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- Principles: Life and Work
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- Rich Dad Poor Dad: What The Rich Teach Their Kids About Money - That the Poor and Middle Class Do Not!
- MONEY Master the Game: 7 Simple Steps to Financial Freedom
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- Secrets of the Millionaire Mind: Mastering the Inner Game of Wealth
- I Will Teach You to Be Rich, Second Edition: No Guilt. No Excuses. No BS. Just a 6-Week Program That Works
- Secrets of Six-Figure Women: Surprising Strategies to Up Your Earnings and Change Your Life
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- The Intelligent Investor

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Gap Management

Risk Management System

1. absolutne 1. market risk - volatility 1. valuation methods 1. traditional methods 1. management strategies

value a. price a. traditional variance conservative

earnings b. interest rate b. non-arbitrage standard deviation active (optimization)

cash flows c. exchange rate c. binomial (captal allocation)

d. simulation 2. concentration

2. relative 2. credit risk and diversification measures 2. limits

simple rate of return creditworthiness changes

logarithmic rate of return a. cash flows adjustments 3. sensitivity measures 3. capital adequacy

credit scoring currency gap regulatory capital

default probabilities interest rate (duration) gap economic capital

recovery rates options , , , ,

b. interest rate adjustments 4. performance measurement

risk premium 4. modern methods V/VaR

migration analysis VaR P&L/EaR

EaR CFAT/CFaR

3. operational risk CFaR

5. Stress test

Goals

n

CFt CVn

(1) PV = +

t =1 (1 + RRR) (1 + RRR) n

t

P Pt 1

Rt = t

Pt 1

Pt

(2) = 1

Pt 1

Pt

=

Pt 1

Pt

(3) 1+ R t =

Pt 1

P

rt = ln (1 + R t ) = ln t

Pt 1

(4) = ln(Pt ) ln (Pt 1 )

= p t p t 1

1

Corporate Finance [3117-26]

Risk factors

price risk

interest rate risk

foreign exchange rate risk)

market risk

credit risk

liquidity risk

capital risk

country/sovereign risk

off-balance-sheet risk

business risk

operational risk

technology risk

marketability risk

environment

war, revolution

Exposure

sensitivity analysis,

scenario analysis,

probabilistic (decision trees),

analytical,

simulation.

Analytical Methods

Taylors expansion:

f(x 0 ) f ' (x 0 ) f '' (x 0 ) f n (x 0 )

(5) f(x) = + (x - x 0 ) + (x - x 0 ) 2 + ... + (x - x 0 ) n + R n

0! 1! 2! n!

(6) W + x

1

(7) W + x + x 2

2

W=f(x)- f(x0) change in value, x=x- x0 change in risk

Risk Measures

Risk arises from the variability of future returns, values, cash flows, earnings and other

stated goals. This variability is caused by changes in prices (price risk), exchange rates

(currency risk), interest rates (interest rate risk), creditworthiness (credit risk) and other

factors.

There are many risk measures:

traditional (variance, standard deviation, coefficient of variation),

modern (Value at Risk, Cash flows at Risk, Earnings at Risk),

specific (duration gap, currency gap).

2

Corporate Finance [3117-26]

financial instruments with a given probability over a pre-set horizon.

Probability f(V)

Assymmetric probability distribution

95%

critical value

expected value

5%

96 100 Value (million zloties)

distribution of the rates of return assuming that past history carries out into the future.

method, is essentially a parametric approach in which an estimate of VAR is derived from the

underlying variances and covariances of the constituents of a portfolio. The

variance/covariance approach is based on the assumption that the underlying market factors

have a multivariate normal distribution. If a probability of 5 percent is used in determining the

value at risk, then the value at risk is equal to 1.65 times the standard deviation of changes in

portfolio value:

VaR 1,65 P Vt 1

Monte Carlo Simulation. The Monte Carlo simulation methodology has a number of

similarities to historical simulation.

The similar risk measures are CFaR and EaR.

specified target, that could be experienced due to the impact of market risk on a specified set

of exposures, for a specified reporting period and confidence level.

Earnings at Risk (EaR) The maximum shortfall of earnings, relative to a specified target,

that could be experienced due to the impact of market risk on a specified set of exposures, for

a specified reporting period and confidence level.

