Risk Management Workshop

1. Risk Management Workshop Ron D'Vari, Ph.D., CFA Sr. Vice President, Portfolio Manager, and Director of Quantitative Research State Street Research & Management Boston Security Analyst Society October 20, 2000

2. Morning Session A: Introduction to Risk Management and Value-at-Risk (VaR) • Morning Session B: Portfolio VaR and Different Approaches to Measuring VaR • Afternoon Session A: Risk Management for Derivatives and Using Derivatives • Afternoon Session B: Risk Management Applications • Afternoon Session C: Credit Risk Management and Integration of Market and Credit Risk Agenda State Street Research & Management, Ron D’Vari, Ph.D., CFA 2

3. Risks Facing Financial Intermediaries • Lending • Funding and Warehousing • Hedging • Servicing • Securitization • Trading • Operation • Deposit Gathering • Treasury • Capital Market Activities Introduction to Risk Management and Value-at-Risk (VaR) State Street Research & Management, Ron D’Vari, Ph.D., CFA 3

4. Objectives of Enterprise-Wide Risk Management • Balance Sheet Management • Performance Measurement • Motivation and Compensation • Strategic Decision Support • Role of Information Flow and Visibility in Risk Management • Implementation Issues For Transitioning to An Enterprise-wide Risk Management • Culture • System • Information flow and visibility • Training • Management Commitment Introduction to Risk Management and Value-at-Risk (VaR) State Street Research & Management, Ron D’Vari, Ph.D., CFA 4

5. Risk-Adjusted Capital Framework • Operational Risk • Credit Risk • Market Risk • Risk-Adjusted Return on Capital (RAROC) • Computation • Benefits • Limitations Introduction to Risk Management and Value-at-Risk (VaR) State Street Research & Management, Ron D’Vari, Ph.D., CFA 5

6. Responsibilities of the Risk Manager • Understanding the Markets • Fixed Income • Equity • Commodities • Foreign Exchange • Emerging Markets Understanding the Businesses • Market Making • Proprietary Trading • Brokerage • Underwriting / Syndication • Lending • Asset Management Introduction to Risk Management and Value-at-Risk (VaR) State Street Research & Management, Ron D’Vari, Ph.D., CFA 6

7. Risk Management Function • Limit Management • Capital Allocation • Performance Evaluation • Regulatory Capital Requirements • Economic Capital Requirements The Risk Management Cycle • Identify • Measure • Manage • Evaluate • Improve Introduction to Risk Management and Value-at-Risk (VaR) State Street Research & Management, Ron D’Vari, Ph.D., CFA 7

8. Risk Management Common Sense • Transparency of Risk • Professional Judgement • Experience Conventional Market Risk Measures • Option Adjusted Duration and Key Rate Durations • Beta • Historical Volatility • Sector Exposure • Currency Exposure • Market Exposure (by country) • Greeks for Derivatives Introduction to Risk Management and Value-at-Risk (VaR) State Street Research & Management, Ron D’Vari, Ph.D., CFA 8

9. Evolution from Asset Liability Management and Elaborate Guidelines to Value-At-Risk • Single Measure • Allows for Integration of Multiple Risks (credit, market, operation, etc.) • Allows for Full Incorporation of Time Variance in Risk Assessment Introduction to Risk Management and Value-at-Risk (VaR) State Street Research & Management, Ron D’Vari, Ph.D., CFA 9

10. Comprehensive Methodology for Measuring Market Risk(s) • Multi-factor Models for Measuring Investment Portfolio Risk • Performance Measurement and Attribution • Value at Risk • Definition and Computation • Treatment of Derivatives • Different Approaches to Measuring VAR • Forecasting Risks and Correlations Introduction to Risk Management and Value-at-Risk (VaR) State Street Research & Management, Ron D’Vari, Ph.D., CFA 10

