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risk management 2022 BATIS

Risk management involves identifying, evaluating, and prioritizing risks to minimize their impact and maximize opportunities, as defined by ISO 31000. The document outlines various types of risks, including pure and speculative risks, and discusses techniques for managing these risks, such as risk control and risk financing. It emphasizes the importance of understanding both objective and subjective risk in decision-making processes.

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risk management 2022 BATIS

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RISK MANAGEMENT

STUDY COURSE DEVELOPER: MAKSIMS GRINČUKS, Turiba University

Definition of Risk Management

Risk Management: Definition and Scope

Risk management is the identification, evaluation, and prioritization of risks

followed by coordinated and economical application of resources to
minimize, monitor, and control the probability or impact of unfortunate
events or to maximize the realization of opportunities.
defined in ISO 31000 as the
effect of uncertainty on
objectives

Risks can come from various sources including:

• uncertainty in financial markets,
• threats from project failures (at any phase in design, development,
production, or sustaining of life-cycles),
• legal liabilities,
• credit risk,
• accidents, natural causes and disasters,
• deliberate attack from an adversary, or
• events of uncertain or unpredictable root-cause.
Chapter 1: RISK AND ITS TREATMENT
Definitions of Risk

Risk traditionally has been defined in terms of uncertainty.

Based on this concept, risk is defined as uncertainty concerning the
occurrence of a loss.

Loss Exposure
The term used by many corporate managers to identify potential losses.
A loss exposure is any situation or circumstance in which a loss is possible,
regardless of whether a loss actually occurs.

Examples of loss exposures include manufacturing plants that may be damaged by an earthquake or
flood, defective products that may result in lawsuits against the manufacturer, possible theft of
company property because of inadequate security, and potential injury to employees because of
unsafe working conditions.
Definitions of Risk

When the definition of risk includes the concept of uncertainty, some authors
make a careful distinction between objective risk and subjective risk.

Objective Risk Objective risk can be

statistically calculated by
Relative variation of actual loss from expected loss. some measure of dispersion,
such as standard deviation
or coefficient of variation.
Example:
Assume that a property insurer has 10,000 houses insured over a long period and, on
average, 1%, or 100 houses, burn each year. However, it would be rare for exactly
100 houses to burn each year. In some years, as few as 90 houses may burn; in
other years, as many as 110 houses may burn.
Thus, there is a variation of 10 houses from the expected number of 100, or a variation
of 10%.
So, objective risk = 10 / 100 = 0.1 = 10%

Objective risk declines as the number of exposures increases.

More specifically, objective risk varies inversely with the square root of the number of cases under
observation (discussed later).
Definitions of Risk

Subjective Risk
Uncertainty based on a person’s mental condition or state of mind.
• Subjective risk is based on perception of risk by individuals.
• It is not a mathematical review of the situation, but rather a quick
assessment based on a person's feelings at the time.

High subjective risk often results in conservative and prudent behavior,

whereas low subjective risk may result in less conservative behavior.

Insurance companies try to avoid using subjective risk to make their decisions
because of the lack of evidence supporting this kind of assessment.
Moreover, the level of subjective risk differs widely from person to person so
it does not allow for a consistent business plan.
e.g., travelling by car is far more risky than travelling by air, though some people have a different
opinion about this.

Instead, insurance companies look at objective risk to make their decisions,

which is the mathematical chance of a problem occurring.
Chance of Loss

Chance of Loss
Probability that an event will occur.
Like risk, probability has both objective and subjective aspects.

Objective Probability
Long-run relative frequency of an event based on the assumptions of an infinite
number of observations and of no change in the underlying conditions.
Objective probabilities can be determined in two ways:

1. By deductive reasoning e.g., probability of

getting a head from
These probabilities are called a priori probabilities. the toss of a perfectly
balanced coin is 50%.

2. By inductive reasoning e.g., probability that a person

age 21 will die before age 26
cannot be logically deduced.
However, by a careful analysis of
past mortality experience, life
insurers can estimate the
probability of death.
Chance of Loss

Subjective Probability
Individual’s personal estimate of the chance of loss.
Subjective probability need not coincide with objective probability. Subjective
probability may be influenced by a person’s age, gender, intelligence,
education etc.

Chance of Loss versus Objective Risk

Chance of loss can be distinguished from objective risk.
Chance of loss may be identical for two different groups, but objective risk may
be quite different.

e.g., assume that a property insurer has 10,000 homes insured in Los Angeles and 10,000 homes
insured in Philadelphia and that the chance of a fire in each city is 1%. Thus, on average, 100
homes should burn annually in each city. However, if the annual variation in losses ranges from
75 to 125 in Philadelphia, but only from 90 to 110 in Los Angeles, objective risk is greater in
Philadelphia even though the chance of loss in both cities is the same.
Peril and Hazard

Peril
e.g., If a house burns because of a fire, the
Cause of loss. peril, or cause of loss, is the fire.

Hazard
A condition that creates or increases the frequency or severity of loss.
There are four major types of hazards:

• Physical hazard
A physical condition that increases the frequency or severity of loss.
e.g., defective wiring in a building that increases the chance of fire

• Moral hazard
Dishonesty or character effects in an individual that increases the frequency or
severity of loss.
e.g., faking an accident to collect benefits from an insurer;
a party has not entered into a contract in good faith or has provided misleading information
about its assets, liabilities, or credit capacity;
If an employee has a company car for which he does not have to pay for repairs or
maintenance, the employee might be less likely to be careful and more likely to take risks with
the vehicle.
Peril and Hazard
• Attitudinal hazard (morale hazard)
Carelessness or indifference to a loss, which increases the frequency or
severity of a loss.
e.g., leaving car keys in an unlocked car, which increases the chance of theft.

• Legal hazard
Refers to characteristics of legal system or regulatory environment that
increase the frequency or severity of a loss.
Classification of Risk

In insurance industry, risk can be classified into several distinct classes. The
most important include the following:

• Pure and Speculative risk

Pure Risk
a situation in which there are only the possibilities of loss or no loss. The only
possible outcomes are adverse (loss) and neutral (no loss).
Examples of pure risks:
premature death,
job-related accidents,
catastrophic medical expenses,
damage to property from fire, lightning, flood, or earthquake.

Speculative Risk
a situation in which either profit or loss is possible.
e.g., if you purchase 100 shares of common stock, you would profit if the price of the stock increases
but would lose if the price declines.
Classification of Risk

It is important to distinguish between pure and speculative risks for the

following reasons:

 Private insurers generally concentrate on pure risks and do not emphasize

the insurance of speculative risks.
However, there are exceptions:
Some insurers will insure institutional portfolio
investments and municipal bonds against loss.
Enterprise risk management is another important
exception where certain speculative risks can be
insured.

 The law of large numbers can be applied more easily to pure risks than to
speculative risks.
The law of large numbers is important because it enables insurers to predict
future loss experience.
In contrast, it is generally more difficult to apply the law of large numbers to
speculative risks to predict future loss experience.
Classification of Risk
• Diversifiable Risk and Nondiversifiable Risk

Diversifiable Risk
a risk that affects only individuals or small groups and not the entire economy.

This risk is also known as unsystematic risk, or company-specific risk

i.e., a risk unique to the operation of an individual firm.

Examples of unsystematic risk:

• a new competitor in the marketplace with the potential to take significant

market share from the company invested in;
• a regulatory change (which could drive down company sales);
• a shift in management;
• outcomes in legal proceedings;
• strikes (which can negatively affect company sales).
Classification of Risk

Diversifiable risk is a risk that can be reduced or eliminated by diversification.

For example, a diversified portfolio of stocks, bonds, and certificates of deposit (CDs) is less risky
than a portfolio that is 100% invested in common stocks. Losses on one type of investment, say
stocks, may be offset by gains from bonds and CDs.

Nondiversifiable Risk
a risk that affects the entire economy or large number of firms and groups
within the economy. This risk is also known as systematic risk, or market
risk.

Examples of systematic risk:

• unexpected inflation and changes in interest rates and exchange rates,
• recessions and cyclical unemployment,
• geopolitical events.

Systematic risk, affects the performance of the entire market simultaneously.

Because it affects the whole market, it is the risk that cannot be eliminated or
reduced by diversification. These risks are also difficult to insure privately.
Classification of Risk
• Enterprise Risk
encompasses all major risks faced by a business firm. In addition to pure risk
and speculative risk, it also includes:

• strategic risk,
• operational risk, and
• financial risk.

Strategic Risk
uncertainty regarding the firm’s financial goals and objectives.
For example, if a firm enters a new line of business, the line may be unprofitable.

Operational Risk
Results from the firm’s business operations and unforeseen and/or
negligent events such as:
 a critical error being overlooked in the manufacturing process;
 a security breach which can expose confidential information about
customers or other types of key proprietary data to criminals.
Classification of Risk

Financial Risk
uncertainty of loss because of adverse changes in commodity prices, interest
rates, foreign exchange rates, and the value of money.

Examples :
A food company that agrees to deliver cereal at a fixed price to a supermarket chain in 6 months may
lose money if grain prices rise.
A bank with a large portfolio of bonds may incur losses if interest rates rise.
A German corporation doing business in Japan may lose money when Japanese yen are exchanged
for EUR.

• Systemic Risk
risk of collapse of an entire system or entire market due to the failure of a single
entity or group of entities that can result in the breakdown of the entire
financial system.
Example:
Lehman Brothers’ size and integration into the U.S. economy made it a source of systemic risk. When
the firm collapsed, it created problems throughout the financial system and the economy. Capital
markets froze up while businesses and consumers could not get loans, or could only get loans if
they were extremely creditworthy.
Commercial Risks

Commercial Risks

Business firms also face a wide variety of pure risks that can financially cripple
or bankrupt the firm if a loss occurs.
These risks include:

• Property risks,

• Liability risks,

• Loss of business income,

• Cyber security and identity theft, and

• Other risks
Commercial Risks

Property Risks
Firms own valuable business property (e.g., tangible assets, inventories of raw
materials and finished products) that can be damaged or destroyed by
numerous perils.

Liability Risks
Firms often operate in highly competitive markets where lawsuits for bodily
injury and property damage are common.

Firms are sued for numerous reasons, including:

• defective products that harm or injure others,

• pollution of the environment,
• damage to the property of others,
• injuries to customers,
• discrimination against employees,
• violation of copyrights and intellectual property, etc.
Commercial Risks

Loss of Business Income

Potential loss of business income when a covered physical damage loss
occurs.
For example, a firm can be shut down for several months because of a physical damage loss to
business property due to a fire, earthquake, or other perils. During the shutdown period, the firm
would lose business income, which includes the loss of profits, the loss of rents if business
property is rented to others, and the loss of local markets.
In addition, during the shutdown period a firm may incur sizeable fixed costs such as rent, utilities,
leases, interest, taxes and some salaries, insurance premiums etc. Fixed costs in this case are
not offset by revenues because a firm’s operations are temporarily discontinued.

Cyber security and Identity Theft

Losses can result from breaking into a firm’s computer system and database.
For example, computer hackers can steal consumer credit records, which can expose individuals to
identity theft and violation of privacy. As a result, commercial banks, financial institutions, and
other business firms are exposed to enormous legal liabilities.
Other crime exposures include:
• robbery and burglary;
• shoplifting;
• employee theft and dishonesty;
• fraud and embezzlement;
• piracy and theft of intellectual property etc.
Commercial Risks

Other Risks
Business firms must cope with a wide variety of additional risks, for example:

Human resources exposures

• job-related injuries and disease of workers;

• death or disability of key employees;
• violation of local laws and regulations.

Foreign loss exposures

• acts of terrorism,
• political risks,
• kidnapping of key personnel,
• damage to foreign plants and property, and
• foreign currency risks.
Commercial Risks

Intangible property exposures

• damage to the market reputation and public image of the company,

• loss of intellectual property.
For many firms, the value of intangible property is greater than the value of
tangible property.

Government exposures

Governments may pass laws and regulations that have a significant financial
impact on the company.

Examples:
• laws that increase safety standards,
• laws that require reduction in plant emissions and contamination, and
• new laws to protect the environment that increase the cost of doing
business.
Techniques For Managing Risks

Techniques for managing risk can be classified broadly as either risk control or
risk financing.
Managers typically use a combination of techniques for treating each loss
exposure.

Risk Control

Risk control refers to techniques that reduce the frequency or severity of

losses.

Major risk-control techniques include:

• Avoidance
Technique for managing risk, i.e., avoiding risk.

• Loss prevention
Reduction of the probability of loss so that the frequency of losses is minimized.
Techniques For Managing Risks
• Loss reduction
Reduction of the severity of loss after it occurs.

– Duplication
Losses can be reduced by duplication, e.g., having back-ups or copies of
important documents or property available in case a loss occurs.

– Separation
Assets exposed to loss are separated or divided to minimize the financial loss
from a single event.

– Diversification
This technique reduces the chance of loss by spreading the loss exposure
across different parties.
Techniques For Managing Risks

Risk Financing

Risk financing refers to techniques that provide for the funding of losses.
Major risk-financing techniques include:

• Retention
An individual or business firm retains part of all of the loss that can result from a
given risk. Risk retention can be active or passive.

– Active Retention
An individual (or business entity) is consciously aware of the risk and
deliberately plans to retain all or part of it.
For example, a firm may deliberately retain the risk of petty thefts by employees, shoplifting, or the
spoilage of perishable goods by purchasing a property insurance with a sizeable deductible.
Active risk retention is used for two major reasons:
• Insurance may not be purchased, or it may be purchased with a deductible;
either way, there is often substantial savings in the cost of insurance.
• The risk may be deliberately retained because commercial insurance is
either unavailable or unaffordable.
Techniques For Managing Risks

– Passive Retention
Certain risks may be unknowingly retained because of ignorance, indifference,
laziness, or failure to identify an important risk.
In case of passive retention, no funds are set aside to cover an upcoming or
estimated loss.
Passive retention is very dangerous if the risk retained has the potential for
financial ruin.

– Self-Insurance
a special form of planned retention by which part or all of a given loss exposure
is retained by the firm.
Also known as self-funding, which expresses more clearly the idea that losses
are funded and paid for by the firm.
For example, a large corporation may self-insure or fund part or all of the group health insurance
benefits paid to employees.

Self-insurance is widely used in corporate risk management programs primarily

to reduce both loss costs and expenses associated with insurance.
Techniques For Managing Risks
• Noninsurance transfers
Risk is transferred to a party other than an insurance company.
Risks can be transferred by several methods, including:

– Transfer of Risk by Contracts

Certain risks may be transferred by contracts.

Examples:
• The risk of a price increase in construction costs can be transferred to the builder by having a
guaranteed price in the contract.
• The risk of a rent increase can be transferred to the landlord by a long-term lease.

A risk can be also transferred by a hold-harmless clause.

For example, a sports club may include a hold harmless clause in its contract to prevent its members
from suing if they are injured in the course of participating in tennis matches.
Techniques For Managing Risks

– Hedging Price Risks Hedging is a technique for transferring the

risk of unfavorable price fluctuations to a
Another example of risk transfer. speculator by purchasing and selling futures
contracts on an organized exchange.

