WHAT IS RISK?

• Definition: • Why Take Risk?

Risk is the probability of an outcome • To generate higher returns a business may
having a negative effect on people, have to take more risks in order to be
systems or assets. Risk is typically competitive.
depicted as being a function of the • Not accepting risk may imply ‘follow the
combined effects of hazards, the assets or leader’ strategy.
people exposed to hazard and the
• Benefits can be financial or intangible.
vulnerability of those exposed elements.
• In both cases above will lead to
competitive advantage.
MANAGEMENTS RESPONSIBILITY WITH REGARD TO
RISK

• The chief responsibility of risk manager can be listed as follows

1. Defining risk
2. Monitoring Risk
3. Controlling Risk
4. Explaining or communicating risk
 RISK MANAGEMENT
PROCESS

This is also called as

risk management
techniques
 Cost and Benefits associated with investing in
information systems
• Technique of cost benefit analysis
1. Selecting an analyst
2. Identifying alternatives
3. Measuring costs and benefits
4. Comparing cost and benefits
5. Analysing all alternatives and select
 Risk quantification is a process of evaluating the risks that
have been identified and developing the data that will be
needed for making decisions as to what should be done
about them
 The objective of risk quantification is to prioritize them in
terms of their severity and likelihood, so that appropriate
action can be taken accordingly. In order to quantify risk, it
needs to be identified first. Once risk is identified then it is
analyzed in terms of probability of occurrence and impact
that it could print on the outcome.
Benefits of quantitative risk analysis

• Objective assessment: Because a quantitative assessment involves

assigning numerical values to each risk, it returns objective results.
• Detailed information: A quantitative assessment breaks down a project
by the expected cost of each potential risk. This allows you to focus
reduction efforts on the risks deemed "most likely" or "most costly."
• Client confidence: When presenting a project assessment to a potential
client, the specificity of a quantitative assessment may provide more
confidence because there is little room for misinterpretation.
• Improved decision making: By creating risk assessments with objective
measures, you and others involved in decision making have an
accurate assessment of potential risks. This can help you make the best
decision for the company.
Quantitative risk analysis methods

•Expected monetary value (EMV) risk analysis:

This is the most simple form of quantitative risk analysis. In an EMV analysis,
all you need is an expected cost of a risk you face and the probability of that risk occurring.
You often set these values through a combination of analyzing data, consulting with experts and
estimating from experience. By multiplying the cost of each risk by its probability
and adding up all the resulting numbers, you generate an overall projected
risk amount for the project.
Decision tree risk analysis:
A decision tree allows you to assess the risk of one
or more choices. Each tree represents a choice as
well as any costs associated with it. Assign
probabilities and costs at each point. By following
a chain and adding all the costs along it, you
identify which choice paths offer the lowest risk.
Monte Carlo risk analysis:
A Monte Carlo analysis creates a range of potential
outcomes and is best used around risks related to project
duration or yield. In a Monte Carlo analysis , you often
assign the highest probability to the expected outcome. As
outcomes get further from this expectation, assign lower
probabilities. Estimate costs for each outcome and
combine with the probabilities for each to find the total
expected cost.
Sensitivity risk analysis:

Sensitivity assessment allows you to examine uncertainty within

a risk analysis and determine which elements are most
responsible for uncertainty. For example, in a project with two
key components, if the more expensive component is stable
and the less expensive is highly variable, the latter would be
responsible for more uncertainty, even though it is a smaller
fraction of the overall cost. Identifying sensitive components
may allow you to identify methods of reducing uncertainty and
make estimates more exact.
Three point risk analysis:

Three point analysis is a method of determining the

expected cost of a risk on a project. To calculate a three
point assessment, determine the most likely cost of a risk,
your most optimistic cost of a risk and most pessimistic cost of
a risk. For a basic triangular three point risk analysis, add all
three numbers then divide by three. A more common
approach to three point analysis is the beta distribution.
Multiply the most likely value by four, then add the optimistic
and pessimistic values and divide the total by six.
Steps in the quantitative risk
analysis process

1. Identify areas for uncertainty

2. Assess the costs of each risk
3. Determine the probability of each risk occurring
4. Calculate the expected cost of each potential
risk
Example 1

• An investor is considering buying stocks which offer annual returns

of 3%. Assuming that a beta factor of 1.1 is associated with this
particular stock, one can calculate the expected dividend earnings
by considering the risk-free premium as 3% and investor
expectation of market appreciation by 7% annually.
Answer of example 1

• Using the CAPM Formula

Cost of Equity (Ke) = Rf + β (Rm – Rf)
Ke = 0.03+ 1.1(0.07-0.03)
Ke = 0.03+ 1.1(0.04)
Ke= 0.074 or 7.4%
Example 2

• the investor is all set to buy stocks worth Rs. 455. Annual returns
from such an investment are expected to be around 5%. Beta
factor, in this case, is 0.8. Risk-free rate is 5%. This investor
expects the market to increase in value by 8% within this next
year.
Answer of Example 2

• Using the CAPM Formula

Cost of Equity (Ke) = Rf + β (Rm – Rf)
Ke = 0.05+ 0.8(0.08-0.05)
Ke = 0.05+ 0.8(0.03)
Ke= 0.074 or 7.4%
Example 3

•Risk-Free Rate (rf) = 3.0%

•Beta (β) = 0.8
•Expected Market Return (rm) = 10.0%
•Tax rate 30%
•Bank lending rate 8%
Calculate cost of Equity using CAPM
Answer of Example 3

• Using the CAPM Formula

Cost of Equity (Ke) = Rf + β (Rm – Rf)
Ke = 0.03+ 0.8(0.10-0.03)
Ke = 0.05+ 0.8(0.07)
Ke= 0.086 or 8.6%
Example 4

Base Scenario Upside Scenario Downside Scenario

Risk-Free Rate (rf) = 2.5% Risk-Free Rate (rf) = 2.0% Risk-Free Rate (rf) = 3.0%
Beta (β) = 1.00 Beta (β) = 1.20 Beta (β) = 0.80
Expected Market Return = 6.0% Expected Market Return = 7.0% Expected Market Return = 5.0%
 Pros And Cons of Decision Tree Analysis

