27 study notes risk management and financial

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Study Notes: Risk Management and Financial Institutions By Zhipeng Yan HDD = max (0, 65 –A), where A is the average of the highest and lowest temperature during the day at a specified weather station, measured in degrees Fahrenheit. - CDD: cooling degree days – a measure of the volume of energy required for cooling during the day. CDD = max (0, A – 65) - A typical over-the-counter product is a forward or option contract providing a payoff dependent on the cumulative HDD or CDD during a month. 2. Energy Derivatives - Oil: virtually any derivative that is available on common stocks is now available with oil as the underlying asset. - Natural gas and electricity. - An energy producer faces two risks: price risk and volume risk. Although prices do adjust to reflect volumes, there is a less-than-perfect relationship between the two. The price risk can be hedged using the energy derivative contracts. The volume risks can be hedged using the weather derivatives . 3. Insurance Derivatives – are beginning to become an alternative to traditional reinsurance as a way for insurance companies to manage the risks of catastrophic events: CAT (catastrophic) bond : a bond issued by a subsidiary of an insurance firm that pays a higher-than-normal interest rate. In exchange for the extra interest, the holder of the bond agrees to provide an excess-of-cost reinsurance contract. Depending on the terms of the CAT bond, the interest or principal (or both) can be used to meet claims. There is no statistically significant correlation between CAT risks and market returns. CAT bonds are therefore an attractive addition to an investor’s portfolio. Chapter 18 Big Losses and What We Can Learn From Them 1. Risk Limits : it is essential that all companies define in a clear and unambiguous way limits to the financial risks that can be taken. Ideally, overall risk limits should be set at board level. These should then be converted to limits applicable to the individuals responsible for managing particular risks. - It is tempting to ignore violations of risk limits when profits result. The penalties for exceeding risk limits should be just as great when profits result as when losses result. Otherwise, traders that make losses are liable to keep increasing their bets in the hope that eventually a profit will result and all will be forgiven. - Do not underestimate the benefits of diversification - Carry out scenario analyses and stress tests: The calculation of risk measures such as VaR should always be accompanied by scenario analyses and stress testing to obtain an understanding of what can go wrong. 2. Managing the trading room - There is a tendency to regard high-performing traders as ‘untouchable’ and to not subject their activities to the same scrutiny as other traders. It is important that all - 28 -
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Study Notes: Risk Management and Financial Institutions By Zhipeng Yan traders – particularly those making high profits – be fully accountable.
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