Example:
The portfolio manager of a pension fund may hold a substantial position in long-
term U.S. Treasury bonds. If interest rates rise, the value of the Treasury
bonds will decline. To hedge that risk, the portfolio manager can sell
Treasury bond futures.
Assume that interest rates rise as expected, and bond prices decline. The value
of the futures contract will also decline, which will enable the portfolio
manager to make an offsetting purchase at a lower price. The profit
obtained from closing out the futures position will partly or completely offset
the decline in the market value of the Treasury bonds owned. Of course,
interest rates do not always move as expected, so the hedge may not be
perfect. Transaction costs also are incurred. However, by hedging, the
portfolio manager has reduced the potential loss in bond prices if interest
rates rise.
Techniques For Managing Risks

– Incorporation of a Business Firm Attachment is a legal process by which a

court of law, at the request of a creditor,
Another example of risk transfer. designates specific property owned by
the debtor to be transferred to the
creditor, or sold for the benefit of the
creditor.
If a firm is a sole proprietorship, the owner’s personal assets can be attached
by creditors for satisfaction of debts.

If a firm incorporates, personal assets cannot be attached by creditors for

payment of the firm’s debts.

In essence, by incorporation, the liability of the stockholders is limited, and the

risk of the firm having insufficient assets to pay business debts is shifted to
the creditors.

• Insurance
a means of protection from financial loss. It is a form of risk management,
primarily used to hedge against the risk of a contingent or uncertain loss.
Chapter 2: INSURANCE AND RISK

Definition of Insurance

Insurance is the pooling of fortuitous losses by transfer of such risks to

insurers, who agree to indemnify insureds for such losses, to provide other
pecuniary benefits on their occurrence, or to render services connected with
the risk.

Basic Characteristics of Insurance

An insurance plan or arrangement typically includes the following

characteristics:

• Pooling of losses
• Payment of fortuitous losses
• Risk transfer
• Indemnification
Basic Characteristics of Insurance
• Pooling of Losses
Pooling (i.e., sharing) of losses is the essence of insurance.

Pooling is the spreading of losses incurred by the few over the entire group, so
that in the process, average loss is substituted for actual loss.

• Primary purpose of pooling, or the sharing of losses, is to reduce the

variation in possible outcomes as measured by the standard deviation or
some other measure of dispersion, which reduces risk.

• Pooling involves the grouping of a large number of exposure units so that

the law of large numbers can operate to provide a substantially accurate
prediction of future losses.

Example on the next slide demonstrates this point.

Basic Characteristics of Insurance

Example:
Assume that two business owners each own an identical storage building
valued at €50,000.
Assume there is a 10% chance in any year that each building will be destroyed
by a peril, and that a loss to either building is an independent event.

Possible Outcome Probability Loss

1. Building is not destroyed 0.90 €0
2. Building is destroyed 0.10 €50,000
The expected annual loss, E(L), for each owner is €5,000 as shown below:

E ( L) 0.90 €0  0.10 €50,000  €5,000

A common measure of risk is standard deviation, which is the square root of the
variance. The standard deviation (σ) for the expected value of the loss is
€15,000, as shown below:

  0.90(0  €5,000) 2  0.10( €50,000  €5,000) 2  €15,000

Basic Characteristics of Insurance

Suppose instead of bearing the risk of loss individually, the two owners decide
to pool (combine) their loss exposures, and each owner agrees to pay an
equal share of any loss that might occur.
Under this scenario, there are 4 possible outcomes:

Possible Outcome Probability

1. Neither building is destroyed 0.90 × 0.90 = 0.81
2. First building destroyed, second building no loss 0.10 × 0.90 = 0.09
3. First building no loss, second building destroyed 0.90 × 0.10 = 0.09
4. Both buildings are destroyed 0.10 × 0.10 = 0.01

If neither building is destroyed, the loss for each owner is €0.

If one building is destroyed, each owner pays €25,000.
If both buildings are destroyed, each owner must pay €50,000.

The expected loss for each owner remains €5,000 as shown below:

E ( L) 0.81€0  0.09 €25,000  0.09 €25,000  0.01€50,000  €5,000

Basic Characteristics of Insurance

Note that while the expected loss remains the same, the probability of the
extreme values, €0 and €50,000, have declined.
The reduced probability of the extreme values is reflected in a lower standard
deviation (σ) as shown below:

0.81(0  €5,000) 2  0.09( €25,000  €5,000) 2 

 2 2
 €10,607
 0.09( €25,000  €5,000)  0.01( €50,000  €5,000)

Thus, as additional individuals are added to the pooling arrangement, the

standard deviation continues to decline while the expected value of the loss
remains unchanged.

For example, with a pool of 100 insureds, standard deviation is €1,500;

with a pool of 1,000 insureds, standard deviation is €474; and
with a pool of 10,000, standard deviation is €150.
Basic Characteristics of Insurance

In addition, by pooling or combining the loss experience of a large number of

exposure units, an insurer may be able to predict future losses with greater
accuracy.
From the viewpoint of the insurer, if future losses can be predicted, objective
risk is reduced. Thus, another characteristic often found in many lines of
insurance is risk reduction based on the law of large numbers.

Law of Large Numbers

The law of large numbers states that the greater the number of exposures,
the more closely will the actual results approach the probable results that
are expected from an infinite number of exposures.
Basic Characteristics of Insurance
• Payment of Fortuitous Losses
A fortuitous loss is one that is unforeseen and unexpected by the insured and
occurs as a result of chance.
The law of large numbers is based
on the assumption that losses are
In other words, the loss must be accidental. accidental and occur randomly.

• Risk Transfer
With the exception of self-insurance, a true insurance plan always involves risk
transfer.
Risk transfer means that a pure risk is transferred from the insured to the
insurer, who typically is in a stronger financial position to pay the loss than
the insured.
Basic Characteristics of Insurance
• Indemnification
Indemnification means that the insured is restored to his approximate financial
position prior to the occurrence of the loss.

Example:
The owner of a commercial property has been paying an insurance premium to an insurance
company so that he can recover the costs for any loss or damage if a future bad event were to
happen to the establishment. If the building sustains significant structural damages from fire, then
the insurance company will indemnify the owner for the costs to repair by way of reimbursing the
owner or by reconstructing the damaged areas using its own authorized contractors.
Characteristics of an Ideally Insurable Risk

Characteristics of an Ideally Insurable Risk

Private insurers generally insure only pure risks. However, some pure risks are
not privately insurable.
From the viewpoint of a private insurer, an insurable risk ideally should have the
following 6 characteristics:

1. There must be a large number of exposure units.

Purpose:
• to enable insurer to predict losses based on the law of large numbers;
• to enable insurer to set appropriate premiums.

2. The loss must be accidental and unintentional (i.e., the loss should be
unforeseen by the insured and outside of the insured’s control)
Purpose:
• prediction of future experience may be highly inaccurate if a large number of
intentional or nonrandom losses occur;
• Moral hazard is increased if the insured deliberately intends to cause a loss.
Characteristics of an Ideally Insurable Risk

3. The loss must be determinable and measurable (i.e., the loss should be
definite as to cause, time, place, and amount).
Purpose:
To enable an insurer to determine if the loss is covered under the policy, and if
it is covered, how much should be paid.

4. The loss should not be catastrophic (i.e., a large proportion of exposure

units should not incur losses at the same time).
Purpose:
Insurers ideally wish to avoid all catastrophic losses. In reality, it is impossible to
avoid all catastrophic losses,
so insurance companies can
use reinsurance.
Reinsurance
An arrangement by which the primary insurer that initially writes the insurance
transfers to another insurer (called the reinsurer) part or all of the potential
losses associated with such insurance. The reinsurer is then responsible for
the payment of its share of the loss.
Characteristics of an Ideally Insurable Risk

5. The chance of loss must be calculable (i.e., insurer must be able to calculate
both the average frequency and the average severity of future losses with
some accuracy).
Purpose:
So that a proper premium can be charged that is sufficient to pay all claims and
expenses and yields a profit during the policy period.

6. The premium must be economically feasible (i.e., the insured must be able to
pay the premium).

Takeaway:
Most personal risks, property risks, and liability risks can be privately insured
because the ideal characteristics of an insurable risk generally can be met.

In contrast, most market risks, financial risks, production risks, and political
risks are difficult to insure by private insurers. These risks are speculative,
and calculation of a correct premium may be difficult because the chance of
loss cannot be accurately estimated. (see Exhibit 2.1 and 2.2)
Characteristics of an Ideally Insurable Risk
Characteristics of an Ideally Insurable Risk
Insurance vs. Hedging

Insurance and Hedging Compared

An insurance contract is not the same thing as hedging.

Although both techniques are similar in that risk is transferred by a contract,

there is an important difference between them:

• An insurance transaction typically involves the transfer of pure risks

because the characteristics of an insurable risk generally can be met.

• However, hedging is a technique for handling speculative risks that may be

uninsurable, such as protection against a decline in the price of agricultural
products and raw materials.
Chapter 3: INTRODUCTION TO RISK MANAGEMENT
Meaning of Risk Management

Risk management is a process that identifies loss exposures faced by an

organization and selects the most appropriate techniques for treating such
exposures.
In the past, risk managers generally considered only pure loss exposures
faced by the firm. However, new forms of risk management have emerged
that consider both pure and speculative loss exposures.

Objectives of Risk Management

Risk management has important objectives. These objectives can be classified

as follows:

• Pre-loss objectives

• Post-loss objectives
Objectives of Risk Management

Pre-Loss Objectives

Important objectives before a loss occurs include:

1. Economy
The firm should prepare for potential losses in the most economic way, i.e.,
• Analyze the costs of safety programs and insurance premiums paid;
• Analyze the costs associated with different techniques for handing losses.

2. Reduction of anxiety

3. Meeting any legal obligations

The firm must see that certain legal obligations are met, i.e.,
• Install safety devices to protect workers from harm;
• Dispose of hazardous waste materials properly;
• Label consumer products properly.
Objectives of Risk Management

Post-Loss Objectives

Important objectives after a loss occurs include:

1. Survival of the firm

After a loss occurs, the firm can resume at least partial operations within some
reasonable time period.

2. Continue operating
For some firms, the ability to operate after a loss is extremely important.
Otherwise, business will be lost to competitors.

3. Stability of earnings
Earnings per share can be maintained if the firm continues to operate.
However, a firm may incur substantial additional expenses to achieve this
goal (such as operating at another location), and perfect earnings stability
may be difficult to obtain.
Objectives of Risk Management

4. Continued growth of the firm

A firm can grow by developing new products and markets or by acquiring or
merging with other firms. The risk manager must therefore consider the
effect that a loss will have on the firm’s ability to grow.

5. Social responsibility
The firm should minimize the adverse effects that a severe loss may have on:
• customers;
• employees;
• suppliers;
• investors;
• creditors, and
• community in general.

For example, a severe loss that shuts down a plant in a small town for an extended period can cause
considerable economic distress in the local area.
Steps in Risk Management Process

Step 1 in Risk Management Process:

Identify loss exposures

1 Property loss exposures

• Building, plant, and other structures

• Furniture, equipment, supplies
• Computers, computer software, and data
• Inventory
• Accounts receivable, valuable papers, and records
• Company vehicles, planes, boats, and mobile equipment
Steps in Risk Management Process

Step 1 in Risk Management Process:

Identify loss exposures

• Employee theft and dishonesty
• Fraud and embezzlement
• Internet and computer crime exposures
• Theft of intellectual property
Steps in Risk Management Process

Step 1 in Risk Management Process:

Identify loss exposures

Employee benefit loss

6 exposures

• Failure to comply with government regulations

• Violation of fiduciary responsibilities
• Group life, health, and retirement plan exposures
• Failure to pay promised benefits
Steps in Risk Management Process

Step 1 in Risk Management Process:

Identify loss exposures

7 Foreign loss exposures

• Acts of terrorism
• Plants, business property, inventory
• Foreign currency and exchange rate risks
• Kidnapping of key personnel
• Political risks, such as expropriation of property
Steps in Risk Management Process

Step 1 in Risk Management Process:

Identify loss exposures

Intangible property loss

8 exposures

• Damage to the firm’s public image

• Loss of goodwill and market reputation
• Loss or damage of intellectual property
Steps in Risk Management Process

Step 1 in Risk Management Process:

Identify loss exposures

Failure to comply with

9 government laws
Steps in Risk Management Process

Step 1 in Risk Management Process:

Identify loss exposures

Sources of information risk managers can use to identity the preceding loss
exposures:
• Risk analysis questionnaires and checklists
These require the risk manager to answer numerous questions that identify
major and minor loss exposures.

• Physical inspection
A physical inspection of company plants and operations can identify major loss
exposures.

• Flowcharts
Flowcharts that show the flow of production and delivery can reveal production
and other bottlenecks as well as other areas where a loss can have severe
financial consequences for the firm.
Steps in Risk Management Process

Step 1 in Risk Management Process:

Identify loss exposures

Sources of information risk managers can use to identity the preceding loss
exposures:
• Financial statements
Analysis of financial statements can identify the major assets that must be
protected, loss of income exposures, key customers and suppliers, and
other important exposures.

• Historical loss data

Historical loss data can be invaluable in identifying major loss exposures.

In addition, risk managers must keep track of industry trends and market
changes that can create new loss exposures and cause concern.
Steps in Risk Management Process

Step 2 in Risk Management Process:

Identify loss exposures

Measure and analyze

loss exposures
Steps in Risk Management Process

Step 2 in Risk Management Process:

Identify loss exposures

Measure and analyze

loss exposures

Estimate the frequency

1
of loss
Loss frequency is the probable number of losses that may Once the risk manager
occur during some given time period. estimates the frequency and
severity of loss for each
Estimate the severity of type of loss exposure, the
2 various loss exposures can
loss be ranked according to their
relative importance.
Loss severity is the probable size of the losses that may occur.
Steps in Risk Management Process

Step 2 in Risk Management Process:

Identify loss exposures

Measure and analyze

loss exposures

Estimate the frequency

1
of loss

Estimate the severity of Maximum possible loss is the

2. Risk Financing
Means that the firm retains part or all of the
Retention losses that can result from a given loss.
Steps in Risk Management Process

Risk Financing

1. No other method of treatment is

Retention is available
1 efficient IF: 2. The worst possible loss is not serious
3. Losses are fairly predictable

2. Risk Financing

Retention
Steps in Risk Management Process

Risk Financing

1. No other method of treatment is

Retention is available
1 efficient IF: 2. The worst possible loss is not serious
3. Losses are fairly predictable

Determine Retention level is the euro amount of

2 retention losses that the firm will retain
levels A firm can determine the maximum
2. Risk Financing uninsured loss it can absorb without
adversely affecting its profit.
e.g., 5% of operating profit before tax,
Retention or 1-5% of net working capital.
Steps in Risk Management Process

Risk Financing

1. Current net income (i.e., pay losses

Select out of current net income and treat
3 methods for losses as expenses for that year)
paying losses: 2. Funded reserve (i.e., set aside liquid
funds to pay losses)
3. Credit line (i.e., use borrowed funds to
pay losses as they occur)

certain benefits – generally health
benefits or disability benefits – to
employees and funds claims from a
specified pool of assets rather than
through an insurance company

2. Risk Financing

Retention
Advantages Disadvantages
• Saving money on insurance premiums • Possible higher losses that exceed the loss
• Lower expenses component in insurance premiums
• Greater incentive for loss prevention • Possible higher expenses
• Increased cash flow • Possible higher taxes
Steps in Risk Management Process

Risk Financing

2. Risk Financing

Noninsurance Transfers Methods other than insurance by which a pure

risk and its potential financial consequences are
transferred to another party
Steps in Risk Management Process

Risk Financing

Step 4: Implementation and Monitoring

Identify loss exposures

Measure and analyze

loss exposures

Select appropriate combination of

techniques for treating loss exposure

Implement and monitor risk

management program

1. Prepare risk management policy statement

2. Cooperate closely with other individuals and departments
3. Periodically review the entire risk management program
Steps in Risk Management Process

Which technique should be used?

In determining the appropriate technique or techniques for handling loss

exposures, a matrix can be used that classifies the various loss exposures
according to frequency and severity.

