Financial Risk Management

Transcription

1 Synopsis Financial Risk Management 1. Introduction This module introduces the sources of risk, together with the methods used to measure it. It starts by looking at the historical background before going on to define risk. It then examines the basic approaches used to identify, measure and reduce risks. Managing risk is a key activity for firms, and a range of different approaches is outlined. Firms may seek either to examine the totality of the risks they face in the aggregate, an approach known as top-down, or to build up their exposures from the individual risks, a procedure referred to as ground-up. In practice, many firms use both methods. The function of risk management is to control the effects of uncertain and generally adverse external developments (or events) on firms activities and projects. Financial risk management is a more specific activity that seeks to limit the effects of changes in financial variables such as interest rates, currencies and commodity prices. After reading this module, you should be able to understand: what financial risk management is designed to achieve; the difference between uncertainty and risk; the multidimensionality of risk; how different attitudes to risk lead to different decisions as to what amount of risk is acceptable; the basic approaches used to manage risk; the basic nature of the financial risks facing the firm; the three key steps used in risk management: risk awareness, risk measurement and risk adjustment. 1.1 Introduction 1.2 What Is Risk? 1.3 What Is Financial Risk? 1.4 Steps to Risk Identification 1.5 Top-Down and Building-Block Approaches to Risk Management

2 This module has introduced the concept of risk as an unavoidable consequence of human activity. The increased risks facing firms from changes in economic variables have meant a greater focus on risk management activities. Risk can be variously defined, no two definitions being identical. Generally, we can define risk as the variability of future outcomes. This variability is in some way measurable, rather than being pure uncertainty, where measurement is not possible or is inaccurate. Financial risk is that part of a wider risk management process concerned with managing changes in, among other areas, the business, social, economic, political, technological and legal environment. Corporate risk management is a natural response to an uncertain future. These risks can be measured in different ways: using accounting information, future cash flows, contingent and economic exposures. The risk management process is simple to define, and it follows a series of simple steps that involve the firm in (a) becoming aware of the risks; (b) measuring the risks; and (c) adjusting the risk, if necessary. There are a number of different approaches that can be used to measure risk, either taking an equity view or building up the relevant exposures from the basic unit level. Risk can also be related to the asset and liability obligations of the organisation. In practice, organisations tend to use a combination of methods depending on the quality and timeliness of the information available. 2. Risk and the Management of the Firm This module explains why firms are willing to devote resources to risk management. As a general rule, firms will be risk takers in areas where they have unique or specialised expertise, but seek to hedge or eliminate those risks that do not form part of the firm s core competencies. There are a number of different reasons why managing risk is desirable. The two principal reasons are that, first, firms have more information about the risks they face than do investors and, second, firms can undertake risk management more efficiently than individuals. An added reason is that, for some types of firm, financial difficulties can jeopardise survival and, at the same time, lead to considerable loss of value due to the nature of the firm s business. After studying this module, you should be able to understand the impact of: firm-specific factors on the decision as to whether to hedge a risk or to leave it unhedged; asymmetric information on the risk management decision; Financial Risk Management Edinburgh Business School 2

