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Financial Risk Management

Financial Risk Management. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Breakfast. $2 $4 $5 $7 $9 $11 $13 $15 . 50% 50%. Lunch. 50% 50%.  = $11  = ??.  = $11  = $4. Correlation =+1. Breakfast. $2 $4 $5 $7 $9

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Financial Risk Management

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

  2. FRM-2

  3. Breakfast $2 $4 $5 $7 $9 $11 $13 $15 50% 50% Lunch 50% 50%  = $11  = ?? FRM-2

  4.  = $11  = $4 Correlation =+1 Breakfast $2 $4 $5 $7 $9 $11 $13 $15 50% 50% Lunch 50% 50% FRM-2

  5.  = $11  = $2 Correlation =-1 Breakfast $2 $4 $5 $7 $9 $11 $13 $15 50% 50% Lunch 50% 50% FRM-2

  6.  = $11  = $3.16 Correlation =0 Breakfast $2 $4 $5 $7$9 $11 $13$15 50% 50% Lunch 50% 50% FRM-2

  7. Example We will receive n dollars where n is determined by a die. What would be a fair price for participation in this game? FRM-2

  8. Example 1 Score Probability 1 1/6 2 1/6 3 1/6 4 1/6 5 1/6 6 1/6 Fair price is 3.5 NIS. Assume that we can play the game for 3 NIS only. FRM-2

  9. Example If there is a pair of dice the mean is doubled. What is the probability to gain $5? FRM-2

  10. Example All combinations: 1,1 2,1 3,1 4,1 5,1 6,1 1,2 2,2 3,2 4,2 5,2 6,2 1,3 2,3 3,3 4,3 5,3 6,3 1,4 2,4 3,4 4,4 5,4 6,4 1,5 2,5 3,5 4,5 5,5 6,5 1,6 2,6 3,6 4,6 5,6 6,6 36 combinations with equal probabilities FRM-2

  11. Example All combinations: 1,1 2,1 3,1 4,1 5,1 6,1 1,2 2,2 3,2 4,2 5,2 6,2 1,3 2,3 3,3 4,3 5,3 6,3 1,4 2,4 3,4 4,4 5,4 6,4 1,5 2,5 3,5 4,5 5,5 6,5 1,6 2,6 3,6 4,6 5,6 6,6 4 out of 36 give $5, probability = 1/9 FRM-2

  12. Additional information: the first die gives 4. All combinations: 1,1 2,1 3,1 4,1 5,1 6,1 1,2 2,2 3,2 4,2 5,2 6,2 1,3 2,3 3,3 4,3 5,3 6,3 1,4 2,4 3,4 4,4 5,4 6,4 1,5 2,5 3,5 4,5 5,5 6,5 1,6 2,6 3,6 4,6 5,6 6,6 1 out of 9 give $5, probability = 1/9 FRM-2

  13. Additional information: the first die gives 4. All combinations: 1,1 2,1 3,1 4,1 5,1 6,1 1,2 2,2 3,2 4,2 5,2 6,2 1,3 2,3 3,3 4,3 5,3 6,3 1,4 2,4 3,4 4,4 5,4 6,4 1,5 2,5 3,5 4,5 5,5 6,5 1,6 2,6 3,6 4,6 5,6 6,6 4 out of 24 give $5, probability = 1/6 FRM-2

  14. Example 1 -2 -1 0 1 2 3 FRM-2

  15. Example 1 1 2 3 4 5 6 we pay 1 2 3 4 5 6 7 6 NIS. 2 3 4 5 6 7 8 3 4 5 6 7 8 9 4 5 6 7 8 9 10 5 6 7 8 9 10 11 6 7 8 9 10 11 12 FRM-2

  16. P&L 1 2 3 4 5 6 1 -4 -3 -2 -1 0 1 2 -3 -2 -1 0 1 2 3 -2 -1 0 1 2 3 4 -1 0 1 2 3 4 5 0 1 2 3 4 5 61 2 3 4 5 6 FRM-2

  17. Example 1 (2 cubes) FRM-2

  18. Example 1 (5 cubes) FRM-2

  19. Value dollar Interest Rate interest rates and dollar are NOT independent FRM-2

  20. Regulation of Financial Intermediaries • take deposits, give loans • very small equity capital, big leverage • FDIC, CDIC, Israel - implicit • domino effect • Minimal capital requirements (8-9%) FRM-2

