jan-02 risk management zvi wiener 02-588-3049 mswiener/zvi.html financial risk management

Jan-02 Risk Management

Zvi Wiener

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

Financial Risk Management

Feb-2001 slide 2Zvi Wiener


Risk

• Business Risk

• Financial Risk

– market risk

– credit risk

– liquidity risk

• Operational Risk

• Legal Risk


Risk Management

• Examples of good and bad risk management

• Good or bad risk management is NOT the

same as profits and losses.

• There are many examples of good RM that

lead to losses and bad RM that lead to gains.


Barings

• February 26, 1995

• 233 year old bank

• 28 year old Nick Leeson

• $1,300,000,000 loss

• bought by ING for $1.5


Metallgesellshaft

• 14th largest industrial group• 58,000 employees• offered long term oil contracts• hedge by long-term forward contracts• short term contracts were used (rolling hedge)• 1993 price fell from $20 to $15• $1B margin call in cash


Orange County

• Bob Citron, the county treasures

• $7.5B portfolio (schools, cities)

• borrowed $12.5B, invested in 5yr. notes

• interest rates increased

• reported at cost - big mistake!

• realized loss of $1.64B


Public Funds

($ million)• Orange County 1,640• San Diego 357• West Virginia 279• Florida State Treasury 200• Cuyahoga County 137• Texas State 55


Derivatives 1993-1995

($ million)•Shova Shell, Japan 1,580•Kashima Oil, Japan 1,450•Metallgesellschaft 1,340•Barings, U.K. 1,330•Codelco, Chile 200•Procter & Gamble, US 157


Investec Clali, Jan-01

Client bought put options without sufficient funds.

Loss is 8-15M NIS.


• Barings $1.3B• Bank Negara, Malaysia 92 $3B• Banesto, Spain $4.7B• Credit Lyonnais $10B• S&L, U.S.A. $150B• Japan $500B

Financial Losses


Value of an Option at Expiration

E. Call

X Underlying


Call Value before Expiration

E. Call

X Underlying


Call Value before Expiration

E. Call

X Underlying

premium


Put Value at Expiration

E. Put

X Underlying

X


Put Value before Expiration

E. Put

X Underlying

premium

X


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.


Collar payoff

payoff

90 100 K stock

90

K


Options in Hi Tech

Many firms give options as a part of

compensation.

There is a vesting period and then there is a

longer time to expiration.

Most employees exercise the options at

vesting with same-day-sale (because of tax).

How this can be improved?


Long term options

payoff

k K stock

50

K

Sell a call

Your option

Result


ExampleYou have 10,000 vested options for 10 years

with strike $5, while the stock is traded at $10.

An immediate exercise will give you $50,000

before tax.

Selling a (covered) call with strike $15 will

give you $60,000 now (assuming interest rate

6% and 50% volatility) and additional profit at

the end of the period!


Example

payoff

10 15 26

50

K

Your option

Result

60

exercise


How much can we lose?

Everything

correct, but useless answer.

How much can we lose realistically?


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


Risk Management• Risk measurement

• Reporting to board

• Limits monitoring

• Diversification, reinsurance

• Vetting

• Reporting to regulators

• Decision making based on risk


Who manages risk?

Citibank

Bank of England

CIBC

J. P. Morgan

Bankers Trust

AIG

General Re

Swiss Re

Aetna

Zurich

Nike

Sony

Dell Computers

Philip Morris

Ford Motor


Regulators

• BIS

• FSA

• SEC

• ISDA

• FASB

• Bank of Israel

• Galai’s committee


Basic Steps in RM process

• Identify risks

• Data base (market + position)

• Risk measurement

• Regulators

• Risk Management

• Reporting

• Strategic decisions


Building a RM system• Initial study of risks

• Decision, Risk Manager

• Risk measurement system

• Responsibilities and structure

• Testing

• Active Risk Management

• Staff training and maintenance


Risk Management and

Risk Measurement


Risk Management System• Predict future• Identify business opportunities• Be always right!