3 the interaction of financing and investment decisions; the impact of agency and other costs on the risk management decision; the problem presented by financial distress; the effect of taxation; firm-specific risks and the undiversified investor in the firm. 2.1 Introduction 2.2 The Pervasiveness of Risk 2.3 Why Manage Risk? 2.4 Taxes 2.5 Agency and Other Costs 2.6 Business Performance 2.7 Financial Risk and Financial Distress 2.8 The Costs of Risk Management The rationale behind firms engaging in risk management activity is that it adds value to the firm in ways that investors in the firm cannot do for themselves. In particular, it addresses contracting problems between a well-informed insider management and less well-informed providers of capital. It also allows investors to capture some, or all, of the internal benefits of firm-specific assets, such as tax shields and positive net present value investments, or to reduce contingent liabilities, such as the direct and indirect costs of financial distress. To summarise, maximum risk levels in the firm will be determined by: investor appetite for volatility of equity value. Investor appetite for risky cash flows is likely to be low if the firm is owned by ill-diversified investors such as owner-managers; this is most likely in the case of private or closely held firms; the threat of bankruptcy or other restructuring costs. These can arise because of high financial gearing and/or volatile net cash flows (income); a significantly higher probability of a costly financial distress (or bankruptcy) situation. Businesses with firm-specific assets that offer services, provide warranties, require specialised staff and purchase customised inputs are particularly exposed to significant financial distress costs and benefit most from corporate risk management; management preferences as to the amount of risk they are willing to assume. As managers have a significant proportion of their wealth in the businesses they manage, they are generally risk averse; the potential and/or actual conflicts between different classes of securities, in particular those between shareholders and debtholders. These tend to be Financial Risk Management Edinburgh Business School 3

4 most severe when there is high indebtedness and when there is a wide range of investment (growth) opportunities available to the firm; the nature of underlying assets or business activity. The greater the volatility of the underlying cash flow, the greater the benefits from risk management, as it helps mitigate underinvestment, agency costs and financial distress; tax effects such as the ability to defer tax liabilities and the tax rate being related to profits. Risk management can reduce the amount the firm pays in corporate taxes. This applies even if corporate tax rates are not progressive; the opportunities available to the firm to invest in positive net present value projects. The greater the investment opportunities available to the firm, the greater the incentive to undertake the risk management. 3. Market Mechanisms and Efficiency The key learning objective of this module is to provide an understanding of the three main risk factors market risk, specific risk and credit risk that make up the principal source of risk for financial instruments. Other risks, for instance liquidity risk, are also discussed. The module ends with a brief overview of the role of intermediaries in the transaction process. The module starts with some general observations on markets and how they operate. The competitiveness of markets, namely the degree of transparency or ability of market participants to see how the market is operating and how well the market absorbs new information, is discussed. This will be critical if the risk management process is to use market information for measuring and modelling the different risk factors. Current financial theories about the nature and behaviour of risk are briefly covered, namely interest rate risk, currency risk, equity risk and commodity price risk, and this forms a prelude to later modules that look in detail at these major asset types of financial risk. After reading this module, you should understand: the diverse risks facing the firm; the concept of risk sensitivity; the nature of the different market mechanisms that underpin financial markets; the theoretical basis for risk as proposed by the capital asset pricing model and the arbitrage pricing theory; the source of major financial risks arising from changes in interest rates, currency values, commodity prices and equity values; the effect of credit risk on value; Financial Risk Management Edinburgh Business School 4

5 the role of financial intermediaries in facilitating transactions in financial markets. 3.1 Introduction 3.2 Market Efficiency 3.3 Market Liquidity 3.4 The Role of Financial Intermediaries 3.5 Systematic Risk and Non-Systematic Risk 3.6 Managing Market Risks 3.7 Effect of Credit Risk This module has considered how markets work and some of the ways that market mechanisms and efficiency affect the process of financial risk management. Risks in financial markets can arise in a variety of ways, ranging from price risk, credit risk and liquidity risk to more complex interconnection risks. The structure and behaviour of the market can also have a bearing on these risks based on how efficient and transparent the market is. This module shows that the risk of a position in the market is multidimensional. Any exposure to the market by being long or short is a package of all the individual risk factors or elements that are in the asset and the way it trades in the market. The direction of the exposure will depend on the sensitivity, whether the asset is owned (a long position) or is to be purchased (a short position). With a long position, price increases lead to gains, price decreases to losses. For a short position, the opposite applies. The standard model used for valuation in finance, the capital asset pricing model, suggests that risk should be broken down into at least two elements: the asset s systematic risk, which cannot be diversified, and its specific risk, which can. The asset s sensitivity to changes in the market can then be measured by its beta. Another approach, arbitrage pricing theory, proposes that risk is a function of a variety of macroeconomic and systematic factors. This latter theoretical model has more relevance to the risk management approach that unbundles a particular exposure into its constituent risk factors. However, the theory does not specify what these factors should be. The major financial risk categories are interest rates, foreign exchange rates, commodity price risk and equity price risk. Each of these is subject to particular kinds of risk: Market or price risk arises from changes in the demand and supply of an asset over time, which changes the equilibrium price and hence the price of the asset observed in the market. Financial Risk Management Edinburgh Business School 5

