Risk Transfer

Based on an enormously popular "derivative instruments and applications" course taught by risk expert Christopher Culp at the University of Chicago, Risk Transfer will prepare both current practitioners and students alike for many of the issues and problems they will face in derivative markets. Filled with in-depth insight and practical advice, this book is an essential resource for those who want a comprehensive education and working knowledge of this major field in finance, as well as professionals studying to pass the GARP FRM exam.

Christopher L. Culp, PhD (Chicago, IL), is a Principal at CP Risk Management LLC and is also Adjunct Professor of Finance at the University of Chicago. He is the author of Corporate Aftershock (0-471-43002-1) and The ART of Risk Management (0-471-12495-8).

Preface: The Demonization of Derivatives.

Introduction and Structure of the Book.

Mathematical Notation.

PART ONE: The Economics of Risk Transfer.

CHAPTER 1: The Determinants of Financial Innovation.

CHAPTER 2: Risk, Uncertainty, and Profit.

CHAPTER 3: Methods of Controlling Risk and Uncertainty.

CHAPTER 4: Risk Transfer and Contracting Structures.

CHAPTER 5: The Evolution of Derivatives Activity.

CHAPTER 6: Derivatives Trading, Clearance, and Settlement.

PART TWO: Derivatives Valuation and Asset Lending.

CHAPTER 7: Principles of Derivatives Valuation.

CHAPTER 8: Own Rates of Interest and the Cost of Carry Model.

CHAPTER 9: The Supply of Storage and the Term Structure of Forward Prices.

CHAPTER 10: The Term Structure of Interest Rates.

CHAPTER 11: Basis Relations and Spreads.

PART THREE: Speculation and Hedging.

CHAPTER 12: Speculation and the Speculative Risk Premium.

CHAPTER 13: Hedging Objectives.

CHAPTER 14: Hedge Ratios.

CHAPTER 15: Quality Basis Risk.

CHAPTER 16: Calendar Basis Risk.

PART FOUR: Appendixes.

APPENDIX 1: Economic Theory and Equilibrium.

APPENDIX 2: Derivation of the Fundamental Value Equation.

APPENDIX 3: Relation between the Cost of Carry Model and the Fundamental Value Equation.

References.

Index.

CHRISTOPHER L. CULP is an Adjunct Professor of Finance at the University of Chicago’s Graduate School of Business, a Principal at Chicago Partners LLC, and, during the winter academic term, a Resident Guest Professor of Risk and Insurance in the Institut für Finanzmanagement at Universität Bern in Switzerland. Culp is an active consultant to various financial and non-financial firms on risk management, financial instrument selection, and capital allocation. In addition, he is an independent non-executive Director of Idaho Power Company, Inc., and IDACORP, Inc., where he is a member of the Audit and Governance Committees of both boards, and he is a Senior Fellow in Financial Regulation with the Competitive Enterprise Institute in Washington, D.C. Culp is the author of two previous books (both published by Wiley), The ART of Risk Management and The Risk Management Process. He recently coedited for Wiley (with William Niskanen) Corporate Aftershock: The Public Policy Lessons from the Collapse of Enron and Other Major Corporations. Culp holds a PhD in finance from the Graduate School of Business of the University of Chicago and a BA in economics from the Johns Hopkins University. "Derivatives are an essential weapon in the corporate arsenal for managing risk, controlling cost, and increasing shareholder value. They are not weapons of mass destruction, but rather smart bombs that can be very precisely targeted at specific risk or areas of concern. Indeed, perhaps the greatest risk of derivatives to a firm is the risk of not using them when it is appropriate to do so."
–From the Preface

The use of derivatives to manage risk dates back nearly 4,000 years. And despite the current anti-derivatives uproar–fueled by the popular press, driven by well-regarded financiers like Warren Buffett and George Soros, and accompanied by government proposals to prohibit, limit, tax, or further regulate derivatives–these irreplaceable instruments are in truth straightforward and vital to numerous financial practitioners and companies.

Risk Transfer provides a basic understanding of the driving economic theory behind derivatives and risk transfer, then examines the advanced application and implementation of derivative instruments by corporations and institutional investors. Building the book around his popular University of Chicago graduate course, Professor Christopher L. Culp explores three fundamental areas in the structure and use of derivatives:

• PART I: The Economics of Risk Transfer
  Micro and macro foundations underlying risk transfer as a financial activity, and the evolution and use of derivatives as an efficient means of transferring risk
• PART II: Derivatives Valuation and Asset Lending
  The function of derivatives as intertemporal and interspatial resource allocation markets, with discussions of related concepts including own rates of interests, the cost of carry, backwardation and contango in the term structure of futures/forward prices, basis and spread relations, and more
• PART III: Speculation and Hedging
  The role of–and risk premium paid to–speculators, how firms determine their specific objectives and hedge ratios, and how hedging is affected by and can be used to address quality and calendar basis risks

While derivatives have always been–and will always be–a necessary tool in managing exposure to financial risk, professionals must understand the entire picture before they can successfully relate to its individual components. Risk Transfer helps researchers and practitioners to fill in that picture, providing a comprehensive examination of the theoretical foundations of derivatives as risk transfer instruments along with hands-on techniques and examples of how that theory can be successfully applied to the everyday practice of financial risk management.

Praise for Risk Transfer

"Culp’s book is a masterly account of the economics of risk and the development of derivatives. It is not only soundly based in theory but it serves as a splendid practical guide to the multiplicity of traded risks in the financial markets."
–Sir Alan Walters, Chief Economic Advisor to Margaret Thatcher (1980-85 and 1989) and former Vice Chairman, AIG Trading Group (1990-2000)

"As always, Chris Culp makes me rethink things I thought I already understood. The idea he champions in this book–that derivatives can be viewed through the lens of an asset lending instrument–helps in understanding the behavior of the producers and users of derivatives. And Culp’s historical notes add color to the tapestry of risk management."
–Charles Smithson, Managing Director, Rutter Associates

"Derivatives are the highest financial life form on the planet, and Culp does a great job of explaining why. I was especially delighted by Chapter 2, which traces the way we think about risk and uncertainty from Adam Smith (who would have taught at the University of Chicago if he had been born later), through Frank Knight and Bob Lucas. It is a great reminder of why we study economics in the first place. Well done."
–Galen Burghardt, Director of Research, Carr Futures

"Chris Culp’s Risk Transfer is an important addition to the literature on derivatives, and not just because it successfully bridges theory and practice. The presentation of the underlying economic thought and academic literature relevant to the broader issues of how we view and treat risk in the economy and in the business world is excellent. It’s what makes this new book unique and valuable."
–Wendy L. Gramm, Chairman of Regulatory Studies
Mercatus Center, George Mason University

"Culp’s book explains the role derivatives play in our financial system as an invaluable tool for risk transfer in the marketplace. He takes the reader from the macro aspects of derivatives through detailed modern theories, in addition to offering a practical perspective on speculation and hedging. This book is essential for every derivatives professional."
–Dennis A. Dutterer, President and CEO, The Clearing Corporation