MFM 842 : FINANCIAL RISK

MANAGEMENT
 Risk Concept
• Risk has been defined as the possibility of occurrence of an unfavorable
deviation from the expected outcome.
• In finance, risk refers to the degree of uncertainty and/or potential financial loss
inherent in an investment decision.
• Risk can be defined as the probability or likelihood of occurrence of losses
relative to the expected return on any particular investment.
Key term of Risk
• Possibilities (probabilities)
• Deviation
• Expected Outcome
Type of risk
A. On the basis of loss expectation
Pure Risk : There was only the chance of a loss occurring
Speculative risk: chance of either gain or loss
B. On the basis of control
Systematic risk [ uncontrollable] : link to market
Unsystematic risk [controllable]: Specific to firm
C . Common form of Financial risk.
• These financial risks are not necessarily independent of each other.
• Market risks: These are the financial risks that arise because of possible
losses due to changes in future market prices or rates. The price changes
will often relate to interest or foreign exchange rate movements, but also
include the price of commodities (goods) that are vital to the business.

The confectionery giant, Cadbury, recognized in its 2007 annual report that
it has an exposure to market risks arising from changes in foreign exchange
rates, particularly the US dollar. More than 80% of the group’s revenue is
generated in currencies other than the reporting one of sterling. This risk is
managed by the use of asset and liability matching (revenue and borrowings),
together with currency forwards and swaps.
• Credit risks: Financial risks associated with the possibility of default by a counter-
party. Credit risks typically arise because customers fail to pay for goods supplied
on credit. Credit risk exposure increases substantially when a firm depends heavily
upon a small number of large customers who have been granted access to a
significant amount of credit. The significance of credit risk varies between sectors,
and is high in the area of financial services, where short- and long-term lending are
fundamental to the business.
A firm can also be exposed to the credit risks of other firms with which it is heavily
connected.
Amazon, the global online retailer, accepts payment for goods in a number of
different ways, including credit and debit cards, gift certificates, bank checks, and
payment on delivery. As the range of payment methods increases, so also does the
company’s exposure to credit risk. Amazon’s exposure is relatively small, however,
because it primarily requires payment before delivery, and so the allowance for
doubtful accounts amounted to just $200 million in 2018, against net sales of $1.2
billion
• Financing, liquidity and cash flow risks:
Financing risks affect an organization’s ability to obtain ongoing financing. An
obvious example is the dependence of a firm on its access to credit from its
bank.
Liquidity risk refers to uncertainty regarding the ability of a firm to unwind a
position at little or no cost, and also relates to the availability of sufficient funds
to meet financial commitments when they fall due.
Cash flow risks relate to the volatility of the firm’s day-to-day operating cash
flow . A firm can also be exposed to the credit risks of other firms with which it
is heavily connected.
Such risk is very common in financial institutions , like banks; recent problem
with yes bank , Laxmi Vilas Bank.
Why Should Firms’ Manage Risk ?
• [Modigliani-Miller theorem of capital structure, we similarly know that the value
of a firm is independent of its risk structure(leverage); firms should simply
maximize expected profits, regardless of the risk entailed]
Benefits of Risk management for firm:
• Stability in earning and income : Sustainable growth rate(SGR)
• Cost of bankruptcy: The direct and indirect costs of bankruptcy are large and
well known. Risk management can increase the value of a firm by reducing the
probability of default.
• Firm’s reputation or ‘brand’ enhancement due to better cash flow management.
• Stable income helps in reduction of average tax liabilities.
• Easy source of fund due to better credit rating.
• Reduction in net cost of capital
• Competitive advantage ( protect from hostile takeover)
Special Note: Sustainable growth rate(SGR)

• Sustainable growth rate implies how well the company can grow in the
future without depending on any extra financing in terms of equity or
debt and instead using its own resources.
• Sustainable growth meaning gives a clear vision to the stakeholders on
what it should focus on for the expected growth rate.
• SGR is also an important indicator of association of risk in business.

