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Tools for risk management

Learn about risk management principles, measurement tools, financial instruments like options, forwards, and swaps. Understand the distinction between risk taking and control. Discover key concepts such as VaR and benchmarking. Find out more about derivatives, forward contracts, and strategies for managing risks effectively.

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Tools for risk management

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  1. Tools for risk management Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  2. Tools • Measurement tools • Financial tools • options • forwards, futures • swaps • insurance • Outsourcing Jun-2000

  3. Finance Marketing Supply Senior Management Cashflow Capital Jun-2000

  4. Important Principles Distinction between risk taking and risk control. Backtesting. Transparent reporting. Timing is more important then precision! Jun-2000

  5. Basic decisions • Goal of Risk Management • Base currency • Time horizon (embedded options) • Economic or Accounting approach • Admissible risk • Stop losses or other actions Jun-2000

  6. Can NOT Risk Management System • 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 Jun-2000

  7. Measurement Tools • CATS, CARMA $400K/yr • Algorithmics, Risk Watch >$1M • Infinity >$1M • J.P. Morgan, FourFifteen $25K/yr • FEA, Outlook $18K • Risk Manager, RMG $30K/yr • Theoretics, TARGA $75K • Bankers Trust, RAROC $50K/run • INSSINC, Orchestra $25-75K Jun-2000

  8. Definition VaR is defined as the predicted worst-case loss at a specific confidence level (e.g. 99%) over a certain period of time. Jun-2000

  9. VaR1% 1% Profit/Loss VaR Jun-2000

  10. Benchmarking • Financial assets • create an imaginary portfolio and measure performance relative to this portfolio. • Industry • measure relative to competitors. Jun-2000

  11. Financial Tools • Options • Futures/Forwards • SWAP • FRA • Insurance Jun-2000

  12. Derivatives Contracts that are priced according to underlying variables (prices are derived from underlying). Options, Futures, Forwards, Swaps, Warrants, etc. Jun-2000

  13. Derivatives Contingent claims gold shipped KTUBA insurance an option not to undertake a project an option to leave an option to change price Jun-2000

  14. Financial Tools • Options • Futures/Forwards • SWAP • FRA • Insurance Jun-2000

  15. Forward and Futures • Forward agreement • Futures - standard traded contracts • margin • mark to market • Final result is very similar • settlement risk Jun-2000

  16. Forward payoff Forward at maturity Underlying asset Jun-2000

  17. 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! Jun-2000

  18. 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? Jun-2000

  19. 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. Jun-2000

  20. Forward Price Jun-2000

  21. 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! Jun-2000

  22. After a year $ Forward Your balance 3.9 25 3.9*100-410+25= 5 4.0 15 4.0*100-410+15= 5 4.1 5 4.1*100-410+ 5 = 5 4.2 -5 4.2*100-410- 5 = 5 4.3 -15 4.3*100-410-15 = 5 Complete protection with no cost! Jun-2000

  23. 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. Jun-2000

  24. Initial margin Maint. margin margin call Marking to Market Your balance time Jun-2000

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