This chapter provides an overview of financial risk and risk management. It defines key terms like risk and exposure. Financial risk can arise from market changes, counterparties, and internal failures. Risk management involves identifying risks, setting risk tolerance, and implementing strategies like diversification and derivatives. Derivatives contracts discussed include forwards, futures, options, and swaps. The role, criticisms, misuses, and career opportunities related to derivatives are also outlined.

1. CHAPTER #1

2. Chapter Objectives
Overview
Reasons of Financial Risk
What Is Risk and Exposure?
How Does Financial Risk Arise?
What Is Financial Risk Management?
Steps for Reducing Financial Risk

3. Cont…
 Diversification
 Strategies for Financial Risk Management
 Derivatives
 Type of Derivatives
 Forward Contract
 Future Contract
 Option Contract
 SWAP Contract
 The Role of Derivative Markets
 Criticisms of Derivative Markets
 Misuses of Derivatives
 Derivatives and Your Career

4. Overview
 This course is all about the risk incurred by
Financial System
 Financial market
 Financial Instrument
 Financial Institution
 The Strategies (Derivative Securities) used
for mitigating that risk

5. Reasons of Financial Risk
 In recent years the financial risk has
increased significantly the reasons are
1. Global Markets
2. Information is Available Instantaneously
3. Economic Climate
4. Competition

6. What Is Risk & Exposure?
 The terms risk and exposure have subtle
differences in their meaning.
 Risk refers to the probability of loss and risk
provides the basis for opportunity, while exposure
is the possibility of loss, although they are often
used interchangeably.
 Risk arises as a result of exposure.

7. (a). Risk
 Risk is the likelihood of losses resulting from events
such as changes in market prices.
 Events with a low probability of occurring, but that
may result in a high loss, are particularly troublesome
because they are often not anticipated.
 Put another way, risk is the probable variability of
returns.

8. (b). Exposure
 Exposure to financial markets affects most
organizations, either directly or indirectly.
 When an organization has financial market
exposure, there is a possibility of loss but
also an opportunity for gain or profit.
 Financial market exposure may provide
strategic or competitive benefits.

9. Since it is not always possible or desirable
to eliminate risk, understanding it is an
important step in determining how to
manage it. Identifying exposures and
risks forms the basis for an appropriate
financial risk management strategy.

10. How Does Financial Risk Arise?
 There are three main sources of financial risk:
I. Financial risks arising from an organization’s
exposure to changes in market prices, such as
interest rates, exchange rates, and commodity prices.
II. Financial risks arising from the actions of, and
transactions with, other organizations such as
vendors, customers, and counterparties in
derivatives transactions.
III. Financial risks resulting from internal actions or
failures of the organization, particularly people,
processes, and systems

11. What Is Financial Risk Management?
 Financial risk management is the practice of
creating economic value in a firm by using financial
instruments to manage exposure to risk, particularly
credit risk and market risk.
OR
 Financial risk management is a process to deal with
the uncertainties resulting from financial markets. It
involves assessing the financial risks facing an
organization and developing management strategies
consistent with internal priorities and policies.

12. Steps for Reducing Financial Risk
 Financial risk management requires identifying its
sources, measuring it, and plans to address them.
 In general, the process can be summarized
 as follows:
1. Identify and prioritize key financial risks.
2. Determine an appropriate level of risk tolerance.
3. Implement risk management strategy in accordance with
policy.
4. Measure, report, monitor, and refine as needed.

13. Diversification
 In finance, diversification means reducing risk by
investing in a variety of assets.
 If the asset values do not move up and down in perfect
synchrony, a diversified portfolio will have less risk
than the weighted average risk of its constituent
assets, and often less risk than the least risky of its
constituent.
 Therefore, any risk averse investor will diversify to at
least some extent, with more risk-averse investors
diversifying more completely than less risk-averse
investors.

14. Strategies for Financial Risk Management
 Strategies for risk management often involve derivatives.
 Derivatives are traded widely among financial institutions
and on organized exchanges.
 Derivative security is defined as;
A security whose price is dependent upon or derived
from one or more underlying assets. The derivative
itself is merely a contract between two or more
parties. Its value is determined by fluctuations in the
underlying asset. The most common underlying assets
include stocks, bonds, commodities, currencies,
interest rates and market indexes.

15. Cont…
 The Derivative Contracts include
1. Future
2. Forward
3. Option
1. Call Option
2. Put Option
4. Swaps
 The value of derivatives is derived from the price of the
underlying asset.

16. 16
Forward Contracts
• Agreement between a buyer and a seller at time
zero(0) to exchange a nonstandardized assets for
cash at some future date.
• The detail of the asset and the price to be paid at
the forward contract expiration date are set at
time zero(0).
• The price of the forward contract is fixed over the
life of the contract.

17. Cont…
 Forward contract can also be based on a specific
interest rate (LIBOR) rather than a specified assets
(called forward rate agreement FRA’s)
• A party assuming to buy the underlying asset is
said to have assumed a long-position
• The other party assumes a short-position and
agrees to sell the asset

18. 18
Futures Contracts
• Agreement between a buyer and a seller at time zero(0) to
exchange a standardized assets for cash at some future
date.
• Each contract has a standardized expiration and
transactions occur in a centralized market
• The price of the future contract changes daily as the market
value of the asset underlying the future fluctuates.
• Contract price is adjusted each day as the future price for
the contract changes.

19. Types of Futures Contracts
 Energies: Oil, gasoline, diesel, heating oil, natural gas,
ethanol
 Currencies: Euro, Pound, Yen, Peso, etc. (more than
FOREX), mostly but not entirely priced in Dollars
(called Crosses if not).
 Financials: Interest rate futures in mostly Dollar and
Euro.
 Indices: Multiple stock indices of different countries.
 Metals: Aluminum, gold, palladium, platinum, copper,
silver, uranium

20. 20
Option Contracts
A contract that gives the holder
(buyer/seller) right, but not the
obligation, to buy or sell a specified
asset at a specified price within a
specified period of time.
Types of Option Terminology
Call option
Put option

21. Call Option
 A currency call option grants the right to buy a specific
currency at a designated price within a specified
period of time.
 The price at which the owner is allowed to buy that
currency is known as the exercise or strike price and
there are monthly expiration dates for each option

22. Put Option
 A currency put option receive the right to sell a
specific currency at a designated price within a
specified period of time.
 The owner of the put option is not obligated to
exercise the option
 The maximum potential loss to the owner of the
put option is the price(or Premium) paid for the
option contract.

23. 23
Swap Contracts
 Financial contracts obligating one party to
exchange a set of payments it owns for another set
of payments owed by another party.
 Currency swaps
 Interest rate swaps
 Usually used because each party prefers the terms
of the other’s debt contract.
 Reduces interest rate risk or currency risk for both
parties involved.

24. The Role of Derivative Markets
 Risk Management
 Hedging vs. speculation
 Setting risk to an acceptable level
 Price Discovery
 Operational Advantages
 Transaction costs
 Liquidity
 Ease of short selling
 Market Efficiency

25. Criticisms of Derivative Markets
 Speculation
 Comparison to gambling

26. Misuses of Derivatives
 High leverage
 Inappropriate use

27. Derivatives and Your Career
 Financial management in a business
 Small businesses ownership
 Investment management
 Public service