Market Risk Management and its overlap with Credit (“Convergence Risk”)

Market Risk Managementand its overlap with Credit(“Convergence Risk”) Dominic Wallace EMEA Head of Market Risk Management Advanced Risk Issues Istanbul, March 2007

Market Risk Management and Convergence Risk What is Market Risk Management? • What is Market Risk? • Market Risk Management – techniques • Policies and limit setting • Hot topics When does it converge with Credit Risk Management? • Traditional overlaps – the liquidity crunch • Current developments – four examples • The golden rules

Market Risk Libor JPY Prepay Market Risk is the risk to earnings or capital due to changes in market variables (such as interest rates, foreign exchange, equity and commodities levels and volatilities) which affect the price of trading positions. Citigroup Stock US Interest Rates Oil EUR

Market Risk – The Greeks and other common terms Delta Technically, the way that an option value changes as the price of the underlying changes (e.g. if an option value increases by 75c for a $1 increase in the underlying price the option would be described as having delta of 75%). Now often used to describe any simple, linear risk. Gamma Used to describe options (originally) or, more generally, portfolios whose value does not change in a linear fashion. Negative gamma can lead to significant losses in extreme market moves, which is why stress testing is important, but in stable markets can be a profitable strategy. Also known as convexity. DV01 Simplest measure of interest rate risk – exposure to a one basis point move in interest rates. Other organizations have different names – there is no one market standard. Also useful to know, for future reference… Theta The change in value of an option portfolio as time passes, assuming nothing else changes. Positions which are “long gamma” (i.e. benefit from large market moves) are typically “short theta” (i.e. they gradually bleed money away if markets don’t move) Vega The change in value of an option portfolio as a function of changes in implied volatilities. Volatility is a measure of uncertainty in an asset’s future price and is therefore one of the inputs used to calculate option values (or, alternatively, is implied by the quoted prices of options in the market, hence the term “implied volatility”). IRE Interest Rate Exposure – used in a specific sense at Citigroup to measure the interest rate exposure of accrual, rather than mark-to-market, portfolios. Cost to close The difference between life-to-date accounting and mark-to-market revenue for an accrual portfolio, in other words the gain or loss that would be incurred by liquidating the portfolio at market value.

P&L Market move Linear approximation Actual Market Risk – The Greeks and other common terms Often a portfolio’s behaviour can be represented accurately enough as a simple linear function of market moves. At other times (especially for options portfolios) it is necessary to include the effects of convexity, especially if they are negative (“negative gamma”).

Market Risk Management Market Risk Management is three things: • Understanding management’s risk appetite and expressing it in more specific terms • Understanding trading desks’ exposure and communicating it upwards – comprehensibly • Acting as “honest brokers” in support of other control groups as required

Market Risk Management - Techniques Three main techniques of Market Risk Management: • Value at Risk • Stress Testing • P&L Attribution …although none is as important as common sense.

Market Risk Management – Techniques – Value at Risk What is it? • “What happens on a bad day?” • Statistical estimate • Simplest measure of “market risk” • Expressed in terms of a confidence level and a holding period • Various approaches, but all based on historical assumptions Advantages: • Simple, easy to understand • Enables comparison between businesses • Capital relief if you meet the Basel guidelines Drawbacks: • Doesn’t address the “worst case” • Can be opaque in some approaches • Not a “coherent” risk measure

1% VaR Market Risk Management – Techniques – Value at Risk Probability Revenue

Market Risk Management – Techniques – Stress Testing What is it? • Tries to answer “What’s the worst that could happen?” • Two reasons: non-linear portfolios, extreme events • Various scenarios: historical, quasi-statistical, tailored Advantages: • Does address the “worst case” (at least in theory) • Historical scenarios are very transparent • Provides a measure of economic capital Drawbacks: • Significant judgmental input (correlation, liquidity) • Can give false confidence • Very dependent on trader/management behaviour

Market Risk Management – Techniques – VaR, Stress Testing Coherent risk measures • Various technical conditions must be satisfied • Largely just means they make sense • Critical condition is “sub-additivity”: R(a+b) <= R(a) + R(b) When does this matter? • Rarely if ever an issue for VaR within Market Risk • Discontinuous risks • High confidence levels In other words: • Stress testing • Credit risk • Operational risk For more information: P.Artzner, F.Delbaen, J.M.Eber, and D. Heath (1999): “Coherent Measures of Risk”, Mathematical Finance 9, 203-228.

