Tunis Business School - Fall 2024

Introduction to Financial Risk

Management

Eymen Errais, PhD, FRM

 Introduction to Risk Management

▪ Financial risk management is the process by which financial risks are identified,
assessed, measured, and managed in order to create economic value.

▪ The risk manager, like physicists must have a telescope (anticipate the future) and
a microscope (understand the details of processes)

▪ Building blocks in the risk management process

1. Identify risks.
2. Measure and manage risks.
3. Distinguish between expected and unexpected risks.
4. Address the relationship between risks.
5. Develop a risk mitigation strategy.
6. Monitor the risk mitigation strategy and adjust as needed
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 Loss Categories

•Expected Loss: The average loss anticipated

over a specific period based on historical data and
statistical models. Example: EL = EAD x PD X LGD

•Unexpected Loss: The potential loss that

exceeds the expected loss but falls within a
predictable range of outcomes.

•Known Unknowns: Risks that are identified but

whose likelihood and impact are uncertain and
cannot be precisely quantified.

•Unknown Unknowns: Completely unforeseen

risks that cannot be predicted or quantified based
on current knowledge and historical data

Page 3 Risk Management – Eymen Errais

 Types of Risks

Types of Risks

Equity market Market Risk Commodities Operational Risk

Credit Risk market

▪ Default Risk ▪ Interest Rate ▪ Fraud

▪ Counterparty Risk ▪ Stock prices ▪ Process Execution
▪ Bankruptcy risk ▪ Commodities ▪ Labor Relations
▪ Downgrade risk ▪ FX ▪ Assets Damage
▪ Inflation ▪ Business Practices

▪ Funding liquidity risk ▪ Market liquidity risk

Liquidity Risk
Types of risks

Page 4 Types of risks

 Risk Management Techniques

Techniques

Extreme Value Equity market Commodities Scenario Analysis

Greeks
Theory market

▪ Value at Risk ▪ Delta ▪ Scenario Analysis

▪ Credit VaR ▪ Gamma ▪ Stress Testing
▪ Cash Flow at Risk ▪ Duration ▪ Jump Prcesses:
▪ Loss at Risk ▪ Volatility Poisson Process,
▪ Economic Capital ▪ Theta Doubly stochastic
process

Page 5
 Relationship between Risk and Reward (Return).

▪ There is a natural trade-off between risk and reward. In general, the greater the risk
taken, the greater the potential reward. However, one must consider the variability
of the potential reward

▪ The portion of the variability that is measurable as a probability function could be

thought of as risk (EL) whereas the portion that is not measurable could be thought
of as uncertainty (unexpected loss).

▪ The risk/reward trade-off becomes much more complex to analyze for assets that
are either thinly traded or not publicly traded. This is especially true for illiquid
assets

▪ Risk Adjusted Return on Captial (RAROC) = Reward/Risk

= After tax net Risk Adjusted Expected Return / Economic Capital
Page 6
 Understanding Return

➢ Holding - Period Returns – Single Period ➢ Expected Return

1 − P 0 + D1
1 n
E (r ) = s =1 p( s)r ( s) = s =1 r ( s)
n

HPR = P
n
P0

▪ HPR = Holding Period Return

▪ P0 = Beginning price
▪ P1 = Ending price
▪ D1 = Dividend during period one

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 Understanding Return

➢ . TV n = (1+ r1 )(1+ r2 ) x x = (1+ rn )

TV = Terminal Value of the Investment

➢ . g = TV 1/ n
−1

g= geometric average rate of return

➢ If returns are normal:

Page 8
 Measuring Risk

n 2
1
▪ Variance
 =  p ( s )  r ( s ) − E (r )   =   r ( s) − r 
2 2 2

s n s =1
▪ Volatility

▪ Value at Risk

▪ Beta

▪ Correlation

▪ Copula Functions

Page 9 Value at Risk (VaR) Risk Management – Eymen Errais

 Understanding (Risk, Return) – Sharp Ratio

▪ Returns are not enough to make the right decision. Sometimes we might be taking
too much risk for the return we are seeking.
▪ How can the performance be adjusted for risk in a single measure ?

