The new risk management

1. The new risk management The good, the bad, and the ugly

2. SIMPLE INTRODUCTION • Author: Philip H. Dybvig, Pierre Jinghong Liang, and William J.Marshall • Brief Introduction: The authors described the good, the bad, and the ugly features of what they called the new risk management, which means to hedge the risk within the firm by using financial derivatives. • Key word: New Risk Management, Black-scholes Formula, Dynamic Hedge, Accounting Issue

3. index • A. New Risk Management • Tools for the new risk management • Option pricing and risk management • B. Risk Management in Manufacturing • C. Dynamic Hedge • D. Some Fundamental Questions • Why should we hedge • What risk should we hedge • With what instruments should we hedge • E. Accounting Issue • F. Cost Issue • G. Thought about the paper

4. A. New Risk Management • Definition: • Once, risk management meant buying corporate insurance, implementing procedures to avoid lawsuits and accidents, and installing safety equipment. • New risk management focuses on hedging the risk of the firm by trading derivatives. • Risks: • interest rate, input prices and currency fluctuation, etc.

5. A. New Risk Management • Black-Scholes Formula: • Hedging strategy: • An investment policy with an investment equal to the model’s option price and the same terminal value. ( Replication Strategy ) • Aiming at capture its pure economic profit, like insurance

6. B. Risk Management in Manufacturing • Manufacturing Example: • Common One: • Panel A: • Panel B:

7. B. Risk Management in Manufacturing • More then hedged by increased sales:

8. C. Dynamic Hedge • Full hedge by buying options or by dynamic trading in forward or futures contracts.

9. C. Dynamic Hedge • Derivation of dynamic hedge: • No. of contracts in 6 months = Δ( Cash in 1year ) / Δ( price in 1 year) = 6000 / 5 = 1200 So, in 6 months we need to short 1200 contracts. And the calculation at the next-earlier date proceeds in the same way, and so forth back to the start.

10. D. Some Fundamental Questions • First: Why should we hedge • It reduces the volatility of value received by shareholders. However, Majority of shareholders don’t care about additional risk in terms of well-diversified portfolio. Benefit the large shareholders (members of the founding family) at the expense of the rest of the shareholders. Benefit the management who has a significant proportion of their wealth tied up in the firm’s share by reducing the risk that threatens their jobs.

11. D. Some Fundamental Questions • First: Why should we hedge • Failure to do so may cause ancillary damage within the firm. Example 1, deadweight costs to the firm, such as payments to lawyers and accountants and the loss of profitable future projects. Example 2, related tax reason Reduction of risk makes it possible to maintain more leverage to reduce corporate taxes and avoid ’double taxation’ Double taxation: Corporate and personal taxes

12. D. Some Fundamental Questions • First: Why should we hedge • Many firms have a policy of smoothing earnings. Hedging can reduce the volatility of earnings resulting in making management more comfortable and minimizing criticism However, It may discourage profitable innovation, because one related strategy for limiting earnings volatility is to maintain low leverage ( Low tax benefit )

13. D. Some Fundamental Questions • First: Why should we hedge • Making it easier to give managers incentives to produce profits. Ruling out other uncontrollable element. Like the input price, etc.

14. D. Some Fundamental Questions • Second: What risk should we hedge • One certain type: interest rate, • we can hedge the direct interest mismatch of existing assets and liabilities • or we can hedge the full economic value, which would include the value of future business. • Hedge cash flows or value? • If the purpose of hedging is to eliminate sources of noise beyond the manager’s control, accounting number is more appropriate.

15. D. Some Fundamental Questions • Third: With what instruments should we hedge? Common way: investment bank Advantage: expertise Pay attention: understand how the hedge works and how much? Although competition among IB may reduce the cost. And it doesn’t work when hedging is unnecessary.

16. E. Accounting Issue • Hedging accounting is a relatively new and technical area. • Current guide for hedging accounting standards in the U.S—— SFAS No.133 • Two kinds: Fair value hedge and cash flow hedge Fair value hedge: hedge the fluctuation of the fair value of existing assets, liabilities. Cash flow hedge: hedge the fluctuation of the future sales or costs. Several conditions must be met to qualify for CF hedging accounting treatment. The hedge in our example presents an interesting accounting challenge: price risk or quantity risk

17. F. Cost Issue • Cost of any securities purchased in the hedge program. • However, • In practice, the cost includes transaction costs, such as commissions, bid-ask spread, and any internal cost of trading. • Build-in cost • Opportunity cost

18. G. Thought about the paper • Good point: The author uses the manufacturing example showing that the subtle relation in the copper price and unit sold could make the hedging problem totally different. It indicates that we should not blindly hedge but think about these kinds of problem, like over hedging. • Improvement: It will be better that we can do some research about how to develop a set of principle to find the correct hedging method for each situation step by step.

19. Risk Management lessons from the credit crisis • Author: Philippe Jorion, Paul Merage School of Business, University of California at Irvine and Pacific Alternative Asset Management Company(PAAMCO) • Brief Introduction: Risk management, even if flawlessly executed, does not guarantee that big loss will not occur. We can category the risk as known knowns, Known unknowns, unknown unknowns. • Key word: Risk Management, Financial crisis, Risk Models, Stress Test.

20. Risk Management lessons from the credit crisis • PART I. Risk Measurement Systems • From market data, construct the distribution of risk factors. • Collect the portfolio positions and map them onto the risk factors • Use the risk engine to construct the distribution of portfolio profit and loss.

21. Risk Management lessons from the credit crisis • PART I. Risk Measurement Systems • Two measurements: • Returns-based information Easy, cheap to implement, But offer no data for new instruments, markets, and managers. Do not or slow at identifying——style drift. Not reveal hidden risk • Position-based information Fix all these drawbacks However, expensive, ignore dynamic hedge, susceptible to errors in data and models.

22. Risk Management lessons from the credit crisis • PART II. Classification of Risks • Known Knowns Risk manager correctly identifies all the risk factors then properly identifies the distribution of total profits and losses. However losses can still occur due to bad luck and too much exposure(Beta).

23. Risk Management lessons from the credit crisis • PART II. Classification of Risks • Known unknowns Model risk: • ignore important risk factor; • volatilities and correlation measured inaccurately; • mapping process incorrect Example 1: basis trades, basis widened sharply, leading to large mark-to-market losses. Example 2: estimate vol using a fixed 2-year period.

24. Risk Management lessons from the credit crisis • PART II. Classification of Risks • Unknown unknowns regulatory risk, such as sudden restrictions on short sales or structural changes such as the conversion of investment banks to commercial banks.

25. Risk Management lessons from the credit crisis • PART III. Risk management lessons • Lessons for Risk Managers • should be aware of these risk • Should stress test their models, changing the assumptions for the distributions and parameters, vol and correlations. • Prepared to react if they see developing signs of weakness in their model

26. Risk Management lessons from the credit crisis • Lessons for regulators

27. Risk Management lessons from the credit crisis Thought about the paper: • Good point: The author systematically analyzes the credit crisis and talks about all kinds of risks combining with several real event in the financial crisis to support his argument. • Improvement: If the author could use some calculations or talk about some solutions in the unknown unknowns section, it will be more obvious and better for us to understand.