Managing Market Risk for TMAC - Toronto

1. Managing Market Riskfor TMAC - Toronto February 2011

2. James MacKinnonjames_mackinnon@scotiacapital.comDirector, Risk Solutions Group416-866-5443 Presenting today:

3. Table of Contents Section Strategic Planning and Market Risk Uses and Abuses of Forecasts Measuring Market Risk Event Risk and Black Swans Solutions: Symmetrical and Asymmetrical Managing Banks and Dealers Assessing the Results

4. Strategic Planning and Market Risk

5. Strategic Planning and Market Risk Management • Strategy • Overall objectives, aligned with and supporting the organization’s goals • SWOT analysis – internal and external • Set enterprise objectives • Develop strategic plan to achieve objectives • Evaluation of plan: suitability (economic sense?), feasibility (break-even, budgeting), • acceptability: returns to stakeholders and their likely reaction, and risks • Risks - Probability and consequences of failure of strategy - Enterprise Risk Management process

6. Strategic Planning and Market Risk Management • Enterprise risk management steps: • Identify risks • Pricing risk: commodity prices, interest rates • Asset risk: financial securities • Currency risk: translation risk • Liquidity • Analyze and understand - Quantify and assess materiality - Integrate: identify any portfolio offsets • Respond • Avoidance • Reduction • Insurance • Accept • Monitor and review

7. Strategic Planning and Market Risk Management • Market Risk types: • Financial • Pricing risk: cost of capital, interest rates • Asset risk: liquidation values of real assets and financial securities • Currency risk: translation risk for non-domestic obligations • Liquidity: re-financing risk, cash flow risk • Commodity - Pricing risk: cost of inputs - Asset risk: value of inventory, reserves - Liquidity: availability and security of supply • Currency • Pricing risk: exchange risk impact on revenues and expenses • Asset risk: balance sheet translation risk • Liquidity: especially for non-G20 currencies, or countries with exchange controls

8. Strategic Planning and Market Risk Management • Market Risk Management • Best practice: integrated with the strategic planning process • Not isolated in the Treasury or Purchasing functions • Executive sponsorship • Risk appetite/tolerance defined at Board level • Liquidity: re-financing risk, cash flow risk • Best practice: integrated across functions, including audit - Common risk language/metrics needed - Risk inventory - Prioritization - Cross Functional Risk Committee - Chief Risk Officer - Clear accountability

9. Strategic Planning and Market Risk Management • Which market variables are material? - Stress testing - Potential impact on EBITDA, EPS, free cash flow - Risk tolerance threshold - Board-approved process - Clear accountability

10. Strategic Planning and Market Risk Management • “What is our risk?” • Using forecasts as a risk management tool: • Forecasts are a useful ‘base case’ • Implied forwards can also be used (“market consensus”) • But forecasts and the market forwards change constantly with new information • Random walk • Also known as “the piper’s walk”

11. Uses and Abuses of Forecasts

12. BoC Update • On January 18th, the Bank of Canada (“BoC”) held its overnight target rate at 1.00%, and the market is forecasting the next rate hike to be on April 12th, 2011. • Core inflation is projected to edge gradually to its 2% target by the end of 2012, as excess supply in the economy is slowly absorbed. • What the BoC do over the next 18 months? BoC Overnight Target Rate Source: Bloomberg

13. Market Consensus - BoC Overnight Target Rate • By mid-2012, the BoC overnight rate will be between 1.25% and 3.25%, depending on which forecast you read. • The BoC will begin hiking between May and October Forecasts of BoC Overnight Target Rate Source: Bloomberg

14. Market Consensus - BoC Overnight Target Rate • In October, 2009, the forecast for the BoC rate as at Q1 2011 was 2.2% • It is currently 1.0% Average Forecast - BoC Overnight Rate Q1 2011 Source: Bloomberg

