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
Tools

Measurement tools

Financial tools
– options
– forwards, futures
– swaps
– insurance

Risk Management Tools
Outsourcing
Jun-2000
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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

Risk Management Tools
Jun-2000
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Measurement Tools
CATS, CARMA
 Algorithmics, Risk Watch
 Infinity
 J.P. Morgan, FourFifteen
 FEA, Outlook
 Risk Manager, RMG
 Theoretics, TARGA
 Bankers Trust, RAROC
 INSSINC, Orchestra

Risk Management Tools
Jun-2000
$400K/yr
>$1M
>$1M
$25K/yr
$18K
$30K/yr
$75K
$50K/run
$25-75K
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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
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2
3
slide 9
Benchmarking

Financial assets
– create an imaginary portfolio and measure
performance relative to this portfolio.

Industry
– measure relative to competitors.
Risk Management Tools
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Financial Tools
Risk Management Tools

Options

Futures/Forwards

SWAP

FRA

Insurance
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Derivatives
Contracts that are priced according to underlying
variables (prices are derived from underlying).
Options, Futures, Forwards, Swaps, Warrants, etc.
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Derivatives
Contingent claims
gold shipped
KTUBA
insurance
an option not to undertake a project
an option to leave
an option to change price
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Financial Tools
Risk Management Tools

Options

Futures/Forwards

SWAP

FRA

Insurance
Jun-2000
slide 14
Forward and Futures

Forward agreement

Futures - standard traded contracts
– margin
– mark to market

Final result is very similar
– settlement risk
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Forward payoff
Forward at maturity
Underlying asset
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Forward Price

Note that forward price is not a price
Forward price does NOT depend on the
expected exchange rate. It depends on the
current exchange rate and interest rates only!

It is important to chose appropriate time
horizon!

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Forward Price
Consider a NIS/USD forward contract for
10,000 USD to be exchanged in 6 months to
NIS according to the forward price.


Current exchange rate is $1=4NIS,
– USD interest rate is 6%
– NIS interest rate is 10%

How to define the forward rate?
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Forward Price
Buy 6 month T-bill, $10,000 nominal, it
will cost 10,000*4/1.03= 38,835 NIS


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.
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Forward Price
(1  rNIS )
F S
T
(1  rUSD )
T
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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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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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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.
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Marking to Market
Your balance
Initial
margin
Maint.
margin
margin call
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time
slide 24