Financial Risk Management

Part 1
Introduction of Financial Risk Management
Dr. Zahid Irshad Younas
Financial Risk Management
1. Course organization
2. On the management of necessary risk
3. Types of risk
4. Identification of risk sources
5. Back testing and stress testing
6. Fundamentals of financial derivatives
7. Hedging strategies for selected risk types
Financial Risk Management

What is risk management? Or

What is risk?
Pre-requisite of the risk management is
understanding term risk
• Financial losses as a risk
• Uncertainity of achieving specific goals
• Dispersion of a parameter from its expected target value.
• Random negative deviation of financial variables from previously
defined reference value of asset positions.
Characteristics of Risk
• Randomness ( Deterministic results dont represent risk)
• Negative deviations (Chance vs risk)
• Financial: we will focus only Financial risk
• Ideally: measureable
The Falls of Barings Bank
• Discussion: Are only negative deviations/ losses a risk?
• Counter example 1: The british investment bank Barings bank plc.
• Established in 18th century, in 1995 became insolvent
• Large speculative transactions in derivatives
• Loss of 1.4 billion US dollars witin few months
• Nick leeson (Earth quake in Japan) Asian Markets collapsed.
• How was the“ rogue traders“ was allowed to do business on such a large scale?
 Adding profits and losses account to seperate account
 Take large risks
 Report high profits to bosses.
The Madoff Case
• Discussion: Are only negative deviations/ losses a risk?
• Counterexample 2: Bernie Madoff
• Operator of the largest ponzi scheme. Estimated damage to the
investor approx 65 billion dollars.
• The course of his fraud: taking investor funds, promising constant
returns, attracting further investors and paying out the promised
returns with newly raised money minus his own profits.
• Statement of a whistle blower: But the biggest tip off of fraud was that
Madoff reported his fund was down only three months out of 87, while
S&P 500 was down 28 months during the sam period.
Defintion of risk mangement
• The term risk management is understood as the total of all measures
for the systematic identification, measurement, management and
control of risks in enterprise and its relevant environment. Its primary
goal is the stabilization or increase of the shareholder value.
• What is shareholder value?
How to measure Financial risk?
• Single asset (Concentration of wealth)
• risk and return
• Expected return
• Average return
• Variance or risk
• Calculate business
• Risk it is also called as dispersion
• Standard deviation
How to measure Financial risk?
• Absolute dispersion is standard deviation
• Why i have taken square, because to avoid negative
• Values
• There is a characteristic of A.M
• Sum of the deviation taken
• From mean is zero
• Relative dispersion
• Consistency of returns
• Mean and variance theory
• Select one asset for investment purpose
• Sd and var they may be misleading
• They are only absolute dispersion
• Relative dispersion
• Coeffecient of variation. Cv= sd/average
• You will prefer an asset with the lowest value of
• Cv
• In other words we can say that cv tells us
About risk per unit.
Tells us consistency of returns
How to measure Financial risk?
• Semi Variance Theory
• What are the characteristics of Semi variance theory?
1. Expected return or average return
2. Seperate the returns less than average return
3. Ignore above average return
4. Calculate the average returns of downward returns again
5. Calculate the variance of downward returns again
6. Calculate the risk per unit again.
How to measure Financial risk?
• Business risk (Unsystematic Risk)
• Systematick Risk
• Is there any solution of risk?
• What about diversification?
• What is diversification
• Portfolio of asset is the list of assets we select for investment purpose
• Diversification is spreading of risk from one asset to another
• What are the principles of diversification
Financial risk management
• Portfolio
• Portfolio returns (a+b)2
• How you can write this risk formula for five assets.
• Portfolio risk (a+b)2= a2+b2+2ab
• Ho
• Principles of diversification
• Co-variance: Sum of the product of deviations of returns of two assets from their respective means
• Upward= +ve
• Downward= +ve
• Upward and other are moving downward with respect to average=-ve
• -ve covariances
• What is the problem of co-variance?
• It does not give us standardised result
• It only describes the direction of movement
• It tells the positive or negative association
• Its does not quantify the relationship
• Correlation coeffecient
• Correlation coeffecient
• Degree of association between two asset
• It actually standardise the relationship between the returns of two
assets
• Thus its value ranges between -1 and 1
• -1 perfect negative association
• 1 perfect positive association
• r, p
• r= cov (x,y)/sd.x*sd.y
• Cov(x,y)= r(x,y).sd.x*sd.y
• Coeffecient of determination?
• R2 ranges between 0, 1
• If R2 is near to one = Explained variation/ total variation
• Total variations= explained variations+ unexplainend variations
• Unexplained= 1-R2
• Unexplained= residuals, they are basically risk
• We can add further assets in our portfolio, so that value of R2 may increase
• Because R2 is an increasing
• Portfolio theory was initially proposed by Herry Markowitz
• If the stock returns are normally distributed, symetrically distributed
• To know that my stock returns are normally distributed or not, which of
the graph can help me to answer this question. Histogram.
• If the stocks returns are asymetrically distributed, skewed, fat tail
• Fat tail or tail risk
• Copula
• Return on portfolio
• Rp= w1*avergex1+w2*averge x2+w3*average x3.............wn*Average n
How to measure Financial risk?
• Covariance

