jan-02 risk management zvi wiener 02-588-3049 mswiener/zvi.html financial risk management
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Jan-02 Risk Management
Zvi Wiener
02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Financial Risk Management
Feb-2001 slide 2Zvi Wiener
Feb-2001 slide 3Zvi Wiener
Risk
• Business Risk
• Financial Risk
– market risk
– credit risk
– liquidity risk
• Operational Risk
• Legal Risk
Feb-2001 slide 4Zvi Wiener
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.
Feb-2001 slide 5Zvi Wiener
Barings
• 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 slide 6Zvi Wiener
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
Feb-2001 slide 7Zvi Wiener
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 $1.64B
Feb-2001 slide 8Zvi Wiener
Public Funds
($ million)• Orange County 1,640• San Diego 357• West Virginia 279• Florida State Treasury 200• Cuyahoga County 137• Texas State 55
Feb-2001 slide 9Zvi Wiener
Derivatives 1993-1995
($ million)•Shova Shell, Japan 1,580•Kashima Oil, Japan 1,450•Metallgesellschaft 1,340•Barings, U.K. 1,330•Codelco, Chile 200•Procter & Gamble, US 157
Feb-2001 slide 10Zvi Wiener
Investec Clali, Jan-01
Client bought put options without sufficient funds.
Loss is 8-15M NIS.
Feb-2001 slide 11Zvi Wiener
• Barings $1.3B• Bank Negara, Malaysia 92 $3B• Banesto, Spain $4.7B• Credit Lyonnais $10B• S&L, U.S.A. $150B• Japan $500B
Financial Losses
Feb-2001 slide 12Zvi Wiener
Value of an Option at Expiration
E. Call
X Underlying
Feb-2001 slide 13Zvi Wiener
Call Value before Expiration
E. Call
X Underlying
Feb-2001 slide 14Zvi Wiener
Call Value before Expiration
E. Call
X Underlying
premium
Feb-2001 slide 15Zvi Wiener
Put Value at Expiration
E. Put
X Underlying
X
Feb-2001 slide 16Zvi Wiener
Put Value before Expiration
E. Put
X Underlying
premium
X
Feb-2001 slide 17Zvi Wiener
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?
Feb-2001 slide 18Zvi Wiener
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.
Feb-2001 slide 19Zvi Wiener
Collar payoff
payoff
90 100 K stock
90
K
Feb-2001 slide 20Zvi Wiener
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?
Feb-2001 slide 21Zvi Wiener
Long term options
payoff
k K stock
50
K
Sell a call
Your option
Result
Feb-2001 slide 22Zvi Wiener
ExampleYou 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!
Feb-2001 slide 23Zvi Wiener
Example
payoff
10 15 26
50
K
Your option
Result
60
exercise
Feb-2001 slide 24Zvi Wiener
How much can we lose?
Everything
correct, but useless answer.
How much can we lose realistically?
Feb-2001 slide 25Zvi Wiener
What is the current Risk?
duration, convexity
volatility
delta, gamma, vega
rating
target zone
• Bonds• Stocks • Options• Credit • Forex• Total ?
Feb-2001 slide 26Zvi Wiener
Standard Approach
Feb-2001 slide 27Zvi Wiener
Modern Approach
Financial Institution
Feb-2001 slide 28Zvi Wiener
Risk Management• Risk measurement
• Reporting to board
• Limits monitoring
• Diversification, reinsurance
• Vetting
• Reporting to regulators
• Decision making based on risk
Feb-2001 slide 29Zvi Wiener
Who manages risk?
Citibank
Bank of England
CIBC
J. P. Morgan
Bankers Trust
AIG
General Re
Swiss Re
Aetna
Zurich
Nike
Sony
Dell Computers
Philip Morris
Ford Motor
Feb-2001 slide 30Zvi Wiener
Regulators
• BIS
• FSA
• SEC
• ISDA
• FASB
• Bank of Israel
• Galai’s committee
Feb-2001 slide 31Zvi Wiener
Basic Steps in RM process
• Identify risks
• Data base (market + position)
• Risk measurement
• Regulators
• Risk Management
• Reporting
• Strategic decisions
Feb-2001 slide 32Zvi Wiener
Building a RM system• Initial study of risks
• Decision, Risk Manager
• Risk measurement system
• Responsibilities and structure
• Testing
• Active Risk Management
• Staff training and maintenance
Feb-2001 slide 33Zvi Wiener
Risk Management and
Risk Measurement
Feb-2001 slide 34Zvi Wiener
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
Can NOT
Feb-2001 slide 35Zvi Wiener
Tool, not rule!
