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Risk Management at a Leading Canadian BankAn Actuarial Science Graduate's View

Yu Zhou

Quantitative Analytics, Group Risk ManagementTD Bank Financial Group


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Risk Management at a Leading Canadian Bank:

An Actuarial Science Graduates View

Yu Zhou

Quantitative Analytics, Group Risk ManagementTD Bank Financial Group

4 0t hA c t u a r i a l Re s e a r c h Co n f e r e n c e , M e x i co C i t y

A u g u s t 1 1 - 1 3 , 2 0 0 5


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Ob j e c t i v e s

To review a leading Canadian Banks Enterprise Risk

Management (ERM) framework To provide an overview of the following Risk Management:

Market Risk Credit Risk

Operational Risk To introduce Credit Derivatives

To review Tranched Portfolio Credit Products Credit Default Swaps (CDS)

Credit Derivatives Indices Nth to Default Baskets Collateralized Debt Obligations (CDOs) Single Tranche Trading

CDO of CDOs (CDO Squareds)


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Go a l s o f R i s k M a n a g em e n t

The primary goal of Risk Management is to support the

Banks goal to earn satisfactory returns from our variousbusiness activities within an acceptable level of risk. *

*TD Bank Financial Group Annual Report 2004


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Risk Management

En t e r p r i s e R i s k M a n a g em e n t Th e Fr a m e w o r k

Enterprise risk management is a process, effected by an entitys board of directors,

management and other personnel, applied in strategy setting and across the enterprise,

designed to identify potential events that may affect the entity, and manage risk to be within

its risk appetite, to provide reasonable assurance regarding the achievement of entity

objectives. (COSO* Enterprise Risk Management Integrated Framework)

Strategic Risk

Credit Risk Market Risk Liquidity Risk Operational

Risk

Regulatory &

Legal Risk

Reputational Risk

*COSO Committee of Sponsoring Organizations of the Treadway Commission


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Risk Management

R i s k M a n a g em e n t

The Risk Management function contributes to the Banksuccessfully achieving its business and strategic objectives byproviding oversight and enabling the businesses and corporatesupport functions to effectively manage their risk exposures toan acceptable level.

Risk Management Division is organized around three key riskcategories within the Enterprise Risk Management Framework:

Market Risk

Credit Risk

Operational Risk


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Risk Management

Ma r k e t R i s k

Market risk is the potential for loss from changes in

the value of financial instruments. The value of afinancial instrument can be affected by changes in:

Interest rates;

Foreign exchange rates;

Equity and commodity prices;

Credit spreads.


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Risk Management

Market Risk in Trading Activities

The four main trading activities that expose us to market risk are:

Market-making. We provide markets for a large number of securitiesand other traded products. We keep an inventory of these securities tobuy from and sell to investors, profiting from the spread between bidand ask prices. Profitability is driven by trading volumes.

Sales. We provide a wide variety of financial products to meet the needsof our clients, earning money on these products from mark ups andcommissions. Profitability is driven by sales volumes.

Arbitrage. We take positions in certain markets or products and offsetthe risk in other markets or products. Our knowledge of various

markets and products and how they relate to one another allows us toidentify and benefit from pricing anomalies.

Positioning. We aim to make profits by taking positions in certainfinancial markets in anticipation of changes in those markets. This is the

riskiest of our trading activities and we use it selectively.


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Risk Management

How We Manage Market Risk in Trading Activities

Trading Limits on key measurements of market risk:

- Notional limits

- Credit Spread limits

- Yield Curve shift limits

- Loss exposure limits

- Stop-loss limits

- For options and exotic products, impacts of volatilities, correlations,time-decay

Value at Risk (VaR)

Stress Testing


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Risk Management

How We Manage Market Risk in Trading Activities

Value-at-Risk (VaR)

A value-at-risk (VaR) calculation is aimed at making a statement of theform We areXpercent certain that we will not lose more than Vdollarsin the next Ndays. The variable Vis the VaR,Xis the confidence level,and Nis the time horizon.[1]

Stress Testing: A formalized what if analysis that...Stress testing involves estimating how the portfolio would haveperformed under some of the most extreme market moves seen in thelast 10 to 20 years. It can be considered as a way of taking into accountextreme events that do occur from time to time but that are virtually

impossible according to the probability distributions assumed for marketvariables.[1]


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Risk Management

Cr e d i t R is k

Credit risk is the potential for financial loss if

a borrower or counterparty in a transaction fails tomeet its obligations.


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Risk Management

How We Manage Credit Risk

Setting guidelines to limit portfolio concentrations of creditexposure by country, industry and affiliated group.

Approving the discretionary limits for officers throughout theBank for extending lines of credit.

Setting standards for measuring credit exposure.

Approving the scoring techniques used in extending personalcredit.