▪ Sharpe Ratio (SR) : could be the simplest answer :

Sharpe Ratio (SR)

▪ The Information Ratio :

Information Ratio

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How do Firms Manage Financial Risk ?
 Relationship between Risk and Reward (Return).

▪ At a high level, a firm can pick from four different risk management strategies.
Senior management and the board of directors are ultimately responsible for
strategy selection, but risk managers can help inform the decision-making process.
The risk management strategies are as follows:
• Accept the risk
• Avoid the risk Profil

• Mitigate the risk

• Transfer the risk

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 Relationship between Risk and Reward (Return).

▪ Risk Capacity: The maximum amount of risk an organization

is able to assume, given its financial resources, objectives,
and regulatory constraints.
Capacity
▪ Risk Appetite: The amount and type of risk an organization is
Appetite
willing to pursue or retain in order to achieve its objectives.
Profil

Profile
▪ Risk Profile: The overall assessment of the types and levels
of risk an organization currently faces, considering its risk
capacity, risk appetite, and external environment.

▪ Risk Limit: Specific thresholds or boundaries set by an

organization to control the amount of risk exposure within its
risk appetite and capacity.
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 Risk appetite and Firm’s risk management decisions

▪ With an awareness of the high-level strategies available, risk managers can

proceed through a five-step risk management process:

1. Identify risk appetite.

2. Map known risks.
Profil
3. Operationalize the risk appetite.
4. Implement a plan.
5. Monitor and adjust the plan as needed

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 Risk transfer: Hedging strategies

▪ Benefits of deploying a hedging ▪ Disadvantages of deploying a hedging

strategy strategy

1. Reduced costs 1. The potential for managerial focus to be

shifted away from core operations
2. Smoother operating performance
2. Profil
Compliance costs
3. Enhanced business planning
3. The possibility that new risks might be
4. The ability to lock-in positive results in
introduced in an attempt to minimize
the short-term
other risks
4. The high level of complexity associated
with many hedging strategies

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Risk Regulations
 Basel Accords evolution

Basel II
Free Banking Mc Donough Ratio

Basel I Abandon du
1824 ratio Cooke
Ratio Cooke
Suffolk bank

Avt 1837 1861 1933 1975 1988 1999 2001 2004 2006 2007 2010 2013

New cycle of consultation 1st application of

Mc Donough Ratio
Charter System
Period
Basel III Accords
Banking Act
European Directive

National Bank Surveillance System

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 Basel I

▪ The original goal of the 1988 Basel Accord, which came into force in 1992, was to
set minimum capital requirements for commercial banks as a buffer against financial
losses.

▪ Basel I requires banks to hold a minimum level of capital of at least 8% of the total
risk-weighted assets (RWA). RWA include on-balance-sheet and off-balance-
sheet items, using risk weights that provided a rough classification of assets by
credit risk.

▪ Capital includes the book value of equity on the balance sheet, with adjustments,
as well as other entries such as subordinated debt.

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 Basel II

Credit Risk

Pillar 1
Operational Risk
Min Cap Requirements

Market Risk

Pillar 2
Basel II Supervisory Review - Risk assessment and monitoring process
Process

Pillar 3 - Minimum financial disclosure

Market Discipline requirements

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 Basel III

New Definition of Initially programmed for 2020-2021:

Capital
- Definition revised (Tier 1 and AT1)
Capital Reform
- Conservation and countercyclical
Buffer
Capital Buffers

LCR - Liquidity Coverage Ratio =

High Quality Asset Amount (HQLA) / Total
Basel III Liquidity Standard net CF amount
NSFR - Initially Programmed for
2020-2021

Leverage Ratio - Levergae capial ratio : Equity/ Asset >= 3%

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 Tunisian context - Capital Adequacy Standards

