Title: Risk Management
1Tools for risk management
- Zvi Wiener
- 02-588-3049
- http//pluto.mscc.huji.ac.il/mswiener/zvi.html
2Options
- Call, Put
- European, American
- Strike, volatility, time to maturity
- In-the-money, Out-of-the-money
- Black-Merton-Scholes
- OTC and Exotic options
3Call Value before Expiration
E. Call
X Underlying
4Put Value before Expiration
5Other Options
- Callable bond
- Warrants
- Asian, Bermudian, Digital
- Real options
- to start a new project
- to change prices
- to close some divisions
6Hedge 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 ...
7Call Delta
E. Call
S
8Put Delta
E. Put
current value
S
9What type of risk protection would you suggest
for a pension fund?
payoff
floor
Stock market
10(No Transcript)
11UPC 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
12UPC 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
13UPC
150
After tax capital gain is between 53M and 80M
108
125 153 173 212 UPC share
These options cover 800,000 shares only.
14How 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!
15Risk 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?
16Butterfly2Call(550)-Call(540)-Call(560)
payoff
540 550 560 Stock market
17Hedge 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!
18After 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!
19What 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.
20Hedge 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!
21After 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.
22Example
- 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?
23Example
- 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
24Example
- Assume that now
- USD 4 SHEKELS
- EUR 3.5 SHEKELS
- rNIS 10
- rUSD 6
- rEUR 5
25Example
- 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.
26Example
- 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.
27Example
28Example
- 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.
29Example
- 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?
30How 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.
31pluto.mscc.huji.ac.il/mswiener/
Risk Management resources
- Useful Internet sites
- Regulators
- Insurance Companies
- Risk Management in SEC reports
32RMG
- http//www.riskmetrics.com/
- http//www.pictureofrisk.com/
- http//www.riskmetrics.com/rm/splash.html
- rmgaccess
33Consulting
- Oliver, Wyman and Co.
- Willis Corroon
- Richard Scora
- Ernst and Young
- Enterprise Advisors
- Kamakura
34Examples of Risk Reports
- http//www.pictureofrisk.com
- http//www.mbrm.com/
- http//www.riskmetrics.com/rm/splash.html
35Regulators
- BIS
- G-30
- FSA
- SEC
- market risk disclosure rules
- market risk reporting
- FED, FRB
- our GARP report
- Swiss Central Bank
- Financial Accounting Standards Board
36Who 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
37SEC reports
- Edgar
- Yahoo
- find symbol
- profile
- raw SEC reports
- market risk in 10K 7A
383 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/
40World 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!
41Agriculture
- www.cfonet.com/html/Articles/CFO/1999/99APkita.htm
l - 1998 revenues 1.25B
- consulting Willis Corroon
42Nike
- Salaries are paid in Asia
- Shoes are sold worldwide
- Financing comes from USA
- Marketing, storing, shipping worldwide
- use VaR since 1998.
43Merck
- 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
44Articles
- 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
45Publications
- 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/
46Web tour
- ZW, students, VaR and risk management
- Gloriamundy
- GARP
- SEC reports
- Google
47What is more risky and why?
- A. 1 year bond
- B. 10 year bond
48What is more risky and why?
- A. An in-the-money option?
- B. An out-of-the-money option?
49Call Value before Expiration
Call
X Underlying
50What is more risky and why?
- A. A fixed interest loan?
- B. A floater (variable interest rate)?
51The End
52Tools
- Measurement tools
- Financial tools
- options
- forwards, futures
- swaps
- insurance
- Outsourcing
53 Senior Management
Cashflow Capital
54Important Principles
- Distinction between risk taking and risk
control. - Backtesting.
- Transparent reporting.
- Timing is more important then precision!
55Basic decisions
- Goal of Risk Management
- Base currency
- Time horizon (embedded options)
- Economic or Accounting approach
- Admissible risk
- Stop losses or other actions
56Risk 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
57Definition
- VaR is defined as the predicted worst-case loss
at a specific confidence level (e.g. 99) over a
certain period of time.
58VaR