the rationale for ‘value-based’ management strategies.

information on its activities. In addition, if the firm prospers, the owners may
receive a proportion of the profits generated – through the payment of dividends.
Dividends are, however, discretionary, and the firm’s management can reduce the
amount paid, or even stop paying any dividends at all. Shareholders also normally
have the right to transfer ownership by selling their shares in the company to
another party at whatever price they can obtain.
Scania to Cut Production ___________________________________
Scania, the Swedish truck producer, announced in October 2011 that it would
cut production by 10–15 per cent as the problems within the eurozone began
to affect its markets. Truck makers are particularly exposed to swings in
business sentiment, and this affects decisions by customers to replace and
expand their fleet. Even so, reporting its first-quarter 2011 results, Scania
managed to increase net sales to Skr21.13 billion ($3.2 billion), a 14 per cent
rise on the previous first quarter, 2010. On the other hand, net profit only rose
by a much more modest 2 per cent compared to the same period in the
previous year to Skr2.34 billion ($354 million). In deciding to cut production in
spite of increased sales, the company was seeking to avoid an undesirable build-
up in inventories.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
6.1.1 Who Is Affected by Equity Risk?

It is not only investors who own equities who can be affected by equity risk. An
asset manager that manages investments for others and invests these funds in the
equity market is particularly exposed to equity risk. Most asset managers are paid a
fee that is based on the value of the assets under management (AUM). So, if a
manager has funds of €500 million under management and it is paid 1 per cent per
year to manage these funds, it will have income of €5 million per year. If the stock
market and equity prices generally fall and the fund value contracts to, say, €450
million, the manager’s income will drop to €4.5 million.
6.1.2 The Equity or Firm’s Value Model

To help us understand the nature of the risks in equity, it is useful to think of the
firm as a cash-generating box, out of which a number of liabilities have to be met.
These are the returns to shareholders, the interest and principal of lenders, the costs
of production and any taxes, rents and other ancillary costs of being in business.
Recall the earlier model of the firm’s value used in Module 2:
V ∑ ﴾6.1﴿
We said that, conceptually, the value of the firm can be considered the present
value (V) of its future cash flows, discounted at the appropriate rate (r) for the
period t. Note that, strictly speaking, the cash flows in Equation 6.1 are the proba-
bility-weighted average of a range of possible future cash flows that might occur at
each point in the future. From the equity perspective, we can take this cash flow as

being the net cash flow (NCF) after meeting all prior charges, including interest
and principal repayments on debt and corporate income taxes.§§§§§§§§§§§§§§§
The simple cash flow model suggests two potential sources of equity risk, one of
which will be systematic, or general to all firms, and the other firm specific, or
stock specific. The required return (r) that investors demand will be a function of
both the required risk-free rate and the risks attached to future cash flows: that is,
the distribution of the cash flows. Change one or both of these and the present
value attached to the shares will change. Thus we may expect individual shares to
change in value from (a) changes in interest rates and (b) changes in the firm’s
systematic risk; that is, its covariance of future returns relative to the market
portfolio.
Unless the firms issuing shares can change their business dramatically over the
short term, the covariance term is likely to remain constant. It is likely to change only
slowly over time as a firm restructures its operations in response to changes in its
environment. (This constancy of a share’s systematic risk assumes no changes to the
firm’s financial risk, the effect of which is discussed below.) This stability can be
interpreted as follows. Take the iron and steel industry: in the nineteenth century, this
was central to most industrialised nations and steel firms were growth industries. As
economies have matured through technological developments, the role of steel, while
remaining important, has diminished. The degree to which the industry is sensitive to
the underlying economy has changed over the last century, but it has been a gradual,
long-term process that has taken years.
The other possible change is an increase or decrease in the expected future cash
flows (CFt) over time, and their dispersion. Some of these changes will be common
to all firms to a greater or lesser degree, such as the effect of boom and recession on
firms’ cash flows as economies go through the business cycle. Other cash flow
effects will be firm specific. Changes in firm-specific cash flows can happen for a
wide variety of reasons, some of which might have been predictable, while others
are just short-run shocks. It is probably not possible to predict events such as the
BP Gulf of Mexico oil spill incident and the impact it had on the company. Howev-
er, on the other hand, it may be possible for an astute investor to anticipate the
impact of a reassessment in the prospects of a firm that takes place with a change in
its management, or the price effect of a takeover on the company’s shares. Equity
§§§§§§§§§§§§§§§ This is a simplification. In practice, most investors will hold shares only for a given period,
so the value will be made up of two elements: the dividends (which will be a fraction of the firm’s
reported profit or earnings in each accounting period) and the value obtained when the share is finally
sold. The market price at this point will be the market’s then best estimate of what future cash flows
will be thereafter. Hence, the dividend discount model of share valuation proposes that the share value
is:
∑
where Dt is the dividend at time t, the tilde indicating that it is a more or less uncertain amount, and rrr
is the required rate of return. When the share is to be sold at time m, the model becomes:
∑

analysts are employed by many investing institutions to try to evaluate just such
questions.
Equity price risk will therefore be a complex package that will include actual and
expected changes in interest rates (that is, the discount rate used to value future cash
flows), and macroeconomic, sector or industry and specific company performance,
including the effects of innovation, changes in technology, corporate taxes, competi-
tion and regulation. In addition, those investing in small or unquoted companies or
abroad will need to factor in considerations such as market liquidity and foreign
exchange rate risks. For instance, there is a considerable body of research showing
that a small-companies effect exists in countries such as Belgium, Canada, France,
Germany, Japan and the Netherlands, and in the US and the UK. Such small cap
stocks (Levis, 1989, and Reinganum, 1992), as they are known, have produced
higher returns than large companies.
One explanation for the effect may be that such small firms have more systemat-
ic risk than large firms. Another is that they are only marginal firms (Chan and
Chen, 1991). Another line of evidence (Stoll and Whaley, 1983) suggests that higher
returns may be partially attributed to poor marketability (or poor liquidity) in such
small issues.
Firms will also be exposed to other market risks such as currencies and commod-
ities, the effects of which are likely to differ in severity on an individual or sector
basis. The above suggests different analytical approaches for managing the two
kinds of equity risks, as given in Table 6.1.
Table 6.1 Equity analysis and the nature of the risks of equity
Type of equity risk Causation Analysis
Systematic Market factors Market related
Sector related
Stock specific Company performance Stock selection
Event risk None
On the Breadline ___________________________________________

Premier Foods, the UK-domiciled breadmaker known for its Mr Kipling cakes
and Hovis bread ranges, suffered a 19 per cent share price fall on 12 October
2011 to close at the end of trading at 3.8 pence per share. This came in re-
sponse to continued negative sentiment about the company, leaving it with a
market capitalisation of just £90 million.* The new low price for the
company’s shares (which had traded as high as 35 pence as late as May 2011)
reflected a number of important negative factors for the company. These
included 1) the deteriorating underlying operational performance of the heavily
indebted company, 2) continued very difficult trading conditions in the UK – its
* Market capitalisation is the number of shares times the share price and is a reflection of the
total shareholder worth of the company at prevailing market prices.

major area of operations – and 3) the announcement ahead of its results that
performance was likely to be below market expectations.
Its problems stemmed from acquisitions made in 2007 that were financed by
issuing debt. In the last quarter it had reported a loss to shareholders of
£12 million, down from a loss of £40 million for the comparable six-month
period in 2010. The balance sheet showed that it had £1.14 billion in outstand-
ing net debt, which, in book equity or shareholders’ funds of £975 million, gave
a debt/equity ratio of 1.17.
The interest bill on its debt mountain for the six-month period was £59 million,
which was barely covered by the profit from operations. Due to the difficult
trading conditions, the company saw a decline in trading profit from its opera-
tions, which for the six-month period was £67 million, compared to £94 million
for the same period in 2010. While the company’s management was positive
that it would be able to trade out of its problems and renegotiate its loan
agreements with lenders, commentators felt that a break-up of the company, a
significant debt-for-equity swap – which would virtually wipe out existing
shareholders – or a takeover offer from a rival were distinct possibilities.
Given the possibility of the company failing, shareholders were just a breadth
away from losing the last of their money. In fact, some brokers suggested that,
given the company’s apparently insurmountable difficulties, the share price could
hit a rock-bottom 1 pence in the near future.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
There are a few other kinds of risk associated with equities that ought to be men-
tioned briefly. Since equities relate to ownership claims on real assets, they are very
susceptible to political risk arising from changes in government policies. For
example, government attitudes to the corporate sector can affect valuation. How
firms are taxed and the treatment of dividends – even restrictions on the payment of
dividends – affect the cash flows equity holders can expect from their holdings and
hence their market value.
A schematic representation of the factors that have an impact on shareholder
wealth (that is, share values) is shown in Figure 6.1. This shows that there are some
factors that relate to the firm and can be influenced by the firm’s management and
which we may call ‘firm specific’. These include decisions such as what quantities to
produce, which markets to sell in and how to produce the output that the firm sells.
These are what we might call operational decisions. The board of directors, which
is made up of the firm’s senior managers, is also responsible for determining
dividend payments, if any, and these will affect the cash flows shareholders receive
at any point in time. How well or otherwise the management of the firm addresses
these issues will to a great extent determine how well the company does and the
rewards to shareholders.
Equally, macroeconomic conditions in the countries in which the firm operates,
as well as elements such as the corporate taxes the company has to pay, which are
outside the control of management, will have an effect on the firm’s share price – as
they will on the share prices of other firms.

Consequently, the risk in a particular firm’s equity is a combination of macroeco-

nomic risks, which are reflected in the systematic risk of the firm, and firm-specific
risks, although the distinction is somewhat blurred in terms of Figure 6.1. For
instance, how the firm chooses the mix between fixed and variable costs in its
production process will influence its overall business risk through operational
leverage, and this will be reflected in the firm’s systematic risk. In addition, leverage
or borrowing money will raise the systematic risk of the firm’s shares by creating
financial risk. This is discussed in detail in Section 6.1.3.
The equity risk any shareholder has to deal with in a particular firm will thus be a
mix of macroeconomic risk and how this affects the firm’s business risk plus the
‘add-on’ of the way the firm organises its liabilities, which is called financial risk.
Factors that affect one firm will lead to changes in the prices of the shares of that
firm only – and will be firm-specific risk. Factors that affect all firms to a greater or
lesser extent will be systematic.
Share Values Financial Markets

(Shareholder
wealth) Optimism/pessimism
on the economy
Interest rates
Inflation
Resultant
Cash Flows
(Amount, timing,
and risk in firm's
future cash
flows)
External Economic Environment Decisions Management May Take

Conditions That Affect Corporate Value to Affect Corporate Value
Level of economic activity Range and type of products and

Competition: services offered
- threat of new competitors and substitutes Marketing and distribution methods
- bargaining power of buyers and network
- bargaining power of suppliers Investment policy
- industrial rivalry Production methods and technology
Taxes and regulations Employment compensation policies
Employment and workforce Form of ownership
International business environment and - sole proprietor
foreign exchange rates - partnership (limited partnership)
Interest rates - limited company (incorporated)
Capital structure (debt and equity used)
Management of working capital
Dividend policy
Figure 6.1 Schematic of determinants of share (firm) values

In terms of the relationship between the two risks, we can consider the fact that
the standard deviation of the return in the firm’s shares reflects the entire firm’s
equity risk, both firm-specific and systematic. Systematic risk is normally measured

by the beta coefficient, which relates to the return of the shares to the market index,
as discussed in Module 3. We can express the relationship between the total risk and
the firm-specific risk and systematic risk as follows:
Total risk Firm˗specific risk Systematic risk ﴾6.2﴿

More formally, we can express Equation 6.2 in terms of the standard deviation of
return of the firm’s shares (σshares), as follows:
﴾6.3﴿
where is the beta coefficient of the firm’s shares, is the variance in
return on the market and σ2 eshares is the variance in the residual or stock-specific
risk.*
An example will help make this clear. If the market volatility is 20 per cent and
the beta for the firm’s shares is 1.2, then the market component of the total risk of
the shares is 1.22 × 0.22. If the firm-specific risk is 0.252, then we can complete
Equation 6.3 as follows:
1.2 0.2 0.25 ﴾6.4﴿

0.347
We can also work from the standard deviation of the shares and the beta to find
out the specific risk, by solving for the unknown value in Equation 6.3. This is
useful for risk management purposes as it allows us to work with easily computed
variables: the standard deviation of the shares’ return and the beta. The former is a
simple statistical calculation that we will work through in a later module, while the
latter requires us to perform the following regression calculation:
﴾6.5﴿
where rshares is the return on the shares and rmarket is the return on the market over
some predetermined period, say one day, one week or one month.† By taking a
reasonably large number of observations, we can determine the beta (β) quite
accurately.
Note that, as previously discussed in Module 3, financial markets only ‘price’ the
systematic component of the return on an asset, since, as we will see later, in
Module 9, we can diversify and reduce the specific risk by creating portfolios that
include a large number of assets.
Finally, it is worth mentioning that the great complexities involved in trying to
determine equity values can lead to overcomplex models that are difficult to
understand and prone to errors derived from the sensitivity of the result to the
inputs used. Equally, reliance on simple models, such as relative dividend yields or
* Note that the variance is simply the standard deviation squared.

† We look at how to calculate returns in detail in a later module of this course.

price/earnings ratios, can provide too simplistic a valuation. Considerable thought,

ingenuity and effort are required to value individual shares correctly.
The Attributes of Ordinary Shares ___________________________
Ownership of ordinary shares provides the holders with (pro rata):
 the right to dividends, or a distribution of the profits of the company.
Dividends may be varied by the company’s board of directors in the light of
trading conditions. Since there is an ability to increase the payment in line
with corporate performance, shares are often considered to provide a real
claim on assets and a hedge against inflation;
 a share of any assets in the liquidation or sale of the business after the
debtholders (prior claims) have been paid off;
 limited access to the company’s financial records and accounts, together with
an obligation of the company to notify the holder of any material develop-
ments in the business;
 voting privileges at company general meetings and the right to approve or
disapprove of resolutions put to such general meetings;
 for companies quoted on an exchange, the right freely to transfer ownership;
 subscription privileges for new shares (pre-emptive rights) so as to maintain
the shareholder’s pro-rata holding in the company. This is true for the UK
but not necessarily for other countries;
 liability limited to the investment made in the shares.
Note that preference shares are often classified as a form of equity since they
pay a dividend out of after-tax profits. There are many kinds, and each requires
specialised analysis. Some, like fixed dividend preference shares, are more
akin to a junior form of debt than to ordinary shares.
Because of the above characteristics, shares are often referred to as a residual
claim. They obtain the value of the underlying assets once all prior claims (debt
claims) have been met. Hence their value is dependent on the value of the firm’s
assets (or equivalently, as given in the model, the net cash flows from these
assets). Since the risks related to these cash flows will not be the same between
firms, different shares will have different risks.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
6.1.3 Financial Risk from the Capital Structure of the Firm

We also need to include in the analysis effects arising from the firm’s financial
structure. Since firms typically use a mixture of debt and equity for financing
purposes, the equity beta will be a function of the firm’s capital structure, namely:
﴾6.6﴿
Note that Equation 6.6 shows that the firm’s systematic risk, its beta, is reflected
in the systematic risk component of the firm’s liabilities and its capital structure,
namely the debt and equity.

When the firm has no debt, then the βfirm equals the βequity. As debt is a prior
claim on the firm’s cash flows, it will have less risk than the firm’s equity, which is a
residual claim, as discussed. So, in cases where the firm borrows money, this raises
the risk of the firm’s equity by creating financial risk. This is, in essence, the risk that
the firm cannot repay the borrowed money and becomes insolvent. When there is
no debt, this cannot happen; but lenders expect to be repaid, and, if the firm cannot
repay its debts, debtholders take control of the firm in a legal process called bank-
ruptcy or, as it is called in the UK, insolvency.
We can show the leverage effect on beta:
1 1 ﴾6.7﴿
where βshares is the beta of the shares when the firm uses leverage (gearing) by
borrowing money, βfirm is the firm beta, which is equivalent to the unleveraged beta
of the same shares, and tc is the corporate tax rate and the ratio of the firm’s debt to
equity (D/E).
So, if a firm has an unleveraged beta of 0.6, the corporate tax rate is 30 per cent
and the debt-to-equity ratio is 0.7, we can find what the leveraged shares beta will
be, namely:
1 1 ﴾6.8﴿
0.6 1 1 0.30 0.7

0.894
The difference in the systematic risk from the unleveraged share beta of 0.6 and
the leveraged beta of 0.894 reflects the systematic risk impact of the firm using
leverage (that is, borrowing money) to fund its operations.
Oil’s Rollercoaster Ride _____________________________________
What are consumers to make of the fluctuations in crude oil prices? The price
of Brent oil, produced in the North Sea, has fluctuated significantly in recent
years, as has that of the benchmark Western Texas Intermediate (WTI), which
is the bellwether for North American oil prices. The yearly average oil price
from 1998 to 2011 is given in Table 6.2.
Table 6.2 The oil price 1998 to 2011 (average for the year) and changes in profits at BP
plc
Year 2005 2006 2007 2008 2009 2010 2011
Average 49.92 58.30 64.20 91.48 53.51 71.21 90.33
oil price
Change 33.4% 16.8% 10.1% 42.5% −41.5% 33.1% 26.9%
BP profits 22 341 22 000 20 845 21 157 16 578 (3 324) 25 700
40.0% −1.5% −5.3% 1.5% −21.6% −120.1% 673.2%

Year 1998 1999 2000 2001 2002 2003 2004

Average 11.91 16.55 27.40 23.00 22.81 27.69 37.41
oil price
Change 39.0% 65.6% −16.1% −0.8% 21.4% 35.1%
BP profits 2 089 2 322 10 209 6 617 6 872 12 618 15 961
11.2% 339.7% −35.2% 3.9% 83.6% 26.5%
You might expect oil producers to have done well over this period, but their
profits have not risen in the same way as the oil price. The compound annual
growth rate in the oil price from 1998 to 2009, the last year of profit for BP, is
14.6 per cent per year. Over the same period, the growth in BP profits has been
20.7 per cent compound annual growth per year.
Of course, it has not quite worked out like that for BP, since in 2010 it suffered
a significant loss from the Macondo Well disaster in the Gulf of Mexico, which
resulted in a large oil spill, significant environmental clean-up costs and damages,
as well as ongoing litigation.
If we look at the year-by-year performance, it is clear that BP’s profit goes up
when oil prices have risen and tends to decline (or sees reduced growth) when
oil prices go down.
BP is an integrated oil company: its raw material is crude oil and it sells the
finished product to consumers. It has significant exposure to the oil market, and
its profits rise and fall with the crude oil price. An increase in the price of crude
oil makes BP’s operations more profitable. In the same way, a fall in the oil price
has a significant negative impact on BP’s profitability.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
6.2 Commodity Price Risk

Commodities (or produce, as they are also known) is a generic term for traded raw
materials, foodstuffs and services. They differ from the other kinds of risk hitherto
analysed in that they are a factor of production and a real rather than a financial asset
or liability. For this reason commodities are sometimes referred to as consumption
assets. However, in some areas, notably various precious metals, for instance gold
and silver, they are also used for investment purposes. Note that, in many firms, the
management of commodity price risk is treated as part of the firm’s overall financial
risk management strategy. This applies even though commodities are either inputs or
outputs. The reason is that firms may have a large long-term strategic exposure to one
or more commodities and hence managing their price risk is a major concern. In
addition, the tools of financial management can be applied to commodity price risk
since there is an active market in which risk management techniques may be applied.
Fall in Copper Price Affects Chile’s Antofagasta ______________
For the six-month period to June 2001, Antofagasta, the Chilean copper-mining
company, reported pre-tax profits of $50.6 million on sales of $343 million,

down from $100 million on sales of $316 million in the same period in the
previous year as a result of a fall in the copper price. Copper prices averaged
77.6 cents/lb in the first half of 2001 compared to 80.2 cents/lb in the first half
of the previous year.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
6.2.1 Commodity Market Characteristics

There is much more diversity in commodities than in, for instance, bonds. With
bonds, although the instruments differ, there is considerable scope for substitution.
With commodities, factors such as storage costs, location and transportation
have a significant influence. For instance, a glance at a newspaper might lead one to
believe there is an opportunity to profit from the price differential, by buying one
and selling the other, between North Sea Oil (Brent) and West Texas Intermediate
(WTI), two market crude oil benchmarks that are often reported in the financial
press. This is not the case, as the price differential reflects the costs of delivery at
different geographical locations in Europe and the US and differences in the quality
of the two fields. Oil, as with most other commodities, is not a wholly homogene-
ous product. There are differences in grade and quality (for instance, the sulphur
content), which make the produce of one field more or less valuable than that from
another well, possibly located nearby. These differences are not significant for
financial instruments: financial assets can be transferred around the globe at minimal
cost. The interest rate on a bank deposit for US dollars is likely to be, at most, only
fractionally different in Tokyo from what it is in London. Effecting delivery of
financial assets is a very small part of the overall cost of making transactions. This is
not so for commodities.
The traded markets in commodities cover a wide range of the more important
factors of production and are generally divided into several different categories
based on their characteristics. Hard commodities are those non-perishable
commodities the markets for which are further divided into precious metals (for
example gold, silver and platinum), which have a high price/weight value, and base
metals (for example copper, zinc and tin), whose value is much lower in terms of
weight. Perishable commodities, or commodities that are hard to store, are known
as soft commodities, softs, or agriculturals (such items as grains, coffee or sugar).
Energy commodities consist of oil, natural gas, electricity and other energy
products. Table 6.3 shows the major traded commodities. Trading in commodities
takes place both over the counter (OTC) – that is, between principals taking each
other’s credit risk – and via organised exchanges where a centralised clearing house
intermediates between the parties. Commodity exchanges typically have a degree of
specialisation, some concentrating on hard commodities, others on energy products,
base metals or precious metals.
The markets for commodities are divided into cash markets or physical spot
markets and markets with delayed settlement, either forward or future markets. A
detailed discussion of the nature of such terminal markets is reserved for the
Derivatives course text.

Table 6.3 Categorisation of commodities markets

Hard commodities Base metals Copper
Tin
Lead
Nickel
Zinc
Aluminium (ingots; alloy)
Precious metals Gold (bullion; coins)
Silver
Platinum
Palladium
Rare elements (e.g. scandium, thulium and so
on)
Soft commodities (‘softs’) Cocoa
or agriculturals Frozen orange juice
Robusta coffee
Coffee
Sugar (raw; white)
Potatoes
Cattle (feeder; live)
Pigs (hogs; pork bellies)
Lamb
Broiler chickens
Soybean (beans; meal; oil)
Grains (wheat; corn; barley; rice; oats)
Orange juice
Coconut oil
Palm oil
Copra
Cotton
Wool
Rubber
Pepper
Energy products Oil (crude; heating; unleaded gasoline)
Natural gas
Jet kerosene
Electricity
Miscellaneous Freight rates
Insurance
Lumber
Wood pulp
Weather
Note: Freight, insurance and weather are considered a type of commodity (a factor of
production/distribution).

6.2.2 Price Determination in the Commodities Markets

The price dynamics of commodities markets are somewhat different from those that
pertain in the equity, debt and currency markets, even though the price ultimately
does depend on supply and demand. With financial claims, it is possible either to
issue new claims to meet demand or to switch to close substitutes if the price of a
particular stock or security should move out of line. This ability to substitute does
not apply to commodities. In the case of commodities, there is often only a limited
degree of interchange. For instance, copper is most frequently used for electrical
wiring; other metals may be substituted, but they have inferior conducting character-
istics. Thus, unless there was an actual shortage of physical supply or the price
differentials became so great, users would be unlikely to make the substitution (quite
apart from any costs associated with modifying the production process). Users
would, of course, seek to limit the use of expensive commodities whenever possible.
Higher prices mean that users will economise on their use and recycle scrap
whenever possible.
In addition, for some commodities, such as agricultural products, output is highly
seasonal and is affected by the weather during the production cycle. Yet another
source of influence comes from the activities of various trade organisations such as
the International Coffee Organisation (ICO) in seeking to set a floor (and some-
times a ceiling) to prices, or the Organization of Petroleum Exporting Countries
(OPEC) in trying to control the price of oil. Finally, the trade in some commodities
is subject to price subsidies by governments or supra-governmental bodies, for
instance the Common Agricultural Policy (CAP), operated by the European Union.
To summarise, in terms of price behaviour, there are real differences between the
behaviour of commodities markets and that of other financial markets.
 There is a significant holding cost attached to a commodity due to warehousing,
insurance, interest charges, wastage, deterioration and, possibly, transportation.
Except when a supply shortage is expected in the future, the price of the com-
modity in the cash market is usually at a discount to the price for future delivery,
reflecting the costs of holding physical commodities over time. These costs are
made up of the costs of storage, insurance, wastage and lost interest on the phys-
ical holding – since no interest is earned on the commodity.
 As the supply available to the market changes erratically over time, there exists a
real possibility of short-term price rises occurring as the result of temporary
shortages of the physical commodity. The opposite is equally likely, with rapid
price collapses as gluts of deliverable commodities swamp the market. Wide
price swings are particularly true of the behaviour of terminal markets where the
actual delivery is delayed to the end of the contract period and where a supply
shortage in the physical commodity can create a squeeze, pushing up the cash
price of the commodity that is due to be delivered to buyers as speculators seek
to purchase in the physical market to cover their short positions. Supply shortag-
es can be made worse by the technical requirement that deliverable supplies be
stored in approved warehouses.
 Commodities may be subject to significant price abnormalities in the commodity
term structure that are due to the limited scope for substitution. Unlike financial

assets, which are held as investments in their own right, there is a value to a user
of having an assured supply of a commodity at hand and in the future. These
price abnormalities go by the name of convenience yields and are generally not
observed in markets trading in financial instruments. Note that convenience
yields are not directly observable. They can be seen by deviations in the market
price away from the theoretical price given by the cost-of-carry model.‡
Table 6.4 summarises how market forces affect the price of a commodity.
Table 6.4 The effect of market forces on the commodity price

Demand for commodity Supply of commodity
Users’ requirements for the commodity Producers supply
Speculators who anticipate a rise in the Speculators who anticipate a fall in the
commodity price commodity price
Shortage of immediately deliverable Excess supply of immediately deliverable
commodity (i.e. a decrease in ware- commodity (i.e. an increase in ware-
house stocks) house stocks)
Intervention by producer cartels or Intervention by producer cartels or
other regulatory body designed to shore other regulatory body designed to
up the commodity price (increase in reduce the commodity price (reduction
stocks held by official body) in stocks held by official body)
Increase in expectation of market Decrease in expectation of market
shortage (convenience yield rises) shortage (convenience yield falls)
The general market force dynamics of the different commodities markets are as
follows: price movements are determined by the balance of current demand and
supply, coupled to stocking and destocking by market participants. Added to this are
a mixture of technical factors such as (a) the availability of the commodity from
stockpiles, (b) the technical position of stocks held at exchange warehouses, (c) the
effect of speculative activity, which can have either a positive or a negative impact
depending on expectations of future price behaviour and (d) any real or perceived
threat of shortages in the physical commodity. The technical position of commodi-
ties markets is complicated because of the potential limit to the amount of the
commodity that is deliverable or made available at recognised warehouses, together
with the transportation and other costs associated with delivering additional stock to
meet contractual obligations. Because of the costs incurred in holding commodities,
the normal condition of the market is for the price for deferred, or future, delivery
to be higher than the current cash (spot) price in order to compensate. With soft
commodities there is a natural annual price cycle as the growing season advances
and the new supply position becomes clearer.
There are three groups who are affected by commodity price risk. The first are
the producers of these commodities. Their income and hence cash flows will rise
and fall with the prices at which they are able to sell their output. Their main
concern is that the price of the commodity will fall below their cost of production.
‡ The cost-of-carry model is discussed in detail in the Derivatives course.

For consumers, the problem is the reverse: they are concerned that the price will
rise significantly – as it has for crude oil, for instance, in the period since 2004 – and,
furthermore, that the supply of the commodity will be interrupted due to a break-
down in the market. Investors in commodities are treating these in the same way
they would treat investment in equities, fixed income or real estate, an asset class
that provides both diversification and a good return for the risks involved. Together
these three groups interact in the market to determine the spot price at any point in
time.
Have Investors Increased the Price of Commodities? __________
There has been a debate as to whether financial investors speculating or
diversifying their portfolios into commodities are partly responsible for the rise
in agricultural commodity prices. That is certainly the view held by the United
Nations, which in a 2010 report maintained that ‘a significant portion of the
increases in price and volatility of essential food commodities can only be
explained by the emergence of a speculative bubble’ (De Schutter, 2010).
Others are not so convinced, as those commodities that received the smallest
inflow of speculative flows during this period experienced the highest spike in
prices. Headey and Shenggen (2008) point out that the direction of causality is
weak, since a rise in the price of a commodity is likely to induce speculation. In
their considered view, there is no clear evidence as yet. A key determinant in
the period 2007–9 seems to have been the depreciation of the US dollar, the
currency in which commodities are traded globally.
The debate has highlighted the fact that there is a multitude of factors that affect
commodity prices and that speculation is only one of them. In many foodstuffs,
the margin between plenty and insufficiency is quite narrow, and minor shifts in
global production can lead to significant price swings. This is particularly evident
in the global demand and supply for oil, where the loss of one or more major
areas of production can push up prices significantly.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Learning Summary
This module has looked at two different kinds of market risk: those that affect
equities and those that affect commodities. Equity risk relates to the ability of firms
to manage the future economic performance of real assets. Problems arise in two
areas. One relates to how the market discounts the future cash flows and the
covariance of these cash flows to the market factor. The second area is firm- or
sector-specific shocks that affect the value of individual firms but not of other
equities. Complex analysis, often of a heuristic nature, is required to understand the
interrelated and complex package of the many different kinds of risk that are
included in equity ownership. These risks are far more wide-ranging than just
economic factors, including political risk, regulatory risk, legal risk, environmental
risks and so on.
Commodity risk is important since commodities often form part of the inputs or
outputs for many firms, either directly as raw materials or indirectly as a component

of intermediate or finished goods or services. As such, the risk has two sides. For
consuming firms in which such raw materials are an important factor of production,
their price risk has to be carefully managed. For producing firms, the revenues from
selling commodities can be subject to significant price swings, affecting profitability
and cash flows.
Equally, to investors they are potentially a separate investment asset class. Re-
gardless of the reasons for having exposures to commodities, there are a number of
special idiosyncratic factors that have to be considered when managing commodity
price risk. These include potential shortages of supply, the lack of close substitutes
leading at times to hoarding by consumers, which manifests itself through the
convenience yield and various kinds of official intervention to support or depress
the price.
Review Questions
6.1 The role of equity in corporate finance is to:

I. provide risk capital for the firm.
II. provide a real return to the providers of finance.
III. provide a claim on real assets.
IV. provide a claim on the firm’s assets.
A. I, II and IV.
B. I, III and IV.
C. II, III and IV.
6.2 Which of the following is correct? Changes in the market price of a share due to
systematic effects will depend on:
A. changes in a market-wide index.
B. important news about economic conditions.
C. important news about the firm.
6.3 Which of the following is correct? Specific risk is that element of a share’s risk due to:
A. changes in value of a market-wide index.
B. news about conditions in the economy.

6.4 BOC plc, the British industrial gases company, announces during the course of its
current financial year what its dividend will be for the following year. Which of the
following will be the effect on the company’s shares?
A. It has no effect.
B. It makes the shares less risky to hold.
C. It makes the shares more risky to hold.
D. It increases the price of the shares.
6.5 Which of the following is correct? All else being equal, the more debt in a firm’s balance
sheet:
A. the higher the financial risk and hence return required by shareholders.
B. the higher the business risk and hence return required by shareholders.
C. the higher the systematic risk of the firm and hence return required by
shareholders.
D. the higher the specific risk and hence return required by shareholders.
6.6 Which of the following is correct? Financial distress arises when a firm:
A. cannot meet maturing contractual liabilities.
B. has great difficulty in meeting maturing contractual liabilities.
C. has more current liabilities than current assets.
D. has too much debt in its balance sheet.
6.7 The main difference between commodities and other financial assets is which of the
following?
A. Commodities are traded globally, whereas financial assets are not.
B. Commodities are factors of production, whereas financial assets are not.
C. Commodities are denominated in negotiable currencies, whereas financial
assets are not.
D. There is no difference between commodities and financial assets.
6.8 A company has a beta of 0.7, equity of £150 million and debt of £50 million. The
corporate tax rate is 28 per cent. What will be the beta of the company’s shares?
A. 1.03
B. 0.94
C. 0.87
D. 0.75
6.9 The market volatility is 32 per cent. A firm’s equity beta is 1.2 and its specific risk is 25
per cent. What is the total risk of the shares?
A. 6.34 per cent.
B. 51.7 per cent.
C. 45.8 per cent.
D. 43.9 per cent.

6.10 A company has a share beta of 1.5, equity of £250 million and debt of £450 million. The
corporate tax rate is 28 per cent. What will be the firm beta? That is, what is unlever-
aged beta for the company?
A. 1.16
B. 0.83
C. 0.65
D. 0.60
6.11 Which of the following is correct? Commodity price risk arises because the prices for
commodities:
A. are denominated in a foreign currency (usually US dollars).
B. are based on fixed delivery points and users have to arrange for onward
delivery.
C. change in response to market forces.
D. refer to high-grade supplies, and lower-quality deliveries are usually sold for
less than the quoted price.
6.12 Some or all of the following apply to commodities but not to financial instruments.
I. Interest costs.
II. Storage costs.
III. Transportation costs.
IV. Delivery costs.
V. Quality factors.
A. I, II and IV.
B. II, III and IV.
C. II, IV and V.
6.13 The market price for North Sea crude oil for delivery in Rotterdam (the Netherlands)
due in one month’s time is $121.40/bbl and the current delivery price for North Sea oil
for spot delivery (i.e. immediate) is $120.15/bbl, landed at Aberdeen (Scotland). The
cost of delivery between Aberdeen and the Netherlands is 80¢/bbl and the one-month
US dollar interest rate is 4.5 per cent. Which of the following is the arbitrage that can
be made between the two prices?
A. There is no arbitrage.
B. 2¢ per barrel.
C. 8¢ per barrel.
D. 88¢ per barrel.

6.14 Some or all of the following types of commodities will have seasonal characteristics.
I. Precious metals, such as gold and silver.
II. Base metals, such as nickel and zinc.
III. Soft commodities, such as broiler chickens, copra and coconut oil.
IV. Energy commodities, such as crude oil and jet kerosene.
A. I and III.
B. II and III.
C. III and IV.
6.15 Which of the following is correct? In a commodity market not subject to supply
shortages, we would expect that:
A. early delivery months are less expensive than later delivery months.
B. early delivery months are more expensive than later delivery months.
C. all delivery months are at the same price.
D. some delivery months have higher prices than others but there is no pattern to
the prices.
6.16 The spot price of a commodity is $500/ton. The cost of storage is 0.25 per cent of the
dollar value per year and the interest rate is 12 per cent per year. The commodity is not
subject to deterioration or loss in storage. The one-month forward price is quoted in
the market as $506.25. Which of the following is the market’s opinion about the future
availability of the commodity?
A. Future supplies of the commodity will be freely available.
B. Future supplies of the commodity will be somewhat unreliable or disrupted.
C. Future supplies of the commodity will be significantly disrupted.
D. The market is making no judgements about the future availability of the
commodity.
6.17 Which of the following is correct? Convenience yields arise in commodities because
consumers:
A. wish to hold the commodity in anticipation of a price rise.
B. wish to sell the commodity in anticipation of a price fall.
C. wish to hold the commodity in anticipation of a future shortage of the com-
modity.
D. wish to hold the commodity in anticipation of a future glut of the commodity.
6.18 Which of the following is correct? The market risk is that element of risk in ordinary
shares (common stocks) that is due to:
A. changes in value of a market-wide index.
B. news about conditions in the economy.

6.19 Which of the following is not a specific risk?

A. An industrial accident.
B. The takeover of one firm by another.
C. The appointment of a new chief executive.
D. The decision by the central bank to raise interest rates.
6.20 Which of the following is correct? All else being equal, if a company were to retire debt
from its balance sheet:
A. shareholders would require a higher return than before.
B. shareholders would require the same return as before.
C. shareholders would require a lower return than before.
6.21 Which of the following is likely to be the effect on the future delivery price of cocoa if
the Ivory Coast (a major producer) announces that bad weather has adversely affected
the local crop?
A. There is no effect.
B. The price of future delivery cocoa will rise.
C. The price of future delivery cocoa will drop.
D. There is insufficient information to answer the question.
Case Study 6.1: Banking

Consider a bank that, like most banks, is financed largely by debt with a little equity. The ratio
of debt to equity is about 9:1. The bank’s business is to lend money to customers. What might
be the major risks facing shareholders in the bank? What sort of reassurance from the bank’s
management about the way they manage their operations would they need to have in order to
reduce or eliminate such fears?
1 List the major risks and the reassurances that the bank’s managers might provide to
shareholders.
Case Study 6.2: Copper

1 Consider the copper market. Use a market report from a financial newspaper, such as
the Financial Times or the Wall Street Journal, as the basis of an analysis of the current
state of the market in copper.

References
Chan, K.C. and Chen, N. (1991) ‘Structural and Return Characteristics of Small and Large
Firms’, Journal of Finance, 46, 1467–84.
De Schutter, O. (2010) ‘Food Commodity Speculation and Food Price Crises’, United Nations
Briefing Note 2, September 2010.
Headey, D. and Shenggen, F. (2008) ‘Anatomy of a Crisis: The Causes and Consequences of
Surging Food Prices’, Agricultural Economics, 39, supplement, 375–91.
Levis, M. (1989) ‘Stock Market Anomalies: A Reassessment Based on UK Evidence’, Journal
of Banking and Finance, 13, 675–96.
Reinganum, M.R. (1992) ‘A Revival of the Small Companies Effect’, Journal of Portfolio
Management, 18 (Spring), 55–62.
Stoll, H.R. and Whaley, R.E. (1983) ‘Transaction Costs and the Small Firm Effect’, Journal of
Financial Economics, 12, 57–79.

Module 7
The Behaviour of Asset Prices

Contents
7.1 Introduction.............................................................................................7/1
7.2 The Price-Generating Process for Financial Assets ............................7/2
7.3 Understanding Volatility ..................................................................... 7/18
7.4 Describing the Price-Generating Process ......................................... 7/28
Appendix to Module 7: Statistical Measures of a Probability
Distribution .......................................................................................... 7/37
Learning Objectives
This module looks at the behaviour of asset prices over time. How asset prices
change is an important consideration in managing financial market risks.
After studying this module, you should be able to understand the essential fea-
tures of asset price behaviour, namely that:
 asset price changes are random; that is, they cannot be predicted;
 the price-generating process or distribution of price changes follows what is
known as a stochastic process and, for modelling purposes, can be treated as
having a lognormal distribution;
 the process and nature of asset price volatility can be modelled using statistical
methods.
7.1 Introduction
In the UK, advertisements for financial products normally end with the rather
deflating proviso that ‘the value of investments can fall as well as rise’. To any casual
observer or student of, say, the stock market, this is easily borne out by the daily
evidence. On some days share prices rise; on others they fall. The key question
facing any budding investor is whether there is any way that these changes can be
predicted. Many people have tried to devise ingenious methods for predicting share
prices but have failed. Analysing share price behaviour with the most powerful tools
at our disposal suggests that share prices are essentially random in nature. This is
what, of course, makes stock market investments ‘risky’. That is not to say that, ex
post, over the long run share prices are not linked to underlying economic factors –
they are. However, the immediate direction and magnitude of the price change – be
it a rise or a fall – is, so far as we know, unpredictable. That said, the overall

Module 7 / The Behaviour of Asset Prices
behaviour of share prices and other financial asset prices is not. We can observe that
the returns obtained from holding such investments largely conform to a normal
distribution (in point of fact, a lognormal distribution), a type of behaviour observed
in many other economic and natural phenomena. The caveat ‘largely’ is necessary
because there is some discrepancy between the actual data and the theoretical
properties of the normal distribution. In particular, there is a higher incidence of
extreme price changes or jumps and, at the same time, more small price changes
than are to be expected. This has prompted a number of researchers to suggest that
the price-generating process should be described as something other than a normal
distribution. While these alternative theories as to the price-generating process are
interesting, for simplicity and exposition the assumption of normality will be
retained as a convenient approximation in this module when we look at the price-
generating process in detail.
7.2 The Price-Generating Process for Financial Assets

Understanding how the price-generating process behaves is important for measuring
risk. Our earlier discussion of the different financial risks has already alluded to the
way prices move in a financial market and the way this affects individuals and firms.
We can think of a series of financial prices, such as 100, 102, 101, 99, 100, 98, 97,
99, being reported in the press on consecutive days. What these represent are
simultaneous purchases and sales by market participants. Visually, there is a strong
relationship between the prices over time, and this would be evident if we were to
graph them as shown in Figure 7.1.
102
101
100
99
Price
98
97
96
95
94
Time
Figure 7.1 The time–price graph of a theoretical financial asset price

However, from an investor’s perspective, it is the changes in price that matter,

since it is the return or gain from holding the asset over time that is important. If we
take the simple first differences in price, namely the difference in price for time t
and that for time t – 1, we have +2, −1, −2, +1, −2, −1, +2 for the original data.
For Days 1 and 2, where the price is initially 100 and then goes up to 102, the
difference is +2 (102 – 100). This is shown in Figure 7.2.
Gains
2.0
1.5
1.0
0.5
0.0
–0.5
–1.0
–1.5
–2.0
Losses
Time
Figure 7.2 Price changes for the theoretical asset
The price changes in Figure 7.2 show less relationship than the time–price series
in Figure 7.1. Adding more data points will demonstrate this, and to do so we will
use real financial data. The graph in Figure 7.3 shows the behaviour of the British
pound against the US dollar over time in the same way as our fictional series is
shown in Figure 7.1.§ It too suggests a high degree of predictability in the exchange
rate over time. However, when we take the first differences in prices from time t to
t – 1, we obtain a highly unpredictable result, as is demonstrated in Figure 7.4.
§ Recall that we discussed currencies and currency risk in Module 5.

1.62
1.60
1.58
1.56
1.54
1.52
1.50
1 5 8 13 16 21 26 29 34 37 42
Figure 7.3 The time trend for the British pound against the US dollar
Note: The exchange rate is expressed in American terms; that is, the number of dollars
per British pound.
1.00
0.50
0.00
1 3 6 8 12 14 16 20 22 26 28 30 34 36 40 42
–0.50
–1.00
–1.50
Figure 7.4 The natural log percentage price changes for the US dol-
lar/British pound exchange rate shown in Figure 7.3
Note: The reason for using the natural log of price changes is explained in Section 7.2.1.
In Figure 7.4, the price changes follow no predictable pattern and in fact have
been described as a random walk, although a more technically correct description
would be geometric Brownian motion.** What we find is that over time the price
departs or ‘diffuses’ away from the current price in a random fashion. The further
away in time we go, the further the price is likely to have moved from today. If we
look at the exchange rate, it starts close to $1.60 = £1 at t = 0. A little later, it is still
close to this rate. However, by the end of the time series, the exchange rate has
fallen to around $1.54, a change of 4 cents. The random walk theory in financial
markets has been likened to a drunkard who is unsure which direction to move in
and tends to meander around his point of origin, each direction being chosen
haphazardly and having little pattern or consistent duration. So what the random
walk predicts is that tomorrow’s price will be close to today’s price, but that the
** A random walk and Brownian motion are both mathematical models for stochastic processes. Changes
in price over time follow just such a stochastic process, and it is a matter of determining the underlying
mathematical model that best describes this. This is beyond the scope of this course.

prices in one week, one month, or longer will be progressively further away from
today’s price. We cannot predict in which direction they will have moved, only that
the likelihood of larger movements increases with time.
7.2.1 Calculating Price Changes

To model the behaviour of prices, we are not so much interested in the level of the
price – that is, the value of the asset we are observing over time – as we are interest-
ed in the changes in the price. These price changes can be described in a number of
different ways. As shown earlier, we can take the first differences in the prices or we
can calculate the percentage price change and so on. An important point to note is
that, in most cases, the price change is bounded on the lower side by a fall to zero,
at which point the asset becomes worthless, whereas the upward potential gain is
theoretically unlimited. The exception to this is perhaps foreign exchange, where,
even in a hyper-inflating currency, there will always be some value against which it
can be exchanged for other, sounder money.
One way in which we could look at prices is to take the price change or differ-
ence from observation to observation as our measure. So, if the price was 120 on
Day 1 and then moved to 125 on Day 2, it has changed by a value of +5. However,
such a change would have a very different meaning if the price on Day 1 had been
5, since the change would have represented a doubling in price.†† In this respect,
simple price differences are a flawed measure of what is happening to the price,
since they require us to know the underlying price in order to be meaningful.
In order to measure the risk of assets, we want a measure of the magnitude of
price (or value) changes over a given time period that is independent of the price
and can be used to compare the risk and behaviour of different assets. A simple
approach would be to turn the changes into percentage returns. Our example above,
when the price changed from 120 to 125, would have had a daily percentage change
of 4.17 per cent and, when the price was 5, a more extreme change of 100 per cent.
There is, however, a problem in using percentages. We might expect that, if the
price of an asset had moved up by 10 per cent and then down by 10 per cent, the
net change would be zero. In fact, taking just the percentage return in this case
would be misleading: an asset with a price of 100 that increased by 10 per cent
would then have a price of 110; if it subsequently decreased by 10 per cent it would
have a price of 99.‡‡ The reason for this discrepancy is that the percentage return is
based on the previous price and not on the initial starting price. If we had used the
starting price for the price increase and decrease, we would have got back to 100
and got the correct answer. We can get around the problem of percentages by using
the price relative to measure changes, as shown in Equation 7.1:
Price relative ﴾7.1﴿
†† If the initial price had been 5 and the difference was also 5, the price for the next period must be 10,
double the price of the period before.
‡‡ With the up price we have 100 × 0.10 = 10, so the price becomes 110. Ten per cent of 110 is 11
(110 × 0.10 = 11), so the price is then 99.

In our asset with an initial price of 100, the price relative is therefore 1.1
(110/100) and 0.9091 (100/110), so that we return to our starting point. The price
of 100 becomes 110 when we multiply it by 1.1, and the price of 110 multiplied by
0.9091 equals 100, which takes us back to where we started, as we want. So using
price relatives will eliminate the percentage change problem. However, they need to
be chained together (technically they are a geometric series). The computational
formula to determine the average return for a set of n price relatives is found by
Equation 7.2:
∏ ﴾7.2﴿
where it is the price relative as previously defined, Π is the mathematical symbol for
multiply and then the nth root of the product is taken. For the initial two-period
example, we would therefore compute the geometric average return as:
0 √1.1 0.9091 1 ﴾7.3﴿

or, in terms of the change in initial and terminal values, as:
100 100 √1.1 0.9091 ﴾7.4﴿

This gives us the earlier result we got, in that the price returns to the starting
point of 100. The use of price relatives and chaining them together as a geometric
series gives us the correct answer. In principle, we could estimate the behaviour of
asset prices using price relatives. There is, however, a simpler approach that builds
on the use of price relatives and involves the use of natural logarithms (to the base e
= 2.71828). This also has two important advantages that make this solution to how
to calculate returns the preferred choice.
To calculate returns using natural logarithms, we do two things. First, we calcu-
late the price relative of the two prices at time t and t – 1. This simply involves us
dividing the price at time t by the price at t – 1. So, for the price change from 100 to
110, we have the price relative of 1.1. The second step is to convert this into its
natural logarithm by calculating the ln(1.1), where ln is the natural logarithm, which
gives us a value of 0.09531. Note that this is close to the percentage return of 0.10
we calculated earlier.
Recalculating our example with the change now expressed in natural logs gives
the results shown in Table 7.1.
Table 7.1 Price changes using natural logarithms (to the base e =
2.71828)
Price change Natural logarithm
ln 0.0953
ln − 0.0953
Sum of the changes 0.0000

The result indicates that the change in price (or return) is equal but opposite in
the two cases and that the sum of the two is zero, as we require. After two periods
there is no gain or loss and the return is zero (our price is back to 100).
As mentioned earlier, converting returns into log returns provides two ad-
vantages. The first advantage of logarithms over price relatives is that they allow us
to use addition and subtraction (as in Table 7.1). Thus by using logs we can calculate
many useful statistics, such as the mean return of a series and its dispersion using
standard statistical techniques. Another advantage is that the logarithmic return
values we obtain, as above, have an immediate identity to our intuitive understand-
ing of returns. For small price changes (of below 5 per cent), the natural logarithm
and percentage change give nearly the same result. If the price change had been
from 100 to 102, we would have had a natural logarithm with a value of 0.0198,
which is just about equal to the percentage return of 2 per cent. The logarithm of
return is slightly smaller because it implies a continuous change over the period; that
is, the return is being continuously compounded. We will look at this in more
detail in the next section.
7.2.2 Log of Returns as a Description of Asset Price Behaviour

As discussed in the previous section, the term ert provides the continuously com-
pounded rate of return on an asset; that is, the gain accruing with continuous
compounding. It is as if interest, or return, were being added at every moment.
Continuous returns take the concept of interest to its ultimate conclusion, namely
that interest is being added every instant. If interest is paid annually – that is, once a
year – then for whatever nominal interest rate is quoted the actual interest element is
credited once a year. If the interest is paid quarterly, the interest is credited four
times a year. Although the nominal rate of interest for these two periods may be
quoted as the same, the effective rate of interest, when interest is being paid
quarterly, will be higher than that for the once-a-year interest. This is because the
quarterly interest can be reinvested to earn interest on interest. To see this, let us
assume that the interest rate is 10 per cent per year for both the quarterly and the
annual interest and that the amount involved is £1000. It is conventional, when
interest is paid more than once a year, to express the interest rate as a per cent per
year by multiplying the periodic interest rate by the number of periods in the year.
So, if interest is paid quarterly (four times per year) and is 10 per cent, this means
that the quarterly rate of interest is 2.5 per cent (2.5% × 4 = 10%). When the loan
amount is £1000, the two alternatives will pay returns as shown in Table 7.2. The
interest is simply the amount, £1000, multiplied by the interest due. For the quarter-
ly interest that will be £1000 × 2.5% = £25 each quarter, and for the yearly interest
£1000 × 10% = £100. Note that the sum of the two is the same; it is their timing
that is different and that affects the effective return investors get from these two
alternatives.

Table 7.2 Payment flows on an annual-pay and a quarterly-pay

investment, both quoted at 10 per cent
Loan Q1 Q2 Q3 Q4
Annual 1100
Quarterly 25 25 25 1025
The price relative for the annual loan will be 1.1 (£1100/£1000), but because the
quarterly loan pays out £25 after three months, which can then be reinvested, we
have a quarterly price relative of 1.025 (£1025/£1000). That is, if the loan was for
three months only, the total repayment would be £1025 (£1000 principal and £25
interest) divided by the initial outlay of £1000. Alternatively, we can use the return,
the interest divided by the principal, and add 1 ([25/1000] + 1).
We can calculate the equivalent annual interest rate using the following equation:
Equivalent annual interest rate 1 1 ﴾7.5﴿
where r is the rate expressed as an annual rate, (i.e. Periodic rate Frequency); and f
is the frequency, which is 1 for annual pay, 2 for semi-annual pay, 4 for quarterly pay
and 12 for monthly pay. So, if r is 10 per cent, we have:
0.10 4
1 1 10.38%
4
This comes to 0.1038 or 10.38 per cent; the 0.38 per cent difference between the
quarterly and the annual interest alternatives represents the beneficial compounding
or interest-on-interest effect of being able to reinvest the £25 received quarterly for
the second and subsequent quarters. In money terms, the quarterly compounding
result gives an extra £3.80 over the year for the £1000 loan above that available on
the one-year interest frequency.§§
Alternatively, we could use Equation 7.2 to provide the quarterly equivalent of
the annual interest alternative; that is, the rate of interest required with quarterly
compounding to give the same terminal value when interest is paid yearly (the
quarterly compounding interest rate that gives exactly the terminal value of £1100
after one year). This rate is the fourth root of the price relative, minus 1, and then
converted into a percentage:
2.41% √1.1 1 100 ﴾7.6﴿

The annual equivalent is 9.64 per cent (2.41% × 4). Note that it is the convention
when discussing interest rates to express them in terms of their per-year rate,
regardless of the term. So, if the period was only three months, we would still be
talking of a three-month loan that pays 9.64 per cent per year.
§§ Note that this advantage only applies if the quarterly interest payment is fixed and the reinvestment
rate is, in fact, 10 per cent. In the case of a loan, as we observed in Module 4, where the interest rate is
reset every quarter, the outcome is dependent on the prevailing interest rate at the start of Quarters 2, 3
and 4. Hence the interest rate risk characteristics of the two are potentially very different.

Taking the analysis further, we can see the effect in Table 7.3 of shortening the
interest payment interval from one year to once a quarter to daily, and then finally
continuously. As the interest period is reduced, the effective rate of interest paid
goes up. (Or, equally, the annual percentage rate goes down, since in order to match
the return gained from having interest paid once a year we only need a quarterly
interest rate of 9.646 per cent to give us the same terminal value.)*** The highest
possible effective interest rate is when it is added continuously, a process known as
continuous compounding or the force of interest. In practical terms, continuous
compounding is virtually equivalent to daily compounding.†††
Table 7.3 The effect of the compounding interval on the nominal

interest rate of 10 per cent and the annual equivalent rate
Number of compounding Effective interest Annual nominal
periods in the year rate (% per rate (% per
year), given a year), given an
nominal annual effective annual
rate of 10% target rate of
10%
1 – annual 10.00 10.00
2 – semi-annual 10.25 9.76
3 – tri-annual 10.33 9.68
4 – quarterly 10.38 9.65
6 – bi-monthly 10.43 9.61
12 – monthly 10.47 9.57
52 – weekly 10.51 9.54
365 – daily 10.5156 9.5323
Continuously compounded rate ert 10.5171 9.5310
Note: The actual difference between daily compounding (10.5156 per cent) and continu-
ous compounding (10.5171 per cent) at 10 per cent is 0.0015 per cent. A one-year
interest rate of 10 per cent is equivalent to a continuously compounded rate of 9.5310
per cent.
The effective interest rate is calculated as:

1 1
while the annual nominal rate is simply the periodic interest times the number of
periods in the year (rperiodic × n).
*** The annual percentage rate is simply the periodic rate multiplied by the number of periods in the year
that interest is paid.
††† Note that there are some mathematical advantages to using continuous interest or compounding that
mean that, for the more advanced financial modelling, this is the norm, although it is not the normal
usage in financial markets.

Converting Interest Frequencies _____________________________

A spreadsheet explaining how to convert interest frequencies is available on the EBS
course website.
To convert from a higher-frequency-pay interest (for instance semi-annual-pay
interest) to the equivalent effective lower-frequency-pay interest (for example,
annual interest), allowing for the effect of compounding, we apply the following
formula:
﴾7.7﴿
1 1
where rSA is the nominal semi-annual rate, f is the frequency and rE is the
effective rate. For example, to convert a 5 per cent semi-annual-pay interest
into its equivalent annual interest:
.
1 1 5.0625%
That is, to be no worse off compared to a 5 per cent semi-annual-pay invest-

ment, we would need to receive 5.0625 per cent per year when interest is
credited annually.
Equally, we can convert lower- to higher-frequency payment using:
1 1 ﴾7.8﴿
For example, to convert an annual effective interest of 5 per cent to its quarter-
ly annual nominal rate:
¼
1 0.05 1 4 4.9089%
We would be no worse off from holding a security that pays 5 per cent per year
paid annually as against a security that pays 4.9089 per cent per year paid
quarterly.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
A feature of the use of the natural log conversion of the price relative that is
most useful if we are using weekly or monthly observations rather than daily ones is
how continuous compounding relates the longer return to each sub-period (days or
weeks). By converting the weekly or monthly price relative into continuous returns
in relation to time, we effectively obtain a series of one-day (or -week) returns. If we
have a monthly continuous return of 10 per cent per year, the daily equivalent is
0.0274 per cent (0.10/365 × 100%), which is also 10 per cent per year (0.0274%
× 365 = 10%).
To determine the return, regardless of the period over which we measure (e.g.
daily, weekly, monthly, yearly), we convert this observation frequency into a
continuous rate of change. So, if we are observing prices monthly and find that the
average return per month is 1.755 per cent, we can express this as an annual rate of
21.06 per cent (1.755 × 12). The continuous monthly return is 1.7398 per cent
(ln(1.01755)), or a continuously compounded annual return of 19.1116 per cent

(ln(1.2106)). This continuous variable approach is one way in which the price-
generating process can be characterised.‡‡‡
There is another virtue in using the natural logarithm of returns, and that relates to
the distribution of the returns. With a continuous stochastic process, the return and
hence the underlying price can take any value within a certain range. For a discrete
variable process, only certain discrete values are allowed. One advantage of converting
price changes to a continuous process is that continuous probability distributions can
be used to estimate the likelihood that a return (and hence the future price) will fall
within a given parameter. Such a distribution is readily available for variables given a
log transformation and is known as the lognormal distribution.
There is considerable empirical evidence, which will be discussed in Section 7.4,
to suggest that the lognormal distribution provides a reasonable approximation to
the observed behaviour of financial asset prices. The lognormal distribution also fits
the earlier condition of financial market price behaviour that the value of changes is
bounded on the downside by zero. This is indeed the case for the lognormal
distribution, which has a skewed function, bounded by zero on the left side of the
tail but with an infinite right-sided tail.
Let us see how the price-generating process works if we have an asset with a
current value of 100 and the price-generating process provides a rise or fall of 5 per
cent per period. The price relative (future price/current price) will be 1 plus the
return in the case of a price increase (1.05) or its reciprocal (1/1.05 = 0.954) when
the price drops. The price P at the next period will be either P(1.05) or P(0.9524).
Substituting by U = 1.05 and D = 0.9524, we have PU and PD. If we plot this price
behaviour on the condition that the price must go either up (U) or down (D) at each
point and for each price at each period, Table 7.4 shows the price drift that we can
expect over an eight-period time span.
‡‡‡ This is the approach used by Black and Scholes in deriving an analytic solution to the problem of
option pricing. This is discussed in the Derivatives course.

Table 7.4 Price changes for an asset with a 5 per cent per period price
change
0 1 2 3 4 5 6 7 8
147.7
5
140.7
1
134.0 134.0
1 1
127.6 127.6
3 3
121.5 121.5 121.5
5 5 5
115.7 115.7 115.7
6 6 6
110.2 110.2 110.2 110.2
5 5 5 5
105.0 105.0 105.0 105.0
0 0 0 0
100.0 100.0 100.0 100.0 100.0
0 0 0 0 0
95.24 95.24 95.24 95.24
90.70 90.70 90.70 90.70
86.38 86.38 86.38
82.27 82.27 82.27
78.35 78.35
74.62 74.62
71.07
67.68
Note: The price change follows a binomial distribution with a 0.54 chance of obtaining a
rise and 0.46 of a fall.
Table 7.4 shows that, when the asset price can move either up (U) or down (D),
the initial price of 100 is followed after one period with a price of either 105 or
95.24. In subsequent periods the price range gets greater – as with a random walk as
discussed earlier – so that in Period 2 the price can have reached 110.25 or fallen to
90.70. After all eight periods, the range of prices goes from a low of 67.68 to a high
of 147.75. These are the extremes, but to get to these points the price had to either
fall continuously or rise continuously over all eight periods. It is far more likely that
the price will be around the 100 mark – but how far away will be a function of the
stochastic process. The model in Table 7.4 follows what is known, as in the binomi-
al distribution. This is one of many types of probability distributions and one that,
when the number of observations is very great, approximates to the normal distribu-
tion.

Price changes from period to period are taken to be independent. In fact, the
specific condition is that they are independent and identically distributed (iid). This
is the case since we know that the price increase U and price decrease D are the
same throughout our table. So, if we calculate the price relative for Period 7 to
Period 8 for the lowest price in Period 7, we have 74.62/71.07 = 1.05 and
67.68/71.07 = 0.9524.
Given the fact that the price can only go up (U) or down (D), at the end of the
first period we have two prices, PU and PD (henceforth we will simply refer to
these as U and D). Since the probability of getting two consecutive price move-
ments is independent, we find that, after two periods, we have the following
possible outcomes: UU, UD, DU, DD. To work out the likelihood of getting these
outcomes (one of which we will get with certainty), we need to know the likelihood
of a price increase and of a price decrease. For this discussion, we will assume that
the probability of a price increase is 0.54 and of a price decrease 0.46 (1 – 0.54).
Returning to the likelihood of the price rising over two consecutive periods (that is,
we observe UU), the chance of two consecutive upward movements is 0.54 × 0.54,
or 0.2916; in the same way, the likelihood of two consecutive downward move-
ments is 0.2116 (0.46 × 0.46). Then, by elimination, the chance of getting both UD
and DU is 0.4968 (1 – (0.2916 + 0.2116)). That is, there is a strong possibility that
the price will be unchanged after two periods. Note that we could simply sum two
possible paths, namely UD + DU, which is 0.54 × 0.46 + 0.46 × 0.54 =
0.2484 + 0.2484 = 0.4968.
Now we move to three periods, the situation is more complicated as we have
more potential ‘paths’: UUU, UUD, UDU, DUU, DDU, DUD, UDD, DDD. The
potential outcomes are shown in Figure 7.5.
The probability of getting three consecutive upward price movements is now
(0.54)3 or 0.1575. The probability of three downward movements is (0.46)3 or
0.0973. The probability of two ups and a down (in any order, i.e. UUD, UDU or
DUU) is 0.4024 (0.1341 × 3 paths) and of two downs and an up (again in any order,
i.e. DDU, DUD or UDD) is 0.3428 (0.1143 × 3). Note that the chance of a price
increase (that is, of two out of three changes being a price increase, i.e. the sum of
U3 and all the combinations of UUD, etc.) is 0.1575 + 0.4024 = 0.56. So the price is
slightly more likely to be higher than the original value of 100 after three periods.
UUU
UU
U UUD, UDU, DUU

UD, DU
D DDU, DUD, UDD
DD
ρU = 0.54
ρD = 0.46 DDD
Figure 7.5 Binomial tree with three periods

If we plot the probabilities for each terminal point of the binomial tree and their
corresponding prices at the end of the eighth period, we would see that they range
from the low price 67.68 (which is 0.468 = 0.002) on the downside and up to 147.75
on the upside (0.548 = 0.0072). The likelihood of getting seven Us and one D is
0.547 × 0.46 = 0.0062. However, there are many more opportunities for this
combination to occur since the price could initially fall then rise for seven periods;
rise for one period then fall and then rise for six periods, etc. This gives us eight
possibilities, so the combined likelihood is 0.00062 × 8 = 0.0493. Note that, as we
would expect, the probability of getting a higher price is larger on the upside than
the downside. This is because there is not an equal probability of getting a price fall
or a rise. A histogram of the asset prices, shown in Figure 7.6 (derived from Table
7.4 and calculating the probabilities of each outcome at t = 8 based on combining
all the possible price paths for each ending value), indicates that there is a skewness
to the distribution based on the greater probability of getting a higher price. What
Figure 7.6 shows is that there is a greater likelihood of the price being 100 or above
after eight periods than of it being 100 or less. However, because the process is
stochastic, we do not know for certain whether, starting at t = 0, the price will be
higher or lower at t = 8. What we can say is that the likelihood of it being higher is
greater than the likelihood of it being lower.
Probability (%)
0.30
0.27
0.25
0.25
0.18 0.20
0.15
0.15
0.08 0.10
0.05
0.05
0.02
0.00 0.01
0
67.68 82.27 100.00 121.55 147.75

Asset price
Figure 7.6 Distribution of the asset price after eight periods
Now, if we extend our analysis and include the return earned on the asset over
the eight periods, we would have the histogram shown in Figure 7.7. While a
binomial distribution with eight steps is still very granular, it is already showing signs
of conforming to the (log)normal distribution.

Probability (%)
0.30
0.27
0.25
0.25
0.18 0.20
0.15
0.15
0.08 0.10
0.05
0.05
0.02
0.00 0.01
0
–39.03% –19.52% 0.00% 19.52% 39.03%
Asset return (log of)
Figure 7.7 Distribution of asset return (log of) after eight periods
The distribution increasingly resembles that for the lognormal distribution as we
add further steps. In Figure 7.8, the earlier analysis is extended to 25 periods. This
now shows a much more definite bell-shaped distribution for the range of terminal
values.

Probability
0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0
29.53 48.10 78.35 127.63 207.89 338.64
Asset value
Figure 7.8 Distribution of asset value after 25 periods
As with our earlier analysis and as shown in Figure 7.7, Figure 7.9 shows the
return on the asset. After 25 periods or ‘steps’, the distribution of asset price
changes is beginning to approximate that of a normal (or lognormal) distribution.
There is a much greater probability of obtaining a result close to the mean of the
distribution, and large price changes are correspondingly rare.

Probability
0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0
–112.22% 73.19% 34.15% 4.88% 43.91% 82.94% 121.98%
Asset return (log of)
Figure 7.9 Distribution of the asset return (log of) after 25 periods
How well does this model conform to reality? Figure 7.10 is a histogram of actual
share prices from a company that have been turned into log returns and then
graphed as a histogram of returns. What this shows is that this empirical data
matches the pattern generated by our model. However, and as we shall discuss later,
there are some divergences compared to the normal distribution, in particular with
the excessive number of observations around the peak and in the tails of the
distribution.
Before moving on to discuss the nature of volatility – that is, the dispersion of
price changes that is observed in Figure 7.8 and Figure 7.9 – it is worth noting the
fact that, for the eight-stage process, under our simple binomial diffusion model the
maximum and minimum prices allowed are 67 and 148. By the time we get to 25
steps, the range is 29 to 339, even if the chance of getting such extreme results is
very small! Recall that it is the diffusion rate, or the 5 per cent change per period,
that gives this result. If we had used a smaller diffusion rate, the spread of outcomes
would have been less – in essence that is what volatility is: a measure of the diffu-
sion process of asset prices over time.

400
350
300
250
Frequency
200
150
100
50
0
–0 4
–0 3
–0 2
1
–0 0
–0 9
–0 8
–0 7
–0 6
–0 5
0
01
02
03
04
05
06
07
08
09
10
.0
.0
.0
.0
.1
.0
.0
.0
.0
.0
0.
0.
0.
0.
0.
0.
0.
0.
0.
0.
–0
Return
Figure 7.10 Histogram of daily share prices for a company ( = 3210 daily
observations)
7.3 Understanding Volatility

As we have already argued, it is changes in financial asset prices, in interest rates, in
exchange rates and in commodity prices that create risk. Volatility is the term that is
commonly applied to measure the price or, more correctly, dispersion in the rate of
return seen in assets and financial markets. We can illustrate the idea using a simple
analogy. If, over a given time period, an asset with a price range of £80 to £120 is
compared to another asset that is traded between £75 and £125, we would describe
the latter as being ‘more risky’ than the former. To put it simply, the asset with a
price range of £75 to £125, a difference of £50, has more uncertainty in relation to
the range of its outcomes than the asset with a range of £80 to £120, a difference of
£40. Volatility provides the quantification of this price-dispersion relationship.
Discussing asset risk in terms of volatility also removes the scale or price effect,
so that assets with different prices can be readily compared. For instance, a price
range of £10 would imply a highly volatile asset if the asset price was £20, but only a
modest volatility if the price was £200.
Any examination of historical data will disclose that individual assets and asset
classes show periods of high volatility and low volatility. There is no ready explana-
tion for these changes, but it is important to understand that the historical record
provides only a potential guide to future risk in this context.

7.3.1 Volatility and Value

Let us now consider a simple example of volatility, so that the concept becomes well
understood. Let us consider two assets that both have a current price of 100. Over a
given time frame the price can rise or fall in value by 1 for the first asset and by 2
for the second. This means that in the next period the value will be either 101 or 99
for the first asset and 102 or 98 for the second asset. The relationship is shown in
Figure 7.11. The current value of the asset will be its expected value, which is the
weighted average of the possible future outcomes.§§§ The assumption behind
expected value is, of course, that the event is repeated sufficiently often that each
outcome takes place in proportion to its statistical probability.
Panel A:
Asset with one-point volatility
Expected asset price
101 0.5 0.5 x 101
100
99 0.5 0.5 x 99
100
Panel B:
Asset with two-point volatility
102 0.5 0.5 x 102
100
98 0.5 0.5 x 98
100
Figure 7.11 Asset price volatility with one period

Figure 7.11 applies a 50 per cent probability or chance that the price will rise or
fall to 101 or 99 in the case of the asset with one-point volatility and to 102 or 98 in
the case of the asset with two-point volatility. In both cases, the weighted average
outcome, or the expected asset price, is 100. For the one-point volatility asset, the
calculation is 101 × 0.5 + 99 × 0.5. Note that, whether the price moves by one or
two points, the expected value is the same in both cases; volatility has no effect on
the expected price.
A single-period case may be considered rather simplistic. If the price behaviour is
extended to two periods, we have three possible outcomes, as shown in Figure 7.12,
which is how we characterised the behaviour of asset prices in Section 7.2. The
probability or chance of getting a price of 102 after two periods is 0.5 times 0.5, or
0.25, since the price must rise both in the first period with a probability of 0.5 and in
§§§ The expected value of any asset will simply be:

E V ∑
where i is the ith possible outcome and vi and pi are the value of the outcome i and the probability of
outcome i occurring.

the second with a probability of 0.5.**** However, the chance of getting an un-
changed price after two periods will be along two different paths: either an initial
increase followed by a decrease, or a decrease followed by an increase; that is,
(0.5 × 0.5) + (0.5 × 0.5), or 0.5. Given the diffusion tree, you will notice there is a
greater tendency for the asset price to remain close to the existing price.
Panel A: Asset with one-point volatility

102 0.25 0.25 x 102
101
0.5 100 0.50 0.50 x 100
100
0.5 99
98 0.25 0.25 x 98
100
Panel A: Asset with two-point volatility

104 0.25 0.25 x 104
102
100 0.5 100 0.50 0.50 x 100
0.5 98
96 0.25 0.25 x 96
100
Figure 7.12 Asset price with two periods

Extending our analysis slightly, we have in Figure 7.13 a four-period example
with our asset whose price can change by one point per period.†††† If we look at the
price behaviour, we can see that, as we move into the future from Period 1 to
Period 4, the probabilities of getting very high or very low prices decline. A price
increase or decrease is equally likely in the next period. However, from the present
to the end of Period 4 there is only a 6.25 per cent chance of getting a price of 104
or 96 in our example, and we are still more likely to get a price close to the original
value. Equally, there is no change to the expected value of the asset, as calculated in
Table 7.5. We can generalise from this observation and say that the current price of
the asset embodies all future values weighted according to the probability of their
occurrence.
**** A simple rule for calculating probabilities is that, when one outcome is dependent on the other (as in
this case), the probabilities are multiplied together; when they are independent (as in Figure 7.12), they
are summed.
†††† You may care to draw the same ‘tree’ for the two-point asset.

Asset price value with four periods and one-point volatility
T=1 T=2 T=3 T=4
104
103 0.0625
102 0.125
102
0.25
101 101 0.25
0.5 0.375
100 100 100
0.5
99 99 0.375
0.5
98 0.375
98
0.25
97 0.25
0.125
96
0.0625
Figure 7.13 Asset price with four periods
Table 7.5 Expected value from the range of outcomes in Figure 7.13
after four periods – one-point volatility
Asset price Probability (ρ) Expected asset price
104 0.0625 0.0625 × 104
102 0.25 0.25 × 102
100 0.375 0.375 × 100
98 0.25 0.25 × 98
96 0.0625 0.0625 × 96
1.0 100
Now let us move forward in time to the first period and take the case where the
price of the asset has increased to 101. The new range of outcomes is shown in
Figure 7.14, but starting at the new price of 101. The spread of potential outcomes
by the end of Period 3 has now narrowed to a high of 104 and a low of 98. The
dotted lines in Figure 7.14 now show those outcomes that, given the asset’s volatili-
ty, are no longer possible. If the opposite situation had occurred, with the asset price
falling to 99, the top end of the tree would have been impossible and the new price
range would be 102 to 96. Given that we have moved forward one period, we now
have a new set of probabilities for the different outcomes. These are given in Table
7.6. Note these probabilities remain the same whether the asset price had risen or
fallen.

Asset price value with three periods and one-point volatility
T=1 T=2 T=3
104
103 0.125
0.25
102 102
0.5
101 101 0.375
0.5
100 100 100
0.5
99 99 0.375
0.25
98 98
0.125
97
96
Figure 7.14 Range of outcomes for the asset price in Figure 7.13 with one
fewer period and when the asset price at time T+1 has in-
creased to 101
Table 7.6 Expected asset price from Figure 7.13

104 0.125 0.125 × 104
102 0.375 0.375 × 102
100 0.375 0.375 × 100
98 0.125 0.125 × 98
96 – –
1.0 101
If, for the analysis in Table 7.6, we used the asset with two-point volatility per
period, we would have a new range of outcomes, as shown in Figure 7.15. In this
case, after four periods, we have a potential high of 108 and a low of 92. However,
as with our one-period example, the expected value of the asset is still 100 today, as
shown in Table 7.7, given that the probabilities of price changes remain unaltered.
Asset price value with four periods and two-point volatility
T=1 T=2 T=3 T=4
108
106 0.0625
104 0.125
104
0.25
102 102 0.25
0.5 0.375
100 100 100
0.5
98 98 0.375
0.5
96 0.375
96
0.25
94 0.25
0.125
92
0.0625
Figure 7.15 Asset price with two-point volatility and four periods

Table 7.7 Expected asset price for Figure 7.15

108 0.0625 0.0625 × 108
104 0.25 0.25 × 104
100 0.375 0.375 × 100
96 0.25 0.25 × 96
92 0.0625 0.0625 × 92
1.0 100
Finally, in Figure 7.16, we have the situation where the price with three periods is
at 101, as with the one-point volatility asset, but now the volatility is two points per
period. Again, the expected value is 101, as shown in Table 7.8, as we might have
surmised from the earlier discussion, but the range of prices is now from a high of
107 to a low of 95.
Asset price value with three periods and two-point volatility
T=1 T=2 T=3
107
105 0.125
0.25
103 103
0.5 0.375
101 101
0.5
99 99
0.5
97 0.375
0.25
95
0.125
Figure 7.16 Asset with three periods and a price of 101
Table 7.8 Expected value for the asset in Figure 7.16

107 0.125 0.125 × 107
103 0.375 0.375 × 103
99 0.375 0.375 × 99
95 0.125 0.125 × 95
1.0 101
In the above discussion, the theoretical or expected value of the asset was calcu-
lated from the prices that were created from the assumptions made about the
probability of a price increase or decrease and the price change allowed at each step.
In reality, the future is unknown and the price change is not limited, as with our
model, to a fixed price change up or down. Also, the size of the price movement
may not be constant over time.
What it does show is that changes in volatility will lead to an increase or decrease
in the possible prices that we may expect to see for the asset as the price goes up

and down in response to new information. New information is likely to increase or

decrease the volatility of the asset as this encapsulates the future uncertainty
surrounding the value of the asset, which is embedded in the current price of the
asset.
A final point in relation to the working out of the expected asset price is that
there are two components driving the asset value. The first is the range of values
that can be assumed at the end of the tree; the second is the probabilities attached to
this range. For market participants, changes in assessments of both these factors
over time will change the current value, since both will have an impact on the
expected asset price.
To round off our discussion, we can say that it is not the known distribution that
led to the expected value of the asset, as we do not know what this distribution is,
but it was the expected distribution of price changes that gave us the asset’s
current value. Most practitioners refer to the distribution of expected prices as the
asset’s volatility. Formally, volatility is a measure of the dispersion of the returns
over some specified period. This is normally calculated using the standard deviation
of return using the standard formula from statistics, namely:
﴾7.9﴿
∑
Market participants also distinguish between four kinds of estimate of volatility:

historical volatility, future volatility, expected volatility and implied volatility.
7.3.2 Historical Volatility

Historical volatility is a measure of the dispersion of actual asset price movements
over a given time period in the past. As a measure, historical volatility is the annual-
ised standard deviation of daily return. Two assets with different annualised
standard deviations of daily returns based on the same historical price behaviour
would be considered to have different risks. If the first asset had a standard devia-
tion of 12 per cent per year and the second asset, 15 per cent, we would consider
the second asset to be ‘riskier’. That is, the price behaviour of the second asset
exhibits greater uncertainty.
While historical volatility is a useful way of thinking about asset price behaviour,
it may suffer from the problem of extrapolation if used to predict how the asset will
behave in the future. To use it, we have to assume that the future will be more or
less like the (recent) past.
That said, historical volatility is used in many cases, since, in the absence of vola-
tility-changing developments, the past volatility is likely to continue into the future.
We will see later on, in Module 9, that, for regulatory purposes, historical volatility is
used when determining the confidence limits on value-at-risk calculations.

7.3.3 Implied Volatility

Options are volatility-sensitive instruments, and their price is greatly determined by
the volatility that is expected to prevail over the life of the option. Where option
markets exist, it is possible to obtain a value for the volatility implied from their
prices. This implied volatility is the market consensus as to the future potential
distribution of outcomes that may exist over the life of the option. The approach
involves ‘backing out’ the volatility in observed options prices using an option-
pricing model as shown in Figure 7.17.* In essence, this involves running an
option-pricing model backwards to find the volatility that goes to make up the
option’s market price. Typically, five factors go into the pricing of an option: the
asset price; the strike or exercise price; the maturity, life or tenor of the option; the
short-term interest rate over the life of the option; and the asset’s volatility. Given
that all the pricing factors other than the asset’s volatility are observable and
generally agreed upon, the approach allows the market’s consensus estimate forecast
of the actual volatility to be derived. The market price of the option will balance
those who think that the volatility used to price the option is too low (and hence
you would purchase options, as these are trading below their implied volatility)
against those who think the volatility in the price is too high (and hence would sell
options). Implied volatility is that volatility that justifies the current market price of
an option.†
Option valuation Deriving implied volatility from

using an option-pricing model an option-pricing model
Option’s
market price
Asset price Asset price
Tenor Tenor
Option- Option-
Interest Interest
pricing pricing
rate rate
model model
Strike Strike
price price
Volatility Volatility
Option Implied
value volatility
Figure 7.17 Deriving the implied volatility from volatility-sensitive

instruments
Implied volatility may be a better estimate of future volatility than historical vola-
tility if the market, as a whole, believes that there may be significant value-shifting
information or events over the life of the option. For instance, we may have a long-
run estimate for the volatility of a particular stock that is based on a one-year
* The exact details of how an option-pricing model works are discussed in the elective course Derivatives
and are beyond the scope of this course.
† We will ignore the existence of what is termed the ‘volatility smile’. That the volatility seems dependent
on the relationship between the asset price and strike price is an unfortunate, complicating factor.

analysis. If the industry or sector is, however, undergoing sudden change, the actual
underlying volatility may be, in reality, higher than that given from the historical
data.
To understand what implied volatility means, re-examine Figure 7.13 and Figure
7.16. In the first figure, the volatility was one point. In the second, we have a
situation where, for the first period, the volatility was one point, but it now rises to
two points over the remaining three periods. In the first case, the range of outcomes
is from a high of 104 to a low of 96, whereas in the second the high is 107 and the
low 95. The increase in volatility has widened the possible range (and hence
dispersion) of the future outcomes. A volatility-sensitive instrument, such as an
option, will capture this change in the spread of potential outcomes (that is, the
expected volatility) through a change in price of the option, even if the market price
of the asset may not have changed – or only changed by a small amount.
7.3.4 Forecast Volatility

In some situations, rather than attempt to forecast asset prices, it makes more sense
to forecast the volatility of asset price behaviour. This applies, for instance, with
options where it is necessary to price correctly the volatility of the underlying asset
or instrument. The price risk can be hedged, in the absence of market imperfections,
in such a way that the option writer is compensated for the costs of dynamic
hedging.*
The methods used to forecast volatility include economic, fundamental and tech-
nical analysis. One simple idea is a volatility cone that is based on past volatility
estimates over time and gives a confidence limit to the term structure of implied
volatility derived from traded option prices. Such a volatility cone is illustrated in
Figure 7.18.
Volatility
Volatility confidence limits
Implied volatility from traded options
Maturity
Figure 7.18 Term structure of volatility and a volatility cone
* At its simplest it involves the writer remaining delta neutral throughout the option period. If the option
has been correctly priced, the writer should end up with the anticipated trading spread. Note that each
rebalancing of the delta hedge will involve transaction costs and other costs.

7.3.5 The Cause of Volatility

Volatility arises because market participants reassess the value of an asset in re-
sponse to new information that affects its future cash flows and the risk in those
cash flows. Recall that, in an efficient market, the price of an asset reflects known
information about the asset. As new information is received, views about the value
of the asset change. As a result, its price changes as the balance of market forces
changes.
New information in the form of economic, business, political and foreign news
will have an impact on the asset price. For the same news, the impact will be
different, depending on the exact nature of the asset. For instance, an oil company
will have exposure to the oil price. News from the Middle East about events in that
region is likely to affect any assessment of the company’s worth, since this is the
major oil-producing region in the world. The same news is likely to have a lesser
impact on a different type of company, say a supermarket chain. Consequently, the
nature of the new information over time and the structural exposure of the firm to
changes in economic, business, political and foreign factors that the new infor-
mation conveys will dictate the degree of price change in a given period for the
particular firm. Other firms will have different exposures, and hence the differences
in risk.
It has also been noted that financial asset prices tend to be more volatile during
trading hours.* Although the arrival of new information may be expected to occur
continuously, we would expect price changes to be the same whether an asset is
being traded or on non-trading days. Yet empirical research shows that there is
more volatility during trading days than at weekends. This would suggest that
trading itself creates volatility! Although this is possible, such an approach does not
fit well with the efficient markets hypothesis.
Understanding Volatility: An Analogy ________________________
In seeking to explain the source of volatility, we find that one cause is trading
itself. To try and understand how trading might be a factor, without negating the
concept of an efficient market, it is useful to use an analogy. We may think of
the observed asset price volatility seen in the market as being equal to traffic
flows. We know, from observation, that in most cities there are two peaks in
traffic that happen during the morning and evening rush hours. We might
therefore conclude that the arrival of the morning and the evening created
traffic. We would be partially correct: but we also know that the heavy traffic
seen in the morning and evening rush hours is the result of a large number of
people going to and returning from work. In that sense, city rush hours are an
observable phenomenon of another effect, people moving from home to
workplace and back.
We can consider trading and higher volatility in the same way. Trading hours
somehow encapsulate the movement of asset values. We are observing price
* See, for instance, Fama (1965), French (1980) and French and Roll (1986).

volatility from trading when what we would really like to see is market partici-
pants’ (unobservable) revaluation of asset prices.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
The above discussion suggests that, when we estimate volatility from past data,
we need to be very careful in using any historical estimate. Some of our assessed
volatility is caused by the act of trading itself. As a result, most users of volatility (as
in options pricing) take into account the fact that volatility is higher during trading
days and will calculate it using trading days only and annualise it with the following
equation:
Annualised volatility Volatility per trading day ﴾7.10﴿
No. of trading days per year
There are 365 or 366 days in the year, and we would expect 260 of those days to
be trading days, but we would find that there are only 252 trading days when we
allow for the normal number of national holidays in a year (eight days) that occur in
most Western countries.*
7.4 Describing the Price-Generating Process

As discussed earlier, the behaviour of asset prices has often been described as a
‘random walk’. That is, the past price is no guide as to the future price and prices
appear to move randomly. Statisticians call such random behaviour stochastic.
When looking at financial market price behaviour, there has been considerable
research into the exact nature of this dynamic process, which has led to a number of
alternative models being put forward to describe the price behaviour that we
observe in financial markets.
The Markov process is characterised by the fact that the current (today’s) price
is the only useful variable for predicting the future price. That is to say that asset
prices with the Markov process have ‘no memory’. Such a model is consistent with
the weak-form efficient market hypothesis. Observing past price behaviour does not
allow market participants to generate abnormal returns. Note that this does not
mean that using information on the dispersion or volatility of past price behaviour is
a useless exercise. This model of price behaviour states that observing past behav-
iour will not lead to excess returns. For instance, using technical analysis methods to
predict price changes will be useless.
* National holidays are often called ‘bank holidays’, as the banks will be shut on those days. Typical
holidays in Europe include Christmas, New Year’s Day and so on.

