frm-3 zvi wiener 02-588-3049 mswiener/zvi.html rm functions

FRM-3

Zvi Wiener

02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

RM functions

Zvi Wiener FRM-3 slide 2

Structuring RM functions

• Set firm-wide policies

• Develop methodology

• Set RM structure

• Risk communication


Integrated

Risk M

anagemen

t

Identify and avoid

MonitorLimit Management

StressMarket, Credit VaR

Risk Analysis

Allocate capital RAROC

Active RiskManagement


RAROC

• Risk Adjusted Rate of Return

• Performance measurement

• Marginal impact of any new transaction

• Consistent pricing


New Approach

Three pillars

A. Minimum Capital Requirement

B. Supervisory Review Process

C. Market Discipline Requirements


Goals and Instruments

• Risk Tolerance - “worst loss”

• Stop losses

• Capital allocation

• Credit risk policy

• Operational risk policy


Risk Measurement

• Consistent market based method

• Old limits duration, ALM

• VaR + Stress

• Backtesting


Systems

• Data bases market position rules

• Risk measuring tool

• Reports and decision support


IT - Information Technology

• Unifying information from various units

• Unifying information from various markets

• Unifying information for various ownership

• Back office and execution control


Organizational structure

• Front office

• Middle office

• Back office


Front office

• execution

• risk taking

• marketing


Middle office

• risk management

• pricing

• economic forecasts


Back office

• verification

• booking

• reporting

• collection

• settlement


ALCO

• Assets Liability management committee

• responsible for establishing documenting enforcing all policies involving market risk

• FX

• liquidity

• interest rate


Interdependence of RM

Senior Management

Risk Management Operations

Trading Room

Finance


Senior management

• Approves business plan and targets

• Sets risk tolerance

• Establishes policy

• Ensures performance


Trading Room Management

• Establishes and manages risk exposure

• Ensures timely and accurate deal capture

• Signs off on official P&L


Operations

• Books and settles the trades

• Reconciles front and back office positions

• Prepares and decomposes daily P&L

• Provides independent MTM

• Supports business needs


Finance

• Develops valuation and finance policy

• Ensures integrity of P&L

• Manages business planning process



Risk Management

• Develops risk policies

• Monitors compliance to limits

• Manages ALCO process

• Vets models and spreadsheets

• Provides independent view on risk



Risk Limits

• Global risk limit

• Risk limits for trading desks/units

• Dynamic monitoring and adjustment


Risk Approaches

• Accounting - reported P&L

• Economic - value

• Liquidity needs


Liquidity Rank

• Based on forecasts and potential availability

of funds.

• Hot funds - can be withdrawn quickly.

• Stable funds - typically to maturity.


Israel 339

• Definitions of risk types

• Relates to all banking institutions

• Management structure

• Exposure document

• Directors and policy

• Risk manager

• Internal audit


Israel 339

• IR risk

• Market risk

• Risk audit unit


Israel 341

• Capital requirements against market risk

• Risk measurement

• Trading portfolio

• Reporting

• Examples of standard approach and VaR


Qualitative Requirements

• An independent risk management unit• Board of directors involvement• Internal model as an integral part• Internal controller and risk model• Backtesting• Stress test


Quantitative Requirements

• 99% confidence interval• 10 business days horizon• At least one year of historic data• Data base revised at least every quarter• All types of risk exposure• Derivatives


Types of Assets and Risks

• Real projects - cashflow versus financing

• Fixed Income

• Optionality

• Credit exposure

• Legal, operational, authorities


Risk Factors

There are many bonds, stocks and currencies.

The idea is to choose a small set of relevant economic

factors and to map everything on these factors.

• Exchange rates

• Interest rates (for each maturity and indexation)

• Spreads

• Stock indices


Board of Directors(Basle, September 1998)

• periodic discussions with management concerning the effectiveness of the internal control system• a timely review of evaluations of internal controls made by management, internal and external auditors• periodic efforts to ensure that management has promptly followed up on recommendations and concerns expressed by auditors and supervisory authorities on internal control weaknesses• a periodic review of the appropriateness of the bank’s strategy and risk limits.


Forward agreement

• Is an obligation on both sides

• No initial money transfer

• Final price is fixed in advance

• Typical cash settlement

• Margin account and mark to market


Forward/Futuresvalue

spotr

rX

T

USD

NIS

1

1

Spot X $


Options

• Put or Call

• European or American

• Underlying asset

• Strike price

• Premium

• Time to maturity

• Hedge ratio


Call Option

X underlying

premium

value


Hedge Ratio

X underlying

value


Put Option

X underlying

value


Exotic Options

• Asian

• Path dependent

• Digital

• Bermudian

• Knock-in, out

• Exchange of assets

• Swaptions


Swap

• currency or interest rate

• two loans with swapped payments

• low credit risk

• changes exposure:

currency

duration


Structured Note

• tailor made solution

• for example, IO, PO

• higher priority obligations or junk

• collar, IAS, ratchet, etc.


Collar

• Firm B has shares of firm C of value $200M

• They do not want to sell the shares, but need

money.

• Moreover they would like to decrease the

exposure to financial risk.

• How to get it done?


Collar

1. Buy a protective Put option (3y to maturity,

strike = 90% of spot).

2. Sell an out-the-money Call option (3y to

maturity, strike above spot).

3. Take a “cheap” loan at 90% of the current

value.


Buy stock

Sell call

Result

Buy put


UPC example

• Aug 98, a $90M convertible loan to UPC

• Feb 99, $49M paid for 1.55M shares (10%)

• The share price rose to $162 (5 times)

• Four options were used to protect the value


UPC example

• Buy 2 put options maturing 06-Feb-2002

put option for 500,000 shares, strike $125

put option for 300,000 shares, strike $153

• Sell 2 call options maturing 06-Feb-2002

call option for 500,000 shares, strike $173

call option for 300,000 shares, strike $212


UPC

125 153 173 212 UPC share

108

150

After tax capital gainis between $53M and$80M

These options cover 800,000 shares only.


How much did it cost?

• The results are not precise and very sensitive to volatility

if volatility is 10% $6.5M if volatility is 20% $10M if volatility is 30% $13M if volatility is 40% $15M

This is the amount the bank should pay to DASKASCH!


Risk Management Issues

• Why only half of the bond was called?

• Why only 800,000 shares were protected?

• How to choose the protection level?

• When does it make sense to hedge?


New proposals

• BIS 2000

• VaR based approach to credit risk. CreditMetrics

CreditRisk+

KMV

Merton.


What is the current Risk?

duration, convexity

volatility

delta, gamma, vega

rating

target zone

• Bonds

• Stocks

• Options

• Credit

• Forex• Total ?


Standard Approach


Modern Approach

Financial Institution

frm-3 zvi wiener 02-588-3049 mswiener/zvi.html rm functions

Documents

office slide

rate slide

performance slide

adjustment slide

marketing slide

zvi wienerfrm

business needs slide

official pl slide