1. FRM BoI-2001 Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html Tools for risk management

2. Risk Management Tools Zvi Wiener slide 2 Tools F Measurement tools F Financial tools – options – forwards, futures – swaps – insurance F Outsourcing

3. Risk Management Tools Zvi Wiener slide 3 Senior Management Marketing Finance Supply Cashflow Capital

4. Risk Management Tools Zvi Wiener slide 4 Important Principles Distinction between risk taking and risk control. Backtesting. Transparent reporting. Timing is more important then precision!

5. Risk Management Tools Zvi Wiener slide 5 Basic decisions F Goal of Risk Management F Base currency F Time horizon (embedded options) F Economic or Accounting approach F Admissible risk F Stop losses or other actions

6. Risk Management Tools Zvi Wiener slide 6 Risk Management System F Predict future F Identify business opportunities F Be always right! Risk Management System Can F Predict loss, given event F Identify most dangerous scenarios F Recommend how to change risk profile Can NOT

7. Risk Management Tools Zvi Wiener slide 7 Measurement Tools F CATS, CARMA$400K/yr F Algorithmics, Risk Watch>$1M F Infinity>$1M F J.P. Morgan, FourFifteen$25K/yr F FEA, Outlook$18K F Risk Manager, RMG$30K/yr F Theoretics, TARGA$75K F Bankers Trust, RAROC$50K/run F INSSINC, Orchestra$25-75K

8. Risk Management Tools Zvi Wiener slide 8 Definition VaR is defined as the predicted worst-case loss at a specific confidence level (e.g. 99%) over a certain period of time.

9. Risk Management Tools Zvi Wiener slide 9 Profit/Loss VaR 1% VaR 1%

10. Risk Management Tools Zvi Wiener slide 10 Benchmarking F Financial assets – create an imaginary portfolio and measure performance relative to this portfolio. F Industry – measure relative to competitors.

11. Risk Management Tools Zvi Wiener slide 11 Financial Tools F Options F Futures/Forwards F SWAP F FRA F Insurance

12. Risk Management Tools Zvi Wiener slide 12 Derivatives Contracts that are priced according to underlying variables (prices are derived from underlying). Options, Futures, Forwards, Swaps, Warrants, etc.

13. Risk Management Tools Zvi Wiener slide 13 Derivatives Contingent claims gold shipped KTUBA insurance an option not to undertake a project an option to leave an option to change price

14. Risk Management Tools Zvi Wiener slide 14 Financial Tools F Options F Futures/Forwards F SWAP F FRA F Insurance

15. Risk Management Tools Zvi Wiener slide 15 Forward and Futures F Forward agreement F Futures - standard traded contracts – margin – mark to market F Final result is very similar – settlement risk

16. Risk Management Tools Zvi Wiener slide 16 Forward agreement F Is an obligation on both sides F No initial money transfer F Final price is fixed in advance F Typical cash settlement F Margin account and mark to market

17. Risk Management Tools Zvi Wiener slide 17 Forward/Futures value SpotX $

18. Risk Management Tools Zvi Wiener slide 18 Forward Price F Note that forward price is not a price F Forward price does NOT depend on the expected exchange rate. It depends on the current exchange rate and interest rates only! F It is important to chose appropriate time horizon!

19. Risk Management Tools Zvi Wiener slide 19 Forward Price F Consider a NIS/USD forward contract for 10,000 USD to be exchanged in 6 months to NIS according to the forward price. F Current exchange rate is $1=4NIS, – USD interest rate is 6% – NIS interest rate is 10% F How to define the forward rate?

20. Risk Management Tools Zvi Wiener slide 20 Forward Price F Buy 6 month T-bill, $10,000 nominal, it will cost 10,000*4/1.03= 38,835 NIS F Sell 6 month MAKAM, for 38,835 NIS This will guarantee that in 6 months you will receive $10,000 and pay 38,835*1.05 NIS.

21. Risk Management Tools Zvi Wiener slide 21 Forward Price

22. Risk Management Tools Zvi Wiener slide 22 Hedge using Forward Current exchange rate 4.00 USD interest rate6% 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 4.00*1.1/1.06=4.15. The time match is important!

23. Risk Management Tools Zvi Wiener slide 23 After a year $ForwardYour balance 3.9253.9*100-410+25= 5 4.0154.0*100-410+15= 5 4.1 54.1*100-410+ 5 = 5 4.2-54.2*100-410- 5 = 5 4.3-154.3*100-410-15 = 5 Complete protection with no cost!

24. Risk Management Tools Zvi Wiener slide 24 What if there is no perfect time match? F 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. F Do it very carefully! F Or better use OTC, but check prices.