SGR= Retention Ratio*Return of equity

Q. Rank the company on the basis of associated risk in business based
on financial data, as below:
Company A Company B Company C Company D
Dividend Per share $3.00 $6.00 $6.00 $6.50
Outstanding share with value of
$100 each 5000000 5000000 5000000 5000000
Net Earning $60,000,000.00 $65,000,000.00 $70,000,000.00 $75,000,000.00
Current annual growth rate 12% 12% 12% 12%
Q. Calculate net cost of capital for a firm paying tax at rate of 30%, on
data of capitals’ components , as below:
• 10% of capital through 12% debenture of face value Rs.100 each and
realizes Rs.95 per debenture, which redeemable at premium of 10%
after 10 years.
• 20% of capital through 14% preference share of face value Rs.100
each , sold for Rs.92 each per share for 12 years
• Remaining of capital through common equity trading at price of
Rs.140 , expected dividend of Rs.18 next year and with growth rate of
3% every year.
Summary of Firms’ Manage Risk

Source : MIT Sloan- open courseware

 Risk Management
• Risk management is the process of identifying, assessing and controlling risk and factors of
risk to meet organization's goal. 
• These risks could stem from a wide variety of sources, financial uncertainty, legal issues,
strategic management errors, accidents and natural disasters, but will impact organization’s
earning of capital.

Steps of risk Management [CIMA]

• Step 1: Identify the Risk.
• Step 2: Understand and access (analyze) scale of the Risk.
• Step 3: Develop risk response strategy
• Step4: Implementation of strategy.
• Step 5: Implementation Monitoring and control.
• Step 6: Monitor and Review the Risk process.
Identify the Risk and access
• Risk identification needs to be
methodical, and to address the
main financial activities and their
associated risks.
• The scale of each identified risk
should be estimated using a mix of
qualitative and quantitative
techniques.
• A commonly used approach is to
map the estimated risks against a
risk impact matrix. ( probability of
occurrence or/and impact)
• Some firms may keep “risk
register”
Risk Response (treatment of risk)
• The basic treatment for risk —avoidance,
retention, sharing, transferring, and
loss prevention and reduction
The above treatment can be categorized
into three risk strategies category.
• Internal strategies: imply a willingness to
accept the risk and manage it internally
within the framework of normal business
operations.
• Risk sharing strategies relate to strategies
that mitigate or share risks with an
outside party.
• Risk transfer involves paying a third party
to take over the downside risk, while
retaining the possibility of taking
advantage of the upside risk
 Risk Control Implementation
• Implementation includes allocating responsibility for managing specific risks
and, underlying that, creating a risk-aware culture in which risk management
becomes embedded within the organizational language and methods of
working.
Control and Review of Risk control implementation
• The control loop is closed when the effectiveness of the risk controls is
evaluated.
• It has three parameters:
Review process: This should include a regular review of risk forecasts, a review
of the management responses to significant risks, and a review of the
organization’s risk strategy
• Internal reporting to the management group: This might include a
(a) review of the organization’s overall risk management strategy, and
(b) reviews of the processes used to identify and respond to risks, and of
the methods used to manage them. It should also include an assessment
of the costs and benefits of the organization’s risk responses.

• External reporting: External stakeholders should be informed of the

organization’s risk management strategy, and be given some indication
of how well it is performing. Such reporting has direct impact on
valuation of firm, price of stocks.
Market Data: Concept
• Market data is the data issued by a trading venue and authorized
government agencies, such as a stock exchange , DBIE , RBI etc. , to
inform traders and investors about the latest prices of financial
instruments and key economic indicators. Some popular examples are
shares, bonds, derivatives, commodities , interest rate , Index of
economy and currencies.
• Market data provides detail about the current prices (value) , and
historical movements.

Need of data : is for future.

Market Data Analysis
Information in market data:
• In efficient markets, asset prices impound information and points of
view widely dispersed among market participants
• Asset prices inherently forward-looking
• Asset prices summarize not only dispersed information about current
and future conditions, but also about future asset prices themselves
• Germane to risk measurement , because may give us an external,
market-adjusted assessment of future to compare with model-generated
• Chief challenge to extracting information about future asset prices
from current asset prices: asset prices also heavily affected by Risk.
Information derived from market data
• Cash securities and exchange rates embed information
• Interest rates and future interest movement related information
• Future price movement related information
• Social and Political issue related information
• Probability of distribution related information for future price
movement
Probability and distributions of Asset Prices
• For most of the assets, guaranteed returns are uncertain or risky. So, the
assets price should be plot (distribute) under concept of probability.
• Chances of loss or gain is linked to the concept of probability.
• In terms of risk under influence: Objective probability approach or
Subjective probability approach.
• Objective probability: Mathematical practice with long term relative
frequency for infinite number of observation without change in underlying
condition. [ toss of coin]
• Subjective Probability : personal estimate of loss with more influence of
self factors, [ buying lottery on birthday dates]
 Use of Probability in Stock investment
• In prediction of probability of return of a share based on the historical return , by Z
score of normal distribution.