A variant on the Markov process for the price-generating process assumes that
prices follow a Weiner process. There are two basic requirements that must be
fulfilled for the behaviour of price changes to be characterised as a Weiner process.
First, the change in price for a given period (r) must be:
√ ﴾7.11﴿
where Φ is a random variable drawn from an independently and identically distrib-
uted (i.i.d.) normal probability distribution that has a mean of zero and a standard
deviation equal to 1 (0, 1). The important criteria here are that the values for r and
Δt over any two short time periods are independent. The main problem with the
Weiner process is that it assumes that the mean of the returns is zero, yet we know
that assets, such as equities, rise over long periods of time.
The generalised Weiner process addresses the problem, as it includes a ‘drift’
term. This includes a deterministic growth term as well as the random term. In
discrete time, this can be expressed as:
√ ﴾7.12﴿
The deterministic element is aΔt, and the stochastic element is √ . The coef-
ficients a and b are constants.
A further stochastic process is known as an Ito process, which allows both
coefficients a and b to change over time in a modified Equation 7.12.
A special case of the Ito process that is generally referred to as geometric
Brownian motion (GBM) allows a practicable way of modelling asset price
behaviour. This assumes some form of trend to the price, caused either by inflation
or by a positive return per period of time and some random variation around the
trend. Typically, such a model of price behaviour is formulated as:
√ ﴾7.13﴿
where ∂P is the change in price (P) for some short period and μ is the continuous
rate of change for the asset.
If asset prices change in discrete time, we can rewrite Equation 7.13 so that the
price change for a given small time interval will be as follows:
√ ﴾7.14﴿
The model states that, for a small time period (Δt), the change in the asset price
(ΔP) will be a random variable drawn from a standard normal distribution (Φ) where
the term μ is the expected return per unit of time on the asset and the volatility of
the asset price (σ). A key feature of this model is that it assumes that the behaviour
of asset prices is normally distributed.
Empirical evidence on the statistical properties of financial asset prices suggests
that the assumption of normality of returns (or, more correctly, lognormality of
returns) is a reasonable approximation to the observed price behaviour. Figure 7.19
shows a histogram of the monthly percentage returns for the British market using

an index. To show how well this data matches to normality, a normal distribution
with the same mean (μ) and standard deviation (σ) is shown behind the histogram.
An examination of the two distributions shows that the histogram distribution
generally conforms to a normal distribution, a result that corresponds well to the
results of other empirical studies of asset price behaviour. However, Figure 7.19 and
other studies show that the distribution has ‘fat tails’ (that is, more extreme observa-
tions than would be predicted by the normal distribution). The excess of large price
changes is coupled with an overabundance of observations around the mean, a
condition known as kurtosis. Therefore, the observed distribution, although nearly
normal, has some non-normal characteristics. To explain why the observed pattern
of returns differs from the normal distribution, a number of different hypotheses
have been put forward.
Note excess
250
of observations
around the mean
200
Normal distribution for comparison

150
100 Note shortage of

observations in middle
of distribution
Note existence of
50 extreme outliers
0
-0.27 -0.16 -0.05 0.06 0.17 0.28 0.39 0.50
Figure 7.19 Distribution of price changes

In risk management terms, the knowledge that there may be a larger number of
outlying observations than predicted by the normal distribution creates what is
known as tail risk and has led to the use of the stress test approach to managing
risk, which we discuss in Module 9. A stress test recognises that, while most
observations can be characterised via the use of the normal distribution and an
asset’s or portfolio’s volatility (that is, the standard deviation of return), this is less
satisfactory for extreme price movements. There is a much greater probability of
these extreme movements occurring than would be predicted by the normal
distribution. This tail risk is a particular problem in analysing financial markets, since
there is a much greater number of events that are at the extreme end of the distribu-
tion than allowed for in the normal distribution. The solution to this observed
deviation from what would be predicted involves separating the distribution of price

changes into two components. The first might be considered normal market
conditions, and hence the use of volatility as a measure of risk in these circumstanc-
es provides a satisfactory indicator of the risks. However, to address the abnormal
and extreme price behaviour evident in the markets requires a different approach
that involves modelling extreme price events via scenarios or simulation.* These go
by the generic term stress test.†
7.4.1 Deviations from the Assumption of the Normal Distribution

In many statistical analyses and applications, it is convenient to assume that the
underlying process follows a normal, or lognormal, distribution. As Figure 7.19
shows, there are departures from true normality in the case of financial data. In
looking at the figure of asset price changes, we can identify the following factors.
 There are more observations around the mean than are expected in a normal
distribution. That is, the distribution is peaked.
 There are fewer observations around the slope of the distribution than are to be
expected in a normal distribution. That is, there is an absence of mid values in
the data when compared to what the normal distribution would lead us to ex-
pect.
 There are more extreme outlier observations than expected (the distribution is
said to have ‘fat tails’); this is a characteristic known as kurtosis.
 Asset returns are often negatively skewed. That is, there are more observations
to the left of the mean than to the right.
 Returns have small autocorrelations. That is, the likelihood of a positive (nega-
tive) return in the next period is greater if the current observed return is positive
(negative). The values are quite small, but they indicate that there is some trend-
ing in the data.
The above differences suggest that financial market data are not well represented
by the normal distribution. This is in contrast to many natural phenomena where
the normal distribution provides a good ‘fit’ to the observed data. The fact that
market data does not conform to a normal distribution process has led to the
development of alternative models about the nature of the price-generating process
underlying financial assets. This is a big subject, and what follows is a short sum-
mary of the different approaches. The important point to absorb is that, although
the normality assumption is convenient – and essential for most parametric ap-
proaches – observed price behaviour is not fully explained by the use of the normal
distribution, and the assumption that the price-generating process follows the
normal distribution can create surprises in a risk management context. In fact, when
the asset return distributions do not conform to the normal, this can lead to the
* Note that some complex techniques exist that make no assumption about the nature of the
distribution, nor assume other kinds of distribution. However, many sophisticated models, such as that
used by RiskMetrics™, assume normality for computational purposes.
† This comes from the fact that, when markets become ‘stressed’ due to high conditions of uncertainty
(for instance the eurozone crisis), there are more extreme movements than normal. We will look at
stress testing approaches in Module 9.

wrong choice of portfolio, the underestimation of the potential for extreme losses
or mispricing of certain derivative securities. Consequently, models using other
distributions and models that allow securities to ‘jump’ have gained popularity
among financial market practitioners.
The non-normal alternatives can be classified in two ways. First, there are those
distribution models that are time independent (that is, the price-generating mecha-
nism is independent of past price behaviour). The second category comprises
conditional distribution models that assume that volatility (and hence the price-
generating distribution) is, in some sense, time dependent. This second class of
distributions takes as a starting point the fact that the data are not independent and
identically distributed (i.i.d.). The major classifications of the approaches are
summarised in Table 7.9.
We have already discussed the normal and lognormal distributions. Given the
difficulties in reconciling observed data to the normal distribution, a serious
contender that explains the observed phenomena is the compound distribution.
When two normal distributions with different standard deviations are combined, we
have a compound distribution with the required characteristics observed in financial
prices (that is, showing kurtosis), as shown in Figure 7.20.
Table 7.9 Alternative models for asset price behaviour

Type of price-generating process Model
Time independent (volatility is not conditional on Finite variance class:
past price behaviour)  Normal distribution
 Compound normal distribu-
tion
 Student’s t-distribution
 Mixed-diffusion jump
distribution
Infinite variance class:

 Symmetric stable Paretian
distribution
 Asymmetric stable Paretian
distribution
Time dependent (volatility is conditional on past Auto-regressive class:

price behaviour)  Normal distribution
 Student’s t-distribution
Stochastic volatility:
 Normal distribution
 Student’s -distribution
 Generalised error distribu-
tion

Asset returns
Figure 7.20 Compound normal distribution

Note: When the peaked and flat thin-lined distributions are combined, the thick-line
distribution is formed. This has the characteristics of fat tails observed in financial asset
return distributions.
The compound normal model suggests that over time (and as observed) the
volatility of the underlying price-generating mechanism changes. We therefore see a
compound distribution, as in Figure 7.20, that has the required kurtosis. As a model
it follows common sense and the earlier observation that volatility changes over
time. A particular asset may either exhibit periods of instability in relation to its
future value or have a definite trend. For instance, the start-up of a new business
will have considerable risk. As the business matures, its riskiness, and hence the
spread of expected values for the business, is likely to decline. In the same way,
shares in a company or the exchange rate are subject to different levels of uncertain-
ty and hence differences in the underlying volatility. Thus what we observe when we
analyse the data is several different underlying distributions that, when observed
together, produce the observed fat tails.
We also observe major price changes that should not be present if the price pro-
cess is normal. The assumption for the normal distribution is for prices to change
by small amounts – not in large jumps. Consequently, an alternative and equally
appealing model is the mixed-diffusion jump distribution. The mechanics of such a
model, in its binomial distribution form (which makes it easier to explain and show
visually), are illustrated in Figure 7.21. In this ‘mixed’ model, for most of the time
the price diffuses as predicted by the normal distribution but may have occasional

‘jumps’ in response to some value-shifting event. These jumps can either increase or
decrease the expected value and lead to sudden shifts in the distribution, which,
again, shows up in the observed ‘fat tails’ of actual data sets. There is empirical
support for jumps in the case of the release of new significant information, such as
the announcement of major financial transactions, like takeovers, or major political
developments, like a military coup.
Asset price
binomial
‘diffusion’ Asset price
‘jumps’
Figure 7.21 Mixed-diffusion jump process (binomial form)

Note that the compound normal and mixed-diffusion jump process models have
much in common. With the compound normal, the variance is shifting over time,
whereas, with the mixed-diffusion jump process, these shifts are instantaneous. As
mentioned, jumps are occasionally observable in financial prices, for instance in the
reaction of a stock price to a takeover bid where the price ‘jumps’ to the offer level
or above in response to the news.
An alternative approach is to assume that price behaviour belongs to a set of
distributions with infinite variances. While intellectually appealing, these models
make the use of statistical techniques to model risk somewhat problematical. Even if
the true underlying distribution is of this variety, for practical purposes we would
still need to assume parametric characters to the observed data for computational
purposes.
Another approach has evolved from the requirements to model volatility for
option-pricing purposes. These models seek to ascertain not whether the price
behaviour as such is predictable but whether the volatility of the time series shows
evidence of predictable behaviour. If a market or other specific shock occurs, we
can expect a jump in volatility (that is, the future becomes more uncertain). As the
news is digested, the behaviour of asset prices begins to revert to a more normal
pattern and observed volatility returns to its long-run equilibrium. Such a process is
illustrated in Figure 7.22.

Implied
volatility
Observed volatility
Shock
pushes up
implied
volatility
Long-run average volatility
Time after event
Figure 7.22 Effect of shocks or ‘price-moving events’ on volatility

Time-dependent models seek to look at how volatility changes over time. Where-
as actual price changes may not be predictable, the future uncertainty encapsulated
in volatility might be. If the rate of reversion is predictable, then future levels of
volatility can be predicted. We can think of these models as modelling uncertainty
and can interpret them in the following intuitive way. If an event occurs that upsets
(or stresses) a market, the value placed on assets is affected. That is, uncertainty over
the future paths assets can take increases. As time progresses, the asset prices can
only take on certain values (recall the discussion in Section 7.3.1). As these values
are realised, the future uncertainty surrounding payoffs and their probabilities is
adjusted in the light of the new information in a variance-reducing fashion. That is,
the market’s consensus over the distribution of future outcomes is tightened. As a
result, as we move further away in time from the shock that generated the increased
uncertainty, and more information is received after the event, the volatility declines
to a normal uncertainty level.
7.4.2 How the Price-Generating Process Affects Risk Management

The above non-technical overview of the price-generating processes driving
financial asset prices suggests two practical results for the risk manager.
 First, a statistical approach to risk management will be successful in capturing
most of the stochastic behaviour of asset prices. As an approximation, the nor-
mal or lognormal distributions provide a reasonable description of the
probabilities surrounding future outcomes.
 Second, observed departures from normality are a feature of financial markets.
We can observe situations where markets become stressed and undergo signifi-
cant value shifts over short periods of time. These radical moves are not well

captured in a distribution model, nor are they readily open to be forecasted using
current mathematical techniques.‡
The problems that stem from the observed behaviour of asset prices consequently
require the risk manager to adopt two different approaches to risk assessment. The
first involves using statistical modelling, forecasting and other quantitative tech-
niques, whereas the other involves scenario analysis based on ‘worst-case’ situations.
This is the approach suggested by, for instance, the RiskMetrics™ system, but
equally it is found in all value-at-risk models.§
In the following modules we will look at both modelling and scenario building
and, in the case of the latter, in particular the worst-case approach used in what is
known as a ‘stress test’.
Learning Summary
This module has examined the nature of the price behaviour of assets. The im-
portant relationship from a modelling point of view is not the change in price but
the asset’s return. From a conceptual perspective, the natural logarithm of price
relatives provides a measure of the continuous rate of change in the asset price.
Changes in prices lead to differences in return. The dispersion of such changes is
generally known in financial markets as volatility. Specifically, volatility is the
annualised standard deviation of daily returns.
The module also looks at the sources of volatility. Volatility occurs as a result of
changes in the factors affecting asset value. This arises from macro- and microeco-
nomic factors, such as changes in exchange rates, interest rates, commodity prices
and cash flows. It is also due to news that affects the current and future prospects
for individual assets, sectors or whole markets. Changes in volatility arise from a
revaluation of the range of outcomes that are expected in the future together with
the probabilities that are attached to these. The wider the range of potential future
prices, the greater the volatility.
Although it is convenient to assume that asset returns follow a normal or
lognormal distribution, there is considerable empirical evidence that asset returns
may be non-normal. A number of alternative formulations for asset price-generating
processes have been put forward, including, inter alia, infinite variance, mixed-
diffusion jump, compound normal and stochastic volatility models. The implications
of non-normal behaviour are that standard statistical techniques must be used with
care and that adjustments must be made to take account of observed price behav-
iour.
‡ This is not to say that there are no methods available to try to do so. An example is Paul Wilmott’s
Crashmetrics model (2007).
§ See, for instance, Chew (1996).

Appendix to Module 7: Statistical Measures of a Probability

Distribution
This appendix lists the statistical measures of a distribution used for risk assessment
purposes by JP Morgan’s RiskMetrics™ system, which is in the public domain and
for which up-to-date information is available (reproduced by permission).
Series individual items

Range Minimum, maximum of daily rate changes (Xi)
Count Number of data points: N
Mean Sum of daily rate changes divided by count
∑
Mode Most frequent rate change in the series
Measures of dispersion
 Standard deviation: Indication of the width of the distribution of changes
around the mean.
 1.65 STD: Assuming a normal distribution, 90 per cent of observations are

contained between −1.65 and +1.65 standard deviations of the mean. We can set
any number of standard deviations and find the percentage of observations that
fall within or without this range. So, for instance, we could set 1.96 standard
deviations, which gives us 95 per cent – and so on.
 Kurtosis: Characterises the relative peakedness or flatness of distribution
compared to normal distribution. Positive kurtosis implies fat tails.
∑
 Skewness: Characterises the degree of asymmetry of the distribution around its
mean. Positive skews indicate asymmetric tail extending toward positive values
(right-hand side). Negative skewness implies asymmetry toward negative values
(left-hand side).
∑

Review Questions
7.1 Which of the following is correct? Asset prices have been described as following a
random walk. This means that:
A. the price from period to period should reverse itself, price increases being
followed by price declines, but not necessarily of the same magnitude.
B. the price will change with time in an unpredictable fashion.
C. the price tomorrow will be different from today’s price, in a largely predictable
fashion.
D. the price from period to period should increase or decrease steadily over time,
although there is some chance price increases (or declines) will be followed by
price declines (or increases).
7.2 Which of the following is correct? The natural logarithm of the price change from 450
to 440 is:
A. −0.0225
B. 0.0225
C. 0.9778
D. 1.0227
7.3 An investment is stated as having a flat rate of 20 per cent when it pays interest
monthly. Which of the following is the true annual rate to investors?
A. 18.37 per cent.
B. 20 per cent.
C. 21.94 per cent.
D. 240 per cent.
7.4 Which of the following is the growth of an investment of £10 000, where interest is
credited quarterly, when held for 15 months when interest rates are 11 per cent (to the
nearest £)?
A. £11 375
B. £11 405
C. £11 453
D. £11 745
7.5 Ashley Finance offers two alternative investments, the ‘prime account’, where interest is
credited monthly, and the ‘savers account’, where it is credited every half-year. The
prime account states that investors will get 14.00 per cent annual percentage rate on
their holding. The savers account states that holders will get an effective 15.05 per cent
per year on their holding. Which of the following is correct? The accounts:
A. offer the same rate of interest.
B. allow prime account holders to earn more than savers account holders.
C. allow savers account holders to earn more than prime account holders.
D. do not provide enough information to determine the outcome.

7.6 If, in Question 7.5, Ashley Finance now switches the way it indicates its interest rates on
offer on its two accounts to annual percentage rate (APR) pricing, which of the follow-
ing will be the effect on the posted interest rate differential between the two accounts
to two decimal places?
A. There will be no change to the differential.
B. The differential will widen.
C. The differential will narrow.
D. There is not sufficient information to determine the outcome.
7.7 Which of the following defines the term ‘force of interest’?

A. The effect on borrowers of having contractually to agree to pay interest.
B. The power of compounded interest to ‘grow’ a sum over time.
C. The effect of reducing the compounding interval on the terminal value.
D. The way that market forces equilibrate the demand and supply of money
through the interest rate.
7.8 In a binomial asset price model for the price drift, if the chance of getting a price
increase is 0.509, which of the following is the probability of getting three consecutive
falls?
A. 0.118
B. 0.132
C. 0.50
D. 0.509
7.9 If the distribution model in Question 7.8 has a price change of 1.5 per cent and a
starting price of 500, which of the following will be the price if there are three consecu-
tive falls?
A. 478.2
B. 457.6
C. 455.0
D. 350.0
7.10 Which of the following is correct? Volatility is a measure of:

A. how uncertain we are about the future price that an asset will take.
B. the standard deviation of annualised returns on an asset.
C. the rate of dispersion on an asset.
7.11 If an asset can take three values in the future: a price of 150, with a probability of 0.45, a
price of 110, with a probability of 0.20, and a price of 90, which of the following is the
asset’s expected value (to the nearest whole unit)?
A. There is not enough information to determine the asset’s expected value.
B. 114
C. 117
D. 121

7.12 In a four-period tree when the asset price at time zero is 600 and the price change per
period is 10, which of the following will be the highest and lowest prices that will exist
at the end of the four periods?
A. 610–590
B. 620–580
C. 630–570
D. 640–560
7.13 If, in Question 7.12, the probability of a price rise is 0.505, what is the probability that
the price will be below 600 at the end of the fourth period?
A. 0.063
B. 0.250
C. 0.305
D. 0.495
7.14 If, in Question 7.12, time has moved forward one period (that is, there are now three
periods), which of the following is the possible range of prices at the end of the third
period if the price move to Period 1 involved a decline in the price?
A. 630–590
B. 630–580
C. 620–570
D. 620–560
7.15 Which of the following is the meaning of the term ‘implied volatility’ when applied to
asset prices?
A. It is the dispersion of future returns (as measured by the standard deviation)
calculated from the historical price series.
B. It is the dispersion of future returns (as measured by the standard deviation)
calculated using a forecast of future volatility.
C. It is the dispersion of future returns (as measured by the standard deviation)
found by using an option pricing model to derive the price at which volatility is
being bought and sold in the market.
D. It is the dispersion of future returns (as measured by the standard deviation) by
interpolating the volatility for different maturities in the future.
7.16 ‘Volatility’ is the annualised standard deviation of daily returns. If the volatility of asset A
is 0.25 and that of asset B is 0.30, which of the following is correct?
A. Assets A and B have equal risk.
B. Asset A is less risky than asset B.
C. Asset B is less risky than asset A.
D. It is meaningless to talk of differences in risk in this context.

7.17 Which of the following is correct? If the volatility of an asset were to change, it follows
that:
A. the asset price will change but not the price of an option on the asset.
B. the asset price will not change but the price of an option on the asset will.
C. neither asset price nor the price of an option on the asset will change.
D. the asset price may change but the price of an option on the asset will change.
7.18 Some or all of the following factors might lead implied volatility to be higher than
historical volatility.
I. The past is no guide to the future.
II. Rapid developments are taking place in the fundamentals of the asset.
III. Significant new information is expected in the future.
IV. Recent past observed volatility has been extremely low by historical standards.
A. I.
B. II and III.
C. III and IV.
7.19 If we calculate that the daily volatility of an asset during trading days is 0.04, the
annualised volatility would be which of the following?
A. 0.63
B. 0.76
C. 10.08
D. 14.60
7.20 For a risk manager, the knowledge that the observed distribution of returns on a
particular asset has more observations in the ‘tails’ than are evident in a normal
distribution would mean that:
I. the risk manager cannot use the normal distribution as a proxy for the price-
generating process.
II. it only allows the risk manager to approximate the likelihood of price changes using
the normal distribution.
III. the risk manager is required to use other techniques to model the extreme price
behaviour of the asset.
IV. the risk manager is required to transform the distribution so as to make it conform
to the normal distribution.
A. I and IV.
B. II and III.
C. II and IV.
D. III and IV.

7.21 Observed price changes differ from the normal distribution by having:
I. no variance (standard deviation).
II. more observations close to the mean.
III. fewer observations close to the mean.
IV. more observations with extreme values.
V. fewer observations with extreme values.
VI. more observations to the left side of the mean.
VII. more observations to the right side of the mean.
VIII. a distribution that is made up of several underlying distributions.
A. I.
B. II, IV and VI.
C. III, V and VII.
D. VIII.
7.22 Which of the following is correct? The skewness of a normal distribution is a measure
of:
A. the frequency between observations in a sample. A distribution is more skewed
if the time lapse between observations is increased.
B. the degree to which the sample distribution has more extreme values than
would be predicted.
C. the degree to which the sample distribution has more values to the right or left
of the mean.
D. the number of observations used to derive the statistics of the sample distribu-
tion. A distribution is more skewed the fewer the observations used in the
sample.
Case Study 7.1: Diffusion Trees

Construct two diffusion trees with eight periods (i.e. seven steps from now). The first should
have a diffusion rate that is 2.7 per cent per period. The second should have a price change of
3 per period. Both should have a starting price of 100.
1 Consider the results of the two trees. What are the major differences in the result from
using a return change and a price change?
2 If the probability of a rise is 0.505, what will be the probability of getting a price (a) at
the end of the eighth period above 110 and (b) at or below 85?
3 Draw the histogram of prices to their probability for the tree at the end of the eighth
period. Do the same for the returns, using natural logarithms.
4 Calculate the expected return and standard deviation (volatility) of the price series at
the end of the eighth period. To do this you will need to use the log return from the
tree. The mean return and standard deviation of return are found from the following
equations:

 The mean is found by:
∑ 1
 The standard deviation is found by:
where ρi is the probability of the occurrence of return i.
References
Chew, L. (1996) Managing Derivatives Risk: The Use and Abuse of Leverage. New York: Wiley,
Frontiers in Finance.
Fama, E. (1965) ‘The Behaviour of Stock Market Prices’, Journal of Business, 38 (January), 34–
105.
French, K. (1980) ‘Stock Returns and the Weekend Effect’, Journal of Financial Economics, 8
(March), 55–69.
French, K. and Roll, R. (1986) ‘Stock Return Variances: The Arrival of New Information
and the Reaction of Traders’, Journal of Financial Economics, 17 (September), 5–26.
JP Morgan (1995) RiskMetrics™ – Technical Document. 3rd edn. New York: Morgan Guaranty
Trust Co.
Wilmott, P. (2007) Paul Wilmott Introduces Quantitative Finance. Winchester: John Wiley & Sons.

PART 3
Risk Assessment
Module 8 Controlling Risk
Module 9 Quantifying Financial Risks
Module 10 Financial Methods for Measuring Risk
Module 11 Qualitative Approaches to Risk Assessment

Module 8
Controlling Risk
Contents
8.1 Introduction.............................................................................................8/2
8.2 The Top-Down Approach to Risk Assessment ................................ 8/13
8.3 The Building-Block Approach to Risk Assessment .......................... 8/16
8.4 Reporting and Controlling Risk .......................................................... 8/19
8.5 A Note of Warning .............................................................................. 8/38
Learning Objectives
Undertaking risk management requires some thought. Risk management and the
control of risk, as with most other aspects of commercial decision making, are not
without cost. In order to control risk, information has to be gathered and processed
and management time devoted to analysing the result. Firms also need to set
objectives in relation to the right decisions to be made once the analysis has been
completed.
This module looks at some of the managerial issues and methods that are used by
firms in analysing and controlling risks. There are two basic approaches, one
involving a ‘top-down’ analysis of the firm’s activities; the other – starting with
individual risk factors – makes use of a ‘building-block’ approach.
The module then goes on to examine different approaches to risk control using
the firm’s accounting records. The first method is based on limits, and this is
expanded to introduce the forward-looking value-at-risk approach that is the
current, best practice, method. This latter approach attempts to predict the expected
loss from a given exposure at any particular time during some predetermined time
period. To ensure a complete risk profile, this approach is usually coupled with a
stress test scenario to provide a worst-case loss.
After reading this module, you should be able to:
 see how and why firms set relevant exposure limits to different risks;
 understand how different assessment methods work;
 differentiate between macro-based and micro-based assessment methods as to
the quality of the analysis and insights into the different risks;
 understand the differences in approach of and the insights provided by account-
ing data, management information and the value-at-risk methodology, which is
based on statistical and worst-case-scenario analysis;
 identify the problems of and limitations to any risk management activity.

Module 8 / Controlling Risk
8.1 Introduction
When I was a trader in a bank, one of my ongoing activities was to look at the
positions I had and to manage the risks from being long or short securities. When I
had a position in the market, by having an inventory of securities to sell or having
sold securities I did not own, I was constrained in the amount of risk I was allowed
to take by the firm’s policies on exposures. On a given day, I was told how much
exposure I was allowed to have on my trading book; any excess had to be hedged
(in practice, I left a safety margin on this limit). This requirement arose out of the
firm’s risk control policies, which had been set by the bank’s Asset Liability Man-
agement Committee (ALMAC). These policies were designed to provide me with a
degree of flexibility to carry out my job but did not allow me unrestrained freedom
to jeopardise the firm by taking on too much risk. This, in essence, is the delicate
balance required in controlling risk. Furthermore, the positions I had, the gross
market position plus any hedging activity, were reported to senior management on a
daily basis so that they were fully aware of what I was doing. The definition of
acceptable exposures and the subsequent control and reporting of risk positions are
the initial starting points in any risk management process. This module introduces
the requirements and methods used by firms in their risk control functions.
The control and management of risk, defined in the broadest terms, encompass a
wide-ranging process that starts with how risks are perceived, their identification
and assessment (which might alternatively be termed measurement or evaluation)
and leads through to decisions made in the light of the result. Although we may
describe the process as a logical progression from one stage to another, in practice it
is much less well defined.
As with all human activity, we seek to simplify and order the environment within
which we operate, to rank, sort and order its different aspects. In part, our own
perception acts as a filter, and, in part, the sorting process reduces complexities to
more manageable proportions, but at the expense of completeness. One of the great
dangers in risk management arises when our ‘world view’ distorts the underlying
reality. For example, it is possible that the magnitude of risks is perceived differently
from their actuality, and considerable research suggests this is true. Equally, analysis,
in order to function, requires a reduction in the complexities of situations to more
manageable proportions. In the analysis of a situation, aspects considered irrelevant
or minor are dropped from the model. In so doing, there is a great danger that
essential elements may be left out or ignored.
Before the management of risk can start, the risk analyst and risk manager need
to be conscious of the dangers and potential limitations of such an exercise. At the
beginning of the process, namely in deciding what particular risks the firm is facing
and how to manage these, the objectives of the process need to be carefully set out.
It is to this definition process that we must now turn.
Risk Control and Risk Management: The Barings Disaster _____
Barings is one of a number of examples of a spectacular failure of risk control. It
is a failure that should not have happened. Few people can be unfamiliar with
Barings and Nick Leeson, the ‘rogue’ trader who ran up losses for the bank by

trading in derivatives. Within a few months of moving to Singapore to work for

Barings’ derivatives operations there, Leeson began hiding losses on proprietary
trading in a special account numbered 88888.
The official report on the collapse by the Bank of England’s Board of Banking
Supervision highlighted the fact that hidden losses in the Singapore subsidiary
grew rapidly throughout 1994, when Leeson – unbeknown to his local or
London-based managers – was seeking to gamble his way out of trouble. The
extraordinary losses that eventually amounted to £830 million were funded by
Barings in London and transferred to the Singapore International Monetary
Exchange (SIMEX) to meet margin calls. The bank’s managers thought the
margin calls being financed belonged to customers and were not the result of
proprietary trading. The sums transferred were more than the entire share
capital of the parent firm (equal to about £380 million). The losses were finally
revealed at the end of February 1995 when Barings went bankrupt. By the time
of the collapse, Leeson had managed to acquire positions in futures and options
contracts worth a notional value of over US$33 billion!
There are a number of extraordinary points about this disaster. How was
Leeson able to carry out the deception? How was it that he was able to report
profits on his activities yet at the same time run up enormous losses? How
could Barings transfer more than its entire capital to support a trading activity
on such inadequate and confusing evidence? Why were checks not made? What,
since it was a bank, were the regulatory authorities doing? Why did Barings’
auditors fail to spot the scam over such a long period?
While some of these issues are external to the bank, Lilian Chew (1996)
highlights a catalogue of poor management and control practices at Barings that
was responsible for the debacle:
 There was no segregation of the front- and back-office functions in Singa-
pore.
 There was a lack of involvement by senior management in running the
business.
 There was inadequate capital to support the risks being taken.
 There were poor or non-existent control procedures on both the funding
side and credit control despite the existence of an Asset Liability Committee
(ALCO) set up to manage such risks.**
It might be tempting to explain Barings as a total aberration, a unique event.
However, at the time The Economist provided a list of 12 other large-scale risk
control disasters in industries as diverse as petroleum, mining, chemicals,
printing, drinks and the public services, and others continue to come to light.††
** These are taken from Chapter 10 of Chew (1996).

†† The Economist, 10 February 1996: 4. The list included: Hammersmith and Fulham Council (UK), Allied
Lyons (UK), Showa Shell (Japan), Metalgesellschaft (Germany/US), Codelco (Chile), Kashima Oil

Even after this wake-up call to managers, firms still continue to experience such
actions, with the similar notable events at Société Générale in 2008 and UBS in
2011.
The message is clear: firms need to devote as much care and attention to risk
control as to product design and packaging.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
8.1.1 Management Objectives in Measuring Risk

As mentioned above, measuring risk is one part of managing the risk. In order to
get meaningful measures of risk, however, it is necessary to have an unclouded
understanding of the objectives involved. This requires a clear definition of what the
risk measurement process is trying to do. For instance, there has to be a clear
awareness of which risks are to be managed and over what time frame. If decisions
are made on, say, a weekly basis, then this is the risk horizon and the span over
which risks should be measured. If, on the other hand, risk is a product of trading,
as it is in many financial intermediaries, then the time horizon may be as short as the
next transaction. Management must have a clear understanding of the timescale over
which the exposure (the amount at risk times the risk factor) is likely to remain
outstanding before a decision can be made to take corrective action.
Figure 8.1 shows a framework for understanding risk. A firm’s activities, prod-
ucts and transactions will be the foundation of the organisation’s awareness of the
nature and types of risk involved. It will then need to assess the degree to which
financial and other risks may potentially, or actually, have an impact on the firm.
Decisions then have to be made about how much risk may be acceptable and how
much exposure can be tolerated. This should lead the firm to make strategic choices
about what risks to accept and how risks are to be managed.
(Japan), Procter & Gamble (US), Air Products (US), Sandoz (Germany), Gibson Greetings (US), Glaxo
(UK), Orange County (US) and Barings (UK).

Awareness Assessment
Management
Risk How much

factors risk?
Interest rates
Strategic
Activities Currencies choices
Evaluation
Financial
Products Equity
Operational
Products
Transactions Commodities
etc...
Credit How much
exposure?
Operations - volatility
- materiality
Figure 8.1 A risk management framework

A key element is the amount of risk that will be accepted. This is the firm’s risk
threshold. In determining this, the organisation must be fully aware of the risks and
must understand their actual and potential severity. The less the risk is understood,
the less exposure the firm will generally be willing to accept. Typically a firm will
face many risks: some will be important and require attention; others will be
insignificant.‡‡ Knowing which are which is one of the tasks facing the risk manager.
A prerequisite for any quantification of and control of exposures is an initial risk
audit to understand the different threats facing the firm.
The best approach to managing these then has to be determined. Can these risks
be quantified and monitored using existing procedures? If not, what new control
policies, procedures and systems are required to manage these risks? Has the
organisation a clear line for decision making with the appropriate and timely
reporting of exposures up the line to senior management?
The third element relates to the confidence limits or boundaries placed on the
estimates of the risk factors. It can be expected that a standard two-tailed, 2-
standard-deviation confidence limit based on the normal distribution will be
exceeded once in every 20 times.§§ If the data are based on daily price changes, in
risk management terms this means that the confidence limit will be exceeded more
than once a month, given that there are about 22 working days in an average month.
Setting the appropriate limit on the probability of various outcomes will be a
function of both (a) the potential spread of outcomes (that is, ‘volatility’) and, as
mentioned in the previous paragraph, (b) the firm’s own comfort level about the
risks being taken (its ‘risk appetite’). The observed or deduced degree of dispersion
(the distribution or variance in possible future conditions) for the risk factor will
‡‡ The regulations for bank risks distinguish three categories of risk: market risk (relating to changes in
market prices due to changing market conditions), credit risk (the risk of default by a counterparty or
credit downgrade) and operational risk (risk to the functioning of the institution).
§§ That is, the confidence limit is set at the 95 percentile on the distribution.

obviously be a critical element in determining the amount of risk that may be safely
assumed. Confidence or divergence limits are designed to make managers aware that
corrective action may have to be undertaken as losses have reached some critical
point.
In designing a risk management approach, the issue of materiality must also be
addressed. Since there is a cost to managing risks, there is little point in devoting
much time to insignificant risks that will only have a tangential effect on the firm’s
financial position. There are a great many risks involved in running a business, some
of which relate to the financial markets. Most of these risks are immaterial. Some of
these risks will have offsetting effects, and the firm will usually act as a diversified
portfolio, eliminating a large part of the individual consequences of such small risks.
Decisions about whether a risk needs to be managed should form part of the
evaluation process and be reviewed at each stage of the analysis. Managers should
always be considering the cost–benefit consequences of devoting resources actively
to managing risks.
The risk management process also raises two other important managerial consid-
erations. The first is changing the firm’s behaviour in the face of risks, and the
second is selling risk capacity. Changing behaviour involves conducting the firm’s
activities in such a way as to minimise risks. For instance, if delivery risk (the risk
that the transaction will not take place) is significant, an appropriate response might
be to batch transactions together or break them up into larger or smaller units to
reduce the potential adverse effects. Appropriate analysis will often reveal how
changes in behaviour can largely mitigate the effects of many risks. The firm should
also analyse to what degree it can usefully structure its operations to offset different
risks within the organisation before resorting to outside transactions (i.e. it should
analyse its scope for operational hedging).
The other issue related to the costs involved in undertaking risk management is
the potential opportunity of selling the firm’s risk capacity to others. Since options
represent a form of insurance where the writer receives an upfront income for
assuming the risk, acting as an underwriter for the risks associated with an option
may be a way of reducing the total cost of desirable risk management activities. It
has to be said at this point that option writing by non-specialist firms has received a
bad press in the past, but in principle there is nothing to stop firms writing options.
In many instances, they do this already. An option package, variously known as a
cylinder, a collar or a spread, involves the simultaneous purchase and sale of an
option on the same underlying risk position. The combined position offers a large
measure of risk reduction when combined with an exposed position but at a lower
cost than just purchasing the option alone. There are disadvantages to this structure
in that potential gains are capped, but equally it does reduce the upfront costs of
setting up the position since the income from the written option is used partially (or,
in some cases, fully) to fund the desired risk position.***
*** Options, their characteristics and pricing are examined in detail in the MBA elective Derivatives. Module
2 introduces these instruments as part of the risk management product set, and Modules 6 through 10
of that book cover them in detail. They are also covered in the core course Finance.

To summarise, firms will want to set a limit on the risks being taken that allows
for the amount or value that is ‘at risk’. This will be a function of the time required
to take corrective action, the potential spread of future outcomes and the amount
involved. Judgements will have to be made about what constitutes a material
exposure in the context of the business. Inevitably, such decisions will be subjective,
and will be based on prior experience and the risk appetite of the firm itself.
Five Questions to Ask When Building a Risk Management
System ____________________________________________________
The following five-point checklist highlights the kind of questions the risk
manager needs to ask when putting in place a risk management system.
1. What are the risks the firm is taking?
2. Can these risks be quantified?
 What monitoring is required?
 How frequent should the review process be?
3. What are the risks the firm can manage well?
 What risks should be managed internally?
 What risks should be passed to others?
4. Does the infrastructure for risk control exist?
 In particular, does the firm have well-thought-out policies for control of
decision making?
 Does the firm have adequate process control?
 Are auditing and review processes adequate and designed to ask the right
questions?
5. Are the decision-making processes about risk clearly formulated?
 Are those taking and managing risks accountable for the risks they take?
 Is the risk-taking authority of such managers well defined?
 Are reporting lines clear and unambiguous?
 Can the firm’s managers act appropriately within the set time frame?
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
8.1.2 Operational and Financial Approaches to Controlling Risks

Firms have two possible routes to managing excess risk in their operations. The first
involves changes to their operations, the second the use of financial markets to
modify their exposures to their risks. When building a risk management strategy,
the firm will start by looking at its operational management to see if it can find
ways to reduce the risks it is taking. In doing so, it will look both at its industry and
its competitors and at how it manages its own products and services. It will,
wherever possible, seek to apply the matching principle: to balance the asset and
liability positions. That is, it will seek to ensure that inflows and outflows are
balanced in nature, by currency and interest rate sensitivity and so forth, thus
creating internal hedges matching costs and revenues. Another response is to
undertake productivity and quality improvement programmes to maintain the firm’s
competitiveness and enhance its differentiation in the market. Firms operating in
appreciating currencies, such as the euro, the Swiss franc or the Japanese yen,

managed to retain market share by such improvements despite the adverse effects of
economic exposure. These differentiation strategies reduce the price sensitivity of
their outputs, while improvements to productivity reduce the costs of production.
Of course, ultimately there are limits to the ability of firms to manage their risks this
way.
When looking at the use of operational hedging, the firm will take into account
its competitive position and the nature of its products. Whenever possible, it will
look for flexibility in sourcing and aim to match competitors’ sources and competi-
tors’ markets. It will, for instance, try to move to weak-currency input sources and
away from strong-currency input sources. Within the firm, strategic decisions on
product diversification and product differentiation may mitigate adverse economic
factors. On the whole, differentiated products are less price sensitive and hence
have less elasticity of demand. Another route is to undertake geographical diversifi-
cation of the firm’s markets.
A more radical step may involve selective location of plants overseas, although in
most cases managing risk is a secondary consideration in deciding upon such major
and, by definition, fixed and largely irreversible investments. To some extent the
location may be based upon selecting assets in economies and currencies that have a
low correlation to the firm’s base currency. Equally, faced with an intractable
economic and business environment, firms may resort to acquisitions or the
disposal of unattractive businesses.
However, there will be a limit to the effectiveness or the desirability of such
operational hedges. They are essentially fixed in nature and may not be easily
adjusted in the face of changing economic circumstances. Furthermore, they take
time to implement and rely on the firm’s competencies for success. Firms therefore
face a trade-off between operational efficiency and reducing exposures to macroe-
conomic factors. Since disturbing operations (for instance, by switching suppliers)
can be costly, firms will apply the matching principle whenever possible but will, in
the end, recognise that any excess must be hedged out via the financial markets.
The financial markets offer a range of methods to the firm, some being ‘on bal-
ance sheet’, others ‘off balance sheet’.††† The principal on-balance-sheet methods
relate to liability management and the matching principle: for instance, the firm can
hedge foreign currency inflows by foreign currency borrowing. If it has a fixed
future income flow, it may prefer to borrow at a fixed rate and so on.
When it comes to financial risk management methods, the purpose of the in-
struments, using derivatives, is to modify risks. Such ‘contracts for differences’
provide a hedge against economic exposure to a particular risk factor without
disturbing the underlying economic operations of the firm. Thus a firm can hedge
out the currency risk in foreign trade transactions by using currency forwards. The
firm eliminates transaction risk and is able to make the foreign currency sales and
purchases. The risk management product set – that is, derivatives (forwards, futures,
††† This distinction between on balance sheet and off balance sheet has largely been removed by the
introduction of International Financial Reporting Standards (IFRS), but it is useful to retain the idea
that on balance sheet refers to those items that relate directly to the operations of the firm, while off
balance sheet refers to financial instruments that are used to manage risks, such as derivatives.

swaps and options) – together with a number of hybrid instruments, provides the
risk manager with a range of tools for modifying the firm’s risk profile. Such
instruments are examined in detail in the course on Derivatives.
A Lesson in Exposure Measurement _________________________
In the autumn of 1984, Lufthansa, the German airline, signed a contract to
acquire Boeing aircraft, an order that would cost the company US$3 billion – a
very large sum for the airline at the time. When Lufthansa placed the order, the
US dollar was strong against the Deutschmark – and looked set to go even
higher. In order to manage the currency risk, Lufthansa’s chief financial officer
partly hedged the liability by entering into a forward foreign exchange contract
for $1.5 billion. The thinking was as follows: if the dollar continued to strength-
en as expected, the firm would have to pay more – in Deutschmark terms – for
the aircraft but be compensated from the gain on the forward foreign exchange
contract. On the other hand, if the US dollar weakened, the firm would lose on
the hedge but gain in having to pay less in Deutschmarks for the planes. In acting
this way, Lufthansa was applying the principles of financial risk management – or
so it thought.
However, there was a flaw in this hedging scheme. Lufthansa’s cash flow,
although ultimately reported in Deutschmarks, was also in effect US dollar
denominated. What the company had not understood was that it had a natural
hedge on the contract to buy Boeing jets. In the event, after the hedge had been
put in place, the dollar weakened, falling over 30 per cent from its peak, with
the result that Lufthansa’s hedge left the company with large losses. As its
revenues were in part linked to the US dollar, it was not able to offset the
decline in the currency through higher Deutschmark revenues.
The danger of overhedging or misunderstanding the true economic exposure of
a business, as Lufthansa did in the 1980s, is not an unusual occurrence. Deciding
to hedge an exposure is one thing; getting it right, quite another. Firms continue
to make the same kinds of risk management errors today that Lufthansa did.
However, they are not on the same scale and tend not to come to the attention
of outsiders and the press.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
8.1.3 An Illustrative Example of Risk Management

Risk management aims to control the amount of exposure a firm takes to one or
more risk factors. One way of looking at risk is to see how much the value of a
position will shift for a given change in the underlying exposure. Figure 1.16 was
given in Module 1 to explain the sensitivity of a position to a risk. The steepness of
the slope (or coefficient) is indicative of how sensitive the value or exposure is to a
change in the underlying risk, as shown in Figure 8.2. At the same time, the direc-
tion indicates whether the exposure is positively or negatively related to changes in
the risk. Three different exposure sensitivities are shown:
 average negative sensitivity, where the relationship between the change in the
risk factor and the value of the position is approximately one for one (A);

 moderate positive sensitivity, where there is only a small change for a given
change in the underlying risk (B);
 extreme negative sensitivity, where a small change in the underlying risk factor
causes a large change in the value of the position (C).
Change in value
of position
Gains
A Moderate
Average
positive sensitivity
negative sensitivity
B
Change in value
for risk factor
Falls Rises
Area of
concern
due to
capacity
for losses
C Extreme
negative sensitivity
Losses
Figure 8.2 Sample risk factor sensitivities

The area of most concern to management is the potential for losses; that is, the
downside risk from the position.
Risk control requires that the risk in a position be estimated and the amount of
a potential value loss from the exposure estimated. To show the idea, in Figure 8.3 a
distribution of possible outcomes (I) is superimposed on a typical risk profile (II),
together with a desired level of exposure (III). Where the possibility of an outcome
in excess of the confidence limit (IV) is possible, the risk of the position has to be
adjusted downwards via the appropriate risk modification.‡‡‡ This is shown by the
dashed line (V).
‡‡‡ Note that this confidence limit is usually set on the basis of some value or proportion. The technique
goes by the generic name ‘value at risk’ (VaR) and is widely used by firms everywhere.

Position
Original
Risk profile
(II)
Adjusted Confidence limit

Risk profile (IV) Extreme
(V) outcomes
scenario
'stress' tests
Acceptable Risk factor (I)

exposure
Area (III)
of
concern
Unacceptable
exposure Risk adjustment
(IV) (V)
Figure 8.3 Risk control
8.1.4 Risk Awareness

Risk awareness begins at home. Experiences where risks have been taken or where
the firm has suffered (or, less likely, benefited from) exposure to risk are an obvious
starting point for becoming aware of risks. Firms operate in an uncertain environ-
ment, management decisions involve risk taking and each firm has a unique set of
circumstances within which to learn about the risks facing it: be it industry, technol-
ogy, product lines, management methods, sales coverage and so on. Thus each
firm’s awareness will be slightly different, based on the differentiation between
firms.
Another area comes from a firm’s history. Some firms may have experienced rare
or unique ‘risk events’, such as equipment or system failures, frauds or other
criminal activity, that have highlighted within the organisation a particular set of
risks. Sometimes these are public knowledge to outsiders; sometimes it is proprie-
tary knowledge. Such events raise awareness of the risk problem.
Firms also typically engage in strategic business planning, if only to prepare
budgets within the firm for cash management and other control purposes. Better-
organised firms will have strategic plans and will have evolved long-range planning
procedures. These will show where the potential risks lie in any set of future actions.
Generally such self-assessment starts with questions such as: what is the business?;
what will it be?; what should it be?; what will prevent it getting there? Peter Drucker
(1973) summarised this managerial task as ‘the application of thought, analysis,
imagination and judgement’.
For effective risk management, it is necessary to understand the risks that are
being taken by the firm in preparing for the future. It is essential that the risks that

are to be assumed are the right bets. That is, management must be aware of the risks
that underlie the business and take the appropriate course of action to minimise or
eliminate the undesirable ones. For instance, an automobile manufacturer must deal
with both the business issues of designing, producing and selling its output in a
competitive marketplace and also the impact of macroeconomic factors that affect
both the firm and its competitors. Hence, for instance, an overvalued currency will
lead to unfavourable economic exposure. Understanding how these two conjoint
factors affect the firm’s future cash flows is essential when seeking to effectively
manage the risks. It also leads to decisions as to which risks the firm should accept
and which it should minimise or eliminate.
At its best, strategic planning involves a systematic examination of the future and
its consequences. The idea can be expanded into short-, medium- and long-range
analyses based on the firm’s planning horizon, within which changes can be made.
Hence a capital-intensive firm will have to build in a longer planning horizon and be
aware of hazards over a much longer period of time than some types of service
firms where rebuilding the organisation can be done in a matter of months or, at
most, a few years.
Another means by which risk management can benefit is monitoring the situation
of the industry, of competitors and of the world at large. This involves maintaining a
general watch on developments and events outside the organisation that can have
implications for current and future activities. Thus a fire at another firm or a plane
crash may cause users of similar equipment to review their own operations to ensure
they are not likely to suffer a similar fate. There is a good story about the reactions
of the chief executive officer at General Electric (GE, of the US) on hearing the
news about the October 1987 stock market crash. He was visiting Hong Kong at
the time, but immediately contacted his board of directors to put in train a review of
the implications of the dive in share prices for GE. The disaster experienced by BP,
the British oil major, in the Gulf of Mexico in 2010 is another example. Following
this, all the major oil operators reviewed their risk management procedures to be
sure that a similar catastrophe would not happen to their operations.
8.1.5 Integrated Risk Management

Integrated risk management (IRM), also known as ‘enterprise-wide risk manage-
ment’ (ERM), ‘corporate risk management’ (CRM), ‘comprehensive risk
management’ or ‘risk-enabled company’ has become a buzzword in financial
institutions and large corporations. It is based around the common-sense idea that
the risks in the firm should be managed in a coherent and coordinated process. The
concept is designed to overcome the silo mentality where a firm’s market risks,
credit risks and operational risks are managed separately and quite possibly at cross-
purposes. By failing to integrate these different types of risk and manage them as a
whole, firms do not take into account the possible interdependency that might exist
between the different types of risk.
IRM offers a more fundamental improvement to the way firms manage risk. The
leading-edge approaches to risk management have been in quantitative analysis. The
challenge is to marry these sophisticated models with more qualitative risks such as

operational risks, strategic risks and political, technological and environmental risks.
Risk management practitioners recognise the importance of these risks and their
capacity to prevent the realisation of the firm’s objectives – or even threaten its very
existence. BP, mentioned earlier, suffered huge losses as a result of the Gulf of
Mexico oil spill, as well as very significant reputational damage. The firm’s very
existence was thrown into doubt.
There is a difficulty in setting up IRM within a firm in that it requires the combi-
nation of management approaches, which by definition are qualitative, with
quantitative modelling. The process starts with (a) identifying the firm’s risk
tolerance and appetite to assume risk. This is then followed by (b) the evaluation
and development of the firm’s risk management processes and procedures and (c)
the establishment of appropriate information and risk-modelling systems. The
process, if it is to work, requires a development of (d) managerial approaches to the
risk management task, which is then followed by (e) appropriate risk control and
risk ownership, where individual managers take responsibility for elements of the
overall firm’s risk. This requires a change in the role of the risk manager. This
individual is no longer concerned simply with evaluation and reporting but is now
also required to help re-engineer the corporation to ensure it has a sustainable risk
management structure that addresses all the risks facing the firm. To coordinate the
management of risks within firms, the appointment of a chief risk officer (CRO)
within the board, or, at the least, reporting to a member of the board, has become
mandatory. Equally, firms now report a lot more on how they go about managing
their risks. In the UK, for instance, it is now compulsory for large companies to
include in their annual report and review a clear explanation of how the firm
manages its major risks.
8.2 The Top-Down Approach to Risk Assessment

At the level of industrial safety there is a generally recognised procedure to follow if
a system malfunctions or fails. The immediate solution is to seek to find where the
failure or fault has developed in relation to its normal operation. There are basically
two different approaches that can be used: a macro, or top-down, approach and a
micro, or unit-based, method; that is, a building-block approach. Although the
methods are similar, the premise on which they operate is different.
The top-down method looks for the fault by examining the system and finding
where it failed. The building-block method looks at the effect of a particular basic
event on the overall system. In practice, firms tend to use a combination of
methods, using both a building-block and a top-down analysis.

A
4
B
5 C
2
D
1
6
E
3
F
7
G
Figure 8.4 A top-down approach to risk assessment (a fault tree

analysis)
Note: In the top-down approach, the source of the risk problem (1) is broken down into
a sequence of causes (2 and 3), which lead to a lower layer of causation (4 to 7) and
ultimately to the basic events (A to G).
The top-down approach for financial risk assessment is based on the relationship
of a firm’s profitability to a range of market factors that are taken to affect the firm.
Thus the changes in quarterly earnings of a firm may be related (using standard
statistical techniques) to changes in exchange rates, interest rates and commodity
prices. For example, the following analysis uses quarterly earnings from a group to
analyse the firm’s profit sensitivity to various risk factors. The earnings and the risk
factors, exchange rates for the US dollar, euro and the Japanese yen, and the British
pound short- and long-term interest rates, are given in Table 8.1.
Table 8.1 Earnings performance and related economic data for a

company over 15 quarters
Quarter Earnings US$/£ £/€ ¥/£ 3-month £ long-term
(£m) £ Libor interest rate
1 57.78 1.6125 1.1365 231.88 2.52 1.66
2 61.17 1.6455 1.1613 259.74 2.55 1.91
3 66.48 1.7440 1.2111 265.35 2.50 1.84
4 64.76 1.8705 1.2203 258.35 2.49 1.89
5 72.76 1.9295 1.2031 261.93 2.30 1.73
6 68.00 1.7385 1.2376 245.74 2.07 1.68
7 86.61 1.6215 1.2243 223.28 1.87 1.72
8 97.38 1.7505 1.2133 232.73 1.72 1.59
9 85.26 1.8678 1.1835 233.19 1.80 1.59
10 89.75 1.7350 1.1910 231.19 1.77 1.59
11 107.31 1.9030 1.2080 239.53 1.66 1.50

Quarter Earnings US$/£ £/€ ¥/£ 3-month £ long-term

(£m) £ Libor interest rate
12 94.56 1.7770 1.0456 213.19 1.67 1.53
13 116.88 1.5150 1.0217 189.07 1.19 1.47
14 106.25 1.5062 1.0106 172.91 1.00 1.39
15 119.00 1.5005 1.0632 159.31 0.98 1.40
A regression analysis is performed on the changes in the reported profits over the
15 quarters in the form:
$/£ €/£ ¥/£ £Libor LTIR ﴾8.1﴿
where the inputs are the change in the variables per quarter, expressed as a natural
logarithm.§§§
Table 8.1 shows the firm’s sensitivity to changes in profits.
Table 8.2 Regression parameters from Equation 8.1 based on the data
in Table 8.1
Coefficients
Intercept a0 0.021009
Change in $/£ a1 0.004349
Change in €/£ a2 0.756336
Change in ¥/£ a3 0.395818
£ short-term interest rate a4 −0.69351
£ long-term interest rate a5 0.15243
Table 8.2 gives regression parameters for the firm’s sensitivity to changes in the
risk factors. For instance, a 1 per cent change in the euro against the British pound,
with all the other estimated sensitivities held constant, will lead to a change of 0.76
per cent in earnings. The sign of the coefficient is positive, and this shows that the
firm will gain if the British pound rises against the euro. The opposite occurs in
terms of the British pound short-term interest rate (which is the three-month British
pound London interbank offered rate (Libor)), where an upward change in this rate
leads to a fall in earnings. That is, profits are adversely affected by an increase in
interest rates.
Such an analysis shows the effects of changes in the macroeconomic factors on
the firm’s reported quarterly earnings.**** It provides management with an indication
§§§ That is, we express the change in earnings as follows:
ln /
So for the first period we have:
ln £61.17/£57.78 0.0570
**** A risk analysis method that uses this approach for analysing the performance of portfolios and their
sensitivities to key factors is called ‘style analysis’. This is a standard way of analysing the risks of equity
portfolios. We do not cover style analysis in detail in this course.

of the potential magnitude of the exposure to the various factors and the direction
of the sensitivity. The nature of the exercise means that, although this knowledge is
useful at the strategic level, it cannot be easily turned into operational directives
since the use of earnings means that much of the fine detail about what underlies
these sensitivities is lost. For instance, the company may already undertake hedging
activities to mitigate some or all of the risks. In order to obtain detailed knowledge
of the individual exposures, a finer cut of the data is required. This can be achieved
by building the sensitivities from the individual exposures in the firm. The latter
approach obviously requires a great deal more information and the ability to process
and manipulate it in meaningful ways.
8.3 The Building-Block Approach to Risk Assessment

Whereas the top-down method uses aggregate information to derive a residual
sensitivity, the building-block approach builds up the sensitivity by taking the basic
risk factor and adding up the different exposures, netting off the opposing sensitivi-
ties wherever possible, in order to derive the net exposure at the topmost (group)
level. Such an approach is shown schematically in Figure 8.5.
vi
v
iii iv
i ii
A B C D E F G
Figure 8.5 The building-block approach to risk analysis (a modes and

effects
analysis)
Note: The elements of the system (the boxes A to G) are examined, and their effects on
the overall system (i to vi) are determined from analysis. The different modes (the
Roman numerals) of interaction are used to examine the effect on the whole system.
The combined effects of potential risk factors tend to be ignored in the simpler uses of
this approach.
How might the building-block approach be applied in practice? This can be illus-
trated from the following example. A group of companies with common ownership
are engaged in buying and selling in a number of different currencies. Let us
consider how the building-block approach might work for two of the subsidiaries,
companies A and B, when they have exposures in the two currencies X and Y. The
two firms’ positions are shown in Table 8.3, divided into income (receivables) and
expenditures (payables) and classed by maturity (that is, payments and receipts are
due in the next three months).

Table 8.3 A building-block approach to determine the exposures to currency X for a

group of companies
Currency X
Subsidiary A Subsidiary B Group
Time Receivable Payable Receivable Payable Receivable Payable Net exposure
(months) (+) (−) (+) (−) (+) (−)
1 20 (40) 50 (20) 70 (60) 10
2 15 (25) 20 (15) 35 (40) (5)
3 30 (40) 25 (5) 55 (45) 10
Total 65 (105) 95 (40) 160 (145) 15
Net (40) 55 15
The net individual exposure to currency X for subsidiary A is a 40-unit, short

(payable) position in the currency and for subsidiary B, a 55-unit, long (receivable)
position. By combining these two, we see that the group’s net position is a 15-unit,
long position. This is made up (as shown above as net exposure) of two 10-unit long
positions in Months 1 and 3 and an offsetting 5-unit, short position in Month 2.
Thus the net positions of the units, plus the ability to offset risks, suggest that the
maximum monthly exposure at any one time is 10 units of currency X, rather than
the potential 30 units (for one month for subsidiary B).
The same analysis can be extended to all currency exposures facing companies A
and B. A further example is shown in Table 8.4, for the same subsidiaries, this time
for currency Y.
Table 8.4 A group-based building-block approach to determine the exposures to

currency Y
Currency Y
Subsidiary A Subsidiary B Group
Time Receivable Payable Receivable Payable Receivable Payable Net exposure
(months) (+) (−) (+) (−) (+) (−)
1 10 (25) 5 (10) 15 (35) (20)
2 5 (20) 15 (35) 20 (55) (35)
3 5 (30) 10 (15) 15 (45) (30)
Total 20 (75) 30 (60) 50 (135) (85)
Net (55) (30) (85)
With currency Y, both subsidiaries have the same exposure profile, having overall
net short (payable) positions, and the internal currency offsets are less able to reduce
the exposure of the group to the currency, which for Y nets to an 85-unit, short
position.
The next level of analysis takes the residual currency positions from the group
and aggregates these exposures at the higher level in terms of the group’s base
currency, currency Z. This is shown for currencies X and Y in Table 8.5.

Table 8.5 Aggregate currency exposures of Subsidiaries A and B to currencies X and Y

in terms of the group’s base currency Z
Currency Z
Currency X Currency Y (base currency)
Time From Table Net exposure From Table Net exposure Net exposure
(months) 8.3 in units of 8.4 in units of
currency Z currency Z
(X/Z = 2.5) (Y/Z = 5)
(i) (ii) (iii) (iv) (v)
1 10 4.0 (20) (4.0) 8.0

2 (5) (2.0) (35) (7.0) 9.0
3 10 4.0 (30) (6.0) 10.0
Long 20 8.0 – 8.0
Short (5) (2.0) (85) (17.0) (19.0)
Total 15 6.0 (85) (17.0) 27.0
Note that, as given in Table 8.5, the positions in the two different currencies
reported by Subsidiaries A and B (columns (ii) and (iv) in the table) are not offset-
ting, so that the aggregate exposure translated into the reporting currency Z for
currencies X and Y in column (v) ignores the potential offsetting positions in terms
of long (receivable) and short (payable) positions in the two currencies. That is, the
exposures are aggregated without regard to their sign based on their absolute
values.††††
Such a consolidated report provides the group with information about the net
level of currency exposures (risks) being assumed by the group at any one time. This
is shown as 27 units of the reporting currency Z. One approach to controlling risk
would be to set exposure limits for the group as a whole to currency movements.
The limit might be set at a maximum exposure of 25 units of currency Z as accepta-
ble. In this case, Table 8.5 shows that the group has too much currency risk and
needs to act to reduce the overall exposure. It could do this by offsetting transac-
tions, probably in the three-months maturity, the obvious candidate being the 30-
unit, short position in currency Y (that is, by reducing the translated 6.0 units of Z
to bring the total within the approved limit).
One frequently used extension of the above method is to set up a centralised
treasury function where the different exposures of the group are handled by a
reinvoicing system.‡‡‡‡ The basic operation of such a system is shown in Figure 8.6.
†††† A more sophisticated approach might factor in the correlation between X, Y and Z to determine such
an offset. Such an approach is part of the value-at-risk method discussed later in this module (see
Section 8.4.3) and the financial approach given later, in Module 9.
‡‡‡‡ This is where operations and financial risk management intersect. There may be good operational
reasons for centralising the firm’s treasury operations, but it also makes sound financial risk manage-
ment sense.

Company A Company B
EUR
USD
USD GBP
Central
Treasury
GBP USD
EUR SKR
Company C Company D
Figure 8.6 Reinvoicing centre arrangement, using a centralised treasury

for a group of companies (GBP = British pounds; USD = US
dollars; EUR = euros; SKR = Swedish kronor)
In the reinvoicing system the different currency exposures are netted internally by
the centralised treasury, and only the residual net exposure needs to be hedged
externally. That is, each company in the system sells or buys its currency require-
ments with the central treasury unit, thus totally eliminating any currency exposures.
The centralised treasury matches the various opposing positions as available and
either carries or hedges out any residual exposures depending on their size and the
mandate it has within the organisation.
8.4 Reporting and Controlling Risk

The modern firm makes extensive use of data-processing techniques for control and
reporting processes. Most firms have sophisticated financial reporting systems
aimed at ensuring that the various activities are correctly accounted for. Unfortu-
nately, such an accounting approach is retrospective in effect: for risk management
purposes it is necessary to have forward-looking processes that capture the potential
outcome before it becomes an actuality. Such methods are increasingly being used
by firms as one method of risk control.
We can divide the various approaches into three types: historical, contempora-
neous and predictive. The historical method looks at the final result once the
position has been closed out and is that used in financial reporting; the contempo-
raneous method looks at the current situation and typically makes use of
management accounting and transactional information; the predictive method aims
to anticipate the potential loss. This last approach has come to be known as the
earnings-at-risk or value-at-risk method.
8.4.1 Financial Reporting

Financial reporting, the use of accounting systems to monitor risks, suffers from a
great problem in that, in most cases, the information is of a historical or reported
nature. The firm’s activities are only recorded when actual transactions are under-
taken. For instance, the firm will record the purchase of an asset at £100 and this
will be the book price until such time as the asset is sold or otherwise disposed of, at
which point the difference will be recorded as a gain or loss in the accounts and

ultimately to the firm’s income statement. In addition, for many assets, the conven-
tion is to apply depreciation if the asset is held for any length of time – although this
might not be the case if the asset is a financial one, where a mark-to-market ap-
proach might be used. A similar process is applied to liabilities. However, the firm
will not know the full extent of the loss or gain until after closing out of the
transaction, by which time it may be too late.
8.4.2 Limits and Mark to Market

One way of adapting accounting information for risk management purposes is to set
particular limits on the various ledger entries. For instance, the individual credit
exposures for the receivable accounts may be set in such a way that there is no
excessive amount of exposure to a single firm, thus controlling credit exposures.
While the accounting reports are historical, the limit method is contemporaneous in
that it shows the current position at any one time. If a particular purchaser has
reached the limit, then no more sales on credit are available until some of the
outstanding bills have been settled. Such a system can be quite sophisticated and
provide useful insights. For instance, as in the analysis shown in Table 8.6, it can
break down the outstanding accounts by age.
Table 8.6 Ageing schedule for creditors by time period

Maturity Credit for A Credit for B Credit for C Total
Within month 120 100 25 245
1–2 months 70 40 25 135
2–3 months 10 30 50 90
3+ months – 30 100 130
Total outstanding 200 200 200 600
Credit limit 300 300 200
Table 8.6 shows that firms A and B are well within their credit limit. In addition,
the detailed ageing schedule on firm A would suggest that it is a more prompt payer
than firm B. Firm C is up against its limit, has a poor payment record and would
need to be monitored. In fact, firm C is responsible for most of the credit outstand-
ing in the three-months-plus category. Based on such a report, the credit control
manager might wish to find out why firm C is delaying making payments.
In other contexts, the limit method can be supplemented by what is known as
marking to market or revaluation. In this case the value of the asset or liability is
repriced in line with the current market price. This is typically used, for example, in
financial firms where the portfolio may be revalued daily – if not more frequently –
as market prices change. This system provides managers with contemporaneous
data – what the assets or liabilities are worth in the market – and can be used to
estimate the closing-out value of a given set of positions.
For example, in the foreign exchange market, the maturity ladder of forward
transactions entered into may be revalued at the close of business each day. If the

bank’s position in the British pound and US dollar currency pair is as given in Table
8.7 (British pounds is the base currency in this case), then it might be revalued at the
closing price for the day to show the gains and losses arising from the exposure.
Table 8.7 Foreign exchange maturity ladder for the British pound/US
dollar currency pair forward (foreign exchange) trading book
Period British pounds Original US dollar equivalent
amount rate
Spot £20 000 000 1.50 $30 000 000
1 month (£1 000 000) 1.49 ($1 490 000)
2 months £25 000 000 1.48 $37 000 000
3 months (£5 000 000) 1.46 ($7 300 000)
6 months (£2 000 000) 1.43 ($2 860 000)
12 months (£1 500 000) 1.41 ($2 115 000)
24 months £1 000 000 1.39 $1 390 000
Total £36 500 000 $54 625 000
Table 8.7 shows the maturity and original rate at which the contracts were en-
tered into. The total book in British pound terms is £36.5 million, which is equal to
$54.625 million (representing an average exchange rate of 1.4966 [$54.625/£36.5]).
The revaluation is shown in Table 8.8, where the booked forward rates are replaced
by the new forward exchange rate (the revaluation rate) for the same maturity.
Analysis of the entries shows that some positions have improved in value as the
exchange rate has moved in the bank’s favour while others have lost value, the net
change being a gain of $365 000. The gains and losses arising from such forward
transactions will depend on both the change in the interest rate differential and the
sign of the position (that is, the position’s sensitivity to changes in the market’s
forward rate). Such an analysis shows the bank which transactions are making
profits and which are making losses. Decisions can then be reached about what
might need to be done to manage the exposures.

Table 8.8 Revaluation of the trader’s exchange rate maturity ladder from Table 8.7 at
the current rate
Period British Original US dollar Current US dollar Current
pounds rate equivalent exchange equivalent profit/loss
amount rate at current
rate mark
to market
Spot £20 000 000 1.50 $30 000 000 1.51 $30 200 000 $200 000
1 month (£1 000 000) 1.49 ($1 490 000) 1.50 ($1 500 000) ($10 000)
2 months £25 000 000 1.48 $37 000 000 1.49 $37 250 000 $250 000
3 months (£5 000 000) 1.46 ($7 300 000) 1.48 ($7 400 000) ($100 000)
6 months (£2 000 000) 1.43 ($2 860 000) 1.42 ($2 840 000) $20 000
12 months (£1 500 000) 1.41 ($2 115 000) 1.40 ($2 100 000) $15 000
24 months £1 000 000 1.39 $1 390 000 1.38 $1 380 000 ($10 000)
Total £36 500 000 $54 625 000 $54 990 000 $365 000
In the futures markets, the mark-to-market method is used for revaluing the
collateral of a user’s position, a process known as margining.§§§§ If the initial long
position involving five contracts had been set up at a futures price of 78.00 and the
market moved to 77.85, then this ‘15 ticks movement’ (78.00 – 77.85 = 15 ticks)
would result in a loss.***** The formula used to calculate the value change is number
of ticks times number of contracts times value of a tick (tick × number of con-
tracts × value of one tick). If each tick (one-tenth of 1 per cent, or 0.01 per cent)
was equal to £10.00 on the value of the contract (with £1 000 000 value per con-
tract), the losses would be £150.00 per contract, or £750.00 in all (15 × 5 × £10). In
order to protect the exchange against non-performance of the contract, the partici-
pant would be required to deposit that amount with the exchange as collateral,
known as a variation margin.
In practice the futures exchange (actually, the exchange’s clearing house) normal-
ly requires an amount equal to a large one-day movement in value (regardless of
whether a long or short position has been entered into), plus an additional deposit,
the latter being taken so as to avoid the requirement that the position holder has to
top up the amount in the event of small changes in price that are subsequently
reversed. To set up a position in futures requires an initial margin that is allowed to
fluctuate down to a limit known as the maintenance margin, after which it has to be
topped up again if the position is to be kept in the market. Failure to provide
additional collateral usually means the clearing house will close out the position,
using the available margin to offset any losses. Margin requirements are set to
protect the exchange against the maximum likely price movement and hence any
credit losses from the non-performance of market participants.
§§§§ At the Chicago Mercantile Exchange, margin or collateral is known as a performance bond. It is the
equity or investment that the participant invests in the position and which acts as a surety against
losses. A detailed treatment is given on futures in the Derivatives course text.
***** Buying at 78.00 and the price falling to 77.85 results in a loss.

Many financial instruments used for risk management purposes behave like fu-
tures contracts in that they are ‘contracts for differences’ but are not traded on an
organised exchange. Even so, marking to market of these contracts can lead to the
buyer and seller of these contracts agreeing to make or receive collateral, just like the
exchange does, as a way of protecting against non-performance.†††††
A problem with mark to market is that it only tells us what the current position
is. In most cases, we need to know what the future value of the position is in the
future.
8.4.3 The Value-at-Risk Approach

To address the question of what the future value may be, we need a different
approach. The contemporaneous method provides an indication of the current
exposure, but it does not provide any guidance as to what the exposure will be in
the future. For this we need a forward-looking measure of risk. The example above
on how derivatives exchanges protect themselves by requiring users to make margin
payments based on some estimation of the potential changes underlies the idea of
the forward-looking measures that we discuss in this section. This is provided by the
‘value-at-risk’ (VaR) approach.
The earnings-at-risk (EaR) or value-at-risk (VaR) method is designed to predict
the likely gains and losses on a particular exposure at some probability level. A risk
manager has to address three key issues in trying to forecast the amount of potential
losses:
 What is the risk and what is the exposure to the underlying risk factors?
 How much could prices change?
 What is the position sensitivity to changes in the risk factor?
The answers to these questions will allow the risk manager to answer the ques-
tion: how much could I lose?
Recall the discussion of the behaviour of asset prices in Module 7. While we
cannot predict with any certainty what the exchange rate for British pounds against
the US dollar may be in a week’s time, given our understanding of the price (or rate)
diffusion process, we can make predictions about the range of future price move-
ments. The value-at-risk approach allows the risk manager to make the following
statements about potential losses:
 A one-month value at risk of £15 million with a 95 per cent confidence limit
means there is only a 5 per cent chance that the loss over the next 30 days will
exceed that amount.
 What is the most that can be lost over the next month, quarter or year with 90,
95 or 99 per cent confidence?
We can think of VaR as the maximum expected loss over a given target time
horizon and target confidence limit.
††††† Note too that under International Financial Reporting Standards (IFRS) many assets and
liabilities are required to be marked to market for financial reporting purposes.

Why has the value-at-risk approach reached such prominence in financial institu-
tions and even among some corporate firms? First, it allows the risk manager to
capture the holistic effects of risk by uniting all product lines and asset segments
using a common methodology. So, with the VaR approach, it is possible to link the
risk of loans with that of bonds and equities. The methodology is generally robust
(if not without its computational difficulties), and as a result of the public disclosure
by JP Morgan in publishing the methodology behind RiskMetrics™ it has attained
prominence within the financial services industry and is used by regulators to assess
how well financial institutions manage their risks. But, perhaps more importantly,
the approach has an immediacy and relevance for management. The techniques we
have examined earlier in this module are, at best, telling how matters stand today;
VaR promises to tell us how matters might look in the future, which is what a risk
manager wants to know. Finally, the approach meets with the desire of financial
services regulators to see enhanced disclosure of the risks underlying individual
firms.
The basic concept behind the approach is shown in Figure 8.7. We start with the
exposure and its sensitivity (left-hand diagram) and apply a probabilistic assessment
of the future value (right-hand diagram) together with some probability limit
(bottom diagram). The VaR method makes use of a statistical estimate based around
the distribution of future values or returns to calculate the probability of a particular
value or rate in the future. In doing so, it implicitly assumes that future price or rate
behaviour will be statistically similar to that of the past estimation period or that
future behaviour can be estimated statistically. As we shall see, there are three
alternative approaches to estimating this future behaviour, known as parametric
VaR, historical VaR and simulation VaR. These are generic models; in practice every
firm will use its own version of these models.

Position sensitivity Probability of value changes
+DValue
- +DMarket
Value at risk
+DValue
Maximum loss
within
confidence
limit
- +DMarket
Figure 8.7 Elements of the value-at-risk approach

To use the method and to determine the value at risk, we need to know the time
frame over which the exposure lasts (or the time required to close out the position
and eliminate the risk) and the potential change in value over this at-risk period at
some predetermined confidence limit or probability level. Therefore, the basic
approach to determining the value at risk involves four elements:
1. the amount of the exposure (A);
2. the volatility (σ) of the asset position, usually expressed as an annual rate;
3. a confidence limit (α) in terms of the number of standard deviations, usually
α = 1 < n < 2 standard deviations on a normal distribution (if we are using par-
ametric VaR). Sometimes this confidence limit is expressed in terms of the
probability of breaching the confidence limit (typically between 1 and 5 per
cent), which is the same thing;
4. a time horizon over which decisions can be made about the position (T). If T is
less than one year, then the annualised volatility is adjusted by √T.
Given the above, the value at risk for a single exposure is computed as:‡‡‡‡‡
VaR √ ﴾8.2﴿
An example will illustrate the workings of the model. The amount (A) is £10
million, the volatility (σ) is either 10 per cent or 20 per cent and the confidence limit
(α) is 2 standard deviations, or 97.72 per cent (or, equivalently, a 2.28 per cent risk
(= 100 – 97.72) of breaching the probability limit). The time horizon is either one,
‡‡‡‡‡ We look at how to compute the VaR of a portfolio subject to the benefits of diversification
in the next module.

three or six months. For the one month, using Equation 8.2, the computation is
£10m × 0.10 × 2 × √T, where T = 1/12:
VaR £10m 0.10 2 0.28865
The VaR for the one-month horizon with 10 per cent volatility and a confidence
limit of 2 standard deviations is £577 350. This is the maximum loss we would
expect to see on the position over the one-month period with 97.72 per cent
certainty. That is, we would expect the loss to be less than the £577 350 figure 97.72
per cent of the time.
We can now compute the VaR results for the different time periods and volatili-
ties given earlier, and this is shown in Table 8.9. Note that the results are computed
in the same way as those for the example given above.
Table 8.9 Estimates of the value at risk for a £10 million position for
one, three, and six months and with volatility of 10 and 20
per cent
1 month 3 months 6 months
0.288675 0.50000 0.707107
Volatility
0.1 £577 350 £1 000 000 £1 414 214
0.2 £1 154 700 £2 000 000 £2 828 428
Note: The confidence limit (α) is set at 2 standard deviations throughout.
Table 8.9 shows that the risk increases with the volatility (recall in Module 7 that
we said that volatility is a measure of future uncertainty about values) and with time.
The further in time we go, the more potential the asset price has for straying from
its current value. Equally, for the same time period, a higher volatility leads to a
larger VaR.
We can scale VaR for any period using the square root of time law. The one-
day value at risk when the volatility is 10 per cent is £104 685
(£10m × 0.10 × 2 × √1/365). Rather than calculating it directly, we could have
calculated the one-day VaR and multiplied it by the square root of 365/12 to obtain
the one-month VaR (£104 685 × √365/12 = £577 352).§§§§§ Similarly, we can
calculate the three-month VaR as the daily VaR times the square root of 365/4
(£104 685 × √365 = £1 000 002). We can do the reverse and find the daily VaR
from the monthly VaR by dividing by the square root of time
(£577 350/√365/12 = £104 685). Hence our VaR estimate increases when we
extend the horizon period and decreases when we reduce the horizon period.
If volatility increases, our VaR number increases. The three-month VaR when
volatility is 10 per cent is £1 000 000. If volatility doubles to 20 per cent, we have
£2 000 000 (£10m × 0.20 × 2 × √365/4).
§§§§§ There are slight rounding differences in these calculations.

If we change the confidence limit, our VaR will also change. If the confidence
limit is set at 1.95 standard deviations, rather than 2, we get a lower VaR. For the
three-month 10 per cent volatility, it becomes £975 000
(£10m × 0.10 × 1.95 × √0.25).
Equation 8.2 is interpreted as follows. The value-at-risk number is the potential
loss in money terms from changes in prices or rates due to future uncertainty at
some predetermined confidence limit or probability. This is based on the volatility
of the risk factor expressed as a standard deviation (σ) and the confidence limit (α)
we set on the risk.****** Thus, the value-at-risk number is our estimate of the
maximum expected loss. We can think of the confidence limit as the frequency with
which our revaluation of the position (as per Section 8.4.2) will be equal to or less
than the VaR estimate. For instance, using a daily estimate of the VaR, if we set our
confidence limit at 99 per cent (which is equal to 2.33 standard deviations under a
normal distribution curve), then we would expect only once in a 100 days the value
change to exceed our VaR estimate. Typically, for financial institutions that are
actively involved in trading, the time frame will be daily – if not more frequently –
while for an investment manager this might be monthly, quarterly or longer,
depending on how often decisions are made to change a position or exposure. For
industrial and commercial firms where making changes involves real assets, the
exposure period between changes to the value at risk might, in some cases, extend
for several years.
Different asset classes (and assets within a given class) will have different volatili-
ties and hence risk. This is illustrated in Figure 8.8. A long-dated UK government
bond (known as a ‘gilt’), for example, is more volatile than a medium-dated bond, as
we would expect.†††††† With currencies, there are significant differences: for instance,
the US dollar is more stable against the Canadian dollar than it is against the
Japanese yen. The close relationship of the Canadian and US dollar is due to the
interconnection of the two countries’ economies. Equities are more volatile than
currencies or bonds, but commodities typically evidence the greatest volatility of all.
This latter fact is not surprising since they are more prone to ‘shocks’ – that is,
price-moving information – from a variety of macro and commodity-specific
factors.
****** Note that the assumption of most VaR models is that the distribution of value changes
follows a normal distribution and the standard deviation increases with the square root of time. In
practice it will be a lognormal distribution. Such a distribution will have the same properties as a
normal distribution. The price, as discussed in Module 7, diffuses with time according to the square
root law.
†††††† This is clear when we consider how the value is arrived at. The future coupon interest
payments and principal are discounted using interest rates. Longer maturities lead to more interest rate
sensitivity and hence, for a given change in interest rates, a greater change in price. Take a 5-year and a
30-year bond with a 5 per cent coupon when the interest rate is 5 per cent. Both bonds will have a
value equal to 100 per cent of par. If interest rates rise to 6 per cent, the 5-year bond will decline by
4.21 per cent, whereas the 30-year bond will decline by 13.6 per cent.

Interest rates Currencies Equities Commodities

43%
23%
19%
13%
8%
6%
Gilt Gilt C$/ Y/ FTSE Crude oil

edged edged US$ US$ 100 spot
‘shorts’ ‘longs’
Figure 8.8 Examples of asset-class volatility

Other things being equal, the same amount of a position or exposure in two
different assets with different volatilities leads to different value at risk for each
position. The amount of value change in a given position is therefore a function of
the asset’s volatility. This is illustrated in Figure 8.9 for the same amount invested in
medium-term government bonds and the leading 100 companies in the UK (Finan-
cial Times Stock Exchange 100 Index (FTSE 100 index or Footsie)). The same
investment has different value-at-risk consequences. This means we can use value at
risk as a ‘proxy’ for risk if all the VaRs of different assets are computed in the same
way. Alternatively, we can restrict positions to a given level of VaR so that higher-
risk positions will be smaller than lower-risk positions, given the same VaR.
Same amount ... … different exposures
Risk
factors 23%
Short gilts 8%
FTSE 23%
8%
Gilt FTSE Short FTSE

edged 100 gilts 100
‘shorts’
Figure 8.9 Risks and values at risk

But the asset or position volatility is only part of the picture. The longer the
position is held, the greater the potential for loss. Therefore, a key element of the
approach is to include within the risk management framework (a) the time over

which a decision can be reached to ‘close out’ a particular risk and (b) the actual
time required to carry out the decision. One way of understanding this is to consider
the value at risk as being related to the potential price changes over time, as illustrat-
ed in Figure 8.10. The binomial approach shows clearly that, the longer the time
required to act on the risk, the greater the value at risk.
T0 T1 T2 Value
at risk
(rG,T2) V2,GG
(rT1) V1,G
(1 - rG,T2)
V0 V2,GB,BG
(rB,T2)
(1 - rT1) V1,B
T1
(1 - rB,T2) V2,BB
T2
Time frame
Figure 8.10 Value at risk within a decision framework

The other element is the confidence limit. As mentioned earlier, the higher the
confidence limit, the less frequently the actual position will exceed the maximum
expected loss estimate. What is required is an estimate that will be exceeded only
occasionally, say once a month if we are considering VaR on a daily basis. If there
are 21 trading days in a normal month, then one breach per month of the VaR
estimate implies a cut-off at the 95 per cent confidence limit. While there is no
generally accepted standard for what the probability limit should be, in practice
individual institutions set a confidence limit around this criterion, for instance
Deutsche Bank use 99 per cent, JP Morgan Chase 95 per cent and Citigroup 95.4
per cent. Table 8.10 shows the number of standard deviations on a normal distribu-
tion and the corresponding confidence limits (or the probability that the expected
value will lie within that standard deviation).
Table 8.10 Areas under the normal distribution and the corresponding
confidence limits
Nσ’s Confidence limit
1.00 84%
1.28 90%
1.65 95%
1.96 97.5%
2.33 99%
Note: This is a two-tailed test.

Value at Risk and Prudential Capital _________________________

The Basel Accord of 1988 and its subsequent revisions under Basel II and III set
prudential capital limits for regulated financial institutions. In calculating the
amount of risk, banks have been allowed to use their ‘internal risk models’. In
practice this means variants of the value-at-risk approach to determine the
amount of prudential capital that is required to support their operations. In
authorising the use of the models, the regulators have determined that an
appropriate yardstick for estimating risk is a 99 per cent confidence limit (that
is, the level will be breached once in 100 days), a minimum holding period of 10
days and volatility estimated over a minimum period of one year.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
The final element in the value-at-risk approach is the effect of position sensitivity
and diversification on the total risk. A full treatment of the portfolio model is
reserved for the next module. However, it is important to understand that, through
the benefits of diversification, the total value at risk of a portfolio is unlikely to be
the sum of the individual value at risks of its components. Take, for example, a
portfolio that is made up of a long position in one security and a short position in
another. The long security’s price behaviour sensitivity will be positively related to
how the market performs, whereas the short security’s sensitivity will be negatively
related to the market. To the extent that one position offsets the other, the total risk
will be relatively small. An important determinant will be the degree to which the
two securities co-vary together, which can be measured via the covariance or the
correlation coefficient. In the portfolio model, the degree of covariance, or, more
usually, correlation, is important in determining the total position risk. How much
risk there is in a portfolio involves a complex matrix calculation, which we will look
at in detail in the next module. For now, Figure 8.11 shows the basic approach.
Starting with two positions, we have a simple, undiversified VaR that is the sum of
the two positions’ values at risk (VaRportfolio = VaRA + VaRB), which we can term the
undiversified VaR. Due to the fact that the two securities are not perfectly
correlated, the total risk when we include diversification is less than this undiversi-
fied VaR. That is, VaRundiv < VaRdivers where VaRundiv is the estimate of the
undiversified value at risk and VaRdivers is the diversification or portfolio value at
risk. When we take account of the fact in Figure 8.11 that one security is held and
will have a positive sensitivity to changes in the market or underlying risk, the other
security has been sold short, so has a negative sensitivity to the underlying risk
factor. When we combine these two into a portfolio, the total value at risk is close
to zero. In the case where the correlation is perfectly negative, we can subtract the
values at risk of the two securities (VaRportfolio = VaRA – VaRB).

Position VaR Correlation Netted
r = 0.67
12.5%
5.1%
Can 0.5%
Govt.
UST
5 Yr.
Position offsets (+ / –)
and correlation ( r)
act to reduce level of risk
at the portfolio level
6% 6.5% Risk
factor
Figure 8.11 Effect of diversification and position sensitivity on the value at

risk of a portfolio
Obviously the efficacy of the model will depend on getting good estimates for
the individual volatilities and the correlation between assets. This is an important
issue and not without its difficulties, but a detailed discussion of these modelling
issues is beyond the scope of this module. Suffice to say that, in times when markets
become destabilised, or stressed (as it is generally called), market volatility also
seems to increase and assets become more correlated. This means that choosing the
right parameters for the model is important if the results are to be valid under
stressed market conditions. But doing this leads to an overestimate of the value at
risk under normal conditions. So whatever is decided is something of a compromise.
However, as we shall see in the next section, practitioners prefer to model the
effects of stressed conditions directly through a ‘worst-case scenario’ rather than
relying on a model that works well under normal market conditions. So the value-at-
risk approach involves two different elements: a VaR estimate that is a reasonable
estimate of the amount at risk under normal circumstances and a stress test that
shows what might happen under stressed market conditions.
Figure 8.12 shows the function of the value-at-risk estimates. Their purpose is to
alert managers to deviations from the expected value behaviour or profitability of a
position. Any movement of the revalued position beyond the VaR estimate will, at
the very least, prompt a review of the situation. Behind the VaR number will be an
action line where mandatory steps are taken to eliminate the risk. The function of
the VaR estimate is therefore to act as a signal that the outcome may require

potential action. So values of the underlying risk in the shaded part of Figure 8.12
may prompt corrective action in consideration of the danger of breaching the action
line.
Value of risk factor
Upper action line

Risk control action may be taken if the risk factor is in this area
Statistical confidence
Upper VaR estimate
Actual outcomes
limits
Acceptable norm line
Lower VaR estimate
Risk control action may be taken if the risk factor is in this area
Lower action line
Time
Figure 8.12 Function of the value-at-risk estimate in risk control

A breach of a particular value may trigger action if outside the estimated VaR, depending
on the cause and management policy. Action will be taken if the value moves outside the
alarm line.
The attraction of the value-at-risk approach is that risk is seen as the total devia-
tion in the current values without differentiating between specific items. As a
decision support tool, it has a shorter time horizon than conventional reporting and
provides a common framework for risk management. Unlike mark to market, it is
forward looking and is based around differences in the risk of the underlying
positions. All assets, securities and positions can be converted into their VaR
equivalents.‡‡‡‡‡‡ In seeking to manage risk and make choices between different
assets, it allows for a more sophisticated discussion of the alternatives. It also allows
for comparisons of differences in appetite for, and management of, (market) risks
by business units and firms. Finally, it also provides regulators with a common
reporting framework.
To summarise, the value-at-risk methodology is designed to show the expected
loss from any situation. (Note that, following the practice of the decision sciences,
this is taken to be a positive number, regardless of the position’s sensitivity). What it
‡‡‡‡‡‡ That said, this is not without its difficulties since some positions that have very varied
payoffs, such as options, have non-linear payoffs that depend on the underlying optioned instrument’s
future value. The basic approach is to convert such instruments into their asset equivalent when using
parametric VaR methods. This, however, only provides an approximation of their future price
behaviour. When using simulation VaR, these non-linearities can be modelled directly, albeit by adding
complexity to the analysis.

will not show is what the worst-case outcome might be. This is the function of the
stress test.
Risk Measurement in All Its VaR-ieties _______________________
While the basic value-at-risk model is conceptually easy to explain, in practice
variations exist. The principal ones are detailed below.
Parametric VaR, which is also known as variance–covariance VaR or analytic
VaR. This makes use of the estimated volatilities and correlations between the
different assets in the portfolio. It assumes that the behaviour of price changes is
normally distributed: (PVaR = – ασ + μ), where α is the confidence limit, σ the
standard deviation and μ the mean value.
Historical VaR. This involves ranking past value changes over the assessment
period to find the value change at the confidence limit: (1, 2, 3 …α, …μ),
HVaR = 1 – α, where α is the confidence limit.
Simulation VaR. There are two possible approaches used here. The first is a
parametric simulation approach where a model is built that identifies the market
factors that govern the value of the portfolio. Appropriate distributions for the
changes in these factors are selected; a number of simulation ‘runs’ of the model
(typically between 1000 < N < 10 000) hypothetical future values are computed.
The other approach is to randomly select from past data returns to generate
the scenarios. In both cases SVaR = 1 – α, where α is the confidence limit.
In assessing the results, practitioners also calculate:
Undiversified VaR. This is the sum of the individual component VaRs exclud-
ing any diversification benefits, namely:
UVaR ∑ |VaR |
This is a prudent estimate of the total risk since the value does not include any
portfolio benefits and ignores long and short positions.
Diversified VaR. This is the expected VaR number, which includes the
diversification benefits of holding assets that are not perfectly correlated in a
portfolio.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
8.4.4 Corporate Value at Risk

For non-financial companies, calculating a value-at-risk estimate requires the risk
manager to analyse the firm’s business exposures. These may include different types
of exposures, namely contractual exposures, forecasted cash flows, economic
exposures and so on. This number represents the firm’s total ‘business risk’. Such a
calculation may then be used to help decision makers compare, for instance, the risk
involved in building production capacity in the European Union as against building
the same facility in the Far East. In addition, the firm will run a VaR on all the
financial transactions that are used to manage the firm’s business exposures. This
estimate is useful both from a reporting perspective and as an indication of the
amount of financial risk management, should top management ever decide to
liquidate its outstanding financial positions.

The next step is to combine the business exposures and the financial VaR esti-
mate into a firm-wide exposure. If a firm’s financial risk management programme is
working as it should, then the firm-wide VaR figure should be less than either the
business risk VaR or the financial risk management VaR. This should be the case
since the intention of the financial risk management, as previously discussed, is to
reduce or lay off the elements of the underlying firm risks that management has
decided it does not want to retain within the firm. If this corporate VaR (CVaR) is
not smaller, then there is probably some flaw in the way the firm is undertaking its
financial risk management, particularly in cases where it has to use proxy hedging as
part of its risk-reduction strategy. Proxy hedging is relying on the behaviour of
financial instruments or combinations of financial instruments that, when taken
together, have characteristics that match the underlying exposure being hedged.
In addition to the CVaR estimate, given the importance of counterparty credit
risk, firms need to be aware of the credit exposures they have with counterparties to
their hedging transactions. Considering potential positive income statement changes
in, say, financial instruments such as options, makes it possible for firms to measure
how their exposures to counterparties vary and how these exposures are changing
relative to their limits.
Value at risk is a useful tool for non-financial firms. The goal of the CVaR ap-
proach is to give the board of directors a simple number that defines risk. The
problem in implementing CVaR is that being able to understand the results requires
a more complex level of understanding by management. Also implementation issues
may cause the company to give up on the approach altogether. VaR, with its many
underlying assumptions, is harder to understand by non-specialists than the more
straightforward scenario analysis approach. Consequently, it can be difficult to
convince decision makers that they should accept a CVaR estimate as a viable basis
for making a decision.
8.4.5 The ‘Stress Test’

While value at risk is a useful forward-looking way to analyse risk, it does not
provide the worst-case scenario that risk managers may need. In particular, VaR
does not attempt to measure losses under any particular set of market conditions,
nor does it address the problem of cumulative losses. That is, the VaR estimate will
be the same whether the position has experienced significant losses in the immedi-
ate past – or profits. Finally, when applying parametric VaR, it is not good at
capturing any positive or negative skewness in the underlying returns distribution.
Therefore, as a measure of the underlying risk, value at risk by itself is not a suffi-
cient risk measure.
Value at risk is therefore an incomplete analysis in that the actual outcome might
follow a worst-case path. To see how the position might perform in such a situation,
it is usual to perform a stress test based on some scenario of extreme market
conditions. Usually such a test is based on some major market-disrupting event.
Examples include the behaviour of equity markets in the Great Crash of 1929 or the
crash of 1987; for currencies, the events surrounding the UK’s exit from the

Exchange Rate Mechanism (ERM) in 1992; and, for oil prices, the Gulf Crisis
precipitated by the Iraqi invasion of Kuwait in 1990. This is shown in Figure 8.13.
0.50
0.45 h
as on
0.40 Cr lu ati
29 ar va
19 e
0.35 lf W yd
Gu nc
rre
0.30 Cu
0.25
0.20
0.15
0.10
0.05
2 standard deviations
0
–4 –3 –2 –1 0 1 2 3 4
Stress tests
Figure 8.13 Stress test risk analysis

The very large price or rate movements of these ‘market events’ is used to calcu-
late the worst-case outcome. Thus if, using the earlier example from Table 8.9, the
price of similar assets had changed by 3.7 standard deviations during a period of
market disturbance, the worst-case loss would be £2 176 610.§§§§§§ Is this realistic?
Table 8.11 details the actual worst-case scenarios for a range of stressed markets.
Table 8.11 Examples of extreme market movements

Largest Pre-event One-day move in Implied percentage change
one-day volatility terms of pre-event for the confidence limit (α)
move (%) (%) volatility set at:
Market (I) (II) (n standard 2 3 20

deviations) (II) × 2 (II) × 3 (II) × 20
(III) = (I)/(II)
Peso/US dollar 20.4 2.5 8.1 5.0 7.6 50.4
Thai baht/US 19.5 17.6 1.1 35.2 52.7 351.5
dollar
Russian rou- 41.2 1.6 25.8 3.2 4.8 32.0
ble/US dollar
Brazilian real/US 9.0 0.9 9.9 1.8 2.7 18.2
dollar
§§§§§§ This is based on the one-month exposure with a volatility of 0.20 and a 3.77 standard
deviation movement in prices/rates (£10m × 0.20 × 3.77 × √1/12).