Pros Cons
 Has the possibility of becoming complex
• Offer a clear and reliable if you stuff in too many decisions or
ideas.
method for you to choose the
best possible option.
 If the data keeps changing, the whole
• Clear representations make tree system might become unstable.
your work easier and more
efficient.  If you don’t perform a thorough analysis
of the potential outcomes, the result
• The method is adaptable and might be risky.
can easily accommodate new
ideas or outcomes if needed.
Sectors Where Decision Tree Can Be
Used
Decision tree analysis can assist decision-making in
several areas, including budget planning,
operations management, project management,
and expansion decisions of the company. It is a
cost-effective, efficient, and transparent method
that can help you make the most profitable
decision wherever there is a possibility of several
similar options to a particular project.
Decision Models to deal with
uncertainty in decision making
Decision-making is a crucial task in day-to-day life. Decision-makers should be
able to make decisions under conditions of risk and uncertainty. It means that
decision-makers should analyse and assess several options regarding their
probable outcomes and likelihood. As you can see, decision-making can be
classified into two categories based on the surrounding environment. The first
category of decisions is those made under uncertainty, i.e., situations involving a
lot of uncertainty. More simply, it involves situations where the results are not
known in advance. The other category of decisions involves decisions that are
made under risk, i.e., the decision taken has some risk associated with it. Risk-
based decisions are made in circumstances when it is known or possible to
assess the likelihood of each possible result. In these situations, decision-makers
might examine the potential outcomes using statistical approaches to determine
the optimal course of action.
How to Make Decisions Under
Uncertainty?

 Decision-making under uncertainty involves situations

where the outcome of a decision is unknown. Decision-
makers must consider multiple possible outcomes and
their probabilities in such cases. There are several
techniques that decision-makers can use to make
decisions under uncertainty, including the Laplace
criterion, Maximin, Maximax, Hurwicz, and Minimax
regret.
Maximin

 The Maximin criterion is a decision-making technique

that can be used to make decisions under uncertainty
using AI. When faced with a situation where the
probability of each outcome is unknown or cannot be
estimated, decision-makers can employ this technique
to select the best course of action. The Maximin
criterion assumes that the worst possible outcome of a
decision is the most important consideration. It means
that decision-makers must consider the most negative
result of each decision.
Let's say you are playing a game with a friend and
have to choose between two options: Option A gives
you a guaranteed win of Rs. 5/-, while Option B
provides a 50-50 chance of winning either Rs.10/- or
Rs.0/-. If you use the Maximin strategy, you will choose
Option A because it gives you the highest minimum
payoff (i.e., Rs. 5/-) compared to Option B, which has
a minimum payoff of Rs. 0/- if you lose the coin toss.
Maximax

 The Maximax criterion is a decision-making technique

that can be used to make decisions under uncertainty
using AI. When faced with a situation where the
probability of each outcome is unknown or cannot be
estimated, decision-makers can employ this technique
to select the best course of action. The Maximax
criterion assumes that the best possible outcome of a
decision is the most important consideration. The
decision with the highest outcome is selected as the
output.
Suppose you are a product lead manager considering
launching a new product. You have estimated the potential
profits for the new product under three different scenarios:
low demand, moderate demand, and high demand. The
estimated profits for each scenario are as follows: Low
demand will give Rs. 10,000/- profit, moderate demand
would provide Rs. 50,000/- profit, and a high demand would
give Rs. 1,00,000/- profit. Using the Maximax strategy, you
would choose the option that maximizes the potential profit
in the best-case scenario. The best-case scenario is high
demand, potentially generating Rs. 1,00,000/- profit.
Therefore, you should launch the new product because it
has the highest potential profit in the best-case scenario.
Minimax Regret

 The Minimax regret technique involves choosing the

decision that minimizes the maximum regret. Regret is
the difference between the best outcome and the
outcome of the chosen decision. This technique aims to
minimize the regret of making a suboptimal decision.
Illustration 1.

Mr. X runs a kitchen that provides food for various canteens throughout a large
organisation. A particular salad is sold to the canteen for $10 and costs $8 to prepare.
Therefore, the contribution per salad is $2.

Based upon past demands, it is expected that, during the 250 day working year, the
canteens will require the following daily quantities:

On 25 days of the year, 40 salads.

On 50 days of the year, 50 salads.
On 100 days of the year, 60 salads.
On 75 days 70 salads.

The kitchen must prepare the salads in batches of 10 meals in advance. The manager has
asked you to help decide how many salads the kitchen should supply for each day of the
forthcoming year.
Constructing a payoff table:

If 40 salads will be required on 25 days of a 250 day year, then the

probability that demand = 40 salads is

P(Demand of 40) = 25 days ÷ 250 days = 0.10

Likewise,
•P(Demand of 50) = 0 .20;
•P(Demand of 60) = 0.40 and
•P(Demand of 70) = 0.30
Now let's look at the different values of profit or losses depending on how
many salads are supplied and sold.
For example, if we supply 40 salads and all are sold, our profits amount to 40 x
$2 = 80.
If however we supply 50 salads but only 40 are sold, our profits will amount to
40 × $2 - (10 unsold salads × $8 unit cost) = 80 - 80 = 0.
SIMILARLY, WE CAN NOW CONSTRUCT A PAYOFF TABLE AS FOLLOWS:

Daily supply

Probability 40 salads 50 salads 60 salads 70 salads

40 salads 0.10 $80 $0 $(80) $(160)

Daily
50 salads 0.20 $80 $100 $20 $(60)
Demand
60 salads 0.40 $80 $100 $120 $40

70 salads 0.30 $80 $100 $120 $140

 DECISION RULES

To decide how many salads should be made very day, Mr. X will first have to define his attitude to risk,
and use one of the following rules to make up his mind :

•The maximax rule for an optimist - i.e. someone who wants the best possible upside potential without
being very concerned about possible losses or downside.

•The maximin rule for a pessimist looking to minimise his losses - i.e. someone who wants to minimise
the potential downside exposure.

•The minimax regret rule is for someone who doesn't like making the wrong decision. This approach
seeks to minimise such "regret".
•Alternatively, expected values of profits could be used to make a decision. These are averages and
essentially ignore the spread or risk of outcomes. Risk must thus be brought back into the decision
making process another way.
Equity price risk
Equity price risk is the risk that arises from security price volatility – the risk of a decline in
the value of a security or a portfolio. Equity price risk can be either systematic or
unsystematic risk. Unsystematic risk can be mitigated through diversification, whereas
systematic cannot be.