• Z score trading concept based on chance of bankruptcy in near future [Altman's

Z score] by professor Edward Altman
Z score = (EBIT / total assets x 3.3)
+ (Retained earnings / total assets x 1.4)
+ (Working capital / total assets x 1.2)
+ (Net sales / total assets x 0.9)
+ (Market capitalization / total liabilities x 0.6)
Z-score below 1.8 is symbol of danger, 1.8-3.0 is Grey zone and above 3 is green zone.
Q. A share of X ltd has given a mean return of 20% with deviation of 25%
in last few years.
a. What are chances of giving return of more than 25% this year.
b. What are chances of giving return of less than 25% this year.
c. What are chances of giving return of between 25% to 35% this year
Q. A share of X ltd has reported a average capital gain of 15% with
deviation of 20% from last few years with current market price of Rs.250
per share
a. What are chances of reaching its price more than Rs.312.5 this year.
b. What are chances of reaching its price less than Rs.312.5 this year.
c. What are chances of reaching its price between Rs.312.5 this year
Note: The share is under category of no dividend stock.
 Risk aversion and Asset prices
• Asset prices express “consensus” risk preferences
• If market participants seek insurance, assets with high payoffs in bad times are dear
and even more so if market participants risk averse
• Expectations/views on probability distribution of future outcomes entangled with risk
preferences but overall strong evidence of risk aversion
• Asset prices embed risk premiums
• Risk premiums express difference between expected values of risky and risk-free
securities.
• Capital asset pricing Model (CAPM): Simple explanation of risk premium as compensation
for holding market portfolio, an asset with low payoffs in bad times And simple way to
measure, via beta to market portfolio.
 Measuring Return and Risk
• In
  investing, risk and return are highly correlated. Increased potential returns on investment
usually go hand-in-hand with increased risk.
• A return, also known as a financial return, is the income earned or lost on an investment over
some period of time.
• Return in random variable from drawn from an infinite set, ( continuous distribution).
• Key Term with return ( different Calculation of return)
Historical return : Real return , Nominal return , Holding period return , Time Weighted
return(TWRR), Money weighted return (MWRR).

Expected return: The profit or loss an investor anticipates on an investment . It is calculated by

multiplying potential outcomes by the chances of them occurring and then totaling these results.
Q. An Investor has purchased a share of Kinetics Ltd at price of Rs.100 per
share at 1-Jan-2018. The price of share go down by Rs.10 due to bad market
situation at 31-Dec-2018.The company have paid dividend of Rs.20 for year
2019. The price of share is Rs.135 per share at 31-dec-2019.
a) Calculate total return in year 2018 , 2019 and for whole period from this
investment.
b) Find annualized HPR for the investment.

Q. Arab Banking Company’s common stock has a present market price per
share of $29. At the end of 1 year , you estimate the market price of the stock
to be $25 per share with a probability of 0.2, $29 with a probability of 0.3,
$34 with a probability of 0.3, and $37 with a probability of 0.2. Calculate
expected rate of return from Arab Banking share.
 Sharpe ratio [ Risk Adjusted
• Investment risk is the idea that an measurement]
investment will not perform as Treynor ratio
expected, that its actual return will Value at Risk (VaR)
Non-linearity in VaR
deviate from the expected return.
Implied Volatility
• Measuring risks provides clarity on  Autoregressive moving average 
the choice of actions and decisions (ARMA)
that should enforce balance in  Exponentially weighted moving average
the risk-reward trade-off . (EWMA)
• Popular risk measures include:  Autoregressive conditionally
heteroscedastic (ARCH)
Standard Deviation  General Autoregressive conditionally
Volatility heteroscedastic (GARCH)
 Appraisal Ratio [ Specific to style of
Beta
making investment , applicable to fund
R-squared managers of MF and investment]
Q. Consider the following scenario and find the risk in both asset class.
Scenario Prob. Stocks Bonds

