Lahore University of Management Sciences. FINN 326 Financial Risk Management Spring Semester 2012

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1 FINN 326 Financial Risk Management Spring Semester 2012 Instructor Dr. Bushra Naqvi Room No. 312 Office Hours TBA Telephone Secretary/TA Saleem Ahmed Khan TA Office Hours TBA Course URL (if any) Course Basics Credit Hours 4 Lecture(s) Nbr of Lec(s) Per Week 2 Lectures/Week Duration 100 minutes Recitation/Lab (per week) Nbr of Lec(s) Per Week Duration Tutorial (per week) Nbr of Lec(s) Per Week Duration Course Distribution Core Elective Open for Student Category Close for Student Category Elective Juniors, Seniors COURSE DESCRIPTION This is an advanced level course in Risk Management and provides the core body of knowledge for financial risk managers. Need of Risk Management has rapidly evolved over the past decade and it has almost become an inevitable function in many institutions. The course is primarily designed for the readers who have good background in finance. Nonetheless, only the strong foundation in finance is not sufficient due to the rigorous nature of the course and a lot of hard work and dedication is expected from the participants. The course will cover topics on different hedging tools, hedging strategies, risk valuation models and practical examples to understand the true nature of real time problems. The first half is dedicated towards building of mathematical and quantitative foundations which are required for the effective risk management, while the next half is allocated to the use and application of those quantitative concepts in different risk estimation and risk management settings. COURSE PREREQUISITE(S) Principles of Economics Principles of Finance Statistics COURSE OBJECTIVES This course, apart from developing pure financial concepts like different hedging tools, hedging strategies, risk valuation models, etc., also intends to widen critical and analytical thinking of students in the field of finance through interactive discussion on some recent episodes of financial crisis and new emerging financial risks. Undoubtedly, this dual perspective will act as the foundation for generating new research in the field of financial risk management.

2 Learning Outcomes By the end of this course students should be able to realize: That a working knowledge of risk management is important particularly if you are planning a career in finance. Besides wanting to pass this course, why do you need to understand risk management? What are the nature, types and sources of different financial risks? What types of financial products and derivatives are available to hedge different risks? What are the different hedging strategies and how we can minimize risk by deploying them? Analyze the causes of some big risk management failures? And how can we improve the existing risk management systems in an organization. Grading Breakup and Policy Assignment(s): 10% Home Work: Quiz(s): 20% Class Participation: 10% Attendance:5% Midterm Examination: 25% Project: Final Examination: 30% Examination Detail Midterm Exam Yes/No: Yes Combine Separate: Duration: 2 hours Preferred Date: Exam Specifications: Objective & Subjective Final Exam Yes/No: Yes Combine Separate: Duration: 2 hours Exam Specifications: Objective & Subjective COURSE OVERVIEW Lecture Topics of Lecture Recommended Readings Objectives/ Application 1 3 Introduction and Types of Risks, & Foundations of Risk Management Course Pack Lecture 01 Introduction to Financial Risk management Definition of Risk Types of Risk (Market, Liquidity, Operational, Credit etc.) Lecture 02 Sources of Risk Why Financial Risk Management is Required Role of Financial Risk Manager Investors and Risk Management Lecture 03 A quick glance on Portfolio theory and; Some measures of risk in Traditional Finance like Sharpe, Treynor, Information Ratio, Sortino Ratio Volatility and contagion risk