For example, you buy 500 ABC stocks for $20 per stock with the aim of selling the shares
at a higher price. But then, the unexpected resignation of the CEO causes the share
price to drop to $14. If you sell the shares then, you will make a $3000 loss. That is the
equity price risk you must carry.
Commodity Price Risk

Commodity price risk is the financial risk on an entity's financial performance/ profitability upon
fluctuations in the prices of commodities that are out of the control of the entity since they are
primarily driven by external market forces.

Commodities include agricultural products such as wheat and cattle, energy products such as
oil and natural gas, and metals such as gold, silver and aluminum. There are also “soft”
commodities, or those that cannot be stored for long periods of time, which include sugar,
cotton, cocoa and coffee.
Foreign Exchange Risk
Foreign exchange risk is the chance that a company will lose money on
international trade because of currency fluctuations. Also known as currency risk, FX
risk and exchange rate risk, it describes the possibility that an investment’s value
may decrease due to changes in the relative value of the involved currencies. It
affects investors and any business involved in international trade.

The risk occurs when a contract between two parties specifies exact prices for
goods or services as well as delivery dates. If a currency’s value fluctuates between
the date the contract is signed and the delivery date, a loss for one of the parties
could result.
 Types of foreign exchange risk
Transaction Risk

Occurs when a company buys products from a supplier in another country, and price is
provided in the supplier’s currency. If the supplier’s currency appreciates vs. the buyer’s
currency, the buyer will have to pay more in its base currency to meet the contracted price.

The risk of transaction exposure typically impacts one side of a transaction: the business that
completes the transaction in a foreign currency. The company receiving or paying a bill using
its home currency is not subjected to the same risk.

Translation Risk
Refers to how a foreign exchange transaction will impact financial reporting; i.e., the risk that a
company’s equities, assets, liabilities or income will change in value as a result of exchange rate
changes.

This risk occurs because subsidiaries of a parent company in another country denominate their
currency in the countries where they are located. The parent company faces potential losses
when it must translate the subsidiaries’ financial statements into its own country’s currency.
Economic Risk
Also known as operating exposure, this refers to the impact on a company’s market value
from exposure to unexpected currency fluctuations. This can affect a company’s future
cash flows, foreign investments and earnings.

Economic exposure can have a substantial impact on a company’s market value:

•Exposure is greater for multinational companies with many overseas subsidiaries and a large
number of transactions involving foreign currencies.

•Globalization has increased economic exposure for all companies.

•Effects are far-reaching and long-term in nature.

•Economic exposure is difficult to measure precisely.

Causes of Foreign Exchange Risk
Foreign exchange risk is caused by fluctuations in international currencies. There are several
causes of these fluctuations

•Macroeconomic factors such as significant swings in exchange rates

•Government policies
• Can result in a dip or hike in market movement
• Changes in inflation, interest rates, import-export duties and taxes impact the exchange
rate
•Sovereign risk: that a government is unable to repay its debt and defaults on its payments
• Can have a direct impact on investment rates as repercussions can trigger other business-
related troubles.
• Includes political unrest and even a change in government policies, which can impact
the exchange rate and, in turn, affect business transactions.
•Collapse of a foreign government
•Credit risk: that the counterparty will default in making the obligations it owes
• Out of a seller’s control as it depends on another party’s commitment to pay its debts
• Counterparty’s business activities must be monitored so business transactions are closed
at the right time without risk of default
What is interest rate risk?

All investments come with a certain amount of risk, but fixed-income securities such as
government and corporate bonds are generally less volatile than stocks. And although they may
carry less risk than stocks, bonds are still subject to losses in value. For example, when interest
rates rise above the rate locked in at the time of purchase, the bond's price falls. This is known as
interest rate risk.

The recent collapse of Silicon Valley Bank offers a real-world example of interest rate risk. When
interest rates were low, the bank moved tens of billions of dollars into long-term bonds. But when
the Federal Reserve raised rates over the course of 2022, newly issued bonds had higher yields
than the bonds SVB was holding, causing the value of SVB's bonds to plummet.

This was a clear reminder that while Treasury securities are often billed as "risk free," that's only the
case when they're held to maturity.
Value at Risk (VaR)

 Value at risk (VaR) is a statistic that quantifies the extent of possible

financial losses within a firm, portfolio, or position over a specific time
frame. This metric is most commonly used by investment and
commercial banks to determine the extent and probabilities of
potential losses in their institutional portfolios.

 Risk managers use VaR to measure and control the level of risk
exposure. One can apply VaR calculations to specific positions or
whole portfolios or use them to measure firm-wide risk exposure.
Understanding Value at Risk (VaR)

 VaR modeling determines the potential for loss in the entity being
assessed and the probability that the defined loss will occur. One
measures VaR by assessing the amount of potential loss, the
probability of occurrence for the amount of loss, and the time
frame.

 For example, a financial firm may determine an asset has a 3% one-

month VaR of 2%, representing a 3% chance of the asset declining
in value by 2% during the one-month time frame. The conversion of
the 3% chance of occurrence to a daily ratio places the odds of a
2% loss at one day per month.
Using a firm-wide VaR assessment allows for the determination of the cumulative
risks from aggregated positions held by different trading desks and departments
within the institution.

Using the data provided by VaR modeling, financial institutions can determine
whether they have sufficient capital reserves in place to cover losses or whether
higher-than-acceptable risks require them to reduce concentrated holdings.
VaR Methodologies

There are three main ways of computing VaR: the historical method, the
variance-covariance method, and the Monte Carlo method.

Historical Method

The historical method looks at one’s prior returns history and orders them from
worst losses to greatest gains—following from the premise that past returns
experience will inform future outcomes.
 Variance-Covariance Method

Rather than assuming that the past will inform the future, the variance-covariance
method, also called the parametric method, instead assumes that gains and losses are
normally distributed. This way, potential losses can be framed in terms of standard
deviation events from the mean.

The variance-covariance method works best for risk measurement in which the
distributions are known and reliably estimated. It is less reliable if the sample size is very
small.

Monte Carlo Method

A third approach to VaR is to conduct a Monte Carlo simulation. This technique uses
computational models to simulate projected returns over hundreds or thousands of possible
iterations. Then, it takes the chances that a loss will occur—say, 5% of the time—and reveals the
impact.

The Monte Carlo method can be used with a wide range of risk measurement problems and relies
upon the assumption that the probability distribution for risk factors is known.
Advantages of Value at Risk (VaR)

There are several advantages to using VaR in risk measurement:

1.It is a single number, expressed as a percentage or in price units, and is easily

interpreted and widely used by financial industry professionals.

