2Lecture Topics This session will cover: Basics of financial markets and financial riskMarket risk concepts:Risk factorsRisk measures: Greeks, VaR, stress testsHedgingRole of regulation
3Basics of Financial Markets If you were given $ where would you invest?
4Basics of Financial Markets Participants:Corporations – to raise capital, buy/sell their inputs/outputs, acquire assets or competitors, hedge their risksGovernments – to raise capital, stabilize and stimulate the marketsBanks – to facilitate transactions between other participants at a profitPension funds and insurance companies – for long term investmentsOther funds and individuals – usually for speculationQ:
5Basics of Financial Markets (2) Main markets and products:Equity – stocks, optionsInterest Rate Products (IRP) – government bonds, forward rate agreements, swapsCredit – corporate bonds, credit default swaps, collateralized debt obligationsForeign Exchange (FX) – spot currency, forwards, optionsCommodities – futures, forwards, swaps, optionsIf you got $100M – where would you invest and why?
6Basics of Financial Markets (3) Methods of trading:Exchanges – rules of trade are defined and contracts are standardized; prices are public for all contractsOver the Counter (OTC) – rules depend on the agreement between the counterparties and contracts do not have to be standardized; prices are not disclosed
7Financial RiskIf you invested $ – what are the risks that you are running?
8Basics of Financial Risk Liquidity RiskReputational RiskMarket RiskFinancial Risk*Definitions from Wikipedia.What is the most important one? (Depends on who you are)Which one makes financial institutions fail? (Liquidity)Which one is hardest to recover from? (Reputational)With all this risk – why invest at all? (No risk – no profits)Operational RiskCredit Risk
9Basics of Financial Risk - Liquidity Liquidity Risk - is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss or make the required profitMajor reason why banks and financial institutions fail (default or go bankrupt) is because they run out of liquid assets (cash, government bonds) and are unable to meet the current obligations. Failure to pay leads to a default.A corporation can have a positive net worth and still defaultDefault – failure to make payments on timeBankruptcy - A legal proceeding involving a person or business that is unable to repay outstanding debts. All of the debtor's assets are measured and evaluated, whereupon the assets are used to repay a portion of outstanding debtDEFAULT
10Basics of Financial Risk – Market Risk Market Risk - is the risk of losses in positions arising from movements in market prices*Taken from Google FinanceWhich investment is more risky – NASDAQ Index or Apple?Which strategy here is a clear money-maker for investment starting in May’12?
11Basics of Financial Risk - Credit Credit Risk – is the risk of a borrower failing to make obligated payments on time and the risk of a borrower reducing ability to make payments in the futureCredit ratings are the most basic form of credit risk assessment. Companies providing credit ratings like Standard & Poor’s, Moody’s and Fitch use historical default statistics with balance sheet analysis. This is backward looking approach.Using information from the CDS market (if available) is forward looking and represents what market participants think is the probability of default on debt for a particular company.*Definitions from Wikipedia.Left graph – 2008 crisis in USARight graph – Greeces “Restructuring Credit Event“ which was a practical default
12Basics of Financial Risk – Operational Risk Event CategoriesInternal FraudExternal FraudEmployment PracticesClients, Products and Business PracticesDamage to Physical AssetsBusiness Disruption & System FailuresExecution, Delivery and Process ManagementOperational Risk - the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events*Definitions from Basel II Committee. (http://en.wikipedia.org/wiki/Operational_risk)
13Basics of Financial Risk – Reputational Risk Reputational Risk - risk related to the trustworthiness of business and ability to keep existing and attract new clients*Articles taken from Bloomberg and WSJWould you do business with a bank that has just been charged of rigging rates? (Yes, you would.)
14Basics of Financial Risk – Example You are an EUR-based investor.You buy an at-the-money European call option on BP (British Petroleum) on NYSEYou sell an at-the-money European put option on BP to CitiBank over the counterWhat risks are you running?Market:Equity – on BP spot price movesInterest Rates – option is priced using discounting of cash flows, so interest rates move the option priceCommodity (indirect) – BP spot price is highly correlated to oil pricesCredit – CitiBank may not be able to pay on expiry if your option is in the money and they are in defaultLiquidity – you need to fund your positionOperational – always present with any transactionReputational – Depends on the situation. Why are you buying BP?
