Part 1 Money Management – Hedging

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FRM Part 1 (2020) – Book 1 – Foundations of Risk Management

    Сертификат об окончании
  • No prerequisites

In this course, Prof. James Forgan, PhD, summarizes each chapter from the Foundations of Risk Management book so you can learn or review all of the important concepts for your FRM part 1 exam. James Forjan has taught college-level business classes for over 25 years.

This course includes the following chapters:

1. The Building Blocks of Risk Management

2. How Do Firms Manage Financial Risk?

3. The Governance of Risk Management

4. Credit Risk Transfer Mechanisms

5. Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM)

6. The Arbitrage Pricing Theory and Multifactor Models of Risk and Return

7. Risk Data Aggregation and Reporting Principles

8. Enterprise Risk Management and Future Trends

9. Learning From Financial Disasters

10. Anatomy of the Great Financial Crisis of 2007-2009

11. GARP Code of Conduct

  • FRM candidates

After completing this reading you should be able to:

Explain the concept of risk and compare risk management with risk taking.

Describe elements, or building blocks, of the risk management process and identify problems and challenges that can arise in the risk management process.

Evaluate and apply tools and procedures used to measure and manage risk, including quantitative measures, qualitative assessment and enterprise risk management.

Distinguish between expected loss and unexpected loss and provide examples of each.

Interpret the relationship between risk and reward and explain how conflicts of interest can impact risk management.

Describe and differentiate between the key classes of risks, explain how each type of risk can arise, and assess the potential impact of each type of risk on an organization.

Explain how risk factors can interact with each other and describe challenges in aggregating
risk exposures.

After completing this reading, you should be able to:

Compare different strategies a firm can use to manage its risk exposures and explain situations in which a firm would want to use each strategy.

Explain the relationship between risk appetite and a firm’s risk management decisions.

Evaluate some advantages and disadvantages of hedging risk exposures and explain challenges that can arise when implementing a hedging strategy.

Apply appropriate methods to hedge operational and financial risks, including pricing, foreign currency, and interest rate risk.

Assess the impact of risk management tools and instruments, including risk limits and derivatives.

After completing this reading you should be able to:

Explain changes in corporate risk governance that occurred as a result of 2007-2009
financial crisis.

Compare and contrast best practices in corporate governance with those of risk management.

Assess the role and responsibilities of the board of directors in risk governance.

Evaluate the relationship between a firm’s risk appetite and its business strategy, including the role of incentives.

Illustrate the interdependence of functional units within a firm as it relates to risk management.

Assess the role and responsibilities of a firm’s audit committee.

After completing this reading you should be able to:

Compare different types of credit derivatives, explain how each one transfers credit risk and describe their advantages and disadvantages.

Explain different traditional approaches or mechanisms that firms can use to help mitigate credit risk.

Evaluate the role of credit derivatives in the 2007-2009 financial crisis and explain changes in the credit derivative market that occurred as a result of the crisis.

Explain the process of securitization, describe a special purpose vehicle (SPV) and assess the risk of different business models that banks can use for securitized products.

After completing this reading, you should be able to:

Explain modern portfolio theory and interpret the Markowitz efficient frontier.

Understand the derivation and components of the CAPM.

Describe the assumptions underlying the CAPM.

Interpret the capital market line.

Apply the CAPM in calculating the expected return on an asset.

Interpret beta and calculate the beta of a single asset or portfolio.

Calculate, compare, and interpret the following performance measures: the Sharpe performance index, the Treynor performance index, the Jensen performance index, the tracking error, information ratio, and Sortino ratio.

After completing this reading, you should be able to

Explain the arbitrage pricing theory (APT), describe its assumptions, and compare the APT to the CAPM.

Describe the inputs (including factor betas) to a multifactor model.

Calculate the expected return of an asset using a single-factor and a multifactor model.

Explain models that account for correlations between asset returns in a multi-asset portfolio.

Explain how to construct a portfolio to hedge exposure to multiple factors.

Describe and apply the Fama-French three-factor model in estimating asset returns.

After completing this reading you should be able to:

Explain the potential benefits of having effective risk data aggregation and reporting.

Describe key governance principles related to risk data aggregation and risk reporting practices.

Identify the data architecture and IT infrastructure features that can contribute to effective risk data aggregation and risk reporting practices.

Describe characteristics of a strong risk data aggregation capability and demonstrate how these characteristics interact with one another.