Risk Management System Can

• Predict loss, given event• Identify most dangerous scenarios• Recommend how to change risk profile

Can NOT


Tool, not rule!

Limits, Duration, ALM, DFA, VaR


Definition

VaR is defined as the predicted worst-case

loss at a specific confidence level (e.g. 99%)

over a certain period of time.


-3 -2 -1 1 2 3

0.2

0.4

0.6

0.8

1

Profit/Loss

VaR

1% VaR1%


Meaning of VaR

A portfolio manager has a daily VaR equal $1M at 99% confidence level.

This means that there is only one chance in 100 that a daily loss bigger than $1M occurs,

1%VaR

under normal market conditions.


History of VaR

• 80’s - major US banks - proprietary

• 93 G-30 recommendations

• 94 - RiskMetrics by J.P.Morgan

• 98 - Basel

• SEC, FSA, ISDA, pension funds, dealers

• Widely used and misused!


Risk Management Structure

Market data Current position

Risk Mapping

Valuation

Value-at-Risk

Reporting and Risk Management


1011

1213

14 4.1

4.15

4.2

4.25

4.3

7.257.5

7.758

8.25

1011

1213

14

interest rates and dollar areNOT independent

Value

Interest Ratedollar


Risk Measuring Software• CATS, CARMA• Algorithmics, Risk Watch• Infinity• J.P. Morgan, FourFifteen• FEA, Outlook• Reuters, Sailfish• Kamacura• Bankers Trust, RAROC• INSSINC, Orchestra


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


How to measure VaR

• Historical Simulations

• Variance-Covariance

• Monte Carlo

• Analytical Methods


Historical Simulations

• Fix current portfolio.

• Pretend that market changes are

similar to those observed in the past.

• Calculate P&L (profit-loss).

• Find the lowest quantile.


Returns

year

1% of worst cases


-3 -2 -1 1 2 3

0.2

0.4

0.6

0.8

1

Profit/Loss

VaR

1% VaR1%


Weights

Since old observations can be less relevant, there is a technique that assigns decreasing weights to older observations. Typically the decrease is exponential.

See RiskMetrics Technical Document for details.


Variance Covariance

• Means and covariances of market factors

• Mean and standard deviation of the portfolio

• Delta or Delta-Gamma approximation

• VaR1%= P – 2.33 P

• Based on the normality assumption!


Variance-Covariance VVVaR 33.2%1

2.33

-2.33

1%


Monte Carlo

-1 -0.5 0.5 1

-1

-0.5

0.5

1


Monte Carlo

• Distribution of market factors

• Simulation of a large number of events

• P&L for each scenario

• Order the results

• VaR = lowest quantile


Monte Carlo Simulation

10 20 30 40

-15

-10

-5

5

10

15


Real Projects

Most daily returns are invisible.

Proper financing should be based on risk

exposure of each specific project.

Note that accounting standards not always reflect

financial risk properly.


Example

• You are going to invest in Japan.

• Take a loan in Yen.

• Financial statements will reflect your

investment according to the exchange rate

at the day of investment and your liability

will be linked to yen.

• Actually there is no currency risk.


Airline company

• fuel - oil prices and $• purchasing airplanes - $ and Euro• salaries - NIS, some $• tickets $• marketing - different currencies• payments to airports for services


Airline company

• loans

• equity

• callable bonds


Airline company

Base currency - by major stockholder.

Time horizon - by time of possible price change.

Earnings at risk, not value at risk, since there is too much optionality in setting prices.

One can create a one year cashflow forecast and measure its sensitivity to different market events.


Reporting

Division of VaR by business units, areas of

activity, counterparty, currency.

Performance measurement - RAROC (Risk

Adjusted Return On Capital).


How VaR is used

• Internal Risk Management

• Reporting

• Regulators


Backtesting

Verification of Risk Management models.

Comparison if the model’s forecast VaR with

the actual outcome - P&L.

Exception occurs when actual loss exceeds

VaR.After exception - explanation and action.