International Tunisia
➢ Basel I (1988)
The Cooke ratio was set at 8% of weighted assets. 𝑁𝐶
This ratio is articulated in 3 layers of Capital: ▪ Solvability Ratio = 𝐴𝑊 12.5 12.5 ≥ 10%
+ +
𝐶𝑅 𝑅𝑂 𝑀𝑅
✓ Tier 1 capital with a floor at 4% of the ratio
✓ Tier 2 capital
✓ Tier 3 capital 𝑁𝐶𝐶
Cooke Ratio = Net Capital / RWA (credit) >= 8%
▪ Ratio Tier 1 = 𝐴𝑊 12.5 12.5 ≥ 7%
+ +
𝐶𝑅 𝑅𝑂 𝑅𝑀
Such that:
➢ Basel II (2004)
NC: Net Capital
Make banks comply with minimum capital requirements for the
NCC: Net Core Capital
risks of: Credit Risk, Operational Risk and Market Risk
AW/CR : Assets weighted on credit risk
McDonough Ratio: This is the ratio between the prudential net
equity of the bank (bases (Tier 1) and supplementary (Tier 2)) OR: Capital Requirements for Operational Risk
and the weighted bank assets or adjusted for different risk MR: Capital Requirements for Market Risk
classes (credit, market, and operational).
Mc Donough Ratio : Net Capital /(credit + market + ops)
risks >= 8%
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 Tunisian context - Capital Adequacy Standards

International Tunisia
➢ Basel III The implementation of the BCT’s 2016-2020 five-year
A new definition of capital: Basel III eliminates Tier 3 Capital plan:
and define the total regulatory capital as the sum of the
following elements: The BCT plan to bring the prudential framework into line
• Tier 1 Capital = CET 1 + AT 1 (going-concern capital) with Basel 2 and Basel 3 and is now at an advanced
• Tier 2 Capital (supplementary Capital, gone-concern stage:
capital) Additional guidance on the Definition for Equity:
Minimum Capital Standards ▪ Split complementary equity into two components: Tier 1
• Total capital must be equal at least 8% of RWA. equity and Tier II equity according to Basel II
• The Basel III accord raised the minimum capital instrument.
requirements for banks from 2% to 4.5% of common equity, ▪ Deduction of shareholding and subordinated debt (Tier
as a percentage of the bank’s risk-weighted assets. 3) in other banks and financial institutions from their
• The Tier 1 capital requirement increased from 4% in Basel corresponding component as per Basel 3 standards.
II to 6% in Basel III. The 6% includes 4.5% of CET1 and an 2020-2021 Plan:
extra 1.5% of AT1. ● The introduction of counter-cyclical equity buffer,
conservation buffer and additional provisions in terms
of capital for systemic local banks.

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 Tunisian context - The liquidity standard

International Tunisia
➢ Basel III
Basel III introduces two new liquidity measurements: The BCT published circular No. 2014-14 of 11 November
2014 reviewing the liquidity ratio by introducing a new one
Short-term: Liquidity Coverage Ratio (LCR): A measure that which is largely based on the Liquidity Coverage Ratio of
evaluates whether a bank has enough liquidity to meet Basel 3 with adaptation to the Tunisian context. The
expected cash outflows during a 30-day stress scenario. It implementation was in 2015.
requires banks to hold high quality liquid (liquid in markets The LCR is the rate of coverage of total net cash outflows
during a time of stress and ideally, be central bank eligible) by the outstanding balance of high-quality liquid assets
assets to survive in emergent stress scenario. The higher the within 30 days in a liquidity crisis.
ratio the better.
Stock of High-Quality Assets/ Net Cash outflows over a 30-day 2015 2016 2017 2018 2019
Time Period <= 100%
LCR 60 70 80 90 100
(%)

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 Tunisian context - The liquidity standard

International Tunisia
➢ Basel III
Long-term: Net Stable Funding Ratio (NSFR): a long-term The BCT plan during, 2020-2021 to implement an average
structural measure that evaluates the amount of funding
available from stable sources relative to the funding needs of liquidity ratio called: Net Stable Funding Ratio (NSFR) to
the bank’s assets. comply with the Basel 3 guidelines.
ASF/ RSF >=100
• ASF: Available amount of stable funding is defined as the
total amount of an institution’s capital, preferred stock with
maturity of one year or greater than one year, liabilities with
effective maturities of one year or greater deposits and/or
term deposits with maturities of less than one year that
2015 2016 2017 2018 2019
would be expected to stay with the institution for an
extended period. LCR 60 70 80 90 100
• RSF: Required Stable funding is calculated as the sum of (%)
the value of the assets held and funded by the institution,
multiplied by RSF factor, added to the amount of Off-
balance sheet (OBS) activity (potential liquidity exposure)
multiplies by its associated RSF factor.