15. Market Consensus – Bond Yields • In October, 2009, the average forecast for the 10 year GOC bond yield as at Q1 2011 was 4.25%, and the implied forward yield was 4.15%. • The average closing yield on this bond for the month of January was 3.25%. Average Forecast and Implied Forward - 10 Year GOC Bond Yield Q1 2011 Source: Bloomberg

16. Unknown: Will US Consumers Save Or Spend Stimulus? Consumers are paying down debt and avoiding risky investments.

17. Unknown: Will US Consumers Spend Some Liquidity? Consumers are paying down debt and avoiding risky investments.

18. Unknown: When Will US Companies Redeploy Excess Cash? Consumers are paying down debt and avoiding risky investments.

19. Unknown: Will The US Raise Its Debt Ceiling and What Then? Consumers are paying down debt and avoiding risky investments.

20. Unknown: When Will US House Prices Begin to Recover? Total US net borrowing declined despite large fiscal deficits, as businesses and households paid down debt. Net borrowing has been increasing as the economy recovers.

21. Unknown: How Will Bonds React As Demand For Capital Heats Up? Total US net borrowing declined despite large fiscal deficits, as businesses and households paid down debt. Net borrowing has been increasing as the economy recovers.

22. Unknown: Can Global Markets Take Down Sovereign Rollover? Total US net borrowing declined despite large fiscal deficits, as businesses and households paid down debt. Net borrowing has been increasing as the economy recovers.

23. Unknown: How Will China React To Policy Tightening, Currency Wars? Total US net borrowing declined despite large fiscal deficits, as businesses and households paid down debt. Net borrowing has been increasing as the economy recovers. Forecasts are not a replacement for a prudent risk management strategy.

24. Measuring Market Risk

25. Strategic Planning and Market Risk Management • If forecasts are not useful, then how do you measure risk? • Two basic approaches: • Subjective judgment about the future – “guesstimation” • Quantification based on historical patterns • Cash-Flow-at-Risk • Value-at-Risk • Subjective judgment - Susceptible to influence by recent news - Biases harder to spot - “Rule of thumb” errors - Can be helpful in generating scenarios: “What If?” How could markets react to a specific event?

26. Strategic Planning and Market Risk Management • Cash-flow-At-Risk models • Forecast income, expenses can be drawn from the budget spread sheet • Interest rates, currency exchange rates, raw materials prices • Vary the market variable to gauge potential impact • Stress-testing: market variables - Use historic high and low - Use theoretical equilibrium level (eg., CAD/USD PPP approx. US$ 0.80) - Use historical data: one or two Standard Deviations

27. Strategic Planning and Market Risk Management • Value-At-Risk: the preferred measure of market risk • Emerged in late 1980s after the 1987 stock market crash • Extreme market movements can exceed expected (historical) ranges • VaR • Initially, individual desks calculated VaR independently • - Later was made firm wide in most banks, and was incorporated in Basle II Accord • Highly statistical - Provides a structure for thinking about risk - Not widely understood by decision-makers - Can create the illusion of certainty - 1-3x VaR is not unusual - Stress testing should be done outside of these VaR ranges

28. Strategic Planning and Market Risk Management • VaR models • Widely used risk measure of the risk of loss on a portfolio of assets • Risk is defined as a mark to market (fair value) loss over a specified time span • How much money could we lose today? • You need a time period, a confidence level, and a loss amount • What is possibility that a portfolio could lose a certain amount of money over the next 24 hours with a 95% probability? • Example: a portfolio with a one-day 95% VaR of $ 1 MM: there is a 0.05 probability • that the portfolio will fall in value by more than $ 1 MM over a one day period • (a loss of $ 1 MM or more is expected on 1 day in 20)

29. Strategic Planning and Market Risk Management • Three methods of calculating VaR: • Historical method - If in the last 5 years, the worst 5% of all one-day results was a loss of 5 to 10% - then with 95% confidence: our worst one-day loss will be less than 5% • Variance-covariance method - assumes results are normally distributed - requires that we measure expected (average) return, and standard deviation - then we repeat the process used in Historical method, but use the binomial curve rather than actual data • Monte Carlo simulation - randomly generate future paths based on historical patterns - then repeat the process used above using the resulting data rather than actual data