16Who is exposed to Market Risk? Every investor, producer and consumer is exposed to market risk (to a different degree)Example:You are a Serbian producer of X using local resources and local labour.Your major competitor is in China, and he produces X at a 50% lower price including transport.You are competing in the Serbian market and your competitor starts taking over market share.What do you do?Price war – you lower your prices and sell at a loss until you drive the competition out, but you may go bankrupt in the processBuy your competitor – you will put on a large amount of debt or risk your own fundsTry to negotiate – competitor must agree for you to be the distributor; you can start a monopoly or price fixing which causes legal issuesSell your business and close the shop – the last resort of any entrepreneurAlternatives?What your competitor is doing is using weak CNY (Chinese Yuan) against RSD (Serbian Dinar) rates to make his product a lot cheaper in RSD terms. As long as CNY is relatively weak, he can continue selling in RSD market at low prices.If CNY gets stronger, it will take more RSD to buy each product from China and consequently it will make all products from China relatively more expensive.Your strategy:If CNY gets weaker, you will lose more market share. You buy put options on CNY and make money to compensate for losing the market share. You use that money to buy from your competitor and re-sell locally to keep the business going.Ideally, you would buy the put option before the competitor enters the market.If CNY gets stronger, you will regain market share and competition goes away. You lose the premium you paid on the put option but your business is still open and making profits.
17Market Risk - Background Why do we care about market risk?We want to know how much money we can lose each dayso we can hedge the exposures we are not comfortable with(and hope that our calculations are right!)Evolution of market risk:ExposureGreeks (Delta, Gamma, Vega, Theta...)VaR and Stress testMajor assumptions:Historical moves are a good indicator of future movesMarkets are efficient and pricing instruments correctlyHistorical moves: “‘Seeing things that were 25-standard deviation events, several days in a row’. A 25-standard deviation event is, as every statistician knows, something that only happens once in every 100,000 years.”*taken fromAre we delusional? YES!The ‘better than average driver test’‘This time it’s different’
18Main Risk Factors – Spot and Forward Price Spot Price: The current price at which a particular security can be bought or sold at a specified time and place.Forward Price: The predetermined delivery price for an underlying commodity, currency or financial asset decided upon by the buyer and the seller to be paid at predetermined date in the future.ExxonMobil Corporation (NYSE:XOM) stock price May 2012 – May 2013*Definitions from Investopedia.*Graph from Google FinanceDoes anyone know why ExxonMobil was selected?ExxonMobil is the world's largest company by revenue and in 2013, became the largest publicly traded company by market capitalization in the worldMkt cap B
19Main Risk Factors – Volatility Volatility is commonly expressed through standard deviation of returns assuming Normal Distribution. It is used for pricing options using Black-Sholes and other pricing models and for pricing other derivatives.Historical volatility takes the actual returns of an asset during a defined period (i.e. a year) and it is backward-looking.Implied volatility is taken from the markets by using market option prices and back-solving for volatility. It is forward-looking from market expectation.Black-Scholes pricing formula of a European call option premium:*Formula and graph taken from Wikipedia.
20Main Risk Factors – Correlations “Don’t put all eggs in one basket”Diversification helps improve portfolio performance by reducing the risk on same expected returnsCorrelations are not constant. They change the risk and return of portfolio.Correlations increase in the times of financial stress and crises.*Taken from
21Risk Measures - Exposure Quantity: Knowing the quantities of each financial instrument in the portfolio is the first step in the valuation.Price: Price of each instrument can be determined from the published market prices where these are available (i.e. Price of IBM stock can be read from the exchange) or by using the pricing model to determine the theoretical price.Total portfolio value is determined by calculating Price * Quantity for each instrument in the portfolioQuantity may not be trivial if
22Risk Measures - GreeksRisk measures that describe how much a portfolio value changes when the underlying risk factor changes by a set value. They are used by traders to asses their positions (exposures) and risk.Delta: Change in portfolio value if a stock increases price by 1$.Gama: Change in Delta if a stock increases price by 1$.Vega: Change in portfolio value for a 1 percentage point increase in VolatilityTheta: Change in portfolio value for a 1 day change in time.Greeks give a good linear approximation of changes in portfolio value for linear instruments and for smaller market moves.
