Fundamentals of Risk Management.pdf

Fundamentals of Risk Management.pdf - Fundamentals of Risk...

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Fundamentals of Risk Management Salvatore Ferraro and Dominic Rossini
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Whilst we have made considerable e ff orts to contact all holders of copyright material contained in this book, we may have failed to locate some of them. Should holders wish to contact the Publisher, we will be happy to come to some arrangement with them. Copyright c 2016 Corpus Education Pty. Ltd. Corpus Education Pty. Ltd. www.corpuseducation.com.au Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Australian Copyright Act 1968 and the Copyright Amendment Act 2006, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the prior permission in writing of the publishers, or in the case of reprographic reproduction in accordance with the terms of licences issued by the Copyright Licensing Agency. Enquiries concerning reproduction outside those terms should be sent to the publishers. The use of registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant laws and regulations and therefore free for general use. The publisher makes no representation, express or implied, with regard to the accuracy of the information contained in this book and cannot accept any legal responsibility or liability for any errors or omissions that may be made. Microsoft Excel is a registered trademark of Microsoft Corporation in the United States and other countries. First printing, December 2016 This electronic publication is not in scope for deposit with the National Library. ISBN: 978-0-9942767-7-3
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Contents 1 INTRODUCTION TO RISK MANAGEMENT . . . . . . . . . . . . . . . . . 11 1.1 Introduction 12 1.1.1 Historical Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 1.1.2 Increased Volatility in Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.1.3 Availability of Financial Risk Management Products . . . . . . . . . . . . . . . . . . . . . . . . 20 1.2 Risk: A Closer Examination 21 1.2.1 Definitions of Risk and Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 1.2.2 The Three Dimensions of Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 1.3 Risk Management 30 1.3.1 Objectives of Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 1.4 What Is Financial Risk? 32 1.4.1 The Nature of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 1.4.2 Accounting Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 1.4.3 Contingent & Competitive Exposures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
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1.5 Steps to Risk Identification 35 1.5.1 Risk Awareness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 1.5.2 Risk Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 1.5.3 Risk Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 1.5.4 The Step-By-Step Risk Management Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 1.6 Top-Down and Building-Block Approaches 39 1.6.1 Equity Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 1.6.2 Asset–Liability Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 1.6.3 Transactions and the Cash Flow Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 1.7 Problem Set 42 2 RISK MANAGEMENT OF FIXED INCOME SECURITIES . . . . . . 43 2.1 Introduction 44 2.2 Sources of IRR 44 2.3 E ff ects of IRR 45 2.3.1 Interest Rate Sensitivity of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 2.4 Sound IRR Management Practices 48 2.5 Term Structure of Interest Rates 49 2.5.1 Expectations Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 2.5.2 Liquidity Premium Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 2.6 Yield Curve Shifts 52 2.7 Quantitative Methods of IRR Management 54 2.7.1 Macaulay Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 2.7.2 Modified Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 2.7.3 Portfolio Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 2.7.4 Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
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2.7.5 Basis Point Value (BPV) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 2.8 Yield Volatility (Interest Rate Volatility) 62 2.9 Duration GAP Management 63 2.9.1
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