30. Strategic Planning and Market Risk Management • What’s wrong with VaR?: • Results are probabilistic • Assumes that history will repeat itself • Can be complex and hard to understand • Can create an illusion of certainty and false sense of security • Making VaR control the focus of risk management: • Can result in bias to focus on manageable risks near the centre of the • distribution and ignores the tails • Ignores risk of extreme losses – can lead to excessive risk taking • Does not measure liquidity risk • Does not fully reflect leverage risk • “Lies, damn lies, and statistics” - Based on historical data over limited time periods - “Garbage in, garbage out” - “It’s like the historical data only has rain storms and then a tornado hits”

31. Strategic Planning and Market Risk Management • Applying VaR in an enterprise setting • Start with the budget spread sheet • Key revenues/expenses driven by market variables • Vary the variables by specified amount - historical high and low - VaR amount • Assess potential impact on key bogey: - Free cash flow - EPS • Consider risk of extreme moves: • Black Swans

32. Event Risk and Black Swans

33. The Allegory of the Black Swan

34. The Allegory of the Black Swan • Popularized by Nassim Nicholas Taleb, NYU • Rare, high-impact events that have a disproportionate impact on markets • Examples of past Black Swans: • World War 1 • 9/11 • the internet • The probability of such events cannot be calculated using statistical methods • It may be possible to predict ‘known unknowns’, where we know the ‘frame’ • It is impossible to predict ‘unknown unknowns’, where there is no precedent • Market participants tend to ignore a probability if it is low, and they after the fact • they tend to develop retrospective explanations which make them look predictable

35. The Allegory of the Black Swan • We cannot predict extreme events, but we can reduce our vulnerability to them • Property insurance • Insurance is not an option • We can’t drive looking in a rear-view mirror: past events are not predictive • Approaches to risk mitigation: • Balance complexity with simplicity • Diversification • Risk Management

36. The Allegory of the Black Swan • Examples of Black Swan risks: • Hyperinflation (rising government debt) • Geopolitical crisis (Middle East, Korean Peninsula, South Asia) • Instability in China: double digit economic growth and property value inflation • Internet event: cyber attack • Natural disaster • Prolonged period of limited economic growth • We can’t drive looking in a rear-view mirror: past events are not predictive • Interest in protection against “tail risks”, is increasing • May 6 stock market drop: Dow fell almost 1,000 points • Sovereign debt crisis may increase hyperinflation risk

37. The Allegory of the Black Swan “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” - Mark Twain

38. Solutions: Symmetrical and Asymmetrical

39. Hedges: Symmetrical and Asymmetrical

40. Symmetrical Hedges • Interest Rates: • > Interest Rate Swaps • Currencies: • FX Forwards • FX Swaps • Commodities: • Commodity Forwards • Commodity Price Swaps

41. Operations: Let us assume that an enterprise was to execute a swap today to fix the underlying interest rate of its Term Facility for 5 years, at a fixed rate of Y%. Borrower’s all-in fixed rate would be: On Swap: Borrower Pays Fixed Y% Monthly (paid in arrears) Borrower Receives Floating 3-month BA rate (paid in arrears) On Debt: Borrower Pays Floating 3-month BA rate (reset in advance, paid in arrears) Borrower Pays Loan Credit Spread (paid in arrears) Result: Borrower Net Cost of Debt Y% + Loan Credit Spread Symmetrical: Interest Rate Swap Interest Rate Swap Underlying Bank Debt Y% Swap Fixed Rate Borrower 3-mth BA + Credit Spread 3-mth BA

