Financial Risk & Operations/ Insurance Risk Management Chapters 9 & 15

1. Financial Risk & Operations/Insurance Risk Management Chapters 9 & 15 Kenneth L. Parkinson, CCM Managing Director Treasury Information Services, LLC kenp@tisconsulting.com

2. Chapter Overview

3. Value at Risk • Value at risk (VAR) • Effects of rate changes on assets, exposures • Variance-covariance technique assumes normal distribution of future outcomes • Need to estimate average and std. deviation • VaR computed @95% or 99% confidence levels (shown as 5% and 1% VaR) • Compute 5% VaR with average CF of $5.0 billion and std. dev. = $2.0 billion (note that lower end of std dev for normal = -1.65 … so:VaR = ($5.0) – 1.65(2.0) = $5 – 3.3 = $1.70 billion

4. Risk Profile Techniques • Sensitivity analysis • Change one variable at a time • Limited • Scenario analysis • Change several variables at a time • Best-worst-expected cases • Simulation (Monte Carlo) • Computerized analysis of all variables

5. Hedging, Speculation, Arbitrage • Hedging • Use financial instruments to eliminate risks from future cash flows (like insurance) • Speculation • Taking on risk to make money • Naked speculators – exposed at least one way if rates change • Arbitrage • Straddle markets (buy in one, sell in another) to make easy profit

6. Benefits from Fin Risk Mgt • Reduce variability in future cash flows • Smooth flows with hedges • Better forecasts • Lower likelihood of financial distress • Maybe more attractive to investors? • Better borrowing advantage from less perceived risk

7. Derivatives • Use: • Hedging or speculation • Risks: Depend on • Instrument underlying derivative • Complexity of derivative • Whether hedging or speculative in nature • Whether OTC or exchange traded • Strength of counter-party (for OTC)

8. Tools: Forward Contracts • Forwards • Contract between two parties requiring action at a later time. • Usually involve delivery of underlying asset: • Currency forwards: currency • Financial forwards: governmental security • Commodity forwards: standard agricultural or resource commodities • Markets managed and supported by banks, dealers, traders • Most active: FX (currency) and money mkts. (govt. securities) • Forwards can be created for any asset, any period of time, for any amount • Forwards have costs for each contract, regardless of amount. • Heavy use for hedging FX exposures.

9. Futures Based on standardized contracts, underlying assets, amounts, delivery dates, terms Bought and traded on organized exchanges Contracts are marked to market on continual basis (daily). Investors use leverage via margins. Margin calls based on mark to market, excesses can be withdrawn. Futures yield the value when contracts are closed out (so do not worry about calc.) Swaps Notional amount: value of underlying asset (doesn't change hands) Interest rate swaps: convert fixed-rate to floating-rate (and vice versa) Currency swaps: convert obligation from one currency to another Commodity swaps: convert floating price to a fixed price Basis swaps: convert borrowing agreement from one rate basis to another Tools: Futures and Swaps

10. Tools: Options • Options • Call: right to buy underlying asset vs. Put: right to sell underlying asset. • Strike price: price at which option can be exercised • Buyer of option pays premium to writer of option (seller). • Exist for stocks, currencies, market indices, futures, commodities. • American options (exercisable up to/including expiration date) and European options (only exercisable on expiration date). • Many are exchange traded.

11. Positions If I buy an option, I have taken the long position. The party that sells me the option (or writes it), has taken the short position. Don’t confuse this with a put or a call. Call option – right to buy [underlying security] or commodity at a fixed price in the future. Put option – opposite of a call; right to sell. Other key Elements Exercise or Strike Price Premium or Price Maturity or Expiration American option Can be exercised [when?]. European option Can [only] be exercised [when?]. Others Barrier – depends on whether a ‘barrier’ has been crossed, like a min. price. Asian – depend on average price of underlying Option Terminology

12. Market and Exercise Prices • In the Money - exercise of the option would be profitable … • Call (buy): market price > exercise price • Put (sell): market price < exercise price • Out of the Money - exercise of the option would not be profitable … • Call: market price < exercise price • Put: market price > exercise price • At the Money - exercise price and asset price are equal.

