tools for risk management
DESCRIPTION
Tools for risk management. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Tools. Measurement tools Financial tools options forwards, futures swaps insurance Outsourcing. Finance. Marketing. Supply. Senior Management. Cashflow Capital. - PowerPoint PPT PresentationTRANSCRIPT
FRMBoI-2001
Zvi Wiener
02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Tools for risk management
Zvi Wiener slide 2Risk Management Tools
Tools Measurement tools
Financial tools
– options
– forwards, futures
– swaps
– insurance
Outsourcing
Zvi Wiener slide 3Risk Management Tools
Senior Management
Marketing Finance Supply
Cashflow
Capital
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Important Principles
Distinction between risk taking and risk control.
Backtesting.
Transparent reporting.
Timing is more important then precision!
Zvi Wiener slide 5Risk Management Tools
Basic decisions
Goal of Risk Management
Base currency
Time horizon (embedded options)
Economic or Accounting approach
Admissible risk
Stop losses or other actions
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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
Can NOT
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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
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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 slide 9Risk Management Tools
-3 -2 -1 1 2 3
0.2
0.4
0.6
0.8
1
Profit/Loss
VaR
1% VaR1%
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Benchmarking
Financial assets– create an imaginary portfolio and measure performance relative to this portfolio.
Industry– measure relative to competitors.
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Financial Tools
Options
Futures/Forwards
SWAP
FRA
Insurance
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Derivatives
Contracts that are priced according to underlying variables (prices are derived from underlying).
Options, Futures, Forwards, Swaps, Warrants, etc.
Zvi Wiener slide 13Risk Management Tools
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 slide 14Risk Management Tools
Financial Tools
Options
Futures/Forwards
SWAP
FRA
Insurance
Zvi Wiener slide 15Risk Management Tools
Forward and Futures
Forward agreement
Futures - standard traded contracts
– margin
– mark to market
Final result is very similar
– settlement risk
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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
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Forward/Futuresvalue
spotr
rX
T
USD
NIS
1
1
Spot X $
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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 slide 19Risk Management Tools
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 slide 20Risk Management Tools
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 slide 21Risk Management Tools
Forward Price
TUSD
TNIS
r
rSF
)1(
)1(
Zvi Wiener slide 22Risk Management Tools
Hedge using ForwardCurrent 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 $100.
Forward price is 4.00*1.1/1.06=4.15.
The time match is important!
Zvi Wiener slide 23Risk Management Tools
After a year$ 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 slide 24Risk Management Tools
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 slide 25Risk Management Tools
Marking to Market
Your balance
time
Maint.margin
margin call
Initialmargin
FRMBoI-2001
Zvi Wiener
02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Tools for risk management
Zvi Wiener slide 27Risk Management Tools
Options
Call, Put
European, American
Strike, volatility, time to maturity
In-the-money, Out-of-the-money
Black-Merton-Scholes
OTC and Exotic options
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Call Value before Expiration
E. Call
X Underlying
premium
Zvi Wiener slide 29Risk Management Tools
Put Value before Expiration
E. Put
X Underlying
premium
X
Zvi Wiener slide 30Risk Management Tools
Other Options Callable bond
Warrants
Asian, Bermudian, Digital
Real options
– to start a new project
– to change prices
– to close some divisions
Zvi Wiener slide 31Risk Management Tools
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 ...
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Call Delta
E. Call
S
S
C
current value
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Put Delta
E. Put
S
S
P
current value
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What type of risk protection would you suggest for a pension fund?
payoff
Stock market
floor
Buy index
Buy put
Sell calls
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Buy stock
Sell call
Result
Buy put
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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
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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 slide 38Risk Management Tools
UPC
125 153 173 212 UPC share
108
150
After tax capital gainis between $53M and$80M
These options cover 800,000 shares only.
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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 slide 40Risk Management Tools
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?
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Butterfly2*Call(550)-Call(540)-Call(560)
payoff
540 550 560 Stock market
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Hedge using ForwardCurrent 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 $100.
Forward price is 4.00*1.1/1.06=4.15.
The time match is important!
Zvi Wiener slide 43Risk Management Tools
After a year$ 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 slide 44Risk Management Tools
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 slide 45Risk Management Tools
Hedge using OptionsCurrent 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 $100.
The time match is important!
Zvi Wiener slide 46Risk Management Tools
After a year$ 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 slide 47Risk Management Tools
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 slide 48Risk Management Tools
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:
EURUSDNIS r
EUR
r
USD
r
111
8
Zvi Wiener slide 49Risk Management Tools
Example
EURUSDNIS r
EUR
r
USD
r
111
8
Assume that now
USD = 4 SHEKELS
EUR = 3.5 SHEKELS
rNIS = 10%
rUSD= 6%
rEUR = 5%
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Example
EURUSDNIS r
EUR
r
USD
r
111
8
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.
