Managing Market Risk
for TMAC - Toronto
February 2011
Private and Confidential: For discussion purposes only
Presenting today:
James MacKinnon
Director, Risk Solutions Group
james_mackinnon@scotiacapital.com
416-866-5443
1
Table of Contents
Section
1. Strategic Planning and Market Risk
2. Uses and Abuses of Forecasts
3. Measuring Market Risk
4. Event Risk and Black Swans
5. Solutions: Symmetrical and Asymmetrical
6. Managing Banks and Dealers
7. Assessing the Results
2
Strategic Planning and Market Risk
Private and Confidential: For discussion purposes only
Strategic Planning and Market Risk Management
• Strategy
 Overall objectives, aligned with and supporting the organization’s goals
- SWOT analysis – internal and external
- Set enterprise objectives
- Develop strategic plan to achieve objectives
- Evaluation of plan: suitability (economic sense?), feasibility (break-even, budgeting),
acceptability: returns to stakeholders and their likely reaction, and risks
 Risks
- Probability and consequences of failure of strategy
- Enterprise Risk Management process
4
Strategic Planning and Market Risk Management
• Enterprise risk management steps:
 Identify risks
- Pricing risk: commodity prices, interest rates
- Asset risk: financial securities
- Currency risk: translation risk
- Liquidity
 Analyze and understand
- Quantify and assess materiality
- Integrate: identify any portfolio offsets
 Respond
- Avoidance
- Reduction
- Insurance
- Accept
 Monitor and review
5
Strategic Planning and Market Risk Management
• Market Risk types:
 Financial
- Pricing risk: cost of capital, interest rates
- Asset risk: liquidation values of real assets and financial securities
- Currency risk: translation risk for non-domestic obligations
- Liquidity: re-financing risk, cash flow risk
 Commodity
- Pricing risk: cost of inputs
- Asset risk: value of inventory, reserves
- Liquidity: availability and security of supply
 Currency
- Pricing risk: exchange risk impact on revenues and expenses
- Asset risk: balance sheet translation risk
- Liquidity: especially for non-G20 currencies, or countries with exchange controls
6
Strategic Planning and Market Risk Management
• Market Risk Management
 Best practice: integrated with the strategic planning process
- Not isolated in the Treasury or Purchasing functions
- Executive sponsorship
- Risk appetite/tolerance defined at Board level
- Liquidity: re-financing risk, cash flow risk
 Best practice: integrated across functions, including audit
- Common risk language/metrics needed
- Risk inventory
- Prioritization
- Cross Functional Risk Committee
- Chief Risk Officer
- Clear accountability
7
Strategic Planning and Market Risk Management
• Which market variables are material?
- Stress testing
- Potential impact on EBITDA, EPS, free cash flow
- Risk tolerance threshold
- Board-approved process
- Clear accountability
8
Strategic Planning and Market Risk Management
• “What is our risk?”
 Using forecasts as a risk management tool:
- Forecasts are a useful ‘base case’
- Implied forwards can also be used (“market consensus”)
- But forecasts and the market forwards change constantly with new information
- Random walk
- Also known as “the piper’s walk”
9
Uses and Abuses of Forecasts
Private and Confidential: For discussion purposes only
BoC Update
• On January 18th, the Bank of Canada (“BoC”) held its overnight target rate at 1.00%, and the
market is forecasting the next rate hike to be on April 12th, 2011.
• Core inflation is projected to edge gradually to its 2% target by the end of 2012, as excess
supply in the economy is slowly absorbed.
• What the BoC do over the next 18 months?
BoC Overnight Target Rate
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
Source: Bloomberg
Jan '08
Jan '09
Jan '10
Jan '11
11
Market Consensus - BoC Overnight Target Rate
• By mid-2012, the BoC overnight rate will be between 1.25% and 3.25%, depending on which
forecast you read.
• The BoC will begin hiking between May and October
Forecasts of BoC Overnight Target Rate
Source: Bloomberg
12
Market Consensus - BoC Overnight Target Rate
• In October, 2009, the forecast for the BoC rate as at Q1 2011 was 2.2%
• It is currently 1.0%
Average Forecast - BoC Overnight Rate Q1 2011
Source: Bloomberg
13
Market Consensus – Bond Yields
• In October, 2009, the average forecast for the 10 year GOC bond yield as at Q1 2011 was
4.25%, and the implied forward yield was 4.15%.
• The average closing yield on this bond for the month of January was 3.25%.
Average Forecast and Implied Forward - 10 Year GOC Bond Yield Q1 2011
Source: Bloomberg
14
Unknown: Will US Consumers Save Or Spend Stimulus?
Consumers are paying down debt and avoiding risky investments.
15
Unknown: Will US Consumers Spend Some Liquidity?
Consumers are paying down debt and avoiding risky investments.
16
Unknown: When Will US Companies Redeploy Excess Cash?
Consumers are paying down debt and avoiding risky investments.
17
Unknown: Will The US Raise Its Debt Ceiling and What Then?
Consumers are paying down debt and avoiding risky investments.
18
Unknown: When Will US House Prices Begin to Recover?
Total US net borrowing declined despite large fiscal deficits, as businesses and households
paid down debt. Net borrowing has been increasing as the economy recovers.
19
Unknown: How Will Bonds React As Demand For Capital Heats Up?
Total US net borrowing declined despite large fiscal deficits, as businesses and households
paid down debt. Net borrowing has been increasing as the economy recovers.
20
Unknown: Can Global Markets Take Down Sovereign Rollover?
Total US net borrowing declined despite large fiscal deficits, as businesses and households
paid down debt. Net borrowing has been increasing as the economy recovers.
21
Unknown: How Will China React To Policy Tightening, Currency Wars?
Total US net borrowing declined despite large fiscal deficits, as businesses and households
paid down debt. Net borrowing has been increasing as the economy recovers.
Forecasts are not a replacement for a prudent risk management strategy.
22
Measuring Market Risk
Private and Confidential: For discussion purposes only
Strategic Planning and Market Risk Management
• If forecasts are not useful, then how do you measure risk?
• Two basic approaches:
 Subjective judgment about the future – “guesstimation”
Quantification based on historical patterns
- Cash-Flow-at-Risk
- Value-at-Risk
 Subjective judgment
- Susceptible to influence by recent news
- Biases harder to spot
- “Rule of thumb” errors
- Can be helpful in generating scenarios: “What If?”
How could markets react to a specific event?
24
Strategic Planning and Market Risk Management
• Cash-flow-At-Risk models
 Forecast income, expenses can be drawn from the budget spread sheet
 Interest rates, currency exchange rates, raw materials prices
- Vary the market variable to gauge potential impact
 Stress-testing: market variables
- Use historic high and low
- Use theoretical equilibrium level (eg., CAD/USD PPP approx. US$ 0.80)
- Use historical data: one or two Standard Deviations
25
Strategic Planning and Market Risk Management
• Value-At-Risk: the preferred measure of market risk
 Emerged in late 1980s after the 1987 stock market crash
 Extreme market movements can exceed expected (historical) ranges
 VaR
- Initially, individual desks calculated VaR independently
- Later was made firm wide in most banks, and was incorporated in Basle II Accord
 Highly statistical
- Provides a structure for thinking about risk
- Not widely understood by decision-makers
- Can create the illusion of certainty
- 1-3x VaR is not unusual
- Stress testing should be done outside of these VaR ranges
26
Strategic Planning and Market Risk Management
• VaR models
 Widely used risk measure of the risk of loss on a portfolio of assets
 Risk is defined as a mark to market (fair value) loss over a specified time span
 How much money could we lose today?
 You need a time period, a confidence level, and a loss amount
 What is possibility that a portfolio could lose a certain amount of money over the next
24 hours with a 95% probability?
- Example: a portfolio with a one-day 95% VaR of $ 1 MM: there is a 0.05 probability
that the portfolio will fall in value by more than $ 1 MM over a one day period
(a loss of $ 1 MM or more is expected on 1 day in 20)
27
Strategic Planning and Market Risk Management
• Three methods of calculating VaR:
 Historical method
- If in the last 5 years, the worst 5% of all one-day results was a loss of 5 to 10%
- then with 95% confidence: our worst one-day loss will be less than 5%
 Variance-covariance method
- assumes results are normally distributed
- requires that we measure expected (average) return, and standard deviation
- then we repeat the process used in Historical method, but use the binomial curve
rather than actual data
 Monte Carlo simulation
- randomly generate future paths based on historical patterns
- then repeat the process used above using the resulting data rather than actual data
28