Recession 0.2 -5% 14%

Normal 0.6 15% 8%

Boom 0.2 25% 4%

Q. Assuming that agent Rs.1,00,000 portfolio contains Rs.60,000 worth of

Stock X and Rs.40,000 worth of Stock Y. computing the risk of portfolio with
σx= 0.016284, σy=0.015380, and ρ=-0.19055
Q. Assuming that agent Rs 1,00,000 portfolio contains Rs. 60,000
worth of Stock X and Rs. 40,000 worth of Stock Y with σx= 0.016284
σy=0.015380 ρ=-0.19055
Find the maximum value of portfolio at risk for a DAY, a MONTH and a
YEAR with 95% confidence level.
 Defining Risk state
The securities or investment options will be ranked on the basis of risk state.
• Mean-variance dominance provides a partial ordering of investments, ranking
those with the same variance but a higher mean, or those with the same mean but
a lower variance, as preferable. But this approach doesn’t rank securities with
both a different mean and variance.
• Stochastic dominance focuses on the entire distribution of payoffs, and stipulates
says that payoff distributions that are skewed more to high payoffs are ranked
higher.
• Expected utility is an approach in which investments are ranked by the expected
value of the investor’s utility function, a measure of the satisfaction or welfare he
derives from different amounts consumption.
 Value at risk
• Value at Risk (VAR) calculates the maximum loss expected (or worst case
scenario) on an investment, over a given time period and given a specified
degree of confidence.
• Specifically, VAR is a measure of losses due to “normal” market movements.
• The focus in VaR is clearly on downside risk and potential losses. Its use in
banks reflects their fear of a liquidity crisis, where a low-probability
catastrophic occurrence creates a loss that wipes out the capital and creates a
client exodus.
• There are three key elements of VAR- a specified level of loss in value, a fixed
time period over which risk is assessed and a confidence level.
 History of VaR
• VAR was well established in quantitative trading groups at several FI’s before
1990,(due to financial events in early 1990s), though it was not standardized.
• Development was most extensive at J.P. Morgan, which published
methodology and gave free access to estimates of necessary underlying
parameters in 1994.
• In 1997, US SEC, made it compulsory to disclose all quantitative measures of
derivate and present financial statements including VAR.
Need Of VaR

• In other words, volatility refers to the amount of uncertainty or risk

about the size of changes in a security's value.
• Commonly, the higher the volatility, the riskier the security.
• However, is that it does not care about the direction of an investment's
movement.
• VAR answers the question, "What is my worst-case scenario?"
Methodologies of VAR

• HISTORICAL SIMULATION

• VARIANCE-COVARIANCE METHOD

• MONTE CARLO SIMULATION

 Historical simulation

• Historical simulation is a simple, theoretical approach that requires relatively few

assumptions about the statistical distributions of the underlying market factors.
• Historical Simulation can be described in terms of five steps:-
1. expressing the mark-to-market value of the contract in terms of the market
factors.
2. Obtain historical values of the market factors for the last N periods.
3. Calculate the daily profits and losses that would occur if comparable daily
changes in the market factors are experienced and the current portfolio is
marked-to-market.
4. Order the mark-to-market profits and losses from largest profit to largest loss.
5. Finally, select the loss which is equaled or exceeded 5 % of the time.
• Main idea (assumption) : history will repeat itself, from a risk perspective.
• With 95% confidence, we expect that our worst daily loss will not exceed 4%.
• If we invest $100, we are 95% confident that our worst daily loss will not
exceed $4 ($100 x -4%)
 Q. What is VaR of a stock at 90% confidence level from the detail
of return based on historical performance ?

Retur -
ns 16 -14 -10 -7 -5 -4 -3 -1 0 1 2 4 6 7 8 9 11 12 14 18 21 23
Freq
uenc
y 1 1 1 2 1 3 1 2 3 1 2 1 1 1 1 1 1 1 2 1 1 1
 VARIANCE-COVARIANCE METHOD

• It is based on the assumption that the underlying market factors have a

multivariate Normal distribution.
• A key step in the variance covariance approach is known as "risk mapping." This
involves taking the actual instruments and "mapping" them into a set of simpler,
standardized positions or instruments.
• Method can be described in terms of four steps:-
1. Identify the basic market factors and the standardized positions that are directly
related to the market factors, and map the contract onto the standardized
positions.
2. Assume that percentage changes in the basic market factors have a multivariate
Normal distribution with means of zero, and estimate the parameters of that
distribution. This is the point at which the variance covariance procedure
captures the variability and co-movement of the market factors.
3. Use the standard deviations and correlations of the market factors to
determine the standard deviations and correlations of changes in the value
of the standardized positions.
4. calculate the portfolio variance and standard deviation using uses
standard mathematical results about the distributions of sums of Normal
random variables and determine the distribution of portfolio profit or loss.
•  Mathematically VaR will calculated as :

