risk management workshop ron d'vari, ph.d., cfa sr. vice president, portfolio manager, and...

State Street Research

Risk Management WorkshopRisk Management Workshop

Ron D'Vari, Ph.D., CFASr. Vice President, Portfolio Manager, and Director of Quantitative Research

State Street Research & Management

Boston Security Analyst Society

October 20, 2000

AgendaAgenda

• Morning Session A: Introduction to Risk Management and Value-at-Risk (VaR)

• Morning Session B: Portfolio VaR and Different Approaches to Measuring VaR

• Afternoon Session A: Risk Management for Derivatives and Using Derivatives

• Afternoon Session B: Risk Management Applications

• Afternoon Session C: Credit Risk Management and Integration of Market and Credit Risk

State Street Research & Management, Ron D’Vari, Ph.D., CFA 2

Introduction to Risk Introduction to Risk Management and Value-at-Risk Management and Value-at-Risk

(VaR)(VaR)


Risks Facing Financial Intermediaries•Lending•Funding and Warehousing•Hedging•Servicing•Securitization•Trading•Operation•Deposit Gathering•Treasury•Capital Market Activities


(VaR)(VaR)


Objectives of Enterprise-Wide Risk Management Balance Sheet Management Performance Measurement Motivation and Compensation Strategic Decision Support

Role of Information Flow and Visibility in Risk Management

Implementation Issues For Transitioning to An Enterprise-wide Risk Management

CultureSystem Information flow and visibilityTrainingManagement Commitment


(VaR)(VaR)


Risk-Adjusted Capital Framework Operational Risk Credit Risk Market Risk

Risk-Adjusted Return on Capital (RAROC) Computation Benefits Limitations


(VaR)(VaR)


Responsibilities of the Risk Manager Understanding the Markets Fixed Income Equity Commodities Foreign Exchange Emerging Markets

Understanding the Businesses Market Making Proprietary Trading Brokerage Underwriting / Syndication Lending Asset Management


(VaR)(VaR)


Risk Management Function• Limit Management Capital Allocation Performance Evaluation Regulatory Capital Requirements Economic Capital Requirements

The Risk Management Cycle Identify Measure Manage Evaluate Improve


(VaR)(VaR)


Risk Management Common Sense Transparency of Risk Professional Judgement Experience

Conventional Market Risk Measures Option Adjusted Duration and Key Rate Durations Beta Historical Volatility Sector Exposure Currency Exposure Market Exposure (by country) Greeks for Derivatives


(VaR)(VaR)


Evolution from Asset Liability Management and ElaborateGuidelines to Value-At-Risk

Single Measure Allows for Integration of Multiple Risks (credit, market,

operation, etc.) Allows for Full Incorporation of Time Variance in Risk

Assessment


(VaR)(VaR)


Comprehensive Methodology for Measuring Market Risk(s) Multi-factor Models for Measuring Investment Portfolio

Risk Performance Measurement and Attribution

Value at Risk Definition and Computation Treatment of Derivatives Different Approaches to Measuring VAR Forecasting Risks and Correlations


(VaR)(VaR)


Credit Risk Management Fundamental and traditional risk measurements

Underwriting standards Rating Categories Due Diligence and Monitoring Portfolio Risk Limits

Average RatingMinimum RatingMaturity

Diversification Risk mitigation (workout)

Option-based Credit Risk Management Expected Default Frequency

Single Name RatingPortfolio VaR

Morning Session BMorning Session BPortfolio VaR and Portfolio VaR and

Different Approaches Different Approaches to Measuring VaRto Measuring VaR


Afternoon Session C: Afternoon Session C: Credit Risk Credit Risk

Management and Management and Integration of Market Integration of Market

and Credit Riskand Credit Risk


Credit DerivativesCredit Derivatives

Most Active Transactions:

• Asset Swap

• Total Return and Index Swap

• Default Swap

Structured Instruments:

• Credit Linked Notes (CLNs)