Describe the characteristics of effective risk reporting practices.

After completing this reading you should be able to:

Describe Enterprise Risk Management (ERM) and compare an ERM program with a traditional silo-based risk management program.

Compare the benefits and costs of ERM and describe the motivations for a firm to adopt an ERM initiative.

Explain best practices for the governance and implementation of an ERM program.

Describe important dimensions of an ERM program and relate ERM to strategic planning.

Describe risk culture, explain characteristics of strong corporate risk culture, and describe challenges to the establishment of a strong risk culture at a firm.

Explain the role of scenario analysis in the implementation of an ERM program and describe its advantages and disadvantages.

Explain the use of scenario analysis in stress testing programs and in capital planning.

After completing this reading, you should be able to:

Analyze the key factors that led to and derive the lessons learned from case studies involving the following risk factors:

Interest rate risk, including the 1980s savings and loan crisis in the US

Funding liquidity risk, including Lehman Brothers, Continental Illinois, and Northern Rock

Implementing hedging strategies, including the Metallgesellschaft case

Model risk, including the Niederhoffer case, Long Term Capital Management, and the London Whale case

Rogue trading and misleading reporting, including the Barings case

Financial engineering and complex derivatives, including Bankers Trust, the Orange County case, and Sachsen Landesbank

Reputational risk, including the Volkswagen case

Corporate governance, including the Enron case

Delusiveness and hidden hedging opportunities. Part 1

Vadim Epstein of Emet Trading Solutions takes a look at strategies traders should use when deciding to hedge their trades.

This guest article was written by Vadim Epstein from

Inexperienced traders have always had problems raking income from the financial markets. This has been attributed to their inclination to hedging as a strategy. This article gives a finer focus on hedging and expounds on some simple strategies that do don’t need market ingenuity or any occult detectors to earn you money from the markets.


Hedging is a process of offsetting losses by taking a contra position on the market that reduces accrued losses. Suppose you have an open buy position that has accrued some losses you don’t feel to close the position. You can offset the losses by taking a sell position of the same asset with the same amount. You will definitely reduce the losses that were accruing but at the same time you will freeze capital in your account. This is action is referred to as hedging.

The figure above is an illustration of a poor hedging strategy that worked against the intended hedging purpose. From the figure above the trader tried to hedge the buy position with a sell order which after the market execution the prices retraced upwards making further losses.

From such a scenario you will agree that not everyone is knowledgeable on using hedging as a strategy to gain profits as well as to reduce losses. It is important to understand some basic technical tenets whenever it comes to hedging. Hedging is not a quick rush promo as it may be seen advertised by many internet promotional hedging robots that are on sale across the internet. Even without the robots you need to understand hedging. Know when it is appropriate to hedge, why you should hedge and what markets as to hedge. This are some of the insights that will be rarely addressed by the developers of these robots and it only require the skills of an advanced trader to correctly use hedging.

Technical approach to the trade—the key to success

Trading cost is a thing observed by many traders and should be of interest to any trader whether novice or a seasoned trader. One of the most common trading costs is spread. Spread is the difference between the bid and ask price. Whenever it comes to hedging it is a must to incur this cost twice since you will need to have two open positions. Whenever a broker’s spread is high this becomes a liability to the trader and has led to many traders changing brokers in pursuit of a broker with the least spread.

However, the MetaTrader4 (charting platform) allows you to close positions that you have hedged incurring only spread from one of the trades. This is done by a method referred as “OrderCloseBy”. This method is not on the open platform, it is only done via scripts and advisors.

Whenever it comes to scripts, advisors and indicators it is very important to exercise caution whenever you are choosing a developer. Your losses and profits will depend on the quality of the scripts, advisors and indicators that you have. Some developers don’t have an understanding of the financial markets and will produce scripts, advisors and indicators that are misguiding and are detrimental to your capital.

An important tip: Choose approved software manufacturers that you have no doubt on the quality of the development and it’s testing too. Random software from an online store may bring harm to your trading account. Therefore, you should exercise caution while choosing a developer for your scripts, advisors and indicators.

Hedging comes with its advantages if embraced well, it offers many money making opportunities

What you should avoid

Hedging of a position in case you start to incur losses was and still remains to be common among traders. However, there has been a shift of this thinking and the new school of thinking from the experienced traders, suggest that you should not hedge whenever you are making losses. The new school of thinking suggests closing a trade that is accruing losses. The argument behind this is ‘cut your losses short and let your profits run’.

