Risk ManagementUniversity of Economics, Kraków, 2012

Tomasz Aleksandrowicz

financial risk management

financial risks types

sources of financial risks

• organization’s exposure to changes in market prices, such as interest rates, exchange rates, and commodity prices

• 2. Financial risks arising from the actions of, and transactions with, other organizations such as vendors, customers, and counterparties in derivatives transactions

• 3. Financial risks resulting from internal actions or failures of the organization, particularly people, processes, and systems

financial risk overview

• market risks– equity price risk– interest rate risk– foreign exchange risk– commodity price risk

• credit risk– transaction risk– portfolio concentration risk

• liquidity risk– `funding liquidity risk– asset liquidity risk

market risk

equity price riskinterest rate risk

foreign exchange riskcommodity price risk

equity price risk

• risk resulting from holding equities or assets with performance tied to equity prices

• faced by all organizations possessing or issuing equities

interest rate risk

• risk resulting from volatility of interest rates• faced by all companies with borrowings (affecting

cost of funds)– loan with fixed rate of interest– loan with floating (variable) rate of interest

• impact depends on company structure / relation of:– capital and debt (leverage ratio) – short and long term debt– fixed and floating rate debt

foreign exchange rate risk

• risk resulting from change in the exchange rate of one currency against another

• faced by all organizations involved in foreign exchange or utilizing commodities denominated in other currency

commodity price risk

• risk resulting from commodity prices rising or falling

• faced by all organizations that produce or purchase commodities

derivatives

Portfolio creation approach

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diversification (I)

• diversification means reducing risk by investing in a variety of assets

• it means: don't put all your eggs in one basket• diversified portfolio will have less risk than the weighted

average risk of its elements• often less risk than the least risky of its parts• crucial element is selection of assets with low correlation • correlaton values:[-1,1]

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two assets portfolio

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two assets portfolio

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divrsification (II)

• specific risk and systematic risk• individual, specific securities are much more risky than the

market• specific risk can be lowered by diversification• systematic risk is a limit for diversification efficiency – can not

be elimitnated by diversification

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Diversification (III)

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Asset specific risk – variance / sd

• specicfic risk could be measured by variance and standard deviation of the asset

• sd and var how far a set of numbers are spread out from each other (from mean/expected value)

• variance:

• standard deviation (sq root ov variance):

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Assets historical return and sd

Based on annual returns from 1926-2004

Avg. Return Std Dev.Small Stocks 17.5% 33.1%Large Co. Stocks 12.4% 20.3%L-T Corp Bonds 6.2% 8.6%L-T Govt. Bonds 5.8% 9.3%U.S. T-Bills 3.8% 3.1%

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Asset systematic risk - beta factor

• systematic risk can be measured as the sensitivity of a stock’s return to fluctuations in returns on the market portfolio

• the systematic risk is measured by the beta coefficient, or β.• variation in asset/portfolio return depends on return of market portfolio

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b = % change in asset return

% change in market return

Beta Factor Interpretation

• if = 0b– asset is risk free

• if = 1b– asset return = market return

• if > 1b– asset is riskier than market index

if < 1b– asset is less risky than market index

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Beta Factor Sample (5 yr)

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.31Heinz.H.J

.41ExxonMobil

.57Pfizer

.66sMcDonald'

.67PepsiCo

1.00Airlines Delta

1.05Ford

1.18GE

2.14 er DellComput

3.30Amazon

BetaStock