13. 13 Payoff Profiles for Calls Payoff Call Holder At the money In the money 0 Out of the money option premium Call Writer Exercise Price Stock Price How would this look for puts?

14. FX Rates • For US, usually quoted in currency/US$ • Pound and euro usually opposite • Know bid-ask rate quotation (bid or buy 1st) • So, for JPY of 92.32-38 what would you pay to sell yen? Your yen/which rate = US$ • Forwards depend on 3 things: • Current spot rate (what’s a spot rate?) • Term of the forward • Interest rates in the two countries trading

15. FX Exposures • Types of exposures • Transaction: exposure of B/S accounts (e.g., A/R, A/P, loans) to change in FX rates between time transaction booked and when it is paid • Translation: created when foreign sub's fin. stmt. are translated into US$ for consolidation (FASB 52 applies). Adjustments made to equity; no effect on cash flow, EPS, or P&L • Economic: LT effect of transaction exposure on PV of cash flows to the firm. This even exists for firms dealing in domestic sales (denominated in US$) because FX rate changes affect competitive relationships.

16. Transaction Lifecycle & Exposures(similar to Ex. 9.3 of Essentials, P. 310) Economic Exposure Translation Exposure Most corporate activity Implicit Transaction Exposure Explicit Transaction Exposure PO Ship LRP Fin Fcst Price set Settle

17. Interest Rate Exposure • Exposure to falling/rising or ST/LT rates • Types of contracts • Forward rate agreements (FRAs): • Agree on interest rate to be paid on future date. • Principal never exchanged; contracts settled in cash • Interest rate futures: • Binding commitments to sell financial instruments at specified future date a at a specified price. • Not used for buying/selling but for generating gains/losses on value of instruments • ST instruments: 90 day Euro TDs, 90-day T-Bills, 90-day CDs. • LT instruments: 30-yr. T-Bonds, 10-yr. T-Notes, 5-yr. T-Notes

18. Interest Rate Exposure • Options: put or call depending on expected interest rate movements • Swaps: to convert fixed-rate payment to floating-rate payment or vice versa. • Interest rate caps, collars, and floors • Caps: guarantees that rates on floating-rate loans will not exceed specified levels; if rates do, lender pays difference to borrower • Floors: minimum interest rates for floating-rate loan • Collars: give holders minimum and maximum rates

19. Commodities • Exposures • Price • Availability of commodity • Exchange traded (Chicago Board of Trade, Chicago Mercantile Exchange, Commodity Exchange in NYC) • Types of contracts same as FX, et al.

20. Other FRM Issues • Impact of Dodd-Frank Act • More transparency & accountability in derivs. • Hedging policy statements • Protection & transparency (internally) • Emerging market currencies • Free float, some ctls., not traded (BRL, KRW,CNY) • Exotic currencies • No good FX market • NDFs: non-deliverable forwards via a base currency • NDOs (non-deliverable options) also

21. Chapter 15 Enterprise Risk Management

22. Risk Management Process • 5 steps • Determine risk tolerance • Identify level of exposures and impact • Measure level and impact in quant. & qual. terms • Develop and implement risk mgmt. strategy: avoid, transfer, hedge (mitigate), keep • Report and monitor exposure (evaluate strategy) • Risk Tolerance? • New cos. May be more aggressive • Mature cos. May be more cautious • Then there are governments And not-for-profits

23. Risk Profile [Analysis] • Risk profile: how overall value changes as price of financial variable, such as EPS or stock price, changes • Risk profile analysis • Categorize risks • Quantify probabilities of occurrence • Quantify impact on variables • Risk and control self-assessment (RCSA)

