Ch01 Introduction PDF

4/9/2019
Financial Risk Management

Lecturer： Quyen Do Nguyen, PhD
Corporate Finance Department
Faculty of Banking and Finance
Foreign Trade University
Email： quyendn@ftu.edu.vn
Course Materials: https://www.dropbox.com/sh/ihd4rcawpp0jndx

/AADx-A64kwSewfDTCFxhnsJia?dl=0
Financial Risk Management
An overview of financial risk management
Managing risk using derivatives

 Using Forwards to manage risk
 Using Futures to manage risk
 Using Swaps to manage risk
 Using Options to manage risk
Binominal Trees, Black-Scholes-Merton models

Quyen Nguyen, PhD - FBF - FTU 2
Exams Scale
Participation Quiz 10%
Mid-term exam Group Test 30%
Final exam Multiple choice+Problem 60%

solving questions
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Curriculum
 John, C., H., (2009)
Option, Future and
other derivatives.
Pearson Prentice
Hall, 7E.
Chapter 1
Introduction
What is risk?
 The possibility that an actual return
will differ from our expected return.
 Uncertainty in the distribution of

possible outcomes.
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Standard Normal Distribution

The probability of a standard normal S t an d a rd N o rm a l D is trib ut io n
distribution ranging within 1 standard 0.4
deviation from an average value (both

0.3
sides) is 0.6826, or approximately 0.68.
f(z)
0.2
The probability of a standard normal

distribution ranging within 2 standard 0.1
deviations from an average value (both 0.0

-5 -4 -3 -2 -1 0 1 2 3 4 5
sides) is 0.9544, or approximately 0.95. Z
The probability of a standard normal

distribution ranging within 3 standard
deviations from an average value (both
sides) is 0.9974, or approximately 0.99.
Risk and Return - Measurement

n
Average return: x i
x1  x2  ...  xn
x i 1

n n
Variance:  (x i - x) 2
 i
2 i =1
n -1
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The objective of FRM

Impact of Financial Risk Management
on Cash Flow Volatility
After
FRM
Likelihood
Before
FRM
Cash Flow
What is a Derivative?
A derivative is an instrument whose value
depends on, or is derived from, the value of
another asset.
Examples: futures, forwards, swaps, options,
exotics…
Why Derivatives Are Important

Derivatives play a key role in transferring risks in the
economy
The underlying assets include stocks, currencies,
interest rates, commodities, debt instruments,
electricity, insurance payouts, the weather, etc.
Many financial transactions have embedded
derivatives
The real options approach to assessing capital
investment decisions has become widely accepted
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How Derivatives Are Traded

On exchanges such as the Chicago Board
Options Exchange (CBOE)
In the over-the-counter (OTC) market where
traders working for banks, fund managers
and corporate treasurers contact each other
directly
The OTC Market Prior to 2008

Largely unregulated
Banks acted as market makers quoting bids and
offers
Master agreements usually defined how transactions
between two parties would be handled
But some transactions were handled by central
counterparties (CCPs). A CCP stands between the
two sides to a transaction in the same way that an
exchange does
Since 2008…
OTC market has become regulated. Objectives:
Reduce systemic risk
Increase transparency
In the U.S and some other countries, standardized

OTC products must be traded on swap execution
facilities (SEFs) which are similar to exchanges
CCPs must be used for standardized transactions
between dealers in most countries
All trades must be reported to a central registry
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Size of OTC and Exchange-Traded Markets
Source: Bank for International Settlements. Chart shows total principal amounts for
OTC market and value of underlying assets for exchange market
Derivatives market in Vietnam (1)

Established on 10/08/2017 on the basis of the
17-year old stock market.
The first derivative that was traded was

Futures on VN30 Index. The following
derivative products were HNX30 index and
futures on government bonds.
Derivatives market in Vietnam (2)

7 securities companies were members of
derivatives market on HNX and were clearing
house members of VSD including: VPBank
security company (VPBS), Ho Chi Minh
Security company (HSC), Sài Gòn security
company (SSI), BIDV security company (BSC),
VNDirect security company (VNDS), Bản Việt
security company (VCSC), MB security
company (MBS).
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The Lehman Bankruptcy (Business Snapshot)

Lehman’s filed for bankruptcy on September 15, 2008.
This was the biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives
markets and got into financial difficulties because it took
high risks and found it was unable to roll over its short
term funding
It had hundreds of thousands of transactions
outstanding with about 8,000 counterparties
Unwinding these transactions has been challenging for
both the Lehman liquidators and their counterparties
How Derivatives are Used

To hedge risks
To speculate (take a view on the future
direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment
without incurring the costs of selling one
portfolio and buying another
Foreign Exchange Quotes for GBP,