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 Definition of Capital

➢ In the Basel Accord, “capital” has a broader interpretation than the book value of
equity. The key purpose of capital is its ability to absorb losses, providing some
protection to creditors and depositors. The Basel Accord recognizes three forms of
capital :
▪ Tier 1 Capital (Core Capital)

▪ Tier 2 Capital (Supplementary Capital)

▪ Tier 3 Capital, for market risk only : it consists of short-term subordinated debt
with a maturity of at least two years. This is eligible to cover market risk only.

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 Definition of Capital – Tier 1

➢ Tier 1 capital includes equity capital and disclosed reserves, most notably after-tax
retained earnings
▪ Equity capital : common stock + preferred stock
▪ Disclosed reserves : correspond to share premiums, retained profits, and
general reserves.
▪ Goodwill : This is an accounting entry that, after an acquisition, goes into book
equity to represent the excess of the purchase value over book value.

➢ Tangible Common Equity (TCE) = Equity − Intangible Assets − Goodwill −

Preferred

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 Definition of Capital – Tier 2

➢ Tier 2 capital. This is sometimes referred to as Supplementary Capital. It includes

components of the balance sheet that provide some protection against losses but
ultimately must be redeemed or contain a mandatory charge against future
income. These include :
▪ Undisclosed reserves
▪ Asset revaluation reserves
▪ General provisions/loan loss reserves
▪ Hybrid debt capital instruments
▪ Subordinated term debt

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 Definition of Capital – Tier 2

➢ Tier 2 capital includes components of the balance sheet that provide some
protection against losses but ultimately must be redeemed or contain a mandatory
charge against future income. These include :
▪ Undisclosed reserves
▪ Asset revaluation reserves
▪ General provisions/loan loss reserves
▪ Hybrid debt capital instruments
▪ Subordinated term debt

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 Basel III extra buffers

➢ The major goal of the so-called Basel III revisions to the Capital Accord was to
increase the level and quality of bank capital.

➢ Basel III added a capital conservation buffer (CCB) of 2.5%. Banks will be
allowed to draw on this buffer during periods of stress but will be then subject to
constraints on earnings distribution (e.g., dividend and bonus payments).

➢ Basel III added a countercyclical buffer consisting of common equity within a

range of 0% to 2.5%, but according to “national circumstances.” The goal of this
buffer is to increase the amount of bank capital when there is excess credit growth
that could result in a buildup of risk.

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Risk Charges
 Basel I Credit Risk Charge

CRC = 8% x RWA

Risk Capital Weights by Asset Class

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 Basel II Credit Risk Charge

Under Basel II, banks have a choice of three approaches for the risk weights :

➢ Standardized Approach

➢ Foundation Internal Ratings-Based Approach (FIRB Approach)

➢ Advanced Internal Ratings-Based Approach (AIRB Approach)

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 Basel II Credit Risk Charge – Standardized Approach

➢ This is an extension of the Basel I approach, but with finer classification of

categories for credit risk, based on external credit ratings, provided by external
credit assessment institutions.

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 Basel II Credit Risk Charge – FIRB Approach

Under the internal ratings-based

approach (IRB), banks are allowed to
use their internal estimate of
creditworthiness, subject to regulatory
standards. Under the foundation IRB
approach, banks estimate the
probability of default (PD) and
supervisors supply other inputs, which
carry over from the standardized
approach.

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 Basel II Credit Risk Charge – AIRB Approach

➢ Under the advanced IRB approach, banks can supply other inputs as well. These
include loss given default (LGD) and exposure at default (EAD).