6 Liquidity risk arises from (a) a lack of available buyers at a specific point in time, known as timing risk, and (b) changes in the market price owing to delays in carrying out transactions; this can arise when assets have limited marketability. Liquidity risk can be considered as either selling price risk or purchasing price risk, or both if the transaction involves switching between two assets that are illiquid. Credit risk arises from a potential default by the issuer of the asset or the counterparty to a transaction. A range of other risks, such as legal risk, regulatory risk and tax risk may also need to be considered. 4. Interest Rate Risk Module 4 discusses the risks that arise from changes in interest rates. It looks at the different theories that have been put forward to explain the behaviour of interest rates. The nature, cause and effect of the key sources of interest rate risk are also covered in detail. The similarities and differences in interest rate risks, as well as the source and nature of the different risks, are brought out. Interest rate risk is a major component of any financial risk. In particular, the value of (interest) rate-sensitive assets depends directly, or indirectly, on the interest rate (or the discount rate) used to present value the cash flows of these assets. After studying this module, you should be able to understand: the sources of interest rate risk; the impact of the different types of interest rate risk on a given exposure; how interest rate price risk is inversely related to the level of interest rates and the maturity of the set of fixed cash flows; how reinvestment risk is directly related to interest rates; the problems and attractions of the right to early repayment of a set of fixed cash flows; the causation of extension risk in some fixed-interest securities; the nature of, and theories used to explain, the term structure of interest rates: expectations theory; liquidity preference theory; market segmentation theory; volatility theory of the term structure; how different securities are affected by the various components of interest rate risk. Financial Risk Management Edinburgh Business School 6

7 4.1 Introduction 4.2 Interest Rate Risk 4.3 The Term Structure of Interest Rates 4.4 Analysing Yield Curve Behaviour 4.5 The Money Markets 4.6 Term Instruments This module has looked at the effects of interest rate risk on cash flows. There are a number of different risks within the definition of interest rate risk, and these depend on the exact nature of the cash flows: Price or market risk arises from changes to the present values of cash flows from changes in the discount rates used to value these cash flows. This risk is inversely related to the interest rate: higher interest rates will reduce the present value of cash flows, and lower interest rates will increase the present value of cash flows. Reinvestment risk happens whenever maturing cash flows give rise to new transactions in the market and the new borrowings or investments are made at a rate different from that originally anticipated. This risk is directly linked to the level of interest rates. Higher interest rates will increase the future value of reinvested cash flows; lower interest rates will reduce the future value of reinvested cash flows. It is possible to balance price risk and reinvestment risk so that the two risks offset each other through a process called immunisation. Prepayment risk arises when one party to a contract with a fixed set of cash flows has the right to terminate the agreement early and pay back the money involved on pre-agreed terms. This is a contingent risk and will occur only if the market rate is below (or above) the rate at which the party that has the right to terminate the contract can borrow (or lend) in the market. If interest rates drop, borrowers can benefit from refinancing at a lower rate. If interest rates rise, lenders can ask for repayment and reinvest at a higher (interest) rate. Extension risk happens if expected, but not contractually fixed, cash flows are delayed. This occurs when there are non-contractual factors at work allowing one party to defer terminating the agreement. Examples include mortgage securities where homeowners may move due to changes in jobs, which may or may not be associated with rises and falls in interest rates. The term structure of interest rates, or the yield curve, is a depiction of the relationship of interest rates to time. It embodies the market s best guess as to what interest rates are likely to be in the future. A number of different theories have been put forward to explain the observed shapes of the yield curve. There are four characteristic shapes: upward sloping, downward sloping, flat and humped. Financial Risk Management Edinburgh Business School 7