2.VaR computations can be compared across different types of assets—shares,

bonds, derivatives, currencies, and more—or portfolios.

3.Thanks to its popularity, VaR is often included and calculated for you in various
financial software tools, such as a Bloomberg terminal.
Disadvantages of Value at Risk (VaR)

One problem is that there is no standard protocol for the statistics used to determine
asset, portfolio, or firm-wide risk. Statistics pulled arbitrarily from a period of low volatility,
for example, may understate the potential for risk events to occur and the magnitude of
those events. Risk may be further understated using normal distribution probabilities,
which rarely account for extreme or black swan events.

Another disadvantage is that the assessment of potential loss represents the lowest
amount of risk in a range of outcomes. For example, a VaR determination of 95% with
20% asset risk represents an expectation of losing at least 20% one of every 20 days on
average. In this calculation, a loss of 50% still validates the risk assessment.

The financial crisis of 2008 that exposed these problems as relatively benign VaR
calculations understated the potential occurrence of risk events posed by portfolios of
subprime mortgages. Risk magnitude was also underestimated, which resulted in extreme
leverage ratios within subprime portfolios. As a result, the underestimations of occurrence
and risk magnitude left institutions unable to cover billions of dollars in losses as subprime
mortgage values collapsed.1
CREDIT RISK

• Credit risk refers to the probability of loss due to a borrower’s failure to make payments
on any type of debt. Credit risk management is the practice of mitigating losses by
assessing borrowers’ credit risk – including payment behavior and affordability. This
process has been a longstanding challenge for financial institutions.
Continued global economic crises, ongoing digitalization, recent developments in technology and the
increased use of artificial intelligence in banking have kept credit risk management in the spotlight. As a
result, regulators continue to demand transparency and other improved capabilities in this space. They
want to know that banks have a thorough knowledge of customers and their associated credit risk. And
as Basel regulations evolve, banks will face an even bigger regulatory burden.

To comply with ever-changing regulatory requirements and to better manage risk, many banks are
overhauling their approaches to credit risk. But banks who view this as strictly a compliance exercise are
being short-sighted. Better credit risk management presents an opportunity to improve overall
performance and secure a competitive advantage.
 Challenges to successful credit risk management

•Inefficient data management. An inability to access the right data when it’s needed causes
problematic delays.
•No groupwide risk modeling framework. Without it, banks can’t generate complex,
meaningful risk measures and get a big picture of groupwide risk.
•Constant rework. Analysts can’t change model parameters easily, which results in too much
duplication of effort and negatively affects a bank’s efficiency ratio.
•Insufficient risk tools. Without a robust risk solution, banks can’t identify portfolio
concentrations or re-grade portfolios often enough to effectively manage risk.
•Cumbersome reporting. Manual, spreadsheet-based reporting processes overburden
analysts and IT.
Types of Credit Risk

#1 – Default Risk
It is a scenario where the borrower is either unable to repay the amount in full or is already 90 days past the due date of
the debt repayment. Default risk influences almost all credit transactions—securities, bonds, loans, and derivatives. Due to
uncertainty, prospective borrowers undergo thorough background checks.

#2 – Concentration Risk
When a financial institution relies heavily on a particular industry, it is exposed to the risk associated with that industry. If
the particular industry suffers an economic setback, the financial institution incurs massive losses.

#3 – Country Risk
Country risk denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of
economic slowdown or political unrest. Even a small rumor or revelation can make a country less attractive to investors.
The sovereign risk mainly depends on a country’s macroeconomic performance.
#4 – Downgrade Risk
It is the loss caused by falling credit ratings. Looking at the credit ratings, market
analysts assume operational inefficiency and a lower scope for growth. It is a vicious
cycle; the speculation makes it even harder for the borrower to repay.
#5 – Institutional Risk
Borrowers may fail to comply with regulations. In addition to the borrower,
contractual negligence can be caused by intermediaries between the lenders and
borrowers
Calculation and Formula
To gauge creditworthiness, lenders use a system called “The 5Cs of Credit Risk.”

1.Credit history: Lenders look into borrowers’ credit scores and check their backgrounds.

2.Capacity to repay: To ascertain borrowers’ repayment ability, lenders rely on the debt-to-
income ratio. It indicates efficiency in paying off debts from earnings.

3.Capital: Lenders determine every borrower’s net worth. It is computed by subtracting overall
liabilities from total assets.

4.Conditions of loan: It is important to determine if the terms and conditions suit a particular
borrower.
5.Collateral: Lenders assess the value of collateral submitted by borrowers. Collateralization
mitigates lenders’ risk.
What is settlement risk?

 Settlement risk is the possibility that one or more parties will fail to
deliver on the terms of a contract at the agreed-upon time.
Settlement risk is a type of counterparty risk associated with default
risk, as well as with timing differences between parties. Settlement
risk is also called delivery risk or Herstatt risk.
Key Takeaways
•Settlement risk is the possibility that one or more parties will fail
to deliver on the terms of a contract at the agreed-upon time.

•Settlement risk is usually nearly nonexistent in securities

markets.

•The two main types of settlement risk are default risk and
settlement timing risks.

•Settlement risk is sometimes called "Herstatt risk," named after

the well-known failure of the German bank Herstatt.
Types of Settlement Risk
The two main types of settlement risk are default risk and settlement timing risks.

Default Risk
Default risk is the possibility that one of the parties fails to deliver on a contract
entirely. This situation is similar to what happens when an online seller fails to send
the goods after receiving the money. Default is the worst possible outcome, so it
is really only a risk in financial markets when firms go bankrupt. Even then, U.S.
investors still have Securities Investor Protection Corporation (SIPC) insurance.

Settlement Timing Risks

Settlement timing risks include potential situations where securities are
exchanged as agreed, but not in the agreed-upon time frame. Settlement
timing risks are generally far less serious than default risk, as transactions still take
place. These risks are the securities market equivalent of everyday situations
where a pizza or a package from Amazon shows up late. However, the speed
and liquidity of financial markets make the consequences much more severe.
What Is a Credit Derivative?