➢ The combined PDs and LGDs for all applicable exposures are then mapped into
regulatory risk weights. The capital charge is obtained by multiplying the risk
weight by EAD by 8%.

➢ The advanced IRB approach applies only to sovereign, bank, and corporate
exposures and not to retail portfolios.

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 Basel II Market Risk Charge

The capital charge can be computed using two methods :

➢ A standardized method, similar to the credit risk system with add-ons determined
by the Basel rules. Because diversification effects are not fully recognized, this
method generates a high market risk charge.

➢ Internal models approach (IMA) : this approach is based on the banks’ own risk
management systems, which are more adaptable than the rigid set of standardized
rules.

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 Solvency II

➢ Solvency II has many similarities to Basel II. There are three pillars:
▪ Pillar 1 is concerned with the calculation of capital requirements and the types of
capital that are eligible.
▪ Pillar 2 is concerned with the supervisory review process.
▪ Pillar 3 is concerned with the disclosure of risk management information to the
market.

➢ Pillar 1 of Solvency II specifies a minimum capital requirement (MCR) and a

solvency capital requirement (SCR).

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 Helpful Resources

• The origins of the Basel Accords

• Introduction to Basel II and Basel I Vs. Basel II

• Introduction to Basel III and Basel II vs. Basel III

• Basel III

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Annex
Capital Asset Pricing Model (CAPM)
 Understanding (Risk, Return) – CAPM

▪ Capital Asset Pricing Model (CAPM) was developed by William Sharp in 1964 to
link the returns with the systematic risk measured by the coefficient beta :

ri − rf =  i (rM − rf )
 iM
where i =
 M2
▪ Assumptions
▪ Investors are rational mean-variance optimizers
▪ Existence of risk-free asset
▪ Short selling is allowed
▪ Markets are efficient (Availability of information to all investors, no transaction and tax
costs, atomicity of investors, etc.)

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 CAPM – Example

Let rf=8%, and (rM ,  M ) = (12%,15%)

What is the expected return on an asset whose covariance with the market is 0.045?

Solution: Use CAPM:

 iM 0.045
Compute beta:  i = 2 = = 2.0
M (0.15) 2

Hence:
ri = rf +  i (rM − rf ) = 0.08 + 2(0.12 − 0.08) = 0.16

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 CAPM - Proof

▪ Capital Asset Pricing Model (CAPM) was developed by William Sharp in 1964 to
link the returns with the systematic risk measured by the coefficient beta :

▪ Assumptions
▪ Investors are rational mean-variance optimizers
▪ Existence of risk-free asset
▪ Short selling is allowed
▪ Markets are efficient (Availability of information to all investors, no transaction and tax
costs, atomicity of investors, etc.)

Page 43 Risk Management – Eymen Errais

 CAPM - Proof

Consider a portfolio of

 in asset i r
weights: M
(1-) in the market portfolio
rM x

This portfolio has: rf

x i
Expected return: r = ri + (1 −  )rM
Standard Deviation: M 
  =  2 i2 + 2 (1 −  ) iM + (1 −  ) 2  M2

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 CAPM - Proof

At = , the curve and the capital market line are tangent.

i.e., they have the same slope.

 rM − r f 
Slope of Capital Market Line=  
 M 
Slope of portfolio at =
−1
dr  dr  d   dr  d 
=     =     
d   =0  d  d    =0  d  d   =0

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 CAPM - Proof

r = ri + (1 −  )rM
dr
Calculation of
d    =  2 i2 + 2 (1 −  ) iM + (1 −  ) 2  M2
 =0

dr
= ri − rM
d  =0

d   i2 + (1 − 2 ) iM + ( − 1) M2  iM −  M2
= =
d  =0   =0
M

(ri − rM ) M
−1
dr  dr  d  
So =   =
d   =0  d  d   =0
 iM −  M2
Page 46 Risk Management – Eymen Errais
 CAPM - Proof

( ri − rM ) M rM − r f
Set slopes equal: =
( iM −  M )
2
M

r
M
rM x
rf
x i

M 
 iM  iM
ri = rf + 2 (rM − rf ) = rf +  i (rM − rf ) where = qed!
M  M2
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 CAPM Consequences – Security Market Line

