Financial Risk Management

Zvi Wiener
02-588-3049
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Jan-02 Risk Management
Zvi Wiener Feb-2001 slide 2
 Risk
• Business Risk
• Financial Risk
– market risk
– credit risk
– liquidity risk
• Operational Risk
• Legal Risk

Zvi Wiener Feb-2001 slide 3

 Risk Management

• Examples of good and bad risk management

• Good or bad risk management is NOT the
same as profits and losses.
• There are many examples of good RM that
lead to losses and bad RM that lead to gains.

Zvi Wiener Feb-2001 slide 4

 Barings

• February 26, 1995

• 233 year old bank
• 28 year old Nick Leeson
• $1,300,000,000 loss
• bought by ING for $1.5

Zvi Wiener Feb-2001 slide 5

 Metallgesellshaft
• 14th largest industrial group
• 58,000 employees
• offered long term oil contracts
• hedge by long-term forward contracts
• short term contracts were used (rolling hedge)
• 1993 price fell from $20 to $15
• $1B margin call in cash

Zvi Wiener Feb-2001 slide 6

 Orange County

• Bob Citron, the county treasures

• $7.5B portfolio (schools, cities)
• borrowed $12.5B, invested in 5yr. notes
• interest rates increased
• reported at cost - big mistake!
• realized loss of $1.64B

Zvi Wiener Feb-2001 slide 7

 Public Funds
($ million)
• Orange County1,640
• San Diego 357
• West Virginia 279
• Florida State Treasury 200
• Cuyahoga County 137
• Texas State 55

Zvi Wiener Feb-2001 slide 8

 Derivatives 1993-1995
($ million)
•Shova Shell, Japan 1,580
•Kashima Oil, Japan 1,450
•Metallgesellschaft 1,340
•Barings, U.K. 1,330
•Codelco, Chile 200
•Procter & Gamble, US 157

Zvi Wiener Feb-2001 slide 9

 Investec Clali, Jan-01
Client bought put options without sufficient
funds.
Loss is 8-15M NIS.

Zvi Wiener Feb-2001 slide 10

 Financial Losses
• Barings $1.3B
• Bank Negara, Malaysia 92 $3B
• Banesto, Spain $4.7B
• Credit Lyonnais $10B
• S&L, U.S.A. $150B
• Japan $500B

Zvi Wiener Feb-2001 slide 11

 Value of an Option at Expiration
E. Call

X Underlying

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 Call Value before Expiration
E. Call

X Underlying

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 Call Value before Expiration
E. Call

premium

X Underlying

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 Put Value at Expiration
E. Put

X Underlying

Zvi Wiener Feb-2001 slide 15

 Put Value before Expiration
E. Put

premium

X Underlying

Zvi Wiener Feb-2001 slide 16

 Collar
• Firm B has shares of firm C of value $200M
•They do not want to sell the shares, but need
money.
•Moreover they would like to decrease the
exposure to financial risk.
• How to get it done?

Zvi Wiener Feb-2001 slide 17

 Collar
1. Buy a protective Put option (3y to maturity,
strike = 90% of spot).
2. Sell an out-the-money Call option (3y to
maturity, strike above spot).
3. Take a “cheap” loan at 90% of the current
value.

Zvi Wiener Feb-2001 slide 18

 Collar payoff
payoff
K

90

90 100 K stock

Zvi Wiener Feb-2001 slide 19

 Options in Hi Tech
Many firms give options as a part of
compensation.
There is a vesting period and then there is a
longer time to expiration.
Most employees exercise the options at
vesting with same-day-sale (because of tax).
How this can be improved?

Zvi Wiener Feb-2001 slide 20

 Long term options
payoff
Your option

K
Result

50

k K Sell a call stock

Zvi Wiener Feb-2001 slide 21

 Example
You have 10,000 vested options for 10 years
with strike $5, while the stock is traded at $10.
An immediate exercise will give you $50,000
before tax.
Selling a (covered) call with strike $15 will
give you $60,000 now (assuming interest rate
6% and 50% volatility) and additional profit at
the end of the period!

