Zvi Wiener

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RM functions

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

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Structuring RM functions

• Set firm-wide policies
• Develop methodology
• Set RM structure
• Risk communication

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Active Risk Management
Allocate capital
Stress Market, Credit VaR
Monitor
Identify and avoid
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RAROC

• Risk Adjusted Rate of Return
• Performance measurement
• Marginal impact of any new transaction
• Consistent pricing

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New Approach

• Three pillars
• A. Minimum Capital Requirement
• B. Supervisory Review Process
• C. Market Discipline Requirements

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Goals and Instruments

• Risk Tolerance - worst loss
• Stop losses
• Capital allocation
• Credit risk policy
• Operational risk policy

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Risk Measurement

• Consistent market based method
• Old
• limits
• duration, ALM
• VaR Stress
• Backtesting

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Systems

• Data bases
• market
• position
• rules
• Risk measuring tool
• Reports and decision support

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IT - Information Technology

• Unifying information from various units
• Unifying information from various markets
• Unifying information for various ownership
• Back office and execution control

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Organizational structure

• Front office
• Middle office
• Back office

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Front office

• execution
• risk taking
• marketing

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Middle office

• risk management
• pricing
• economic forecasts

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Back office

• verification
• booking
• reporting
• collection
• settlement

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ALCO

• Assets Liability management committee
• responsible for
• establishing
• documenting
• enforcing all policies involving market risk
• FX
• liquidity
• interest rate

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Interdependence of RM
Trading Room
Senior Management
Operations
Risk Management
Finance
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Senior management

• Approves business plan and targets
• Sets risk tolerance
• Establishes policy
• Ensures performance

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Trading Room Management

• Establishes and manages risk exposure
• Ensures timely and accurate deal capture
• Signs off on official PL

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Operations

• Books and settles the trades
• Reconciles front and back office positions
• Prepares and decomposes daily PL
• Provides independent MTM
• Supports business needs

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Finance

• Develops valuation and finance policy
• Ensures integrity of PL
• Manages business planning process
• Supports business needs

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Risk Management

• Develops risk policies
• Monitors compliance to limits
• Manages ALCO process
• Vets models and spreadsheets
• Provides independent view on risk
• Supports business needs

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Risk Limits

• Global risk limit
• Risk limits for trading desks/units
• Dynamic monitoring and adjustment

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Risk Approaches

• Accounting - reported PL
• Economic - value
• Liquidity needs

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Liquidity Rank

• Based on forecasts and potential availability of
  funds.
• Hot funds - can be withdrawn quickly.
• Stable funds - typically to maturity.

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Israel 339

• Definitions of risk types
• Relates to all banking institutions
• Management structure
• Exposure document
• Directors and policy
• Risk manager
• Internal audit

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Israel 339

• IR risk
• Market risk
• Risk audit unit

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Israel 341

• Capital requirements against market risk
• Risk measurement
• Trading portfolio
• Reporting
• Examples of standard approach and VaR

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Israel 341

• Capital requirements against market risk
• Risk measurement
• Trading portfolio
• Reporting
• Examples of standard approach and VaR

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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

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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

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Types of Assets and Risks

• Real projects - cashflow versus financing
• Fixed Income
• Optionality
• Credit exposure
• Legal, operational, authorities

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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

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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
  banks strategy and risk limits.

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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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Options

• Put or Call
• European or American
• Underlying asset
• Strike price
• Premium
• Time to maturity
• Hedge ratio

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Call Option
value
X underlying
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Hedge Ratio
value
X underlying
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Put Option
value
X underlying
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Exotic Options

• Asian
• Path dependent
• Digital
• Bermudian
• Knock-in, out
• Exchange of assets
• Swaptions

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Swap

• currency or interest rate
• two loans with swapped payments
• low credit risk
• changes exposure
• currency
• duration

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Structured Note

• tailor made solution
• for example, IO, PO
• higher priority obligations or junk
• collar, IAS, ratchet, etc.

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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?

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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.

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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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New proposals

• BIS 2000
• VaR based approach to credit risk.
• CreditMetrics
• CreditRisk
• KMV
• Merton.

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What is the current Risk?

• duration, convexity
• volatility
• delta, gamma, vega
• rating
• target zone

• Bonds
• Stocks
• Options
• Credit
• Forex

• Total ?

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Standard Approach
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Modern Approach
Financial Institution