tools for risk management

FRMBoI-2001

Zvi Wiener

02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

Tools for risk management

Zvi Wiener slide 2Risk Management Tools

Tools Measurement tools

Financial tools

– options

– forwards, futures

– swaps

– insurance

Outsourcing


Senior Management

Marketing Finance Supply

Cashflow

Capital


Important Principles

Distinction between risk taking and risk control.

Backtesting.

Transparent reporting.

Timing is more important then precision!


Basic decisions

Goal of Risk Management

Base currency

Time horizon (embedded options)

Economic or Accounting approach

Admissible risk

Stop losses or other actions


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


Measurement Tools CATS, CARMA $400K/yr Algorithmics, Risk Watch >$1M Infinity >$1M J.P. Morgan, FourFifteen $25K/yr FEA, Outlook $18K Risk Manager, RMG $30K/yr Theoretics, TARGA $75K Bankers Trust, RAROC $50K/run INSSINC, Orchestra $25-75K


Definition

VaR is defined as the predicted worst-case

loss at a specific confidence level (e.g. 99%)

over a certain period of time.


-3 -2 -1 1 2 3

0.2

0.4

0.6

0.8

1

Profit/Loss

VaR

1% VaR1%


Benchmarking

Financial assets– create an imaginary portfolio and measure performance relative to this portfolio.

Industry– measure relative to competitors.


Financial Tools

Options

Futures/Forwards

SWAP

FRA

Insurance


Derivatives

Contracts that are priced according to underlying variables (prices are derived from underlying).

Options, Futures, Forwards, Swaps, Warrants, etc.


Derivatives

Contingent claims

gold shipped

KTUBA

insurance

an option not to undertake a project

an option to leave

an option to change price


Financial Tools

Options

Futures/Forwards

SWAP

FRA

Insurance


Forward and Futures

Forward agreement

Futures - standard traded contracts

– margin

– mark to market

Final result is very similar

– settlement risk


Forward agreement

Is an obligation on both sides

No initial money transfer

Final price is fixed in advance

Typical cash settlement

Margin account and mark to market


Forward/Futuresvalue

spotr

rX

T

USD

NIS

1

1

Spot X $


Forward Price

Note that forward price is not a price

Forward price does NOT depend on the

expected exchange rate. It depends on the

current exchange rate and interest rates only!

It is important to chose appropriate time

horizon!


Forward Price

Consider a NIS/USD forward contract for

10,000 USD to be exchanged in 6 months to

NIS according to the forward price.

Current exchange rate is $1=4NIS,

– USD interest rate is 6%

– NIS interest rate is 10%

How to define the forward rate?


Forward Price

Buy 6 month T-bill, $10,000 nominal, it

will cost 10,000*4/1.03= 38,835 NIS

Sell 6 month MAKAM, for 38,835 NIS

This will guarantee that in 6 months you will

receive $10,000 and pay 38,835*1.05 NIS.


Forward Price

TUSD

TNIS

r

rSF

)1(

)1(


Hedge using ForwardCurrent exchange rate 4.00

USD interest rate 6%

NIS interest rate 10%

In a year you will receive $100 and will have to pay 410 NIS.

Enter into a forward for 1 year for $100.

Forward price is 4.00*1.1/1.06=4.15.

The time match is important!


After a year$ Forward Your balance

3.9 25 3.9*100-410+25= 5

4.0 15 4.0*100-410+15= 5

4.1 5 4.1*100-410+ 5 = 5

4.2 -5 4.2*100-410- 5 = 5

4.3 -15 4.3*100-410-15 = 5

Complete protection with no cost!


What if there is no perfect time match?

One can use shorter contracts and roll them

over. This will neutralize completely the

exchange rate risk, but you will have some

interest rate risk.

Do it very carefully!

Or better use OTC, but check prices.


Marking to Market

Your balance

time

Maint.margin

margin call

Initialmargin

FRMBoI-2001

Zvi Wiener

02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

Tools for risk management


Options

Call, Put

European, American

Strike, volatility, time to maturity

In-the-money, Out-of-the-money

Black-Merton-Scholes

OTC and Exotic options


Call Value before Expiration

E. Call

X Underlying

premium


Put Value before Expiration

E. Put

X Underlying

premium

X


Other Options Callable bond

Warrants

Asian, Bermudian, Digital

Real options

– to start a new project

– to change prices

– to close some divisions


Hedge Ratio = Delta

Delta measures sensitivity of a position

relative to a risk factor.

Similar to duration for bonds.

Delta of a call option is …

Delta of a put option is ...


Call Delta

E. Call

S

S

C

current value


Put Delta

E. Put

S

S

P

current value


What type of risk protection would you suggest for a pension fund?

payoff

Stock market

floor

Buy index

Buy put

Sell calls


Buy stock

Sell call

Result

Buy put


UPC example

Aug 98, a $90M convertible loan to UPC

Feb 99, $49M paid for 1.55M shares (10%)

The share price rose to $162 (5 times)

Four options were used to protect the value


UPC example

Buy 2 put options maturing 06-Feb-2002

– put option for 500,000 shares, strike $125

– put option for 300,000 shares, strike $153

Sell 2 call options maturing 06-Feb-2002

– call option for 500,000 shares, strike $173

– call option for 300,000 shares, strike $212


UPC

125 153 173 212 UPC share

108

150

After tax capital gainis between $53M and$80M

These options cover 800,000 shares only.


