Risk Finance and Asset Pricing

Value, Measurements, and Markets

Charles S. Tapiero

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470892381
• Edition: 1
• Topic: Commerce
• Subtopic: Investissements et valeurs mobilières

A comprehensive guide to financial engineering that stresses real-world applications

Financial engineering expert Charles S. Tapiero has his finger on the pulse of shifts coming to financial engineering and its applications. With an eye toward the future, he has crafted a comprehensive and accessible book for practitioners and students of Financial Engineering that emphasizes an intuitive approach to financial and quantitative foundations in financial and risk engineering. The book covers the theory from a practitioner perspective and applies it to a variety of real-world problems.

• Examines the cornerstone of the explosive growth in markets worldwide
• Presents important financial engineering techniques to price, hedge, and manage risks in general
• Author heads the largest financial engineering program in the world
  Author Charles Tapiero wrote the seminal work Risk and Financial Management.

CHAPTER 1

Risk, Finance, Corporate Management, and Society

OVERVIEW

Financial engineering is a profession that bridges theoretical finance and financial practice. It spans the many occupations prevalent in financial services. This chapter provides a nonquantitative introduction to financial management and risk engineering. Terms such as risk, uncertainty, securities, bonds, derivatives, options, and the like are defined and their applications to a broad number of financial concerns outlined. Terms such as trading, investing, speculating, credit, leverage, environmental finance, securitization, and others are defined and applications considered. Real-life financial problems, including safety, reliability, claims, insurance, your pension, and so forth, are highlighted to emphasize the relevance of financial analysis and management to everyday life. Finally, outstanding financial issues, a growing concern for financial ethics, and regulation are also discussed. This chapter may be covered singly or together with the next chapter in one or two lectures with students reading and commenting on the issues the chapter raises.

RISKS EVERYWHERE—A CONSEQUENCE OF UNCERTAINTY

Uncertainty is part of our lives. Its presence underlies our attitudes, our search for information, and the efforts we expend to mitigate and manage its positive and adverse consequences. To do so, we seek definitions, measurements, and the quantification of uncertainty in order to analyze the risks, protect ourselves from the losses uncertainty may lead to, and profit from the opportunities it can provide. In theory and in practice, uncertainty is latent in everything we do. It remains a shadow that never departs, always challenging, for better or for worse.

Risk may be specific or have broad connotations to various persons or groups. For some, it is a threat; for others it is an opportunity to be sought and to revel in. In all cases, risk results from uncertain events and their consequences: whether positive or negative; whether direct or indirect; whether they are accounted for or not; whether of external origin or internally induced; whether predictable or not; and whether of concern to individuals, firms, or the society at large. Uncertain events may be due to failures of persons or machines, a misjudgment by investors or speculators, accidental hazards, or macroeconomic and environmental factors over which we have partial or no control. To mitigate or profit from risk (also known as risk management), preventive means, controls, insurance, hedging, trades in optional markets, and other actions are taken ex ante (before the fact) and ex post (after the fact, seeking to recover from adverse consequences). These activities broadly summarize the function of financial and risk management.

Risk mitigation is common to many professions, each of which has an approach and uses techniques based on the needs and the accrued experience specific to that profession and acquired over long periods of time. For example, a machine operator maintains a machine to prevent failure or nonconforming operations. Careful diet and exercise, medicines, and planned visits to a doctor for a checkup are used preventively to maintain one’s health and avoid disease. By the same token, an airplane has numerous built-in fail-safe mechanisms to counter predictable (albeit extremely rare) potential components or system failures.

Risk finance is focused in particular on money: how to invest it and manage it; how to price assets, contracts, options, and so on; and how to use it for the many real ends for which individuals and corporate, social, or other entities may need it. Pricing assets and the risks of mispricing are particularly important. When an asset is priced properly it allows an efficient exchange between the many parties that consume and supply such an asset. When it is mispriced, exchanges may be severely curtailed, contributing to a lack of liquidity. Financial pricing of an asset allows one to unlock the values embedded in the asset, whether real or virtual values, and render such an asset tradable.

For example, to price a corporate firm engaged in a real economic activity (such as producing cars, making movies, selling a service, performing high-tech or medical research and development, etc.), its value is unlocked by trading current and future returns and risks in units called securities or shares of stock. A security then translates the firm value into money by letting a buyer and a seller exchange money in a financial market for the right to own part of the firm’s future monetary potential. Such an exchange defines, then, both the price of the security and the monetary value that buyers and sellers of the security ascribe to the firm being traded. Real firms and assets and their prospects are thus securitized and exchanged in denominated price contracts (in this case, a unit of stock ascribing to its owner some rights over the firm). Predicting the price of a security can be quite complex, however, based on all available real and financial data, future predictions regarding the economic environment, competitive forces, technology, management, and other factors that contribute to enhancing or decreasing the value of firms and their price. A common belief is that such prices cannot be predicted with absolute certainty but may be guessed at best by using the information we can assemble, interpret, and understand, based on insights and an understanding of the market mechanism.

To meet the many challenges of finance and its application in real life, financial institutions and financial markets have defined and commercialized standard financial instruments that are traded, including, among many others, securities, insurance contracts, bonds, options, credit contracts, and the like. In addition, a plethora of financial institutions—banks, insurance firms, brokers, credit providers, and so forth—have conspired to provide the means for investors, speculators, firms, and persons to improve their financial well-being while managing the risks of financial transactions. In other words, investors willing to assume more risks will do so, and those who seek to assume less risk will do so as well.