25. Risk Management Tools Zvi Wiener slide 25 Marking to Market Your balance time Maint. margin margin call Initial margin

26. FRM BoI-2001 Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html Tools for risk management

27. Risk Management Tools Zvi Wiener slide 27 Options F Call, Put F European, American F Strike, volatility, time to maturity F In-the-money, Out-of-the-money F Black-Merton-Scholes F OTC and Exotic options

28. Risk Management Tools Zvi Wiener slide 28 Call Value before Expiration E. Call XUnderlying premium

29. Risk Management Tools Zvi Wiener slide 29 Put Value before Expiration E. Put XUnderlying premium X

30. Risk Management Tools Zvi Wiener slide 30 Other Options F Callable bond F Warrants F Asian, Bermudian, Digital F Real options – to start a new project – to change prices – to close some divisions

31. Risk Management Tools Zvi Wiener slide 31 Hedge Ratio = Delta F Delta measures sensitivity of a position relative to a risk factor. F Similar to duration for bonds. F Delta of a call option is … F Delta of a put option is...

32. Risk Management Tools Zvi Wiener slide 32 Call Delta E. Call S current value

33. Risk Management Tools Zvi Wiener slide 33 Put Delta E. Put S current value

34. Risk Management Tools Zvi Wiener slide 34 What type of risk protection would you suggest for a pension fund? payoff Stock market floor Buy index Buy put Sell calls

35. Risk Management Tools Zvi Wiener slide 35 Buy stock Sell call Result Buy put

36. Risk Management Tools Zvi Wiener slide 36 UPC example F Aug 98, a $90M convertible loan to UPC F Feb 99, $49M paid for 1.55M shares (10%) F The share price rose to $162 (5 times) F Four options were used to protect the value

37. Risk Management Tools Zvi Wiener slide 37 UPC example F Buy 2 put options maturing 06-Feb-2002 – put option for 500,000 shares, strike $125 – put option for 300,000 shares, strike $153 F Sell 2 call options maturing 06-Feb-2002 – call option for 500,000 shares, strike $173 – call option for 300,000 shares, strike $212

38. Risk Management Tools Zvi Wiener slide 38 UPC 125153173212UPC share 108 150 After tax capital gain is between $53M and $80M These options cover 800,000 shares only.

39. Risk Management Tools Zvi Wiener slide 39 How much did it cost? F 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!

40. Risk Management Tools Zvi Wiener slide 40 Risk Management Issues F Why only half of the bond was called? F Why only 800,000 shares were protected? F How to choose the protection level? F When does it make sense to hedge?

41. Risk Management Tools Zvi Wiener slide 41 Butterfly 2*Call(550)-Call(540)-Call(560) payoff 540550560Stock market

42. Risk Management Tools Zvi Wiener slide 42 Hedge using Forward Current exchange rate 4.00 USD interest rate6% 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 4.00*1.1/1.06=4.15. The time match is important!

43. Risk Management Tools Zvi Wiener slide 43 After a year $ForwardYour balance 3.9253.9*100-410+25= 5 4.0154.0*100-410+15= 5 4.1 54.1*100-410+ 5 = 5 4.2-54.2*100-410- 5 = 5 4.3-154.3*100-410-15 = 5 Complete protection with no cost!

44. Risk Management Tools Zvi Wiener slide 44 What if there is no perfect time match? F 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. F Do it very carefully! F Or better use OTC, but check prices.

45. Risk Management Tools Zvi Wiener slide 45 Hedge using Options Current exchange rate 4.00 USD interest rate6% 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!

46. Risk Management Tools Zvi Wiener slide 46 After a year $Put Opt.Your balance 3.9203.9*100 - 410 + 20= 0 4.0104.0*100 - 410 + 10= 0 4.1 04.1*100 - 410 + 0 = 0 4.2 04.2*100 - 410 - 0 =10 4.3 04.3*100 - 410 - 0 =20 Protection with some cost! The initial cost of options.

47. Risk Management Tools Zvi Wiener slide 47 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?

48. Risk Management Tools Zvi Wiener slide 48 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:

49. Risk Management Tools Zvi Wiener slide 49 Example Assume that now USD = 4 SHEKELS EUR = 3.5 SHEKELS r NIS = 10% r USD = 6% r EUR = 5%

50. Risk Management Tools Zvi Wiener slide 50 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.

51. Risk Management Tools Zvi Wiener slide 51 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.

52. Risk Management Tools Zvi Wiener slide 52 Example

53. Risk Management Tools Zvi Wiener slide 53 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.

54. Risk Management Tools Zvi Wiener slide 54 Example F Assume that for the following 7 years you have to pay each year $1M and you will get each year 5M NIS. F How one can hedge this cash flow? F What if amounts or timing is not precise?