May 26, 2013
Bid Offer
Spot 1.5541 1.5545
1-month forward 1.5538 1.5543
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Forward Price
The forward price for a contract is the
delivery price that would be applicable to the
contract if were negotiated today (i.e., it is
the delivery price that would make the
contract worth exactly zero)
The forward price may be different for
contracts of different maturities (as shown by
the table)
Forward Contracts
A forward contract is an agreement between a
buyer and a seller to trade a specified quantity of an
asset
at a specified price (forward/delivery price)
at a specified time (maturity/delivery date) and
place.
In contrast, a spot contract is an agreement to

buy or sell an asset today
Terminology
The party that has agreed to buy
has what is termed a long position
The party that has agreed to sell

has what is termed a short position
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Example
On May 6, 2013, the treasurer of a corporation
enters into a long forward contract to buy £1
million in six months at an exchange rate of
1.5532
This obligates the corporation to pay
$1,553,200 for £1 million on November 6, 2013
What are the possible outcomes?
Profit from a Long Forward Position

(K= delivery price=forward price at time contract is entered into,
ST is the spot price at maturity)
Profit
Price of Underlying at
K Maturity, ST
Payoff from a long position:

ST –K
Profit from a Short Forward Position

(K= delivery price=forward price at time contract is entered into,
ST is the spot price at maturity)
Profit
Price of Underlying
K at Maturity, ST
Payoff from a short position:

K–ST
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Futures Contracts
Agreement to buy or sell an asset for a
certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC,

a futures contract is traded on an exchange
Exchanges Trading Futures

CME Group (formed when Chicago
Mercantile Exchange and Chicago Board of
Trade merged)
NYSE Euronext (being acquired by bteh
InterContinental Exchange)
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see list at end of book)
Examples of Futures Contracts

Agreement to:
Buy 100 oz. of gold @ US$1400/oz. in
December
Sell £62,500 @ 1.5500 US$/£ in March
Sell 1,000 bbl. of oil @ US$90/bbl. in April
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1. Gold: An Arbitrage
Opportunity?
Suppose that:
The spot price of gold is US$1,400
The 1-year forward price of gold is US$1,500
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity?
2. Gold: Another Arbitrage

Opportunity?
Suppose that:
- The spot price of gold is US$1,400
- The 1-year forward price of gold is US$1,400
- The 1-year US$ interest rate is 5% per
annum
The Forward Price of Gold

(ignores the gold lease rate)
If the spot price of gold is S and the forward

price for a contract deliverable in T years is F,
then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
In our examples, S = 1400, T = 1, and r =0.05 so
that
F = 1400(1+0.05) = 1470
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1. Oil: An Arbitrage Opportunity?

Suppose that:
- The spot price of oil is US$95
- The quoted 1-year futures price of oil is
US$125
annum
- The storage costs of oil are 2% per annum
2. Oil: Another Arbitrage

Opportunity?
Suppose that:
- The spot price of oil is US$95
- The quoted 1-year futures price of oil is
US$80
annum
- The storage costs of oil are 2% per
annum
Options
An Option is a contract which indicates the right to buy or
to sell an asset
A call option is an option to buy a certain asset by a
certain date for a certain price (the strike price)
A put option is an option to sell a certain asset by a
certain date for a certain price (the strike price)
Remember:
Buying the option = Having a Long Position
Selling the option = Having a Short Position
Seller of the option = Writer of the option
Combinations:
Long Call: Buy the right to buy
Short Call: Sell the right to buy
Long Put: Buy the right to sell
Short Put: Sell the right to sell
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American vs European Options

An American option can be exercised at any
time during its life
A European option can be exercised only at

maturity
Google Call Option Prices from CBOE (May 8, 2013; Stock

Price is bid 871.23, offer 871.37)
Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer
820 56.00 57.50 76.00 77.80 88.00 90.30
840 39.50 40.70 62.90 63.90 75.70 78.00
860 25.70 26.50 51.20 52.30 65.10 66.40
880 15.00 15.60 41.00 41.60 55.00 56.30
900 7.90 8.40 32.10 32.80 45.90 47.20
920 n.a. n.a. 24.80 25.60 37.90 39.40
Google Put Option Prices from CBOE (May 8, 2013; Stock

Price is bid 871.23, offer 871.37)
Strike Jun 2013 Jun 2013 Sep 2013 Sep 2013 Dec 2013 Dec 2013
Price Bid Offer Bid Offer Bid Offer
820 5.00 5.50 24.20 24.90 36.20 37.50
840 8.40 8.90 31.00 31.80 43.90 45.10
860 14.30 14.80 39.20 40.10 52.60 53.90
880 23.40 24.40 48.80 49.80 62.40 63.70
900 36.20 37.30 59.20 60.90 73.40 75.00
920 n.a. n.a. 71.60 73.50 85.50 87.40
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Options vs. Futures/Forwards