Backtesting

Green zone - up to 4 exceptions

Yellow zone - 5-9 exceptions

Red zone - 10 exceptions or more

OK

increasing k

intervention


Stress

Designed to estimate potential losses in abnormal markets.

Extreme events

Fat tails

Central questions:

How much we can lose in a certain scenario?

What event could cause a big loss?


Unifying Approach

• One number

• Based on Statistics

• Portfolio Theory

• Verification

• Widely Accepted

• Easy Comparison


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.


Open Questions

• Risks related to cashflow

• Non-traded assets

• Credit information

• Global Database

• Liquidity problem


Issues Specific to Israel

• Indexation

• Exchange Band

• Shallow Markets


pluto.mscc.huji.ac.il/~mswiener/

• Useful Internet sites

• Regulators

• Insurance Companies

• Risk Management in SEC reports

Risk Management resources


How to hedge financial risk?• Static hedge

Forwards agreements that fix the price

Futures

Options static hedge• Dynamic delta or vega hedge, with a variable amount of options held. It is applicable if there is a very liquid market and low transaction costs.


RMG

• http://www.riskmetrics.com/

• http://www.pictureofrisk.com/

• http://www.riskmetrics.com/rm/splash.html

• rmgaccess


Consulting

• Oliver, Wyman and Co.

• Willis Corroon

• Richard Scora

• Ernst and Young

• Enterprise Advisors

• Kamakura


Examples of Risk Reports

http://www.pictureofrisk.com

http://www.mbrm.com/

http://www.riskmetrics.com/rm/splash.html


Regulators• BIS • G-30 • FSA • SEC • market risk disclosure rules • market risk reporting • FED, FRB • our GARP report • Swiss Central Bank • Financial Accounting Standards Board


SEC reports

• Edgar

• Yahoo

– find symbol

– profile

– raw SEC reports market risk in 10K 7A


3 methods

• Sensitivity

– requires a deep understanding of positions

• Tabular

– when there are 1-2 major risk factors

• Value-at-Risk

– for active risk management


KPMG report

Survey of disclosures: SEC Market Risk, 1999

SEC:http://www.sec.gov/smbus/forms/regsk.htm#quan

http://www.sec.gov/rules/othern/derivfaq.htm

GARP

http://www.garp.com/


World Experience

• Bankers Trust, J.P. Morgan, investment banks

• Bank regulators, commercial banks

• Insurance, dealers

• Investment funds (LTCM)

• Real companies

• Investors learn to read risk information!


Agriculture

www.cfonet.com/html/Articles/CFO/1999/99APkita.html

1998 revenues $1.25B

consulting Willis Corroon


Nike

• Salaries are paid in Asia

• Shoes are sold worldwide

• Financing comes from USA

• Marketing, storing, shipping worldwide

use VaR since 1998.


Merck

http://www.palisade-europe.com/html/Articles/merck.html

http://www.sec.gov/Archives/edgar/data/64978/0000950123-99-005573-index.html see “sensitivity”


Articles

Value at Risk as a Diagnostic Tool for Corporates: The Airline Industry

http://netec.mcc.ac.uk/WoPEc/data/Papers/dgruvatin19990023.html

Agricultural Applications of Value-at-Risk Analysis: A Perspective

http://netec.mcc.ac.uk/WoPEc/data/Papers/wpawuwpfi9805002.html


Publications

“The New Risk Management: the Good, the Bad, and the Ugly”, P. Dybvig, W. Marshall

http://dybfin.olin.wustl.edu/research/papers/riskman_fed.pdf

Association for Investment Management and Research

http://www.aimr.org/


Web tour

• ZW, students, VaR and risk management• Gloriamundy• GARP• SEC reports• Google


What is more risky and why?

A. 1 year bond

B. 10 year bond


What is more risky and why?

A. An in-the-money option?

B. An out-of-the-money option?

jan-02 risk management zvi wiener 02-588-3049 mswiener/zvi.html financial risk management

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