market risk slides

Market RiskLearning Outcomes (18.1 – 20.6)

Market Risk (LO 18.1 – 18.4)1

4 Liquidity risk (LO 20.1 – 20.6)

Cash flow exposures (LO 19.7 – 19.15)

2 Foreign Exchange Risk (LO 19.1 – 19.6)

3

Market Risk

Market risk is “the risk related to the uncertainty

of a financial institution’s earnings on its trading

portfolio caused by changes in market conditions

such as the price of an asset, interest rates, market

volatility, and market liquidity”

(Saunders, Chapter 10)

LO 18.1: Define market risk

Market RiskLO 18.1: Define market risk

Assets Liabilities

Investment

(Banking)

Book

Loans Capital

Other illiquid assets Deposits

Trading Book

Bonds (long) Bonds (short)

Commodities (long) Commodities (short)

FX (long) FX (short)

Equities (long) Equities (short)

Derivatives (long) Derivatives (short)


Assets Liabilities

Investment

(Banking)

Book

Loans Capital


Trading Book






Securitization

Market Risk

1. Management information: MRM gives senior managers information about risk exposures.

2. Setting limits: MRM helps set logical position limits

3. Resource allocation: Because it compares return-versus-risk across asset classes, helps allocate capital effectively.

4. Performance evaluation: Rather than pay traders merely for taking on more risk, considers the return-risk ratio, and therefore helps for more rational compensation scheme.

5. Regulation: Because regulations may tend to over-price some risks, the use of internal models may lead to superior capital allocation.

LO 18.2: Describe five reasons why market risk measurement is important

Market RiskLO 18.3: List the models being used to calculate market risk exposure.

RiskMetrics (variance/covariance)

• Market Risk = Position (Confidence)(Volatility)(Sensitivity)

Historic or back simulation

• When returns are non-normal

• Simple

Monte Carlo simulation

• When actual data is limited

• Like historic, percentile (%) rank

Market Risk

1st Model: RiskMetrics Model for Daily Earnings at

Risk (DEAR)

LO 18.3: List the models being used to calculate market risk exposure.

Market Risk

1st Model (Variance Covariance) Fixed Income


Daily Price Volatility = Modified Duration

Adverse Daily Yield Move

Market Risk

1st Model (Variance Covariance) Equities


2 2 2 2i i m ei

Total Risk = Systematic risk +

Unsystematic risk

Market Risk

The RiskMetrics model assumes normality. Due to this drawback,

most banks deploy market risk models that use a historic or

back simulation approach. There are six steps to the historic

approach (using foreign exchange as an example):

1. Measure exposures

2. Measure sensitivity

3. Measure risk

4. Repeat Step 3

5. Rank days by risk from worst to best

6. Determine VAR.


2nd Model: Historic or Back Simulation Approach


Measure exposures

Measure sensitivity

Measure risk

Repeat Step 3

Rank days

by risk: worst

to best

Determine VAR

Market Risk

3rd Model: The Monte Carlo Simulation Approach


The Monte Carlo approach overcomes the problem of

limited observations. A typical Monte Carlo simulation

produces a large number of synthesized observations—

sometimes a very large number.

Market Risk

The Bank for International Settlement (BIS) includes the

largest central banks in the world. Since January 1998,

banks in BIS member countries can calculate market risk

(i.e., market risk only, not credit and operational risk)

exposure in one of two ways:

1. Use a simple standardized framework.

2. Use an internal model, contingent on regulatory approval.

However, an internal model is subject to regulatory

audit(s) and certain constraints.

LO 18.4: List the methods the Bank for International Settlement uses to regulate market risks

Market Risk

Fixed Income

Specific Risk Charge

The specific risk charge measures the risk of a decline in the liquidity or credit

risk quality of the portfolio over the holding period. Multiplying the absolute

dollar values of the long and short positions by the specific risk weights

produces a specific risk capital (or requirement charge) for each position.

Summing the individual charges for specific risk gives the total specific risk

charge.

General Market Risk Charge

The general market risk charges the product of the modified durations and

interest rate shocks expected for each maturity. The positive or negative dollar

values of the positions in each instrument are multiplied by the general market

risk weights to determine the general market risk charges for the individual

holdings. Summing these gives the total general market risk charge of the entire

fixed-income portfolio.


Market Risk

Fixed Income

Vertical Offsets

The BIS model assumes that long and short positions, in the same maturity

bucket but in different instruments, cannot perfectly offset each other. Thus, the

general market risk charge tends to underestimate interest rate or price risk

exposure. To account for this, BIS requires additional capital charges for basis

risk, called vertical offsets or disallowance factors.

Horizontal Offsets within Time Zones

In addition, the debt trading portfolio is divided into three maturity zones.