Risk Management Matrix

Steps in Risk Management Process

Chapter 4: MEASURING RISK
Describing Data Using Numerical Measures

In risk management one should be competent in converting quantitative data

into useful information.
It is possible to use histograms which give a visual indication of where data are
centered and how much spread there is the data around the center.
However, to fully describe a quantitative variable we also need to use the
numerical measures, such as the
• measures of location (central tendency) and
• measures of dispersion.
These measures can then be coupled with the histogram to give a clear picture
of the variable’s distribution.

Measures of Location
Measures of location are often referred to as averages.
The purpose of a measure of location is to pinpoint the center of a distribution
of data.
An average is a measure of location that shows the central value of the data.
Measures of Central Tendency

Population Mean
The average for all values in the population computed by dividing the sum of all
values by the population size:

x i
where: N – population size,
 i 1
xi – ith individual value of variable x
N

Sample Mean
The average for all values in the sample.
For grouped data:
N K

x i xn i i
x  i 1 x  i 1
n n
Measures of Central Tendency

Mode
The mode (Mo) is the value in a data set that occurs most frequently.
A data set may have more than one mode if two or more values tie for the most
frequently occurring value.

Median
To find the median (Me), arrange the data in ascending order (smallest value to
largest value).

• For an odd number of observations, the median is the middle value.

• For an even number of observations, the median is the average of the two
middle values.

Although the mean is the more commonly used measure of central location, in
some situations the median is preferred. The mean is influenced by
extremely small and large data values, therefore, whenever a data set
contains extreme values, the median is often the preferred measure of
central location.
Measures of Dispersion

Dispersion is a statistical term that describes the size of the distribution of

values expected for a particular variable.
Dispersion can be measured by several different statistics, such as range,
variance, and standard deviation.
For example, in financial risk management, dispersion can be used to measure
the risk inherent in a particular financial asset. It is often interpreted as a
measure of the degree of uncertainty, and thus, risk.

The following are the common measures of the dispersion of data.

Range
The range is a measure of variation that is computed by finding the difference
between the maximum and minimum values in a data set.

A limitation of the range is that it is based on only two values,

R  xmax  xmin the maximum and the minimum; it does not take into account
all of the values.
The variance does. It measures the mean amount by which the
values in a population, or sample, vary from their mean.
Measures of Dispersion
Variance
Variance is the average of the squared distances of the data values from the
mean.
Population variance, σ2 :
N

 i
( x   ) 2

 2  i 1
N
Sample variance, s2 : For grouped data:
n k

 ( xi  x ) 2
 ni ( xi  x) 2
s2  i 1
s2  i 1
n 1 n 1
The units of measure in the variance are squared.
Because dealing with original units is easier than dealing with the square of the
units, we usually use the standard deviation to measure variation in a
population or sample.
Measures of Dispersion
Standard Deviation

Standard deviation is the square root of the variance. It is easier to interpret.

Population standard deviation, σ:

 i
( x   ) 2

 i 1
N
Sample standard deviation, s:
For grouped data:
n k

 i
( x  x ) 2

i 1
ni ( xi  x) 2
s i 1 s 
n 1 n 1
Measures of Dispersion
Coefficient of Variation

The coefficient of variation (CV) is a statistical measure of the dispersion of

data points in a data series around the mean.
It represents the ratio of the standard deviation to the mean, and is useful for
comparing the degree of variation from one data series to another, even if
the means are drastically different from one another.

s
CV  100%
x

In finance, the coefficient of variation allows investors to determine how much

volatility, or risk, is assumed in comparison to the amount of return expected
from investments.
Shape of Distribution
Skewness

Skewness Sk is a measure of symmetry, or more precisely, the lack of

symmetry. A distribution, or data set, is symmetric if it looks the same to the
left and right of the center point.

If Sk = 0, then x̄ = Me = Mo and the distribution symmetrical.

Sk = 0
Frequency

Mo = Me = x̄ Variable
Skewness
If Sk < 0, then x̄ < Me < Mo.
Sk < 0
Frequency

x̄ Me Mo Variable
If Sk > 0, then x̄ > Me > Mo.

Sk > 0 Skewness can be calculated

using MS Excel function
SKEW

Mo Me x̄ Variable
Skewness
Example 3.1.:
Company EPS (in $), 2019 The table gives information about earnings per
(in ascending order)
share (EPS) of selected companies (2019).
1 0.09
2 0.13
3 0.41
4 0.51
5 1.12
6 1.20
7 1.49
8 3.18
9 3.50
10 6.36
11 7.83
12 8.92
13 10.13 1. Calculate the arithmetic mean, median,
14 12.99 sample standard deviation and skewness.
15 16.40
Skewness
Solution:

x
 x $74.26
 $4.95
n 15

Me $3.18

 i
( x
i 1
 x ) 2
($0.09  $4.95) 2  ...  ($16.40  $4.95) 2
s  $5.22
n 1 15  1

Skewness can be calculated using the following formula:

3
 n   xi  x 
n
S K 
( n  1)( n  2 )    s 
  i 1  
Skewness
EPS (in $), 2019 (x - x̄) / s ((x - x̄) / s)3
(in ascending
order)
0.09 -0.9310 -0.8070
3
0.13 -0.9234 -0.7873  n  n  xi  x 
0.41 -0.8697 -0.6579
S K    
 (n  1)(n  2)  i 1  s 
 
0.51 -0.8506 -0.6154
15
1.12 -0.7337 -0.3950  (11 .8274) 0.975
1.20 -0.7184 -0.3708
(15  1)(15  2)
1.49 -0.6628 -0.2912
3.18 -0.3391 -0.0390
3.50 -0.2778 -0.0214
6.36 0.2701 0.0197
7.83 0.5517 0.1679
8.92 0.7605 0.4399
10.13 0.9923 0.9772
12.99 1.5402 3.6539
16.40 2.1935 10.5537
11.8274
Skewness
EPS
1 0.09
2 0.13
3 0.41
4 0.51
5 1.12
6 1.2
7 1.49
8 3.18
9 3.5
10 6.36
11 7.83
12 8.92
13 10.13
14 12.99
15 16.4

skewness 0.973355
Kurtosis
Kurtosis

Kurtosis KE is a measure of whether the data are heavy-tailed or light-tailed

relative to a normal distribution. Data sets with low kurtosis tend to have
light tails, or lack of outliers. A uniform distribution would be the extreme
case.
Kurtosis for normal distribution is equal to zero, i.e., KE = 0.
If KE > 0, the data tend to have heavy tails, or outliers. The distribution is more
peaked.
KE > 0
Frequency

Variable
Kurtosis

If KE < 0, the distribution is flatter than a normal curve.

KE < 0
Frequency

Variable

Kurtosis can be calculated

using MS Excel function KURT
Basic Probability Concepts
Probability is a value between zero and one, inclusive, describing the relative
possibility (chance or likelihood) an event will occur.
The application of probability is crucial in risk management.

Rules of Probability

1. If we are certain about the outcome of an event, we will assign the event a
probability of 0 or 1, where

• P(Ei) = 0 indicates the event Ei will not occur and

• P(Ei) = 1 means Ei will definitely occur.

2. If we are uncertain about the result of an experiment, we measure this

uncertainty by assigning a probability between 0 and 1.
Basic Probability Concepts
3. For any event Ei

0 P ( Ei ) 1 for all i

4. All possible outcomes associated with an experiment form the sample

space. Therefore, the sum of the probabilities of all possible outcomes is 1:
k

 P( E ) 1
i 1
i
where:
k = number of outcomes in the sample;
Ei = ith outcome

Complement Rule
Given an event A, the complement of A is defined to be the event consisting
of all sample points that are not in A. The complement of A is denoted by Ac.
In any probability application, either event A or its complement Ac must occur.
Therefore, P ( A)  P ( Ac ) 1
Ac
COMPLEMENT RULE A
P ( A) 1  P ( Ac ) Sample
space
Basic Probability Concepts
Addition Rule for Mutually Exclusive Events
Events A and B are mutually exclusive if, when one event occurs, the other
cannot occur.
When two events are mutually exclusive then the probability of A or B
occurring can be expressed as:

SPECIAL RULE OF ADDITION

A B
P ( A  B )  P ( A)  P ( B ) Sample
space
Addition Rule for Non-Mutually Exclusive Events
If two events are non-mutually exclusive, this means that it is possible for
both events to occur. In this case, the probability of A or B occurring can be
expressed as:

GENERAL RULE OF ADDITION

P ( A  B )  P ( A)  P ( B )  P ( A  B ) A AB B
where: P(A  B) – probability of both A and B Sample
space
occurring together (joint probability)
Basic Probability Concepts
Conditional Probability for Any Two Events
Often, the probability of an event is influenced by whether a related event
already occurred.
Suppose we have an event A with probability P(A). If we obtain new information
and learn that a related event, denoted by B, already occurred, we will want
to take advantage of this information by calculating a new probability for
event A. This new probability of event A is called a conditional probability
and is written P(A | B).
Probability of event A given the condition that event B has occurred is:

CONDITIONAL PROBABILITY FOR ANY TWO EVENTS

P( A  B) A A∩B B
P( A | B) 
P( B) Sample
space

P( A  B)
Also, P ( B | A) 
P ( A)
Basic Probability Concepts
Conditional Probability for Independent Events
If the probability of event A is not changed by the existence of event B — that
is, P(A|B) = P(A) — we would say that events A and B are independent
events.

CONDITIONAL PROBABILITY FOR INDEPENDENT EVENTS

P ( A | B )  P ( A) P( B)  0
and
P ( B | A)  P ( B ) P ( A)  0

Multiplication Rule for Independent Events

For two independent events A and B, the probability that A and B will both
occur is found by multiplying the two probabilities:

SPECIAL RULE OF MULTIPLICATION

P ( A  B )  P ( A) P ( B )
Basic Probability Concepts
Multiplication Rule for Any Two Events
If events A and B are dependent, the probability that A and B will both occur
is found by multiplying the two probabilities:

GENERAL RULE OF MULTIPLICATION

P ( A  B )  P ( A) P ( B | A) This formula says that we can multiply the

probabilities of two events, but we need to take
and the first event into account when considering
the probability of the second event.
P( A  B) P( B) P( A | B)
Discrete Probability Distribution
Random Variable
A variable that takes on different numerical values based on chance.

Discrete Random Variables

A random variable that may assume either a finite number of values or an
infinite sequence of values such as 0, 1, 2, . . . is referred to as a discrete
random variable. A discrete random variable can assume only a certain
number of separated values.
For example, the bank counts the number of credit cards carried for a group
of customers. The data are summarized in the table:
Number of credit cards Relative frequency
0 0.30
1 0.10
2 0.18
3 0.21
4 or more 0.48 In this frequency table, the number of
Total 1.00 cards carried is the discrete random
variable.
Discrete Probability Distribution
Displaying Discrete Probability Distributions Graphically
The probability distribution for a discrete random variable is composed of
the values the variable can assume and the probabilities for each of the
possible values.
The Figure shows the probability distribution for a discrete variable that has 21
possible outcomes:
Discrete Probability Distribution
Discrete Probability Density Function

Discrete probability density function (PDF) of a discrete random variable X

can be represented in a table, graph, or formula, and provides the
probabilities P(X = x) for all possible values of x.

Cumulative Distribution Function of a Discrete Random Variable

Cumulative distribution function (CDF) of a random variable X is denoted by
F(x), and is defined as

F ( x)  P( X  x)

The cumulative distribution function for a random variable at x gives the

probability that the random variable X is less than or equal to a particular
number x.
Discrete Probability Distribution
Example 3.3.:
The table gives information on the number of marriages that end up in divorce,
depending on marriage duration.
Marriage duration, years Number of failed marriages
0 10
1 80
2 177
3 209
4 307
5 335
6 358
7 413
8 432
9 402
10 and more 3287
Total 6010

1. Construct the probability distribution for marriage duration.

Discrete Probability Distribution
Marriage duration, Number of Failures Probability F(x)
years
0 10 0.002 0.002
1 80 0.013 0.015
2 177 0.029 0.044
3 209 0.035 0.079
4 307 0.051 0.130
5 335 0.056 0.186
6 358 0.060 0.246
7 413 0.069 0.314
8 432 0.072 0.386
9 402 0.067 0.453
10 and more 3287 0.547 1.000
Total 6010 1

2. Find the probability that a marriage would end up in divorce if its duration is 5 years.
Discrete Probability Distribution
Marriage duration, Number of Failures Probability F(x)
years
0 10 0.002 0.002
1 80 0.013 0.015
2 177 0.029 0.044
3 209 0.035 0.079
4 307 0.051 0.130
5 335 0.056 0.186
6 358 0.060 0.246
7 413 0.069 0.314
8 432 0.072 0.386
9 402 0.067 0.453
10 and more 3287 0.547 1.000
Total 6010 1

Solution: 335
p (5)  0.056
6010
Discrete Probability Distribution
Marriage duration, Number of Failures Probability F(x)
years
0 10 0.002 0.002
1 80 0.013 0.015
2 177 0.029 0.044
3 209 0.035 0.079
4 307 0.051 0.130
5 335 0.056 0.186
6 358 0.060 0.246
7 413 0.069 0.314
8 432 0.072 0.386
9 402 0.067 0.453
10 and more 3287 0.547 1.000
Total 6010 1

3. Find the probability that marriage duration is less or equal to 7 years.

Solution:
F (7)  P ( X 7)  p (7)  p (6)  p (5)  ...  p (0) 0.314
Discrete Probability Distribution
Mean and Variance of Discrete Distribution

The expected value is a weighted avreage of the values of the random variable
where the weights are the probabilities. Expected value of a discrete
probability distribution, E(X) or μ is calculated as:
n
  E ( X )  xi pi where xi – values of random variable,
i 1 pi – probability of the i-th value of random variable

Variance of a discrete probability distribution:

n
  ( xi   ) 2 pi
2 where μ – expected value of x
i 1

Skewness of a discrete probability distribution can be calculated as follows:

 i
( x   ) 3
pi
S K  i 1
3
Binomial Distribution
Binomial Distribution

One of the most widely used discrete distributions, the binomial distribution
deals with consecutive trials, each of which has two possible outcomes.
The outcomes can be identified in general terms, such as “success” versus
“failure” or “yes” versus “no”.
The binomial distribution relies on what is known as the Bernoulli process:

Characteristics of a Bernoulli Process:

1. There are two or more consecutive trials.

2. In each trial, there are just two possible outcomes—usually denoted as
success or failure.
3. The trials are statistically independent; that is, the outcome in any trial is not
affected by the outcomes of earlier trials, and it does not affect the
outcomes of later trials.
4. The probability of a success remains the same from one trial to the next.
Binomial Distribution
In the binomial distribution, the discrete random variable, x, is the number of
successes that occur in n consecutive trials of the Bernoulli process.

The Binomial Probability Distribution:

The probability of exactly x successes in n trials is

n!
P( x)  p x (1  p ) n  x
x!(n  x)!

where:
n = number of trials;
x = number of successes;
p = probability of success in any given trial;
1 – p = probability of failure in any given trial.
Binomial Distribution
Mean and Variance of Binomial Distribution

Mean  np

Variance  2 np (1  p )
Standard Deviation   np (1  p )
Poisson Distribution
Poisson Distribution

The Poisson distribution describes a process that extends over space, time,
or any well-defined interval or unit of inspection in which the outcomes of
interest occur at random and we can count the number of outcomes that occur
in any given interval.
The Poisson distribution, rather than the binomial distribution, is used when the
total number of possible outcomes cannot be determined.

