Risk Mgmt and Capital Requirements in Banking

correlatioon: p

risk measure: variance of returns = (σ^2)

correlation: p

standard deviation (std) of asset and hedge

Example:

if h = -1.2 --> Per unit of asset A (long postion) 1.2 units of the hedge product H have to be sold (short postion)

if h = 0 --> don't hedge!

h* = optimal hedge leads to minimum risk

Tendency of hedging could change!

short / long / don't hedge

if costs = 0 we hege as much as possible

if costs > 0 the optimal hedge changes   --> the chaeper the costs the more we hedge!

1. Equlibrium condition: ra=rf+Beta(rm-rf)

2. A portfolio is "efficient" if it has the best possible expected level of return for its level of risk

3. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta)

4. risk premium equals to zero

5. Price of the asset C is too low --> buy this asset

only systematic risk is compensated

all other (diversifiable) risk are not compensated!

Privately owned companies:

Risk preference of owners / Asymmetrical risk profile in financial distress, in taxes

All other companies: --> Asymmetries in:

1. Financial distress

2. Taxes (progressive tax scales)

3. Information asymmetries: knowledge of risk profil is unequal between shareholders and management

Financial Distress deforms an originally symmetrical risk profile into an asymmetrical one. In addition to the losses caused by risk factor (R) financial distress leads to an acceleration in losses.

--> after passing the "point of min. equity" the losses are getting worse! --> non-linear

with gambling one gets the chance of surviving!

no one cares if the company goes bankrupt with -100 or -120, therefore the company makes that risky project

1. increaseequity

2. change the risk profile

CD: Value contribution of risk management = (opportunity) loss prevented

--> do risk mgmt one prevents the additional loss of CD

BC: additional equity required to obtain an acceptable probability of distress in case the original risk profile is not changed.

--> BC: additional equity to absorbe losses

Risk management in progressive tax regimes reduce the average tax burden (through the reduction in profit volatility).

Company risk reduction for risk averse private owners

Reduction of planning costs and of the probability of financial emergency situations

Reduction in the probability of “financial distress”

Protection of required liquidity for project financing purposes

Reduction in average corporate taxes

Reduction of manager’s risk exposures and increase inmanager performance (e.g. bonus as a function of profit
=> reduction in profit fluctuation)

Factors that have an impact on the value of the harvest: Change in Price and Change in Quantity

1. concave

2. U(E((x)) > E(U(x))

1. linear

2. E(U(x)) ? U(E(x))

1. Completeness

2. Transitivity

3. Continuity

4. Substitution

unsufficient description of human behavior towards risk.

B over A; C over D --> result violates the substitution axiom (= common ration effect)

From decision1 to decision2 one goes from a certain to a uncertain situation. In this case certainty creates additional value.

People act risk-aversely when dealing with gains/profits.

People are getting riskier by dealing with losses.

1. Potential of loss because of unexpected changes in market prices

2. generally symmetrical distribution

Example: Depreciation of USD leads to decline in the CHG value of USD assets.

1. Potential of loss because of an unexpected default of a debtor.

2. generally non-symmetrical

1. Potential of loss because of an unexpected development in business.

2. generally symmetrical distibution

1. Potential of loss because of an unexpected process failure or event

2. non symmetrical

graphic

1. risk profile of farmer = upward; risk profile of buyer = downward

2. The risk profile of the buyer is the opposite of the buyer's risk profile

Forward (OTC) / Futures

* liabilties work like an hedge

* Assets -5 ; Liabilities -2 --> net change = -3