1. Jun-00 Risk Management Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html Tools for risk management

2. Risk Management Tools Jun-2000 slide 2 Tools F Measurement tools F Financial tools – options – forwards, futures – swaps – insurance F Outsourcing

3. Risk Management Tools Jun-2000 slide 3 Senior Management Marketing Finance Supply Cashflow Capital

4. Risk Management Tools Jun-2000 slide 4 Important Principles Distinction between risk taking and risk control. Backtesting. Transparent reporting. Timing is more important then precision!

5. Risk Management Tools Jun-2000 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 Jun-2000 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 Jun-2000 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 Jun-2000 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 Jun-2000 slide 9 Profit/Loss VaR 1% VaR 1%

10. Risk Management Tools Jun-2000 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 Jun-2000 slide 11 Financial Tools F Options F Futures/Forwards F SWAP F FRA F Insurance

12. Risk Management Tools Jun-2000 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 Jun-2000 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 Jun-2000 slide 14 Financial Tools F Options F Futures/Forwards F SWAP F FRA F Insurance

15. Risk Management Tools Jun-2000 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 Jun-2000 slide 16 Forward payoff Forward at maturity Underlying asset

17. Risk Management Tools Jun-2000 slide 17 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!

18. Risk Management Tools Jun-2000 slide 18 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?

19. Risk Management Tools Jun-2000 slide 19 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.

20. Risk Management Tools Jun-2000 slide 20 Forward Price

21. Risk Management Tools Jun-2000 slide 21 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!

22. Risk Management Tools Jun-2000 slide 22 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!

23. Risk Management Tools Jun-2000 slide 23 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.

24. Risk Management Tools Jun-2000 slide 24 Marking to Market Your balance time Maint. margin margin call Initial margin