Properties of a Poisson Experiment

1. The random variable is the number of times some event occurs during a
defined interval.
2. The probability of the event is proportional to the size of the interval.
3. The intervals do not overlap and are independent.
Poisson Distribution
The Poisson Probability Distribution:

 xe  where x = the number of occurrences (successes);

P( x)  μ = the mean number of occurrences
x! (successes) in a particular interval;
e = 2.7183
P(x) = probability of a specified value of x

To calculate Poisson probability density function P(x) and cumulative Poisson

probability F(x) we can also use MS Excel function POISSON

where x – the number of events;

Mean – the mean value μ;
Cumulative – logical value where:
0 (FALSE) – logical value for the
Poisson density function P(x);
1 (TRUE) – logical value for the
cumulative Poisson probability F(x);
Poisson Distribution
Mean and Variance of Poisson Distribution

 np
The variance of the Poisson is equal to its mean.
Continuous Distribution
Continuous Random Variables
For a continuous random variable, probability is for a range of values. The
probability for a specific value of a continuous random variable is 0.
Continuous random variables, as compared to discrete random variables, are
not whole numbers, but take fractional or decimal values.
Continuous Distribution
Probability density function for a continuous random variable is determined
as follows:
F ( x  x)  F ( x)
f ( x)  lim  F ' ( x)
x  0 x

If probability density function is known, it is possible to determine probability

that the value of a particular random variable belongs to interval [a; b]:

F (b)  F (a )  P ( X b)  P ( X a )  P (a  X b),

a a
P (a  X b) f ( x)dx or F (a )  P ( X a )  f ( x)dx
b 

f(x)
P(a ≤ X ≤ b)
Probability that the value of a random variable X is
within the interval [a; b].


Note that f ( x) 0 and  f ( x)dx 1
a b x 

Probability distribution of continuous random variable

Uniform Distribution
Uniform Distribution

The uniform probability distribution is the simplest distribution for a continuous

random variable. This distribution is rectangular in shape and is completely
defined by its minimum and maximum values.
0, for x  a
 1 x  a
 , for x  [a, b] 
f ( x)  b  a F ( x)  , for x  [a, b]
 b  a

0, for x  [a, b] 
1, for x  b

f(x) F(x)

1 1
b a

a b x a b x
Probability Density Function Cumulative Distribution Function
Uniform Distribution
Properties of Uniform Distribution

a b
Mean 
2

2(b  a ) 2
Variance  
12

(b  a )
Standard deviation 
12

Skewness S K 0

d c
P(c  X d )  , for c, d  [a, b]
b a
Normal Distribution
Normal distribution

A continuous probability distribution. Its probability density function is bell-

shaped and determined by its mean μ and standard deviation σ:

( x  )2
1  where
f ( x)  e 2 2
x – any value of the continuous random
 2 variable;
μ – mean;
f(x) σ – standard deviation;
e = 2.17828...;
1 π = 3.1416...
 2

x
μ–σ μ μ+σ
Probability density function of normal distribution N (μ,σ2)
Normal Distribution
Properties of Normal Distribution

1. It is unimodal
2. It is symmetric
3. The mean, median, and mode are equal: Mo = Me = μ;
4. It is asymptotic to the x axis.

f(x)

1
 2

x
μ–σ μ μ+σ
Probability density function of normal distribution N (μ,σ2)
Normal Distribution
Properties of Normal Distribution

The amount of variation in the random variable determines the height and
spread of the normal distribution.

f(x)
σ1 < σ2 < σ3

x
μ
Normal Distribution
Cumulative distribution function for the normal distribution:

( x  )2
x x 
1 2 2
F ( x)  f ( x)dx  e dx

 2 

To calculate the probability density function f(x) and cumulative distribution

function F(x) for the normal distribution, use MS Excel function NORMDIST:

where x – value of random variable;

Mean – arithmetic mean μ of
normal distribution;
Standard_dev –standard
deviation σ;
Cumulative – logical value:
0 (FALSE) – for the probability
density function f(x);
1 (TRUE) – for the cumulative
distribution function F(x).
Standard Normal Distribution
Standard Normal Distribution

The simplest case of a normal distribution is known as the standard normal

distribution. This is a special case when μ = 0 and standard deviation σ = 1.

f(z)

1
2

z
-3 -2 -1 0 1 2 3
z2
1 
Probability density function for standard normal distribution : f ( z)  e 2
2
Standard Normal Distribution
Standard Normal Distribution

The simplest case of a normal distribution is known as the standard normal

distribution. This is a special case when μ = 0 and standard deviation σ = 1.

F(z)

0.5

z
-3 -2 -1 0 1 2 3
z2
z 
1 2
Cumulative distribution function for a standard normal
distribution:
F ( z) 
2 e

dz
Standard Normal Distribution
Any normal probability distribution can be converted into a standard normal
probability distribution by subtracting the mean from each observation and
dividing this difference by the standard deviation. The results are called z-
values or z-scores.

The standardization simplifies the process of determining the probabilities

because it makes it possible use the special statistical tables.

A z-score is the distance from the mean, measured in units of the standard
deviation. The formula for this conversion is:

x 
z

Standard Normal Distribution
To standardize the value of a random variable X, we can use MS Excel function
STANDARDIZE assuming that the mean μ and the standard deviation σ are
known:

where X – the value of a random variable (the value you want to normalize);
Mean – the arithmetic mean μ of a normal distribution;
Standard_dev – standard deviation σ.
The Empirical Rule
The Empirical Rule states that if a random variable is normally distributed,
then:
1. Approximately 68% of the observations will lie within plus and minus one
standard deviation of the mean, i.e., μ ± σ.
f(x)

68.27%

x
μ-3σ μ-2σ μ-σ μ μ+σ μ+2σ μ+3σ
The Empirical Rule
The Empirical Rule states that if a random variable is normally distributed,
then:
2. About 95% of the observations will lie within plus and minus two standard
deviations of the mean, i.e., μ ± 2σ.
f(x)

95.45%

68.27%

x
μ-3σ μ-2σ μ-σ μ μ+σ μ+2σ μ+3σ
The Empirical Rule
The Empirical Rule states that if a random variable is normally distributed,
then:
3. Practically all, or 99.7% of the observations, will lie within plus or minus
three standard deviations of the mean i.e., μ ± 3σ.
f(x)

99.73%

95.45%

68.27%

x
μ-3σ μ-2σ μ-σ μ μ+σ μ+2σ μ+3σ
Standard Normal Distribution
In case of a standardized random variable, these intervals are 0±1, 0±2, 0±3,
respectively:

f(z)
99.73%

95.45%

68.27%

z
-3 -2 -1 0 1 2 3
Normal Distribution
Example 3.22.:
A manufacturing firm produces electronic components whose service life is a
normally distributed random variable with a mean of 1,000 hours and
standard deviation of 200 hours.

What is the probability that a randomly selected component will have a service
life of at least 900 hours?
Normal Distribution
Example 3.22.:
A manufacturing firm produces electronic components whose service life is a
normally distributed random variable with a mean of 1,000 hours and
standard deviation of 200 hours.

Solution:

To find the probability using statistical tables, the random variable has to be
standardized first.

x  900  1000
z   0.50
 200
Then we can use a Z-table to find its cumulative distribution function. The table
used is one that gives areas to the left of z (the cumulative distribution
function).
Normal Distribution
z  z2
1
Cumulative distribution function of standard normal distribution F ( z ) 
2 e

2
dz

Z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
-2.4 0.0082 0.0080 0.0078 0.0075 0.0073 0.0071 0.0069 0.0068 0.0066 0.0064
-2.3 0.0107 0.0104 0.0102 0.0099 0.0096 0.0094 0.0091 0.0089 0.0087 0.0084
-2.2 0.0139 0.0136 0.0132 0.0129 0.0125 0.0122 0.0119 0.0116 0.0113 0.0110
-2.1 0.0179 0.0174 0.0170 0.0166 0.0162 0.0158 0.0154 0.0150 0.0146 0.0143
-2.0 0.0228 0.0222 0.0217 0.0212 0.0207 0.0202 0.0197 0.0192 0.0188 0.0183
-1.9 0.0287 0.0281 0.0274 0.0268 0.0262 0.0256 0.0250 0.0244 0.0239 0.0233
-1.8 0.0359 0.0351 0.0344 0.0336 0.0329 0.0322 0.0314 0.0307 0.0301 0.0294
-1.7 0.0446 0.0436 0.0427 0.0418 0.0409 0.0401 0.0392 0.0384 0.0375 0.0367
-1.6 0.0548 0.0537 0.0526 0.0516 0.0505 0.0495 0.0485 0.0475 0.0465 0.0455
-1.5 0.0668 0.0655 0.0643 0.0630 0.0618 0.0606 0.0594 0.0582 0.0571 0.0559
-1.4 0.0808 0.0793 0.0778 0.0764 0.0749 0.0735 0.0721 0.0708 0.0694 0.0681
-1.3 0.0968 0.0951 0.0934 0.0918 0.0901 0.0885 0.0869 0.0853 0.0838 0.0823
-1.2 0.1151 0.1131 0.1112 0.1093 0.1075 0.1056 0.1038 0.1020 0.1003 0.0985
-1.1 0.1357 0.1335 0.1314 0.1292 0.1271 0.1251 0.1230 0.1210 0.1190 0.1170
-1.0 0.1587 0.1562 0.1539 0.1515 0.1492 0.1469 0.1446 0.1423 0.1401 0.1379
-0.9 0.1841 0.1814 0.1788 0.1762 0.1736 0.1711 0.1685 0.1660 0.1635 0.1611
-0.8 0.2119 0.2090 0.2061 0.2033 0.2005 0.1977 0.1949 0.1922 0.1894 0.1867
-0.7 0.2420 0.2389 0.2358 0.2327 0.2296 0.2266 0.2236 0.2206 0.2177 0.2148
-0.6 0.2743 0.2709 0.2676 0.2643 0.2611 0.2578 0.2546 0.2514 0.2483 0.2451
-0.5 0.3085 0.3050 0.3015 0.2981 0.2946 0.2912 0.2877 0.2843 0.2810 0.2776
-0.4 0.3446 0.3409 0.3372 0.3336 0.3300 0.3264 0.3228 0.3192 0.3156 0.3121
-0.3 0.3821 0.3783 0.3745 0.3707 0.3669 0.3632 0.3594 0.3557 0.3520 0.3483
-0.2 0.4207 0.4168 0.4129 0.4090 0.4052 0.4013 0.3974 0.3936 0.3897 0.3859
-0.1 0.4602 0.4562 0.4522 0.4483 0.4443 0.4404 0.4364 0.4325 0.4286 0.4247
-0.0 0.5000 0.4960 0.4920 0.4880 0.4840 0.4801 0.4761 0.4721 0.4681 0.4641
Normal Distribution
Example 3.22.:
A manufacturing firm produces electronic components whose service life is a
normally distributed random variable with a mean of 1,000 hours and
standard deviation of 200 hours.

Solution:

The probability that a randomly selected component will have a service life of at
least 900 hours, is 69%:

P ( X 900) 1  P ( X 900) 1  P ( Z  0.50) 1  0.3085 0.6915

Using MS Excel, the probability can be also calculated with the function
NORMDIST:
1 – NORMDIST(900,1000,200,1) = 1 – 0.3085 = 0.6915
Normal Distribution
The standard normal distribution can be shown as follows:

f(z)

P(Z ≥ –0.5) = 0.6915

P(Z ≤ –0.5) = 0.3085

-0.5 0 z
Chebyshev’s Theorem
Chebyshev’s Theorem

The theorem specifies the minimum percentage of observations that will fall
within a given number of standard deviations from the mean, regardless of
the shape of the distribution.

The proportion of the observations within k standard deviations of the arithmetic

mean is at least (1 – 1/k²) for all k > 1.

k Interval around the Proportion (%)

Sample Mean
1.25 x̄ ± 1.25s 36
1.50 x̄ ± 1.50s 56
2.00 x̄ ± 2s 75 1
1 0.75
2.50 x̄ ± 2.50s 84 22

3.00 x̄ ± 3s 89
4.00 x̄ ± 4s 94
Value at Risk
Value at Risk (VaR)

VaR is the minimum loss that would be expected a certain percentage of the
time over a specific period of time (e.g., a day, a week, a month) given the
modeled market conditions.
It is typically expressed as the minimum loss that can be expected to occur 5%
of the time.

VaR is a probability-based measure of loss potential for a company, fund,

investment portfolio, strategy or transactions.
Expressed either in % or in units of currency.
Can be computed in several ways, including the historical, variance-covariance,
and Monte Carlo methods.

Example:
If daily VaR (95) = 3%, there is 5% chance (100% – 95%) to lose 3% or more
on a given day.
Note: 95% is a confidence level, 5% - significance level
Value at Risk
Value at Risk (VaR)

Example:
A financial firm determines that its investment portfolio has a 5% daily VaR of
10 million.
This means that there is a 5% chance that the investment portfolio could lose
more than $10mn in the next trading day.
Value at Risk
Implications of Definition of VaR

1. VaR measures minimum loss only i.e. the actual loss can be much greater
than the specified amount.

2. VaR is associated with a given probability i.e. 5%, 1% etc. The lower the
probability (or higher the confidence level), the greater will be VaR in
magnitude.

3. VaR is based on specified time period; thus it cannot be compared directly

for different time intervals.
Generally, the longer the period, the greater is the potential loss. But mostly,
longer time periods increase VAR in a non-linear fashion.
Value at Risk
Elements of Measuring VaR

1. Selection of an appropriate probability: typically 5% or 1% is used.

1% is more conservative approach because it results in higher VAR.

2. Selection of an appropriate time period to match turnover or reporting period:

e.g.
· Derivative dealers use one day
· Banks use two weeks
· Industrial firms use quarterly or annually
The longer the period, the greater the VAR in magnitude.

3. Selection of an appropriate modeling technique i.e.:

• historical method,
• analytical (a.k.a. variance-covariance or delta normal) method,
• Monte Carlo simulation technique.
Value at Risk
Measuring VaR Using Historical Method

This method uses actual historical returns (or values) from a user-specified
period in the recent past i.e. plotting these returns using:
• a histogram or
• ranking these returns in descending order
e.g. if there are 100 observations of returns, 5% of 100 is 5. Thus, VAR at 5% probability will be 5th
worst return.
Note that if nth return is not a discrete number then average is taken.

Key assumptions:
Future returns will be the same as actual returns over some historical period.
• A non-parametric approach i.e. it does not involve any assumption regarding
probability distribution.
• Easy to calculate and easy to understand.
• It can be applied to any time period according to industry custom.
Main drawback:
It is based on historical data, which may not hold in the future.
Value at Risk
Measuring VaR Using Historical Method

Example:
Total number of asset returns = 248. To calculate 5% daily VAR:
5% × 248 = 12 returns. Thus, VaR would be the 12th worst return in the
observations.
Assume that after rank-ordering the data, the 12th worst return is -0.0294.
If total value of assets under risk is $50 million, then one-day VaR would thus
be 0.0294 × $50,000,000 = $1.47 million.
Chapter 5: RISK TRANSFER: DERIVATIVES
Using Derivatives to Transfer Risks

Most traditional way in which companies transfer risk is through the purchase
of various kinds of insurance (e.g., workers’ compensation, general liability,
and property/casualty insurance. When a business buys an insurance
policy, some or all of the risk associated with any event covered by that
policy is effectively transferred from the business to the insurer.