8 We can analyse changes in the yield curve through two principal effects: a parallel shift, when the rate for all maturities changes equally, and a rotational shift, when the curve pivots around a particular maturity to either steepen or flatten. When changes to the yield curve are observed, it is likely that both effects take place at the same time, leading to twisting effects. Financial instruments, whose values are directly related to interest rates, either can be characterised by a simple pair of cash flows, consisting of an inflow, an outflow and a short maturity, as is the case with the money markets, or are complex bundles of simple cash flows, as are the instruments traded in the term debt markets. The characteristics of the instruments cash flows will dictate their exposure to the different types of interest rate risk. 5. Currency Risk This module looks at currency risk, one of the major types of financial risk, which is also called foreign exchange risk, as it relates to changes in the price at which one currency is exchanged for another. Currency risk can arise in a variety of different ways: from undertaking transactions between currencies and through consolidating financial statements in different currencies and the effects the exchange rate has on competition. The module also looks at the different theories that have been advanced to explain the behaviour of currencies. The nature, cause and effect of the key sources of currency risk are also detailed. After completing this module, you should know: how foreign exchange rates are determined; the sources of currency risk: transaction exposure; translation exposure; economic exposure; the complexities involved in managing economic exposures arising from currency movements; the role of interest rates in setting forward exchange rates; the different theories advanced to explain the behaviour of currencies. 5.1 Introduction 5.2 Foreign Exchange Rate Risk 5.3 Foreign Exchange Exposure Financial Risk Management Edinburgh Business School 8

9 The changes in the value of currencies over time are a major source of risk. Foreign exchange rate risk arises whenever the value of one currency against another changes in an unexpected way. In a world of floating exchange rates, market forces and participants expectations determine the value of one currency against another. A number of different theories have been advanced to explain the relationship of the current market rate for a currency and the forward exchange rate. These models purchasing power parity, interest rate parity, expectations and the international Fisher effect are based on economic or arbitrage arguments. These theories provide alternative explanations for the paths that currencies may pursue over time. The fact that a number of theories exist indicates that we do not really understand how exchange rates are determined at any time. There are three major sources of exchange rate risk for most organisations: transaction risk, when a cash flow in one currency has to be converted at the prevailing market rate into another currency; translation risk or accounting risk, when a reported accounting item in one currency is converted into another currency for financial reporting purposes; economic or competitive risk, when changes in the value of a currency against other currencies lead to increased or decreased competitiveness of the firm and alter the future cash flows from its operations. This form of exchange rate risk is both direct, as it affects the firm itself and its subsidiaries, and indirect, when it affects the position of its competitors and domestic and foreign suppliers. 6. Equity and Commodity Price Risk This module covers equities and commodities and continues and concludes the analysis of risk in the main financial asset classes. The overall objective of this module is to provide an understanding of the three main risk factors market risk, specific risk and credit risk that make up the principal sources of risk for financial instruments. Equity risk is, in effect, the risks from asset ownership, since the equity holder has a residual claim on the firm s cash flows and by implication the value of the firm s assets after prior charges have been met. Ownership brings both gains and losses. The risks inherent in equities can be either market-wide, which affect all equities to a greater or lesser extent, or firm-specific factors. The second section looks at commodities. These are both consumption assets, in that firms use commodities as the raw material for their processes (e.g. agricultural Financial Risk Management Edinburgh Business School 9