55. Risk Management Tools Zvi Wiener slide 55 How to hedge financial risk? F Static hedge Forwardsagreements that fix the price Futures Optionsstatic hedge F 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.

56. Risk Management Tools Zvi Wiener slide 56 pluto.mscc.huji.ac.il/~mswiener/ F Useful Internet sites F Regulators F Insurance Companies F Risk Management in SEC reports Risk Management resources

57. Risk Management Tools Zvi Wiener slide 57 RMG F http://www.riskmetrics.com/ F http://www.pictureofrisk.com/ F http://www.riskmetrics.com/rm/splash.html F rmgaccess

58. Risk Management Tools Zvi Wiener slide 58 Consulting F Oliver, Wyman and Co. F Willis Corroon F Richard Scora F Ernst and Young F Enterprise Advisors F Kamakura

59. Risk Management Tools Zvi Wiener slide 59 Examples of Risk Reports http://www.pictureofrisk.com http://www.mbrm.com/ http://www.riskmetrics.com/rm/splash.html

60. Risk Management Tools Zvi Wiener slide 60 Regulators F BIS F G-30 F FSA F SEC F market risk disclosure rules F market risk reporting F FED, FRB F our GARP report F Swiss Central Bank F Financial Accounting Standards Board

61. Risk Management Tools Zvi Wiener slide 61 Who manages risk? Citibank Bank of England CIBC J. P. Morgan Bankers Trust AIG General Re Swiss Re Aetna Zurich Nike Sony Dell Computers Philip Morris Ford Motor

62. Risk Management Tools Zvi Wiener slide 62 SEC reports F Edgar F Yahoo – find symbol – profile – raw SEC reports u market risk in 10K 7A

63. Risk Management Tools Zvi Wiener slide 63 3 methods F Sensitivity – requires a deep understanding of positions F Tabular – when there are 1-2 major risk factors F Value-at-Risk – for active risk management

64. Risk Management Tools Zvi Wiener slide 64 KPMG report Survey of disclosures: SEC Market Risk, 1999 SEC: http://www.sec.gov/smbus/forms/regsk.htm#quan http://www.sec.gov/rules/othern/derivfaq.htm GARP http://www.garp.com/

65. Risk Management Tools Zvi Wiener slide 65 World Experience F Bankers Trust, J.P. Morgan, investment banks F Bank regulators, commercial banks F Insurance, dealers F Investment funds (LTCM) F Real companies F Investors learn to read risk information!

66. Risk Management Tools Zvi Wiener slide 66 Agriculture www.cfonet.com/html/Articles/CFO/1999/99APkita.html 1998 revenues $1.25B consulting Willis Corroon

67. Risk Management Tools Zvi Wiener slide 67 Nike F Salaries are paid in Asia F Shoes are sold worldwide F Financing comes from USA F Marketing, storing, shipping worldwide use VaR since 1998.

68. Risk Management Tools Zvi Wiener slide 68 Merck http://www.palisade-europe.com/html/Articles/merck.html http://www.sec.gov/Archives/edgar/data/64978/000095012 3-99-005573-index.htmlsee “sensitivity”

69. Risk Management Tools Zvi Wiener slide 69 Articles Value at Risk as a Diagnostic Tool for Corporates: The Airline Industry http://netec.mcc.ac.uk/WoPEc/data/Papers/dgruvati n19990023.html Agricultural Applications of Value-at-Risk Analysis: A Perspective http://netec.mcc.ac.uk/WoPEc/data/Papers/wpawu wpfi9805002.html

70. Risk Management Tools Zvi Wiener slide 70 Publications “The New Risk Management: the Good, the Bad, and the Ugly”, P. Dybvig, W. Marshall http://dybfin.olin.wustl.edu/research/papers/riskma n_fed.pdf Association for Investment Management and Research http://www.aimr.org/

71. Risk Management Tools Zvi Wiener slide 71 Web tour F ZW, students, VaR and risk management F Gloriamundy F GARP F SEC reports F Google

72. Risk Management Tools Zvi Wiener slide 72 What is more risky and why? A. 1 year bond B. 10 year bond

73. Risk Management Tools Zvi Wiener slide 73 What is more risky and why? A. An in-the-money option? B. An out-of-the-money option?

74. Risk Management Tools Zvi Wiener slide 74 Call Value before Expiration Call XUnderlying In-the-money option Out-of-the-money option

75. Risk Management Tools Zvi Wiener slide 75 What is more risky and why? A. A fixed interest loan? B. A floater (variable interest rate)?

76. Risk Management Tools Zvi Wiener slide 76 The End