Financial Risk Management
Responsibilities of Senior Management
•  Senior management is ultimately responsible
for all organizational activities
•  For risk management, here is a summary:
–  Establish written policies
–  Define roles and responsibilities
–  Identify acceptable strategies
–  Ensure that personnel are qualified
–  Ensure that control systems are in place
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Financial Risk Management
•  This aspect of risk management focuses
on exposures due to:
–  Fluctuating commodity prices
–  Fluctuating interest rates
•  These might be dealt with by using
–  Futures contracts
–  Swaps
–  Options
Should Public Firms Hedge?
•  The theoretical answer is no, because
investors
–  Can diversify the risk
–  Or hedge on their own
•  Why hedge, then?
–  Cost of being informed
–  Transactions costs
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Should a financial institution or
institutional investor hedge?
Theoretically, the answer is no
But, the “real world” answer may be yes:
•  it may be costly for clients to hedge on their own
•  clients may not have access to knowledge about the institution’s
natural position
•  hedging is like buying insurance
–  it allows managers to turn their attention from risks beyond their
control
–  concentrate on value-drivers they can influence
•  the marketplace has an advantage in forecasting, so managers
don’t need to try predicting the future
Market Timing for Bonds
•  The basic idea of market timing is to get into the
market before it rises and get out before it falls
–  Translation:
•  Long duration in advance of falling interest rates
•  Short duration in advance of rising interest rates
•  Extreme market timing
–  Very long duration in advance of falling interest rates
–  Very long negative duration in advance of rising interest rates
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Basic Bond Market Timing
•  So, if you hold a portfolio of bonds worth
$1,000,000 (duration 15 years) and you think
you can predict ups and downs of interest rates,
do the following:
–  When you think the rate is about to fall, hold the
portfolio without any position in the index futures,
so duration is 15 years
–  When you think the rate is about to rise, continue to
hold the portfolio while selling $1,000,000 worth of
the bond futures, so duration is near 0
Immunization
•  Immunization might be appropriate for a bank
with the following
–  Asset portfolio has average duration of 10 years
–  Liability portfolio has average duration of 1 year
•  Immunization would use the same techniques
as market timing strategies in order to
–  Shorten the duration of the asset portfolio
–  Adjust the duration of the liability portfolio so they
are both nearly the same
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Should a financial institution or
institutional investor hedge?
Theoretically, the answer is no
But, the “real world” answer may be yes:
•  it may be costly for clients to hedge on their own
•  clients may not have access to knowledge about the institution’s
natural position
•  hedging is like buying insurance
–  it allows managers to turn their attention from risks beyond their
control
–  concentrate on value-drivers they can influence
•  the marketplace has an advantage in forecasting, so managers
don’t need to try predicting the future
Practical problems with
hedging
Marking to market
•  Suppose you are naturally long in wheat, and hedge by
shorting futures
Futures
Spot
Uncertain Future
Place Hedge
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Practical problems with
hedging
Marking to market
•  Then prices rise, bringing a series of margin calls that
leave you scrambling to hold the hedge
Scramble to Hold Hedge
Futures
Uncertain Future
Spot
Place Hedge
Practical problems with
hedging
Marking to market
•  Then prices fall, bringing profits from the futures side
of the hedge to offset the losses in your “natural”
position
Scramble to Hold Hedge
Futures
Spot
Uncertain Future
Place Hedge
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Practical problems with
hedging
Marking to market
•  But prices turn up again, and finally you can’t meet the
margin calls
Scramble to Hold Hedge
Forced Out of Hedge
Futures
Uncertain Future
Spot
Place Hedge
Practical problems with
hedging
Marking to market
•  Then, prices fall again, and without the hedge you sell
the inventory at a loss
Scramble to Hold Hedge
Futures
Spot
Place Hedge
Forced Out of Hedge
Uncertain Future
Sell Inventory
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Practical problems with
hedging
•  But prices continue rising to a level that would have
given you a profit, before falling again.
•  You are unhappy, and blame your misfortune on poor
timing.
Futures
Scramble to Hold Hedge
Forced Out of Hedge
Spot
Place Hedge
Sell Inventory
Practical problems with
hedging
Marking to market
•  With insufficient liquidity
–  you may be forced out of the hedge early
–  and may even lose twice: once on the futures, again
on the spot
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Practical problems with
hedging
Taxes
•  Problem: outcomes from futures trading may
be taxed differently than outcomes from
“natural” position
–  Can’t predict which side of hedge will gain
and which side will lose
–  So, hedge doesn’t balance after tax
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