A credit derivative is a financial contract that allows parties to

minimize their exposure to credit risk. Credit derivatives consist of a
privately held, negotiable bilateral contract traded over-the-counter
(OTC) between two parties in a creditor/debtor relationship. These
allow the creditor to effectively transfer some or all of the risk of a
debtor defaulting to a third party. This third party accepts the risk in
return for payment, known as the premium.
Understanding a Credit Derivative

As their name implies, derivatives stem from other financial instruments. These products are
securities whose price depends on the value of an underlying asset, such as a stock's share price
or a bond's coupon. In the case of a credit derivative, the price derives from the credit risk of
one or more of the underlying assets.

A long put is a right (though not an obligation) to sell an asset at a set price, known as the strike
price, while a long call is a right (though not an obligation) to buy the underlying asset at a set
price. Investors use long puts and calls to hedge or provide insurance against an asset moving in
an adverse price direction. The flip side of these types of trades is short puts and calls, whereby
the person entering into a short position has the obligation to purchase the asset, in the case of
the put, or sell the asset, in the case of a call.
In essence, all derivative products are insurance products, especially credit
derivatives. Derivatives are also used by speculators to bet on the direction of the
underlying assets.

The credit derivative, while being a security, is not a physical asset. Instead, it is a
contract. The contract allows for the transfer of credit risk related to an underlying
entity from one party to another without transferring the actual underlying entity.
For example, a bank concerned a borrower may not be able to repay a loan can
protect itself by transferring the credit risk to another party while keeping the loan
on its books.
Several types of credit derivatives exist, including:

•Credit default swaps (CDS)

•Collateralized debt obligations (CDO)

•Total return swaps

•Credit spread options/forwards

What Is a Credit Default Swap and How
Does It Work?
A credit default swap (CDS) is a financial derivative that allows an investor to swap or offset their
credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from
another investor who agrees to reimburse them if the borrower defaults.
Most CDS contracts are maintained via an ongoing premium payment similar to the regular
premiums due on an insurance policy. A lender who is worried about a borrower defaulting on a
loan often uses a CDS to offset or swap that risk.
Credit Events
The credit event is a trigger that causes the CDS buyer to settle the contract. Credit events are
agreed upon when the CDS is purchased and are part of the contract. The majority of single-name
CDSs are traded with the following credit events as triggers:

•Reference entity default other than failure to pay: An event where the issuing entity defaults for
a reason that is not a failure to pay

•Failure to pay: The reference entity fails to make payments

•Obligation acceleration: When contract obligations are moved, such as when the issuer needs to
pay debts earlier than anticipated

•Repudiation: A dispute in the contract validity

•Moratorium: A suspension of the contract until the issues that led to the suspension are resolved

•Obligation restructuring: When the underlying loans are restructured

•Government intervention: Actions taken by the government that affect the contract
Collateralized Debt Obligation (CDOs):
What It Is, How It Works
A collateralized debt obligation (CDO) is a complex structured finance product that is backed by
a pool of loans and other assets and sold to institutional investors.
A CDO is a particular type of derivative because, as its name implies, its value is derived from
another underlying asset. These assets become the collateral if the loan defaults.
The earliest CDOs were constructed in 1987 by the former investment bank Drexel Burnham
Lambert, where Michael Milken, then called the "junk bond king," reigned.
The Drexel bankers created these early CDOs by assembling portfolios of junk bonds, issued by
different companies. CDOs are called "collateralized" because the promised repayments of the
underlying assets are the collateral that gives the CDOs their value.
To create a CDO, investment banks gather cash flow-generating assets—such as mortgages,
bonds, and other types of debt—and repackage them into discrete classes, or tranches based on
the level of credit risk assumed by the investor.
Total Return Swap (TRS): What It Is, How It
Works?
A total return swap is a swap agreement in which one party makes payments based on a set
rate, either fixed or variable, while the other party makes payments based on the return of an
underlying asset, which includes both the income it generates and any capital gains.
In total return swaps, the underlying asset, referred to as the reference asset, is usually an
equity index, a basket of loans, or bonds. The asset is owned by the party receiving the set rate
payment.
Credit Spread Option: Definition, How
They Work
In the financial world, a credit spread option (also known as a "credit spread") is an
options contract that includes the purchase of one option and the sale of a second
similar option with a different strike price. Effectively, by exchanging two options of the
same class and expiration, this strategy transfers credit risk from one party to another.
In this scenario, there is a risk that the particular credit will increase, causing the spread
to widen, which then reduces the price of the credit. Spreads and prices move in
opposite directions. An initial premium is paid by the buyer in exchange for potential
cash flows if a given credit spread changes from its current level.
Forecasting techniques

He/she has further performed some calculations for a linear regression

calculation as follows:
 the sum of the advertising expenditure (x) column is 450
 the sum of the sales revenue (y) column is 4,050
 when the two columns are multiplied together and summed (xy)
the total is 326,500
 when the advertising expenditure is squared (x2) and summed,
the total is 38,300
 when the sales revenue is squared (y2) and summed, the total is
2,849,300.
Calculate the correlation coefficient.

The coefficient of determination, r2

The coefficient of determination, r2 measures the proportion of changes in y that
can be explained by changes in x when a straight line relationship has been
established.

Test your understanding 5

Calculate the coefficient of determination for the small supermarket
chain in TYU 4 and comment.

4 Time series analysis

A time series is a series of figures recorded over time, e.g. unemployment over
the last 5 years, output over the last 12 months.
Time series analysis is a technique used to:
 identify whether there is any underlying historical trend
 use this analysis of the historical trend to forecast the trend into the future
 identify whether there are any seasonal variations around the trend
 apply estimated seasonal variations to a trend line forecast in order to
prepare a forecast season by season.
A time series has 4 components:
 Trend
 Seasonal variations
 Cyclical variations
 Residual or random variations.

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The trend

Most time series follow some sort of long term movement. In time series
analysis the trend is measured by:
1 Inspection. A graph of the data is produced and the trend line is drawn by
eye with the aim of plotting the line so that it lies in the middle of the data
points.
2 Least squares regression analysis. x represents time (each month
would be given a number e.g. January =1, February =2 etc) and y is the
data.
3 Moving averages. This method attempts to remove seasonal or cyclical
variations by a process of averaging.