• Credit Spread Option

• CBOs, CLOs, Synthetic CLOs

• Synthetic Leveraged Loan

• Synthetic Revolving Credit Agreements



Credit Derivative Strategies - Credit Derivative Strategies - BuysideBuyside

• Flexible Credit/Sector Exposure Tailoring

– Access: Sourcing names and maturities not available through cash instrument market

– Flexibility: Uncoupling of interest and credit exposure

• Diversification

• Yield Enhancement

– Exposure to short maturities with low price sensitivity

• Relative Value and Replication

– Cheaper synthetic cash positions

• Hedging

• Leverage or Financing

Buyside ChallengesBuyside Challenges• Internal and External EducationInternal and External Education

• Accurate Portfolio Analytics and Risk ModelsAccurate Portfolio Analytics and Risk Models

• Consistent Framework for Use In Portfolio ContextConsistent Framework for Use In Portfolio Context

• Infrastructure: Compliance, Trading, and Accounting Infrastructure: Compliance, Trading, and Accounting SystemsSystems

• Signing ISDA AgreementsSigning ISDA Agreements

– Several hundred plan sponsors and separate accountsSeveral hundred plan sponsors and separate accounts

– Multiple dealers and banks Multiple dealers and banks

– A dozen custodiansA dozen custodians

– Legal resourcesLegal resources

• Shortcomings of the Standard Representations in ISDAShortcomings of the Standard Representations in ISDA

– Not developed for investment managers acting as agentNot developed for investment managers acting as agent

– Often impossible for managers to makeOften impossible for managers to make

– Requires involvement of plan sponsors and custodiansRequires involvement of plan sponsors and custodiansState Street Research & Management, Ron D’Vari, Ph.D., CFA 16

Portfolio Level Considerations of Credit Portfolio Level Considerations of Credit DerivativesDerivatives

• Besides fundamental analysis of reference credit and counterparty overall portfolio suitability has to be established.

• Optimal allotment of risk budget to credit derivatives– Portfolio’s total risk is budgeted to key active exposures

Level and shape of term structure of interest ratesVolatilitySector/Credit exposures (by sector by credit by

maturity)

• Risk Analysis and Its Transparency – Accurate accounting of credit derivatives in daily and

intraday portfolios’ multi-factor absolute and relative risk reports

– Measure credit, spread change, and structural risks

• Quantitative Relative Value Framework– W.r.t. cash instruments or other forms of risk

• Liquidity and Pricing

• Infrastructure


InfrastructureInfrastructure

• DocumentationDocumentation

• TradingTrading

• Counterparty Risk ManagementCounterparty Risk Management

• Compliance Compliance

• Accounting and Custodial Accounting and Custodial


DocumentationDocumentation

• Limited RecourseLimited Recourse

– Sub-account managed by managerSub-account managed by manager

• Size MattersSize Matters

– No trigger withNo trigger with account size change account size change

– May require lower collateral threshold and minimum transfer May require lower collateral threshold and minimum transfer

• Collateralization Collateralization

– EligibilityEligibility

– Threshold and minimum transfer amountThreshold and minimum transfer amount

• Manager TerminationManager Termination

– Avoid early terminationAvoid early termination through assignment through assignment

• AssignmentAssignment

– Both parties consentBoth parties consent


Understanding Factors Impacting Understanding Factors Impacting PricesPrices

• Changes in Credit Condition

• Credit Spreads in Cash Market

• Cost of Alternatives

• Regulatory Capital Requirements

• General Market Liquidity

• Pricing Models

– Traditional Credit JudgmentTraditional Credit Judgment

– Quality of Historical Default Rates and RecoveriesQuality of Historical Default Rates and Recoveries

– Availability and Quality of Historical SpreadAvailability and Quality of Historical Spread

– Availability of Volatility and Correlation dataAvailability of Volatility and Correlation data

– Credit Default Swap CurvesCredit Default Swap Curves

– Basis Between Credit Swap and Other Credit PoolsBasis Between Credit Swap and Other Credit Pools

