FRM

FINANCIAL RISK MANAGEMENT:

1. Define the market risk, how is the risk divided?

Market risk is a possibility of losses caused by the changes of market asset prices that we own. The price changes can happen by the influence of bad interest or currency rates, prices of shares and commodities. According to this we have:

4 types of market risk:

a) delta risk: δ p/ δ S, is the risk of linear changes of the value of portfolio p on the change of value of underlying assets S, that is δ p/ δ S. This risk includes the above mentioned division on share, commodity and currency risk

b) gamma risk: δ²p/ δS², - changes of value of portfolio from linear changes of value of portfolio by means of the change of base tools S, that is δ²p/ δS². Example: option risk

c) vega risk: δ p /δ t- risk of volatility, it means the change of value of portfolio by means of change of expected volatility of underlying assets, that is δ p /δ t

d) theta risk: is the time risk, decrease of value of assets in time, δ p /δ t

e) rho risk: δ p /δ r, the risk of the change of interest risk

2. Define the risk generally, how is the risk divided?

· The risk can be defined as an undesirable and unforeseen future development of human activities which the person or group cannot influence.

· Risk is linked only with negative effects

· The risk means the danger of rise of loss, damage of failure at business.

· The risk is connected with the future

· The risk can mean the possibility, that the negative effects are moved to someone other and the undesired development will be eliminated for us

· The risk has to dimensions:

o the size of undesired effect

o the probability of possible undesired effect in future

Financial risk is divided into:

1. credit risk –the risk caused by failure of debtor against creditor

2. market risk - the risk caused by the losses of changes of market prices

interest, share, currency risk);

3. liquid risk (the risk of losses in case of temporary inability of payment or the risk from the small liquidity on the market with financial instruments)

3. What is the systematic and unique risk, how it is calculated?

Unique risk is the earning and risk of share portfolio or single share.

The unique risk is influenced by the factors that are specific for each company and they result directly from specific economy of these companies.

Systematic risk is the earning and risk of the whole capital market.

It results from the economy as a whole and it is not possible to reduce it by diversification.

The risk of earning of portfolio is calculated by standard deviation.

4. What is the credit risk and how do we detect it?

- The credit risk represents the probability that the credit will not be paid.

- Credit risk is the risk caused by failure of debtor against creditor, it means of not payment of debt, the creditor receives the loss.

- It is directly the risk from credit, loan, deposit, obligation, bills.

- External credit rating should be a help to protect oneself from this danger. States, companies and debt emissions are evaluated. The emphasis is put on the profitability of economic sector in which the issuer or company makes a business. The rating is very effective instrument for forecasting of inability of companies.

1. What is interest risk, how it is calculated?

- It is the risk caused by the changes of interest rates.

- If the interest rates are increasing the price of bonds is decreasing and vice versa.

- The analysts use the duration for measuring of interest rate risk or the average term of expiration.

- It is the weight average of term of expiration of bond.

6. What are the derivatives and their use?

- Financial derivatives can be divided into groups.

- They can be applied on interest rates, currency, share, but even on credit rating of obligations and companies, derivatives eliminate the influence of weather fluctuations, etc.

- The aim is the transfer of risk from one trader to another.

- A person who has resistance to risk and this investor is willing to pay an adequate amount of money to somebody who will take over his risk.

7. What are the forwards and how do we use them?

- The forward is a security that obliges the owner to sell or buy the base instrument under negotiated price.

- The party that obliges to sell the underlying assets “sells” forward

- the party that obliges to buy the underlying assets “buy” forward.

- The future contract is standardised forward contract which it is possible to trade on the exchange with.

- The basic equation is: share-forward= risk free bond.

- We use forwards to eliminate the risk which is caused by the movement of interest rate and the reasons for use forwards are security and speculation.

8. What are the futures and how do we use them?

- Future contract eliminate the risk of not filling the trade, is done by the fact that the trade with futures is made by clearing centre.

- The clearing centre standardize the amount and quality of assets, the time of filling by the futures.

The principles of financial futures

- are documents to sell or buy the delivery of underlying asstes at standard amount and quality in determined time and at the price negotiated.

- The contract needs not to be ended by the delivery of the underlying asset, instead of delivery the financial compensation can be done.

- In the futures contracts we have more buyers and sellers than in forwards.

- They are making the profits from transactions.

- The buyer who wants to buy the underlying assets under certain time and agreed value is in the so called long position, and the seller who wants to sell –short position.

- to minimize the risk that is given by ownership, interest or currency rates

9. What are the swaps and how do we use them?

- Swap is a time limited periodical exchange of interest engagements or active assets between two or more subjects.

- The objects of exchange are: payments or interests (Zinszahlung).

- The participants are the owners of original interest active debts or engagements from the law point of view.

- Swaps can be divided into currency and interest

- The active swaps enable the exchange of active debts, then asset balance of partners

- The passive swaps enable the exchange of engagements, then the sum of debts of balance of swap partners

- The purpose of using of interest payments is the possibility to change the structure of debts on the base of fixed or movable interest rate.

- The reasons are the security against the risk of change of interest rates.

. What are the options and how do we use them?

- The options represent the right to buy or sell the underlying assets (share, index share, foreign currency, futures).

- The owner of the options has the right of decision, if the trade will be realized or not.

- Options represent the right to buy or sell the underlying assets under ahead set price

- The buyer of options can close his positions by these ways:

o the option expires, the right is not used

o the option is used, the right is used

o the cancel of position by backward sell of option to market maker

- In regard to European options, there are four basic option positions – long call, short call, long put, short put.

11. What is the fuzzy logic and its use?

- The theory defines the fuzzy logic as the set, as a collection of elements of certain properties.

- It determines “how much” the element belongs to the set (the interval is from 1 to 0, where 0 means non-membership and 1 full membership)

- it measures the certainty or uncertainty of how the element belongs to the set

Fuzzy processing - The fuzzy logic system consists of three fundamental steps:

1. Fuzzification: to determine the attributes/variables of the risk (no, very low, low , medium,…)

Types of membership functions are: D, p, Z, S

2. Fuzzy Inference: defines the system behaviour by means of the rules of the type IF THEN.

This rules evaluate the input variables and show the financial risk

3. Defuzzification: to transform the values to linguistic expressions, like high risk or not

12. What are the artificial neural networks and their use?

- The artificial neural network model represent the thinking of the human brains, as it is not possible to know the inside structure of system in detail.

- It is suitable to use in cases, where the influences on searched phenomena are random and where the relations are complicated.

- The simplest artificial neuronal network is called perceptron.

- Generally the artificial network has one input, one or more hidden and one output layer.

Process

- to prepare the input data in form of a table, with all necessary information

- the variables are multiplied by weight coefficients and the value b influences the output

Use

- to solve various problems by the method of artifical networks

- the advantages consist that the big quantity of criteria and the quantity of cases can not be evaluated and interpredet correctly by the human

13. What are the genetic algorithms and their use?

- The genetic alogrithms are used in the field, where exact solution by systematic searching would take ages

- Genetics is connected with terms that are called:

- chromosomes: consist of genes that inherit one or several bits and the visualisation of chromosomes is represented hy binary string (consists of 1 or 0)

- Process of selection – means the choice of chromosomes that become the parents

- Process of crossover – means the exchange of part of two or more parent’s chromosomes, which cause the modification

- Process of mutation – means the modification of chromosome, done by change of some bit

- During the process you have to determine the fitness function, values that have to be optimized, restrections.

USE

- The method of GA increases the quality of solution of financial risk mm and

- leads to minimizatio of risk, looses and costs

15. Describe the use of advanced methods in risk management!