Seasonal variations

Once the trend has been found, the seasonal variation can be determined.
Seasonal variations are short-term fluctuations in value due to different
circumstances which occur at different times of the year, on different days of the
week, different times of day, for example traffic is greatest in the morning and
evening rush hours.
If there is a straight-line trend in the time series, seasonal variations must
cancel each other out. The total of the seasonal variations over each cycle
should be zero. Seasonal variations can be measured:
 in units or in monetary values
 as a percentage value or index value in relation to the underlying trend.
Seasonal variations are used to forecast future figures by amending the trend.
There are two main models:
1 The additive model. Here the seasonal variation is expressed as an
absolute amount to be added on to the trend to find the actual result, e.g.
ice cream sales in summer are expected to be $200,000 above the trend.
Forecast = Trend + Seasonal variation
2 The multiplicative model. Here the seasonal variation is expressed as a
ratio/proportion/percentage to be multiplied by the trend to arrive at the
actual figure, e.g. ice cream sales are expected to be 50% more than the
trend.
Forecast = Trend × Seasonal variation

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Illustration 3 – Seasonal variations

Consider a business with the following actual results in a year:

Year Quarter Units sold
20X1 1 65
20X1 2 80
20X1 3 70
20X1 4 85

The trend is expected to increase by 10 units per quarter and has been
calculated as 60 units for the first quarter. This provides the following
table:
Year Quarter Units sold Trend
20X1 1 65 60
20X1 2 80 70
20X1 3 70 80
20X1 4 85 90
Required:
How might these figures be used to develop a time series model in
order to forecast unit sales in each quarter of year 2, using
(a) an additive approach
(b) a multiplicative approach.

Solution
Compare the trend figures with the actual figures for year 1 in order to
determine the seasonal variation from the trend for each quarter. This
variation can be expressed as (a) an absolute value for each quarter
(the additive model) or (b) a percentage of the trend (the multiplicative,
or proportional, model).
Year Quarter Units sold Trend (a) Variation (b) Variation %
20X1 1 65 60 5 +8.33%
20X1 2 80 70 10 +14.29%
20X1 3 70 80 –10 –12.50%
20X1 4 85 90 –5 –5.56%
Note that the multiplicative model seasonal variations may be
expressed in several different ways. For example, the quarter 3
variation may be expressed as 87.5% or 0.875.

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These variation figures can then be applied to an extrapolated trend in

order to produce a quarterly forecast for unit sales in Year 2. The two
modelling approaches produce two alternative forecasts:
Year Quarter Trend Forecast Forecast
Additive Multiplicative
approach approach
20X2 1 100 100 + 5 = 105 100 × 1.0833 = 108
20X2 2 110 110 + 10 = 120 110 × 1.1429 = 126
20X2 3 120 120 – 10 = 110 120 × 0.875 = 105
20X2 4 130 130 – 5 = 125 130 × 0.9444 = 123

Cyclical variations

Cyclical variations are medium-term to long term influences usually

associated with the economy. These cycles are rarely of consistent length and
we would need 6 or 7 full cycles of data to be sure that the cycle was there.

Residual or random variations

Residual or random variations are caused by irregular items, which cannot be

predicted, such as a fire or flood.

Forecasting with time series

We are only really interested in the first two components of time series, the
trend and any seasonal variations, when we are looking to forecast for a budget
as the cyclical variations are too long term and residual variations are too
unpredictable.
A trend over time, established from historical data, and adjusted for seasonal
variations, can then be used to make predictions for the future.

5 Moving averages

Calculating a moving average

A moving average is a series of averages calculated from historical time

series data.
By using moving averages, the variations in a time series can be eliminated
leaving a ‘smoothed’ set of figures which is taken as the trend.
It is important that the correct cycle is chosen for the moving average; otherwise
the result will not be as good as it should be. For instance, if there are seasonal
variations present in a time series and the pattern is repeated every third period
(quarterly), the moving average should be calculated based on three periods at
a time to get the best results. It is possible to calculate a moving average based
on any length of cycle.

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Illustration 4 – Moving averages

A business is forecasting the value of their sales for the first quarter of
the coming year. Current year values to date are as follows:
Month Sales value
June 851
July 771
August 916
September 935
October 855
November 1,000
December 1,019
Required:
Using moving averages calculate the forecast sales values for January
to March.
Solution:
Step 1 – calculate the 3 month moving average total
Month Sales value Moving average total
$ $
June 851
July 771 2,538
August 916 2,622
September 935 2,706
October 855 2,790
November 1,000 2,874
December 1,019
Step 2 – calculate the trend by dividing the 3 month moving average
total by 3 to get the average for the 3 months.
Month Sales value Moving average total Trend
$ $ $
June 851
July 771 2,538 846
August 916 2,622 874
September 935 2,706 902
October 855 2,790 930
November 1,000 2,874 958
December 1,019

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Step 3 – compare the trend to the actual sales value to calculate the
seasonal variation. Remember that the variation is 'from the trend' so in
the case of July the sales value of $771 is less than the trend of $846
hence the negative variation.
Month Sales value Trend Seasonal variation
$ $ $
June 851
July 771 846 –75
August 916 874 42
September 935 902 33
October 855 930 –75
November 1,000 958 42
December 1,019
Step 4 – extrapolate the trend. In this example the trend is increasing
by $28 each month.
Month Trend
$
June
July 846
August 874
September 902
October 930
November 958
December 986
January 1,014
February 1,042
March 1,070
Step 5 – apply the season variation to the trend to calculate the
forecast sales value. In this example the seasonal variation has a
cyclical pattern so we repeat the variation until we have forecast the
figures required.
Month Trend Seasonal Forecast
variations sales value
$ $ $
September 902 33
October 930 –75
November 958 42
December 986 33
January 1,014 –75 939
February 1,042 42 1,084
March 1,070 33 1,103

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A more detailed approach to moving averages

A small business operating holiday homes in Scotland wishes to
forecast next year’s sales for the budget, using moving averages to
establish a straight-line trend and seasonal variations.
Seasonal
Year Quarter Trend
variation
1 3 100 –6
4 102 25
1 106 –22
2 111 –5
2
3 114 6
4 116 25
1 118 –24
2 120 –8
3
3 123 7
4 126 21
4 1 129 –17
2 134 –16
Step 1
Average trend
= (Last known trend – first known trend) ÷ (number of sets of data – 1)
= (134 – 100) ÷ (12 – 1) = 3.09
Step 2
Since the seasonal variations, in this example, change, an average
adjustment is computed, by adding together each quarter’s variations
and dividing by the number of observations.
Quarter
Year 1 2 3 4
1 – – (6) 25
2 (22) (5) 6 25
3 (24) (8) 7 21
4 (17) (16) – –
–––– –––– –––– ––––
Sum (63) (29) 7 71
–––– –––– –––– ––––
Average (21) (9.67) 2.33 23.7
–––– –––– –––– ––––