Because of basis risk (i.e., the imperfect correlation of interest rates on

securities of different maturities), short and long positions of different

maturities in these zones will not perfectly hedge each other. This results in

additional (horizontal) disallowance factors for each maturity zone, as follows:

Zone 1 (1 to 12 months): 40%

Zone 2 (>1 year to 4 years): 30%

Zone 3 (> 4 to 20 years or more): 30%


Market Risk

Foreign Exchange (Under BIS Standardized Framework)

The standardized model or framework requires the bank to calculate its

net exposure in each foreign currency and then convert this into dollars at

the current spot exchange rate. The BIS standardized framework imposes

a capital requirement equal to 8% multiplied by the maximum absolute

value of the aggregate long or short positions.


Market Risk

Equities (Under BIS Standardized Framework)

Two sources of risk in holding equities: (1) a firm-specific, or unsystematic, risk

element and (2) a market, or systematic, risk element.

Unsystematic risk is charged by adding the long and short positions in any

given stock and applying a 4% charge against the gross position in the stock.

(This is called the x factor).

Market or systematic risk is reflected in the net long or short position.

The capital charge is 8% against the net position. (This is called the y

factor).

The total capital charge for the stock is the “x factor” plus the “y

factor”.

This approach is crude and does not fully consider the benefits of portfolio

diversification (i.e., that unsystematic risk is not diversified away).


FX Risk

Net exposurei = (FX assetsi - FX liabilitiesi) +

(FX boughti - FX soldi)

= Net foreign assetsi +

Net FX boughti

i = ith currency

Positive net exposure: net long a currency

Negative net exposure: net short a currency

LO 19.1: Describe the different sources of foreign exchange risk exposure

FX Risk

Purchase/sale of foreign currencies

1.To allow customers to participate in international commercial trade transactions

2.To allow customers to take positions in foreign investments (real or financial assets)

3.For hedging purposes—i.e., to offset currency exposure

4.For speculative purposes

LO 19.2: Explain the different types of foreign trading activities and the sources of most profits and losses on foreign exchange trading.

FX RiskLO 19.3: Describe foreign exchange exposure resulting from mismatches between foreign financial asset and liability portfolios, and explain how returns and risks of foreign investing can impact returns.

Assets Liabilities

$100 million, US Loans, US

Dollars

$200 million U.S. Dollars

$100 million equivalent, Foreign

Loans, Foreign Dollars

FX RiskLO 19.4: Explain on-balance-sheet hedging

Assets (loans) Liabilities (CDs)

Invest: Lend:

$100.00 $ @ 9% $100.00 $ @ 8%

$100.00 £ @ 15% $100.00 £ @ 11%

$/£

Start $1.60

End $1.45

$100.00 £62.50 $100.00 £62.50

$104.22 £71.88 $100.59 £69.38

4.22% 0.59%

ROA 6.61% COF 4.30%

ROI 2.31%



Invest: Lend:

$100.00 $ @ 9% $100.00 $ @ 8%

$100.00 £ @ 15% $100.00 £ @ 11%

$/£

Start $1.60

End $1.70

$100.00 £62.50 $100.00 £62.50

$122.19 £71.88 $117.94 £69.38

22.19% 17.94%

ROA 15.59% COF 12.97%

ROI 2.63%

FX RiskLO 19.5: Explain off-balance-sheet hedging


Invest: Lend:

$100.00 $ @ 9% $200.00 $ @ 8%

$100.00 £ @ 15% $0.00 £ @ 11%

$/£

Spot $1.60

Discount $0.05

Forward $1.55

$100.00 £62.50

Loan @ 15%

Returned (£) £71.88

Returned ($) $111.41

Loan Return 11.41%

ROA 10.20% COF 8.00%

ROI: 2.20%

FX Risk

To the degree that domestic and foreign interest rates

(or stock returns) are not perfectly correlated, potential

gains from asset-liability portfolio diversification can

offset risk of asset-liability currency mismatch

LO 19.6: Explain why diversification in multicurrency

foreign asset-liability positions could reduce portfolio risk.

FX Risk







ei i ir rr i

The nominal interest rate in country The real interest rate in country

The expected one-period inflation rate in country

i

iei

r irr i

i i

Cash flow exposures

Transaction exposure (to a currency) is the exposure due

to holding receivables and payables (in a foreign currency).

Transaction exposure results from past business deals.

Contractual exposure (to a currency) is exposure due to

contractual commitments.

Competitive exposure is when the cash flow is exposed

to a change in the firm's competitive position. Competitive

exposure broadly defined; all firms have competitive exposure.

LO 19.7: Distinguish among transaction exposure, contractual exposure, and competitive exposure to exchange rate fluctuations.