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Example
EURUSDNIS r
EUR
r
USD
r
111
8
Each time the USD/NIS rate increases by 1 AGORA, our position loses 9,434 NIS.
Each AGORA in Euro exchange rate causes a loss of 9,524 NIS.
Assume that yearly volatility of USD/NIS is 10%, and EUR/NIS is 20%.
Correlation between them -0.1.
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Example
EURUSDNIS r
EUR
r
USD
r
111
8
2.0350524,91.0400434,91.02
)2.0350524,9()1.0400434,9( 222
P
482,732P
595,208,1%5 VaR
Zvi Wiener slide 53Risk Management Tools
Example
The best way to hedge this risk is by forward
contracts that will allow you to exchange the
appropriate amount of foreign currency to
SHEKELS at the rate fixed in advance.
Another alternative is to use static (or better
dynamic) hedge with options.
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Example
Assume that for the following 7 years you
have to pay each year $1M and you will get
each year 5M NIS.
How one can hedge this cash flow?
What if amounts or timing is not precise?
Zvi Wiener slide 55Risk Management Tools
How to hedge financial risk? Static hedge
Forwards agreements that fix the price
Futures
Options static hedge Dynamic delta or vega hedge, with a variable amount of options held. It is applicable if there is a very liquid market and low transaction costs.
Zvi Wiener slide 56Risk Management Tools
pluto.mscc.huji.ac.il/~mswiener/
Useful Internet sites
Regulators
Insurance Companies
Risk Management in SEC reports
Risk Management resources
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RMG
http://www.riskmetrics.com/
http://www.pictureofrisk.com/
http://www.riskmetrics.com/rm/splash.html
rmgaccess
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Consulting
Oliver, Wyman and Co.
Willis Corroon
Richard Scora
Ernst and Young
Enterprise Advisors
Kamakura
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Examples of Risk Reports
http://www.pictureofrisk.com
http://www.mbrm.com/
http://www.riskmetrics.com/rm/splash.html
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Regulators BIS G-30 FSA SEC market risk disclosure rules market risk reporting FED, FRB our GARP report Swiss Central Bank Financial Accounting Standards Board
Zvi Wiener slide 61Risk Management Tools
Who manages risk?
Citibank
Bank of England
CIBC
J. P. Morgan
Bankers Trust
AIG
General Re
Swiss Re
Aetna
Zurich
Nike
Sony
Dell Computers
Philip Morris
Ford Motor
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SEC reports
Edgar
Yahoo
– find symbol
– profile
– raw SEC reports market risk in 10K 7A
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3 methods
Sensitivity
– requires a deep understanding of positions
Tabular
– when there are 1-2 major risk factors
Value-at-Risk
– for active risk management
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KPMG report
Survey of disclosures: SEC Market Risk, 1999
SEC:http://www.sec.gov/smbus/forms/regsk.htm#quan
http://www.sec.gov/rules/othern/derivfaq.htm
GARP
http://www.garp.com/
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World Experience
Bankers Trust, J.P. Morgan, investment banks Bank regulators, commercial banks Insurance, dealers Investment funds (LTCM) Real companies Investors learn to read risk information!
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Agriculture
www.cfonet.com/html/Articles/CFO/1999/99APkita.html
1998 revenues $1.25B
consulting Willis Corroon
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Nike
Salaries are paid in Asia
Shoes are sold worldwide
Financing comes from USA
Marketing, storing, shipping worldwide
use VaR since 1998.
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Merck
http://www.palisade-europe.com/html/Articles/merck.html
http://www.sec.gov/Archives/edgar/data/64978/0000950123-99-005573-index.html see “sensitivity”
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Articles
Value at Risk as a Diagnostic Tool for Corporates: The Airline Industry
http://netec.mcc.ac.uk/WoPEc/data/Papers/dgruvatin19990023.html
Agricultural Applications of Value-at-Risk Analysis: A Perspective
http://netec.mcc.ac.uk/WoPEc/data/Papers/wpawuwpfi9805002.html
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Publications
“The New Risk Management: the Good, the Bad, and the Ugly”, P. Dybvig, W. Marshall
http://dybfin.olin.wustl.edu/research/papers/riskman_fed.pdf
Association for Investment Management and Research
http://www.aimr.org/
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Web tour
ZW, students, VaR and risk management Gloriamundy GARP SEC reports Google
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What is more risky and why?
A. 1 year bond
B. 10 year bond
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What is more risky and why?
A. An in-the-money option?
B. An out-of-the-money option?
Zvi Wiener slide 74Risk Management Tools
Call Value before Expiration
Call
X Underlying
In-the-money option
Out-of-the-money option
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What is more risky and why?
A. A fixed interest loan?
B. A floater (variable interest rate)?
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The End