Limits, Duration, ALM, DFA, VaR
Feb-2001 slide 36Zvi 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.
Feb-2001 slide 37Zvi Wiener
-3 -2 -1 1 2 3
0.2
0.4
0.6
0.8
1
Profit/Loss
VaR
1% VaR1%
Feb-2001 slide 38Zvi Wiener
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,
1%VaR
under normal market conditions.
Feb-2001 slide 39Zvi Wiener
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 used and misused!
Feb-2001 slide 40Zvi Wiener
Risk Management Structure
Market data Current position
Risk Mapping
Valuation
Value-at-Risk
Reporting and Risk Management
Feb-2001 slide 41Zvi Wiener
1011
1213
14 4.1
4.15
4.2
4.25
4.3
7.257.5
7.758
8.25
1011
1213
14
interest rates and dollar areNOT independent
Value
Interest Ratedollar
Feb-2001 slide 42Zvi Wiener
Risk Measuring Software• CATS, CARMA• Algorithmics, Risk Watch• Infinity• J.P. Morgan, FourFifteen• FEA, Outlook• Reuters, Sailfish• Kamacura• Bankers Trust, RAROC• INSSINC, Orchestra
Feb-2001 slide 43Zvi Wiener
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
Feb-2001 slide 44Zvi Wiener
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
Feb-2001 slide 45Zvi Wiener
Types of Assets and Risks
• Real projects - cashflow versus financing
• Fixed Income
• Optionality
• Credit exposure
• Legal, operational, authorities
Feb-2001 slide 46Zvi Wiener
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
Feb-2001 slide 47Zvi Wiener
How to measure VaR
• Historical Simulations
• Variance-Covariance
• Monte Carlo
• Analytical Methods
Feb-2001 slide 48Zvi Wiener
Historical Simulations
• Fix current portfolio.
• Pretend that market changes are
similar to those observed in the past.
• Calculate P&L (profit-loss).
• Find the lowest quantile.
Feb-2001 slide 49Zvi Wiener
Returns
year
1% of worst cases
Feb-2001 slide 50Zvi Wiener
-3 -2 -1 1 2 3
0.2
0.4
0.6
0.8
1
Profit/Loss
VaR
1% VaR1%
Feb-2001 slide 51Zvi Wiener
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.
Feb-2001 slide 52Zvi Wiener
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!
Feb-2001 slide 53Zvi Wiener
Variance-Covariance VVVaR 33.2%1
2.33
-2.33
1%
Feb-2001 slide 54Zvi Wiener
Monte Carlo
-1 -0.5 0.5 1
-1
-0.5
0.5
1
Feb-2001 slide 55Zvi Wiener
Monte Carlo
• Distribution of market factors
• Simulation of a large number of events
• P&L for each scenario
• Order the results
• VaR = lowest quantile
Feb-2001 slide 56Zvi Wiener
Monte Carlo Simulation
10 20 30 40
-15
-10
-5
5
10
15
Feb-2001 slide 57Zvi Wiener
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.
Feb-2001 slide 58Zvi Wiener
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 there is no currency risk.
Feb-2001 slide 59Zvi Wiener
Airline company
• fuel - oil prices and $• purchasing airplanes - $ and Euro• salaries - NIS, some $• tickets $• marketing - different currencies• payments to airports for services
Feb-2001 slide 60Zvi Wiener
Airline company
• loans
• equity
• callable bonds
Feb-2001 slide 61Zvi Wiener
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.
Feb-2001 slide 62Zvi Wiener
Reporting
Division of VaR by business units, areas of
activity, counterparty, currency.
Performance measurement - RAROC (Risk
Adjusted Return On Capital).
