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RM functions

RM functions. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Structuring RM functions. Set firm-wide policies Develop methodology Set RM structure Risk communication. Integrated Risk Management. Limit Management. Risk Analysis. RAROC. Active Risk

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RM functions

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  1. RM functions Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  2. Structuring RM functions • Set firm-wide policies • Develop methodology • Set RM structure • Risk communication FRM-3

  3. Integrated Risk Management Limit Management Risk Analysis RAROC Active Risk Management Allocate capital Stress Market, Credit VaR Monitor Identify and avoid FRM-3

  4. RAROC • Risk Adjusted Rate of Return • Performance measurement • Marginal impact of any new transaction • Consistent pricing FRM-3

  5. New Approach Three pillars A. Minimum Capital Requirement B. Supervisory Review Process C. Market Discipline Requirements FRM-3

  6. Goals and Instruments • Risk Tolerance - “worst loss” • Stop losses • Capital allocation • Credit risk policy • Operational risk policy FRM-3

  7. Risk Measurement • Consistent market based method • Old • limits • duration, ALM • VaR + Stress • Backtesting FRM-3

  8. Systems • Data bases • market • position • rules • Risk measuring tool • Reports and decision support FRM-3

  9. IT - Information Technology • Unifying information from various units • Unifying information from various markets • Unifying information for various ownership • Back office and execution control FRM-3

  10. Organizational structure • Front office • Middle office • Back office FRM-3

  11. Front office • execution • risk taking • marketing FRM-3

  12. Middle office • risk management • pricing • economic forecasts FRM-3

  13. Back office • verification • booking • reporting • collection • settlement FRM-3

  14. ALCO • Assets Liability management committee • responsible for • establishing • documenting • enforcing all policies involving market risk • FX • liquidity • interest rate FRM-3

  15. Interdependence of RM Trading Room Senior Management Operations Risk Management Finance FRM-3

  16. Senior management • Approves business plan and targets • Sets risk tolerance • Establishes policy • Ensures performance FRM-3

  17. Trading Room Management • Establishes and manages risk exposure • Ensures timely and accurate deal capture • Signs off on official P&L FRM-3

  18. Operations • Books and settles the trades • Reconciles front and back office positions • Prepares and decomposes daily P&L • Provides independent MTM • Supports business needs FRM-3

  19. Finance • Develops valuation and finance policy • Ensures integrity of P&L • Manages business planning process • Supports business needs FRM-3

  20. Risk Management • Develops risk policies • Monitors compliance to limits • Manages ALCO process • Vets models and spreadsheets • Provides independent view on risk • Supports business needs FRM-3

  21. Risk Limits • Global risk limit • Risk limits for trading desks/units • Dynamic monitoring and adjustment FRM-3

  22. Risk Approaches • Accounting - reported P&L • Economic - value • Liquidity needs FRM-3

  23. Liquidity Rank • Based on forecasts and potential availability of funds. • Hot funds - can be withdrawn quickly. • Stable funds - typically to maturity. FRM-3

  24. Israel 339 • Definitions of risk types • Relates to all banking institutions • Management structure • Exposure document • Directors and policy • Risk manager • Internal audit FRM-3

  25. Israel 339 • IR risk • Market risk • Risk audit unit FRM-3

  26. Israel 341 • Capital requirements against market risk • Risk measurement • Trading portfolio • Reporting • Examples of standard approach and VaR FRM-3

  27. Israel 341 • Capital requirements against market risk • Risk measurement • Trading portfolio • Reporting • Examples of standard approach and VaR FRM-3

  28. Qualitative Requirements • An independent risk management unit • Board of directors involvement • Internal model as an integral part • Internal controller and risk model • Backtesting • Stress test FRM-3

  29. Quantitative Requirements • 99% confidence interval • 10 business days horizon • At least one year of historic data • Data base revised at least every quarter • All types of risk exposure • Derivatives FRM-3

  30. Types of Assets and Risks • Real projects - cashflow versus financing • Fixed Income • Optionality • Credit exposure • Legal, operational, authorities FRM-3

  31. Risk Factors There are many bonds, stocks and currencies. The idea is to choose a small set of relevant economic factors and to map everything on these factors. • Exchange rates • Interest rates (for each maturity and indexation) • Spreads • Stock indices FRM-3

  32. FRM-3

  33. FRM-3

  34. FRM-3

  35. Board of Directors(Basle, September 1998) • periodic discussions with management concerning the effectiveness of the internal control system • a timely review of evaluations of internal controls made by management, internal and external auditors • periodic efforts to ensure that management has promptly followed up on recommendations and concerns expressed by auditors and supervisory authorities on internal control weaknesses • a periodic review of the appropriateness of the bank’s strategy and risk limits. FRM-3

  36. Forward agreement • Is an obligation on both sides • No initial money transfer • Final price is fixed in advance • Typical cash settlement • Margin account and mark to market FRM-3

  37. Forward/Futures value Spot X $ FRM-3

  38. Options • Put or Call • European or American • Underlying asset • Strike price • Premium • Time to maturity • Hedge ratio FRM-3

  39. premium Call Option value X underlying FRM-3

  40. Hedge Ratio value X underlying FRM-3

  41. Put Option value X underlying FRM-3

  42. Exotic Options • Asian • Path dependent • Digital • Bermudian • Knock-in, out • Exchange of assets • Swaptions FRM-3

  43. Swap • currency or interest rate • two loans with swapped payments • low credit risk • changes exposure: • currency • duration FRM-3

  44. Structured Note • tailor made solution • for example, IO, PO • higher priority obligations or junk • collar, IAS, ratchet, etc. FRM-3

  45. Collar • Firm B has shares of firm C of value $200M • They do not want to sell the shares, but need money. • Moreover they would like to decrease the exposure to financial risk. • How to get it done? FRM-3

  46. Collar 1. Buy a protective Put option (3y to maturity, strike = 90% of spot). 2. Sell an out-the-money Call option (3y to maturity, strike above spot). 3. Take a “cheap” loan at 90% of the current value. FRM-3

  47. Buy stock Result Buy put Sell call FRM-3

  48. 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 FRM-3

  49. 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 FRM-3

  50. 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. FRM-3

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