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Unformatted text preview: Version: January 3, 2011 FIN 7400: Financial Risk Management Unit IB Notes Page 1 of 23 D. M. Chance, LSU I. CONCEPTS OF RISK MANAGEMENT B. Basic Concepts of Financial Risk Risk arises from volatility in interest rates, exchange rates, commodity prices and equity prices. The primary focus in this course is on interest rate and exchange rate risk with some attention to commodity price risk. Risk must be managed, which does not necessarily mean eliminated. Eliminating or reducing risk is often called hedging . But there are some cases in which risk must be increased. Example: A portfolio manager wants to keep a 50-50 allocation of stocks and bonds. The portfolio is currently worth $100 million so $50 million is in stocks and $50 million is in bonds. The stocks then decrease by 10% and the bonds increase by 3%. The portfolio now consists of $45 million of stock and $51.5 million of bonds for a total of $96.5 million. The allocation is now $45/$96.5 = 0.466 stock and 0.534 bonds. To maintain the desired allocation, the risk must be increased by increasing the allocation to stock. Moreover, if risk is completely eliminated, one can expect to earn only the risk-free rate. Some risks must be accepted. Risks that cannot be avoided at little or no cost offer a return in the form of an ex ante expected risk premium. Some risks, however, do not offer risk premiums. For example, diversifiable risk is thought to offer no reward, because the risk can be easily eliminated. Strategically, good risk management usually means accepting the risks in which management has some expertise and eliminating the risks in which it has none. Hence, banks would accept financial risks (mostly the risks associated with interest rates and exchange rates), while corporations would eliminate those risks and accept the risks in the markets for their products and services. This course focuses primarily on managing financial risk. But in any case, risk management means making sure that the risk accepted is the risk you want to accept. Risk can be managed by trading in the underlying assets (e.g., selling bonds and using the money to buy stock in the above example). Alternatively, risk can be managed with financial products designed specifically to do so, i. e., to transfer the risk from those wanting less to those wanting more. Risks can be unbundled so that one type of risk is separated from another. The desired risks can be assumed and the undesired risks can be eliminated. A First Look at Risk There are several key sources of risk that we tend to follow in the financial markets. These are interest rates, exchange rates, stock prices, energy prices, and commodity prices (energy is sometimes treated as a commodity). We will look at several representative series from each of Version: January 3, 2011 FIN 7400: Financial Risk Management Unit IB Notes Page 2 of 23 D. M. Chance, LSU these categories: 90-day Eurodollars, a weighted average of the U. S. dollar against other major currencies, the S&P 500, oil, and gold. currencies, the S&P 500, oil, and gold....
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