10 commodities are eaten), and used for investment purposes. As a result, commodity price risk is a significant problem for firms if the commodity is used in the manufacturing process and for consumers of products in general. After completing this module, you should understand: the sources and types of risk relating to equities; problems in analysing future cash flows relating to equity; the difference between systematic and stock-specific risks; the difference between commodities, which are consumption assets, and other financial assets, which are held for investment purposes; the factors that determine commodity prices, including the existence of a convenience yield for commodities. 6.1 Equity Market Risks 6.2 Commodity Price Risk This module has looked at two different kinds of market risk: those that affect equities and those that affect commodities. Equity risk relates to the ability of firms to manage the future economic performance of real assets. Problems arise in two areas. One relates to how the market discounts the future cash flows and the covariance of these cash flows to the market factor. The second area is firm- or sector-specific shocks that affect the value of individual firms but not of other equities. Complex analysis, often of a heuristic nature, is required to understand the interrelated and complex package of the many different kinds of risk that are included in equity ownership. These risks are far more wide-ranging than just economic factors, including political risk, regulatory risk, legal risk, environmental risks and so on. Commodity risk is important since commodities often form part of the inputs or outputs for many firms, either directly as raw materials or indirectly as a component of intermediate or finished goods or services. As such, the risk has two sides. For consuming firms in which such raw materials are an important factor of production, their price risk has to be carefully managed. For producing firms, the revenues from selling commodities can be subject to significant price swings, affecting profitability and cash flows. Equally, to investors they are potentially a separate investment asset class. Regardless of the reasons for having exposures to commodities, there are a number of special idiosyncratic factors that have to be considered when managing commodity price risk. These include potential shortages of supply, the lack of close substitutes leading at times to hoarding by consumers, which manifests itself through the Financial Risk Management Edinburgh Business School 10

11 convenience yield and various kinds of official intervention to support or depress the price. 7. The Behaviour of Asset Prices This module looks at the behaviour of asset prices over time. How asset prices change is an important consideration in managing financial market risks. After studying this module, you should be able to understand the essential features of asset price behaviour, namely that: asset price changes are random; that is, they cannot be predicted; the price-generating process or distribution of price changes follows what is known as a stochastic process and, for modelling purposes, can be treated as having a lognormal distribution; the process and nature of asset price volatility can be modelled using statistical methods. 7.1 Introduction 7.2 The Price-Generating Process for Financial Assets 7.3 Understanding Volatility 7.4 Describing the Price-Generating Process This module has examined the nature of the price behaviour of assets. The important relationship from a modelling point of view is not the change in price but the asset s return. From a conceptual perspective, the natural logarithm of price relatives provides a measure of the continuous rate of change in the asset price. Changes in prices lead to differences in return. The dispersion of such changes is generally known in financial markets as volatility. Specifically, volatility is the annualised standard deviation of daily returns. The module also looks at the sources of volatility. Volatility occurs as a result of changes in the factors affecting asset value. This arises from macro- and microeconomic factors, such as changes in exchange rates, interest rates, commodity prices and cash flows. It is also due to news that affects the current and future prospects for individual assets, sectors or whole markets. Changes in volatility arise from a revaluation of the range of outcomes that are expected in the future together with Financial Risk Management Edinburgh Business School 11

12 the probabilities that are attached to these. The wider the range of potential future prices, the greater the volatility. Although it is convenient to assume that asset returns follow a normal or lognormal distribution, there is considerable empirical evidence that asset returns may be non-normal. A number of alternative formulations for asset price-generating processes have been put forward, including, inter alia, infinite variance, mixeddiffusion jump, compound normal and stochastic volatility models. The implications of non-normal behaviour are that standard statistical techniques must be used with care and that adjustments must be made to take account of observed price behaviour. 8. Controlling Risk Undertaking risk management requires some thought. Risk management and the control of risk, as with most other aspects of commercial decision making, are not without cost. In order to control risk, information has to be gathered and processed and management time devoted to analysing the result. Firms also need to set objectives in relation to the right decisions to be made once the analysis has been completed. This module looks at some of the managerial issues and methods that are used by firms in analysing and controlling risks. There are two basic approaches, one involving a top-down analysis of the firm s activities; the other starting with individual risk factors makes use of a building-block approach. The module then goes on to examine different approaches to risk control using the firm s accounting records. The first method is based on limits, and this is expanded to introduce the forward-looking value-at-risk approach that is the current, best practice, method. This latter approach attempts to predict the expected loss from a given exposure at any particular time during some predetermined time period. To ensure a complete risk profile, this approach is usually coupled with a stress test scenario to provide a worst-case loss. After reading this module, you should be able to: see how and why firms set relevant exposure limits to different risks; understand how different assessment methods work; differentiate between macro-based and micro-based assessment methods as to the quality of the analysis and insights into the different risks; understand the differences in approach of and the insights provided by accounting data, management information and the value-at-risk methodology, which is based on statistical and worst-case-scenario analysis; Financial Risk Management Edinburgh Business School 12