The second common risk transfer mechanism is through derivative products

such as

• futures,
• forwards,
• swaps, and
• options.
Evolution of Derivatives
for Hedging Risks

Source: The Essentials of Risk Management, M.Grouhy, et al, 2014

Forwards and Futures
Derivatives

A derivative is a financial contract or instrument that derives its value from the
value of something else (known as the underlying). The underlying on which
a derivative is based can be an asset (e.g., stocks and bonds), an index
(e.g., S&P 500), or something else (e.g., interest rates, commodities).
Derivatives are often used to hedge various risk exposures.

Forwards

Forwards are customized and private contracts between two parties, where
one party has an obligation to buy an asset, and the counterparty has an
obligation to sell the asset, at a price and future date that are agreed upon
signing of the contract.
If the price of the asset increases after inception of the contract, the buyer
benefits while the seller loses out.

Forward contracts can be written on equities, bonds, assets, or interest rates.

Forwards and Futures
Derivatives

Futures

Futures are standardized derivative contracts where one party, the buyer, will
purchase an underlying asset from the other party, the seller, at a later date
at a price agreed upon contract initiation. Both the buyer and the seller have
the obligation to buy or sell the underlying asset.
For futures contracts, there is daily settlement of gains and losses, and the
futures exchange (through its clearinghouse) provides a credit guarantee.
Note: Futures contracts are standardized contracts that trade on exchanges (e.g., Chicago
Mercantile Exchange), in contrast to forward contracts that are customized and are traded on
over-the-counter (OTC) markets.
Forwards and Futures
Using Forwards / Futures to Hedge Price Risk

Forward and futures contracts are mainly used to hedge against potential
losses. They enable the participants to lock in a price in the future. This
guaranteed price can be very important, especially in industries that
commonly experience significant volatility in prices.
For example, in the oil industry, entering into a forward / futures contract to sell a specific number of
barrels of oil can be used to protect against potential downward swings in oil prices.
Forwards / futures are also commonly used to hedge against changes in currency exchange rates
when making large international purchases and reducing exposure in interest rate risk.
Forwards and Futures
Using Futures / Forwards to Hedge Price Risk

Some companies that are producers or consumers of commodities use

forwards / futures contracts to reduce the risk that an unfavorable price
movement in the underlying asset – typically a commodity – will result in the
company having to face unexpected expenses or losses in the future.
Forwards and Futures
Using Forwards to Hedge Commodity Price Risk

If a company knows that it has to purchase a specific item in the future, it may
decide to take a long position in a forward contract.
A long position is the obligation to buy a commodity, a stock or currency with
the expectation that it will rise in value in the future.

Example A:
Suppose that Company X, a jewelry manufacturer, is planning to purchase
20,000 ounces of silver in six months.
The current market price for silver is $24 per ounce and the price of a six-
month forward contract is $25 per ounce.
Contract Initiation Contract Expiration
t=0 6

S0 = $24
F0(T) = $25
Forwards and Futures
Using Forwards to Hedge Commodity Price Risk

Example A:
Company X faces the risk that the price of silver may rise above $24 per ounce
in the near future.
To eliminate the price risk, the company buys the forward contract on silver.

Contract Initiation Contract Expiration

t=0 6

S0 = $24 ST = ?
F0(T) = $25
Forwards and Futures
Using Forwards to Hedge Commodity Price Risk

Example A:
By buying the forward contract (i.e. taking long position), Company X can
guarantee a price of $25 per ounce. This reduces the company's risk
because it will be able to close its forward position and buy 20,000 ounces
of silver for $25 per ounce in six months at the guaranteed price.

Contract Initiation Contract Expiration

t=0 6

S0 = $24
F0(T) = $25 Guaranteed purchase price = $25
Forwards and Futures
Using Forwards to Hedge Commodity Price Risk

If a company knows that it will be selling a specific item in the future, it may
decide to take a short position in a forward contract.
A short position is the obligation to sell a commodity, a stock or currency with
the expectation that it will decline in value in the future.

Example B:
Company Y operates in silver mining industry. It agrees to a legal contract that
obligates it to sell 20,000 ounces of silver after six months. The current
market price for silver is $24 per ounce and the forward price is $25 per
ounce.

Contract Initiation Contract Expiration

t=0 6

S0 = $24
F0(T) = $25
Forwards and Futures
Using Forwards to Hedge Commodity Price Risk

Example B:
When Company Y closes out its forward position in six months, it will be able to
sell its 20,000 worth of silver at a guaranteed price of $25 per ounce. By
locking in a price for silver today, it is able to eliminate the risk of any
unexpected expenses or losses.

Contract Initiation Contract Expiration

t=0 6

S0 = $24
F0(T) = $25 Guaranteed sales price = $25
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

Forward rate agreements hedge risk by fixing the interest rate on future
borrowing / lending.

FRA is an OTC derivative that has an interest payment as the underlying.

Purpose: Lock in a borrowing or a lending rate for a time period in the future.

The transaction typically involves two parties exchanging a fixed interest rate
for a floating interest rate.

Example:
A company can enter into a FRA with a bank that fixes the rate of interest for
borrowing at a certain time in the future.
If the actual interest rate proves to be higher than the rate agreed, the bank
pays the company the difference. If the actual interest rate is lower than the
rate agreed, the company pays the bank the difference.
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

FRA involves two counterparties:

1. Borrower: the floating receiver (long) “Buying money”

receives an interest payment based on a floating rate and makes an interest
payment based on a fixed rate.
Buyer of the FRA, enters into the contract to protect itself from a future
increase in interest rates.

2. Lender: the fixed receiver (short) “Selling money”

receives an interest payment based on a fixed rate and makes an interest
payment based on a floating rate.
Seller of the FRA, who wants to protect itself from a future decline in interest
rates.
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

FRA Naming Convention:

FRAs are denoted in the form of “X × Y FRA”, where X and Y are months.

Example:
A 1 × 4 FRA expires in 30 days (1 month), and the theoretical loan is for a time
period of the difference between 1 and 4 (3 months = 90 days).
That is, the payoff of the FRA is determined by 3-month reference rate (e.g.,
LIBOR) but the FRA expires in one month.

A 3 × 9 FRA expires in 90 days (3 months). The payoff of FRA is determined by

6-month LIBOR when the FRA expires in 3 months.
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

2 × 3 FRA
2 months 3 months
FRA (0,h,m)  FRA (0,60,30)
(60 days) (90 days)
m

0 h h+m
FRA Initiation FRA Expiration
= “Theoretical” loan “Theoretical” loan
initiation maturity

30-day loan starting

2 months 60 days from today

3 months
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

Calculation of FRA payoff at time = h for receive-floating (long):

Interest differential = Assumption:

[ 𝐿h ( 𝑚 ) − 𝐹𝑅𝐴 ( 0 , h , 𝑚 ) ] 𝑡 𝑚 (floating rate – fixed rate) Dh(m) = Lh(m)
𝑁𝐴 ×
1+ 𝐷h ( m ) 𝑡 𝑚 × (m/360)

Discount factor applied to FRA payoff

where:
NA = notional amount
Lh(m) = Libor (reference rate) on an m-day deposit observed on day h
FRA(0,h,m) = fixed forward rate set at time 0 that expires at time h and is
based on m-day Libor.
tm = accrual period, fraction of year for m-day deposit – t m = m / NTD
NTD = number of total days in a year, used for interest calculations (always 360
in Libor market)
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

Calculation of FRA payoff at time = h for receive-fixed (short):

Interest differential = Assumption:

[ 𝐹𝑅𝐴 ( 0 ,h ,𝑚 ) − 𝐿h ( 𝑚 ) ] 𝑡 𝑚 (fixed rate – floating rate) Dh(m) = Lh(m)
𝑁𝐴 ×
1+ 𝐷h ( m ) 𝑡 𝑚 × (m/360)

Discount factor applied to FRA payoff

Assumption: 1 month = 30 days

Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

Task 6.1.:
The CFO of XYZ Company received a report from the economics department
that states that short-term rates are expected to increase 50 basis points in
the next 90 days.
The company CFO is planning to borrow $5 million after 3 months.
As a floating rate borrower, the CFO recognizes that he must hedge against an
increase in future borrowing costs over the next 90 days because of a
potential increase in short-term interest rates.
He considers many options, but decides on entering into a forward rate
agreement (FRA) and lock in a FRA of 3.5% for 6 months (180 days).

Question 1:
Describe the position that the CFO should take in the FRA to protect the
company from an increase in interest rates.
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

Answer:
The company should enter into a $5 million notional amount receive-floating
FRA (i.e., take a long position) on 180-day Libor that expires after 90 days
(3 months). If the interest rate rises above the forward rate of 3.5%, the
company will receive the compensation from the counterparty (the short).
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

Question 2:
Calculate the FRA payoff if the 180-day Libor is 4% after 90 days.
Will the company make or receive the payment from the counterparty?
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

Answer:
As the Libor rate at contract expiration exceeds the fixed forward rate of 3.5%,
the company will receive the payment from the counterparty (the short).

L30(180) = 4.0%, FRA(0,30,180) = 3.5%, tm = m / NTD = 180 / 360

NA = $5,000,000

Payoff to the long:

= $5,000,000 × = $12,254.9
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

3 × 9 FRA
Receive: 180-day Libor = 4%
Start of FRA Pay: Fixed = 3.5%
Fixed rate set:
3.5% Reference period for borrowing

0 h m h+m
3 months 9 months
(90 days) (210 days)

Expiry / Settlement
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

Question 3:
Calculate the FRA payoff if the 180-day Libor is 2% after 90 days.
Will the company make or receive the payment from the counterparty?
Forwards and Futures
Using Forward Rate Agreement (FRA) to Hedge Interest Rate Risk

Answer:
As the Libor rate at contract expiration is lower than the fixed forward rate of
3.5%, the company will make the payment to the counterparty (the short).

L30(180) = 2.0%, FRA(0,30,180) = 3.5%, tm = m / NTD = 180 / 360

NA = $5,000,000

Payoff to the long:

= $5,000,000 × = – $37,128.7
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Companies are affected both by the exchange rate uncertainty itself and also
by its effects on their ability to plan for the future
e.g. a parent company not only needs to predict its foreign subsidiary’s sales but also needs to
predict the exchange rate at which it will convert its foreign cash flows into domestic cash flows.

Predicting foreign exchange rates with much certainty is extremely difficult;

therefore, companies prefer to manage exchange rate risk with the use of
derivatives.

Types of Foreign Exchange Rate Risk

Risk that contracted future cash flows i.e. foreign

1. Transaction Exposure
currency receipts become less valuable in terms of
domestic currency when foreign currency (FC)
When foreign depreciates relative to domestic currency (DC) or
transactions are made
DC/FC ↓
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Predicting foreign exchange rates with much certainty is extremely difficult;

therefore, companies prefer to manage exchange rate risk with the use of
derivatives.

Types of Foreign Exchange Rate Risk

When planned purchases i.e. foreign currency

1. Transaction Exposure
payments become more expensive when foreign
currency appreciates.
When foreign
transactions are made
DC/FC ↑
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Predicting foreign exchange rates with much certainty is extremely difficult;

therefore, companies prefer to manage exchange rate risk with the use of
derivatives.

Types of Foreign Exchange Rate Risk

Risk that multi-national corporations face due to decline in

2. Translation Exposure
the value of their assets denominated in foreign currencies
as a result of foreign currency depreciation when they are
When holding assets converted into their domestic currency at an appropriate
denominated in FC exchange rate
DC/FC ↓
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Predicting foreign exchange rates with much certainty is extremely difficult;

therefore, companies prefer to manage exchange rate risk with the use of
derivatives.

Types of Foreign Exchange Rate Risk

Risk faced by a domestic exporter when domestic currency

3. Economic Exposure
appreciates relative to foreign currency and negatively
affects its competitiveness.

DC/FC ↓
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Predicting foreign exchange rates with much certainty is extremely difficult;

therefore, companies prefer to manage exchange rate risk with the use of
derivatives.

Types of Foreign Exchange Rate Risk

A domestic importer faces economic exposure when

3. Economic Exposure
domestic currency depreciates relative to foreign currency.

DC/FC ↑
Economic exposure can be difficult to avoid, although diversification of the supplier and customer base across
different countries can reduce this risk exposure.
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

An exchange rate represents the price of one currency in terms of another

currency.
It is stated in terms of the number of units of a particular currency (price
currency) required to purchase a unit of another currency (base currency).
Note: In this reading, we will refer to exchange rates using the convention “P/B,” that is, number of
units of Currency A (price currency) required to purchase one unit of Currency B (base currency).

Example:
Suppose that the USD/GBP exchange rate is currently 1.5125.
Price currency
1 GBP will buy 1.5125 USD or
1 GBP costs 1.5125 USD.
USD/GBP 1.5125

Base currency
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

An exchange rate represents the price of one currency in terms of another

Example:
Suppose that the USD/GBP exchange rate falls to 1.4934.
Price currency Price currency has appreciated against base currency

USD/GBP 1.5125 USD/GBP 1.4934

Base currency Base currency has depreciated

against price currency
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

Spot exchange rates (S) are quotes for transactions that call for immediate
delivery.
For most currencies, immediate delivery means “T + 2” delivery (i.e., the transaction is actually settled
2 days after the trade is agreed upon by the parties).

In professional FX markets, an exchange rate is usually quoted as a two‐sided

price.
Dealers usually quote a bid price (the price at which they are willing to buy),
and an ask price or offer price (the price at which they are willing to sell).
Bid‐ask prices are always quoted in terms of buying and selling the base
currency.
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

Example:
Suppose the quote is USD/EUR 1.3802 – 1.3806

Bid Price the dealer is willing to buy EUR for 1.3802 USD
and is willing to sell EUR for 1.3806 USD.
USD/EUR 1.3802 – 1.3806
The quote represents the price of the base
Base currency Offer Price currency, EUR.
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

Example:
Suppose the quote is USD/EUR 1.3802 – 1.3806

Bid Price the client will receive 1.3802 USD

for selling 1 EUR, but will have to pay 1.3806 USD
USD/EUR 1.3802 – 1.3806 to purchase 1 EUR.

Base currency Offer Price

Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

Forward exchange rates (F) are quotes for transactions that are contracted
(agreed upon) today, but settled at a pre‐specified date in the future
(settlement occurs after a period longer than the two days for spot
transactions).

Forward exchange rates (just like spot exchange rates) are also quoted in
terms of bid and ask (offer) prices.

In professional FX markets, forward exchange rates are quoted in terms of

points (pips), which simply represent the difference between the forward
rate and the spot rate (forward premium or discount).
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

To convert any of these forward point quotes to an actual forward exchange

rate, we divide the number of pips by 10,000 (to scale them down to the
fourth decimal place) and then add the resulting number to the quoted spot
exchange rate.
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

Example:
Maturity Spot Rate or Forward Points
Bid rate is always lower
Spot USD/EUR 1.3802/1.3806
than offer rate.
1 month −5.4/−4.9 Forward points are negative,
3 months −15.8/−15.2 which indicates that EUR
(base currency) is trading at a
6 months −36.9/−36.2 forward discount and that
USD (price currency) is trading
12 months −93.9/−91.4 at a forward premium
Question:
If the client wants to sell EUR 3 months forward, calculate the appropriate
forward rate.
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

Example:
Maturity Spot Rate or Forward Points
Bid rate is always lower
Spot USD/EUR 1.3802/1.3806
than offer rate.
1 month −5.4/−4.9 Forward points are negative,
3 months −15.8/−15.2 which indicates that EUR
(base currency) is trading at a
6 months −36.9/−36.2 forward discount and that
USD (price currency) is trading
12 months −93.9/−91.4 at a forward premium
Answer:
The applicable number of forward points is −15.8.
We use the bid rate because the client is selling the base currency in the
currency quote.
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Foreign Exchange Market Concepts

Example:
Maturity Spot Rate or Forward Points
Bid rate is always lower
Spot USD/EUR 1.3802/1.3806
than offer rate.
1 month −5.4/−4.9 Forward points are negative,
3 months −15.8/−15.2 which indicates that EUR
(base currency) is trading at a
6 months −36.9/−36.2 forward discount and that
USD (price currency) is trading
12 months −93.9/−91.4 at a forward premium
Answer:
We first divide −15.8 by 10,000 to get −0.00158 and then simply add this
number to the spot USD/EUR bid rate.
3 month forward USD/EURbid = 1.3802 + (−0.00158) = 1.37862 USD/EUR
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Causes of Exchange Rate Fluctuations

The exchange rate between two currencies – i.e. the buying and selling rates,
both spot and forward – is determined primarily by supply and demand in
the foreign exchange markets.
Demand comes from individuals, firms and governments who want to buy a
currency and supply comes from those who want to sell it.
Supply and demand for currencies are in turn influenced by:
• The rate of inflation, compared with the rate of inflation in other countries
• Interest rates, compared with interest rates in other countries
• The balance of payments
• Sentiment of foreign exchange market participants regarding economic
prospects
• Speculation
• Government policy on intervention to influence the exchange rate
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Currency hedging generally uses forwards to tailor amounts and dates.