Market Risk Management – Techniques – P&L Attribution What is it? • Two things, not one • Detailed level to prove out the revenue • High level to prove out the exposures Advantages: • If there’s a problem, you find out about it early Drawbacks: • Overhead

Market Risk Management – Techniques – P&L Attribution Simple portfolio: DV01 $10mm SOAF 6 1/2 of 2014 @ 109.963 (6,872) $5 mm SOAF 7 3/8 of 2012 @ 113.183 (2,529) $(15mm) UST 3 5/8 of 2013 @ 97-11 9,854 Prices and yields move as follows: SOAF 2014 109.963  109.695 (5.074%  5.113%) SOAF 2012 113.183  113.011 (5.016%  5.050%) UST 2013 97-11  96-24+ (4.029%  4.117%) P&L systems report a gain of $52,206 “Is it right and where does it come from?”

Market Risk Management – Techniques – P&L Attribution Where does this come from? Financial’s answer: • $86,719 from UST 2013: $(15mm) x (37/64) x 1/100 • $(26,800) from SOAF 2014: $10mm x (0.268) x 1/100 • $(8,600) from SOAF 2012: $5mm x (0.172) x 1/100 Total: $51,319 Risk’s answer is based on risk factors: • $47,000 from spreads narrowing: $(9,401)/bp x (5bp) • $4,100 from rates rising: $453/bp x 9bp Total: $51,100

Policies and Procedures Market Risk Management’s own policies cover areas such as limits setting, model review and price verification. Market Risk Managers also play a key (formal or informal) role in implementation of other policies including: • Policy on New Products, New Activities and Complex Transactions for CIB Global Markets:“The CMAC Policy” to its friends. • Off-Market Transaction Policy:“Loss-deferral” trades are not permitted; other trades where an up-front fee changes hands in exchange for off-market coupons are allowed only in tightly controlled circumstances. • Structured Finance Policy: All our customers must disclose any financing trades, even when accounting standards don’t require it. • Derivatives Sales Practices Policy: Sale of exotic derivatives (or securities with them embedded) to non-professional customers needs specific approvals.

Policies and Procedures – quiz • What do the following have in common? • The UK’s nuclear deterrent in the 1980s • One half of a notorious US crime team • Film starring Vin Diesel • Character in Greek mythology, son of a legendary craftsman • Popular term for an oil spillage at sea • An ultra-dense astronomical body • Characters from two films by Jay Roach

Market Risk - Limit Setting Market Risk limits and exceptions are related to stress tests: Stress tests: exposure x “worst case move” = stress loss Risk limits: loss tolerance ÷ “worst case move” = limit Loss tolerance depends on a number of factors: • Budgeted revenue • Maturity/growth plans • Nature of business (origination/facilitation/positioning) Limits are set at desk, division and CIB levels as appropriate All Market Risk Managers can approve exceptions at desk level (size depends on the seniority of the risk manager) Product and Regional Heads can approve exceptions at division level (including EM seniors for EM division) Only CIB Market Risk head can approve exceptions at CIB level

Market Risk - other hot topics • Model risk • Impact on liquidity of a hedge fund dislocation • Lack of market opportunities vs budget pressure • Remote but outsized risks (the “known unknowns”) • equity market collapse • “super-senior” CDO tranches and related products • The “unknown unknowns” • Argentina - pesification • euro breakdown??