13 identify the problems of and limitations to any risk management activity. 8.1 Introduction 8.2 The Top-Down Approach to Risk Assessment 8.3 The Building-Block Approach to Risk Assessment 8.4 Reporting and Controlling Risk 8.5 A Note of Warning We can summarise the process of controlling and managing risks as a series of evaluation and decision steps. Be aware that, although the approach appears simple, in practice the actual task is quite difficult. The control steps then follow a logical sequence: 1. Identifying risks This requires a risk audit of the firm s activities. Each risk can be broken down into its component parts to derive the individual risk factors that form the fundamental building blocks of the risk management process. 2. Analysing the impact of each risk For risks to be managed, their effects on the firm s activities have to be measured. The resultant exposures will determine whether the risks are material or not. Note that the question of materiality is a subjective one: what is acceptable to one firm may be totally inappropriate to another. 3. Assessing the effect of the exposures on the firm s business and strategy The key question is how vulnerable the firm may be to changes in its financial risk exposures and the degree to which the firm needs to respond to the problem. Firms will need to set a policy for managing such financial risks. The exact mix will depend on the firm s objectives, its appetite for, or dislike of, risk and other operational considerations. 4. Assessing the firm s internal capability for risk management The initial stage of risk reduction will seek to look for internal ways of managing risk. The availability of information and the costs of putting in place such systems, together with other management resources, will determine how much of the firm s financial risks can be managed internally. Natural offsets will reduce the cost of hedging and insurance to the firm. 5. Selecting the most appropriate risk management strategies and/or products Once the firm has set a policy for the amount and types of risk it wants to bear, the unwanted or unacceptable risks can be reduced through the appropriate strategy or the purchase of appropriate risk management products. 6. Keeping the programme under constant review Financial Risk Management Edinburgh Business School 13

14 Any business situation is dynamic and the degree of exposure needs to be kept under constant review as the variables that go into the risk management process can, and are likely to, change over time. The module has discussed a number of issues relating to the management of risks, in particular how they are to be evaluated in terms of the firm s own assessments and the steps required to implement such a programme. The various approaches, using either macro data or building up from the individual risk factors, are discussed. The nature of the analysis requires that any assessment must look to the future this is the intention of the value-at-risk methodology. To complement the expected-value framework of the value-at-risk analysis, the worst-case scenario or stress test is required to provide an indication of the maximum potential exposure when markets are distressed. 9. Quantifying Financial Risks This module continues the examination of approaches to managing risks by looking at how to measure and model financial risks. In particular, it looks at the benefits of diversification. These benefits come from creating portfolios that include assets that are not perfectly correlated. The initial part concentrates on the financial approach used for measuring risk through the use of the standard deviation and then focuses on how risk can be measured for portfolios. The key building blocks of the financial risk analysis framework relate to measuring the expected return, the variance and standard deviation of return, and the probability of outcomes. A key issue is the interdependency or covariation of returns between different assets or risk factors. The module then extends the analysis to look at value at risk in a multi-asset portfolio context. After completing this module, you should be able to: calculate the average value, the variance and the standard deviation of a financial series; calculate the correlation between two different risks; construct a portfolio to show the combined effect of different risks on a position; calculate the benefits of diversification; apply the model to estimating the value at risk of a portfolio. 9.1 Introduction 9.2 Statistical Analysis of Financial Risk Financial Risk Management Edinburgh Business School 14