Where , α = indicate the level of confidence [ represented by standard

normal cumulative distribution value]
95% level : value = 1.645 and 99% level : Value = 2.326

Spread Sheet function for value : NORM.S.INV()

Q. The VAR on a portfolio using a one day horizon is Rs.100 million. What is
the VAR using a 10 day horizon ?

Q. If the daily VAR is $12,500, calculate the weekly, monthly, semi annual
and annual VAR. Assume 250 days and 50 weeks per year.

Q. Calculate Value at risk at 99% for confidence interval over a 10 day

horizon a portfolio of $10 million in shares of Microsoft. The volatility of
Microsoft is 2% per day.
Q. Assuming that agent Rs 1,00,000 portfolio contains Rs. 60,000
worth of Stock X and Rs. 40,000 worth of Stock Y with σx= 0.016284
σy=0.015380 ρ=-0.19055
Find the maximum value of portfolio at risk for a DAY, a MONTH and a
YEAR with 95% confidence level.
 Monte carlo simulation

• The third method involves developing a model for future stock price returns and
running multiple hypothetical trials through the model. N hypothetical portfolio
profits or losses, one chooses a statistical distribution that is believed to capture or
approximate the possible changes in market factors.
• Simulation can be described in terms of four steps:-
1. Identify the basic market factors, and obtain a formula expressing the mark-to-
market value of the forward contract in terms of the market factors.
2. Estimate the parameters of that distribution.
3. Use pseudo-random generator to generate N hypothetical values of changes in
market factors, where N is almost certainly greater than 1000 and perhaps greater
than 10,000. These factors are then used to calculate N hypothetical mark-to-market
portfolio values. Then from each of the hypothetical portfolio values subtract actual
mark-to-market portfolio value to obtain N hypothetical daily profits and losses.
4. The mark-to-market profits and losses are ordered from the largest loss to
the largest profit, and the value at risk is the loss which is equaled or exceeded
5 percent of the time.
• You sell 100 shares of stock short for 40$ per share. You want to limit your
VaR on this transaction to no more than 500$. What order should you
place?

• You are bearish on Telecom and decide to short 100 shares at the current
market price of $50 per share.
a. How much in cash or securities must you put into your brokerage
account if the broker’s initial margin requirement is 50% of the value of
the short position?
b. How high can the price of the stock go before you to increase your VaR
if the maintenance margin is 30% of the value of the short position?
 Advantage and Limitation of VaR
• Captures an important aspect of risk in a single number.
• It provides a measure of total risk.
• It is useful for monitoring and controlling risk within portfolio.
• It is applicable for risk measurement of all types securities.
• As a tool, it is very useful for comparing a portfolio with market portfolio.

• It is nearly impossible to estimate the risks of rare events,

• Gave false confidence.
• The results can be manipulated by traders
Probability and distributions of asset
prices
• A probability distribution is a statistical function that describes all the
possible values and likelihoods that a random variable can take within a
given range. Depend on multiple factors : distribution's mean
(average), standard deviation, skewness, and kurtosis.

• Probability distributions illustrate our view of an asset return's sensitivity

when we think the asset return can be considered a random variable.
 Some common distribution of asset price
• Discrete vs. Continuous Distributions: Discrete refers to a random variable
drawn from a finite set of possible outcomes. While  A continuous
distribution refers to a random variable drawn from an infinite set
• Uniform Distribution: The simplest and most popular distribution is
the uniform distribution, in which all outcomes have an equal chance of
occurring.
• The binomial distribution reflects a series of "either/or" trials. These are
called Bernoulli trials—which refer to events that have only two outcomes.
• The lognormal distribution is very important in finance because many of the
most popular models assume that stock prices are distributed lognormally.
The lognormal distribution is non-zero and skewed to the right
• The Poisson distribution is used to describe the odds of a certain event (a
daily portfolio loss below 5%) occurring over a time interval. 
• The most commonly used distribution is the normal distribution, which is used
frequently in finance, investing, science, and engineering. The normal distribution is
fully characterized by its mean and standard deviation, meaning the distribution is not
skewed and does exhibit kurtosis. 68% of the data collected will fall within +/- one
standard deviation of the mean; approximately 95% within +/- two standard
deviations; and 99.7% within three standard deviations. 
•  There are many tools in our statistical box, to choose the best fit for the occasion.
The normal distribution is omnipresent and elegant and it only requires two
parameters (mean and distribution). Many other distributions converge toward the
normal (e.g., binomial and Poisson). However, many situations, such as hedge
fund returns, credit portfolios, and severe loss events, don't deserve the normal
distributions.
Asset pricing

