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RM functions. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Structuring RM functions. Set firm-wide policies Develop methodology Set RM structure Risk communication. Integrated Risk Management. Limit Management. Risk Analysis. RAROC. Active Risk

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rm functions

RM functions

Zvi Wiener

02-588-3049

http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

structuring rm functions
Structuring RM functions
  • Set firm-wide policies
  • Develop methodology
  • Set RM structure
  • Risk communication

FRM-3

slide3

Integrated Risk Management

Limit Management

Risk Analysis

RAROC

Active Risk

Management

Allocate capital

Stress

Market, Credit VaR

Monitor

Identify and avoid

FRM-3

raroc
RAROC
  • Risk Adjusted Rate of Return
  • Performance measurement
  • Marginal impact of any new transaction
  • Consistent pricing

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new approach
New Approach

Three pillars

A. Minimum Capital Requirement

B. Supervisory Review Process

C. Market Discipline Requirements

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goals and instruments
Goals and Instruments
  • Risk Tolerance - “worst loss”
  • Stop losses
  • Capital allocation
  • Credit risk policy
  • Operational risk policy

FRM-3

risk measurement
Risk Measurement
  • Consistent market based method
  • Old
    • limits
    • duration, ALM
  • VaR + Stress
  • Backtesting

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systems
Systems
  • Data bases
    • market
    • position
    • rules
  • Risk measuring tool
  • Reports and decision support

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it information technology
IT - Information Technology
  • Unifying information from various units
  • Unifying information from various markets
  • Unifying information for various ownership
  • Back office and execution control

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organizational structure
Organizational structure
  • Front office
  • Middle office
  • Back office

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front office
Front office
  • execution
  • risk taking
  • marketing

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middle office
Middle office
  • risk management
  • pricing
  • economic forecasts

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back office
Back office
  • verification
  • booking
  • reporting
  • collection
  • settlement

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slide14
ALCO
  • Assets Liability management committee
  • responsible for
    • establishing
    • documenting
    • enforcing all policies involving market risk
      • FX
      • liquidity
      • interest rate

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interdependence of rm
Interdependence of RM

Trading Room

Senior Management

Operations

Risk Management

Finance

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senior management
Senior management
  • Approves business plan and targets
  • Sets risk tolerance
  • Establishes policy
  • Ensures performance

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trading room management
Trading Room Management
  • Establishes and manages risk exposure
  • Ensures timely and accurate deal capture
  • Signs off on official P&L

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operations
Operations
  • Books and settles the trades
  • Reconciles front and back office positions
  • Prepares and decomposes daily P&L
  • Provides independent MTM
  • Supports business needs

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finance
Finance
  • Develops valuation and finance policy
  • Ensures integrity of P&L
  • Manages business planning process
  • Supports business needs

FRM-3

risk management
Risk Management
  • Develops risk policies
  • Monitors compliance to limits
  • Manages ALCO process
  • Vets models and spreadsheets
  • Provides independent view on risk
  • Supports business needs

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risk limits
Risk Limits
  • Global risk limit
  • Risk limits for trading desks/units
  • Dynamic monitoring and adjustment

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risk approaches
Risk Approaches
  • Accounting - reported P&L
  • Economic - value
  • Liquidity needs

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liquidity rank
Liquidity Rank
  • Based on forecasts and potential availability of funds.
  • Hot funds - can be withdrawn quickly.
  • Stable funds - typically to maturity.

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israel 339
Israel 339
  • Definitions of risk types
  • Relates to all banking institutions
  • Management structure
  • Exposure document
  • Directors and policy
  • Risk manager
  • Internal audit

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israel 33925
Israel 339
  • IR risk
  • Market risk
  • Risk audit unit

FRM-3

israel 341
Israel 341
  • Capital requirements against market risk
  • Risk measurement
  • Trading portfolio
  • Reporting
  • Examples of standard approach and VaR

FRM-3

israel 34127
Israel 341
  • Capital requirements against market risk
  • Risk measurement
  • Trading portfolio
  • Reporting
  • Examples of standard approach and VaR

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qualitative requirements
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

FRM-3

quantitative requirements
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

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types of assets and risks
Types of Assets and Risks
  • Real projects - cashflow versus financing
  • Fixed Income
  • Optionality
  • Credit exposure
  • Legal, operational, authorities

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risk factors
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

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board of directors basle september 1998
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.

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forward agreement
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

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forward futures
Forward/Futures

value

Spot X $

FRM-3

options
Options
  • Put or Call
  • European or American
  • Underlying asset
  • Strike price
  • Premium
  • Time to maturity
  • Hedge ratio

FRM-3

call option

premium

Call Option

value

X underlying

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hedge ratio
Hedge Ratio

value

X underlying

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put option
Put Option

value

X underlying

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exotic options
Exotic Options
  • Asian
  • Path dependent
  • Digital
  • Bermudian
  • Knock-in, out
  • Exchange of assets
  • Swaptions

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slide43
Swap
  • currency or interest rate
  • two loans with swapped payments
  • low credit risk
  • changes exposure:
    • currency
    • duration

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structured note
Structured Note
  • tailor made solution
  • for example, IO, PO
  • higher priority obligations or junk
  • collar, IAS, ratchet, etc.

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collar
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?

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collar46
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.

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slide47

Buy stock

Result

Buy put

Sell call

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upc example
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

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upc example49
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

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slide50
UPC

150

After tax

capital gain

is between

$53M and

$80M

108

125 153 173 212 UPC share

These options cover 800,000 shares only.

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how much did it cost
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!

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risk management issues
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?

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new proposals
New proposals
  • BIS 2000
  • VaR based approach to credit risk.
    • CreditMetrics
    • CreditRisk+
    • KMV
    • Merton.

FRM-3

what is the current risk
duration, convexity

volatility

delta, gamma, vega

rating

target zone

What is the current Risk?
  • Bonds
  • Stocks
  • Options
  • Credit
  • Forex
  • Total ?

FRM-3

modern approach
Modern Approach

Financial Institution

FRM-3

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