15 9.3 The Significance of the Normal Distribution 9.4 Understanding the Risk Measures 9.5 Measuring the Relationship between Assets 9.6 Portfolio Expected Return and Risk 9.7 Practical Considerations in Measuring Risk 9.8 Estimating Portfolio Value at Risk This module has looked at the financial approach to quantifying risk and, in particular, at the role of portfolios in determining the risk of multiple assets or securities. Individual assets can be evaluated in terms of the uncertain return (or future values), which is quantified by a probability distribution of returns. The expected return on an asset is a probability-weighted average return from the possible range of future outcomes. Risk is the dispersion or spread of the possible returns around the (ex ante) expected return, modelled using the variance or standard deviation. If the underlying distribution of returns conforms to the normal probability distribution, the spread of return (which leads to risk) is summarised by its variance. An equivalent measure of dispersion is the standard deviation (which is simply the square root of the variance), which is known as volatility in financial markets. The standard deviation is an easier measure to understand since it is denominated in units of return. We can characterise the normal probability distribution uniquely by its mean and standard deviation. With a normal distribution, the standard deviation provides a measure of the probability of a given set of outcomes away from the mean or average. About two-thirds of the distribution is accounted for by observations falling between 1 and +1 standard deviations; about 95 per cent of the distribution is within 2 and +2 standard deviations. And 99 per cent is accounted for by observations within 3 standard deviations of the mean. When looking at the relationship between two assets, their covariance or their correlation is an important measure of their interdependence. The covariance measures the tendency of two assets to move together. The correlation coefficient is a standardised measure of this tendency that allows comparisons between several assets. The correlation coefficient can take a value between 1 (perfect negative correlation) and +1 (perfect positive correlation); a value of zero means the returns on the two assets are independent. Two assets will be positively correlated if, on average, their returns move in the same direction; two assets will be negatively correlated if, on average, their returns move in the opposite direction. The benefits of risk reduction from creating portfolios result from the correlation effect. The diversification effect arises from creating portfolios with assets that are less than perfectly correlated. As a result, by selecting efficient portfolios, less risk per unit of expected return can be had or higher return for a given risk can be had Financial Risk Management Edinburgh Business School 15

16 due to the risk-reducing benefits of diversification. The lower the correlation (to a minimum of 1, or perfect negative correlation), the greater the risk reduction obtained. Diversification is beneficial because, for imperfectly correlated asset returns, the risk (standard deviation of the portfolio) is less than the weighted-average risk of the individual assets that are used to make up the portfolio. This has important benefits for financial risk management and the calculation of a diversified value at risk for portfolios that include assets that are less than perfectly correlated. 10. Financial Methods for Measuring Risk This module describes the use of financial methods and, in particular, discounted cash flow techniques used to measure risks. It starts by outlining the methods used to create a zero-coupon, or spot-rate, yield curve from observed securities prices and its use for calculating the present value of future cash flows. It then shows how the present-value method can be applied to future cash flows in order to determine their sensitivity to changes in the interest rates used to value these cash flows. This discussion is then extended to show how the risk of a position can be modelled using simulation based on the known statistical relationships between the different elements of risk in the term structure of interest rates. After completing this module, you should be able to: apply the present-value (PV) method to calculate the value sensitivity of assets and liabilities to changes in interest rates; construct spot or zero-coupon rates for each maturity from the yield curve and use these spot rates as the appropriate interest rate for discounting future cash flows at each point in time; apply sensitivity analysis to a given risk position; undertake the simulation of a risk position Introduction 10.2 Using the Present-Value Approach to Determine Risk 10.3 Calculating Spot Discount Rates for Specific Maturities 10.4 The Term-Structure Approach to Risk Measurement 10.5 Simulation Financial Risk Management Edinburgh Business School 16

