jun-00 risk management zvi wiener 02-588-3049 mswiener/zvi.html tools for risk management
TRANSCRIPT
Jun-00 Risk Management
Zvi Wiener
02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Tools for risk management
Jun-2000 slide 2Risk Management Tools
Options
Call, Put
European, American
Strike, volatility, time to maturity
In-the-money, Out-of-the-money
Black-Merton-Scholes
OTC and Exotic options
Jun-2000 slide 3Risk Management Tools
Call Value before Expiration
E. Call
X Underlying
premium
Jun-2000 slide 4Risk Management Tools
Put Value before Expiration
E. Put
X Underlying
premium
X
Jun-2000 slide 5Risk Management Tools
Other Options Callable bond
Warrants
Asian, Bermudian, Digital
Real options
– to start a new project
– to change prices
– to close some divisions
Jun-2000 slide 6Risk Management Tools
Hedge Ratio = Delta
Delta measures sensitivity of a position
relative to a risk factor.
Similar to duration for bonds.
Delta of a call option is …
Delta of a put option is ...
Jun-2000 slide 7Risk Management Tools
Call Delta
E. Call
S
S
C
current value
Jun-2000 slide 8Risk Management Tools
Put Delta
E. Put
S
S
P
current value
Jun-2000 slide 9Risk Management Tools
What type of risk protection would you suggest for a pension fund?
payoff
Stock market
floor
Buy index
Buy put
Sell calls
Jun-2000 slide 10Risk Management Tools
Buy stock
Sell call
Result
Buy put
Jun-2000 slide 11Risk Management Tools
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
Jun-2000 slide 12Risk Management Tools
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
Jun-2000 slide 13Risk Management Tools
UPC
125 153 173 212 UPC share
108
150
After tax capital gainis between $53M and$80M
These options cover 800,000 shares only.
Jun-2000 slide 14Risk Management Tools
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!
Jun-2000 slide 15Risk Management Tools
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?
Jun-2000 slide 16Risk Management Tools
Butterfly2*Call(550)-Call(540)-Call(560)
payoff
540 550 560 Stock market
Jun-2000 slide 17Risk Management Tools
Hedge using ForwardCurrent exchange rate 4.00
USD interest rate 6%
NIS interest rate 10%
In a year you will receive $100 and will have to pay 410 NIS.
Enter into a forward for 1 year for $100.
Forward price is 4.00*1.1/1.06=4.15.
The time match is important!
Jun-2000 slide 18Risk Management Tools
After a year$ Forward Your balance
3.9 25 3.9*100-410+25= 5
4.0 15 4.0*100-410+15= 5
4.1 5 4.1*100-410+ 5 = 5
4.2 -5 4.2*100-410- 5 = 5
4.3 -15 4.3*100-410-15 = 5
Complete protection with no cost!
Jun-2000 slide 19Risk Management Tools
What if there is no perfect time match?
One can use shorter contracts and roll them
over. This will neutralize completely the
exchange rate risk, but you will have some
interest rate risk.
Do it very carefully!
Or better use OTC, but check prices.
Jun-2000 slide 20Risk Management Tools
Hedge using OptionsCurrent exchange rate 4.00
USD interest rate 6%
NIS interest rate 10%
In a year you will receive $100 and will have to pay 410 NIS.
Buy a put option with strike 4.1 for $100.
The time match is important!
Jun-2000 slide 21Risk Management Tools
After a year$ Put Opt. Your balance
3.9 20 3.9*100 - 410 + 20= 0
4.0 10 4.0*100 - 410 + 10= 0
4.1 0 4.1*100 - 410 + 0 = 0
4.2 0 4.2*100 - 410 - 0 =10
4.3 0 4.3*100 - 410 - 0 =20
Protection with some cost!
The initial cost of options.
Jun-2000 slide 22Risk Management Tools
Example
Your company has stable yearly income of
8M (shekels) a year and yearly costs of $1M
and 1M Euro. For simplicity assume that all
payments are on the end of ech calendar year.
How to measure and to manage this risk?
Jun-2000 slide 23Risk Management Tools
Example
Time horizon – 1 year
Basic currency – SHEKELS
Major risk factors – exchange rates USD,
EUR and interest rates (for all 3 currencies).
The present value of the next cashflow is:
EURUSDNIS r
EUR
r
USD
r
111
8
Jun-2000 slide 24Risk Management Tools
Example
EURUSDNIS r
EUR
r
USD
r
111
8
Assume that now
USD = 4 SHEKELS
EUR = 3.5 SHEKELS
rNIS = 10%
rUSD= 6%
rEUR = 5%
Jun-2000 slide 25Risk Management Tools
Example
EURUSDNIS r
EUR
r
USD
r
111
8
The current value of the position is 165,809 NIS.
But this number is subject to the risk factors.
We ignore in this example the interest rates for simplicity.
