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1 Positive attitude far more than the 100 times work hard toward achieving the desired results.

Reasons to Manage Risk/Importance of risk management


Risk is undesirable as it tends to reduce the wealth of the investors. There are some good reasons for managing risk can be explained as below:

Reduce the Costs of Financial Distress and Bankruptcy Bankruptcy and financial distress refers to the critical financial state of a firm in which a firm is unable to meet its debt obligations and is bound for legal proceedings. Firms have to incur the costs of financial distress and bankruptcy such as to hire lawyers, to incur court costs, and to pay all sorts of financial consulting in such a situation. Companies use debt in their capital structure in order to maximize the wealth to the shareholders as the use of debt increases the interest tax savings. However, the uncertain revenues and costs create the risk of financial distress and bankruptcy for a given level of debt and the wealth of shareholders will be reduced by the amount of present value of the future costs of financial distress and bankruptcy. The possibility of insolvency depends on total cash flow variability. Therefore, it is desirable to stabilize the future revenues and costs in order to avoid the costs of financial distress and bankruptcy. The firms may enter into forward contract as a risk management tool among others to stabilize the future revenues and costs. Risk management enables the firm to have higher debt level and hence a greater tax shields from the debt, and avoid any kind of financial distress. Maintaining the Optimal Capital Budget over Time Risk management helps firms smooth out cash flows over time so that the firm can be protected from the shortage of funds to support the optimal capital budget in the bad years when internal cash flows are too low. External equity involves high floating cost as a result debt or internal source of financing is best. Effective Hedging The companies can hedge more effectively than the investors. It is because the companies can take advantage of economy of scale in the cost of hedging. On the other hand, the managers have more expertise in the risk management than the individual investors and know about the risk exposure of the company more than outside investors do. Reducing Interest Cost The companies can reduce the interest rate on debt by using swap to manage risk. The reduction of interest costs will result in the increase of firm's value. Tax Effects Companies manage risk to protect themselves from the adverse effects of tax. For example, the companies whose earning is volatile may go bankrupt at anytime in future. In that case corporate loss carry-forwards and carry-backs can not be utilized. If firm goes bankrupt due to volatile earnings, then tax loss carry-forwards are generally lost. Similarly, firm may not be able to use the facility of carry-back loss when bankruptcy occurs. The optimal risk management utilizes the provisions of carry backs and carry forwards of losses. This is achieved by smoothing out the earning over the periods.

Kaji Dahal/ FDRM/ 7th Semester

2 Positive attitude far more than the 100 times work hard toward achieving the desired results.

Compensation System Compensation to the managers is a cost to the company and reduces the pie of shareholders. Risk management helps to ensure that when managers work hard to increase their compensation, they also work hard to increase shareholder wealth.

Methods of Managing Financial Risk


Investors and firms are subject to uncertainty about variability in expected return. In studying risk management, we referred to risk as the likely variability associated with expected return or income streams. There is risk in every thing that one does, and no one knows when and where he/she will suffer due to uncertainty. This is because we live in a world of uncertainty; certainly risk must be considered in financial decision making. No doubt investor can reduce risk by holding a broadly diversified portfolio of financial assets like stocks, bonds etc. There are other methods to manage the risk associated with financial and commodity markets. Some of the important methods to manage risk have been explained as below:

Portfolio Insurance
Portfolio insurance is the technique to manage the risk of an underlying portfolio. Portfolio insurance provides protection against market decline while preserving the potential for a gain if the market does well. It can be designed by taking long position in put option and stocks. Portfolio of stocks and put guarantees the minimum value of stock will be equal to the strike price no matter what happens in stock price in downside in market.

Duration
The concept of duration was first developed in 1930 by Frederick Macaulay. Thus, it is also called Macaulay Duration. It is a measure of price sensitivity of bond price to interest rate changes. It is the weighted average of full payments. Therefore, duration can be defined as the weighted average length of time it takes the bondholder to receive the interest and the principal. It is to be noted that the duration of a bond is not same as the maturity of the bond. It can be used to measure and compare the sensitivity of the price of bonds to the changes in the market interest rates. Thus, it is the direct measure of interest rate risk for a given change in market interest rate. The longer the duration of a bond, the higher will be the volatility of bond price. To calculate the duration of bond following formula can be used. D=N
Where D = the duration of the bond in year PVIFA = the present value annuity factor N = the maturity period in years INT = The coupon payment = coupon interest rate Face Value of Bond kd = The market interest rate or yield to maturity (YTM) B0 = Current price of bond which equal to

. . . 10.1

= INTPVIFA kd, N +MPVIFkd, N


Where PVIF = The present value interest factor M = Face value of bond PVIFA = The present value interest factor for annuity

. . . 10.2

Kaji Dahal/ FDRM/ 7th Semester

3 Positive attitude far more than the 100 times work hard toward achieving the desired results. Example 11.1
Consider six years bond pays coupons annually. Suppose the annual coupon is 8%, the face value of the bond is Rs 1,000, and the current yield to maturityd)(k also 8%. We show the calculation of is duration as follows. First, calculation of B 0 = Rs 80 PVIFA 6 + Rs 1000 PVIF 6 8%, 8%, = Rs 80 4.6229 + Rs 1,000 0.6302 = Rs 1,000.00 Now Duration of bond is D =6 =6 = 4.993 years Therefore duration of given bond is 4.993 years.