A futures/forward contract gives the holder
the obligation to buy or sell at a certain price
An option gives the holder the right to buy

or sell at a certain price (i.e. the holder is
not obliged to exercise it!)
Types of Traders
• Hedgers use derivatives to reduce risk from potential
future market movements (however there is no guarantee that
the outcome with hedging will be better than the outcome without
hedging!)
• Speculators bet on the future direction of a market

variable
• Arbitrageurs aim to lock in a profit by taking
offsetting positions
Hedging Examples
A US company will pay £10 million for
imports from Britain in 3 months and decides
to hedge using a long position in a forward
contract
An investor owns 1,000 Microsoft shares
currently worth $28 per share. A two-month
put with a strike price of $27.50 costs $1. The
investor decides to hedge by buying 10
contracts
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Value of Microsoft Shares with and

without Hedging
40,000 Value of Holding
($)
35,000
No Hedging
30,000 Hedging
25,000
Stock Price ($)

20,000
20 25 30 35 40
Speculation Example
An investor with $2,000 to invest feels that a
stock price will increase over the next 2
months. The current stock price is $20 and
the price of a 2-month call option with a strike
of 22.50 is $1
What are the alternative strategies?
Arbitrage Example
A stock price is quoted as £100 in London
and $150 in New York
The current exchange rate is 1.5300
What is the arbitrage opportunity?
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Dangers
Traders can switch from being hedgers to
speculators or from being arbitrageurs to
speculators
It is important to set up controls to ensure that
trades are using derivatives in for their
intended purpose (See Business Snapshot 1.2 page 15)
Hedge Funds
Hedge funds are not subject to the same rules as
mutual funds and cannot offer their securities
publicly.
Mutual funds must
disclose investment policies,
makes shares redeemable at any time,
limit use of leverage
Hedge funds are not subject to these constraints.
Hedge funds use complex trading strategies are big
users of derivatives for hedging, speculation and
arbitrage
Types of Hedge Funds

Long/Short Equities
Convertible Arbitrage
Distressed Securities
Emerging Markets
Global Macro
Merger Arbitrage
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End of Chapter 1
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4/9/2019

Financial Risk Management

Course Materials: https://www.dropbox.com/sh/ihd4rcawpp0jndx

Financial Risk Management

An overview of financial risk management

Managing risk using derivatives

 Using Futures to manage risk

 Using Swaps to manage risk

 Using Options to manage risk

Binominal Trees, Black-Scholes-Merton models

Participation Quiz 10%

Mid-term exam Group Test 30%

Final exam Multiple choice+Problem 60%

Quyen Nguyen, PhD - FBF - FTU 3

Quyen Nguyen, PhD - FBF - FTU 4

 Uncertainty in the distribution of

Quyen Nguyen, PhD - FBF - FTU 6

Standard Normal Distribution

distribution ranging within 1 standard 0.4

deviation from an average value (both

The probability of a standard normal

deviations from an average value (both 0.0

The probability of a standard normal

Quyen Nguyen, PhD - FBF - FTU 7

Risk and Return - Measurement

Quyen Nguyen, PhD - FBF - FTU 8

Quyen Nguyen, PhD - FBF - FTU 9

The objective of FRM

Quyen Nguyen, PhD - FBF - FTU 10

Quyen Nguyen, PhD - FBF - FTU 11

Why Derivatives Are Important

Quyen Nguyen, PhD - FBF - FTU 12

How Derivatives Are Traded

Quyen Nguyen, PhD - FBF - FTU 13

The OTC Market Prior to 2008

Quyen Nguyen, PhD - FBF - FTU 14

In the U.S and some other countries, standardized

Quyen Nguyen, PhD - FBF - FTU 15

Size of OTC and Exchange-Traded Markets

Quyen Nguyen, PhD - FBF - FTU 16

Derivatives market in Vietnam (1)

The first derivative that was traded was

Derivatives market in Vietnam (2)

The Lehman Bankruptcy (Business Snapshot)

Quyen Nguyen, PhD - FBF - FTU 19

How Derivatives are Used

Quyen Nguyen, PhD - FBF - FTU 20

Foreign Exchange Quotes for GBP,

1-month forward 1.5538 1.5543

3-month forward 1.5533 1.5538

6-month forward 1.5526 1.5532

Quyen Nguyen, PhD - FBF - FTU 21

Quyen Nguyen, PhD - FBF - FTU 22

In contrast, a spot contract is an agreement to

Quyen Nguyen, PhD - FBF - FTU 23

The party that has agreed to sell

Quyen Nguyen, PhD - FBF - FTU 24

Quyen Nguyen, PhD - FBF - FTU 25

Profit from a Long Forward Position

Payoff from a long position:

Quyen Nguyen, PhD - FBF - FTU 26

Profit from a Short Forward Position

Payoff from a short position: