Market Risk Management
and its overlap with Credit
(“Convergence Risk”)
Dominic Wallace
Advanced Risk Issues
EMEA Head of Market Risk Management
Istanbul, March 2007
Market Risk Management and Convergence Risk
What is Market Risk Management?
•
What is Market Risk?
•
Market Risk Management – techniques
•
Policies and limit setting
•
Hot topics
When does it converge with Credit Risk Management?
•
Traditional overlaps – the liquidity crunch
•
Current developments – four examples
•
The golden rules
Market Risk Management and Convergence Risk
What is Market Risk Management?
•
What is Market Risk?
•
Market Risk Management – techniques
•
Policies and limit setting
•
Hot topics
When does it converge with Credit Risk Management?
•
Traditional overlaps – the liquidity crunch
•
Current developments – four examples
•
The golden rules
Market Risk
Market Risk is the risk to earnings or capital
due to changes in market variables
(such as interest rates, foreign exchange, equity and
commodities levels and volatilities)
which affect the price of trading positions.
Market Risk – The Greeks and other common terms
Delta
Technically, the way that an option value changes as the price of the underlying changes
(e.g. if an option value increases by 75c for a $1 increase in the underlying price the option
would be described as having delta of 75%). Now often used to describe any simple, linear
risk.
Gamma
Used to describe options (originally) or, more generally, portfolios whose value does not
change in a linear fashion. Negative gamma can lead to significant losses in extreme market
moves, which is why stress testing is important, but in stable markets can be a profitable
strategy. Also known as convexity.
DV01
Simplest measure of interest rate risk – exposure to a one basis point move in interest rates.
Other organizations have different names – there is no one market standard.
Also useful to know, for future reference…
Theta
The change in value of an option portfolio as time passes, assuming nothing else changes.
Positions which are “long gamma” (i.e. benefit from large market moves) are typically “short
theta” (i.e. they gradually bleed money away if markets don’t move)
Vega
The change in value of an option portfolio as a function of changes in implied volatilities.
Volatility is a measure of uncertainty in an asset’s future price and is therefore one of the
inputs used to calculate option values (or, alternatively, is implied by the quoted prices of
options in the market, hence the term “implied volatility”).
IRE
Interest Rate Exposure – used in a specific sense at Citigroup to measure the interest rate
exposure of accrual, rather than mark-to-market, portfolios.
Cost to close
The difference between life-to-date accounting and mark-to-market revenue for an accrual
portfolio, in other words the gain or loss that would be incurred by liquidating the portfolio at
market value.
Market Risk – The Greeks and other common terms
Often a portfolio’s behaviour can be represented accurately enough as a
simple linear function of market moves. At other times (especially for
options portfolios) it is necessary to include the effects of convexity,
especially if they are negative (“negative gamma”).
P&L
Market move
Linear approximation
Actual
Market Risk Management
Market Risk Management is three things:
1. Understanding management’s risk appetite
and expressing it in more specific terms
2. Understanding trading desks’ exposure and
communicating it upwards – comprehensibly
3. Acting as “honest brokers” in support of
other control groups as required
Market Risk Management - Techniques
Three main techniques of Market Risk Management:
•
Value at Risk
•
Stress Testing
•
P&L Attribution
…although none is as important as common sense.
Market Risk Management – Techniques – Value at Risk
What is it?
•
•
•
•
•
“What happens on a bad day?”
Statistical estimate
Simplest measure of “market risk”
Expressed in terms of a confidence level and a holding period
Various approaches, but all based on historical assumptions
Advantages:
•
•
•
Simple, easy to understand
Enables comparison between businesses
Capital relief if you meet the Basel guidelines
Drawbacks:
•
•
•
Doesn’t address the “worst case”
Can be opaque in some approaches
Not a “coherent” risk measure
Market Risk Management – Techniques – Value at Risk
Probability
1%
VaR
Revenue
Market Risk Management – Techniques – Stress Testing
What is it?
•
•
•
Tries to answer “What’s the worst that could happen?”
Two reasons: non-linear portfolios, extreme events
Various scenarios: historical, quasi-statistical, tailored
Advantages:
•
•
•
Does address the “worst case” (at least in theory)
Historical scenarios are very transparent
Provides a measure of economic capital
Drawbacks:
•
•
•
Significant judgmental input (correlation, liquidity)
Can give false confidence
Very dependent on trader/management behaviour
Market Risk Management – Techniques – VaR, Stress Testing
Coherent risk measures
•
•
•
Various technical conditions must be satisfied
Largely just means they make sense
Critical condition is “sub-additivity”: R(a+b) <= R(a) + R(b)
When does this matter?
