FINANCIAL RISK MANAGEMENT
1
MSc. Thuy Tien Dinh| Faculty of Banking and Finance
Email: tiendt@ftu.edu.vn
COURSE OBJECTIVES
§
This is an undergraduate level course designed to prepare students to be a financial
risk manager in banks, corporations or other institutions.
§
Through chapters, case analyses, and discussions, we will explore issues related to the
uses and the valuation of the main derivative financial instruments: forward, futures,
swaps and options.
§
The issues cover the trading mechanisms used on derivative markets and explain the
fundamental principles underlying the pricing of derivative instruments and their use in
portfolio management.
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LEARNING OUTCOMES
§
Understand the basics of financial risk and financial risk management.
§
Develop an understanding of the concepts, characteristics and pricing of futures and
forwards, options.
§
Explain the mechanics of trading futures, forwards and option contracts.
§
Describe the nature of SWAP contracts, SWAP valuation approaches and how SWAP
is used in interest rate risk and exchange rate risk management.
§
Understand the concept of credit risk, credit risk classification and methods of
identifying default possibility.
3
READING MATERIALS
v
Textbook
§ Hull,
v
J. C. (2017). Options, Futures and other Derivatives. 10th edition. Pearson.
Optional reading
§ CFA
Institute (2019). CFA Program Curriculum 2020 Level 1 Volume 5. Wiley –
Blackwell.
4
COURSE CONTENT
No.
Content
1-2
Introduction to Financial Risk Management
3-5
Futures Markets and Central Counterparties
6-7
Determination of Forward and Futures Prices
8-9
Options and applications
10-12
Options Pricing
13-15
Swaps Contracts, pricing and applications
5
COURSE ASSESSMENT
v
Score ladder: 10
v Type of
assessment
Form
Attendance
Formative
Summative
Midterm exam
Final test
Criteria
The number of attendances
and participation in lesson
MCQ and/or Written exam
(60 minutes)
MCQ /+ Written exam (60
minutes)
Proportion
10%
30%
60%
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CHAPTER 1:
INTRODUCTION TO
FINANCIAL RISK MANAGEMENT
7
CONTENT
§ Define a derivative
§ Distinguish between exchange-traded and over-the-counter derivatives;
§ Examples: futures, forwards, swaps, options, exotics…
8
DERIVATIVES: DEFINITIONS AND USES
v A derivative is a financial instrument whose value depends on (or derives from)
the values of other, more basic, underlying variables.
§ Interest rate, foreign exchange, and equity derivatives.
§ Credit derivatives.
§ Electricity derivatives.
§ Weather derivatives.
§ Insurance derivatives.
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WHY DERIVATIVES ARE IMPORTANT?
v
Derivatives play a key role in transferring risks in the economy
v The underlying
assets include stocks, currencies, interest rates, commodities, debt
instruments, electricity prices, insurance payouts, the weather, etc
v
Many financial transactions have embedded derivatives
v The real options
accepted
approach to assessing capital investment decisions has become widely
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HOW DERIVATIVES ARE TRADED?
v Exchanged-traded markets
§ A derivatives exchange is a market where individuals and companies trade standardized
contracts.
§ The Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and
merchants together.
ü Its main task was to standardize the quantities and qualities of the grains that were traded.
ü Within a few years, the first futures-type contract (to-arrive contract) was developed.
ü Speculators soon became interested in the contract and found trading the contract to be an
attractive alternative to trading the grain itself.
§ Chicago Mercantile Exchange (CME) was established in 1919.
§ CME and CBOT have merged to form the CME Group, which also includes the New York
Mercantile Exchange (NYME).
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HOW DERIVATIVES ARE TRADED?
v Exchanged-traded markets
§ CBOE started trading call option on 16 stocks in 1973 and put option started trading in 1977.
§ Now, trades options on thousands of stocks and many different stock indices.
§ Traditionally open-outcry system
ü Traders physically meeting on the floor of the exchange, shouting, and sing a complicated
set of hand signals to indicate the trades they would like to carry out.
§ Switching to electronic trading
ü Algorithmic trading: use of computer programs to initiate trades, often without human
intervention
ü Reduce the costs
ü Improve trade execution speed
ü Create an environment less prone to manipulation
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HOW DERIVATIVES ARE TRADED?
v Over-the-counter (OTC) markets
§ In terms of total trading volume, has become much larger than the exchange-traded market.
§ A telephone and computer-linked network of dealers.
§ Telephone conversations in the over-the-counter market are usually taped.
§ Banks, other large financial institutions, fund managers, and corporations are the main
participants in OTC derivatives markets
§ Trades are usually between two financial institutions or between a financial institution and
one of its clients (typically a corporate treasurer or fund manager).
§ Financial institutions (large banks) act as market maker (quote bid and ask price).
