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Risk Management: New Approaches

Risk Management: New Approaches. Prof Ian Giddy New York University. Corporate Value at Risk. Position limits vs. “money at risk” Sensitivity of positions to factors How volatile are the factors? What is the 90% range (1.65 std dev.)?

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Risk Management: New Approaches

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  1. Risk Management:New Approaches Prof Ian Giddy New York University

  2. Corporate Value at Risk • Position limits vs. “money at risk” • Sensitivity of positions to factors • How volatile are the factors? What is the 90% range (1.65 std dev.)? • “How much could I lose on my overnight/monthly position?”

  3. Measuring the Volatility of Stand-Alone Positions in Terms of Dollars at Risk Potential loss (X% probability) = Amount at risk * price volatility =Amount at risk * Sensitivity * Adverse price move per period May further take into account time-to-close: in JP Morgan jargon, Dear vs VaR Var = DeaR * p(unwind period)

  4. Measuring Portfolio Exposure The variance of a 2-asset portfolio, : where wAand wBare the weights of A and B in the portfolio. To evaluate the gains and structure of a portfolio, we need a variance-covariance matrix: $ AT RISK VOL. AUD BEF AUD $85,085 2.909 1 BEF $2,607,892 4.573 -0.273 1

  5. Return and Risk, Generalized Portfolio return: where wi are the weights of each asset in the portfolio. (Expected return is simply the weighted sum of the individual asset returns.) Portfolio variance: When i = j, the term wiwjFiFjDijbecomes wi2Fi2.

  6. The Value-At-Risk Approach Applied to Foreign Exchange Risk Management • Defining and measuring foreign exchange risk exposure • Corporate treasury managers often have a bogey to beat: the forward rate • Spot risk and interest-differential risk • Exchange rate shocks and exchange rate volatility. Can abrupt devaluations and government intervention be handled in the value-at-risk framework? • Crossrate volatilities and correlations: can be derived from direct volatilities and correlations

  7. The Idea of Risk: A Corporate Viewpoint Exposure Volatility in the market Deviation from expectations RISK

  8. A Corporate Foreign Exchange Application: Farmco TRANSACTIONS FORECASTS FROM BUSINESS UNITS NET POSITIONS, BY CURRENCY AND MATURITY VALUE AT RISK CONSOLIDATION VOLATILITY AND CORRELATION FORECASTS

  9. Start with the Company’s Worldwide Cash Flow Projections, by Currency... FARMCO CORPORATION, CASH FLOW PROJECTIONS 1st Quarter 2nd Quarter CURRENCY In Out In Out AUD $0 $0 $0 $0 BEF $4,659 $2,341 $4,854 $2,556 CAD $76,083 $23,001 $80,237 $24,665 $477 DKK $1,280 $546 $1,456 $11005 FFR $33,788 $10,980 $41,578 $29,890 DEM $2,300 $34,567 $1,207 $5561 ITL $29,800 $4,587 $32,459 JPY ($1523) NLG $405 ESB $5,623 SEK $6789 CHF $1,522 GBP ($10,200)

  10. ...Consolidate the Data to a Managable Set

  11. Get Volatility and Correlation Data from the RiskMetrics Web Site... On the World Wide Web, RiskMetrics data may be found at: http://www.riskmetrics.reuters.com

  12. ...to Produce a Correlation Matrix, and...

  13. ...Find Corporate Value at Risk for Farmco

  14. Corporate Value at Risk: Farmco WITH DIVERSIFICATION

  15. A Graphic Interpretation LESS THAN 5% CHANCE LOSS EXCEEDS $10M

  16. The Next Step: Efficient Hedging

  17. Efficient Hedging, Constrained

  18. Application • Farmco is one of the world's largest agricultural equipment manufacturers, with $6 billion in sales in 1994. In December 1994 the Treasury department at Farmco's Atlanta headquarters was concerned about a report from the audit department that showed an exposure to potential foreign exchange losses. The positions were reported to be as on the next page. • Treasury argued that the net exposure was trivial and that it would be too costly to hedge everything. Although the net amount as reported looked small, management was concerned with knowing how much could be lost on these positions before the end-of-December reporting date, and what could be done to reduce losses to a level that would be considered "not material" by the company's external auditors. • Use the Value at Risk demo software to provide Farmco with a report on their exposure to the risk of market rate and price movements, and a proposed hedging strategy. (No “overhedging,” and no forward contracts in krone or pesetas.)

  19. Farmco Assignment

  20. Summary of “Value at Risk” Reporting “At close of business each day tell me what the market risks are across all businesses and locations.” Dennis Weatherstone, JP Morgan Logical steps: • Economic-value accounting (need market prices or models) • Market-price based performance measurement • Volatilities and correlations of market prices • Management of risk • Optimization of hedging

  21. Value at Risk: Assessment Value at Risk and RiskMetrics: • A method for quantifying risk in dynamic, uncertain environments • Based on the observation that volatilities and correlations are somewhat persistent • The RiskMetrics estimates are in the ballpark of other, more sophisticated, methods

  22. Value at Risk: Pitfalls • A single number, like VaR, cannot replace a complete description of possibilities • The method is backward-looking, and ignores qualitative factors to which markets react • The probability and magnitude of large moves may be understated • Estimated correlations may not tell us how markets will interact during extreme conditions • Nonlinear derivatives may have • changing sensitivity to factors.

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