Risk Spectrum Market Credit In the Beginning it was simple… Loans Letters of Credit Sovereigns

Risk Spectrum Market Credit Even now, stable markets mean largely discrete risks High Grade Corporates EM FX and Securities Agencies High Yield Corporates Distressed Debt • Sovereigns • Supranationals Loans Letters of Credit Counterparty Risk

Risk Spectrum Market Credit The Fashion has always been to convert Credit to Market Risk High Grade Corporates EM FX and Securities Agencies High Yield Corporates Distressed Debt • Sovereigns • Supranationals Loans Letters of Credit Counterparty Risk “Risk transfer” instruments

Risk Spectrum Market Credit LIQUIDITY High Low But as Liquidity Evaporates… High Grade Corporates EM FX and Securities Agencies High Yield Corporates Distressed Debt • Sovereigns • Supranationals Loans Letters of Credit Counterparty Risk

Risk Spectrum Market Credit LIQUIDITY High Low It Moves the Other Way Sovereigns Supranationals High Yield Corporates Loans Letters of Credit Agencies EM FX and Securities High Grade Corporates Distressed Debt

Commercial Paper: Liquid or Cement? • In recent years, Commercial Paper issuers have come under the spotlight: • Commercial paper (CP) issuers could routinely “arbitrage” funding sources to reduce the costs of funds between bank borrowings, debt borrowings and CP issuances. Many companies used CP funding for long term uses of cash such as acquisitions. • The current credit environment has resulted in investors looking more closely at CP leverage ratios (e.g., General Electric) and credit rating migrations (e.g., Sprint, Tyco, Quest, WorldCom, Nortel). • ABB Asea Brown Boveri Ltd. had $2.1BB of CP outstanding in February 2001. On March 25, Moody’s downgraded ABB’s CP from P1 to P3, resulting in a split rating of A1/P3. On April 23, ABB’s CP outstanding had fallen to $500MM and S&P downgraded the company to A2. There were no bids in the market. CIB was holding $116MM at the Moody’s downgrade and had no realistic “out” except to wait until maturity and hope to be repaid. (We were). Previously Current Example

Risk Spectrum Market Credit Country’s Economic/Political Situation Government Intervention is a Time-Bomb….

Risk Spectrum Market Credit Exchange Controls FX Rate Sovereign Spread Country’s Economic/Political Situation Local Interest Rates Defaults Credit Spreads Equity Prices …When It Explodes, All Risks Converge Sovereign Liquidity

Market or Credit Risk? AFS portfolio • “Available for sale” portfolios • Marked to market, but through equity not income • Historically treated as credit exposures and using credit lines • Argument to reclassify as market risk is based on liquidity… • …which makes sense in normal circumstances, but beware: • Ability of some markets to turn illiquid suddenly • Implications on expected behaviour in a downturn • Credit risk approach: hold/workout, maximise value • Market risk approach: sell, limit downside

Citi ABC Inc. Recent developments in Convergence (1): Extinguishing swaps Start with a vanilla interest rate or currency swap: Citi is clearly taking counterparty risk to ABC Traditional strategy for mitigating this risk is to buy credit protection (how much depends on the current and projected mark-to-market value of the swap) This has a number of disadvantages: • Basis risk: derivatives claims are not normally deliverable into a CDS • Possible accounting mismatch and likely capital mismatch • Still a creditor in default • Possible solution is the “extinguishing swap”

Recent developments in Convergence (1): Extinguishing swaps Extinguishing swap is identical to a vanilla swap except that all obligations are cancelled on a credit event. Do we still have counterparty risk with an extinguisher? Yes, because: Economically we lose the same money in the same circumstances No, because: Credit risk is the risk that someone defaults and owes you money • Advantages of the extinguishing swap: • Full mark-to-market accounting even without Fair Value Option • Easier to monetise “right-way” exposure • No messy creditor meetings and no exposure to recovery rates • Drawbacks: • Legal enforceability if deal is in the money to the customer • Reputational: association with “self-referenced” products • Moral hazard: customers may have an incentive to default

Bank A Bank B ABC Inc. Recent developments in Convergence (1): Extinguishing swaps • Variations: • Isda “Method 1” • Third-party extinguishers • Legal/credit risk separation with this structure: • Bank B has the legal risk • Bank A has the credit risk

$ fixed $ fixed investors ABC Inc. Citi PHP fixed PHP “fixed” customers Extinguishing swaps - application A Philippines corporate is raising funds in the offshore market in dollars. Their customer revenues are in pesos so a currency swap is the natural hedge. Banks have limited credit appetite for the name, even though the likely/projected mark-to-market of the swap is negative:

