Valuation And Financial Risk Management

Financial risk management and valuation

Introduction

Financial risk framework:
1. Identification of the different risks: structured overview
a. Financial risks
* Market risk:
1. Interest rate risk
2. Price risk (oil),
3. Currency rate risk
* Transaction currency rate risk
* Competitive currencyrate risk: competitive position is effected by the currency rate
* Translation/Accounting currency rate risk: consolidated result is influenced by currency rate
* Liquidity risk
* Credit risk/Default risk: the borrower doesn’t pay as promised

Bear in mind there are second-degree financial risks: These there are risks involved because of using techniques forhedging other financial risks. They are derived from the specific method used.

b. Non-financial risks
* Operational risk: governance risk (most important)

2. Measurement: measurement techniques
c. RARORAC: Risk Adjusted Return On Risk Adjusted Capital
d. VatR: Value at Risk: Maximum that you could lose on a portfolio during a certain period (1week VatR, 1yearVatR) with a certain confidence level/probability. You could include different risks
e. Duration: Just for interest rate risk

3. Strategy and control (of risk management): decided by top management!
f. Risk tolerance: which risks can be taken, and how much can we take (acceptable level)?
g. Control
* Organizational issues. Risk as a cost centre or a profitcentre? If profit centre: Which benchmark?
* Centralized or Decentralized: Centralized is normal! If decentralized, why?: for tax reasons, if you don’t care about risk management.
* Techniques used must be included in the risk strategy! The auditor shouldn’t decide them!
4. Management
h. Strategic Financial Risk Management (SFRM): If you produce in € and your sales arein $, should we move production?
i. Operational Financial Risk Management (OFRM)
* Internal techniques:
4. You don’t need help from outside. You sell in the states but you don’t want a dollar risk. Easiest way to solve: send your invoice in € (you transfer your risk to your client)
5. Cash management techniques
* Netting: centralize thepayments and you compensate (reduce transactions)
* External techniques: Cooperate with financial institution
6. Traditional
* Credit insurance: comparable derivative: CDS (Credit Default Swap)
* Spot/Borrowing/Investment combination: comparable derivative: A Forward (termeincontract)
7. Derivatives: If the value of a financialinstrument is based on the value of another financial instrument we have a derivative! Lego Approach: Bankers always uses the same building blocks, they just combine them differently.
* Building blocks
i. SWAPS (stream of forwards)
ii. Forward & Futures (combination of options)
iii. Options (only financial instrument)Most important job for the executive board is managing uncertainty, managing risks! If you are able to manage the risks better then the competition you deserve a higher salary

Conclusion in newspapers: derivatives are very bad instruments, correct? They are not bad if used for hedging, but they are questionable when used for Trading. The real problem is that bad people use derivatives for abusiveends.

What can be the big difference between credit insurance and a CDS.

B must pay 100 to A, there is a risk is a problem.
So you take a credit insurance.
If B is not bankrupt, B pays to A.
If B is bankrupt, the Credit Insurance Company pays A.
A is always getting the 100
You need to have a receivable to get a credit insurance, which isn’t the case for CDS. Normally you’ll get a CDS...