Approving all policies relating to all Bank products that entail

credit risk. Setting criteria for rating risk on business accounts, based on a

21-category rating system.


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Risk Management

Op e r a t i o n a l R i s k

Operational risk is the risk of loss resulting from

inadequate or failed internal processes, people andsystems or from external events.


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Risk Management

How We Manage Operational Risk

Establishing the Banks Operational Risk Framework.

Consulting with the regulators on implementation andexamination issues relating to Operational Risk.

Designing and developing the components of the BanksOperational Risk Framework, including: operational risk policy,

identification and assessment process and standards forreporting.

Working with the Business Units and Corporate Groups in afederal model to implement and continuously improve

operational risk management including compliance and fraud.

Oversight of Basel II Program for the Bank.


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Risk Management

Basel II Program

En t e r p r i se Cr e d i t a n d O p e r a t i o n a l R i sk O v e r v i e w

Basel project deliverables will fundamentally change theway the Bank manages and reports risk and capital.

Deliverables:

Qualify for Advanced Internal Risk Based (AIRB) for Credit Riskand Standard Approach (SA) and working towards AdvancedMeasurement Approach (AMA) for Operational Risk.

Credit Risk Projects

Operational Risk Projects

Internal Capital Assessment Projects


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Risk Management

Cr e d i t D e r i v a t i v e s

Credit risk is the risk that an obligor does not honor hispayment obligations.

Credit derivatives are contracts where the payoff depends onthe creditworthiness of one or more commercial or sovereignentities.

A credit derivative is a derivative security that is primarily usedto transfer, hedge or manage credit risk.

A c r e d i t d e r i v a t i v e is a derivative security that has a payoff

which is conditioned on the occurrence of a c r e d i t e v e n t . Thecredit event is defined with respect to a or several r e f e r e n c e c r e d i t ( s ) , and the r e f e r e n c e c r e d i t a ss e t ( s ) issued by thereference credit. If the credit event has occurred, the d e f a u l t p a y m e n t has to be made by one of the counterparties.


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Risk Management

T r a n ch e d Po r t f o l i o Cr e d i t P r o d u c t s

Credit Default Swaps (CDS)

Credit Derivatives Indices Nth to Default Baskets

Collateralized Debt Obligations (CDOs)

Single Tranche Trading

CDO of CDOs (CDO Squareds)


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Risk Management

Cr e d i t D e f a u l t Sw a p T r a d e M e c h a n i c s

(Example: ABC (Baa1/BBB-) Senior Unsecured Default Swap)

Notional: USD 10MMTerm: 5 Years

Buyer Seller

Notional186 bp p.a.

Credit Risk of ABC

Buyer Seller

Delivery of 10MMPrincipal ABC SeniorUnsecured Obligation

$10MM Cash

Occurrence of

a Credit Event(PhysicalSettlement)

Ri k M


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Risk Management

Cr e d i t D e r i v a t i v e s I n d i ce s Dow Jones CDX.NA.IG Index

Dow Jones CDX.NA.IGSingle Name CDS

CDS CDS CDS

CDS CDS CDS

CDS CDS CDS

CDS CDS CDS

CDS CDS CDS

CDS CDS CDS

125 equallyweightednames

Buyer Seller

Notional[] bp

XYZ

Credit Risk of

Buyer Seller

Delivery of10MM PrincipalXYZ Obligation

$10MM Cash

Occurrence of a Credit Event

(Physical settlement)

*Morgan Stanley (2004)

Ri k M t


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Risk Management

D ow Jo n e s CDX .N A . I G

Credit Event on a Reference Entity, $125MM Notional

Buyer Seller

50 bp per annum$125MM

Notification of Credit Event

Buyer Seller$1MM

Buyer Seller

1 Name Defaults

Credit Protection on125 Name CDX

$1MM face amount ofdeliverable obligation

50 bp per annum$124MM

Credit Protection on124 Name CDX


Ri k M t


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Risk Management

N t h t o D e f a u l t B a sk e t s

Similar to CDS, except that the payments are defined with respect toa basket of obligors rather than a single name reference asset.

Default payment is triggered by nth default i.e. the nth credit event.