This is possible, of course, if markets are liquid. In some cases, a price results from contractual negotiations between specific parties. These contracts assume many forms, such as insurance contracts, over-the-counter (OTC) trades, and so on. In other cases, prices are set arbitrarily to a price level or allowed to fluctuate between two specific levels (for example, in some countries the prices of certain commodities are set by political decisions while in others they are set by exchanges and allowed to fluctuate between upper and lower limits). When markets are not liquid, we can expect firms and persons to cling to their money, each uncertain of the market price. In these conditions, a lack of business and a lack of needed funds to function may cause firms to falter. For this reason, financial institutions seek to provide liquidity for businesses to remain active, both for their own good and for the public good. The potential for financial institutions to make money in such processes is both immense and varied.

For example, insurance firms set a price that insured parties pay, while at the same time seeking a market price for the risks they aggregate in portfolios. They do so both to profit from a spread between insurance cost and the portfolio price and to maintain the capacity to meet claims when they occur. To mitigate insurance risks, insurers can also buy and sell these risks to other parties (to reinsurers who share payments if claims are made, in return for a portion of the premium paid by the insured) or use securitization—that is, selling standardized revenues and their associated claims in an insurance portfolio to financial markets. The same approach is used by mortgage lenders that aggregate mortgage contracts into a portfolio, which is sold through intermediaries to financial markets (as is discussed in Chapters 9 and 10). By the same token, a municipality seeking to build a subway by issuing a debt obligation will float a proposal to be priced by buyers (the banks) or financial intermediaries seeking to finance such a transaction through financial markets. Throughout, financial engineering contributes by financial innovations that unlock value that can be traded and priced viably and sustainably by an exchange of buyers and sellers.

On the environmental front, financial markets are assuming a growing responsibility to price and allocate, economically and efficiently, environmental risks. In particular, in the matter of global warming, standardized units of carbon dioxide emission rights are traded. Current beliefs are that carbon emissions would be better controlled by money equivalents and thus would contribute to global and sustainable emission levels (at the same time, carbon taxes may be used to raise additional taxes for needed government revenues). Discussions at the World Economic Forum in Davos, Switzerland, and the U.S. policy of 2009 have emphasized the need to use financial markets for greater environmental and social (economic) efficiency. For some, the concern about global warming has become an opportunity to profit. For example, for countries or firms owning rights that they do not use, it becomes a bounty they never had (which of course leads detractors of such a scheme to assert that carbon trades contribute only to an important transfer of financial resources from developed to undeveloped countries). Nonetheless, there are a growing number of financial markets specializing in such trades, such as the Chicago Climate Exchange and Amsterdam markets. Research and applications are needed, however, to develop this potential further and to understand the mechanism for the market making of environmentally friendly products, priced sustainably. Our concern is to define these problems and use finance to manage the risks and the opportunities they imply.

Globalization and financial technology have also provided an extraordinary boost to global finance and financial markets and at the same time have contributed to appreciable investment opportunities and risks. However, whether globalization contributes to an increase in risk dependence and risk contagion (see Chapters 4 and 10) across financial markets remains an issue that has no simple or clear-cut answer. Networking, the density of human settlements and their consequences (both good and bad), and other factors have contributed to a far greater awareness that risks are dependent and have many sources. Further, identity thefts, cyber-crimes, virtual enterprises that operate globally, and the breakdown of traditionally secured pension funds and the like are colluding to highlight that risk is no longer an abstract financial issue but a real one—felt by each one of us, wherever we may be. In a global world, risks are global, and risks are thus assumed, exchanged, shared, traded, valued, and priced globally. They are also implied in corporate strategies, whether financial or not. In such an environment, finance and the risk business are necessarily far greater than ever before.

There are many risks that are not easily defined in monetary terms, however, and cannot be exchanged to produce an agreed-on price. For example, rare events (with an extremely small probability of occurring) and catastrophic risks are notoriously difficult to price as only very few financial parties may have the capacity to bear the implied risks. Such risks are a financial engineering challenge—to better manage, define, value, and price these risks, either uniquely or approximately, and unlock the value or financial consequences embedded in them.

RISK AND FINANCE: BASIC CONCEPTS

Risk and finance are defined by a complex set of factors, each determining the others. It has been claimed that a risk with no financial consequence is not a risk. This statement, of course, cannot be true since one’s accidental death might not have any financial consequence. For our purposes here, risk and finance are defined implicitly and explicitly by factors that have an underlying financial value. Monetizing this value is a financial engineering challenge. Seven essential factors are used to define the value and price of risk:

1. Events and their probabilities (whether common or rare).

2. Predictability and timing of these events and their recurrence.

3. Uncertain financial consequences (whether adverse or beneficial).

4. Individuals’ tolerance for risk bearing, implied in their preferences.

5. Individuals’ information and ability to measure and to assess risks.

6. Risk sharing and exchange (contractual or not).

7. Market pricing, arising from the interaction of many buyers and sellers in a fair and efficient manner with common and shared information.

The first two factors, events and their probabilities and their predictability and timing, need not have financial relevance if they have no financial consequence. An individual’s rationality and personal information expressing a latent preference for uncertain outcomes (see Chapters 5 and 6) are relevant to personal finance but might or might not be relevant to financial markets pricing. Finally, risk sharing and exchange as well as financial markets pricing imply the value of a trade, product, or rights conferred by an exchange, reached at an agreed-on pric...