11. Credit Risk Management • Fundamental and traditional risk measurements • Underwriting standards • Rating Categories • Due Diligence and Monitoring • Portfolio Risk Limits • Average Rating • Minimum Rating • Maturity • Diversification • Risk mitigation (workout) • Option-based Credit Risk Management • Expected Default Frequency • Single Name Rating • Portfolio VaR Introduction to Risk Management and Value-at-Risk (VaR) State Street Research & Management, Ron D’Vari, Ph.D., CFA 11

12. Morning Session B Portfolio VaR and Different Approaches to Measuring VaR State Street Research & Management, Ron D’Vari, Ph.D., CFA 12

13. Afternoon Session C: Credit Risk Management and Integration of Market and Credit Risk State Street Research & Management, Ron D’Vari, Ph.D., CFA 13

14. Most Active Transactions: • Asset Swap • Total Return and Index Swap • Default Swap Structured Instruments: • Credit Linked Notes (CLNs) • Credit Spread Option • CBOs, CLOs, Synthetic CLOs • Synthetic Leveraged Loan • Synthetic Revolving Credit Agreements Credit Derivatives State Street Research & Management, Ron D’Vari, Ph.D., CFA 14

15. Flexible Credit/Sector Exposure Tailoring • Access: Sourcing names and maturities not available through cash instrument market • Flexibility: Uncoupling of interest and credit exposure • Diversification • Yield Enhancement • Exposure to short maturities with low price sensitivity • Relative Value and Replication • Cheaper synthetic cash positions • Hedging • Leverage or Financing Credit Derivative Strategies - Buyside State Street Research & Management, Ron D’Vari, Ph.D., CFA 15

16. Internal and External Education • Accurate Portfolio Analytics and Risk Models • Consistent Framework for Use In Portfolio Context • Infrastructure: Compliance, Trading, and Accounting Systems • Signing ISDA Agreements • Several hundred plan sponsors and separate accounts • Multiple dealers and banks • A dozen custodians • Legal resources • Shortcomings of the Standard Representations in ISDA • Not developed for investment managers acting as agent • Often impossible for managers to make • Requires involvement of plan sponsors and custodians Buyside Challenges State Street Research & Management, Ron D’Vari, Ph.D., CFA 16

17. Besides fundamental analysis of reference credit and counterparty overall portfolio suitability has to be established. • Optimal allotment of risk budget to credit derivatives • Portfolio’s total risk is budgeted to key active exposures • Level and shape of term structure of interest rates • Volatility • Sector/Credit exposures (by sector by credit by maturity) • Risk Analysis and Its Transparency • Accurate accounting of credit derivatives in daily and intraday portfolios’ multi-factor absolute and relative risk reports • Measure credit, spread change, and structural risks • Quantitative Relative Value Framework • W.r.t. cash instruments or other forms of risk • Liquidity and Pricing • Infrastructure Portfolio Level Considerations of Credit Derivatives State Street Research & Management, Ron D’Vari, Ph.D., CFA 17

18. Documentation Trading Counterparty Risk Management Compliance Accounting and Custodial Infrastructure State Street Research & Management, Ron D’Vari, Ph.D., CFA 18

19. Limited Recourse • Sub-account managed by manager • Size Matters • No trigger with account size change • May require lower collateral threshold and minimum transfer • Collateralization • Eligibility • Threshold and minimum transfer amount • Manager Termination • Avoid early termination through assignment • Assignment • Both parties consent Documentation State Street Research & Management, Ron D’Vari, Ph.D., CFA 19

20. Changes in Credit Condition • Credit Spreads in Cash Market • Cost of Alternatives • Regulatory Capital Requirements • General Market Liquidity • Pricing Models • Traditional Credit Judgment • Quality of Historical Default Rates and Recoveries • Availability and Quality of Historical Spread • Availability of Volatility and Correlation data • Credit Default Swap Curves • Basis Between Credit Swap and Other Credit Pools • Modeling Tranched Credit and Basket Understanding Factors Impacting Prices State Street Research & Management, Ron D’Vari, Ph.D., CFA 20

21. Presentation Focus: • Asset Swap • Total Return and Index Swap • Default Swap Buyside Use of Various Credit Derivatives State Street Research & Management, Ron D’Vari, Ph.D., CFA 21

