Risk Management

(AF3317)
Instructor: Hong Xiang
Assistant Professor of Finance @ AF

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Course Outline
⚫ Introduction: risk and returns for investors
⚫ Financial institutions and their trading/risks
⚫ Market risk and risk management
⚫ Financial instruments for risk managements
⚫ How traders manage their risks
⚫ Interest rate risks
⚫ Value-at-risk, expected shortfall, and historical
simulation
⚫ Credit risk: default probability and protection
⚫ Regulation
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More About the Course
⚫ Textbook: Risk Management and Financial
Institutions (5th edition) by John Hull
⚫ E-Book available on our library
⚫ Assessment:
⚫ 10% Class Participation (Quiz)
⚫ 40% Group Project (Case Study + Excel Modeling)
⚫ 50% Final Exam (All based on textbook materials)
⚫ Contact me:
⚫ Office hour: M709, 3pm-5pm on Thursday
⚫ Email: [email protected]
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Introduction
Lecture 1

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Return

⚫ Holding period return (total return) from t to t+1:

𝑃𝑡+1 +𝐷𝑡+1 −𝑃𝑡
𝐻𝑃𝑅𝑡+1 = ,
𝑃𝑡
where 𝑃𝑡+1 and 𝑃𝑡+1 are beginning and ending price, 𝐷𝑡+1
is dividend or other cash flows received at the end

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Return
⚫ HPR is the realized return at time t+1
⚫ This is what you actually get from time t to t+1
⚫ Not to be confused with expected returns at time t
⚫ HPR can be decomposed into:
𝑃𝑡+1 − 𝑃𝑡 𝐷𝑡+1
𝐻𝑃𝑅𝑡+1 = +
𝑃𝑡 ถ𝑃𝑡
𝐶a𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑

⚫ Excess return of an asset:

𝑒
𝐻𝑃𝑅𝑡+1 = 𝐻𝑃𝑅𝑡+1 − 𝑅𝑓,𝑡+1 ,
Where 𝑅𝑓,𝑡+1 is the risk-free return 6
Example

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Arithmetic Average

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Geometric Average

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Which Average?
⚫ When you are evaluating the realized returns
(ex-post/historical returns):
⚫ Without re-investment: Use arithmetic average. E.g., if
you invest the same $ at the beginning of every year
⚫ With re-investment: Use geometric average. E.g., if
you put the capital gains and dividend in year t into
the portfolio at the beginning of year t+1

⚫ When estimating an expected return for the next

period:
⚫ Only use arithmetic average: average of one period
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returns
Cumulative Returns
⚫ Cumulative return measures total investment
return over multiple periods:
⚫ 𝐶𝑅𝑡=1:𝑇 = 1 + 𝐻𝑃𝑅1 ∗ 1 + 𝐻𝑃𝑅2 … ∗ 1 + 𝐻𝑃𝑅𝑇 − 1
⚫ Usually we don’t compute it as:

𝐶𝑅𝑡=1:𝑇 = 1 + 𝐻𝑃𝑅1 + 1 + 𝐻𝑃𝑅2 + ⋯ + 1 + 𝐻𝑃𝑅𝑇 − 1

⚫ Example #1: If you invest $100 in a stock. It’s return is

+20% in the 1st year and -20% in the 2nd year:
⚫ 𝐶𝑅𝑡=1:2 = 1 + 20% ∗ 1 − 20% − 1 = −4%

⚫ However, if you simply add returns up, it seems you

didn’t lose anything… 11
Cumulative Returns
⚫ Cumulative returns can be very tricky…
⚫ Example #2: Investment in (Levered) ETF
⚫ S&P500 ETF: 1% up in S&P500 index today → 1%
return in the ETF today
⚫ 3X S&P500 ETF: 1% up in S&P500 index today → 3%
return in the ETF today

⚫ If you hold the 3X S&P500 ETF for multiple days, will you
get 3X the cumulative returns of S&P500 ETF?