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Seasonal variations need to add up to zero so a small adjustment is

made.
1 2 3 4 Total
Average (21) (9.67) 2.33 23.7 –4.64
Adjustment 1.16 1.16 1.16 1.16 +4.64
Average adjusted (19.84) (8.51) 3.49 24.86 0
These figures can then be applied to the extrapolated trend.
Suppose we want to predict year 5 quarter 3 sales. This would be
done as follows:
Step 1 Extrapolate the trend figure
Starting from the last trend figure available, add on the appropriate
number of trend increments.
Year 4 Quarter 2 = 134
Year 5 Quarter 3 = 134 + 5 movements
= 134 + (5 × 3.09)
= 149.45
Step 2 Adjust for average seasonal variation for quarter 3
Prediction = 149.45 + 3.49 = 152.94
Regression analysis can also be used within a time series context. The period
numbers are the independent variables and the item being measured over time
is the dependent variable.

Illustration 5 – Regression in time series

A company has its own temperature-regulated greenhouses to enable
year round growing of herbs and other ingredients. They are preparing
the forecast purchases of manure (in tonnes) for next year.
Month (x) Tonnes xy x2
purchased (y)
1 5,150 5,150 1
2 5,241 10,482 4
3 5,487 16,461 9
4 5,615 22,460 16
5 5,280 26,400 25
6 5,456 32,736 36
7 5,648 39,536 49
8 5,890 47,120 64
9 5,448 49,032 81
10 5,689 56,890 100
11 5,847 64,317 121
12 6,000 72,000 144
∑x=78 ∑y =66,751 ∑xy =442,584 2
∑x =650

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Required:
Estimate the forecast purchases of manure (in tonnes) for month 17.

Solution
By using regression analysis we can produce the equation of a straight
line (or trend) and then extrapolate to estimate future values.
n = 12
12 × 442,584 – 78 × 66,751
b=
12 × 650 – 782
b = 60.86

66,751 78
a= – 60.86 ×
12 12
a = 5,167
y = 5,167 + 60.86x
So month 17 would be:
y = 5,167 + 60.86 × 17
y = 6,202 tonnes

Test your understanding 6

W plc is preparing its budgets for next year.
The following regression equation has been found to be a reliable
estimate of W plc's deseasonalised sales in units:
y = 10x + 420
Where y is the total sales units and x refers to the accounting period.
Quarterly seasonal variations have been found to be:
Q1 Q2 Q3 Q4
+10% +25% –5% –30%
In accounting period 33 (which is quarter 4) identify the seasonally
adjusted sales units:
A 525
B 589
C 750
D 975

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Test your understanding 7

A company will forecast its quarterly sales units for a new product by
using a formula to predict the base sales units and then adjusting the
figure by a seasonal index.
The formula is BU = 4,000 + 80Q
Where BU = Base sales units and Q is the quarterly period number.
The seasonal index values are:
Quarter 1 105%
Quarter 2 80%
Quarter 3 95%
Quarter 4 120%
Identify the forecast increase in sales units from Quarter 3 to Quarter 4:
A 25%
B 80 units
C 100 units
D 1,156 units

Advantages and disadvantages of time series analysis

The advantages of forecasting using time series analysis are that:

 forecasts are based on clearly-understood assumptions
 trend lines can be reviewed after each successive time period, when the
most recent historical data is added to the analysis; consequently, the
reliability of the forecasts can be assessed
 forecasting accuracy can possibly be improved with experience.
The disadvantages of forecasting with time series analysis are that:
 there is an assumption that what has happened in the past is a reliable
guide to the future
 there is an assumption that a straight-line trend exists
 there is an assumption that seasonal variations are constant, either in
actual values using the additive model (such as dollars of sales) or as a
proportion of the trend line value using the multiplicative model.
None of these assumptions might be valid.

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Test your understanding 4

n ∑ xy – ∑ x ∑ y
r=
n ∑ x2 – ∑ x 2 n ∑ y2 – ∑ y 2

6 × 326,500 – 450 × 4,050

r=
6 × 38,300 – 4502 6 × 2,849,300 – 4,0502

136.500
r=
27,300 × 693,300

r = 0.992

Test your understanding 5

The coefficient of determination
r2 = 0.9922 = 0.984
This means that 98.4% of the changes in sales can be explained by
changes in advertising. The other 1.6% of changes are caused by other
factors.

Test your understanding 6

A
y = 10x + 420
We are told that x refers to the accountancy period, which is 33,
therefore:
y = 420 + 33 × 10 = 750
This is the trend, however and we need to consider the seasonal
variation too. Accounting period 33 is quarter 4. Quarter 4 is a bad
quarter and the seasonal variation is –30%, therefore the expected
results for period 33 are 30% less than the trend.
Expected sales = 750 × 70% = 525 units

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Test your understanding 7

D
Sales in quarter 3 (Q = 3)
Base = 4000 + (80 × 3) = 4,240
Seasonal adjustment 95%
Actual sales = 4,028
Sales in quarter 4 (Q = 4)
Base = 4000 + (80 × 4) = 4,320
Seasonal adjustment 120%
Actual sales = 5,184
Overall increase in sales = 5,184 – 4,028 = 1,156 units

Test your understanding 8

(a) Quantity weighting
Calculate the simple price index
Product A = $6.90/$6.50 × 100 = 106.2
Product B = $2.50/$2.20 × 100 = 113.6
Determine the weightings to be used – total production batches
Product A 10
Product B 30
––
40
Apply weightings to price indices
Price index Quantity Total price index ×
weighting Quantity
A 106.2 10 1,062
B 113.6 30 3,408
–– –––––
40 4,470

4,470
Weighted price index = = 111.8
40

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Time Series with Leading Indicators.
Leading indicators are variables whose movement has some relationship to the movement of
the variable you are actually interested in, but whose movement occurs in advance of the
variable of interest.

The leading indicator may move in the same direction as the variable of interest:

or in the opposite direc on.