Cash flow exposures

Price risk: unexpected changes in price

Quantity risk: unexpected changes in the exposure

LO 19.8: Explain the interaction of price risk and quantity risk in terms of the additional challenges to hedging using examples of industries where the association between price and quantity of the risky factor is negative and where it is positive.

Cash flow exposuresAssume: For U.S. Company, cost to make widget is $100

U.S. company want to receive $120 per widget (i.e., $20 profit)

Baseline, "Before" the Currency Move

Pegged exchange rate: 7.50 Y Yuan/$

$0.1333 $/Yuan

Price of a Widget (Y) 900.00 Y

Converted ($) $120.00

Two Scenarios:

Yuan Yuan

Appreciates Depreciates

Yuan per 1 US$ 7.00 Y 8.00 Y

US$ per 1 Yuan $0.1429 $0.1250

"Negative" Relationship

Price in Yuan 840.00 Y 960.00 Y

Converted to US$: $120.00 $120.00

"Positive" Relationship


Converted to US$: $128.57 $112.50

Cash flow exposuresLO 19.9: Explain the implications of perfect positive correlation, zero correlation, and perfect negative correlation between price risk and quantity risk for the optimal hedge ratio and the risk of the hedged versus the unhedged cash flows.

Dollar

Price of Cash flow in Sw. Francs Cash flow in US $

Swiss Pos Neg. Pos Neg.

franc (+) None (-) (+) None (-)

$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75

$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75

$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75

$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75

Average $1.00 $1.25 $1.00 $0.75

Covariance 0.50 0.25 -

Variance 0.25

Hedge Ratio 2.00 1.00 -


Dollar

Price of Cash flow in Sw. Francs Cash flow in US $ Futures Gain/Loss Net Gain/Loss

Swiss Pos Neg. Pos Neg. Pos Neg. Pos Neg.

franc (+) None (-) (+) None (-) (+) None (-) (+) None (-)

$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75 ($1.00) ($0.50) - $1.25 $1.75 $0.75

$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75 ($1.00) ($0.50) - $1.25 $0.25 $0.75

$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75 $1.00 $0.50 - $1.25 $1.25 $0.75

$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75 $1.00 $0.50 - $1.25 $0.75 $0.75

$1.00 $1.25 $1.00 $0.75 Average

0.50 0.25 - Covariance

0.25 Variance

2.00 1.00 - Hedge Ratio

Cash flow exposures

Dollar




$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75 ($1.00) ($0.50) - $1.25 $1.75 $0.75

$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75 ($1.00) ($0.50) - $1.25 $0.25 $0.75

$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75 $1.00 $0.50 - $1.25 $1.25 $0.75

$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75 $1.00 $0.50 - $1.25 $0.75 $0.75

$1.00 $1.25 $1.00 $0.75 Average


0.25 Variance


Positive Correlation (price, quantity): it can be hedged

Negative Correlation (price, quantity): already “naturally” hedged!

No Correlation (price, quantity): “partial” hedge does not totally work

Cash flow exposures

Exposure of cash flow to a specific risk factor is measured by: the change in value of the cash flow (or the fair value of the asset) for a given unit change in the risk factor. Specifically,

LO 19.10: Describe how the exposure of cash flow to a risk factor, such as exchange rate risk, is measured.

Cash flow per unit

Risk factor

Exposure

Cash flow exposures

Imperfect (limited) competition = elastic demand

Perfect competition = producer is a “price taker”

who cannot increase prices (i.e., perfectly elastic)

LO 19.11: Using supply (marginal cost) and demand analysis, illustrate

the competitive exposure to exchange rate risk for an exporting firm,

considering changes in (i) exchange rates between the firm’s currency

and the currency of the importing country and (ii) exchange rates

between the currency of a third country (that has exporters that

compete with the firm) and the currency of the importing country.

Cash flow exposures

DDMR

MC

£

Pounds

Q

Quantity @ MR = MC

Quantity’ @ MR’ = MC’

Impact on pound price of cars sold in U.S.Depreciation of dollar

Limited Competition = Elastic Demand

Price £

Cash flow exposures

DD’

MR’

MC

Q’

Quantity @ MR = MC


£’

Pounds



Price £

Cash flow exposures

DD

DD’

MR’

MR

MC

£

Q’ Q

Quantity @ MR = MC


£’



Price £

Cash flow exposures

DDMR

MC

$

Dollars

Q

Quantity @ MR = MC


Impact on dollar price of cars sold in U.S.Depreciation of dollar


Price $

Cash flow exposures

DDMR

Q’

Quantity @ MR = MC

Quantity’ @ MR’ = MC’$’

Dollars



Price $

MC’

Cash flow exposures

DDMR

MC

$

Q’ Q

Quantity @ MR = MC




Price $

MC’