– Modeling Tranched Credit and BasketModeling Tranched Credit and Basket


Buyside Use of Various Credit Buyside Use of Various Credit DerivativesDerivatives

Presentation Focus:

• Asset Swap

• Total Return and Index Swap

• Default Swap


Asset SwapAsset Swap

Motivation

• Swap floating assets to fixed or vice versa

• Trade away imbedded options in a bond or layer in options

SSRM Counter Party

Coupon from Bond A

Some Index (Libor, CMT, fixed level etc.)+ Spread

Bond A

Coupon and Principle

Market

Price


Index Total Return SwapIndex Total Return Swap

Motivation

• Adjust exposure without buying or selling individual securities

• Hedging, Relative Value, Market access, Flexibility

• Avoid paying bid-ask spread for a short dated trade

• Get financing (leverage)

SSRM Counter Party

Index Sector Total Return

Libor + Spreador

Total Return of Another Sector

SSRM Holdingsin a Sector

Holdings Total Return

Market

Price


Single Reference-Entity Credit Default Single Reference-Entity Credit Default SwapSwap

• Transfer the credit risk of an issuer (reference entity) from one entity (buyer) to another (seller)

• Seller of protection agrees to buy “obligations” of the reference entity at par in the event of a public notice

• Default event is defined a “publicly available notice” to:

– A payment failure larger or equal than “Payment Requirement” on

– an obligation equal or larger than “Default Requirement”

• Settlement can be “Physical” or “Cash”

• Deliverable obligations can be

– Reference obligation

– Any of Deliverable obligations • According to ISDA it could be any borrowed money: loans,cp, bond, and

bond and loan

• Must be specified in long confirm


Advantages of Default Swap over Short Advantages of Default Swap over Short CorporatesCorporates

• In general they tend to be cheaper than similar cash bond because:In general they tend to be cheaper than similar cash bond because:

– buyers inability to hedge their risk in any other marketbuyers inability to hedge their risk in any other market

(shorting public debt can be quite risky and subject to adverse technicals)(shorting public debt can be quite risky and subject to adverse technicals)

– expensive risk capital charges required against credit riskexpensive risk capital charges required against credit risk

• Increases yield with minimal increase in spread durationIncreases yield with minimal increase in spread duration

– Very attractive break-even cushion against spread wideningVery attractive break-even cushion against spread widening

• Ability to do default swap opens up unique opportunities to tailor credit Ability to do default swap opens up unique opportunities to tailor credit exposure of the portfolio - i.e. take advantage of credit curve steepness (buy exposure of the portfolio - i.e. take advantage of credit curve steepness (buy longer dated cash bonds and roll over short dated credit protection)longer dated cash bonds and roll over short dated credit protection)

• More flexibility - Default swap does not tie up cash to earn spread More flexibility - Default swap does not tie up cash to earn spread

• Allows creating higher information ratio strategies that may be leveraged for Allows creating higher information ratio strategies that may be leveraged for higher returns than similar risk strategieshigher returns than similar risk strategies

• Access to names and maturities that otherwise may not be availableAccess to names and maturities that otherwise may not be available


Pricing MethodologyPricing Methodology


• Method 1: Basis - Asset Swap vs. Default Swap (works only for single name)

• Method 2: Model Loss Distribution

Market Implied Default Probabilities

Credit Spreads Recovery Rates

Asset Correlations

Default Correlations

Simulator

Loss Distribution

Pricing Single-entity Default SwapPricing Single-entity Default Swap• Compare Libor spread of cash bond of the issuer of similar Compare Libor spread of cash bond of the issuer of similar

maturity with the default swap ratematurity with the default swap rate

• Compare all-in yield of a synthetic bond of “Default Compare all-in yield of a synthetic bond of “Default Swap+AAA ABS” with the cash bond Swap+AAA ABS” with the cash bond