Jun-2000 slide 26Risk Management Tools
Example
EURUSDNIS r
EUR
r
USD
r
111
8
Each time the USD/NIS rate increases by 1 AGORA, our position loses 9,434 NIS.
Each AGORA in Euro exchange rate causes a loss of 9,524 NIS.
Assume that yearly volatility of USD/NIS is 10%, and EUR/NIS is 20%.
Correlation between them -0.1.
Jun-2000 slide 27Risk Management Tools
Example
EURUSDNIS r
EUR
r
USD
r
111
8
2.0350524,91.0400434,91.02
)2.0350524,9()1.0400434,9( 222
P
482,732P
595,208,1%5 VaR
Jun-2000 slide 28Risk Management Tools
Example
The best way to hedge this risk is by forward
contracts that will allow you to exchange the
appropriate amount of foreign currency to
SHEKELS at the rate fixed in advance.
Another alternative is to use static (or better
dynamic) hedge with options.
Jun-2000 slide 29Risk Management Tools
Example
Assume that for the following 7 years you
have to pay each year $1M and you will get
each year 5M NIS.
How one can hedge this cash flow?
What if amounts or timing is not precise?
Jun-2000 slide 30Risk Management Tools
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.
Jun-2000 slide 31Risk Management Tools
pluto.mscc.huji.ac.il/~mswiener/
Useful Internet sites
Regulators
Insurance Companies
Risk Management in SEC reports
Risk Management resources
Jun-2000 slide 32Risk Management Tools
RMG
http://www.riskmetrics.com/
http://www.pictureofrisk.com/
http://www.riskmetrics.com/rm/splash.html
rmgaccess
Jun-2000 slide 33Risk Management Tools
Consulting
Oliver, Wyman and Co.
Willis Corroon
Richard Scora
Ernst and Young
Enterprise Advisors
Kamakura
Jun-2000 slide 34Risk Management Tools
Examples of Risk Reports
http://www.pictureofrisk.com
http://www.mbrm.com/
http://www.riskmetrics.com/rm/splash.html
Jun-2000 slide 35Risk Management Tools
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
Jun-2000 slide 36Risk Management Tools
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
Jun-2000 slide 37Risk Management Tools
SEC reports
Edgar
Yahoo
– find symbol
– profile
– raw SEC reports market risk in 10K 7A
Jun-2000 slide 38Risk Management Tools
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
Jun-2000 slide 39Risk Management Tools
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/
Jun-2000 slide 40Risk Management Tools
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!
Jun-2000 slide 41Risk Management Tools
Agriculture
www.cfonet.com/html/Articles/CFO/1999/99APkita.html
1998 revenues $1.25B
consulting Willis Corroon
Jun-2000 slide 42Risk Management Tools
Nike
Salaries are paid in Asia
Shoes are sold worldwide
Financing comes from USA
Marketing, storing, shipping worldwide
use VaR since 1998.
Jun-2000 slide 43Risk Management Tools
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”
Jun-2000 slide 44Risk Management Tools
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
Jun-2000 slide 45Risk Management Tools
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/
Jun-2000 slide 46Risk Management Tools
Web tour
ZW, students, VaR and risk management Gloriamundy GARP SEC reports Google
Jun-2000 slide 47Risk Management Tools
What is more risky and why?
A. 1 year bond
B. 10 year bond
Jun-2000 slide 48Risk Management Tools
What is more risky and why?
A. An in-the-money option?
B. An out-of-the-money option?
Jun-2000 slide 49Risk Management Tools
Call Value before Expiration
Call
X Underlying
In-the-money option
Out-of-the-money option
Jun-2000 slide 50Risk Management Tools
What is more risky and why?
A. A fixed interest loan?
B. A floater (variable interest rate)?
Jun-2000 slide 51Risk Management Tools
The End
Jun-2000 slide 52Risk Management Tools
Tools Measurement tools
Financial tools
– options
– forwards, futures
– swaps
– insurance
Outsourcing
Jun-2000 slide 53Risk Management Tools
Senior Management
Marketing Finance Supply
Cashflow
Capital
Jun-2000 slide 54Risk Management Tools
Important Principles
Distinction between risk taking and risk control.
Backtesting.
Transparent reporting.
Timing is more important then precision!
Jun-2000 slide 55Risk Management Tools
Basic decisions
Goal of Risk Management
Base currency
Time horizon (embedded options)
Economic or Accounting approach
Admissible risk
Stop losses or other actions
Jun-2000 slide 56Risk Management Tools
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
Jun-2000 slide 57Risk Management Tools
Definition
VaR is defined as the predicted worst-case
loss at a specific confidence level (e.g. 99%)
over a certain period of time.
Jun-2000 slide 58Risk Management Tools
-3 -2 -1 1 2 3
0.2
0.4
0.6
0.8
1
Profit/Loss
VaR
1% VaR1%