• Assets are items that give real value to a firm or an investor. An asset can be
defined as a right on future cash flows. Assets can be real assets such as land,
houses, machines or capital.  Financial assets include money, bonds and
securities
• Asset price is the amount one pays for an asset when buying it. 
• The price represents the amount of value the market has assigned, fairly or 
unfairly, to an asset. 
• Normally, prices are expressed in terms of money, but this is not always the 
case; for example, one may trade four chickens for a sheep.
• The financial models help us in judgement and prediction of asset price.
• Asset pricing  refer to a formal development of models for different
situations, like in general equilibrium asset pricing and risk neutral pricing.
• Further asset pricing may different for different quality of asset and situation
of market.
• Asset Pricing models can be cluster in different groups on the basis of certain
specific or similar criteria:
A) Present value method ( discounted value) : The value of an asset depends on
associated cash flows:
• Efficient Market hypothesis
• Constant cash flow method
• Constant growth rate cash flow method
B) Utility theory Approach :
• Expected utility theory : John von Neumann and Oskar Morgenstern introduced
the expected utility hypothesis in 1944, alternative with the highest expected
utility will have high market price.
• Risk aversion selection criteria of asset price
C) Portfolio Theory : help in pricing of asset beyond criteria of risk and return
• Mean variance
• Markowitz frontier
• Capital asset pricing model
• Arbitrage pricing theory
• Intertemporal CAPM
• Consumption and production based asset pricing
 Some Common properties of Asset pricing
•  The today’s price of an asset, P , should equal the expected value of the product
of a stochastic discount factor , m , and the payoff of the asset period ahead , X.

The asset pricing model has at least four senses. First, it holds for any asset,
including stocks, bonds, real estate property, etc. Second, it does not depend on
any specific assumptions about the properties of asset prices, and therefore does
not rely on any particular asset pricing model. Third , it contains many
unobservable elements, such as future payoffs and risk premia demanded by
investors, which are hard to disentangle. Fourth , It tries to forecast value of
asset in future.
Methods of forecasting (time series data)
• Moving average method
• Exponential smoothing method
• Auto-regressive moving average Method (ARMA)
• Multiple regression method
• Auto Regressive Integrated Moving Average
• Autoregressive conditionally Heteroscedastic (ARCH)
• General Autoregressive conditionally Heteroscedastic (GARCH)
Risk and Forecasting issues (interest rate)
• Interest rate : Interest rates play a vital role in financial markets, mainly to
judge value of asset .
Interest rate has impact on investment and credit market at same time.
Forecasting interest rates accurately is one of the hardest tasks in predictive
financial analysis.
Interest rates change continuously and are dependent on a large number of
factors including regimes of countries to banking lending trends.

Spot interest rate and Forward interest rate are link to each other in way of
stochastic process .
 Theories of Interest rate forecasting
• Expectation theory : For predication of short term interest rate
Expectations theory predicts future short-term interest rates based on current long-term
interest rates
The theory suggests that an investor earns the same amount of interest by investing in two
consecutive one-year bond investments versus investing in one two-year bond today .
‘Safe’ securities of various maturities are perfect substitutes in the portfolios of investors.
All investors hold with certainty the same expectations of how future rates are going to
behave.
Forward rate for 2nd year = Spot rate expected over year 2
• liquidity preference:
• Hedging-pressure :
• Segmented Markets
• Substitutability Theory
Q. A two-year bond that pays an interest rate of 20% while a one-year bond pays
an interest rate of 18%. Forecast the interest rate of a future one-year bond.

Q. If the one-year spot rate is 7 percent and the two-year spot rate is 12 percent,
what is forward rate for year 2 (f2)?