What Table 8.11 shows is that, at confidence limit ranges between 2 and 3 stand-
ard deviations, only the Thai baht volatility would have captured the largest one-day
price change. In the other cases, the models would have seriously underestimated
the potential ‘event risk’ price movements. In the case of the Russian rouble this
was a staggering 25.8-sigma event!
There are many historical and more recent examples of stressed market condi-
tions: the Asian crisis in the late 1990s, the sub-prime meltdown in 2007–8 and the
problems associated with the eurozone, to name but a few. Deciding which stressed
event to use depends to some extent on the horizon being used. A one-day event is
unlikely to be repeated over the longer term, but markets can fall considerably over
the medium term in very volatile conditions. Consequently, finding the right
extreme market movement can be problematic. In the eurozone crisis, the European
Banking Authority was criticised in its stress tests of European banks for not
including more extreme scenarios. It is probably better to err on the side of choos-
ing too big a movement, rather than underestimating the extent of potential extreme
events.
8.4.6 Risk Management Using the Value-at-Risk Approach

For risk management purposes, value at risk (VaR) reports can be used to determine
whether the size of the risks identified is acceptable to the firm and whether any risk
reduction or insurance is required. In particular, value-at-risk limits can be set for
particular types of exposures and for the firm as a whole.
By assuming that asset price behaviour is normally distributed or approximately
normally distributed, the risk manager can set the confidence limit or probability of
the price risk factor not to exceed a given level based on the known behaviour of
the normal distribution.******* Thus, for exposure management purposes, an adverse
move in either direction, up or down, could be set as a change (ra) over one day (or
trading session) that is not expected to occur more than, say, once a month.
, 95% ﴾8.3﴿
By substituting into Equation 8.3 we can compute the degree of divergence re-
quired by our confidence limit of 95 per cent:
ra = 1.96σ
In other words, the confidence limit sets an adverse move that is equivalent to a
deviation of 1.96 standard deviations from the average daily price change, assuming
the daily changes are normally distributed.
******* In reality, as previously discussed, evidence shows that asset returns are somewhat skewed
and exhibit a phenomenon known as ‘fat tails’, where there are more observations in the tails of the
distribution than would be predicted by the normal distribution. The approach we discuss here applies
what is known as ‘parametric VaR’, where we need to make assumptions about the distribution of
returns. For modelling purposes, it is necessary to assume the distribution of returns is normal even
though we know this is not the case. We allow for this mis-specification by using the stress test to
model the extreme behaviour of asset prices.

If the maximum position in the British pound against the dollar is £5 000 000,
then, based on an estimate of volatility of 20 per cent (1.04685 per cent on a daily
basis using a year of 365 days [20%/√1/365]), the risk manager is confident that the
maximum loss over a 24-hour period is unlikely to be more than:
Maximum expected loss 1.96 0.0104685 £5 000 000 £102 591
Using this approach, unlikely means a 0.95 expectation of a change in price being
less than 1.96 standard deviations. However, there is a 0.05 possibility of a change
larger than this. This leads to two methods that the risk manager can use to control
exposure: (1) change the confidence limit and (2) change the amount of the expo-
sure at any one point in time.
Changing the confidence limit away from the mean has the effect of reducing the
frequency of the position’s moving beyond the confidence level but increasing the
amount of loss before breaching the VaR limit occurs and hence triggering remedial
action. Where to set this level is a matter of judgement and management preference.
The closer to the mean, the more frequently the confidence limit will be violated;
the further away, the greater the loss that might occur. The level of safety required
will dictate the actual point at which the confidence limit will be set. In practice,
somewhere between 1.5 and 2 standard deviations appears to be a common level,
providing a range between about 87 per cent and 96 per cent respectively.†††††††
Since the confidence limit is designed to set a reasonable level of exposure, it also
needs to be set in the light of the risks being taken. This will be a function of the
exposure assumed and the degree of volatility in asset prices. For the same value at
risk, a higher exposure can be tolerated in a given position if the volatility of the risk
is lower (that is, the expected dispersion of future values as measured by the
standard deviation is smaller). This is illustrated in Table 8.12. If a position is seen as
potentially high risk, or that the amount that is exposed wants to be set as a limit,
then this will dictate the total amount of the exposure to the risk factor that may be
tolerated. This is shown in the second part of Table 8.12, where the exposures have
been set to be equal for each of the confidence levels shown in the table.
††††††† One conservative benchmark is to set a one-tailed 99 per cent confidence limit against
potential losses.

Table 8.12 The effect of volatility on the amount at risk for various levels
of volatility
Position Amount at risk
£5 000 000
Confidence level
0.15 0.10 0.05 0.01
Multiplier for stand- 1.440 1.645 1.960 2.576
ard deviation***
Volatility (σ)
0.1 £720 000 £822 500 £980 000 £1 288 000
0.2 £1 440 000 £1 645 000 –£1 960 000 £2 576 000
0.4 £2 880 000 £3 290 000 –£3 920 000 £5 152 000
Exposure
Volatility (σ)
0.1 £5 000 000 £5 000 000 £5 000 000 £5 000 000
0.2 £2 500 000 £2 500 000 £2 500 000 £2 500 000
0.4 £1 250 000 £1 250 000 £1 250 000 £1 250 000
Note: The upper part shows different levels of loss that can be sustained for a given
exposure of £5 million. The lower part equalises the exposure at the lowest volatility
level. Thus, in order to have a value at risk of £822 500 at the 10 per cent (0.10 level),
the permitted exposure needs to be halved if the estimated or expected volatility
doubles. Note there has been some rounding used in the table to make the numbers
less complex. The actual exposure for the 10 per cent volatility and the 0.15 confidence
limit is £719 766, but it is reported as £720 000 in the table above.
*** Note this is a two-tailed test (i.e. we are looking at both price increases and
decreases).
8.5 A Note of Warning

For reasons already discussed at the start of this module, risk management involves
filtering all possible outcomes down to a set of (apparently) key factors and behav-
ioural relationships. Since, in order to be effective, as much is left out as is included,
it is only a representation or model of reality. If the risk management function and
the models used to control risks are perfect, the risks will be controlled; but life
shows that accidents continue to happen: both to us and to others. Value at risk is
just another tool for helping managers control risks. It is like the instrumentation in
the cockpit of an aircraft. In the hands of a good pilot, it helps with the task of
flying the aircraft. To rely on it without a proper understanding of how the numbers
are put together can be fatal. In the next modules we turn to examining how the
models work.

The Models Take a Beating _________________________________

The introduction of VaR in the early 1990s left risk managers at banks confident
that they had ‘tamed the risks’. This was hubris, as in the late 1990s stressed
markets put the spotlight on financial institutions’ reliance on their risk models.
In the wake of the Russian debt default and the crash in the rouble that took
place in 1998, a number of investment banks that had adopted sophisticated risk
models (such as VaR) and were keen advocates of a more scientific approach to
risk management had to eat humble pie. The summer of 1998 was a particularly
difficult time, as turmoil in the financial markets threw up losses unpredicted by
their internal risk models. For example, Bankers Trust, the US wholesale bank
that had been a pioneer of risk assessment through its Risk-Adjusted Return on
Capital (RAROC) model, reported that in the third quarter to September 30
(1998) its trading account losses had exceeded its one-day, 1 per cent value-at-
risk calculation in five days during the previous quarter – a figure that statistical-
ly, and in fact over the last three years, would be exceeded in just one day in a
hundred.
Criticisms of the models were aired at a meeting of the International Monetary
Fund (IMF) in the autumn of 1998, which raised questions about the capability of
the risk-modelling and portfolio management systems extensively in use at banks
and other financial institutions. The IMF argued that typical VaR models signifi-
cantly understated the likelihood of the occurrence of extreme events and
furthermore assumed that the underlying processes generating market prices
were stable over time. The IMF also found that the models were inadequate at
assessing the risk of default and the liquidity risk of being unable to unwind a
position without unsettling the market.
The IMF and other critics of the models have argued that risk models such as
VaR create a false sense of security among senior executives who do not
understand what the models tell them – or do not tell them.
By the time of the global financial crisis 10 years later, the problem of the
models had not been resolved. Once again, the confidence limits that under-
pinned the market models were found to be breached far more than the models
would allow for. In the stressed markets of the third and fourth quarters of
2008, the models failed, since they presumed a degree of normality that was not
being met by the high volatility swings in the global financial markets.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Learning Summary
We can summarise the process of controlling and managing risks as a series of
evaluation and decision steps. Be aware that, although the approach appears simple,
in practice the actual task is quite difficult. The control steps then follow a logical
sequence:
1. Identifying risks
This requires a risk audit of the firm’s activities. Each risk can be broken down
into its component parts to derive the individual risk factors that form the fun-
damental building blocks of the risk management process.
2. Analysing the impact of each risk
For risks to be managed, their effects on the firm’s activities have to be meas-
ured. The resultant exposures will determine whether the risks are material or
not. Note that the question of materiality is a subjective one: what is acceptable
to one firm may be totally inappropriate to another.
3. Assessing the effect of the exposures on the firm’s business and strategy
The key question is how vulnerable the firm may be to changes in its financial
risk exposures and the degree to which the firm needs to respond to the prob-
lem. Firms will need to set a policy for managing such financial risks. The exact
mix will depend on the firm’s objectives, its appetite for, or dislike of, risk and
other operational considerations.
4. Assessing the firm’s internal capability for risk management
The initial stage of risk reduction will seek to look for internal ways of managing
risk. The availability of information and the costs of putting in place such sys-
tems, together with other management resources, will determine how much of
the firm’s financial risks can be managed internally. Natural offsets will reduce
the cost of hedging and insurance to the firm.
5. Selecting the most appropriate risk management strategies and/or
products
Once the firm has set a policy for the amount and types of risk it wants to bear,
the unwanted or unacceptable risks can be reduced through the appropriate
strategy or the purchase of appropriate risk management products.
6. Keeping the programme under constant review
Any business situation is dynamic and the degree of exposure needs to be kept
under constant review as the variables that go into the risk management process
can, and are likely to, change over time.
The module has discussed a number of issues relating to the management of
risks, in particular how they are to be evaluated in terms of the firm’s own assess-
ments and the steps required to implement such a programme. The various
approaches, using either macro data or building up from the individual risk factors,
are discussed. The nature of the analysis requires that any assessment must look to
the future – this is the intention of the value-at-risk methodology. To complement
the expected-value framework of the value-at-risk analysis, the worst-case scenario
or stress test is required to provide an indication of the maximum potential expo-
sure when markets are distressed.

Review Questions
8.1 In seeking to control risk, managers will include the following factors in their procedures
and processes:
I. the time frame of the exposure.
II. the time required for managers to make a decision.
III. the potency of the risk.
IV. the amount involved.
A. I, II and III.
B. I, III and IV.
C. II, III and IV.
8.2 Which of the following is correct? A firm’s ‘risk threshold’ is:

A. the change in value of a risk factor that leads managers to take corrective
action.
B. the volatility of a particular risk above a predetermined level.
C. managers’ tolerance of various kinds of risks.
D. managers’ understanding and experience of various kinds of risks.
8.3 Which of the following is correct? A ‘risk audit’ is:

A. an assessment of the different risks inherent in a firm’s activities and processes.
B. an investigation and report prepared by the firm’s accountants for statutory
reporting purposes.
C. an investigation and report prepared by the firm’s accountants highlighting the
dangers of fraud.
D. an assessment of the nature of different risks in the business environment.
8.4 Which of the following is correct? ‘Confidence limits’ are used for:
A. establishing the maximum extent for losses from a given risk.
B. establishing the likelihood of losses from a given risk.
C. establishing the degree of uncertainty surrounding statistical estimates of the
risk factors.
8.5 Which of the following is correct? Materiality in the context of risk management refers
to:
A. the process of ranking different exposures by their severity.
B. the process of distinguishing between insignificant and significant exposures.
C. the degree of external offset between different exposures.
D. the degree of internal offset between different exposures.

8.6 Which of the following is correct? Changing a firm’s behaviour in a risk management
context involves:
A. developing new lines of business in response to changes in market conditions.
B. adjusting the amount of risk being taken by the firm.
C. altering the firm’s activities and processes in ways that reduce risks.
8.7 Which of the following is correct? Selling risk capacity involves:

A. selling options.
B. making a profit from the firm’s ability to absorb risks.
C. structuring risk management activities and processes to reduce their cost.
8.8 Which of the following is correct? The operational management of risk by the firm
involves:
A. designing its production and distribution and targeting markets so as to
minimise the impact of changes in the risk factors on the firm’s future cash
flows.
B. matching, as far as possible, the nature of its liabilities to its assets so as to
minimise future differences.
C. matching, as far as possible, by currency and maturity its revenues and expendi-
tures.
8.9 Which of the following is correct? When applying operational risk management, a firm
has to recognise that:
A. only a fraction of the firm’s total risks can be managed in this fashion.
B. excessive concentration on operational risk management can lead to inefficien-
cy.
C. excess market risks can, in the last resort, be hedged out in the financial
markets.
8.10 Which of the following is correct? When seeking to manage risks, firms will be most
concerned about:
A. potential losses.
B. the opportunity to profit from risks.
C. ensuring that the firm’s cash inflows and cash outflows are matched.

8.11 Which of the following is correct? The main differences between the top-down and the
building-block approaches to examining risk are:
A. there are no fundamental differences between the two approaches: the top-
down method and the building-block approach can be applied interchangeably.
B. the top-down approach looks at the firm as a whole, whereas the building-
block method assembles a picture from the individual risks.
C. the top-down approach looks at risk in the firm as a whole, whereas the
building-block method looks at individual risks.
D. the top-down approach is suitable for understanding risks but not in measuring
them, whereas the building-block approach is suitable for measuring risks but
not understanding them.
8.12 There are two companies in a group where the common currency is M and which have
the following exposures to currency A:
Company I Income Expenditure Company Income Expenditure

maturity (+) (–) II maturity (+) (–)
1 month 150 55 1 month 210 150
2 months 180 40 2 months 240 175
3 months 25 80 3 months 85 45
If the two companies offset their mutual exposures, which of the following will be the
total net exposure for the group?
A. 345
B. 545
C. 890
D. 1435
8.13 If in Question 8.12 the company has a policy of keeping its net maturity exposure per
month below 200 units of currency A, the current situation for the group is represented
by which of the following?
A. There is no excess exposure in any of the maturities.
B. There is an excess exposure in the one-month maturity.
C. There is an excess exposure in the two-month maturity.
D. There is an excess exposure in the three-month maturity.
8.14 In Question 8.12, the reporting currency of the group is currency M. The exchange rate
between currency M and currency A is A4 = M1.
Which of the following is the total net exposure in M currency units of the group in
currency A expressed in the reporting currency M?
A. M86.25
B. M136.25
C. M358.75
D. M5740.00

8.15 The following table shows the exposures for two currencies, A and B, that have arisen
during the course of its normal operations by a firm whose reporting currency is
currency X:
Currency A Receivables Payables Currency B Receivables Payables

maturity (+) (–) maturity (+) (–)
1 month 1680 650 1 month 270 348
2 months 2300 450 2 months 564 725
3 months 6200 300 3 months 225 415
The exchange rates between currency X and currencies A and B are 20A = 1X and 6B
= 1X.
Which of the following is the total amount of currency exposure being assumed by the
firm from its operations?
A. 367.70
B. 417.55
C. 510.30
D. 1003.50
8.16 If, in Question 8.15, the company has a policy of keeping its net maturity exposure per
month below 300 units of currency X, the current situation for the group is which of
the following?
A. There is no excess exposure in any of the maturities.
B. There is an excess exposure in the one-month maturity.
C. There is an excess exposure in the two-month maturity.
D. There is an excess exposure in the three-month maturity.
8.17 A US company operates an international reinvoice centre for its European operations,
which are based in France, Germany, Italy and the UK. These subsidiaries trade between
themselves and the parent corporation in the US. The European operations have the
following inter-company transactions:
 sales from the French company using euros to the US parent (using US dollars);
 purchases by the UK subsidiary (in British pounds) from the US parent company;
 sales from the UK subsidiary to the Italian company (using euros);
 purchases from the Italian company by the German company (both in euros);
 purchases from the UK subsidiary by the French company (using euros).
Which of the following are the offsets available to the international reinvoicing centre?
A. There are no offsets available.
B. All currencies can be offset.
C. There is an offset in US dollars and euros.
D. There is an offset in US dollars, euros and British pounds.

8.18 Which of the following is correct? The purpose of a limit is to:

A. indicate when a position needs to be reconsidered.
B. set a maximum loss on a given position.
C. alert managers that there might be a difficulty with a position.
8.19 Which of the following is correct? The purpose of the ‘marking to market’ of a position
is to:
A. indicate how changes in the market price have affected the value of the
position.
B. indicate how much profit (or loss) has been made on the position since it was
established.
C. provide the basis for determining the margin requirement for a position on a
futures exchange.
8.20 The following foreign exchange positions have been entered into by a UK firm to hedge
its foreign purchases and sales with Germany:
Maturity Exchange rate Receivables (+) Payables (–)

1 month 1.60 €250 000 €70 000
2 months 1.65 €345 000 €35 000
3 months 1.70 €285 000 €45 000
If the currency has now changed and the new rates for one to three months are
respectively €1.62, €1.68 and €1.75, which of the following is the revaluation of the
position (rounded to the nearest currency unit)?
A. (£8126)
B. (£8761)
C. (£8778)
D. (£12 269)
8.21 Which of the following is correct? The value-at-risk method is based on:
A. revaluing the gains and losses on a position based on new market prices.
B. predicting the possible changes in value of a position based on the likelihood of
their occurring.
C. forecasting the direction of future price changes.
D. predicting the size of the gains and losses on a position based on the amount of
the exposure.
8.22 Which of the following is computed when calculating a value-at-risk (VaR) estimate?
A. The confidence limit.
B. The volatility (as measured by the standard deviation).
C. The decision time horizon.

8.23 There are two assets, A and B, with annualised volatilities of 0.20 and 0.25 respectively.
The value at risk of the two assets is which of the following?
A. It is the same.
B. A has more value at risk than B.
C. B has more value at risk than A.
D. It is none of the above.
8.24 There are two assets, A and B, with annualised volatilities of 0.20 and 0.12 respectively.
The decision horizon for A is one week and for B it is two weeks. The value at risk for
the two assets is which of the following?
A. It is the same.
B. A has more value at risk than B.
C. B has more value at risk than A.
D. It is none of the above.
8.25 Which of the following events would not be used as the basis of a stress test?
A. The collapse of the Bretton Woods Agreement in 1971.
B. The Asian-Pacific currency and stock market turmoil of August/September
1997.
C. The allied liberation of Kuwait in February 1991.
D. All of A, B and C can be used as the basis for a stress test.
8.26 When applying the value-at-risk approach, the result of portfolio effects between
different classes of assets (such as commodities, equities and debt instruments) on the
overall risk is which of the following?
A. There is no effect on the total amount of risk.
B. The total amount of risk is reduced.
C. The total amount of risk is increased.
D. It depends on the nature of the underlying assets in the portfolio.
8.27 Which of the following is correct? If we adopt a two-tailed confidence limit of 1.9
standard deviations on the normal distribution, we are unlikely to exceed this level
more than:
A. 2.84 per cent of the time.
B. 5.74 per cent of the time.
C. 94.26 per cent of the time.
D. 97.13 per cent of the time.
8.28 A risk manager has adopted a 1.95 standard deviation confidence limit on a position
with a volatility of price changes of 15 per cent where the decision horizon is one week.
If the current value of the position is £950 000, which of the following is the range of
values (to the nearest unit) within which the asset is expected to trade over the
decision horizon?
A. £1 227 875–£672 125
B. £1 092 500–£807 500
C. £988 534–£911 466
D. £968 525–£931 475

8.29 A currency position of €1.5 million against the US dollar has a volatility of 0.35, there is
a 2 standard deviation confidence limit and the decision horizon for the firm is one
month.
What is the amount of price change on the position that is to be expected over the
horizon?
A. €151 555
B. €262 500
C. €303 109
D. €525 000
8.30 In using the value-at-risk method, if the actual distribution is significantly skewed to the
right, the implication for the estimate of the value change will result in which of the
following?
A. There would be no effects on the estimate of the value change.
B. Price increases would be overestimated and price declines underestimated.
C. Price increases would be underestimated and price declines overestimated.
D. Some price increases will be overestimated and some price declines underesti-
mated.
Case Study 8.1: Georgetown Industries

Georgetown Industries plc, based in the UK, is involved in both buying and selling in US
dollars. It has the following set of outstanding contracts in US dollars.
Time Receivables US$ Payables US$ Exchange rate US$/£

1 month 1 500 000 750 000 1.5000
2 months 1 000 000 850 000 1.4975
3 months 900 000 800 000 1.4950
6 months 250 000 700 000 1.4925
1 Estimate how much exposure the company has to the US dollar.
2 If the currency rate should change to the following rates, what will be the effect on the
value of the position?
New exchange rate US$/£

1.5010
1.4995
1.4975
1.4965

3 If Georgetown Industries arranged that it might borrow from its US dollar account at its
bank to address timing mismatches on its dollar cash flows, how much of the residual
US dollar exposure would it have to hedge in the forward foreign exchange market and
at which maturity? The cost of finance is 5 per cent per year. The company can earn
4.875 per cent on any deposits it might make.
4 What might be the attractions of using its US dollar account for such purposes (in
Question 3 above)? From a risk management perspective, what are the implications of
the above, rather than using forward foreign exchange contracts to achieve the same
purpose? What might be the principal disadvantage of the approach?
References
Chew, L. (1996) Managing Derivatives Risk: The Use and Abuse of Leverage. New York: Wiley
Frontiers in Finance.
Drucker, P.F. (1973) Management: Tasks, Responsibilities, Practices. London: Heinemann.

Module 9
Quantifying Financial Risks

Contents
9.1 Introduction.............................................................................................9/2
9.2 Statistical Analysis of Financial Risk .....................................................9/4
9.3 The Significance of the Normal Distribution.......................................9/9
9.4 Understanding the Risk Measures...................................................... 9/11
9.5 Measuring the Relationship between Assets .................................... 9/16
9.6 Portfolio Expected Return and Risk .................................................. 9/21
9.7 Practical Considerations in Measuring Risk ...................................... 9/31
9.8 Estimating Portfolio Value at Risk ..................................................... 9/31
Appendix to Module 9: Example of the Statistical Analysis of Risk .......... 9/35
Learning Objectives
This module continues the examination of approaches to managing risks by looking
at how to measure and model financial risks. In particular, it looks at the benefits of
diversification. These benefits come from creating portfolios that include assets that
are not perfectly correlated. The initial part concentrates on the financial approach
used for measuring risk through the use of the standard deviation and then focuses
on how risk can be measured for portfolios. The key building blocks of the financial
risk analysis framework relate to measuring the expected return, the variance and
standard deviation of return, and the probability of outcomes. A key issue is the
interdependency or covariation of returns between different assets or risk factors.
The module then extends the analysis to look at value at risk in a multi-asset
portfolio context.
After completing this module, you should be able to:
 calculate the average value, the variance and the standard deviation of a financial
series;
 calculate the correlation between two different risks;
 construct a portfolio to show the combined effect of different risks on a
position;
 calculate the benefits of diversification;
 apply the model to estimating the value at risk of a portfolio.

Module 9 / Quantifying Financial Risks
9.1 Introduction
Lord Kelvin (1894) said:
When you can measure what you are speaking about and express it in num-
bers, you know something about it; but when you cannot measure it, when you
cannot express it in numbers, your knowledge is of a meagre and unsatisfactory
kind: it may be the beginning of knowledge, but you have scarcely, in your
thoughts, advanced to the stage of science.
This statement reflects the views of the scientific/engineering approach to risk

management. This is perhaps an extreme view of how the risk management process
works, but it is undeniable that the development of an effective risk management
process based on mathematical analysis has an important function in financial risk
assessment.
To the outsider, financial managers seem totally preoccupied with numbers.
There are the daily, weekly, monthly and quarterly reports of varying complexity that
have to be passed up the chain of command. Typically, such reports concentrate on
numerical data, accounting information, credit losses, exposures, business activity
and so on. Such data relate to how well the firm is performing against benchmarks
and budgets.
Measuring risk is one of the ways that it can be tamed and managed. The mathe-
matical approach to measuring risk is not so very different from that of quality
control in a firm. In a production process, the firm is concerned with establishing
the likely fault rate in a particular production process. In finance, the problem is
somewhat similar. The stages discussed in the previous module are used to establish
a numerical estimate of the value at risk, namely:
1. the distribution of potential outcomes;
2. the time horizon over which the exposure is present;
3. the confidence level, probability or chance that a particular, usually adverse,
outcome will occur;
4. the steps to be taken to control the level of exposure.
Financial markets behave in a random way; that is, they are stochastic by nature.
As described in Module 7, they behave as if prices follow a random walk. It is not
possible to determine today what tomorrow’s price will be, but it is possible to
determine the degree of divergence or spread of asset price changes over time using
standard statistical and econometric methods; that is, computing what is, in the
financial markets, termed ‘volatility’. The statistical approach to risk modelling will
provide an estimate of the likely divergence of outcome, but not of the direction of
such a change. Predicting the future direction of change, its magnitude and the time
span over which it is likely to persist involves forecasting.
This module concentrates on measuring the exposure based on a statistical
treatment of possible future value changes. The emphasis is on the numerical
approach to measuring risk. That is, in the current jargon of financial risk manage-
ment, it is concerned with the ‘earnings at risk’ or ‘value at risk’ of assets and
portfolios. The approach discussed here is not concerned with predicting a particu-

lar outcome or attempting to forecast the likely movements in a risk factor but
allows estimates of the potential spread of outcomes and hence the potential for
losses. This involves an application of what is known as portfolio theory. This is a
model of how to construct and analyse multiple assets as a group; that is, assets
grouped into portfolios.
The concept of frequency, or the probability of a particular outcome, is central to
the mathematical treatment of risk. Generally, in arriving at such probabilities, each
observation is weighted equally, but for time series data, for instance, it may be
preferable to weight the data to give a greater weight to the more recent values. A
variety of methods exist to weight observations in this fashion.
Not All Your Eggs… ________________________________________
The adage ‘Do not place all your eggs in one basket’ is the underlying principle
of portfolio diversification. Harry Markowitz obtained a Nobel Prize for his
insights into the process of portfolio construction and optimisation.
Assume you have an investment worth 1000. The payoff of this investment is
either success, when the investment will be worth 5000, or failure, when the
investment is worth nothing. Each outcome is equally likely. The expected value
of the investment is:
E V 0.5 5000 0.5 0 2500
The variance and standard deviation of the outcome is:
σ 0.5 0 2500 0.5 5000 2500 6 250 000
√6 250 000 2500
Now assume we can add another investment with the same characteristics and
cost as the first one but whose outcome is independent of the first. That is,
there is no connection between the outcomes of the two assets. In this case,
there are four possible outcomes: both investments succeed (GG) (pay-
off = 10 000), both fail (FF) (payoff = 0), the first succeeds and the second fails
(GF) (payoff = 5000), or the first fails and the second succeeds (FG) (payoff =
5000). When the two are independent, the likelihood of the two failing or
succeeding is (0.5 × 0.5) = 0.25. We have two possible intermediate outcomes,
so the chance of a mixed result is (0.5 × 0.5 × 2) = 0.5.
Now let us construct the expected value and risk of this two-asset portfolio.
The expected value of the two investments is FF (0.5 × 0.5)0 + GG
(0.5 × 0.5)10 000 + GF (0.5 × 0.5)5000 + FG (0.5 × 0.5)5000 =
0 + 2500 + 1250 + 1250 = 5000:
E V 0.25 0 0.25 10 000 0.25 5000 0.25 5000 5000
Note that this is unchanged from the single-asset case. The variance or standard
deviation of the two investments when put into the two-asset portfolio is
6 250 000, with standard deviation of 2500 (less the sum of the standard
deviation of the two assets), which is equal to 2500 × 2 = 5000:

σ 0.25 0 5000 0.5 5000 5000 0.25 10 000 5000

6 250 000
√6 250 000 2500
The expected payoff remains unchanged, but the risk as expressed by the
standard deviation has fallen. For uncorrelated investments, it declines at the
rate of
1/√
where N is the number of investments in the portfolio.
Of course, if there is an element of interrelationship between the investments,
then the risk will not decline in this fashion. Much of the arithmetic involved in
the portfolio model is to determine the riskiness of a portfolio when individual
risks are correlated.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
9.2 Statistical Analysis of Financial Risk

The financial approach to risk management involves the estimation of future cash
flows, either payable flows (outflows or future liabilities) or receivable flows (inflows
or future assets). Transactions can be viewed as a series of cash inflows and out-
flows: the future payable is probably the result of an earlier purchase; the receivable,
an earlier sale. These two basic cash flows are shown in Figure 9.1. Firms will have
both types in their day-to-day transactions.
CF0
Current
receivable
cash flow Future
payable
cash flow
CF1
CF1
Future
receivable
Current cash flow
payable
cash flow
CF0
Figure 9.1 Borrowers and lenders cash flows

An example of the first type of transaction, where we are dealing with future
outflows and where there are only two cash flows, is a short-term loan. The initial,
current cash flow for the borrower (CF0) is the borrowed amount, and the future
cash flow (CF1), the repaid loan plus the interest. The second type is, of course, the
opposite for the lender: the advance from the bank, followed by the repayment of
the loan plus interest, which is a future inflow or asset. We have already seen that
more complex instruments, such as a term debt or a bond, can be viewed as
packages of these simple cash flows. This applies even when the future cash flows

are not known with certainty, as with equity, where the amounts (and possibly the
timing) of future dividends are unknown.
We can estimate the cost or return in two ways: as an absolute value or in per-
centage terms. Thus, if a loan had been made for £1000 and the interest was £87.50,
in absolute terms the return would have been:
£1087.50 £1000.00 £87.50 ﴾9.1﴿
In percentage terms, the return would have been:
£ . £ .
100 100 8.75% ﴾9.2﴿
£
It is sometimes useful to know how much the return is in absolute terms. How-
ever, as a way of understanding the return, it is difficult to interpret. There might
have been another investment that had involved £900 as an initial cash flow and had
given £75.50 in absolute terms. If we had to choose which investment offered the
better return, the percentage return allows for easier comparison. The second
opportunity has a percentage return of 8.39 per cent and on a returns basis is
inferior to the first opportunity.
9.2.1 When the Outcome Is Uncertain

If the outcome is uncertain, which is the case we are most interested in from a risk
management perspective, we may be faced with any number of possible outcomes,
some of which are desirable, in that we get back more than we invested, and others
undesirable, as the amount returned is less than the initial investment. Let us extend
the above example when there was no uncertainty about the future return and look
at a situation where the investment is not a deposit that, barring default, has a fixed
return, but a security that – in normal circumstances – may have one of a wide range
of outcomes. An example will illustrate the issues. We have Securities 1 and 2, which
have a current value of 1000 and 900 respectively. We will assume, although it is
unrealistic, that there are only two possible future outcomes. Table 9.1 presents the
value and return on the two securities and shows a high return (giving a financial
gain) and a low return (leading to a loss). For convenience of exposition, we will
take the period to be one year, although this is not critical for the analysis. The
return calculation is straightforward. For Security 2, in the case of a high outcome,
the return is 1075.80/900 − 1 = 0.195, or 19.5 per cent. The other returns are
calculated in the same way.
Table 9.1 Value and returns (including interest income) for Securities 1
and 2 at the end of the period
Outcome Security 1 Return Security 2 Return
value value
High (gain) 1187.50 18.75% 1075.50 19.50%
Low (loss) 937.50 − 6.25% 875.50 − 2.72%

We can calculate the expected value for these securities. The expected value is the
probability-weighted value or return for each possible future outcome. The probabili-
ties here relate to the likelihood of getting the outcome. There are only two
possibilities involved: a high (H) and a low (L). So we need to calculate the expected
value based on these probabilities. Let us say the likelihood of a price increase
(positive return) is 0.55 (or 55 per cent) and by elimination a price decline is
(1 − 0.55), or 0.45, which is 45 per cent. For now, we will leave aside the question as
to how these probabilities were determined. Figure 9.2 illustrates the process. The two
outcomes are at the tips of the V, and the expected value is at the base. We apply the
probability calculations to each possible outcome, namely 1187.50 × 0.55 = 653.125
and 937.50 × 0.45 = 421.875. The expected value (E(V)) is therefore
653.125 + 421.875 = 1075.
H
(r)
Expected
value
(1 – r) L
(r = 0.55) H =1187.50
Expected
value
= 1075.00
(1 – r = 0.45) L = 937.50
Figure 9.2 Expected valuation framework for uncertain cash flows

The expected return will be the expected value of 1075 divided by the initial
investment of 1000 minus 1, which is 0.075 (1075/1000 − 1), or 7.5 per cent. We
could have calculated this expected return by taking the two possible returns and
weighting these by their probabilities, namely
18.75% × 0.55 + (−6.25%) × 0.45 = 7.5%.
Once we have estimated the expected value or the expected return, we can also
calculate the ‘dispersion’ or spread of values or returns around this expected value.
The standard measure of dispersion is the variance or the square root of the
variance, which is the standard deviation.‡‡‡‡‡‡‡ The formula for this variance is:
﴾9.3﴿
‡‡‡‡‡‡‡ Note that we could have simply used the range of possible outcomes, but this is not as
useful as the standard deviation, as we shall see later on. Other possible measures exist, but again these
are less useful than the variance or the standard deviation. We are not concerned here with issues
relating to real-world data such as possible skewness, as discussed in Module 7.

where ρi is the probability of outcome i; E r is the expected return; Ʃ is the

summation sign, meaning that each of the calculations must be added up; and n is
the number of possible outcomes. That is, we sum:
⋯
Note that the sum of the ρi values equals 1. That is:
∑ 1.0
The standard deviation (expressed as the Greek letter sigma, or σ) is the square
root of the variance. That is:
√
The calculations required to derive the variance (σ2) and standard deviation (σ) of
the return for Security 1 are shown in Table 9.2. The variance is 0.015469. The
standard deviation (the square root of the variance) is 0.124373, or 12.44 per cent.
Table 9.2 Calculation of the dispersion of returns (variance and stand-

ard deviation) for Security 1
OutcomeProbability Return Expected Difference Difference Probability
(ρ) return squared × squared
difference
(i) (ii) (iii) (iv) = (ii) − (iii) (v) = (iv)2 (i × v)
High 0.55 0.1875 0.075 0.1125 0.01266 0.006961
Low 0.45 −0.0625 0.075 −0.1375 0.0189 0.008508
1.00 Variance: (σ2) 0.015469
Standard deviation: √(σ2) 0.124373
The same calculation, to derive the variance and standard deviations for Security
2, is given in Table 9.3. We can now summarise our information about the returns
and risks on the two securities. This is given in Table 9.4.
Table 9.3 Calculation of the dispersion of returns (variance and stand-

ard deviation) for Security 2
Outcome Probability Return Expected Difference Difference Probability ×
(ρ) return squared squared
difference
(i) (ii) (iii) (iv) (v) (i × v)
High 0.55 0.19500 0.095 0.1 0.01 0.0055
Low 0.45 −0.027 0.095 −0.12222 0.014938 0.006722
22
1.00 Variance: (σ2) 0.012222

Table 9.4 Summary statistics for the two securities

Statistic Security 1 Security 2
Expected return 0.075 0.095
Variance in returns 0.015469 0.012222
Standard deviation of returns 0.124373 0.110554
Table 9.4 shows that Security 1 has an expected return of 7.5 per cent and a
dispersion, as measured by the standard deviation, of 12.44 per cent. Security 2 has
an expected return of 9.5 per cent and a standard deviation of 11.06 per cent. If the
distribution of returns is derived from the normal distribution, we can make a
number of predictions about the likely outcomes for the two securities, which are
discussed in the next section.
An Example of the Calculation of the Risk Statistics
Table 9.5 provides an example of the more usual way of calculating the average returns
and variance of returns where each observation (in this case the share price at the close
of each day) is given equal weight (that is, they are assigned equal probability) in
computing the return.
Another practical but important adjustment made to Equation 9.3 when calculating the
variance of return is to make what is known as the sample adjustment (n − 1). Statisti-
cians have determined that this gives a better estimate of the true variance when we are
using a sample that is not the entire population of possible cases. So the adjustment will
be as follows when using the equation:
where all the terms have already been defined in connection with Equation 9.3. Hence
we are not dividing by n, as we would expect if each observation had a probability of
1/n, but by n − 1. This is the ‘sample correction’, which helps correct for using only a
sample of data.
Table 9.5 Calculating the average return, variance and standard deviation
for Shares A and B
Security 1 price
Day Share A Rt = ln[Pt +1/Pt] Rt − μ Rt – μ 2 R t – μ 2/ n − 1
price × 100
1 100
2 102 1.980263 1.58421 2.509722 0.62743
3 104 1.941809 1.545756 2.389362 0.59734
4 103 −0.96619 −1.36224 1.855708 0.463927
5 104 0.966191 0.570139 0.325058 0.081264
6 102 −1.94181 −2.33786 5.465595 1.366399
E r = 0.396053 σ2 = 3.136361
σ= 1.770977

Security 2 price
Share B Rt = ln[Pt +1/Pt] Rt − μ Rt – μ 2 R t – μ 2/ n − 1
price × 100
985
988 0.304106 0.081993 0.006723 0.001681
1000 1.207258 0.985146 0.970512 0.242628
993 −0.70246 −0.92457 0.854837 0.213709
989 −0.40363 −0.62575 0.391558 0.097889
996 0.705293 0.48318 0.233463 0.058366
E r = 0.222112 σ2 = 0.614273
σ= 0.783756
Note that in the calculations the volatility is the daily volatility of continuously com-
pounded returns expressed as a percentage.
To find the annualised volatility, we need to multiply the daily volatility by √252, which
gives values for A and B of 28.11 per cent and 12.44 per cent respectively.
9.3 The Significance of the Normal Distribution

If we assume that the returns are normally distributed, we are stating that the distribu-
tion of returns is consistent with one of a number of probability distributions used in
statistical theory. The normal distribution is characterised by a ‘bell-shaped’ curve
where the observations above and below the mean (or expected) are distributed in a
symmetrical or equal manner. That is, there is the same probability of obtaining a
result above the mean as below the mean. The normal distribution is frequently
encountered in natural phenomena. In practice, the behaviour of financial market
returns can be closely approximated with the normal distribution.§§§§§§§
The attraction of the normal distribution is that, once the standard deviation has
been calculated, it allows us to estimate the confidence level or probability that a
particular outcome will be within a given range of returns. The areas under the curve
of a normal distribution are shown in Figure 9.3, with the probability of the value
on the vertical axis and the number of standard deviations above and below the
mean on the horizontal. The normal distribution has the familiar bell-shaped curve,
and this shows that most of the observations are grouped close to the mean – or the
average value of the distribution. When the data are normal, 68.28 per cent of
observations will fall within +1 and −1 standard deviation (1σ). When we look at 2
standard deviations (2σ), we have 95.44 per cent of the observations, and when we
go to 3 standard deviations (3σ), we have 99.74 per cent of the observations. For
any multiple of the standard deviation, we have a fraction of the number of observa-
tions that lie either within the range or outside the range. So, if we look at 1
§§§§§§§ Recall that in Module 7 we discussed the reasonableness of the normal distribution as a
description of the price- or return-generating process.

standard deviation, 68.28 per cent of observations fall within the +1/−1 standard
deviation area, but then 31.72 per cent (100 − 68.28) will fall outside the 1 standard
deviation area. In fact, since the distribution is symmetrical, we will have 15.86 per
cent above and the same below (31.72/2). So we can think of either the area within
the given number of standard deviations or outside this area. And we can consider
whether the result is one tailed (i.e. observations only to the left or right of the
curve), or two tailed (that is, observations on the upper and lower parts of the
curve).
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
–5 –4 –3 –2 –1 0 1 2 3 4 5
+ 1s = 68.26%
–
+ 2s = 95.44%
–
+ 3s = 99.74%
–
Figure 9.3 Areas under the curve of a normal distribution
If the data we are examining are generated by the normal distribution, by using
the standard deviation of returns and the expected return it is possible to make
predictions about the likelihood of a particular outcome. In doing so, the uncertain-
ty about the outcome is not eliminated, merely quantified. What we will have is an
estimate of the risk in terms of the probability of a given movement or deviation
from the expected outcome, which is the mean. The quantification has allowed us to
say that the actual return will lie somewhere between two values with a certain
probability. It works as follows. Let us take the data from the example we calculated
earlier. The expected return or the mean for Security 1 is 7.5 per cent, and the
standard deviation is 12.4373 per cent. Assuming this is drawn from the normal
distribution, we can say that 95.44 per cent of observations will lie within 2 standard
deviations of the mean or expected return. That is, the lower bound is −17.375
(7.5 − 2 × 12.4373) and the upper bound is 32.375 per cent (7.5 + 2 × 12.4373). We
can equally find the number of standard deviations for which the return will take on
a particular value. For instance, we could find the point for zero return, which is
−0.603 standard deviations (0 − 7.5/12.4373 = −0.603).

We can extend our analysis further if we have access to a standard normal distri-
bution table. We can work out the probability of getting a positive return above the
zero return point. The −0.603 point (we will ignore the 0.003 in this example) is
found by looking up the value for the probability under the standard normal
distribution table for values below the mean. This gives a value of 0.2743. That is,
27.43 per cent of the area of the normal distribution lies below the −0.60 point, and
72.57 per cent (100 − 27.43) lies above this point. Taking our analysis further, if we
wanted to know, based on the normal distribution, with 95 per cent confidence
above which the return will fall, we can consult the probabilities in the standardised
normal distribution table and find that the 95 per cent confidence point is −1.65
standard deviations. That is, there are 19 in 20 chances the observed return will lie
above the −1.65 point.
Note that these numbers apply to the distribution of returns only if the price-
generating process is derived from the normal distribution. If the distribution is
non-normal, the confidence intervals will have different values. As discussed in
Module 7, the empirical evidence suggests that the returns on many financial assets
are close to normal but do not quite conform to the normal distribution. Further-
more, many models assume normality, as this makes for less complex modelling.
The assumption that returns are normally distributed is therefore reasonable, if not
entirely supported by empirical research.
9.4 Understanding the Risk Measures

For the securities summarised in Table 9.4, the expected return for Security 1 is
7.5 per cent and the standard deviation of returns is 12.4 per cent. If the returns on
the security are normally distributed, the probability that the actual return will lie
between +19.9 per cent and −4.9 per cent (that is, between +1 and −1 standard
deviation (σ)) is 0.6826. There is a 0.9544 probability that the returns will lie
between +2σ and −2σ (that is, between +32.3 per cent and −17.375 per cent).
There is a 0.9974 probability (that is, a virtual certainty) that the outcome will lie
within +3σ and −3σ, or a return of +44.7 per cent and −29.7 per cent.
9.4.1 How Can We Generalise Using Historical Data?

While there is no assurance that the future will be like the past, the past can be a
guide to the future. If we look one period ahead, there will be a single outcome.
However, if we aggregate these single-period results, we get data that resemble the
normal distribution. The key here is to realise that, for any given period, the actual
outcome will differ from the expected. The shorter the time horizon, the greater this
difference is likely to be. Over the longer term, however, markets have shown a
tendency to resolve uncertainty. That is, the ex ante and ex post behaviour of returns
converge when we look at very long time series. As we cumulate shorter time
periods, we end up close to the average and the dispersion of returns produces the
familiar bell shape of the normal distribution.

9.4.2 Measuring Dispersion with the Standard Deviation

The standard deviation or second moment has important statistical properties if the
underlying distribution of outcomes is either a normal distribution or a natural
logarithmic transformation into the lognormal distribution. Given statistics on the
mean and standard deviation of a range of outcomes, it is possible to establish the
probability or chance of a particular outcome falling a given distance away from the
mean. These probabilities are summarised in Table 9.6.
Table 9.6 The areas under the normal distribution for a given number
of standard deviations
Distance from the mean Percentage of observa- Percentage of observa-
tions falling within the tions falling beyond the
distance from the mean distance from the mean
to to
In both directions
± 1 standard deviation 68.26% 31.74%
± 2 standard deviations 95.45% 4.55%
± 3 standard deviations 99.73% 0.27%
Distance from the mean Areas of the probability Areas of the probability
distribution falling within distribution falling
without
In one direction
± 1 standard deviation 34.13 15.87
± 2 standard deviations 47.725 2.275
Note: A normal probability table shows that there is a probability of 0.1587 of a value
being more than 1 standard deviation above the mean and a 0.1587 probability of a value
being more than 1 standard deviation below the mean. Hence, the probability (ex-
pressed as a percentage in the table) of a value being between ± 1 standard deviation is
1.00 less (2 × 0.1587) = 68.26 per cent.

The general probability density function is shown in Figure 9.3, where the values
for plus and minus 1, 2 and 3 standard deviations are given. The normal distribution
and the lognormal distribution are compared in Figure 9.4.
Figure 9.4 Comparison of the normal distribution and the lognormal

distribution
With the normal distribution, to say that at 1 standard deviation 68 per cent of
the distribution falls within this area means that an observation has a probability
equal to 0.68 of being within this area. That is, the probability of a standard normal
random variable being within 1 standard deviation of the mean is 0.68. Note that
this result provides a probability interpretation of the standard deviation; that is, it
measures the spread of values around the mean within which 68 per cent of all the
outcomes would be expected to fall. It therefore provides a confidence level for the
expected behaviour of the underlying return series if it conforms to the normal or
lognormal distributions.
The degree of spread given by the standard deviation shows that a larger standard
deviation implies a price or rate series that has a wider dispersion of potential
outcomes in terms of their value or return and, as a result, is riskier, since there is
likely to be a greater value movement. Thus, if we consider the two assets, the
statistics of which are summarised in Table 9.4, the second security, with the smaller
standard deviation, is taken to be the less risky of the two, since the actual outcomes
are likely to be less distributed than those for the first security.
The Character of the Normal Distribution
The normal distribution is widely used for describing random movements. It is a
continuous probability distribution that can be characterised by only two parameters:
the mean (the highest and central point) and the standard deviation (the spread of
outcomes around the mean). Its probability density function is:
exp ﴾9.4﴿
√
where is the mean and the standard deviation. The probability density function f x
describes the probability that a value will fall at a point around the mean. The probability
of finding a given value is found by solving for:
exp ﴾9.5﴿
To calculate the probability of a value falling in a given region (−σ to μ + σ), we then
need to compute the integral of f x over that region. It is not possible to provide an
analytical solution to Equation 9.5. Fortunately, it is possible to use a standard normal

distribution and to convert between known values on the standard normal distribution
and the actual distribution being analysed using the following formula:
﴾9.6﴿
where z is the probability on the standard normal distribution, xj is the actual observed
variable and μ is the mean of the observed variables. So, if we had a security that had an
observed volatility of 0.02 (σ) of returns and a mean daily return of 0.001 (μ), we can
find the probability that, on a given day, the return might exceed 0.04 (xj) as:
. .
1.95 ﴾9.7﴿
.
This value is looked up in the table of areas under the curve, which gives a value of
0.0256. That is, the stock is likely to have a return that exceeds 0.04 (4 per cent) on a
daily basis; that is, about 2.6 per cent of the time or about once a year.
9.4.3 A Further Example of Calculating Dispersion of Return

The examples discussed so far are somewhat unrealistic in that we have only two
possible outcomes. To obtain estimates of the mean and variance (or standard
deviation) for financial data, it is usual to take considerable quantities of data daily,
weekly, monthly or for some other period and to calculate the price changes in the
form of natural logarithms. Statisticians usually consider data to be well behaved if 50
or more observations are used to generate the statistics. These data are then used to
calculate the standard deviation of price changes. Such an approach is shown in Table
9.7 for the US dollar/British pound daily exchange rate over a month. Note that the
rate is expressed somewhat differently from usual, in that it is shown in terms of
pence per dollar, the reciprocal of the normal method of quoting the exchange
rate.*
Table 9.7 British pound/US dollar exchange rate analysis based on one
month’s trading data (21 working days)
British pound/ ln Pt/Pt × 100 rt rt − μ £ rt − μ 2
US dollar
Days Exchange (i) (ii) (iii)
rate
1 0.626763
2 0.621891 −0.7804 −0.7693 0.5919
3 0.625547 0.5862 0.5972 0.3566
4 0.623636 −0.3060 −0.2949 0.0870
5 0.623208 −0.0687 −0.0576 0.0033
6 0.622355 −0.1370 −0.1259 0.0159
7 0.623403 0.1683 0.1793 0.0321
* It is normal to quote the US dollar/British pound pair as $1.6525 per £1. In this example,
we take the reciprocal exchange rate $1/1.6525 = £0.6051 per $1.

British pound/ ln Pt/Pt × 100 rt rt − μ £ rt − μ 2

US dollar
Days Exchange (i) (ii) (iii)
rate
8 0.631273 1.2545 1.2656 1.6016
9 0.631353 0.0127 0.0237 0.0006
10 0.632431 0.1706 0.1816 0.0330
11 0.629485 −0.4669 −0.4559 0.2078
12 0.628575 −0.1447 −0.1336 0.0179
13 0.625274 −0.5265 −0.5155 0.2658
14 0.626959 0.2691 0.2801 0.0785
15 0.628220 0.2009 0.2120 0.0449
16 0.625508 −0.4326 −0.4216 0.1777
17 0.627589 0.3321 0.3432 0.1178
18 0.629129 0.2451 0.2561 0.0656
19 0.629327 0.0315 0.0425 0.0018
20 0.628299 −0.1635 −0.1525 0.0232
21 0.625313 −0.4764 −0.4654 0.2166
∑= −0.2316 3.9395
μ= −0.0116 σ2 = 0.2073
n= 20 σ= 0.4554
Note: Calculation of the mean return (μ) and the variance of return (σ2) and standard
deviation of returns (σ) for British pounds against the US dollar. Note that British
pounds are, unusually, expressed in European terms: that is, a fixed amount of US
dollars to a variable amount of British pounds. This is not the normal way of quoting
British pounds, which is usually reported in American terms: that is, as the reciprocal of
the exchange rate as given in the above table. Also the daily returns have been multi-
plied by 100 to give approximate daily percentage returns. Note that the annualised
standard deviation is 7.2285 per cent. This is a low estimate, the data having been taken
from a time when the volatility of the exchange rate was low compared to the long-
term average, which for British pounds has been between 15 per cent and 20 per cent.
This highlights the danger of extrapolating from a small sample of financial data.
As with our earlier discussion, if we had another data series for foreign exchange
that also had a daily mean price change of −0.0116 per cent, as with the British
pound/US dollar data in Table 9.7, but that, in this case, had a standard deviation of
0.35 per cent, this other hypothetical series would be less risky than the estimate for
British pounds against the US dollar with a daily standard deviation of 0.4554 per
cent. The 1 standard deviation price change – for our hypothetical series – within
which about 68.26 per cent of observations are expected to fall will be in a range of
0.3384 per cent to −0.3616 per cent, as compared to 0.4438 per cent to −0.4669 per

cent for the data given in Table 9.7 based on the higher standard deviation of 0.4554
per cent.
9.5 Measuring the Relationship between Assets

Consider the following. If we had Securities 1 and 2 (as given in Table 9.8) and we
knew that Security 1 did well (that is, had a high performance) and at the same time
Security 2 did badly (that is, had a low performance), we could hold both these
securities and largely eliminate the risk of an adverse outcome. This simple ‘packag-
ing’ of the two securities is shown in Table 9.8. The ‘weights’ for the two securities
are 0.526 (1000/(1000 +900)) and 0.474 respectively (900/(1000 + 900)). Hence the
weighted average return for the portfolio in the high versus the low case is 8.579 per
cent (0.526 × 0.1875 + 0.474 × −0.02722).
Table 9.8 A ‘package’ made up of one unit each of Securities 1 and 2

Outcome Return Security Return Security Weighted
1 2 return (%)
(ii) (iii) (iv)
Initial value 1000 900
High portfolio return 0.1875 −0.02722 8.58
Low portfolio return −0.0625 0.195 5.94
If we could package two or more securities that have uncertain returns, as we did
in Table 9.8, we would greatly reduce the risks involved. However, the expected
return and variances (or standard deviations) of the two securities do not convey
any information about their interrelationship. We have grandly assumed that when
Security 1 does well Security 2 does poorly – and the opposite. But how realistic is
that? What we require is a measure of the return behaviour for the two securities
together to tell us if one will do well while the other does not, or if both will do well
or badly together (in which case packaging them together may not be very useful).
Such a statistical measure is known as the covariance or the correlation coeffi-
cient, which is a normalised covariance, since the covariance suffers from the same
problem as the variance: it is hard to interpret. The covariance has been developed
to show the interdependence of behaviour of two sets of data. We will want to use
this or the more easily understood correlation coefficient to determine how well a
‘package’, made up of two or more securities, will help to eliminate their individual
risks by mutually offsetting each other.
The covariance is a statistic similar to the variance we calculated earlier. The
variance of returns for a single asset is calculated by subtracting the expected return
from each of the possible outcomes and then squaring that difference. The covari-
ance is calculated in a similar fashion, except that we match up the two data series,
and the deviations from the expected returns of both series are multiplied together
rather than squared. The covariance (σa,b) is calculated by:

∑ ﴾9.8﴿
, , ,
where ρi is the probability of the returns on assets a and b; ra,i is the ith return on
asset a; E ra is the expected return on asset a; rb,i is the ith return on asset b; and
E rb is the expected return on asset b. Continuing with our earlier example, the
possible outcomes for Securities 1 and 2 are given in Table 9.9, showing the joint
probabilities of both securities having above- and below-average returns.
Table 9.9 Possible outcomes for the two securities and their joint
probabilities (given a set of values of the probabilities)
Security 1
High Low Outcome

0.1875 −0.0625 probabilities
for Security 2
alone
Security 2 High +0.195 0.25 0.30 0.55
Low −0.02722 0.30 0.15 0.45
Outcome probabilities for 0.55 0.45 1.00

Security 1 alone
What Table 9.9 means is that, of the total four joint outcomes, there is a 0.25
probability of getting a joint high-return outcome for both Securities 1 and 2 and a
0.15 probability of a joint low outcome. There is a 0.30 probability in each case that
Security 1 will be high and Security 2 low, or vice versa. Note that the probabilities,
as required, sum to 1.
Given the information in Table 9.9, we can now calculate the covariance between
the two securities, using Equation 9.8, as shown in Table 9.10.
Table 9.10 Calculating the covariance between the two securities

ρi ra,i ra,i − E(ra) rb,i rb,i − E(rb) ρi[ra,i − E(ra)]
[rb,i − E(rb)]
0.25 0.1875 0.1125 0.195 0.100 0.00281
0.30 −0.0625 −0.1375 0.195 0.100 −0.00413
0.15 −0.0625 −0.1375 −0.027 −0.122 0.00252
0.30 0.1875 0.1125 −0.027 −0.122 −0.00413
1.0 −0.002914

The covariance between Security 1 and Security 2 is calculated to be −0.002914.

This statistic is not very meaningful for understanding the relationship between the
two securities. How are we to interpret this result? It is negative, so the two securi-
ties have an inverse return relationship. A more easily understood statistic is the
correlation coefficient (ρab), which can take a value of between +1 and −1. The
correlation coefficient is calculated from the covariance by the following formula:
﴾9.9﴿
The correlation between Security 1 and Security 2 is therefore:

.
0.21212 ﴾9.10﴿
. .
The values for the standard deviations are those derived from Table 9.2 and
Table 9.3.
The correlation of the two securities is negative, but the statistic is very low since
the maximum relationship is 1 and the minimum is 1. With a correlation coefficient,
the positive or negative sign on the statistic indicates the nature of the relationship,
whereas the value provides the magnitude of that relationship. A coefficient of +1
would indicate that the two securities had identical behaviour; that is, they have
perfect positive correlation. A coefficient of −1 would indicate that the two
securities had opposing behaviour; that is, perfect negative correlation, whereas a
coefficient of zero would indicate they are independent. The observed result of
−0.21212 indicates that the returns on Securities 1 and 2 are slightly negatively
correlated.*
Note that we can calculate the covariance by reversing the correlation coefficient
calculation, so that:
﴾9.11﴿
Correlation is often misunderstood. It does not imply causation. It is also wrong to
assume that, if two securities had perfect correlation, a 10 per cent rise in one security
would lead to the same 10 per cent in the other. What correlation says is that, if one
security increases by 10 per cent from its long-term average or mean return, the other
security will also increase. When the correlation is less than +1 but still positive, then,
on average, the other security should also increase, but not all the time. So, even with
positive (but not perfect positive) correlation, the return on one security can fall when
the other rises. Statistically speaking, these two securities would be considered
‘interdependent’.
The correlation coefficient has another useful function. The degree to which one
asset’s behaviour can be explained by the other asset’s behaviour is found by the
coefficient of determination (R2), which is the correlation coefficient squared ( ).
The R2 measures the percentage of the variance in one security that is explained by
the variability of the other security. If the correlation coefficient had been 0.75, then
56.25 per cent of the behaviour in the one is explained by the other
* For significance purposes, we can apply statistical significance levels to this relationship – but this is
beyond the scope of what we need to do at this point.

(0.752 = 0.5625). In the case of the two securities in the example, the correlation
coefficient is −0.21, so that only 4 per cent of the one is explained by the other.
9.5.1 Covariance and Correlation Coefficient: Further Examples
Using the foreign exchange example introduced in Section 9.4.3, let us look at the
relationship between the US dollar, the British pound and the euro. This is shown in
Table 9.11 where the mean, standard deviation, variance and covariance of the two
series against the US dollar are calculated. Note that the data are expressed in terms
of the US dollar.

Table 9.11 Calculation of the mean return (μ), variance (σ2) and standard deviation (σ) of the return for the US dollar against the
British pound (£) and the euro (€) and the covariance (σ£/€) and correlation (ρ£/€) between the £ and € against the US$
US dollar/British pound US dollar/euro*** Correlation
Trading days Exchange rate ln 100% £ £
Exchange rate ln 100% € € £ €
(i) (ii) (iii) (iv) (v) (vi) (ii) × (v)

1 1.5964 1.1849
2 1.5958 − 0.03759 0.05464 0.00299 1.1862 0.10965 − 0.12676 0.01607 − 0.00693
3 1.6019 0.38152 0.47376 0.22445 1.1792 − 0.59187 − 0.82828 0.68605 − 0.39241
4 1.6001 − 0.11243 − 0.02019 0.00041 1.1807 0.12712 − 0.10929 0.01194 0.00221
5 1.5988 − 0.08128 0.01096 0.00012 1.1805 − 0.01694 − 0.25335 0.06419 − 0.00278
6 1.6001 0.08128 0.17351 0.03011 1.1967 1.36297 1.12656 1.26913 0.19547
7 1.6054 0.33068 0.42292 0.17886 1.1914 − 0.44387 − 0.68028 0.46278 − 0.28770
8 1.6090 0.22399 0.31623 0.10000 1.1928 0.11744 − 0.11897 0.01415 − 0.03762
9 1.6033 − 0.35489 − 0.26265 0.06898 1.2048 1.00101 0.76460 0.58461 − 0.20082
10 1.6026 − 0.04367 0.04857 0.00236 1.2066 0.14929 − 0.08712 0.00759 − 0.00423
11 1.6001 − 0.15612 − 0.06388 0.00408 1.2072 0.04971 − 0.18670 0.03486 0.01193
12 1.5885 − 0.72760 − 0.63536 0.40368 1.2229 1.29215 1.05573 1.11457 − 0.67077
13 1.5773 − 0.70757 − 0.61533 0.37863 1.2333 0.84684 0.61043 0.37262 − 0.37561
14 1.5761 − 0.07611 0.01613 0.00026 1.2341 0.06485 − 0.17157 0.02944 − 0.00277
15 1.5533 − 1.45717 − 1.36494 1.86305 1.2749 3.25258 3.01617 9.09726 − 4.11688
16 1.5524 − 0.05796 0.03428 0.00118 1.2756 0.05489 − 0.18152 0.03295 − 0.00622
17 1.5391 − 0.86043 − 0.76819 0.59012 1.2771 0.11752 − 0.11889 0.01413 0.09133
18 1.5450 0.38261 0.47484 0.22548 1.2701 − 0.54962 − 0.78604 0.61785 − 0.37325
19 1.5413 − 0.23977 − 0.14753 0.02177 1.2723 0.17306 − 0.06335 0.00401 0.00935
20 1.5377 − 0.23384 − 0.14161 0.02005 1.2852 1.00881 0.77239 0.59659 − 0.10938
21 1.5429 0.33760 0.42983 0.18476 1.2790 − 0.48358 − 0.71999 0.51839 − 0.30948
22 1.5415 − 0.09078 0.00146 0.00000 1.2802 0.09378 − 0.14263 0.02034 − 0.00021
23 1.5441 0.16852 0.26076 0.06800 1.2786 − 0.12506 − 0.36147 0.13066 − 0.09426
24 1.5519 0.50388 0.59611 0.35535 1.2614 − 1.35435 − 1.59076 2.53053 − 0.94828
25 1.5471 − 0.30978 − 0.21754 0.04732 1.2713 0.78178 0.54537 0.29742 − 0.11864
26 1.5440 − 0.20058 − 0.10834 0.01174 1.2757 0.34550 0.10909 0.01190 − 0.01182
27 1.5491 0.32977 0.42200 0.17809 1.2694 − 0.49507 − 0.73148 0.53507 − 0.30869
28 1.5525 0.21924 0.31148 0.09702 1.2632 − 0.48962 − 0.72603 0.52712 − 0.22614
29 1.5527 0.01288 0.10512 0.01105 1.2646 0.11077 − 0.12564 0.01579 − 0.01321
30 1.5574 0.30224 0.39448 0.15561 1.2631 − 0.11868 − 0.35510 0.12609 − 0.14008
31 1.5479 − 0.61186 − 0.51962 0.27001 1.2789 1.24313 1.00672 1.01348 − 0.52311
32 1.5514 0.22586 0.31809 0.10118 1.2750 − 0.30542 − 0.54183 0.29358 − 0.17235
μ= − 0.09224 ∑= 5.59670 μ= 0.23641 ∑= 21.05118 − 9.14334
N= 31 σ2 = 0.186557 σ2 = 0.70171
(N − 1) = 30 σ= 0.431922 σ= 0.83768
σ£/€ = − 0.30478
ρ£/€ = − 0.84237
*** British pounds and the euro are quoted here in terms of one unit of the currency to a variable number of US dollars ($1.XXX = £1; $1.XXX = €1).

At the beginning of this section it was stated that the dispersion of outcomes can
be reduced by creating portfolios of assets that have opposing characteristics in such
a way that, when combined, they reduce or eliminate risk. The next section looks at
the formal mathematical model for determining a portfolio’s return and risk.
9.6 Portfolio Expected Return and Risk

This section extends the ideas introduced in the earlier sections to multiple-asset
portfolios. There are two components we need to consider. The first is straightfor-
ward, and that is the expected return on the portfolio. The second is the portfolio’s
risk, which is more complicated. Key decisions relate to proportions or weights of
the individual assets that go into the portfolio. Understanding how portfolio risk
differs from the risk of individual assets is a key idea in financial risk management.
We can gain substantial insights into the nature of the portfolio risk when we
understand how the portfolio’s risk characteristics differ from those of the individu-
al assets and what is leading to this result. This is especially true if we are seeking to
change the risk of the portfolio as part of the risk management process.
9.6.1 Expected Returns

The first part of the process is to calculate the portfolio’s expected returns. This is
the weighted average of the returns of the portfolio’s constituents. All we require is
the proportion of the various assets or ‘weights’ that are used to create the portfolio
and the expected returns on those assets. If x is the proportion in Asset a, then
(1 − x) is the proportion in Asset b. The expected return from a two-asset portfolio
will therefore be:
1 ﴾9.12﴿
where E ra and E rb represent the returns on Assets a and b. Table 9.12 shows the
return from holding various proportions of Securities 1 and 2 in a portfolio.
Table 9.12 Portfolio returns for different combinations of Securities 1 and 2; that is, the
weights xa
Security E(ri) Proportion of portfolio in Security 1
x= 0.0 0.1 0.25 0.5 0.75 0.9 1.0
1 0.075 0.0 0.0075 0.01875 0.0375 0.05625 0.0675 0.075
2 0.095 0.095 0.0855 0.07125 0.0475 0.02375 0.0095 0.0
E(rp) 0.095 0.093 0.09 0.085 0.08 0.077 0.075
As we move from all Security 2, where the proportion of Security 1 is zero on the
left-hand side, we start with a return of 9.5 per cent. We now add some of Security 1
and hence have less of Security 2; the return is now a blend of the two securities’
returns. For instance, when the proportions of the two are equal, we have an
expected return of 8.5 per cent (0.5 × 0.075 + 0.5 × 0.095). Finally, when all the

holding is in Security 1, we have an expected return of 7.5 per cent. Note that the
change in expected portfolio returns is a linear combination based on the propor-
tions invested in each of the securities.
The more general formulation of the weighted average expected return on a
portfolio is given by Equation 9.13:
∑ ﴾9.13﴿
such that:
1.0 ∑
Whatever the number of assets or securities in the portfolio, the expected return
will be a weighted average of the returns of the portfolio’s constituents.
9.6.2 Portfolio Risk

Now, as with the single-asset examples, we want to calculate the portfolio risk.
Calculating the risk of a portfolio is more complicated than working out its expected
return, since it requires additional information. We must know not only the variance
or standard deviation of the individual assets but also their covariance or correlation
with each other. Hence we need more information to determine the portfolio risk.
Furthermore, whereas the portfolio’s expected return is the weighted average of its
constituents, the portfolio’s standard deviation is not, in general, the weighted
average of the standard deviations of the portfolio’s assets. To understand why, we
must look at the formula for the variance or standard deviation of a portfolio. For
the two-asset case (Assets or Securities a and b) the portfolio variance is:
2 ﴾9.14﴿
where , and ρab represent, respectively, the variance (standard deviation
squared) of Asset or Security a, the variance of Asset or Security b and the correla-
tion coefficient between Assets a and b. We can get the portfolio standard deviation
simply by taking the square root of the portfolio’s variance – as with the single
assets we looked at earlier.
The portfolio risk equation can also be explained in terms of a variance–
covariance matrix (VCV matrix) and matrix algebra as shown for the two-asset
portfolio in Table 9.13. You will see that there are two variance terms, one for each
asset, and two covariance terms. Equation 9.14 and Table 9.13 show that the
covariance terms of a and b and b and a are the same. So, for a two-asset portfolio,
we have two variance terms and two covariance terms (which are the same). We will
explain later that the covariance terms increase by N2 − N, so a three-asset portfolio
will have three variance terms and six covariance terms.

Table 9.13 Calculating portfolio risk for a two-asset portfolio

Asset a Asset b
Asset a Variance term Covariance term xa,xb
Asset b Covariance term xb,xa Variance term
Let us look at an example, as this will make the formula much clearer. For the
two-security case, we can calculate the portfolio risk for an equal 50 per cent
(xa = 0.50) holding in each security. The portfolio expected return is 8.5 per cent.
The portfolio risk is derived using Equation 9.14, as follows:
0.5 0.124373 0.5 0.110544 2 0.5 0.5 0.21212 0.124373 0.110544
√0.005464 ﴾9.15﴿
0.073919 or 0.07392
This gives a portfolio variance of 0.005464. The square root gives us the portfo-
lio standard deviation, which is 0.07392, or about 7.392 per cent. Note that a
combination of investing half the portfolio in each security provides a lower risk
than holding either security alone. We can show the benefits of creating a portfolio
by calculating the portfolio risk as above, using different combinations of Securities
1 and 2, ranging from zero in Security 1 up to everything invested in Security 1, just
as we did for the expected return. The result is shown in Table 9.14.
Table 9.14 Portfolio variance and standard deviation for the two-security portfolio
Proportion of portfolio in Security 1
x= 0.0 0.1 0.25 0.5 0.75 0.9 1.0
σ2 0.01222 0.009528 0.006747 0.005464 0.008371 0.012127 0.015469
σ 0.110544 0.097611 0.082139 0.073919 0.091494 0.110122 0.124373
What Table 9.14 shows is that, as we combine the two securities in different
proportions, we get the benefits of portfolio diversification. Unlike the case of the
expected return, we get a reduction in the risk as the portfolio mix is less dominated
by one or other security. At the extremes, we have a standard deviation of 11.05 per
cent and 12.44 per cent respectively. At the 50 per cent in each point, the portfolio
risk is lower than either, at 7.39 per cent. With the portfolio’s risk, we find that, as
we move from a portfolio made up only of Security 2 and no Security 1, and we add
some Security 1 to the portfolio, we reduce risk, but, as we move towards a portfo-
lio of all Security 1, the risk rises again. What this suggests is that there will be some
combination of the two securities that has the most effect in reducing the overall
risk. This is a key understanding into how we might use portfolios to reduce risk
and is a major insight into the contribution of portfolio theory to financial risk
management.

9.6.3 The Minimum-Variance Portfolio with Two Assets

As Table 9.14 shows, holding the two securities in roughly equal amounts is likely to
reduce the overall variability of the portfolio significantly, without sacrificing too
much return. If there is flexibility in the proportions that can be held in either
security, we can establish the minimum-risk portfolio using the following:
∗ ﴾9.16﴿
where x* is the optimum position in Asset a. The term ρaσaσb is the covariance
between a and b. The term ρa is the two assets’ correlation coefficient. The mini-
mum risk combination for our two-asset portfolio will therefore be 0.45 in Security
1 and (1 − 0.45) in Security 2. The standard deviation of this portfolio is 0.07339
and the expected return is 0.086, or 8.6 per cent.†
Where the correlation (ρ) is zero, the equation reduces to:
∗ ﴾9.17﴿
For our two-security portfolio example, assuming zero correlation (that is, using
Equation 9.17), this is 0.44 in Security 1 and the balance (1 − 0.44) in Security 2.‡
This least risky combination has a standard deviation of 0.08262 and an expected
return of 0.086173, or 8.62 per cent for the portfolio.
9.6.4 Diversification and Portfolio Risk

Diversification allows us to reduce risk by creating portfolios made up of imperfect-
ly correlated assets or liabilities. Diversification is a principle of investment where
portfolios of imperfectly correlated securities reduce the risk of the overall position.
The fundamental concept behind portfolio diversification and the ability to reduce
risk is the idea that the portfolio’s risk (as measured by its standard deviation) is less
than the sum of the individual standard deviations of the assets. We can measure the
benefits of diversification using the following:
Benefits of diversification ﴾9.18﴿
where the term σwa is the weighted average of the standard deviations of the assets
in the portfolio. In the case where the two securities have a perfectly positive
correlation (that is, the correlation between the two securities is ρ = +1), there will
be no benefits to diversification and the portfolio risk will not be reduced. On the
other hand, in any situation where the correlation between assets making up the
portfolio is less than +1 (ρ > +1), there will be a risk-reduction advantage from
† The calculation to get the portfolio variance is:

(0.45)2(0.1244)2 + (0.55)2(0.1106)2 + 2(−0.21212)(0.1244)(0.1106).
‡ Ignoring the correlation here leads to very similar results, since the correlation is very small.

grouping assets into a portfolio. Taking our earlier example and assuming that the
correlation coefficient is +1, we now have:
0.5 0.124373 0.5 0.110544 2 0.5 0.5 1.0 0.124373 0.110544
√0.013796
0.117459
This is the same as if we had simply summed the weighted average of the two
standard deviations; that is, (0.5)(0.124373) + (0.5)(0.110544). So the undiversified
risk (standard deviation) of the portfolio is 0.117459, or 11.75 per cent. It is
important to remember that risk-reduction gains from portfolio diversification
arise only if the securities in the portfolio are less than perfectly correlated. The best
portfolio will include assets that act to dampen down the return volatility. These will
be assets that have a negative correlation.§
Using the same weights as we used above, we can now analyse the portfolio in
terms of the correlation effect by varying the correlation between Securities 1 and 2
as shown in Table 9.15. In the table we allow the correlation to range from −1.0, or
perfect negative correlation, to +1.0, or perfect positive correlation.
Table 9.15 Portfolio risk and the correlation between the two securities. The weight (xa) is
0.50
Correlation
−1.0 −0.75 −0.5 −0.25 0 0.25 0.5 0.75 1.0
σ 2 4.78E−05 0.001766 0.003485 0.005204 0.006922 0.008641 0.010359 0.012078 0.013796
σ 0.006914 0.042029 0.059034 0.072136 0.083199 0.092956 0.101781 0.109900 0.117459
Table 9.15 shows that:

 the greater the correlation, the less benefit there is to be had from diversification.
There is no diversification benefit if the two securities are perfectly positively
correlated. On the other hand, any combination involving less than perfectly
correlated securities will reduce the overall risk. In the table, a reduction in corre-
lation from +1.0 to +0.5 reduces the risk somewhat from 0.1175 to 0.1018, a
reduction of −0.0157. If the securities had no correlation, the risk is reduced to
0.0832, a reduction of −0.0343. As we move into negative correlation, the bene-
fits of diversification continue to increase, reaching their maximum at the −1.0
point.
 the greater the negative correlation, the more portfolio risk is eliminated. The
greatest gain is achieved if the two securities are perfectly negatively correlated.
The risk of the portfolio declines rapidly if the correlation between the securities
is negative. With a negative correlation of −0.5, the total risk of the portfolio
§ This is the principle of hedging: a two-asset portfolio is created, one asset being the position to be
hedged, the other the hedging instrument. A perfect hedge will have a correlation of −1.0. In choosing
hedging instruments that are not perfectly correlated, the aim is to select those that have values that
approach −1.0.

drops to 0.059, a reduction of 0.0585, or just about half. If perfect negative cor-
relation exists, the portfolio has virtually zero risk.**
We can now integrate these aspects of portfolios to see the interrelation between
the weights of the portfolio’s constituents, the expected return and the overall risk
of the portfolio. If the two assets have perfect positive correlation, then there is no
benefit from diversification. When combining the two assets in a portfolio with
differing weights in each asset, we find the two are linked by a straight line, as
shown by Figure 9.5.
Expected return
Range of portfolios that can be

constructed with different weights
in Assets a and b
E(rb) b
=1
E(ra)
a
a b
Portfolio risk
Figure 9.5 Two-asset portfolios with perfect positive correlation (ρ = +1)

However, once we have a situation where the assets in the portfolio are no longer
perfectly correlated (ρ < + 1.0), we have the curved line shown in Figure 9.6. The
exact degree of curvature will depend on the correlation between the two assets. As
shown in Table 9.15, the lower the correlation, the greater the benefits gained from
diversification.
** The difference is due to the fact we employ fixed weights in the table.

Expected return
Range of portfolios that can be

constructed with different weights
in Assets a and b
E(rb) b
<1
E(ra)
a
a b
Portfolio risk
Figure 9.6 Two-asset portfolios when the correlation is less than one
( < 1)
Ultimately, we move to a condition where the two assets have a perfectly nega-
tive correlation (ρ = −1.0). In this extreme case, we have the situation shown by
Figure 9.7. Combinations of assets a and b have an offsetting risk effect on the
portfolio. There will be a combination of the two where the two risks are exactly
offsetting, giving a riskless portfolio with an expected return of E rp .
Expected return
Range of portfolios that can be constructed

with different weights in Assets a and b
E(rb)
b
r = –1
E(ra)
a
Optimal combination of Assets

a and b that eliminates all risk
sa sb Portfolio risk s
Figure 9.7 Two-asset portfolios with perfect negative correlation (ρ

= 1). There will be an optimum combination (ρ) of Assets
a and b where all variability is eliminated

9.6.5 The Multi-Asset Portfolio Case

The next stage is to increase the number of assets in a portfolio. Adding a further
asset now requires us to calculate the three variance terms for Securities a, b, and c,
and the six covariance terms (but, since the covariance term of x on y is the same as
y on x, this means we have three additional calculations to do (ab, ac and bc)). The
calculation for a three-asset portfolio’s risk is given below:
2 2 2 ﴾9.19﴿
For a portfolio with a large number of assets (m), the expected return will be the
weighted average of the asset returns in the portfolio:
∑
∑ 1 ﴾9.20﴿
where E rp is the expected return on the portfolio, wi is the weight invested in the
ith asset and E ri is the expected return on the ith asset. The portfolio risk (volatili-
ty or standard deviation) is found by:
∑ ∑ ∑ ﴾9.21﴿
where is the variance of return on the ith asset and σij is the covariance of return
between Assets i and j.††
For a many-asset portfolio, the portfolio variance is simply the sum of the
weights in the variance–covariance (VCV) matrix – as shown in Table 9.16.
Table 9.16 Variance–covariance matrix with weights for m holdings

Holding 1 2 3 4 →m
1 w1w2σ12 w1w3σ13 w1w4σ14
2 w2w1σ21 w2w3σ23 …
3 w3w1σ31 w3w2σ32 …
4 w4w1σ41 … … …
↓
m
An examination of Equation 9.21 shows that, as the number of assets in the

portfolio increases, the variance terms become less and less significant. For a
portfolio of two assets, we will have a 2 × 2 matrix with two variance and two
covariance terms. If we double the asset size, we then have a 4 × 4 matrix, with 4
variance terms and 12 covariance terms. We find that the variance terms equal the
number of assets in the portfolio, but that the covariance terms equal (n × n − n)
†† Or we can use the correlation coefficient and convert this to the covariance, and hence the last term in
the equation becomes wiwjρijσiσj.

times the number of assets. In such a case, as the portfolio size increases, the effects
of the variance terms are swamped by the covariance terms. At the limit, as Equa-
tion 9.22 shows, we are left with a portfolio effect where the risk is equal to the
average covariance of all assets in the portfolio.
1 ﴾9.22﴿
That is, as the number of assets increases to infinity, the value of (1/m) reduces
towards zero:
→ ∞, →0 ﴾9.23﴿
As a result of the above analysis, as we continue to add assets, we find that we

have the plot of potential portfolios shown in Figure 9.8. There are a large number
of feasible portfolios from which to choose. However, they will all be dominated
in terms of their risk or expected return by those portfolios that lie on the boundary
region between points I and II. These portfolios provide the best return for a given
level of risk or the least risk for a given level of return. Such portfolios are known as
efficient portfolios because they provide the maximum return that can be expected
for a particular amount of risk, or the minimum risk for a given amount of return.
Such portfolios are more desirable than the other portfolios in the feasible region,
and rational investors will choose these in preference to the others.
In fact, for the designing of portfolios for investment purposes, the diversifica-
tion effect allows the creation of efficient portfolios that either maximise return for
a given risk or minimise risk for a given return by the judicious combination of
different securities. Portfolios consisting of between 20 and 50 individual shares will
minimise risk and virtually eliminate the diversifiable risk.

Expected return
II
III
Portfolio risk
Figure 9.8 Feasible and efficient sets of portfolios

Note: The feasible region for all portfolios is bounded by the lines I–II–III. The efficient
set of portfolios is given by the line I–II. These portfolios provide either the best return
for a given risk or the least risk for a given return.
The final point about the effects of portfolio diversification is that, as shown in
Figure 9.9, as the correlation between the assets declines, the opportunity to earn a
higher expected return for a given level of risk is increased.
Expected return
C < B < A
As the correlation
between assets
declines, there is
a higher expected
return for a given
level of risk
Portfolio risk
Figure 9.9 The effect of a reduction in the correlation between assets in

a portfolio
The above analysis shows that careful combinations of different assets into port-
folios can reduce risk. The whole principle of hedging (which is discussed in

Derivatives) is in essence a special kind of two-asset portfolio, where the correlation

of the hedging position is −1, or thereabouts. By combining the two positions, the
asset and the hedge, and using the correct weights for each, the risk of price or value
changes is almost totally eliminated.
9.7 Practical Considerations in Measuring Risk

It is difficult, in practice, to estimate the ex ante probability distributions of returns
for individual assets. The factors that influence asset values and, hence, their returns
are generally too complex and uncertain to quantify in any meaningful way. Instead,
risk managers rely on past information to provide estimates of the returns in relation
to economic behaviour as a whole and their interdependencies. The implicit
assumption in this method, of course, is that the future will be, statistically speaking,
like the past. If there is any reason to believe that the future will be different, it will
be necessary to adjust the historical estimates in some way. Creating and using
qualitative forecasts is discussed in Module 11, and some thoughts on assessing
volatility (σ) have been given in Module 7. Suffice to say at this point that the
historical data can be adjusted in different ways. The following simple adjustment
method shows the general approach.
Continuing our example based on the two securities, let us consider the situation
where there are three possible future states of world market conditions and the
resultant behaviour of the two securities under those conditions is as shown in
Table 9.17.
Table 9.17 Expected returns and market conditions for different securi-
ties
State of the Probability (ρ) Security 1 σ Security 2 σ
world
Boom 0.2 0.1182 0.1226
Moderate growth 0.5 0.1244 0.1106
Recession 0.3 0.1365 0.1051
1.0
We have already seen that the optimum portfolio where the correlation is
−0.21193 is xa = 0.454. We can now rework the portfolio under the following
forecasts to derive new weights, which give, for a boom condition, 0.52, for
moderate growth, the original 0.4544 and for a recession, 0.37. We can consider
these weights as being the right constituents for an aggressive portfolio, a neutral
portfolio and a defensive portfolio based on our forecasts.
9.8 Estimating Portfolio Value at Risk

As described in Module 8, the value-at-risk methodology can be applied to an
individual exposure or set of exposures to determine the amount at risk up to some
predetermined confidence limit. In order to understand the way portfolio VaR

works, we can use our understanding of how portfolio risk is determined. In doing
so, we can use the difference between an estimate of the VaR that ignores the
benefits of diversification and an estimate that includes these benefits for situations
where the correlation between assets is less than +1. The first step is to compare
like with like by showing the different estimates for risk on a common basis. This is
usually done by reporting all the different risks using a common, annualised
equivalent. An example of the result taken from JP Morgan’s RiskMetrics™ system
is given in Appendix 9.1.
We can also compute the total VaR at a given confidence limit (the value at risk
of a portfolio) for two, or more, assets whose VaRs we have already estimated into a
portfolio VaR using the approach described in this module.
9.8.1 Reporting Volatility

Depending on the time series and the quality of data available, the standard devia-
tion, variances and correlation coefficients for a set of data may relate to daily,
weekly or monthly intervals, or some other period. However, as with interest rates,
it is convenient to think in terms of an annualised volatility (or a standard deviation
of continuous returns), regardless of the period over which it is computed. This is
found by converting the periodic results into an annualised equivalent, using square
root law. The adjustments are given in Table 9.18.
Table 9.18 Annualising periodic volatilities

Monthly data √12 × monthly standard deviation
Weekly data √52 × weekly standard deviation
Daily data √252 × daily standard deviation
(there are 252 trading days in a normal year)
Note: Grossing up by the square root of time is often referred to as the ‘square root
law’.
Note that, with daily data, we use the number of trading days in the year, not the
actual number of days. Empirical research shows that this is a better estimate of the
annualised volatility than the number of calendar days.
The annualised volatility for the British pound against the US dollar as computed
in Table 9.7 is therefore:
0.4554√252 7.23% ﴾9.24﴿

The annualised volatilities for the British pound and the euro against the US
dollar (in US dollar terms) from Table 9.11 are 6.86 per cent and 13.30 per cent
respectively when using 252 trading days.
9.8.2 Value at Risk in a Portfolio of Assets

To recap on how to calculate the risk of a portfolio of assets, we need to have the
following information on each asset:

 mean return (E r );
 standard deviation (σ)/variance of return (σ2);
 correlation of the return with other assets (ρ);
 weight of the asset in the portfolio (x).
Armed with this information, we can establish the portfolio’s risk. For a two-
asset portfolio, the risk will depend on how the prices of the two instruments move
in relation to one another, a relationship measured by their correlation. Since the
correlation between assets is not always 1, we need to estimate it in the same fashion
as we estimate asset price volatilities. Given this preliminary analysis, the formula for
estimating the risk of a two-asset portfolio is:
﴾9.25﴿
, 1 2 1
where xa is the weight in Asset a and (1 − xa) is the weight in Asset b (or xb); σb and
σb are the standard deviation of each asset; and ρab is the correlation coefficient
between Assets a and b.
We can replace (xiσi) in the four elements of the portfolio with the equivalent
VaR numbers to obtain the portfolio value-at-risk estimate as shown in Equation
9.26:
VaR VaR VaR 2 VaR VaR ﴾9.26﴿

Recall that the VaR is the amount times volatility times the confidence limit times
the square root of time. The benefit of holding a diversified portfolio arises from
the third term of Equation 9.26, when, as we have seen, ρ (the correlation coeffi-
cient) is less than 1. Note that, if the prices of the two positions or instruments
move independently – that is, their correlation is equal to zero – the third term from
the equation is eliminated and the total portfolio risk becomes:
VaR VaR VaR ﴾9.27﴿
Let us now apply the theory. We have a zero-coupon bond (ZCB) position in US
dollars worth US$5 million and have determined that the annualised volatility of
such a bond is 16 per cent. At the same time, we also have exchange rate risk, since
our reporting and base currency is British pounds (US$/£). The annualised volatility
for the US dollar/British pound rate is known to be 25 per cent. We also have a
time horizon of one month (t = 1/12) and a 95 per cent confidence limit (2σ).‡‡
The current exchange rate of the British pound to the US dollar is US$1.50 = £1
and the correlation between the ZCB and the exchange rate is 0.20.
We first determine the 2 standard deviation (95 per cent confidence limit)
movement in the two risk factors. Over one month, for the zero-coupon bond, the
volatility will be 4.62 per cent (16%/√1/12 = 4.62%). We also have a 2 standard
deviation confidence limit, which gives us a change of 9.24 per cent. The maximum
‡‡ The ordinate is 0.97725, which gives on a two-tailed test 0.05 of values beyond 2 standard deviations.

value shift we expect over the one-month close-out period is the position value
times the confidence limit:
4.62 2 9.24%
$5 000 000 0.0924 $462 000 ﴾9.28﴿
which gives us a total value at risk of US$462 000. In British pound terms this is
equal to £308 000 at the prevailing exchange rate ($462 000/$1.50). We repeat the
same analysis with the exchange rate:
$/£: 7.22 2 14.42%
$5 000 000 0.1443 $721 500 ﴾9.29﴿
This is equal to £481 000 at the prevailing exchange rate ($721 500/$1.50).
If the two risks had a correlation of +1, the total risk would be simply the sum of
the two positions: £308 000 + £481 000 = £789 000.§§ If, on the other hand, the
two risks had been independent (with ρ = 0), the total risk would be:
£308 000 £481 000 £571 161
However, we know that the two risks have a slightly positive correlation of
+0.20, so the portfolio risk from the position, based on Equation 9.26, is:
308 000 481 000 2 0.20 308 000 481 000 £620 874 ﴾9.30﴿
Note that, because the two risk factors are less than perfectly correlated, the total
risk (that is, the interest rate risk and the currency risk) is less than the sum of the
two risks. Diversification has reduced the risk from the combined position.***
In the next module, we will look at how to estimate the financial risk of interest-
rate-sensitive assets. Once we have done that, we will examine how we can combine
the two sorts of analyses.
Learning Summary
This module has looked at the financial approach to quantifying risk and, in
particular, at the role of portfolios in determining the risk of multiple assets or
securities. Individual assets can be evaluated in terms of the uncertain return (or
future values), which is quantified by a probability distribution of returns. The
expected return on an asset is a probability-weighted average return from the
possible range of future outcomes. Risk is the dispersion or spread of the possible
returns around the (ex ante) expected return, modelled using the variance or standard
deviation.
If the underlying distribution of returns conforms to the normal probability
distribution, the spread of return (which leads to risk) is summarised by its variance.
An equivalent measure of dispersion is the standard deviation (which is simply the
square root of the variance), which is known as volatility in financial markets. The
§§ This is the position’s undiversified VaR.

*** This is the position’s diversified VaR.

standard deviation is an easier measure to understand since it is denominated in

units of return.
We can characterise the normal probability distribution uniquely by its mean and
standard deviation. With a normal distribution, the standard deviation provides a
measure of the probability of a given set of outcomes away from the mean or
average. About two-thirds of the distribution is accounted for by observations
falling between −1 and +1 standard deviations; about 95 per cent of the distribution
is within −2 and +2 standard deviations. And 99 per cent is accounted for by
observations within 3 standard deviations of the mean.
When looking at the relationship between two assets, their covariance or their
correlation is an important measure of their interdependence. The covariance
measures the tendency of two assets to move together. The correlation coefficient is
a standardised measure of this tendency that allows comparisons between several
assets. The correlation coefficient can take a value between −1 (perfect negative
correlation) and +1 (perfect positive correlation); a value of zero means the returns
on the two assets are independent. Two assets will be positively correlated if, on
average, their returns move in the same direction; two assets will be negatively
correlated if, on average, their returns move in the opposite direction.
The benefits of risk reduction from creating portfolios result from the correlation
effect. The diversification effect arises from creating portfolios with assets that are
less than perfectly correlated. As a result, by selecting efficient portfolios, less risk
per unit of expected return can be had or higher return for a given risk can be had –
due to the risk-reducing benefits of diversification. The lower the correlation (to a
minimum of −1, or perfect negative correlation), the greater the risk reduction
obtained.
Diversification is beneficial because, for imperfectly correlated asset returns, the
risk (standard deviation of the portfolio) is less than the weighted-average risk of the
individual assets that are used to make up the portfolio. This has important benefits
for financial risk management and the calculation of a diversified value at risk for
portfolios that include assets that are less than perfectly correlated.
Appendix to Module 9: Example of the Statistical Analysis of Risk

Table 9.19 and Table 9.20 are reproduced with permission from JP Morgan’s
RiskMetrics™ system. These tables date from 1995; as such, some of the currencies
in Table 9.20 are no longer in existence.