42. Asymmetrical Hedges • Interest Rates: • > Interest Rate Caps • > Swaptions • Currencies: • FX Puts and Calls • FX Binaries • Commodities: • Commodity Puts and Calls • Commodity Price Swap Options

43. Cap Mechanics: Let us assume that an enterprise was to purchase a cap today to protect the underlying interest rate of its credit facility for 5 years. For the specified cap strike rate, the amount and term, the cap premium would be a dollar amount due on the trade date. In this case, Borrower’s borrowing costs would be as follow: Loan: Pays BA rate Loan: Pays Loan Credit Spread Cap: Pays premium Cap: Receives BA rate less cap rate, if positive Lesser of BA rate or cap rate + Loan Credit Spread (+ Cap Premium) Asymmetrical: Interest Rate Cap Interest Rate Cap Underlying Bank Debt Cap Premium ($) Borrower 3-mth BA + Spread 3-mth BA less Cap Rate, if positive

44. Comparing Symmetrical and Asymmetrical Hedges • Symmetrical hedges tend to look less costly: • No premium • All critical terms can be easily made to match • Symmetrical hedges tend to track market expectations • > Market expectations usually are reflected in current forecasts

45. Managing Banks and Dealers

46. Managing Relationships • Supplier and customer form a system – you are buying his/her knowledge: • End the practice of awarding business on the basis of price alone • This assumes that the end product is totally commoditized – “we’re not in that world” • Instead, minimize the total cost • Move towards a single supplier for any one item, on a long-term relationship of loyalty and trust • Old School errors: • > Total cost = purchase price + price of use • > Jump-ball supplier system is wrong: • - no loyalty and trust • - “just meet specifications and keep quiet” • - no incentive to improve or add value • Suppliers: • > Competition is needed, but in the right place – let suppliers compete, then work with • the selected one • > Select a supplier based on capability, evidence of quality, record, history, reputation, • training, burning desire to work with you

47. Managing Relationships Possible Risks Associated with Hedge Transactions: • Symmetrical OTC hedge transactions are typically credit-intensive, bilateral contracts • Execution of such transactions poses unique challenges when there are multiple credit providers. These include: • Market Liquidity Risk: Simultaneous dealer activity can adversely affect market rates • Pricing Risk: Hedge providers require a capital charge on hedging transactions, to cover the cost of regulatory capital. Capital charges for hedge transactions tend to be broadly consistent between banks, which are generally subject to regulatory regimes based on the Basle accords. However, if the process is not carefully managed, there can be information discrepancies which may result in non-uniformity of pricing. • Structuring Risk: an enterprise can end up with multiple transactions between several dealers each with its own terms (i.e., credit mitigation, interest rate & daycount differences) • Documentation Risk: an enterprise can end up with multiple legal documents, each with its own terms (i.e., credit appendices, etc.), and associated legal costs • Credit Management: secured creditors effectively bear a pro rata proportion of the credit risk through the dilution of security resulting from an interest rate swap, and will require a commensurate return on this additional risk. • All of these risks need to be considered as they will ultimately impact the process, price, and structure an enterprise receives on its hedge

48. Managing Relationships Risk Mitigation: • To mitigate these risks, it is common market practice to select one hedge advisor to facilitate the deal process for hedge transactions • The hedge advisor is responsible for: • Assisting in the determination of an optimal hedging strategy by an enterprise • Hedging the entire transaction – to reduce transaction costs • Syndicating the hedge to prospective hedge providers - allocations determined by the enterprise • Working with the hedge providers to ensure uniformity of: • pricing, • documentation, and • deal structure. • Using a hedge advisor can reduce market and pricing risk, and ensure that all dealers are providing the company with a uniform hedge

49. Hedge Advisor executes hedges Managing Relationships Identify credit conditions, security and capital charge requirements for hedging program Hedge Advisor provides relevant analysis, research and market colour Hedges are Syndicated Documentation and/or security package completed Enterprise selects Lead Hedge Advisor • Typical Execution Timeline:

50. Assessing the Results