•
•
•
Rarely if ever an issue for VaR within Market Risk
Discontinuous risks
High confidence levels
In other words:
•
•
•
Stress testing
Credit risk
Operational risk
For more information: P.Artzner, F.Delbaen, J.M.Eber, and D. Heath (1999):
“Coherent Measures of Risk”, Mathematical Finance 9, 203-228.
Market Risk Management – Techniques – P&L Attribution
What is it?
•
•
•
Two things, not one
Detailed level to prove out the revenue
High level to prove out the exposures
Advantages:
•
If there’s a problem, you find out about it early
Drawbacks:
•
Overhead
Market Risk Management – Techniques – P&L Attribution
Simple portfolio:
DV01
$10mm SOAF 6 1/2 of 2014 @ 109.963 (6,872)
$5 mm SOAF 7 3/8 of 2012 @ 113.183 (2,529)
$(15mm) UST 3 5/8 of 2013 @ 97-11
9,854
Prices and yields move as follows:
SOAF 2014
SOAF 2012
UST 2013
109.963  109.695
113.183  113.011
97-11  96-24+
(5.074%  5.113%)
(5.016%  5.050%)
(4.029%  4.117%)
P&L systems report a gain of $52,206
“Is it right and where does it come from?”
Market Risk Management – Techniques – P&L Attribution
Where does this come from?
Financial’s answer:
•
•
•
$86,719 from UST 2013:
$(26,800) from SOAF 2014:
$(8,600) from SOAF 2012:
$(15mm) x (37/64) x 1/100
$10mm x (0.268) x 1/100
$5mm x (0.172) x 1/100
Total: $51,319
Risk’s answer is based on risk factors:
•
•
$47,000 from spreads narrowing: $(9,401)/bp x (5bp)
$4,100 from rates rising:
$453/bp x 9bp
Total: $51,100
Policies and Procedures
Market Risk Management’s own policies cover areas such as limits
setting, model review and price verification.
Market Risk Managers also play a key (formal or informal) role in
implementation of other policies including:
• Policy on New Products, New Activities and Complex Transactions for CIB Global
Markets: “The CMAC Policy” to its friends.
• Off-Market Transaction Policy: “Loss-deferral” trades are not permitted; other trades
where an up-front fee changes hands in exchange for off-market coupons are allowed
only in tightly controlled circumstances.
• Structured Finance Policy: All our customers must disclose any financing trades, even
when accounting standards don’t require it.
• Derivatives Sales Practices Policy: Sale of exotic derivatives (or securities with them
embedded) to non-professional customers needs specific approvals.
Policies and Procedures – quiz
What do the following have in common?
•
The UK’s nuclear deterrent in the 1980s
•
One half of a notorious US crime team
•
Film starring Vin Diesel
•
Character in Greek mythology, son of a legendary craftsman
•
Popular term for an oil spillage at sea
•
An ultra-dense astronomical body
•
Characters from two films by Jay Roach
Market Risk - Limit Setting
Market Risk limits and exceptions are related to stress tests:
Stress tests: exposure x “worst case move” = stress loss
Risk limits: loss tolerance ÷ “worst case move” = limit
Loss tolerance depends on a number of factors:

Budgeted revenue

Maturity/growth plans

Nature of business (origination/facilitation/positioning)
Limits are set at desk, division and CIB levels as appropriate
All Market Risk Managers can approve exceptions at desk level (size
depends on the seniority of the risk manager)
Product and Regional Heads can approve exceptions at division level
(including EM seniors for EM division)
Only CIB Market Risk head can approve exceptions at CIB level
Market Risk - other hot topics
• Model risk
• Impact on liquidity of a hedge fund dislocation
• Lack of market opportunities vs budget
pressure
• Remote but outsized risks (the “known
unknowns”)
-
equity market collapse
“super-senior” CDO tranches and related products
• The “unknown unknowns”
-
Argentina - pesification
euro breakdown??
Market Risk Management and Convergence Risk
What is Market Risk Management?
•
What is Market Risk?
•
Market Risk Management – techniques
•
Policies and limit setting
•
Hot topics
When does it converge with Credit Risk Management?
•
Traditional overlaps – the liquidity crunch
•
Current developments – four examples
•
The golden rules
In the Beginning it was simple…
Market
Sovereigns
Credit
Loans
Letters of Credit
Even now, stable markets mean largely discrete risks
Market
Agencies
Sovereigns
Supranationals
High Grade
Corporates
EM FX and
Securities
Credit
High Yield Corporates
Distressed Debt
Loans
Letters of Credit
Counterparty Risk
The Fashion has always been to convert Credit to Market Risk
Market
Agencies
Sovereigns
Supranationals
High Grade
Corporates
EM FX and
Securities
Credit
High Yield Corporates
Distressed Debt
“Risk transfer” instruments
Loans
Letters of Credit
Counterparty Risk
But as Liquidity Evaporates…
Market
Agencies
High Grade
Corporates
EM FX and
Securities
Sovereigns
Supranationals
Credit
High Yield Corporates
Distressed Debt
Loans
Letters of Credit
Counterparty Risk
LIQUIDITY
High
Low
It Moves the Other Way
Sovereigns
Supranationals
Commercial Paper: Liquid or Cement?