24. Operational risk Internal risks: employee risk, process risk, technology risk External risks: financial institution risk, legal-regulatory risk, supplier risk, theft/fraud, security, natural disaster, terrorism Factors affecting risk management strategy Culture: zero tolerance; employee awareness and ethical standards Procedures: documentation, channels for information Technology: used wisely Operational Risk Management Chapter 18

25. Payment System Risks • Systemic • Collapse of market, financial system • Settlement • Counterparty credit • Wire transfer credit • ACH credit • Return item • Payment fraud risk • Check fraud: counterfeit, forgeries, altered checks • Kiting • Electronic debits • Payment cards

26. Enterprise Risk Mgmt. (ERM) • Market/financial risk • Equity price, interest rate, FX, commodity price • Credit risk • Liquidity risk • Funding, asset liq. • Operational risk • Legal/regulatory risk • Business risk • Strategic risk • Reputation risk

27. Disaster Recovery & Business Continuity • Restoring systems and communications after down time (outage). • Disaster avoidance • Disaster recovery plan (including treasury) • Business continuity • Crisis management • Alternative operating procedures • Emergency and temporary communications

28. Disaster Recovery Plan • Identify mission-critical functions • Interruption affects cash flows (in/out) • Technology required (e.g., TWS) • Assess risks (ask “what if” questions) • Risks to resources and infrastructure • How likely to occur • Evaluate contingencies • What works • What doesn’t • Prioritize correction actions • Use simple matrix approach • Test plan regularly

29. Insurance • Effects of accidents • Reduce profitability of company due to liability • Increase liquidity needed to pay out • Hamper financial security due to unexpected liabilities • Types of losses • Property • Business interruption • Breach of contract • Lawsuits • Personnel loss and workers’ comp.

30. Liability Difference in condition (DIC) Umbrella (excess) Property Casualty Workers’ compensation Business interruption Directors and officers (D&O) Fidelity and crime Employee benefits Other Ocean/marine Special multiperil (SMP) Fiduciary Types of Insurance

31. Insurance & Risk Financing • Select provider • LT solvency • Insurer rating (by A. M. Best) • Cost vs. exposure • Select deductible • Per occurrence • Aggregate • Select liability limit • Claims & service • Retention of risk • No insurance • Self-insurance • Captive (single/group) • Retention group • Claims management • Transfer of risk • Hold harmless agrmts. • Guaranteed costs • Retro-rated programs

32. 2. Which of the following options is out-of-the-money if the underlying value of asset ABC is 100? A put with strike price = 100 A put with strike price = 75 A call with strike price = 75 A call with strike price = 100 1. Marking futures contracts to market means … Calculating the value of a forward FX contract. Posting gains and losses to the contract as they occur Computing the value of FX spot contracts outstanding. Resetting the value of options. Practice Questions

33. 4. If an option contract can be exercised only on its maturity date, this a form of European option contract American option contract Exotic option contract Mental cruelty 3. All of the following are types of insurance except Ocean/marine Crime Difference in fidelity Umbrella Practice Questions

34. 6. Assuming the precise date of an expected cash flow is known, which of the following risk management instruments would most likely be used to hedge the expected cash flow in a foreign currency? Swap Forward FX contract Collar Forward rate agreement 5. Which of the following is a method to measure workers’ compensation losses? Replacement costs of business interruption Potential losses from injuries to customers Costs of disability payments Costs of recovering lost customers Practice Questions

35. Practice Questions Transaction Lifecycle & Exposures B A A C D E F G H LRP Settle Price set PO Ship 7. The line shown as E-F is (A) Invoice settlement exposure (B) Implicit transaction exposure (C) Economic exposure (D) Explicit translation exposure 8. The line shown as C-D is (A) Invoice settlement exposure (B) Implicit transaction exposure (C) Economic exposure (D) Explicit translation exposure

36. Answers (No Peeking!) • B • B • C • A • C • B • B • D

37. Any Questions?