17 This module applies the key financial concept of present-value analysis to the valuation of the risks of future cash flows. The aim of such an analysis is to measure the sensitivity of future cash flows to changes in the discount rates being used to value them. In order to be able to value cash flows correctly, it is first necessary to calculate the appropriate zero-coupon rates for the relevant time periods. Zero-coupon or spot interest rates can be derived from standard, coupon-paying instruments via an iterative bootstrapping process in order to create a synthetic zero-coupon yield curve. These zero-coupon interest rates are the appropriate discount factors for each time period regardless of the final maturity of the cash flows. They correct for flaws in the yield-to-maturity approach as they represent interest rates that have no reinvestment risk. Zero-coupon interest rates can also be used to compute forward interest rates, which are the interest rates that are implied in the yield curve and that start at a given point in the future. Starting by valuing future cash flows at current interest rates, once the valuation has been made the value s sensitivity to changes in the current interest rates can be measured. Various approaches can be used, including: modelling a small change in the discount rate using sensitivity analysis. This involves making a very small change to the discount rate to see how much the present value is altered. The value is then grossed up by some estimate of the likely change over the horizon period using a partial revaluation approach; applying a scenario approach that involves changing the discount rate according to some predetermined view on the likely course of interest rates. This entails making some forecast about how interest rates are likely to change over the planning horizon and making suitable adjustments to the present value of the cash flows; applying a statistical assessment of past rate changes to the discount rate in order to derive a probable change in valuation. A more sophisticated approach might involve simulation (also called Monte Carlo simulation) of the different risk factors in the term structure of interest rates. For instance, the behaviour of the term structure can be characterised by two principal risk factors, one representing a parallel shift in interest rates that affects all maturities, the other a rotational shift around some pivotal point in time. Depending on prior analysis of the nature of the term structure, simulation involves concurrently changing all the parameters of the model to obtain an overall assessment of the nature of the value at risk in the exposed set of cash flows. To summarise: financial assessments aim to provide an appraisal of the current market value of a set of future cash flows. The financial methods used for risk assessment apply the established present-value technique in combination with elements of statistical analysis and sensitivity analysis to establish the potential range of values over a given management horizon. Financial Risk Management Edinburgh Business School 17

18 11. Qualitative Approaches to Risk Assessment This module looks at how qualitative models can be prepared for risk management purposes. Such models are used for complex situations that cannot be modelled in formal ways, or as a way of adding a directional or a considered view of the likely evolution of the risk factors. In particular, it looks at how forecasts are created and evaluated. After completing this module, you should be able to: understand the steps required to prepare a qualitative forecast; understand the different methods used to create a qualitative forecast; know the problems that can arise from such an approach; see how the different approaches are integrated into decision making Introduction 11.2 Qualitative Forecasting Methods 11.3 Qualitative Forecasts 11.4 A Practical Example of a Forecast 11.5 Assessing Qualitative Accuracy This module has looked at some qualitative approaches to forecasting as tools to help risk managers develop appropriate strategies for the future. Quantitative or causal models rely on the assumption that the variables being forecast will be generally similar over the forecasting horizon. In contrast, qualitative models can be used when there is little or no prior historical data on which to build a quantitative forecast. The approach may also be considered to be more appropriate when there is a strong belief that past behaviour is not expected to continue into the future. A number of methods have been developed to make best use of intuitive judgements in providing forecasts and in reducing the subjective bias of the forecaster. In practice, most organisations rely on a combination of quantitative and qualitative forecasts to guide their decisions, the weights attached to the different approaches by decision makers varying over time. There are a number of measures that show the quality of forecasts against a reference or benchmark. Some, such as the mean absolute error, for instance, determine only the degree of accuracy; others, such as forecasting skill, relate the Financial Risk Management Edinburgh Business School 18

19 performance metric to the reference performance. In many cases, we require not necessarily a forecast that is accurate against the actual outcome, but one that will measure how well the forecast predicts the direction of change. Financial Risk Management Edinburgh Business School 19