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Risk Management

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Title: Risk Management


1
Tools for risk management
  • Zvi Wiener
  • 02-588-3049
  • http//pluto.mscc.huji.ac.il/mswiener/zvi.html

2
Options
  • Call, Put
  • European, American
  • Strike, volatility, time to maturity
  • In-the-money, Out-of-the-money
  • Black-Merton-Scholes
  • OTC and Exotic options

3
Call Value before Expiration
E. Call
X Underlying
4
Put Value before Expiration
5
Other Options
  • Callable bond
  • Warrants
  • Asian, Bermudian, Digital
  • Real options
  • to start a new project
  • to change prices
  • to close some divisions

6
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 ...

7
Call Delta
E. Call
S
8
Put Delta
E. Put
current value
S
9
What type of risk protection would you suggest
for a pension fund?
payoff
floor
Stock market
10
(No Transcript)
11
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

12
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

13
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.
14
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!
15
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?

16
Butterfly2Call(550)-Call(540)-Call(560)
payoff
540 550 560 Stock market
17
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!

18
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!

19
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.

20
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!

21
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.

22
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?

23
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

24
Example
  • Assume that now
  • USD 4 SHEKELS
  • EUR 3.5 SHEKELS
  • rNIS 10
  • rUSD 6
  • rEUR 5

25
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.

26
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.

27
Example
28
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.

29
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?

30
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.

31
pluto.mscc.huji.ac.il/mswiener/
Risk Management resources
  • Useful Internet sites
  • Regulators
  • Insurance Companies
  • Risk Management in SEC reports

32
RMG
  • http//www.riskmetrics.com/
  • http//www.pictureofrisk.com/
  • http//www.riskmetrics.com/rm/splash.html
  • rmgaccess

33
Consulting
  • Oliver, Wyman and Co.
  • Willis Corroon
  • Richard Scora
  • Ernst and Young
  • Enterprise Advisors
  • Kamakura

34
Examples of Risk Reports
  • http//www.pictureofrisk.com
  • http//www.mbrm.com/
  • http//www.riskmetrics.com/rm/splash.html

35
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

36
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

37
SEC reports
  • Edgar
  • Yahoo
  • find symbol
  • profile
  • raw SEC reports
  • market risk in 10K 7A

38
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

39
  • 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/

40
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!

41
Agriculture
  • www.cfonet.com/html/Articles/CFO/1999/99APkita.htm
    l
  • 1998 revenues 1.25B
  • consulting Willis Corroon

42
Nike
  • Salaries are paid in Asia
  • Shoes are sold worldwide
  • Financing comes from USA
  • Marketing, storing, shipping worldwide
  • use VaR since 1998.

43
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

44
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

45
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/

46
Web tour
  • ZW, students, VaR and risk management
  • Gloriamundy
  • GARP
  • SEC reports
  • Google

47
What is more risky and why?
  • A. 1 year bond
  • B. 10 year bond

48
What is more risky and why?
  • A. An in-the-money option?
  • B. An out-of-the-money option?

49
Call Value before Expiration
Call
X Underlying
50
What is more risky and why?
  • A. A fixed interest loan?
  • B. A floater (variable interest rate)?

51
The End
52
Tools
  • Measurement tools
  • Financial tools
  • options
  • forwards, futures
  • swaps
  • insurance
  • Outsourcing

53
Senior Management
Cashflow Capital
54
Important Principles
  • Distinction between risk taking and risk
    control.
  • Backtesting.
  • Transparent reporting.
  • Timing is more important then precision!

55
Basic decisions
  • Goal of Risk Management
  • Base currency
  • Time horizon (embedded options)
  • Economic or Accounting approach
  • Admissible risk
  • Stop losses or other actions

56
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

57
Definition
  • VaR is defined as the predicted worst-case loss
    at a specific confidence level (e.g. 99) over a
    certain period of time.

58
VaR
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