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Financial Risk Management

Financial Risk Management. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Risk. Business Risk Financial Risk market risk credit risk liquidity risk Operational Risk Legal Risk. Risk Management. Examples of good and bad risk management

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Financial Risk Management

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  1. Financial Risk Management Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  2. Feb-2001

  3. Risk • Business Risk • Financial Risk • market risk • credit risk • liquidity risk • Operational Risk • Legal Risk Feb-2001

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. Investec Clali, Jan-01 Client bought put options without sufficient funds. Loss is 8-15M NIS. Feb-2001

  11. Financial Losses • Barings $1.3B • Bank Negara, Malaysia 92 $3B • Banesto, Spain $4.7B • Credit Lyonnais $10B • S&L, U.S.A. $150B • Japan $500B Feb-2001

  12. Value of an Option at Expiration E. Call X Underlying Feb-2001

  13. Call Value before Expiration E. Call X Underlying Feb-2001

  14. E. Call premium X Underlying Call Value before Expiration Feb-2001

  15. Put Value at Expiration E. Put X X Underlying Feb-2001

  16. E. Put X premium X Underlying Put Value before Expiration Feb-2001

  17. 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

  18. 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

  19. Collar payoff payoff K 90 90 100 K stock Feb-2001

  20. 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

  21. Your option Result Sell a call Long term options payoff K 50 k K stock Feb-2001

  22. Example You 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

  23. Result Your option exercise Example payoff K 60 50 10 15 26 Feb-2001

  24. How much can we lose? Everything correct, but useless answer. How much can we lose realistically? Feb-2001

  25. duration, convexity volatility delta, gamma, vega rating target zone What is the current Risk? • Bonds • Stocks • Options • Credit • Forex • Total ? Feb-2001

  26. Standard Approach Feb-2001

  27. Modern Approach Financial Institution Feb-2001

  28. Risk Management • Risk measurement • Reporting to board • Limits monitoring • Diversification, reinsurance • Vetting • Reporting to regulators • Decision making based on risk Feb-2001

  29. Who manages risk? Nike Sony Dell Computers Philip Morris Ford Motor AIG General Re Swiss Re Aetna Zurich Citibank Bank of England CIBC J. P. Morgan Bankers Trust Feb-2001

  30. Regulators • BIS • FSA • SEC • ISDA • FASB • Bank of Israel • Galai’s committee Feb-2001

  31. Basic Steps in RM process • Identify risks • Data base (market + position) • Risk measurement • Regulators • Risk Management • Reporting • Strategic decisions Feb-2001

  32. Building a RM system • Initial study of risks • Decision, Risk Manager • Risk measurement system • Responsibilities and structure • Testing • ActiveRisk Management • Staff training and maintenance Feb-2001

  33. Risk Management andRisk Measurement Feb-2001

  34. Can NOT 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 Feb-2001

  35. Tool, not rule! Limits, Duration, ALM, DFA, VaR Feb-2001

  36. 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

  37. VaR1% 1% Profit/Loss VaR Feb-2001

  38. VaR 1% 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, under normal market conditions. Feb-2001

  39. 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

  40. Current position Market data Risk Mapping Valuation Value-at-Risk Reporting and Risk Management Risk Management Structure Feb-2001

  41. Value dollar Interest Rate interest rates and dollar are NOT independent Feb-2001

  42. 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

  43. 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

  44. 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

  45. Types of Assets and Risks • Real projects - cashflow versus financing • Fixed Income • Optionality • Credit exposure • Legal, operational, authorities Feb-2001

  46. 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

  47. How to measure VaR • Historical Simulations • Variance-Covariance • Monte Carlo • Analytical Methods Feb-2001

  48. 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

  49. 1% of worst cases Returns year Feb-2001

  50. VaR1% 1% Profit/Loss VaR Feb-2001

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