Strategic Planning and Market Risk Management
• What’s wrong with VaR?:
 Results are probabilistic
 Assumes that history will repeat itself
 Can be complex and hard to understand
 Can create an illusion of certainty and false sense of security
 Making VaR control the focus of risk management:
- Can result in bias to focus on manageable risks near the centre of the
distribution and ignores the tails
- Ignores risk of extreme losses – can lead to excessive risk taking
- Does not measure liquidity risk
- Does not fully reflect leverage risk
 “Lies, damn lies, and statistics”
- Based on historical data over limited time periods
- “Garbage in, garbage out”
- “It’s like the historical data only has rain storms and then a tornado hits”
29
Strategic Planning and Market Risk Management
• Applying VaR in an enterprise setting
 Start with the budget spread sheet
 Key revenues/expenses driven by market variables
 Vary the variables by specified amount
- historical high and low
- VaR amount
 Assess potential impact on key bogey:
- Free cash flow
- EPS
 Consider risk of extreme moves:
- Black Swans
30
Event Risk and Black Swans
Private and Confidential: For discussion purposes only
The Allegory of the Black Swan
32
The Allegory of the Black Swan
• Popularized by Nassim Nicholas Taleb, NYU
• Rare, high-impact events that have a disproportionate impact on markets
• Examples of past Black Swans:
 World War 1
 9/11
 the internet
• The probability of such events cannot be calculated using statistical methods
It may be possible to predict ‘known unknowns’, where we know the ‘frame’
It is impossible to predict ‘unknown unknowns’, where there is no precedent
• Market participants tend to ignore a probability if it is low, and they after the fact
they tend to develop retrospective explanations which make them look predictable
33
The Allegory of the Black Swan
• We cannot predict extreme events, but we can reduce our vulnerability to them
 Property insurance
 Insurance is not an option
• We can’t drive looking in a rear-view mirror: past events are not predictive
• Approaches to risk mitigation:
 Balance complexity with simplicity
 Diversification
 Risk Management
34
The Allegory of the Black Swan
• Examples of Black Swan risks:
 Hyperinflation (rising government debt)
 Geopolitical crisis (Middle East, Korean Peninsula, South Asia)
 Instability in China: double digit economic growth and property value inflation
 Internet event: cyber attack
 Natural disaster
 Prolonged period of limited economic growth
• We can’t drive looking in a rear-view mirror: past events are not predictive
• Interest in protection against “tail risks”, is increasing
 May 6 stock market drop: Dow fell almost 1,000 points
 Sovereign debt crisis may increase hyperinflation risk
35
The Allegory of the Black Swan
“It ain’t what you don’t know that gets you into trouble.
It’s what you know for sure that just ain’t so.”
- Mark Twain
36
Solutions: Symmetrical and Asymmetrical
Private and Confidential: For discussion purposes only
Hedges: Symmetrical and Asymmetrical
38
Symmetrical Hedges
• Interest Rates:
> Interest Rate Swaps
• Currencies:
 FX Forwards
 FX Swaps
• Commodities:
 Commodity Forwards
 Commodity Price Swaps
39
Symmetrical: Interest Rate Swap
Operations:
• Let us assume that an enterprise was to execute a swap today to fix the underlying interest
rate of its Term Facility for 5 years, at a fixed rate of Y%. Borrower’s all-in fixed rate would be:
On Swap:
Borrower Pays Fixed
Borrower Receives Floating
Y% Monthly (paid in arrears)
3-month BA rate (paid in arrears)
On Debt:
Borrower Pays Floating
Borrower Pays
3-month BA rate (reset in advance, paid in arrears)
Loan Credit Spread (paid in arrears)
Result:
Borrower Net Cost of Debt
Y% + Loan Credit Spread
Interest Rate Swap
Underlying Bank Debt
Y% Swap Fixed Rate
3-mth BA + Credit Spread
Borrower
3-mth BA
40
Asymmetrical Hedges
• Interest Rates:
> Interest Rate Caps
> Swaptions
• Currencies:
 FX Puts and Calls
 FX Binaries
• Commodities:
 Commodity Puts and Calls
 Commodity Price Swap Options
41
Asymmetrical: Interest Rate Cap
Cap Mechanics:
• Let us assume that an enterprise was to purchase a cap today to protect the underlying
interest rate of its credit facility for 5 years. For the specified cap strike rate, the amount and
term, the cap premium would be a dollar amount due on the trade date.
