Financial Risk Management
Zvi Wiener
02-588-3049
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Jan-02
Risk Management
Zvi Wiener
Feb-2001
slide 2
Risk
•
Business Risk
•
Financial Risk
– market risk
– credit risk
– liquidity risk
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Operational Risk
•
Legal Risk
Feb-2001
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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.
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Feb-2001
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Barings
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•
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
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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
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Feb-2001
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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 $1.64B
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Feb-2001
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Public Funds
•
Orange County
• San Diego
• West Virginia
• Florida State Treasury
• Cuyahoga County
• Texas State
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Feb-2001
($ million)
1,640
357
279
200
137
55
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Derivatives 1993-1995
•Shova
Shell, Japan
•Kashima Oil, Japan
•Metallgesellschaft
•Barings, U.K.
•Codelco, Chile
•Procter & Gamble, US
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Feb-2001
($ million)
1,580
1,450
1,340
1,330
200
157
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Investec Clali, Jan-01
Client bought put options without sufficient
funds.
Loss is 8-15M NIS.
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Feb-2001
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Financial Losses
•
Barings
• Bank Negara, Malaysia 92
• Banesto, Spain
• Credit Lyonnais
• S&L, U.S.A.
• Japan
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Feb-2001
$1.3B
$3B
$4.7B
$10B
$150B
$500B
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Value of an Option at Expiration
E. Call
X
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Feb-2001
Underlying
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Call Value before Expiration
E. Call
X
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Feb-2001
Underlying
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Call Value before Expiration
E. Call
premium
X
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Feb-2001
Underlying
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Put Value at Expiration
E. Put
X
X
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Feb-2001
Underlying
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Put Value before Expiration
E. Put
X
premium
X
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Feb-2001
Underlying
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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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Feb-2001
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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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Feb-2001
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Collar payoff
payoff
K
90
90
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100
Feb-2001
K
stock
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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?
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Feb-2001
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Long term options
payoff
Your option
K
Result
50
k
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K
Feb-2001
Sell a call
stock
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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!
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Feb-2001
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Example
payoff
K
Result
Your option
60
50
exercise
10
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15
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26
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How much can we lose?
Everything
correct, but useless answer.
How much can we lose realistically?
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Feb-2001
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What is the current Risk?
•
Bonds
• Stocks
• Options
• Credit
• Forex
• Total
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duration, convexity
volatility
delta, gamma, vega
rating
target zone
?
Feb-2001
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Standard Approach
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Feb-2001
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Modern Approach
Financial Institution
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Feb-2001
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Risk Management
•
Risk measurement
•
Reporting to board
•
Limits monitoring
•
Diversification, reinsurance
• Vetting
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Reporting to regulators
•
Decision making based on risk
Feb-2001
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Who manages risk?
Citibank
AIG
Nike
Bank of England General Re Sony
CIBC
Swiss Re
Dell Computers
J. P. Morgan
Aetna
Philip Morris
Bankers Trust
Zurich
Ford Motor
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Feb-2001
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Regulators
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BIS
•
FSA
•
SEC
•
ISDA
•
FASB
•
Bank of Israel
•
Galai’s committee
Feb-2001
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Basic Steps in RM process
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Identify risks
•
Data base (market + position)
•
Risk measurement
•
Regulators
•
Risk Management
•
Reporting
•
Strategic decisions
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Building a RM system
•
Initial study of risks
•
Decision, Risk Manager
•
Risk measurement system
•
Responsibilities and structure
• Testing
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Active Risk Management
•
Staff training and maintenance
Feb-2001
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Risk Management and
Risk Measurement
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Feb-2001
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Risk Management System Can NOT
•
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
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Feb-2001
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Tool, not rule!
Limits, Duration, ALM, DFA, VaR
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Feb-2001
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Definition
VaR is defined as the predicted worst-case
loss at a specific confidence level (e.g. 99%)
over a certain period of time.
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Feb-2001
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VaR
1
0.8
0.6
0.4
VaR1%
1%
0.2
Profit/Loss
-3
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-2
-1
1
Feb-2001
2
3
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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.
VaR
1%
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Feb-2001
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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
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used and misused!
Feb-2001
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Risk Management Structure
Market data
Current position
Risk Mapping
Valuation
Value-at-Risk
Reporting and Risk Management
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Feb-2001
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Value
8.25
8
7.75
7.5
7.25
10
4.3
4.25
4.2
11
4.15
12
13
Interest Rate
14
4.1
dollar
interest rates and dollar are
NOT independent
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Feb-2001
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Risk Measuring Software
•
CATS, CARMA
• Algorithmics, Risk Watch
• Infinity
• J.P. Morgan, FourFifteen
• FEA, Outlook
• Reuters, Sailfish
• Kamacura
• Bankers Trust, RAROC
• INSSINC, Orchestra
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Feb-2001
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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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Feb-2001
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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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Feb-2001
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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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Feb-2001
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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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Feb-2001
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How to measure VaR
•
Historical Simulations
• Variance-Covariance
•
Monte Carlo
• Analytical
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Methods
Feb-2001
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Historical Simulations
•
Fix current portfolio.