Risk Management


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Risk Management

Ex am p l e : Fi r s t t o D e f a u l t Sw a p

ReferencePortfolio

Premium payment

Buyer Seller

188 bpson $10MM

VZ24bps$10MM

GECC27bps$10MM

DUKE

32bps$10MM

SPAC118bps$10MM

1st toDefault

2rd to 4th

DefaultFollowing the first credit eventPremium payments is terminated

Buyer Seller

Bond

$10MM


Risk Management


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Risk Management

Ex a m p l e : 2 n d t h r o u g h 4 t h t o D e f a u l t Sw a p

ReferencePortfolio

Premium payment

Buyer Seller

10 bpson $30MM

VZ24bps$10MM

GECC27bps$10MM

DUKE

32bps$10MM

SPAC118bps$10MM

1st toDefault

2rd to 4th

DefaultFollowing each credit event after the first:Notional on premium payment is reducedby $10MM

Buyer Seller

Bond

$10MM


Risk Management


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Risk Management

Co l l a t e r a l i z e d D e b t O b l i g a t i o n s ( CDO s )

A Collateralized Debt Obligation (CDO) is a way of packagingcredit risk.[1]

Tranche 22nd 10% of lossYield=15%

Tranche 1

1st 5% of lossYield=35%

Tranche 4Residual loss

Yield=6%

Tranche 33rd 10% of loss

Yield=7.5%Trust

Bond 1

Bond 2

Bond 3

Bond nAverage

yield8.5%

Risk Management


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Risk Management

Co l l a t e r a l i z e d D e b t O b l i g a t i o n s ( CDO s )

Mezzanine

Equity

SuperSenior

SeniorSPV

Bond 1

Bond 2

Bond 3

Bond n

Risk Management


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Risk Management

CDO o f CDO s ( CDO - s q u a r e d )

Parent CDO of CDOs Tranche

Issuer2Issuer1 Issuer3Child CDO1

TrancheChild CDO2

Tranche

IssuerPool1

IssuerPool2

Risk Management


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g

T r a n ch e d D o w Jo n e s CD X

IndexDow Jones CDX

TranchedDow Jones CDX

CDS CDS CDS

CDS CDS CDS

CDS CDS CDS

CDS CDS CDS

CDS CDS CDS

CDS CDS CDS

125 equallyweighted

names

Super

Senior Tranche

Senior Tranche

Mezzanine

Equity Tranche*Morgan Stanley (2004)

Risk Management


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g

Example of $30 million Notional Transaction in 7 10% Tranche($1 billion notional portfolio, $8 million per name)

As a protection Seller: Counterparty receives 60.5 bps paid quarterly on the Outstanding Notional Amount

Counterparty pays cumulative loss amounts in excess of $70MM, if any, subject to a

maximum of $30MM

As a protection Buyer: Simulates Counterparty pays 63 bps on the Outstanding Notional Amount to the Bank

Counterparty receives cumulative loss amounts in excess of $70MM, if any, subject to a

maximum of $30MMCounterparty Sells Protection Counterparty Buys Protection

Subordination

The Bank $900MM

$30MM

$70MM

60.5bps on$30MM

CreditProtection

on $70thorough$100MM

The Bank $900MM

$30MM

$70MM

63bps on$30MM

CreditProtection

on $70thorough$100MM

Subordination


Risk Management


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V a l u a t i o n o f N t h t o D e f a u l t Sw a p s , CDO s ,

CDO^ 2

Benchmark model: one factor Gaussian model

- Student tcopula

- Clayton copula

- Double tcopula

- Multifactor Gaussian, Marshall-Olkin

- Random factor loadings

Intensity models

Structural models

Monte Carlo Simulation

Risk Management


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Co n c l u s i o n

Risk Management has become an evolving and challengingarea and provides opportunities for both actuaries andfinancial engineers.

Both insurance and banking industries are developingEnterprise Risk Management frameworks and are resolving

risk management issues using their own respectiveperspectives.

Many problems in practice might need combined skills in

actuarial science and financial engineering to be solved.

Risk Management


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Re l a t e d L i t e r a t u r e [1] Hull, J. C. (2002). Options, Futures and Other Derivatives, 5th

edition, Prentice Hall, Upper Saddle River, NJ.

Hull, J. C. (2005). Credit Derivatives Markets.PRMIA/Sungard/Fields/Rotman Meeting.

Hull, J. C., and A. White. Valuation of a CDO and nth to Default CDSWithout Monte Carlo Simulation.Journal of Derivatives, 12, 2:8-23

Nico Meijer (2005). Tranched Portfolio Credit Products.PRMIA/Sungard/Fields/Rotman Meeting.

D.X.Li. On default correlation: a copula function approach.Journal ofFixed Income, 9:43-54

D.X.Li. Valuing Synthetic CDO Tranches Using Copula Function Approach.Presentation in Hong Kong University.

P.J.Schonbucher (2003). Credit Derivatives Pricing Models. JohnWiley&Sons.

X.Burtschell, J.Gregory and J.-P.Laurent. A comparative analysis of CDOpricing models.

Morgan Stanley (2004). An Overview of: Single Name CDS Market andMechanics, The Suite of Dow Jones Credit Derivative Indices, and Nth toDefault Baskets.

TD Bank Financial Group (2005). Annual Report 2004.

Risk Management


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Qu e s t i o n s & Co m m e n t s

Yu Zhou --- Columbia University, USA

[email protected]

05 zhou riskmanagement

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