Zvi Wiener

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Tools for risk management

• Zvi Wiener
• 02-588-3049
• http//pluto.mscc.huji.ac.il/mswiener/zvi.html

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Tools

• Measurement tools
• Financial tools
• options
• forwards, futures
• swaps
• insurance
• Outsourcing

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Senior Management
Cashflow Capital
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Important Principles

• Distinction between risk taking and risk
  control.
• Backtesting.
• Transparent reporting.
• Timing is more important then precision!

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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
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

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Measurement Tools

• CATS, CARMA 400K/yr
• Algorithmics, Risk Watch gt1M
• Infinity gt1M
• 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.

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VaR
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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.

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Derivatives

• Contingent claims
• gold shipped
• KTUBA
• insurance
• an option not to undertake a project
• an option to leave
• an option to change price

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Financial Tools

• Options
• Futures/Forwards
• SWAP
• FRA
• Insurance

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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/Futures
value
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!

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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 14NIS,
• USD interest rate is 6
• NIS interest rate is 10
• How to define the forward rate?

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Forward Price

• Buy 6 month T-bill, 10,000 nominal, it will
  cost 10,0004/1.03 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 38,8351.05 NIS.

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Forward Price
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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 4.001.1/1.064.15.
• The time match is important!

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After a year

• Forward Your balance
• 3.9 25 3.9100-41025 5
• 4.0 15 4.0100-41015 5
• 4.1 5 4.1100-410 5 5
• 4.2 -5 4.2100-410- 5 5
• 4.3 -15 4.3100-410-15 5
• Complete protection with no cost!

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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.

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Marking to Market
Your balance
time
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Tools for risk management

• Zvi Wiener
• 02-588-3049
• http//pluto.mscc.huji.ac.il/mswiener/zvi.html

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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
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Put Value before Expiration
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Other Options

• Callable bond
• Warrants
• Asian, Bermudian, Digital
• Real options
• to start a new project
• to change prices
• to close some divisions

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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
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Put Delta
E. Put
current value
S
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What type of risk protection would you suggest
for a pension fund?
payoff
floor
Stock market
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(No Transcript)
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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

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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.
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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!
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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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Butterfly2Call(550)-Call(540)-Call(560)
payoff
540 550 560 Stock market
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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 4.001.1/1.064.15.
• The time match is important!

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After a year

• Forward Your balance
• 3.9 25 3.9100-41025 5
• 4.0 15 4.0100-41015 5
• 4.1 5 4.1100-410 5 5
• 4.2 -5 4.2100-410- 5 5
• 4.3 -15 4.3100-410-15 5
• Complete protection with no cost!

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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.

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!

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After a year

• Put Opt. Your balance
• 3.9 20 3.9100 - 410 20 0
• 4.0 10 4.0100 - 410 10 0
• 4.1 0 4.1100 - 410 0 0
• 4.2 0 4.2100 - 410 - 0 10
• 4.3 0 4.3100 - 410 - 0 20
• Protection with some cost!
• The initial cost of options.

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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?

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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

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Example

• Assume that now
• USD 4 SHEKELS
• EUR 3.5 SHEKELS
• rNIS 10
• rUSD 6
• rEUR 5

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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.

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Example

• 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
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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?

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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.

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pluto.mscc.huji.ac.il/mswiener/
Risk Management resources

• Useful Internet sites
• Regulators
• Insurance Companies
• Risk Management in SEC reports

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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

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Who manages risk?
AIG General Re Swiss Re Aetna Zurich
Nike Sony Dell Computers Philip Morris Ford
Motor

• Citibank
• Bank of England
• CIBC
• J. P. Morgan
• Bankers Trust

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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.htmquan
• 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.htm
  l
• 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/64978/00009
  50123-99-005573-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/dgruvatin
  19990023.html
• Agricultural Applications of Value-at-Risk
  Analysis A Perspective
• http//netec.mcc.ac.uk/WoPEc/data/Papers/wpawuwpfi
  9805002.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/riskm
  an_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?

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Call Value before Expiration
Call
X Underlying
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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