Application in Risk Management

12 Pages Posted: 6 Jun 2016

See all articles by Paul Cottrell

Paul Cottrell

affiliation not provided to SSRN

Date Written: June 4, 2016

Abstract

To investigate professional practice regarding applications in corporate finance this Application component provides generalized recommendations on how to use correlations and volatility to determine a hedging strategy in the currency markets. The next section entails a framework to help describe applied risk management methods pertaining to risk exposure in the currency spot market. A formulated discussion on how to implement and use different hedging strategies to improve financial performance either for a corporation or private investor by reducing risk in the currency spot market is provided.

In the Breadth component an analysis of capital budgeting, portfolio investments, risk management, optimization, financial planning, mergers, acquisitions, and corporate governance was put forth. A compare and contrast was performed for each of the above theories in corporate finance. This component included a discussion of how these theories contribute to better performance from a corporate financial perspective. Influential writers from each theory, as to the role that contemporary corporate finance plays in promoting performance, were part of the analysis. There was a question posed: Why do fundamental analysis, risk management strategies, and knowledge of the agency problem still lead to system failure in corporations?

To answer this question moral hazard was investigated through the framework of corporate governance. When the risk and rewards are out of sync excessive risk taking usually results. When socialized risks and privatized rewards are present in a system, such as the banking industry, then imprudent risk behavior is exhibited by the corporate leaders in that industry.

It was shown in the Depth component that risk management can be an important tool to improve investors’ portfolios. Development of hedging models that reduce computational time and hedging error was shown. But hedging a portfolio is just one aspect of a risk manager. Risk managers are also heavily interested in counterparty risk exposure, expected loss calculations, and systemic risk from low probability events. Methods like VaR guide the risk manager in mitigating too much leverage for a corporation, such as a bank or investment firm.

How can a risk manager mitigate risk exposure? This question was explored using different GARCH modeling techniques, the use of Sharpe ratios, systemic risk exposure using different visualization methods, and realization that illiquidity in markets can have distortions in VaR calculations.

In the Application component a model is proposed to help hedge spot market positions in the currency market without the use of complicated mathematical models. An investor or treasurer at a corporation needs to hedge risk with low cognitive processing. If a simple and useful model can be developed then mitigating currency risk exposure will be possible. The key to this proposed hedging strategy is that currency pairs have a correlation with each other and that the returns on a certain currency pair have clustered volatility. It is possible to hedge a spot position in the currency pair with an offset position in a related currency pair. How do we determine the proper weight of the hedge? This can be done by understanding the level of correlation. The level of correlation can be a proxy to a delta hedge. The volatility of the currency pair is a metric to predict through chart patterns that a certain volatility epoch is approaching. When higher volatility is expected then a more immunized hedge is appropriate. Likewise, when volatility is expected to be low the hedge can be less protective.

Keywords: Risk Management, GARCH, Correlations, Volatility

JEL Classification: C10, C49, C5, C53, C63, E17, E30, F47

Suggested Citation

Cottrell, Paul, Application in Risk Management (June 4, 2016). Available at SSRN: https://ssrn.com/abstract=2790065 or http://dx.doi.org/10.2139/ssrn.2790065

Paul Cottrell (Contact Author)

affiliation not provided to SSRN

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