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Annualizing Returns
⚫ Returns are defined in a given holding period
⚫ A period can be one day, one month, one year..
⚫ You cannot compare a monthly return with a
daily returns
⚫ To make returns comparable, a common
method is to annualize the returns
⚫ Annual return: returns over one-year period

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14
Annualizing Returns

Annual Percentage Return

Effective Annual Return

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Risk vs Return
⚫ There is a trade off between risk and return
⚫ The higher the risk, the higher the expected return

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Example
⚫ There are two investment choices:
⚫ Treasury yields 5% per year
⚫ An equity investment with following pay-offs:

Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%
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Example
⚫ Next, we characterize the two investments by
the risk-return trade-offs:
⚫ Expected Return: 𝐸 𝑅
⚫ Risk: Standard deviation of return, 𝐸 𝑅2 − [𝐸 𝑅 ]2
⚫ Treasury:
⚫ Expected return = 5%
⚫ SD of return = 0%

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Example
⚫ Stock:
⚫ 𝐸 𝑅 =
⚫ 𝐸 𝑅2 =
⚫ SD of return = 𝐸 𝑅2 − [𝐸 𝑅 ]2
=
Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%
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Example
⚫ Stock:
⚫ 𝐸 𝑅 = 50% × 0.05 + 30% × 0.25 + 10% × 0.4 +
−10% × 0.40 + −30% × 0.05 = 10%
⚫ 𝐸 𝑅2 = 50%2 × 0.05 + 30%2 × 0.25 + 10%2 × 0.4 +
−10% 2 × 0.40 + −30% 2 × 0.05 = 0.046
⚫ SD of return = 𝐸 𝑅2 − [𝐸 𝑅 ]2 Probability Return
0.05 +50%
= 0.046 − 0.12 = 0.1897
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%
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Example
⚫ Treasury:
⚫ Expected Return = 5%; Risk = 0%
⚫ Stock:
⚫ Expected Return = 10%; Risk = 18.97%

⚫ Implication: Higher risk higher expected returns

⚫ What if we combine these two assets and form a

portfolio? (whiteboard example)
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Combining Two Stocks

⚫ Now we have two stocks: 1 = 10%

 2 = 15%
1 = 16%
 2 = 24%
 = 0 .2

⚫ Investing 𝑊1 share of our money on stock 1

and 𝑊2 on stock 2. We have a portfolio:
 P = w11 + w2 2  P = w12 12 + w22  22 + 2w1w2 1 2

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Combining Two Stocks

⚫ Portfolio risk and return with different 𝑊1 / 𝑊2 :

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Combining Two Stocks

⚫ Portfolio risk and return with different 𝑊1 / 𝑊2 :

Stock 2

Stock 1

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Combining Two Stocks

⚫ What do we see from this example?

⚫ Combining stocks (diversification) can improve our portfolio!
⚫ “Don’t put all your eggs into one basket”

⚫ Where does the benefit of diversification come from?

⚫ Two stocks do not always move up/down together. In other
words, they have a correlation coefficient smaller than 1.
⚫ The lower the correlation, the larger the benefit of
diversification. (Let’s see it in an excel example)

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Efficient Frontiers

⚫ In reality, we have thousands of stocks

⚫ Efficient frontier: for any given σ(R), it has the
highest E(R)

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Efficient Frontiers

⚫ Now, let’s add an risk-free asset: treasury

bond

RF

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Efficient Frontier
⚫ We obtain a new efficient frontier: capital
allocation line
Expected
Return
M
E(RM)

Previous Efficient
Frontier
RF F
New Efficient
Frontier
S.D. of Return

M 28
Efficient Frontier
⚫ What do we see here:
⚫ With risk-free and risky assets, the efficient
frontier is a straight line
⚫ All assets should lie on or below the efficient
frontier
⚫ All investors should hold the same portfolio of
risky assets: the “market portfolio”
⚫ Investors choose asset allocation on the capital
allocation line based on their risk appetite
⚫ A missing part: What is the risk-return trade-
off for individual asset?
⚫ We will introduce Capital Asset Pricing Model next 29
Motivating Risk Decomposition

⚫ Why would these two stocks have the same

expected returns?
⚫ Some part of the σ𝑃 is not rewarded with higher
E[𝑅𝑃 ]

