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Financial Risk Management. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Risk. Business Risk Financial Risk market risk credit risk liquidity risk Operational Risk Legal Risk. Risk Management. Examples of good and bad risk management

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financial risk management

Financial Risk Management

Zvi Wiener

02-588-3049

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

slide3
Risk
  • Business Risk
  • Financial Risk
    • market risk
    • credit risk
    • liquidity risk
  • Operational Risk
  • Legal Risk

Feb-2001

risk management
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.

Feb-2001

barings
Barings
  • February 26, 1995
  • 233 year old bank
  • 28 year old Nick Leeson
  • $1,300,000,000 loss
  • bought by ING for $1.5

Feb-2001

metallgesellshaft
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

Feb-2001

orange county
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

Feb-2001

public funds
Public Funds

($ million)

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

Feb-2001

derivatives 1993 1995
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

Feb-2001

investec clali jan 01
Investec Clali, Jan-01

Client bought put options without sufficient funds.

Loss is 8-15M NIS.

Feb-2001

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

Feb-2001

value of an option at expiration
Value of an Option at Expiration

E. Call

X Underlying

Feb-2001

call value before expiration
Call Value before Expiration

E. Call

X Underlying

Feb-2001

call value before expiration1

E. Call

premium

X Underlying

Call Value before Expiration

Feb-2001

put value at expiration
Put Value at Expiration

E. Put

X

X Underlying

Feb-2001

put value before expiration

E. Put

X

premium

X Underlying

Put Value before Expiration

Feb-2001

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?

Feb-2001

collar1
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.

Feb-2001

collar payoff
Collar payoff

payoff

K

90

90 100 K stock

Feb-2001

options in hi tech
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?

Feb-2001

long term options

Your option

Result

Sell a call

Long term options

payoff

K

50

k K stock

Feb-2001

example
Example

You 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!

Feb-2001

example1

Result

Your option

exercise

Example

payoff

K

60

50

10 15 26

Feb-2001

how much can we lose
How much can we lose?

Everything

correct, but useless answer.

How much can we lose realistically?

Feb-2001

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 ?

Feb-2001

modern approach
Modern Approach

Financial Institution

Feb-2001

risk management1
Risk Management
  • Risk measurement
  • Reporting to board
  • Limits monitoring
  • Diversification, reinsurance
  • Vetting
  • Reporting to regulators
  • Decision making based on risk

Feb-2001

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

Feb-2001

regulators
Regulators
  • BIS
  • FSA
  • SEC
  • ISDA
  • FASB
  • Bank of Israel
  • Galai’s committee

Feb-2001

basic steps in rm process
Basic Steps in RM process
  • Identify risks
  • Data base (market + position)
  • Risk measurement
  • Regulators
  • Risk Management
  • Reporting
  • Strategic decisions

Feb-2001

building a rm system
Building a RM system
  • Initial study of risks
  • Decision, Risk Manager
  • Risk measurement system
  • Responsibilities and structure
  • Testing
  • ActiveRisk Management
  • Staff training and maintenance

Feb-2001

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

Feb-2001

tool not rule
Tool, not rule!

Limits, Duration, ALM, DFA, VaR

Feb-2001

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.

Feb-2001

slide37

VaR1%

1%

Profit/Loss

VaR

Feb-2001

meaning of var

VaR

1%

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,

under normal market conditions.

Feb-2001

history of var
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!

Feb-2001

risk management structure

Current position

Market data

Risk Mapping

Valuation

Value-at-Risk

Reporting and Risk Management

Risk Management Structure

Feb-2001

slide41

Value

dollar

Interest Rate

interest rates and dollar are

NOT independent

Feb-2001

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

Feb-2001

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

Feb-2001

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

Feb-2001

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

Feb-2001

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

Feb-2001

how to measure var
How to measure VaR
  • Historical Simulations
  • Variance-Covariance
  • Monte Carlo
  • Analytical Methods

Feb-2001

historical simulations
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.

Feb-2001

slide50

VaR1%

1%

Profit/Loss

VaR

Feb-2001

weights
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.

Feb-2001

variance covariance
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!

Feb-2001

variance covariance1

1%

2.33

Variance-Covariance

-2.33

Feb-2001

monte carlo
Monte Carlo

Feb-2001

monte carlo1
Monte Carlo
  • Distribution of market factors
  • Simulation of a large number of events
  • P&L for each scenario
  • Order the results
  • VaR = lowest quantile

Feb-2001

real projects
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.

Feb-2001

example2
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.

Feb-2001

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

Feb-2001

airline company1
Airline company
  • loans
  • equity
  • callable bonds

Feb-2001

airline company2
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.

Feb-2001

reporting
Reporting

Division of VaR by business units, areas of activity, counterparty, currency.

Performance measurement - RAROC (Risk Adjusted Return On Capital).

Feb-2001

how var is used
How VaR is used
  • Internal Risk Management
  • Reporting
  • Regulators

Feb-2001

backtesting
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.

Feb-2001

backtesting1
Backtesting

OK

increasing k

intervention

Green zone - up to 4 exceptions

Yellow zone - 5-9 exceptions

Red zone - 10 exceptions or more

Feb-2001

stress
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?

Feb-2001

unifying approach
Unifying Approach
  • One number
  • Based on Statistics
  • Portfolio Theory
  • Verification
  • Widely Accepted
  • Easy Comparison

Feb-2001

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.

Feb-2001

open questions
Open Questions
  • Risks related to cashflow
  • Non-traded assets
  • Credit information
  • Global Database
  • Liquidity problem

Feb-2001

issues specific to israel
Issues Specific to Israel
  • Indexation
  • Exchange Band
  • Shallow Markets

Feb-2001

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

Feb-2001

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.

Feb-2001

slide74
RMG
  • http://www.riskmetrics.com/
  • http://www.pictureofrisk.com/
  • http://www.riskmetrics.com/rm/splash.html
  • rmgaccess

Feb-2001

consulting
Consulting
  • Oliver, Wyman and Co.
  • Willis Corroon
  • Richard Scora
  • Ernst and Young
  • Enterprise Advisors
  • Kamakura

Feb-2001

examples of risk reports
Examples of Risk Reports

http://www.pictureofrisk.com

http://www.mbrm.com/

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

Feb-2001

regulators1
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

Feb-2001

sec reports
SEC reports
  • Edgar
  • Yahoo
    • find symbol
    • profile
    • raw SEC reports
      • market risk in 10K 7A

Feb-2001

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

Feb-2001

slide80
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/

Feb-2001

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!

Feb-2001

agriculture
Agriculture

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

1998 revenues $1.25B

consulting Willis Corroon

Feb-2001

slide83
Nike
  • Salaries are paid in Asia
  • Shoes are sold worldwide
  • Financing comes from USA
  • Marketing, storing, shipping worldwide

use VaR since 1998.

Feb-2001

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”

Feb-2001

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

Feb-2001

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/

Feb-2001

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

Feb-2001

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

A. 1 year bond

B. 10 year bond

Feb-2001

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?

Feb-2001