In recent years, Commercial Paper issuers have come under the spotlight:
Previously
Commercial paper (CP) issuers could routinely “arbitrage” funding
sources to reduce the costs of funds between bank borrowings, debt
borrowings and CP issuances. Many companies used CP funding for
long term uses of cash such as acquisitions.
Current
Example
The current credit environment has resulted in investors looking more
closely at CP leverage ratios (e.g., General Electric) and credit rating
migrations (e.g., Sprint, Tyco, Quest, WorldCom, Nortel).
ABB Asea Brown Boveri Ltd. had $2.1BB of CP outstanding in
February 2001. On March 25, Moody’s downgraded ABB’s CP
from P1 to P3, resulting in a split rating of A1/P3. On April 23,
ABB’s CP outstanding had fallen to $500MM and S&P
downgraded the company to A2. There were no bids in the
market. CIB was holding $116MM at the Moody’s downgrade and
had no realistic “out” except to wait until maturity and hope to be
repaid. (We were).
Government Intervention is a Time-Bomb….
Market
Credit
Country’s
Economic/
Political
Situation
…When It Explodes, All Risks Converge
Sovereign
Market
Credit
Country’s
Economic/
Political
Situation
Liquidity
Market or Credit Risk? AFS portfolio
“Available for sale” portfolios
•
•
•
Marked to market, but through equity not income
Historically treated as credit exposures and using credit lines
Argument to reclassify as market risk is based on liquidity…
…which makes sense in normal circumstances, but beware:
•
•
Ability of some markets to turn illiquid suddenly
Implications on expected behaviour in a downturn
- Credit risk approach: hold/workout, maximise value
- Market risk approach: sell, limit downside
Market Risk Management and Convergence Risk
What is Market Risk Management?
•
What is Market Risk?
•
Market Risk Management – techniques
•
Policies and limit setting
•
Hot topics
When does it converge with Credit Risk Management?
•
Traditional overlaps – the liquidity crunch
•
Current developments – four examples
•
The golden rules
Recent developments in Convergence (1): Extinguishing swaps
Start with a vanilla interest rate or currency swap:
Citi
ABC Inc.
Citi is clearly taking counterparty risk to ABC
Traditional strategy for mitigating this risk is to buy credit
protection (how much depends on the current and projected markto-market value of the swap)
This has a number of disadvantages:
•
Basis risk: derivatives claims are not normally deliverable into a CDS
•
Possible accounting mismatch and likely capital mismatch
•
Still a creditor in default
Possible solution is the “extinguishing swap”
Recent developments in Convergence (1): Extinguishing swaps
Extinguishing swap is identical to a vanilla swap except
that all obligations are cancelled on a credit event.
Do we still have counterparty risk with an extinguisher?
Yes, because:
No, because:
Economically we lose the
same money in the same
circumstances
Credit risk is the risk that
someone defaults and owes
you money
Advantages of the extinguishing swap:
•
•
•
Full mark-to-market accounting even without Fair Value Option
Easier to monetise “right-way” exposure
No messy creditor meetings and no exposure to recovery rates
Drawbacks:
•
•
•
Legal enforceability if deal is in the money to the customer
Reputational: association with “self-referenced” products
Moral hazard: customers may have an incentive to default
Recent developments in Convergence (1): Extinguishing swaps
Variations:
• Isda “Method 1”
• Third-party extinguishers
• Legal/credit risk separation with this structure:
Bank A
Bank B
• Bank B has the legal risk
• Bank A has the credit risk
ABC Inc.
Extinguishing swaps - application
A Philippines corporate is raising funds in the offshore
market in dollars. Their customer revenues are in
pesos so a currency swap is the natural hedge.
$ fixed
Citi
$ fixed
ABC Inc.
PHP fixed
PHP “fixed”
investors
customers
Banks have limited credit appetite for the name, even
though the likely/projected mark-to-market of the swap
is negative:
80%
60%
40%
20%
0%
-20%
0
1
2
3
4
5
6
7
8
-40%
-60%
-80%
-100%
-120%
$ flows
PHP flows
Net MTM
9
10
Extinguishing swaps - application
An extinguishing swap is a natural solution to
everyone’s problem:
• Customer gets a hedge that would otherwise be
unavailable
• Citi has the opportunity to monetise the expected
value by buying bonds
• Creditors in default don’t have the uncertainty of a
potential currency swap claim
Recent developments in Convergence (2): Hedge Fund leverage
Funds and fund investors both looking for leverage:
•
•
Investors: increased upside, non-recourse structure
Funds: fees depend on assets under management
Leverage now available in a range of flavours:
•
Generic FoF product offered to risk-tolerant investors
•
•
Bespoke leverage for single investor
Single-fund product
Credit or market risk?