Q. Assume the following set of rates for G-sec bond:

What are the forward rates over each of the four years?
Q. Suppose that the current one-year rate and expected one-year T-bill rates
over the following three years (i.e., year 2, 3, and 4, respectively) are as
follows: 1R1 = 5%, E(2r1)=6%, E(3r1)= 7%, E(4r1)=7.5%
Using the unbiased expectations theory, calculate the current rates for three-
year and four-year Treasury securities.

Q. Compute the spot rates for years 1 and 2, from use of the data of following
forward rates:
year Forward Rate
1 5%
2 6%
• Liquidity Preference Theory: The model suggests that an investor should
demand a higher interest rate or premium on securities with long-
term maturities that carry greater risk because, all other factors being equal,
investors prefer cash or other highly liquid holdings.
• Liquidity Preference Theory refers to money demand as measured through
liquidity.
Interest rate of longer duration bond > Interest rate of short duration bond
forward rate for 2nd year ≠ Spot rate expected over year 2

Q. The following rates: 1R1= 0.75%,  1R2=1.20%, E(2r1)=0.907%.  If the liquidity

premium theory of the term structure of interest rates holds, what is the liquidity
premium for year 2, L2?
 Forecast of Exchange rate
• Exchange rate forecasting means to estimate the rate of currencies of two countries for future date.
• It is just expectation of currency rate. [currency may be depreciated or may be appreciated from
the spot market].
• Exchange rate forecasts are necessary to evaluate the foreign denominated cash flows involved in
international transactions.
• Exchange rate forecasting is very important to evaluate the benefits and risks attached to the
international business environment.
• Short-term hedging or cash management decisions often rely on a forecast of expected exchange
rate movements
• To evaluate foreign borrowing or investment opportunities, forecasts of future spot exchange rates
are necessary to convert expected foreign currency cash flows into their expected domestic
currencies.
• For long-term strategic decisions, such as whether to build or acquire productive resources in a
particular country.
 Approaches for Exchange rate Forecast
• A forecast represents an expectation about a future value or values of a variable. The
expectation is constructed using an information set selected by the forecaster. Based
on the information set used by the forecaster, there are two pure approaches to
forecasting foreign exchange rates:
(1) The fundamental approach.
(2) The technical approach.

Fundamental approach is a forecasting technique that utilizes elementary data related

to a country, such as GDP, inflation rates, productivity, balance of trade, and
unemployment rate. The principle is that the ‘true worth’ of a currency will eventually
be realized at some point of time. This approach is suitable for long-term investments.
 The fundamental approach.{popular theory}

•  Purchase Power Parity (PPP): Purchasing power parity (PPP) is a popular metric
used by macroeconomic analysts that compares different countries' currencies
through a "basket of goods" approach.
It is based on the law of one price, which says that, if there are no transaction
costs nor trade barriers for a particular good, then the price for that good should be
the same at every location.
As per PPP approach, exchange rate works with equilibrium approach to price of
commodity (represented by inflation rate)
In relative version , exchange rate changes over time are assumed to be dependent
on inflation rate differentials between countries.
Q. As of November 1, 2020, the exchange rate between the Brazilian real and
U.S. dollar is R$1.95/$. The consensus forecast for the U.S. and Brazil inflation
rates for the next 1-year period is 2.6% and 20.0%, respectively. How would you
forecast the exchange rate to be at around November 1, 2021? .

Q. Due to the integrated nature of their capital markets, investors in both the
U.S. and U.K. require the same real interest rate, 2.5%, on their lending. There is
a consensus in capital markets that the annual inflation rate is likely to be 3.5%
in the U.S. and 1.5% in the U.K. for the next three years. The spot exchange rate
is currently $1.50/£. a. Compute the nominal interest rate per annum in both the
U.S. and U.K., assuming that the Fisher effect holds. b. What is your expected
future spot dollar-pound exchange rate in three years from now? c. Can you infer
the forward dollar-pound exchange rate for one-year maturity?
• Interest
  rate Parity (IRP); The IRP is a fundamental law of international finance. IRP
embodies the relation between exchange rate and interest rate.
• In an equilibrium economy situation, the forward rate of a foreign currency will differ (in
%) from the current spot rate by an amount that will equal the interest rate differential (in
%) between the home and foreign country.
• As a result of market forces, the forward rate differs from the spot rate by an amount that
sufficiently offsets the interest rate differential between two currencies to stop covered
interest rate arbitrage.
• When IRP exists, the rate of return achieved from covered interest arbitrage should equal
the rate of return available in the home country.
So, Premium or discount on forward exchange rate will be:

By using , F = S*(1+P),
 Some key point IRP
• When IRP exists, it does not mean that both local and foreign investors will
earn the same returns.
• What it means is that investors cannot use covered interest arbitrage to
achieve higher returns than those achievable in their respective home
countries.
• Various empirical studies indicate that IRP generally holds.
• While there are deviations from IRP, they are often not large enough to
make covered interest arbitrage worthwhile.
• This is due to the characteristics of foreign investments, such as transaction
costs, political risk, and differential tax laws
Q. Today's spot exchange rate: 1 euro = $1.25.
US interest rate (home interest rate) is 7%.
EU interest rate (foreign interest rate) is 10%.
a) If the IRP (Interest rate parity) holds, what should the forward exchange rate be
today?
b) Assume that today, you invest $500 in the EU market for one year and at the
same time, enter a currency forward contract to sell euro in a year at the forward
rate from part a). If today's spot exchange rate is: 1 euro=$1.32 instead of $1.25,
show how much profits or losses you make next year.
Q. The treasurer of Microsoft has an extra cash reserve of $100,000,000 to invest for six
months. The six-month interest rate is 8 percent per annum in the United States and 7 percent
per annum in Germany. Currently, the spot exchange rate is €1.01 per dollar and the six-
month forward exchange rate is €0.99 per dollar. The treasurer of company does not wish to
bear any exchange risk. Where should he/she invest to maximize the return?

Q. During tour to London, you purchased a car for £35,000, payable in three months. You
have enough cash at your bank in New York City, which pays 0.35% interest per month,
compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£ and the
three-month forward exchange rate is $1.40/£. In London, the money market interest rate is
2.0% for a three-month investment. There are two alternative ways of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three
months so that the maturity value becomes equal to £35,000.
Which method would you prefer? Why?
Q. Suppose that the current spot exchange rate is €0.80/$ and the three-month forward
exchange rate is €0.7813/$. The three-month interest rate is 5.6 percent per annum in the United
States and 5.40 percent per annum in France. Assume that you can borrow up to $1,000,000 or
€800,000.
a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want
to realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit.
b. b. Assume that you want to realize profit in terms of euros. Show the covered arbitrage
process and determine the arbitrage profit in euros.
• Relative economy approach :  the relative economic strength approach
looks at the strength of economic growth in different countries in order
to forecast the direction of exchange rates. 
• Econometrics approach: Multivariate regression analysis based on the
economic factors and relative strength between countries.
• Technical approach, the investor sentiment determines the changes in the
exchange rate. It makes predictions by making a chart of the patterns. In
addition, positioning surveys, moving-average trend-seeking trade rules, and
Forex dealers’ customer-flow data are used in this approach.
• Technical forecasts are purely based on statistical method and use historical
trends in the exchange rate with predictive charts modelling past behaviour
patterns to predict future exchange rate movements.
• Technical methods does not include any economic theory. The rationale is that
the past behavior and price patterns can affect the future price behavior and
patterns. The data used in this approach is just the time series of data to use
the selected parameters to create a workable model.
• The popular time series approach is known as the autoregressive moving
average (ARMA) process.
 Autoregressive Moving average (ARMA)
for Exchange rate.
• ARMA model was described in the 1951 thesis of Peter Whittle, Hypothesis
testing in time series analysis, and it was popularized in the 1970 book
by George E. P. Box and Gwilym Jenkins.
• Model provides description  in terms of two polynomials, one for
the autoregression (AR) and the second for the moving average (MA).
• The model is usually referred to as the ARMA(p,q) model where p is the order
of the AR part and q is the order of the MA
AR model:

MA model :

ARMA model : ( Combining two)

 yen-carry trade syndrome
• Carry trade is strategy of going short to low interest bearing currency and
simultaneously long to high interest bearing currency
• The term carry stand for holding an asset in expectation of positive return.
• Basics of carry trade : Funding currency , target currency and Carry to risk
ratio.
• The yen carry trade is when investors borrow yen at a low-interest rate then
purchase either U.S. dollars or currency in a country that pays a high interest
rate on its bonds.
• https://www.slideshare.net/cwhizkid420/yencarrytrade