Zvi Wiener Feb-2001 slide 22

 Example
payoff

Result
K

Your option

60
50
exercise

10 15 26

Zvi Wiener Feb-2001 slide 23

 How much can we lose?
Everything

correct, but useless answer.

How much can we lose realistically?

Zvi Wiener Feb-2001 slide 24

 What is the current Risk?
• Bonds duration, convexity
• Stocks volatility
• Options delta, gamma, vega
• Credit rating
• Forex target zone
• Total ?

Zvi Wiener Feb-2001 slide 25

 Standard Approach

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 Modern Approach

Financial Institution

Zvi Wiener Feb-2001 slide 27

 Risk Management
• Risk measurement
• Reporting to board
• Limits monitoring
• Diversification, reinsurance
• Vetting
• Reporting to regulators
• Decision making based on risk

Zvi Wiener Feb-2001 slide 28

 Who manages risk?
Citibank AIG Nike

Bank of England General Re Sony

CIBC Swiss Re Dell Computers
J. P. Morgan Aetna Philip Morris
Bankers Trust Zurich Ford Motor

Zvi Wiener Feb-2001 slide 29

 Regulators
• BIS
• FSA
• SEC
• ISDA
• FASB
• Bank of Israel
• Galai’s committee
Zvi Wiener Feb-2001 slide 30
 Basic Steps in RM process
• Identify risks
• Data base (market + position)
• Risk measurement
• Regulators
• Risk Management
• Reporting
• Strategic decisions

Zvi Wiener Feb-2001 slide 31

 Building a RM system
• Initial study of risks
• Decision, Risk Manager
• Risk measurement system
• Responsibilities and structure
• Testing
• Active Risk Management
• Staff training and maintenance

Zvi Wiener Feb-2001 slide 32

 Risk Management and
Risk Measurement

Zvi Wiener Feb-2001 slide 33

 Risk Management System Can NOT
• 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 Feb-2001 slide 34

 Tool, not rule!
Limits, Duration, ALM, DFA, VaR

Zvi Wiener Feb-2001 slide 35

 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 Feb-2001 slide 36

 VaR
1

0.8

0.6

0.4
VaR1%
1%
0.2
Profit/Loss

-3 -2 -1 1 2 3

Zvi Wiener Feb-2001 slide 37

 Meaning of VaR
A portfolio manager has a daily VaR equal
$1M at 99% confidence level.

This means that there is only one chance in

100 that a daily loss bigger than $1M occurs,
under normal market conditions.

VaR
1%

Zvi Wiener Feb-2001 slide 38

 History of VaR
• 80’s - major US banks - proprietary
• 93 G-30 recommendations
• 94 - RiskMetrics by J.P.Morgan
• 98 - Basel
• SEC, FSA, ISDA, pension funds, dealers
• Widely used and misused!

Zvi Wiener Feb-2001 slide 39

 Risk Management Structure
Market data Current position

Risk Mapping

Valuation

Value-at-Risk

Reporting and Risk Management

Zvi Wiener Feb-2001 slide 40
 Value
8.25
8 4.3
7.75
7.5 4.25
7.25
10 4.2
11
12 4.15
13 dollar
Interest Rate 14 4.1

interest rates and dollar are

NOT independent
Zvi Wiener Feb-2001 slide 41
 Risk Measuring Software
• CATS, CARMA
• Algorithmics, Risk Watch
• Infinity
• J.P. Morgan, FourFifteen
• FEA, Outlook
• Reuters, Sailfish
• Kamacura
• Bankers Trust, RAROC
• INSSINC, Orchestra

Zvi Wiener Feb-2001 slide 42

 Qualitative Requirements
• An independent risk management unit
• Board of directors involvement
• Internal model as an integral part
• Internal controller and risk model
• Backtesting
• Stress test

Zvi Wiener Feb-2001 slide 43

 Quantitative Requirements
• 99% confidence interval
• 10 business days horizon
• At least one year of historic data
• Data base revised at least every quarter
• All types of risk exposure
• Derivatives

Zvi Wiener Feb-2001 slide 44

 Types of Assets and Risks
• Real projects - cashflow versus financing
• Fixed Income
• Optionality
• Credit exposure
• Legal, operational, authorities