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Risk Decomposition

⚫ Our previous example shows the total risk can

be partially reduced through diversification
⚫ Decomposition of total risk:
Total Risk = Systematic Risk + Idiosyncratic Risk
(Not Diversifiable) (Diversifiable)
⚫ Examples of systematic risks:

⚫ Oil-producing countries institute a boycott

⚫ The government votes for a massive tax cut

⚫ The central bank follows a restrictive monetary

policy
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Risk Decomposition

⚫ Our previous example shows the total risk can

be partially reduced through diversification
⚫ Decomposition of total risk:
Total Risk = Systematic Risk + Idiosyncratic Risk
(Not Diversifiable) (Diversifiable)
⚫ Examples of idiosyncratic risks:

⚫ Gold is discovered under a firm’s property

⚫ The plants of a firm is destroyed by a hurricane

⚫ The CEO suddenly pass away

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Risk Decomposition

⚫ Idiosyncratic risks can be diversified away

through investing in dozens of stocks

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Risk Decomposition
⚫ A convenient way is to decompose stock returns
into a part that moves with market, and the other
part that is uncorrelated with market
⚫ β captures the tendency of a stock to co-move with
market
R = a + RM + 

Systematic Risk /
Market risk Iidiosyncratic risk

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Capital Asset Pricing Model (CAPM)
⚫ In general, there is a positive risk-return relation:
𝐸 𝑅𝑖 = 𝑅𝑓 + 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
⚫ In CAPM, the risk premium comes from the
market risk (β):
𝐸 𝑅𝑖 = 𝑅𝑓 + β𝑖 𝐸[𝑅𝑀 − 𝑅𝑓 ],
𝐶𝑜𝑣(𝑅𝑖 ,𝑅𝑀 )
where β𝑖 =
𝑉𝑎𝑟(𝑅𝑀 )
⚫ β𝑖 is could be estimated through either linear
regressions or above formula (excel example)

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Intuition
⚫ Risk premium of an asset: 𝐸 𝑅𝑖 − 𝑅𝑓
⚫ Risk measure: Cov(𝑅𝑖 , 𝑅𝑀 )
𝐸 𝑅𝑖 −𝑅𝑓
⚫ Expected returns per unit of risk: Cov(𝑅𝑖 ,𝑅𝑀 )

⚫ Reward to risk should be the same for all assets:

𝐸 𝑅𝑖 − 𝑅𝑓 𝐸 𝑅𝑗 − 𝑅𝑓
=
Cov(𝑅𝑖 , 𝑅𝑀 ) Cov(𝑅𝑗 , 𝑅𝑀 )
⚫ Let’s substitute asset j by market portfolio:
𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑀 )
𝐸 𝑅𝑖 − 𝑅𝑓 = × 𝐸[𝑅𝑀 − 𝑅𝑓 ]
𝑉𝑎𝑟(𝑅𝑀 )
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Security market line
⚫ Security market line:

Expected
Return
E(R)
E(RM)

E( R) − RF = [ E( RM ) − RF ]
RF

Beta
 37
A Potential Confusion
⚫ What are the difference between security market
line (SML) and capital market line (CML)?
⚫ SML describes risk-return for all assets. CML
describes the asset allocation between market
portfolio and risk-free asset.
⚫ All assets should lie on SML. All assets should lie
within CML.

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A Potential Confusion
⚫ All assets should lie on SML
⚫ Suppose security S has a β of 0.8, but it’s below the SML…

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Alpha
⚫ Alpha measure the extra return on a portfolio in
excess of that predicted by CAPM
E( RP ) = RF + ( RM − RF )
so that
 = RP − RF − ( RM − RF )

⚫ If CAPM model is correct and the market is

efficient, there is no α
⚫ In reality, there are many hedge funds hunting for α
⚫ Warren Buffett: “business risk vs. volatility/beta” 40
Assumptions
⚫ Investors care only about expected return and SD of
return
⚫ The ’s of different investments are independent
⚫ Investors focus on returns over one period
⚫ All investors can borrow or lend at the same risk-free
rate
⚫ Tax does not influence investment decisions
⚫ All investors make the same estimates of ’s, ’s and
’s.

