introduction to financial risk management · slide1.ppt author: xiaodong zhu created date: 9/8/2011...
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Introduction to Financial Risk Management
Xiaodong Zhu September 9, 2011
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Risk: everywhere, all the time
• Disease • War • Weather changes • Natural disasters • Political instability • …
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Traditional Risk Management: Insurance�
• Sharing, diversifying risk • Informal:
help within family and among neighbors gift giving …
• Formal: insurance policy issued by companies
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Limits to Traditional Insurance �
• Risk sharing within a restricted group
• Only works for low correlation risk
• Relatively small capacity in risk covering Estimated losses of 9/11: 50 billion US$ Capital of US property insurance industry: 100 billion
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Modern Risk Management
• Using financial market to diversify and manage risk
• Capital of US property insurance industry: 100 billion
• Capitalization of NYSE: 4500 billion
• Using financial derivatives as the main tools • Futures, forwards, options, swaps, … • Market value of financial derivatives outstanding:
3800 billion
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Development of Derivatives Market
• Started in the 70s • Driving forces:
• Collapse of fixed exchange rate system • Oil crisis • Inflation induced interest rate risk • Black-Scholes
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Application of Derivatives
Two examples
• Interest rate risk of S&L • Catastrophe risk of property insurance
companies
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Example One
• Saving and Loans:
Asset: long-term loans, fixed interest rate Liability: short-term deposits, floating rate
Risk: rise of short-term rate
• Risk management strategy: interest rate swaps
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Interest Rate Swaps
fixed rate Saving&Loans Investment Bank
floating rate
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Example 2
• Catastrophe risk (earthquakes, hurricanes, floods, terrorism)
• Small probability of happening • Once happened, huge losses • Enormous capital reserves required for Insurance
Co.
• Risk management strategy: Cat Bonds
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CAT BONDS
• 500 million potential losses • 2% probability • Expected loss: 10 million • premium=expected loss+transaction fee=11
million
• Interest rate on treasury 5%
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Cat Bonds(continued)
• Issue 500 million bonds – If no CAT event, interest rate 7% – If CAT event, all liability canceled
• Investing the 500 million in treasury securities – interest income: 25 million – premium: 11 million – interest payment: 35 million – profit: 1 million
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Financial Innovations: Good or Bad?
• Good: help to manage risk more effectively and to intermediate funds to profitable investment projects.
• Bad: help to evade regulation and excess risk taking, which may result in financial crisis