Cash flow exposures

DD = MR

MC

£

Q

Quantity @ MR = MC


£’


Perfect Competition = Perfectly Elastic ()

Price £

Cash flow exposures

DD’ = MR’

MC

£

Q

Quantity @ MR = MC


£’



Price £

Cash flow exposures

DD =

DD’ = MR’

MR

MC

£

Q

Quantity @ MR = MC


£’



Price £

Cash flow exposures

DD = MR

MC

$

Q’ Q

Quantity @ MR = MC


$’



Price £

Cash flow exposures

DD = MR$

Q’ Q

Quantity @ MR = MC


$’



Price £

MC’

Cash flow exposures

DD = MR

MC

$

Q’ Q

Quantity @ MR = MC


$’



Price £

MC’

Cash flow exposuresLO 19.12: Outline the steps in determining cash flow exposure from a pro forma analysis when the correlation of the quantity sold with the risk factor is zero, positive, and negative.

Cash flow Line Item

Base

Case

If we change the risk factor

(scenario-based change to

the risk factor):

Sales (Cash receipts) S +/-S = S Adjusted

Cash Cost of Goods Sold (COGS) - W +/-X = W Adjusted

Cash (SG&A) Expenses - X +/-Y = X Adjusted

Cash Taxes - Y +/-X = Y Adjusted

Net Cash Flow = Z = Z Adjusted

Cash flow exposuresLO 19.13: Explain how the optimal hedge ratio is determined in the context of pro forma cash flow analysis with one risk factor.

cov( , )

var( )

C Gh

G

cov[Cash flow, ]

var( )

Sh

S

Cash flow exposuresLO 19.14: Illustrate the concept of the delta exposure of cash flow, and describe how it is estimated in practice for non-linear exposure to a risk factor.

, , ,i t i i x t i tR R

,

i

i

,

,

firm cash flow or return on securities constant exposure of firm to specified risk factor return of the risk factor error term

i t

x t

i t

R

R

Cash flow exposuresLO 19.15: Describe the steps in using Monte Carlo simulation to estimate the volatility-minimizing hedge ratio and the circumstances under which this approach has significant advantages.

Express Cash Flow as function of risk factor(s)

Identify distribution of risk factor

Random number generator: 10,000 random risk factors

Produces 10,000 “simulated” cash flows

Identify specified percentile (95th

percentile, 99th percentile)

Liquidity risk

Funding liquidity risk

Not enough balance sheet cashto fund ongoing operations (or precipitous drop)

Concern of corporate Chief Financial Officer (CFO)

Market liquidity risk

Deterioration in asset value: • Cannot liquidate the position, and/or

• Cannot sufficiently hedge the position

Concern of market traders and market participants

LO 20.1: Explain the interrelationship between funding liquidity risk and market liquidity risk

Liquidity risk

Liquidity gap = Liquid assets minus (–) volatile

liabilities

LO 20.2: Describe alternative methods for measuring liquidity risk.

Liquidity risk

Liquidity risk elasticity (LRE)

Given a small increase in bank’s liquidity premium (LIBOR + spread) on the marginal funding cost Δ net of assets over funded liabilities

A(t), L(t) are current values of assets, liabilities

w is proportion of liabilities funded with the assets

Ξ is the liquidity premium on the firm’s funding cost


NA(t ) A(t ) L(t )w

LRE Limitations: (i) works for small Δ in funding costs, and (ii) assumes parallel shift in funding costs

Liquidity risk

Time horizon

LO 20.3: Discuss factors that impact an asset’s liquidation cost

Liquidity risk

Time horizon

Asset type


Liquidity risk

Time horizon

Asset type

Asset fungibility


Liquidity risk

Time horizon

Asset type

Asset fungibility

Market microstructure

Temporal aggregation (call or continuous)

Dealership structure (decentralized

centralized)


Liquidity risk

Time horizon

Asset type

Asset fungibility



Temporal aggregation

(call or continuous)

Dealership structure

(decentralized centralized)

Bid-ask spread

Liquidity risk

Bid–ask spread: price difference between buyers and

sellers of the same asset at the same time

LO 20.4: Discuss problems with using the bid-ask spread as a measure of liquidity.

Liquidity risk

Problems with the bid-ask spread:

Assumes trades can be crossed simultaneously

Presumed to reflect a stable market impact function

that relates the cost of the transacting to order size.

Often different sets of bid–ask spreads; may be hard

to know which spread to use


Liquidity risk

j t ,j j j t ,j1LVAR ( ) V [ ( ) S ]

2

LO 20.5: Calculate liquidity-adjusted VAR.

t,j

,

j

S bid-ask spread value of asset mean standard deviation

( ) = confidence parameter

t j

j

V

Liquidity riskLO 20.5: Calculate liquidity-adjusted VAR.