In order to evaluate the leading indicator relationship, you will need:

 To have some reasonable understanding of the causal relationship that connects the
two variables to justify the model
 Evaluate the quantitative nature of that relationship

The causal relationship is critical. It gives a plausible argument for why the movement in the
leading indicator should in some way presage the movement of the variable of interest. It will
be very easy to find apparent leading indicator patterns if you try out enough variables, but if
you can't logically argue why there should be any relationship (preferably make the argument
before you do the analysis on the potential indicator variable, it's always easy to argue
something after the fact!), it's likely that the observed relationship is spurious.

The quantitative nature of the relationship should come from a mixture of analysis of historic
data, and practical thinking. Some leading indicators will have a cumulative effect over time
(e.g. rainfall as an indicator of the water available for use at a hydro-electric plant) and so
need to be summed or averaged. Other leading indicators may have a shorter response time to
the same, perhaps unmeasurable, causal variable as the variable you are interested in (if the
causal variable was measurable, you would use that as the leading indicator instead), and so
your variable may exhibit the same pattern with a time lag.

What Is a Leading Indicator?

A leading indicator is a measurable set of data that may help to forecast future economic
activity. Leading economic indicators can be used to predict changes in the economy before
the economy begins to shift in a particular direction. They have the potential to be useful for
businesses, investors, and policy makers.

Leading indicators are one of three main types of indicators. The other two are lagging
indicators and coincident indicators.
Understanding Leading Indicators

Leading indicators must be measurable to be useful as predictors of where the economy may
be headed. Policy makers and central bankers use leading indicators when setting fiscal or
monetary policy.1 Businesses study them to anticipate the effect of future economic
conditions and then make strategic decisions regarding markets and revenue.

All businesses track their own bottom lines and balance sheets, but such data are lagging
indicators, meaning they're produced by events that have already happened. Importantly, a
business’ past performance does not necessarily indicate how it will do in the future.

Investors use leading indicators to guide their investment strategies as they try to anticipate
market conditions. Many focus on those indicators directly related to the stock market. These
can include the housing market, retail sales, building permits, business startups, and more.

Examples of Leading Indicators

Purchasing Managers’ Index

Economists closely watch the Purchasing Managers’ Index (PMI). The PMI reflects trends in
the manufacturing and service sectors and can be a useful signal of growth in a nation’s gross
domestic product (GDP) due to changes in the demand for materials from corporations.2

Durable Goods Orders

Durable goods orders is a monthly survey of manufacturers that is produced by the U.S.
Census Bureau. It measures industrial activity in the durable goods sector and the state of the
supply chain.

Consumer Confidence Index

Along with durable goods orders, many people consider the Consumer Confidence Index
(CCI) to be one of the most accurate leading indicators. This index surveys consumers about
their attitudes toward the economy and their perceptions of economic activity going forward.

Jobless Claims

The U.S. Department of Labor provides a weekly report on the number of jobless claims as
an indicator of the economy’s health. A rise in jobless claims indicates a weakening
economy, which could have a negative effect on the stock market. A drop in jobless claims
may indicate that companies are growing (and hiring), which can be positive for the stock
market.

Yield Curve

Many market participants consider the yield curve to be a leading indicator. Of particular
interest is the spread between two-year and 10-year Treasury yields. This is because two-year
yields in excess of 10-year yields have been correlated to both recession and short-term
market volatility. If such an inverted yield curve occurs, it may signal that a recession is
approaching.
Company Performance

While not a metric issued by economists or government agencies, customer complaints or

negative online reviews can be seen as a leading indicator of customer dissatisfaction that
may signal problems with a business’ product quality or service failures. These can point to
lower future revenue, growth, or profits. Conversely, positive customer satisfaction data may
suggest that these factors will trend upward in the future.
What are some reasons for hedging?

The primary motivation to hedge is to mitigate potential losses for an existing trade in the event
that it moves in the opposite direction than what you want it to. Assuming you think your trade
will go in the opposite direction than what you want over some period of time, there can be a
variety of reasons why you may want to hedge rather than close it out, including:

•Overconcentration . You may have significant exposure to a specific investment (e.g.,

company stock) and you want to hedge some of the risk.

•Tax implications . You may not want to have a taxable event created by selling a position.

Unrelated to individual investors, hedging done by companies can help provide greater
certainty of future costs. A common example of this type of hedging is airlines buying oil futures
several months ahead. Airlines hedge costs, in large part, so that they are better able to budget
future expenses. Without hedging, airline operators would have significant exposure to volatility
in oil price changes.
Hedging – Strategies

1. Short hedges
A short hedge is when the position taken to hedge the futures or a commodity is
a short position. A short hedge is normally carried out when an investor
anticipates a future asset sale or when the price of the futures is expected to
decrease.

2. Long hedges
A long hedge is when the position taken to hedge the futures or a commodity is
a long position. A long hedge is normally carried out when an investor
anticipates a future asset purchase or when the price of the futures is expected
to increase.
Hedging – Types

1. Static hedge
A static hedge is when the hedging position or the number of hedging
contracts isn’t bought and/or sold, i.e., isn’t changed, over the time period of
the hedge regardless of the movement in the price of the hedging instrument.

2. Dynamic hedge
A dynamic hedge is when an increasing number of hedging contracts are
bought and/or sold over the time period of the hedge to influence the hedge
ratio and bring it towards the target hedge ratio.
For example, assume an investor is heavily invested in technology
stocks, and their portfolio beta is +4. This indicates the
investor's portfolio moves with the market and is theoretically 400
percent more volatile than the market. The investor could purchase
stocks with negative betas to reduce their overall market risk. If they
purchase the same amount of stocks with a beta of -4, the portfolio is
beta neutral.
What Is Delta Hedging?

Unlike beta hedging, delta hedging only looks at the delta of the security or
portfolio. Delta hedging involves calculating the delta of an overall derivatives
portfolio and taking offsetting positions in underlying assets to make the portfolio
delta neutral, or zero delta.

This means that the position is directionally neutral—if the underlying asset goes
up, the hedge goes down in turn. This strategy is most often used by derivatives
traders who use options to trade volatility or correlation strategies such as
dispersion, rather than direction.
For instance, assume an investor has one long call option on Apple.

As an historical example, on Aug. 31, 2018, Apple had a beta of 1.14, which
indicates Apple is theoretically 14% more volatile than the S&P 500.

The investor's position has a delta of +40, which means that for every $1
move in Apple's stock, the option moves by 40 cents. An investor who delta
hedges takes an offsetting position with -40 delta. However, a beta hedger
enters a position with a beta of -1.14.