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Tools for risk management

Tools for risk management

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Tools for risk management

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  1. Tools for risk management Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html BoI-2001

  2. Tools • Measurement tools • Financial tools • options • forwards, futures • swaps • insurance • Outsourcing Zvi Wiener

  3. Finance Marketing Supply Senior Management Cashflow Capital Zvi Wiener

  4. Important Principles Distinction between risk taking and risk control. Backtesting. Transparent reporting. Timing is more important then precision! Zvi Wiener

  5. Basic decisions • Goal of Risk Management • Base currency • Time horizon (embedded options) • Economic or Accounting approach • Admissible risk • Stop losses or other actions Zvi Wiener

  6. 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 Zvi Wiener

  7. 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 Zvi Wiener

  8. Definition VaR is defined as the predicted worst-case loss at a specific confidence level (e.g. 99%) over a certain period of time. Zvi Wiener

  9. VaR1% 1% Profit/Loss VaR Zvi Wiener

  10. Benchmarking • Financial assets • create an imaginary portfolio and measure performance relative to this portfolio. • Industry • measure relative to competitors. Zvi Wiener

  11. Financial Tools • Options • Futures/Forwards • SWAP • FRA • Insurance Zvi Wiener

  12. Derivatives Contracts that are priced according to underlying variables (prices are derived from underlying). Options, Futures, Forwards, Swaps, Warrants, etc. Zvi Wiener

  13. Derivatives Contingent claims gold shipped KTUBA insurance an option not to undertake a project an option to leave an option to change price Zvi Wiener

  14. Financial Tools • Options • Futures/Forwards • SWAP • FRA • Insurance Zvi Wiener

  15. Forward and Futures • Forward agreement • Futures - standard traded contracts • margin • mark to market • Final result is very similar • settlement risk Zvi Wiener

  16. 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 Zvi Wiener

  17. Forward/Futures value Spot X $ Zvi Wiener

  18. 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! Zvi Wiener

  19. 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? Zvi Wiener

  20. 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. Zvi Wiener

  21. Forward Price Zvi Wiener

  22. Hedge using Forward Current 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! Zvi Wiener

  23. 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! Zvi Wiener

  24. 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. Zvi Wiener

  25. Initial margin Maint. margin margin call Marking to Market Your balance time Zvi Wiener

  26. Tools for risk management Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html BoI-2001

  27. Options • Call, Put • European, American • Strike, volatility, time to maturity • In-the-money, Out-of-the-money • Black-Merton-Scholes • OTC and Exotic options Zvi Wiener

  28. premium Call Value before Expiration E. Call X Underlying Zvi Wiener

  29. E. Put X premium X Underlying Put Value before Expiration Zvi Wiener

  30. Other Options • Callable bond • Warrants • Asian, Bermudian, Digital • Real options • to start a new project • to change prices • to close some divisions Zvi Wiener

  31. 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 ... Zvi Wiener

  32. current value Call Delta E. Call S Zvi Wiener

  33. Put Delta E. Put current value S Zvi Wiener

  34. Buy index Buy put Sell calls What type of risk protection would you suggest for a pension fund? payoff floor Stock market Zvi Wiener

  35. Buy stock Result Buy put Sell call Zvi Wiener

  36. 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 Zvi Wiener

  37. 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 Zvi Wiener

  38. UPC 150 After tax capital gain is between $53M and $80M 108 125 153 173 212 UPC share These options cover 800,000 shares only. Zvi Wiener

  39. 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! Zvi Wiener

  40. 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? Zvi Wiener

  41. Butterfly2*Call(550)-Call(540)-Call(560) payoff 540 550 560 Stock market Zvi Wiener

  42. Hedge using Forward Current 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! Zvi Wiener

  43. 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! Zvi Wiener

  44. 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. Zvi Wiener

  45. Hedge using Options Current 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. Buy a put option with strike 4.1 for $100. The time match is important! Zvi Wiener

  46. 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. Zvi Wiener

  47. 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? Zvi Wiener

  48. 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: Zvi Wiener

  49. Example Assume that now USD = 4 SHEKELS EUR = 3.5 SHEKELS rNIS = 10% rUSD= 6% rEUR = 5% Zvi Wiener

  50. Example 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. Zvi Wiener