Assume Initial asset value of $100

Expected return () of 10% per annum

Spread = 0.2

Standard deviation () of 25%

Level of significance = 5%

Time horizon = 1 year

What is the liquidity-adjusted VAR?


Initial asset value of $100


Spread = 0.2




15 100 10 1 645 25 0 22

31 13 10 41 13

jLVAR ( %) [ % ( . )( %) ( . )]

$ . $ $ .

12

j , ,

LVAR ( ) [ ( ) ]t j j j t j

V S

Absolute VAR (Culp’s method)




Spread = 0.2




15 100 1 645 25 0 22

51 13

jLVAR ( %) $ ( . )( %) ( . )

$ .

12

, ,

LVAR ( ) ( )j t j j t j

V S

Relative VAR

Liquidity Risk

Companies can take at least two steps to

minimize liquidity risks:

Diversify liquidity risks across sources

Perform scenario analysis-based planning

LO 20.6: Discuss ways firms can minimize their exposure to liquidity risk.

1

Market RiskLearning Outcomes (18.1 – 20.6)

Market Risk (LO 18.1 – 18.4)1

4 Liquidity risk (LO 20.1 – 20.6)

Cash flow exposures (LO 19.7 – 19.15)

2 Foreign Exchange Risk (LO 19.1 – 19.6)

3

Market Risk

Market risk is “the risk related to the uncertainty

of a financial institution’s earnings on its trading

portfolio caused by changes in market conditions

such as the price of an asset, interest rates, market

volatility, and market liquidity”

(Saunders, Chapter 10)

LO 18.1: Define market risk


Assets LiabilitiesInvestment

(Banking)

Book

Loans Capital


Trading Book







Assets LiabilitiesInvestment

(Banking)

Book

Loans Capital


Trading Book






Securitization

2

Market Risk

1. Management information: MRM gives senior managers information about risk exposures.

2. Setting limits: MRM helps set logical position limits

3. Resource allocation: Because it compares return-versus-risk across asset classes, helps allocate capital effectively.

4. Performance evaluation: Rather than pay traders merely for taking on more risk, considers the return-risk ratio, and therefore helps for more rational compensation scheme.

5. Regulation: Because regulations may tend to over-price some risks, the use of internal models may lead to superior capital allocation.

LO 18.2: Describe five reasons why market risk measurement is important


RiskMetrics (variance/covariance)

• Market Risk = Position (Confidence)(Volatility)(Sensitivity)

Historic or back simulation

• When returns are non-normal

• Simple

Monte Carlo simulation

• When actual data is limited

• Like historic, percentile (%) rank

Market Risk

1st Model: RiskMetrics Model for Daily Earnings at

Risk (DEAR)


Market Risk

1st Model (Variance Covariance) Fixed Income


Daily Price Volatility = Modified Duration

Adverse Daily Yield Move

3

Market Risk

1st Model (Variance Covariance) Equities


2 2 2 2i i m ei

Total Risk = Systematic risk +

Unsystematic risk

Market Risk

The RiskMetrics model assumes normality. Due to this drawback,

most banks deploy market risk models that use a historic or

back simulation approach. There are six steps to the historic

approach (using foreign exchange as an example):

1. Measure exposures

2. Measure sensitivity

3. Measure risk

4. Repeat Step 3

5. Rank days by risk from worst to best

6. Determine VAR.


2nd Model: Historic or Back Simulation Approach


Measure exposures

Measure sensitivity

Measure risk

Repeat Step 3

Rank days

by risk: worst

to best

Determine VAR

Market Risk

3rd Model: The Monte Carlo Simulation Approach


The Monte Carlo approach overcomes the problem of

limited observations. A typical Monte Carlo simulation

produces a large number of synthesized observations—

sometimes a very large number.

4

Market Risk

The Bank for International Settlement (BIS) includes the

largest central banks in the world. Since January 1998,

banks in BIS member countries can calculate market risk

(i.e., market risk only, not credit and operational risk)

exposure in one of two ways:

1. Use a simple standardized framework.

2. Use an internal model, contingent on regulatory approval.

However, an internal model is subject to regulatory

audit(s) and certain constraints.


Market Risk

Fixed Income

Specific Risk Charge

The specific risk charge measures the risk of a decline in the liquidity or credit

risk quality of the portfolio over the holding period. Multiplying the absolute

dollar values of the long and short positions by the specific risk weights

produces a specific risk capital (or requirement charge) for each position.

Summing the individual charges for specific risk gives the total specific risk

charge.