Managing Risk of Foreign Currency Receipt or Payment

Currency Exposure Position in Foreign Action taken to hedge

Currency Currency Risk
Receiving Foreign Currency Long Sell Forward Contract
Paying Foreign Currency Short Buy Forward Contract

Currency forwards and futures allow users to exchange a specified amount of

one currency for a specified amount of another currency on a future date.

Forwards are customized, while futures are standardized contracts.

Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Example:
A U.S.-based manufacturer of large industrial machines has just received an
order for some of its products. The agreed-upon price is £5 million (British
pounds), and the delivery date is 60 days.
The current exchange rate is $1.42 per pound, and the 60-day forward rate is
$1.43 per pound.

Question:
Explain the best way for the U.S.-based company to hedge the corresponding
exchange rate risk.
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Answer:
On the day the order comes in, the U.S.-based company, effectively has a long
position in pounds; therefore, it should take a short position in a forward
contract. This contract would obligate the company to deliver the pounds
that it will receive for dollars.
Ideally, the contract would be to exchange the £5,000,000 for:
$7,150,000 = (5,000,000)($1.43)
According to the contract, in 60 days, the company will exchange the
£5,000,000 for $7,150,000.
Forwards and Futures
Using Forward Contracts to Manage Foreign Exchange Rate Risk

Answer:
If it does not hedge and the realized spot rate in 60 days is $1.429, the U.S.-
based company will receive only $7,145,000 = 5,000,000($1.429), or $5,000
less than with the hedged position.
Forwards and Futures
Using Interest Rate Futures to Hedge Interest Rate Risk

Interest rate futures are widely used to hedge the risk associated with interest
rates changing from the time a loan or a deposit is anticipated until it is
actually implemented.
Borrowers sell futures to hedge against interest rate rises.

Eurodollar Futures Lenders buy futures to hedge against interest rate falls.

Eurodollar futures are interest-rate-based financial futures contracts specific

to the Eurodollar, which is simply a U.S. dollar on deposit in commercial
banks outside of the United States.

Eurodollar futures are cash settled on the basis of the market reference rate for
an offshore deposit having a principal value of $1 million and a three-month
maturity.

Eurodollar futures provide an effective means for companies and banks to

secure an interest rate for money it plans to borrow or lend in the future.
Forwards and Futures
Using Interest Rate Futures to Hedge Interest Rate Risk

Interest rate futures are widely used to hedge the risk associated with interest
rates changing from the time a loan or a deposit is anticipated until it is
actually implemented.

Eurodollar Futures

These contracts are quoted in terms of the “IMM index” that is equal to 100 less
the annualized yield on the security.

A 1 bp (0.01% or 0.0001) change in the value of the futures contract equates to

a $25.00 movement in the contract value.

Thus, the basis point value (BPV) of a $1 million face value, 90-day money
market instrument is given by
BPV = Face value × (Days / 360) × 0.01%
= $1,000,000 × (90 / 360) × 0.01% = $25
Forwards and Futures
Using Interest Rate Futures to Hedge Interest Rate Risk

Example.:
The chief investment officer (CIO) of a US-based philanthropic foundation is
expecting a donation of $30 million in two months’ time from a member of
the foundation’s founding family. This significant donation will then be
invested for three months and subsequently will be divided into smaller
grants to be made to medical and educational institutions supported by the
foundation.
The current (i.e., spot) three-month reference rate is 2.40% (annualized).
The CIO expects interest rates to fall, and she decides to hedge the rate on the
deposit with Eurodollar futures.
Forwards and Futures
Using Interest Rate Futures to Hedge Interest Rate Risk

Analysis:
The CIO buys 30 of the Eurodollar futures contracts at 97.60, locking in a
forward rate of 2.40%.
Forwards and Futures
Using Interest Rate Futures to Hedge Interest Rate Risk

Analysis:
After two months, the donation is received and the CIO initiates the deposit at
the then-lower spot rate of 2.10%.
She unwinds the hedge at a futures price of 97.90, which is 30 bps higher than
where the position was initiated.
Forwards and Futures
Using Interest Rate Futures to Hedge Interest Rate Risk

Analysis:
The foundation will receive $180,000 from the deposit plus the hedge:
1. Interest obtained on the deposit: 2.10% × $30 million × (90/360) = $157,500.
2. Profit on the hedge is 30 bps (30 × $25 = $750), which for 30 contracts
corresponds to $22,500 (= $750 × 30).
Forwards and Futures
Using Interest Rate Futures to Hedge Interest Rate Risk

Analysis:
This corresponds to the return on an investment at the initial three-month
reference rate of 2.40%, or 2.40% × $30 million × (90/360) = $180,000. This
calculation demonstrates that by buying the Eurodollar futures, the CIO did
indeed lock in a forward rate of 2.40%.
Forwards and Futures
Using Currency Futures to Hedge Foreign Exchange Rate Risk

Currency Futures

Currency futures are standardized in terms of quantity of currency to be

exchanged and delivery dates, so a futures hedge may not exactly match
the requirements of a hedger.
The range of currency pairs on which futures are available is limited, although
they are available on most major currency pairs.
The greater liquidity of currency futures is attractive to many currency dealers
and investors.

Hedge ratio (HR) (number of futures contracts required to hedge FX risk):

Forwards and Futures
Using Currency Futures to Hedge Foreign Exchange Rate Risk

Example:
A U.S. firm is due to receive €20 million in 90 days for goods they sold.
The firm is seeking to hedge this risk by selling EUR futures contracts maturing
closest to date the euros will be received.
The EUR-USD FX future contract size is €125,000.
The futures price is 1.3150 USD/EUR.

Analysis:
The firm will sell futures contracts (promising to deliver euros at the rate of
1.3150 USD per EUR).

Calculate the number of futures contracts required to hedge the liability and the
amount of USD to be received at contract settlement.
Forwards and Futures
Using Currency Futures to Hedge Foreign Exchange Rate Risk

Analysis:
Futures position hedge ratio:

= 160 EUR-USD futures

At contract settlement, the firm will deliver €20 million and receive 20 million ×
1.3150 = $26,330,000.
Swaps
Swaps

A swap contract is an over-the-counter derivative contract in which two parties

agree to exchange a series of cash flows whereby one party pays a variable
series that will be determined by an underlying asset or rate and the other
party pays either:
1. A variable series determined by a different underlying asset or rate or
2. A fixed series.

Examples of swaps:
• Interest rate swap
• Equity swap
• Currency swap
• Credit default swap
• Commodity swap
One of the primary functions of swaps is the hedging of risks.
For example, interest rate swaps can hedge against interest rate fluctuations, and currency swaps
are used to hedge against currency exchange rate fluctuations.
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

Interest Rate Swap

An interest rate swap is an over-the-counter (OTC) contract between two

parties that agree to exchange cash flows on specified payment dates —
one based on a variable (floating) interest rate and the other based on a
fixed rate (the “swap rate”) — determined at the time the swap is initiated.
The swap tenor is when the swap is agreed to expire.
Both interest rates are applied to the swap’s notional value to determine the
size of each payment.
Normally, the resulting two payments (one fixed, one floating) are in the same
currency but will not be equal, so they are typically netted, with the party
owing the greater amount paying the difference to the other party. In this
manner, a party that currently has a fixed (floating) risk or other obligation
can effectively convert it into a floating (fixed) one.
Interest rate swaps are among the most widely used instruments to manage
interest rate risk.
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

The company borrows money from the bank, say $10

million for our example, on a floating rate basis. There are
floating rate benchmarks for different currencies i.e.
EURIBOR, LIBOR, etc., which resets every day. The bank
will charge a margin on the money it lends e.g. 2% The
effect for the company is it borrows money at floating rate
+ 2%

The company wishes to fix the interest cost. To achieve this it enters a pay
fixed / receive floating IRS with a bank. Assuming the company wishes to fix
the entire $10 million i.e. the swap is entered for $10 million.
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

Example:
A corporation has borrowed funds by issuing £20 million of three-year floating-
rate bonds that pay a semiannual coupon equal to the six-month market
reference rate plus 50 bps.
A few days later, the firm’s outlook changes substantially, and it now expects
higher rates in the future.
The firm enters into an interest rate swap with a tenor of approximately three
years and semiannual payments, where the firm pays a fixed par swap rate
of 1.25% and receives the six-month reference rate.
The swap settlement dates are the same as the coupon payment dates on the
floating-rate bonds. At the first swap settlement date, the six-month
reference rate is 0.75%.
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

Example:
At the first coupon payment and swap settlement date, the six-month reference
rate is 0.75% (annualized). This means that on the swap the investment firm
will make a net payment of £50,000 as follows:
Payer swap:
Initiation date Receive floating: 6-month reference rate
Settlement date 1
Fixed swap rate set: Pay fixed: 1.25%
1.25% reference rate
= 0.75%

6 months
0 3 years
(180 days)

NA = £20 million 75,000

£ Swap dealer
Firm Receive based on the reference rate:
25 ,000 0.75% × £20 million × (180/360) = £75,000.
£1
Pay based on the fixed rate:
1.25% × £20 million × (180/360) = £125,000.
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

6 months
0 3 years
(180 days)

NA = £20 million 0 Swap dealer

,00
£50
Firm Receive based on the reference rate:
0.75% × £20 million × (180/360) = £75,000.
Pay based on the fixed rate:
1.25% × £20 million × (180/360) = £125,000.
Net payment made to swap dealer:
£125,000 − £75,000 = £50,000.
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

6 months
0 3 years
(180 days)

NA = £20 million 0 Make first semiannual interest payment on

,00 Swap dealer
£50 bonds based on refence rate + 50bps:
Firm (0.75% + 0.50%) × £20 million × (180/360)
= £125,000.
£1
25
,00 Bondholders
0
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

6 months
0 3 years
(180 days)

NA = £20 million 0 Make first semiannual interest payment on

,00 Swap dealer
£50 bonds based on refence rate + 50bps:
Firm (0.75% + 0.50%) × £20 million × (180/360)
= £125,000.
£1
25
,00 Bondholders
0
Total payment made by the firm on
bonds and the swap is £175,000
Net PMT = £175,000 (= £125,000 + £50,000).
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

Example:
Now assume that as we move forward to the second coupon payment and
swap settlement date, interest rates have increased and the six-month
reference rate is 1.50%. On the swap, the firm will receive a net payment of
£25,000: Payer swap:
Receive floating: 6-month reference rate
Settlement date 2 Pay fixed: 1.25%
Fixed swap rate
set: 1.25% reference rate
= 1.50%

12 months
0 3 years
(360 days)
50 ,000
NA = £20 million £1 Swap dealer
Firm Receive based on the new reference rate:
25 ,000 1.50% × £20 million × (180/360) = £150,000.
£1
Pay based on the fixed rate:
1.25% × £20 million × (180/360) = £125,000.
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

12 months
0 3 years
(360 days)

NA = £20 million
5, 000 Swap dealer
£2
Firm Receive based on the new reference rate:
1.50% × £20 million × (180/360) = £150,000.
Pay based on the fixed rate:
1.25% × £20 million × (180/360) = £125,000.
Net payment received by the firm:
£150,000 − £125,000 = £25,000.
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

12 months
0 3 years
(360 days)

NA = £20 million Make second semiannual interest payment

5, 000 Swap dealer
£2 on bonds based on refence rate + 50bps:
Firm (1.50% + 0.50%) × £20 million × (180/360)
= £200,000.
£ 20
0,0
0 Bondholders
0
Swaps
Using Interest Rate Swaps to Hedge Interest Rate Risk

Example:
The firm has effectively fixed its all-in borrowing costs.

Payer swap:
Receive floating: 6-month reference rate
Settlement date 2 Pay fixed: 1.25%
Fixed swap rate
set: 1.25% reference rate
= 1.50%

12 months
0 3 years
(360 days)

NA = £20 million Make second semiannual interest payment

5, 000 Swap dealer
£2 on bonds based on refence rate + 50bps:
Firm (1.50% + 0.50%) × £20 million × (180/360)
= £200,000.
£ 20
0,0
0 Bondholders
0 Total payment made by the firm on
bonds and the swap is again £175,000
Net PMT = £175,000 (= £125,000 + £50,000).
Swaps
Using Currency Swaps to Hedge Foreign Exchange Risk

A currency swap is a contract in which two counterparties agree to exchange

future interest payments in different currencies. These interest payments
can be based on either a fixed interest rate or a floating interest rate.

A currency swap is similar to an interest rate swap, but it is different in two

ways:
(1) The interest rates are associated with different currencies, and
(2) the notional principal amounts may or may not be exchanged at the
beginning and end of the swap’s life.
Swaps
Using Currency Swaps to Hedge Foreign Exchange Risk

Cross-Currency Basis Swap

Currency swaps help the parties in the swap to hedge against the risk of
exchange rate fluctuations and to achieve better rate outcomes.
In particular, a cross-currency basis swap exchanges notional principals
because the goal of the transaction is to issue at a more favorable funding
rate and swap the amount back to the currency of choice.

Applications:
Firms that need foreign-denominated cash can obtain the funding in their local
currency and then swap the local currency for the required foreign currency
using a cross-currency basis swap.
The swap periodically sets interest rate payments, mostly floating for floating,
separately in two different currencies.
The net effect is to use a loan in a local currency to take out a loan in a foreign
currency while avoiding any foreign exchange risk.
Swaps
Using Currency Swaps to Hedge Foreign Exchange Risk

Example:
A euro-based company requires USD but does not have access to direct USD
borrowing or finds it prohibitively expensive.
The company decides to borrow in euros at 90-day Euribor and enter into a
cross-currency basis swap to USD based on 90-day USD LIBOR (a floating-
for-floating swap).
The swap has a tenor of two years with quarterly settlement. The principal on
the euro loan is €50 million and the USD/EUR exchange rate at initiation of
the swap is $1.1236.
Swaps
Using Currency Swaps to Hedge Foreign Exchange Risk

Example:
At initiation, the euro-based company borrows €50 million and delivers the
borrowed funds in exchange for USD at spot rate of 1.1236 USD/EUR :

EUR 50m
European
Swap dealer
Company
USD 56.18m

EUR 50m

(= EUR50 million × 1.1236 USD/EUR)

Bank Loan

Notional principal × spot exchange rate agreed at start for all

payments (at inception, on interest payment dates, and at maturity)
Swaps
Using Currency Swaps to Hedge Foreign Exchange Risk

Example:
At each payment date, each counterparty pays variable interest for the
currency they initially received.