• Correlation
• Tail risk
How to measure Financial risk?
• Correlation

• Tail risk or Fat tail

• Business risk can be controlled with the help of diversification, avoidable
• systematic risk: it is a risk which cant be controlled, cant be diversified, reduced.
Unavoidable
• Total risk = systematic + unsystematic risk
• Systematic risk: Beta
• Systematic risk is also called as market risk
• Systematic risk: The solution of systematic risk is Hedging.
• Hedging? Protection, in finance we say that hedging is
• Off setting financial positions?, through into derivatives, futures, forwards, options and
swaps.
• Spot market and future market
• What is the measurement of systematic risk
• The measurement of systematic risk is beta.
• Beta: slope, response factor, sensitivity factor,
• How much your investment is sensitive to market
• Slope= rise/run
• If some variations take place in stock market returns how much variations will be
there in your stock or in your porfolio as a response to the variation in market.
• Bp= 1.50 (Investment is riskier that market)
• Bp= 1.00 (investment is as riskier as market)
• Bp= 0.50 ( your investment is less riskier than market)
• Calcualtion of beta,
• First of all we have to run regression
• Regression tell us cause and effect relationship
• b= covariance( S, m)/ var(m)= r(x,y). Sd.x.s.d.y/sd.x.sd.x
• = r(x,y).sd.y/sd.x
• Dependent variable: y stock returns
• Independent variable: x market return
• Correlations coeffecient r (-1to1).
• Coeffecient of determination. R2= explained variation/ total variation
• 0, 1
• Total variation in any stock returns= explained variation + unexplained variation
• Unexplained variations are= residuals or dispersions (other factors)
• Dispersions are risk
• r2= 0.54 (exp)
• Total variation= 1
• unexplained= 0.36
• residauls could be reduced? By adding more assets in my portfolio
• Once i will add more assets in my portfolio, the value of r2 will go up,
• Unexplained variation is being reduced.
• R2 is an increasing function
• Total risk of a portfolio= b+ variance or standard deviation of residuals.
• Downward risk?
• Initially we were discussing mean variance theory proposed harry markowitz
• Roy he said i dont agree with the theory of H.M
• He said his measurement of risk is standard deviation
• Flawed measurement of risk?
• It takes into consideration both upward and downward deviations of returns.
• Average returns are target
• Above average returns are upward deviations and these are basically desired returns, then how you consider
these returns for measurement of risk.
• He said we should only consider below average returns are downward returns
• Or negative deviations
• When you will measure the risk from downward returns then it would be accurate measurement of risk. It
would be actual risk.
• Downward risk is basically the vriance of downward returns.
Semi Variance Theory of Risk
• Semi variance theory of risk.
• Was introduced by ROY, According to him mean variance theory is not accurate measurement of risk.
• Average returns are basically target returns
• Desired returns- Upward returns
• Downward retursn-less than average returns
• Sum of the deviations taken from mean is always zero.
• Steps

