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Tools for risk management

Tools for risk management. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Options. Call, Put European, American Strike, volatility, time to maturity In-the-money, Out-of-the-money Black-Merton-Scholes OTC and Exotic options. premium.

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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. Options • Call, Put • European, American • Strike, volatility, time to maturity • In-the-money, Out-of-the-money • Black-Merton-Scholes • OTC and Exotic options Jun-2000

  3. premium Call Value before Expiration E. Call X Underlying Jun-2000

  4. E. Put X premium X Underlying Put Value before Expiration Jun-2000

  5. Other Options • Callable bond • Warrants • Asian, Bermudian, Digital • Real options • to start a new project • to change prices • to close some divisions Jun-2000

  6. Hedge Ratio = Delta • Delta measures sensitivity of a position relative to a risk factor. • Similar to duration for bonds. • Delta of a call option is … • Delta of a put option is ... Jun-2000

  7. current value Call Delta E. Call S Jun-2000

  8. Put Delta E. Put current value S Jun-2000

  9. Buy index Buy put Sell calls What type of risk protection would you suggest for a pension fund? payoff floor Stock market Jun-2000

  10. Buy stock Result Buy put Sell call Jun-2000

  11. 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 Jun-2000

  12. 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 Jun-2000

  13. 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. Jun-2000

  14. How much did it cost? • The results are not precise and very sensitive to volatility • if volatility is 10% $6.5M • if volatility is 20% $10M • if volatility is 30% $13M • if volatility is 40% $15M This is the amount the bank should pay to DASKASCH! Jun-2000

  15. Risk Management Issues • Why only half of the bond was called? • Why only 800,000 shares were protected? • How to choose the protection level? • When does it make sense to hedge? Jun-2000

  16. Butterfly2*Call(550)-Call(540)-Call(560) payoff 540 550 560 Stock market Jun-2000

  17. 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

  18. 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

  19. 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

  20. Hedge using Options 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. Buy a put option with strike 4.1 for $100. The time match is important! Jun-2000

  21. After a year $ Put Opt. Your balance 3.9 20 3.9*100 - 410 + 20= 0 4.0 10 4.0*100 - 410 + 10= 0 4.1 0 4.1*100 - 410 + 0 = 0 4.2 0 4.2*100 - 410 - 0 =10 4.3 0 4.3*100 - 410 - 0 =20 Protection with some cost! The initial cost of options. Jun-2000

  22. Example Your company has stable yearly income of 8M (shekels) a year and yearly costs of $1M and 1M Euro. For simplicity assume that all payments are on the end of ech calendar year. How to measure and to manage this risk? Jun-2000

  23. Example Time horizon – 1 year Basic currency – SHEKELS Major risk factors – exchange rates USD, EUR and interest rates (for all 3 currencies). The present value of the next cashflow is: Jun-2000

  24. Example Assume that now USD = 4 SHEKELS EUR = 3.5 SHEKELS rNIS = 10% rUSD= 6% rEUR = 5% Jun-2000

  25. Example The current value of the position is 165,809 NIS. But this number is subject to the risk factors. We ignore in this example the interest rates for simplicity. Jun-2000

  26. Example Each time the USD/NIS rate increases by 1 AGORA, our position loses 9,434 NIS. Each AGORA in Euro exchange rate causes a loss of 9,524 NIS. Assume that yearly volatility of USD/NIS is 10%, and EUR/NIS is 20%. Correlation between them -0.1. Jun-2000

  27. Example Jun-2000

  28. Example The best way to hedge this risk is by forward contracts that will allow you to exchange the appropriate amount of foreign currency to SHEKELS at the rate fixed in advance. Another alternative is to use static (or better dynamic) hedge with options. Jun-2000

  29. Example • Assume that for the following 7 years you have to pay each year $1M and you will get each year 5M NIS. • How one can hedge this cash flow? • What if amounts or timing is not precise? Jun-2000