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What should you do?

Experienced traders suggest that you should close a losing position and wait for the reversal of the prices and then open the same position again. By doing this you will not incur spread twice at the same time you will not freeze you capital. Avoiding losses 100% is almost impossible in the financial markets. Therefore in a bid to prevent losses you should use every means that try at least to minimize use of your capital.

Hedging comes with its advantages if embraced well, it offers many money making opportunities as discussed below.

Hedging in scalping

ECN are the preferred account type when it comes to hedging. ECN accounts have low spread and the broker doesn’t have a chance to do unscrupulous deals using the client’s money unlike with the money maker account types. Money maker account types allow the broker to play foul against you by stretching the bid and ask price when you close a profitable trade with a stop or a take profit. This is a thing that you will hardly notice with your bare eyes and although the spread manipulation is low, accumulatively it sums up to big amounts. By all means you should avoid falling prey of such scenarios.

Suppose you chose an ECN account that you intend to scalp using it. It is well known that an ECN account provides access to a wide network of liquidity providers. The good thing about an ECN account is that there are no lags and the quotes are real time. The terminal quotes are triggered 300 – 1200 times per minute in the active trade. Such a scenario makes it hard for manual placing of orders, even with a high internet bandwidth. To cover up for the limitations you may allow for price slips but if you snooze you lose.

If you compare the bars formed by an ECN account to the bars formed by a regular account you will realize only some slight differences. The reason behind these differences is the active price movement within a bar. The ECN bars movements are more erratic compared to the regular account and at the same time the regular account has a lag. This movement from ECN accounts is what you need to harness and make profits from its movements.

Normally for the ECN account, only some of the ticks are processed by the trading terminal. You not necessarily need to make money from all the oscillations since these ticks will later be re-assigned to the trading server. The terminal should send a pair of the pending orders to the server on both sides of the current price, pending buy order and pending sell order. For this to happen, the pending buy order needs to be below the pending sell order. During this erratic price movement if it happens that both prices are touched and the orders executed, they should be closed back using the “OrderCloseBy” function. The difference between the opening prices and the warrants will be your profits. From one pair this is minimal since the price difference may be pips or even pipette(s). For you to realize profits the spread needs to be less than the gain.

The above figure gives a vivid picture of opposite orders when they are in multiples. They are arranged in pairs a distance of two spreads. The blue dotted line represents the ‘buy’ while the red dotted line represents the ‘sell’. For clarity between pairs of orders in the grid, an interval of one spread was left. In live trade, there is no need for this because it degrades on the performance of the strategy twice. In a span of a day there are likely more than 50 pairs of orders that can be closed at a profit. If you optimize and put your pairs closer with a smaller gap, in a day you will likely to get a profit from orders of 150 different pairs. With this trading mechanism you will require minimum resources to maintain open position.

Trend motion

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In the financial markets there is no Holy Grail. The only setback of this strategy is a strong trend motion. For instance In the case where the pending sell order is picked and the prices retrace upwards and not picking the pending buy order this will lead to a loss. Things can worsen when the trend gains momentum and the losses from the recent trade exceed the gains from the profitable closed orders. In cases where there is a strong trend, it is difficult to make a profit. To limit the losses that may accrue form the strong trend motion it is recommended to put the pending orders on the borders of price channel. The buy stop order should be placed on top of the upper boundary and the sell stop on the low points of the price boundary. Such a strategy apart from acting as a loss mitigation strategy it also enables you to make additional revenue from the price differences in between the boundary.

The only situation that results to a loss is when both orders are triggered because of the erratic price movements. But this loss can be offset by the gains from other closed orders.

Script allows for adjustment of price boundaries for this strategy. The same effects of adjustments are always reflected and passed to the advisors for the pending orders. This allows you to earn income at once on multiple currency pairs. However, for this to work it needs to be in time and should be congruent with the boundaries of the channel and it should stop the advisors work when the news is published.

The only limiting factor with this strategy is that the ECN account should have $1000 as the threshold amount. The next article will cover a strategy that allows starting with the least investment required to invest on the minimum level of ECN accounts.

