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Tools for risk management. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Options. Call, Put European, American Strike, volatility, time to maturity In-the-money, Out-of-the-money Black-Merton-Scholes OTC and Exotic options. premium.

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Tools for risk management

Tools for risk management

Zvi Wiener

02-588-3049

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


Options
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


Call value before expiration

premium

Call Value before Expiration

E. Call

X Underlying

Jun-2000


Put value before expiration

E. Put

X

premium

X Underlying

Put Value before Expiration

Jun-2000


Other options
Other Options

  • Callable bond

  • Warrants

  • Asian, Bermudian, Digital

  • Real options

    • to start a new project

    • to change prices

    • to close some divisions

Jun-2000


Hedge ratio delta
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


Call delta

current value

Call Delta

E. Call

S

Jun-2000


Put delta
Put Delta

E. Put

current value

S

Jun-2000


What type of risk protection would you suggest for a pension fund

Buy index

Buy put

Sell calls

What type of risk protection would you suggest for a pension fund?

payoff

floor

Stock market

Jun-2000


Buy stock

Result

Buy put

Sell call

Jun-2000


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

Jun-2000


Upc example1
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


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.

Jun-2000


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!

Jun-2000


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?

Jun-2000


Butterfly 2 call 550 call 540 call 560
Butterfly2*Call(550)-Call(540)-Call(560)

payoff

540 550 560 Stock market

Jun-2000


Hedge using forward
Hedge using Forward

Current 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


After a year
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


What if there is no perfect time match
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


Hedge using options
Hedge using Options

Current 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


After a year1
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


Example
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


Example1
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:

Jun-2000


Example2
Example

Assume that now

USD = 4 SHEKELS

EUR = 3.5 SHEKELS

rNIS = 10%

rUSD= 6%

rEUR = 5%

Jun-2000


Example3
Example

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


Example4
Example

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


Example5
Example

Jun-2000


Example6
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


Example7
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


How to hedge financial risk
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


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

Risk Management resources

  • Useful Internet sites

  • Regulators

  • Insurance Companies

  • Risk Management in SEC reports

Jun-2000


RMG

  • http://www.riskmetrics.com/

  • http://www.pictureofrisk.com/

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

  • rmgaccess

Jun-2000


Consulting
Consulting

  • Oliver, Wyman and Co.

  • Willis Corroon

  • Richard Scora

  • Ernst and Young

  • Enterprise Advisors

  • Kamakura

Jun-2000


Examples of risk reports
Examples of Risk Reports

http://www.pictureofrisk.com

http://www.mbrm.com/

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

Jun-2000


Regulators
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


Who manages risk
Who manages risk?

Nike

Sony

Dell Computers

Philip Morris

Ford Motor

AIG

General Re

Swiss Re

Aetna

Zurich

Citibank

Bank of England

CIBC

J. P. Morgan

Bankers Trust

Jun-2000


Sec reports
SEC reports

  • Edgar

  • Yahoo

    • find symbol

    • profile

    • raw SEC reports

      • market risk in 10K 7A

Jun-2000


3 methods
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


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


World experience
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


Agriculture
Agriculture

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

1998 revenues $1.25B

consulting Willis Corroon

Jun-2000


Nike

  • Salaries are paid in Asia

  • Shoes are sold worldwide

  • Financing comes from USA

  • Marketing, storing, shipping worldwide

    use VaR since 1998.

Jun-2000


Merck
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


Articles
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


Publications
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


Web tour
Web tour

  • ZW, students, VaR and risk management

  • Gloriamundy

  • GARP

  • SEC reports

  • Google

Jun-2000


What is more risky and why
What is more risky and why?

A. 1 year bond

B. 10 year bond

Jun-2000


What is more risky and why1
What is more risky and why?

A. An in-the-money option?

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

Jun-2000


Call value before expiration1

In-the-money option

Out-of-the-money option

Call Value before Expiration

Call

X Underlying

Jun-2000


What is more risky and why2
What is more risky and why?

A. A fixed interest loan?

B. A floater (variable interest rate)?

Jun-2000


The end
The End

Jun-2000


Tools
Tools

  • Measurement tools

  • Financial tools

    • options

    • forwards, futures

    • swaps

    • insurance

  • Outsourcing

Jun-2000


Finance

Marketing

Supply

Senior Management

Cashflow

Capital

Jun-2000


Important principles
Important Principles

Distinction between risk taking and risk control.

Backtesting.

Transparent reporting.

Timing is more important then precision!

Jun-2000


Basic decisions
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


Risk management system

Can NOT

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

Jun-2000


Definition
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


VaR1%

1%

Profit/Loss

VaR

Jun-2000


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