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Financial Risk Management

Financial Risk Management. Zvi Wiener mswiener@mscc.huji.ac.il 02-588-3049. Financial Risk Management. Zvi Wiener Head of Finance Department The Hebrew University of Jerusalem 02-588-3049, mswiener@mscc.huji.ac.il. Ronen Midbary 03-562-9924 rmidbary@ovedgubi.com. Statistics.

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Financial Risk Management

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  1. Financial Risk Management Zvi Wiener mswiener@mscc.huji.ac.il 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  2. Financial Risk Management • Zvi Wiener • Head of Finance Department • The Hebrew University of Jerusalem • 02-588-3049, mswiener@mscc.huji.ac.il Ronen Midbary 03-562-9924 rmidbary@ovedgubi.com VaR-PJorion-Ch1-3

  3. Statistics • Random variables • Mean, Standard Deviation, Correlation • Normal distribution VaR-PJorion-Ch1-3

  4. Basic Corporate Finance • NPV, IRR, YTM • Assets, Liabilities • Regulators, Bank of Israel, MOF • ISDA, SEC VaR-PJorion-Ch1-3

  5. Investments • Stocks, Indices, , CAPM,  • Bonds, duration, convexity • NIS, CPI linked • callable, puttable, convertible • Forwards, Futures, Swaps • Options,  • European, American • Call, Put, BS formula • Markets: prices, volatilites, LIBORs, swap rates VaR-PJorion-Ch1-3

  6. Financial Risk Management Following P. Jorion, Value at Risk, McGraw-Hill Chapter 1 The Need for Risk Management http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  7. Financial Risks • Risk is the volatility of unexpected outcomes. • Business Risk • Financial Risk • Legal Risk • Operational Risk VaR-PJorion-Ch1-3

  8. Analytic Risk Management Tools • Duration 1938 • Markowitz mean-variance 1952 • Sharpe’s CAPM 1963 • Multiple factor models 1966 • Black-Merton-Scholes model 1973 • RAROC 1983 • Limits by duration buckets 1986 VaR-PJorion-Ch1-3

  9. Analytic Risk Management Tools • Risk-weighted assets (banks) 1988 • Stress Testing 1992 • Value-at-Risk, VaR 1993 • RiskMetrics 1994 • CreditMetrics 1997 • Integration of credit and market 1998- • Enterprisewide RM 2000- VaR-PJorion-Ch1-3

  10. Derivatives and Risk Management • Stocks and bonds are securities – issued to raise capital. • Derivatives are contracts, agreements used for risk transfer. VaR-PJorion-Ch1-3

  11. Financial Derivatives • Futures, Forwards, Swaps • Options • European, American, Asian, Parisian • Call, Put • Cap, Floor • Credit derivatives VaR-PJorion-Ch1-3

  12. Types of Financial Risks • Market Risk • Credit Risk • Liquidity Risk • Operational Risk • Legal Risk VaR-PJorion-Ch1-3

  13. duration, convexity volatility delta, gamma, vega rating target zone What is the current Risk? Bonds Stocks Options Credit Forex Total ? VaR-PJorion-Ch1-3

  14. Standard Approach VaR-PJorion-Ch1-3

  15. Modern Approach Financial Institution VaR-PJorion-Ch1-3

  16. Example • You live in Herzliya and work in Tel-Aviv. • When do you have to leave your home to be at work at 8:30? VaR-PJorion-Ch1-3

  17. How much can we lose? • Everything • correct, but useless answer. • How much can we lose realistically? VaR-PJorion-Ch1-3

  18. Definition • VaR is defined as the predicted worst-case loss at a specific confidence level (e.g. 99%) over a certain period of time. VaR-PJorion-Ch1-3

  19. Definition (Jorion) • VaR is the worst loss over a target horizon with a given level of confidence. VaR-PJorion-Ch1-3

  20. VaR1% 1% Profit/Loss VaR VaR-PJorion-Ch1-3

  21. VaR 1% Meaning of VaR • A portfolio manager has a daily VaR equal $1M at 99% confidence level. • This means that there is only one chance in 100 that a daily loss bigger than $1M occurs, under normal market conditions. VaR-PJorion-Ch1-3

  22. 1% of worst cases Returns year VaR-PJorion-Ch1-3

  23. Main Ideas • A few well known risk factors • Historical data + economic views • Diversification effects • Testability • Easy to communicate VaR-PJorion-Ch1-3

  24. value scenarios sensitivity Conventional Analysis $ Risk factor VaR-PJorion-Ch1-3

  25. price yield VaR approach $ Risk factor VaR-PJorion-Ch1-3

  26. Important • VaR is a necessary, but not sufficient procedure for controlling risk. • It must be supplemented by limits and controls, in addition to an independent risk-management function. • Sound risk-management practices. VaR-PJorion-Ch1-3

  27. Financial Risk Management Following P. Jorion, Value at Risk, McGraw-Hill Chapter 2 Lessons from Financial Disasters http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  28. Derivatives 1993-1995 • ($ million) • Shova Shell, Japan 1,580 • Kashima Oil, Japan 1,450 • Metallgesellschaft 1,340 • Barings, U.K. 1,330 • Codelco, Chile 200 • Procter & Gamble, US 157 VaR-PJorion-Ch1-3