• Calculate the average return of whole data

• Seperate those returns from data which are less than average returns
• Then again caluate the average return of these seperated returns
• Then again find the variance of these seperate returns
• The answer would be downward risk
• VAR
• Downward risk
• Value at risk
• Maximum potential loss that can arise because of adverse market conditions in future
• Investment banker, potfolio managers, commercial bank managers, risk analyst
• 5% var#
• 95 % we are confindent that no adverse movement in market will occur
• 5 % is the probability of such adverse movements
• earthquake, financial crisis, stock markets can collapse, political instability
• Var is another measurement of market risk
• Historical VAR
• Assignment
• In next class, take at least 10 stocks and get the data of at least last 90
days and apply, mean variance theory, relative dispersion concepts,
Semi variance theory and VAR model and shows your analysis and
interepret your results.
• Downward risk
• VAR is Value at Risk
• It is also the measurement of downward risk
• Who can use this VAR
• Portfolio managers, investment bankers, Mutual fund managers,
commercial bank managers are using this
• What actually the VAR tells
• It tells you in case of some market adverse movements what would
be your potential maximum loss.
• VAR is also a measurement of future market risk
• 5% VAR
• What is meant by 5% var
• 5% percent probability that adverse situations may arise in future
• 95% you are confident that such adverse situation will not arise.
• Historical data
• How much cash I should have to avoid problems on daily basis.
• Historical Var
• VAR actually gives you the lowest value in data
• It is the measurement of downward risk.
• 5 percetile, it means that 95 percent observations are above this
value.
• Take 10 stocks and apply VAR on them to know if you make an
ivestment in these shares what would be your maximum potential
loss?
• Single index model; stock returns of a portfolio or some individual assets follows the movement of
stock marketindex.

• CAPM ( There is a trade off between risk and returns)

• Higher is the market risk higer will be the returns on portfolio.
• Rp= Rf+b(Rm-Rf)
• Rf= risk free returns, it is an intercept
• Intercept is value of dependent variable when independent variable is zero. Constant, becuase they
are not detemined by the market, but they are determined by state bank of pakistan. These are
exogeneous variables.
• B= slope, risk factor
• Rm-Rf= excess market returns or market primium
• B(Rm-Rf)= risk primium, how much you get excess return becuase of market risk.
• CAPM
• Capital asset pricing model; market factor model, single factor model

• Rp= rf+b(rm-rf)= Rp-Rf= B(Rm-Rf)

• Rp-Rf-B(Rm-Rf)
• Rf= alpha
• Jensen‘s alpha or manager‘s alpha
• Rp-Rf-B(Rm-Rf)
• Measures the return on a portfolio in excess of that predicted by CAPM
• Positive= you have beaten the market
• 0= your returns and capm returns are exactly same, (Market is effecient)
• R= required return
• Rf= risk free returns ( parameter)
• Rm-rf= excess market returns
• B(rm-rf)= market risk premium: additiona returns because of market risk
• B= risk factor
• Company x has a beta of 1.45. The expected risk free rate is 2.5% and
expected return on the market as a whole is 10%. What is the
expected return for company x.
• Ans: 13.375
• Risk return relationship, and it also tells us that this relationship is
linear in nature. Higher is the risk higher is the return. So, if you want
more returns then you will have to go for assets which have higher
betas.
• ABC company has a beta of 1.2. The expected risk free rate is is 4% and the
expected primium for the market as a whole is 5%. What is expected return
for ABC:
• Ans: 10%
• Security amount invested Beta expected returns
• A 1.5 million 1.012%
• B 1.0 million 1.513.5%
• C 2.0 million 0.89.0%
• Calculate beta for portfolio.
• Ans= 1.022
• Sharpe ratio: William sharpe, 1966
• Sharpe ratio= (Rp-Rf)/Sd(Rp-Rf)
• standard deviation of excess portfolio return is also called as toal risk.
• Excess return/volatility ratio
• Volatility is basically risk= how much risk is involved in getting excess
returns or how much excess returns you get becasue of risk.
• Primary quesiton: How much will sarah (or any individual or any diversified
investor require/expect to earn on each stock (given its riskiness) in order to
hold it.
• Please fit the different capm for wolfe‘s own capm
• Brown‘s capm
• Calucate the variability or standard deviation of the stock returns of california
REIT and Brown group during the past 2 years. How variable are they
compared with Vanguard index 500 trust?. Which stock appears to be
riskiest?
• Perform a regression of each stock‘s monthly returns on the index to compute
the beta for each stock.
• Suppose beta‘s position had been 99% of equity funds invested in the
index fund and 1% in the individual stock. Calcuate the variability of
this portfolio using each stock. How does each stock affect the
variability of the equity investment and which stock is riskiest.
• How the expected return for each stock relate to its riskiness.
• Sharpe ratio= excess return/std
• Expected Return-risk free/std
Term Risk Management?
• Definition
The term risk management is understood as total of all measures for
the systematic identification, measurement, management and control
of risk in enterprise and its relevant environment. Its primary goal is
stabilization or incrase of the shareholder value.