General Market Risk Charge

The general market risk charges the product of the modified durations and

interest rate shocks expected for each maturity. The positive or negative dollar

values of the positions in each instrument are multiplied by the general market

risk weights to determine the general market risk charges for the individual

holdings. Summing these gives the total general market risk charge of the entire

fixed-income portfolio.


Market Risk

Fixed Income

Vertical Offsets

The BIS model assumes that long and short positions, in the same maturity

bucket but in different instruments, cannot perfectly offset each other. Thus, the

general market risk charge tends to underestimate interest rate or price risk

exposure. To account for this, BIS requires additional capital charges for basis

risk, called vertical offsets or disallowance factors.

Horizontal Offsets within Time Zones

In addition, the debt trading portfolio is divided into three maturity zones.

Because of basis risk (i.e., the imperfect correlation of interest rates on

securities of different maturities), short and long positions of different

maturities in these zones will not perfectly hedge each other. This results in

additional (horizontal) disallowance factors for each maturity zone, as follows:

Zone 1 (1 to 12 months): 40%

Zone 2 (>1 year to 4 years): 30%

Zone 3 (> 4 to 20 years or more): 30%


Market Risk

Foreign Exchange (Under BIS Standardized Framework)

The standardized model or framework requires the bank to calculate its

net exposure in each foreign currency and then convert this into dollars at

the current spot exchange rate. The BIS standardized framework imposes

a capital requirement equal to 8% multiplied by the maximum absolute

value of the aggregate long or short positions.


5

Market Risk

Equities (Under BIS Standardized Framework)

Two sources of risk in holding equities: (1) a firm-specific, or unsystematic, risk

element and (2) a market, or systematic, risk element.

Unsystematic risk is charged by adding the long and short positions in any

given stock and applying a 4% charge against the gross position in the stock.

(This is called the x factor).

Market or systematic risk is reflected in the net long or short position.

The capital charge is 8% against the net position. (This is called the y

factor).

The total capital charge for the stock is the “x factor” plus the “y

factor”.

This approach is crude and does not fully consider the benefits of portfolio

diversification (i.e., that unsystematic risk is not diversified away).


FX Risk

Net exposurei = (FX assetsi - FX liabilitiesi) +

(FX boughti - FX soldi)

= Net foreign assetsi +

Net FX boughti

i = ith currency

Positive net exposure: net long a currency

Negative net exposure: net short a currency

LO 19.1: Describe the different sources of foreign exchange risk exposure

FX Risk

Purchase/sale of foreign currencies

1.To allow customers to participate in international commercial trade transactions

2.To allow customers to take positions in foreign investments (real or financial assets)

3.For hedging purposes—i.e., to offset currency exposure

4.For speculative purposes

LO 19.2: Explain the different types of foreign trading activities and the sources of most profits and losses on foreign exchange trading.

FX RiskLO 19.3: Describe foreign exchange exposure resulting from mismatches between foreign financial asset and liability portfolios, and explain how returns and risks of foreign investing can impact returns.

Assets Liabilities

$100 million, US Loans, US

Dollars

$200 million U.S. Dollars

$100 million equivalent, Foreign

Loans, Foreign Dollars

6



Invest: Lend:

$100.00 $ @ 9% $100.00 $ @ 8%

$100.00 £ @ 15% $100.00 £ @ 11%

$/£

Start $1.60

End $1.45

$100.00 £62.50 $100.00 £62.50

$104.22 £71.88 $100.59 £69.38

4.22% 0.59%

ROA 6.61% COF 4.30%

ROI 2.31%



Invest: Lend:

$100.00 $ @ 9% $100.00 $ @ 8%

$100.00 £ @ 15% $100.00 £ @ 11%

$/£

Start $1.60

End $1.70

$100.00 £62.50 $100.00 £62.50

$122.19 £71.88 $117.94 £69.38

22.19% 17.94%

ROA 15.59% COF 12.97%

ROI 2.63%

FX RiskLO 19.5: Explain off-balance-sheet hedging


Invest: Lend:

$100.00 $ @ 9% $200.00 $ @ 8%

$100.00 £ @ 15% $0.00 £ @ 11%

$/£

Spot $1.60

Discount $0.05

Forward $1.55

$100.00 £62.50

Loan @ 15%

Returned (£) £71.88

Returned ($) $111.41

Loan Return 11.41%

ROA 10.20% COF 8.00%

ROI: 2.20%

FX Risk







7

FX Risk







ei i ir rr i

The nominal interest rate in country The real interest rate in country

The expected one-period inflation rate in country

i

iei

r irr i

i i

Cash flow exposures

Transaction exposure (to a currency) is the exposure due

to holding receivables and payables (in a foreign currency).

Transaction exposure results from past business deals.

Contractual exposure (to a currency) is exposure due to

contractual commitments.