Zvi Wiener Feb-2001 slide 45

 Risk Factors
There are many bonds, stocks and currencies.
The idea is to choose a small set of relevant economic
factors and to map everything on these factors.
• Exchange rates
• Interest rates (for each maturity and indexation)
• Spreads
• Stock indices

Zvi Wiener Feb-2001 slide 46

 How to measure VaR

• Historical Simulations

• Variance-Covariance

• Monte Carlo

• Analytical Methods

Zvi Wiener Feb-2001 slide 47

 Historical Simulations
• Fix current portfolio.
• Pretend that market changes are
similar to those observed in the past.
• Calculate P&L (profit-loss).
• Find the lowest quantile.

Zvi Wiener Feb-2001 slide 48

 Returns

year

1% of worst cases
Zvi Wiener Feb-2001 slide 49
 VaR
1

0.8

0.6

0.4
VaR1%
1%
0.2
Profit/Loss

-3 -2 -1 1 2 3

Zvi Wiener Feb-2001 slide 50

 Weights

Since old observations can be less relevant,

there is a technique that assigns decreasing
weights to older observations. Typically the
decrease is exponential.

See RiskMetrics Technical Document for

details.

Zvi Wiener Feb-2001 slide 51

 Variance Covariance
• Means and covariances of market factors
• Mean and standard deviation of the portfolio
• Delta or Delta-Gamma approximation
• VaR1%= P – 2.33 P
• Based on the normality assumption!

Zvi Wiener Feb-2001 slide 52

Variance-Covariance VaR1%  V  2.33 V

1%
2.33

-2.33 

Zvi Wiener Feb-2001 slide 53

 Monte Carlo
1

0.5

-1 -0.5 0.5 1

-0.5

-1

Zvi Wiener Feb-2001 slide 54

 Monte Carlo
• Distribution of market factors
• Simulation of a large number of events
• P&L for each scenario
• Order the results
• VaR = lowest quantile

Zvi Wiener Feb-2001 slide 55

 Monte Carlo Simulation
15

10

10 20 30 40
-5

-10

-15

Zvi Wiener Feb-2001 slide 56

 Real Projects
Most daily returns are invisible.

Proper financing should be based on risk

exposure of each specific project.

Note that accounting standards not always reflect

financial risk properly.

Zvi Wiener Feb-2001 slide 57

 Example
• You are going to invest in Japan.
• Take a loan in Yen.
• Financial statements will reflect your
investment according to the exchange rate
at the day of investment and your liability
will be linked to yen.
• Actually there is no currency risk.

Zvi Wiener Feb-2001 slide 58

 Airline company
• fuel - oil prices and $
• purchasing airplanes - $ and Euro
• salaries - NIS, some $
• tickets $
• marketing - different currencies
• payments to airports for services

Zvi Wiener Feb-2001 slide 59

 Airline company

• loans
• equity
• callable bonds

Zvi Wiener Feb-2001 slide 60

 Airline company
Base currency - by major stockholder.
Time horizon - by time of possible price change.

Earnings at risk, not value at risk, since there is

too much optionality in setting prices.

One can create a one year cashflow forecast and

measure its sensitivity to different market events.

Zvi Wiener Feb-2001 slide 61

 Reporting

Division of VaR by business units, areas of

activity, counterparty, currency.

Performance measurement - RAROC (Risk

Adjusted Return On Capital).

Zvi Wiener Feb-2001 slide 62

 How VaR is used

• Internal Risk Management

• Reporting
• Regulators

Zvi Wiener Feb-2001 slide 63

 Backtesting
Verification of Risk Management models.
Comparison if the model’s forecast VaR with
the actual outcome - P&L.
Exception occurs when actual loss exceeds
VaR.
After exception - explanation and action.

Zvi Wiener Feb-2001 slide 64

 Backtesting

Green zone - up to 4 exceptions OK

Yellow zone - 5-9 exceptions increasing k
Red zone - 10 exceptions or more intervention

Zvi Wiener Feb-2001 slide 65

 Stress
Designed to estimate potential losses in abnormal
markets.
Extreme events
Fat tails
Central questions:
How much we can lose in a certain scenario?
What event could cause a big loss?