CAPM: ri = rf +  i (rM − rf )

r
rM
Security Market Line
rf

= 

All securities lie along this line

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 CAPM Consequences – Risk and CAPM

Expected Return: ri = rf +  i (rM − rf )

Therefore ri = rf + i (rM − rf ) +  i
where i is a random variable with zero mean. E(i)=0

Take covariance with rM:

cov(ri , rM ) = cov(rf +  i (rM − rf ) +  i , rM )
= cov(rf , rM ) +  i cov(rM , rM ) −  i cov(rf , rM ) + cov( i , rM )
=  i cov(rM , rM ) + cov( i , rM )
= cov(ri , rM ) + cov( i , rM ) cov( i , rM ) = 0

i is uncorrelated with the market!

Page 49 Risk Management – Eymen Errais
 CAPM Consequences – The variance of an asset

 = cov(ri , ri )
i
2

= cov(rf +  i (rM − rf ) +  i , rf +  i (rM − rf ) +  i )

=  i2 M2 + var( i )

The risk in ri is the sum of two parts:

(1)  i2 M2 systematic risk. Associated with the
market as a whole
(2) var( i ) nonsystematic, idiosyncratic, specific risk
uncorrelated with the market
can be reduced by diversification

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 Implications of CAPM

You are only rewarded (expected return) for risk

that you cannot diversify away.

Risk is measured by , not the variance of your asset.

The return on an asset is determined by how it fits

into the market portfolio, not by its characteristics alone.

Instead of Sharpe Ratio, we will use the Treynor Ratio.

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Asset Pricing Theory (APT)
 Understanding (Risk, Return) – APT

▪ The CAPM specification starts from a single-factor model. This can be generalized
to multiple factors.

▪ The mean-variance approach requires that you estimate the mean, variance, and
covariance of all securities in your portfolio.

▪ This can be a huge number. For n stocks, we need n means, n variances, and n(n-
1)/2 covariances (for 1000 stocks, this is 501500 values to be estimated!).

▪ The arbitrage pricing theory (APT) developed by Stephen Ross (1976) relies on
such a factor structure and the assumption that there is no arbitrage in financial
markets.

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 Understanding (Risk, Return) – APT

▪ Simple APT:

Suppose that there are n assets whose rates of return are

governed by m < n factors:
m
ri = ai +  bij f j
j =1

for i = 1,2,...,n. Then there are constants 0, 1, ...,m such
that m
ri = 0 +  bij  j
j =1

for i = 1,2,...,n.

(Corollary: If there exists a risk-free asset with return rf then 0=rf.)

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 APT – Interpreting lambdas

▪ Interpretation of the ’s:

m
ri = 0 +  bij  j
j =1

▪ The lambdas relate the factor loadings to the expected return.

▪ They are often called the “price of risk” associated with the factor, or the “factor price”.

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 APT – proof

Consider two well diversified funds, i and j.

Let’s consider constructing a portfolio of fund i and j:

Fund Weight Return

i w ri = ai + bi f
j 1-w rj = a j + b j f

Portfolio Return: rp = wri + (1 − w)rj

= wai + (1 − w)a j + (wbi + (1 − w)b j ) f
= aP + bP f
Page 56 Risk Management – Eymen Errais
 APT – proof

Portfolio Return: rP = aP + bP f
= wai + (1 − w)a j + (wbi + (1 − w)b j ) f
Let’s make this portfolio riskless!
How?
Let’s choose w such that the factor loading bP is zero:

bP = wbi + (1 − w)b j = 0

bj Let’s plug this in...

w=
b j − bi

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 APT – proof

Portfolio Return: rP = aP + bP f
= wai + (1 − w)a j + (wbi + (1 − w)b j ) f
Now this portfolio
is riskless so it ai b j a j bi
should earn the = + = rf
b j − bi bi − b j
risk-free rate!
Rearranging and
noting that this must ai − rf a j − rf
hold for all well = =c constant
diversified portfolios:
bi bj
ai = rf + bi c
for all well diversified funds!
Clearly, we need an approach that requires less computation.
Page 58 Risk Management – Eymen Errais
 APT – proof

ai = rf + bi c
for all well diversified funds!

