Management of Financial Risk
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Transcript Management of Financial Risk
Tools for risk management
Zvi Wiener
02-588-3049
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Jun-00
Risk Management
Options
Call, Put
European, American
Strike, volatility, time to maturity
In-the-money, Out-of-the-money
Black-Merton-Scholes
OTC and Exotic options
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Jun-2000
slide 2
Call Value before Expiration
E. Call
premium
X
Risk Management Tools
Jun-2000
Underlying
slide 3
Put Value before Expiration
E. Put
X
premium
X
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Jun-2000
Underlying
slide 4
Other Options
Callable bond
Warrants
Asian,
Bermudian, Digital
Real options
– to start a new project
– to change prices
– to close some divisions
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Jun-2000
slide 5
Hedge Ratio = Delta
Delta measures sensitivity of a position
relative to a risk factor.
Similar to duration for bonds.
Delta of a call option is …
Delta of a put option is ...
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Call Delta
E. Call
C
S
current value
S
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Put Delta
E. Put
P
S
current value
S
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Jun-2000
slide 8
What type of risk protection would you
suggest for a pension fund?
payoff
Buy index
floor
Stock market
Buy put
Sell calls
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Jun-2000
slide 9
Buy stock
Result
Buy put
Sell call
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Jun-2000
slide 10
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
Risk Management Tools
Jun-2000
slide 11
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
Risk Management Tools
Jun-2000
slide 12
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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Jun-2000
slide 13
How much did it cost?
The results are not precise and very sensitive
to volatility
– if volatility is 10%
– if volatility is 20%
– if volatility is 30%
– if volatility is 40%
$6.5M
$10M
$13M
$15M
This is the amount the bank should pay to DASKASCH!
Risk Management Tools
Jun-2000
slide 14
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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slide 15
Butterfly
2*Call(550)-Call(540)-Call(560)
payoff
540
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550
Jun-2000
560
Stock market
slide 16
Hedge using Forward
Current exchange rate 4.00
USD interest rate
6%
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!
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Jun-2000
slide 17
After a year
$
3.9
4.0
4.1
4.2
4.3
Forward
25
15
5
-5
-15
Your balance
3.9*100-410+25= 5
4.0*100-410+15= 5
4.1*100-410+ 5 = 5
4.2*100-410- 5 = 5
4.3*100-410-15 = 5
Complete protection with no cost!
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slide 18
What if there is no perfect time
match?
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.
Do it very carefully!
Or better use OTC, but check prices.
Risk Management Tools
Jun-2000
slide 19
Hedge using Options
Current exchange rate 4.00
USD interest rate
6%
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!
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slide 20
After a year
$
Put Opt. Your balance
3.9 20
3.9*100 - 410 + 20= 0
4.0 10
4.0*100 - 410 + 10= 0
4.1 0
4.1*100 - 410 + 0 = 0
4.2 0
4.2*100 - 410 - 0 =10
4.3 0
4.3*100 - 410 - 0 =20
Protection with some cost!
The initial cost of options.
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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?
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Jun-2000
slide 22
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:
8
USD
EUR
1 rNIS 1 rUSD 1 rEUR
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slide 23
Example
8
USD
EUR
1 rNIS 1 rUSD 1 rEUR
Assume that now
USD = 4 SHEKELS
EUR = 3.5 SHEKELS
rNIS = 10%
rUSD= 6%
rEUR = 5%
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slide 24
Example
8
USD
EUR
1 rNIS 1 rUSD 1 rEUR
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.
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slide 25
Example
8
USD
EUR
1 rNIS 1 rUSD 1 rEUR
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.
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slide 26
Example
8
USD
EUR
1 rNIS 1 rUSD 1 rEUR
(9,434 400 0.1) (9,524 350 0.2)
2
P
2
2
2 0.1 9,434 400 0.1 9,524 350 0.2
P 732,482
VaR5% 1,208,595
Risk Management Tools
Jun-2000
slide 27
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.
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Jun-2000
slide 28
Example
Assume
that for the following 7 years you
have to pay each year $1M and you will get
each year 5M NIS.
How one can hedge this cash flow?
What if amounts or timing is not precise?
