FRM Powerpoints 2011 Unit IB Basic Concepts of Financial Risk

FRM Powerpoints 2011 Unit IB Basic Concepts of Financial Risk

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Unformatted text preview: I. Concepts of Risk Management B. Basic Concepts of Financial Risk Version: January 3, 2011 Unit I.B p. 2 of 41 Basic Ideas o Sources of market risk n Interest rates n Exchange rates n Commodity prices n Stock prices o Our primary focus is on the first two Version: January 3, 2011 Unit I.B p. 3 of 41 Basic Ideas (cont.) o What do we mean by managing risk? n Not necessarily eliminating risk or hedging 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. Version: January 3, 2011 Unit I.B p. 4 of 41 Basic Ideas (cont.) o What do we mean by managing risk? (cont.) n What happens if we eliminate risk? n Risk and risk premiums o Diversifiable risk o Nondiversifiable risk n What types of risks should firms accept and which types should they reduce or eliminate? Version: January 3, 2011 Unit I.B p. 5 of 41 Basic Ideas (cont.) o What do we mean by managing risk? (cont.) n How do we manage risk? o Trading in the underlying assets o Using financial products (derivatives) o The unbundling of risk Version: January 3, 2011 Unit I.B p. 6 of 41 A First Look at Risk o We will look at five principal source of risk n Interest rates n Exchange rates n Stock prices n The price of oil n The price of gold Version: January 3, 2011 Unit I.B p. 7 of 41 A First Look at Risk 5 10 15 20 25 Dec-71 Dec-73 Dec-75 Dec-7 Dec-79 Dec-81 Dec-83 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-9 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Rate (%) Time (month) Monthly 90-Day Eurodollar Rate (LIBOR) **This page updated annually Version: January 3, 2011 Unit I.B p. 8 of 41 A First Look at Risk (cont.) 20 40 60 80 100 120 140 160 Dec-73 Dec-74 Dec-75 Dec-76 Dec-7 Dec-78 Dec-79 Dec-80 Dec-81 Dec-82 Dec-83 Dec-84 Dec-85 Dec-86 Dec-87 Dec-8 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-9 Dec-0 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Curency Units per Dolar Time (month) Monthly Value of the Dollar Against the Federal Reserve's Index of Major Currencies **This page updated annually Version: January 3, 2011 Unit I.B p. 9 of 41 A First Look at Risk (cont.) 200 400 600 800 1000 1200 1400 1600 1800-01 1953-01 1956-01 1959-01 1962-01 1965-01-01-01 1974-01 197-01 1980-01 1983-01 1986-01-01-01 195-01 198-01 201-01 204-01 207-01 2010-01 Index Time (month) Monthly Level of S&P 500 **This page updated annually Version: January 3, 2011 Unit I.B p. 10 of 41 A First Look at Risk (cont.) 20 40 60 80 100 120 140 160 Dolars ($) Time (month) Monthly Price of West Texas Intermediate Crude Oil **This page updated annually Version: January 3, 2011 Unit I.B p. 11 of 41 A First Look at Risk (cont.) **This page updated annually Version:...
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FRM Powerpoints 2011 Unit IB Basic Concepts of Financial Risk

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