• In this case, Borrower’s borrowing costs would be as follow:
 Loan:
Pays BA rate
 Loan:
Pays Loan Credit Spread
 Cap:
Pays premium
 Cap:
Receives BA rate less cap rate, if positive
Lesser of BA rate or cap rate + Loan Credit Spread (+ Cap Premium)
Interest Rate Cap
Underlying Bank Debt
Cap Premium ($)
3-mth BA + Spread
Borrower
3-mth BA less Cap Rate,
if positive
42
Comparing Symmetrical and Asymmetrical Hedges
• Symmetrical hedges tend to look less costly:
 No premium
 All critical terms can be easily made to match
• Symmetrical hedges tend to track market expectations
> Market expectations usually are reflected in current forecasts
43
Managing Banks and Dealers
Private and Confidential: For discussion purposes only
Managing Relationships
• Supplier and customer form a system – you are buying his/her knowledge:
 End the practice of awarding business on the basis of price alone
 This assumes that the end product is totally commoditized – “we’re not in that world”
 Instead, minimize the total cost
 Move towards a single supplier for any one item, on a long-term relationship of loyalty and trust
• Old School errors:
> Total cost = purchase price + price of use
> Jump-ball supplier system is wrong:
- no loyalty and trust
- “just meet specifications and keep quiet”
- no incentive to improve or add value
• Suppliers:
> Competition is needed, but in the right place – let suppliers compete, then work with
the selected one
> Select a supplier based on capability, evidence of quality, record, history, reputation,
training, burning desire to work with you
45
Managing Relationships
Possible Risks Associated with Hedge Transactions:
• Symmetrical OTC hedge transactions are typically credit-intensive, bilateral contracts
• Execution of such transactions poses unique challenges when there are multiple credit
providers. These include:
 Market Liquidity Risk: Simultaneous dealer activity can adversely affect market rates
 Pricing Risk: Hedge providers require a capital charge on hedging transactions, to cover the cost of
regulatory capital. Capital charges for hedge transactions tend to be broadly consistent between
banks, which are generally subject to regulatory regimes based on the Basle accords. However, if the
process is not carefully managed, there can be information discrepancies which may result in nonuniformity of pricing.
 Structuring Risk: an enterprise can end up with multiple transactions between several dealers each with
its own terms (i.e., credit mitigation, interest rate & daycount differences)
 Documentation Risk: an enterprise can end up with multiple legal documents, each with its own terms
(i.e., credit appendices, etc.), and associated legal costs
 Credit Management: secured creditors effectively bear a pro rata proportion of the credit risk through
the dilution of security resulting from an interest rate swap, and will require a commensurate return on
this additional risk.
• All of these risks need to be considered as they will ultimately impact the process, price, and
structure an enterprise receives on its hedge
46
Managing Relationships
Risk Mitigation:
•
To mitigate these risks, it is common market practice to select one hedge advisor to facilitate
the deal process for hedge transactions
•
The hedge advisor is responsible for:
 Assisting in the determination of an optimal hedging strategy by an enterprise
 Hedging the entire transaction – to reduce transaction costs
 Syndicating the hedge to prospective hedge providers - allocations determined by the enterprise
 Working with the hedge providers to ensure uniformity of:
i.
pricing,
ii.
documentation, and
iii. deal structure.
•
Using a hedge advisor can reduce market and pricing risk, and ensure that all dealers are
providing the company with a uniform hedge
47
Managing Relationships
Typical Execution Timeline:
Enterprise selects
Lead Hedge Advisor
Hedge Advisor
provides relevant
analysis, research
and market colour
Identify credit
conditions,
security and
capital charge
requirements for
hedging program
Documentation
and/or security
package completed
Hedge Advisor
executes hedges
Hedges are
Syndicated
48
Assessing the Results
Private and Confidential: For discussion purposes only
Assessing the Results
• Repeat the process on a regular basis
• Bring in your risk management advisors/dealers for periodic reviews
50
Scotia Capital’s Qualifications
• Scotia Capital has had the pleasure of leading a number of large and successful risk
management programs
Teranet Inc.
Comber Wind Financial Corp.
$1,500,000,000
Willbros Group, Inc.
McCain Capital Corporation
Videotron Ltee
$350,000,000
$150,000,000
$100,000,000
$260,000,000
Interest Rate Risk Management
Interest Rate Risk Management
Interest Rate Risk Management
Interest Rate Risk Management
Lead Hedge Advisor
Sole Hedge Provider
Lead Hedge Advisor
Lead Hedge Advisor
Lead Hedge Advisor
December 2010
October 2010
September 2010
January 2010
Interest Rate Risk Management
Currency Risk Management
Lead Hedge Advisor
March 2009
Galleon Energy Inc.
Rogers Communications Inc.
Videotron Ltee
Cineplex Entertainment L.P.
Quebecor Media Inc.
$100,000,000
$1,000,000,000
$455,000,000
$235,000,000
$350,000,000
Interest Rate Risk Management
Interest Rate Risk Management
Currency Risk Management
Interest Rate Risk Management
Currency Risk Management
Interest Rate Risk Management
Interest Rate Risk Management
Currency Risk Management
Lead Hedge Advisor
Sole Hedge Provider
Lead Hedge Advisor
Sole Hedge Provider
Lead Hedge Advisor
January 2009
July 2008
April 2008
Lead Hedge Advisor
Lead Hedge Advisor
April 2008
October 2007
51
The Canadian Market Leader in Corporate Risk Management
52