AFF9260 Australian capital markets WEEK 5 Tutorial Questions: Risk and Uncertainty

1. The table below shows the probability distribution of shares prices for Company . !a" Calculate the e#pected $alue of this share price !b" Assume that Company shares ha$e a lon%&term standard de$iation of returns of 0.'(. )f the shares of Company * ha$e an e#pected return of 9.1(+ and a standard de$iation of 0.'2, which company-s shares would be selected by a risk a$erse in$estor and why. Share return (%) Pro a ility

7.95 7.49 8.12 8.42 8.96 9.12 9.25 9.36 9.75 8.75 7.85
2.

0.08 0.06 0.04 0.07 0.08 0.18 0.16 0.12 0.07 0.09 0.05

A risk neutral in$estor is plannin% to in$est his money for one year. )f there is /ero inflation he would be willin% to in$est at 10+ per annum. )n fact he e#pects that the inflation rate o$er the comin% year will be '+ per annum & what is the minimum interest rate he would accept in this case. 0ohn approaches a bank for a loan for one year. The risk a$erse bank has assessed the credit risk of 0ohn, and has decided that 0ohn is a risky borrower with an e#pected default rate of 0.01+. The bank is willin% to lend to 0ohn, pro$ided he pays an interest rate which yields the bank an e#pected return of 11+ per annum. 2hat interest rate would they char%e. !Assume /ero inflation"

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*riefly e#plain !1&2 sentences" what is $olatility, e#cess return, and hed%in%.
3olatiliy 4 refers to the amount of uncertainty or risk about the si/e of chan%es in a security5s $alue. 6#cess return 4 )n$estment returns from a security or portfolio that e#ceed a benchmark or inde# with a similar le$el of risk.! total return of an asset or security portfolio less the risk&free return" 7ed%in% 4 8the practice of mana%in% risk e#posure, usually by takin% contracts !such as deri$ati$es" that ha$e an offsettin% e#posure- and 8a process of establishin% a second position to counterbalance an e#posed e#istin% position-.

1.

6#plain the concept of a risk&return trade&off.

The risk9return tradeoff is the balance between the desire for the lowest possible risk and the hi%hest possible return. 6. :isk mana%ement is important to the lon%&term sur$i$al of a corporation !a" ;efine and e#plain the nature of risk. &:isk is the possibility or probability that somethin% may occur that is une#pected, not anticipated. &:isk adds uncertainty to the business mana%ement and forecastin% processes. &A business is e#posed to both operational risks and financial risks.

AFF9260 Australian capital markets

&<perational risks impact upon the normal day&to&day functions of a business. &Financial risks affect business cash flows and the $alue of balance sheet assets and liabilities. !b" 2hat is the purpose of risk mana%ement. &To ensure an or%anisation is aware of the risks associated with all aspects of its business operations. &To ensure personnel consider the risk outcomes that deri$e from their business decisions. &To establish robust risk mana%ement ob=ecti$es, policies, procedures and strate%ies that result in all risk e#posures bein% identified, measured and mana%ed. &To miti%ate potential ne%ati$e operational and financial impacts of risk. &To protect personnel. !c" ;iscuss who is responsible for the establishment of risk mana%ement ob=ecti$es, policies, procedures and strate%ies in a corporation. 3iney > ?hillips 1@ A 1, p. 609. The board of directors of an or%anisation is responsible for the determination and documentation of all risk mana%ement ob=ecti$es. <nce the board has determined the ob=ecti$es !which risks must be mana%ed", it will determine related risk mana%ement policiesB that is, how the risk mana%ement ob=ecti$es will be implemented. The chief e#ecuti$e officer and e#ecuti$e mana%ement will establish risk mana%ement procedures,strate%ies and reportin% structures. The procedures and strate%ies are de$eloped within the constraints of the risk mana%ement ob=ecti$es and policies set by the board. C. )t is often ar%ued in the risk mana%ement literature that risk must be identified, measured, and mana%ed. ;iscuss the lo%ic and reasons behind the contention that risk must be identified, measured and mana%ed. 3iney > ?hillips 1@ A ', p. 609.

*efore an or%anisation can be%in to mana%e risk e#posures it needs to know what those e#posures areB therefore it is necessary to identify all potential risk e#posures relatin% to all financial and operational components of a business. The number, e#tent and scope of risk e#posures will $ary dependin% on the business operationB for e#ample, a minin% company will be e#posed to a different ran%e of risks than would a financial institution or a hotel chain. <nce a risk e#posure is identified it is necessary to measure the potential operational and financial impacts of the e#posure, %i$en a ran%e of scenarios. *ased on this Duantitati$e analysis, an or%anisation will decide how, or if, the risk is to be mana%ed. Ei$en a decision to mana%e a risk, the or%anisation will determine alternati$e strate%ies that may be appropriate to mana%e the risk determine the most suitable strate%y and put procedures in place to implement the strate%y. @. <F :esources Gimited has recently issued H10 million in floatin% rate notes in order to fund the ne#t sta%e of an e#ploration pro=ect. The notes pay an annual coupon of **I2 plus 210 basis points. The company approaches Je%a *ank Gimited to establish an intermediated $anilla swap. The swap contrast sets a fi#ed rate of 6.10 per cent per annum and a reference rate of the 12 month **I2.

!a" 2hat is an intermediated $anilla swap. !b" At the first interest payment date, the **I2 is 6.C1 per cent per annum. ;raw and fully label a dia%ram showin% all the applicable interest rates at that date. !c" 2hich party to the swap contract is reDuired to make the first payment. 7ow much is the payment. 2hy don-t both parties need to make a payment. 3iney > ?hillips 1@ A 1', p. 610. 9. Kse the followin% returns, calculate the a$era%e returns and the standard de$iations for shares X and Y.

AFF9260 Australian capital markets

Returns

1 2 3 4 5 6 7 8

year 0.18 0.12 0.14 0.17 0.21 0.08 0.08 0.24

X 0.11 0.19 0.06 0.08 0.06 0.21 0.27 0.06