  30. How to hedge financial risk? • Static hedge Forwards agreements that fix the price Futures Options static hedge • Dynamic delta or vega hedge, with a variable amount of options held. It is applicable if there is a very liquid market and low transaction costs. Jun-2000

  31. pluto.mscc.huji.ac.il/~mswiener/ Risk Management resources • Useful Internet sites • Regulators • Insurance Companies • Risk Management in SEC reports Jun-2000

  32. RMG • http://www.riskmetrics.com/ • http://www.pictureofrisk.com/ • http://www.riskmetrics.com/rm/splash.html • rmgaccess Jun-2000

  33. Consulting • Oliver, Wyman and Co. • Willis Corroon • Richard Scora • Ernst and Young • Enterprise Advisors • Kamakura Jun-2000

  34. Examples of Risk Reports http://www.pictureofrisk.com http://www.mbrm.com/ http://www.riskmetrics.com/rm/splash.html Jun-2000

  35. Regulators • BIS • G-30 • FSA • SEC • market risk disclosure rules • market risk reporting • FED, FRB • our GARP report • Swiss Central Bank • Financial Accounting Standards Board Jun-2000

  36. Who manages risk? Nike Sony Dell Computers Philip Morris Ford Motor AIG General Re Swiss Re Aetna Zurich Citibank Bank of England CIBC J. P. Morgan Bankers Trust Jun-2000

  37. SEC reports • Edgar • Yahoo • find symbol • profile • raw SEC reports • market risk in 10K 7A Jun-2000

  38. 3 methods • Sensitivity • requires a deep understanding of positions • Tabular • when there are 1-2 major risk factors • Value-at-Risk • for active risk management Jun-2000

  39. KPMG report Survey of disclosures: SEC Market Risk, 1999 SEC: http://www.sec.gov/smbus/forms/regsk.htm#quan http://www.sec.gov/rules/othern/derivfaq.htm GARP http://www.garp.com/ Jun-2000

  40. World Experience • Bankers Trust, J.P. Morgan, investment banks • Bank regulators, commercial banks • Insurance, dealers • Investment funds (LTCM) • Real companies • Investors learn to read risk information! Jun-2000

  41. Agriculture www.cfonet.com/html/Articles/CFO/1999/99APkita.html 1998 revenues $1.25B consulting Willis Corroon Jun-2000

  42. Nike • Salaries are paid in Asia • Shoes are sold worldwide • Financing comes from USA • Marketing, storing, shipping worldwide use VaR since 1998. Jun-2000

  43. Merck http://www.palisade-europe.com/html/Articles/merck.html http://www.sec.gov/Archives/edgar/data/64978/0000950123-99-005573-index.html see “sensitivity” Jun-2000

  44. Articles Value at Risk as a Diagnostic Tool for Corporates: The Airline Industry http://netec.mcc.ac.uk/WoPEc/data/Papers/dgruvatin19990023.html Agricultural Applications of Value-at-Risk Analysis: A Perspective http://netec.mcc.ac.uk/WoPEc/data/Papers/wpawuwpfi9805002.html Jun-2000

  45. Publications “The New Risk Management: the Good, the Bad, and the Ugly”, P. Dybvig, W. Marshall http://dybfin.olin.wustl.edu/research/papers/riskman_fed.pdf Association for Investment Management and Research http://www.aimr.org/ Jun-2000

  46. Web tour • ZW, students, VaR and risk management • Gloriamundy • GARP • SEC reports • Google Jun-2000

  47. What is more risky and why? A. 1 year bond B. 10 year bond Jun-2000

  48. What is more risky and why? A. An in-the-money option? B. An out-of-the-money option? Jun-2000

  49. In-the-money option Out-of-the-money option Call Value before Expiration Call X Underlying Jun-2000

  50. What is more risky and why? A. A fixed interest loan? B. A floater (variable interest rate)? Jun-2000

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