Table 9.19 Correlation matrix
Yield Curve 1 Day 1 Wk 1 Mo. 3 Mo. 6 Mo. 12 Mo. 2 Yr 3 Yr 4 Yr 5 Yr 7 Yr 9 Yr 10 Yr 15 Yr 20 Yr 30 Yr

RiskMetrics™ 0.003 0.019 0.082 0.25 0.50 1.00 2.00 3.00 4.00 5.00 7.00 9.00 10.00 15.00 20.00 30.00
Yield volatility 1.491 1.133 0.476 0.493 0.739 1.123 1.323 1.268 1.218 1.166 1.054 0.992 0.967 0.920 0.880 0.857
Current yield 6.000 6.016 6.063 6.188 6.344 6.591 6.494 6.672 6.779 6.865 7.010 7.135 7.191 7.487 7.629 7.586
Price volatility 0.000 0.001 0.002 0.008 0.022 0.068 0.157 0.231 0.300 0.364 0.469 0.578 0.632 0.938 1.219 1.772
Correlation Matrix
1 Day 1 0.992 0.178 0.089 0.125 0.030 0.105 0.074 0.051 0.032 0.012 0.007 0.013 0.019 0.024 0.035
1 Week 0.992 1 0.284 0.150 0.178 0.066 0.127 0.095 0.068 0.049 0.030 0.025 0.030 0.037 0.042 0.051
1 Mo. 0.178 0.284 1 0.590 0.509 0.244 0.213 0.185 0.149 0.133 0.139 0.136 0.135 0.149 0.150 0.135
3 Mo. 0.089 0.150 0.590 1 0.744 0.528 0.391 0.384 0.361 0.348 0.322 0.309 0.312 0.277 0.244 0.236
6 Mo. 0.125 0.178 0.509 0.744 1 0.664 0.597 0.590 0.578 0.570 0.556 0.542 0.542 0.500 0.465 0.449
12 Mo. 0.030 0.066 0.244 0.528 0.664 1 0.853 0.863 0.854 0.845 0.806 0.777 0.772 0.696 0.589 0.551
2 Yr. 0.105 0.127 0.213 0.391 0.597 0.853 1 0.990 0.969 0.948 0.889 0.847 0.842 0.766 0.644 0.585
3 Yr. 0.074 0.095 0.185 0.384 0.590 0.863 0.990 1 0.991 0.976 0.928 0.890 0.885 0.807 0.683 0.630
4 Yr. 0.051 0.068 0.149 0.361 0.578 0.854 0.969 0.991 1 0.996 0.961 0.931 0.927 0.850 0.731 0.683
5 Yr. 0.032 0.049 0.133 0.348 0.570 0.845 0.948 0.976 0.996 1 0.978 0.955 0.951 0.879 0.766 0.722
7 Yr. 0.012 0.030 0.139 0.322 0.556 0.806 0.889 0.928 0.961 0.978 1 0.994 0.989 0.929 0.829 0.795
9 Yr. 0.007 0.025 0.136 0.309 0.542 0.777 0.847 0.890 0.931 0.955 0.994 1 0.998 0.956 0.872 0.847
10 Yr. 0.013 0.030 0.135 0.312 0.542 0.772 0.842 0.885 0.927 0.951 0.989 0.998 1 0.968 0.894 0.871
15 Yr. 0.019 0.037 0.149 0.277 0.500 0.696 0.766 0.807 0.850 0.879 0.929 0.956 0.968 1 0.967 0.945
20 Yr. 0.024 0.042 0.150 0.244 0.465 0.589 0.644 0.683 0.731 0.766 0.829 0.872 0.894 0.967 1 0.989
30 Yr. 0.035 0.051 0.135 0.236 0.449 0.551 0.585 0.630 0.683 0.722 0.795 0.847 0.871 0.945 0.989 1
RiskMetrics™ 1 Day 1 Wk 1 Mo. 3 Mo. 6 Mo. 12 Mo. 2 Yr 3 Yr 4 Yr 5 Yr 7 Yr 9 Yr 10 Yr 15 Yr 20 Yr 30 Yr

Total Vertex 0 0 0 70 1597 2343 2965 2780 2612 3288 4357 3031 26 564 0 0 0
RiskMetrics™ 0.00 0.00 0.00 0.01 0.35 1.59 4.66 6.42 7.83 11.97 20.43 17.52 167.89 0.00 0.00 0.00

Table 9.20 FX correlation matrix
FX Volatilities @1.65SD
Original Rebased AUD FX BEF FX CAD FX DKR FX FFR FX DMK FX LIT FX YEN FX DGL FX ESP FX SKR FX SFR FX GBP FX ECU FX USD FX
AUD FX 0.5518% 1.3764% 1.0000 −0.0240 0.1190 −0.0430 −0.0970 −0.0550 −0.4850 0.0820 −0.0580 −0.1510 #### #### #### 0.0970 0.0000
BEF FX 1.2478% 0.0000% −0.0240 1.0000 −0.2500 0.9080 0.9420 0.9640 0.2040 0.8320 0.9830 0.5650 0.3390 0.9410 0.7870 0.9500 0.0000
CAD FX 0.5969% 1.5118% 0.1190 −0.2500 1.0000 0.0190 − 0.2430 −0.3530 −0.0820 −0.1570 −0.3250 0.1680 0.0690 #### #### #### 0.0000
DKR FX 1.0783% 0.5256% −0.0430 0.9080 0.0190 1.0000 0.9000 0.8380 0.2540 0.7680 0.8680 0.6730 0.4200 0.7840 0.7130 0.8870 0.0000
FFR FX 1.1144% 0.4232% −0.0970 0.9420 −0.2430 0.9000 1.0000 0.9390 0.3970 0.8030 0.9360 0.7200 0.5150 0.9140 0.8390 0.9420 0.0000
DMK FX 1.3073% 0.3478% −0.0550 0.9640 −0.3530 0.8380 0.9390 1.0000 0.2420 0.8680 0.9910 0.5170 0.3420 0.9810 0.7810 0.8600 0.0000
LIT FX 1.1176% 1.4957% −0.4850 0.2040 −0.0820 0.2540 0.3970 0.2420 1.0000 0.1760 0.2320 0.4560 0.6830 0.2600 0.3260 0.2160 0.0000
YEN FX 1.1922% 0.7092% 0.0820 0.8320 −0.1570 0.7680 0.8030 0.8680 0.1760 1.0000 0.8610 0.4220 0.2040 0.8560 0.6390 0.7140 0.0000
DGL FX 1.3054% 0.2423% −0.0580 0.9830 −0.3250 0.8680 0.9360 0.9910 0.2320 0.8610 1.0000 0.5030 0.3240 0.9750 0.7640 0.8900 0.0000
ESP FX 1.0632% 1.0901% −0.1510 0.5650 0.1680 0.6730 0.7200 0.5170 0.4560 0.4220 0.5030 1.0000 0.5250 0.4730 0.6580 0.5060 0.0000
SKR FX 1.0494% 1.3306% −0.2600 0.3390 0.0690 0.4200 0.5150 0.3420 0.6830 0.2040 0.3240 0.5250 1.0000 0.3370 0.4660 0.5990 0.0000
SFR FX 1.6044% 0.6028% −0.0470 0.9410 −0.4010 0.7840 0.9140 0.9810 0.2600 0.8560 0.9750 0.4730 0.3370 1.0000 0.7550 0.8170 0.0000
GBP FX 1.2401% 0.8119% −0.0770 0.7870 −0.2820 0.7130 0.8390 0.7810 0.3260 0.6390 0.7640 0.6580 0.4660 0.7550 1.0000 0.8130 0.0000
ECU FX 1.1315% 0.3933% 0.0970 0.9500 −0.0920 0.8870 0.9420 0.8600 0.2160 0.7140 0.8900 0.5060 0.5990 0.8170 0.8130 1.0000 0.0000
USD FX 0.0000% 1.2478% 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 1.0000
Source for this and previous table: JP Morgan’s RiskMetrics™.

Review Questions
9.1 Which of the following best describes the difference between the forecast approach and
the value-at-risk approach to risk assessment?
A. There are no differences between the forecast approach and the value-at-risk
approach.
B. A forecast gives a possible distribution of future values whereas the value-at-
risk approach provides a view on future price changes.
C. A forecast provides a view on future price changes whereas the value-at-risk
approach gives a possible distribution of future values.
D. A forecast only provides for one risk factor whereas the value-at-risk approach
allows for all risk factors at the same time.
9.2 If we borrow €65 000 and repay €65 900 after two weeks, which of the following is the
percentage return on the investment?
A. 1.01 per cent.
B. 1.38 per cent.
C. 35.88 per cent.
D. 42.81 per cent.
9.3 A security has four possible outcomes, depending on the states of the world, as follows:
State of the world Probability (ρ) Value under the state

of the world
High growth 0.2 1800
Moderate growth 0.4 1300
Recession 0.3 900
Depression 0.1 450
The interest rate is 8 per cent. Which of the following is the security’s expected value?
A. 1106.48
B. 1112.50
C. 1195.00
D. 4450.00
9.4 If a security had a two-year maturity, paid no interest, had an expected value of 1275
and was currently trading at 900 in the market, which of the following would be the
security’s expected return?
A. 19.0 per cent.
B. 41.8 per cent.
C. 119.0 per cent.
D. 141.7 per cent.

9.5 Which of the following is the standard deviation of the return on the security in
Question 9.3, if the investment’s market price was 1000?
A. 11.3 per cent.
B. 16 per cent.
C. 19.5 per cent.
D. 40 per cent.
9.6 A security has a mean return of 0.05 and a standard deviation of 0.125 and the returns
are normally distributed. Which of the following is the range of returns the security will
have at the 2 standard deviation confidence level?
A. −0.25 to 0.25
B. −0.20 to 0.30
C. 0 to 0.10
D. 0.05 to 0.25
9.7 Which of the following is correct? In Question 9.6, the likelihood of the uncertain
outcome falling within the 2 standard deviation range will be:
A. 0.046
B. 0.317
C. 0.955
D. 1.0
9.8 In financial markets which of the following is unlikely to be the case when two securities,
A and B, are examined in terms of their expected return and their variance of returns?
A. Security A has a higher expected return than B but a lower variance than B.
B. Security A has a higher expected return than B but a higher variance than B.
C. Security A has a lower expected return than B but a lower variance than B.
9.9 A security has an expected annual return of 15 per cent and a standard deviation of 30
per cent. Which of the following is the probability that the security will give a return of
40 per cent, or above, in any one year?
(Note: You need to look at the areas under the normal curve to answer this.)
A. 0.1666
B. 0.2033
C. 0.7967
D. 0.8333
9.10 Which of the following is correct? If we have a correlation coefficient between two
assets, A and B, of 0.40, we would predict that on average:
A. Asset A would show a high return when the return on Asset B had a low
return.
B. Asset A would show a low return when the return on Asset B had a high
return.
C. Asset A would show a high return when the return on Asset B also had a high
return.
D. there would be no pattern to the returns on Assets A and B.

9.11 Two securities, X and Y, have the following sets of returns and probabilities of returns:
State Probability Security X Security Y

High 0.55 0.17 0.12
Low 0.45 − 0.09 − 0.05
Which of the following is the expected return on the two securities?

A. X: 0.053 and Y: 0.044
B. X: 0.08 and Y: 0.08
C. X: 0.109 and Y: 0.107
D. X: 0.192 and Y: 0.13
9.12 Which of the following is the standard deviation of the two securities in Question 9.11?
A. X: 0.129 and Y: 0.085
B. X: 0.017 and Y: 0.007
C. X: 0.106 and Y: 0.088
D. X: 0.140 and Y: 0.095
9.13 The two securities, X and Y, in Question 9.11 have the following joint probability
function for the two possible states of the world:
Security X
High Low
0.17 − 0.09
Security Y High 0.12 0.35 0.25
Low − 0.05 0.15 0.25
Which of the following is the securities’ correlation coefficient?

A. −0.06
B. 0.06
C. −0.19
D. 0.19
The following data are used for Questions 9.14 to 9.16:
Security Mean return Variance of return Standard deviation

of return
A 0.1025 0.0165 0.1285
B 0.0955 0.0149 0.1219
C 0.0815 0.0148 0.1215
D 0.1275 0.0173 0.1315

9.14 Based on the information in the table, which of the securities has the highest expected
return?
A. Security A.
B. Security B.
C. Security C.
D. Security D.
9.15 Based on the information in the table which of the securities has the highest risk?
A. Security A.
B. Security B.
C. Security C.
D. Security D.
9.16 Which security offers the worst trade-off between risk and return?
A. Security A.
B. Security B.
C. Security C.
D. Security D.
9.17 A portfolio is made up of two securities, K and L, which have a correlation of 0.40
between them. The standard deviation of K = 0.10 and L = 0.08. If the intention is to
create a portfolio with the minimum variance, which of the following proportions of L
should be held in the portfolio?
A. 0.18
B. 0.48
C. 0.50
D. 0.68
The following table is used for Questions 9.18 and 9.19.
State of the world (ρ) Value under the state of the

world
High growth 0.2 1800
Recession 0.3 900
Depression 0.1 450
9.18 The asset whose payoffs are given in the table is trading in the market at 1000. Which of
the following is the asset’s expected return?
A. 19.5 per cent.
B. 119.5 per cent.
C. 445 per cent.
D. It cannot be determined from the information provided.

9.19 Which of the following is the asset’s variance of return for the asset whose payoffs are
given in the table?
A. 0.04
B. 0.16
C. 0.40
D. 0.45
9.20 A commodity has an expected annual return of 7 per cent and a standard deviation of
12 per cent. Which of the following is the probability that the commodity will give a
return of zero per cent, or below, in any one year?
(Note: You need to look at the areas under the normal curve to answer this.)
A. 0.281
B. 0.417
C. 0.583
D. 0.719
9.21 Two assets, J and K, with standard deviations of 0.25 and 0.16 respectively, are
uncorrelated. Which of the following is the optimum ratio of the combination of the
two in a portfolio that will minimise the risk of the portfolio?
A. 0.29
B. 0.41
C. 0.64
D. All the portfolio should be in J.
9.22 Which of the following is correct? Portfolio effects will be greatest if:
A. assets in the portfolio have high positive correlation.
B. assets in the portfolio have low positive correlation.
C. assets in the portfolio have low negative correlation.
D. assets in the portfolio have high negative correlation.
9.23 Which of the following is correct? With portfolios it is possible to:

A. eliminate all the risk of the individual assets in the portfolio.
B. eliminate most of the risk of the individual assets in the portfolio.
C. eliminate some of the risk of the individual assets in the portfolio.
D. eliminate none of the risk of the individual assets in the portfolio.
9.24 Which of the following is the annual standard deviation of an asset if its daily variance is
0.01 (assume 252 trading days in the year)?
A. 0.02
B. 0.12
C. 1.59
D. 2.52

Case Study 9.1: Calculating the Risk Factors for Two Commodities
1 Use the data on the gold and silver price below to calculate the mean return, standard
deviation of return and the covariance and correlation of returns for these two precious
metal commodities. You need to calculate the annualised volatility of the two series
(assume 252 business days in the year).
Business days Gold (US dollars) Silver (US dollars)

1 385.80 5.16
2 386.10 5.19
3 383.20 5.09
5 383.35 5.09
6 381.75 5.03
7 382.65 5.13
8 382.75 5.15
9 384.35 5.22
12 383.75 5.16
13 384.35 5.23
14 384.50 5.29
15 384.05 5.22
16 383.90 5.29
19 383.50 5.22
20 384.50 5.32
21 384.10 5.36
22 383.00 5.50
23 384.85 5.66
26 385.55 5.79
27 383.55 5.71
28 383.45 5.58
29 383.10 5.68
30 382.60 5.59
33 383.30 5.61
34 383.25 5.57
35 381.90 5.45
36 381.65 5.31
37 381.80 5.35
40 379.85 5.29
41 379.40 5.29
42 379.00 5.21
43 380.55 5.39

2 A portfolio is made up of US$1.25 million in gold and US$1.1 million in silver. What is
the total value at risk on the portfolio at the 1.9 standard deviation level if the portfolio
is held for a year?
Case Study 9.2: Portfolio Risk

There are three securities, A, B and C, which have the following payoffs under different states of the
world:
State Probability Security A Security B Security C

Boom 0.2 0.20 0.15 − 0.04
Moderate growth 0.3 0.12 0.10 0.05
Slow growth 0.3 0.06 0.05 0.06
Recession 0.2 − 0.05 − 0.02 0.11
1 Calculate the expected return and variance of the three securities.
2 Calculate the covariance between the three securities. Show the correlation matrix.
3 Construct a portfolio using the three securities that has the proportions 40:40:20 in the
three securities. What is the portfolio’s expected return and portfolio risk?
4 If a portfolio is made up of securities A and C where the amount in A is 1 000 000 and in
C 800 000, what will be the value at risk for the portfolio at 1.96 standard deviations?
References
Kelvin, W.T., Baron (1894), Popular Lectures and Addresses. London: Macmillan.

Module 10
Financial Methods for Measuring Risk

Contents
10.1 Introduction.......................................................................................... 10/1
10.2 Using the Present-Value Approach to Determine Risk .................. 10/3
10.3 Calculating Spot Discount Rates for Specific Maturities ................. 10/5
10.4 The Term-Structure Approach to Risk Measurement.................. 10/15
10.5 Simulation........................................................................................... 10/20
Learning Summary ....................................................................................... 10/33
Appendix to Module 10: Bootstrapping Zero-Coupon Rates from
the Par Yield Curve ........................................................................... 10/34
Review Questions ......................................................................................... 10/37
Learning Objectives
This module describes the use of financial methods and, in particular, discounted
cash flow techniques used to measure risks. It starts by outlining the methods used
to create a zero-coupon, or spot-rate, yield curve from observed securities prices
and its use for calculating the present value of future cash flows. It then shows how
the present-value method can be applied to future cash flows in order to determine
their sensitivity to changes in the interest rates used to value these cash flows. This
discussion is then extended to show how the risk of a position can be modelled
using simulation based on the known statistical relationships between the different
elements of risk in the term structure of interest rates.
 apply the present-value (PV) method to calculate the value sensitivity of assets
and liabilities to changes in interest rates;
 construct spot or zero-coupon rates for each maturity from the yield curve and
use these spot rates as the appropriate interest rate for discounting future cash
flows at each point in time;
 apply sensitivity analysis to a given risk position;
 undertake the simulation of a risk position.
10.1 Introduction
The financial approach to risk measurement is based around determining how
changes in the risk factors affect the value of assets and liabilities. In particular, it is
concerned with measuring the potential loss in value due to changes in the interest
rate used to value future cash flows. The most sophisticated valuation method used

Module 10 / Financial Methods for Measuring Risk
in finance involves discounted cash flow (DCF) analysis, which makes use of the
time value of money to discount future assets and liabilities by the appropriate
spot interest rate. This is the modelling approach that forms the basis of the
assessment techniques described in this module.
We will start with an intuitive examination of the ideas that are covered in this
module. In the eurodollar money markets where I once worked, traders often made
use of a simple value ‘ready reckoner’ for the effect of a one-hundredth of a
percentage point (called an ‘oh one’), or a basis point (bp). They used this on the
current value of a money market instrument like a certificate of deposit (CD), a
short-term bank deposit or loan, commercial paper (CP) or a banker’s acceptance
(BA). A reduced version of this ready reckoner is shown in Table 10.1.
Table 10.1 The US dollar value of a 0.01 per cent (1 basis point) change
in the interest rate on a principal amount of $1 million
Time (days) US dollar value for a 0.01% per $1 million
1 $0.28
30 $8.33
60 $16.67
90 $25.00
180 $50.00
270 $75.00
360 $100.00
Note: The market’s method for computing interest rates for short-term periods is based
on the actual number of days involved divided by a notional year of 360 days (Actu-
al/360).†††
The trader would estimate the risk of a given position by reference to the table
and the amount and the maturity of the instrument that was held in inventory. For
example, a $5 million CD with a 90-day maturity has a dollar value of $125 for each
basis point change in interest rates ($5 million × 0.0001 × 90/360 = $125). If the
rate was expected to move by, say, one-eighth per cent (0.125 per cent), the value of
the position would change accordingly, based on the following simple formula:
Value of an 01 per million No. of millions Change in interest rates basis
points
Hence the dealer’s position would change by $25 × 5 × 12.5 = $1562.50; this
could be a gain or loss depending on the direction of the interest rate change and
whether the position was an asset or a liability.
The technique briefly outlined above provides a simple method for valuing
changes in money market instruments and establishing the value risk of a given
††† The exact formula is $1 million × 0.01 × Number of days/360 (for instance, the 90-day calculation is
$1 million × 0.0001 × 90/360 = $25). Note that this makes use of what is called simple interest.

position or security and, if aggregated, the entire position held by the trader. As an
approach it uses two elements that are central to the financial approach to risk
measurement. These are (1) the effect of time and (2) the impact of a given change
in interest rates (or the discounting rate) on the value of a future set of cash flows.
Using the Value of a Basis Point for Risk Management
We can illustrate how the price value of a basis point (PVBP) can be used to determine
the sensitivity of short-dated money market instruments to changes in interest rates.
The three-month eurodollar futures contract that is traded on the Chicago Mercantile
Exchange has a 90-day contract period on the underlying $1 million notional deposit.
This means that a 1 basis point change in the interest rate used to value the contract
will change the value of the futures by $25.
Assume we have a two-month maturity position worth $12 million for which we want
to eliminate the price risk from changes in interest rates. (This is known as hedging.)
The 1 basis point price sensitivity of the position is $16.67 × 12 = $200. In order to
work out the number of contracts that provide the same value change as the position
being hedged, we simply divide the price sensitivity of the contract into the price
sensitivity of the position ($200/$25), which gives us 8 contracts. (Note that the
maturity of the underlying deposit for short-term interest rate futures contracts is three
months; that is, 90 days. The notional deposit amount is $1 million. Hence the sensitivity
of the futures to a 1 basis point change in the underlying interest rate is $1 mil-
lion × 90/360 × 0.0001 = $25.)
The result is:
A 1 basis point change in the two-month position will be: 1 × $16.67 × 12 = $200.
A 1 basis point change in the eurodollar contract will be: 1 × $25 × 8 = $200.
To ensure the hedge works, we set the sensitivity (or value change) of the futures
contract to be the opposite of the position to be managed. That is, we want the cash
position change, say –$200, to be offset by a gain in the futures position of +$200.
Hence we want the two positions to have the opposite sensitivities. The cash position
has a negative sensitivity to interest rates, which is the risk factor, while the hedge has a
positive sensitivity to interest rates. The process of hedging and insuring risk is covered
in detail in the elective Derivatives.
10.2 Using the Present-Value Approach to Determine Risk

The method described above can generally be extended using the present-value (PV)
approach in order to value any set of future cash flows. It makes use of the basic
discounting equation that is common to finance:
﴾10.1﴿
This discount rate, sometimes called a negative interest rate, is applied to future
cash flows. For instance, the valuation of a bond with a fixed coupon uses this
approach to determine the price of the bond today, given the interest rate. The value
of the bond is simply the sum of the different cash flows, namely:

Value ⋯ ﴾10.2﴿
where r is the discount factor, C is the coupon interest paid on the bond and P is the
principal or face amount of the bond that is repaid at maturity (m).
If we have a bond with an annual coupon of 8 per cent with a three-year maturity
and the appropriate discount rate for three years is 9 per cent per year, we can use
Equation 10.2 to calculate the bond’s present value (and presumably its market or
current realisable value) as 97.4687 per cent of par (or the principal amount of the
bond):
97.4687
. . .
If the discount rate of 9 per cent used to price the bond changes, the valuation
we place on the future cash flows will also change. We can see that, if the required
discount rate changes by a basis point (that is, by 0.01 per cent), then the new value
is 97.4439:
97.4439
. . .
For a 1 basis point change in the discount rate, we have a −0.0248 change in the
present value (97.4439 – 97.4687). Therefore, the price or value sensitivity of the
bond to a small change in interest rates is 0.0248 per cent.‡‡‡ Hence we know that
the bond’s price sensitivity to a 1 basis point change in value, which is called the
price value of a basis point, is 0.0248 per 100 nominal of the bond. If the bond has a
face or redemption value of 100 000, then the PVBP is 24.8 (100 000 × 0.0248%).
To work out, from changes in interest rates, the potential value risk in the bond
or the set of future cash flows that the bond represents, we also need to estimate or
forecast how large the change in the discount rate will be. This requires either a
statistical estimate or a forecast of the potential changes in interest rates over the
likely horizon during which the exposed position is expected to last.
‡‡‡ Note that, following the presentation common in the management sciences, risk is presented as a
positive value.

Let us assume that the maximum expected change in interest rates is 10 basis
points (0.10 per cent) for the three-year bond.§§§ The predicted change for 1 basis
point is 0.0248, so for 10 basis points it is 0.0248 × 10, or a 0.2480 change in the
present value.
The approach just described above is referred to as a partial revaluation model
in that we are using the PVBP to predict how the value will change, given a number
of basis points’ change in the interest rate. To understand the difference between
the partial and full revaluation models, we will now recalculate the value of the cash
flows using the new discount rate of 9.1 per cent (that is, we will fully revalue the
cash flows), as follows:
97.2205
. . .
The new value for the bond is 97.2205, compared to the original value of
97.4687. The difference of 0.2482 in value (97.2205 – 97.4687) accords closely with
the difference in the computed present value of the cash flows at the current rate of
9 per cent and 9.1 per cent multiplied by the number of changes in basis points
(0.02480 × 10).
Note that the partial revaluation works when the expected change is a small
multiple of the sensitivity of the cash flow (in this case the 0.01 per cent change). If
the 1 basis point change in value had been used to predict a value change for a full
point (1 per cent), there would be some inaccuracy in the estimate. Using this
method, we find that the predicted change is 2.4800, with the actual change being
2.4424, a difference of 0.0376. The reduced accuracy of the partial revaluation
approach compared to the full revaluation approach is due to the former’s approxi-
mating the actual change. The reason is that it ignores the second derivative of the
present value in respect to interest rates, which is known as convexity. It is also
sometimes called gamma, a term taken from the sensitivity variables used in option
pricing. The partial revaluation approach is based on a linear change in value and
interest rates, whereas it is in fact curved. This means it will lose accuracy when we
apply it to large changes in interest rates. However, as we will see in Section 10.4.1,
even if the partial revaluation approach has this limitation, it also has advantages in
that it makes it straightforward to model the behaviour of individual risk factors in
the term structure, namely the level shift, the rotational shift and the steepness
factors that together determine how the yield curve changes over time.
10.3 Calculating Spot Discount Rates for Specific Maturities

The example given in Section 10.2 assumes that the discount rate is constant for all
maturities. In reality, as discussed in Module 4 on interest rate risk, this is not likely
to be the case. The yield curve is very likely to have a shape that implies different
discount rates for different time periods. We therefore want to use the appropriate
discount rate for the time period in which the cash flow occurs. To do this, we need
§§§ We can arrive at this based on the ideas introduced in Module 7 and Module 8, namely the volatility of
the three-year interest rate and the confidence limit.

to have the correct spot rate or zero-coupon rate for the period in question. Spot
rates and zero-coupon rates are interest rates that have no reinvestment risk. That is,
they correctly value a future cash flow. The only way the future cash flow – or its
present-value equivalent – can change is if the spot rate changes. Note that this is
important since the approach requires us to calculate the correct values for assets
and liabilities.
We can use the term structure of interest rates to derive spot rates. We start by
observing the market prices for a range of debt securities that provide a claim on
future cash flows. At the short end, we will have simple money market instruments
and, further out along the yield curve, a variety of term debt instruments that mostly
pay periodic interest or coupon interest prior to maturity. In some markets, such as
the British- and US-government bond markets, there may be market prices of zero-
coupon instruments. These are known as strips.
To obtain zero-coupon discount rates for the relevant time period, first we can
directly use the simple money market instruments, since they have a zero-coupon
structure.**** This will work for interest rates out to about a year. Second, further out
along the yield curve we have to use an iterative procedure to unbundle the complex
package of fixed-interest securities that are observable in the marketplace. As we
saw in Module 4, a bond is a bundle of sequential cash flows. We will start by
showing how the process works and then discuss the important role of par bonds.
Par bonds are bonds whose coupon rates are the same as their internal rates of
return, or yield, and which have market prices equal to their principal amount.
Let us start by assuming that there is a zero-coupon money market instrument
with a one-year maturity that yields 8 per cent. The present value of this security is
100 000, and the amount paid at maturity is 108 000. The zero-coupon, or spot rate,
of interest is therefore:
1 0.08
which is 8 per cent.†††† This shows that 8 per cent is the one-year zero-coupon
interest rate, which we shall denote as Z1. The subscript for the zero rate denotes the
maturity of the interest rate, which in this case is one year.‡‡‡‡ All cash flows that
have a maturity of one year are valued using this one-year rate of 8 per cent – even
cash flows that are part of other securities, such as the two-year bond to which we
turn next.
**** Recall that this was discussed in Module 4.

†††† One should add a note of caution here about how interest rates are calculated. Money market
instruments are normally calculated using bank basis interest: this is not the same as the discount rate
used for valuing cash flows. The discount rate will be based on the actual days per period; the bank
basis is a simple interest rate that is often based on the actual number of days divided by a basis year,
either of 360 or 365 days. Thus the discount rate for an instrument yielding 8 per cent on a bank basis
will be 1.0138888 times higher; that is, 8.1111 per cent in the example.
‡‡‡‡ The time frame could be less than a year. If it is half a year, then it is 0.5, or, if it is 28 days, then it is
0.077. For forward interest rates, F, we need both the start date (prefix) and the end date (suffix). So
the one-year zero-coupon rate in one year’s time would be denoted by 1F2.

The bond with a two-year maturity has a coupon of 9 per cent and a market
value of 99.5 per cent of par. The yield to maturity of the bond is 9.2853 per cent.
We now want to use this security to get the zero-coupon rate for the two-year
period (Z2).
We already know that the one-year zero-coupon rate from above is 8 per cent.
We can now calculate the present value of the coupon payment (C) on the bond at
the required one-year zero-coupon rate by substituting it into the bond valuation
formula:
Value 99.50
﴾10.3﴿
1 1
9 109
1.08 1
By rearranging the above, we can solve for the unknown two-year zero-coupon
rate Z2:
9 109 ﴾10.4﴿
Value 99.50
1.08 1
109
8.3333
1
109
99.50 8.3333
1
109
91.1667
1
109
1
91.1667
1 1.1956
1 √1.1956
1 1.093441
0.093441
The two-year zero-coupon rate is therefore 9.3441 per cent. Note how we have
found this rate. We have done this by eliminating the intervening cash flow at Year
1, whose present value we knew already. We then treat the remaining two cash flows
as a zero-coupon security and simply derive the interest rate that links the present
value to the future value of these cash flows. In doing so, we calculate the zero-
coupon rate on the proportion of the present value (that is, the bond’s market price)
that represents the second-year cash flow. Note that interest rates, including zero-

coupon rates, are quoted on a per-year basis. So the zero-coupon rate for Year 2 is
therefore 9.3441 per cent per year. The approach we are using is called a bootstrap.
We used an earlier result for Year 1 to allow us to calculate the zero-coupon rate for
Year 2. There is no limit to this process as long as we have the required bonds.
Let us continue our analysis and determine the three-year zero-coupon rate. To
do this, we can now use the one- and two-year zero-coupon rates to uncover the
three-year rate. Assume we have an 11 per cent coupon bond with a market price of
101.25 (this bond has a 10.4930 per cent yield to maturity). The calculation proceeds
as before, using the one- and two-year zero-coupon rates to eliminate the cash flows
of the first two periods:
Value 101.25
﴾10.5﴿
1 1 1
11 11 111
1.08 1.093441 1
111
10.1852 9.2003
1
111
101.25 10.1852 9.2003
1
111
81.8645
1
111
1
81.8645
1 1.3559
1 ∛1.3559
1 1.106817
0.106817
Thus the three-year zero-coupon rate is 10.6817 per cent per year. We continue
with the bootstrapping process, using the result derived from each earlier period and
using longer and longer maturity bonds until the desired maturities have been
covered or until no more securities are available.
10.3.1 Par Bonds

A spreadsheet explaining how to calculate par bonds is available on the EBS course website.
Having explained how we calculate zero-coupon rates (which are also called spot
interest rates), we want to turn to par bonds. As discussed earlier, par bonds are
bonds that have a market price that is the same as their principal amount and where
the yield (y) on the bond is the same as the coupon rate (C). That is:

V 100 ⋯ ﴾10.6﴿
We will now look at some important ways par bonds behave. We will use the
two-year bond to illustrate the effect, but remember that this applies to par bonds of
any maturity. The two-year par yield is 9.2837 per cent (note that, for the par bond,
the par yield = the coupon rate).§§§§ Using the values calculated earlier, we have the
following result. For ease of exposition, we will take the principal amount as
1 million, as a 1 basis point price change leads to a very small change in value for a
two-year bond. We start by showing the par yields and the underlying spot interest
rates that are used to price the one- and two-year cash flows, which are the coupon
interest (principal amount times par yield in this instance) at Year 1 and the principal
and coupon interest at Year 2. (Note that, given the par yield of 9.2837 per cent, and
the one-year spot rate of 8 per cent, we worked out the two-year spot rate of 9.3441
per cent used in the following table using the bootstrapping approach.)
Period Par yield Spot Discount Cash flow Present
(years) rate factor value
1 9.2837% 8.0000% 0.92593 92 837.20 85 960.37
2 9.2837% 9.3441% 0.83639 1 092 837.20 914 039.68
1 000 000.05
This shows that the bond is indeed standing at ‘par’. That is, using the correct
valuation process, we obtain the bond’s principal amount of 1 million.*****
Now let us change the par yield for the two-year maturity by a small amount – in
this case 1 basis point – but keep the coupon rate on the two-year par bond fixed as
above, so the cash flows do not change. (Note that, given the higher par yield and
the constant one-year spot rate of 8 per cent, we worked out the new two-year spot
rate of 9.3546 per cent used in the following table.) We therefore have:

1 9.2837% 8.0000% 0.92593 92 837.20 85 960.37
2 9.2837% 9.3546% 0.83623 1 092 837.20 913 863.77
999 824.14
The value of the two-year par bond has changed, because the par yield has now
changed. The price sensitivity of the bond to a 1 basis point change in the two-year
interest rate pricing factor is 175.91 (1 000 000.05 – 999 824.14).
If, on the other hand, the one-year spot rate changed by 1 basis point (to 8.01 per
cent), we would find that the value of the two-year par bond would not change,
§§§§ This is slightly different from the yield on the two-year bond given earlier. The two-year bond has a
yield of 9.2853 per cent, which is higher, since the bond is at a discount to par.
***** There is a very small amount of rounding error in the calculations.

although the underlying two-year spot rate would change. (Note that, given the new
one-year spot rate of 8.01 per cent, we worked out the two-year spot rate of 9.3436
per cent used in the following table.)
1 9.2837% 8.0100% 0.92584 92 837.20 85 952.41
2 9.2837% 9.3436% 0.836399 1 092 837.20 914 047.59
1 000 000.00
Hence there is no interest rate sensitivity of the two-year par bond to changes in
the one-year par yield. Note that this is true regardless of the maturity of the par
bond. Par bonds of maturity m are not sensitive to changes in par yield changes for
maturities (m – 1).
We can draw three conclusions from this analysis:
1. If the par yield for maturity m changes, and the coupon on what was previously
the par bond with maturity m does not change, the price of the par bond will
change.
2. The par bond and hence par yield is unaffected by changes in par yields other
than that of the maturity of the bond itself. This applies for any maturity, not
just the two-year par bond shown here.
3. Conclusion 2 applies only to par bonds and not to bonds standing at a premium
to par or a discount to par. The following analysis shows that, for a premium
bond that has a coupon of 15 per cent – which is above the par coupon rate of
9.2837 per cent – when the par yield for one year goes up by 1 basis point, we
get a change in value of 4.53.
Period Par yield Spot rate Discount Cash flow Present value
(years) factor
1 9.2837% 8.0000% 0.92593 150 000 138 888.89
2 9.2837% 9.3441% 0.83639 1 150 000 961 850.15
[A] 1 100 739.04
1 9.2837% 8.0100% 0.92584 150 000 138 876.03

2 9.2837% 9.3436% 0.83640 1 150 000 961 858.48
[B] 1 100 734.51
Change [A – B] 4.53
Choosing a Yield Curve and Other Considerations When
Calculating Zero-Coupon Rates ______________________________
The method outlined above showed a bootstrapping approach to calculating
zero-coupon rates. In practice, such a methodology depends on the availability
in the market of a liquid supply of bonds with the appropriate maturities. In
applying this method, it is important to understand how the market sets prices

for different securities. For a number of reasons, securities with the same
maturity but with different coupon rates may trade at prices that imply different
zero-coupon rates. This can arise, for instance, when bonds are trading above
par, because the coupon interest is greater than the discount rates applied by
the market. Many investors dislike premium bonds, since holding such a security
will automatically lock in a capital loss if held to maturity (a process known as
the ‘pull to par’). As a result, such bonds may overstate the zero-coupon rates.
Equally, other bonds may be at a discount to par and investor appetite for
capital gains may lead to overvaluation of such securities, leading to an under-
statement of the zero-coupon rates. For this reason, estimates of the zero-
coupon rate often rely on bonds trading at par, or close to par, where the yield
to maturity is the same as the coupon rate. The discount rates used to present
value the cash flows of these issues are not affected by the aforementioned
biases. Such par bonds are sometimes known as ‘on-the-run issues’.
In addition, one method of measuring the price sensitivity of a set of fixed cash
flows employs a mathematical method known as duration. The duration of a
set of cash flows is influenced by the size of the periodic payments. High coupon
bonds that pay out a higher proportion of their value in coupon interest will
have, as a result, a shorter duration or discounted mean term. Hence high
coupon bonds have a lower duration than bonds with low coupons of the same
maturity. In this sense, the two bonds are not comparable and the market might
price them accordingly.
Also, some bond issues will suffer from illiquidity and may trade at prices that
are not true to the market, reflecting large bid–offer spreads, or lack of supply.
When calculating the zero-coupon rate, the type of security has to be consid-
ered. The rate for government bonds will be a default-free rate, whereas that
for individual corporate securities will include a default-risk premium. This
tends to rise with maturity, since there is greater uncertainty over the firm’s
ability to repay as time increases.
Two approaches to determining the zero-coupon rates are commonly used by
practitioners:
 The first method involves using par or near-par bonds from recently issued
securities. These zero-coupon rates are thus based on current yields and
reflect the market consensus on the underlying zero-coupon rates that are
to be expected from new issues.
 The second method involves calculating zero-coupon rates from a large
number of issues and weighting the results based on liquidity and other crite-
ria. This latter approach aims to capture the market-wide consensus based
on most, if not all, available prices.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Bonds at Par (and Any Other Price) _________________________

A bond can be issued with any price. It is convention to issue bonds for their
principal amount (i.e. par amount). A bond will therefore have a face value or

redemption amount that represents the value of the security and can be for any
amount, although values of thousands, tens of thousands and hundreds of
thousands are the most common denominations. Whatever the value of the
principal amount, it is conventional to refer to the value of a bond in terms of
its percentage of par. So par is 100 per cent. A premium bond will have a value
greater than par (Valuebond > 100), and a bond at a discount will have a value
less than par (Valuebond < 100).
Once a bond is issued, it has a fixed coupon rate. The exception is zero-coupon
bonds, which have no coupon interest payments – these are pure discount
instruments.††††† As market discount rates change, the bond price will increase if
the discount rates in the market fall – and then it will be trading above par – or,
if discount rates in the market rise, the bond will trade below par.
It is necessary to distinguish between bonds that are at par (a special case) and
other bonds. Par bonds have a discount rate (their internal rate of return or
yield) equal to their coupon rate. This identity does not apply to non-par bonds.
We can think of bonds at a premium or discount to par as comprising two
elements: a par bond at the current market rate for the bond’s maturity, plus or
minus an annuity strip for the difference.
If we have a par yield of 6 per cent for five years and the bond we are valuing
has a coupon payment of 4 per cent, then it is equal to the par bond at 6 per
cent, less the 2 per cent annuity strip:
Par bond value = 100
Less five-year 2 per cent annuity strip discounted at 6 per cent
= 2 × 4.2123 = 8.4246
Value of 4 per cent bond = 100 – 8.4246 = 91.58
The cash flows on such a bond are:
Year 1 Year 2 Year 3 Year 4 Year 5

4 4 4 4 104
You may wish to discount these back at the 6 per cent yield to check the
correctness of the valuation.
If an issuer has a probability of default, then the coupon rate on the bond may
be higher for that issuer than for another issuer with an identical maturity bond
not subject to default. The difference in yields (internal rates of return) used to
value the bond is known as a credit spread.
If the credit spread changes, then the PV of the bond will change (the cash flows
are ‘fixed’ contractually).
††††† Some bonds, called notes, have coupon interest that is reset periodically in line with market interest
rates. These are variously known as floating rate notes (FRNs) or variable rate notes (VRNs). Such
securities will normally always trade near their par value.

A premium bond will pay more of its cash flows before maturity. If the bond
above had an 8 per cent coupon, we would have:

8 8 8 8 108
We are receiving +4 difference in Years 1–5 compared to the 4 per cent bond.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Calculating the Bond Value Given the Yield __________________

Note that interest rates are quoted as the annualised rates. For bonds where
the payment frequency on the coupon is not a year, the yield and coupon
payment need to be divided by the number of payments in the year. So an 8 per
cent bond paying semi-annually will pay a coupon of 4 per cent after six months
and a further 4 per cent after 12 months. If the bond was at par, the yield on
the bond would be stated as 8 per cent (that is, 4% × 2). That is, for par bonds
the coupon rate and the yield are the same. If the same bond paid interest
quarterly, then the first three-month interest payment would be 2 per cent;
another coupon of 2 per cent would be paid after 6, 9 and then 12 months. If
the bond was a par bond, the yield would still be given as 8 per cent (2% × 4).
Note that, in terms of compounded interest, the quarterly pay bond is offering a
higher effective yield.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Example of a Semi-Annual-Pay Bond Valuation

A five-year, semi-annual-pay 5 per cent bond with a yield to maturity of 6 per cent will
be priced using the following formula:
∑
/ ﴾10.7﴿
/ /
where C is the annual coupon interest, which is paid twice a year; P is the principal
amount; and y is the nominal annualised semi-annual constant discount rate; that is, the
periodic rate times the frequency. Substituting values, we have:
/
95.73 ∑
. / . /
We can reconfigure the above valuation formula and use a simple bond calculation
method, which involves:
. .
100 1.03
. .
Alternatively, we can treat the pricing as equivalent to a par bond less an annuity strip
for the coupon difference between the par coupon rate and the bond coupon rate
present valued at the par yield for semi-annual par bonds of 6 per cent per year:

.
Five‐ year annuity factor at 6% per year 8.5302
.
Coupon difference between the par bond and the bond being valued 6 5 /2
0.5
PV of difference 8.5302 0.5 4.2651
Bond value 100 4.2651 95.73
10.3.2 The Relationship between Par Yields, Zero-Coupon Rates and

Forward Interest Rates
There is a relationship between par yields, the underlying zero-coupon rates and
forward interest rates.
The par yield is the constant discount rate that equates the bond’s principal and
coupon payments to the par value of the bond. For par bonds this will be the same
as the bond’s coupon rate. This identity does not apply when bonds are at a
premium or a discount. In these cases, the yield on the bond is not equal to the
coupon rate.
The zero-coupon interest rate (or spot rate) is the interest rate that relates a cash
flow from today to a given cash flow at some point in the future with no intervening
cash flows. For this reason zero-coupon rates are known as pure interest rates.
Regardless of what happens to interest rates in the future, by holding a zero-coupon
security to maturity you are guaranteed the interest rate at which you entered the
transaction. The zero-coupon rate can also be considered the par yield from which
the reinvestment risk has been removed.
Forward interest rates are interest rates that start at some point in the future,
rather than immediately, and relate to future borrowing and lending. The forward
interest rate is the rate that at any moment links two zero-coupon interest rates of
different maturities. We can calculate the forward interest rate for any maturity using
the following formula:
1 ﴾10.8﴿
where the forward rate (F) is the interest rate for the period t to t + n and Z is the
interest rate. For example, if the four-year zero-coupon rate is 8 per cent and the
two-year zero-coupon rate is 6 per cent, the forward interest rate for Years 3 and 4
will be:
. .
1 1.2108
. .
1 √1.2108 1.1004

10.04%
10.4 The Term-Structure Approach to Risk Measurement

Once the required zero-coupon rates (0Zt) have been calculated, these are used to
calculate the present value of a set of cash flows. Using the estimates for the zero
rates above and those for Years 4 and 5 (which are not shown), we have the rates as
shown in Table 10.2.
Table 10.2 Zero-coupon spot rates for Years 1 to 5 derived from term debt
instruments
8.0000 9.3421 10.6817 11.0641 11.7854
Knowing what these rates are, we can now also calculate the forward rates that
are implied in the zero-coupon yield curve. Under the expectations hypothesis, the
two-year rate will consist of two one-year rates: the current one-year rate and the
expected one-year rate in one year, or forward rate (1F2). This forward rate can be
calculated from the zero-coupon rates using Equation 10.8:
.
1
.
.
.
1.107009
We find the one-year forward rate in one year is 10.7009 per cent. Since we can
calculate any maturity forward rate starting at any point in the future, we can
calculate a range of interest rates, giving us a number of forward-start yield curves in
Years 1, 2, 3 and so forth. These are shown in Table 10.3.
Table 10.3 Zero-coupon spot rates for Years 1 to 5 and the implied
forward rates
Time Year 1 Year 2 Year 3 Year 4 Year 5
Spot rate 8.0000% 9.3421% 10.6817% 11.0641% 11.7854%
1Ft 10.7009% 12.0474% 12.1047% 12.7523%
2Ft 13.4103% 12.8132% 13.4445%
3Ft 12.2192% 13.4616%
4Ft 14.7177%
Note: The line of rates for 1F is the one-year forward zero-coupon term structure for
one-, two-, three- and four-year maturities.

Calculating Zero-Coupon Forward Rates _____________________

We have the identity that a given interest rate for the maturity m is a function
of the interest rates of the intervening periods. The sub-period forward rate nFm
will be embodied in the rate for period m:
1 1 1 ﴾10.9﴿
For periods of less than one year, this approach must be modified to take into
account the simple interest rate used to calculate interest as used in the money
markets. If a simple interest rate is used, Equation 10.9 has to be modified as
follows:
1 1 1 ﴾10.10﴿
365 365 365
If, however, compound rates are used, Equation 10.9 can be used, where the
powers become fractions of the year, as in Equation 10.11:
﴾10.11﴿
1 1 1
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
10.4.1 Using the Zero-Coupon Term Structure

The first application is to use the zero-coupon rates derived in Table 10.2 to value a
given set of cash flows. Let us assume that there is a contract that involves the net
receipts shown in Table 10.4 over the next five years:
Table 10.4 Future cash flows on a contract

t0 t1 t2 t3 t4 t5
100 000 −50 000 60 000 150 000 300 000
The value risk of these cash flows can be calculated using the relevant zero-
coupon discount rates for the periods t1 to t5. This discounting process to give us
the present value of the cash flows based on the current zero-coupon interest rates
is shown in Table 10.5.

Table 10.5 Present value of contractual cash flows on the contract shown in Table
10.4
Time t0 t1 t2 t3 t4 t5
Cash flow 100 000 −50 000 60 000 150 000 300 000
Zero 8.0000% 9.3421% 10.6817% 11.0641% 11.7854%

coupon
Discount factor 0.925926 0.836421 0.737518 0.657212 0.572894
Present ∑ = 365 472.6 92 592.6 −41 821.1 44 251.1 98 581.8 171 868.2
value of
cash flows
For financial risk management purposes, we want to know how sensitive the
value of these cash flows is today to changes in the underlying risk factor, which is
the interest rates used to present value these cash flows. Consequently, the next
stage is to undertake a value sensitivity analysis of the cash flows for an appropri-
ate change in the interest rate, which, in common with standard practice, we will
take to be 1 basis point (0.01 per cent). We therefore revalue all the cash flows by
modifying the zero-coupon interest rates for each maturity by this amount and
recalculating the discount factors. For instance, the two-year zero-coupon interest
rate is 9.3421 per cent. After we do the sensitivity analysis, this becomes 9.3521 per
cent (9.3421% + 0.01%) and the new discount factor becomes 0.836269. We use
these modified discount factors to recalculate the present value of the cash flows as
shown in Table 10.6.
Table 10.6 Modified present value (PV) of contractual cash flows showing PV
sensitivity for a level shift in the discount rate by 0.01 per cent; that is, a
1 basis point parallel shift in the zero-coupon yield curve
Cash flow 100 000 −50 000 60 000 150 000 300 000
Zero 8.0100% 9.3521% 10.6917% 11.0741% 11.7954%

coupon
Discount factor 0.925840 0.836269 0.737318 0.656975 0.572638
Present ∑ = 365 347.4 92 584.0 −41 813.4 44 239.1 98 546.2 171 791.5
value of
cash flows
The new value is 365 347.5. The value sensitivity of the cash flows to a 1 basis
point parallel change in the zero-coupon yield curve is −125.2 (365 347.4 − 365
472.6).

This is the sensitivity for 1 basis point. We now use the partial revaluation ap-
proach and the expected change in interest rates or confidence level over the
horizon period. For illustrative purposes, let us say this is 25 basis points. This will
give a value risk of 3130. Because all the zero-coupon rates changed by the same
amount, this is known as parallel shift risk. (See Figure 10.1, Panel A.)
Yield
Panel A:
parallel
rate shift
Maturity
Yield
Panel B:
rotational
rate shift
Maturity
Figure 10.1 The yield curve

Panel A shows a parallel rate shift, when all maturities change by the same amount;
Panel B shows a rotational rate shift, when the yield curve pivots or rotates around a
particular point. Illustrated is an upward shift from time zero.
We also know from the earlier discussion on interest rate risk that the shape of the
yield curve can change in different ways. We can see a flattening or a steepening of the
yield curve, as well as inversions. This means that the zero-coupon interest rate
derived from changes in the yield curve may change more for longer time periods
than for shorter ones. Hence we might see a 1 basis point shift at, say, Year 1 but
increasing changes at Year 2 (say, 1.1 basis points) and later (say, Year 3, 1.2 basis
points; Year 4, 1.3 basis points, and so on). This is known as rotational shift risk. (See
Figure 10.1, Panel B.) To illustrate how we calculate the value sensitivity of a position
subject to a rotational shift, we shall assume that there is a 1 basis point rotation in the
yield curve at the five-year maturity and a zero change in the one-year rate. That is, the
zero-coupon curve pivots upwards from one year. This means that at Year 4 we get a
0.75 basis point change; at Year 3 a 0.5 basis point; at Year 2 a 0.25 basis point; and
zero change at Year 1. The new zero-coupon rates for the five years are now as shown
in Table 10.7.

Table 10.7 Modified present value (PV) of contractual cash flows showing PV
sensitivity for a pivotal shift at one year and outward in the discount
rate, giving a 0.01 per cent increase at the five-year maturity; that is, the
zero-coupon yield curve has a rotational shift of a basis point at the five-
year maturity on the one-year rate
Cash 100 000 −50 000 60 000 150 000 300 000
flow
Zero 8.0000% 9.3446% 10.6867% 11.0716% 11.7954%

coupon
Discount factor 0.925926 0.836383 0.737418 0.657034 0.572638
Present ∑ = 365 365.1 92 592.6 −41 819.2 44 245.1 98 555.1 171 791.5
value of
cash flows
The result is a rotational risk value change of −107.5 for the cash flows (that is,
365 365.1 – 365 472.6). Continuing our analysis, we now need to estimate the
confidence limit or maximum degree of rotational shift. If the expected rotation is
30 basis points, the total risk from a steepening or flattening of the zero-coupon
yield curve is 3225.
Level shift risk and rotational shift risk are two different risks. If we want to
establish the total interest rate risk on the cash flows, they have to be combined.
Empirical analysis will show whether a change in the level of the yield curve is
connected (or correlated) with a steepening or flattening of the curve. If the two are
unconnected then we can establish the total risk, as explained in the previous
module, as being the square root of the sum of the squared individual risks:
Total risk Parallel risk Rotational risk
If perfectly correlated, the total risk is simply the sum of the two risks (parallel
risk and rotational risk).

Table 10.8 Total risk factors for interest rate risk assuming (i) perfect
correlation (ρl = 1) between level shift risk and rotational shift
risk and (ii) no correlation (ρl = 0
Risk factor Perfectly correlated Uncorrelated or
or connected unconnected
ρl = 1 ρl = 0
(i) (ii)
Level shift risk 31 317.5 31 317.52 = 980 785 806.3
Rotational shift risk 32 268.5 32 268.52 = 1 041 256 092.0

√2 022 041 899
Total risk 63 585.0 = 44 967.12
Note that, if we know the correlation (ρ) of the two risks, we can estimate the
risk as a portfolio as shown in Module 9. To do this, we apply the portfolio model
using:
Total risk ﴾10.12﴿
Parallel risk Rotational risk 2 Parallel risk Rotational risk
So, if the correlation between the two risks was 0.2, the total risk would be:
Total risk Parallel risk Rotational risk 2 Parallel risk Rotational risk
31 317.5 32 268.5 2 0.2 31 317.5 32 268.5
49 257.18
We can now see that the total amount of risk depends on the degree of correla-
tion between the risk factors. When the two are perfectly correlated (ρ = 1.0), the
total risk is 63 585. If the risk is uncorrelated (ρ = 0), it is 44 967.12. With a modest
degree of positive correlation (ρ = 0.2), we have a total risk of 49 257.18.
Sensitivity analysis will give only one value. In most cases, this is acceptable.
However, there may be uncertainties involved in the estimates, and we may want to
get a distribution of the value of the total risk. We can do this via simulation. We
will, therefore, now turn to how the sensitivity of a given set of cash flows can be
modelled using simulation.
10.5 Simulation
Sometimes it is not possible to have an exact estimate of the relationship between
the risk factors. Different time periods, for instance, may lead to differences in the
estimate for the correlation coefficient or the volatility of a parallel or rotational
shift in the yield curve. On the one hand, one may simply accept that the interrela-
tionship can only be measured with a degree of uncertainty. However, one

quantitative method that allows specifically for such uncertainties is simulation. This
technique randomly generates a set of values for each risk factor from the underly-
ing distribution of possible values, and these estimates are then incorporated in the
risk model to give a large number of values of the risk of a given position. Figure
10.2 shows the simulation process. We start by determining the probability distribu-
tions for the key factors. We then randomly select values from these risk factors
based on their probability distributions (which we determine empirically). We
combine these variables in our model and continue the process until we get a
picture of the results, which typically involves doing this 500 to 1000 times, alt-
hough 10 000 trials are not unknown. We can then examine the resultant probability
distribution.
Step 1: Develop probability distributions for key factors
Data
Step 2: Randomly select values from these distributions
Position size Correlation Parallel shift Rotational shift

Probability
Value range
Credit shift Stressed Other ...

market
Step 3: Combine these factors to determine key variable e.g. value at risk, etc.
Step 4: Continue to repeat this process until a clear picture of the results is obtained
Probability
Value range
Step 5: Evaluate the resultant probability distribution
Figure 10.2 The simulation process, which involves sampling from a

distribution of variables at random
Looking at applying simulation for risk management purposes involves, at its
simplest, three elements:
1. Model the process we want to simulate results for. In the earlier discussion, we
have suggested that the term structure can be modelled using two variables: a
level or parallel shift in rates that affects all time periods by an equal amount and
a rotational shift that steepens or flattens the present yield curve. So our model,
which is the one developed in the previous section, needs to take these factors
into account if it is to be a good representation of real conditions.
2. Specify a set of random numbers that correspond to the chance of a given
outcome. These numbers will be based on the probability of a given occurrence

of change based on historical or other data. This approach means that particular
values of the outcome will be generated in proportion to their likelihood. How-
ever, the approach allows the generation of numbers to occur in a random
fashion.
3. Select numbers and calculate the present value of the cash flows at risk.
There are basically two approaches that can be used for simulation models: one is
based on sampling randomly from historical data, the other generates values from a
distribution whose parameters have been predetermined by the modeller. These
parameters will be based on past evidence, possibly modified by forecasting or other
qualitative inputs. For interest rates we can therefore use historical yield curve data
in the first type of simulation and base the other directly on the distribution of
interest rate changes.
Leaving aside historical simulation for a moment, a great advantage of the model-
ler’s determining the distribution is that this can be any shape that fits the data or is
considered likely by the modeller. A selection of possible distributions is given in
Figure 10.3 and ranges from the normal distribution through to a custom-designed
distribution, including some other probability distributions used in statistical
analysis, such as the binomial and the Weibull. The two types that were discussed in
Module 7 are the normal and the lognormal distribution. It is possible that the
behaviour of risk factors might be better simulated using other types of distribution,
such as the binomial or the poisson or even a custom-built distribution.
Normal Lognormal Triangular Uniform
Binomial Poisson Geometric Hypergeometric
Weibull Beta Exponential Custom
Figure 10.3 Examples of possible probability distributions that can be

used in developing simulation models

Computer Simulation ______________________________________

The use of computer simulation as a numerical technique for determining the
future value of an asset or portfolio has grown significantly as a risk management
tool following the rapid increase in personal computer power available on the
desktop.‡‡‡‡‡ Simulation can be used to study the behaviour of a complex real-
world system such as a portfolio of securities. First the model must be devel-
oped, and then its output has to be compared to the real-world behaviour. By
undertaking a series of computer runs, we can learn about the behaviour of the
computer model. The properties observed in the model can then be used to
make inferences about how the real situation will behave. The development of
such a model can be seen in terms of the steps shown in Figure 10.4.
Problem definition
and formulation
Model construction Data collection
Computerise model
Refinement and enhancement

Verification and validation
Refinement and
enhancement
Experimental design
Simulation runs
Analysis and evaluation
Decision based on results
Figure 10.4 The computer simulation process

In developing the model, the computerisation process makes use of numbers
that are drawn randomly and applied in proportion to the frequency of the
occurrence of a given outcome. If we have the distribution shown in Panel A in
Figure 10.5, we can achieve the same proportionality by combining two random
digits between 0 and 9, as shown in Panel B. Results of draws are assigned to
the values 9 to 15 based on the relative frequency of their occurrence in the
distribution histogram.
‡‡‡‡‡ Simulation
is often called Monte Carlo simulation after the roulette wheel at the casino in Monte
Carlo, which throws out a series of random numbers each time it is spun.

Frequency Panel A
9 10 11 12 13 14 15
Frequency Panel B
9 10 11 12 13 14 15
00 09 19 29 39 49 59 69 79 89 99
Figure 10.5 The Monte Carlo sampling method using random numbers
In Figure 10.5 the physical space of the different values in Panel A is recreated in
Panel B in terms of a given frequency and a variable set of random numbers. For
instance, the probability of getting a value of 9 is 0.10. In order to obtain
random numbers in this proportion, the numbers are paired, giving a range of
values from 00 to 99. The values between 00 and 09 are assigned to the first
value 9, the values 10 to 29 to the value 10 and so on. When sampling from
random numbers with two digits, over the long run we would expect to obtain
pairs of digits between 00 and 09 about one in nine times and the value 9 to
have the desired 0.10 frequency of outcomes. We can refine the analysis to any
degree we want by simply using more random numbers, so rather than just two
digits we could use three, four or more and have greater precision for the
distribution.
A major advantage of this approach is that it can be applied in complex situa-
tions where analytic procedures are difficult or impossible. This approach is
useful, for instance, when the problem does not satisfy the assumptions of
analytic models, and it can address the problems highlighted in Module 7 that
financial data do not conform exactly to the normal distribution. As a general
rule, the larger the number of stochastic elements in the model, the more likely
it is that simulation is the desired evaluation method.
A second advantage of the approach is that the model can be used as a labora-
tory device to experiment on how changes (or future scenarios) influence the
result. (This is the perennial ‘what if’ question of the risk manager.)
Although these advantages make the process attractive, there are disadvantages:
it requires someone to develop and build the simulation model. Another failing
of such models is that they cannot guarantee an optimal solution. Since different

data parameters will be used in testing the model and its effects, there is no
guarantee that the best simulation solution is also the overall best solution to
the problem.
The danger of obtaining a false result is, however, on the whole relatively
unlikely if the risk manager uses good judgement in developing the model and
understands the underlying process being modelled.
__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
10.5.1 Simulation with Historical Data

Simulation with historical data uses a large set of, preferably, past daily interest rate
changes that are then sampled randomly, as explained above. A databank of changes
in the yield curve using historical data is built up, and, using this, a simulation is run
involving repeated, random sampling from changes in the yield curve. The change in
zero-coupon rates is then used to give the change in the present value of the
position being analysed. A refinement might be to set up the simulation so as to
select more occurrences from one particular time period, such as periods of
expansion or recession, based on an assessment of the current economic climate.
An example of historical data of interest rate changes for carrying out such an
analysis is given in Table 10.9.
Table 10.9 Daily yield changes in zero-coupon rates over 30 working

days
Day 1-year 5-year 15-year
1 −0.06 −0.01 −0.01
2 0.06 0.05 0.05
3 0.00 0.00 0.00
4 0.00 0.02 0.00
5 0.06 −0.10 −0.09
6 −0.06 0.01 0.01
7 0.00 −0.05 −0.06
8 0.00 −0.03 −0.03
9 0.00 −0.03 0.00
10 0.00 0.02 0.03
11 0.00 −0.07 −0.06
12 −0.06 0.10 0.08
13 0.00 0.12 0.15
14 0.13 0.07 0.00
15 0.06 −0.11 −0.07
16 −0.19 −0.02 0.00
17 0.00 −0.06 −0.04
18 0.00 −0.05 −0.05
19 −0.06 −0.02 −0.02

Day 1-year 5-year 15-year

20 0.00 0.02 0.02
21 0.00 −0.01 0.02
22 −0.06 −0.02 −0.04
23 0.00 −0.01 0.00
24 −0.06 −0.01 0.00
25 0.06 0.04 0.05
26 0.00 −0.16 −0.12
27 −0.13 −0.04 −0.04
28 0.00 0.00 0.01
29 −0.06 0.00 −0.02
30 0.00 0.02 0.01
The data from Table 10.9 would be used to simulate changes in the discount rate,
using each daily change as part of the equation. Thus, suppose the initial value had
been:
111.2577
. . .
If a simulation had thrown up the result from Day 29, where the rates change by
–0.06, zero and –0.02, the new discount rates would be 7.14 per cent (7.20% – 0.06),
7.86 per cent (unchanged) and 8.25 per cent (8.27% – 0.02) respectively for Years 1,
5 and 15. The new valuation would then be:
111.3681
. . .
This particular analysis would have provided a result indicating a gain of 0.1104
(111.3681 – 111.2577).
As already mentioned, when undertaking such a simulation, it is essential to carry
out a large number of such calculations in order to build up the distribution of
potential changes in values calculated from the trials. These would be used to
determine the amount of risk in the position. So for the above example, for in-
stance, we may end up with a distribution of values that looks very much like the
one in Figure 10.6.

Frequency
106.70 111.25 123.85
95 per cent confidence limit
Figure 10.6 Simulation histogram of possible price changes showing the

values that breach the 95 per cent confidence limit
10.5.2 Statistical Sampling of Changes in the Yield Curve

The second simulation method is to use a given distribution of interest rate changes
as the source of random change. As previously discussed, this can be taken from any
probability distribution the modeller considers appropriate. We will illustrate the
process using the two simple histograms of rate changes that are shown in Figure
10.7 and Figure 10.8. Note that the detail of such a model can be greatly refined to
improve its accuracy by having smaller intervals between categories and by increas-
ing the number of factors being simulated. Consequently, for exposition purposes,
the analysis that follows is a much simplified illustration of the process. Thus, in
practice, the model might allow for the rotation point to be varied along the yield
curve (we will assume it is fixed). Equally it will incorporate any correlation between
the two (or more) risk factors that have been identified from prior analysis (we will
include correlations later on as we build up the model). To be useful, the model will
be built to be as representative of the process as possible.§§§§§ So our model assumes
that there are just two interest rate risk factors: parallel shift and rotational shift.
Note that we are using the same model as in the earlier section that discussed
interest rate sensitivity analysis, when we estimated the value shifts from these
§§§§§ Riskmanagers verify the validity of such models by a process of ‘backtesting’ to check how well the
predictions performed against the actual outcomes and to see if there were any unexpected inaccuracies
in the modelling process.

factors. Now when we use simulation we undertake a great many such analyses,
rather than just one.
0.50
0.40
0.30
0.20
0.10
0.00
–1.00% –0.50% 0.00% 0.50% 1.00%
Figure 10.7 Probability distribution for interest rate changes for the
parallel shift
0.50
0.40
0.30
0.20
0.10
0.00
–1.20% –0.60% 0.00% 0.60% 1.20%
Figure 10.8 Probability distribution for interest rate changes for the
rotational shift
Using our simulation model, the position to be analysed is now subjected to a
large number of trials based on randomly selecting changes in the yield curve from
parallel and rotational shifts. Note that these changes will be both positive and
negative, because, as shown earlier, we want to model the possible distribution of
such changes rather than apply a confidence limit directly. As the histograms show,
the simplified model we are using will have only nine possible changes in interest
rates. The likelihood of getting any particular change will correspond to the proba-
bility of the outcome, although we will never be sure that any particular change in
interest rates will be chosen, since this is determined by the random number
generator. The method used in our example weighs the outcome based on the
observed dispersion of interest rates. These are the 25 basis points for the parallel
shift and 30 basis points for the rotational shift. We assign random numbers in the
correct proportion for the probabilities to the various outcomes. The probabilities
and random numbers for the change in interest rates for the parallel shift are shown
in Table 10.10. All possibilities are taken account of, and the probability of each
shift and combinations of random numbers between 0.00 and 1000.00 are assigned
to each possible change in interest rates. This means the chance of getting a random

number within the range for each possible change in interest rates is based on the
probability of that particular change. A very small probability, for instance, is
assigned to the likelihood of a 1 per cent change in interest rates, whereas there is a
much greater probability that, over a given day, interest rates will not change – or
will change by only a very small amount. In this regard, the model is representative
of reality.
Table 10.10 Simulating interest rate changes, the probability of a particu-

lar change in rate and the random numbers assigned to each
potential outcome
Interest rate Probability Random numbers
change (%)
From To
1.00 0.0001 0.00 0.13
0.75 0.0044 0.14 4.57
0.50 0.0540 4.58 58.56
0.25 0.2420 58.57 300.57
0.00 0.3990 300.58 699.57
−0.25 0.2420 699.58 941.57
−0.50 0.0540 941.58 995.57
−0.75 0.0044 995.58 999.05
−1.00 0.0000 999.06 1000.00
We proceed as follows. For each run or trial of the simulation a random number
is generated. Table 10.11 shows a series of random numbers of the right type for the
simulation in Table 10.10. For instance, starting with the first value in the random
number generation table and applying it to the change in interest rates in Table
10.10 would generate a fall of 0.25 per cent in the interest rate. This is because the
randomly generated value of 824.39 falls in the range 699.58 to 941.57, which
indicates a –0.25 per cent change in interest rates. The second random number in
Table 10.11, which is 905.25, would also involve a reduction in the interest rate of
0.25 per cent. The third random number, which is 035.16, would mean we model a
rise by 0.50 per cent in the interest rate.

Table 10.11 A selection of random numbers

824.39 274.91 214.13 311.06 114.95 585.19 816.51
905.25 381.32 438.43 870.35 138.31 894.83 589.74
035.16 466.47 927.62 024.79 563.01 512.10 280.58
997.61 000.39 796.35 631.95 315.99 739.32 224.61
778.32 253.24 408.01 936.26 947.50 885.15 159.19
066.80 318.17 015.07 572.46 390.14 964.03 084.52
600.94 699.07 998.74 065.49 260.39 555.30 630.96
626.23 296.56 725.79 130.87 865.94 178.59 636.81
725.67 462.27 665.48 474.47 615.13 382.10 929.06
251.47 430.49 455.53 436.10 639.85 055.28 310.02
We proceed in the same way, selecting random numbers and using these to de-
termine what the new interest rate will be, for as many trials as we have determined
are necessary. The results of the random sampling are then used to modify the zero-
coupon discount rates for the position whose future value is being simulated. The
process and calculations for the first few trials are shown in Table 10.12. Note that
this is the same process as was shown in the analysis in Section 10.4.1 when looking
at sensitivity, but in this case we are randomly sampling the changes in the risk
factors.
Table 10.12 Example of simulation of the yield curve using the distribu-
tion of interest rate changes
Cash flow 100 −50 60 150 300
Zero 8.00% 9.34% 10.68% 11.06% 11.79%

coupon
Discount factor 0.925926 0.836421 0.737518 0.657212 0.572894
Present ∑ = 365.4523 92.59 −41.82 44.25 98.56 171.79

value of
cash flows
Run 1 Parallel shift 7.50% 8.84% 10.18% 10.56% 11.29%

Rotational shift 0.00% −0.08% −0.15% −0.23% −0.30%

Rotational shift 0.00% 0.08% 0.15% 0.23% 0.30%


The next stage is to use the results from Table 10.13 to establish the total risk
from each run. This is shown in Table 10.14 for the first three runs of the simula-
tion. The total risk that we calculate in the table at this point is based on the
assumption that there is no correlation between parallel shifts and rotations of the
term structure.****** We are assuming that the two risks are independent, but, as we
will see in the next section, it is quite possible to relax this point and assume that
there is a measure of correlation between the two risks.
Table 10.13 Calculation of the present value of the position based on the
simulated interest rates in Table 10.11
Current valuation
Zero coupon 8.00% 9.34% 10.68% 11.06% 11.79%

PV 365.4523 92.59 −41.82 44.25 98.58 171.87

PV 371.794 93.02 −42.21 44.86 100.38 175.76
Rotational shift 0.00% −0.08% −0.15% −0.23% −0.30%

PV 368.717 92.59 −41.88 44.43 99.39 174.19

PV 362.339 92.38 −41.63 43.95 97.70 169.96

PV 362.234 92.59 −41.76 44.07 97.79 169.58

PV 365.452 92.59 −41.82 44.25 98.58 171.87

PV 359.089 92.59 −41.71 43.89 97.00 167.33
Note: The rotational shift is based on the current zero-coupon discount rates, not those
created from simulating the parallel shift.
Table 10.14 Results of simulations on present value of the position

Parallel shift Rotational shift Total risk
Run 1 6.3413 3.2645 7.1323
Run 2 −3.1131 −3.2181 4.4774
Run 3 0 −6.3633 6.3633
****** That is, the value risk = Parallel shift Rotational shift .

Note: Total risk is the square root of the squared parallel and rotational shift risks and is
taken to be independent for illustrative purposes.
10.5.3 Incorporating Correlation in the Analysis

As previously mentioned, the simulation model can be constructed in any way so
that it reflects reality. In particular, modifications of the simple simulation approach
described above may have to be made for the known interdependencies between the
risk variables. Obviously, if there is positive correlation, two series will tend to move
together part or most of the time, so we need to include this when modelling total
risk from individual risk factors. Therefore, a realistic model has to incorporate such
interdependencies; otherwise, if the risks are assumed to be independent, the results
will understate the amount of risk in a position.†††††† To include correlated but not
perfectly correlated risks, we can use the portfolio approach described in the
previous module to calculate the total risk estimate of the portfolio. For a two-asset
(risk factor) portfolio, the portfolio risk is found by:
Total risk Risk Risk 2 Risk Risk ﴾10.13﴿
Substituting the results from Table 10.14, where the correlation (ρ) between
parallel shifts and rotational shifts is taken to be 0.6, we have the result as laid out in
Table 10.15.
Table 10.15 Simulation runs for total risk with correlation between two variables
Run RiskParallel RiskParallel2 RiskRotational RiskRotational2 Correlation 2×ρ Total risk
(ρ)(Parallel, Rotational) RiskParallel
RiskRotational
(i) (ii) (iii) (iv) (v) (vi) (vii) (viii)
1 6.3413 40.2122 3.6450 10.6568 0.6 24.8413 8.7012
2 −3.1131 9.6915 −3.2181 10.3559 0.6 12.0219 5.6630
3 0 0 −6.3633 40.4918 0.6 0 6.3633
The results from the three trials based on three different assumptions about the
behaviour of the term structure (namely, the two risks are independent (ρ = 0); the
two risks have a degree of positive correlation (ρ = 6); and the two risks are perfect-
ly correlated (ρ = 1)) are summarised in Table 10.16.
In Module 7 we noted that markets can become stressed and that, when this
happens, the correlation between assets and risks increases. If we are unsure as to
the exact degree of correlation between the risk factors, this can also be treated as a
stochastic factor rather than a constant. This involves the same methods of sam-
†††††† Of course, if we had assumed in the earlier analysis that the two risks were perfectly
correlated, then this does not apply. But then one must question the approach of modelling the two
risks separately since they would represent one risk.

pling from a series of random numbers to create a random correlation coefficient

based on the distribution of correlation coefficients between the two factors.
Table 10.16 Risk estimates derived from simulation runs 1 to 3 under

different assumptions of the interdependency of the total risk
involved
Total risk (parallel and rotational shifts of the yield curve)
Run When independent When correlated When interdependent
(ρ = 0) (ρ = 0.6) (ρ = 1)
1 7.1323 8.4639 9.3117
2 4.4774 5.6630 6.3312
3 6.3633 6.3633 6.3633
Note: Note how the correlation affects the amount of risk involved.
We can extend the detail and complexity of the analysis to make the simulation
model more realistic. Therefore, a more sophisticated simulation might have
stochastic elements for the parallel rate shift, the rotational rate shift, the pivot point
for the shift, the changes in the steepness of the curve and the correlation between
parallel and rotational rate shifts, as well as the dispersion or variance of each of the
factors and any correlation in their variances. Such models rely on using spread-
sheets and specialised software and are beyond the scope of this module.
Learning Summary
This module applies the key financial concept of present-value analysis to the
valuation of the risks of future cash flows. The aim of such an analysis is to measure
the sensitivity of future cash flows to changes in the discount rates being used to
value them.
In order to be able to value cash flows correctly, it is first necessary to calculate
the appropriate zero-coupon rates for the relevant time periods. Zero-coupon or
spot interest rates can be derived from standard, coupon-paying instruments via an
iterative bootstrapping process in order to create a synthetic zero-coupon yield
curve. These zero-coupon interest rates are the appropriate discount factors for
each time period regardless of the final maturity of the cash flows. They correct for
flaws in the yield-to-maturity approach as they represent interest rates that have no
reinvestment risk. Zero-coupon interest rates can also be used to compute forward
interest rates, which are the interest rates that are implied in the yield curve and that
start at a given point in the future.
Starting by valuing future cash flows at current interest rates, once the valuation
has been made the value’s sensitivity to changes in the current interest rates can be
measured. Various approaches can be used, including:
 modelling a small change in the discount rate using sensitivity analysis. This
involves making a very small change to the discount rate to see how much the
present value is altered. The value is then grossed up by some estimate of the
likely change over the horizon period using a partial revaluation approach;

 applying a scenario approach that involves changing the discount rate according
to some predetermined view on the likely course of interest rates. This entails
making some forecast about how interest rates are likely to change over the
planning horizon and making suitable adjustments to the present value of the
cash flows;
 applying a statistical assessment of past rate changes to the discount rate in order
to derive a probable change in valuation.
A more sophisticated approach might involve simulation (also called Monte
Carlo simulation) of the different risk factors in the term structure of interest rates.
For instance, the behaviour of the term structure can be characterised by two
principal risk factors, one representing a parallel shift in interest rates that affects all
maturities, the other a rotational shift around some pivotal point in time. Depending
on prior analysis of the nature of the term structure, simulation involves concurrent-
ly changing all the parameters of the model to obtain an overall assessment of the
nature of the value at risk in the exposed set of cash flows.
To summarise: financial assessments aim to provide an appraisal of the current
market value of a set of future cash flows. The financial methods used for risk
assessment apply the established present-value technique in combination with
elements of statistical analysis and sensitivity analysis to establish the potential range
of values over a given management horizon.
Appendix to Module 10: Bootstrapping Zero-Coupon Rates from the

Par Yield Curve
As discussed in the main text of this module, we can convert a par yield curve into a
set of zero-coupon rates and hence a zero-coupon yield curve. Assume for simplici-
ty that a par yield curve is given and that these rates are C1, C2 and C3 for the first
three years, where C is the par yield. We want to find the corresponding one-, two-
and three-year zero-coupon rates, Z1, Z2 and Z3, that underlie the par yields.
We can do this by solving for:
100 ⋯
It is difficult to find these zero-coupon rates directly; it is easier to find the value
of a corresponding zero-coupon bond for the required maturities. However, few
markets actually offer observable zero-coupon securities to investors, and hence
direct calculation of the zero-coupon interest rates is not usually possible. As
discussed in this module, we can bootstrap these from existing bonds and in
particular par bonds.
This appendix shows an efficient way to bootstrap the par yield curve to find the
zero-coupon interest rate. To simplify the arithmetic, we will take 100 per cent (the
par amount) to be 1 and a percentage such as 6 per cent to be 0.06. So a zero-
coupon bond with a three-year maturity trading at a yield of 6 per cent will have a
price of 0.8396 (= 1/(1.06)3). You will notice that this is equivalent to the discount
factor used to present value a payment at 6 per cent for three years. To get the
underlying zero-coupon interest rate, given the present value (PV) and future value

(FV) of the zero-coupon security, we solve for the zero-coupon rate, given the zero-
coupon bond price by using the price relative relationship, namely:
1
So, to get the zero-coupon rate for any maturity n, we modify the above to solve
for Zn, so that:
1
If we calculate the prices of zero-coupon bonds with a value of 1, these are
equivalent to zero-coupon discount factors, since we know that from the earlier
discussion:
One year PV1 1/ 1 Z1
Two years PV2 1/ 1 Z2 2
Three years PV3 1/ 1 Z3 3
and so on. We will notate these as DF1, DF2 and so on.

In Module 5 we explained that coupon-paying bonds are in fact portfolios of
zero-coupon bonds, so we can express their value as:
One˗year bond: 1 1
Two˗year bond: 1 1
Three˗year bond: 1 1
and so on. Note that, under the rules of arithmetic, the following is also true:
1
1
where we can think of the values [DF1 + DF2] in the above as an annuity. This is a
special kind of annuity created by summing the individual discount factors. We can
set up a model or computerised model for solving the above.
Let us define:
i. e.
i. e.
These variables, A1, A2 and A3, are simply the annuity factors for one, two and
three years respectively derived from the three zero-coupon interest rates.
We now have the means to calculate zero-coupon rates from the par curve. To
facilitate computation, we use the following formula:
1
∑
where Zn is the nth period zero-coupon interest rate and Cn is the nth year par bond
coupon or interest rate, expressed as a decimal.

The example in Table 10.17 shows how the method works.
Table 10.17 Bootstrapping zero-coupon rates from the par yield curve
Time Par yield 1 +Cn An − 1 An 1 − (Cn×An − 1) Zero-coupon
period (%) rate (%)
1 6.00 1.06 0 0.9434 6.00
2 6.25 1.0625 0.9434 1.8291 0.94104 6.2578
3 6.375 1.06375 1.8291 2.6596 0.88340 6.3885
4 6.4375 1.064375 2.6596 3.4383 0.82879 6.4542
Additional Explanation
We know the zero-coupon rate for t = 1: it is simply the ‘par’ rate for the first
period as there are no intervening cash flows other than the one at t = 0 and at
the maturity date t = 1. Given this, we know the value for Z1 and can use it to
bootstrap the next shortest ‘coupon’ bond. This is the two-period bond with
one coupon interest payment (C2) at t = 1 and one maturity and coupon interest
payment (1 + C2) at t = 2. The first payment is discounted at the zero-coupon
rate Z1. Let us say the two-period ‘par’ bond has a coupon of 5.1 per cent
(C2 = 5.1 per cent) and the zero-coupon rate for t = 1 is 5 per cent
(Z1 = 5 per cent). We therefore know that the price of this two-period par
bond, with a value of 100 per cent today, is made up of:
5.1 105.1
100
1.05 1
We can rearrange the above to derive Z for Period 2:
5.1 105.1
100
1.05 1
100 4.8571 105.1
1
95.14286 105.1
1
1 105.1
95.14286
1 1.104655
1 √1.104655
0.051026

This gives us Z = 5.1026 per cent. The discount factor for t = 2 is 0.90526
(1/1.104655). That for t = 1 is 0.95238 (1/1.05). The combined discount factors
are 1.875764 (0.90526 + 0.95238), that is the annuity factor for a constant
payment stream for t = 1 and t = 2. In the notation in the text, this is An, so
A2 = 1.875764.
We now proceed to t = 3. Let us assume the par coupon rate is 5.3 per cent.
We can make use of the annuity to ‘save on computations’ since the present
value of the coupon interest payments to m – 1, that is to t = 2, is found by
5.3 × 1.875764 = 9.8455. The present value of the last cash flow on the bond
with a maturity of t = 3 (principal and coupon interest) will be 100 –
9.8455 = 90.1545. Therefore:
105.3
1 1.16799
90.1545
Z3 is therefore 5.3126 per cent.
Note that with a rising yield curve, the zero-coupon rates will lie above the
par rates. With a falling par yield curve, they will lie below.
Zero-coupon rates are also known as spot rates.
Review Questions
10.1 The following interest rates apply. Assume that all instruments use the same method of
calculating interest.
Tenor Tenor Yield (%)

1 year Treasury bill 6.25
2 years Two-year government bond trading at par (100% of face 6.625
value) and a coupon of 6.625%, payable annually
Which of the following is the two-year spot rate (zero-coupon rate)? The answer
should be rounded to two decimal places.
A. 7.00 per cent.
B. 6.44 per cent.
C. 6.64 per cent.
D. 6.24 per cent.
10.2 Which of the following is the present value per 100 nominal of a 10-year bond that has
an 8 per cent annual coupon when the yield to maturity is 10 per cent?
A. 87.71
B. 90
C. 100
D. 160

10.3 Which of the following is correct? The alternative name for a ‘strip’ is:
A. a perpetuity.
B. an annuity.
C. a zero-coupon bond.
D. a straight bond.
10.4 Which of the following is correct? When discussing the interest rates in the term
structure of interest rates, the spot rate is:
A. the discount rate used to discount the value of a cash flow of a particular
maturity to the present.
B. the quoted rate on a zero-coupon bond.
C. the interest rate for a money market instrument.
10.5 The six-month interest rate on deposits is 8.25 per cent. There is a one-year bond that
pays interest semi-annually, trading at 100 in the market with a 9 per cent coupon.
Which of the following is the one-year spot rate?
A. 9 per cent.
B. 9.22 per cent.
C. 9.76 per cent.
D. 9.95 per cent.
10.6 The six-month deposit rate is 9 per cent, there is a one-year deposit rate of 9.25 per
cent and an 18-month bond outstanding with a market price of 99 that pays 10 per cent
semi-annually. Which of the following is the 18-month zero-coupon rate?
A. 9.42 per cent.
B. 11.02 per cent.
C. 11.11 per cent.
D. 17.14 per cent.
10.7 If the one-year spot rate is 12 per cent and the two-year spot rate is 12.25 per cent,
which of the following is the one-year forward rate?
A. 12.125 per cent.
B. 12.50 per cent.
C. 12.625 per cent.
D. 25.72 per cent.
10.8 The zero-coupon yield curve for the first three years is as follows:
Time t=1 t=2 t=3

Zero-coupon curve 9.5% 9% 8.75%
Which of the following is the implied forward rate between Years 2 and 3?
A. 8.25 per cent.
B. 8.50 per cent.
C. 8.96 per cent.
D. 9.08 per cent.

10.9 Using the information from the previous question, what is the three-year par rate?
A. 8.75 per cent.
B. 8.7851 per cent.
C. 9.0829 per cent.
D. 18.7185 per cent.
The following table of spot rates is used for Questions 10.10 to 10.13.
Time 3 months 6 months 9 months 12 months 15 months 18 months

Spot rate 6.25% 6.3125% 6.375% 6.5% 6.625% 6.9375%
10.10 Which of the following is the forward rate for the three-month period starting in six
months’ time?
A. 6.31 per cent.
B. 6.34 per cent.
C. 6.44 per cent.
D. 6.50 per cent.
10.11 Which of the following is the current value of a 15-month bond with a semi-annual
coupon of 10 per cent based on the spot term structure in the table?
A. 101.68
B. 104.11
C. 106.58
D. 106.61
10.12 Which of the following is the level shift sensitivity at 10 basis points for a bond with an
18-month maturity with a coupon of 6 per cent, paid semi-annually? (The shift value is
expressed per 100 per cent.)
A. 0.1345
B. 0.1374
C. 0.1413
D. 1.2668
10.13 Which of the following is the rotational risk on the bond in Question 10.12 if the yield
curve should steepen by 10 basis points at the one-year maturity?
A. 0.1413
B. 0.1990
C. 0.2033
D. 0.7793
10.14 The level shift risk and the rotational risk of an interest-rate-sensitive asset are 1.40 and
1.60 respectively. Which of the following will be the total risk of the position if the two
risks are independent?
A. 0.78
B. 2.13
C. 2.24
D. 3.00

risks have a correlation of 0.40?
A. 1.44
B. 2.58
C. 3.03
D. 3.15
risks have a correlation of −0.10?
A. 2.49
B. 2.42
C. 3.13
D. 3.50
10.17 XYZ Bank is using financial futures to hedge $1 million in debt securities. The
correlation between the position and the hedge has been determined to be −0.95, and
the debt securities and futures have a standard deviation of 0.05 and 0.045 respectively.
Which of the following will be the value at risk at a 2 standard deviation confidence limit
on the hedged portfolio?
A. $31 623
B. $64 012
C. $90 000
D. $131 320
10.18 Which of the following is the present value per 100 nominal of a five-year bond that has
an 18 per cent semi-annual coupon when the market’s quoted yield to maturity is 12
per cent?
A. 100
B. 121.63
C. 122.08
D. 138
The following par yield curve is used for Questions 10.19 and 10.20.
Time 6 months 1 year 1.5 year 2 years 2.5 years 3 years

Par yield 7.25% 7.625% 7.8125% 7.9375% 8.0625% 8.375%
10.19 Given the par yield curve above, which of the following is the market price of the two-
year bond with a coupon rate of 7.9375 per cent?
A. 100
B. 100.28
C. 100.31
D. 100.77

10.20 Which of the following is the three-year zero-coupon rate based on the above par yield
curve?
A. 7.84 per cent.
B. 8.375 per cent.
C. 8.61 per cent.
D. 9.21 per cent.
10.21 The value of a three-year zero-coupon bond is 71.50 in the market. Which of the
following is the bond’s rotational risk from a 25 basis points rotation in the yield curve
at the five-year maturity? Assume the yield curve rotates from t = 0.
A. Nil.
B. 0.18
C. 0.29
D. 0.48
10.22 The main differences between simulation models and analytic models are that:
I. simulation models require a large number of trials to give correct results whereas
analytic models do not.
II. there is a good theory underpinning analytic models but not simulation models.
III. analytic models deliver an optimum result whereas simulation models do not.
IV. analytic models can only be used for simple problems whereas simulation models can
be applied to all types of problems.
A. I, II and III.
B. I, III and IV.
C. II, III and IV.
10.23 The level shift and the rotational risk on a position are 2.1 and 2.4 respectively. Which
of the following will be the total risk of the position if the two risks are perfectly
correlated?
A. 0.30
B. 3.19
C. 4.50
D. 5.04

Case Study 10.1: The Jabberwocky Company

The Jabberwocky Company has received a contract to build the central steam locomo-
tive at Swansea. It will receive payments for this in equal instalments of £120 million
over the next three years, paid every six months commencing in six months’ time. The
current par yield curve is as follows:
Period Interest rate

0.5 6.25
1.0 6.875
1.5 7.0
2.0 7.125
2.5 7.25
3.0 7.375
3.5 7.50
1 What is the Jabberwocky Company’s interest rate risk from the contract?
2 Undertake a sensitivity analysis of the effects of changing the interest rate by 25 basis
points (0.25 per cent) in a parallel shift. Also undertake the same analysis for a rotational
shift, if the yield curve pivots at the three-year point by 25 basis points.
3 If the correlation between the two factors is 0.75, what is the overall exposure of the
company to interest rate risk?

Module 11
Qualitative Approaches to Risk

Assessment
Contents
11.1 Introduction.......................................................................................... 11/1
11.2 Qualitative Forecasting Methods ....................................................... 11/3
11.3 Qualitative Forecasts .......................................................................... 11/7
11.4 A Practical Example of a Forecast ..................................................... 11/9
11.5 Assessing Qualitative Accuracy........................................................ 11/12
Learning Summary ....................................................................................... 11/19
Review Questions ......................................................................................... 11/20
Learning Objectives
This module looks at how qualitative models can be prepared for risk management
purposes. Such models are used for complex situations that cannot be modelled in
formal ways, or as a way of adding a directional or a considered view of the likely
evolution of the risk factors. In particular, it looks at how forecasts are created and
evaluated.
 understand the steps required to prepare a qualitative forecast;
 understand the different methods used to create a qualitative forecast;
 know the problems that can arise from such an approach;
 see how the different approaches are integrated into decision making.
11.1 Introduction
One of my duties when involved in trading securities was to attend a monthly Asset
Liability Management Committee (ALMAC) meeting to discuss the bank’s overall
sensitivity to interest rates and currency movements. At the start of the meeting, we
were given a forecast by the bank’s economists for the forthcoming year. The aim
was to provide a framework for discussing the bank’s exposure over the planning
horizon, in this case over the forthcoming year. To enable us to focus on what
might happen, the forecast itself provided an expected outcome and other, less
expected but possible scenarios, each of which was assigned a probability. The point
of this exercise was an attempt to provide the bank’s treasury with some kind of
view about the likely direction of the markets over the planning horizon. The

Module 11 / Qualitative Approaches to Risk Assessment
approach was largely qualitative in that no formal mathematical or statistical models

were used.
Forecasting is one way in which risks can be managed. If conditions are expected
to become less favourable, action is taken ahead of time to reduce the level of risk.
For example, on a consulting visit to a firm that had a currency exposure to the US
dollar, I was told that, based on their view or expectation of the dollar’s behaviour
over the next year, they had hedged the bulk of their exposure in the forward
market. The treasurer then went on to say that this was not normal practice but was
undertaken for the coming year since they had a strong view that the dollar was
going to weaken further and they wanted to lock in the current rate before this
happened.
As a method, forecasting can be simply judgemental; that is, it simply encapsu-
lates the individual or group view on developments over the forecasting horizon. It
can also be done by sophisticated econometric modelling or scenario building, or be
purely qualitative in scope. A wide variety of techniques is available, and the effort
and reliance placed on the forecast will depend on how valuable the prediction is
likely to be. The four common qualitative methods involve expert opinion, Delphi
forecasting, polling and surveys.
The need for a forecast or qualitative assessment of the risk is part of the analytic
process used to evaluate and manage financial risks. This process can be described
as a set of steps, the qualitative model being one outcome of the risk awareness
stage. The generic approach is illustrated in Figure 11.1.
Risk awareness Risk assessment
Quantitative
risk model
Define Identify Determine

Evaluation Decision
problem alternatives criteria
Qualitative
risk scenario
Figure 11.1 The risk management process as a decision problem
11.1.1 Problems with Mathematical Models of Risk Assessment

We have already discussed several different ways of assessing risk using quantitative
methods. Most of these techniques require historical data on the risk factor, so they
cannot be applied if:
 there are no data available, or
 the future is expected to be significantly different from the past.