  29. Public Funds • ($ million) • Orange County 1,640 • San Diego 357 • West Virginia 279 • Florida State Treasury 200 • Cuyahoga County 137 • Texas State 55 VaR-PJorion-Ch1-3

  30. Barings • February 26, 1995 • 233 year old bank • 28 year old Nick Leeson • $1,300,000,000 loss • bought by ING for $1.5 VaR-PJorion-Ch1-3

  31. Metallgesellshaft • 14th largest industrial group • 58,000 employees • offered long term oil contracts • hedge by long-term forward contracts • short term contracts were used (rolling hedge) • 1993 price fell from $20 to $15 • $1B margin call in cash VaR-PJorion-Ch1-3

  32. Orange County • Bob Citron, the county treasures • $7.5B portfolio (schools, cities) • borrowed $12.5B, invested in 5yr. notes • interest rates increased • reported at cost - big mistake! • realized loss of $1.64B VaR-PJorion-Ch1-3

  33. Daiwa • 12-th largest bank in Japan • September 1995 • Hidden loss of $1.1B accumulated over 11 years • Toshihide Igushi, trader in New York • Had control of front and back offices • In 92 and 93 FED warned Daiwa about bad management structure. VaR-PJorion-Ch1-3

  34. VaR-PJorion-Ch1-3

  35. Big Losses • Bank Negara, Malaysia $3B 92 • Banesto (Spain’s 5th bank) $4.7B 93 • Credit Lyonnais $15B 94 • S&L short deposits, long loans $150 80s • Japan $550 90s VaR-PJorion-Ch1-3

  36. Responses • G-30 report • DPG = Derivatives Policy Group, risk.ifci.ch • JPMorgan’s RiskMetrics www.riskmetrics.com • GARP www.garp.com • PRMIA www.prmia.org • GAO = General Accounting Office, www.gao.gov/reports.htm • FASB FAS 133 www.fas133.com, FAS 107 • IASC, IAS 39 www.iasc.org.uk • SEC = Securities and Exchange Commission • www.sec.gov/rules/final/33-7386.txt VaR-PJorion-Ch1-3

  37. Financial Risk Management Following P. Jorion, Value at Risk, McGraw-Hill Chapter 3 Regulatory Capital Standards with VaR http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  38. Why regulation? • Externalities • Deposit insurance • Moral hazard – less incentives to control risk • Basel Accord 1988 • measure of solvency = Cooke ratio VaR-PJorion-Ch1-3

  39. Cooke ratio • The Basel Accord requires capital to be at least 8% of the total risk-weighted assets of the bank. • Capital definition is broad: • Tier 1. Stocks, reserves (retained earnings) ( 50%) • Tier 2. Perpetual securities, undisclosed reserves, subordinated debt >5 years. VaR-PJorion-Ch1-3

  40. Weights Asset Type • 0% Cash • Claims on OECD central government • local currency claims on central banks • 20% Cash to be received • OECD banks and regulated securities firms • non-OECD banks below 1 year • multilateral development banks • foreign OECD public sector entities • 50% residential mortgage loans VaR-PJorion-Ch1-3

  41. Weights Asset Type • 100% Claims on private sector (corp. debt, equity…) • Claims on non-OECD banks above 1 year • Real estate • Plant and equipment • At national discretion • 0-50% Claims on domestic OECD public-sector entities • OECD (Organization for Economic Cooperation and Development): Austria, Belgium, Canada, Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, The Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, UK, Japan, Finland, Australia, New Zealand, Mexico, Czech Republic, Hungary, Korea and Poland. VaR-PJorion-Ch1-3

  42. Credit Risk Charge VaR-PJorion-Ch1-3

  43. Activity Restrictions • Restrictions on large risks (over 10% of capital) • must be reported • over 25% prohibited • total of large risks can not exceed 8*capital VaR-PJorion-Ch1-3

  44. Criticism of 1988 Approach • Regulatory arbitrage (securitization) • Credit derivatives • Inadequate differentiation of credit risks • Non-recognition of term structure effect • Non-recognition of risk mitigation • Non-recognition of diversification • Non-recognition of market risk VaR-PJorion-Ch1-3

  45. Market Risk Amendment 1996 • Trading book – financial instruments that intentionally held for short-term resale and are typically marked-to-market • Banking book – other instruments, like loans. • TRC = CRC + MRC • Tier 3 capital: short-term subordinated debt (must be less than 2.5*Tier1) VaR-PJorion-Ch1-3

  46. The Standardized Model • Maturity bands • Partial netting • Duration weights • No diversification across risks VaR-PJorion-Ch1-3

  47. The Internal Models Approach • Quantitative parameters for VaR • 10 business days or 2 weeks • 99% confidence level • at least one year of historical data updated at least quarterly • Treatment of correlations – can be recognized VaR-PJorion-Ch1-3

  48. 1 day can be scaled by square root of 10 • Typically average times k is used. • k initially is set to 3, but later it can be increased • Specific Risk Charge SRC is added. VaR-PJorion-Ch1-3

  49. Basel Rules MRC • Market Risk Charge = MRC • SRC - specific risk charge, k 3. VaR-PJorion-Ch1-3

  50. Backtesting • Verification of Risk Management models. • Comparison if the model’s forecast VaR with the actual outcome - P&L. • Exception occurs when actual loss exceeds VaR. • After exception - explanation and action. VaR-PJorion-Ch1-3

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