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slide 29
How to hedge financial risk?
Static hedge
Forwards agreements that fix the price
Futures
Options static hedge
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.
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slide 30
Risk Management resources
Useful Internet sites
Regulators
Insurance Companies
Risk Management in SEC reports
pluto.mscc.huji.ac.il/~mswiener/
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RMG
http://www.riskmetrics.com/
http://www.pictureofrisk.com/
http://www.riskmetrics.com/rm/splash.html
rmgaccess
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slide 32
Consulting
Risk Management Tools
Oliver, Wyman and Co.
Willis Corroon
Richard Scora
Ernst and Young
Enterprise Advisors
Kamakura
Jun-2000
slide 33
Examples of Risk Reports
http://www.pictureofrisk.com
http://www.mbrm.com/
http://www.riskmetrics.com/rm/splash.html
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Jun-2000
slide 34
Regulators
BIS
G-30
FSA
SEC
market risk disclosure rules
market risk reporting
FED, FRB
our GARP report
Swiss Central Bank
Financial Accounting Standards Board
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Jun-2000
slide 35
Who manages risk?
Citibank
AIG
Nike
Bank of England
General Re
Sony
CIBC
Swiss Re
Dell Computers
J. P. Morgan
Aetna
Philip Morris
Bankers Trust
Zurich
Ford Motor
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Jun-2000
slide 36
SEC reports
Edgar
Yahoo
– find symbol
– profile
– raw SEC reports
Risk Management Tools
market risk in 10K 7A
Jun-2000
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3 methods
Sensitivity
– requires a deep understanding of positions
Tabular
– when there are 1-2 major risk factors
Value-at-Risk
– for active risk management
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slide 38
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/
Risk Management Tools
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World Experience
Bankers Trust, J.P. Morgan, investment banks
Bank regulators, commercial banks
Insurance, dealers
Investment funds (LTCM)
Real companies
Investors learn to read risk information!
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Agriculture
www.cfonet.com/html/Articles/CFO/1999/99APkita.html
1998 revenues $1.25B
consulting Willis Corroon
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Nike
Salaries are paid in Asia
Shoes are sold worldwide
Financing comes from USA
Marketing, storing, shipping worldwide
use VaR since 1998.
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Merck
http://www.palisade-europe.com/html/Articles/merck.html
http://www.sec.gov/Archives/edgar/data/64978/000095012
3-99-005573-index.html see “sensitivity”
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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
Risk Management Tools
Jun-2000
slide 44
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/
Risk Management Tools
Jun-2000
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Web tour
ZW, students, VaR and risk management
Gloriamundy
GARP
SEC reports
Google
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Jun-2000
slide 46
What is more risky and why?
A. 1 year bond
B. 10 year bond
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slide 47
What is more risky and why?
A. An in-the-money option?
B. An out-of-the-money option?
Risk Management Tools
Jun-2000
slide 48
Call Value before Expiration
Call
In-the-money option
Out-of-the-money option
X
Risk Management Tools
Jun-2000
Underlying
slide 49
What is more risky and why?
A. A fixed interest loan?
B. A floater (variable interest rate)?
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The End
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Tools
Measurement tools
Financial tools
– options
– forwards, futures
– swaps
– insurance
Risk Management Tools
Outsourcing
Jun-2000
slide 52
Senior Management
Marketing
Finance
Supply
Cashflow
Capital
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Important Principles
Distinction between risk taking and risk control.
Backtesting.
Transparent reporting.
Timing is more important then precision!
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Basic decisions
Goal of Risk Management
Base currency
Time horizon (embedded options)
Economic or Accounting approach
Admissible
Risk Management Tools
risk
Stop losses or other actions
Jun-2000
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Risk Management System Can NOT
Predict future
Identify business opportunities
Be always right!
Risk Management System Can
Predict loss, given event
Identify most dangerous scenarios
Recommend how to change risk profile
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Definition
VaR is defined as the predicted worst-case
loss at a specific confidence level (e.g. 99%)
over a certain period of time.
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VaR
1
0.8
0.6
0.4
VaR1%
1%
0.2
Profit/Loss
-3
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-2
-1
1
Jun-2000
2
3
slide 58