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Tools for risk management. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Tools. Measurement tools Financial tools options forwards, futures swaps insurance Outsourcing. Finance. Marketing. Supply. Senior Management. Cashflow Capital.

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## Tools for risk management

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**Tools for risk management**Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html BoI-2001**Tools**• Measurement tools • Financial tools • options • forwards, futures • swaps • insurance • Outsourcing Zvi Wiener**Finance**Marketing Supply Senior Management Cashflow Capital Zvi Wiener**Important Principles**Distinction between risk taking and risk control. Backtesting. Transparent reporting. Timing is more important then precision! Zvi Wiener**Basic decisions**• Goal of Risk Management • Base currency • Time horizon (embedded options) • Economic or Accounting approach • Admissible risk • Stop losses or other actions Zvi Wiener**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 Zvi Wiener**Measurement Tools**• CATS, CARMA $400K/yr • Algorithmics, Risk Watch >$1M • Infinity >$1M • J.P. Morgan, FourFifteen $25K/yr • FEA, Outlook $18K • Risk Manager, RMG $30K/yr • Theoretics, TARGA $75K • Bankers Trust, RAROC $50K/run • INSSINC, Orchestra $25-75K Zvi Wiener**Definition**VaR is defined as the predicted worst-case loss at a specific confidence level (e.g. 99%) over a certain period of time. Zvi Wiener**VaR1%**1% Profit/Loss VaR Zvi Wiener**Benchmarking**• Financial assets • create an imaginary portfolio and measure performance relative to this portfolio. • Industry • measure relative to competitors. Zvi Wiener**Financial Tools**• Options • Futures/Forwards • SWAP • FRA • Insurance Zvi Wiener**Derivatives**Contracts that are priced according to underlying variables (prices are derived from underlying). Options, Futures, Forwards, Swaps, Warrants, etc. Zvi Wiener**Derivatives**Contingent claims gold shipped KTUBA insurance an option not to undertake a project an option to leave an option to change price Zvi Wiener**Financial Tools**• Options • Futures/Forwards • SWAP • FRA • Insurance Zvi Wiener**Forward and Futures**• Forward agreement • Futures - standard traded contracts • margin • mark to market • Final result is very similar • settlement risk Zvi Wiener**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 Zvi Wiener**Forward/Futures**value Spot X $ Zvi Wiener**Forward Price**• Note that forward price is not a price • Forward price does NOT depend on the expected exchange rate. It depends on the current exchange rate and interest rates only! • It is important to chose appropriate time horizon! Zvi Wiener**Forward Price**• Consider a NIS/USD forward contract for 10,000 USD to be exchanged in 6 months to NIS according to the forward price. • Current exchange rate is $1=4NIS, • USD interest rate is 6% • NIS interest rate is 10% • How to define the forward rate? Zvi Wiener**Forward Price**• Buy 6 month T-bill, $10,000 nominal, it will cost 10,000*4/1.03= 38,835 NIS • Sell 6 month MAKAM, for 38,835 NIS This will guarantee that in 6 months you will receive $10,000 and pay 38,835*1.05 NIS. Zvi Wiener**Forward Price**Zvi Wiener**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 $100. Forward price is 4.00*1.1/1.06=4.15. The time match is important! Zvi Wiener**After a year**$ 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! Zvi Wiener**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. Zvi Wiener**Initial**margin Maint. margin margin call Marking to Market Your balance time Zvi Wiener**Tools for risk management**Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html BoI-2001**Options**• Call, Put • European, American • Strike, volatility, time to maturity • In-the-money, Out-of-the-money • Black-Merton-Scholes • OTC and Exotic options Zvi Wiener**premium**Call Value before Expiration E. Call X Underlying Zvi Wiener**E. Put**X premium X Underlying Put Value before Expiration Zvi Wiener**Other Options**• Callable bond • Warrants • Asian, Bermudian, Digital • Real options • to start a new project • to change prices • to close some divisions Zvi Wiener**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 ... Zvi Wiener**current value**Call Delta E. Call S Zvi Wiener**Put Delta**E. Put current value S Zvi Wiener**Buy index**Buy put Sell calls What type of risk protection would you suggest for a pension fund? payoff floor Stock market Zvi Wiener**Buy stock**Result Buy put Sell call Zvi Wiener**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 Zvi Wiener**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 Zvi Wiener**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. Zvi Wiener**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! Zvi Wiener**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? Zvi Wiener**Butterfly2*Call(550)-Call(540)-Call(560)**payoff 540 550 560 Stock market Zvi Wiener**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 $100. Forward price is 4.00*1.1/1.06=4.15. The time match is important! Zvi Wiener**After a year**$ 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! Zvi Wiener**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. Zvi Wiener**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 $100. The time match is important! Zvi Wiener**After a year**$ 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. Zvi Wiener**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? Zvi Wiener**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: Zvi Wiener**Example**Assume that now USD = 4 SHEKELS EUR = 3.5 SHEKELS rNIS = 10% rUSD= 6% rEUR = 5% Zvi Wiener**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. Zvi Wiener

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