There are at least two important uses for the concept of duration. The first is that it serves as a measure of price volatility. The second is its use in immunization strategies. Duration as a measure of price risk, we can predict the percentage change in bond price for a given change in market interest rate. Or duration of a bond can be used to predict the amount by which a bonds price changes in response to the changes in interest rates in the market. However, the wider the fluctuation of market interest rates, the larger will be the forecasting error. It is because the bond duration maintains the linear relationship between the change in bond price and the change in market interest rates. In reality, there is not linear relationship between the change in bond price and the change in interest rates. % in B0 = D kd
Where % in B0 = percentage change in bond price for a given change in interest rate y = Change in yield to maturity

. . . 10.3

If interest rate goes to 9% from 8%, percentage change in bond price is


% B0 = 4.993 0.01 = 4.993 0.01 = % B0 = 0.04623 i.e. 4.623%

Negative sign in front of duration (D) indicates the inverse relationship between bond price and interest rate. Thus, increase in interest rate by 1%, the bond price will decrease by 4.623%. In other word, price of bond goes down to Rs 953.77 {1,000 (1 0.04623} from Rs 1,000.

Immunization
The second use of duration is immunization. Immunization is a strategy that reduces or eliminates the risks caused by interest rate changes. According to this strategy investor should match duration to investment period/holding period in order to minimize interest rate risk by measuring the portfolio of bond with different maturity. Immunization helps to achieve a realized return at the end of holding period that is not less than the expected return at the beginning of the period. A bondholder can receive a predicted amount of cash from the bond if the bond is hold for the duration of bond irrespective of change in the market interest rate. Matching the desired holding period of

Kaji Dahal/ FDRM/ 7th Semester

4 Positive attitude far more than the 100 times work hard toward achieving the desired results. bonds to the duration of bond is called immunization that is done in order to minimize the interest rate risk. The bond duration is affected by the changed interest rates too. Therefore, the investor that applies the immunization strategy needs to maintain the active bond investment strategies to constantly match the desired holding period and the bond duration. Example 11.2
Recall the six year bond whose duration is 4.993 years i.e. 5 years approximately. Now to immunize the interest rate risk, one should hold this bond for 5 year. Now assume that the interest rate remain at 8 percent for the holding period of 5 years. The cash flows received by the investor on the bond if interest rates stay at 8% throughout the five years would be 1. Coupons for five years (5Rs 80) Rs 400 2. Reinvestment income (Rs 80FVIFA,5 Rs 400) Rs 69 8% 3. Proceeds from the sales of bond at the end of the Rs fifth year 1 1,000 =Rs 1080/(1+0.08) Total value at the end of five year Rs 1,469 1. The coupons of Rs 400 is simply the annual coupon of Rs 80 received in each of the five years. 2. Reinvestment income is the interest income earned at 8% per year from the investment of Rs 80 every year for five years. 3. The proceeds from the sales of bond at the beginning of six year is the present value of maturity value of Rs 1000, and Rs 80 coupon payment in six year. Assume that the interest rates rise to 9%. The cash flows from the bond would be 1. Coupons for five years (5Rs 80) 2. Reinvestment income (Rs 80FVIFA,5 Rs 400) 9% Rs 400 Rs 78

3. Proceeds from the sales of bond at the end of the fifth year 1 Rs 991 =Rs 1080/(1+0.09) Total value at the end of five year Rs 1,469

Note that the income earned on the investment of Rs 80 every year for five years is made at9%. This is why reinvestment income is greater in this case. But the proceeds from the sales of bond at the beginning of six year is lower since discount interest rate increase. However, total value from the bond is same as it was when interest rates were 8% throughout the five years. Assume that the interest rates fall to7%. The cash flows from the bond would be 1. Coupons for five years (5Rs 80) Rs 400 2. Reinvestment income (Rs 80FVIFA,5 Rs 400) Rs 60 7% 3. Proceeds from the sales of bond at the end of the Rs fifth year 1 1,009 =Rs 1080/(1+0.09) Total value at the end of five year Rs 1,469 Note that the total value from the bond is same as it was when interest rates were 8%, although interest rates fall to 7% throughout the five years. The income earned on the investment of Rs 80 every year for five years is made at 7%. This is why reinvestment income is lesser in this case. But the proceeds from the sales of bond at the beginning of six year is greater since discount interest rate decreases.

Kaji Dahal/ FDRM/ 7th Semester

5 Positive attitude far more than the 100 times work hard toward achieving the desired results.
Thus, to have the same value form the investment in bond, one should hold the bond equal to duration. By doing so, interest rate risk can be eliminated. This strategy is adopted to make the riskless investment in bond. Note that if holding period is different form the duration of bond, the terminal value would never be same as we seen above for the change in interest rates.

Derivative Tools of Hedging


Study it from the book.

Kaji Dahal/ FDRM/ 7th Semester