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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 l.jpg

RM functions

Zvi Wiener

02-588-3049

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


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Structuring RM functions

  • Set firm-wide policies

  • Develop methodology

  • Set RM structure

  • Risk communication

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Integrated Risk Management

Limit Management

Risk Analysis

RAROC

Active Risk

Management

Allocate capital

Stress

Market, Credit VaR

Monitor

Identify and avoid

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RAROC

  • Risk Adjusted Rate of Return

  • Performance measurement

  • Marginal impact of any new transaction

  • Consistent pricing

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New Approach

Three pillars

A. Minimum Capital Requirement

B. Supervisory Review Process

C. Market Discipline Requirements

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Goals and Instruments

  • Risk Tolerance - “worst loss”

  • Stop losses

  • Capital allocation

  • Credit risk policy

  • Operational risk policy

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Risk Measurement

  • Consistent market based method

  • Old

    • limits

    • duration, ALM

  • VaR + Stress

  • Backtesting

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Systems

  • Data bases

    • market

    • position

    • rules

  • Risk measuring tool

  • Reports and decision support

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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

  • Front office

  • Middle office

  • Back office

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Front office

  • execution

  • risk taking

  • marketing

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Middle office

  • risk management

  • pricing

  • economic forecasts

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Back office

  • verification

  • booking

  • reporting

  • collection

  • settlement

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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

Trading Room

Senior Management

Operations

Risk Management

Finance

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Senior management

  • Approves business plan and targets

  • Sets risk tolerance

  • Establishes policy

  • Ensures performance

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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

  • 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

  • Develops valuation and finance policy

  • Ensures integrity of P&L

  • Manages business planning process

  • Supports business needs

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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

  • Global risk limit

  • Risk limits for trading desks/units

  • Dynamic monitoring and adjustment

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Risk Approaches

  • Accounting - reported P&L

  • Economic - value

  • Liquidity needs

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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

  • 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 339

  • IR risk

  • Market risk

  • Risk audit unit

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Israel 341

  • Capital requirements against market risk

  • Risk measurement

  • Trading portfolio

  • Reporting

  • Examples of standard approach and VaR

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Israel 341

  • Capital requirements against market risk

  • Risk measurement

  • Trading portfolio

  • Reporting

  • Examples of standard approach and VaR

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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

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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

  • Real projects - cashflow versus financing

  • Fixed Income

  • Optionality

  • Credit exposure

  • Legal, operational, authorities

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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)

  • 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

  • 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

value

Spot X $

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Options

  • Put or Call

  • European or American

  • Underlying asset

  • Strike price

  • Premium

  • Time to maturity

  • Hedge ratio

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premium

Call Option

value

X underlying

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Hedge Ratio

value

X underlying

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Put Option

value

X underlying

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Exotic Options

  • Asian

  • Path dependent

  • Digital

  • Bermudian

  • Knock-in, out

  • Exchange of assets

  • Swaptions

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Swap

  • currency or interest rate

  • two loans with swapped payments

  • low credit risk

  • changes exposure:

    • currency

    • duration

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Structured Note

  • tailor made solution

  • for example, IO, PO

  • higher priority obligations or junk

  • collar, IAS, ratchet, etc.

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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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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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Buy stock

Result

Buy put

Sell call

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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 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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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?

  • 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

  • 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

  • BIS 2000

  • VaR based approach to credit risk.

    • CreditMetrics

    • CreditRisk+

    • KMV

    • Merton.

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duration, convexity

volatility

delta, gamma, vega

rating

target zone

What is the current Risk?

  • Bonds

  • Stocks

  • Options

  • Credit

  • Forex

  • Total ?

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Modern Approach

Financial Institution

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