Lack of data is probably not a major problem in financial markets. Most asset
classes and financial instruments are actively traded, and good-quality price histories
are available. There might be difficulties if non-market risks are to be modelled, as
obtaining data in this area might be a problem. For instance, credit loss experiences
and bad debts are generally not publicly available.
The second problem, namely differences between the past and the predicted
future, may mean that quantitative assessments have to be treated with caution.
Most quantitative models implicitly assume that the future will be more or less
similar to the past used to derive the model. If this is not the case, various modifica-
tions can be made to historical data. For example, subjective estimates can be used
to make adjustments to the parameters derived from past data. However, there is a
limit to how well such models can be adapted.
The use of qualitative techniques offers an alternative way of approaching the
problem. These are largely based around the views of individuals and experts and
hence can deal with the two problems identified above.
11.2 Qualitative Forecasting Methods

For the reasons referred to above, the need to use qualitative methods has led to the
development of a number of well-structured approaches to qualitative forecasting.
These involve formulating plans about the future based on expectations as to what
is likely to happen, the use of experts either jointly – in a process called Delphi
forecasting – or individually, building scenarios or intuition.
11.2.1 Planning (‘Strategic Business Planning’)
Firms typically engage in planning if only to prepare budgets within the firm for cash
management and other control purposes. Better-organised firms will have strategic
plans and long-range planning procedures. These will show where the potential risks
lie in the future. Planning starts with basic questions such as: what is the business?;
what will it be?; what should it be?; what will prevent it getting there? In the words of
the management thinker Peter Drucker (1973), planning is ‘the application of thought,
analysis, imagination and judgement’.
To plan effectively, it is necessary to understand the risks that are taken in pre-
paring for the future. It is essential that the risks to be taken are the right risks.
Management, in formulating its business intentions, needs to be aware of risks and
to take the appropriate course of action to manage them in relation to the firm’s
capacity to handle risk. This might require the plan to minimise or eliminate the
undesirable risks. An example would be a firm engaged in some major project, the
risks of which are such as to make the firm eliminate any currency risks via hedging.
Planning, at its best, involves a systematic examination of the future and its con-
sequences. The idea can be expanded into short-, medium- and long-range
analyses based on the firm’s flexibility horizon. Table 11.1 explains the differences
between the three types of forecast.

Table 11.1 Horizon and planning decisions

Timescale of forecast Types of decision Examples
Short term Operating decisions Amount of inventory;
(3–6 months) production; transac-
tional hedging
Medium term Tactical Product prices;
(3–6 months to 2 years) employment; plant and
equipment; financial
risk management;
managing economic
exposure
Long term Strategic Product changes;
(beyond 2 years) location of production;
research and develop-
ment; strategic risk
management
The short-, medium- and long-term forecasts relate to the time spans within
which different categories of change can be made to the firm’s operating and
business environments. Hence a capital-intensive firm will have to build in a longer
planning horizon and be aware of hazards over a much longer time frame than
would some types of service firms where reconfiguring the organisation as econom-
ic and business conditions change may take only months or, at most, a few years.
11.2.2 Delphi Forecasting (‘Ask the Experts’)
Delphi forecasting is one of the most common methods of qualitative forecasting. It

was developed at the Rand Corporation in California and is a method of combining
expert knowledge of processes and systems in order to try to obtain a consensus
view. At its simplest it involves asking a panel of experts in a particular area to give
their views as to where there may be problems. The assumption is that the combined
result is superior to the input of each individual. The procedure involves the panel of
experts – who are separated from and unknown to each other – responding to a series
of questions posed by the panel coordinator. These responses are consolidated and
fed back to the panel, who are then asked to reconsider their original responses and
possibly revise them in the light of the group information. This process is repeated
until the coordinator is of the opinion that a sufficient degree of consensus has been
achieved. Note that, in using the Delphi method, the idea is not to produce a single
point forecast but to generate a relatively narrow spread of opinions within which the
majority of the experts concur.
Various modifications of the method are in common use. In areas such as eco-
nomics and finance, where expert forecasts are combined, the forecast of forecasts
is commonly available. However, unlike in the true Delphi method, the forecasting
expert is not then in a position to revise his judgement. In essence, a consensus
forecast is more like a poll of experts, where the consensus is simply the average of
the different forecasts. A major advantage of the consensus forecast is that it helps

to remove bias, but this does not mean an improvement in forecasting ability. The
lack of improvement arises from the variance in the average of the forecasts against
the individual point estimates. Looking at actual outcomes against the consensus
forecast in any given period, the point estimate of one (or more) of the forecasters is
likely to be superior to that of the average of all forecasters. So, if we had five
forecasters who predicted interest rates of 4.6 per cent, 4.7 per cent, 4.8 per cent,
4.85 per cent and 4.9 per cent, the simple average is 4.77 per cent. Unless the actual
result comes in very close to 4.77 per cent, the forecaster who predicted 4.8 per cent
would be ‘more accurate’ than the consensus. This would be the case if the actual
interest rate was 4.81 per cent. The expert was just 0.01 per cent away; the consen-
sus would be 0.04 away.
11.2.3 Expert Judgement

Qualitative forecasting can be based on the judgement of a single individual or be
the consensus of a group of experts. Each of the members of the expert panel
individually considers his or her view on the forecasting period, using whatever
information and method each deems most appropriate, and then their views are
combined into a consensus group forecast. Such an approach involves no formal
model or weighting of the different approaches, and no two experts are likely to
assign the same weight to items of information. Note that, in this approach, each
judgement is allowed to stand as a valid forecast and no consensus is reached.
Expert judgement is often put forward as a means of assessing the future when
conditions are thought to deviate significantly from the past. It is therefore appro-
priate in assessing situations of change (for instance, the impact of technology on
firms, business sectors and so forth). Note that the use of experts is not guaranteed
to provide a superior forecast. However, past uses of the method have shown that it
can provide accurate forecasts, especially when the range of views between experts
is explicitly included in the forecast.
11.2.4 Scenario Building (‘Write Stories’)

Scenario writing is a type of approach that involves developing a conceptual
scenario of the future over the forecast period based on a well-defined set of
assumptions. To work well, it requires the writer(s) to have a good qualitative
understanding of the market, system or process in order to develop likely scenarios.
It is the approach typically used by planners, for instance in foreign affairs, when
trying to ascertain the outcome of alternative policies and developments in foreign
countries. In creating the scenario, the writer uses judgement to structure the
developments in a logical and coherent way, so that, for instance, if the scenario is
looking at economic conditions, business performance is consistent with those
conditions.
The approach can be quantified to some extent using decision trees and/or
game models. For risk management purposes, the qualitative scenario is probably
sufficient, as with the opening account of how economists fed in their views to the
deliberations of the ALMAC meeting. A more complex scenario approach may
actually involve real or accelerated-time role play or simulations. These seek to

recreate the key elements of the process(es) in a semi-structured format in order to

teach decision makers about the complexities of the interactions and to bring out
any potential surprises.
11.2.5 Intuitive Approaches

Subjective or intuitive qualitative methods are based on the ability of the human
mind to assess and make sense of a variety of information that is not, in most cases,
open to quantification. Determining the risks facing the firm has been referred to as
‘risk imagination’. The approach works best when done by groups; it goes under the
appealing name of brainstorming.
Brainstorming is usually seen as a preliminary process in any problem-solving
activity. It is often used at the ideas-generation phase to create alternatives.
These alternatives are then examined in a more logical fashion using expert judge-
ment or quantitative investigation. As part of the risk management process, the
main use for brainstorming, as with other lateral thinking approaches, is to break
free from the constraints, the ‘tramlines’ of positive thinking and bounded rationali-
ty. Most problem solving involves routine, repeat decisions or at best variations on a
theme. In risk management, we are at times attempting to think the unthinkable. A
logical thought process is probably ill suited to the task. Risk managers are trying to
think about the unknown unknowns, as they are called: those potential events or
occurrences that have yet to manifest themselves and of which no one has any
previous experience.
When they take place, brainstorming sessions are informal, inventive, uncon-
trolled and non-judgemental. If the objective is to be imaginative, censure and
control are counter-productive. Nor need the ideas generated be related to specific
matters. The object of the process is to invent new solutions or, in its risk manage-
ment guise, a new interpretation of the future and sources of risk.
11.2.6 Polls and Surveys

Another way to obtain qualitative insights is to make use of polls and surveys. The
difference between a poll and a survey is that in the former there is usually only one
question and there are fixed multiple choice answers. On the other hand, a survey is
a more complicated exercise, since they are longer, involve more in-depth – even
probing – questions and make use of an extended range of approaches such as
open-ended questions as well as closed-ended questions.
A survey has the attraction of allowing the user to gain insights from a range of
individuals or organisations and, in many respects, is like the first phase of the
Delphi forecasting process. What it aims to do is to get a range and diversity of
opinion on a particular topic – for instance, inflation over the medium term –
without trying to create consensus. When it involves interviews, it can be highly
interactive, as the researcher can explore interesting insights generated from
participants’ responses to the questions and issues.

Polls work best when a limited set of questions is being asked and the researcher
can set the response options.‡‡‡‡‡‡ Surveys provide a rich data source and insights
into critical areas. However, they are harder to interpret and require considerable
time and resources to undertake. That said, when carried out correctly, they can
provide new knowledge and understanding on a problem or issue.
11.3 Qualitative Forecasts

There are as many ways of putting together qualitative forecasts as there are
forecasters. The degree of sophistication and amount of detail will depend on the
nature of the forecast being made. A simple example is given in Section 11.4. This
qualitative forecast is for the British economy and the outlook for interest rates.
Note that the result is an opinion or estimate of the future.
Qualitative approaches to forecasts via scenario construction can take two basic
forms. The scenarios themselves can be qualitative in that they describe the forecast
outcome. For instance, the economic assessment can make statements such as ‘We
expect the authorities to reduce interest rates in the next three months in response
to the weakening economic outlook.’ Alternatively they can lead to quantitative
assessments. To extend the example above, the purely qualitative forecast might be
rephrased to say, ‘We anticipate a 50 basis point reduction in interest rates over the
next three months in response to a decline in growth from 2.5 per cent to 1.8 per
cent.’ As it is a qualitative forecast, it uses judgement to determine this opinion, and
hence there is no direct way to determine how the forecast is arrived at.
11.3.1 Qualitative and Quantitative Forecasts

The use of one method of assessing a potential risk, for instance using a quantitative
approach via a formal mathematical model, does not preclude the use of additional
methods, such as a qualitative forecast. Consequently, in practice, qualitative
forecasts are often combined with quantitative ones. In putting together a forecast,
it is useful to have recourse to all the help one can get. Thus a full forecast might
combine elements from different approaches. Figure 11.2 shows an integrated
forecasting approach that combines a variety of data sources, namely historical data,
judgements and market consensus. The forecast makes use of statistical analysis,
scenarios and judgement as well as the embedded consensus opinion that exists in
traded market prices. These include, for instance, the forward prices or interest
rates. As this example is quite sophisticated, it includes a probabilistic assessment
based on the past that is modified by the qualitative and market consensus views. As
such it makes use of all the possible sources of insight in developing the forecast.
‡‡‡‡‡‡ We can see this in that polling is the favourite approach for simple political questions such as
voting intentions, where the list of candidates plus the non-voting alternative can be pre-specified and
results easily tabulated.

Historical Judgement Market

data consensus
Educated
Scenario guess/
Statistical analysis Forward rates/
selection judgement prices
Historical range Implied volatilities

& volatility (distribution of
future returns)
Scenario of future
outcomes/values
Extrapolation
Implied forward
values
Distribution of future
outcomes/values Estimate of future
outcomes/values
Decision
Figure 11.2 The role of different assessment methods for predicting

future prices
What Figure 11.2 shows is that the analyst will seek to make use of all the availa-
ble information in deriving the forecast. Historical data provide a record of the
range of past prices and an estimate of historical volatility. This can be used to
extrapolate into the future to give the possible range of future outcomes and values.
In addition, there is a market consensus that is reflected in current asset prices. For
instance, as discussed in Module 10, the current yield curve includes a view about
future interest rates. Equally, the current prices for options include the market’s best
guess as to the future uncertainty over the life of the option. These provide a
consensus estimate of the future outcome or values. As with historical data, the
analyst incorporates such information into the assessment. This can take the form
of scenario selection – that is, comparing the current environment or market to past
patterns or events – or it can be an educated guess about the future over the
forecast period using the available information to guide the judgement. This leads to
the most likely scenario of future outcomes and/or values together with any
confidence limits or distribution of outcomes. Based on the forecast, the manager
makes his or her decision.
Statistical and other data-modelling techniques can be applied to historical data to
provide an extrapolation of past trends. Another forecast might rely on the single or
collective judgement of experts to provide a scenario or an ‘educated guess’ forecast
– or be based on the results of a poll. Addressing the problem from a different
perspective, financial markets provide information on the market consensus. Using

current market data, it is possible to observe or calculate forward rates and prices or,
via options, implied future volatilities.
As discussed earlier, a particular forecast is likely to turn out to be wrong – as
might be expected given the difficulties involved. However, combinations of
forecasts can help improve the accuracy and robustness of individual forecasts.
There may be a problem if the different methods lead to major divergences in their
predictions. Ultimately it is the risk manager who must weigh the perhaps conflict-
ing results from the different approaches and make a decision.
Note that, in the case of a qualitative forecast, we are looking for both an esti-
mate of the extent of a potential movement and its direction. In this sense, the
analysis is somewhat different from that made by a quantitative risk assessment or
deduced from the market consensus.
11.4 A Practical Example of a Forecast

This section shows how a forecast may be put together and presented. The analysis
is of the UK economy over the next 12 months with a view to deriving an interest
rate forecast for both the short-term rate (the 3-month interbank rate) and the long-
term rate (the 20-year government bond yield). The bare bones of the process are
shown in the following tables. Table 11.2 shows the economic indicators that are
regarded by the forecaster as having a key impact on financial market prices. The
implications for official policy are also given. In most cases, the signal is for an
easing of policy, although actions to raise the external value of the British pound
would be beneficial.
The policy diagnoses based on assessments of Table 11.2 are shown in Table
11.3.
Table 11.2 Qualitative economic assessment of the British economy

Economic indicators
Indicator (all changes are Latest Policy Comments
year-on-year) data signal
Real economy Output growth still remarkably strong.
Industrial production +1.4% ↓
Manufacturing output +1.3%
Retail sales +1.1% ↓ No sign of a pick-up from past flat trend.
Trade balance −£1.6bn Deficit still increasing, but erratic.
Financial
M0 +5.7% M0 growth declining with the weaker trend in retail sales.
M1 6.8%
M4 lending +£1.9bn Bank lending is trending upwards.
Consumer credit +£584m Increased consumer credit inconsistent with weak sales trend.
Three-month interbank rate 5.6% Interest rates likely to remain steady until next year.
Long government bond yield 8.2%
Real interest rate 3.6% Real rate of interest down from recent highs.
FTSE 100 index 3680 Vulnerable to developments in US market.
Trade-weighted index 81.5 ↑

Economic indicators
Indicator (all changes are Latest Policy Comments
year-on-year) data signal
€/£ 1.15 British pound to remain weighed down by political and/or fiscal
fears and the strong €.
$/£ 1.52
Costs and prices
Retail Prices Index (Inflation) +3.5% Consumer demand not strong enough to create increase in RPI.
House prices −1.9% ↓ House prices reflect poor housing market.
Producer output prices +2.8% ↑ No signs of increased pressure to raise prices by producers.
Producer input prices +5.6% ↑ Input prices continue to trend upwards.
Unit wage costs (in manufacturing) +2.8% Starting to rise as output growth moderates.
Average earnings +2.9% Only modest increases expected over next 12 months.
Labour market
Employment +12k No acceleration in jobs being created.
Unemployment −4.5k First monthly rise in unemployment for 37 months.
Vacancies −0.5k
Sentiment
Confederation of British Industry +6 Confidence not reflecting the improvement in the economy in
(CBI) business confidence index recent months
Consumer confidence −2
Policy signal:
tightening required: ↑ – modest ↑↑ – substantial ↑↑↑ – drastic
easing required: ↓ – modest ↓↓ – substantial ↓↓↓ – drastic
Table 11.3 Policy implications from the qualitative economic assessment

in Table 11.2
Policy diagnoses
 The weak domestic demand growth suggests no further interest rate increases,
despite an increase in reported inflation.
 The further deterioration in consumer confidence may lead to a need for lower
interest rates in the next three months.
 The scope for any tax cuts is limited by an overshoot in the Public Sector Borrow-
ing Requirement (PSBR = government borrowing) from lower than anticipated
growth; the political situation suggests modest tax cuts in the next budget coupled
to a small upward review in borrowing targets in the next fiscal year.
 An appreciation of the British pound would be welcome but has little policy
implication as interest rates will not be raised to defend the exchange rate.
The final step is to translate the assessment into the relevant forecasts. This is
shown in Table 11.4 for interest rates for the coming year, giving data for each
quarter (Qx). The table starts with the actual conditions (A) for the previous year to
help in understanding how interest is expected to evolve over the coming year based
on the forecast.
Note that Table 11.4 provides a directional view over the 12-month horizon of the
forecast. The major implication of the forecaster’s analysis is that long-term interest

rates are likely to rise in the coming months based on a subjective interpretation of
the key factors.
Table 11.4 Qualitative interest rate forecast based on assessments in

Table 11.2 and Table 11.3
Interest rate outlook
Horizon 3-month interest 20-year gilt yield
rate (%) (benchmark) (%)
−Q3 A 5.4 8.4
−Q2 A 5.6 8.1
−Q1 A 5.6 8.2
Current A 5.6 8.2
Q1 F 5.2 7.8
Q2 F 5.2 8.0
Q3 F 5.3 8.1
Q4 F 5.3 8.2
11.4.1 Problems with Qualitative Forecasts

We have seen that a judgemental or qualitative approach to forecasting is a useful
tool in addressing some types of risk management problems. However, there are
special difficulties with qualitative forecasts, which, although they may also be
present in quantitative approaches, can create particular problems.
The first problem relates to the assumptions that go to make up the forecast.
Since the approach is largely heuristic, as it is based on the forecaster’s judgement, it
is difficult for the recipient to check the validity of the assessment in a meaningful
way. Although some forecasts are carefully argued, the user must be conscious of
the judgemental nature of the process. This comment also applies to quantitative
models, but the creator in this case has less scope for fudging the issue, since the
quantitative method is based on known procedures. Of course, with these systems,
there is the potential problem of selection bias and misspecification. However,
generally the components of such a formal model are explicit and known to the
model user.
The next element is the prevalence of forecast bias where the forecaster has
introduced a systematic, subjective element that reflects the writer’s ‘world view’.
Thus a pessimistic forecaster will always provide a ‘low’ forecast, an optimistic one a
‘high’ forecast. Knowing the forecaster’s predilection allows the user to adjust the
result for this bias. This is most problematic when it is not possible to determine
whether there is an underlying bias.
Finally, there is the general problem that arises with any model. A model is only a
representation of reality and may ignore problems of causality. Inevitably, it simpli-
fies the real world and may not include all the relevant factors. Because of the
above, risk managers often refer to these problems as model risk. This is the risk
that, somehow, the model is misspecified and does not provide a good enough fit

when used. To deal with the problem, when there are repeated forecasts made using
the same forecaster or forecasting model, it is possible to test the forecast for
accuracy and consistency.
11.5 Assessing Qualitative Accuracy

Given the subjective nature of qualitative assessment methods, it is important to be
able to determine how much reliance the decision maker can place on the analyst. In
a sense, it is the counterpart to ex post model validation that is required in quantita-
tive models (a process known as backtesting).
There are a number of different methods that can be applied to determine how
much confidence the decision maker can place in the result. We can simply measure
the degree of forecasting error. However, if the analyst is forecasting an event,
then we might be interested in the analyst’s directional accuracy; that is, the
number of times a particular event is missed or the number of false alarms. As an
alternative it might be important to focus on profitability or returns. So, while the
number of correct calls versus false ones may be important, it is equally important
that, although there may be a lot of noise in the analyst’s predictions, the analyst has
the ability to correctly anticipate a high proportion of key value-changing events.
Hence metrics such as financial return, risk-adjusted excess returns or the excess-
return-to-risk measures might be more appropriate.§§§§§§
To assess the analyst’s track record, we want to calculate an appropriate error
metric. Since there will always be an alternative, we need to compare the error to a
simple decision rule (or random selection) or benchmark performance.
11.5.1 Measuring Forecasting Error

A spreadsheet explaining how to measure forecasting error is available on the EBS course website.
To address the issue of accuracy, a number of measures of the amount of error in
a forecast have been developed. We will look at how some of these measures work.
In order to do so, we need a sample of forecasts and the actual outcomes of these
forecasted events. We show the results of an analyst who has made 10 forecasts and
the actual outcomes as given below:
Number 1 2 3 4 5 6 7 8 9 10
Forecast 85 79 77 73 75 78 81 84 88 91
Actual 83 81 78 75 73 76 77 80 86 92
The first measure, called the mean absolute error (MAE), simply measures the
average absolute forecasting error between the paired actual (A) outcome and the
forecast (F).******* The formula is:
§§§§§§ These are commonly used in investment performance appraisal.

******* This is also sometimes referred to as the mean absolute deviation (MAD).

∑ | | ﴾11.1﴿
Mean absolute error MAE
where the lines around the calculation | At–Ft | indicate that we take the absolute
value.
So the absolute deviations for the forecasts above are:
Number 1 2 3 4 5 6 7 8 9 10
Forecast 85 79 77 73 75 78 81 84 88 91
Actual 83 81 78 75 73 76 77 80 86 92
Deviation 2 2 1 2 2 2 4 4 2 1
Note that, while the first forecast is 85 and the actual outcome is 83, we want the
absolute difference, namely 2 rather than –2. The same applies across all the
forecasts. The total of the absolute deviations is 22, and the average is 2.2 (22/10).
A problem with giving only the mean absolute deviation is that it does not tell us
how accurate the forecaster is. An average deviation of 2.2 is low if the forecast
value is high; it is high if the forecast value is low. To allow for this, a variation on
the MAE is the mean absolute percentage error (MAPE).* The formula for this
is:
﴾11.2﴿
∑
1
Mean absolute percentage error MAPE
The percentages for the forecasts are given below:

Number 1 2 3 4 5 6 7 8 9 10
Per cent 2.41 2.47 1.28 2.67 2.74 2.63 5.19 5.00 2.33 1.09
deviation
The total percentage deviation is 27.81 per cent, and the average is 2.78 per cent.
Another measure similar to the mean absolute error is the mean squared error
(MSE), which, rather than taking the absolute value, squares the deviations and then
finds the average. The formula is:
∑ ﴾11.3﴿
Mean squared error MSE
The total of the squared errors for the 10 forecasts is 58, and hence the mean
squared error is 5.8. A variation on the mean squared error is the root mean squared
error (RMSE), which takes the square root of the mean squared error. The formula
is:
* This also called the percentage mean absolute deviation (PMAD).

﴾11.4﴿
∑
Root mean squared error RMSE
The RMSE for the data is 2.41 (√5.8).

The above measures all benchmark the forecast against the actual outcome. It
might be fairer and more appropriate to benchmark the forecast against an appro-
priate reference process rather than simply the difference between the actual and
forecast outcome. For instance, we might take the view that we should measure the
forecast against a naïve model that simply assumes that the past actual outcomes will
continue into the future. This leads to the idea of the forecast skill (FS), which can
be calculated as:
Forecast skill FS 1 ﴾11.5﴿
To illustrate this, we will assume that the reference forecast is the previous actual
outcome. So we will now have only 9 rather than 10 forecasts. The results for both
the forecaster and the naïve model are given below:
Number 1 2 3 4 5 6 7 8 9 10
Forecast 85 79 77 73 75 78 81 84 88 91
Actual 83 81 78 75 73 76 77 80 86 92
Forecast deviation 2 1 2 2 2 4 4 2 1
Reference deviation 4 4 5 0 5 5 7 8 5
The mean squared error for the forecast is 6, and that for the reference model is
27.22; consequently the forecast skill is:
Forecast skill FS 1 0.7796

.
The higher the value, usually expressed as a percentage, the better the forecast is
against the reference forecast. A negative score would indicate that the forecast was
less skilful than the reference forecast. A score of 77.96 per cent indicates that the
forecast is significantly better than the naïve alternative of assuming that the
previous actual will be repeated at the next point in time.
We can now summarise the results of the different tests below.
Test Result
Mean absolute error (MAE) 2.2
Mean absolute percentage error (MAPE) 2.78%
Mean squared error (MSE) 5.8
Root mean squared error (RMSE) 2.41
Forecast skill (FS) 77.96%

What this shows is that we end up with different metrics depending on which
measure we use. From an intuitive point of view, MAPE is probably the easiest to
understand, while MSE and RMSE are hard to interpret in the absence of any
reference point. Forecast skill suggests the forecast is better than the reference
forecast.
While the above are important when reviewing the quality of a forecast, there is
an additional consideration when looking at forecasts, namely whether the forecast
is providing a guide as to the direction of the next actual outcome – not simply how
close the prediction is. In the above measures, we ignored directional accuracy.
However, in many cases it may be more important to have directional accuracy than
to have a good mean absolute percentage error. We turn to this in the next section.
11.5.2 Computing Directional Accuracy

Take the situation where we have an analyst who is predicting the likely direction in
short-term interest rates every week over the next month. Over a four-month
period the analyst makes 100 predictions for the US dollar, British pound and euro
interest rates. In 65 cases the analyst has predicted a fall in interest rates and in 35
cases a rise. In the event, the analyst correctly predicted 41 rate falls and 20 rate
rises. We can work out the percentage of the correct ‘calls’ made by the analyst as
follows:
. .
Directional accuracy DA 100% ﴾11.6﴿
.
The analyst’s directional accuracy (DA) is therefore:
61%
The DA statistic shows that the analyst’s performance, at 61 per cent, is better
than 50 per cent, which could be obtained by simply tossing a coin, but is it signifi-
cantly better? To answer this question, it is necessary to find an appropriate
benchmark to test the analyst’s skill. We can interpret the analyst’s results in terms
of a contingency table as given in Table 11.5.
Table 11.5 Contingency table of analyst’s recommendations

Actual performance
Forecast Rate fall Rate rise Total
Rate fall 41 24 65
Rate rise 15 20 35
56 44 100
As discussed in the previous section, a simple benchmark would postulate an

uninformed analyst making predictions with the same frequency as the analyst but
without any skill. The contingency table for such an analyst is given in Table 11.6.

Table 11.6 Unskilled analyst’s forecasting frequency

Actual performance
Predicted Rate fall Rate rise Total
performance
Rate fall 36.4 28.6 65
Rate rise 19.6 15.4 35
56.0 44.0 100
So an unskilled analyst predicting a rate fall with the same frequency as the ana-
lyst being assessed would have (correctly) predicted 36.4 rate falls and 15.4 rate rises
by chance alone. The question now is to measure the validity of the differences
between our reference directional accuracy and that of the forecast or analyst. This
can be done by measuring the difference between the reference (R) and the analyst
(F) as given in Table 11.7.
Table 11.7 Forecast and reference predictions

Forecast Reference Difference
(F) (R)
Correct Rate fall 41 36.4 4.6
Rate rise 20 15.4 4.6
Incorrect Rate fall 15 19.6 −4.6

Rate rise 24 28.6 −4.6
The question we want to answer is whether the better performance of the analyst
is due to random deviation or is the result of the analyst’s skill. We can carry out a
formal test using statistical methods, in this case using the chi-squared statistic (χ2).
We want to be able to reject at some level of confidence (say with 95 per cent
likelihood) that the result is not due to chance. Numbering the actual predictions
entries in Table 11.7 F1 to F4 and the benchmark entries R1 to R4, the chi-squared
(χ2) value will be:
﴾11.7﴿
If there is a significant difference between the forecast predictions and the refer-
ence predictions, then the chi-squared value (χ2) will be a large number. Specifically,
this value will exceed the critical 5 per cent value (where there is only a 5 per cent
likelihood that the result is due to chance) when the statistic exceeds 3.84. At the
more challenging 1 per cent (where there is only a 1 per cent likelihood that the
result is due to chance), then the value must exceed 6.63. A summary table of chi-
squared statistics for different confidence levels and degrees of freedom is given in
Table 11.8.

Table 11.8 Some common chi-squared values

Degrees of freedom
Probability 1 2 3 4 5
0.5 0.45 1.39 2.37 3.36 4.35
0.4 0.71 1.83 2.95 4.04 5.13
0.3 1.07 2.41 3.66 4.88 6.06
0.2 1.64 3.22 4.64 5.99 7.29
0.1 2.71 4.61 6.25 7.78 9.24
0.05 3.84 5.99 7.81 9.49 11.07
0.01 6.63 9.21 11.34 13.28 15.09
We apply Equation 11.7 to test the forecast directional accuracy against the
benchmark. The computed value is:
. . . . ﴾11.8﴿
. . . .
This gives a chi-squared (χ2) value of 3.78. This means we cannot reject the hy-
pothesis that the analyst has no skill in forecasting the direction of short-term
interest rates.*
11.5.3 Relative Performance and Profitability

Up to this point we have focused on accuracy. However, this may not be appropri-
ate. A forecast can be less than accurate but useful if it leads to the intended
performance and/or profitability. In this case, therefore, we are not so much
concerned with the forecast’s directional accuracy as with the extent to which
following the forecast leads to superior results. If one wanted to analyse the validity
of the decisions arising from the analyst’s opinions, assume that the resultant actual
portfolio return and volatility of return (as measured by the portfolio’s standard
deviation of return) are as given in Table 11.9.
Table 11.9 Forecast and reference portfolio performance and risk

Forecast Reference
Return 5.1895 4.9385
Volatility (σ) 15.268 14.7526
Risk-free rate 4.0385 4.0385
Sharpe ratio 0.075 0.061
* The chi-squared distribution indicates that the probability value of the test statistic is 5.203 per cent,
just out of the significance range. However, we are not using many forecasts, and hence it is a challenge
to meet the statistical proof at the 5 per cent level – we can reject the no-skill hypothesis at the 10 per
cent level.

The forecast performance is compared to an appropriate reference or benchmark

portfolio. The benchmark in this case is an appropriate index.† The forecast
performance is measured in terms of the portfolio’s Sharpe ratio.‡ This is:
﴾11.9﴿
where rP is the return on the portfolio, rf is the risk-free return and σP is the portfolio’s
volatility. This measure is also known as the reward-to-volatility ratio (RVR). It
measures the excess return per unit of risk. The result can be interpreted graphically to
show how the forecast portfolio dominates the reference portfolio, despite the higher
risk in the forecast, as shown in Figure 11.3.
Return
P
rP
P*
rP*
rB B
rf
Risk
sB sP Standard deviation
of return
Figure 11.3 Graphical illustration of analyst’s performance against the

benchmark
Figure 11.3 illustrates that holding the forecast portfolio dominates, in terms of
performance, the reference portfolio. A portfolio (P*) of the same risk as the
reference portfolio (B), made up of a fractional investment in the forecast portfolio
and cash, will have a superior return than the reference portfolio. Hence the forecast
is able to create a higher return than the reference portfolio, even adjusting for risk,
and demonstrates analytic ability. Note that this approach does not simply count the
number of correct predictions but seeks to measure the impact on the result in
terms of profitability or, as in this case, in terms of return or performance. So the
† In general we want a mechanical way of creating an appropriate benchmark portfolio that requires no
analytic skill.
‡ See Sharpe (1966, 1994).

forecast may score poorly under the directional accuracy test but provide a superior
performance under the relative performance criteria.
Learning Summary
This module has looked at some qualitative approaches to forecasting as tools to
help risk managers develop appropriate strategies for the future. Quantitative or
causal models rely on the assumption that the variables being forecast will be
generally similar over the forecasting horizon. In contrast, qualitative models can be
used when there is little or no prior historical data on which to build a quantitative
forecast. The approach may also be considered to be more appropriate when there
is a strong belief that past behaviour is not expected to continue into the future. A
number of methods have been developed to make best use of intuitive judgements
in providing forecasts and in reducing the subjective bias of the forecaster.
In practice, most organisations rely on a combination of quantitative and qualita-
tive forecasts to guide their decisions, the weights attached to the different
approaches by decision makers varying over time.
There are a number of measures that show the quality of forecasts against a ref-
erence or benchmark. Some, such as the mean absolute error, for instance,
determine only the degree of accuracy; others, such as forecasting skill, relate the
performance metric to the reference performance. In many cases, we require not
necessarily a forecast that is accurate against the actual outcome, but one that will
measure how well the forecast predicts the direction of change.

Review Questions
11.1 Which of the following is correct? The principal difference between a quantitative
forecast and a qualitative one is that:
A. with a quantitative forecast we can model both direction and extent, whereas
with a qualitative forecast we can only model direction.
B. with a quantitative forecast we can model extent, whereas with a qualitative
forecast we can model both direction and extent.
C. with a quantitative forecast we can model extent, whereas with a qualitative
forecast we can only model direction.
D. there is no difference between the two methods.
11.2 Which of the following is correct? Qualitative forecasts are useful when:
A. the forecaster has a strong view of the direction of the risk factor.
B. there are not enough data to make a quantitative forecast.
C. there is an expectation that future events will be different from those that have
occurred in the past.
11.3 Which of the following is correct? Quantitative forecasts create problems because they
involve:
A. the user making judgements on the underlying risks.
B. the user creating models that make assumptions about the underlying risks.
C. the user accepting assumptions about the underlying behaviour of the risk
factors over the forecast horizon.
D. the user predicting future asset price behaviour.
11.4 Which of the following is correct? In risk management terms, strategic business planning
seeks to identify:
A. the key competitive threats to the firm.
B. the key competitive opportunities available to the firm.
C. those factors that will prevent the firm realising its objectives.
D. those factors that will allow the firm to realise its objectives.
11.5 Which of the following is correct? The Delphi method has been advocated as a tool for
providing risk management forecasts on the grounds that:
A. it shows the possible spread of future potential outcomes based on consulting a
wide range of experts.
B. it allows a group consensus outcome to be developed that reflects the views of
a wide range of experts.
C. it takes the best guess from a wide range of experts based on their unique
knowledge.
D. it takes the best and worst guess from a wide range of experts based on their
unique knowledge.

11.6 Which of the following is correct? The difference between the Delphi method and the
use of expert judgement in qualitative forecasts is that:
A. there is no difference and the two techniques are interchangeable.
B. the Delphi method allows respondents to change their forecasts based on the
panel’s results, whereas the expert judgement method does not.
C. the Delphi method does not allow respondents to change their forecasts based
on the panel’s results, whereas the expert judgement method does.
D. the Delphi method does not involve experts whereas the expert judgement
approach requires their use.
11.7 Which of the following is correct? The scenario-building approach to qualitative

forecasting assumes that:
A. the most likely outcome will prevail and the scenario is built around this.
B. the most unlikely outcome will prevail and the scenario is built around this.
C. a random set of outcomes will prevail and the scenario is built around this.
D. plausible outcomes will prevail and the scenario is built around this.
11.8 Which of the following is correct? Brainstorming is particularly useful in risk

management for:
A. examining all the sources of risk.
B. determining the procedures the firm should adopt.
C. developing a consensus about how risk should be managed.
D. none of the above.
11.9 Which of the following is correct? The difference between polls and surveys is that:
A. polls address a question using a set of fixed answers, whereas surveys allow for
more general answers.
B. polls address a question allowing more general answers, whereas surveys use a
set of fixed answers.
C. polls address a question that requires a quantitative answer, whereas surveys
address questions requiring qualitative answers.
D. there is no difference: polls and surveys are interchangeable.
11.10 Which of the following is correct? When using qualitative and quantitative forecasts we
should:
A. always combine qualitative and quantitative forecasts.
B. sometimes combine qualitative and quantitative forecasts.
C. never combine qualitative and quantitative forecasts.
D. not use qualitative forecasts when quantitative ones are available.
11.11 Which of the following cannot be used as an input into the forecasting process?
A. Market sentiment.
B. The price or rate history of financial assets.
C. The best guess of experts.
D. Current market prices.

11.12 Which of the following is correct? With qualitative forecasts, the main problem for the
user is:
A. to understand the basis upon which the forecast has been built.
B. to know the variables used in developing the forecast.
C. to recognise any biases that may exist.
11.13 When looking at the problem of model risk – that is, the risk that a model is
misspecified – which of the following is correct?
A. This is a problem for quantitative forecasts but not for qualitative ones.
B. This is a problem for qualitative forecasts but not for quantitative ones.
C. This is a problem for all types of forecasts.
D. This is a minor problem in using forecasting models.
11.14 An analyst has produced 270 interest rate forecasts over the last nine months. Of the
predictions made by the analyst, 54 correctly forecast that interest rates would rise and
69 correctly predicted that interest rates would fall. The actual number of cases of
interest rate rises was 95 and interest rate declines 175. What is the analyst’s percent-
age of correct forecasts?
A. 35 per cent.
B. 46 per cent.
C. 59 per cent.
D. 65 per cent.
11.15 In evaluating an analyst’s forecasts, the performance of the proposed currency portfolio
giving the analyst’s predictions has a return over the assessment period of 6.152 per
cent and a standard deviation of return of 13.148 per cent. The benchmark portfolio
over the same period had a return of 5.914 per cent and a standard deviation of return
of 11.985. The risk-free interest rate over the period was 3.985 per cent. Which of the
following is correct?
A. The analyst took more risk than the benchmark but achieved an above-average
risk-adjusted performance.
B. The analyst took more risk than the benchmark but achieved the same risk-
adjusted performance.
C. The analyst took more risk than the benchmark but achieved a below-average
risk-adjusted performance.
D. It is not possible to compare the analyst’s performance with the benchmark.

The following information is used for Questions 11.16 to 11.18.

An analyst using a qualitative model made the following 12 forecasts:
Number 1 2 3 4 5 6
Forecast 86.5 92.3 96.2 97.6 101.3 98.3
Actual 82.1 89.6 96.3 99.7 97.6 96.5
Number 7 8 9 10 11 12
Forecast 97.2 95.8 93.0 92.1 91.2 89.7
Actual 96.8 96.5 94.2 93.0 90.8 88.6
11.16 Which of the following is the mean absolute error of the forecasts?
A. 1.95
B. 1.63
C. 1.48
D. 0.79
11.17 Which of the following is the root mean squared error of the forecasts?
A. 2.09
B. 0.79
C. 1.63
D. 4.36
11.18 Using as the reference forecast a naïve forecast that the next actual outcome is the
same as the previous one, what is the forecasting skill of the analyst compared to the
naïve forecast? The actual outcome at t0 is 84.30.
A. 0.709
B. 0.46
C. 0.57
D. 0.71
Case Study 11.1: Bloomberg Minerals Economics

Bloomberg Minerals Economics (BME), a specialist consultancy in the copper industry,
has evolved a balance sheet supply and demand approach to forecasting the copper
market. Note that copper is the most actively traded metal in the world. Figure 11.4
shows the recent price behaviour of the copper market where the price ranged from a
low of $2762 per metric tonne ($/mt) to $4641/mt, and averaged about $3641/mt.

5000
4500
4000
3500
Copper price ($/mt)
3000
2500
2000
1500
1000
500
May 26 2011
Sep 13 2011
Nov 07 2011
Feb 06 2011
Apr 01 2011
Jul 20 2011
Oct 19 2010
Apr 22 2012
Aug 25 2010
Jan 02 2012
Oct 03 2012
Nov 17 2009
Jan 12 2010
Jun 29 2010
Dec 13 2010
May 05 2010
Feb 26 2012
Aug 09 2012
Jun 15 2012
Mar 08 2010
Figure 11.4 Historical copper price from 2009 to 2012

A shortened version of BME’s demand and supply model is given in Figure 11.5 for
the years 2013 to 2016. It shows that there has been and will continue to be a copper
shortage over the period as demand outstrips supply, which, in the absence of any
shocks or major supply/demand change over the forecasting period, suggests considera-
ble upward pressure on the copper price short term before additional capacity comes
on stream. The long-term forecast for copper is given below:
2013 2014 2015 2016 2017 2018 2019 2020 2025

$/mt 4025 3819 3377 3173 2964 3049 3136 3225 3275
In order to arrive at this conclusion, BME predicts copper production on the basis of
company production statistics and estimates of global copper consumption, to which is
added the increase/decrease in available copper stocks.
One of the big influences on the copper price, the activities of China’s Strategic
Reserve Bureau (SRB) are also included in the model. The SRB’s buying and selling
activity, in effect, acts as a buffer to prevent prices rising or falling too far. In establishing
its forecast, BME considers that the SRB will become a willing buyer at prices below
$4000/mt and a willing seller at prices above $6000/mt due to the impact of higher
copper prices on Chinese consumers. China accounts for nearly a quarter of global
copper demand.
The major advance claimed for the BME model is that it involves first determining
global production and consumption levels, and not just those for the developed OECD
economies. These are partly determined by general trends in demand modified by
economic forecasts for the growth outlook for major countries and the world. Adjust-
ments are then made for working stock requirements, stockpiling and disposals, to give

the net position. The net result, shown in Figure 11.5, is the expected increase/decrease
of stocks at exchange warehouses. (These are stocks held at recognised warehouses,
reported by the London Metal Exchange (LME) and the New York Commodity Ex-
change (Comex) and available to the market.)
Based on the analysis, BME estimates that the dampening effect of purchases and
sales from the SRB should operate to ensure copper prices remain between $3173/mt
and $4025/mt over the forecast horizon. A concomitant factor in the forecast is a
requirement for exchange warehouse stocks to be kept within the range of 325 000
tons to 375 000 metric tonnes.
2013 2014 2015 2016

Production 17 080 17 593 18 121 18 664
Demand 20 105 20 680 21 255 21 830
Balance 0
– 100
– 200
– 300 – 3025 – 3087 – 3134 – 3166
– 400
Adjustments
Working stock
requirement – 223 – 227 – 174 – 214
Chinese strategic
minerals reserve – 210 – 102 – 110 – 87
Effective balance – 3457 – 3416 – 3418 – 3467
Figure 11.5 The copper market supply/demand balance and metal stocks
(After Bloomberg Minerals Economics)
BME cites the following factors that will affect the forecast to 2013–16:
 Increased global demand over the forecast period will exert an upward influence on
the copper price due to growing demand for copper, which is rising at over half a
million metric tonnes per year, and new copper production supply not matching this
increased demand. Consequently the trend in prices, adjusted for seasonal demand,
is towards the upper end of the range seen in the 2009–12 period. In BME’s view,
during periods of seasonally weak demand, the copper price may go as low as
$3000/mt.
 If supply shortages, technical shortages or other squeezes should develop, the price
may temporarily move above the $4000/mt limit for short periods.
1 Consider the approach used in forecasting the copper price and the validity of the
supply/demand approach used in the analysis.
2 What might be the biases or weaknesses in the approach used by Bloomberg Minerals
Economics?

References
Drucker, P. (1973) Management: Tasks, Responsibilities, Practices. London: Heinemann.
Sharpe, W. (1966) ‘Mutual Fund Performance’, Journal of Business, January, 119–38.
Sharpe, W. (1994) ‘The Sharpe Ratio’, Journal of Portfolio Management, Fall, 21 (1), pp. 49–59.

Appendix 1
Practice Final Examinations and

Solutions
Contents
Examination One ...............................................................................................1/2
Examination Two ........................................................................................... 1/12
Examination Answers .................................................................................... 1/23
This appendix contains two practice final examinations with solutions. Each exam is
in two sections:
Section A: Multiple Choice Questions

30 questions each worth 2 marks.
Total marks available in Section A 30 × 2 = 60
Section B: Case Studies
3 case studies worth 40 marks each.
Total marks available in Section B 3 × 40 = 120
Total marks available = 180
Financial Risk Management Edinburgh Business School A1/1

Appendix 1 / Practice Final Examinations and Solutions
Examination One

Each question is worth 2 marks. No marks are deducted for incorrect answers.
1 A firm’s currency transaction risk or transaction exposure arises:

I. in the normal course of buying goods and services denominated in a foreign
currency.
II. in the normal course of selling goods and services denominated in a foreign curren-
cy.
III. when the prices charged by the firm’s competitors are adjusted to take account of
changes in the foreign exchange rate.
A. I only.
B. II only.
C. III only.
D. I and II.
2 When undertaking financial risk management, the taxation of the firm influences the
outcome for which of the following reasons?
A. The existence of tax shield benefits and progressive tax rates means that
managing exposures to minimise losses reduces the taxes that have to be paid.
B. Losses by the firm can only be offset against future taxes. By limiting losses, the
firm reduces the taxes that have to be paid in any one period.
C. Since firms pay more taxes the greater their profits, managing the firm’s
exposures so as to limit profits also limits the taxes that have to be paid.
D. The existence of tax shield benefits and progressive tax rates means that
managing the timing and size of the firm’s profits reduces the amount of taxes
that have to be paid in any one period.
3 You enter into a forward contract to buy £1 million against the US dollar for three
months delivery at a rate of $1.5240/£. The three-month interest rates in the British
pound and the dollar are 5.5 per cent and 7.25 per cent respectively. Immediately
following the transaction the forward rate moves to $1.5235/£. Which of the following
is the revaluation gain or loss on the contract, to the nearest US dollar?
A. A gain of $7200.
B. A loss of $7200.
C. A gain of $493.
D. A loss of $500.
4 Which of the following is correct? When we ‘insure’ a risk, the result is:
A. to transfer all the risk to another party better able to absorb the risk.
B. to retain the risk within the firm and pass it to the equity holders.
C. to remove the undesirable elements of a risk while retaining the desirable
elements.
A1/2 Edinburgh Business School Financial Risk Management

5 Which of the following is correct? The operational approach to managing financial risk
involves the firm in:
A. matching, as far as possible, the firm’s revenues and expenses by currency and
maturity.
B. arranging its production and distribution and targeting markets so as to
minimise their impact on the firm’s future cash flows.
C. matching, as far as possible, the nature of the firm’s liabilities to its assets so as
to minimise future differences.
6 Which of the following is a firm’s ‘risk threshold’?

A. The change in the amount of an exposure that leads the firm to take corrective
action.
B. An increase in the volatility of a risk that triggers steps in risk reduction.
C. Managers’ prior experience in dealing with particular kinds of risk.
D. The firm’s ability to tolerate different levels of risk.
7 There are two companies in a group where the common currency is B and which have
the following exposures to currency X:
Company Income Expendi- Company Income Expendi-

I ture II ture
(+) (–) (+) (–)
1 month 75 140 1 month 90 20
2 months 85 410 2 months 150 260
3 months 130 50 3 months 375 95
If the two companies offset their mutual exposures, what is the total net exposure for
the group (positive numbers = long currency X; negative numbers = short currency X)?
A. 870.
B. (70).
C. (1880).
D. 85.
8 There are two assets, X and Y, with volatilities of 0.29 and 0.34 per year. The
confidence limit is 1.8 standard deviations and the decision horizon for X is one month
and that for Y is one week.
Which of the following is the value at risk (VaR) for X and Y?
A. It is the same for both X and Y.
B. X has more value at risk than Y.
C. Y has more value at risk than X.
D. It is not possible to distinguish value-at-risk differences from the information
supplied.

9 A forecast model has produced the following outcomes against the actual outcomes in
the last six months:
Number 1 2 3 4 5 6
Forecast 5.25 5.34 5.22 5.32 5.41 5.39
Actual 5.12 5.25 5.38 5.50 5.43 5.50
What is the mean absolute error of the forecasts?

A. 0.04
B. 0.12
C. 0.25
D. 0.29
10 In a five-period binomial tree when the asset price at time zero is 215 and the price
change per period is 5, which of the following will be the highest and lowest prices that
will exist at the end of the five periods?
A. 225–205.
B. 230–200.
C. 235–175.
D. 240–190.
11 Which of the following is correct about the relationship of par yields and zero-coupon
(spot) interest rates, or yields?
A. When the yield curve is upward sloping, the zero-coupon interest rate or yield
will lie above the par yield.
B. When the yield curve is upward sloping, the zero-coupon interest rate or yield
will lie below the par yield.
C. When the yield curve is upward sloping, the zero-coupon interest rate or yield
will be the same as the par yield.
D. When the yield curve is upward sloping, the zero-coupon interest rate or yield
can be above, below or the same as the par yield.
12 A firm is engaged in cross-border transactions between the United States and Europe. If
the company invoices its exports from the US to Europe in US dollars, which exchange
rate risk does it face?
A. Transaction risk.
B. Translation risk.
C. Economic risk.
D. It has no exchange rate risk since it invoices in its domestic currency.
13 A company has a beta of 0.75, the market volatility is 32 per cent and the firm has a
specific risk of 22 per cent. The market risk premium is 5 per cent and the risk-free
interest rate is 3 per cent. What is the firm’s total risk?
A. 6.75 per cent.
B. 14.85 per cent.
C. 24 per cent.
D.33 per cent.

Volatility Correlation
Asset Amount (σ) A B C D
A 300 0.15 1.00
B 300 0.20 0.20 1.00
C 250 0.25 0.30 0.15 1.00
D 150 0.20 1.00 1.00 0.60 1.00
14 In this table, which of the following asset combinations has the greatest value at risk in
the situation where the confidence limit is 2 standard deviations?
A. A + B.
B. A + C.
C. B + C.
D. D + C.
15 The six-month deposit rate is 5 per cent, there is a one-year deposit rate of 4.9 per
cent and an 18-month bond outstanding with a market price of 99 that pays 4 per cent
semi-annually. Which of the following is the 18-month zero-coupon rate?
A. 4.42 per cent.
B. 4.75 per cent.
C. 7.21 per cent.
D. 7.44 per cent.
16 In making use of the value at risk (VaR) approach, if the observed historical distribution
is significantly skewed to the left, which of the following is the implication for any
prediction of future value changes?
A. It has no effect on the estimate of the possible future changes in value.
B. It means that price increases are being overestimated and price declines
underestimated.
C. It means that price increases are being underestimated and price declines
overestimated.
D. It means, depending on their extent, that some price increases will be overes-
timated and some price declines underestimated.
17 Which of the following is correct? When managing risk, one would expect a firm that is
risk averse to:
A. spend more resources on risk management activities than a firm that is not risk
averse.
B. spend fewer resources on risk management activities than a firm that is not risk
averse.
C. spend the same resources on risk management activities as a firm that is not
risk averse.

18 The Delphi method has been advocated as a tool for determining the risk of a situation
on which of the following grounds?
A. It shows the possible spread of potential future outcomes based on consulting a
wide range of experts.
B. It provides for a group consensus forecast outcome to be developed that
accurately reflects the views of a wide range of experts.
C. It provides the average of the best forecasts of a wide range of experts based
on their unique knowledge.
D. It provides the average of the best and worst forecasts of a wide range of
experts based on their unique knowledge.
The following information is used for Questions 19 and 20:
State of the world (ρ) Value under the state of the world
in two years’ time
High growth 0.1 600
Recession 0.3 1800
Depression 0.1 2500
19 The asset whose payoffs are given in the table is currently trading in the market at 1000.
It pays no interest and has a two-year maturity. Which of the following is the asset’s
expected return per year over the two years?
A. 14.02 per cent.
B. 20.42 per cent.
C. 30.38 per cent.
D. 240.83 per cent.
20 Which of the following is the asset’s variance of return?

A. 0.35
B. 0.59
C. 1.00
D. 1.13
21 Default risk consists of:

I. the nature or type of contract between the parties.
II. the probability that a firm or individual will default in the future.
III. the amount involved.
IV. the fraction of the amount that the creditor can recover following the default.
A. I and II.
B. II and III.
C. II, III and IV.

22 Which of the following types of debt instrument, when issued by the same firm and with
the same final maturity, will have the greatest amount of price risk?
A. A loan where the interest rate is reset periodically in line with current market
rates.
B. A fixed-rate bond where the instrument pays a periodic fixed amount of
C. A zero-coupon bond where the instrument pays no interest and is issued at a
discount.
D. A fixed-rate annuity that repays both interest and principal in equal instalments.
23 Which of the following describes the ‘market risk’ of an asset or liability?

A. It is the danger that counterparties will not honour their commitments when
entering transactions.
B. It is the difficulty sellers have in finding buyers in the market for such assets and
liabilities.
C. It is the lack of market makers willing to buy and sell in a given market.
D. It is the likelihood that transaction prices will change unpredictably over time.
24 A risk manager has adopted a 1.95 standard deviation confidence limit on a position
with an annualised volatility of price changes of 20 per cent where the decision horizon
is one month. If the current value of the position is £750 000, which of the following is
the range of values (to the nearest unit) within which the asset is expected to trade
over the decision horizon?
A. £1 042 500–£457 500.
B. £1 000 000–£500 000.
C. £834 438–£665 562.
D. £784 860–£715 140.
25 Which of the following is not a valid reason for firms to manage their financial risks?
A. The existence of differences between managers and shareholders as to the
appropriate strategy for the firm.
B. That, unless they manage their risks, firms have to pay more in taxes.
C. That, unless they manage their risks, firms are more likely to become financially
distressed.
D. That managers have more information about the future prospects of the firm
than outside providers of finance.
26 Some or all of the following factors might lead to the implied volatility of an asset being
higher than the historical volatility:
I. Recent observed volatility has been below the long-run average.
II. Significant news is expected in the immediate future.
III. Recent developments have led to a fundamental reappraisal of the asset.
IV. Extreme price changes have been observed in the market.
A. I, II and IV.
B. I, II and IV.
C. II, III and IV.

27 For which of the following is the ‘marking to market’ of a position designed?

A. To provide the amount of gain or loss to be credited to a margin account at a
futures clearing house.
B. To show the profit or loss on a position since it was set up.
C. To show the effect of changes in the market price on a position.
28 ABC shares and XYZ shares with standard deviations of 0.20 and 0.16 respectively are
uncorrelated securities. Which of the following is the optimum combination of the two
shares that will provide the least risk portfolio?
A. Half the portfolio should be invested in each share.
B. ABC = 0.56 and XYZ = 0.44.
C. ABC = 0.39 and XYZ = 0.61.
D. ABC = 0.28 and XYZ = 0.72.
29 Which of the following is the correct definition of the term ‘risk factor’?
A. A measure of the severity of a particular risk.
B. The sensitivity of one risk to other types of risk.
C. The coefficient used to adjust a risk when combining positions in a portfolio.
D. A particular cause of risk.
30 The benefit–cost assessment approach is frequently applied to determine the desirability

of assuming a risk. In applying the technique, which of the following is the correct
procedure?
A. The benefit of not analysing risk is measured against the cost of risk analysis
before a decision is made as to whether to assume the risk.
B. The benefit of analysing risk is measured against the cost of risk analysis before
a decision is made as to whether to assume the risk.
C. The benefits of assuming the risk are weighed against the potential losses
assume the risk.
D. The benefits of not assuming the risk are weighed against the potential losses
assume the risk.

Case Study 1
Minos Electronics is exposed to the three risks, A, B and C, with the following charac-
teristics, which have been estimated from historical data:
Standard
deviation Correlation
Risk Amount per year A B C
A £2m 0.15 1.0 0.4 0.3
B £5m 0.18 0.4 1.0 0.5
C £6m 0.17 0.3 0.5 1.0
Note: The amount of the exposure to each risk is current.
1 What is the value at risk (VaR) for the individual risks if Minos Electronics uses a 1.95
standard deviation confidence limit and a one-month decision horizon? [3 marks]
2 What is the value at risk for the individual risks if Minos Electronics sets a stress test
value for the individual risks at 4 standard deviations and a three-month horizon?
[3 marks]
3 What is the total risk of Minos Electronics from the three risks, A, B and C, given their
correlation at the value at risk confidence limit of 1.95 standard deviations and a horizon
of one month? [15 marks]
4 If Minos Electronics applies a stress test with a 4 standard deviation movement in the
risks A, B and C and if, in a stressed situation, the correlation rises to +1.0, what will be
the total risk of the position? [3 marks]
5 If Minos Electronics wanted to reduce its value at risk (VaR), which risk, or risks, should
it seek to reduce first? [8 marks]
6 Briefly outline the advantages and drawbacks of the value-at-risk method. [8 marks]

Case Study 2
The following data show the receivables and payables for three subsidiary companies A,
B and C that are owned by the Eurocover group, a UK-based public limited company.
Euro maturity ladder (€ millions)

Subsidiary A Subsidiary B Subsidiary C
€ Receivable Payable Receivable Payable Receivable Payable
1m 10 17 6 11 7 19
2m 5 19 5 15 5 26
3m 2 7 4 0 1 9
Swedish kronor maturity ladder (SKr millions)

SKr Receivable Payable Receivable Payable Receivable Payable
1m 15 6 19 8 14 2
2m 20 11 17 4 9 2
3m 4 1 5 0 0 1
US dollar maturity ladder ($millions)

$ Receivable Payable Receivable Payable Receivable Payable
1m 5 4 12 9 9 11
2m 8 6 15 4 5 8
3m 1 2 10 2 2 5
The exchange rates to the British pound are:

€3.00/£
SKr10.00/£
$1.60/£
1 Using the information provided, briefly explain the nature of the currency risks facing
the Eurocover group. [5 marks]
2 Assuming that at the group level maximum advantage is taken of any currency offsets,
what is the total currency being taken by the group in the reporting currency?
[16 marks]
3 What steps could the group take to mitigate its currency risks by reorganising the way
in which it operated? [12 marks]
4 Briefly describe the role of a reinvoicing centre as a way of controlling currency risk.
[7 marks]

Case Study 3
A risk manager is evaluating the risk in a portfolio of interest-rate-sensitive assets and
liabilities. The asset and liability position is as given in the following table:
Market Years
value 1 2 3 4 5
Asset cash flows
1 109.30 10 10 110
2 83.46 3 3 3 3 103
3 76.88 100
269.63
Liability cash
1 99.06 105
2 90.58 4 4 4 104
3 83.73 2 2 2 102
273.37
Par yield (per cent) 6.00 6.25 6.50 6.75 7.00
1 What are the underlying zero-coupon interest rates or yields in the market? [10 marks]
2 Undertake a 10 basis point sensitivity analysis of the cash flow position to (1) a parallel
shift in interest rates and (2) a rotational shift in interest rates at the five-year maturity.
[20 marks]
3 What is the combined interest rate risk of the above position if the parallel rate shift
and rotational rate shift have a correlation of 0.3? [5 marks]
4 Briefly explain what the risk manager could do to reduce the risk in his position.
[5 marks]

Examination Two

Each question is worth 2 marks. No marks are deducted for incorrect answers.
Zero-coupon bond prices for different maturities

Term (years) Price
1 95.24
2 89.00
3 82.79
4 76.29
1 Which of the following is the one-year forward rate in three years’ time?
A. 8.52 per cent.
B. 6.75 per cent.
C. 5.00 per cent.
D. 7.50 per cent.
2 Assume there is an efficient market in currencies and that there are no transaction
costs. Which of the following should market participants be able to undertake when
using covered interest arbitrage?
A. Sell the foreign currency in the spot market and buy it in the forward market
and deposit the difference.
B. Borrow the domestic currency, invest spot in the foreign currency, sell the
foreign currency in the forward market and be able to pay off the loan.
C. Borrow the foreign currency, invest spot in the domestic currency, buy the
foreign currency in the forward market and make a risk-free profit when the
transaction is closed out.
D. Borrow the domestic currency, invest spot in the foreign currency, sell the
foreign currency in the forward market and make a risk-free profit when the
transaction is closed out.

3 The following foreign exchange positions have been entered into by a UK firm to hedge
its foreign purchases and sales with the US:
Maturity Exchange rate Receivables (US$) Payables (US$)

US$/£
1 month 1.60 260 000 340 000
2 months 1.62 958 000 150 000
3 months 1.63 1 210 000 270 000
If the currency has now changed and the new rates for one, two and three months are
respectively $1.61, $1.63 and $1.64, which of the following is the revaluation of the
position (rounded to the nearest currency unit)?
A. (£6240)
B. (£6264)
C. (£6343)
D. (£6575)
4 We have the following three cash flows and the market interest rate for the same
maturities:
Time Cash flow Market interest

rate (%)
1 100 4
3 150 6
6 250 5
Which of the following is the present value of the cash flows?

A. 408.7
B. 411.4
C. 434.8
D. 1766.0
5 Which of the following defines the difference, if any, between market liquidity risk and
funding liquidity risk?
A. There is no difference between market liquidity risk and funding liquidity risk.
B. Market liquidity risk involves systematic problems with the market’s exchange
mechanisms, whereas funding liquidity risk relates to specific transactions.
C. Market liquidity risk is unique to a particular market, whereas funding liquidity
risk affects all credit markets.
D. Market liquidity risk results from an excess of sellers over buyers, whereas
funding liquidity risk results from an excess of buyers over sellers.

6 Operational hedging of a firm’s risk involves which of the following?

A. Improving financial and operational reporting procedures so as to highlight the
firm’s exposures.
B. Undertaking transactions using financial instruments such as forwards, futures,
swaps and options.
C. Undertaking transactions that modify the firm’s balance sheet and its produc-
tion, marketing and selling processes.
D. Setting up a risk management function to monitor the risks in a firm.
7 If the interest rate in Mondovia, whose currency is the Mondovian franc (MFr), is a
constant 4 per cent and that of the United States is 7 per cent and the spot exchange
rate between the two is MFr8/$, which of the following will be the nine-month forward
exchange rate between the two currencies?
A. MFr7.7757/$.
B. MFr7.8246/$.
C. MFr7.8311/$.
D. MFr8.1793/$.
8 If, in Question 7 above, immediately after agreeing the contract, the Mondovian Central
Bank raises the interest rate to a constant 5 per cent, which of the following will be the
gain or loss for a forward exchange contract with a nine months’ maturity, where the
buyer had agreed to buy Mondovian francs and sell US dollars?
A. A gain of MFr0.0585/$.
B. A loss of MFr0.0565/$.
C. A gain of MFr0.0653/$.
D. A loss of MFr0.0758/$.
9 The ‘value-at-risk’ (VaR) method estimates risk by which of the following methods?
A. Predicting the future direction of price changes over a predetermined decision-
making horizon.
B. Analysing and extrapolating from past price behaviour over a predetermined
decision-making horizon.
C. Forecasting possible price changes based on the likelihood of their taking place
over a predetermined decision-making horizon.
D. Forecasting the maximum size of gains and losses on an exposure over a
predetermined decision-making horizon.
10 There is a currency exposure of €2.5 million against the US dollar. The €/$ has a
volatility of 0.28, there is a 1.65 standard deviation confidence limit established and the
decision horizon is one week. Which of the following is the maximum amount of the
price change that is expected at the confidence limit over the decision horizon?
A. €160 170.
B. €1 443 750.
C. €97 073.
D. €333 420.

11 Under the interest rate parity theory of foreign exchange, which of the following will be
correct?
A. The forward exchange rate will be the spot rate × (1 + the difference between
the historical inflation rates of the two currencies).
B. The forward exchange rate will be the spot rate × (1 + the product of the
interest rate differentials between the two currencies).
C. The forward exchange rate will be the spot rate × (1 + the product of the
combined interest rates of the two currencies).
D. The forward exchange rate will be the spot exchange rate × (the product of
the differential of 1 + the interest rates of the two currencies).
12 If the volatility of an asset changes, which of the following will happen?

A. The asset price will change but not the price of an option on the asset.
B. The asset price will not change, but the price of an option on the asset will
change.
C. Neither the asset price nor the price of an option on the asset will change.
D. The asset price may change, but the price of an option on the asset will change.
13 Which of the following describes the process of operational risk management by a firm?
A. Designing production and distribution facilities and targeting markets with a
view to anticipating changes in factor costs and selling prices.
B. Matching, as far as possible, the nature of the firm’s liabilities with those of its
assets, so as to minimise divergences.
C. Matching, as far as possible, currency, interest rate and maturity to the firm’s
revenues and expenditures.
14 The following table shows the exposures for two currencies, A and B, that have arisen
during the course of the normal operations of a firm whose reporting currency is
currency X:
Currency Receivables Payables Currency Receivables Payables

A B
(+) (−) (+) (−)
1 month 620 120 1 month 85 150
2 months 815 95 2 months 100 225
3 months 485 110 3 months 145 320
The exchange rates between currency X, the company’s base or reporting currency,
and currencies A and B are A/X = 10 and B/X = 4.
Which of the following is the total amount of currency exposure being assumed by the
firm from its operations expressed in the company’s base currency?
A. X1230.00
B. X68.25
C. X480.75
D. X250.75

15 There is a portfolio with two assets, A and B, which have a correlation of 0.4 and
standard deviations of 0.20 and 0.25 respectively. Asset C has a standard deviation of
0.25 and a correlation with A of 0.3. Leaving all other factors unchanged, if we substitute
asset C for asset B which of the following is correct?
A. Substituting C for B will increase the risk of the new portfolio of A and C as
compared to the old portfolio of A and B.
B. Substituting C for B will decrease the risk of the new portfolio of A and C as
compared to the old portfolio of A and B.
C. It will not change the risk of the portfolio to substitute C for B.
D. There is insufficient information to answer the question.
16 Which of the following is correct? In setting up a reinvoice centre, a company is aiming

to:
A. manage its overall cash position so as to minimise its borrowing.
B. manage its overall foreign exchange position so as to minimise its exposure to
currency effects.
C. manage the order flow between the company’s different divisions or business
units.
D. manage all of A, B and C.
17 In a particular position with respect to interest rates, the level shift risk and the
rotational shift risk are 3.4 and 3.8 respectively. Which of the following will be the total
interest rate risk of the position if the level shift risk and the rotational shift risk are
independent risks?
A. 0.2
B. 3.6
C. 5.1
D. 7.2
18 A fully amortising loan with a principal of £1 million and a five-year maturity has a cash
payment per year of £237 396, paid at the end of the first and subsequent years. If the
market interest rate on the loan is 6 per cent, what will be the loan’s 1 basis point price
sensitivity to changes in interest rates?
A. £100.
B. £272.
C. £471.
D. It is not possible to calculate the loan’s interest rate sensitivity.
19 Which of the following is a valid reason for a firm to manage its translation exposure?
A. Because instruments to hedge currency risk are available in financial markets.
B. Because translation effects lead to wide swings in reported company profits
that are unrelated to the fundamental performance of the firm.
C. Because of the growing globalisation of trade and the increased importance and
size of cross-border transactions being undertaken by firms.
D. There are no valid reasons for a firm to manage its translation risk.

Interest rates US dollar (%) € (%)

3 months 3.4844 5.5938
6 months 3.5469 5.625
12 months 3.875 5.7188
The spot exchange rate is $1.8273/€.
20 Which of the following will be the value of a forward foreign exchange contract
between the two currencies in three months’ time?
A. €1.8181/$.
B. €1.7970/$.
C. €1.8193/$.
D. €1.8365/$.
21 How much will a forward foreign exchange contract with a 12 months’ maturity change
in value when it is agreed to sell euros and buy the US dollar forward if, after agreeing
the contract, the forward exchange rate immediately becomes €1.7958?
A. A loss of €0.0211 per dollar.
B. A loss of €0.0004 per dollar.
C. A loss of €0.0184 per dollar.
D. A gain of €0.0016 per dollar.
22 The convenience yield on a commodity is due to which of the following effects?

A. A commodity convenience yield arises because commodities provide a return
or yield that is linked to short-term interest rates.
B. A commodity convenience yield arises because of the demand for holding
commodity forward and futures contracts to hedge against shortages of the
physical product in the future.
C. A commodity convenience yield arises because of the demand by users for
holding the physical commodity in order to have an assured supply.
D. A commodity convenience yield arises because the demand for selling com-
modity forward and futures contracts to hedge against price fluctuations
requires commodity buyers to be compensated for holding supplies of the
physical product.
23 Which of the following is the correct definition of the specific risk of a share?
A. It is that element of risk that arises from new information about conditions in
the economy.
B. It is that element of risk that arises from changes in value of a market-wide
share index.
C. It is that element of risk that arises from important new information about the
firm.

24 A two-year fixed-rate loan pays interest at 4 per cent semi-annually. Assuming each
period is an exact half-year, which of the following would be the equivalent interest rate
if the interest were paid annually when the term structure interest rate is flat at 7 per
cent?
A. 4.04 per cent.
B. 7.12 per cent.
C. 4.07 per cent.
D. 6.88 per cent.
25 A bank has agreed to advance money for a given period to a firm in one of the following
ways:
I. The bank will reset the interest rate every six months in line with the prevailing
market interest rate for six-month loans.
II. The bank will reset the interest rate every 12 months in line with the prevailing
market interest rate for 12-month loans.
III. The bank will set the interest rate at the start of the loan for the entire loan period.
Which of the loan alternatives has the greatest price risk from the bank’s perspective?
A. I only.
B. II only.
C. III only.
D. All the alternatives, I, II and III, have the same price risk.
26 Which of the following is the correct definition of the term ‘interest rate sensitive’?
A. It is the sensitivity of the value of an asset or liability to changes in interest
rates.
B. It describes the fact that firms earn significantly higher returns on their cash
holdings when interest rates rise.
C. It describes certain financial instruments, such as short-term loans and over-
drafts, that have their interest rate reset periodically in line with the interest
rate prevailing in the market.
D. It is the sensitivity of the forward value of a pair of currencies to changes in the
interest rate differential between the two currencies.
27 In the case where a financial intermediary endorses a transaction, which of the following
describes the process?
A. The intermediary undertakes to locate the other party to the transaction.
B. The intermediary agrees to buy and sell for its own account.
C. The intermediary adds its name to the transaction.
D. The intermediary stands ready to buy or sell the instrument, as required.
28 The term ‘economic exposure’ is used to describe a firm’s sensitivity to financial risks.
Which of the following is not a source of economic exposure?
A. Changes in the published balance sheet and income statement of a company.
B. Management decisions about the nature and type of business activities pursued
by the firm.
C. Management decisions about the nature and type of business activities pursued
by competing firms.
D. Changes in exchange rates, interest rates and commodity prices.

29 In a four-period or -step asset price diffusion tree where the asset has a price of 520 at
time zero and the price change per period is 20, which of the following will be the
lowest and highest prices that can exist at the end of the four periods?
A. 480–560.
B. 420–580.
C. 460–580.
D. 440–600.
30 By applying risk-modification techniques, we can adjust the firm’s exposure to risks.

Which of the following are risk-modification techniques?
A. The firm can sell the risk to another party.
B. The firm can enter into transactions that have the opposite risk to the current
risk.
C. The firm can pursue policies which seek to take risks into account.
Case Study 1
Forecourt Finance is a motor finance company in the UK that specialises in providing
loans to buyers of used cars. Used cars sold by second-hand dealers can vary in age
from just a few months to, more typically, two to three years. There is a reason for the
large number of three-year-old cars coming onto the market. Many firms provide their
managers and sales representatives with a company car. These are replaced on a three-
year cycle that is designed to minimise the combined depreciation and maintenance
costs. There is thus a steady supply of second-hand company cars that are sold through
used-car dealer networks to private individuals. The bigger, more reputable dealers tend
to handle cars up to three or four years old, since these are still in reasonable condition
and can be sold at a decent profit. There is also a large market in older used cars that
are sold directly between buyers and sellers who use the media of newspaper and
magazine advertisements and the Internet to establish contact.
Forecourt Finance operates as follows. In order to sell its loans, Forecourt provides
major used-car dealers with a personal computer linked directly via a modem to the
finance house’s processing office or an online calculator and deal processor on a
webpage. Using the computer link, dealers can directly input details of prospective
buyers who need to borrow to finance their purchase. The company can then immedi-
ately indicate the terms and conditions under which it will advance a loan.
Over the computer link, the dealer will provide the individual’s personal details such
as address, postcode, job, credit card number, bank account and so forth and the details
of the amount required, the type of car being purchased and the maturity of the loan.
Using this information, the company will indicate whether and how much it will be
prepared to lend against the value of the vehicle and how much of an end-payment it
will accept. This end-payment will be based on the finance company’s estimate of the
depreciated market value of the vehicle less a margin at the end of the loan period. The
balance of principal, plus interest, then becomes the monthly charge.
If the transaction is accepted, Forecourt requires the borrower to set up a direct
debit against their bank account for the monthly contractual payment. A direct debit

allows Forecourt to transfer the stated amount from the borrower’s account into the
company’s account every month. In the event that Forecourt is unable to transfer funds,
staff will immediately telephone the customer and seek to find out if there is a problem.
In order to avoid bad debts, the finance house will offer to take back the vehicle and sell
it and pay the customer any balance after the loan is cleared. By setting the maximum
amount of the loan at a margin below the vehicle’s market price throughout the loan
period, Forecourt aims to avoid significant losses from repossessions.
Typical loan terms are as follows:
Borrower: John Doe

Age of car when purchased: 3 years
Purchase value: £10 000
Estimated market value after five years: £5 000
Amount of the advance: £8 000
Term of the loan: 5 years
Payments: Monthly, in arrears by direct debit

Amount of monthly payment: £178 – if the loan is fully amortising
£129 – if the loan has a final balance
Maximum end-payment at the
end of the five-year term: £4 000
Special terms and conditions: The borrower may repay at any time
with one month’s penalty interest and
a fee of 1 per cent of the final loan payment
Note that Forecourt charges interest of 1 per cent per month on the loan (12 per
cent per year flat). The company can either finance itself in the short term with three-
month rolling loans at 7 per cent or borrow term, out to five years at a fixed rate of 7.5
per cent.
1 Identify the nature of the risks being taken by Forecourt Finance in the ordinary course
of its business. [15 marks]
2 What is interest rate risk? [10 marks]
3 How much interest rate risk is Forecourt Finance assuming in its business? Use the
information provided in the case to undertake a simple interest rate sensitivity analysis
of Forecourt Finance’s lending business. [15 marks]
Case Study 2
1 Discuss the implications of the following quotation: ‘Active corporate risk management,
since it reduces risk, is good for shareholders. Active corporate risk management, since
it reduces risk, is bad for shareholders. Active corporate risk management is neither
good nor bad: it is simply irrelevant to shareholders.’

Case Study 3
Alliance Foods is a UK-based processed-foods importer and buys from a number of
foreign sources. The UK food industry, both processing and retailing, is highly competi-
tive, with a small number of large and sophisticated supermarkets dominating retailing.
The UK is part of the European Union, which is committed to a single market between
all member states, and a party to the Common Agricultural Policy. As a result Alliance
Foods has to compete against foreign producers in supplying retailers. To do that, it has
to remain competitive.
Alliance Foods’ North American and Far East sources require the company to pay in
US dollars, whereas its European suppliers accept payment in euros (€), the joint
currency used by many European Union member states. The firm is invoiced and pays all
its bills within one month. The accounting system shows the following outstanding
balances and the exchange rate for the euro and the US dollar against British pounds.
Currency Amount in foreign Exchange rate of British pounds

currency foreign currency equivalent amount
against British of the foreign
pounds currency
Euro 30 000 000 €1.20 25 000 000
US$ 72 000 000 $1.60 45 000 000
The euro and the US dollar are quoted currencies and British pounds is the base
currency; that is: €1.20 = £1 and $1.60 = £1.
Alliance Foods has also computed the annualised volatility of the two foreign curren-
cies. For the euro against British pounds this is 0.15, and for the US dollar against British
pounds it is 0.20. The correlation between the two currency pairs is 0.60.
1 What is the value at risk (VaR) of the company’s currency exposure expressed in the
company’s base currency when the firm uses a 1.95 standard deviation confidence limit
on its currency exposure? [8 marks]
2 Some of the firm’s Far East suppliers have indicated that they are willing to accept
payment in Japanese yen instead of US dollars. The new exposures, allowing for the yen
to replace the US dollar, are given in the following table. From a risk management
perspective, is the firm better off in switching to yen? Calculate the new portfolio risk at
the 1.95 standard deviation confidence limit.
Currency Amount in foreign Exchange rate of British pounds

currency foreign currency equivalent amount
against British of the foreign
pounds currency
€ 30 000 000 €1.20 25 000 000
$ 48 000 000 $1.60 30 000 000
¥ 3 300 000 000 ¥220.0 15 000 000
All the currencies, euro, US dollar and Japanese yen, are the quoted currencies and
British pounds is the base currency; that is: €1.20 = £1, $1.60 = £1 and ¥220.0 = £1.

The volatility and correlation matrix between the three currencies is computed as:
Volatility € per £ $ per £ ¥ per £

(annual)
€ per £ 0.15 1.0 0.6 0.4
$ per £ 0.20 0.6 1.0 0.7
¥ per £ 0.26 0.4 0.7 1.0
[12 marks]
3 Why is it necessary also to undertake a stress test when using the value-at-risk method
for determining the amount of risk being assumed? [8 marks]
4 Use Alliance Foods as an example briefly to describe, when considering currency risk,
what is meant by a firm’s economic exposure or risk. [12 marks]

Examination Answers
Examination One

1 The correct answer is D. A firm’s currency transaction risk or transaction exposure
arises from actual cash payments and receipts that have to be made in a foreign
currency in the normal course of its business.
2 The correct answer is D. There are two tax-based arguments for applying financial
risk management when firms pay taxes: (1) to ensure the firm can take advantage of
the available tax shields on its income and (2) to avoid having to pay higher rates of
tax. This may mean fixing profits in any one period to be sure of being able to take
advantage of existing allowances, thus avoiding having to pay taxes in higher bands,
as well as being able to defer the crystallisation of a tax liability.
3 The correct answer is D. The original agreement is struck at $1.5240/£. Therefore,
you require $1.524 million to obtain the £1 million in three months’ time. The new
rate is now $1.5235/£, which would require only $1 523 500 to buy the same
amount of British pounds. The loss is therefore the difference of $500.
4 The correct answer is C. To insure a risk involves removing the undesirable
elements (that is, the ‘downside’).
5 The correct answer is D. The operational approach to managing financial risk
involves the firm, in so far as this is possible, in matching its revenues and expenses
by currency and maturity, in arranging its production and distribution and targeting
markets so as to minimise their impact on the firm’s future cash flows and in
matching the nature of the firm’s liabilities to its assets so as to minimise future
differences.
6 The correct answer is D. A firm’s risk threshold is its ability to tolerate different
levels of risk.
7 The correct answer is B. The total net exposure for the group will be the sum of the
two exposures that are netted. The calculation is given in the following table:
Income Expend. Income Expend. The Groups

Co. I (+) (−) Co. II (+) (−) Income Expend. Net
1 mth 75 140 1 mth 90 20 165 160 5
2 mths 85 410 2 mths 150 260 235 670 (435)
3 mths 130 50 3 mths 375 95 505 145 360
Total 290 600 Total 615 375 905 975 (70)
8 The correct answer is B. If we have the two assets with different decision horizons,
to compare the amount of risk in each we need to establish the amount of variability
in the position before corrective action is deemed to be taken. For X this is one
month, and hence the one month standard deviation = 0.29/√12 = 0.0837. For Y it

is one week = 0.34/√52 = 0.0472. So X has more value at risk to the decision
horizon than Y.
9 The correct answer is B. We need to calculate the absolute differences between the
actual outcome and forecast, as below, sum these and take the average:
Number 1 2 3 4 5 6
|A – F| 0.13 0.09 0.16 0.18 0.02 0.11
The sum is 0.69 and the average is 0.12 (0.69/6).
10 The correct answer is D. The high and low of a range of prices for a binomial tree
with a price change of 5 per period when the starting value is 215 will be 215 ± (5 ×
5) = 240–190.
11 The correct answer is A. When the yield curve is upward sloping – that is, the term
structure of interest rates shows longer-dated par yields are higher than short-dated
ones – then the zero-coupon interest rates or yields will lie above the par yields.
12 The correct answer is C. Transaction risk (A) arises when the firm has payables or
receivables in a foreign currency. Translation risk (B) arises from converting
financial statements from one currency into another for consolidation purposes.
Neither A nor B applies in the question. The company faces economic risk (C). That
is, it has exposure to changes in the exchange rate indirectly, since, although it is
invoicing in US dollars, the operating purchasing currency for the buyer of its
exports is in euros. A rise in the dollar against the euro will reduce the exporter’s
competitive position. Note that, given the existence of economic exposure, D
cannot be correct. Certainly the firm has no transaction risk, but the competitive-
ness of its exports will fluctuate as the exchange rate changes.
13 The correct answer is D. The total risk of the firm is found by:
√0.75 0.32 0.22 0.33

14 The correct answer is C. To determine the answer, we need to compute the
following equation for the four pairs of assets:
Total risk Risk Risk 2 Risk Risk
where RiskA = 300 × 0.15 × 2. The results for the four assets and the portfolio are
given in the following table.
Asset Riskx Riskx 2 Portfolio risk (Total risk)2 Total risk

A 90 8 100 A+B 26 820 163.77
B 120 14 400 A+C 30 475 174.57
C 125 15 625 B+C 34 525 185.81
D 60 3 600 D+C 28 225 168.00

15 The correct answer is B. The zero-coupon rate for 18 months is uncovered from the
bond by finding the price relative between the current market price and the value of
the final cash flow. We remove the value of the two intervening coupon payments
of 2 each by discounting them by the half- and one-year rates:
99 . .
. . .
Solving for Z1.5 and expressing the result as an annual rate gives 4.75 per cent.
16 The correct answer is B. With a skewed distribution (that is, a distribution with
more observations to one or other side of the mean than predicted by the symmet-
rical bell shape of the normal distribution), the probability of getting increases
(decreases) will be more (less) than that predicted by the areas under the normal
curve. For a negative skew (more observations to the left than to the right of the
mean), if we assume that the distribution is normal, this will overestimate price
increases and underestimate price decreases.
17 The correct answer is A. To be risk averse means a lower toleration for risk. A firm
that has this characteristic can be expected to devote more resources to managing
risk than a firm that is not risk averse (for instance, is risk neutral).
18 The correct answer is B. The Delphi method, developed by the Rand Corporation
of the United States, is designed to provide a consensus forecast derived from
questioning a group of experts in the problem. The idea is that the use of multiple
forecasts, which are then fed back to the experts to be refined, leads to a final
forecast scenario or result incorporating all the diverse knowledge of the individual
forecasters. Thus the final consensus is better than any individual forecast.
19 The correct answer is A. To find the asset’s expected return for the two years, we
must first find the returns on the investment for each of the four states as follows
and take their probabilistically weighted average:
State of the (ρ) Value under the Price Return Return × ρ

world state of the world relative
in one year’s time (FV/PV)
High growth 0.1 600 0.6 −0.4 −0.04
Moderate 0.5 900 0.9 −0.1 −0.05
recession
Recession 0.3 1800 1.8 0.8 0.24
Depression 0.1 2500 2.5 1.5 0.15
0.30
The price relative is determined by:

Price relative
The return is therefore the price relative less 1. This is then multiplied by the
probability. This gives 0.30. This is the two-year return. The annualised
rate = (1 + 0.30)0.5 = 14.02 per cent.

Or alternatively we can find the expected (or the weighted average) value of the
asset as (0.1 × 600 + 0.5 × 900 + 0.3 × 1800 + 0.1 × 2500) = 1300.
The two-year return is (1300/1000 1) = 0.30 and the annualised rate is
(1 + 0.30)0.5 = 14.02 per cent.
20 The correct answer is A. To compute the asset’s variance of return, we need to
calculate the sum of the squared deviations from the expected return weighted by
their probability, as given in the following table:
State of the (ρ) Value Return Return ri − μ ri − μ 2 ri − μ 2 ×

world ×ρ ρ
High growth 0.1 600 −0.4 −0.04 −0.7 0.49 0.049
Moderate 0.5 900 −0.1 −0.05 −0.4 0.16 0.080
growth
Recession 0.3 1800 0.8 0.24 0.5 0.25 0.075
Depression 0.1 2500 1.5 0.15 1.2 1.44 0.144
1.0 μ= 0.30 0.348
21 The correct answer is D. The risk of loss in a given situation will be a function of
the terms of the contract between the parties, the probability that the individual or
firm will default, the amount involved and the fraction that can be recovered after
the default.
22 The correct answer is C. The instrument with the most price risk will be a zero-
coupon bond since all the value will be received at maturity in a single cash pay-
ment. Because the value of such a security depends on the discount rate used to
value this future single cash flow, it will have the most price risk.
23 The correct answer is D. Market risk, also variously known as price risk or rate risk,
is that element of the total risk of an asset or liability that is due to unpredictable
changes in market prices.
24 The correct answer is C. Applying the value-at-risk model, the price change that can
be expected over the decision horizon (one month) will be:
.
1.95 £750 000 £84 438
√
The price range is therefore £834 438–£665 562.

25 The correct answer is A. There are a number of arguments for firms to manage their
risks. Firms benefit from managing risk when they must pay taxes, since they may
be able to reduce or defer these. They are also less likely to become financially
distressed (or to become bankrupt) if they can reduce the future variability of their
cash flows. Managers also have better information about the future prospects of the
firm than outside providers of finance. By managing financial risks they can reassure
outside financial providers of the stability of the business and the safety of the debt.
However, differences about future strategy between a firm’s managers and share-
holders cannot be resolved by the firm’s implementing risk management policies. So
A is not a good reason for managing risks.

26 The correct answer is D. There is evidence that volatility has a ‘long-run’ average.
Periods of low volatility tend to be followed by periods of higher volatility. Signifi-
cant new information in the future will lead to a change in the market’s estimate of
the asset’s worth. Extreme price changes are indicative of a market’s uncertainty as
to the asset’s intrinsic worth, as are recent developments, which lead to a fundamen-
tal reappraisal of the asset’s worth.
27 The correct answer is D. The marking to market or revaluation of a position is
designed to show the profit or loss on a position since it was established. It also
shows the effect of changes in the market price on a position and, at a futures
exchange clearing house, the amount of margin to be credited or debited to a
margin account.
28 The correct answer is C. The solution is found by the following equation:
Thus we have 0.162/(0.202 + 0.162) = 0.39. So XYZ has 0.61.

29 The correct answer is D. A risk factor is a particular cause or source of risk in a
given situation.
30 The correct answer is C. The correct benefit–cost or cost–benefit approach to risk
involves measuring the benefits to be gained from assuming a risk against the
potential losses according to predetermined criteria before making the decision as to
whether to assume the risk, based on the results of the analysis.
Case Study 1
1 The value at risk for each of the risks is found by:
Amount Confidence limit
√
For risk A, it is:
.
A £2m 1.95 168 875
√
Applying the same calculations, the values at risk of risks B and C are £506 625 and
£574 175 respectively.
2 To find the stress test value, we repeat the exercise in Question 1, substituting the
extreme values.
For risk A, it is:
.
A £2m 4 600 000
√
For risks B and C, the stress test values are: £1 800 000 and £2 040 000.
3 The value of the portfolio will be:

2 2 2
(VaRA) + (VaRB) + (VaRC) +
2rAB(VaRA)(VaRB) +
VaRPortfolio =
2rAC(VaRA)(VaRC) +
2rBC(VaRB)(VaRC)
The VaR for the individual elements will be:

.
A £2m 1.95 168 874.95
√
.
B £5m 1.95 506 624.86
√
.
C £6m 1.95 574 174.84
√
The portfolio VaR will therefore be:
2 2 2
(168 874.95) + (506 624.86) + (574 174.84) +
2(0.4)(168 874.95)(506 624.86) +
VaRPortfolio =
2(0.3)(168 874.95)(574 174.84) +
2(0.5)(506 624.86)(574 174.84)
which gives a value of 1 016 060.41.