USD 56.18m ×
quarterly
LIBOR
European
Swap dealer
Company
EUR 50m ×
EUR 50m ×
quarterly
quarterly
EURIBOR
EURIBOR

Bank Loan

The euro-based company will be paying USD interest to the swap dealer.
The swap dealer will be paying the euro interest to the company, which will then
use it to service the interest on its loan with the bank.
Swaps
Using Currency Swaps to Hedge Foreign Exchange Risk

Example:
At the swap’s expiration (after 2 years), the notional principal amounts are
exchanged. The amounts are the same as those exchanged initially.

USD 56.18m
European
Swap dealer
Company
EUR 50m

EUR 50m

Bank Loan
Changes in the exchange rate over the life of the swap do not affect notional
amounts, so there is no uncertainty (exchange rate risk) on the principal
flows.
The European company receives the €50 million and uses it to repay its bank
loan.
Swaps
Using Credit Default Swaps to Manage Credit Risk

Credit Risk

Credit risk is the risk of loss resulting from the borrower failing to make full and
timely payments of interest and/or principal.
Traditionally, it refers to the risk that a lender may not receive the owed
principal and interest, which results in an interruption of cash flows and
increased costs for collection.

When lenders offer mortgages, credit cards, or other types of loans, there is a
risk that the borrower may not repay the loan.
Credit risk also describes the risk that a bond issuer may fail to make payment
when requested or that an insurance company will be unable to pay a claim.
Swaps
Using Credit Default Swaps to Manage Credit Risk

Credit Default Swap

Scenario 2:
For example, if ABC Company declared bankruptcy and the post-default value
of the bonds were determined to be $4,500,000 in an auction
(approximately 45% recovery rate of the par amount), the payment would
be 10,000,000 – 4,500,000 = $5,500,000

USD 5.5m
Protection Protection Cash Settlement
Buyer Seller
Swaps
Using Credit Default Swaps to Manage Credit Risk

Types of Credit Default Swaps

CDS can be constructed on a single entity or as indexes containing multiple

entities:

Single-Name CDS
The reference obligation is the specific debt issuer’s fixed-income security on
which the swap is written, usually a senior unsecured obligation (in the case
of a senior CDS).
The issuer of the reference obligation is called the reference entity.
The CDS pays off not only when the reference entity defaults on the reference
obligation but also when the reference entity defaults on any other issue
that is ranked pari passu (i.e., same rank) or higher.
The CDS payoff is based on the market value of the cheapest-to-deliver
(CTD) bond that has the same seniority as the reference obligation.
Swaps
Using Credit Default Swaps to Manage Credit Risk

Example:
Party X is a protection buyer in a $10 million notional principal senior CDS of
Alpha, Inc.
There is a credit event (i.e., Alpha defaults) and the market prices of Alpha’s
bonds after the credit event are as follows:
• Bond P, a subordinated unsecured debenture, is trading at 15% of par.
• Bond Q, a five-year senior unsecured debenture, is trading at 25% of par.
• Bond R, a three-year senior unsecured debenture, is trading at 30% of par.

What will be the payoff on the CDS?

Swaps
Using Credit Default Swaps to Manage Credit Risk

Solution:
The cheapest-to-deliver senior unsecured debenture (i.e., same seniority as the
senior CDS) is bond Q.
The payoff will be the difference between the notional principal and market
value of the CTD.
payoff = par value – market value
= $10 million − (0.25)($10 million) = $7.5 million.
Swaps
Using Credit Default Swaps to Manage Credit Risk

Types of Credit Default Swaps

CDS can be constructed on a single entity or as indexes containing multiple

entities:

Index CDS
An index CDS covers multiple debt issuers, allowing market participants to
reduce exposure to the credit risk of several companies simultaneously.

Index CDS generates a payoff based on any default that occurs on any entity
covered by the index.

North American indexes are identified by the symbol CDX, and European, Asian, and Australian
indexes are identified as iTraxx.
Swaps
Using Credit Default Swaps to Manage Credit Risk

Example:
Party X is a protection buyer in a five-year, $100 million notional principal
CDS for CDX-IG, which contains 125 entities.
One of the index constituents, company A, defaults and its bonds trade at 30%
of par after default.

1. What will be the payoff on the CDS?

Swaps
Using Credit Default Swaps to Manage Credit Risk

Solution:
The notional principal attributable to entity A is $100 million / 125 = $0.8 million.

Party X should receive payment of $0.8 million – (0.3)($0.8 million) = $560,000.

Swaps
Using Credit Default Swaps to Manage Credit Risk

2. What will be the notional principal of the CDS after default?

Swaps
Using Credit Default Swaps to Manage Credit Risk

Solution:
Post the default event, the remainder of the CDS continues with a notional
principal of $99.2 million.
Options
Basic Characteristics of Options

Options

An option is a derivative contract in which one party, the buyer, pays a sum of
money to the other party, the seller of the option or writer, and receives the
right to either buy or sell and underlying asset at a fixed price either on a
specific expiration date or at any time prior to the expiration date.

Options are financial derivatives that give buyers the right, but not the
obligation, to buy or sell an underlying asset at an agreed-upon price and
date.

Unlike futures or forwards, the holder of an option is not required to buy or sell
the asset.

Call options and put options form the basis for a wide range of option strategies
designed for hedging, income, or speculation.
Options
Basic Characteristics of Options

Specifications of an Options Contract

Basic Elements Notation Description

Underlying Asset An asset upon which an options contract is based
Expiration Date The date the option contract will expire and be
exercised, after this date, the contract is no longer valid.
Strike Price X The price at which the buyer has the right to buy or sell
(Exercise Price) the underlying asset at expiry.
Call Option Gives the holder/buyer the right to buy (or call) the
underlying asset, for the given exercise price at the
expiration date of the option.
Put Option Gives the holder/buyer the right to sell (or put) the
underlying asset, for the given exercise price, at the
option’s expiration date.
Premium c0 The price the buyer pays to the seller for the right to buy
(Option Price) p0 or sell the asset at the strike price on the expiry date.
Options
Basic Characteristics of Options

Positions in Options

There are four types of participants in options markets depending on the

position they take:
• Buyers of calls (long call position)
• Sellers (writers) of calls (short call position)
• Buyers of puts (long put position)
• Sellers (writers) of puts (short put position)

Call Put
Buyer Long Call Long Put
Has the right to buy asset Has the right to sell asset
at a strike price at a strike price
Seller Short Call Short Put
Has the obligation to sell Has the obligation to buy
asset at a strike price asset at a strike price
Options
Basic Characteristics of Options

Call Option

A call is an option contract giving the owner the right but not the obligation to
buy a specified amount of an underlying asset at a specified price (known
as strike price) within a specified time.

Call option buyer must pay a fee to purchase a call option, called the premium.

A call option writer/seller has the obligation to sell the asset to the holder of the
call option, for the given exercise price, should the option holder choose to
exercise the option.

A call is a right to buy

Options
Basic Characteristics of Options

Example:
The call option on CSC Company’s share costs €2. The call option grants its
holder the right to buy a share of CSC for €20 six months from today.

c0 = €2
15 X = €20
Payoff

Call holder’s
payoff
10

5
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5

-10

-15
Options
Basic Characteristics of Options

Example:
Scenario A: At contract expiry (after 6 months), CSC share price (S T) = €30.

c0 = €2
15 X = €20, ST = €30
Payoff

Call holder’s
payoff
10

5
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5

-10

-15
Options
Basic Characteristics of Options

Example:
Call option buyer exercises the call option, buys a share for €20, when its
market price is €30, and realizes a payoff of €10.

c0 = €2
15 X = €20, ST = €30
Payoff

Call holder’s
payoff
10
Payoff for call option buyer (long call) =
5 ST – X = 30 – 20 = 10
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5

-10

-15
Call option is in-the-money (ITM)
Options
Basic Characteristics of Options

Example:
Writer (seller) of the option, is obligated to perform on the terms of the option.

c0 = €2
15 X = €20, ST = €30
Payoff

Call holder’s
payoff
10
Payoff for call option buyer (long call) =
5 ST – X = 30 – 20 = 10
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5

-10
Call writer’s
-15 payoff
Options
Basic Characteristics of Options

Example:
If option holder chooses to exercise the option, option seller would have to
deliver an asset worth €30 in the market to option buyer for €20 (strike price).
c0 = €2
15 X = €20, ST = €30
Payoff

Call holder’s
payoff
10
Payoff for call option buyer (long call) =
5 ST – X = 30 – 20 = 10
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5

-10
Call writer’s
-15 payoff
Options
Basic Characteristics of Options

Example:
Option seller’s payoff in this scenario is negative (–€10).

c0 = €2
15 X = €20, ST = €30
Payoff

Call holder’s
payoff
10
Payoff for call option buyer (long call) =
5 ST – X = 30 – 20 = 10
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5 Payoff for call option seller (short call) =
–(ST – X) = –(30 – 20) = –10
-10
Call writer’s
-15 payoff
Options
Basic Characteristics of Options

Example:
Buyer's profit on the entire trade equals its payoff adjusted for the cost of the
option.

c0 = €2
15 X = €20, ST = €30
Payoff

Call holder’s
payoff
10
Profit for call option buyer (long call) =
5 ST – X – c0 = 30 – 20 – 2 = 8
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5

-10
Call writer’s
-15 payoff
Options
Basic Characteristics of Options

Example:
Seller's profit (loss) equals its payoff adjusted for the income from selling the
option.

c0 = €2
15 X = €20, ST = €30
Payoff

Call holder’s
payoff
10
Profit for call option buyer (long call) =
5 ST – X – c0 = 30 – 20 – 2 = 8
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5 Profit for call option seller (short call) =
–(ST – X) + c0 = –(30 – 20) + 2 = –8 (loss)
-10
Call writer’s
-15 payoff
Options
Basic Characteristics of Options

Example:
Scenario B: At contract expiry (after 6 months), CSC share price (S T) = €15.

c0 = €2
15 X = €20, ST = €15
Payoff

Call holder’s
payoff
10

5
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5

-10

-15
Options
Basic Characteristics of Options

Example:
Call option buyer will not exercise the call option, because the market price of
the asset is lower than the exercise price (€20).

c0 = €2
15 X = €20, ST = €15
Payoff

Call holder’s
payoff
10

5
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5

-10

-15
Call option is out-of-the-money (OTM)
Options
Basic Characteristics of Options

Example:
So, the payoff for the option holder is €0.
And its profit on the trade is –€10, i.e., a loss.
c0 = €2
15 X = €20, ST = €15
Payoff

-10

-15
Options
Basic Characteristics of Options

Example:
Because call option holder does not exercise the option, the call option seller
also has zero payoffs from the option. The option seller makes profit of €2.

c0 = €2
15 X = €20, ST = €15
Payoff

Call holder’s
Payoff for call option buyer (long call) = 0 payoff
10
Profit for call option buyer (long call)
= payoff – c0 = 0 – 2 = –2 (loss)
5
Strike Price (X) Share Price
at Option
0 Expiration
5 10 15 20 25 30 35
(ST)
-5 Payoff for call option seller (short call) = 0
Profit for call option seller (short call)
-10 = payoff + c0 = 0 + 2 = 2
Call writer’s
-15 payoff
Options
Basic Characteristics of Options

Put Option

A put is an option contract giving the owner the right but not the obligation to
sell (or put) a specified amount of an underlying asset at a specified price
(known as strike price) within a specified time.

Put option buyer must pay a fee to purchase a put option, called the premium.

A put option writer/seller has the obligation to buy the asset from the holder of
the put option, for the given exercise price, should the option holder choose
to exercise the option.

A put is a right to sell

Options
Basic Characteristics of Options

Example:
The put option on PSP Company’s share costs €5. The put option grants its
holder the right to sell a share of PSP for €40 three months from today.

Put holder’s p0 = €5
30 payoff X = €40
Payoff

10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10

-20

-30
Options
Basic Characteristics of Options

Example:
Scenario A: At contract expiry (after 3 months), PSP share price (S T) = €30.

Put holder’s p0 = €5
30 payoff X = €40, ST = €30
Payoff

10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10

-20

-30
Options
Basic Characteristics of Options

Example:
Put option buyer exercises the put option by selling a share for €40, when its
market price is €30, and realizes a payoff of €10.

Put holder’s p0 = €5
30 payoff X = €40, ST = €30
Payoff

Payoff for put option buyer (long put) =

20 X – ST = 40 – 30 = 10

10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10

-20

-30
Put option is in-the-money (ITM)
Options
Basic Characteristics of Options

Example:
Put holder’s profit on the option position is €5 (payoff adjusted for the cost of
the put option).

Put holder’s p0 = €5
30 payoff X = €40, ST = €30
Payoff

Payoff for put option buyer (long put) =

20 X – ST = 40 – 30 = 10
Profit for put option buyer (long put) =
X – ST – p0 = 40 – 30 – 5 = 5
10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10

-20

-30
Options
Basic Characteristics of Options

Example:
Put writer (seller) is obligated to buy PSP stock from put option buyer for €40
(the option’s strike price) when the market price is only €30.

Put holder’s p0 = €5
30 payoff X = €40, ST = €30
Payoff

Payoff for put option buyer (long put) =

20 X – ST = 40 – 30 = 10
Profit for put option buyer (long put) =
X – ST – p0 = 40 – 30 – 5 = 5
10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10

-20
Put writer’s
payoff
-30
Options
Basic Characteristics of Options

Example:
Put option seller will incur a negative payoff of €10, and a loss on the option
position of €5.

Put holder’s p0 = €5
30 payoff X = €40, ST = €30
Payoff

Payoff for put option buyer (long put) =

20 X – ST = 40 – 30 = 10
Profit for put option buyer (long put) =
X – ST – p0 = 40 – 30 – 5 = 5
10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10 Payoff for put option seller (short put) =
–(X – ST) = –(40 – 30) = –10
Profit for put option seller (short put) =
-20 –(X – ST) + p0 = –(40 – 30) + 5 = –5
Put writer’s
payoff
-30
Options
Basic Characteristics of Options

Example:
Scenario B: At contract expiry (after 3 months), PSP share price (S T) = €60.

Put holder’s p0 = €5
30 payoff X = €40, ST = €60
Payoff

10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10

-20

-30
Options
Basic Characteristics of Options

Example:
Put option buyer chooses not to exercise the option because the asset can be
sold in the market for a higher price (€60) rather than for €40 (strike price).

Put holder’s p0 = €5
30 payoff X = €40, ST = €60
Payoff

10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10

-20

-30
Put option is out-of-the-money (OTM)
Options
Basic Characteristics of Options

Example:
Put option holder’s payoff is €0, and the loss on the option position is €5.

Put holder’s p0 = €5
30 payoff X = €40, ST = €60
Payoff

Payoff for put option buyer (long put) = 0

20 Profit for put option buyer (long put)
= payoff – p0 = 0 – 5 = –5 (loss)
10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10

-20

-30
Options
Basic Characteristics of Options

Example:
Put option seller’s payoff also equals zero, and it makes a profit equal to the
premium it collected when the put option was written (sold).

Put holder’s p0 = €5
30 payoff X = €40, ST = €60
Payoff

Payoff for put option buyer (long put) = 0

20 Profit for put option buyer (long put)
= payoff – p0 = 0 – 5 = –5 (loss)
10
Strike Price (X) Share Price
at Option
0 Expiration
10 20 30 40 50 60 70
(ST)
-10
Payoff for put option seller (short put) = 0
-20 Profit for call option seller (short put)
= payoff + p0 = 0 + 5 = 5

-30
Options
Basic Characteristics of Options

Moneyness

Moneyness refers to whether an option is in‐the‐money or out‐of‐the‐money.

