Introduction

Chapter 1

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 1
 Who am I?
 Name: Dr Tao Huang
 Email address: taohuang@uic.edu.cn
 Office telephone number: 8145
 Room number: T1-402-R11
 Preferred means of contact: Email

2
 Teaching Plan
Class Assignment
Week   Chapter Title / Topic
Discussion
Introduction to FRM    
1 Lec 1
Value-at-Risk (VaR) Measure questions
2 Lec 2 selected from
Tutorial
Market Risk Measurement questions Assignment 1 posted
3 Lec 3 selected from
Tutorial
Market Risk Measurement questions
4 Lec 4 (continued): selected from
Tutorial
Market Risk Estimation: historical questions Assignment 1 due
5 Lec 5 simulation selected from
Tutorial
Market Risk Estimation: model questions
6 Lec 6 building approach selected from
Tutorial
Credit Risk Measurement  questions  Assignment 2 posted
3
7  Lec 7 selected from
Tutorial
 Teaching Plan
Week   Chapter Title / Topic Class Discussion Assignment
8 Reading Week
Credit Risk Estimation questions Assignment 2 due
9 Lec 8 selected from
Tutorial
Market Risk Stress Testing questions
10 Lec 9 selected from
Tutorial

Operational Risk questions Assignment 3 posted

11 Lec 10 selected from
Tutorial
Liquidity Risk questions
12 Lec 11 selected from
Tutorial
Enterprise Risk Management questions Assignment 3 due
13 Lec 12 selected from
Tutorial
14   Final Review    
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Learning Outcomes

1. Explain a broad range of financial risks and related knowledge (CILO 1)

2. Explain how to model volatility and correlation, and estimate model

parameters (CILO 2)

3. Apply financial risk management methods using concepts from areas

such as value-at-risk, derivatives, hedging and financial engineering (CILO
3)
 Methods of Learning and
Teaching

 Pre-/post- reading
 Lectures
 Tutorials, example questions
 Problem oriented, research-led
learning

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 Textbook

 Hull, John C., Risk Management and Financial

Institutions, 4th Ed., John Wiley & Sons, 2015.

7
 Assessment
 Class Participation 10%
 Assignments (three) 50%
 Final Examination (3 hours) 40%
 100%

8
Introduction
 Risk vs Return

 There is a trade off between risk and

expected return
 The higher the risk, the higher the
expected return

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 10
Example (Table 1.1, page 2)
Suppose Treasuries yield 5% and the
returns for an equity investment are:

Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%
Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 11
 Example continued
 We can characterize investments by their
expected return and standard deviation of
return
 For the equity investment:
 Expected return =10%
 Standard deviation of return =18.97%

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 12
 Combining Two Risky Investments (page 5)

 P  w11  w2 2  P  w12 12  w22  22  2w1w2 1 2

16
Expected
14 Return (%)
1  10% 12

 2  15% 10

1  16% 8

6
 2  24%
4

  0.2 2 Standard Deviation

of Return (%)

0
0 5 10 15 20 25 30

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 13
 Efficient Frontier of Risky
Investments (Figure 1.3, page 6)

Efficient
Expected Frontier
Return

Investments

S.D. of
Return

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 14
 Efficient Frontier of All Investments
(Figure 1.4, page 6)

Expected J
Return
M
E(RM)
I
Previous Efficient
F Frontier
RF
New Efficient
Frontier
S.D. of Return

M

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 15
 Systematic vs Non-Systematic Risk
(equation 1.3, page 8)

We can calculate the best fit linear

relationship between return from investment
and return from market

R  a  RM  

Systematic Risk
Non-systematic risk
(non-diversifiable)
(diversifiable)
Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 16
 The Capital Asset Pricing Model
(Figure 1.5, page 9)
Expected
Return
E(R)
E(RM)

E ( R )  RF   [ E ( RM )  RF ]
RF

Beta


Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 17
 Assumptions
 Investors care only about expected return and SD of
return
 The ’s of different investments are independent
 Investors focus on returns over one period
 All investors can borrow or lend at the same risk-free
rate
 Tax does not influence investment decisions
 All investors make the same estimates of ’s, ’s and
’s.

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 18
 Alpha
 Alpha measure the extra return on a
portfolio in excess of that predicted by
CAPM
E ( RP )  RF  ( RM  RF )
so that
  RP  RF  ( RM  RF )

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 19
 Arbitrage Pricing Theory
 Returns depend on several factors
 We can form portfolios to eliminate the
dependence on the factors
 This leads to result that expected return is
linearly dependent on the realization of the
factors

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 20
 Risk vs Return for Companies
 If shareholders care only about systematic risk, should
the same be true of company managers?
 In practice companies are concerned about total risk
 Earnings stability and company survival are important
managerial objectives
 The regulators of financial institutions are primarily
interested in total risk
 “Bankruptcy costs” arguments show that that managers
may be acting in the best interests of shareholders when
they consider total risk

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 21
 What Are Bankruptcy Costs?
(Business Snapshot 1.1, page 15)

 Lost sales (There is a reluctance to buy

from a bankrupt company.)
 Key employees leave
 Legal and accounting costs

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 22
Approaches to Bank Risk
Management
 Risk aggregation: aims to get rid of non-
systematic risks with diversification
 Risk decomposition: tackles risks one by
one
 In practice banks use both approaches

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 23
 Credit Ratings
Moody’s S&P and Fitch
Aaa AAA
Aa AA Investment
A A grade bonds
Baa BBB
Ba BB
B B
Non-investment
Caa CCC grade bonds
Ca CC
C C

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 24
 Subdivisions
 Moody’s divides Aa into Aa1, Aa2, Aa3.
 S&P and Fitch divide AA into AA+, AA, and
AA−
 Other rating categories are subdivided
similarly except AAA (Aaa) and the two
lowest categories.

Risk Management and Financial Institutions 4e, Chapter 1, Copyright © John C. Hull 2015 25
Classification of Risk
 Market risk
 Credit risk
 Operational risk
 Liquidity risk
 Model risk