1. Mistakes that arise from hedging are manageable and can be controlled.
2. The modern technical tools of a trader have potential to increase revenue opportunities.
3. High quality trading tools provide trading opportunities even when the market is calm.
4. The efficiency of your hedging relies on the quality of the software you receive from the developer as well as other programs that you use.

Hedge Funds and Money Laundering

Money laundering is a heinous crime. Although it does not directly lead to loss of human lives, it allows money to reach the hands of wrong individuals. The proceeds from money laundering end up in the hands of gangsters, warlords, drug dealers and terror groups. No financial institutions would want to enable such transactions. However, many times hedge funds unwittingly become part of such transactions. In this article, we will understand how hedge funds can identify and avoid dealing with money launderers.


Hedge funds are requested to take a declaration from their clients verifying that the money being invested has not been realized as a result of criminal or illegal activities. Also, hedge funds are required to ask their customers to give a declaration that their name does not feature on the list of high risk investors. In case their name appears on such a list, hedge funds are instructed to not accept money from them.

Symptoms of An Investor Being Engaged in Money Laundering

Not Following The Process: Attempts to avoid the required documentation are a big red flag which the hedge funds need to watch out. People who want to launder their money have dubious sources of income. Therefore, they may not have the required paperwork or may be unwilling to provide details. Hedge funds need to ensure that they do not give leeway to any investor regardless of the amount that they propose to invest. Unethical individuals who indulge in money laundering have a strategy of overwhelming the fund with the scale of their investments and forcing them to avoid following the proper procedure. However, the recent crackdowns by the SEC and FSA have made this strategy redundant as funds are not willing to compromise on process.

Questionable Backgrounds: Hedge funds are like a private club. The management of the fund has the right to decide who gets inside and who does not. Therefore, it is in the best interest of the hedge funds to stay away from people who either have a questionable background or associate with others who do. The media has already vilified the hedge funds several times. Associating with a questionable person may invite unnecessary scrutiny and media attention which is likely to do more harm than good. Also, in most cases the people who do associate with people like drug lords, mafia and terror groups, do in fact invest money in the hedge fund with an intention to launder it.

Lying About Personal Business: Sometimes potential investors may have their paperwork in place. However, while talking to them something may seem unusual. They may be projecting themselves as being very successful at a legitimate business. However, they may know very few details or may avoid talking about their business altogether. In such cases, the hedge funds must verify their background since they could be potential money launderers.

No Questions about Risks and Returns: Each hedge fund investment is worth a million dollars or so. Hedge fund managers therefore expect the investor to ask a wide variety of questions before they decide whether they want to invest or not. Significant sums of money require significant due diligence. However, in some cases, the investors that turn up at the offices of hedge fund seem all too eager to invest their money. They do not appear to be sophisticated enough to understand the investments that are being made and do not make an attempt to truly understand the risks involved. Hedge fund management must understand that the intention of these people is not to earn money by making investments. Instead they may be laundering the money and may be using hedge funds as a tool to do so.

Wiring Money to Narco Destinations: A huge red flag that most hedge funds should stay away from is when investors ask the money to be wired to narco destinations. Many countries in South America and Central Asia are known for drugs. Often times, they resort to using the hedge funds in order to settle their accounts. For instance, an investor may put down a significant sum in a hedge fund and two months later may decide to make a withdrawal for no apparent reason. However, he/she may ask for the proceeds to be wired to nations where these criminal enterprises have a lot of clout. Therefore instead of using a bank transfer that would spark interest of the authorities, a fake hedge fund investment is used. Hedge funds may therefore become unwilling participants to money laundering schemes.

Wiring to Unrelated Parties: Regulators have also instructed hedge funds to only wire funds back to the same people from whom they were received. Narco and terror groups had been passing off hedge fund investments to one another creating a complex web of transactions that becomes very difficult to trail.

For instance A makes an investment in a hedge fund and while withdrawing the amount asks for the money to be deposited in B’s account. B then makes a separate investment and while withdrawing gets the money credited to C’s account. This process is repeated several times until a huge web of transactions is created to obscure the relationship between the sender and the receiver. To counter this problem, hedge funds must ensure that they only transfer money back to the same entity or person who invested with them. When people ask for their interests to br transferred to third parties that should be a definite red flag and must raise an alarm.

Hedge funds must therefore be very careful as to whom they accept money from. Failure to know the background of their customers is likely to get these funds involved in major legal hassles. Although, they are free from most regulations, they still have to be careful to not be part to felonies like money laundering.

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