Duration Gap

Duration is the average life of an asset, or more exactly, the weighted average time to

maturity using the relative present values of the cash flows as weights. Duration is measured

in years. The modified duration is a measure of the interest sensitivity of an assets price.

Important features of the modified duration (True or False)

1. Duration increases with the maturity.

2. Duration increases as yield decreases.

3. Duration increases as the coupon rate decreases.

3

Corporate Finance [3117-26]

Bonds Modified duration Convexity

Coupon bonds

(annual D=

( [ ]

B c[1 + i] (1 + i ) 1 + iT[i c]

T

)

[ ]

2B c[1 + i]2 (1 + i )T 1 ciT[1 + i] + i 2 T[T + 1]

[i c]

interests) Pi (1 + i )

2 T +1

C= 2

Pi 3 (1 + i )T +2

Zero coupon T T (T + 1)

D= C=

bonds (1 + i ) (1 + i )2

Consol bonds 1 2

D= C= 2

i i

where: P - price, i annualized yield, c coupon rate, B face value, T - maturity.

Duration Model

W

(8) = - D i

W

Duration and convexity model

P

= - Di + C(i )

1 2

(9)

P 2

Macaulay Duration Model

W i Dz

(10) = Dz = i

W 1+ i 1+ i

D

(11) D= z

1+ i

Effective duration and effective convexity

V V+ V V+ 2 V0

(12) D = - , C= -

2V0 (y )

2

2V0 y

(P/P)

Error

True relationship

dP Error

tg =

di

Interest rate (i)

Matching the duration of an asset to the investors target horizon immunizes it against

interest rate risk.

4

Corporate Finance [3117-26]

Duration can be calculated for assets or liabilities as a market value weighted average of

the individual durations of all items. The duration gap is just a difference between the

duration of asset portfolio and the duration of liability portfolio.

(13) DA = wA1DA1 + wA2DA2 + ... + wAnDAn

(14) DL = wL1DL1 + wL2DL2 + ... + wLnDLn

(15) A = - D A A y

(16) L = - D L L y

(17) E = A - L = [- D A A + D L L] y

(18) E = -[D A - D L k ] A y

L

k = - is a leverage measure.

A

(19) E = -[D A - D P ] A y

Conservative management prefers to hedge cash flows and cost of capital against price risk,

interest rate risk and, currency risk and credit risk. Hedging allows for stabilization of value of

assets and equity. The simplest and historical way of hedging is diversification. It does not

increase returns, but it lowers risk. Financial markets and especially derivative markets offer

participants the opportunity to reduce or eliminate risk through hedging which involves

taking out counterbalancing contracts to offset existing risks (price risk, currency risk, interest

rate risk, credit risk). Derivative instruments may be used to reduce the risk of the firms cash

flows and the risk of the cost of capital. Risk reduction is the motivation for hedging.

Hedging can increase firms value and hence shareholders wealth. By managing strategic

risks, a firm can increase the magnitude of the expected cash flows and hence increase firm

value.

Passive strategies include: buy and hold and indexing. The last involves building a

portfolio that will match the performance of a specified index. Matched-funding techniques

(dedicated portfolios, horizon matching, immunizations) are also considered as conservative

strategies. Dedication refers to techniques that are used to construct a portfolio of assets with

cash flows that will match the future liabilities.

Active management or speculation means a company has open interest rate gap or

currency gap and tries to obtain higher returns in risky environment. It is possible to speculate

on future direction or volatility of price movement.

Active strategies rely on forecasts, valuation analysis, credit analysis, yield spread

analysis, volatility analysis. Active management includes strategies that attempt to outperform

a passive benchmark portfolio. These strategies use derivatives (especially options) as an

instrument to increase returns.

Arbitrage is defined as transaction of buying a security at a low price in one market and

simultaneously selling in another market (or at the same market but in different time) at a

higher price to make a profit. In efficient markets such opportunities cannot exist. For most of

firms arbitrage opportunities do not exist. Arbitrage may be compared to money being left on

the street (rare situation, usually small amounts, somebody may raise this money before you

bend, even if you see this situation).

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