§ Non-standardized contract
negotiate mutually attractive deal.
§ Credit risk.
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SIZE OF OTC AND EXCHANGE-TRADED MARKETS
800
700
Size of Market
($ trillion)
600
500
400
300
OTC
200
Exchange
100
0
-98
-99
-00
-01
-02
-03
-04
-05
-06
-07
-08
-09
-10
-11
-12
-13
-14
-15
-16
-17
-18
-19
J un J un J un J un J un J un J un J un J un J un J un J un J un J un J un J un J un J un J un J un J un J un
Total principal amounts for OTC and exchange-traded markets
Source: Bank for International Settlements
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HOW DERIVATIVES ARE USED?
v To hedge risks
v To speculate (take a view on the future direction of the market)
v To lock in an arbitrage profit
v To change the nature of a liability
v To change the nature of an investment without incurring the costs of selling one portfolio and
buying another
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FORWARD CONTRACTS
v Spot contract: agreement to buy / sell an asset today.
v Forward contract: agreement to buy/sell an asset at specified time in the future for a certain
price.
v Traded in OTC market.
§ Long position: the party that agrees to buy.
§ Short position: the party that agrees to sell.
v Popular on foreign exchange forward contracts
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FORWARD CONTRACTS
v Forward price: the delivery price that would be applicable to the contract that negotiated
today.
v It is the delivery price that would make the contract worth exactly zero today.
v The forward price may be different for contracts of different maturities.
Table 1.1 Spot and forward quotes for the exchange rate between
USD and GBP on May 21, 2020 (GBP = British pound; USD = U.S. dollar;
quote is number of USD per GBP).
Bid
Ask
Spot
1.2217
1.2220
1-month forward
1.2218
1.2222
3-month forward
1.2220
1.2225
6-month forward
1.2224
1.2230
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FORWARD CONTRACTS
v Example: Long and Short position
On May 21, 2020, the treasurer of a corporation enters into a long forward contract to buy £1
million in six months at an exchange rate of 1.2230 $/£. This obligates the corporation to pay
$1,223,000 for £1 million on November 21, 2020.
The bank has a short forward contract on GBP. On November 21, 2020, it will sell £1 million for
$1.2230 million.
Both sides have made a binding commitment.
What are the possible outcomes at the end of the 6 months?
What if the spot exchange rate rose to 1.3000?
What if the spot exchange rate fell to 1.2000?
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FORWARD CONTRACTS
v Example: Long and Short position
What are the possible outcomes at the end of the 6 months?
§ Payoff from a long forward position = ST – K.
§ Payoff from a short forward position = K – ST.
§ ST: spot price at maturity.
§ K: delivery price.
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FORWARD CONTRACTS
v Profit and Loss of Long and Short Position
ST: spot price at maturity
K: delivery price
Profit
Profit
K
Price of Underlying at
Maturity, ST
Long position
K
Price of Underlying
at Maturity, ST
Short position
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FORWARD CONTRACTS
v An Arbitrage Opportunity?
Example: Suppose that:
The price of a non-dividend-paying stock is $60
The 1-year US$ interest rate is 5% per annum
Is there an arbitrage opportunity if:
a. The 1-year forward price of the stock is $67
b. The 1-year forward price of the stock is $58
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FORWARD CONTRACTS
v An Arbitrage Opportunity? - The Forward Price of a Non-Dividend Paying Stock
If the spot price is S and the forward price for a contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-free rate of interest.
In our examples, S = 60, T = 1, and r = 0.05 so that
F = 60(1+0.05) = 63
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FUTURES CONTRACTS
v Futures contract: agreement to buy or sell an asset at a certain time in future for a certain
price.
v Similar to forward contract, but traded on an exchange.
v Standardized contract.
v Margin requirement.
Example: Agreement to:
§ Buy 100 oz. of gold @ US$1800/oz. in December
§ Sell £62,500 @ 1.2500 US$/£ in March
§ Sell 1,000 bbl. of oil @ US$40/bbl. in April
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FUTURES CONTRACTS
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FUTURES CONTRACTS
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OPTIONS
v An option is a financial security that gives the holder the right to buy or sell a specified
quantity of a specified asset at a specified price on or before a specified date.
v The price in the contract is known as the exercise price or strike price.
v An American option can be exercised at any time during its life.
v A European option can be exercised only at maturity.
v Traded on both OTC and exchange markets.
v Most of the options that are traded on exchanges are American.
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OPTIONS
v A call option is an option to buy a certain asset by a certain date for a certain price (the strike
price)
v A put option is an option to sell a certain asset by a certain date for a certain price (the strike
price)
v Buyer / holder / long position: has the right.
§ Pay premiums.
§ Buy a call = long a call.
v Seller / writer / short position: has the obligation.
§ Receive premiums.
§ Sell a call = write a call = short a call.