• An option is in‐the‐money (ITM) when immediate exercise of the option
will generate a positive payoff for the holder.
• An option is out‐of‐the‐money (OTM) when immediate exercise will
generate a negative payoff for the holder.
• An option is at‐the‐money (ATM) when immediate exercise will result in
neither a positive nor a negative payoff for the holder.
Options
Basic Characteristics of Options

Intrinsic (Exercise) Value of Options

Intrinsic value (or exercise value) of an option is the amount an option is in‐
the‐money by.
It is the amount that would be received by the option holder if he were to
exercise the option immediately.
An option has zero intrinsic value if it is at, or out‐of‐the money.

Intrinsic value of a call option is given as:

Intrinsic value of a put option is given as:

Options
Risk Management Strategies with Options and Underlying Asset

Protective Put Strategy

A protective put is a risk management strategy that involves holding a long

position in the underlying asset (e.g., stock) and buying a put option with a
strike price equal or close to the current price of the underlying asset.

Protective puts may be placed on stocks, currencies, commodities, and indexes

and give some protection to the downside.

It is similar to “insurance" i.e. buying insurance in the form of the put, paying a
premium to the seller of the insurance, the put writer.

Protective put strategy is often used to manage equity price risk.

A protective put = long asset position + long put position

Options
Risk Management Strategies with Options and Underlying Asset

Protective Put Strategy

Characteristics:

• It provides downside protection while retaining the upside potential.

• It requires the payment of cash up front in the form of option premium.
• The higher the exercise price of a put option, the more expensive the put
will be and consequently the more expensive will be the downside
protection.

When this strategy appropriate? Loss protection + Upside preservation

• An investor owns an asset (e.g., stock) and does not want to sell it.
• An investor expects a decline in the value of the asset in the near future but
wants to preserve the asset’s upside potential.
Options
Risk Management Strategies with Options and Underlying Asset

Protective Put Strategy: Profit and Loss at Contract Expiration

Consider a protective put strategy using a stock as the underlying asset:

Value of Protective Put at Expiration (VT):

= +

Stock price Exercise value

at expiration of a put

At the option expiration, the value of the protective put is the greater of the stock price (S T) or the
exercise price (X).
The reason is because the stock can rise to any level but has a floor value of the put exercise price.
Options
Risk Management Strategies with Options and Underlying Asset

Protective Put Strategy: Profit and Loss at Contract Expiration

Consider a protective put strategy using a stock as the underlying asset:

Initial Value of Protective Put (V0):

= Investment at Inception

Long stock + long put

Initial stock Put option price
price
Profit of Protective Put at Expiration (∏):

= = + – The maximum loss with a protective

= put is limited because the downside
risk is transferred to the option writer
= in exchange for the payment of the
option premium.
Options
Using Protective Put Strategy to Manage Equity Price Risk

Example:
An investor owns the company's PTP stocks and does not want to sell them.
His research suggests there may be a negative shock to the stock price in
the next four to six weeks, so he wants to be protected against a price
decline. Also the investor wants to preserve any upside potential.
He is planning to buy insurance in the form of the put, paying a premium to the
seller of the insurance, the put writer.
The current PTP share price is $37.50. The cost of a 2-month put option on
PTP stock is $1.40 with a strike price of $35.
The investor also has a choice to buy a 2-month put on PTP stock with a strike
price of $34 which costs $1.20.

Question 1:
Explain the advantages and disadvantages of buying the put with a lower strike
price.
Options
Using Protective Put Strategy to Manage Equity Price Risk

Answer:
Advantages: The put option with a lower strike price is less expensive.
Note: The investor can reduce the cost of insurance by increasing the size of the deductible (i.e., the
current stock price minus the put exercise price), by choosing a put option with a lower exercise
price.
Options
Using Protective Put Strategy to Manage Equity Price Risk

Answer:
Disadvantages: A put option with an exercise price of $34 would have a lower
premium but would not protect against losses in the stock until it falls to $34
per share.
Options
Using Protective Put Strategy to Manage Equity Price Risk

Example:
The investor decides to use the protective put strategy to hedge the price risk
of PTP stock.
Assume that the current market price of PTP stock is $37.50 and the investor
buys a 2-month put option on PTP stock for $1.40 with a strike price of $35.

Question 2:
Compute the maximum profit, maximum loss, and the breakeven price of the
protective put strategy.
Options
Using Protective Put Strategy to Manage Equity Price Risk

Answer:
Maximum profit = theoretically unlimited
Maximum loss = S0 – X + p0 = $37.50 − $35.00 + $1.40 = $3.90

The breakeven price is the premium added to the unhedged breakeven price
of $37.50, so $37.50 + $1.40 = $38.90.
Options
Using Protective Put Strategy to Manage Equity Price Risk

Question 3:
Compute the profits for when the price is $0, $30, $35, $40, $45, and $50.
Options
Using Protective Put Strategy to Manage Equity Price Risk

Answer:
Profit of protective put at expiration = ST + Max[(X – ST), 0] – S0 – p0
If ST = $0, profit = $0 + max(0, $35 − $0) − $37.5 − $1.40 = –$3.90
If ST = $30, profit = $30 + max(0, $35 − $30) − $37.5 − $1.40 = –$3.90
If ST = $35, profit = $35 + max(0, $35 − $35) − $37.5 − $1.40 = –$3.90

If ST = $40, profit = $40 + max(0, $35 − $40) − $37.5 − $1.40 = $1.10

If ST = $45, profit = $45 + max(0, $35 − $45) − $37.5 − $1.40 = $6.10
If ST = $50, profit = $50 + max(0, $35 − $50) − $37.5 − $1.40 = $11.10
Options
Using Protective Put Strategy to Manage Equity Price Risk
Max Profit = theoretically unlimited
p0 = $1.40
X = $35
15 Breakeven Price
S0 = $37.50
Profit

= S0 + p0 = $37.50 Protective Put

+ $1.40 = $38.90
10

5
Strike Price (X) PTP Stock
Price at
0 Option
10 20 30 40 50 60 70
Expiration
5 (ST)
Maximum loss =
10 S0 – X + p0 =
Loss

$37.50 − $35.00
15 + $1.40 = $3.90
Long Stock
Options
Risk Management Strategies with Options and Underlying Asset

Covered Call Strategy

A covered call is a risk management strategy that involves holding a long

position in the underlying asset (e.g., stock) and selling (writing) a call
option on the underlying asset.

The strategy is usually employed by investors who believe that the underlying
asset will experience only minor price fluctuations.

The strategy serves as a short-term hedge on a long stock position and allows
investors to earn income via the premium received for writing the option.
Covered calls can be used to change an investment’s risk–reward profile by
effectively enhancing yield or reducing/exiting a position when the shares hit
a target price.

A covered call = long asset position + short call position

Options
Risk Management Strategies with Options and Underlying Asset

Covered Call Strategy

Characteristics:

• It provides only limited downside protection.

• It generates cash up front in the form of option premium but removes some
of the upside potential.
• It reduces both the overall risk and the expected return compared with
simply holding the underlying asset. This loss in potential upside gains is
compensated by option premium received by selling a call.

When this strategy appropriate?

• An investor owns an asset (e.g., stock) and

• Expects that its price will neither increase nor decrease in the near future.
Options
Risk Management Strategies with Options and Underlying Asset

Covered Call Strategy: Profit and Loss at Contract Expiration

Consider a covered call strategy using a stock as the underlying asset:

Value of Covered Call at Expiration (VT):

Stock price Exercise value

at expiration of a call

Any appreciation beyond the exercise price belongs to the option buyer, so the covered call writer
does not earn any gains beyond that point.
Options
Risk Management Strategies with Options and Underlying Asset

Covered Call Strategy: Profit and Loss at Contract Expiration

Consider a covered call strategy using a stock as the underlying asset:

Initial Value of Covered Call (V0):

= Investment at Inception

Long stock + short call

Initial stock Call option
price premium
Profit of Covered Call at Expiration (∏):

= = – The risk of the short option position

= is hedged by ownership of the stock

=
Maximum loss would occur if ST = 0,
thus maximum loss = S0 – c0
Options
Using Covered Call Strategy
Example:
c0 = $8
X = $110
S0 = $100
Profit

Covered Call
18
Stock Price
at Option
0 Expiry (ST)

X = 110

S0 = 100

Let’s suppose that we write a call on a stock that we already own. We earn $8 from
writing a call on the stock that currently trades at $100. The exercise price of the call
is $110.
Options
Using Covered Call Strategy

c0 = $8
X = $110
S0 = $100
Profit

Covered Call
18
Stock Price
8
at Option
0 Expiry (ST)

X = 110

S0 = 100
Short Call

If ST < $110, the call option will not be exercised (call option is OTM).
We would continue to hold the stock and would have earned extra revenue equal to the
premium ($8).
Options
Using Covered Call Strategy

c0 = $8
X = $110
S0 = $100
Profit

Covered Call
18
Stock Price
8
at Option
0 Expiry (ST)

X = 110

S0 = 100
Short Call
Breakeven = 92

We breakeven at a stock price of $92.

Breakeven price = S0 – c0 = $100 – $8 = $92
Options
Using Covered Call Strategy

c0 = $8
Long Stock X = $110
S0 = $100
Profit

Covered Call
18
Stock Price
8
at Option
0 Expiry (ST)
-8
X = 110

S0 = 100
Short Call
Breakeven = 92

At a price of $92, the loss in the value of our stock holding ($100 − $92 = $8) equals the
amount we earned from writing the option.
Options
Using Covered Call Strategy

c0 = $8
Long Stock X = $110
S0 = $100
Profit

Maximum profit
Covered Call
18
Stock Price
8
at Option
0 Expiry (ST)
-8
X = 110

S0 = 100
Short Call
Breakeven = 92

Between stock prices of $100 and $110, we benefit from stock price appreciation, and the
option is not exercised. Our total gain (including option premium) varies between $8
and $18. Note that the maximum gain = (X – S0) + c0 = ($110 – $100) + $8 = $18
Options
Using Covered Call Strategy

c0 = $8
Long Stock X = $110
S0 = $100
Profit

Maximum profit
Covered Call
18
Stock Price
8
at Option
0 Expiry (ST)
-8
X = 110

S0 = 100
Short Call
Breakeven = 92

The maximum gain on the covered call position occurs when the option expires at-the‐
money (i.e., when X = ST), where we gain $10 in stock appreciation and $8 in
premium.
Options
Using Covered Call Strategy

c0 = $8
Long Stock X = $110
S0 = $100
Profit

Maximum profit
Covered Call
18
Stock Price
8
at Option
0 Expiry (ST)
-8
X = 110

S0 = 100
Short Call
-92 Breakeven = 92
-100 Maximum loss
The maximum loss occurs when the stock price falls to zero. Our loss of $100 (in stock
value depreciation) would only be offset to the extent of $8 from the option premium
and leave us with a total loss of $92. Maximum loss = S0 – c0 = $100 – $8 = $92
Options
Risk Management Strategies with Options and Underlying Asset

Collar

A collar is a risk management strategy that is created as a combination of a

protective put and covered call option.

The strategy is used to manage equity price risk.

More specifically, it is created by

• holding an underlying stock,
• buying an out of the money put option, and
• selling an out of the money call option.

A collar = protective put + covered call

= long stock + long put + short call
Options
Risk Management Strategies with Options and Underlying Asset

Collar Low cost + downside protection + upside

limit
Characteristics:

• Collars allow a shareholder to acquire downside protection through a

protective put but reduce the cash outlay by writing a covered call (i.e., the
call option is sold to reduce the cost of the put option).

• To set up a collar, the owner of the underlying stock buys a protective put
and simultaneously sells a call to offset the put premium. If the premiums of
the two are equal, it is called a zero-cost collar.

• Both the upside and downside are limited:

the downside is limited by the long put and
the upside is limited by the short call.
Options
Risk Management Strategies with Options and Underlying Asset

Collar: Profit and Loss

Consider a collar option strategy using a stock as the underlying asset:

Value of Collar at Expiration (VT):

Stock price Exercise value Exercise value

at expiration of a put of a call

where:
XL = put strike price A collar effectively puts a band around the possible returns of a long
XH = call strike price stock position.
XL < X H Any stock price movement above XH is lost (due to the short call), and
any movement below XL is protected (due to the long put).
Options
Risk Management Strategies with Options and Underlying Asset

Collar: Profit and Loss

Consider a collar option strategy using a stock as the underlying asset:

Initial Value of Collar (V0):

= Investment at Inception

Long stock + long put + short call

Initial stock Put option Call option
price premium premium
Profit of Call at Expiration (∏):

= = – –
=)
= +)
Options
Using Collar Strategy to Manage Equity Price Risk

Example:
An investor purchases a stock for $29 and a put for p0 = $0.20 with a strike
price of XL = $27.50. The investor sells a call for c0 = $0.20 with a strike
price of XH = $30.

Question 1:
Demonstrate the expression for the profit and calculate the maximum profit,
maximum loss, and the breakeven price.
Options
Using Collar Strategy to Manage Equity Price Risk

Example:
An investor purchases a stock for $29 and a put for p0 = $0.20 with a strike
price of XL = $27.50. The investor sells a call for c0 = $0.20 with a strike
price of XH = $30.

Answer:
This is a zero-cost collar because the premiums on the call and put are equal
(i.e., p0 = c0).
profit = (ST – S0) + max(0, XL – ST) – max(0, ST – XH) – (p0 – c0)
= (ST – $29) + max(0, $27.50 – ST) – max(0, ST – $30.00) – 0

maximum profit = XH – S0 – (p0 – c0) = $30 – $29 – 0 = $1

maximum loss = S0 – XL + (p0 – c0) = $29.00 – $27.50 + 0 = $1.50
breakeven price = S0 + (p0 – c0) = $29 + 0 = $29.
Options
Using Collar Strategy to Manage Equity Price Risk

Example:
An investor purchases a stock for $29 and a put for p0 = $0.20 with a strike
price of XL = $27.50. The investor sells a call for c0 = $0.20 with a strike
price of XH = $30.

Question 2:
Calculate the profits when the stock price is $0.00, $20.00, $25.00, $28.50,
$30.00, and $100.00.
Options
Using Collar Strategy to Manage Equity Price Risk

Answer:
The table shows the calculations for profits on this zero-cost (ZC) collar:

Stock Price, ST ZC Collar, Profit = max(0, XL – ST) – max (0, ST – XH) + ST –S0
$0.00 max(0, $27.50 – $0) – max(0, $0 – $30.00) + $0 – $29.00 =
= –$1.50
$20.00 max(0, $27.50 – $20.00) – max(0, $20.00 – $30.00) + $20.00
– $29.00 = –$1.50
$25.00 max(0, $27.50 – $25.00) – max(0, $25.00 – $30.00) + $25.00
– $29.00 = –$1.50
$28.50 max(0, $27.50 – $28.50) – max(0, $28.50 – $30.00) + $28.50
– $29.00 = –$0.50
$30.00 max(0, $27.50 – $30.00) – max(0, $30.00 – $30.00) + $30.00
– $29.00 = $1.00
$100.00 max(0,$27.50 – $100.00) – max(0, $100.00 – $30.00) +
$100.00 – $29.00 = $1.00
Options
Using Collar Strategy to Manage Equity Price Risk

Answer:
At option expiration, maximum loss occurs at the lower strike price, even if the
stock price fell sharply.
Maximum gain occurs at the higher strike, even if the underlying stock
increased sharply.
If the stock closes between the strike prices, the collar has no impact on profit.

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