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Quick Questions
⚫ True or false: The most important characteristic in
determining the expected return of a portfolio is the
variances of the individual assets in the portfolio.

⚫ Which industry has a higher β?

⚫ Utility (Power, Water, etc.), Transportation (Railroads)

⚫ If we think of unemployment insurance as an asset, why

should it have negative returns (i.e., we pay for the
insurance)?

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Application of CAPM
⚫ CAPM is commonly used in estimating the cost
of equity capital of firms

Source: Graham and Harvey (2001) 43

Project Evaluation
⚫ Suppose Company ABC is an all-equity firm with a beta
of 1.21. Further suppose the market risk premium is 9.5
percent, and the risk-free rate is 5 percent.
⚫ There are three projects with the same risk as the
company ABC and their cash flows are as follows. Which
projects should be accepted?

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Failure of CAPM
⚫ CAPM is theoretically appealing but often fails to
explain asset returns in data
⚫ A figure from Frazzini and Pedersen (2014). Y-axis is
the CAPM α of each β-sorted portfolios

𝛼
= 𝑅𝑃 − 𝑅𝐹
− 𝛽(𝑅𝑀 − 𝑅𝐹 )

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Failure of CAPM
⚫ A figure from Frazzini and Pedersen (2014). Y-axis is
the CAPM α of each β-sorted portfolios

𝛼
= 𝑅𝑃 − 𝑅𝐹
− 𝛽(𝑅𝑀 − 𝑅𝐹 )

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Failure of CAPM
⚫ A figure from Frazzini and Pedersen (2014). Y-axis is
the CAPM α of each β-sorted portfolios

𝛼
= 𝑅𝑃 − 𝑅𝐹
− 𝛽(𝑅𝑀 − 𝑅𝐹 )

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Failure of CAPM
⚫ A figure from Frazzini and Pedersen (2014). Y-axis is
the CAPM α of each β-sorted portfolios

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Arbitrage Pricing Theory (APT)
⚫ APT is an alternative way to model risk-return
relationship:
⚫ APT can accommodate more systematic risks:
Inflation, Economic Growth (GNP), and interest rate
⚫ The stock return decomposition:

⚫ ത expected return, U: surprises

R: actual return, 𝑅:
⚫ F: surprise in systematic risk factors
⚫ β: the impact of a systematic risk on stock returns 49
Arbitrage Pricing Theory (APT)
⚫ Example:
⚫ 𝑅ത = 4%,
⚫ Expected Inflation, GNP change, Interest rate change
are: 5%, 2%, and 0%
⚫ Actual Inflation, GNP change, and interest rate
changes are: 7%, 1%, and -2%
⚫ β𝐼 = 2，β𝐺𝑁𝑃 = 1， βr = −1.8
⚫ What would be the contribution of systematic
risk to the stock returns?

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Risk vs Return for Companies
⚫ If shareholders care only about systematic risk, should
the same be true of company managers?
⚫ In practice ccompanies are concerned about total risk.
This is partly because managers have large stakes in the
company
⚫ Earnings stability and company survival are important
managerial objectives
⚫ The regulators of financial institutions are primarily
interested in total risk
⚫ “Bankruptcy costs” arguments show that that managers
may be acting in the best interests of shareholders when
they consider total risk 51
Bankruptcy Costs
⚫ In a perfect world, bankruptcy would be a fast affair
where the company’s assets are sold at their fair market
value. Unfortunately, by the time a company reaches the
point of bankruptcy, it is likely that its assets have lost
some value. The bankruptcy process itself invariably
reduces the value of its assets further.
⚫ Lost sales (There is a reluctance to buy from a
bankrupt company.)
⚫ Key employees leave

⚫ Legal and accounting costs

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Credit Ratings
Moody’s S&P and Fitch
Aaa AAA
Aa AA Investment
A A grade bonds
Baa BBB
Ba BB
B B
Non-investment
Caa CCC grade bonds
Ca CC
C C

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