Examiners’ comments on Question 3
Question 3 is similar to Case Study 9.2 at the end of Module 9. The only major
differences are that the correlation coefficient is given rather than the covari-
ance and that the portfolio risk is being computed at the 1.95 standard deviation
point for the value at risk. Apart from that, the major difficulty is computational:
the steps for deriving the value at risk of the portfolio involve a large number of
calculations and it is quite easy to get them wrong. Neatly setting everything out
along the lines of the model answer will help the candidate avoid errors and
allow it to be checked – if there is time in the examination.
4 When the correlation coefficient is +1.0, the stress test value-at-risk numbers for A,
B and C simply become additive. In the answer to Question 2, the 4 standard
deviation movement in the risks has already been computed. The total stress test
value at risk becomes:
Risk Stressed value at risk

A £600 000
B £1 800 000
C £2 040 000
Total risk £4 440 000

5 The earlier analysis in the answers to Questions 1 to 3 shows how the three risks
contribute to the overall risks facing Minos. In order to reduce its risks, it will have
to reduce its exposure. Since the amount of risk is linked to both the amount of the
firm’s exposure and the spread of possible outcomes, reducing just the exposure
amount may not be the most appropriate action. It may be necessary also to look at
the risk’s volatility. The amount and the volatility of the three risks are given below:
Risk Exposure Standard deviation per year

A £2m 0.15
B £5m 0.18
C £6m 0.17
Risk A does not come into contention since it has both the lowest amount and the
lowest volatility. We can therefore focus on risks B and C, which have higher levels
of exposure and larger standard deviations. If we recalculate the value at risk for
risks B and C using the same amount (say £1 million) we have:
Risk B: £51 962

Risk C: £49 075
There is only £2887 in value at risk per million of exposure between the two risks.
Therefore, based on the above, it would be (slightly) preferable to reduce risk B
before C if the risks are being tackled individually. If the risks were being reduced at
the portfolio level, it would be necessary to recalculate the portfolio risk for the
changed exposures to see if this choice also applied when integrated at the portfolio
level.
6 The major advantage of the value-at-risk approach is that it provides a quantified
assessment of the potential loss within certain probability criteria. The value-at-risk
measure is forward looking since it is based on an estimate of the potential change
in value over the decision horizon based on the asset’s or position’s volatility at a
given level of confidence. It will not, unless joined with a stress test, indicate the
maximum loss that can be sustained.
The main disadvantages are the possible problems with the quality of the statistical
estimates. The model depends very much on having the ‘correct’ volatility, correla-
tion and amount of the position. This last, if contractual, is easiest for a firm to
correctly ascertain. However, both the volatility measure and the correlation
between assets are harder to estimate and may be subject to error.
The other assumption is that statistical measures are derived from past data (alt-
hough they can be modified by forecasts) and that the future will be like the past. If
it is not, the estimate will be wrong and the amount of risk being assumed will also
be wrong.
It matters. A portfolio made up equally of two assets (w = 0.50), with a volatility of
0.20 for both assets and a correlation of 0.5 between the two assets, will have a
standard deviation of 0.1732. The same portfolio when the standard deviation of the

two assets is 0.21 and the correlation is 0.21 will have a standard deviation of
0.1633. This means, for a £1 million position at 2 standard deviations, the value at
risk of the two portfolios will be £346 410 and £326 683 respectively. The result is
that there is about 6 per cent more risk in the portfolio with the higher correlation,
despite the lower volatilities.
The calculation for the initial portfolio is:
0.5 0.20 0.5 0.20 2 0.5 0.5 0.5 0.20 0.20
This gives 0.1732.
The higher volatility/lower correlation portfolio is:
0.5 0.21 0.5 0.21 2 0.21 0.5 0.5 0.21 0.21
This gives 0.1633.
The VaR numbers are:
£1 000 000 × 2 × 0.1732 = £346 410
£1 000 000 × 2 × 0.1633 = £326 683
Interest rate calculations
Note: It is conventional to quote interest rates on an annualised basis regardless
of the actual maturity of the transaction.
A 6 per cent annualised rate translates into a two-month rate in one of two
ways.
If the annualised rate is the annual percentage rate (APR) or flat rate, we
simply divide it by six (i.e. 0.06/6 = 0.01).
The more normal approach given in financial texts refers to the effective rate.
In this case, it is necessary to find the periodic actual interest rate by:
periodic rate % 1 effective annual rate 1 100
where T is the period, and the effective rate is quoted as a decimal (i.e. 6 per
cent = 0.06). The periodic rate for 2 months in the earlier example is:
⅙
1.06 1 100 0.9758794%
Note that in this case the interest rate computed in this manner is lower than
that computed by the flat rate. The reason is simple. The flat rate takes the
periodic rate (e.g. monthly) and multiplies it by the number of times in the year
it is paid. So if it is six times a year (bi-monthly) then the annualised flat rate is
0.01 × 6 = 0.06.
On the other hand, the annualised effective rate in the above is (1.01)6 – 1 =
0.06152. This is higher than the flat rate.
There is a lot of confusion about how interest rates are computed. Mortgage
lenders would want to quote the annualised flat rate whenever possible. The
real interest rate, of course, being paid on an annualised basis is the effective
rate (known as the annual percentage rate (APR) in the UK).

For a course on financial risk management, you will need to solve computations
such as:
.
1
That is, for periods greater than a year (here 1.5 years).
.
1
That is, for periods less than a year (here 0.5 years).
To do this efficiently requires a calculator with an [xy] function. We input one
plus the interest rate – as a decimal (i.e. x) – and then press the function and
then input the period involved (i.e. y).
This question makes use of material from Module 8 and Module 9. The only
major difficulty is in computing the results using the portfolio model. It also
requires the candidate to integrate material from the two modules. The last part
of the question requires an understanding of the limitations of the portfolio and
value-at-risk approach.
Case Study 2
1 A firm will be concerned about its exposure to currencies because of the likelihood
that the contracted value of foreign receivables and payables will change over time
before they can be settled in the firm’s base or home currency. This is transaction
exposure. To take an example: subsidiary A has €7 million payable in three months’
time. This is equivalent to £2.33 million at the exchange rate. If the British pound
rate were to fall against the euro over the three months, from €3.00/£ to €2.90/£,
the amount in home currency terms the company would need to find would rise to
£2.41 million. That is, the company would have to find an additional £0.08 million
to meet the liability. Of course, if the exchange rate has risen to €3.10/£, the
company is £0.07 million better off. However, the risk of loss outweighs the
possibility of gain. This is true since the payable has been budgeted for in the firm’s
domestic currency and also since unanticipated cash outflows that result from
exchange rate swings make planning difficult. It is also likely that currency swings
between the British pound and other currencies will be of a systematic nature. That
is, all the group’s exposures will behave in a similar fashion. The company will thus
be exposed to large swings from its residual currency exposure (since it has an
element of internal operational hedging from also receiving foreign currencies).
Other risks the firm will also face are translation risk, if it has foreign-domiciled
subsidiaries and economic exposure, arising from the different effects of changes in
the value of currencies on the firm’s customers and suppliers and their customers
and suppliers and also on the firm’s competitors. No information is given in the
question on these possible currency-related risks.
2 The first step is to compute the offsets available at the subsidiary level and the
group level in each currency. (Rec. = Receivable; Pay. = Payable.)

A B C Group
€ Rec. Pay. Net Rec. Pay. Net Rec. Pay. Total
1m 10 17 −7 6 11 −5 7 19 −12
2m 5 19 −14 5 15 −10 5 26 −21
3m 2 7 −5 4 0 4 1 9 −8
To- 17 43 −26 15 26 −11 13 54 −41
tal
The group exposure in euros taking account of any offsets within the currencies is:
€ A B C Group
1m −7 −5 −12 −24
2m −14 −10 −21 −45
3m −5 4 −8 −9
Total −26 −11 −41 −78
For the Swedish kronor, the exposure is:
A B C Group
SKr Rec. Pay. Net Rec. Pay. Net Rec. Pay. Total
1m 15 6 9 19 8 11 14 2 12
2m 20 11 9 17 4 13 9 2 7
3m 4 1 3 5 0 5 0 1 −1
To- 39 18 21 41 12 29 23 5 18
tal
The group exposure in Swedish kronor, taking account of any offsets within the
currencies, is:
SKr A B C Group
1m 9 11 12 32
2m 9 13 7 29
3m 9 5 −1 7
Total 21 29 18 68

For US dollars, the position is:
A B C Group
US$ Rec. Pay. Net Rec. Pay. Net Rec. Pay. Total
1m 5 4 1 12 9 3 9 11 −2
2m 8 6 2 15 4 11 5 8 −3
3m 1 2 −1 10 2 8 2 5 −3
Total 14 12 2 37 15 22 16 24 −8
The group exposure in US dollars, taking account of any offsets within the curren-
cies, is:
US$ A B C Group
1m 1 3 −2 2
2m 2 11 −3 10
3m −1 8 −3 4
Total 2 22 −8 16
The group exposure in the various currencies is:
€ SKr US$
1m −24 32 2
2m −45 29 10
3m −9 7 4
Total −78 68 16
The group total results have to be converted into the reporting currency, British
pounds, in order to determine how much currency exposure there is on a common
basis:
€ SKr US$ Group

1m −8 3.2 1.25 12.45
2m −15 2.9 6.25 24.15
3m −3 0.7 2.50 6.20
Total −26 6.8 10 42.8
Note that exposures with one sign in one currency, although expressed in British
pounds, cannot be offset against exposures in another currency with the opposite
sign. That means that exposures in the three currencies are added regardless of their
sign. The total exposure is £42.8 million.


It is important here to remember that, when the currency exposures in euros,
Swedish kronor and US dollars are being expressed in British pounds terms so
as to allow for consolidation, because exposures in these currencies are
different things, they are not simply added up where long positions (pluses) in
one currency are netted against short positions (minuses) in another. Other
than that, the exercise is very similar to the example given in Module 8.
3 The company is receiving payments in Swedish kronor from customers. If it could
persuade some of these to agree to be billed in euros, this would help the group
offset its currency exposures. Let us assume for simplicity that it can hedge the
excess between its receivables and payables in Swedish kronor by changing its
invoicing procedures to bill in euros.
The € amount is determined by using the cross-exchange rate between euros and
Swedish kronor. The cross-rate is €3.00 = £1.00 = SKr10.00. Therefore, each €1.00
= SKr3.33. The answer to Question 1 shows that there are the following amounts
available from the Swedish kronor side:
SKr maturity ladder Group offsets in SKr €

1m 32 9.6
2m 29 8.7
3m 7 2.1
68 16
Reworking the exposure table adjusting the euro position for the inflows above, we
now have:
€ SKr US$
1m −14.4 0 2
2m −36.3 0 10
3m −6.9 0 4
−57.6 0 16
And in British pounds:
€ SKr US$ £
1m −4.8 0 1.25 6.05
2m −12.1 0 6.25 18.35
3m −2.3 0 2.5 4.8
−19.2 0 10 29.2
The total exposure has reduced from £42.8 million to £29.2 million by changing the
invoicing procedure. Of course, this may not be realistic given the need to get
customers to accept invoicing in what is, to them, a foreign currency. However, to

the extent that any are prepared to change currencies (they may have, for instance,
offsetting receivables in euros, so it may help them!) this allows for more internal
netting.
This question requires an understanding of what the netting or matching
element in risk management is intended to do. In this case it is understanding
how modifications to the way the firm operates – by invoicing in euros – can
provide additional matching of exposures. Obviously, the business case or the
ability of the firm actually to persuade some of their Swedish customers to
change is key to this. Note that this is an example of operational risk manage-
ment.
4 A reinvoicing centre is a centralised treasury organisation for a multinational
company that has operations in more than one country. What it does is act as the
group’s foreign exchange banker where all transactions involving currencies are
transacted with the reinvoicing centre. The centre thus has all the information on all
the foreign exchange flows within the group and can use naturally occurring offsets,
as in Questions 1 and 2, to reduce its transaction costs. By netting internally, the
group saves itself the bid–offer spread on foreign exchange transactions. There may
be other benefits, such as reduced bank charges and staffing costs and better foreign
exchange rates from bundling smaller transactions into larger, more marketable
sizes, which also make the approach attractive.
From a risk management perspective, the most important benefit is that it enables
the group to have up-to-date information on the cross-currency cash flows that are
taking place. Senior management is thus better able to evaluate the extent of
currency risk within the group and how this can be best managed.
Examiners’ comments on Case Study 2
This case study deals with currency risk management and makes use of material
covered in Module 5 and Module 8. The first two questions relate to Module 5
on the sources and nature of currency risk. The remaining questions are derived
from Module 8 on controlling risk. There is some relatively simple calculation
required in order to derive the group’s overall currency exposure, but getting
the right answer depends on knowing how to do these calculations correctly.
Knowing how to mitigate or reduce the group’s exposure in Question 3
requires a little thought and understanding of how the risk management process
can be applied to the problem. The actual computational element is relatively
simple, although it is necessary to know how to create the appropriate cross-
rate.
[Total marks 40]
Case Study 3
1 We need to compute the zero-coupon interest rates from the par yield curve. The
basic approach is to separate the intervening cash flows from the par bonds by
bootstrapping the yield curve method.

Year 1 presents no problem since the par yield = the zero-coupon rate, namely 6 per
cent. The one-year discount factor = 1/(1.06) = 0.9434
The two-year zero-coupon rate is found by:
.
1 0.062578
. .
We proceed in a similar fashion to calculate the zero-coupon rates for Years 3 to 5:
Year Par yield 1 + Cn An−1 An 1 − Cn × An−1 Zero-

coupon
rate
1 0.06 1.06 0.0000 0.9434 1.0000 0.060000
2 0.0625 1.0625 0.9434 1.8291 0.9410 0.062578
3 0.065 1.065 1.8291 2.6564 0.8811 0.065221
4 0.0675 1.0675 2.6564 3.4252 0.8207 0.067940
5 0.07 1.07 3.4252 4.1357 0.7602 0.070748

The exact approach to bootstrapping par yields is given as an appendix to
Module 10.
2 This requires us to present value the cash flows given. However, we can simplify the
analysis by netting off the inflows from the assets and the outflows on the liabilities
to determine the net cash inflow/outflow per year. This is given below:
Year 1 2 3 4 5
Asset cash flow 13 13 113 103 103
Liability cash 111 6 6 206 0
flow
Net cash flow −98 7 107 −103 103
We now apply our risk assessment to the net cash flows in the above table:
First we value the ‘as is’ position of the net cash flows using the unadjusted zero-
coupon rates:
Year 1 2 3 4 5
Zero-coupon rate 0.06 0.062578 0.065221 0.067940 0.070748
Present value 0.9434 0.8857 0.8273 0.7688 0.7105
PV net cash flows −3.733 −92.453 6.200 88.525 −79.186 73.182
Next we apply the interest rate adjustment for a parallel shift:

Year 1 2 3 4 5
Parallel shift 0.061000 0.063578 0.066221 0.068940 0.071748
Present value 0.9425 0.8840 0.8250 0.7659 0.7072
PV net cash flow −3.951 −92.366 6.188 88.276 −78.890 72.841
Difference 0.218
Note: following the decision sciences convention we ignore the sign on the difference.
The change in value is 0.218.

The rotational shift is done in a similar fashion, but we need to decide how the yield
curve rotates. If it rises by 10 basis points at Year 5, then we assume 8 basis points
at Year 4, 6 at Year 3 and so on.
Year 1 2 3 4 5
Change: 0.2 0.4 0.6 0.8 1
Rotational shift 0.0602 0.062978 0.065821 0.0687401 0.071748
Present value 0.9432 0.8850 0.8259 0.7665 0.7072
PV net −3.974 −92.435 6.195 88.375 −78.949 72.841
cash flow
Difference 0.241
This gives a value change of 0.241.

The above analysis follows the treatment of interest rate risk valuation in
Module 10. The only real complication is that, unlike the example in the text,
we are given separate asset and liability cash flows. To the extent that one
offsets the other, these matching portions of the future cash flows can be
eliminated. Hence we work with net amounts, greatly simplifying the calcula-
tions.
It is also advisable to carefully lay out the calculations as provided here in the
model answer.
Note that, for the rotational shift, we only have to compute Years 1 to 4 again
as the value for Year 5 remains unchanged if the rotation is the same size as the
parallel shift.
3 We are not provided with any information about the volatility relating to the parallel
and rotational shifts. If we take the amounts in Question 2 as being the values at
risk, then we can apply the portfolio model version to determine the total risk. This
formula substitutes the value-at-risk number for wi σi in the equation. This gives
us:
Total risk
VaR VaR 2 VaR VaR
Substituting the values already derived and the known correlation coefficient gives:

Total risk 0.218 0.241 2 0.3 0.218 0.241

This gives a value of 0.3702
4 The risk manager can reduce the risk by reducing the mismatch between the cash
flows on the assets and liabilities.
If we go back to the aggregated cash flows for the two, we have:
Year 1 2 3 4 5
Asset cash flow 13 13 113 103 103
Liability cash flow 111 6 6 206 0
Net cash flow −98 7 107 −103 103
If the five-year asset cash flow were converted to a four-year cash flow with the
same amount, then the timing mismatch between these two years, which increases
the rotational risk, could be eliminated. Equally other elements of the cash flow
differences could be addressed.
Note that the risk manager cannot influence the market risk (in this case taken to be
a 10 basis points change at some value-at-risk level). The only elements he can
influence are the size and timing of the asset and liability cash flows. Reducing the
mismatch reduces the risk.
Obviously financial hedging would also reduce the risk.
This discussion picks up on the ideas of operational hedging that are examined
in Module 8.
[Total 40 marks]
Examination Two

1 The correct answer is A. We calculate the price relative as:
/ . .
1.0852
/ . .
So the one-year forward rate = 8.52 per cent.

2 The correct answer is B. In an efficient market with no transaction costs there will
be no risk-free investment opportunities as all the elements – the domestic cost of
borrowing (or lending), the foreign cost of (lending) borrowing and the forward
exchange rate – are correctly priced in relation to each other. Therefore the only
transaction that can be undertaken is to borrow the domestic currency and pay the
domestic interest rate, invest this in the foreign currency at the spot exchange rate
and earn the foreign rate of interest. The forward exchange rate, which will reflect
the interest rate differentials, will therefore provide just enough of the domestic
currency to pay back the domestic loan plus interest.

3 The correct answer is B. To determine the answer, we first need to calculate the net
exposure on the positions. This is given by subtracting the receivables and payables
positions:
Maturity Receivables (+) Payables (−) Net position

1 month 260 340 (80)
2 months 958 150 808
3 months 1210 270 940
The revaluation process now recalculates the value based on the change in the
exchange rate:
Period US$ amount Original British Current British Current

exchange pounds exchange pounds profit/loss
rate equivalent rate equivalent
at original at current
rate rate
1 month (80 000) 1.60 (50 000) 1.61 (49 689) 311
2 months 808 000 1.62 498 765 1.63 495 706 (3059)
3 months 940 000 1.63 576 687 1.64 573 171 (3516)
1 668 000 1 025 452 1 019 188 (6264)
Since we are receiving future US dollar inflows, the rise in British pounds/fall in the
US dollar means there is a loss of £6264.
4 The correct answer is A. The present value of the cash flows is:
100 1.04 −1 150 1.06 −3 250 1.05 −6 408.7
5 The correct answer is B. Market liquidity risk is the risk arising from the inability of
a market to function due to problems in the market’s exchange mechanism (howev-
er caused), whereas funding liquidity risk relates to specific credit units and affects
specific transactions with those units.
6 The correct answer is C. Operational hedging involves the firm in undertaking
transactions that modify the firm’s balance sheet and its operations.
7 The correct answer is C. The forward exchange rate is set by the interest rate
differentials for the relevant period. The forward rate will therefore be:
. .
MFr8 . MFr7.8311/$
.
8 The correct answer is B. The original value of the contract was at an exchange rate
of MFr7.8311/$. If the interest rate in Mondovia is now 5 per cent, rather than 4
per cent, the new forward rate will be MFr7.8876/$. As the transaction involves
buying Mondovian francs and selling US dollars, there is a loss of 7.8311 – 7.8876 =
MFr0.0565/$. This is because, if the firm had been able to enter at the new rate, it
would receive the new forward rate of MFr7.8876 rather than the contracted rate of

MFr7.8311. It therefore receives fewer Mondovian francs than it might otherwise

have done.
9 The correct answer is D. The value-at-risk method aims to provide risk managers
with an estimate of the maximum size of gains and losses (within a confidence limit)
on an exposure over a predetermined decision-making horizon.
10 The correct answer is A. With a one-week decision horizon and a 1.65 standard
deviation confidence limit, the amount of price change that is expected is:
.
€2.5 million 1.65 €160 170
√
11 The correct answer is D. The forward exchange rate under the interest rate parity
model will be the spot exchange rate times the product of the differential of 1 plus
the interest rates of the two currencies. That is:
where FC is the foreign currency and D is the domestic currency.

If interest rates in British pounds are 5 per cent and US dollars 6 per cent, and the
spot expressed in domestic terms is £0.70 ($1.42 = £1; therefore
£1/£1.42 = £0.70), then the forward rate will be:
.
0.70 0.6934 or $1.4422 per £
.
12 The correct answer is D. If the volatility of an asset changes, then the asset price
may or may not change. In fact it is more likely to change than not, since presuma-
bly the change in volatility reflects some new information about the asset. The price
of an option on the asset will change since the option price is sensitive to changes in
volatility (it is a volatility-sensitive instrument).
13 The correct answer is D. In using operational risk management techniques, a firm
will seek to organise its production and distribution in such a way as to minimise the
impact of changes in factor costs and selling prices. It will also seek to do this by
matching, as far as possible, the nature of its liabilities to its assets, and also revenues
and expenditures to currency, interest rate and maturity.
14 The correct answer is D. To obtain the answer, we must first determine the net
exposure per currency, as in the following table:
Curr. A Receivables Payables Net Curr. B Receivables Payables Net

Maturity (+) (−) Maturity (+) (−)
1 month 620 120 500 1 month 85 150 (65)
2 months 815 95 720 2 months 100 225 (125)
3 months 485 110 375 3 months 145 320 (175)
1920 325 1595 330 695 (365)
This net position (that is, after the internal offsets have been taken) is then convert-
ed into the base currency X at the exchange rate, as in the following table:

Currency A in X Currency B in X Net position of

currencies
A10 = X1 B4 = X1 A and B reported in X
(A) (X) (B) (X)
500 50 (65) (16.25) 66.25
720 72 (125) (31.25) 103.25
375 37.5 (175) (43.75) 81.25
1595 159.5 (365) (91.25) 250.75
Because we cannot offset risks between currencies A and B, we now add the two
currencies in X regardless of the sign to give a total currency exposure of 250.75
units of X.
15 The correct answer is B. In a two-asset portfolio, the elements that will dictate the
amount of risk are the weights of the two assets in the portfolio (α and (1 − α)), the
standard deviations (or variance) of the assets (σ) and the correlation between the
two assets (ρ). The total portfolio risk equation for a two-asset portfolio is:
1 2 1
If the only factor to change is the correlation coefficient ρAB = 0.4 , and this is
changed to ρAC = 0.3 , the total risk of the portfolio will drop.
16 The correct answer is D. By setting up a reinvoice centre a company is seeking to
manage its cash position, the effect of currencies and the order flow between the
different divisions.
17 The correct answer is C. If level shift risk and rotational shift risk are independent
risks, then the total risk will be the square root of the sum of the squared risks:
3.4 3.8 5.1
18 The correct answer is B. The loan is amortised using a 6 per cent annuity factor. The
calculation for the 6 per cent factor will be:
PVIFA . %, 4.2124
. . .
The present value of the loan at this discount rate is:

£237 396 4.2124 £1 000 000
The new annuity factor at 6.01 per cent will be:
PVIFA . %, 4.2112
. . .
The present value of the loan at the altered discount rate will be £237 396 × 4.2112
= £999 728. The difference between the two values is £272.
19 The correct answer is B. A valid reason for a firm to manage its translation risk is
that there may be wide swings in corporate performance from exogenous currency
effects that are unrelated to the fundamental performance of the firm. The ‘noise’
created by wide swings in reported profits makes it difficult for providers of capital
to understand the performance drivers of the firm. There is a so-called ‘signal
extraction problem’.

20 The correct answer is A. The required result involves the interest rate parity
equation to derive the forward rate:
. .
$1.827 . $1.8181
.
21 The correct answer is B. Since the contract requires the sale of euros and the
purchase of dollars, the changed 12 months’ forward rate from €1.7954 to €1.7958
means a loss of €0.0004 per euro sold. That is, we could immediately reverse the
transaction and extract, at the maturity of the two forward contracts, the difference
of €0.0004 per euro in the value of the two forwards.
22 The correct answer is C. A convenience yield arises for commodities because there
is a demand by users for an assured supply of the physical commodity and because
users will store it to ensure an adequate supply if there is any possibility that there
will be a shortage of physical product in the future.
23 The correct answer is C. The systematic risk of a share is that part of the share’s
value, or return, arises from the firm-specific events or conditions and hence is
unique to the share.
24 The correct answer is C. If the annual equivalent rate is taken to be x per cent, the
two cash flows are:
Year Semi-annual Annual (A) Difference (SA − A)

(SA)
0.5 2.0 0 2.0
1.0 2.0 x 2.0 – x
1.5 2.0 0 2.0
2.0 102.0 100 + x 2.0 – x
For the two loans to be equivalent the present value (PV) of the two cash flows
must be equal, so the PV of the difference column must equal 0. The PV will be
zero if the two PVs of the first year’s cash flow are equal. This will happen if
.
2.0/ 1 2.0/ 1 equals x/ 1 + ra . If the required discount rate on
the semi-annual payment = 7 per cent, substituting we have:
x 1.07 1.9335 1.8692
which is 4.07 per cent.
Note the difference in result if we had simply converted the semi-annual payments
to the annual equivalent, using the following formula:
1 1 100
This would give:
%
4.04% 1 1 100
25 The correct answer is C. When making a loan, the bank has the risk that interest
rates will rise, thus reducing the value to another party. (Alternatively, we can
consider the loss in terms of the opportunity cost of having a loan with a below-

market rate of interest.) Both loan alternatives I and II allow the bank to reset the
interest rate in line with prevailing market rates, at which point, all other factors
being equal, the loan value will be equal to the principal amount of the loan.
However, loan III has a fixed interest rate. The value of the loan will change if the
interest rate used to present value the future cash flows changes. Since the amount
of future interest is fixed, this loan alternative may result in significant price changes.
If interest rates fall, this means the bank gains; if rates rise, the bank loses. So loan
III is the loan with the greatest price risk.
26 The correct answer is A. ‘Interest rate sensitive’ relates to those assets and liabilities
whose value is predominantly determined by the discount rates or the interest rate
used to value their future cash flows.
27 The correct answer is C. Endorsement is the process by which an intermediary
validates a transaction by adding its name to the transaction.
28 The correct answer is A. Economic risk arises from changes in market risk factors,
such as exchange rates and commodity prices. The degree of exposure in a particular
firm will be related to management decisions on products, manufacturing processes,
markets and so on. Changes in interest rates, exchange rates and commodity prices
will have an impact on firms’ future cash flows, as will the actions of competing
firms. A firm’s financial statements are reports of the firm’s activities and hence
show the results of economic risk. Consequently, A is not a source of economic
exposure.
29 The correct answer is D. The shape of the price tree, allowing a change of 20 per
period and an initial price of 520, will be as follows:
600
580
560
560
540 540
520 520 520

500 500
480 480
460
440
The range is 440−600.

30 The correct answer is D. All the above methods are used to manage risk. Selling the
risk to another party is the insurance approach. Entering into transactions with the
opposite risk to the current risk is hedging, and following policies that seek to take
risk into account is risk reduction and management. All the methods will modify the
risks of the firms, although the results will be different.

Case Study 1
1 The major concern that Forecourt Finance will have will be the credit risks it is
taking with its customers. A sum of £8000, or a monthly payment of £129 – if the
balloon arrangement is chosen – is quite substantial for an individual, if he or she
should lose their job or their personal circumstances should suddenly change. There
is, therefore, a significant risk of loan default or delinquency (late payments and so
forth). There is also some risk of fraud since individuals and vehicles can simply
‘disappear’. The company addresses this by using the personal information provided
by buyers through the dealers to ‘score’ the applicant in order to determine eligibil-
ity. Where the likelihood of default is unacceptable, the company will refuse the
loan.
Depending on the way the company finances itself, it may also be taking on interest
rate risk. The loans that the consumer finance company makes are at a fixed rate: to
protect itself it may wish to borrow at a fixed rate for the average term of the loan.
However, in matching the loan maturity to the funding maturity, it has a problem.
The customer can and may well prepay the loan with the one month’s penalty
interest, and so the company also has prepayment risk. Although the funds
released by the repaid loan will be reused, these are only going to earn at the current
interest rate that Forecourt is charging on new loans. This is likely to be a lower rate
than that of the redeemed loan. In addition, as with other types of consumer loans
such as mortgages, there are likely to be a number of prepayments that are inde-
pendent of any interest rate effects: these arise from cars being written off as a result
of accidents or being stolen, or from the borrower’s changed circumstances
requiring the vehicle to be sold and other personal factors.
If the company borrows at the lower variable rate and earns a higher spread
between its lending and funding rates, it will face an interest rate mismatch
between the fixed interest rate on its assets and the variable cost of its liabilities.
Higher interest rates could therefore significantly reduce the company’s margin.
Further, if Forecourt funds itself, not to the contractual maturity of five years but,
say, for just two years, it could possibly experience difficulties in raising further
finance, a problem known as funding risk. Note that, by having a maturity on its
funding that is less than its assets, the firm is thereby reducing the effect of prepay-
ment risk but at the expense of more funding risk. That is, some of the risks are
offsetting. It would want to know what its early-termination profile was in order to
balance these two effects.
The company also faces other threats: if competition in the consumer loan market
were to intensify, the company could face downward pressure on the difference
between its cost of funds and its earning rate. The 4.5 per cent to 5 per cent spread
being earned has to cover Forecourt’s operating, overhead and establishment costs,
any losses from default and the required level of profits. The finance house’s
profitability may be threatened if other providers are able to operate more efficiently
and undercut it. All competitors have to pay the market rate of interest, but the

required loan margin will be a matter of how cost-effective the company can be and,
especially, of how good it is at preventing credit losses.
If interest rates fall – and/or industry margins are squeezed – then Forecourt will
have more prepayments than anticipated as customers avail themselves of cheaper
funding alternatives, such as bank finance. When economic conditions are difficult,
the loan is more likely to run to maturity since car owners will not want to replace
their car and may even be sitting on losses from their existing one. Hence Forecourt
is also exposed to extension risk on its lending. However, because, when economic
conditions are difficult, interest rates tend to be low, extension risk may not be a
problem for the company: the loans may be earning an above-market rate of
interest.
Finally, Forecourt has some exposure to the used-car dealers it uses to market its
loans. It has provided a computer to each dealer, which, if there was any problem
with the dealership, might not be recoverable. There may also be some legal or
regulatory risks in employing an agent for selling the loans. Therefore there are
some costs in ensuring that the dealers are reputable and some legal risk or
reputational risks for the finance house itself.
This question is very similar to the case study that appears at the end of Module
4. It is an exercise in risk identification based on the information provided. The
wider aspects of risk management that also underlie this question are discussed
in Modules 1 to 3 and are also commented upon at other points in the text.
2 Interest rate risk is the effect of changes in the discount rate (or rates) used to
present value future cash flows or to compound present values. There are a number
of different effects.
Price risk is that element of interest rate risk on the market value or price (and
hence is also referred to as price risk) on a future cash flow or set of cash flows. If
we present value a future cash flow of £100 for five years at 10 per cent, its current
price (or present value) is £62.09. If, however, interest rates increase to 11 per cent,
the current price (market price/present value) will fall to £59.35. The realisable
value will have dropped by £2.74. Price risk is inversely related to interest rates:
prices will fall with a higher interest rate.
Reinvestment risk is that element of interest rate risk relating to future interest.
This risk is positively related to changes in interest rates. Using the earlier example,
if we can invest £100 for five years at 11 per cent, we will have a terminal value of
£168.51. If, however, interest rates fall and we can only invest at 10 per cent, the
terminal value falls to £161.05, a loss of £7.46 in terminal value.
Prepayment or call risk is a possible feature of the contractual relationship for
interest-rate-sensitive instruments. A borrower may have the right to prepay (call) a
liability, or a lender may have the right to repay (put) an asset. In these cases, the
other party stands to lose from having granted such an option since it will be
exercised when it is to the advantage of the holder: in the case of the liability, when
interest rates fall; in the case of the asset, when interest rates rise.

Extension risk is another contractual risk when instruments such as mortgages are
repaid or redeemed at a lower rate than expected and hence the effective life of the
loan or security is longer than anticipated.
Finally, it is worth pointing out that other non-interest-rate effects can also affect
returns, for instance, credit risk and liquidity risk as well as currency risk (if
applicable), inflation and political risk.
This question requires an understanding of the sources of interest rate risk as
detailed in Module 4. An examiner will be looking to see how well the candidate
understands the issues. Note that the use of examples, as given in the model
answer, can help illustrate the argument and save on the amount of written
explanation.
3 The analysis will be based on the loan example given in the case study. The interest
rate sensitivity of Forecourt’s loan package will depend on whether it is fully
amortising or bullet. When the loan is first granted, it will be ‘at market’, so if the
loan was, say, cancelled after one month, the finance house could probably make a
new loan at much the same rate. If we assume that interest rates fall by 1 per cent
per year, then the amount of value risk after one year is as follows. The amount of
principal outstanding on the loan after one year at 12 per cent (1 per cent per
month) is £6758.36. This is found by solving for the annuity:
.
£178 £6758.36
.
At the new interest rate of 11 per cent, this provides a monthly payment of £175.
This is found by recalculating the annuity factor for the 11 per cent rate (that is, at
0.0917 per cent per month), which gives 38.6914, and then dividing the amount of
principal outstanding by the annuity factor (£6758.36/38.6914 = 175).
Therefore the loss is about £3 per month, or £129 in present-value terms. To the
extent that the firm has borrowed short term, it will not suffer this amount of loss,
since the funding can be paid off from the cancelled loan.
To the above must be added the one month’s penalty interest of £178, giving a £49
profit. If the interest rate had changed by more than 1 per cent, the penalty monthly
payment would not cover the firm, but it provides some protection.
To the extent that the finance house had not anticipated early redemption, there is a
potential loss. The following table quantifies the loan value with between four years
and one year remaining, based on a £178 per month payment on the fully amortis-
ing loan and changes in interest rates of up to 4 per cent. What the analysis shows is
that, by imposing a one-month penalty fee, the company is protected as long as
interest rates do not move more than 1 per cent per year in the first two years.
(Note: A more detailed grid could be produced – if required.)
The shaded areas show the losses that exceed the one month’s penalty interest
payment. The company could therefore determine the penalty based on an assess-
ment of future interest rate volatility. Also, once the loan nears term, customers are
less likely to terminate early given the interest rate penalty.

Remaining term
£178 monthly 12% 11% 10% 9% 8%
payment £ £ £ £ £
4 years 6758 6885 7016 7151 7 289
3 years 5358 5436 5515 5596 5 679
2 years 3780 3818 3856 3895 3 935
1 year 2003 2013 2024 2035 2 046
Loss from early redemption as a result of a change in inter-
est rates
0% –1% –2% –3% –4%
£ £ £ £ £
4 years 0 128 259 393 532
3 years 0 78 157 238 321
2 years 0 38 76 115 154
1 year 0 11 21 32 43
If the loan is amortising, then the loss is somewhat different. The original present
value of the monthly loan payment and the final bullet payment with four years to
go and the value of the loan at the new, lower interest rate are given in the following
table:
Element 12% flat 11% flat Difference

Monthly payment (PV of 48 4898.64 4991.19 (92.55)
payments of £129 at above rate %)
Balloon payment 2481.04 2581.31 (100.27)
Total 7379.68 7572.50 (192.82)
If the loan was ongoing and not repaid, at the new 11 per cent rate of interest it is
worth £7572.50. If it is repaid early, the company loses the difference between this
and the original value at the 12 per cent (1 per cent per month) rate. That is, to
generate the same cash flows at 11 per cent as it had at 12 per cent, it would have to
lend £192.82 more than before.
So, if the customer borrows on a balloon arrangement, the loss is £192.82 and the
one month’s penalty interest payment of £129 and the 1 per cent of the final
amount – worth £40 – only partially cover the loss of value, leaving a small loss of
£23.82.
Note that the different effects of the two loans arise from the timing of the cash
flows, in that the balloon arrangement has more prepayment risk.
[Total marks 40]

Case Study 2
1 Corporate risk management is the process, or series of processes, by which firms

seek to manage their risks. In putting forward a case as to whether active risk
management is desirable, undesirable or simply irrelevant to shareholders, it is
necessary to know what the objectives of the firm are.
In the modern theory of corporate finance, the company’s objective is to maximise
shareholder value. This means making decisions that add to shareholders’ wealth.
In financial decision terms, this means undertaking projects with a positive net
present value.
One situation in which active risk management may be seen to be beneficial is when
shareholders are risk averse. By managing the volatility or dispersion of future cash
flows, the firm can deliver a more stable set of future earnings and dividends.
Greater stability means that investors require less of a risk premium and that future
cash flows, because they are discounted at a lower risk-adjusted rate, are now worth
more in present-value terms, thereby raising the value of the firm and shareholder
wealth.
The opposite perspective, that managing risk is undesirable, is based on the view
that value is created by the firm’s assuming risk in pursuit of gain. By not taking on
risks, the firm is not creating any value for shareholders. At its extreme, the logic of
avoiding risk leads the firm to forgo any risk and invest in safe, short-term invest-
ments, such as government treasury bills. But, in order to create value, the firm must
assume reasonable risks and, if it avoids or transfers these by hedging, it surrenders
any value it may seek to create.
While the above statements encapsulate two possible rationales for actively manag-
ing risks, both are deficient in explaining the value of active risk management to
shareholders. For shareholders to be better off from the actions of the firm’s
managers, the firm needs to generate investments that provide a surplus to the risk-
adjusted present value of the investment’s future cash flows.
For well-diversified shareholders, many of the risks within a firm are irrelevant.
Many firm-specific or idiosyncratic risks can be diversified away. That is, the losses
from such risks may be compensated for by the gains made elsewhere in the
portfolio. For instance, a portfolio with holdings of both Ford Motor Company
(Ford) and General Motors (GM) will see a drop in the Ford share price if it
launches a new model that turns out not to be a commercial success and a gain in
GM’s since it will be able to sell more of its own competing product line. So an
investor with a diverse portfolio of shares is unlikely to want to see firms actively
remove such risks if there is a significant cost involved.
There are some advantages to hedging pervasive risks that relate to various exoge-
nous costs of being in business. These arise from frictions and deadweight costs in
the financial system. One way to consider how value may be added is to conceive of
the market value of the firm as being a function of its future cash flows under all
conditions. This can be functionally equated to the discounted value of the firm’s
future expected cash flows:

V ∑
where E(NCF) are the firm’s expected net cash flows after costs and rrr is the
required rate of return on the firm based on the firm’s systematic risk. In this model,
the firm can therefore be considered a portfolio of projects. To increase shareholder
wealth, as mentioned above, it is necessary to undertake actions that provide an
excess of return over what they cost.
Some of the market value of the firm can be attributed to the tax advantages of
debt, the value loss from financial distress and agency and other costs. That is,
Value of the firm Value of all‐equity‐financed firm PV Tax shield − PV Costs
of financial distress − PV Agency costs
where PV is the present value of these future benefits and costs.
What will active risk management achieve in this context? In seeking to provide
benefits, managing risks can:
 increase the firm’s expected net cash flows (E(NCF));
 decrease the required rate of return being demanded by investors (rrr).
If the value of the firm is sensitive to interest rates, exchange rates or commodity
prices, it can be increased if these are actively managed. However, for corporate risk
management to benefit shareholders, such actions must change the firm’s cash flows
in ways that shareholders value. Since risk management has a cost, the benefit to
shareholders must outweigh the costs involved. Second, corporate risk management
activities must be the least-cost means of changing the firm’s expected net cash
flows. That is, the firm must be at least as efficient at risk management as share-
holders themselves. This efficiency test means that actions such as corporate
diversification (which can be undertaken by shareholders for their own account at
far less cost and with far more flexibility) are, in most cases, suspect.
The advantage – or otherwise – of corporate hedging will also differ depending on
the nature of the firm’s shareholders. Ill-diversified owner-managers have a stronger
incentive for active risk management since they will have inefficient portfolios with
large amounts of idiosyncratic risk. This is particularly true for non-quoted private
firms.
As the conceptual model for the firm given above suggests, the benefits from active
corporate risk management arise from market imperfections. In particular, the effect
of taxes, financial distress and bankruptcy costs, agency costs and conflicts of
interest between the different classes of claimholders on the firm, commitments and
costs for financing new investments or projects and information asymmetries – that
is, the market’s signal extraction problem – are all areas where corporate, as opposed
to shareholder, risk management is beneficial.
By managing risk, the firm can – to some extent – control the amount of taxation
being levied. Where tax benefits and write-offs are dependent on the firm’s having
profits, controlling the volatility of the firm’s cash flows so as to have sufficient
profits against which to use tax allowances ensures these are used effectively. Also,

when tax rates are progressive, higher profits in some years will lead to increased tax
rates that may not be offset against lower profits or even losses in other years.
Financial distress, or the difficulty in meeting the firm’s maturing fixed claims, can
push a firm into expensive bankruptcy (insolvency) proceedings. To the extent that
the volatility of a firm’s cash flows is likely to place the firm in such difficulties,
reducing this volatility – and the likelihood of the firm’s becoming financially
distressed – will increase value. This may be a direct effect, when the firm can
borrow more tax-efficient and cheaper debt finance. Or it may be an indirect effect
when concerns about the firm’s survival affect customers’ perception of the value of
the firm’s products or services, the warranties or service agreements it provides and
hence the firm’s market share, sales and prospects. It also applies to the willingness
of the firm’s own employees to commit to investing in firm-specific skills and the
firm’s ability to undertake new investment projects.
Conflicts of interest arise between shareholders and lenders because of the option
structure of the firm’s liabilities. In this model, shareholders hold a call option on
the value of the firm (or, equivalently, have a put to the debt holders). As with any
option, the value of the option holder’s claim increases in value when the volatility
of the underlying position increases. Shareholders and their managers therefore have
an incentive for the firm to increase its risk. Lenders will seek to protect themselves
against the opportunistic behaviour of shareholders by increasing the interest rate –
or yield – required on the loans to the company to compensate for this risk. Also,
contractual arrangements will be designed to prevent such activities. Active corpo-
rate risk management can help reduce these conflicts.
Since firms require money to undertake investments or new projects, uncertainty
over the future availability of funds can make planning difficult or even undermine
the proposal. To the extent that the firm can ‘lock in’ future cash flows by risk
management activities, this can facilitate investment decisions and the future growth
of the firm’s expected cash flows. If the firm does not actively manage this, it risks
having to raise funds for new investments in periods when it has seen an adverse
variance in its cash flows. This means that, where firms have unpredictable profits
and wide swings in reported earnings, it is difficult for the market to determine
whether these are due to changes in exogenous risk factors, such as interest rates,
currencies or commodity prices, or down to poor management. If the firm can
reduce the impact of these economic factors, the underlying value creation due to
the firm’s managers is more easily discerned by the market. That is, there is an
improvement in the signal-to-noise ratio in the firm’s reported results. Further,
locking in output prices by managing risk can also turn otherwise unacceptably risky
investments into acceptable ones.
To conclude, the case for active risk management by the firm rests on how such
activities increase the firm’s value to shareholders. The case for active risk manage-
ment rests on market frictions and the fact that the firm is best placed to mitigate
these adverse effects. In particular, tax effects, agency costs and significant financial
distress costs, as well as potential conflicts of interest and asymmetry of information
between firms and financial providers, provide grounds for corporate risk manage-
ment activities that enhance the value of the firm to shareholders (and other

stakeholders). Finally, active risk management activities will be particularly important

where owners are ill-diversified investors with a large fraction of their wealth tied up
in the firm.
[Total marks 40]
Examiners’ comments on Case Study 2
The question on Case Study 2 requires an examination of the valid reasons that
firms should seek to manage risks. The objective is to test the candidate’s
understanding of the rationale for active management of corporate risks that is
to be found in Module 2. The question requires a straightforward discussion of
the issues.
Note that the diagrams used to illustrate financial distress and taxes in Module 2
have not been used in the model answer, in order to avoid repetition. However,
when answering a question of this type, they could form part of the answer and
be inserted at the appropriate point in the discussion. If the candidate chooses
to use diagrams, their relevance must be clearly explained in the text.
Case Study 3
1 The company’s value at risk for the two currencies separately is:
€ exposure: £25m × 0.15/√12 × 1.95 = £2 110 937
$ exposure: £45m × 0.20/√12 × 1.95 = £5 066 249
The total portfolio risk, using a two-asset portfolio, is found by:
€,$ €/£ $/£ 2 €/£,$/£ €/£ $/£
Substituting the values, we have:

£2 110 937 £5 066 249 2 0.60 £2 110 937 £5 066 249
This gives a value at risk for the portfolio at 1.95 standard deviations and a one-
month decision horizon of £6 554 111.
This question is similar to the example given in Module 9. Since the answer
requires the computation of the value at risk, candidates should carefully lay out
all the steps to show how they derived their solution. This allows marks to be
awarded for the candidate’s understanding of the methodology even if the final
answer may be wrong as a result of an undiscovered computational error. This
point also applies to Question 2 below.
2 To determine the amount of risk in the total portfolio, it is necessary to compute
the new portfolio, including the additional currency. The elements of the three-asset
portfolio’s risk are:

Element € per £ $ per £ ¥ per £

€ per £ 2 2 w€/£w$/£σ€/$ w€/£w¥/£σ¥/€
€/£ €/£
$ per £ w€/£w$/£σ€/$ 2 2 w¥/£w$/£σ¥/$
$/£ $/£
¥ per £ w€/£w¥/£σ¥,€ w¥/£w$/£σ¥/$ 2 2
¥/£ ¥/£
First we need to compute the value at risk for the two new positions as follows:
$: £30m × 0.20/√12 × 1.95 = £3 377 499
¥: £15m × 0.26/√12 × 1.95 = £2 195 374
Substituting, we have:
Element € per £ $ per £ Y/£

€ per £ (£2 110 937)2 (£2 110 937)(£3 377 499)(0.6) (£2 195 374)(£2 110 937)(0.4)
$ per £ (£2 110 937)(£3 377 499)(0.6) (£3 377 499)2 (£2 195 374)(£3 377 499)(0.7)
¥ per £ (£2 195 374)(£2 110 937)(0.4) (£2 195 374)(£3 377 499)(0.7) (£2 195 374)2
This gives:
Element € per £ $ per £ ¥ per £

€ per £ 4 456 054 687 500 4 277 812 500 000 1 853 718 750 000
$ per £ 4 277 812 500 000 11 407 500 000 000 5 190 412 500 000
¥ per £ 1 853 718 750 000 5 190 412 500 000 4 819 668 750 000
The total of the matrix is 43 327 110 937 500 and the square root of the sum is
£6 582 333.
By comparing this to the answer in Question 1, where we had a total value at risk of
£6 554 111, we see that changing the currency of invoice to Japanese yen does not
reduce the overall risk of the currency portfolio. In fact, the risk is increased
marginally, by £28 222. So, from a risk management perspective, changing the
existing relationships does not reduce the firm’s existing currency risk. However, the
firm may have sound commercial grounds for making the switch.
This is an extension of Question 1 in that, instead of a two-asset portfolio, there
are now three assets. Apart from that, the major difficulty is again computation-
al: the steps for deriving the value at risk (VaR) of the portfolio involve a large
number of calculations and it is quite easy to get them wrong. Neatly setting
everything out along the lines of the model answer will help the candidate to
avoid errors and allow it to be checked – if there is time in the examination.
3 To ensure a complete analysis of the exposure to a particular risk, it is necessary to
add to the value-at-risk method a stress test scenario to provide a worst-case loss.
The value-at-risk method shows the ‘normal’ exposure defined within some
acceptable confidence limit. For the company above this was defined as 1.95

standard deviations and one month. That is to say, if the change in the exchange
rate for the individual currencies and the portfolio of currencies is normally distrib-
uted, then on a two-tailed spread of outcomes, 95 per cent of the time the actual
value should be within these parameters.
However, there are times when markets become disturbed by significant political
and/or economic events, and these ‘stressed’ market conditions lead to unusual
price and rate behaviour in financial assets. From a risk management perspective,
two things happen. First, the change in values exceeds the confidence limit and
three and even four or five standard deviation rate changes have been observed as a
result. Second, there are many interdependencies between asset, currency and
commodity returns, or their correlation may change unexpectedly, usually increasing
and thereby reducing the benefits of diversification. In these circumstances,
correlation coefficients computed under normal market conditions underestimate
the amount of common variability in the portfolio and hence its risk. Therefore, the
benefits of portfolio effects, when all assets evidence significant positive correlation,
are reduced. When all assets are perfectly positively correlated, then portfolio effects
vanish.
The stress test is therefore a measure of the potential value at risk under extreme
market conditions. The basis for undertaking such a test is usually some major
market-disrupting event. Possible examples include the behaviour of financial
markets during the Great Crash of 1929, or the worldwide market crash of October
1987. For currency markets, the events surrounding the UK’s exit from the Ex-
change Rate Mechanism (ERM) in 1992 would be appropriate for analysing the risks
of a UK importer. For commodity prices, the Gulf Crisis precipitated by the Iraqi
invasion of Kuwait in 1990 and the effect on the oil price would be used.
The very large price or rate movements of these events is used to calculate the
worst-case outcome. If the company were concerned about its maximum exposure,
it could recalculate the total portfolio risk of its position in euros and US dollars,
assuming a correlation of +1 and a maximum rate movement of 5 standard devia-
tions. The stress-test value at risk then becomes:
€: £25m × 0.15/√12 × 5 = £5 412 266
$: £45m × 0.20/√12 × 5 = £12 990 381
The total stress test is now simply the sum of the two: £18 402 647. This is signifi-
cantly more than the value-at-risk amount of £6 554 111 calculated in Question 1 (it
is nearly three times as much!).
A discussion of the need for a stress test is covered in Section 8.4.5 of Module
8. The model answer also makes use of examples to help explain the principles
behind the stress test. In answering the question, candidates might also choose
to include Figure 8.13, showing the dispersion of returns and the extreme value
modelling process of the stress test. In order to avoid repetition these were not
used in the model answer.
4 Economic exposure is concerned with the extent to which unexpected movements
in the exchange rate change the value of the firm’s expected future cash flows. The

change in the expected value of the firm’s future cash flows arises from the effect
that unexpected changes in the exchange rate may have on future foreign and
domestic sales, sales volumes, prices and costs directly and indirectly from these
effects on the firm’s suppliers and their competitors and their suppliers and compet-
itors and so on. Because of this effect, economic exposure is also sometimes
referred to as competitive, strategic or operating exposure.
There are two elements to economic exposure: direct economic exposure and
indirect economic exposure. Direct exposure is that element of unexpected changes
in the exchange rate that directly affects the firm. That is, it has an impact directly
on the firm’s future cash flows – which are either reduced or increased as a result.
Indirect exposure is the impact of changes in the exchange rate on the firm’s
competitors and suppliers or their competitors and suppliers and so on. Indirect
exposures arise from decisions within the firm (for instance, decisions as to where
to source the firm’s inputs) and from actions outside the firm (by suppliers, custom-
ers and competitors), which, although they do not have a direct effect on expected
future cash flows, do have an indirect impact through increased/decreased costs and
competitive effects.
Different firms will have different levels of economic exposure depending on what
aspects of their future cash flows are directly or indirectly affected by changes in the
exchange rate. The Flood and Lessard model proposes four broad categories of
firms grouped according to whether they have high or low sensitivity to changes in
the exchange rate of their inputs and outputs. The types of firm, together with some
examples, are given in the following table:
Sensitivity of firm’s Low factor costs High factor costs

cash flows to changes sensitivity sensitivity
in the exchange rate
Low revenue sensitivity Low economic exposure High cost exposure
Local market firms Importers
Alliance Food fits this
category
High revenue sensitivity High income exposure Low economic exposure
Exporters World market firms
Local market firms (with Importers (with similar
global competitors) competitors)
The definitions of the types of firms are:

 Local market firms: these obtain inputs and sell in local markets. These would
include most local services, firms protected from foreign competition by barri-
ers, monopoly suppliers and so on.
 Exporting firms: these firms obtain their inputs locally and sell their output on the
world market. The same effects are felt by firms that are selling locally but com-
peting against imports from the world market.

 Importers: these firms obtain their inputs from the world market and their outputs
are sold locally. As an importer, Alliance Foods falls into this category.
 World market firms: these firms obtain their inputs and sell their outputs on the
world market. As long as their input sensitivities and output sensitivities are simi-
lar, they have little economic risk. This category of firm also includes those
importers who are competing with other importers who have the same exposure
(for instance, oil importers in Japan, which has no indigenous reserves).
Alliance Foods fits the category of ‘Importer’. It obtains its inputs from competitive
world markets and sells into the domestic market. It therefore has a cost/revenue
sensitivity mismatch between the two sides.
The effects of unexpected changes in exchange rates differ with time. In the
immediate term, that is, within a budgetary cycle, it is difficult for the firm to make
adjustments. Unexpected changes in exchange rates will mean that the actual
realised cash flows will differ from those anticipated in the budgeting process.
Over the medium term, the degree of economic exposure will depend on whether
the exchange rate moves back to its purchasing power equilibrium, thus preserving
the firm’s existing expected cash flows, or remains in disequilibrium. In the equilib-
rium case, for Alliance Foods this means that the cost of imports adjusts to preserve
the price relationship relative to domestic alternatives before the unexpected change
in the exchange rate. In the disequilibrium case, when the exchange rate takes an
extended departure from purchasing power parity conditions, cash flows – and
profitability – can be affected for years. Firms that have established strong barriers
to market entry or are selling a unique product and hence have less demand elastici-
ty are likely to suffer less in such a situation. Firms that are price takers or
commodity producers, or those susceptible to market penetration from external
suppliers or competitors, are likely to suffer the most. The extent to which Alliance
Foods will be able to maintain market share will depend on whether the company
has been able to differentiate its processed foodstuffs from those of other providers
(probably somewhat difficult to do) and how competitive the food industry is. In
the UK, it is highly competitive and, as a result of the European Union’s single
market initiative, open to opportunistic behaviour by foreign processors based in
the eurozone.
Finally, it should be noted that the effects of economic exposure, with their second-
and higher-order effects, are subtle and difficult to quantify. It is important for the
firm and its managers to understand how a particular product, source of supply or
firm is affected by economic risk in order properly to manage the exposure.
[Total marks 40]
Economic exposure is described in Module 5. This question requires candidates
to use their understanding of economic risk to explain the sensitivity of Alliance
Foods to its effects. The Flood and Lessard model provides a useful analytical
‘template’ to help categorise the firm and as a way of understanding what its
sensitivity to currency risk might be.

Appendix 2
Statistical Tables
Table A2.1 Normal distribution tables
z .00 .01 .02 .03 .04 .05 .06 .07 .08 .09
0.0 .0000 .0040 .0080 .0120 .0160 .0199 .0239 .0279 .0319 .0359
0.1 .0398 .0438 .0478 .0517 .0557 .0596 .0636 .0675 .0714 .0753
0.2 .0793 .0832 .0871 .0910 .0948 .0987 .1026 .1064 .1103 .1141
0.3 .1179 .1217 .1255 .1293 .1331 .1368 .1406 .1443 .1480 .1517
0.4 .1554 .1591 .1628 .1664 .1700 .1736 .1772 .1808 .1844 .1879
0.5 .1915 .1950 .1985 .2019 .2054 .2088 .2123 .2157 .2190 .2224
0.6 .2257 .2291 .2324 .2357 .2389 .2422 .2454 .2486 .2517 .2549
0.7 .2580 .2611 .2642 .2673 .2704 .2734 .2764 .2794 .2823 .2852
0.8 .2881 .2910 .2939 .2967 .2995 .3023 .3051 .3078 .3106 .3133
0.9 .3159 .3186 .3212 .3238 .3264 .3289 .3315 .3340 .3365 .3389
1.0 .3413 .3438 .3461 .3485 .3508 .3531 .3554 .3577 .3599 .3621
1.1 .3643 .3665 .3686 .3708 .3729 .3749 .3770 .3790 .3810 .3830
1.2 .3849 .3869 .3888 .3907 .3925 .3944 .3962 .3980 .3997 .4015
1.3 .4032 .4049 .4066 .4082 .4099 .4115 .4131 .4147 .4162 .4177
1.4 .4192 .4207 .4222 .4236 .4251 .4265 .4279 .4292 .4306 .4319
1.5 .4332 .4345 .4357 .4370 .4382 .4394 .4406 .4418 .4429 .4441
1.6 .4452 .4463 .4474 .4484 .4495 .4505 .4515 .4525 .4535 .4545
1.7 .4554 .4564 .4573 .4582 .4591 .4599 .4608 .4616 .4625 .4633
1.8 .4641 .4649 .4656 .4664 .4671 .4678 .4686 .4693 .4699 .4706
1.9 .4713 .4719 .4726 .4732 .4738 .4744 .4750 .4756 .4761 .4767
2.0 .4772 .4778 .4783 .4788 .4793 .4798 .4803 .4808 .4812 .4817
2.1 .4821 .4826 .4830 .4834 .4838 .4842 .4846 .4850 .4854 .4857
2.2 .4861 .4864 .4868 .4871 .4875 .4878 .4881 .4884 .4887 .4890
2.3 .4893 .4896 .4898 .4901 .4904 .4906 .4909 .4911 .4913 .4916
2.4 .4918 .4920 .4922 .4925 .4927 .4929 .4931 .4932 .4934 .4936
2.5 .4938 .4940 .4941 .4943 .4945 .4946 .4948 .4949 .4951 .4952
2.6 .4953 .4955 .4956 .4957 .4959 .4960 .4961 .4962 .4963 .4964
2.7 .4965 .4966 .4967 .4968 .4969 .4970 .4971 .4972 .4973 .4974
2.8 .4974 .4975 .4976 .4977 .4977 .4978 .4979 .4979 .4980 .4981
2.9 .4981 .4982 .4982 .4983 .4984 .4984 .4985 .4985 .4986 .4986
3.0 .4987 .4987 .4987 .4988 .4988 .4989 .4989 .4989 .4990 .4990

Appendix 2 / Statistical Tables
Table A2.2 Present value of £1 to be received at time point t
Period
t 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
1 .9901 .9804 .9709 .9615 .9524 .9434 .9346 .9259 .9174 .9091 .9009 .8929
2 .9803 .9612 .9426 .9246 .9070 .8900 .8734 .8573 .8417 .8264 .8116 .7972
3 .9706 .9423 .9151 .8890 .8638 .8396 .8163 .7938 .7722 .7513 .7312 .7118
4 .9610 .9238 .8885 .8548 .8227 .7921 .7629 .7350 .7084 .6830 .6587 .6355
5 .9515 .9057 .8626 .8219 .7835 .7473 .7130 .6806 .6499 .6209 .5935 .5674
6 .9420 .8880 .8375 .7903 .7462 .7050 .6663 .6302 .5963 .5645 .5346 .5066
7 .9327 .8706 .8131 .7599 .7107 .6651 .6227 .5835 .5470 .5132 .4817 .4523
8 .9235 .8535 .7894 .7307 .6768 .6274 .5820 .5403 .5019 .4665 .4339 .4039
9 .9143 .8368 .7664 .7026 .6446 .5919 .5439 .5002 .4604 .4241 .3909 .3606
10 .9053 .8203 .7441 .6756 .6139 .5584 .5083 .4632 .4224 .3855 .3522 .3220
11 .8963 .8043 .7224 .6496 .5847 .5268 .4751 .4289 .3875 .3505 .3173 .2875
12 .8874 .7885 .7014 .6246 .5568 .4970 .4440 .3971 .3555 .3186 .2858 .2567
13 .8787 .7730 .6810 .6006 .5303 .4688 .4150 .3677 .3262 .2897 .2575 .2292
14 .8700 .7579 .6611 .5775 .5051 .4423 .3878 .3405 .2992 .2633 .2320 .2046
15 .8613 .7430 .6419 .5553 .4810 .4173 .3624 .3152 .2745 .2394 .2090 .1827
16 .8528 .7284 .6232 .5339 .4581 .3936 .3387 .2919 .2519 .2176 .1883 .1631
17 .8444 .7142 .6050 .5134 .4363 .3714 .3166 .2703 .2311 .1978 .1696 .1456
18 .8360 .7002 .5874 .4936 .4155 .3503 .2959 .2502 .2120 .1799 .1528 .1300
19 .8277 .6864 .5703 .4746 .3957 .3305 .2765 .2317 .1945 .1635 .1377 .1161
20 .8195 .6730 .5537 .4564 .3769 .3118 .2584 .2145 .1784 .1486 .1240 .1037
21 .8114 .6598 .5375 .4388 .3589 .2942 .2415 .1987 .1637 .1351 .1117 .0926
22 .8034 .6468 .5219 .4220 .3418 .2775 .2257 .1839 .1502 .1228 .1007 .0826
23 .7954 .6342 .5067 .4057 .3256 .2618 .2109 .1703 .1378 .1117 .0907 .0738
24 .7876 .6217 .4919 .3901 .3101 .2470 .1971 .1577 .1264 .1015 .0817 .0659
25 .7798 .6095 .4776 .3751 .2953 .2330 .1842 .1460 .1160 .0923 .0736 .0588
26 .7720 .5976 .4637 .3607 .2812 .2198 .1722 .1352 .1064 .0839 .0663 .0525
27 .7644 .5859 .4502 .3468 .2678 .2074 .1609 .1252 .0976 .0763 .0597 .0469
28 .7568 .5744 .4371 .3335 .2551 .1956 .1504 .1159 .0895 .0693 .0538 .0419
29 .7493 .5631 .4243 .3207 .2429 .1846 .1406 .1073 .0822 .0630 .0485 .0374
30 .7419 .5521 .4120 .3083 .2314 .1741 .1314 .0994 .0754 .0573 .0437 .0334
35 .7059 .5000 .3554 .2534 .1813 .1301 .0937 .0676 .0490 .0356 .0259 .0189
40 .6717 .4529 .3066 .2083 .1420 .0972 .0668 .0460 .0318 .0221 .0154 .0107
45 .6391 .4102 .2644 .1712 .1113 .0727 .0476 .0313 .0207 .0137 .0091 .0061
50 .6080 .3715 .2281 .1407 .0872 .0543 .0339 .0213 .0134 .0085 .0054 .0035

13% 14% 15% 16% 17% 18% 19% 20% 25% 30% 35% 40% 50%
.8850 .8772 .8696 .8621 .8547 .8475 .8403 .8333 .8000 .7692 .7407 .7143 .6667
.7831 .7695 .7561 .7432 .7305 .7182 .7062 .6944 .6400 .5917 .5487 .5102 .4444
.6931 .6750 .6575 .6407 .6244 .6086 .5934 .5787 .5120 .4552 .4064 .3644 .2963
.6133 .5921 .5718 .5523 .5337 .5158 .4987 .4823 .4096 .3501 .3011 .2603 .1975
.5428 .5194 .4972 .4761 .4561 .4371 .4190 .4019 .3277 .2693 .2230 .1859 .1317
.4803 .4556 .4323 .4104 .3898 .3704 .3521 .3349 .2621 .2072 .1652 .1328 .0878
.4251 .3996 .3759 .3538 .3332 .3139 .2959 .2791 .2097 .1594 .1224 .0949 .0585
.3762 .3506 .3269 .3050 .2848 .2660 .2487 .2326 .1678 .1226 .0906 .0678 .0390
.3329 .3075 .2843 .2630 .2434 .2255 .2090 .1938 .1342 .0943 .0671 .0484 .0260
.2946 .2697 .2472 .2267 .2080 .1911 .1756 .1615 .1074 .0725 .0497 .0346 .0173
.2607 .2366 .2149 .1954 .1778 .1619 .1476 .1346 .0859 .0558 .0368 .0247 .0116
.2307 .2076 .1869 .1685 .1520 .1372 .1240 .1122 .0687 .0429 .0273 .0176 .0077
.2042 .1821 .1625 .1452 .1299 .1163 .1042 .0935 .0550 .0330 .0202 .0126 .0051
.1807 .1597 .1413 .1252 .1110 .0985 .0876 .0779 .0440 .0254 .0150 .0090 .0034
.1599 .1401 .1229 .1079 .0949 .0835 .0736 .0649 .0352 .0195 .0111 .0064 .0023
.1415 .1229 .1069 .0930 .0811 .0708 .0618 .0541 .0281 .0150 .0082 .0046 .0015
.1252 .1078 .0929 .0802 .0693 .0600 .0520 .0451 .0225 .0116 .0061 .0033 .0010
.1108 .0946 .0808 .0691 .0592 .0508 .0437 .0376 .0180 .0089 .0045 .0023 .0007
.0981 .0829 .0703 .0596 .0506 .0431 .0367 .0313 .0144 .0068 .0033 .0017 .0005
.0868 .0728 .0611 .0514 .0443 .0365 .0308 .0261 .0115 .0053 .0025 .0012 .0003
.0768 .0638 .0531 .0443 .0370 .0309 .0259 .0217 .0092 .0040 .0018 .0009 .0002
.0680 .0560 .0462 .0382 .0316 .0262 .0218 .0181 .0074 .0031 .0014 .0006 .0001
.0601 .0491 .0402 .0329 .0270 .0222 .0183 .0151 .0059 .0024 .0010 .0004 .0001
.0532 .0431 .0349 .0284 .0231 .0188 .0154 .0126 .0047 .0018 .0007 .0003 .0001
.0471 .0378 .0304 .0245 .0197 .0160 .0129 .0105 .0038 .0014 .0006 .0002 .0000
.0417 .0331 .0264 .0211 .0169 .0135 .0109 .0087 .0030 .0011 .0004 .0002 .0000
.0369 .0291 .0230 .0182 .0144 .0115 .0091 .0073 .0024 .0008 .0003 .0001 .0000
.0326 .0255 .0200 .0157 .0123 .0097 .0077 .0061 .0019 .0006 .0002 .0001 .0000
.0289 .0224 .0174 .0135 .0105 .0082 .0064 .0051 .0015 .0005 .0002 .0001 .0000
.0256 .0196 .0151 .0116 .0090 .0070 .0054 .0042 .0012 .0004 .0001 .0000 .0000
.0139 .0102 .0075 .0055 .0041 .0030 .0023 .0017 .0004 .0001 .0000 .0000 .0000
.0075 .0053 .0037 .0026 .0019 .0013 .0010 .0007 .0001 .0000 .0000 .0000 .0000
.0041 .0027 .0019 .0013 .0009 .0006 .0004 .0003 .0000 .0000 .0000 .0000 .0000
.0022 .0014 .0009 .0006 .0004 .0003 .0002 .0001 .0000 .0000 .0000 .0000 .0000

Table A2.3 Present value of £1 per period for t periods
Period
t 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502
11 10.368 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377
12 11.255 10.575 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944
13 12.134 11.348 10.635 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235
14 13.004 12.106 11.296 10.563 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282
15 13.865 12.849 11.938 11.118 10.380 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109
16 14.718 13.578 12.561 11.652 10.838 10.106 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740
17 15.562 14.292 13.166 12.166 11.274 10.477 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.3719 8.7556 8.2014 7.7016 7.2497
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.6036 8.9501 8.3649 7.8393 7.3658
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.8181 9.1285 8.5136 7.9633 7.4694
21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.2922 8.6487 8.0751 7.5620
22 19.660 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.4424 8.7715 8.1757 7.6446
23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.5802 8.8832 8.2664 7.7184
24 21.243 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.7066 8.9847 8.3481 7.7843
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.8226 9.0770 8.4217 7.8431
26 22.795 20.121 17.887 15.983 14.375 13.003 11.826 10.810 9.9290 9.1609 8.4881 7.8957
27 23.560 20.707 18.327 16.330 14.643 13.211 11.987 10.935 10.027 9.2372 8.5478 7.9426
28 24.316 21.281 18.764 16.663 14.898 13.406 12.137 11.051 10.116 9.3066 8.6016 7.9844
29 25.066 21.844 19.188 16.984 15.141 13.591 12.278 11.158 10.198 9.3696 8.6501 8.0218
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.4269 8.6938 8.0552
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.6442 8.8552 8.1755
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.7791 8.9511 8.2438
45 36.095 29.490 24.519 20.720 17.774 15.456 13.606 12.108 10.881 9.8628 9.0079 8.2825
50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.233 10.962 9.9148 9.0417 8.3045

13% 14% 15% 16% 17% 18% 19% 20% 25% 30% 35% 40% 50%
0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 0.8000 0.7692 0.7407 0.7143 0.6667
1.6681 1.6467 1.6257 1.6052 1.5852 1.5656 1.5465 1.5278 1.4400 1.3609 1.2894 1.2245 1.1111
2.3612 2.3216 2.2832 2.2459 2.2096 2.1743 2.1399 2.1065 1.9520 1.8161 1.6959 1.5889 1.4074
2.9745 2.9137 2.8550 2.7982 2.7432 2.6901 2.6386 2.5887 2.3616 2.1662 1.9969 1.8492 1.6049
3.5172 3.4331 3.3522 3.2743 3.1993 3.1272 3.0576 2.9906 2.6893 2.4356 2.2200 2.0352 1.7366
3.9975 3.8887 3.7845 3.6847 3.5892 3.4976 3.4098 3.3255 2.9514 2.6427 2.3852 2.1680 1.8244
4.4226 4.2883 4.1604 4.0386 3.9224 3.8115 3.7057 3.6046 3.1611 2.8021 2.5075 2.2628 1.8829
4.7988 4.6389 4.4873 4.3436 4.2072 4.0776 3.9544 3.8372 3.3289 2.9247 2.5982 2.3306 1.9220
5.1317 4.9464 4.7716 4.6065 4.4506 4.3030 4.1633 4.0310 3.4631 3.0190 2.6653 2.3790 1.9480
5.4262 5.2161 5.0188 4.8332 4.6586 4.4941 4.3389 4.1925 3.5705 3.0915 2.7150 2.4136 1.9653
5.6869 5.4527 5.2337 5.0286 4.8364 4.6560 4.4865 4.3271 3.6564 3.1473 2.7519 2.4383 1.9769
5.9176 5.6603 5.4206 5.1971 4.9884 4.7932 4.6105 4.4392 3.7251 3.1903 2.7792 2.4559 1.9846
6.1218 5.8424 5.5831 5.3423 5.1183 4.9095 4.7147 4.5327 3.7801 3.2233 2.7994 2.4685 1.9897
6.3025 6.0021 5.7245 5.4675 5.2293 5.0081 4.8023 4.6106 3.8241 3.2487 2.8144 2.4775 1.9931
6.4624 6.1422 5.8474 5.5755 5.3242 5.0916 4.8759 4.6755 3.8593 3.2682 2.8255 2.4839 1.9954
6.6039 6.2651 5.9542 5.6685 5.4053 5.1624 4.9377 4.7296 3.8874 3.2832 2.8337 2.4885 1.9970
6.7291 6.3729 6.0472 5.7487 5.4746 5.2223 4.9897 4.7746 3.9099 3.2948 2.8398 2.4918 1.9980
6.8399 6.4674 6.1280 5.8178 5.5339 5.2732 5.0333 4.8122 3.9279 3.3037 2.8443 2.4941 1.9986
6.9380 6.5504 6.1982 5.8775 5.5845 5.3162 5.0700 4.8435 3.9424 3.3105 2.8476 2.4958 1.9991
7.0248 6.6231 6.2593 5.9288 5.6278 5.3527 5.1009 4.8696 3.9539 3.3158 2.8501 2.4970 1.9994
7.1016 6.6870 6.3125 5.9731 5.6648 5.3837 5.1268 4.8913 3.9631 3.3198 2.8519 2.4979 1.9996
7.1695 6.7429 6.3587 6.0113 5.6964 5.4099 5.1486 4.9094 3.9705 3.3230 2.8533 2.4985 1.9997
7.2297 6.7921 6.3988 6.0442 5.7234 5.4321 5.1668 4.9245 3.9764 3.3254 2.8543 2.4989 1.9998
7.2829 6.8351 6.4338 6.0726 5.7465 5.4509 5.1822 4.9371 3.9811 3.3272 2.8550 2.4992 1.9999
7.3300 6.8729 6.4641 6.0971 5.7662 5.4669 5.1951 4.9476 3.9849 3.3286 2.8556 2.4994 1.9999
7.3717 6.9061 6.4906 6.1182 5.7831 5.4804 5.2060 4.9563 3.9879 3.3297 2.8560 2.4996 1.9999
7.4086 6.9352 6.5135 6.1364 5.7975 5.4919 5.2151 4.9636 3.9903 3.3305 2.8563 2.4997 2.0000
7.4412 6.9607 6.5335 6.1520 5.8099 5.5016 5.2228 4.9697 3.9923 3.3312 2.8565 2.4998 2.0000
7.4701 6.9830 6.5509 6.1656 5.8204 5.5098 5.2292 4.9747 3.9938 3.3317 2.8567 2.4999 2.0000
7.4957 7.0027 6.5660 6.1772 5.8294 5.5168 5.2347 4.9789 3.9950 3.3321 2.8568 2.4999 2.0000
7.5856 7.0700 6.6166 6.2153 5.8582 5.5386 5.2512 4.9915 3.9964 3.3330 2.8571 2.5000 2.0000
7.6344 7.1050 6.6418 6.2335 5.8713 5.5482 5.2582 4.9966 3.9995 3.3332 2.8571 2.5000 2.0000
7.6609 7.1232 6.6543 6.2421 5.8773 5.5523 5.2611 4.9986 3.9998 3.3333 2.8571 2.5000 2.0000
7.6752 7.1327 6.6605 6.2463 5.8801 5.5541 5.2623 4.9995 3.9999 3.3333 2.8571 2.5000 2.0000

Table A2.4 Future value of £1 t periods hence

(1 + i)t
Period
t 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 1.0900 1.1000 1.1100 1.1200
2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.2100 1.2321 1.2544
3 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250 1.2597 1.2950 1.3310 1.3676 1.4049
4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4116 1.4641 1.5181 1.5735
5 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.5386 1.6105 1.6851 1.7623
6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.6771 1.7716 1.8704 1.9738
7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.8280 1.9487 2.0762 2.2107
8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 1.9926 2.1436 2.3045 2.4760
9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.9990 2.1719 2.3579 2.5580 2.7731
10 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.3674 2.5937 2.8394 3.1058
11 1.1157 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.5804 2.8531 3.1518 3.4785
12 1.1268 1.2682 1.4258 1.6010 1.7959 2.0122 2.2522 2.5182 2.8127 3.1384 3.4985 3.8960
13 1.1381 1.2936 1.4685 1.6651 1.8856 2.1329 2.4098 2.7196 3.0658 3.4523 3.8833 4.3635
14 1.1495 1.3195 1.5126 1.7317 1.9799 2.2609 2.5785 2.9372 3.3417 3.7975 4.3104 4.8871
15 1.1610 1.3459 1.5580 1.8009 2.0789 2.3966 2.7590 3.1722 3.6425 4.1772 4.7846 5.4736
16 1.1726 1.3728 1.6047 1.8730 2.1829 2.5404 2.9522 3.4259 3.9703 4.5950 5.3109 6.1304
17 1.1843 1.4002 1.6528 1.9479 2.2920 2.6928 3.1588 3.7000 4.3276 5.0545 5.8951 6.8660
18 1.1961 1.4282 1.7024 2.0258 2.4066 2.8543 3.3799 3.9960 4.7171 5.5599 6.5436 7.6900
19 1.2081 1.4568 1.7535 2.1068 2.5270 3.0256 3.6165 4.3157 5.1471 6.1159 7.2633 8.6128
20 1.2202 1.4859 1.8061 2.1911 2.6533 3.2071 3.8697 4.6610 5.6044 6.7275 8.0623 9.6463
21 1.2324 1.5157 1.8603 2.2788 2.7860 3.3996 4.1406 5.0338 6.1088 7.4002 8.9492 10.804
22 1.2447 1.5460 1.9161 2.3699 2.9253 3.6035 4.4304 5.4365 6.6586 8.1403 9.9336 12.100
23 1.2572 1.5769 1.9736 2.4647 3.0715 3.8197 4.7405 5.8715 7.2579 8.9543 11.026 13.552
24 1.2697 1.6084 2.0328 2.5633 3.2251 4.0489 5.0724 6.3412 7.9111 9.8497 12.239 15.179
25 1.2824 1.6406 2.0938 2.6658 3.3864 4.2919 5.4274 6.8485 8.6231 10.835 13.585 17.000
26 1.2953 1.6734 2.1566 2.7725 3.5557 4.5494 5.8074 7.3964 9.3992 11.918 15.080 19.040
27 1.3082 1.7069 2.2213 2.8834 3.7335 4.8223 6.2139 7.9881 10.245 13.110 16.739 21.325
28 1.3213 1.7410 2.2879 2.9987 3.9201 5.1117 6.6488 8.6271 11.167 14.421 18.580 23.884
29 1.3345 1.7758 2.3566 3.1187 4.1161 5.4184 7.1143 9.3173 12.172 15.863 20.624 26.750
30 1.3478 1.8114 2.4273 3.2434 4.3219 5.7435 7.6123 10.063 13.268 17.449 22.892 29.960
35 1.4166 1.9999 2.8139 3.9461 5.5160 7.6861 10.677 14.785 20.414 28.102 38.575 52.800
40 1.4889 2.2080 3.2620 4.8010 7.0400 10.286 14.974 21.725 31.409 45.259 65.001 93.051
45 1.5648 2.4379 3.7816 5.8412 8.9850 13.765 21.002 31.920 48.327 72.890 109.53 163.99
50 1.6446 2.6916 4.3839 7.1067 11.467 18.420 29.457 46.902 74.358 117.39 184.56 289.00

13% 14% 15% 16% 17% 18% 19% 20% 25% 30% 35% 40% 50%
1.1300 1.1400 1.1500 1.1600 1.1700 1.1800 1.1900 1.2000 1.2500 1.3000 1.3500 1.4000 1.5000
1.2769 1.2996 1.3225 1.3456 1.3689 1.3924 1.4161 1.4400 1.5625 1.6900 1.8225 1.9600 2.2500
1.4429 1.4815 1.5209 1.5609 1.6016 1.6430 1.6852 1.7280 1.9531 2.1970 2.4604 2.7440 3.3750
1.6305 1.6890 1.7490 1.8106 1.8739 1.9388 2.0053 2.0736 2.4414 2.8561 3.3215 3.8416 5.0625
1.8424 1.9254 2.0114 2.1003 2.1924 2.2878 2.3864 2.4883 3.0518 3.7129 4.4840 5.3782 7.5938
2.0820 2.1950 2.3131 2.4364 2.5652 2.6996 2.8398 2.9860 3.8147 4.8268 6.0534 7.5295 11.391
2.3526 2.5023 2.6600 2.8262 3.0012 3.1855 3.3793 3.5832 4.7684 6.2749 8.1722 10.541 17.086
2.6584 2.8526 3.0590 3.2784 3.5115 3.7589 4.0214 4.2998 5.9605 8.1573 11.032 14.758 25.629
3.0040 3.2519 3.5179 3.8030 4.1084 4.4355 5.7854 5.1598 7.4506 10.604 14.894 20.661 38.443
3.3946 3.7072 4.0456 4.4114 4.8086 5.2338 5.6947 6.1917 9.3132 13.786 20.107 28.925 57.665
3.8359 4.2262 4.6524 5.1173 5.6240 6.1759 6.7767 7.4301 11.642 17.922 27.144 40.496 86.498
4.3345 4.8179 5.3503 5.9360 6.5801 7.2876 8.0642 8.9161 14.552 23.298 36.644 56.694 129.75
4.8980 5.4924 6.1528 6.8858 7.6987 8.5994 9.5964 10.699 18.190 30.288 49.470 79.371 194.62
5.5348 6.2613 7.0757 7.9875 9.0075 10.147 11.420 12.839 22.737 39.374 66.784 111.12 291.93
6.2543 7.1379 8.1371 9.2655 10.539 11.974 13.590 15.407 28.422 51.186 90.158 155.57 437.89
7.0673 8.1372 9.3576 10.748 12.330 14.129 16.172 18.488 35.527 66.542 121.71 217.80 656.84
7.9861 9.2765 10.761 12.468 14.426 16.672 19.244 22.186 44.409 86.504 164.31 304.91 985.26
9.0243 10.575 12.375 14.463 16.879 19.673 22.901 26.623 55.511 112.46 221.82 426.88 1477.9
10.197 12.056 14.232 16.777 19.748 23.214 27.252 31.948 69.389 146.19 299.46 597.63 2216.8
11.523 13.743 16.367 19.461 23.106 27.393 32.429 38.338 86.736 190.05 404.27 836.68 3325.3
13.021 15.668 18.822 22.574 27.034 32.324 38.591 46.005 108.42 247.06 545.77 1171.4 4987.9
14.714 17.861 21.645 26.186 31.629 38.142 45.923 55.206 135.53 321.18 736.79 1639.9 7481.8
16.627 20.362 24.891 30.376 37.006 45.008 54.649 66.247 169.41 417.54 994.66 2295.9 11223.
18.788 23.212 28.625 35.236 43.297 53.109 65.032 79.497 211.76 542.80 1342.8 3214.2 16834.
21.231 26.462 32.919 40.874 50.658 62.669 77.388 95.396 264.70 705.64 1812.8 4499.9 25251.
23.991 30.167 37.857 47.414 59.270 73.949 92.092 114.48 330.87 917.33 2447.2 6299.8 37877.
27.109 34.390 43.535 55.000 69.345 87.260 109.59 137.37 413.59 1192.5 3308.8 8819.8 56815.
30.633 39.204 50.066 63.800 81.134 102.97 130.41 164.84 516.99 1550.3 4460.1 12348. 85223.
34.616 44.693 57.575 74.009 94.927 121.50 155.19 197.81 646.23 2015.4 6021.1 17287. *
39.116 50.950 66.212 85.850 111.06 143.37 184.68 237.38 807.79 2620.0 8128.5 24201. *
72.069 98.100 133.18 180.31 243.50 328.00 440.70 590.67 2465.2 9727.9 36449 * *
132.78 188.88 267.86 378.72 533.87 750.38 1051.7 1469.8 7523.2 36119. * * *
244.64 363.68 538.77 795.44 1170.5 1716.7 2509.7 3657.3 22959. * * * *
450.74 700.23 1083.7 1670.7 2566.2 3927.4 5988.9 9100.4 70065. * * * *
* Interest factors exceed 99999.

Table A2.5 Future value of £1 per period for t periods
Period
t 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
1 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
2 2.0100 2.0200 2.0300 2.0400 2.0500 2.0600 2.0700 2.0800 2.0900 2.1000 2.1100 2.1200
3 3.0301 3.0604 3.0909 3.1216 3.1525 3.1836 3.2149 3.2464 3.2781 3.3100 3.3421 3.3744
4 4.0604 4.1216 4.1836 4.2465 4.3101 4.3746 4.4399 4.5061 4.5731 4.6410 4.7097 4.7793
5 5.1010 5.2040 5.3091 5.4163 5.5256 5.6371 5.7507 5.8666 5.9847 6.1051 6.2278 6.3528
6 6.1520 6.3081 6.4684 6.6330 6.8019 6.9753 7.1533 7.3359 7.5233 7.7156 7.9129 8.1152
7 7.2135 7.4343 7.6625 7.8983 8.1420 8.3938 8.6540 8.9228 9.2004 9.4872 9.7833 10.089
8 8.2857 8.5830 8.8923 9.2142 9.5491 9.8975 10.260 10.637 11.028 11.436 11.859 12.300
9 9.3685 9.7546 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579 14.164 14.776
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937 16.722 17.549
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531 19.561 20.655
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384 22.713 24.133
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523 26.212 28.029
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975 30.095 32.393
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772 34.405 37.280
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950 39.190 42.753
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545 44.501 48.884
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599 50.396 55.750
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159 56.939 63.440
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275 64.203 72.052
21 23.239 25.783 28.676 31.969 35.719 39.993 44.865 50.423 56.765 64.002 72.265 81.699
22 24.472 27.299 30.537 34.248 38.505 43.392 49.006 55.457 62.873 71.403 81.214 92.503
23 25.716 28.845 32.453 36.618 41.430 46.996 53.436 60.893 69.532 79.543 91.148 104.60
24 26.973 30.422 34.426 39.083 44.502 50.816 58.177 66.765 76.790 88.497 102.17 118.16
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347 114.41 133.33
26 29.526 33.671 38.553 44.312 51.113 59.156 68.676 79.954 93.324 109.18 128.00 150.33
27 30.821 35.344 40.710 47.084 54.669 63.706 74.484 87.351 102.72 121.10 143.08 169.37
28 32.129 37.051 42.931 49.968 58.403 68.528 80.698 95.339 112.97 134.21 159.82 190.70
29 33.450 38.792 45.219 52.966 62.323 73.640 87.347 103.97 124.14 148.63 178.40 214.58
30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.28 136.31 164.49 199.02 241.33
35 41.660 49.994 60.462 73.652 90.320 111.43 138.24 172.32 215.71 271.02 341.59 431.66
40 48.886 60.402 75.401 95.026 120.80 154.76 199.64 259.06 337.88 442.59 581.83 767.09
45 56.481 71.893 92.720 121.03 159.70 212.74 285.75 386.51 525.86 718.90 986.64 1358.2
50 64.463 84.579 112.80 152.67 209.35 290.34 406.53 573.77 815.08 1163.9 1668.8 2400.0

13% 14% 15% 16% 17% 18% 19% 20% 25% 30% 35% 40% 50%
1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
2.1300 2.1400 2.1500 2.1600 2.1700 2.1800 2.1900 2.2000 2.2500 2.3000 2.3500 2.4000 2.5000
3.4069 3.4396 3.4725 3.5056 3.5389 3.5724 3.6061 3.6400 3.8125 3.9900 4.1725 4.3600 4.7500
4.8498 4.9211 4.9934 5.0665 5.1405 5.2154 5.2913 5.3680 5.7656 6.1870 6.6329 7.1040 8.1250
6.4803 6.6101 6.7424 6.8771 7.0144 7.1542 7.2966 7.4416 8.2070 9.0431 9.9544 10.946 13.188
8.3227 8.5355 8.7537 8.9775 9.2068 9.4420 9.6830 9.9299 11.259 12.756 14.438 16.324 20.781
10.405 10.730 11.067 11.414 11.772 12.142 12.523 12.916 15.073 17.583 20.492 23.853 32.172
12.757 13.233 13.727 14.240 14.773 15.327 15.902 16.499 19.842 23.858 28.664 34.395 49.258
15.416 16.085 16.786 17.519 18.285 19.086 19.923 20.799 25.802 32.015 39.696 49.153 74.887
18.420 19.337 20.304 21.321 22.393 23.521 24.709 25.959 33.253 42.619 54.590 69.814 113.33
21.814 23.045 24.349 25.733 27.200 28.755 30.404 32.150 42.566 56.405 74.697 98.739 171.00
25.650 27.271 29.002 30.850 32.824 34.931 37.180 39.581 54.208 74.327 101.84 139.23 257.49
29.985 32.089 34.352 36.786 39.404 42.219 45.244 48.497 68.760 97.625 138.48 195.93 387.24
34.883 37.581 40.505 43.672 47.103 50.818 54.841 59.196 86.949 127.91 187.95 275.30 581.86
40.417 43.842 47.580 51.660 56.110 60.965 66.261 72.035 109.69 167.29 254.74 386.42 873.79
46.672 50.980 55.717 60.925 66.649 72.939 79.850 87.442 138.11 218.47 344.90 541.99 1311.7
53.739 59.118 65.075 71.673 78.979 87.068 96.022 105.93 173.64 285.01 466.61 759.78 1968.5
61.725 68.394 75.836 84.141 93.406 103.74 115.27 128.12 218.04 371.52 630.92 1064.7 2953.8
70.749 78.969 88.212 98.603 110.28 123.41 138.17 154.74 273.56 483.97 852.75 1491.6 4431.7
80.947 91.025 102.44 115.38 130.03 146.63 165.42 186.69 342.94 630.17 1152.2 2089.2 6648.5
92.470 104.77 118.81 134.84 153.14 174.02 197.85 225.03 429.68 820.22 1556.5 2925.9 9973.8
105.49 120.44 137.63 157.41 180.17 206.34 236.44 271.03 538.10 1067.3 2102.3 4097.2 14962.
120.20 138.30 159.28 183.60 211.80 244.49 282.36 326.24 673.63 1388.5 2839.0 5737.1 22443.
136.83 158.66 184.17 213.98 248.81 289.49 337.01 392.48 843.03 1806.0 3833.7 8033.0 33666.
155.62 181.87 212.79 249.21 292.10 342.60 402.04 471.98 1054.8 2348.8 5176.5 11247. 50500.
176.85 208.33 245.71 290.09 342.76 405.27 479.43 567.38 1319.5 3054.4 6989.3 15757. 75752.
200.84 238.50 283.57 337.50 402.03 479.22 571.52 681.85 1650.4 3971.8 9436.5 22057. *
227.95 272.89 327.10 392.50 471.38 566.48 681.11 819.22 2064.0 5164.3 12740. 30867. *
258.58 312.09 377.17 456.30 552.51 669.45 811.52 984.07 2580.9 6714.6 17200. 43214. *
293.20 356.79 434.75 530.31 647.44 790.95 966.71 1181.9 3227.2 8730.0 23222. 60501. *
546.68 693.57 881.17 1120.7 1426.5 1816.7 2314.2 2948.3 9856.8 32423. * * *
1013.7 1342.0 1779.1 2360.8 3134.5 4163.2 5529.8 7343.9 30089. * * * *
1874.2 2590.6 3585.1 4965.3 6879.3 9531.6 13203. 18281. 91831. * * * *
3459.5 4994.5 7217.7 10436. 15090. 21813. 31515. 45497. * * * * *
* Interest factors exceed 99999.