Competitive exposure is when the cash flow is exposed

to a change in the firm's competitive position. Competitive

exposure broadly defined; all firms have competitive exposure.

LO 19.7: Distinguish among transaction exposure, contractual exposure, and competitive exposure to exchange rate fluctuations.

Cash flow exposures

Price risk: unexpected changes in price

Quantity risk: unexpected changes in the exposure

LO 19.8: Explain the interaction of price risk and quantity risk in terms of the additional challenges to hedging using examples of industries where the association between price and quantity of the risky factor is negative and where it is positive.

Cash flow exposuresAssume: For U.S. Company, cost to make widget is $100

U.S. company want to receive $120 per widget (i.e., $20 profit)

Baseline, "Before" the Currency Move

Pegged exchange rate: 7.50 Y Yuan/$

$0.1333 $/Yuan

Price of a Widget (Y) 900.00 Y

Converted ($) $120.00

Two Scenarios:

Yuan Yuan

Appreciates Depreciates

Yuan per 1 US$ 7.00 Y 8.00 Y

US$ per 1 Yuan $0.1429 $0.1250

"Negative" Relationship


Converted to US$: $120.00 $120.00

"Positive" Relationship


Converted to US$: $128.57 $112.50

8


Dollar

Price of Cash flow in Sw. Francs Cash flow in US $

Swiss Pos Neg. Pos Neg.

franc (+) None (-) (+) None (-)

$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75

$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75

$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75

$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75

Average $1.00 $1.25 $1.00 $0.75

Covariance 0.50 0.25 -

Variance 0.25

Hedge Ratio 2.00 1.00 -


Dollar




$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75 ($1.00) ($0.50) - $1.25 $1.75 $0.75

$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75 ($1.00) ($0.50) - $1.25 $0.25 $0.75

$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75 $1.00 $0.50 - $1.25 $1.25 $0.75

$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75 $1.00 $0.50 - $1.25 $0.75 $0.75

$1.00 $1.25 $1.00 $0.75 Average


0.25 Variance


Cash flow exposures

Dollar




$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75 ($1.00) ($0.50) - $1.25 $1.75 $0.75

$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75 ($1.00) ($0.50) - $1.25 $0.25 $0.75

$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75 $1.00 $0.50 - $1.25 $1.25 $0.75

$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75 $1.00 $0.50 - $1.25 $0.75 $0.75

$1.00 $1.25 $1.00 $0.75 Average


0.25 Variance


Positive Correlation (price, quantity): it can be hedged

Negative Correlation (price, quantity): already “naturally” hedged!

No Correlation (price, quantity): “partial” hedge does not totally work

Cash flow exposures

Exposure of cash flow to a specific risk factor is measured by: the change in value of the cash flow (or the fair value of the asset) for a given unit change in the risk factor. Specifically,

LO 19.10: Describe how the exposure of cash flow to a risk factor, such as exchange rate risk, is measured.

Cash flow per unit

Risk factor

Exposure

9

Cash flow exposures

Imperfect (limited) competition = elastic demand

Perfect competition = producer is a “price taker”

who cannot increase prices (i.e., perfectly elastic)

LO 19.11: Using supply (marginal cost) and demand analysis, illustrate

the competitive exposure to exchange rate risk for an exporting firm,

considering changes in (i) exchange rates between the firm’s currency

and the currency of the importing country and (ii) exchange rates

between the currency of a third country (that has exporters that

compete with the firm) and the currency of the importing country.

Cash flow exposures

DDMR

MC

£

Pounds

Q

Quantity @ MR = MC




Price £

Cash flow exposures

DD’

MR’

MC

Q’

Quantity @ MR = MC


£’

Pounds



Price £

Cash flow exposures

DD

DD’

MR’

MR

MC

£

Q’ Q

Quantity @ MR = MC


£’



Price £

10

Cash flow exposures

DDMR

MC

$

Dollars

Q

Quantity @ MR = MC




Price $

Cash flow exposures

DDMR

Q’

Quantity @ MR = MC


Dollars



Price $

MC’

Cash flow exposures

DDMR

MC

$

Q’ Q

Quantity @ MR = MC




Price $

MC’

Cash flow exposures

DD = MR

MC

£

Q

Quantity @ MR = MC


£’



Price £

11

Cash flow exposures

DD’ = MR’

MC

£

Q

Quantity @ MR = MC


£’



Price £

Cash flow exposures

DD =

DD’ = MR’

MR

MC

£

Q

Quantity @ MR = MC


£’



Price £

Cash flow exposures

DD = MR

MC

$

Q’ Q

Quantity @ MR = MC


$’



Price £

Cash flow exposures

DD = MR$

Q’ Q

Quantity @ MR = MC


$’



Price £

MC’

12

Cash flow exposures

DD = MR

MC

$

Q’ Q

Quantity @ MR = MC


$’



Price £

MC’

Cash flow exposuresLO 19.12: Outline the steps in determining cash flow exposure from a pro forma analysis when the correlation of the quantity sold with the risk factor is zero, positive, and negative.