•
Pretend that market changes are
similar to those observed in the past.
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Calculate P&L (profit-loss).
•
Find the lowest quantile.
Feb-2001
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Returns
year
1% of worst cases
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Feb-2001
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VaR
1
0.8
0.6
0.4
VaR1%
1%
0.2
Profit/Loss
-3
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-2
-1
1
Feb-2001
2
3
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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.
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Feb-2001
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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!
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Feb-2001
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Variance-Covariance VaR1%  V  2.33 V
1%
2.33
-2.33
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
Feb-2001
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Monte Carlo
1
0.5
-1
0.5
-0.5
1
-0.5
-1
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Feb-2001
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Monte Carlo
•
Distribution of market factors
•
Simulation of a large number of events
•
P&L for each scenario
•
Order the results
• VaR
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= lowest quantile
Feb-2001
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Monte Carlo Simulation
15
10
5
10
20
30
40
-5
-10
-15
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Feb-2001
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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.
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Feb-2001
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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
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there is no currency risk.
Feb-2001
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Airline company
•
fuel - oil prices and $
• purchasing airplanes - $ and Euro
• salaries - NIS, some $
• tickets $
• marketing - different currencies
• payments to airports for services
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Feb-2001
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Airline company
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•
loans
•
equity
•
callable bonds
Feb-2001
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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.
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Feb-2001
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Reporting
Division of VaR by business units, areas of
activity, counterparty, currency.
Performance measurement - RAROC (Risk
Adjusted Return On Capital).
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Feb-2001
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How VaR is used
•
Internal Risk Management
•
Reporting
•
Regulators
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Feb-2001
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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.
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Feb-2001
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Backtesting
Green zone - up to 4 exceptions
OK
Yellow zone - 5-9 exceptions
increasing k
Red zone - 10 exceptions or more
intervention
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Feb-2001
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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?
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Feb-2001
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Unifying Approach
•
One number
•
Based on Statistics
•
Portfolio Theory
• Verification
• Widely Accepted
•
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Easy Comparison
Feb-2001
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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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Feb-2001
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Open Questions
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•
Risks related to cashflow
•
Non-traded assets
•
Credit information
•
Global Database
•
Liquidity problem
Feb-2001
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Issues Specific to Israel
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Indexation
•
Exchange Band
•
Shallow Markets
Feb-2001
slide 70
pluto.mscc.huji.ac.il/~mswiener/
Risk Management resources
•
Useful Internet sites
•
Regulators
•
Insurance Companies
•
Risk Management in SEC reports
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Feb-2001
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Feb-2001
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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.
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Feb-2001
slide 73
RMG
•
http://www.riskmetrics.com/
•
http://www.pictureofrisk.com/
•
http://www.riskmetrics.com/rm/splash.html
•
rmgaccess
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Feb-2001
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Consulting
•
Oliver, Wyman and Co.
• Willis
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Corroon
•
Richard Scora
•
Ernst and Young
•
Enterprise Advisors
•
Kamakura
Feb-2001
slide 75
Examples of Risk Reports
http://www.pictureofrisk.com
http://www.mbrm.com/
http://www.riskmetrics.com/rm/splash.html
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Feb-2001
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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
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Feb-2001
•
•
•
•
•
•
•
•
slide 77
SEC reports
•
Edgar
• Yahoo
– find symbol
– profile
– raw SEC reports

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market risk in 10K 7A
Feb-2001
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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
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Feb-2001
slide 79
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/
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Feb-2001
slide 80
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!
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Feb-2001
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Agriculture
www.cfonet.com/html/Articles/CFO/1999/99APkita.html
1998 revenues $1.25B
consulting Willis Corroon
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Feb-2001
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Nike
•
Salaries are paid in Asia
•
Shoes are sold worldwide
•
Financing comes from USA
•
Marketing, storing, shipping worldwide
use VaR since 1998.
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Feb-2001
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Merck
http://www.palisade-europe.com/html/Articles/merck.html
http://www.sec.gov/Archives/edgar/data/64978/000095012
3-99-005573-index.html see “sensitivity”
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Feb-2001
slide 84
Articles
Value at Risk as a Diagnostic Tool for Corporates:
The Airline Industry
http://netec.mcc.ac.uk/WoPEc/data/Papers/dgruvati
n19990023.html
Agricultural Applications of Value-at-Risk
Analysis: A Perspective
http://netec.mcc.ac.uk/WoPEc/data/Papers/wpawu
wpfi9805002.html
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Feb-2001
slide 85
Publications
“The New Risk Management: the Good, the Bad,
and the Ugly”, P. Dybvig, W. Marshall
http://dybfin.olin.wustl.edu/research/papers/riskma
n_fed.pdf
Association for Investment Management and
Research
http://www.aimr.org/
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Feb-2001
slide 86
Web tour
•
ZW, students, VaR and risk management
• Gloriamundy
• GARP
• SEC reports
• Google
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Feb-2001
slide 87
What is more risky and why?
A. 1 year bond
B. 10 year bond
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Feb-2001
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What is more risky and why?
A. An in-the-money option?
B. An out-of-the-money option?
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Feb-2001
slide 89