Part I
Introduction
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Introduction
This book presents the economic foundations of risk management. It presents the theory, the practice, and applies this knowledge to provide a forensic analysis of some well-known risk management failures. By doing so, this book presents a unified framework for understanding how to manage the risk of an individualâs or corporationâs or financial institutionâs assets and liabilities. Providing a framework for analysis, understanding the underlying economics, is essential in practical risk management.
An individual or firm, financial or non-financial, owns a portfolio of assets and liabilities. This portfolio can be represented by a balance sheet that changes across time. Each asset and liability has a present value. For an asset this represents the cash received today if the asset is sold. For a liability this represents the cash paid today to retire the liability. The sum of the assetsâ less the liabilitiesâ present values represents the individualâs or firmâs equity value. This is their net worth.
Assets and liabilities generate future cash flows, both positive and negative. As the future is uncertain, these future cash flows are also uncertain. They are random variables. As time passes, information about these future cash flows changes. This changing information changes the assetsâ, liabilitiesâ, and equityâs present values. We say that the prices of the assets, liabilities, and equity are a stochastic process. Alternatively stated, the prices of these quantities involve across time in a random fashion.
Since equity is the entityâs net worth, if the value of equity declines then this is a loss. If the value of the equity increases, then this is a gain. Such random changes in value and cash flows across time have a variance, therefore the portfolioâs changing equity value and cash flows entail ârisk.â
Individuals and firms utilize the cash flows from the portfolio to consume or to manage the firmâs activities, respectively. They also buy/sell new assets and liabilities across time. The cash flows and changing balance sheet positions so obtained generate benefits or costs for these entities. The entities have preferences (likes/dislikes) over the different patterns of cash flows and balance sheet configurations obtained. It is natural, therefore, that rational entities will seek to maximize these preferences across time by managing the assets and liabilities in their portfolio - by managing the balance sheet. Managing this risk of an individualâs portfolio or a firmâs balance sheet is the topic of this book, called ârisk management.â
As alluded to in this description, there are four topics that need to be mastered in risk management. The first is to understand the assets and liabilities that trade. The second is to understand how to model the risks from holding the assets and liabilities. The third is to characterize an individual or firmâs preferences. And, the fourth is to understand how to manage the risks of the traded assets and liabilities to maximize their preferences. These four topics compose the four parts of this book.
Part II
Traded Assets and Liabilities
Overview
To understand how to risk manage an entityâs portfolio or balance sheet, we first need to understand what assets and liabilities are available for trading, and what are the characteristics of the markets within which they trade. Since one personâs liability is another personâs (the counter partyâs) asset, we really only need to understand the traded assets in an economy.
There are two basic types of assets: primary assets and derivatives. Derivatives are financial securities whose payoffs depend on the primary assetâs payoffs and/or values. We discuss each of these in turn. The subsequent discussion is conceptual focusing on the economic considerations in trading assets. Institutional details are presented, but only in an abstract form so that the relevant economics of the institutional structures are understood.
Chapter 1
Primary Assets
This chapter discusses the primary assets. To understand the traded primary assets, the markets in which they trade need to be understood first.
1.1Market Types
There are two types of markets in which assets trade: spot markets and forward markets.
By definition, a spot market is a market in which an asset is exchanged immediately for cash. An example of a spot market is a grocery store where one can buy oranges for cash.
By definition, a forward market is a market in which one agrees today, to buy an asset at a future (forward) date. Cash will be exchanged at the future date when the asset is delivered. An example of a forward market is an auto dealer who agrees to sell you a car which will be made in 2 months time at the auto factory. Delivery will take place immediately after production in 2 months. To trade in a forward market, a financial contract must be created and âsignedâ by both parties. This financial contract is an example of a derivative security. As such, we will discuss forward markets in the next Chapter. This chapter just concentrates on spot markets.
The structure of a spot market in which an asset trades can be different for different assets. From an economic point of view, the most important aspects of spot markets are the following three characteristics:
1.Competitive or not. Competitive means that the traders have no quantity impact from trading on the price of the asset purchased or sold. Hence, when trading they act as price takers. Any other market situation is defined to be non-competitive. An example of a non-competitive market is one where buyers bargain with sellers over the price, and different buyers get different prices.
2.Frictionless or not, and the type of frictions. A frictionless market is a market without transaction costs and trading constraints. Transaction costs are fees paid to trade. Trading constraints include indivisibilities in the quantity of an asset traded, short sale restrictions, collateral/margin requirements, borrowing constraints, and bounds on quantities transacted. A frictionless market is the proverbial âidealâ market.
3.Actively traded (large volume) or not. This characteristic of a market often corresponds to liquid or illiquid markets. A liquid market is defined to be a competitive market where there is no quantity impact from trading on the price.
1.2Asset Types
This section discusses the different types of assets that trade in spot markets. Notation for asset prices will be introduced. For the notation, we assume that the time horizon is given by t â [0, T]. This is called a finite horizon model. Because the terminal date T can be quite large, say 10,000 years, finite horizon models are really without loss of generality. We impose the finite horizon assumption to simplify the mathematics.
There are two types of assets that trade in spot markets: physical commodities and financial securities.
1.2.1Physical Commodities
Physical commodities that trade include currencies (U.S. dollars, Euros, etc.), precious metals (gold, silver, etc.), agricultural commodities (corn, wheat, etc.), energy related commodities (oil, gas, etc.), and so forth. Physical commodities also include residential housing and commercial pro...