Cash flow Line Item

Base

Case

If we change the risk factor

(scenario-based change to

the risk factor):

Sales (Cash receipts) S +/-S = S Adjusted

Cash Cost of Goods Sold (COGS) - W +/-X = W Adjusted

Cash (SG&A) Expenses - X +/-Y = X Adjusted

Cash Taxes - Y +/-X = Y Adjusted

Net Cash Flow = Z = Z Adjusted

Cash flow exposuresLO 19.13: Explain how the optimal hedge ratio is determined in the context of pro forma cash flow analysis with one risk factor.

cov( , )

var( )

C Gh

G

cov[Cash flow, ]

var( )

Sh

S

Cash flow exposuresLO 19.14: Illustrate the concept of the delta exposure of cash flow, and describe how it is estimated in practice for non-linear exposure to a risk factor.

, , ,i t i i x t i tR R

,

i

i

,

,

firm cash flow or return on securities constant exposure of firm to specified risk factor return of the risk factor error term

i t

x t

i t

R

R

13

Cash flow exposuresLO 19.15: Describe the steps in using Monte Carlo simulation to estimate the volatility-minimizing hedge ratio and the circumstances under which this approach has significant advantages.

Express Cash Flow as function of risk factor(s)

Identify distribution of risk factor

Random number generator: 10,000 random risk factors

Produces 10,000 “simulated” cash flows

Identify specified percentile (95th

percentile, 99th percentile)

Liquidity risk

Funding liquidity risk

Not enough balance sheet cashto fund ongoing operations (or precipitous drop)

Concern of corporate Chief Financial Officer (CFO)

Market liquidity risk

Deterioration in asset value: • Cannot liquidate the position, and/or

• Cannot sufficiently hedge the position

Concern of market traders and market participants

LO 20.1: Explain the interrelationship between funding liquidity risk and market liquidity risk

Liquidity risk

Liquidity gap = Liquid assets minus (–) volatile

liabilities


Liquidity risk

Liquidity risk elasticity (LRE)

Given a small increase in bank’s liquidity premium (LIBOR + spread) on the marginal funding cost Δ net of assets over funded liabilities

A(t), L(t) are current values of assets, liabilities

w is proportion of liabilities funded with the assets

Ξ is the liquidity premium on the firm’s funding cost


NA(t ) A(t ) L(t )w

LRE Limitations: (i) works for small Δ in funding costs, and (ii) assumes parallel shift in funding costs

14

Liquidity risk

Time horizon


Liquidity risk

Time horizon

Asset type


Liquidity risk

Time horizon

Asset type

Asset fungibility


Liquidity risk

Time horizon

Asset type

Asset fungibility


Temporal aggregation (call or continuous)

Dealership structure (decentralized

centralized)


15

Liquidity risk

Time horizon

Asset type

Asset fungibility



Temporal aggregation

(call or continuous)

Dealership structure

(decentralized centralized)

Bid-ask spread

Liquidity risk

Bid–ask spread: price difference between buyers and

sellers of the same asset at the same time


Liquidity risk

Problems with the bid-ask spread:

Assumes trades can be crossed simultaneously

Presumed to reflect a stable market impact function

that relates the cost of the transacting to order size.

Often different sets of bid–ask spreads; may be hard

to know which spread to use


Liquidity risk

j t ,j j j t ,j1LVAR ( ) V [ ( ) S ]

2

LO 20.5: Calculate liquidity-adjusted VAR.

t,j

,

j

S bid-ask spread value of asset mean standard deviation

( ) = confidence parameter

t j

j

V

16


Assume Initial asset value of $100


Spread = 0.2




What is the liquidity-adjusted VAR?




Spread = 0.2




15 100 10 1 645 25 0 22

31 13 10 41 13

jLVAR ( %) [ % ( . )( %) ( . )]

$ . $ $ .

12

j , ,

LVAR ( ) [ ( ) ]t j j j t j

V S

Absolute VAR (Culp’s method)




Spread = 0.2




15 100 1 645 25 0 22

51 13

jLVAR ( %) $ ( . )( %) ( . )

$ .

12

, ,

LVAR ( ) ( )j t j j t j

V S

Relative VAR

Liquidity Risk

Companies can take at least two steps to

minimize liquidity risks:

Diversify liquidity risks across sources

Perform scenario analysis-based planning

LO 20.6: Discuss ways firms can minimize their exposure to liquidity risk.

market risk slides

Documents