• Compare a given spread with valuation based on long-term Compare a given spread with valuation based on long-term default probability and recovery rates based on transition default probability and recovery rates based on transition probability matrix and recovery valueprobability matrix and recovery value

ACCOUNT

Default Option on $10mm TCI

7 ¼ 6/99

COUNTER-PARTY

40BP/Annum

AAA Asset Back Maturing

6/15/99(+20 to 25bp over

Treasury)

Bond $10mm


Transition Probability (S&P Transition Probability (S&P CreditWeekCreditWeek 15 15 April 96)April 96)

IntialRating

Rating At Year-End (% )

AAA AA A BBB BB B CCC D

AAA 90.81 8.33 0.68 0.06 0.12 0.00 0.00 0.00

AA 0.70 90.65 7.79 0.64 0.06 0.14 0.02 0.00

A 0.09 2.27 91.05 5.52 0.74 0.26 0.01 0.06

BBB 0.02 0.33 5.95 86.93 5.30 1.17 0.12 0.18

BB 0.03 0.14 0.67 7.73 80.53 8.84 1.00 1.06

B 0.00 0.11 0.24 0.43 6.48 83.46 4.07 5.20

CCC 0.22 0.0 0.22 1.30 2.38 11.24 64.86 19.79

• Four sources of transition probability matrices: S&P, Moody, CreditMetrix, KMV

•Over 15 years of data with more than 25,000 firm/years of observations, adjusted for “no-longer rated” entities


•Recovery rates (CreditMetrix using several studies)Recovery rates (CreditMetrix using several studies)Seniority Class Mean(% ) Std. Dev. (% )

Senior Secured 53.80 26.86

Senior Unsecured 51.13 25.45

Senior Subordinated 38.52 23.81

Subordinated 32.74 20.18

Junior Subordinated 17.09 10.90

Term 1 3 5 10 15

AAA 0.00 0.07 0.24 1.40 1.40

AA 0.00 0.12 0.43 1.29 1.48

A 0.06 0.27 0.67 2.17 3.00

BBB 0.18 0.72 1.78 4.34 4.70

BB 1.06 6.12 10.97 17.73 19.91

B 5.20 15.95 21.88 29.02 30.65

CCC 19.79 31.63 40.15 45.10 45.10

SSoouurrccee:: SS&&PP CCrreeddiittWWeeeekk 1155 AApprriill 9966

•Average Cumulative Default Rates (%)Average Cumulative Default Rates (%)


•Annual Breakeven Spread

(1-Spread)^n = (1- Cumulative Default Rate * Recovery Rate)

Annual Break-even Spread for Sr. Sec. Class (bp)Term 1 3 5 10 15AAA 0 1 2 6 4AA 0 2 4 6 5A 3 4 6 10 9BBB 8 11 17 20 15BB 49 95 103 85 64B 240 252 211 143 101CCC 914 513 402 231 155

Annual Break-even Spread for Sr. Unsec. Class (bp)Term 1 3 5 10 15AAA 0 1 2 7 5AA 0 2 4 6 5A 3 4 7 11 10BBB 9 12 17 21 15BB 52 101 110 90 68B 254 267 224 152 108CCC 967 544 427 246 165

Annual Break-even Spread for Sr. Sub. Class (bp)Term 1 3 5 10 15AAA 0 1 3 9 6AA 0 2 5 8 6A 4 6 8 13 12BBB 11 15 22 27 20BB 65 127 139 115 87B 320 338 285 195 138CCC 1217 695 551 320 214

Annual Break-even Spread for Sub. Class (bp)Term 1 3 5 10 15AAA 0 2 3 9 6AA 0 3 6 9 7A 4 6 9 15 14BBB 12 16 24 30 21BB 71 139 152 126 95B 350 371 313 215 153CCC 1331 766 610 355 238


Simple Example of Breakeven SpreadsSimple Example of Breakeven Spreads

risk management workshop ron d'vari, ph.d., cfa sr. vice president, portfolio manager, and...

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