23Risk Measures - VaRValue at Risk or VaR is a statistical measure of how much money can be lost on a portfolio in given period of time with a given confidence level.What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next month?If 95% 1-day VaR of your portfolio is $100k, it means that:statistically in the next 95 out of 100 days your losses will be limited to $100kstatistically in the next 5 out of 100 days you will lose more than $100kSimple formula to calculate linear VaR based on the Normal distribution:σ is the standard deviation of portfolio returnsMV is the market value of portfolio*Graph taken from Investopedia
24Risk Measures – VaR (2)VaR can be back-tested to measure the quality of profit and loss (PnL) estimation.The number of VaR breaches is compared to the confidence level on the period:I.e. You expect to have 5 breaches in any 100-day period for the below graph*Graph taken from Investopedia
25Risk Measures – Stress Testing Stress tests are ‘what-if’ analysis tools which show the impact of changes in risk factors to the value of the portfolioTypically, there are two types of stress tests that financial institutions run:Sensitivity test: focuses on a single risk factor and explains pre-defined movements. I.e. How much does portfolio value change if USD/EUR changes +5%, -5%, +10%, -10%, etc.Scenario test: focuses on multiple risk factors and explains custom movements. I.e. How much does portfolio value change if market crash of 2008 would happen again in the next month*Table taken from “MARKET RISK STRESS TESTING FOR INTERNATIONALLY ACTIVE FINANCIAL INSTITUTIONS” (Petar Marković and Branko Urošević)
26Hedging Market Risk Ways to change market risk exposure: Change exposure – buy or sell the assets to change the risk. Selling your portfolio in the market and converting it into cash removes almost all market risk.Hedge – you pay (or receive) the premium for hedging the risk. Typical instruments used are options for Equities, FX, Commodities and IRP and credit default swaps in CreditConvert – enter into a swap, go into a structured trade which removes one exposure and replaces it with another one (long and short) or make an opposite position in a correlated assetA bank will always run market risk as a nature of the business. The efficiency and cost of hedges will determine the profitability.A corporation should hold only the market risk related to it’s operations.Which risk are you running when you hold cash? – Inflation!Hedging – draw the payout of an option to show the effect.Conversion – instead of holding cash, you can pay fix + LIBOR to get almost any exposuure – equity, credit, commodity, etc.
27Role of RegulatorsMarket stability and (de)stimulation – regulations are put in place to reduce excessive risk taking and prevent large company failures; regulations can stimulate or de-stimulate the marketsDisclosure of positions and risks – companies are mandated by law to disclose significant and large investments to the publicEnforcement of risk limits – companies pay penalties and publicly disclose breaches of risk limits (loss of reputation)Bureaucracy – the cost of regulation to the companies significantGive me an example of why you would want to de-stimulate the market
28Popular Media Movies: Margin Call (2011) Too Big to Fail (2011) Wall Street (1987, 2010)Inside Job (2010)Books:“The Big Short: Inside the Doomsday Machine “, Michael Lewis (2010),“When Genius Failed: The Rise and Fall of Long-Term Capital Management”, Roger Lowenstein (2001)“Liar’s Poker”, Michael Lewis (1989)Watch the movies, get interested, google, use wikipedia!
29Professional Literature Market risk:“Market Risk Management”, David C. Shimko, Peter Went, GARP (2010)“Risk Management and Financial Institutions”, John Hull (2012)“Elements of Financial Risk Management”, Peter F. Christoffersen (2011)Financial basics:“Options, Futures, and Other Derivatives “, John C. Hull, (2011)“Elements of Financial Risk Management” – very useful for understanding beyond the basics.“Options, Futures, and Other Derivatives “ is a bible and everyone should read it if they are working in the financial industry.