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FEI Week 8 – Risk Analysis & Building Financial Models

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What is risk analysis

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• Process of defining and analysing the dangers to the

business posed by potential natural and human‐caused adverse events

• Quantitative
• Qualitative
• For example, risk analysis techniques in IT

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Risks in financial world

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• Credit risk: loss arising from a borrower who does not make

payments as promised

• Operation risk: arising from execution of a company's

business functions

• Market risk: value of a portfolio, either an investment

portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors

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Risks in business world

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• Profit=revenue – cost

=Average Price *Quantity ‐ (fixed cost + variable cost)

• Revenue risks: actual benefits of a venture being lower than

the projected, or estimated, benefits of that venture

• Cost risks: unexpected cost incurred in excess of a budgeted

amount due to an under‐estimation of the actual cost during budgeting

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Other risks in business world

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• Financing risk
• Equity contribution not received
• Bank loans guarantee forfeited
• Bank reduces overdraft facility
• Reputation risk
• E.coli & Spanish vegetables
• Melamine & Chinese milk
• Burgers & horse meat
• Currency risk
• Export & import
• Political risk/country risk

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Measuring risks

• Variance: how far a set of numbers are spread out from each
• ther

6

2 1 2

) ( n Mean Value

n i i 

 





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Measuring risks

• Standard deviation: how much variation or "dispersion"

there is from the average

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n Mean Value

n i i 2 1

) (   





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Currency risk

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• Transaction risk: cash flow
• Translation risk: assets and liabilities
• Cause:
• Buy and sell in foreign countries
• Financing arrangements – equity

, debt

• Multinational corportions
• Speculation v hedge

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Currency risk ‐ examples

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• Japanese companies experiencing difficulties in export when

yen went up

• Eastern European countries borrowing from western banks

in Euro

• UK investor investing in US stocks
• Chinese companies floating on US exchanges

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— Source Ashwath Damodaran, Stern School of Business, New York University — http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

Country Risk

12 TITLE HERE 00 MONTH 0000 Country Local Currency Rating Rating-based Default Spread Total Equity Risk Premium Country Risk Premium CDS Default Spread Total Equity Risk Premium Country Risk Premium Abu Dhabi Aa2 0.50% 5.75% 0.75% 1.00% 5.81% 0.81% Albania B1 4.50% 11.75% 6.75% NA NA NA Andorra A3 1.20% 6.80% 1.80% NA NA NA Angola Ba3 3.60% 10.40% 5.40% NA NA NA Argentina B3 6.50% 14.75% 9.75% 14.73% 26.41% 21.41% Armenia Ba2 3.00% 9.50% 4.50% NA NA NA Aruba Baa1 1.60% 7.40% 2.40% NA NA NA Australia Aaa 0.00% 5.00% 0.00% 0.70% 5.36% 0.36% Austria Aaa 0.00% 5.00% 0.00% 0.74% 5.42% 0.42% Azerbaijan Baa3 2.20% 8.30% 3.30% NA NA NA Bahamas Baa1 1.60% 7.40% 2.40% NA NA NA Bahrain Baa2 1.90% 7.85% 2.85% 2.97% 8.77% 3.77% Bangladesh Ba3 3.60% 10.40% 5.40% NA NA NA Barbados Ba1 2.50% 8.75% 3.75% NA NA NA Belarus B3 6.50% 14.75% 9.75% NA NA NA Belgium Aa3 0.60% 5.90% 0.90% 0.97% 5.77% 0.77% Belize Caa2 9.00% 18.50% 13.50% NA NA NA Benin B2 5.50% 13.25% 8.25% NA NA NA Bermuda Aa3 0.60% 5.90% 0.90% NA NA NA Bolivia Ba3 3.60% 10.40% 5.40% NA NA NA Bosnia and Herzegovina B3 6.50% 14.75% 9.75% NA NA NA Botswana A2 0.85% 6.28% 1.28% NA NA NA

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Foreign exchange derivatives

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• Forward contract: transaction agreed to executed in a fixed

future time

• Flexible in amount, execution date
• Obligation to execute
• Suitable to hedge certain cash flows
• Rapid growth after Bretton Woods system
• Extremely large market – banks & corporations to manage

FX risks

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Foreign exchange derivatives

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• E.g. Your start‐up firm selling to US and receiving US$1.65

million in 3 months

• Solution – long the forward contract, i.e. Long the Sterling

and short the dollar

• Current rate 1.60 v forward rate 1.65 v in 3 month 1.70
• Can settle in cash or actual delivery of the currency

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Foreign exchange derivatives

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• Futures – standardised forward contracts
• Designated size and quotation unit
• e.g. A Euro contract covers €125,000 and is quoted in

dollars per euro. Futures price such as $0.8555 stated in

• dollar. Contract price=125,000*$0.8555=$106,937.50
• Leveraged
• Margin calls
• Obliged to execute

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Foreign exchange derivatives

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• Not as widely used as forward but market still very active
• Mostly

traded

• n

exchanges e.g. Chicago Mercantile Exchange, New York Board of Trade

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Foreign exchange derivatives

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• Options – allows the holder, who pays an amount of money,

to buy (if a call) or sell (if a put) an underlying currency at a fixed exercise rate, expressed as an exchange rate, on (European option) or up to (American option) the exercise date.

