Risk Management an der Universität Zu Köln | Karteikarten & Zusammenfassungen

Lernmaterialien für Risk Management an der Universität zu Köln

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LTCM Case: Founder Team

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Dreamteam: Scholes, Meriwether & Merton (1979)

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Two major sources of risk

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1. Business Risk:

The risk that a firm is subjected to during daily operations and includes the risks that result from business decisions and the business environment (e.g., market downturn or demand decrease)


2. Financial Risk:

The result of a firm’s financial market activities (e.g., interest rate movement or foreign exchange rate)


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LTCM Case: Risk Management Lessons (4)

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1. Enough Initial Margin

2. Incorporate Liquidation Cost

3. Utilisation of Stress Testing

4. Greater Position Disclosure


-> Aggressive Investment Strategies demand risk management

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LTCM Case: Risks (3)

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1. Model Risk:

-> believed that risk premiums and market volatility would ultimately decline in the long term (too optimistic)


2. Liquidity Risk:

-> could not provide cash to the investors


3. Credit Risk:

-> Russian government bond (extrem credit event)

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The Role of Risk Management (3 tasks)

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— Assess all risks faced by the firm 

— Communicate these risks to risk-taking decision makers 

— Monitor and manage these risks (make sure that the firm only takes the necessary amount of risk)

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Deregulation & Globalization effect on Risk

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The two major factors that have led to increase in the sensitivity of economic and financial variables.

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Globalization

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Globalization led to firms doing business outside their respective domestic borders causing these firms to have more exposure to currency changes.

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Deregulation (2)

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— Deregulation in banks led to increase in interest rate sensitivity. 

— Took down barriers to competition between financial institutions

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Functions of Financial Institutions (4)

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— Serve as financial intermediaries for managing financial risk. 

— Create markets and instruments to share and hedge risks. 

— Provide risk advisory services. 

— Act as a counterparty by assuming the risk of others.


Examples: 

Insurance companies, Finance companies or Securities firms

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Risk Measurement Tools (4)

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  • Duration => Measurement of interest rate risk
  • Beta => Measurement of market risk (stock price)
  • Delta => Measurement of derivative securities (options)
  • VaR => Measurement of value which is at risk
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LTCM Case: Downfall

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  • LTCM continued on selling equity volatility with success (early 1998)
  • Optimistic view on financial market (ignored Asian financial crisis)
  • May: The financial market’s results were opposite to LTCM’s initial anticipations (growing attention on Russia as the new hotspot)
  • LTCM’s huge fall started with the Russian Moratorium, and the loss became unrecoverable (because they invested much in Russian bond)
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LTCM Case: Golden Age (4)

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  • LTCM skyrocketed in performance through its core strategy of Arbitrage Convergence (taking advantage of differences in prices in near identical bonds) 
  • Core concept: Calculation of Volatility
  • With the dawn of LTCM’s Golden Age, aggressive investments showed signs of risks 
  • The LTCM group laid the foundation for a new formula in the trading market (Investment became too big, which became the first major challenge)
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Q:

LTCM Case: Founder Team

A:

Dreamteam: Scholes, Meriwether & Merton (1979)

Q:

Two major sources of risk

A:

1. Business Risk:

The risk that a firm is subjected to during daily operations and includes the risks that result from business decisions and the business environment (e.g., market downturn or demand decrease)


2. Financial Risk:

The result of a firm’s financial market activities (e.g., interest rate movement or foreign exchange rate)


Q:

LTCM Case: Risk Management Lessons (4)

A:

1. Enough Initial Margin

2. Incorporate Liquidation Cost

3. Utilisation of Stress Testing

4. Greater Position Disclosure


-> Aggressive Investment Strategies demand risk management

Q:

LTCM Case: Risks (3)

A:

1. Model Risk:

-> believed that risk premiums and market volatility would ultimately decline in the long term (too optimistic)


2. Liquidity Risk:

-> could not provide cash to the investors


3. Credit Risk:

-> Russian government bond (extrem credit event)

Q:

The Role of Risk Management (3 tasks)

A:

— Assess all risks faced by the firm 

— Communicate these risks to risk-taking decision makers 

— Monitor and manage these risks (make sure that the firm only takes the necessary amount of risk)

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Q:

Deregulation & Globalization effect on Risk

A:

The two major factors that have led to increase in the sensitivity of economic and financial variables.

Q:

Globalization

A:

Globalization led to firms doing business outside their respective domestic borders causing these firms to have more exposure to currency changes.

Q:

Deregulation (2)

A:

— Deregulation in banks led to increase in interest rate sensitivity. 

— Took down barriers to competition between financial institutions

Q:

Functions of Financial Institutions (4)

A:

— Serve as financial intermediaries for managing financial risk. 

— Create markets and instruments to share and hedge risks. 

— Provide risk advisory services. 

— Act as a counterparty by assuming the risk of others.


Examples: 

Insurance companies, Finance companies or Securities firms

Q:

Risk Measurement Tools (4)

A:
  • Duration => Measurement of interest rate risk
  • Beta => Measurement of market risk (stock price)
  • Delta => Measurement of derivative securities (options)
  • VaR => Measurement of value which is at risk
Q:

LTCM Case: Downfall

A:
  • LTCM continued on selling equity volatility with success (early 1998)
  • Optimistic view on financial market (ignored Asian financial crisis)
  • May: The financial market’s results were opposite to LTCM’s initial anticipations (growing attention on Russia as the new hotspot)
  • LTCM’s huge fall started with the Russian Moratorium, and the loss became unrecoverable (because they invested much in Russian bond)
Q:

LTCM Case: Golden Age (4)

A:
  • LTCM skyrocketed in performance through its core strategy of Arbitrage Convergence (taking advantage of differences in prices in near identical bonds) 
  • Core concept: Calculation of Volatility
  • With the dawn of LTCM’s Golden Age, aggressive investments showed signs of risks 
  • The LTCM group laid the foundation for a new formula in the trading market (Investment became too big, which became the first major challenge)
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