Therefore: ri = ai + bi f
= rf + bi c + bi f
= rf + bi (c + f )
Take expectations: ri = rf + bi (c + f ) = 0 + bi 1
where 0 = rf 1 = c + f

Hence, we may write: ri = 0 + bi 1

Page 59 Risk Management – Eymen Errais
 APT – Example

Consider an economy where all assets returns can be represented by the

factor model (E[f1]=E[f2]=0):
ri =  + bi1 f1 + bi 2 f 2
Let A, B, and C be well diversified portfolios with factor models:

rA = 0.8 + 1 f1 + 2 f 2
rB = 0.6 + 2 f1 + 1 f 2
rC = 0.5 + 4 f1

What is the expected return – factor loading relationship in this economy? What is
the risk-free rate?

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 APT – Example

By APT:
ri = 0 + bi11 + bi 22
For A, B, and C:
0.8 = 0 + 11 + 22
0.6 = 0 + 21 + 12
0.5 = 0 + 41 + 02
Solve for the factor prices:
0 = 0.1, 1 = 0.1, 2 = 0.3
then:
ri = 0.1 + bi1 0.1 + bi 2 0.3
rf = 0.1

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 What are possible factors

External Factors:

GDP, PPI, CPI, Unemployment, Interest Rates, etc...

Extracted Factors:

Market Portfolio, Industry Averages, etc...

(One can also include firm specific factors such as size, price/book, etc. However, in
the following APT theory only factors that apply to many firms will be relevant.)

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Value of Risk Management
 Irrelevance of Risk Management

▪ The CAPM emphasizes that investors dislike systematic risk. They can diversify
other, non-systematic risks on their own. Hence, systematic risk is the only risk that
needs to be priced.

▪ Companies could use financial derivatives to hedge their volatility. If this changes
the volatility but not the market beta, however, the company’s cost of capital and
hence valuation cannot be affected. Such a result holds only under the perfect
capital market assumptions that underlie the CAPM.

▪ In this abstract world, risk management is irrelevant. This is an application of the

classic Modigliani and Miller (MM) theorem, which says that the value of a firm
cannot depend on its financial policies. The intuition for this result is that any
financing action undertaken by a corporation that its investors could easily
undertake on their own should not add value.
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 Relevance of Risk Management

▪ The MM theorem, however, is based on a number of assumptions: There are no

frictions such as financial distress costs, taxes, and access to capital markets;
there is no asymmetry of information between financial market participants.

▪ In practice, risk management can add value if some of these assumptions do not
hold true:
o Hedging should increase value if it helps avoid a large cost of financial distress.
o Corporate income taxes can be viewed as a form of friction. Risk management
can stabilize earnings and hence reduces the average tax payment over time,
which should increase their value.
o Hedging helps avoid this underinvestment problem when external financing is
very coslty, which should increase firm value.
o Hedging helps identify the good managers.

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 Helpful Resources

▪ CAPM-What is the Capital Asset Pricing Model: https://www.youtube.com/watch?v=-fCYZjNA7Ps

▪ CAPM Vs APT Calculation: https://www.youtube.com/watch?v=-0EgQ97whWg
▪ CAPM VS APT: https://www.youtube.com/watch?v=vm2To3TKTHA
▪ CAPM: https://www.youtube.com/watch?v=UiLKoRKppY8
▪ APT: https://www.youtube.com/watch?v=FR3Fl-GUbqc&t=495s

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Takeaways
 Important Concepts

▪ Types of risks
▪ Risk Management Techniques
▪ Basel I, II, III
▪ CAPM
▪ APT

Page 68 Risk Management – Eymen Errais

 Important Formulas

1 n
E (r ) = s =1 p( s)r ( s) = 
n
s =1
r ( s) ▪ Basel I, II, III Formulas
n
− +
HPR = P1 P0 D1
P0

ri = rf +  i (rM − rf )

m
ri = 0 +  bij  j
j =1

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