Ø Long call: right to buy.
Ø Short call: obligation to sell.
Ø Long put: right to sell.
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Ø Short put: obligation to buy
OPTIONS
v Apple Call Option Prices from CBOE (May 21, 2020); Stock Price is bid 316.23, ask 316.50
Strike
Price
Jun 2020 Jun 2020 Sep 2020
Bid
Ask
Bid
Sep 2020
Ask
Dec 2020
Bid
Dec 2020
Ask
290
29.80
30.85
39.35
40.40
46.20
47.60
300
21.55
22.40
32.50
33.90
40.00
41.15
310
14.35
15.30
26.35
27.25
34.25
35.65
320
8.65
9.00
20.45
21.70
28.65
29.75
330
4.20
15.85
16.25
23.90
24.75
340
1.90
11.35
12.00
19.50
20.30
5.00
2.12
Ø The price of call option decreases as strike price increases and become more valuable as
their time to maturity increases.
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OPTIONS
Example: On June 18, 2020, a trader decided to buy 100 call options on Apple stock with strike
price = $340, expiring in December.
a. What if the price of Apple stock is $300 by December 18, 2020?
b. What if the price of Apple stock is $400 by December 18, 2020?
Strike
Price
Jun 2020 Jun 2020
Bid
Ask
Sep 2020
Bid
Sep 2020
Ask
Dec 2020
Bid
Dec 2020
Ask
290
29.80
30.85
39.35
40.40
46.20
47.60
300
21.55
22.40
32.50
33.90
40.00
41.15
310
14.35
15.30
26.35
27.25
34.25
35.65
320
8.65
9.00
20.45
21.70
28.65
29.75
330
4.20
15.85
16.25
23.90
24.75
340
1.90
11.35
12.00
19.50
20.30
5.00
2.12
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OPTIONS
v Apple Put Option Prices from CBOE (May 21, 2020); Stock Price is bid 316.23, ask 316.50
Strike
Price
Jun 2020 Jun 2020 Sep 2020
Bid
Ask
Bid
Sep 2020
Ask
Dec 2020
Bid
Dec 2020
Ask
290
3.00
3.30
12.70
13.65
20.05
21.30
300
4.80
5.20
15.85
16.85
23.60
24.90
310
7.15
7.85
19.75
20.50
28.00
28.95
320
11.25
12.05
24.05
24.80
32.45
33.35
330
17.10
17.85
28.75
29.85
37.45
38.40
340
24.40
25.45
34.45
35.65
42.95
44.05
Ø The price of put option increases as strike price increases and become more valuable as
their time to maturity increases.
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OPTIONS
Example: On September 18, 2020, a trader decided to sell 100 put options on Apple stock with
strike price = $290, expiring in December.
a. What if the price of Apple stock is $300 by December 18, 2020?
b. What if the price of Apple stock is $250 by December 18, 2020?
Strike
Price
Jun 2020
Bid
Jun 2020
Ask
Sep 2020
Bid
Sep 2020
Ask
Dec 2020
Bid
Dec 2020
Ask
290
3.00
3.30
12.70
13.65
20.05
21.30
300
4.80
5.20
15.85
16.85
23.60
24.90
310
7.15
7.85
19.75
20.50
28.00
28.95
320
11.25
12.05
24.05
24.80
32.45
33.35
330
17.10
17.85
28.75
29.85
37.45
38.40
340
24.40
25.45
34.45
35.65
42.95
44.05
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PRACTICE QUESTIONS
1. An investor enters into a short forward contract to sell 100,000 British pounds for U.S. dollars at an
exchange rate of 1.3000 USD per pound. How much does the investor gain or lose if the exchange rate at
the end of the contract is (a) 1.2900 and (b) 1.3200?
2. A trader enters into a short cotton futures contract when the futures price is 50 cents per pound. The
contract is for the delivery of 50,000 pounds. How much does the trader gain or lose if the cotton price at
the end of the contract is (a) 48.20 cents per pound and (b) 51.30 cents per pound?
= short a put contract (a right to sell)= bán quyền bán, thì mình là short put (obligation to buy)
3. Suppose that you write a put contract with a strike price of $40 and an expiration date in 3 months. The
current stock price is $41 and the contract is on 100 shares. How much could you gain or lose if (a) The
price is $30 and (b) The price is $20.
4. A trader enters into a short forward contract on 100 million yen. The forward exchange rate is $0.0090
per yen. How much does the trader gain or lose if the exchange rate at the end of the contract is (a)
$0.0084 per yen and (b) $0.0101 per yen?
5. The price of gold is currently $1,200 per ounce. The forward price for delivery in 1 year is $1,300 per
ounce. An arbitrageur can borrow money at 3% per annum. What should the arbitrageur do? Assume that
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the cost of storing gold is zero and that gold provides no income.