22. Coupon from Bond A Counter Party SSRM Asset Swap Some Index (Libor, CMT, fixed level etc.) + Spread Coupon and Principle Market Price Bond A Motivation • Swap floating assets to fixed or vice versa • Trade away imbedded options in a bond or layer in options State Street Research & Management, Ron D’Vari, Ph.D., CFA 22

23. Index Sector Total Return Counter Party SSRM Index Total Return Swap Libor + Spread or Total Return of Another Sector Holdings Total Return Market Price SSRM Holdings in a Sector Motivation • Adjust exposure without buying or selling individual securities • Hedging, Relative Value, Market access, Flexibility • Avoid paying bid-ask spread for a short dated trade • Get financing (leverage) State Street Research & Management, Ron D’Vari, Ph.D., CFA 23

24. Single Reference-Entity Credit Default Swap • Transfer the credit risk of an issuer (reference entity) from one entity (buyer) to another (seller) • Seller of protection agrees to buy “obligations” of the reference entity at par in the event of a public notice • Default event is defined a “publicly available notice” to: • A payment failure larger or equal than “Payment Requirement” on • an obligation equal or larger than “Default Requirement” • Settlement can be “Physical” or “Cash” • Deliverable obligations can be • Reference obligation • Any of Deliverable obligations • According to ISDA it could be any borrowed money: loans,cp, bond, and bond and loan • Must be specified in long confirm State Street Research & Management, Ron D’Vari, Ph.D., CFA 24

25. Advantages of Default Swap over Short Corporates • In general they tend to be cheaper than similar cash bond because: • buyers inability to hedge their risk in any other market (shorting public debt can be quite risky and subject to adverse technicals) • expensive risk capital charges required against credit risk • Increases yield with minimal increase in spread duration • Very attractive break-even cushion against spread widening • Ability to do default swap opens up unique opportunities to tailor credit exposure of the portfolio - i.e. take advantage of credit curve steepness (buy longer dated cash bonds and roll over short dated credit protection) • More flexibility - Default swap does not tie up cash to earn spread • Allows creating higher information ratio strategies that may be leveraged for higher returns than similar risk strategies • Access to names and maturities that otherwise may not be available State Street Research & Management, Ron D’Vari, Ph.D., CFA 25

26. Credit Spreads Recovery Rates Market Implied Default Probabilities Asset Correlations Default Correlations Simulator Loss Distribution Pricing Methodology • Method 1: Basis - Asset Swap vs. Default Swap (works only for single name) • Method 2: Model Loss Distribution State Street Research & Management, Ron D’Vari, Ph.D., CFA 26

27. Default Option on $10mm TCI 7 ¼ 6/99 COUNTER-PARTY ACCOUNT 40BP/Annum Bond $10mm AAA Asset Back Maturing 6/15/99 (+20 to 25bp over Treasury) Pricing Single-entity Default Swap • Compare Libor spread of cash bond of the issuer of similar maturity with the default swap rate • Compare all-in yield of a synthetic bond of “Default Swap+AAA ABS” with the cash bond • Compare a given spread with valuation based on long-term default probability and recovery rates based on transition probability matrix and recovery value State Street Research & Management, Ron D’Vari, Ph.D., CFA 27

28. Transition Probability (S&P CreditWeek 15 April 96) Over 15 years of data with more than 25,000 firm/years of observations, adjusted for “no-longer rated” entities Four sources of transition probability matrices: S&P, Moody, CreditMetrix, KMV State Street Research & Management, Ron D’Vari, Ph.D., CFA 28

29. Recovery rates (CreditMetrix using several studies) Average Cumulative Default Rates (%) State Street Research & Management, Ron D’Vari, Ph.D., CFA 29

30. Simple Example of Breakeven Spreads • Annual Breakeven Spread (1-Spread)^n = (1- Cumulative Default Rate * Recovery Rate) State Street Research & Management, Ron D’Vari, Ph.D., CFA 30