Appendix 3
Formula Sheet for Financial Risk

Management
Contents
1. Compounding and Discounting ...................................................................3/1
2. Expected Value ..............................................................................................3/2
3. Capital Asset Pricing Model (CAPM) and Arbitrage
Pricing Theory (APT) .............................................................................3/2
4. Currency Relationships .................................................................................3/3
5. Statistical Measures.......................................................................................3/3
6. Portfolio Model ..............................................................................................3/4
7. Measures of Forecasting Accuracy ..............................................................3/4
1. Compounding and Discounting
Compounding factor (future value of an interest factor r% for time t):

FVIF%, 1
Discount factor (present value of an interest factor r% for time t):

PVIF%,
Future annuity factor (future value of an annuity factor for r% for n periods):
FVIFA%,
Present annuity factor (present value of an annuity factor for r% for n

periods):
PVAF%,
Net present value (NPV) of a project:
NPV ∑

Appendix 3 / Formula Sheet for Financial Risk Management
Value of the firm:
V ∑
Dividend discount model for the share price (S0):
Real interest rate:

1 1 1 expected inflation
Spot or zero-coupon rates (Zi) derived from the par yield curve:
1
∑
2. Expected Value
E V ∑
3. Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory

(APT)
CAPM:
Capital structure on firm beta (β):
Leveraged beta (β):
1 1
Total risk of shares:

APT:
⋯
4. Currency Relationships
Interest rate parity:

⁄
⁄
Purchasing power parity:

⁄
⁄
Expectations theory:
⁄ ⁄
⁄ ⁄ ⁄ ⁄
⁄ ⁄
International Fisher effect:

⁄ ⁄
⁄
5. Statistical Measures
Mean ( or μ):
∑
Standard deviation (σ):
Kurtosis (K):
Skewness (S):

Covariance (σab):
∑ , , ,
Correlation (ρab):
6. Portfolio Model
Portfolio expected return (ρp):
1.0 ∑
Portfolio risk σp for two-asset portfolio:

2
Portfolio risk ρp for m-asset portfolio:

∑ ∑ ∑
Minimum variance portfolio weights for two-asset portfolio:

∗ ,
,
7. Measures of Forecasting Accuracy
Mean absolute error (MAE):

∑ | |
MAE
Mean absolute percentage error (MAPE):

∑
MAPE
Mean squared error (MSE):

∑
MSE

Root mean squared error (RMSE):
∑
RMSE
Forecast skill (FS):

FS 1
Directional accuracy (DA):

. .
DA 100%
.
Sharpe ratio:

Appendix 4
Answers to Review Questions

Contents
Module 1 .............................................................................................................4/1
Module 2 .............................................................................................................4/5
Module 3 .......................................................................................................... 4/11
Module 4 .......................................................................................................... 4/17
Module 5 .......................................................................................................... 4/28
Module 6 .......................................................................................................... 4/33
Module 7 .......................................................................................................... 4/38
Module 8 .......................................................................................................... 4/45
Module 9 .......................................................................................................... 4/52
Module 10 ........................................................................................................ 4/62
Module 11 ........................................................................................................ 4/70
Module 1
Review Questions

1.1 The correct answer is B. By definition the unpredictable is not predictable. Nor is
the unexpected. Risk is about change in the world and the interaction of events
upon one another that we can anticipate but not predict.
1.2 The correct answer is D. The whole firm is responsible for risk management. The
managing director will have a major supervising role. It is generally the case that the
financial function will have responsibility for financial risk management. The firm’s
advisers may be called upon to assist in devising policies, strategies and procedures
to implement decisions.
1.3 The correct answer is B. It is impossible to eliminate all risks. Eliminating
unacceptable risks may be desirable – but unachievable or too costly. Managing risks
is more proactive than just monitoring risks and taking action as required; it involves
making risk acceptable and choosing between alternatives.
1.4 The correct answer is D. All of the above can help to explain the greater importance
of risk management processes within firms.
1.5 The correct answer is C. Both increases and decreases can be observed. The
direction of the effect will depend on whether the currency appreciates (making

Appendix 4 / Answers to Review Questions
foreigners pay more for the product or service) or depreciates (allowing buyers to
pay less).
1.6 The correct answer is B. Lenders have generally reacted to uncertainty by refusing to
make long-term fixed lending commitments because, as a result, they assume too
much interest rate risk. For borrowers and savers, depending on the period ana-
lysed, the cost of borrowing might be higher, but then again it might not be. It
depends on the period over which the average is measured. The same is true of
volatility. If we are comparing the Bretton Woods and post-Bretton Woods periods,
certainly this is true. But volatility is merely a measure of how much interest rates
deviate from some average; it is not a consequence but a measure of uncertainty.
1.7 The correct answer is D. Firms react to increases in interest rate risk by doing all of
A to C. A higher hurdle rate will provide a greater cushion on future cash flows,
which can be used to service debt. Equally a shorter payback period means that
borrowings can be repaid at an earlier date, and devoting more resources to manag-
ing risk can mitigate its effects (via hedging, etc.).
1.8 The correct answer is A. Over-the-counter markets in risk management products
have liquidity problems due to the nature of the bilateral contract between the buyer
and seller, which creates counterparty credit risk. Exchange-traded instruments get
around this and therefore do open the market in financial risk management prod-
ucts to all users, corporate or individual, regardless of their credit risk. The
exchanges did not provide any new instruments, as options on stocks and forward
contracts on currencies and interest rates already existed. There was no requirement
to trade risk management products on an organised exchange, although it might
have been desirable to do so.
1.9 The correct answer is D. The building blocks for financial engineers to devise
corporate solutions include derivative instruments such as forward contracts,
futures, swaps and options but may also include cash securities. Creating new types
of securities may form part of the solution to helping firms manage risk – as would
the ability to split risks into their constituent parts, but the financial engineer first
and foremost helps firms by designing special hedge programmes to manage their
risks.
1.10 The correct answer is D. All the above have been used as definitions for risk. Risk
has two basic components: uncertainty concerning future outcomes and the chance
of loss. Beyond that, no two authors can quite agree on how to define risk. Risk may
be only the potential for losses, as suggested by answer A under conditions of
uncertainty. It can also be an outcome other than the one expected or the unintend-
ed consequence of a course of action, decision or policy as proposed in B, or, to use
the terminology of probability theory, it is the deviation or dispersion from an
expected or anticipated result, as C suggests.
1.11 The correct answer is B. Whereas it is generally accepted that risks can be measured,
if somewhat inaccurately, it is only possible to establish that uncertain conditions
exist. It is not possible to establish parameters or bounds for the outcomes when
facing uncertainty.

1.12 The correct answer is A. In an uncertain situation, the main parameters are known
but not measurable, whereas in an indeterminate situation, the causation is un-
known.
1.13 The correct answer is D. The correct cost–benefit approach to risk involves
measuring the benefits to be gained from assuming a risk against the potential losses
according to predetermined criteria prior to a decision being made whether to
assume the risk, this decision being based on the results of the analysis.
1.14 The correct answer is A. Individuals and organisations are risk averse and the pain
of loss outweighs the pleasure of gain. People feel the loss of £1 more than the gain
of £1. This concept is embodied in the value of wealth, or utility, which is used to
measure people’s attitudes to risk.
1.15 The correct answer is A. Price risk, also known as market risk, is that the price of an
asset, security or other instrument will change over time. Price risk includes the
buyer’s and the seller’s risk. The direction of the risk will be different for buyer and
seller: if market prices fall, that is good news for buyers, bad news for sellers – and
vice versa if prices rise.
1.16 The correct answer is C. Liquidity risk is one type of market-related risk. It is
generally considered to be the problem of not being able to execute a transaction in
a timely manner at a price close to the current market price. The longer the transac-
tion’s execution is delayed, the more the market price may change in the meantime.
Note that liquidity risk can also be applied to a firm’s ability to meet maturing
obligations as they fall due or to raise money as required (this last is also called
funding risk). Some writers make a clear distinction between market liquidity risk
and firm-specific liquidity risk.
1.17 The correct answer is D. A risk profile is a graphical representation of the effects of
an exposure to a given risk (or risk factor) in a given situation. The horizontal axis
shows the changes in the risk whereas the vertical axis records the potential gains
and losses from being exposed. The slope provides a measure of the sensitivity of
the position.
1.18 The correct answer is A. Exposure measures the materiality of a risk. It is
determined by the risk or the risk factor times the amount at risk. The result is often
referred to as the ‘value at risk’.
1.19 The correct answer is B. Speculation is deliberately taking on risks with a view to
making a profit.
1.20 The correct answer is D. All the methods are used to manage risk. Selling the risk to
another party is the insurance approach; entering into transactions with the opposite
risk to the current risk is hedging; and following policies that seek to take risk into
account is risk reduction and management.
1.21 The correct answer is D. Transaction exposure arises whenever a company enters
into an agreement to buy or sell a product or service where the actual payment (or
cash flow) is deferred. Although companies report purchases and sales in their
accounts, both in the firm’s books and ledgers and – in aggregate – in their income
statements and balance sheets, it is the element of deferral that creates the risk.

1.22 The correct answer is D. All of A, B and C lead to contingent exposures. A promise
to do business with the firm in the future is not usually enforceable in law. Some, or
all, of the future cash flows from expected sales may not materialise if conditions
suddenly change. In bidding or tendering for future business, a firm cannot auto-
matically expect to be successful. The cash flows are ‘contingent’ upon some event
or a series of events occurring.
1.23 The correct answer is D. Economic risk arises from changes in market risk factors,
such as exchange rates. The degree of exposure will be related to management
decisions on products, manufacturing processes, etc. Changes in interest rates,
exchange rates and commodity prices will have an impact on firms’ future cash
flows, as will the actions of competing firms. A firm’s financial statements are
reports and show the results of economic risk in a given reporting period.
1.24 The correct answer is A. In pure insurance, an individual or firm will pool a risk (for
instance, the chance of a house burning down) via an insurance company acting as
intermediary. The insurance company is better able to accept the risk since the sum
of the premiums or sums paid by the insured is set so that this is more than the
losses that will be sustained in any given time period. The insurance company is
usually able to take on these risks if the individual losses are not correlated and
when large numbers of insured are involved. The financial strength of the insurance
company acts to absorb the losses. Action to offset one risk with another is known
as hedging. Changing a firm’s operations to reduce the risk is known as operational
hedging.
1.25 The correct answer is C. Operational hedging consists of those activities that firms
use to hedge (that is, match one risk with another) their exposures. Thus a firm with
an inflow of foreign currency might borrow in that currency, the receivables in the
foreign currency thus being matched to the payables on the loan.
1.26 The correct answer is D. Firms use all the information they have to hand to manage
risk.
1.27 The correct answer is B. Lack of data for analysis is a common problem in risk
assessment, and qualitative approaches can be used to get round the problem, but it
should not affect the identification of risks. The identification stage involves finding
out what risks the firm is facing, and for this to be complete all the risks the firm has
should be included. Including factors that might not be risks is preferable to leaving
them out, since we want a complete picture of the risks. They can always be
removed from the list at a later stage. Ignoring risks because they are seen as
unimportant is, therefore, a major difficulty. This is because the firm’s perception of
these risks may be distorted. As a result, while these risks are taken as unimportant,
there may be important risks that are excluded from the analysis. This can mean the
analysis is less complete or objective than it otherwise might be.
1.28 The correct answer is D. A properly conceived risk management programme will
manage the sum of all the risks, taking into account any natural, internally generated
offsets and, of the risks, those that exceed a given exposure.

Case Study 1.1: Attitudes to Risk

1 Risk is not the same for everyone. As mentioned in the module, people are risk
averse, risk neutral or risk takers (risk seekers).
The children will delight in the opportunity to play on the ice. For them, ice is fun
and something to be enjoyed. They would want to experiment with it and get a buzz
out of sliding about and falling down. They are unlikely to hurt themselves much. In
this context, they are risk seekers.
Their parents probably see the ice as a passable obstacle: certainly if the children
wanted to cross it they would go too, but taking care in doing so. Unless properly
equipped with skates, etc., it is unlikely they would sport on it. In this context, they
can be seen as risk neutral.
The grandparents would see the ice as a significant hazard. The consequences of a
fall – which would be highly probable given their age – would be horrific, leading to
broken bones, or worse. Even with help they would be unlikely to agree to venture
out onto the ice unless they absolutely had to. They would only willingly go across
the ice if the alternative was even worse. In this context, they are risk averse.
The important observation here is the one objective phenomenon but different
attitudes of the parties. The example clearly demonstrates that risk is not the same
for everyone; it depends on the context and who is facing the risk.
For an informative, detailed discussion of the cultural context of risk, from which
the above example derives, look at John Adams (1995) Risk. London: UCL Press.
This is a highly recommended introduction to the behavioural aspects of risk.
Module 2
Review Questions

2.1 The correct answer is D. When applied to the firm, risk management is used by
managers to enhance existing core activities, to eliminate risks from peripheral
activities and to gain strategic advantage.
2.2 The correct answer is B. Economically speaking, the value of a firm’s assets will be
the same as that of its liabilities. This is because the liabilities derive their value from
the future cash flows or ‘earning power’ of the firm’s assets. If the firm were to be
sold, it would be sold for its economic value (in financial terms, this is the present
value of its future cash flows), and the owners of the liabilities would get this
amount and no more. Accounting numbers are not the same as economic values,
since they largely reflect historical prices and firms are sold for values that are
significantly different from their book or accounting value. To obtain economic
values, the financial approach is to look at the market value of the firm’s liabilities,
as in a competitive market the value of the firm’s liabilities will be close to the
economic value of the firm.

2.3 The correct answer is C. Financial risk management is a set of methods for
controlling a firm’s exposure to different (financial) risks. It therefore cannot be
used to correct discrepancies in a firm’s financial statements. Nor can it guarantee
the firm will make a profit. On the other hand, it can be used to reduce – over a
given time horizon – the firm’s sensitivity to a level that is acceptable to manage-
ment by reducing the firm’s exposure to risk.
2.4 The correct answer is D. Risk management, at the level of the firm, is concerned
with the future variability of the firm’s cash flows and managing that variability to
create value or, at a minimum, to protect value.
2.5 The correct answer is C. A risk profile, often prepared as a diagram, shows the
relationship between a position (for instance the value of a company, the value of a
share, the value of a receivable and payable in one currency) to the underlying risk.
It is not B, since an exposure is the amount at risk from changes in the underlying
risk. Sensitivity is the degree of slope, the rate of change in the value of the position,
to changes in the risk factor.
2.6 The correct answer is D. Borrowing in a foreign currency, sourcing materials and
semi-processed goods abroad and diversifying the firm’s product line can be used as
operational hedges. Decisions that manage risks and are made as part of the firm’s
business and funding strategy are generally operational hedges. Buying options,
which are financial instruments, is therefore not an operational hedge: it is a
financial hedge.
2.7 The correct answer is D. In applying strategic risk management, a firm will pursue
all the alternatives, A, B and C. By being flexible in its sourcing policy, it can seek to
acquire inputs at least cost to itself. By diversifying product and markets, it leaves
itself less exposed to one particular economy and its prospects and the external
value of the currency. By pursuing an active programme of product innovation and
diversification, the company seeks to make its products less price sensitive.
2.8 The correct answer is D. To be mutually offsetting, the value of a firm’s liabilities
(whether an increase or decrease) must respond in a similar fashion to the firm’s
assets. Hence, if interest rates rise, this depresses the price of assets with future fixed
cash flows; to be offsetting we would expect the value of the firm’s liabilities also to
fall. That is, they both have the same directional sensitivity to changes in interest
rates. This might not be the case, however, if the liabilities were floating rate; that is,
the interest rate paid on the debt was reset in line with changing interest rate levels.
In this case, the two would not be mutually offsetting.
2.9 The correct answer is C. Transaction risk arises from the time delay between the
moment a transaction is contracted and the actual moment the cash is received or
disbursed. Hence it is reflected in the fact that firms have payables and receivables,
which are accounting entries for contracts where the company owes or is due
money in the future. It can arise from the firm’s daily activities, but – if the firm is
being paid or pays cash, as is the case with a supermarket – it may not have any
transaction risk. Note that a firm such as a supermarket will still have other kinds of
operational risks (for instance, theft, fraud, etc.).
2.10 The correct answer is D. In an efficient market, the value at which the firm can be
purchased is equal to the discounted value of the (expected) future cash flows. The

value of such future cash flows will be the market price of the firm’s debt and
equity.
2.11 The correct answer is A. Firms benefit from managing risk when they must pay
taxes, since they may be able to reduce or defer these. They are also less likely to go
bankrupt (or get into financial distress) if they manage the future variability of their
cash flows. Also, managers do have better information about the future prospects of
the firm than outside providers of finance. In this case, by managing financial risks
they can reassure outside financial providers of the stability of the business. Howev-
er, there is no reason that differences about future strategy between the firm’s
managers and shareholders can be resolved by the firm implementing risk manage-
ment policies.
2.12 The correct answer is D. Modern portfolio theory proposes that the unsystematic or
firm-specific risks can be eliminated by portfolio diversification. In that case, actions
by managers to control unsystematic risks will have no effect on the firm’s value.
The other actions will. Therefore, D is the correct answer. All else being equal,
increasing the expected cash flows raises the present value of those cash flows.
Reducing the required discount rate on investments will also raise their present
value. Modifying and eliminating risks within the firm means it is less likely to
become financially distressed. This will also raise the present value of the firm.
2.13 The correct answer is D. The two main arguments for applying financial risk
management when firms pay taxes are (1) to take advantage of available tax shields
and (2) to avoid paying higher rates of taxes. This may mean fixing profits in any
one period to be sure of benefiting from existing tax allowances and other tax
offsets, avoiding paying taxes in higher bands, as well as being able to defer the
crystallisation of a tax liability.
2.14 The correct answer is B. By implementing risk management, managers can constrain
their own future behaviour to avoid exploiting lenders. While risk management may
be useful in addressing the divergence of interest between managers and sharehold-
ers and may also be useful in addressing disputes between shareholders and lenders,
these are only occasional and incidental benefits. Risk management programmes are
not put in place specifically to address these problems of corporate governance.
2.15 The correct answer is B. In seeking to control the situation where shareholders, with
a relatively small investment, use lenders’ money to engage in riskier projects,
lenders either do not lend at all or, if they do, will require a higher rate of return to
compensate them for taking on this risk. In addition they may require the firm to
undertake risk management and other specific actions to mitigate the risk. While
they may want shareholders to undertake lower-risk projects, they cannot force
them to do so. They can only make it more difficult for shareholders to take risks.
2.16 The correct answer is A. By managing the volatility of future cash flows, firms seek
to avoid the inherent difficulties of raising funds in times of adversity. Fixing future
cash flows also facilitates the budgetary process by matching up the known income
to expenditures. It also allows firms to separate decisions about when to raise funds
from those about whether to proceed on projects.
2.17 The correct answer is D. Firms can sell the risk to another party, as when they take
out insurance. Hedging involves the firm in entering into transactions that have the

opposite sensitivity to the current, underlying risk, and – at the operational level –
the firm may pursue policies that seek to minimise or control risks.
2.18 The correct answer is B. Deciding on policy, in a properly managed firm, is the
collective responsibility of the firm’s board of directors. The chief executive and the
chief financial officer will have an input as to what the firm’s risk policy will be and
certainly will be in charge of devising operational procedures to implement the
board’s directives.
2.19 The correct answer is B. Firms will seek to accept risks in areas where they can
manage those risks. If they have no choice, then they may take on risks that they
would prefer not to. Just because they have experience of a particular type of risk
does not mean they would want to take such risks in the future. They are unlikely to
be guided in their choice by their shareholders, who are unlikely to have as good an
understanding of the firm as its management.
2.20 The correct answer is B. Financial distress is costly if value is lost through the need
to reorganise the firm in ways that destroy value. This will arise if sales – and hence
revenues – depend on the continued existence of the firm and cannot be easily
transferred to a new entity. Customers will be wary of buying if they become
concerned that the firm will not be around to honour service guarantees and so on.
Value will also be lost if the firm uses specialised equipment for which there is no
alternative use: the greater the degree of asset specificity, the more sunk value in the
current business. To the extent that workers are specifically trained or acquire firm-
specific skills, such unrealisable investments are likely to be lost if the firm ceases to
exist. Lastly, in conditions where the firm has few customers and suppliers, value
will be transferred away from the company to these powerful groups.
2.21 The correct answer is D. By undertaking risk management activity, firms aim to
reduce the probability that future cash flows will be less than those required to
service the firm’s fixed liabilities.
2.22 The correct answer is A. By managing risk, the firm can reduce the chances (or
probability) of becoming financially distressed. It can also gain by being able to use
tax allowances against profits, which, if it made losses, might be otherwise deferred
– or possibly lost altogether. If earnings are smoothed by the firm managing the
volatility of future cash flows (or reported profits), outside providers of finance are
likely to have more confidence in the financial conditions of the firm – and its
management – and to accord it a higher credit standing. This means such a firm will
pay less for externally raised funds.
2.23 The correct answer is B. By controlling the variability of its future cash flows, the
firm can increase its expected cash flows and, at the same time, reduce its risk.
2.24 The correct answer is D. When undertaking risk management activities, the firm
may give up the opportunity to benefit from favourable changes in economic
variables. A firm that borrows at a fixed rate is protected from a rise in interest rates
but cannot benefit from lower interest rates if that is, indeed, the outcome. If a firm
buys insurance, it has to pay for the protection and this can turn out to be quite
costly. Lastly, by hedging out economic risks, while at the same time its competitors
do not, the firm can be left at a competitive disadvantage.

2.25 The correct answer is B. Strategic risk management, or operational hedging, requires
a firm to match its business asset/liability structure to economic factors. Because a
firm will generally have a stable relationship with suppliers and customers, making
changes is slow to implement. While it might be thought that it requires a firm to
change the nature of its business, this is unlikely. A firm will be deriving its compar-
ative advantage from its current business activities. It therefore does not make sense
for the firm to surrender that by becoming another type of business in the face of
changing economic conditions. A firm may, over time, alter the location of its
production facilities, its suppliers and so on, but this will only occur gradually. By
the time such changes are made, the economic conditions that led to these changes
may well have altered out of all recognition. The major drawback of applying
strategic risk management is that it is slow to implement in response to rapidly
changing economic conditions.
2.26 The correct answer is B. Ill-diversified investors who are, for instance, owner-
managers have a strong incentive to reduce the probability that the firm – in which a
large part of their wealth is tied up – may become financially distressed or bankrupt.
They are in a similar position to the individual who owns a house and insures it – its
loss, without compensation, would be traumatic. In that sense, such owner-
managers are risk averse and will take a more active role in managing the risk of
their firms.
2.27 The correct answer is D. Firms use risk management to gain competitive advantage
and to select the risks in which the firm has special advantages, such as product
development and servicing, while at the same time eliminating risks in its peripheral
areas, such as exchange rates. Firms also use risk management to fix future costs and
revenues to facilitate planning and decision making.
2.28 The correct answer is B. A risk factor is a single type of risk. Hence, we might use
the term for currency risk (also known as exchange rate risk) where the source is the
single fact that the value of the two currencies may change over time.
2.29 The correct answer is A. It is borrowing in a foreign currency, as this involves actual
inflows of significant sums of money that inflate the firm’s balance sheet. Such a
decision would rationally be made only if the firm was confident that it had a source
of foreign income to ‘match out’ (or ‘offset’) the payments it had to make on the
foreign borrowing or was being ‘swapped’ into another currency. Buying an option,
a forward contract or entering into a cross-currency swap agreement are all exam-
ples of financial instruments that are used to modify and manage risks and hence are
‘financial hedges’.
2.30 The correct answer is D. Economic risk is the risk from changes in economic
factors. In describing this, the terminology of financial risk management also uses
the terms strategic risk, business risk and competitive risk for the same ideas.

Case Study 2.1: Laker Airlines

1 Laker’s schematic economic balance sheet looks as follows:
Assets Liabilities
Aircraft, etc. Equity
Operator goodwill/franchise Debt ($)
The firm operated out of the UK, so its revenues were, for the large part, in British
pounds, as most of its customers booked their flights to go abroad. The demand for
foreign holidays from the UK will be at its highest when the British pound is
relatively strong against other currencies – and the US dollar. Demand will be
relatively weak when the British pound is weak against foreign currencies and the
US dollar. Hence, the firm’s British pounds revenues that could be used to service
its US dollar debt are positively related to the British pounds external value. Also,
demand for foreign holidays by British customers is linked to the economic cycle:
during periods of expansion when individuals feel more wealthy, they are more
likely to holiday abroad. To the extent that currency movements and the economic
cycle affect each other, these two effects might have reinforcing or offsetting
consequences for Laker Airlines’ revenues and its ability to service its US dollar
debt.
To finance its expansion, the company had borrowed US dollars to purchase its
fleet of wide-bodied aircraft, which were used to ferry passengers to their destina-
tion. Debt service, in the absence of any hedging activity, would increase when the
British pound depreciated against the US dollar.
A diagram of the currency risks facing Laker Airlines is given below.
Domestic demand linked

to economic cycle
$ paid for
USA UK
to servicing debt
Laker Airlines
receives payment Fuel costs tied Demand for
for its services in to US dollar foreign package
British pounds from holidays linked
travellers but makes to exchange rate
debt service on its between £ and
fleet of aircraft and Strong connection European
other miscellaneous between $ and currencies
payments in foreign European currencies
currency
Rest of Europe
From a financial risk management perspective, the key problems are:

 demand for Laker’s services is directly linked to the strength of the British
pound against European currencies and, to a lesser extent, the US dollar;

 payment on its US dollar debt is directly linked to the strength of the British
pound against the US dollar. Buying planes – to be paid for in dollars – increased
the firm’s revenue–cost currency mismatch;
 various costs, such as those for aviation fuel, hotel bookings and so forth are
also linked to the British pound’s external value.
In retrospect it is obvious that Laker Airlines’ business risk and its financial risks are
likely to be highly correlated: a decline in foreign holidays, probably due to a
weakening pound, also means that foreign debt service will be on the increase. So
the way it had set up its business and the way it was financed meant the airline’s
costs would go up just when its revenues were likely to be reduced as demand fell.
Since both business risks and financial risks are strongly connected, such a business
ought to have considerable equity – or share capital – as a cushion against such an
eventuality. In fact, in common with most airlines and tour operations, the compa-
ny, as might be inferred from the nature of the business, was highly geared. Hence,
the company had a relatively high probability of becoming financially distressed.
Consequently, it should have been proactive in managing such risks. As events
showed, the company did not perceive its currency risks to be severe and it did not
understand the linkage between its revenues and costs. In fact, little was done to
mitigate the firm’s strategic risks.
The inevitable happened to Sir Freddie and his ambition to run a package-tour
operation ‘for the people’. Not long after acquiring the new aircraft, which greatly
expanded the travel firm’s fixed costs, the company went bankrupt due to the
combination of falling revenues and increased (British pound) service costs. A
failure of risk management had killed the airline.
Module 3
Review Questions

3.1 The correct answer is D. Financial markets allow buyers and sellers to meet and
hence provide a mechanism by which demand for particular financial assets,
instruments or securities can be balanced. Since the price mechanism acts as a
signal, the prices at which buyers and sellers agree to transact provide signals. A
lower price will encourage buyers to enter the market; a higher price will encourage
sellers to enter the market.
3.2 The correct answer is A. Firms use the factor markets to exchange their production,
but not for capital, and they obtain cash in exchange. Firms seeking capital go to the
capital markets.
3.3 The correct answer is B. Market risk, also known as price risk or rate risk, is that
element of total risk due to unpredictable changes in overall market prices.
3.4 The correct answer is C. Liquidity risk arises from a lack of transactions in a market.
Hence – all else being equal – a market with few buyers and sellers is likely to be

illiquid. The liquidity risk problem occurs from the delay in being able to execute
transactions, so that, in the interim, the market price may have changed in an
adverse manner. It is also referred to as execution risk.
3.5 The correct answer is C. Credit risk is the risk that borrowers cannot repay lenders
and hence fail to make the necessary payment (that is, they default).
3.6 The correct answer is B. Financial intermediation is the process whereby financial
institutions interpose themselves between buyers and sellers of financial instru-
ments, products, services and so on. Intermediation, but not of the financial type,
can take place between producers and consumers (these are distributors and
wholesalers).
3.7 The correct answer is B. A firm will have its credit downgraded when there is an
increased likelihood that the firm will default on its obligations.
3.8 The correct answer is D. Settlement risk involves all aspects of the clearing or
processing of transactions. It arises when the settlement process breaks down. It
may be relatively minor, as when a payment is delayed. It can be more serious when,
for a variety of reasons, the other party to the transaction cannot deliver the asset
that is being exchanged or provide the money to purchase the asset. Therefore, D is
correct, since any of the above can lead to settlement problems.
3.9 The correct answer is C. To be ‘long’ is to hold a position that is directly related to a
particular risk. The exposure is positive in that increases in the value of the underly-
ing risk factor lead to profits, while falls in the value of the risk factor lead to losses.
Hence, the sensitivity to the risk is positive (that is, the risk profile has a positive
slope against the risk factor).
3.10 The correct answer is C. An efficient market is a market where the values at which
securities, assets, instruments, currencies and so on are bought and sold incorporate
information about their value in their transaction prices. Efficiency has been
classified at three levels: weak form, where prices reflect the past price behaviour;
semi-strong form, which incorporates past price behaviour and publicly available
information of a price-sensitive nature; and, finally, strong form, where prices reflect
all information, whether publicly available or not; that is, prices also incorporate
privately held information.
3.11 The correct answer is A. A market is transparent if market users can observe the
activities of other participants and how market prices are being determined. Markets
that operate via organised exchanges, such as futures markets, or where organisa-
tional structures are such that market activity can be observed, would qualify as
transparent.
3.12 The correct answer is B. In a direct search market, market users have to ‘search out’
an appropriate counterparty who is prepared to take the opposite side of a transac-
tion. Direct search markets are, typically, markets where assets have unique
characteristics – such as real estate – rather than markets where assets have largely
similar characteristics.
3.13 The correct answer is B. Execution risk arises when it is not possible to undertake a
transaction at exactly the desired time. This can occur if there are more buyers
(sellers) than sellers (buyers) at any one time. It can also occur if an asset is to be

sold in one market and matched to the purchase of an asset in another. Delays in
buying/selling mean that the price at which the package of transactions can be
executed has, in the meantime, changed. Market makers’ purpose is to provide
immediate execution, so having even a few market makers is likely to reduce
execution risk.
3.14 The correct answer is A. A broker is an intermediary who searches out the other
party to a transaction but does not buy or sell for his own account. A broker who
buys and sells for his own account is known as a broker-dealer, a market maker or,
simply, a dealer.
3.15 The correct answer is B. An over-the-counter market is an informal marketplace
that is open to all participants who are free to transact directly with each other at
any location and at any time.
3.16 The correct answer is C. Organised exchanges will reduce search costs, they help to
greatly reduce – but not totally eliminate – counterparty risk, and they provide
timely price information about the securities traded and information on market
conditions. Exchanges, because they trade in relatively homogeneous instruments,
will not help market users to reduce mismatch risk. So C is not an advantage of
having financial instruments traded via an organised exchange.
3.17 The correct answer is D. Market makers fulfil all the functions I to IV. They stand
ready in the market to buy when market users sell and sell when market users buy;
by these actions they help to stabilise the market as they are trading against the order
flow. That is, buying when users are selling and vice versa reduces price fluctuations
from timing mismatches in demand and supply in the market. Market makers help
the operation of markets by providing information, controlling the flow of orders,
etc., and they help determine prices by indicating the prices at which they are willing
to transact.
3.18 The correct answer is D. The inside spread, or the ‘touch’ as it is colloquially known
in financial markets, represents the range between the best bid and best offer in a
particular security by all market makers. The best offer is from C at 1003/16
(100.1875), and the best bid is from B at 9915/16 (99.9375), so the touch is a quarter
or 0.25. In financial language, 0.25 would be called 25 basis points.
3.19 The correct answer is B. If a market maker is short of a security – that is, seeking to
buy – the price at which he will bid for it will be raised. The highest bid price is
from B, which is 1003/8. In like manner, a market maker seeking to sell will quote
the lowest offer price, which comes from C, which is 9913/16.
3.20 The correct answer is A. To make profits when prices rise means that we are ‘long
the market’. That is, we have a positive sensitivity to increases in the underlying risk
factor. If we are ‘insensitive to the market’, we do not gain from a rise in the market.
3.21 The correct answer is C. Systematic risk is that element of risk that is common to all
assets. It is sometimes referred to as that element of an asset’s total risk that is
created by the market.
3.22 The correct answer is A. Both the CAPM and APT are linear models of the
relationship of risk to return, but neither is directly observable. The difference is

that the CAPM assumes that only one factor (market risk) is involved whereas APT
allows for a multiplicity of factors.
3.23 The correct answer is A. Operational assets are those assets, such as property, plant
and equipment, inventory and the like, that a company acquires for the purpose of
carrying out its business operations. This contrasts with financial assets, which are
held to finance or facilitate transactions or for financial risk management purposes.
3.24 The correct answer is B. Derivatives offer users an enhanced, leveraged or geared
exposure to underlying economic risks. Under International Financial Reporting
Standards, their fair value is reported on a firm’s balance sheet. It is not true that no
payment is required to enter into such agreements; options require an upfront
payment in the form of a premium. Nor is it critical that the exchange takes place at
some future date. The key feature of derivatives is that they offer geared or lever-
aged exposure to an underlying economic risk (or an asset that has underlying
economic risks).
3.25 The correct answer is B. To be default free means that the borrower will repay the
debt at its duly appointed date for repayment and that there is no chance, however
small, that the obligation will not be met.
3.26 The correct answer is C. The difference in the return on a debt instrument and
government debt arises from concern about the possibility of default on the former.
The greater the spread, the more concern there is about possible default. The credit
standing of the issuer is a reflection of, amongst other things, this potential default.
3.27 The correct answer is B. A semi-strong efficient market is one in which the past
history of price changes and information available in the public domain (but not
private or inside information) has been incorporated in current market prices. Inside
information in this context is information held by officers and managers of firms
who may be better informed of the real conditions and hence of the true worth of
their firms. The theory of market efficiency makes no statement about market
makers or market users.
3.28 The correct answer is D. Counterparty risk or, as it is sometimes referred to,
counterparty credit risk is the risk that, in entering a given transaction, the other
party may not be able to carry out its obligation when called upon. This obligation
to perform will last until the contract is terminated or settlement takes place.
3.29 The correct answer is D. To be short is to have sold a position that is subject to a
particular risk. The exposure is negative in that falls in the value of the underlying
asset or market lead to profits since the asset can be (notionally) repurchased at a
lower price. Increases, on the other hand, create losses. Hence, the sensitivity to the
risk is negative (that is, the risk profile has a negative slope). One can be short if one
needs to acquire the asset at some date in the future and currently does not own the
asset.
3.30 The correct answer is C. Endorsing a transaction involves the intermediary attaching
its name and credit to the transaction. Documentary credits used in international
trade are an example of endorsing where the documentary credit is guaranteed
(endorsed) by a bank (for a fee).

3.31 The correct answer is B. The inside spread represents a cost – and hence a loss –
that is paid to market makers for their services in the markets. Market users have to
buy at the higher offer (ask or sell) price and sell at the lower bid (purchase) price at
which dealers or market makers are willing to transact.
3.32 The correct answer is B. The factors that will influence the spread are the maturity
of the issue, since longer maturity issues are likely to increase the chance of future
default; the name of the issuer, since this includes knowledge about the issuer’s
creditworthiness; any tax effects; the liquidity of the issue, since investors will
discount the price to reflect liquidity problems; and any special conditions that may
be applicable to the issue.
3.33 The correct answer is D. Only counterparty risk is not related to changes in the
prices at which assets are bought and sold, so it is not a ‘market’ risk. Therefore, D
is the odd one out.
3.34 The correct answer is D. We need to apply the capital asset pricing model (CAPM)
to obtain the risk-adjusted return and add to this the credit default spread. The
CAPM gives:
rdebt = rf + β r m − rf
= 6% + 0.5(20% − 6%)
= 6% + 0.5(14%)
= 6% + 7%
= 13%
To this must be added the 2 per cent credit spread, giving a total required return of
15 per cent.
Case Study 3.1: Omega Corporation

1 In order to determine the market’s view on Omega Corporation’s credit risk, we
need to back out the market’s credit risk premium. To do this, we need to calculate
the implied yield for the zero-coupon bonds. We do this by solving the pricing of
zero-coupon bonds for their yield (y) using the following formula:
You should be familiar with this formula from the Finance course or from having
earlier studied finance. It is, of course, the present-value formula. Here, we are
solving for the unknown value of y. To do this, we simply rearrange the formula to
give:
1
Hence, for the five-year zero-coupon bond, we know we get back 100 (the principal
at maturity) and the current price is 55.74; we therefore have:
1 1
.

1.7940 1
√1.7940 1
1.1240 1
1.1240 1
0.1240
So the yield on the five-year zero-coupon bond is 12.40 per cent per year. Using the
same approach, we find that the yields on Omega Corporation’s outstanding zero-
coupon bonds are therefore:
Maturity Yield on Omega Current market Difference (in

Corporation’s rate of interest basis points)
zero-coupon (%) between Omega
bonds (%) yields and market
rate of interest
1 year 10.25 10.10 15
2 years 10.50 10.25 25
5 years 12.40 11.50 90
8 years 14.00 13.00 100
The implication is that the market is evaluating the risk of default by Omega
Corporation as being only slight in one year – the premium is only 15 basis points –
but rising significantly by Year 2 and becoming a lot higher by Years 5 and 8. The
market may consider that, given the current interest rate environment (and by
inference the poor economic outlook), Omega Corporation may encounter long-
term difficulties in meeting its future fixed liabilities. That is, it may experience
financial distress, default on its obligations and go bankrupt.
2 To answer this, we need to recalculate the values of the zero-coupon bonds that
remain outstanding. The two-year bond has now become a one-year bond, and the
five-year and eight-year bonds now have only four and seven years to go. The
results are given below:
Maturity Yield on Omega Current market Difference (in

Corporation’s rate of interest basis points)
zero-coupon (%) between Omega
bonds (%) yields and market
rate of interest
1 year 8.10 8.0 10
4 years 9.10 8.50 60
7 years 9.70 9.0 70

What is evident, once we present the data correctly, is that the default spread for
Omega Corporation’s bonds has fallen over the year. For the directly comparable
one-year maturity, this has fallen from 15 basis points to 10 basis points. The other
maturities are not directly comparable, but the direction of the change is also
significantly downward and, even allowing for the maturity differences, the fall is
about 25–30 basis points. We can therefore safely conclude that the market has
reduced its estimate of the default risk in Omega Corporation.
It is worth considering why the market is now placing a higher value on Omega
Corporation’s bonds. The first point, which was discussed in Module 1, is that
different risks are interconnected. There may be more risk of default by Omega
when interest rates are high than when they are low. Although we are not told, there
may be a direct link between the firm’s business risk and interest rates. Lower rates
therefore reduce Omega’s credit risk. Note, however, that we are also assuming that
there has been no significant change in the firm’s financial risk from the redemption
of the one-year zero-coupon bond.
The second point is that default is made up of two elements: the probability of
default and the amount recovered given a default (or, equivalently, the loss if default
takes place). Both can have a positive effect on the spread. It is possible that Omega
Corporation is just as likely to default after one year – even with lower interest rates
– but that the amount that is likely to be recovered after the default has gone up.
Enhanced recovery values may result because the open-market value of the assets
has risen (or their asset specificity has been reduced) or the waiting time for
payment post default has dropped. For instance, changes in bankruptcy proceedings
may have led to a significant acceleration in payments to creditors.
The third reason is a combination of the two earlier points: lower interest rates are
favourable to Omega Corporation while at the same time the expected recovery rate
is also up.
Module 4
Review Questions

4.1 The correct answer is C. An increase in the capitalisation rate or, equally, the
required earning rate and the required discount rate, or the required rate of return,
will reduce an asset’s value. If a future cash flow is worth £100 and it is capitalised at
10 per cent for one year, its current value is £90.91. If the capitalisation rate is raised
to 12 per cent, its current value falls to £89.29.
4.2 The correct answer is C. Price risk arises because future cash flows are discounted at
prevailing interest rates. If interest rates rise, the discount rate used to present value
the cash flow also rises and the present value falls. If interest rates fall, the opposite
happens. Hence, if rates rise, the value of interest-rate-sensitive assets falls and vice
versa.

4.3 The correct answer is B. Reinvestment risk is the risk of having to reinvest
intervening cash flows on an investment at interest rates that are lower than
anticipated when the investment was first made. It will only arise on maturity if the
maturity of the asset is less than the investment horizon.
4.4 The correct answer is A. When the bulk of the cash flows are received at the
maturity of the investment, the investment is most sensitive to price risk. The
ultimate example of this is with a zero-coupon bond where all the risk is price risk
since there are no intermediate cash flows to be reinvested. In the case of the above
set of cash flows, the final cash flow dominates the others, so price risk will pre-
dominate.
4.5 The correct answer is B. The holding period return is that return on a debt
instrument that is earned when the instrument is held to a date before its maturity
and then sold at the prevailing market price.
4.6 The correct answer is D. The instrument with the most price risk will be a zero-
coupon bond since all the value will be received at maturity in a single cash flow.
Because the value of such a security depends on the discount rate used to value this
future single cash flow, it will have the most price risk.
4.7 The correct answer is C. Prepayment risk arises from a contractual feature of some
interest-rate-sensitive instruments. Where a borrower or issuer has the right to
‘prepay’ before the stated maturity of a fixed-rate instrument, a reduction in interest
rates may lead the borrower to exercise the right of early payment. Since the holder
or lender would be receiving an above-market rate of interest on the instrument, the
lender stands to lose out.
4.8 The correct answer is D. By agreeing a fixed-rate loan with an early prepayment
clause, the lender has created prepayment risk on the loan (III) and has sold an
option on future interest rates (VI). If interest rates fall, the borrower will repay the
loan early, leading to a loss for the lender.
4.9 The correct answer is D. The yield curve is a graphical representation of the yield or
internal rate of return on fixed-rate debt instruments against their maturity.
4.10 The correct answer is A. It is normal practice to create a yield curve either from a
single borrower, as with the government when it issues bonds, or from a group of
similar borrowers (for instance, those with the same credit rating, industry type, etc.)
who can be treated as the same for this purpose.
4.11 The correct answer is D. The diagram shows a discount market or inverted term
structure curve, which is also known as a backwardated yield curve.
4.12 The correct answer is B. When a yield curve is downward sloping, the implication is
that future short-term interest rates will be lower. In order for this to be the case,
future monetary policy must be loosened so that short-term interest rates are
reduced. Lower interest rates mean that reinvestment rates will be reduced.
For instance, if the one-year zero-coupon rate is 10 per cent and the two-year zero-
coupon rate is 8 per cent, then the one-year rate in one year’s time will be:
.
1.06 1 6%
.

4.13 The correct answer is D. Under the expectations theory of the term structure, all of
the above should give the same ex ante expected return. The market’s estimate of the
rate of interest applicable for the second year is implicit in the prices of zero-coupon
bonds for the two maturities. If the zero-coupon interest rates for one year and two
years are 6 per cent and 8 per cent respectively, the market is expecting rates to be
10.04 per cent in Year 2. This implied forward rate is calculated as follows:
.
1.1004 1 10.04%
.
The two-year maturity zero-coupon bond will be trading at 85.73 in the market. It
will have a price of 90.88 at the end of Year 1 (85.73 × 1.06), giving a return of
10.04 per cent for the second year (100/90.88 – 1).
4.14 The correct answer is C. The implied short-term interest rates derived from
observable market prices will both overstate, when the term structure is rising, and
understate, when the term structure is falling, the expected future short-term interest
rate for any given period.
4.15 The correct answer is B. The market segmentation hypothesis, or preferred habitat
theory, suggests that the term structure is the product of investors with specific
maturity requirements needed to match asset–liability requirements. Hence, such
investors will want to hold securities within a narrow maturity range only. They will
have some flexibility within which they are prepared to hold securities. However,
the greater the divergence, the more they have to be compensated for the mismatch
risk to their underlying requirements. If other investors are happy to hold securities
that match their maturity preferences, then such investors who have strayed outside
their natural habitat are unlikely to be compensated by the market price (hence
return) from such ill-suited purchases. Given their preferences for a given maturity,
preferred habitat investors are unlikely to seek out price bargains regardless of the
maturity involved.
4.16 The correct answer is B. Mean reversion is the market tendency of interest rates to
revert to some long-run value rather than to spread out over time.
4.17 The correct answer is C. The real interest rate is found by the following formula:
1
So, if the nominal rate is 12 per cent and inflation is 9 per cent, the real rate of
interest is [1.12/1.09] – 1 = 0.0275, or 2.75 per cent.
4.18 The correct answer is B. In a rotational shift, the yield curve pivots around a given
maturity point. In doing so, one would normally expect the longer maturities to
change by more than the shorter ones. We can see this if the yield curve starts as
being flat at 6 per cent and then rotates at the 1-year with the 10-year changing by
10 basis points. The 5-year-old yield will now be 10.05 per cent and the 10-year yield
10.10 per cent.
4.19 The correct answer is D. A twist in the yield curve means that the shape has become
steeper – or flatter – between short and long maturities. The implication is that the
relationship between the long end and the short end, as measured by taking one
from the other, has increased (a widening of the maturity spread) or decreased (a

flattening of the maturity spread). But it does not say how it can happen. It can arise
from:
 both short- and long-term rates rising (falling), but longer ones by more (less)
than shorter ones (the spread widens);
 both short- and long-term rates rising (falling), but longer ones less (more) than
shorter ones (the spread narrows);
 short- (long-) term rates remain static whereas long- (short-) rise or fall.
None of the answers to the question satisfactorily describes the above process, so
the answer is D.
4.20 The correct answer is B. A money market instrument will have two cash flows: an
initial investment/receipt followed at a later date by a repayment.
4.21 The correct answer is C. When making a term loan that is repriced every six months,
the lender is transforming the nature of the risk being taken relative to making 10
sequential semi-annual loans to the same borrower. With the sequence of loans, the
lender can always decide not to continue making these, hence the borrower is
subject to ‘funding risk’. Also the lender is taking on more risk with the term loan if
the margin or spread to the reference rate for such a borrower were to change as a
result of a credit downgrade of the borrower. A numerical analysis will help explain
the issue. If the required spread on such a borrower changed after the loan had been
made and before the first rollover was fixed such that an additional 10 basis points
(0.10 per cent) was required, then the value of the loan will be less than its par value.
If the appropriate interest rate was 6 per cent semi-annually, this would mean that
the value of the loan to the lender was reduced by 0.10/2 × PVIFA3%,10 per 100.
The present value of the interest factor of an annuity (PVIFA) is found by:
PVIFA%,
where r is the periodic interest rate and n the number of periods.
The loss will be 0.05 × 8.5302 = 0.43. That is, if the loan was sold at the time, it
would only fetch 99.57 per cent. The correct answer is therefore C, since the risks
are being transformed: funding risk has been eliminated for the borrower and the
lender has assumed additional credit-spread risk. Note that it is for these reasons
that variable-rate-term loans, although functionally equivalent to a strip of short-
term advances, carry a higher spread to the reference (interest) rate.
4.22 The correct answer is D. A money market instrument has only two cash flows. The
only term instrument that has the same characteristic is the zero-coupon bond.
4.23 The correct answer is A. A term structure change involving a flattening of the yield
curve will take place if future, implied nominal interest rates are expected to fall.
This occurs when future inflation expectations fall. Thus interest rates at the long
end of the term structure will decline as the linked short-term implied rates drop, so
bond prices, which are inversely related to interest rates, will rise.
4.24 The correct answer is C. The bond that will increase most in price will be a zero-
coupon bond. If the current interest rate is 10 per cent, then the zero will have a
value of 62.09. If interest rates fall to 9 per cent, the zero will have a price of 64.99,
a percentage price change of 4.67 per cent. For the straight bond (which is closest in

character to a zero, at 10 per cent), the package of cash flows will be worth 137.91.
At 9 per cent, the package will be valued at 142.79, a percentage price change of
3.53 per cent. Due to the time/rate effect of discounting, neither the annuity nor the
declining cash flows will respond as aggressively to changes in interest rates.
4.25 The correct answer is D. This requires us to present value the cash flows using the
standard discount formula:
∑
The value of the cash flows is thus:

492
. . . . .
4.26 The correct answer is C. The price of the zero-coupon bond if interest rates are 10
per cent is 310.46. If the interest rate rises to 10.10 per cent, the price will then drop
to 309.05, a price difference of 1.4.
4.27 The correct answer is A. Price risk will make the liability price fall, while
reinvestment risk will increase the liability cost. This is because a rise in interest rates
will lower the price whereas it will raise the future interest cost. The degree to which
price risk operates to lower the price will depend on how long it is before the
liability is repriced. For the floating-rate borrowing, reinvestment risk – in the form
of higher future borrowing costs – is likely to predominate.
4.28 The correct answer is B. The biggest cash flow is at time t = 1, so reinvestment risk
will predominate over the life of the investment, since the rate at which this large
cash flow relative to the much smaller, later ones can be reinvested will dominate
over the price risk.
4.29 The correct answer is B. The value of a debt instrument is based on discounting
future cash flows at the market discount rate. Therefore, a loan where the interest
rate is being reset in line with the market interest rate will have the least price risk
since the future cash flows will be revised upward (and downward) in line with
current interest rates and the discount rates used to value the instrument. Another
way of seeing it is that with C the coupon interest is always close to the market
interest rate, since C is reset each period at the prevailing market interest rate.
4.30 The correct answer is D. When the yield curve or term structure is rising – that is, it
is a premium market or is in contango – longer maturities have a higher interest rate
cost than shorter ones. The implied short-term future interest rates embedded in the
yield curve will be higher. For instance, if one-year money costs 9 per cent, two-year
money costs 10 per cent and three-year money 10.50 per cent, then the implied one-
year rate in one and two years is 11 per cent and 11.51 per cent respectively.
4.31 The correct answer is C. The expectations hypothesis postulates that the expected
return on a security of whatever maturity is the same for the same holding period.
Hence investors who buy longer-dated securities expect to earn the same as if they
were buying a series of shorter-dated ones.

Time Value of Money Calculations

4.32 The correct answer is A. The future value of an investment is determined by the
price relative function: (1 + r)t, so the future value will be:
/
£1000 1 0.06 £1044.05
Note that the use of simple interest to calculate the result would have given the
value £1044.38.
4.33 The correct answer is A. The correct annualised rate of interest is calculated as:
/
800 1 897
Solving for r gives 9.59 per cent.
4.34 The correct answer is C. The correct result, 200.07, is found by summing the results
of:
200.07
. . .
4.35 The correct answer is C. The correct annualised interest rate which takes account of
the timing differences for monthly payments is 19.56 per cent. The calculation is:
.
1 1
4.36 The correct answer is B. If the annual equivalent rate is taken to be x per cent, the
two cash flows are:
Year Semi-annual Annual Difference

(SA) (A) (SA − A)
0.5 3.0 0 3.0
1.0 3.0 x 3.0 − x
1.5 3.0 0 3.0
2.0 103.0 100 + x 3.0 − x
For the two loans to be equivalent, the present value (PV) of the two cash flows
must be equal. Therefore, the PV of the difference column must equal zero. The PV
will be zero if the two PVs of the first year’s cash flow are equal. This will happen if
. .
.
equals
x/(1 +Ra)
If the required discount rate on the semi-annual payment is 5 per cent, substituting
we have:
x 1.05 2.9277 2.8571
which is 6.074 per cent.
Note the difference in result, if we had simply converted the semi-annual payments
to annual equivalent, using the following formula:
1 1 100

This would give:

%
6.09% 1 1 100
Although the difference is slight (0.02 per cent), it can have a material impact if the
investment is large. The reason you cannot use the simple conversion is that the
loan has an interest rate payment that is different to the discount rates involved.
4.37 The correct answer is A. The present value of the annuity for 30 months at 2 per
cent needs to be calculated:
PVIFA % , 22.3965
. . .
Dividing this into the sum to be borrowed gives £133.95 (£3000/22.3965).

4.38 The correct answer is D. The price relative is equal to the inverse of the discount
factor (1/0.9608) = 1.04080; this then has to be adjusted to give the annual rate
1.04080[365/184] to give 1.08255. So the interest rate is 8.255 per cent.
4.39 The correct answer is B. For Dorothy, the loan is a liability. Therefore, she will want
to select the lowest-cost alternative. First determine if interest rates are 12 per cent.
We can do this by calculating the present value of an annuity for 12 per cent and 20
years. The annuity factor and PV of repayments under each option at 12 per cent
(12 per cent for annual repayments, 3 per cent for quarterly repayments and 1 per
cent for monthly repayments) are given in the following table:
Option Annuity factor PV of repayments
I 7.4694 Oz£114 999.55
II 30.2008 Oz£114 661.73
III 90.8194 Oz£115 000.09
The lowest-cost and, therefore, best alternative for Dorothy is Option II.
Advanced Interest Rate Topics

4.40 The correct answer is B. The correct implied interest rate is 8 per cent. The yield on
the three-year bond is 7 per cent, that on the two-year 6.50 per cent. The relation-
ship of the two price relatives is:
1 1 1
where t = three years, k = one year, t − k is two years and r is the interest rate.
Solving for the equation, given the observed pricing relationships in the table gives:
.
1.080
.
Hence the one-year rate in two years’ time is 8 per cent.
4.41 The correct answer is A. Under the expectations hypothesis, the holding period
return of two years will be the same whether the two-year or the four-year bonds
have been purchased. Hence, the expected return will be 6.5 per cent, the yield on
the two-year bond.
4.42 The correct answer is D. Under the expectations hypothesis, the interest rate – or
yield – that is expected to be earned from investing from Year 3 to Year 4 will be

given by the implied interest rate between Years 3 and 4. The three-year rate = 7 per
cent and the four-year rate = 7.10 per cent, so the implied forward rate for one year
in three years’ (3F4) time is given by:
. .
1.0740
. .
So the rate is 7.40 per cent.
4.43 The correct answer is D. An arbitrage exists when there is a replicating transaction
that either at the onset or at maturity can be executed in such a way that there is no
net investment of funds. Since borrowing and lending can take place, if one element
of the alternatives is mispriced then an opportunity exists for a riskless gain. The
arbitrage to undertake to exploit any mispricing between market prices and the
forward contract price is:
1. issue the two-year bond at 88.16 (in the ratio of 94.33/88.16 (1.07) nominal to
get enough to buy the one-year bond);
2. buy the forward contract and enter into the obligation to receive the bond in one
year’s time for (1.07 × the face amount = 99.05);
3. hold the one-year at 6 per cent, to give 100 at the end of the year;
4. the net position in one year is to pay 99.05 to exercise the contract and buy the
bond. This is held to maturity to extinguish the liability;
5. the net gain is 0.85 of the investment without incurring any interest rate risk
since all the elements of the transaction are determined today and there is no
uncertainty on the cash flows.
Note that, if you understood the nature of the price relationships, calculating what
the two-year bond is worth in one year’s time, at the current market rate of interest
of 6 per cent, will tell you which of the transactions will make money – if any: 88.16
× 1.06 = 93.45. Hence the forward contract is trading below (or cheap) to its fair
value; that is, prices for interest-rate-sensitive securities being inversely related to
yields. Under these circumstances, the arbitrage transaction involves buying the
cheap element: the forward. No need to undertake the complicated analysis really!
Case Study 4.1: Panthos Finance

1 Panthos will be concerned about the credit risks of its borrowers. A sum of
£10 000 is quite substantial for an individual and, since companies are likely to have
a number of cars, exposure to one company may also be a substantial part of the
Panthos loan book. There is, therefore, a significant risk of default.
Depending on the way that the company finances itself, it may be taking interest
rate risk. The loans that the consumer finance company makes are at a fixed rate: to
protect itself it may wish to borrow for the average term of the loan also at a fixed
rate. However, it has a problem in that the customer can – and may very well –
prepay the loan with one month’s interest, and so the company faces prepayment
risk. The termination fee is waived if the customer refinances with Panthos.
Presumably only if the new loan is competitive with other such loans being offered
will the customer take advantage of the offer. So, although the funds returned from
the existing loan may be recycled – and possibly ‘topped up’ when the new finance
is extended – this is only going to earn interest at the current, lower rate, not the old

one. As with mortgages, there will probably be a number of prepayments that are
independent of interest rate effects. These would be due to cars being written off or
stolen or from the borrower’s changed circumstances – requiring the vehicle to be
sold and so forth.
If the company borrows at a variable rate, it will face an interest rate mismatch
between the fixed assets and the variable cost liabilities. Higher interest rates could
therefore significantly reduce the company’s margin. If the company funds itself,
not to the contractual maturity of five years but, say, for two years, it may experi-
ence difficulties in raising further finance, a problem known as funding risk.
The company also faces another threat: if competition intensifies, the company may
face downward pressure on its margin as well. The 5 per cent spread being charged
to cover profit, overhead and establishment costs, losses from default, etc. may be
threatened by other providers who might undercut Panthos’s rates. Everyone will
have to earn the market rate of interest, but the margin above that will be a matter
of how competitive the company can be and, especially, how good it is at control-
ling its credit losses and other establishment and business costs.
If interest rates fall – and/or industry margins are squeezed – then Panthos will have
more prepayments than anticipated as customers avail themselves of cheaper
funding alternatives, such as bank finance. When economic conditions are difficult,
the loan is more likely to run to maturity since car owners will not want to buy a
new car and may even be sitting on losses from their existing one, if second-hand
prices have fallen in line with economic conditions. Hence Panthos is exposed to
extension risk on its financing. However, because interest rates tend to be low
when economic conditions are difficult, extension risk may not be a problem for the
company: the loans may be earning an above-market return.
2 The earlier analysis shows that there is interest rate risk in Panthos Finance’s lending
activities. The amount will partly depend on the nature of the cash flows. Three
different structures for the loan finance used to purchase the car are given in the
diagram below. The top part of the diagram shows what is known as a timeline. As
the finance house is lending, the initial cash flow at t = 0 is an outgoing, represented
by a downward arrow, while the future cash flows at t = 1 to t = m are upward
arrows representing future receipts. The direction of the arrows for the borrower
would be reversed.

t=0 t=1 t=2 t=3 ...... t=m–1 t=m

Terminal
Cash inflows Monthly premiums payment
Cash flow timeline
Cash outflow
Fully amortising structure:
Interest only structure:
Part-amortising structure:
The company has three possibilities:

1. A fully amortising loan
This is priced using the annuity factor for the 60 periods. The one-month inter-
est rate at which Panthos will end will be 10 per cent from the market plus the 5
per cent margin, expressed as a monthly rate. This is:
1.15 1 100% 1.1715%
The five-year present-value interest factor of an annuity (PVIFA) will be:
.
PVIFA . %, 42.9216
.
The monthly loan cost in this case is £10 000/42.9216 = £232.98.
2. Interest only loan
This means the entire £10 000 is repaid at maturity. The interest cost is £10 000
× 0.011715 per month, or £117.15.
3. Part-amortising loan
This is the offer in the term sheet in the question. In this case, the payment is
£150 per month. The valuation is as follows:
£ £
£10 000 ∑
. .

To determine the terminal amount, we proceed as follows. Knowing the month-

ly payment, we use the 60-month annuity factor to find the present value of the
periodic payments:
PV monthly payments £150 42.9216 £6438.24
The amount borrowed is £10 000, so the monthly payments (interest and princi-
pal) recover £6438.24 and the bullet payment in present-value terms will be
£10 000 – £6438.24 = £3561.76. But the finance house has to fund this for five
years since this is not received until the end of the lease period. So we need to
future value this payment:
£3561.76 1.15 5 £7164
With alternative 3, the partly amortising loan, the company is getting back principal
every month. But not a lot: enough to cover potential depreciation on the motor
car, so that the value of its collateral is being maintained. The amount due at the
end, £7164, represents the unamortised principal that is due.
Let us now consider the situation with four years left on the loan. The amount of
unamortised principal at this point is £9580. This is found by getting the present
value of the monthly payments for Year 1 at the 15 per cent annual rate, that is at
1.1715 per cent per month and subtracting this from the original £10 000 and
compounding it for one year. (There are other ways of doing it.)
£
£1670.11 ∑
.
£10 000 £1670.11 1.011715 £9579.37

£8329.89 1.15 £9579.37
This is the amount of the loan remaining outstanding at the end of the first year.
If the loan is now cancelled, a further £150 is received, so the total sum at this point
is £9730. If a new loan is made for the £9580 but earns only 13 per cent, with the
terms otherwise unchanged, then the total principal due at maturity is £6382. The
difference between the original principal and the new represents the loss of value
due to refinancing at the lower interest rate (£7165 – £6382 = £783). Present valued
to Year 1 when the new loan is granted at 13 per cent per year gives £480.
If the company had used a fully amortising loan instead, it would have received
£233 per month. The outstanding principal at the end of Year 1 would have been
£8517. With the fully amortising loan, the future payments are now reduced, so that
they are now £226. The loss = £233 − £226, or £7 per month, which, present
valued as above, equals £264.
However, the extent of this loss will depend on the financing alternatives used by
Panthos Finance. The greater the match between the term of the assets and the term
of the borrowing, the less interest rate risk inherent in Panthos Finance’s balance
sheet. Its main problem is therefore predicting when repayment is likely.
As with mortgage lenders it may use a prepayment model in the form:
Monthly prepayment rate Refinancing incentive Seasoning multiplier
Month multiplier Burnout multiplier

where the multipliers are determined statistically from historical behaviour patterns,
the current level of interest rates, defaults, vehicle write-offs and the like.
Module 5
Review Questions

5.1 The correct answer is D. Foreign exchange rate risk arises when transactions are
denominated in a foreign currency, be they purchases, sales or long-term invest-
ments.
5.2 The correct answer is A. That factor prices change is, of itself, not a source of
foreign exchange rate risk. That oil prices rise, for instance, does not necessarily
make any difference to a US domiciled company’s currency position since oil is
priced in US dollars. It can have an indirect effect from higher inflation, etc. So A is
not a direct source of foreign exchange rate risk.
5.3 The correct answer is D. All of the above may influence the exchange rate.
Domestic producers’ prices that are internationally expensive or cheap will influence
demand for foreign preferences for goods and services. An active market for inward
investment will raise the demand for domestic currency. The level of interest rates in
the economy as determined by the central bank will have a bearing on foreigners’
willingness to hold the currency, as will government policies on trade, remittances
and so forth. Past currency movements, although not a guide to the future, may
influence the decision whether to hold the currency, based on expectations about
the future path of the currency.
5.4 The correct answer is D. Country risk is the risk of doing business in a particular
country. Any restrictions on the free movement of capital into and out of the
country will raise the risks of investing in the currency. This risk also involves the
danger of expropriation. A change in government, and hence policy, can affect the
currency: for example, if capital controls are suddenly imposed.
5.5 The correct answer is A. Under the interest rate parity model, the forward rate will
be the product of the interest rate differentials for the two currencies. For a six-
month period, this will be:
. .
200 . 202.73
.
5.6 The correct answer is A. If the interest rate on A should jump to 10 per cent, the
new forward rate for the six-month period will now be 201.81 (200 ×
1.120.5/1.100.5). If the transaction involves a sale of B and a purchase of A, then the
forward user loses nothing – the user has in fact gained. This is evident. At the
maturity of the contract, the user has to deliver B and receive A. Under the original
contract the user is due to receive A202.73/B. Since the rate has fallen, the user only
needs A201.81/B to reverse the transaction, netting A0.92 per unit of currency B.

5.7 The correct answer is D. The forward exchange rate under the interest rate parity
theory is the product of the differentials in the interest rates of the two currencies.
The formal model states that:
/ /
where rF is the foreign rate and rD the domestic rate. In the model, the spot rate will
change by the ratio:
for any period t.

5.8 The correct answer is D. Purchasing power parity (PPP) states that the prices of
traded goods and services should be equal when expressed in terms of their pur-
chasing power. For this to happen over time, countries that experience higher
inflation must become more competitive in international markets. Usually this
occurs via an adjustment to the exchange rate to reflect differentials in inflation. For
PPP to operate, arbitrageurs must be willing to act to bring discrepancies into line.
5.9 The correct answer is C. The expectations theory of foreign exchange proposes that
the forward rate, for whatever maturity, embodies the market’s consensus as to what
the future spot rate will be. It does not require that the forward rate be based on
interest rate differentials (as with the interest rate parity model), nor that it is the
best current estimate of the future spot rate.
5.10 The correct answer is D. The international Fisher effect postulates that changes in
the exchange rate will take account of different nominal interest rates and what that
means for future expected inflation.
5.11 The correct answer is D. Translation exposure arises when companies have foreign
subsidiaries. Accounting items denominated in one currency are converted into the
consolidated statements of the parent in the base, or home, currency.
5.12 The correct answer is D. Currency risk arises in buying and selling goods and
services in a foreign currency through transaction risk. It also occurs when foreign
currency assets are acquired (transaction and translation risk apply). Although it
might appear that buying and selling abroad in the domestic currency is without
exchange risk, the risk has merely been shifted to providers and customers and still
exists.
5.13 The correct answer is D. Covered interest arbitrage is also known as interest rate
parity. In such a situation, the forward exchange rate (or points, as it is known) is set
in such a way that the rate reflects the interest rate differentials between the curren-
cies. So borrowing in one currency and lending in another should not lead to a risk-
free profit. Equally, when entering a spot and forward transaction there is no receipt
or payment on the forward until it is executed at its due date.
5.14 The correct answer is C. The forward exchange rate will be set by the interest
differentials of the two currencies. This is found by:
/ /
For X and Y, this means:

. .
400 . 401.91
.
5.15 The correct answer is C. If the interest rate rises in Y from 4 per cent to 5 per cent,
the value of the forward contract for three months will become 400.95. By agreeing
to the original contract, the seller of X has to provide 401.91, so the change in value
is −0.96.
5.16 The correct answer is C. With the currency trading at 412.25, against an interest rate
parity value of 413.53 (= 400 × 1.07/1.035), users can take advantage of this fact by:
1. borrowing currency Y for one year at 3.5 per cent;
2. exchanging it into currency X at the spot rate of 400 to earn 7 per cent for one
year;
3. entering into the forward exchange contract to sell X and buy Y at the end of the
year.
The net result is a profit of 1.28 units of currency X, or 0.003 units of Y at the year-
end. The arithmetic is as follows: to have one future unit of currency Y in one year,
we borrow the PV = 0.9992 current units. Exchanging this at X400/Y gives 386.47
units of X, invested at 7 per cent, and this becomes 413.53 units. The difference
between the forward rate of 412.25 to get one unit of Y and the investment of
413.53 units of X is 1.28 units.
5.17 The correct answer is D. Purchasing power parity (PPP) proposes that the price of
traded goods sold in different markets should, in the absence of barriers and
adjusting for transportation costs, be the same. The conversion price of the same
McDonald’s product being offered in different countries provides an indication of
the degree of divergence away from PPP. In the two models of PPP, absolute PPP
assumes the law of one price holds, whereas relative PPP assumes that inflation
effects are offset between two currencies that are in equilibrium. However, it is not
possible to ‘transport’ Big Macs from one country to another since part of the price
is in the form of local services and costs, which are not subject to exchange rate
effects.
5.18 The correct answer is A. Transaction exposure arises when payables and receivables
are exchanged across currencies.
5.19 The correct answer is C. Current income, even if not repatriated, is reported
through the income statement, whereas foreign balance sheet elements are translat-
ed using either the exchange rate that prevailed when acquired (the historical rate) or
the current rate. There are a number of different translation methods in use for
determining the result.
5.20 The correct answer is D. If the prices at which currencies were exchanged did not
alter, then transaction exposure would not exist. A principal cause of the problem
arises from delays between the contract being agreed and the moment of actual
payment. If contracts are agreed involving a foreign currency, then the payment has
to be converted into that currency.
5.21 The correct answer is B. The argument put forward for managing translation
exposure is that, unless there is mitigation of its effects, it leads to wide swings in
corporate performance that are unrelated to the firm’s fundamentals.

5.22 The correct answer is D. Economic exposure arises when unexpected changes in
the exchange rate change the value of future expected cash flows. The effect is both
direct and indirect and hence is not limited to direct foreign competition or sourcing
but also includes the results on competitors’ and suppliers’ cash flows from such
changes.
5.23 The correct answer is A. When a currency appreciates, the indirect economic effects
(that is, those that touch a firm’s competitors and its suppliers and customers) are
that foreign competitors obtain an economic advantage (I) and that suppliers that
source in a foreign currency become more competitive (III), as do customers (V).
5.24 The correct answer is A. The sensitivity to economic exposure model (see Table
5.12) classifies firms as having economic exposure sensitivity from currency effects
in terms of how competitors are likewise affected. Only those firms that have
sensitivity to changes in the exchange rate, whether inputs or outputs, whereas at
the same time competitors do not, will be classified as having economic exposure. If
all firms are more or less equally affected by changes in the currency, then there are
no (major) economic effects, so sensitivity is low.
5.25 The correct answer is D. In the medium term, if equilibrium exchange rates are
restored, then prices and costs will adjust to reflect the new competitive situation in
such a way as to maintain the value of the firm’s real cash flows.
Case Study 5.1: Airbus Industries

1 The business environment within which the firm operates is characterised by the
following:
 highly competitive with a competitive duopoly across most of its product range;
 involves highly technical and difficult-to-replicate products in relatively small
numbers;
 has multiple sources of inputs, although there are limited suppliers in any given
category;
 as a buyer of foreign inputs, the company is exposed to currency risks when, for
example, it purchases outside the eurozone from US- or UK-based suppliers;
 many of the aircraft being sold by Airbus are subject to strong competition,
especially from Boeing;
 demand for aircraft is dependent on the demand for air travel and the ability of
airlines to buy new jets; this gives the demand for aircraft a degree of economic
pro-cyclicality.
2 An analysis of the company’s case indicates the following currency-linked inflows
and outflows:

EMU zone Boeing (US$)

suppliers
€ costs Bombardier (C$)

€ revenues
Euro costs
Global market
Airbus for commercial Embraer (BR)
aircraft
Foreign currency costs $ revenues
(US dollar)
Comac (yuan)
$ costs
£, ¥, etc.
costs
Others (various)
Non-euro US-dollar-based
suppliers suppliers
Cash flows
Potential offsets
Direct/transaction risks:
 Inputs or parts for aircraft, such as their engines, from non-eurozone suppliers
have to be paid for in foreign currency, whereas revenues arise for the large part
in US dollars. These revenue and cost flows are shown by the solid arrows in the
figure. To the extent that these mismatch, the company faces transaction risks.
 The firm is supplying a specialised capital good product for which there is a
global market, for which there are a limited number of other suppliers and which
is priced in US dollars. Revenues arise some considerable time after costs are
incurred, given the lengthy production process in building an aircraft – several
years in some cases. This exposes Airbus to significant exchange rate risk be-
tween the US dollar and the euro, which needs to be managed. One mitigating
factor is that, to the extent that customers have revenues in euros, they may be
willing to purchase Airbus aircraft in euro terms, but this is likely to be a small
part of their revenues. These offset opportunities are shown as dashed lines in
the diagram.
 By purchasing aircraft components from the US or countries that have their
currency tied to the US dollar, the company can offset or hedge US dollar re-
ceipts with US dollar payments.
Competitive and indirect risks:
 The major competitive issue for Airbus is the critical US dollar/euro exchange
rate. As Airbus has significant costs in euros and revenues in US dollars, in order
to make a profit, if the US dollar is weak against the euro, it may have to forgo
sales or accept lower profit margins. As its major rival is Boeing, which has both
costs and revenues in US dollars, when the US dollar rises (falls) against the euro,
Airbus benefits (suffers) from the competitive effect of having reduced (in-
creased) costs when converted into US dollars. Hence Airbus’s competitive
position is very significantly affected by the path of the exchange rate, although

technological innovation and advantage can, to some extent, redress the compet-
itive balance.
 Airbus is threatened longer term by the emergence of choices in some of its
segments, notably that for the A320. Looking ahead, there is a threat that lower-
cost producers in Brazil and China (two emerging-market countries that together
with Russia and India form the BRIC group of nations) may be in a position to
offer comparable aircraft at much lower prices. In the longer term, Russia and
even India may add to the industry rivalry by producing attractive designs.
 The company is exposed to the global economic cycle and, in particular, the
growth in airline travel in future years. Depending on how the world economy
and airlines fare, this will either add to or reduce its growth rate in orders and,
ultimately, the number of aircraft delivered in any given period. Periods of slug-
gish demand will greatly affect its future cash flows as orders are delivered and
paid for.
Module 6
Review Questions

6.1 The correct answer is B. Equity is also known as risk capital, since it gets the
residual value claim on the firm’s assets after other, fixed providers have been paid
off. It also provides a claim on real assets. It will not, however, guarantee to provide
a real return to the providers of finance.
6.2 The correct answer is B. Systematic effects arise from changes in economic
conditions in the economy. A market-wide index will mirror such changes, not
cause them. Company news is specific and may cause the company’s share prices to
change but will not affect the prices of other company shares in any systematic way.
6.3 The correct answer is C. Specific risk or stock-specific risk is that element of a
share’s total risk due to unique or firm-specific events.
6.4 The correct answer is B. By setting the amount of the dividend to be paid in
advance, the company has both reduced the uncertainty attached to the payment
and given information about how the company sees its business prospects. To the
extent that providing such information in advance informs investors about the firm,
it makes the shares less risky to hold.
6.5 The correct answer is A. In the case where a company adds debt to the balance
sheet (that is, the ratio of debt to equity or the leverage or gearing ratio is increased),
financial risk is increased and shareholders will require a higher return since that
element of the risk in the shares has risen. Changes to the liabilities of a business
should not have an impact on business risk or on the systematic risk of a firm.
Specific risk is idiosyncratic.
6.6 The correct answer is B. Financial distress is the business condition whereby firms
have great difficulty in meeting maturing contractual liabilities. If a firm cannot meet

these, it is insolvent or bankrupt. That it may have more current liabilities than
current assets may mean it is illiquid, but if it can borrow against future receipts it is
not financially distressed. The use of debt in the balance sheet does not of itself
create financial distress.
6.7 The correct answer is B. Commodities, although also used for investment purposes,
ultimately derive their value as inputs or factors of production in manufacturing
processes.
6.8 The correct answer is C. When a firm borrows, it creates the financial risk for the
firm’s shares. The conversion formula is:
1 1
0.70 1 1 0.28
0.70 1.24
0.87
6.9 The correct answer is C. We solve using Equation 6.3, namely:
√1.2 0.32 0.25

0.458
6.10 The correct answer is C. We need to reverse the financial leverage equation,
Equation 6.7, so that we solve for the firm beta, namely:
.
.
.
.
0.65
6.11 The correct answer is C. Commodity price risk arises because the market price at
which commodities can be bought and sold changes – due to changes in demand
and supply (that is, market forces). Commodity price risk is also known as market
risk or, simply, price risk.
6.12 The correct answer is B. Financial instruments are influenced by (I) interest costs
and (V) quality factors. All things being equal, a highly rated issuer will trade for a
lower yield/higher price than a lower-rated issuer. Commodities are affected by (II)
costs of storage (oil, for instance, if purchased, has to be stored), (III) transportation
(if oil is purchased from the Gulf, it has to be shipped to the markets in America,
Europe or Asia), refining and then (IV) delivery to end users.
6.13 The correct answer is A. There is no arbitrage because buying the oil spot at $120.15
needs to be funded for one month, making the price required to sell it and still break
even $120.60. Because the oil has to be delivered to Rotterdam, 80¢ has to be added

to that, giving a price of $121.40, the same at which it can be purchased/sold in

Rotterdam with one month’s delivery.
6.14 The correct answer is C. Seasonal characteristics exist for soft commodities (or
agriculturals) due to the food production cycle. In the autumn, when products
become available, the price normally is lower than at other times. Energy is more in
demand in the winter, so spring and summer prices tend to be lower.
6.15 The correct answer is A. In a normal commodity market that is not subject to
supply shortages (or squeezes), we would expect to see early delivery months being
less expensive than later delivery months simply because the cost of storage,
interest, insurance and any wastage means that buying the commodity today and
holding it for future delivery has a cost that is reflected in future delivery prices.
6.16 The correct answer is B. The normal forward price of the commodity in one
month’s time will be found by calculating the cost of holding the commodity for
one month. This is $500 × (1.1225)1/12, which is $504.84. The market price is
$506.25, a difference of $1.41. Hence the forward price is somewhat above what we
might expect to see in the market. The difference represents the convenience yield
(this is 3.8 per cent on a per year basis) being paid by the market for guaranteed
supplies.
6.17 The correct answer is C. A convenience yield on a commodity is the price
consumers are willing to pay to guarantee having the commodity in the event of a
future potential shortage. Since substitution is difficult, any threat to supply raises
the convenience yield.
6.18 The correct answer is B. The market risk of shares is that element of risk that is
prevalent in all shares to a greater or lesser extent (and hence also known as
systematic) and is due to the common impact on valuations of news about the
economy.
6.19 The correct answer is D. The decision by the central bank to raise interest rates will
affect all firms to a greater or lesser extent. However, an industrial accident, the
takeover of one firm by another and the appointment of a new chief executive will
only have an impact on the particular company and, possibly, those of competitors
as well. These are firm-specific events.
6.20 The correct answer is C. In the case where a company retires debt, the ratio of debt
to equity (the leverage or gearing ratio) falls, hence the financial risk falls and
shareholders will require a lower return since that element of the risk in the shares
has declined.
6.21 The correct answer is B. The announcement that supplies from a major producing
region are likely to be less than anticipated will, in the absence of any countervailing
factors, raise the future delivery price of cocoa.
Case Study 6.1: Banking

1 A bank’s major activity is in lending money provided by depositors to borrowers.
Since the deposits are loans, these have to be repaid. The cushion provided by
equity (as risk capital) is very small (about 9:1), so there is not much margin for error

(industrial companies typically have a ratio of between 4:5 and 5:4). The managers
need to prevent a serious lending loss undermining the solvency of the bank.
The major risks from this kind of activity are:
 credit risk: the risk that the borrower is unable or unwilling to repay the loan;
 interest-rate risk: if the bank borrows short term and lends long term, it may have a
significant interest rate mismatch (known as a gap) between the cost of money
and the rate at which it earns it from the loans it has made;
 funding risk: the bank, if it borrows short term and lends long term, is exposed to
the danger that it cannot raise funds in the market; it has already lent out the
money so will be in difficulties if it cannot fund itself;
 currency risk: if the bank lends in a different currency from its deposits (and share
capital), it may be assuming significant exchange rate risk;
 operational risks: how well the bank manages its operations and processes, the
managerial qualities of its staff, the procedures designed to prevent fraud and
other actions by employees (such as colluding with borrowers).
Note that in 2008, and again for European banks in 2011, we have seen significant
concerns from shareholders about the strength and stability of banks due to exactly
the kinds of concerns given above. In particular in both instances, there was a great
deal of fear that banks had hidden losses from lending and hence undisclosed credit
risk losses. This meant that governments had to intervene to shore up systemically
important banks and, in some cases, inject significant amounts of new equity to
prevent the bank failing.
Faced with the above concerns, the kinds of reassurances the bank might provide to
shareholders are:
 for credit risk: details of how the bank assesses customer risk and undertakes its
lending policy. In addition, the bank might indicate how well diversified the
bank’s lending is, so that the default of one borrower does not materially affect
the bank’s standing. It might also provide details of the significant major expo-
sures to particular types of borrowers and details of previous loan loss
experience;
 for interest rate risk: an indication of its policy about the extent of maturity and
interest rate mismatching allowed as well as an indication of the effects of such
policies;
 for currency risk: details of currency exposures and policies used to mitigate the
risks, as well as an indication of the impact of changes in exchange rates on the
bank;
 for operational risks: details of how the bank organises itself, its investment in
systems and training and the qualifications and experience of key bank person-
nel.
Case Study 6.2: Copper

1 Prices for copper as quoted on the London Metal Exchange (LME) in October
2011 were:

Copper Prompt date Buyer ($) Seller ($)

Cash 19/10/2011 7565 7566
3 months 17/01/2012 7569 7570
December 1 19/12/2012 7590 7600
December 2 18/12/2013 7570 7580
December 3 17/12/2014 7530 7540
15 months 16/01/2013 7590 7600
27 months 15/01/2014 7565 7575
The US interest rates were:

overnight: 0.14278%
1 month: 0.24444%
3 months: 0.40583%
6 months: 0.59556%
The commodity market report from the Financial Times of 18 October 2011 high-
lighted the following about the copper market:
1. Growing concerns about a fall in supply due to strike action at the Grasberg
mine in Indonesia, which has the largest recoverable reserves of copper and
which sent the price of copper for forward delivery in three months’ time as
traded on the LME up by 0.7 per cent to $7560 per tonne.
2. The continuing industrial relations problem had forced the mine’s managers to
operate a minimum production schedule after 12 000 of its 23 000-strong work-
force opted for strike action.
3. As a result of problems at the Grasberg mine, its parent company, Freeport-
McMoRan, the largest listed copper-production company in the world, fell by 4.2
per cent.
4. An exhibit showing the behaviour of the copper price for three-month delivery
as traded on the LME, which ranged from above $10 000 in January–February
of 2011 to a low of about $6800 by the start of October 2011. The current price
represented a rally from this low point driven by supply and demand factors.
Observations:
1. The forward prices for copper delivery are clearly affected by the troubles at the
Grasberg mine. If we look at the three-month delivery price on the LME, the
one most affected by the industrial dispute, it is $7569 per tonne, whereas the
15-month contract is at $7590 per tonne, in spite of the additional time period
involved. This is most evident when we compare the prices for the three De-
cember contracts with maturities in 2012, 2013 and 2014. These indicate a lower
price as we move out in time.
2. Consequently, the forward prices of the commodity are consistent with the view
that, the further out in time, the higher the price should be. The longest available
maturity is trading at $7565 per tonne, compared to the 15-month maturity, a
small decline in price of $25 per tonne. This indicates that the market is affected

by the current potential supply shortages if the Grasberg mine remains closed
for any protracted period, given its importance as a source of new supply for the
global market in copper.
3. Hence the prices reflect the prevalence of a convenience yield as users may be
concerned about the availability of future supply, although this is currently mod-
est. While not provided in the question, the upsurge in the copper price followed
a significant price decline in the first nine months of 2011. At the start of the
year, the price had been around $9500 and spiked at over $10 000 but subse-
quently fell from August onwards to reach a low of around $6800 before
recovering somewhat to the price above $7500.
Module 7
Review Questions

7.1 The correct answer is B. The random walk model for asset prices predicts that the
price at any point in time should diffuse in a random way away from the current
price in an unpredictable fashion.
7.2 The correct answer is A. The steps for determining the right answer are to divide
440 by 450 and take the natural log of the result:
ln 0.0225
7.3 The correct answer is C. The true interest rate earned on an investment takes
account of the periodicity of the payments. Because a monthly investment earns
interest on interest, it will have a higher effective rate than the quoted annualised
monthly rate. A 20 per cent rate will represent 1.67 per cent per month (20%/12).
Compounding this gives 21.94 per cent ((1.0167)12).
7.4 The correct answer is C. An investment paying interest quarterly will grow by
(1 + 0.0275)5 = 1.14527 for the period, so £10 000 invested at this rate will have
grown to £11 453.
7.5 The correct answer is C. The rate on prime accounts of 14 per cent per year is an
annual percentage rate. This will not explicitly include the compounding rate, so it is
not an effective rate. The effective rate is 14.93 (1 + [0.14/12])12. We are told that
investors with the savers account get an effective 15.05 per cent on their holding. So
the savers get a better deal – by 0.12 per cent.
7.6 The correct answer is B. If the company switches to indicating the APR (rather than
an effective rate), the prime rate will be quoted at 14 per cent and the savers rate at
14.52 per cent ([(1.1505)0.5 – 1× 200]), a differential of 0.52 per cent.
7.7 The correct answer is C. The term ‘force of interest’ refers to the effect of reducing
the compounding interval for a given sum. Compounding a sum at 20 per cent, for
one year once a year, gives a terminal value of 1.20. If the same interest rate is
compounded every day, the terminal value rises to 1.221.

7.8 The correct answer is A. In a binomial asset price model, there are only two
possibilities for the price at any given point: the up (U) with 0.509 probability and
the down (D) with (1 − 0.509) or 0.491 probability. Since each change is independ-
ent, the probability of getting three consecutive falls is (0.491)3 or 0.118.
7.9 The correct answer is A. A 1.5 per cent price change per period represents a price
fall of 1/1.015 per period, or 0.9852. There are three periods so (0.9852)3 = 0.9563.
The initial price was 500, the price change = 500 × 0.9563, so the price after three
falls should be 478.2.
7.10 The correct answer is D. Technically, volatility is the annualised daily standard
deviation on an asset. However, it is also an indication of how uncertain we are
about the future price an asset will take, as well as a measure of the rate of disper-
sion on an asset.
7.11 The correct answer is D. The expected value of the asset is the sum of the values for
each outcome multiplied by their probability: (150 × 0.45) + (110 × 0.20) + (90 × (1
− 0.45 − 0.20)) = 121. Note that, although the probability of a price of 90 is not
given, since all outcomes have to add to 1, it can be calculated from the other two
outcomes.
7.12 The correct answer is D. The tree of future prices, allowing a price change of 10 and
an initial price of 600, will be as shown below:
640
630
620 620
610 610
600 600 600
590 590
580 580
570
560
7.13 The correct answer is C. The probabilities of the outcomes for the different prices
are:
t=0 t=1 t=2 t=3 t=4

0.0650
0.1288
0.2550 0.2550
0.505 0.3787
1 0.5000 0.3749
0.495 0.3712
0.2450 0.2450
0.1213
0.0600

The possible paths leading to the two prices below 600 are 580, which has a
probability of 0.2450, and 560, which has a probability of 0.0600. So the combined
probability of getting both (they are additive in this instance) is 0.305.
7.14 The correct answer is D. The decline in price means that, now for a three-period
tree with a price change of 10, only the range 620–560 is obtainable.
7.15 The correct answer is C. Implied volatility is the volatility for a given maturity being
traded in the market, as derived from backing out its value from an option-pricing
model.
7.16 The correct answer is B. Volatility measures the dispersion of returns. A higher
volatility means there is more dispersion to the return (that is, a histogram of such a
distribution is flatter). Asset A has a volatility of 0.25 and B of 0.30, consequently B
is riskier than A. Or A is less risky than B, which is the same thing.
7.17 The correct answer is D. If the volatility of an asset changes, then the asset price
may or may not change (in fact it is more likely to change than not) but the price of
an option on the asset will change since the option price is sensitive to changes in
volatility (that is, it is a volatility-sensitive instrument).
7.18 The correct answer is D. Rapid developments taking place in the fundamentals of
the asset will lead to a significant re-evaluation of its value. The arrival of infor-
mation and knowledge about the likelihood of such information having an impact
on the price will lead to more uncertainty as to what the future value may be. Low
levels of observed volatility are probably unlikely to be maintained and hence the
market is expecting volatility to return to more normal levels. Finally, the past is not
necessarily a good guide to the future.
7.19 The correct answer is A. For conversion, we use the formula:
Annualised volatility Periodic volatility √Time
Since there are 252 trading days in the year, the result is:
0.04 √252 0.63
7.20 The correct answer is B. When faced with the evidence that the distribution does
not conform to the normal distribution, the risk manager will only be able to
approximate the likelihood of price changes by assuming normality. To handle the
extreme price changes, the risk manager will also use other techniques (for instance,
stress testing).
7.21 The correct answer is B. Observed asset price changes have more observations that
are close to the mean, that have extreme values, and that tend to be skewed to the
left (that is, they have negative skewness) than does the normal observation.
Because we are looking at a sample of prices, we cannot say that the distribution is
without a variance (the variance being a statistic of the data), nor can we determine
whether the data underlying the observed distribution are made up of several
different distributions.
7.22 The correct answer is C. Skewness (the third moment of a normal distribution) is a
measure of the degree to which the observed distribution has more values to the
right (positive skewness) or the left (negative skewness). Many financial data series
show negative skewness.

Case Study 7.1: Diffusion Trees

1 The upward move in prices is computed as:
Pt × 1.027
The downward move as:
Pt/1.027
The two tree diagrams are given below.
Tree with price change of 2.7 per cent per period 120.50
117.33
114.25 114.25
111.25 111.25
108.32 108.32 108.32
105.47 105.47 105.47
102.70 102.70 102.70 102.70
100.00 100.00 100.00 100.00
97.37 97.37 97.37 97.37
94.81 94.81 94.81
92.32 92.32 92.32
89.89 89.89
87.53 87.53
85.23
82.99
Tree with price change of 3 per cent per period 121

118
115 115
112 112
109 109 109
106 106 106
103 103 103 103
100 100 100 100
97 97 97 97
94 94 94
91 91 91
88 88
85 85
82
79

The numbers, as you will have become aware from computing the tree, were set so
as to give approximately the same results on the upside at the end of the eighth
period. The key point about assuming that the asset price changes by a fixed amount
is that the rate of fall, in price declines, is more rapid than with the return assump-
tion. With returns, the price goes to a maximum low of 83, whereas, with the price
moves, it is at 79. This is a function of the different models: with the price change
model, a fixed amount is being added/subtracted. With the return model, the price
at the end of the period is a function of the previous period’s price.
2 To answer this question we must compute the probabilities of the outcomes for
each of the branches of the tree. This is shown in the table below. Note we can use
the binomial distribution (from a statistics textbook) to work out the probabilities or
calculate them from the tree itself.
Tree with price change of 2.7 per cent per period 120.50
117.33 0.008
114.25 0.017 114.25
111.25 0.033 111.25 0.057
108.32 0.065 108.32 0.098 108.32
105.47 0.129 105.47 0.161 105.47 0.169
102.70 0.255 102.70 0.255 102.70 0.239 102.70
100.00 0.505 100.00 0.379 100.00 0.316 100.00 0.276
97.37 0.500 97.37 0.375 97.37 0.312 97.37
0.495 94.81 0.371 94.81 0.309 94.81 0.271
0.245 92.32 0.245 92.32 0.230 92.32
0.121 89.89 0.152 89.89 0.159
0.060 87.53 0.090 87.53
0.030 85.23 0.052
0.015 82.99
0.007
Note: Numbers in italics are probabilities.
For the returns table, the chance of getting a price above 110 is 0.008 + 0.057, or
0.065. To get a price below 85, the probability is just 0.007.