How much did it cost?

The results are not precise and very sensitive to volatility

– if volatility is 10% $6.5M– if volatility is 20% $10M– if volatility is 30% $13M– if volatility is 40% $15M

This is the amount the bank should pay to DASKASCH!


Risk Management Issues

Why only half of the bond was called?

Why only 800,000 shares were protected?

How to choose the protection level?

When does it make sense to hedge?


Butterfly2*Call(550)-Call(540)-Call(560)

payoff

540 550 560 Stock market


Hedge using ForwardCurrent exchange rate 4.00




Enter into a forward for 1 year for $100.

Forward price is 4.00*1.1/1.06=4.15.



After a year$ Forward Your balance

3.9 25 3.9*100-410+25= 5

4.0 15 4.0*100-410+15= 5

4.1 5 4.1*100-410+ 5 = 5

4.2 -5 4.2*100-410- 5 = 5

4.3 -15 4.3*100-410-15 = 5

Complete protection with no cost!


What if there is no perfect time match?

One can use shorter contracts and roll them

over. This will neutralize completely the

exchange rate risk, but you will have some

interest rate risk.

Do it very carefully!

Or better use OTC, but check prices.


Hedge using OptionsCurrent exchange rate 4.00




Buy a put option with strike 4.1 for $100.



After a year$ Put Opt. Your balance

3.9 20 3.9*100 - 410 + 20= 0

4.0 10 4.0*100 - 410 + 10= 0

4.1 0 4.1*100 - 410 + 0 = 0

4.2 0 4.2*100 - 410 - 0 =10

4.3 0 4.3*100 - 410 - 0 =20

Protection with some cost!

The initial cost of options.


Example

Your company has stable yearly income of

8M (shekels) a year and yearly costs of $1M

and 1M Euro. For simplicity assume that all

payments are on the end of ech calendar year.

How to measure and to manage this risk?


Example

Time horizon – 1 year

Basic currency – SHEKELS

Major risk factors – exchange rates USD,

EUR and interest rates (for all 3 currencies).

The present value of the next cashflow is:

EURUSDNIS r

EUR

r

USD

r

111

8


Example

EURUSDNIS r

EUR

r

USD

r

111

8

Assume that now

USD = 4 SHEKELS

EUR = 3.5 SHEKELS

rNIS = 10%

rUSD= 6%

rEUR = 5%


Example

EURUSDNIS r

EUR

r

USD

r

111

8

The current value of the position is 165,809 NIS.

But this number is subject to the risk factors.

We ignore in this example the interest rates for simplicity.


Example

EURUSDNIS r

EUR

r

USD

r

111

8

Each time the USD/NIS rate increases by 1 AGORA, our position loses 9,434 NIS.

Each AGORA in Euro exchange rate causes a loss of 9,524 NIS.

Assume that yearly volatility of USD/NIS is 10%, and EUR/NIS is 20%.

Correlation between them -0.1.


Example

EURUSDNIS r

EUR

r

USD

r

111

8

2.0350524,91.0400434,91.02

)2.0350524,9()1.0400434,9( 222

P

482,732P

595,208,1%5 VaR


Example

The best way to hedge this risk is by forward

contracts that will allow you to exchange the

appropriate amount of foreign currency to

SHEKELS at the rate fixed in advance.

Another alternative is to use static (or better

dynamic) hedge with options.


Example

Assume that for the following 7 years you

have to pay each year $1M and you will get

each year 5M NIS.

How one can hedge this cash flow?

What if amounts or timing is not precise?


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.


pluto.mscc.huji.ac.il/~mswiener/

Useful Internet sites

Regulators

Insurance Companies

Risk Management in SEC reports

Risk Management resources


RMG

http://www.riskmetrics.com/

http://www.pictureofrisk.com/

http://www.riskmetrics.com/rm/splash.html

rmgaccess


Consulting

Oliver, Wyman and Co.

Willis Corroon

Richard Scora

Ernst and Young

Enterprise Advisors

Kamakura


Examples of Risk Reports

http://www.pictureofrisk.com

http://www.mbrm.com/

http://www.riskmetrics.com/rm/splash.html


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


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


SEC reports

Edgar

Yahoo

– find symbol

– profile

– raw SEC reports market risk in 10K 7A


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


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/


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!


Agriculture

www.cfonet.com/html/Articles/CFO/1999/99APkita.html

1998 revenues $1.25B

consulting Willis Corroon


Nike

Salaries are paid in Asia

Shoes are sold worldwide

Financing comes from USA

Marketing, storing, shipping worldwide

use VaR since 1998.


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”


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


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/


Web tour

ZW, students, VaR and risk management Gloriamundy GARP SEC reports Google


What is more risky and why?

A. 1 year bond

B. 10 year bond



A. An in-the-money option?

B. An out-of-the-money option?


Call Value before Expiration

Call

X Underlying

In-the-money option

Out-of-the-money option



A. A fixed interest loan?

B. A floater (variable interest rate)?


The End

tools for risk management

Documents

risk manager

risk watch

risk control

price forward price

forward rate

risk managementzvi wiener02

forwardcurrent exchange

expected exchange rate