Zvi Wiener Feb-2001 slide 66

 Unifying Approach
• One number
• Based on Statistics
• Portfolio Theory
• Verification
• Widely Accepted
• Easy Comparison

Zvi Wiener Feb-2001 slide 67

 Board of Directors
(Basle, September 1998)
• periodic discussions with management concerning
the effectiveness of the internal control system
• a timely review of evaluations of internal controls
made by management, internal and external auditors
• periodic efforts to ensure that management has
promptly followed up on recommendations and
concerns expressed by auditors and supervisory
authorities on internal control weaknesses
• a periodic review of the appropriateness of the
bank’s strategy and risk limits.

Zvi Wiener Feb-2001 slide 68

 Open Questions
• Risks related to cashflow
• Non-traded assets
• Credit information
• Global Database
• Liquidity problem

Zvi Wiener Feb-2001 slide 69

 Issues Specific to Israel

• Indexation
• Exchange Band
• Shallow Markets

Zvi Wiener Feb-2001 slide 70

 pluto.mscc.huji.ac.il/~mswiener/

Risk Management resources

• Useful Internet sites

• Regulators

• Insurance Companies

• Risk Management in SEC reports

Zvi Wiener Feb-2001 slide 71
Zvi Wiener Feb-2001 slide 72
 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 Feb-2001 slide 73

 RMG

• http://www.riskmetrics.com/

• http://www.pictureofrisk.com/

• http://www.riskmetrics.com/rm/splash.html

• rmgaccess

Zvi Wiener Feb-2001 slide 74

 Consulting
• Oliver, Wyman and Co.
• Willis Corroon
• Richard Scora
• Ernst and Young
• Enterprise Advisors
• Kamakura

Zvi Wiener Feb-2001 slide 75

 Examples of Risk Reports

http://www.pictureofrisk.com
http://www.mbrm.com/
http://www.riskmetrics.com/rm/splash.html

Zvi Wiener Feb-2001 slide 76

 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 Feb-2001 slide 77
 SEC reports
• Edgar
• Yahoo
– find symbol
– profile
– raw SEC reports
 market risk in 10K 7A

Zvi Wiener Feb-2001 slide 78

 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

Zvi Wiener Feb-2001 slide 79

 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/

Zvi Wiener Feb-2001 slide 80

 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!

Zvi Wiener Feb-2001 slide 81

 Agriculture

www.cfonet.com/html/Articles/CFO/1999/99APkita.html

1998 revenues $1.25B

consulting Willis Corroon

Zvi Wiener Feb-2001 slide 82

 Nike
• Salaries are paid in Asia

• Shoes are sold worldwide

• Financing comes from USA

• Marketing, storing, shipping worldwide

use VaR since 1998.

Zvi Wiener Feb-2001 slide 83

 Merck

http://www.palisade-europe.com/html/Articles/merck.html

http://www.sec.gov/Archives/edgar/data/64978/00009501
23-99-005573-index.html see “sensitivity”

Zvi Wiener Feb-2001 slide 84

 Articles
Value at Risk as a Diagnostic Tool for Corporates:
The Airline Industry
http://netec.mcc.ac.uk/WoPEc/data/Papers/dgruvati
n19990023.html

Agricultural Applications of Value-at-Risk

Analysis: A Perspective
http://netec.mcc.ac.uk/WoPEc/data/Papers/wpawu
wpfi9805002.html
Zvi Wiener Feb-2001 slide 85
 Publications
“The New Risk Management: the Good, the Bad,
and the Ugly”, P. Dybvig, W. Marshall
http://dybfin.olin.wustl.edu/research/papers/riskma
n_fed.pdf

Association for Investment Management and

Research
http://www.aimr.org/

Zvi Wiener Feb-2001 slide 86

 Web tour

• ZW, students, VaR and risk management

• Gloriamundy
• GARP
• SEC reports
• Google

Zvi Wiener Feb-2001 slide 87

 What is more risky and why?

A. 1 year bond

B. 10 year bond

Zvi Wiener Feb-2001 slide 88

 What is more risky and why?

A. An in-the-money option?

B. An out-of-the-money option?

Zvi Wiener Feb-2001 slide 89