Tree with price change of 3 per cent per period

121
118 0.008
115 0.017 115
112 0.033 112 0.057
109 0.065 109 0.098 109
106 0.129 106 0.161 106 0.169
103 0.255 103 0.255 103 0.239 103
100 0.505 100 0.379 100 0.316 100 0.276
97 0.500 97 0.375 97 0.312 97
0.495 94 0.371 94 0.309 94 0.271
0.245 91 0.245 91 0.230 91
0.121 88 0.152 88 0.159
0.060 85 0.090 85
0.030 82 0.052
0.015 79
0.007
A spreadsheet version of this table is available on the EBS course website. In order to produce
this table, you need to alter the price change from 2.7 per cent to 3 per cent in the spread-
sheet (using the input cells coloured in orange).
Note: Numbers in italics are probabilities.
For the price change tree, the probability of a price above 110 is 0.008 + 0.057, or
0.065. The probability of a price at or below 85 is 0.052 + 0.007, or 0.059.
3 The price histogram should look as follows:
0.300
0.271 0.276
0.250
0.200
0.169
0.159
0.150
0.100
0.052 0.057
0.050
0.007 0.008
0.000
82.99 92.32 102.70 114.25

The return histogram should look as follows:
0.300
0.271 0.276
0.250
0.200
0.169
0.159
0.150
0.100
0.052 0.057
0.050
0.007 0.008
0.000
–0.186 –0.133 –0.080 –0.027 0.027 0.080 0.133 0.186
4 The returns for the asset for each future value after seven steps is calculated by:
ln
where P is the asset price, and t is the time (t = 0,…7)

For the topmost price, we have:
.
0.18649 ln
The calculation of the mean expected return is:
ri ρi riρi
−0.18649 0.007 −0.00136
−0.13321 0.052 −0.00693
−0.07993 0.159 −0.01272
−0.02664 0.271 −0.00721
0.02664 0.276 0.00736
0.07993 0.169 0.01351
0.13321 0.057 0.00766
0.18649 0.008 0.00156
μ= 0.00186
The calculation of the standard deviation is as follows:

ri μ ri− μ ri − μ 2 ρi ri − μ 2ρi
−0.18649 0.00186 −0.18836 0.03548 0.007 0.00026
−0.13321 0.00186 −0.13507 0.01825 0.052 0.00095
−0.07993 0.00186 −0.08179 0.00669 0.159 0.00106
−0.02664 0.00186 −0.02851 0.00081 0.271 0.00022
0.02664 0.00186 0.02478 0.00061 0.276 0.00017
0.07993 0.00186 0.07806 0.00609 0.169 0.00103
0.13321 0.00186 0.13134 0.01725 0.057 0.00099
0.18649 0.00186 0.18463 0.03409 0.008 0.00029
∑ 0.00497
√ 0.07048
Module 8
Review Questions

8.1 The correct answer is D. Managers will be concerned about the time frame or
period over which risks are to be managed. They will also be concerned about the
decision horizon; that is, the time required to reach a decision on changing the
exposure. The degree of concern will be related to the potency of the risk or, in
mathematical terms, its volatility as well as the amount involved.
8.2 The correct answer is C. A firm’s risk threshold is the degree of tolerance within the
firm for accepting various kinds of risk.
8.3 The correct answer is A. A risk audit is the process undertaken by a risk manager to
identify (but not necessarily quantify) the different risks inherent in a firm’s com-
mercial activities, its production processes and so forth.
8.4 The correct answer is B. Confidence limits are used to establish the parameters
within which changes in risk factors are likely to fall and are used for alerting
managers to the potential need to take corrective action.
8.5 The correct answer is B. Materiality is a management principle that distinguishes
between exposures that are significant and those that are insignificant. An exposure
is the effect of a particular risk and the amount involved in relation to the firm’s size
and condition. Significance will differ between firms, organisations and individuals.
8.6 The correct answer is C. Changing a firm’s behaviour in response to risks involves
the risk manager finding ways to alter the firm’s activities and processes in ways that
reduce risks.
8.7 The correct answer is B. A firm may sell risk capacity when it has the ability to
absorb risks that other firms wish to transfer or insure against. Selling options, if
done properly, does not involve risk capacity since, in theory, the written option can

be fully hedged. Nor does it necessarily involve structuring risk management

activities and processes in such a way as to reduce their cost.
8.8 The correct answer is D. A firm will seek to organise its operations in such a way as
to minimise the impact of changes in the risk factors. It can do this by designing its
production and distribution and targeting markets so as to minimise their impact on
the firm’s cash flows. It can also do this by matching, as far as possible, the nature
of its liabilities to its assets and by matching revenues and expenditures by currency
and interest rate.
8.9 The correct answer is D. There are limits to the degree that designing operations
with a view to reducing risk will successfully insulate the firm from financial risk. By
overconcentrating on such operational hedges, the firm can end up with an ineffi-
cient set of products and processes. Also excess market risks can be – if required –
hedged out in the financial markets.
8.10 The correct answer is A. A firm, when seeking to manage risks, will be most
concerned about the potential losses that might ensue. Some firms may wish to
profit from risk taking, as well as ensuring that cash inflows and outflows are
matched. But the main concern will be the potential for losses from being exposed
to different kinds of risk.
8.11 The correct answer is B. The top-down, or macro, perspective involves examining
the firm as a whole, whereas the building-block, or micro, approach starts from the
perspective of the individual risks and then builds up to the full picture. In essence,
one approaches from the organisational perspective, the other the object perspec-
tive.
8.12 The correct answer is A. The total net exposure for the group will be the sum of the
two exposures that are netted. The calculation is given in the following table:
Co. I Income Expend. Co. II Income Expend. The Group

Maturity (+) (−) Maturity (+) (−) Income Expend. Net
1 month 150 55 1 month 210 150 360 205 155
2 months 180 40 2 months 240 175 420 215 205
3 months 25 80 3 months 85 45 110 125 (15)
Total 355 175 Total 535 370 890 545 345
8.13 The correct answer is C. A review of the table in the answer to Question 8.12 shows
that the net exposure in the two-month maturity is above the 200 units of currency
A limit authorised by the group.
8.14 The correct answer is A. The net exposure for the two companies, from the table in
the answer to Question 8.12, is 345 units of currency (after internal offsets), so at
the exchange rate A4/M, this is 86.25 units of currency M.
8.15 The correct answer is C. To obtain the answer, we must first determine the net
exposure per currency, from the following table:

Co. I Receivables Payables Net Co. II Receivables Payables Net

Maturity (+) (–) Maturity (+) (–)
1 month 1680 650 1030 1 month 270 348 (78)
2 months 2300 450 1850 2 months 564 725 (161)
3 months 6200 300 5900 3 months 225 415 (190)
Total 10180 1 400 8780 Total 1 059 1 488 (429)
This net position (that is, after the internal offsets have been taken) is then convert-
ed into the base currency X at the exchange rate, from the following table:
Currency A in X Currency B in X Net position of

currencies
A20 = X1 B6 = X1 A and B
reported in X
(A) (X) (B) (X)
1030 51.5 (78) (13) 64.50
1850 92.5 (161) (26.8) 119.30
5900 295 (190) (31.5) 326.50
8780 439 (429) (71.3) 510.30
Because we cannot offset risks between currency A and currency B, we now add the
two currencies in X regardless of the sign to give a total currency exposure of
510.30 units of X.
8.16 The correct answer is D. The answer, referring to the table in the solution to
Question 8.15, is that there is an excess currency exposure in the three-month
maturity.
8.17 The correct answer is D. In order to determine offsets, we need to find flows
between two pairs of currencies where the transactions are offsetting. The different
transactions have the following signs (payments, or short-currency position = −;
long-currency position, receipts = +):
 sales from the French company to the US parent (+$, −€);
 purchases by the UK subsidiary from the US company (−$, +£);
 sales from the UK subsidiary to the Italian company (−€, +£);
 purchases from the Italian company by the German company (+€, −€);
 purchases from the UK subsidiary by the French company (−£, +€).
To see the effects of these multicurrency flows, the currency matrix for the groups
is given below.

Euros British
pounds
+ − + −
US + Yes Y
− Yes Y
France + Yes Y
−
Germany + Yes Y
−
Italy + Yes Y
− Yes Y
UK + Yes Y
−
Sum Y Y
For an offset to occur, we need both receivables and payables in the two pairs of
currencies in relation to the third. This occurs in the first column and first row. The
US parent company is selling to the UK subsidiary and buying from the French one.
The UK subsidiary, at the same time, is selling to the French company. Hence an
offset exists between the three currencies.
8.18 The correct answer is B. The purpose of a limit is to set a maximum loss on a given
position under adverse conditions. By setting such a limit, the manager knows that
the amount of exposure under unfavourable developments will not be more than
the predetermined limit.
8.19 The correct answer is D. By marking to market a position one is revaluing the
position in the light of how market prices have changed since the position was
established. This will show whether the position made a profit (or a loss). It is used
on futures exchanges to determine the margin requirement (if any) depending on
whether the position has earned or lost money.
8.20 The correct answer is C. To determine the answer, we first need to calculate the net
exposure on the positions. This is given by subtracting the receivables and payables
positions:
Maturity Receivables (+) Payables (−) Net position

1 month €250 000 €70 000 €180 000
2 months €345 000 €35 000 €310 000
3 months €285 000 €45 000 €240 000

The revaluation process now recalculates the value based on the change in the
exchange rate:
Period € amount Original British pounds Current British pounds Current

rate equivalent at ex- equivalent at profit/
original rate change current rate loss
rate
1 mth €180 000 1.60 £112 500.00 1.62 £111 111.11
£1388.89
2 mths €310 000 1.65 £187 878.79 1.68 £184 523.81
£3354.98
3 mths €240 000 1.70 £141 176.47 1.75 £137 142.86
£4033.61
€730 000 £441 555.26 £432 777.78
£8777.48
8.21 The correct answer is B. The value-at-risk method is concerned with predicting the
possible changes in value of a position based on a statistical estimate of possible
future price changes.
8.22 The correct answer is B. When applying a value-at-risk assessment to a position, the
only computed element is the volatility of the underlying risk. The confidence limit
and the decision time horizon are both determined by the decision maker or risk
manager.
8.23 The correct answer is C. Assuming that the other factors involved in the VaR
calculation are the same, asset B with the higher volatility will mean that it has more
value at risk.
8.24 The correct answer is B. Volatility is the annualised periodic volatility. If the one-
year rate = Periodic rate × √Time, then the periodic rate for the decision horizon
will be: One-year rate/√Time. The one-week volatility of asset
A = 0.20/√52 = 0.0277 and that for B = 0.12/√26 = 0.0235. So, based on the
differences in the decision horizon, A is riskier than B.
8.25 The correct answer is A. Applying the stress test for extraordinary market
conditions aims to look at those times when market prices have moved significantly
over a short period. Also, given the view that markets have evolved and changed
over time, the risk manager will wish to use a recent demonstrable event in prefer-
ence to a distant one. Consequently, the collapse of the Bretton Woods Agreement,
although a significant event of itself, does not fit the requirements of a market
event.
8.26 The correct answer is B. When applying portfolio effects to a position using the
value-at-risk approach, the total risk of the position will be reduced. It might be
argued that it depends on the nature of the underlying assets in the portfolio.
Whereas for assets within a class there may be no effect, between assets in different
classes, as stated in the question (such as commodities and equities, currencies and
debt instruments), there will be less than perfect correlation. If there is less than
perfect correlation, then portfolio diversification effects hold.

8.27 The correct answer is B. To answer this you need to look up the area under the
curve in a normal distribution. A z score of 1.9 in the areas under the normal curve
translates to a value of 0.0287. However, we can expect price rises and price falls, so
the total area is twice that, or 0.0574. So based on the normal distribution density
function we are unlikely to get more than 5.74 per cent of observations beyond ±1.9
standard deviations.
8.28 The correct answer is C. Applying the value-at-risk model, the price change that can
be expected over the decision horizon (one week) will be:
.
1.95 £950 000 £38 534
√
The price range is therefore £988 534 – £911 466 (£950 000 + £38 534 and
£950 000 – £38 534).
8.29 The correct answer is C. With a one-month time horizon and a 2 standard deviation
confidence limit, the amount of price change that is to be expected is:
.
€1.5m 2 €303 109
√
8.30 The correct answer is C. With a skewed distribution (that is, a distribution with
more observations to one or other side of the mean than predicted by the symmet-
rical bell shape of the normal distribution), the probability of getting increases
(decreases) will be more (less) than that predicted by the areas under the normal
curve. For a positive skew (more observations to the right than the left of the
mean), this means that making an assumption that the distribution is normal will
underestimate price increases and overestimate price decreases.
Case Study 8.1: Georgetown Industries

1 On the basis of netting income and expenditures in the US dollar, the company has
the following net position:
Time Receivables Payables US$ Net position Exchange

US$ US$ rate US$/£
1 month 1 500 000 750 000 750 000 1.5000
2 months 1 000 000 850 000 150 000 1.4975
3 months 900 000 800 000 100 000 1.4950
6 months 250 000 700 000 (450 000) 1.4925
3 650 000 3 100 000 550 000
Ignoring the timing differences, the company has a net long position in the US
dollar of $550 000.

2 The effect of a change in the currency position will be as follows:
Time Net Exchange Original Exchange Revalued

position rate value of rate position
US$ US$/£ position US$/£
1 month 750 000 1.5000 500 000 1.5010 499 667
2 months 150 000 1.4975 100 167 1.4995 100 033
3 months 100 000 1.4950 66 890 1.4975 66 778
6 months (450 000) 1.4925 (301 508) 1.4965 (300 702)
550 000 365 549 365 776
The value of the overall position has moved, in British-pound terms, from £365 549
to £365 776, a slight improvement of £227 on the original value.
3 By borrowing and lending, Georgetown Industries can offset the differences
between its receivables and payables positions across time. On the basis that it
would want the position to net to zero at the longest maturity, it can offset the net
$450 000 payables in Month 6 against receipts in earlier months. The calculation
proceeds by matching out the longest maturity first:
Time Action Cash flow

Month 6 Net payments required – company wants to deposit funds to meet the ($450 000)
obligation
Next earliest cash flow is three months away:
Value discounted by three months ($444 544)
Month 3 Net receipts in US dollars; this only partially covers exposure $100 000
Amount remaining to be covered in earlier months: ($344 544)
Next earliest cash flow is one month away:
Value discounted by one month ($343 146)
Month 2 Net receipts in US dollars; this only partially covers exposure $150 000
Amount remaining to be covered in earlier months: ($193 146)
Next earliest cash flow is one month away:
Value discounted by one month ($192 363)
Month 1 Net receipts in US dollars: $750 000
Residual amount required to be hedged forward in FX market: $557 637
A spreadsheet explaining this solution is available on the EBS course website.
To cover its longest maturity position, which is a net payable, the company wants to
deposit the discounted value of the payable in Month 6 = $444 677 for three
months ($450 000/(1.04875)0.25). It receives $100 000 in Month 3, so the net
position will be $444 677 – $100 000 = $344 677 needs to be carried back to Month
2. The company now also receives a net $150 000 in Month 2, so the net amount

will now be $344 677/(1.04875)1/12 – $150 000, or $193 312. The next step is to
move to Month 1, where the present value of this is $192 547. However, the
company has a net receivable of $750 000, so a net $556 688 will need to be ex-
changed forward at one month to hedge the position against currency risk.
4 Operational considerations might play a part in the decision to use the company’s
US dollar account to hedge out future net receipts in the currency. (1) The company
might use its dollar inflows and outflows for hedging purposes, rather than mediat-
ing them through the foreign exchange market, if the funds cannot be used more
profitably elsewhere. (2) Having funds in US dollars might also help the company
manage any uncertainty as to the timing of the receipts and payables. If the actual
disbursement date depended on, for instance, completion and quality certification,
then the expected and actual payment dates might not coincide. (3) If the company
had a future requirement to use US dollars, it might prefer to leave surplus funds in
the US dollar account (albeit subject to exchange rate risk) rather than repatriate the
funds. (4) Finally, if the amount to be repatriated was small, the transaction costs
might mitigate against repatriation.
From a risk management perspective, there is little to be gained from holding US
dollars. Assuming the company is happy with the creditworthiness of its foreign
exchange counterparties, the company could have achieved the same result as was
obtained from depositing US dollars in the account by selling the net amounts due
in Months 1 to 3 and buying the net amount due in Month 6. Then the proceeds
would have been in the company’s British-pounds account.
The principal disadvantages of leaving funds in US dollars is the credit risk the
company is taking with its US bankers and possibly interest rate risk/mismatch risk.
Assuming that any surplus to future payments (see the answer to Question .3) has
been sold in the foreign exchange market, the company has no exchange rate risk
since inflows and outflows (across time) are exactly matched. However, there might
be some interest rate risk and mismatch between the expected deposit rate and
payments to be made if the bank is not willing to guarantee the rate to be earned on
the forward-start deposits. As a re-examination of the cash flows in Question .3 will
show, the deposit periods start in one, two and three months. By the time these
deposits start, interest rates may have changed in such a way as to make the terminal
amount less than that required to net the cash flow to zero in Month 6. For this
reason, the foreign exchange forward contracts are likely to be preferred.
Module 9
Review Questions

9.1 The correct answer is C. A forecast will include both an indication of the direction
and the magnitude of a change in value, whereas the value-at-risk approach only
predicts the magnitude of future changes.

9.2 The correct answer is D. The percentage return on the investment will be
(€65 900/€65 000 − 1) × 100% = 1.38 per cent over the two-week period. Note
that the annualised percentage return is 35.88 per cent (1.38 × 26) and the equiva-
lent annual return is 42.81 per cent ([1.013826 − 1] × 100%). However, the question
did not ask for these: so B is technically correct. However, normally returns, for
whatever period, by convention are expressed as an annualised rate to facilitate
comparisons between opportunities. You are absolutely correct if you selected D.
9.3 The correct answer is C. The expected value of the security will be the value under
each of the different outcomes multiplied by the probability of their occurring. So
the value will be:
(0.2 × 1800) + (0.4 × 1300) + (0.3 × 900) + (0.1 × 450) = 1195
9.4 The correct answer is A. It is normal to quote the returns on a security in an
annualised fashion, to facilitate comparison. So, for the above security, the expected
return is found by:
1 100 19.02%
9.5 The correct answer is D. To compute the answer, we must first find the returns on
the investment for each of the four states as follows and take their weighted
average:
State of the world (ρ) Value under the Return P1/P0 Return ×
state of the −1 (ρ)
world
High growth 0.2 1800 0.8 0.16
Moderate growth 0.4 1300 0.3 0.12
Recession 0.3 900 −0.1 −0.03
Depression 0.1 450 −0.55 −0.055
0.195
We now have to compute the dispersion of returns:
(ρ) Return Return in each (Return − (Return −

state − expected expected)2 expected)2 × ρ
0.2 0.8 0.605 0.366 0.0732
0.4 0.3 0.105 0.011 0.0044
0.3 −0.1 −0.295 0.087 0.0261
0.1 −0.55 −0.745 0.555 0.0555
0.1592
The standard deviation is the square root of the variance, which is √0.1592 = 0.40,
or 40 per cent.

9.6 The correct answer is B. The range of returns will be between −0.20 and 0.30. The
lower boundary of 2 standard deviations = 0.05 − (0.125 × 2) and the upper
boundary will be (0.125 × 2) + 0.05.
9.7 The correct answer is C. For a normal distribution, the likelihood of observations
falling ± 2 standard deviations is 0.955.
9.8 The correct answer is A. In an efficient market, a security will have a higher
expected return than another if it has a higher risk. In other words, there is more
expected return for taking on more risk. So statement A is unlikely since no investor
would want to hold security B because it has a lower expected return than A and a
higher variance. A is promising more and has less risk!
9.9 The correct answer is B. To find out the probability of the return being 40 per cent
or above, we first normalise the result into a z score by:
. .
0.83
.
Depending which table for the area under the normal curve is used, a z score of 0.83
will indicate either 0.7967 for the value 0.83, or 0.2033. Since we are interested in
the area outwith the 0.83 value, for the larger number we want the product of (1 −
0.7967) = 0.2033, or we have it direct. As a result there is an approximate 20 per
cent chance that the return will be above 40 per cent.
9.10 The correct answer is C. A correlation coefficient of 0.40 would indicate a degree of
positive correlation between the two assets. We would expect both A and B to tend
to have higher returns than average at the same time.
9.11 The correct answer is A. The mean return for the two securities will be the weighted
average of the returns in the high and low states:
For X, this is 0.55 × 0.17 + 0.45 × −0.09 = 0.053.
For Y it is 0.044.
9.12 The correct answer is A. To determine the variance or the standard deviation (the
square root of the variance), we need to calculate the results of the two cases:
Security X
State Probability (ρ) Return Expected Difference Difference Probability
return squared × squared
difference
(i) (ii) (iii) (iv) (v) (vi)
High 0.55 0.17 0.053 0.117 0.0137 0.0075
Low 0.45 −0.09 0.053 −0.143 0.0205 0.0092
1.00 Variance: (σ2) 0.0167

Security Y
State Probability (ρ) Return Expected Difference Difference Probability
return squared × squared
difference
(i) (ii) (iii) (iv) (v) (vi)
High 0.55 0.12 0.044 0.076 0.0058 0.0032
Low 0.45 −0.05 0.044 −0.094 0.0088 0.0040
1.00 Variance: (σ )
2 0.0072
Standard deviation: √(σ )
2 0.0849
9.13 The correct answer is D. The covariance is found by solving for the different states:
ρi rx rx − E(rx) ry ry − E(ry) ρi[rx − E(rx)]

[ry− E(ry)]
0.35 0.17 0.117 0.12 0.076 0.003112
0.15 0.17 0.117 −0.05 −0.094 −0.001650
0.25 −0.09 −0.143 0.12 0.076 −0.002720
0.25 −0.09 −0.143 −0.05 −0.094 0.003361
Covariance 0.002106
Correlation coefficient 0.191994
Hence the covariance = 0.002106.

The correlation coefficient is found by dividing the above by the product of the 2
standard deviations:
.
0.191994
. .
9.14 The correct answer is D. There is no calculation needed here.

9.15 The correct answer is D. There is no calculation needed here.
9.16 The correct answer is C. We can answer this by working out the ratio of expected
return per unit of risk by dividing the expected return by the standard deviation of
return (a variation of what is known as the Sharpe ratio). The security that offers the
worst trade-off is C, with a coefficient of 0.67. D has the highest coefficient at 0.97.
9.17 The correct answer is D. The minimum variance portfolio for two assets that are
correlated is found by the following formula:
Substituting the values given in the question, we have:

. . . .
. . . . .
0.68
Hence the proportions of the two assets are L = 0.68 and K = (1 − 0.68) = 0.32.

9.18 The correct answer is A. To compute the answer, we must first find the returns on
the investment for each of the four states as follows and take their weighted
average:
State of the world (ρ) Value under the Return Return × (ρ)
state of the world
High growth 0.2 1800 0.8 0.16
Moderate growth 0.4 1300 0.3 0.12
Recession 0.3 900 −0.1 −0.03
Depression 0.1 450 −0.55 −0.055
1.0 0.195
9.19 The correct answer is B. To compute the variance, we need to calculate the sum of
the squared deviations from the expected return weighted by their probability as
given in the following table:
State of the world (ρ) Return ri − μ 2 ×ρ

High growth 0.2 0.8 0.0732
Moderate growth 0.4 0.3 0.0044
Recession 0.3 −0.1 0.0261
Depression 0.1 −0.55 0.0555
1.0 0.1592
9.20 The correct answer is A. To find out the probability of the return being zero per
cent or below, we first normalise the result into a z score by:
. .
0.583
.
Depending on which table for the area under the normal curve is used, a z score of
0.583 will indicate either 0.7190 for the value 0.583, or 0.281. The area under the
curve we are interested in lies beyond the 0.583 value in the normal distribution
table. If we are using a continuous normal distribution table, we want the product of
(1 − 0.719) = 0.281; and if we are using a table for only half the normal distribution,
looking up the value 0.583 will give us 0.281 directly. As a result there is an approx-
imate 28 per cent chance that the return will be zero or below.
9.21 The correct answer is A. For assets where the correlation equals zero, the equation
for deriving the optimum combination of the two in a minimum variance portfolio
is:
Substituting into the equation, the result is 0.29.

9.22 The correct answer is D. The greatest benefits from portfolio diversification will
arise if assets have high negative correlation since gains in one (above the average)
will be offset by losses in the other.

9.23 The correct answer is A. A well-constructed portfolio can eliminate all the risk of
the individual assets in the portfolio.
9.24 The correct answer is C. The annualised standard deviation =
Daily variance 252 0.01 252 1.59
Case Study 9.1: Calculating the Risk Factors for Two Commodities
1 The table below shows the calculation of the daily returns, the sum and average
return for the data and the variance and standard deviation as well as the calculation
of the covariance between gold and silver.
Trad Gold Silver Gold (ri) Silver (ri) Gold Silver Covariance
ing
Days
ln(Pt+1/Pt) × ln(Pt+1/Pt) × 100 ri − μ 2 ri − μ 2 ri − μ ri − μ
100
1 385.80 5.16
2 386.10 5.19 0.078 0.580 0.015 0.193 0.054
3 383.20 5.09 −0.754 −1.946 0.504 4.352 1.481
5 383.35 5.09 0.039 0.000 0.007 0.020 −0.012
6 381.75 5.03 −0.418 −1.186 0.140 1.759 0.496
7 382.65 5.13 0.235 1.969 0.078 3.341 0.511
8 382.75 5.15 0.026 0.389 0.005 0.062 0.017
9 384.35 5.22 0.417 1.350 0.213 1.463 0.558
12 383.75 5.16 −0.156 −1.156 0.013 1.682 0.145
13 384.35 5.23 0.156 1.347 0.040 1.456 0.242
14 384.50 5.29 0.039 1.141 0.007 1.000 0.083
15 384.05 5.22 −0.117 −1.332 0.005 2.169 0.107
16 383.90 5.29 −0.039 1.332 0.000 1.419 0.006
19 383.50 5.22 −0.104 −1.332 0.004 2.169 0.088
20 384.50 5.32 0.260 1.898 0.093 3.087 0.535
21 384.10 5.36 −0.104 0.749 0.004 0.370 −0.036
22 383.00 5.50 −0.287 2.578 0.059 5.943 −0.591
23 384.85 5.66 0.482 2.868 0.277 7.436 1.435
26 385.55 5.79 0.182 2.271 0.051 4.538 0.481
27 383.55 5.71 −0.520 −1.391 0.226 2.347 0.729
28 383.45 5.58 −0.026 −2.303 0.000 5.972 −0.044
29 383.10 5.68 −0.091 1.776 0.002 2.675 −0.077
30 382.60 5.59 −0.131 −1.597 0.007 3.020 0.150
33 383.30 5.61 0.183 0.357 0.052 0.047 0.049
34 383.25 5.57 −0.013 −0.716 0.001 0.733 −0.027
35 381.90 5.45 −0.353 −2.178 0.095 5.376 0.716

Trad Gold Silver Gold (ri) Silver (ri) Gold Silver Covariance
ing
Days
ln(Pt+1/Pt) × ln(Pt+1/Pt) × 100 ri − μ 2 ri − μ 2 ri − μ ri − μ
100
36 381.65 5.31 −0.065 −2.602 0.000 7.524 0.058
37 381.80 5.35 0.039 0.750 0.007 0.372 0.051
40 379.85 5.29 −0.512 −1.128 0.219 1.609 0.593
41 379.40 5.29 −0.119 0.000 0.006 0.020 0.010
42 379.00 5.21 −0.105 −1.524 0.004 2.771 0.102
43 380.55 5.39 0.408 3.397 0.205 10.601 1.473
Sum −1.3702 4.3609 2.3375 85.5250 9.3848
Average −0.0442 0.1407 0.0754 2.7589
Variance 0.0779 2.8508
Standard deviation 0.2791 1.6884
Observations 31
The average return per day is simply:
1
For ease of exposition and to convert them to continuous percentages, as discussed

in the text, these values are multiplied by 100 to give percentages. The value for the
average return for gold is 0.0442. For silver it is 0.1407.
The variance is calculated as:
1
2
1
Each observation (ri) is subtracted from the average return and the sum then
squared to remove any negative values. We correct for the fact that we have a
sample of the population by adjusting the average by N−1, where N is the sample
size (31 in our example), so the divisor is 30 (31−1). The variance of gold is 0.0779
and for silver 2.8508.
And the standard deviation is:
1
1
Taking the square root of the variances for gold and silver, we have 0.2791 and
1.6884 respectively.
To calculate the interdependency in the two assets, we need to calculate the covari-
ance between the two sets of returns, which allows us then to calculate the
correlation coefficient. The covariance is found by:

1
1
The covariance between gold and silver is 1/30 × 9.3848 = 0.3128.
We find the correlation coefficient by:
The correlation is therefore 0.3128/0.2791 × 1.6884 = 0.6638.

So, to summarise the results, we have:
Statistics Gold Silver

Mean daily return −0.0442 0.1407
Daily variance 0.0779 2.8508
Daily standard deviation 0.2791 1.6884
Correlation (gold/silver) 0.664
Expressing these as annualised rates, taking 252 trading days in the year (see Section
9.8.1), we have:
Statistic Gold Silver

Variance 19.64 718.41
Standard deviation 4.431 26.803
2 To calculate the total value at risk (VaR) of the portfolio made up of the two assets,
gold and silver, we need to solve the following equation (which is Equation ﴾9.26﴿):
VaR VaR VaR 2 VaR VaR
We can therefore reformulate Equation 9.26 as:
VaR VaR VaR 2 / VaR VaR
We first calculate the VaR for both gold and silver at the confidence limit of 1.9
standard deviations:
Asset Amount Standard Confidence VaR (USD)
deviation* limit
Gold 1 250 000 4.4312 1.9 105 240.26
Silver 1 100 000 26.8032 1.9 560 186.37
* Remember this is a percentage value, so needs to be divided by 100 in the calculation of the VaR.
Putting these values into the equation gives:
VaR
105 240.26 560 186.37 2 0.664 / 105 240.26 560 186.37
This gives a portfolio VaR of $634 937.

Case Study 9.2: Portfolio Risk

1 The expected return on the three securities is found by calculating the weighted
average of the four possible state returns:
State ρ A ρ×A B ρ×B C ρ×C

Boom 0.2 0.20 0.04 0.15 0.03 −0.04 −0.008
Mod. growth 0.3 0.12 0.036 0.10 0.03 0.05 0.015
Slow growth 0.3 0.06 0.018 0.05 0.015 0.06 0.018
Recession 0.2 −0.05 −0.01 −0.02 −0.004 0.11 0.022
1.0 0.084 0.071 0.047
The variance and standard deviation are found by:
ρ A ri − μ ρ× B (ri− μ) ρ× C ri − μ ρ×
ri − μ 2 ri − μ 2 ri − μ 2
0.2 0.20 0.116 0.002691 0.15 0.079 0.001258 −0.04 −0.087 0.001514
0.3 0.12 0.036 0.000389 0.10 0.029 0.000252 0.05 −0.003 0.000003
0.3 0.06 −0.024 0.000173 0.05 −0.021 0.000132 0.06 0.013 0.000050
0.2 −0.05 −0.134 0.003591 −0.02 −0.091 0.001656 0.11 0.063 0.000794
1.0 σ2 = 0.006844 σ 2= 0.003289 σ2 = 0.002361
σ= 0.082728 σ= 0.057350 σ= 0.048590
A spreadsheet version of these tables is available on the EBS course website.
2 To calculate the covariance between the three securities, we need to undertake three
different calculations: A to B, A to C and B to C.
Covariance A to B
A B A×B×ρ
0.2 0.116 0.079 0.001833
0.3 0.036 0.029 0.000313
0.3 −0.024 −0.021 0.000151
0.2 −0.134 −0.091 0.002439
σAB 0.004736
ρAB 0.998217 or 0.99822

Covariance A to C
A C A×C×ρ
0.2 0.116 −0.087 −0.00202
0.3 0.036 0.003 3.24E−05
0.3 −0.024 0.013 −9.4E−05
0.2 −0.134 0.063 −0.00169
σAC −0.00377
ρAC −0.93736
Covariance B to C
B C B×C×ρ
0.2 0.079 −0.087 −0.00137
0.3 0.029 0.003 2.61E−05
0.3 −0.021 0.013 −8.2E−05
0.2 −0.091 0.063 −0.00115
σBC −0.00258
ρBC −0.92477
The correlation matrix for the three securities therefore looks as follows:
A B C
A 0.08273
B 0.99822 0.05735
C −0.93736 −0.92477 0.04859
The terms in italics on the diagonal are the standard deviation of the series.
3 The expected return will be a linear combination of the three securities by their
weights in the portfolio: (0.4)0.084 + (0.4)0.071 + (0.2)0.047 = 0.0714, or 7.14 per
cent.
A portfolio made up of three securities will have the following terms in the vari-
ance–covariance matrix for the risk of the portfolio:
Security A B C
A 2 2 wAwBσAB wAwCσAC
B wAwBσBA 2 2 wBwCσBC
C wCwAσCA wCwBσCB 2 2
Of course, we know that CA = AC and so forth, so the computations required are:

Security A B C
A (0.40)20.006844 (0.40)(0.40)0.004736 (0.40)(0.20) − 0.00377
B (0.40)(0.40)0.004736 (0.40)20.003289 (0.40)(0.20) − 0.00258
C (0.20)(0.40) − 0.0377 (0.20)(0.40) − 0.00258 (0.20)20.002361
This gives the following results:
Security A B C
A 0.001095 0.000758 −0.0003
B 0.000758 0.000526 −0.00021
C −0.0003 −0.00021 9.44E−05
σ2 0.002216
σ 0.047075
So the portfolio risk (standard deviation) = 4.71 per cent.
4 A spreadsheet explaining this solution is available on the EBS course website.
To calculate this, we need to solve the equation:
The standard deviation of A = 0.082728 and C = 0.048590. The value for Risk A at
1.96 standard deviations = 0.082728 × 1 000 000 × 1.96 = 162 146.9. For C, the
value at risk = 76 189.1. The correlation between A and C = −0.93736. Substituting
these into the equation, we have:
Total risk 162 146.9 76 189.1 2 0.93736 162 146.9 76 189.1
The total value at risk of the portfolio at 1.96 standard deviations is therefore
94 532.7.
Module 10
Review Questions

10.1 The correct answer is C. The calculation involves discounting the first year’s coupon
from the two-year instrument at the first-year rate of 6.25 per cent: 6.625/1.0625 =
6.24. The two-year instrument is at par, so trades at 100, the value minus the first
year’s coupon = 93.77. The two-year price relative is:
.
1.1372
.
The square root of 1.1372 = 1.0664, so the interest rate = 6.64 per cent.

10.2 The correct answer is A. The present value of a bond with an 8 per cent coupon and
the interest rate used to discount its future cash flow is 10 per cent is found by
solving:
∑
. .
One efficient approach to computing the above is to make use of a variation on the
formula for an annuity:
PVIFA %,
Adding the end principal and rearranging slightly gives:

100 1.1
. .
The present value of the bond is 87.71.
10.3 The correct answer is C. A strip is a zero-coupon bond created by ‘stripping’ out the
individual coupon and principal payments from a conventional or straight bond.
10.4 The correct answer is D. A spot rate is, barring differences in its method of
computation, the discount rate used to present value a particular maturity cash flow
to the present, the quoted rate on a zero-coupon bond and the interest rate earned
on a money market instrument. It is also the implied interest rate linking the present
value of a cash flow to its future value.
10.5 The correct answer is B. The one-year spot rate is found by solving for the second
cash flow once the intermediate half-year coupon payment has been removed:
.
. 1 100
. .
This gives a value of 9.22 per cent.

10.6 The correct answer is C. The zero-coupon rate for 18 months is uncovered from the
bond by finding the price relative between the current market price and value of the
final cash flow. We remove the value of the two intervening coupon payments of 5
each by discounting them by the half- and one-year rates:
99 . .
. . .
99 . .
. . .
99 4.7891 4.5767 .
.
89.6342 .
.
.
1 . 1.1715
.
.
√1.1715 1.1111
Solving for z1.5 and expressing the result as an annual rate gives 11.11 per cent.
10.7 The correct answer is B. The one-year forward rate is found by finding the solution
to the following equation:
1 1 1

Substituting values and rearranging, we have:

.
1.1250
.
So the one-year rate in one year’s time will be 12.50 per cent.
10.8 The correct answer is A. To calculate the implied forward rate, we need to solve the
following equation:
1 1 1
Substituting and rearranging, we have:
.
1.0825
.
So the implied forward rate for one-year in two years’ time = 8.25 per cent.
10.9 The correct answer is B. To calculate the par bond, note that we are solving for the
unknown value of the coupon rate on the par bond, namely:
100
Rearranging, we have:
100
100
Solving for the above gives a value of 8.7851 for the coupon rate, which is the par
yield.
10.10 The correct answer is D. The three-month rate in six months’ time is found by
solving for:
. . .
1 0.06375 1.063125 1 . .
Substituting and rearranging, we have:
. .
. 1.015869
.
We find the annualised rate by (1.015869)4 = 1.0650. So the annualised rate = 6.50
per cent.
10.11 The correct answer is D. A 15-month bond paying 10 per cent semi-annual coupon
will have the following remaining cash flows:
Time t=3 t=9 t = 15

Cash flow 5 5 105
These need to be present valued at the spot rates:
Time t=3 t=9 t = 15

Cash flow 5 5 105
Spot discount rate 0.9850 0.9547 0.9230
Present value 4.9248 4.7735 96.9093

The present value = 106.6076

As an aside, note that this is the value of the bond, including all the coupon pay-
ment being paid to the holder of the bond at the end of t = 3. If the bond was being
traded in the market, its price would be quoted at 104.11 (that is, net of the accrued
coupon value to date (5 × 0.5 = 2.5), which would be netted off to give the bond’s
clean price).
10.12 The correct answer is A. The required calculations are given in the following table.
We must first value the bond at the current interest rate, then modify the spot rates
by adding 0.10 per cent and recalculate the bond’s value.
Time 6 months 12 months 18 months

Spot rate 6.31% 6.50% 6.94%
Bond’s cash flow 3 3 103
Discount factor 0.969857 0.938967 0.904284
98.86775 2.909572 2.816901 93.14128
+ 0.10% 6.41% 6.60% 7.04%
Discount factor 0.969401 0.938086 0.903017
98.73324 2.908204 2.814259 93.01078
−0.13451
The difference is 0.1345 (ignoring the sign, as is conventional with risk measures).
10.13 The correct answer is B. The required calculations are given in the following table.
We must first value the bond at the current interest rate, then modify the spot rates
by adding 0.10 per cent at the one-year rate and corresponding differences at the
earlier and later maturities and recalculate the bond’s value. If the yield curve has
steepened by 10 basis points at the one-year maturity, then it will steepen by half
this at 6 months (that is, 5 basis points) and 1.5 times this at 18 months.
Time 6 months 12 months 18 months

Spot rate 6.3125% 6.50% 6.9375%
Bond’s cash flow 3 3 103
Discount factor 0.969857 0.938967 0.904284
98.86775 2.909572 2.816901 93.14128
Rotation = 1 year
+ 0.10% 6.36125% 6.60% 7.0875%
Discount factor 0.9696 0.9381 0.9024
98.66879 2.9089 2.8143 92.9456
−0.19896
The difference is 0.1990 (ignoring the sign, as is conventional with risk measures).
10.14 The correct answer is B. The total risk of the position will be the product of the
square root of the sum of the squared risks of the individual positions:

Total risk 1.40 1.60

This is equal to 2.13.
10.15 The correct answer is C. To find the total risk of a position that involves correlation,
we need to compute the additional risk inherent in the tendency of the two risks to
move together. The total risk is the result of the individual risks and their correla-
tion:
Total risk 1.50 2.1 2 0.40 1.50 2.1
This gives a value of 3.03.
10.16 The correct answer is B. To determine the total risk of a position that involves
correlation, we need to compute the reduction in risk inherent in the tendency of
the two risks to move apart. The total risk is the result of the individual risks and
their correlation:
Total risk 1.70 1.9 2 0.10 1.70 1.9
10.17 The correct answer is A. The values at 2 standard deviations for the two sides of the
hedged portfolio will be 0.05 × 2 × $1m = $100 000 and $90 000. The portfolio
risk will thus be:
Total risk $100 000 $90 000 2 0.95 $100 000 $90 000
This gives a value at risk of $31 623.
10.18 The correct answer is C. The present value of a bond with an 18 per cent semi-
annual coupon and interest rate of 12 per cent (semi-annual) is found by solving the
following equation:
100 1.06
. .
10.19 The correct answer is A. A par yield curve and bond will have, by definition, a
market value of 100.
10.20 The correct answer is C. To calculate the zero-coupon rate for the three-year
maturity, we need to proceed using the following approach:
1. Calculate the first periodic discount factor from the first zero-coupon rate
(= 1/√1.07625 = 0.965609).
2. We now back out the second zero-coupon rate by the following formula:
where Cn is the par interest rate (expressed as a decimal) and An − 1 is the sum of
the previous zero-coupon discount rates (that is, it is the present value of an
annuity). For the one-year maturity, this is:
.
1.0738
. .
Hence the one-year zero-coupon rate = 7.38 per cent.
Using a table to compute the results gives us the following:

Time Par yield 1 + Cn An − 1 An 1 −Cn × 1 + Cn/(1 − Zero-

(%) An − 1 (Cn × An − 1)) coupon
rate
0.5 7.25 1.03625 0 0.965018 1.03625 7.381406
1 7.63 1.038125 0.965018 1.892853 0.963209 1.077778 7.777786
1.5 7.81 1.039063 1.892853 2.784099 0.92606 1.122025 7.977905
2 7.94 1.039688 2.784099 3.639651 0.889506 1.168837 8.11276
2.5 8.06 1.040313 3.639651 4.459862 0.853277 1.219197 8.250421
3 8.38 1.041875 4.459862 5.24042 0.813243 1.281136 8.608808
So the three-year zero-coupon rate = 8.61 per cent.

10.21 The correct answer is C. The rotational risk at the five-year maturity = 25 basis
points. The current spot interest rate used to value the three-year zero = 11.8316
per cent. At the three-year maturity, the yield will change by 15 basis points (25 ×
3/5) giving a new zero-coupon rate of 11.9816 per cent. The new value of the zero
will be 71.21, so the difference = 0.29.
10.22 The correct answer is B. A simulation model will require a large number of trials or
runs in order to give correct results. By definition, analytic models provide a unique
answer based on the variables used. Given the numerical method used in simulation,
such a model may not give an optimum result. Analytic models tend to work best
on simple problems whereas simulation models can be applied to all types of
problems. It is not the case, however, that the quality of the theory underpinning
analytic models should be inherently superior to that used for numerical analysis, so
II is the odd one out.
10.23 The correct answer is C. When the risks of a position are perfectly correlated, the
total risk is simply the sum of the individual risks (2.1 + 2.4 = 4.50).
Case Study 10.1: The Jabberwocky Company

1 The company is due to receive future payments, so is exposed to future interest rate
risk. The present value of the future cash flows will fall if interest rates rise.
2 A spreadsheet explaining the solution to this question is available on the EBS course website.
In order to work out the interest rate sensitivity of the exposure, we need to do the
following:
(i) calculate the underlying zero-coupon (or spot) rates for the relevant maturities;
(ii) use the zero-coupon rates from i. to calculate the present value of the future
cash flows;
(iii) modify the present value by a small amount. That is, we want to make a small
change in the risk factor. The normal standard change is 1 basis point (0.01 per
cent). In this case, we are using a 25 basis points parallel shift and a 25 basis
point rotational shift at the three-year maturity point;
(iv) since there are two risk factors in the term structure (parallel shifts and rotation-
al shifts), we need to undertake two sensitivity analyses for each of these risk
factors;

(v) combine the two risk factors (in this case, using the portfolio model) to
determine the total interest rate risk.
The first step is to create the zero-coupon or spot yield curve, as follows. Because
we are given the par yield curve, we can back out the spot rates using the quick-
method formula given in the appendix to Module 10:
where Cn is the par interest rate (expressed as a decimal) and An − 1 is the sum of the
previous zero-coupon discount rates (i.e. it is the present value of an annuity for all
but the last period where the components are the zero-coupon discount factors).
The quoted interest rate for the first six-month period is 6.25 per cent. But this is not
what an investor would receive. They would get half this, or 3.125 per cent per 100
invested.
For the first period, the calculation is:
1.03125/1 1 0.03125%
The value for A1 is simply 1/(1.03125) = 0.969697.
For the second and subsequent periods, we need the values from the previous calcula-
tion.
The one-year coupon is 6.875/2 = 0.034375 expressed as a decimal. There will be a
coupon paid at six months, which needs to be eliminated if we want to obtain the
zero-coupon one-year security:
. .
1 .
.
Solving for Z1 we get a spot interest rate of 7.00431 per cent.

For the 18-month period, we proceed using the 6-month and the one-year zero-
coupon rates to uncover the 18-month spot rate.
. . .
1 . .
. . .
In doing the above, we can take account of the fact that:

. .
. . .
is the same as:

0.035 .
. .
where the term in the square brackets is simply the two-period annuity derived from
summing the two zero-coupon discount factors. This is An above. Note that we
need to compute this only once and record it. For the third period, we simply need
to add the value for 1/ 1 + Z1.5 1.5 to A2 to get A3. The computations are laid out in
the following table:

Period N Interest rate 1 + Cn An − 1 An 1 −Cn×An − 1 1 +Cn/(1 Zero rate

(%) −(Cn×An − 1)) (spot rate)
0.5 1 6.25 1.03125 0 0.969697 1.03125 6.3477
1 2 6.875 1.034375 0.969697 1.904239 0.966667 1.070043 7.00431
1.5 3 7.00 1.035 1.904239 2.806028 0.933352 1.108907 7.13467
2 4 7.125 1.035625 2.806028 3.675102 0.900035 1.150649 7.268325
2.5 5 7.250 1.03625 3.675102 4.511558 0.866778 1.19552 7.404569
3 6 7.375 1.036875 4.511558 5.315547 0.833636 1.243798 7.543277
3.5 7 7.50 1.0375 5.315547 6.087275 0.800667 1.295795 7.6845
The company is due to receive six equal instalments over Periods 0.5 to 3. The
company is due to receive a set of level payments of £120m/6 = £20m. We have
already calculated the annuity factor for the three years in the above table: 5.315547.
So the present value of the payments = 5.315547 × £20m = £106.31m.
We now need to recalculate the annuity factor with a 25 basis point increase in
interest rates. The new rates are given in the following table:
Parallel rate shift

N Zero rate (spot rate) All rates raised by 0.25%
1 6.347700 6.597700
2 7.004310 7.254310
3 7.134670 7.384670
4 7.268325 7.518325
5 7.404569 7.654569
6 7.543277 7.793277
7 7.684500 7.934500
The new annuity factor, made up of the shifted zero-coupon rates = 5.294619. The
revised value, with a 25 basis point shift = £105.89m. The level shift risk = 0.418.
We now calculate the rotational shift. This is more complicated in that each maturity
has to be changed by a proportionate amount. The curve shifts upwards at Year 3
by 25 basis points and pro rata at each of the earlier dates. The new values are found
by changing the current spot rates as follows:

Period Original zero- Rotational New zero- Discount

coupon yield shift coupon yield factor
0.5 6.347656 0.04 6.389323 0.969507
1 7.00431 0.08 7.087644 0.933815
1.5 7.13467 0.13 7.25967 0.900213
2 7.268325 0.17 7.434992 0.86638
2.5 7.404569 0.21 7.612902 0.832414
3 7.543277 0.25 7.793277 0.798408
5.300737
Because the yield curve has rotated, the amount of shift in the zero-coupon rate
differs depending on the maturity. The resultant annuity factor = 5.300737. The
new rotational present value = 5.300737 × £20m = £106.02m. This gives a rota-
tional shift risk factor of 0.2962, or, say, 0.300.
We can now summarise the value sensitivity of the contract to changes in the
parallel and rotational yield shifts:
Present value of cash Δ25 bp parallel shift Δ25 bp rotational shift

flow at three years
£106.31m 0.418 0.300
3 We now apply the portfolio model for two correlated risks. Having computed the
individual factor risks, we know the total value at risk from the two interest rate risk
factors will be:
Total risk 0.418 0.300 2 0.75 0.418 0.300
So the total risk of the position = £0.673m.
Module 11
Review Questions

11.1 The correct answer is B. With a quantitative model, we can forecast only the extent
of price moves. In a qualitative model we can aim to forecast both the extent and
the direction of such moves.
11.2 The correct answer is D. A qualitative forecast is useful when a strong view is held
about the direction of the risk. Equally, it is useful when there are not enough data
to make a quantitative forecast. It is also necessary when the future is likely to be
different from the past.

11.3 The correct answer is C. Quantitative models require the user to accept assumptions
that the future behaviour of the risk factors over the forecast horizon will corre-
spond to that experienced in the past.
11.4 The correct answer is C. As a risk management tool, strategic business planning will
seek to identify those factors that will prevent the firm from realising its objectives.
11.5 The correct answer is B. The Delphi method, developed by the US Rand
Corporation, makes use of a consensus forecast from a wide range of experts. The
idea is that the use of multiple forecasts, which are then fed back to the experts to
be refined, leads to a final result that incorporates all the diverse knowledge of the
individual forecasters. Thus the final consensus is better than any individual
forecast.
11.6 The correct answer is B. The difference between the Delphi method and expert
judgement is based on the multiple-round process involved in the former. In
applying the Delphi method, the panel members are invited to review their ap-
proach based on the initial forecasts made and to modify their judgement in the
light of this new information. In the expert judgement process, differences of
opinion are not ‘ironed out’ in this way.
11.7 The correct answer is D. In developing a scenario, the idea is to explore potential
outcomes so that no single plot will prevail. A good scenario for forecasting
purposes will review as many plausible outcomes as may be conveniently handled to
show how the different paths eventually affect the outcome(s).
11.8 The correct answer is A. Brainstorming is a non-judgemental ideas-generation
process that is best suited to developing risk awareness within a firm.
11.9 The correct answer is A. Polls address a question using a set of fixed answers, like a
multiple choice question, while a survey allows for more general answers and
comments – such as might be included in a case study.
11.10 The correct answer is B. Qualitative and quantitative forecasts provide different
insights into the same process. It is too prescriptive to say that they should always
be combined, but on the whole it is helpful to use the two approaches in tandem.
11.11 The correct answer is A. When making a forecast, we can use past price or rate
information as part of the process. We may also use the best guess from experts as
to the outcome. Current market prices embody information about the future (as in
the term structure of interest rates and volatility), which is useful for forecasting
purposes. So only A is not used in forecasting.
11.12 The correct answer is D. All of A, B and C are problems with qualitative forecasts.
Since such a forecast is likely to involve some degree of heuristic judgement, it may
be difficult to understand the basis on which the forecast has been derived. Equally,
even a listing of the variables does not necessarily mean that ‘other factors’ have not
also been excluded from the report. Finally, forecasters have biases, and these will
affect the resultant forecast. It may be possible to recognise these. On the other
hand, it may be very difficult to know what they are.
11.13 The correct answer is C. All models suffer from the danger that they are
misspecified. With a quantitative model it is more obvious that the model fails to
conform to reality. When a qualitative forecast is used, the model is often implicit

and in the developer’s mind. But the problem of misspecification still exists. It is
also not a minor problem!
11.14 The correct answer is B. The correct percentage of correct forecasts is (54 +
69)/270 = 46 per cent.
11.15 The correct answer is A. Applying the Sharpe ratio, we can determine the reward
per unit of risk for the analyst and the benchmark. This gives:
Actual Benchmark
Return 0.06152 0.05914
Volatility 0.13148 0.11985
Rf 0.03985 0.03985
Sharpe ratio 0.165 0.161
This indicates that the analyst was able to match the performance of the benchmark
with a Sharpe ratio of 0.165 versus the benchmark’s 0.161.
11.16 The correct answer is B. We need to calculate the absolute difference between the
actual and forecast for each value, sum these and divide by the number of forecasts,
namely:
Number 1 2 3 4 5 6
Difference 4.4 2.7 0.1 2.1 3.7 1.8
Number 7 8 9 10 11 12
Difference 0.4 0.7 1.2 0.9 0.4 1.1
The sum is 19.5 and the mean or average is 1.63 (19.5/12).
11.17 The correct answer is A. We need to calculate the squared difference between the
actual and forecast for each value, sum these and divide by the number of forecasts,
namely:
Number 1 2 3 4 5 6
Squared 19.36 7.29 0.01 4.41 13.69 3.24
Difference
Number 7 8 9 10 11 12
Squared 0.16 0.49 1.44 0.81 0.16 1.21
Difference
The sum of the squared difference is 52.27, the mean average is 4.36, the square
root of the mean sum is 2.09 (√4.36).
11.18 The correct answer is A. We need to (1) calculate what the naïve forecast would be
and then (2) calculate the mean squared error of this naïve forecast. The MSE for
the analyst’s forecast is calculated in Question 11.17. The MSE for the naïve
forecast and the squared differences are calculated as:

Number 1 2 3 4 5 6
Forecast 86.5 92.3 96.2 97.6 101.3 98.3
Reference 84.3 82.1 89.6 96.3 99.7 97.6
Forecast
difference
squared 4.84 104.04 43.56 1.69 2.56 0.49
Number 1 2 3 4 5 6
Forecast 97.2 95.8 93 92.1 91.2 89.7
Reference 96.5 96.8 96.5 94.2 93 90.8
Forecast
difference
squared 0.49 1.00 12.25 4.41 3.24 1.21
The sum of the squared differences is 179.78, and the mean squared difference is
14.98. The FS is found by:
Forecast skill FS 1
.
1 0.709
.
Case Study 11.1: Bloomberg Minerals Economics

1 You will recall from Module 6 that the main determinants for commodity prices are
supply and demand. Any qualitative or quantitative forecast aimed at determining
the copper price would want to try to model this relationship, since this will
ultimately determine future prices for the commodity. From the information
provided, we are given only a brief outline as to how to determine these elements.
However, we are told that, unlike other forecasts, the analysts at BME do try to
capture global effects. In particular, they have explicitly included a significant force
in the analysis in the form of China’s Strategic Reserve Bureau, since it is a key
player and represents nearly a quarter of global demand. They have also tried to
incorporate changes in working stocks in the analysis. In a sense, this is a hidden
source of supply or demand as users either increase or run down stockpiles outside
the exchanges’ warehouses. It does incorporate all the features one would expect to
see in a properly constructed formal model.
2 An obvious difficulty with their forecast is in interpreting the long-term intentions
of China’s Strategic Reserve Bureau. They make a case that it is to stabilise prices for
Chinese consumers. If the SRB is acting as a buffer for the price, this will dampen
volatility. If they have misunderstood the SRB’s intentions, then this could have a
dramatic impact on the copper price over the forecast period.
Another difficulty arises in accurately forecasting global demand and supply. Supply
is less of a problem since new production takes considerable time to come ‘on
stream’ and the intentions by mining companies are clear since new mining capacity
takes some considerable time to come on stream. Obvious delays and other setbacks

(e.g. loss of production due to mines suffering a disaster) can affect the supply
situation, but the forecast explicitly ignores such shocks. Given the uncertain global
outlook, there are very likely to be some changes in demand, difficult to discern
(especially from emerging nations – the OECD is more predictable given its mature
economies), which may exert additional upward pressure on copper over the period
2013–16.
Also, are we to assume, given the balance of demand and supply and the offsetting
effects of the working stock and SRB, that the ultimate imbalance is as large as they
forecast? Being critical, one might wonder that their model should not lead to a
greater price increase than the one they are forecasting. They anticipate significant
deficits on the basis of supply and demand, but these have not been evident for
some years prior to the forecast period, and yet the copper price has not exploded
as a result. One may well question whether their forecast adequately captures some
elements of the copper supply and demand behaviour.
The model is also what we might call a ‘normal’ forecast that is aimed at a medium-
term average price. It therefore does not take into account short-run effects on
copper prices. They quite rightly point out that short-run effects of supply shocks
and other market disruptions on their projection can push the price away from their
‘equilibrium’ projection.

Glossary
AMOUNT AT RISK
See VALUE AT RISK.
ANNUITY
A set of future cash flows characterised by constant payment amounts and fixed
payment dates. A level payment of £150 per month is thus an annuity. The
computational formula for the present-value interest factor of an annuity with i
per cent periodic interest and n periods (PVIFAi%,n) is:
1
1
1 1 1
PVIFA %, or PVIFA %,
1
where the periodic interest rate i is expressed as a decimal. Note this interest
rate is not necessarily the annual rate.
Given the present value of the annuity factor and the cash flow payment (PMT)
we can calculate the present value of the annuity:
PVIFA %, PMT
Given the present value, we can calculate the payment:
PMT
PVIFA %,
BOND
A debt instrument issued by a firm or other legal entity (for instance a govern-
ment). In its simplest form, it pays a series of coupon interest payments and
repays the principal (see also PAR) amount at maturity. Bonds are valued using
discounted cash flow techniques.
COMPOUNDING
The process of adding interest to a given present-value (PV) sum of money to
calculate its future value (FV). The compounding factor or future value interest
factor (FVIFr) is computed as:
FVIF 1
where r is the periodic interest rate and t is the number of periods.
DISCOUNTED CASH FLOW
A set of valuation techniques for determining the current price or value of fu-
ture cash flows by present valuing or discounting their values to take account of
the time value of money. The negative interest rate used to convert future val-
ues to current values is known as the discount factor. The two principal techniques
are the internal rate of return method and the net present-value method.
Financial Risk Management Edinburgh Business School G/1

Glossary
DISCOUNT FACTOR
The present-valuing factor, sometimes called a negative interest rate, that relates
the future value (FV) of a monetary sum to the equivalent current or present
value (PV) taking into account the time value of money. The discount factor
formula is:
1
1
where r is the interest rate and t is the time from the PV date to the FV date. In
this case, the interest rate is normally quoted as the annual interest rate. If the
time period t is less than one year, then the value of t will be a fraction.
DISCOUNTING
The process of converting future values into present values. By (notionally)
converting future values into present values, it is possible to add them and sub-
tract them (under the law of conservation of value).
EXPOSURE
This is the amount that is at risk from a particular type or source of risk. Market
practitioners talk of their exposures in relation to a particular counterparty or
credit. It is normally calculated by adding up the individual elements of value
due to the particular source of risk. This is not the potential loss, since there is
usually some residual value to be realised. The statistical estimate of the expo-
sure is called the value at risk.
HEDGE and HEDGING
A risk management process used for eliminating (or reducing) the risk on a posi-
tion or exposure by adding financial instruments that have the opposite sensitivity
to the initial position. Changes in the value of the initial position are compen-
sated for by opposing value changes in the hedging transaction to eliminate the
exposure to the risk factor. An instrument or transaction entered into for the pur-
poses of risk reduction is known as a hedge.
PAR
The face or principal amount of a debt or other financial instrument or security
(for instance, the par value of a share, the par value of an interest rate swap).
For bonds, it is the amount to be repaid in normal circumstances excluding the
coupon interest. The par bond has a market value equal to its principal amount.
That is, the internal rate of return used to discount the bond’s future cash flows
is equal to the bond’s coupon interest rate.
PAR BOND
A bond that is trading in the market at its principal value. For a semi-annual-pay
bond, the yield (internal rate of return) is equal to its coupon rate. For instance a
6 per cent semi-annual-pay bond with one-year maturity will have a yield of 6
per cent:
3 103
100
1.03 1.03
G/2 Edinburgh Business School Financial Risk Management

Glossary
Par bonds are important since the zero-coupon discount factors (or spot inter-
est rates) derived from such bonds are taken as being the most representative
since such bonds have coupon rates most closely tied to market yields. Also
such bonds are price invariant for changes in all yield changes other than their
final maturity.
Assume the above bond has a yield that is equal to the zero-coupon discount
factor of 5.75 per cent for the first six months, then:
3 103
100
1.02875 1.06094
If the six-month yield factor changes to 5.90 per cent, then:
3 103
100
1.0295 1.06092
PORTFOLIO
A combination of two or more assets, securities, financial instruments or deriva-
tives. Constructing a portfolio allows for a greater or lesser degree of
diversification, depending on how it is put together, and hence the amount of
risk reduction that is obtained. Hedging a position is an application of the portfo-
lio model that aims to reduce the risk to zero.
POSITION
An exposure to a particular risk or market. It is usually taken to mean the number
of units or quantity in the market. To say one has a position in the market is to
imply that changes in market prices will positively (negatively) affect wealth.
Hence, a long (short) position involves positive (negative) sensitivity to the under-
lying risk factor. The terms position and exposure are often used interchangeably.
RISK
Variously defined by different sources and often treated as the same as uncer-
tainty. In finance it is generally taken to be the spread or deviation from some
expected value as measured by the standard deviation of returns. Volatility is
sometimes used interchangeably for risk.
RISK FACTOR
A source of a particular risk. Note that, depending on the level of analysis, a risk
factor itself can be broken down into its own risk factors. So, at one level of
analysis, interest rate risk is a risk factor, but at a greater level of detail interest
rate risk is composed of price risk, reinvestment risk, extension risk and so
forth.
RISK PROFILE
A graphical representation of the relationship (and sensitivity) of a position to
an underlying risk. Also known as a payoff diagram. It is also used in a more gen-
eral sense as the characteristics of the pattern and structure of a firm’s or
portfolio’s exposure to particular risks.
Financial Risk Management Edinburgh Business School G/3

Glossary
SENSITIVITY
The degree of responsiveness of an exposure to a particular risk. The higher the
sensitivity, the greater the degree of value changes from a given change in the
risk factor. This is often shown graphically using a risk profile.
In application, changing the risk factor by a small amount allows the computa-
tion of the value sensitivity for the position (see Module 10 for a detailed
treatment of the process). One of the best-known sensitivity measures in fi-
nance is the beta coefficient (β) in portfolio investment, which measures the
relative sensitivity of an individual security’s returns or that of a portfolio
against that for the market as a whole.
SIMULATION
A numerical replication technique that involves the repetition of potential out-
comes of a scenario using stochastic processes to give an estimate of the range
and likelihood of possible future outcomes. The technique involves developing
a mathematical model that represents the underlying reality and then drawing
random numbers according to predetermined criteria to determine the result. It
is as if a large number of future potential outcomes or scenarios were being ex-
plored. The technique is also known as Monte Carlo simulation.
STRESS TEST
A scenario normally performed in the context of a value-at-risk analysis. It usu-
ally takes the form of applying a historical situation where extreme value
changes have occurred to the given portfolio or position. Examples include major
price changes from the 1987 stock market crash, the 1990 Gulf crisis, the Asian
crisis in 1997, the Russian default of 1998 and so forth. The idea is to model the
most extreme price movements that can occur in these unsettled market condi-
tions to show how well (or badly) the position or portfolio will perform given
such a major event. The technique will also model the observed correlation be-
tween markets and asset classes, since in such conditions co-movement in prices
and rates tends to rise. That is, stressed markets tend to reduce normal portfolio
diversification effects.
VALUE AT RISK
A statistical or insurance-type estimate of the future value loss based on some
estimate of the probability of changes in the underlying risk factor and the
amount of the exposure to the risk. Note that it is not the total sum of the loss
but the likely loss given some confidence limit (a change of 1 in 20; 1 in 100,
etc.). Also sometimes known as earnings at risk.
VOLATILITY
Technically a term derived from options theory and one of the pricing parame-
ters used for deriving the fair value of an option. It is the standard deviation of
the continuously compounded rate of return on the underlier to the option ex-
pressed as an annualised rate (like interest rates). It is used in a more general
sense to indicate the risk of a security, financial instrument, portfolio or market.
High volatility markets are seen as high risk; low volatility markets as low risk.
G/4 Edinburgh Business School Financial Risk Management

Index
absolute purchasing power parity 5/7 Brent Walker plc 2/23
accounting 3/5, 5/19–5/23, 8/19 Bretton Woods Agreement 1/2, 1/4, 5/2
accounting exposure 1/35, 5/15, 5/19– British pound 1/7, 1/10
5/23 exchange rates 1/7, 5/3, 5/14
accounting numbers 1/35, 1/42 Brownian theory 7/29
adjustment, risk 1/38–1/40 building-block approach 1/41–1/42,
agents 2/15–2/19, 3/13 8/13, 8/16–8/19
agricultural commodities 6/12 business performance 2/19–2/23
amortisation 4/10, 4/37 capital markets 3/2
annualised volatility 9/32 capital structure, firm’s 2/20, 2/24, 6/9
anomalies, price 3/9 capitalisation rate 4/2, 10/5–10/14
APT (Ross’s Arbitrage Pricing Theory) CAPM (Sharpe–Lintner Capital Asset
1/21 Pricing Model) 1/21, 3/19–3/20
arbitrage 1/21, 5/6, 5/13 case studies
Asset Liability Management Committee Airbus Industries 5/37–5/38
(ALMAC) 1/41, 8/2, 11/1 attitudes to risk 1/50
assets 3/2, 3/21–3/23, 8/20, 9/16–9/19 banks 6/21
benchmark 3/14 Bloomberg Minerals Economics
consumption/commodities 6/9 11/23–11/25
current 7/19 copper market 6/21
long/short 3/5–3/6 diffusion trees 7/42
multi-portfolio 9/28–9/31 Georgetown Industries 8/47
prices 1/19, 3/18–3/21, 4/13, 7/1, Laker Airlines 2/35
7/3, 7/7–7/18 Omega Corporation 3/34
risk management 1/42 Panthos Finance 4/55
specificity 2/23 portfolio risk 9/44
valuation 3/23–3/26 risk factor calculation 9/43
asymmetric information 2/18 cash and derivative market instruments
audits 8/5 3/21–3/23
balance sheet 2/4 cash flow 1/33–1/35, 1/42, 2/10
Barings disaster 8/2 analysis 4/36, 10/1, 10/4, 10/16
basic risk 1/19–1/22, 3/7, 3/14 estimating 9/4–9/8
benchmark assets 3/13 net 6/9
bid–offer spread 3/12, 3/14, 3/17 variance in 2/19, 2/24
binomial distribution 7/11–7/18 Casserley, Dominic 1/37
Black, Fisher 1/13 CBOE (Chicago Board Options
bonds 3/2, 4/16, 6/12 Exchange) 1/12
package 4/37, 4/38, 9/4 certainty equivalent approach 1/22
premium bonds 10/11 Chan, K.C. 6/5
zero-coupon 4/25, 10/8 Chen, N. 6/5
bootstrapping 10/34–10/37 Chew, L. 8/3
borrowing 4/19 Chicago Mercantile Exchange (CME)
BP oil spill 6/4 1/12–1/13
brainstorming 11/6 China 1/7
Brazil CIR (Cox, Ingersoll and Ross) model
foreign exchange 1/5–1/8 4/30
breakeven analysis 4/14
Financial Risk Management Edinburgh Business School I/1

Index
CME (Chicago Mercantile Exchange) US dollar 1/4, 5/4

1/12–1/13 current assets 7/19
collateral debt obligations (CDOs) 1/37 CVC (variance–covariance matrix) 9/28
combination analysis 11/9 database 1/28
commodity markets 3/2, 6/14–6/16 DCF (discounted cash flow), analysis
commodity price risk 2/9, 3/7, 3/27, 10/2
6/1, 6/11–6/16 debt 3/2, 3/25, 6/14
commodity prices 2/9, 3/18 decision theory 1/22, 11/5
Common Agricultural Policy 6/14 default
competitive exposure 1/36, 5/2, 5/23– credit risk 3/4, 3/24, 4/17
5/29 default risk premium 10/11
compound interest 7/5–7/7 default-free discount 3/24
compounded distribution model 7/33– default-free rate 10/11
7/34 delivery 6/12, 8/6
computer simulation 10/23–10/25 Delphi forecasting 1/37, 11/4
confidence limits 8/36, 9/33 demand and supply 3/12, 6/15
consensus forecasting 11/4 Demsetz, H. 3/17
consumption assets 6/11 derivatives 1/13, 3/21–3/23
contemporaneous accounting 8/19 determination coefficient 9/18
contingent exposures 1/33, 1/35 diffusion trees 7/13, 7/17, 7/20, 7/42
continuous compounding 7/9 direct costs 2/23, 2/25
contracted transactions 1/35 direct search market 3/11
contracts 1/12, 3/4, 3/22, 5/18 discount rates 4/8, 4/31, 10/5–10/15
convenience yields 6/15 discounted cash flow (DCF), analysis
convexity 2/14, 4/15, 10/5 10/4
core activities 2/2 dispersion 1/22, 9/12–9/15
corporate risk management 2/12 distress, financial 2/23–2/25, 6/12
corporate value at risk 8/33–8/34 distribution 7/31–7/35, 9/9–9/11
correlation 8/30, 9/16–9/21, 9/24–9/28, lognormal 7/2, 7/11, 7/9–7/18, 9/13
9/33, 10/32–10/33 probability 7/37, 10/28
cost–benefit analysis 1/22 diversification 3/19, 9/24–9/27, 9/33–
costs 2/10, 2/23–2/24, 6/14 9/34
risk management 2/25–2/28, 8/5– dividends 6/3, 6/6, 6/9
8/7 downward yield curve 4/21, 4/23
counterparty risk 3/3, 3/4, 3/13, 3/23 Drucker, P. 8/11
country risk 1/39, 5/5 Drucker, Peter 11/3
covariance 8/30, 9/16–9/21, 9/28 duration models 4/15, 4/35, 10/11
covenanting 2/19 earnings at risk 8/19, 8/23, 9/2
covered interest arbitrage 5/6, 5/13 econometric forecasting 4/35, 11/2
Cox, J. 4/30 economic balance sheet 2/4
credit 8/20 economic exposure 1/33, 1/36, 2/2,
quality 2/18 5/15, 5/23–5/29
credit crunch 2/19 direct 5/24–5/26
credit rating agencies 2/18 indirect 5/24–5/26
credit risk 3/4, 3/23–3/26 economic risk 2/10
credit downgrade 3/4 economies of scale 3/17
default risk 3/4, 3/24, 4/17 efficient markets hypothesis (EMH) 3/8
currency 1/4–1/12, 1/35, 3/7, 4/17, efficient portfolios 9/29
5/1–5/31 endorsement, transaction 3/13
British pound 1/4, 1/10, 5/3, 5/17 energy commodities 6/12
gold 1/9, 1/10 Equitable Life 4/2–4/5
I/2 Edinburgh Business School Financial Risk Management

Index
equity 1/41, 3/2, 3/7, 3/21, 6/1–6/9 force of interest 7/9

and commodity markets 6/9–6/16 Ford Motor Company 2/2, 2/6
euro 5/14 forecast skill (FS) 11/14
European Union 6/14 forecasting 7/36, 11/4, 11/7–11/12
event risk 4/17 exchange rates 5/14–5/15
Exchange Rate Mechanism (ERM) 8/35 interest rates 4/35
exchange rates 5/14–5/15 measuring error 11/12–11/15
British pound 1/4, 1/7, 5/3, 5/17 polls and surveys 11/6–11/7
exchange-traded transactions 3/13–3/14 qualitative 11/2, 11/3–11/6, 11/11–
execution risk, shares 3/12 11/12
expectations theory 4/1, 4/25–4/27, quantitative 11/2, 11/7–11/11
10/15 to manage risk 11/2
expected average life 4/16 volatility 7/26
expected returns 9/5–9/8, 9/21–9/22 foreign exchange 1/4–1/8, 3/2, 5/15–
expected value 1/22, 2/10, 7/19 5/30
expected volatility 7/24 Brazil 1/5–1/8
expert forecasting 11/5 forecasting 5/14–5/15
exporters 1/4, 1/7, 5/17, 5/28 risk 1/4–1/9, 1/36, 2/9, 3/21, 5/3–
exposure 1/20, 1/36, 2/2, 8/9 5/5
economic 1/36, 2/2, 5/23–5/29 forward contracts 1/12, 3/21, 5/18
foreign exchange 5/15–5/29 forward exchange rate 5/3–5/16
management of 1/16–1/29, 8/37 forwards and futures 3/21, 6/12, 8/8
risk table 1/27 FS (forecast skill) 11/14
transaction 1/35, 1/42, 5/17–5/19 future volatility 7/25
translation 1/35, 5/19–5/23 game models 11/5
extension risk 4/16–4/17 gamma 10/5
external funding 2/11, 2/19 General Electric 8/12
feasible portfolios 9/29 geometric Brownian motion 7/29
Fielder, D. 2/8 gold 1/10, 6/11, 6/12
finance 3/19, 7/2–7/18 Goldman Sachs investment bank 4/34
Financial Accounting Standards Board Greek crisis 1/37
(FASB) 5/21 group forecasting 11/5
financial control approaches 8/7–8/9, hard commodities 6/12
10/1–10/34 hedging 1/13, 1/32, 2/20, 2/24–2/25
financial distress 2/11, 2/23–2/25 and competitors 2/27
financial futures 1/12, 3/21, 7/24, 8/8 and taxes 2/13–2/15
financial hedging 1/38, 2/4, 2/7–2/8 example 2/19–2/23
financial instruments 1/12–1/13, 3/21– financial 1/38, 2/7–2/8
3/23, 4/36–4/41, 10/2 operational 1/38, 2/7–2/8, 3/21,
financial markets 3/2, 3/13, 6/14–6/16, 8/7–8/9
8/7 historical data 9/11, 9/31, 10/25, 11/3
financial reporting 8/19–8/20 historical reporting 8/19
financial risk 1/2, 1/12–1/16, 1/33, 9/1– historical volatility 7/24
9/38 history, risk management 1/3–1/4
statistical analysis 9/4–9/8 holding periods 4/10
firm value 2/10, 2/22, 2/23, 6/3–6/9 humped yield curve 4/21, 4/23
firms 2/1–2/29, 5/29, 6/9, 8/4 hurdle rates, interest 1/10
firm-specific risk 6/6–6/10 ill-diversified investors 2/25
Fisher effect (Irving Fisher) 5/11–5/14 immediate term 5/29
flat yield curve 4/21, 4/23 immunisation 4/13
floating-rate interest 4/37 implied volatility 7/25–7/26

Index
importers 1/4, 1/7, 5/28 Litterman, R. 4/34

indeterminacy 1/20 location of commodities 6/12
indirect costs 2/23, 2/25 log of returns 7/7–7/18
inflation 1/26, 4/32, 5/13, 6/9 logarithms 7/7–7/18
Ingersoll, J. 4/30 lognormal distribution 7/1, 7/2, 7/9–
inside spread 3/18 7/18, 9/12
insurance 1/38–1/41 London Stock Exchange 3/11, 3/13
intangible assets 3/2 long/short assets 3/5–3/6
interest rate parity (IRP) 5/5–5/7 long-term planning 11/3
interest rate risk 2/9, 3/7, 3/21, 4/5– Lufthansa airline 8/9
4/19, 6/9 M & M’s theory 2/5, 2/11
interest rate spread 3/23–3/25 MacCrimmon, K.R. 1/21
interest rates 4/31–4/35, 4/37 macroeconomic factors 1/14, 3/19, 6/5,
and inflation 1/26 6/6
forecasting 4/35 MAE (mean absolute error) 11/12
price movement of 3/18 MAPE (mean absolute percentage error)
risk 2/9, 3/7, 3/21, 4/5–4/19, 6/5 11/13
volatility 1/9 margining 8/22
intermediaries 1/13, 3/1, 3/2, 3/13– market efficiency 3/8–3/11
3/18, 6/12 market liquidity 3/11–3/13
intermediated market 3/11 market makers 3/14–3/18
International Coffee Organisation (ICO) market risk 1/26, 3/3, 3/21–3/23
6/14 market segmentation 4/1, 4/24, 4/29–
international Fisher effect 5/11–5/14 4/30
international parity relationships 5/5– market value, firm’s 1/41, 2/10
5/11, 5/12 marketability 1/25, 3/3
investments 6/11 market-related risk 3/7
investors 2/25, 2/28, 4/25 markets 3/2
IRP (interest rate parity) 5/5–5/7 capital 3/2
JP Morgan 9/32 commodities 3/2, 6/14–6/16
judgemental forecasting 11/2 financial 3/2, 3/13, 6/14–6/16, 8/7
Kelvin, Lord 9/2 foreign exchange 3/2
kurtosis 7/30, 7/31, 7/33, 7/37 intermediated 3/14–3/18
lateral thinking 11/6 local firms 5/28
law of one price 5/7 money 3/2, 4/36–4/41
LBO (leveraged buyout) 2/18 Markov price process 7/28
Leeson, Nick 8/2 mark-to-market 8/20–8/23
legal risk 1/29, 3/4, 4/17 matching 3/12–3/13, 8/7
Less Developed Country (LDC) crisis materiality 1/27, 8/6
1/37 mathematical models 11/2
level shift risk 10/19 maturity 4/33, 8/21, 10/5–10/15
leveraged buyout (LBO) 2/18 mean absolute error (MAE) 11/12
Levis, M. 6/5 mean absolute percentage error (MAPE)
liabilities 3/2 11/13
limited company 6/2 mean return 9/12, 9/15, 9/19, 9/33
limits, credit 8/20–8/23 mean squared error (MSE) 11/13
Lintner, J. 1/21 medium term 5/29
liquidity preference theory 4/1, 4/24, medium-term planning 11/3
4/27–4/29 Micawber’s philosophy 2/10
liquidity risk 1/25, 3/3, 4/17, 6/5 Miller, M. 2/5, 2/11
liquidity, market 3/11–3/12 mixed diffusion jump model 7/33–7/35

Index
model risk 11/11 payback periods 1/10

Modigliani, F. 2/5, 2/11 pension funds 4/18
money markets 3/2, 4/36–4/41 percentage returns 7/5, 7/29
mortgage-backed securities 4/16 perishables 6/12
MSE (mean squared error) 11/13 physical spot markets 6/12
multi-asset portfolio case 9/28–9/31 planning 8/12, 11/3–11/5
multidimensional risk 1/25, 1/29–1/30, political risk 1/39, 4/17, 6/6
3/5 portfolios 2/9, 2/11, 8/36–8/38, 9/21–
Murphy’s law 1/37 9/31, 9/33–9/34
negative convexity 4/15 precious metals 6/11, 6/12
negative interest rate 10/3 predictive accounting 7/2, 8/19
net cash flow 6/4 preference shares 6/9
nominal interest rates 4/32, 5/13 Premier Foods 6/5
non-accounting data 1/42 premium bonds 10/11
non-core activities 2/2 prepayment risk 4/6, 4/13–4/17, 4/40
non-systematic risk 3/18–3/21 present value (PV) 2/10, 4/8, 10/3–10/5
normal distribution curve 9/9–9/11 price risk 1/25, 3/3, 3/12
North Sea Oil (Brent) 6/12 commodities 2/9, 3/11, 3/21, 6/1,
notional principal amount 3/23 6/11–6/16
objectives of risk measurement 8/4–8/8 interest rate 4/5–4/9
odds 1/17 prices 3/8, 7/2
off balance sheet 8/8 changes 7/2–7/7, 7/28, 7/31–7/35
oil price 1/11 commodity 1/10, 2/9, 3/16
on balance sheet 3/22, 8/8 price-time trends 7/2–7/5
opaque markets 3/9, 3/13 pricing models 1/13, 3/18–3/21
OPEC (Organization of Petroleum probability concept 1/28, 7/19–7/24,
Exporting Companies) 6/14 7/37, 9/3, 10/27
operating exposure 1/36, 2/2, 5/23, progressive tax rates 2/13
5/24–5/29 purchasing power parity 5/7–5/8, 5/13
operational change 8/7 qualitative assessment 11/12
operational decisions 6/6 qualitative forecasting 4/36, 11/3–11/6,
operational hedging 1/38, 2/4, 2/7–2/8, 11/11–11/12
3/22, 8/7–8/9 example 11/9–11/11
operational management 1/29, 8/7 quantitative forecasting 11/2, 11/7–
option pricing models 3/21, 4/31, 7/25– 11/11
7/26, 8/6 random walk theory 7/4, 7/28
options 1/12, 4/15 rate risk 3/2
ordinary shares 1/12, 6/9–6/10 receivables and payables 1/35, 5/17
OTC (over the counter) 1/12, 3/13– Reinganum, M.R. 6/5
3/14, 6/12 reinvestment risk, of interest rate risk
outside funding 2/19 4/5–4/12, 4/37
over the counter (OTC) 1/12, 3/13– reinvoicing system 8/19
3/14, 6/12 relative purchasing power parity 5/7
PacifiCorp Holdings 2/27 reporting 8/19–8/38, 9/32
packaging, financial 4/37, 4/38, 9/4, residual claim 6/2, 6/9
9/16–9/17 risk 1/16–1/29, 2/2, 3/5, 3/6–3/8
par yield curve 10/37 firm-specific 6/6–6/10
parallel shift risk 10/18 identifying 1/36–1/41
parallel yield curve 4/33 systematic 6/6–6/10
parity relationships 5/5–5/11, 5/12 risk adjustment 1/38–1/41
payables and receivables 1/35, 5/17 risk assessment 1/19–1/22, 11/2

Index
building-block approach 1/41–1/42, signalling 2/19, 3/2

8/16–8/19 silver 6/11
top-down approach 8/13–8/16 simulation method 10/20–10/33, 11/5
risk attitudes 1/27 Singapore International Monetary
risk audit 8/5 Exchange (SIMEX) 8/3
risk awareness 1/36–1/38, 8/12 skewness 7/37
risk capital 3/2 small cap stocks 6/5
risk control 8/1, 8/9–8/11, 8/40 soft commodities 6/12
risk horizon 8/4 specific risk 3/19, 6/1
risk landscape 1/29–1/30 speculation, corporate 1/32, 2/27
risk management 1/30–1/33, 1/41–1/42, spot rate 5/3, 5/8–5/9, 5/14
2/1, 7/35 discount 4/31, 10/5–10/15
benefits of 2/10–2/23 spread risk 3/14
checklist 8/7 standard deviation 1/18, 9/15, 9/12–
defined 1/2, 1/16–1/19 9/16
example 8/9–8/11 calculating 9/19–9/21
framework 8/4, 8/5 portfolio risk 9/22
risk measurement 1/38, 8/4–8/7, 9/11– standards, accounting 5/19–5/23
9/16, 10/1 Statement of Financial Accounting
risk models 1/38 Standards (SFAS) 5/21
risk modification 8/10 statistical analysis 9/4–9/8
risk profile 1/26, 2/5, 3/5 stochastic models 4/15, 4/30, 7/11, 7/28
risk reduction 2/4, 2/18 stock-specific risk 6/1
risk reward 1/22, 4/19 Stoll, H.R. 6/5
risk threshold 8/5 storage costs 6/12
risk topography 1/29, 3/6–3/8 strategic planning 8/12, 11/3–11/5
risk/reward 1/25 stress test 8/34–8/36
RMSE (root mean squared error) 11/13 strips, zero-coupon 10/6
root mean squared error (RMSE) 11/13 strong-form efficiency 3/9
Ross, S. 4/30 supply and demand 3/2, 6/14, 6/15
Ross, Stephen 1/21 swap 3/21
Ross’s Arbitrage Pricing Theory (APT) systematic risk 3/18–3/21, 6/1, 6/4,
1/21 6/6–6/10
rotational shift 4/33, 10/18 tail risk 7/30
scenario analysis 1/42, 7/36, 11/2, 11/7 tangible assets 3/2
Scheinkman, J. 4/34 tax shields 2/11
Scholes, M. 1/13 taxes 2/13–2/15, 3/17
sector analysis 4/17 term instruments 4/37, 9/5
selling risk capacity 8/6 term structure 4/2, 4/19–4/31, 10/15–
semi-strong form efficiency 3/9 10/20
sensitivity 2/6, 4/35, 8/9, 10/4, 10/17 modern theories 4/30–4/31
categories 5/27–5/29 terminal markets 6/12
settlement risk 3/5 time distribution models 7/35
shareholders 6/2 time frame, risk measurement 8/4
shares 3/11, 3/18, 6/9–6/10, 7/2 time horizon 5/29, 9/33, 11/3–11/5
Sharpe, W. 1/21 time value of money 4/2, 4/41, 10/2
Sharpe–Lintner Capital Asset Pricing time-price trends 7/2–7/5
Model (CAPM) 1/21 timing risk 3/12
shock model, price 7/34, 8/27 top-down approach 1/41–1/42, 8/13–
short/long assets 3/5–3/6 8/16
short-term planning 11/3 total risk 1/26

Index
trade organisations 6/14 cash flow 2/18, 2/24

trade-off 4/19 variance–covariance matrix (CVC) 9/28
trade-weighted index 1/7 volatility 1/23, 3/7, 4/1, 4/15, 7/18–
transaction costs 2/11 7/28
transaction exposure 1/35, 1/42, 5/15, annualised 9/32
5/17–5/19 commodity prices 1/10
transaction risk 2/10, 3/21–3/23 foreign exchange rates 1/4–1/9
transfer risk, currency 5/5 gold price 1/10
translation exposure 1/35, 5/15, 5/19– interest rates 1/9
5/23 reporting 9/32
transparent markets 3/9 weak-form efficiency 3/9
transport 6/12 Wehrung, D.A. 1/21
two-factor models 4/31 Weiner process 7/29
uncertainty 1/20, 1/28, 9/5–9/8 West Texas Intermediate (WTI) 6/12
unknown risks 1/37 Whaley, R.E. 6/5
unmeasurable risks 1/37 world market firms 5/28
upward yield curve 4/20, 4/23 ‘worst-case’ analysis 7/36, 8/33
US 1/4, 5/4 Wynne, B. 1/20
value 3/23–3/26 yield curve 4/31–4/35, 10/5, 10/27–
and volatility 7/19–7/24 10/32
expected 1/17, 1/22, 7/19 downward 4/21
firm 2/10, 2/23, 6/3–6/9 flat 4/21
present 2/10, 4/2, 10/3–10/5 humped 4/21
ready reckoner 10/2 par 10/37
time money 4/6, 4/41 parallel shift 4/33
value at risk 7/36, 8/19, 8/23–8/33, rotational 4/34, 10/18
8/36–8/38, 9/2 upward 4/20
estimating 9/32–9/34 zero coupon 4/12, 4/31, 10/6, 10/10–
variable-rate interest 4/37 10/11, 10/15–10/20
variance 1/22, 9/14, 9/16, 9/19–9/20

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Financial Risk

FK-A3-engb 1/2018 (1011)

Edinburgh Business School

Tel + 44 (0) 131 451 3090

1.1 Introduction 1/2

Module 2 Risk and the Management of the Firm 2/1

2.1 Introduction 2/2

PART 2 THE MARKETS

3.1 Introduction 3/2

Financial Risk Management Edinburgh Business School v

3.3 Market Liquidity 3/11

Module 4 Interest Rate Risk 4/1

4.1 Introduction 4/2

Module 5 Currency Risk 5/1

5.1 Introduction 5/1

Module 6 Equity and Commodity Price Risk 6/1

6.1 Equity Market Risks 6/1

vi Edinburgh Business School Financial Risk Management

Module 7 The Behaviour of Asset Prices 7/1

7.1 Introduction 7/1

PART 3 RISK ASSESSMENT

8.1 Introduction 8/2

Module 9 Quantifying Financial Risks 9/1

9.1 Introduction 9/2

Financial Risk Management Edinburgh Business School vii

Module 10 Financial Methods for Measuring Risk 10/1

10.1 Introduction 10/1

Module 11 Qualitative Approaches to Risk Assessment 11/1

11.1 Introduction 11/1

Appendix 1 Practice Final Examinations and Solutions A1/1

Appendix 2 Statistical Tables A2/1

viii Edinburgh Business School Financial Risk Management

Appendix 4 Answers to Review Questions A4/1

Financial Risk Management Edinburgh Business School ix

Arrangement of the Course

Financial Risk Management Edinburgh Business School xi

Topic area Modules

Approach and Key Concepts

xii Edinburgh Business School Financial Risk Management

† This dispersion is often referred to as ‘volatility’ by market participants.

Financial Risk Management Edinburgh Business School xiii

Section Number of Marks obtainable Total marks

xiv Edinburgh Business School Financial Risk Management

Financial Risk Management Edinburgh Business School xv

Financial Risk Management Edinburgh Business School

Financial Risk Management Edinburgh Business School 1/1

1/2 Edinburgh Business School Financial Risk Management

An example of risk management is the case of a commodity producer who is

1.1.1 Historical Background

Financial Risk Management Edinburgh Business School 1/3

and the willingness of individuals to create arrangements to mitigate its worst

1.1.2 Increased Volatility in Foreign Exchange Rates

1/4 Edinburgh Business School Financial Risk Management

$0.5 Fixed exchange rate Floating exchange rate

Figure 1.1 British pound–US dollar monthly changes in exchange rates

Fixed exchange rate Floating exchange rate

Figure 1.2 British pound–US dollar monthly volatility

Financial Risk Management Edinburgh Business School 1/5

115 ERM period

Figure 1.3 British pound trade-weighted index from 1990 to 2001

1/6 Edinburgh Business School Financial Risk Management

Financial Risk Management Edinburgh Business School 1/7

Figure 1.4 Brazil real versus the US dollar

1/8 Edinburgh Business School Financial Risk Management