Extinguishing swaps - application An extinguishing swap is a natural solution to everyone’s problem: • Customer gets a hedge that would otherwise be unavailable • Citi has the opportunity to monetise the expected value by buying bonds • Creditors in default don’t have the uncertainty of a potential currency swap claim

Recent developments in Convergence (2): Hedge Fund leverage • Funds and fund investors both looking for leverage: • Investors: increased upside, non-recourse structure • Funds: fees depend on assets under management • Leverage now available in a range of flavours: • Generic FoF product offered to risk-tolerant investors • Bespoke leverage for single investor • Single-fund product Credit or market risk? Citi lends $252mm for three years at 6% to Rosetta Leveraged Master Fund Ltd., whose only assets are holdings in each of eight third-party hedge funds, with current value $50mm each. Citi takes a charge over the fund units. James King, founder and managing partner of King’s Road Capital LLP, pays $148mm for a call option giving him the right to buy a basket of 50 units in each of eight King’s Road funds, in three years’ time, at a cost (strike) of $300mm. Each unit is currently valued at $1mm.

$252mm $148mm James King pledge on units Rosetta Citi Citi $300mm $300mm Pledge unwound fund units fund units fund units $400mm fund units $400mm $400mm x return $400mm x return fund units Fund managers King’s Road $252mm King’s Road fund units Citi $300mm fund units Recent developments in Convergence (2): Hedge Fund leverage These are basically the same deal: King’s Road Rosetta …and if you combine the related parties you get something even simpler:

Recent developments in Convergence (3): EMCT loan program Simple in concept: Citibank lends to an EM borrower (usually corporate) and simultaneously sells the risk to the market in CDS or CLN form • A customer-based product on both sides: • Borrowers: raise finance by tapping a broader investor base • Investors: take exposure to previously inaccessible credits Citigroup should be uniquely well positioned for this business given its access to both borrower and investor markets • Closely related to four existing and mature businesses: • Loan syndication: Citibank lends to an EM borrower and simultaneously distributes to the bank market (Credit/underwriting risk) • Bond syndication: Citigroup underwrites issuance of securities to the general investor market (Market/underwriting risk) • EMCT secondary business: Citigroup purchases a corporate loan (or security) and simultaneously sells the risk to the market in CDS or CLN form (Market risk) • Portfolio Optimisation: Citibank lends to an EM borrower and later may sell the risk to the market in CDS or CLN form (Credit risk)

Recent developments in Convergence (3): EMCT loan program • So… • Is this market risk or credit risk? • Is there anything else we need to think about? • The short answers: • Mainly credit/underwriting risk as long as EMCT do habitually defease it as planned: once defeased, it becomes market risk. If EMCT start to hold positions routinely, the answer changes. • YES! There are key differences to each of the existing businesses (all now addressed in the program, although US distribution remains sensitive):

Recent developments in Convergence (4): Non-recourse lending Not strictly recent, but a big growth area as hedge funds and private equity sponsors look for more leverage and to monetise perceived gains. Citigroup is increasingly asked to lend money with recourse only to specified assets (or to lend money to an SPV with no other assets). Regulation requires that Credit Policy be followed (assuming a bank-chain vehicle lends): but when should we use market risk techniques and when should we try to use traditional credit analysis? Rarely a hard and fast rule – try these examples (most of which are real)… • Lend $100mm for one year to European bank X, secured by shares representing a 5% stake in large corporate company A and valued at $150mm; extra margin required if LTV exceeds 80%, or we liquidate the portfolio • Same as (1) but with no extra margin requirement: pure term deal • Same as (1) but where $150mm is spread across a large number of liquid equities • Same as (3) but where customer is a hedge fund and this is the bulk of their portfolio • Same as (3) but where the security is private equity valued at $300mm • Lend $100mm to Canadian corporate Y, secured by shares representing a 95% stake in subsidiary Z and valued at $300mm • Same as (6) but Y is a financial sponsor, not a corporate

Convergence – the golden rules • Talk to each other and know who the point people are • It is better for you to tread on someone’s toes than for both of you to miss something • Don’t wait to be asked But of course • Respect the public/private divide • Be responsive: Convergence shouldn’t mean approvals take twice as long (don’t ask for all the details and then say “not my job”)

Market Risk Management and its overlap with Credit (“Convergence Risk”)