2. Risk Management: New Approaches
Prof Ian Giddy
New York University

3. Corporate Value at Risk
Position limits vs. “money at risk”
Sensitivity of positions to factors
How volatile are the factors? What is the 90% range (1.65 std dev.)?
“How much could I lose on my overnight/monthly position?”

4. Measuring the Volatility of Stand-Alone Positions in Terms of Dollars at Risk
Potential loss (X% probability)
= Amount at risk * price volatility
=Amount at risk * Sensitivity * Adverse price move per period
May further take into account time-to-close: in JP Morgan jargon, Dear vs VaR
Var = DeaR * p(unwind period)

5. Measuring Portfolio Exposure
The variance of a 2-asset portfolio, :
where wA and wB are the weights of A and B in the portfolio.
To evaluate the gains and structure of a portfolio, we need a variance-covariance matrix:
$ AT RISK VOL. AUD BEF
AUD $85,
BEF $2,607,

6. Return and Risk, Generalized
Portfolio return:
where wi are the weights of each asset in the portfolio. (Expected return is simply the weighted sum of the individual asset returns.)
Portfolio variance:
When i = j, the term wiwjFiFjDij becomes wi2Fi2.

7. The Value-At-Risk Approach Applied to Foreign Exchange Risk Management
Defining and measuring foreign exchange risk exposure
Corporate treasury managers often have a bogey to beat: the forward rate
Spot risk and interest-differential risk
Exchange rate shocks and exchange rate volatility. Can abrupt devaluations and government intervention be handled in the value-at-risk framework?
Crossrate volatilities and correlations: can be derived from direct volatilities and correlations

8. Volatility in the market Deviation from expectations
The Idea of Risk: A Corporate Viewpoint
Exposure
Volatility in the market
Deviation from expectations
RISK

9. A Corporate Foreign Exchange Application: Farmco
TRANSACTIONS
FORECASTS FROM
BUSINESS UNITS
NET POSITIONS,
BY CURRENCY
AND MATURITY
VALUE AT
RISK
CONSOLIDATION
VOLATILITY AND
CORRELATION
FORECASTS

10. Start with the Company’s Worldwide Cash Flow Projections, by Currency...
FARMCO CORPORATION, CASH FLOW PROJECTIONS
1st Quarter
2nd Quarter
CURRENCY In
Out In
Out
AUD $0 $0 $0 $0
BEF
$4,659
$2,341
$4,854
$2,556
CAD
$76,083
$23,001
$80,237
$24,665
DKK
$1,280
$546
$1,456
$477
FFR
$33,788
$10,980
$41,578
$11005
DEM
$29,890
$2,300
$34,567
$1,207
ITL
$29,800
$4,587
$32,459
$5561
JPY
($1523)
NLG
$405
ESB
$5,623
SEK
$6789
CHF
$1,522
GBP
($10,200)

11. ...Consolidate the Data to a Managable Set

12. On the World Wide Web, RiskMetrics data may be found at:
Get Volatility and Correlation Data from the RiskMetrics Web Site...
On the World Wide Web, RiskMetrics data may be found at:

13. ...to Produce a Correlation Matrix, and...

14. ...Find Corporate Value at Risk for Farmco

15. Corporate Value at Risk: Farmco
WITH DIVERSIFICATION

16. A Graphic Interpretation
LESS THAN 5%
CHANCE LOSS
EXCEEDS $10M

17. The Next Step: Efficient Hedging

18. Efficient Hedging, Constrained

19. Application
Farmco is one of the world's largest agricultural equipment manufacturers, with $6 billion in sales in In December 1994 the Treasury department at Farmco's Atlanta headquarters was concerned about a report from the audit department that showed an exposure to potential foreign exchange losses. The positions were reported to be as on the next page.
Treasury argued that the net exposure was trivial and that it would be too costly to hedge everything. Although the net amount as reported looked small, management was concerned with knowing how much could be lost on these positions before the end-of-December reporting date, and what could be done to reduce losses to a level that would be considered "not material" by the company's external auditors.
Use the Value at Risk demo software to provide Farmco with a report on their exposure to the risk of market rate and price movements, and a proposed hedging strategy. (No “overhedging,” and no forward contracts in krone or pesetas.)

20. Farmco Assignment

21. Summary of “Value at Risk” Reporting
“At close of business each day tell me what the market risks are across all businesses and locations.”
Dennis Weatherstone, JP Morgan
Logical steps:
Economic-value accounting (need market prices or models)
Market-price based performance measurement
Volatilities and correlations of market prices
Management of risk
Optimization of hedging

22. Value at Risk: Assessment
Value at Risk and RiskMetrics:
A method for quantifying risk in dynamic, uncertain environments
Based on the observation that volatilities and correlations are somewhat persistent
The RiskMetrics estimates are in the ballpark of other, more sophisticated, methods

23. Value at Risk: Pitfalls
A single number, like VaR, cannot replace a complete description of possibilities
The method is backward-looking, and ignores qualitative factors to which markets react
The probability and magnitude of large moves may be understated
Estimated correlations may not tell us how markets will interact during extreme conditions
Nonlinear derivatives may have
changing sensitivity to factors.