Risk Management: Principles and Applications

Welcome to this module on Risk Management: Principles and Applications. This module has four main aims, to:

• illustrate the main types of risk
• present the most important ideas and methods used in the analysis of portfolios of financial securities, including stocks and bonds
• explain how rational investors can use financial derivatives (mainly, futures and options) in order to alter the risk of their investment position
• illustrate some more specialised risk management techniques, such as Value at Risk and Credit Risk.

The emphasis throughout is on the general principles behind the investment decisions, rather than on case studies or anecdotal evidence. Thus, you will study, for instance,

• the main features of portfolios, which include stocks and bonds,
• how to calculate their risk, and
• how investors can combine their holdings of different securities to reduce their overall risk without sacrificing return.

Similarly, when you deal with futures and options, you will explore how these instruments can be used to manage risk and to expand the opportunity set of investors.

Learning outcomes

When you have completed this module, you will be able to:

• outline the most important strategies of risk management
• explain how stocks and bonds can contribute to the risk and return of a financial portfolio
• discuss the key principles of diversification of financial investment
• correctly measure the risk of financial portfolios
• explain the risk profile involved in financial derivatives, such as futures and options
• discuss the importance of Value at Risk and scenario analysis
• define and use the principles of credit risk analysis

Tuition and assessment

Students are individually assigned an academic tutor for the duration of the module, with whom you can discuss academic queries at regular intervals during the study session.

You are required to complete two Assignments for this module, which will be marked by your tutor. Assignments are each worth 15% of your total mark. You will be expected to submit your first assignment by the Tuesday of Week 6, and the second assignment at the end of the module, on the Tuesday after Week 10. Assignments are submitted and feedback given online. In addition, queries and problems can be answered through the Virtual Learning Environment.

You will also sit a three-hour examination on a specified date in September/October, worth 70% of your total mark. An up-to-date timetable of examinations is published on the website in July each year.

Study resources

Study guide: The module study guide is carefully structured to provide the main teaching, defining and exploring the main concepts and issues, locating these within current debate and introducing and linking the assigned readings.

Key texts: Elton EJ, Gruber MJ, SJ Brown & WN Goetzmann (2014) Modern Portfolio Theory and Investment Analysis. 9th Edition. John Wiley & Sons.
Hull JC (2017) Fundamentals of Futures and Options Markets. 9th Edition. Pearson
Crouhy M, D Galai & R Mark (2014) The Essentials of Risk Management. 2nd Edition. McGraw-Hill.

Virtual learning environment: You will have access to the VLE, which is a web-accessed study centre. Via the VLE, you can communicate with your assigned academic tutor, administrators and other students on the module using discussion forums. The VLE also provides access to the module Study Guide and assignments, as well as a selection of electronic journals available on the University of London Online Library.

Study calendar 2022/23

Study calendars are subject to change.

Module overview

Unit 1 Introduction to Risk Management

• 1.1 Introduction to Portfolio Analysis
• 1.2 Risks Faced by Financial and Non-financial Institutions
• 1.3 Financial Securities and Financial Markets
• 1.4 The Mean-Variance Approach
• 1.5 The Opportunity Set under Risk – Efficient Portfolios
• 1.6 Short Sales and Riskless Lending and Borrowing
• 1.7 How to Compute the Efficient Set
• 1.8 Conclusion

Unit 2 Portfolio Analysis

• 2.1 Introduction
• 2.2 The Single-Index Model
• 2.3 Methods for Estimating Betas
• 2.4 Fundamental Betas
• 2.5 Multi-Index Models
• 2.6 Fundamental Multi-Index Models
• 2.7 Conclusion

Unit 3 Management of Bond Portfolios

• 3.1 Introduction
• 3.2 Returns on Bonds
• 3.3 The Term Structure of Interest Rates
• 3.4 Default Risk and Callable Bonds
• 3.5 Duration
• 3.6 Convexity
• 3.7 Passive Bond Portfolio Management – Matching, Immunisation, Indexation
• 3.8 Active Bond Portfolio Management – Index Models
• 3.9 Active Bond Portfolio Management – Swaps
• 3.10 Conclusion

Unit 4 Futures Markets

• 4.1 Introduction
• 4.2 Description of Financial Futures
• 4.3 Pricing of Financial Futures
• 4.4 Futures Strategies
• 4.5 Examples of Using Futures
• 4.6 Interest Rate Futures
• 4.7 Currency Futures
• 4.8 Conclusion

Unit 5 Options Markets

• 5.1 Introduction
• 5.2 Features of Options Contracts
• 5.3 Options on Stocks and Futures
• 5.4 Risk Exposure and Profit Potential of Options and Futures
• 5.5 The Put-Call Parity Formula
• 5.6 Option Pricing – The Black-Scholes Formula
• 5.7 Pricing of Options on Futures
• 5.8 Price Volatility
• 5.9 Conclusion

Unit 6 Risk Management with Options

• 6.1 Introduction
• 6.2 Speculation with Options – Combinations of Calls and Puts
• 6.3 Hedging with Options – against a Price Increase
• 6.4 Hedging with Options – against a Price Decline
• 6.5 Sensitivities of Option Prices
• 6.6 Delta Hedging
• 6.7 The 2007 Credit Crisis and the Role of Derivatives
• 6.8 Conclusion

Unit 7 Value at Risk

• 7.1 Introduction
• 7.2 Definition of Value at Risk
• 7.3 Calculation of Value at Risk – the Variance-Covariance Approach
• 7.4 Delta-Normal VaR
• 7.5 Historical Simulations Approach
• 7.6 Incremental-VaR and DeltaVaR
• 7.7 Stress Testing and Scenario Analysis
• 7.8 Limitations of VaR – EVaR
• 7.9 Conclusion

Unit 8 Credit Risk

• 8.1 Introduction
• 8.2 Credit Rating Systems
• 8.3 Internal Risk Rating
• 8.4 CreditMetrics
• 8.5 Analysis of Credit Migration
• 8.6 Valuation of Bonds
• 8.7 Forward Distribution of Changes in the Value of Bonds
• 8.8 Credit VaR for a Bond or Loan Portfolio
• 8.9 Credit VaR and Calculation of Capital Charge
• 8.10 Conclusion

Module samples

• M423 Module Introduction (PDF)
• M423 Specimen Examination (PDF)
• M423 Unit 1 (PDF)

Disclaimer

Important notice regarding changes to programmes and modules