Feb-2001 slide 63Zvi Wiener
How VaR is used
• Internal Risk Management
• Reporting
• Regulators
Feb-2001 slide 64Zvi Wiener
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.
Feb-2001 slide 65Zvi Wiener
Backtesting
Green zone - up to 4 exceptions
Yellow zone - 5-9 exceptions
Red zone - 10 exceptions or more
OK
increasing k
intervention
Feb-2001 slide 66Zvi Wiener
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?
Feb-2001 slide 67Zvi Wiener
Unifying Approach
• One number
• Based on Statistics
• Portfolio Theory
• Verification
• Widely Accepted
• Easy Comparison
Feb-2001 slide 68Zvi Wiener
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.
Feb-2001 slide 69Zvi Wiener
Open Questions
• Risks related to cashflow
• Non-traded assets
• Credit information
• Global Database
• Liquidity problem
Feb-2001 slide 70Zvi Wiener
Issues Specific to Israel
• Indexation
• Exchange Band
• Shallow Markets
Feb-2001 slide 71Zvi Wiener
pluto.mscc.huji.ac.il/~mswiener/
• Useful Internet sites
• Regulators
• Insurance Companies
• Risk Management in SEC reports
Risk Management resources
Feb-2001 slide 72Zvi Wiener
Feb-2001 slide 73Zvi Wiener
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.
Feb-2001 slide 74Zvi Wiener
RMG
• http://www.riskmetrics.com/
• http://www.pictureofrisk.com/
• http://www.riskmetrics.com/rm/splash.html
• rmgaccess
Feb-2001 slide 75Zvi Wiener
Consulting
• Oliver, Wyman and Co.
• Willis Corroon
• Richard Scora
• Ernst and Young
• Enterprise Advisors
• Kamakura
Feb-2001 slide 76Zvi Wiener
Examples of Risk Reports
http://www.pictureofrisk.com
http://www.mbrm.com/
http://www.riskmetrics.com/rm/splash.html
Feb-2001 slide 77Zvi Wiener
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
Feb-2001 slide 78Zvi Wiener
SEC reports
• Edgar
• Yahoo
– find symbol
– profile
– raw SEC reports market risk in 10K 7A
Feb-2001 slide 79Zvi Wiener
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
Feb-2001 slide 80Zvi Wiener
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/
Feb-2001 slide 81Zvi Wiener
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!
Feb-2001 slide 82Zvi Wiener
Agriculture
www.cfonet.com/html/Articles/CFO/1999/99APkita.html
1998 revenues $1.25B
consulting Willis Corroon
Feb-2001 slide 83Zvi Wiener
Nike
• Salaries are paid in Asia
• Shoes are sold worldwide
• Financing comes from USA
• Marketing, storing, shipping worldwide
use VaR since 1998.
Feb-2001 slide 84Zvi Wiener
Merck
http://www.palisade-europe.com/html/Articles/merck.html
http://www.sec.gov/Archives/edgar/data/64978/0000950123-99-005573-index.html see “sensitivity”
Feb-2001 slide 85Zvi Wiener
Articles
Value at Risk as a Diagnostic Tool for Corporates: The Airline Industry
http://netec.mcc.ac.uk/WoPEc/data/Papers/dgruvatin19990023.html
Agricultural Applications of Value-at-Risk Analysis: A Perspective
http://netec.mcc.ac.uk/WoPEc/data/Papers/wpawuwpfi9805002.html
Feb-2001 slide 86Zvi Wiener
Publications
“The New Risk Management: the Good, the Bad, and the Ugly”, P. Dybvig, W. Marshall
http://dybfin.olin.wustl.edu/research/papers/riskman_fed.pdf
Association for Investment Management and Research
http://www.aimr.org/
Feb-2001 slide 87Zvi Wiener
Web tour
• ZW, students, VaR and risk management• Gloriamundy• GARP• SEC reports• Google
Feb-2001 slide 88Zvi Wiener
What is more risky and why?
A. 1 year bond
B. 10 year bond
Feb-2001 slide 89Zvi Wiener
What is more risky and why?
A. An in-the-money option?
B. An out-of-the-money option?