3 Lecture 04 Statistical concepts related to market risk and return Measures of Central Tendency and Dispersion Symmetry and Skewness in Return Distribution Lecture 05 Probability Concepts Probability, Random Variables, Expected Value and Variance (Standalone asset and Portfolio) Lecture 06 Conditional Probability Bayes Formula Spiegel, Chapter Small Cases Quantitative Concepts Related to 1 8 Lecture Risk and Risk Management Discrete and Continuous Random Variables Jorion, Chapter Some Important Probability Distributions 21,22 Standard Normal Distribution and Area Under the Curve Application of Standard Normal Distribution (Roy s Safety First Ratio) Lecture 08 Regression Analysis Assumption, Hypothesis Testing, Limitations and Violations Lecture 09 Estimating and Forecasting Volatility, Covariance and Correlation 1. EWMA 2. GARCH (1,1) Monte Carlo Simulations Lecture 10 Financial Markets, Market Organization and Structure Derivatives & Hedging Strategies Assets and Contracts Positions Orders Primary and Secondary Markets Financial Intermediaries, Structural Hubs, Clearinghouses, Derivative Product Companies and Exchanges Lecture 11 Derivative Market and Instruments Purpose and Criticism on Derivative Markets Elementary Principles of Derivative Pricing Hull, Chapter 1 10 Lecture 12, 13 Forward Markets and Contracts Structure of Global Forward Markets Types of Forward Contracts Pricing and Valuation of Forward Contracts Credit Risk and Forward Contracts Lecture 14, 15 Futures Markets and Contracts Futures Trading, Clearinghouse, Margins, and Price Limits Delivery and Cash Settlement Futures Exchanges Types of Futures Contracts Pricing and Valuation of Futures Contracts Role of Futures Markets and Exchanges 16 Mid Term Week Mid Term Exam Financial Markets, Derivatives & Lecture 17, 18 Hull, Chapter 1 10 Hedging Strategies Options Markets and Contracts

4 23 28 VAR (Value At Risk) Application of VAR in Credit, Market & Operational Risk Modelling Lahore University of Management Sciences Saunders, Chapter 1,3 Jorion, Chapter 10,11 De Servigny and Renault, Chapter 2,3,4,6,7 Structure of Global Options Markets Types of Options Principles of Option Pricing Covered Call, Protective Put and Put Call Parity Role of Options Markets Lecture 19, 20 Swap Markets and Contracts Structure of Global Swap Markets Types of Swaps Pricing and Valuation of Swaps Credit Risk and Swaps Lecture 21, 22 Risk Management Applications using Forwards, Futures, Options and Swaps Trading Strategies: Bull and Bear Spread, Butterfly Spread, Calendar Spread, Diagonal Spread, Straddle, Strangle, Strips and Straps, Collar Lecture 23 Introduction to Value at Risk VAR Methods Lecture 24 Market Risk Management Introduction Sources of Market Risk Use of VAR in Market Risk Management Application: Basel Standards Lecture 25 Credit Risk Management Rating Agencies External and Internal Rating Country Risk Models and Sovereign Risk Loan Portfolios and Expected Loss Unexpected Loss PD, LGD and EAD Securitization Lecture 26 Operational Risk Management LDA (Loss Distribution Approach) Model Risk Lecture 27 Integrated Risk Management Enterprise Risk Management: Theory and Practice Risk Measurement, Risk Management and Capital Adequacy and Financial Conglomerates Lecture 28 Case Studies: Risk Management Failures Metallgesellschaft Sumitomo Barings Long Term Capital Management (LTCM) Subprime Mortgage Crisis

5 Textbook(s)/Supplementary Readings Course pack will be available. 1. Arnaud de Servigny and Olivier Renault, Measuring and Managing Credit Risk, (New York: McGraw Hill, 2004) 2. Damodar N. Gujrati, Essentials of Econometrics (3 rd Edition) 3. Hull, Options, Futures, and Other Derivatives, 6th ed. 4. Kevin Dowd, Measuring Market Risk, 2nd ed., (West Sussex: John Wiley & Sons, Inc., 2005). 5. Linda Allen, Jacob Boudoukh, Anthony Saunders, Understanding Market, Credit and Operational Risk: The Value At Risk Approach (Oxford: Blackwell Publishing, 2004) 6. Michael Crouhy, Dan Galai, and Robert Mark, Risk Management (New York: McGraw Hill, 2001) 7. Murray R. Spiegel, John Schiller, and R. Alu Srinivasan, Probability and Statistics, Schaum s Outlines, 2nd ed. (New York: McGraw Hill, 2000) 8. Philippe Jorion, Value at Risk: The New Benchmark for Managing Financial Risk, 3rd ed. (New York: McGraw Hill, 2007). 9. Robert L. McDonald, Derivatives Markets, (Boston: Addison Wesley, 2003). 10. René Stulz, Risk Management & Derivatives (Mason, Ohio: South Western, 2003). 11. Saunders, Financial Institutions Management, 5th ed.