Citi lends $252mm for three years at
6% to Rosetta Leveraged Master
Fund Ltd., whose only assets are
holdings in each of eight third-party
hedge funds, with current value
$50mm each. Citi takes a charge
over the fund units.
James King, founder and managing
partner of King’s Road Capital LLP,
pays $148mm for a call option
giving him the right to buy a basket
of 50 units in each of eight King’s
Road funds, in three years’ time, at
a cost (strike) of $300mm. Each
unit is currently valued at $1mm.
Recent developments in Convergence (2): Hedge Fund leverage
These are basically the same deal:
King’s Road
Rosetta
$252mm
$148mm
James
King
pledge on units
Rosetta
$300mm
Citi
Citi
fund units
$400mm x return
fund units
$400mm x return
fund units
fund units
$400mm
Pledge unwound
$300mm
King’s
Road
Fund
managers
…and if you combine the related parties you get something even simpler:
$252mm
King’s
Road
fund units
$300mm
fund units
Citi
Recent developments in Convergence (3): EMCT loan program
Simple in concept: Citibank lends to an EM borrower (usually corporate)
and simultaneously sells the risk to the market in CDS or CLN form
A customer-based product on both sides:
• Borrowers: raise finance by tapping a broader investor base
• Investors: take exposure to previously inaccessible credits
Citigroup should be uniquely well positioned for this business given
its access to both borrower and investor markets
Closely related to four existing and mature businesses:
• Loan syndication: Citibank lends to an EM borrower and simultaneously
distributes to the bank market (Credit/underwriting risk)
• Bond syndication: Citigroup underwrites issuance of securities to the
general investor market (Market/underwriting risk)
• EMCT secondary business: Citigroup purchases a corporate loan (or
security) and simultaneously sells the risk to the market in CDS or CLN
form (Market risk)
• Portfolio Optimisation: Citibank lends to an EM borrower and later may sell
the risk to the market in CDS or CLN form (Credit risk)
Recent developments in Convergence (3): EMCT loan program
So…
1. Is this market risk or credit risk?
2. Is there anything else we need to think about?
The short answers:
1. Mainly credit/underwriting risk as long as EMCT do habitually defease it as
planned: once defeased, it becomes market risk. If EMCT start to hold
positions routinely, the answer changes.
2. YES! There are key differences to each of the existing businesses (all now
addressed in the program, although US distribution remains sensitive):
Difference compared to:
Disclosure
Bank regulation
Accounting
Loan syndication
Investors are public side
Bond syndication
No prospectus
Citibank lender
Ongoing
EMCT secondary
New money;
Citi is private side
Citibank lender
Loan accrued
Portfolio optimisation
Level of diligence;
Trader involvement
Hedge MtM
Recent developments in Convergence (4): Non-recourse lending
Not strictly recent, but a big growth area as hedge funds and private equity
sponsors look for more leverage and to monetise perceived gains.
Citigroup is increasingly asked to lend money with recourse only to specified
assets (or to lend money to an SPV with no other assets).
Regulation requires that Credit Policy be followed (assuming a bank-chain
vehicle lends): but when should we use market risk techniques and when should
we try to use traditional credit analysis?
Rarely a hard and fast rule – try these examples (most of which are real)…
1.
Lend $100mm for one year to European bank X, secured by shares representing a 5%
stake in large corporate company A and valued at $150mm; extra margin required if
LTV exceeds 80%, or we liquidate the portfolio
2.
Same as (1) but with no extra margin requirement: pure term deal
3.
Same as (1) but where $150mm is spread across a large number of liquid equities
4.
Same as (3) but where customer is a hedge fund and this is the bulk of their portfolio
5.
Same as (3) but where the security is private equity valued at $300mm
6.
Lend $100mm to Canadian corporate Y, secured by shares representing a 95% stake
in subsidiary Z and valued at $300mm
7.
Same as (6) but Y is a financial sponsor, not a corporate
Convergence – the golden rules
• Talk to each other and know who the point
people are
• It is better for you to tread on someone’s toes
than for both of you to miss something
• Don’t wait to be asked
But of course
• Respect the public/private divide
• Be responsive: Convergence shouldn’t mean
approvals take twice as long (don’t ask for all
the details and then say “not my job”)