• Right, not obligation, to execute
• Suitable to hedge uncertain cash flows
• Call options v put options

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Foreign exchange derivatives

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• Large market, similar to forward
• Mostly OTC
• E.g. Your export to US will bring you $3.2m in 3 months.
• Solution ‐

buy a call option on sterling specified in terms of dollar

• Current rate 1.60 vs exercise rate 1.65. Rate in 3 months

1.70/1.50

• Other applications – equity shareholders

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Black Scholes model for valuing Derivatives

• Call
• ption
• Put option

where

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Foreign exchange derivatives

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• Swap – each party makes interest payments to the other in

different currencies

• Example: American firm Target Corporation (TGT) needs €9m

but can‘t issue bond in European market at reasonable rate. What to do?

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Foreign exchange derivatives

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• (TGT) issue $10m bond for lower rate available to it

in US at 6%

• Deutsche Bank (DB) agrees to swap
• At outset, DB pays TGT €9m and TGT pays DB

$10m

• DB pays TGT 6% in $ twice a year

(0.06*0.5*$10m=$300,000)

• TGT pays DB 4.9% in € twice a year

(0.049*0.5*€9m=220,500)

• At the end, DB pays TGT $10m and TGT

pays DB €9m

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Foreign exchange derivatives

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• Currency swap – equivalent of bond swap here
• TGT issues bond in € to DB
• DB issues bond in $ to TGT
• End result – TGT issues bond in € at lower rate

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Source: How to value a start-up? The use of options to assess the value of equity in start-ups - Guillaume Desaché

Problems in Valuing Start-Ups

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source: How to value a start-up? The use of options to assess the value of equity in start-ups - Guillaume Desaché

Survival of Start-Ups

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http://www.ft.com/cms/s/0/40146b80-91bf-11e5-94e6-c5413829caa5.html#ixzz3sOtZjDin

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Increasing Defaults

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The jump in defaults has been reflected in the average yield on US corporate junk bonds, rising from 5.6% at the start of 2014 to 8% at present, according to Barclays. The sell-off has been concentrated in the energy and materials industries and the average yield for junk bonds in the two sectors shot above 12% last week; no other sector has a yield above the overall average. Emerging market borrowers have accounted for 19 of the defaults — the second largest source of failures, Europe has counted 13 and the remainder are in other developed countries, such as Japan and Canada. The number of weaker companies rated by the credit agencies has also risen from 167 in the previous quarter to 178. S&P defines these “weakest links” as borrowers with junk bonds rated B-minus or lower and at risk of further downgrade. Diane Vazza, head of global fixed income research at S&P, said: “By most measures, the rising number of defaults in the near future likely will be muted by historical standards, but the current crop of US speculative-grade issuers appears fragile and particularly susceptible to any sudden or unanticipated shocks.”

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Ashwarth Damodaran - Valuing Growth companies” AAII Journal December 2011 p.30

Case Study – Valuing LinkedIn at IPO

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• Start-up with limited history, negative cash flows, fast growth
• Given the size of the advertising business and the manpower

that Linkedin currently has, it should have a growth of 50% a year in revenues for the next five years, starting from $243m, and then scale down linearly to a 3% perpetual growth rate at year 10.

• Current operating profit of $20m (c. 8% of revenues)
• Margins should increase linearly to the industry average, 15%
• EBIT after tax is 12m (tax rate of 40%)
• Reinvest $1 in capital to get $2.14 of additional revenues

(median across firms in the sector).

• - The cost of capital will be first assumed to be 12% (risk-free

rate is 3%, beta is 1.8, market risk premium is 5%), and will linearly decrease from year 5 to reach the industry’s average

• f 7.5%. Its ROCE will stabilize at 10% forever.

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Ashwarth Damodaran - Valuing Growth companies” AAII Journal December 2011 p.30

Case Study – Valuing LinkedIn at IPO

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No adjustment for survival because the firm

• does not depend on key personnel,
• has the first mover advantage in a sector in which it

is key (social networks)

• has no debt (and should remain so after its IPO).

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Source: http://www.aaii.com/journal/article/valuing-young-growth-companies

Cash Flows

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Forecasts

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Modellling the Terminal Value

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