  21. Banks • major increase of off-balance sheet in 80s • 1988 Basle accord (88 BIS Accord) - international minimum capital guidelines (credit risk). • 1996 Amendment - market risk + VaR. • Amendment = BIS 98 FRM-2

  22. Accord + Amendment • assets to capital  20 • eligible capital/risk weighted assets  8% • minimal capital charge for market risk • concentration risk: • positions of 10% must be reported • positions of 25% need special permission FRM-2

  23. Accord + Amendment • regulators encourage banks to develop models. • Banks must implement a RM infrastructure in their daily RM - limits, monitoring, etc. • G-30 report, 1993. FRM-2

  24. G-30 policy recommendations • The Role of senior management • Marking to market • Market valuation methods • Identifying revenue sources • Measuring market risk (VaR) • Stress simulation • Investing and funding forecasts FRM-2

  25. G-30 policy recommendations • Independent risk management • Practices by end-user • Measuring credit exposure • Master agreements • Credit enhancements • Promoting enforceability • Professional expertise FRM-2

  26. G-30 policy recommendations • Systems • Authority • Accounting practices • Disclosures • Recognizing netting • Legal and regulatory uncertainty • Tax treatment • Accounting standards FRM-2

  27. 1988 BIS Accord • Developed by Basle committee • Accepted by G-10: Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, UK, USA. • minimum asset to capital multiple • risk based capital ratio FRM-2

  28. 1988 BIS Accord risk based capital ratio - solvency ratio (Cooke ratio). Capital divided by risk weighted on-balance-sheet assets plus off-balance-sheet exposures. Weights are based on credit risk. No netting or portfolio effects! No market risk. FRM-2

  29. 1988 BIS Accord The Assets-to-capital multiple  20 Bank’s total assets divided by its total capital. Some off-balance-sheet items, like letters of credit are accounted at nominal. FRM-2

  30. Weights in Cooke ratio On-balance-sheet items: 0% Cash, gold, OECD government claims, insured mortgages. 20% OECD banks, OECD public sector entities. 50% Uninsured residential mortgages. 100% All other claims. FRM-2

  31. Cooke ratio Off-balance-sheet credit equivalent. 1. Nonderivative exposure - conversion factor is set by regulators between 0 and 1. 2. Derivative exposure = Current replacement cost + Add-on amount Risk weighted amount = Assets*W+Credit equivalent*W FRM-2

  32. Cooke ratio • Banks are required to maintain capital equal to at least 8% of their total risk weighted assets. (In Israel 9%.) FRM-2

  33. Capital • Tier 1. Stock equity, preferred stock, minority equity interest in consolidated subsidiaries, less goodwill and other deductions. • Tier 2. Cumulative perpetual preferred shares, 99 year debentures, some subordinated debt (5y). • Tier 3. Can be used to cover market risk only. Short term subordinated debt (2y). • Tier 1 + Tier 2  8%, and Tier 1 must be at least 50% of this amount. FRM-2

  34. Models • Standard model. • Internal models (based on VaR). (3*marketVaR10d +4*creditVaR10d)*trigger/8 trigger = 8 in North America and between 8 and 25 in the UK FRM-2

  35. Problems with the current approach • No distinction between a loan of $100 and 100 loans of $1 each one. • Turkish bank has lower capital requirements than General Electric. • A loan to AA rated firm is treated as a loan to a B rated firm. • Some similar contracts are treated differently. FRM-2

  36. New proposals • BIS 2000 • VaR based approach to credit risk. • CreditMetrics • CreditRisk+ • KMV • Merton. FRM-2

  37. New Approach Three pillars A. Minimum Capital Requirement B. Supervisory Review Process C. Market Discipline Requirements FRM-2

  38. duration, convexity volatility delta, gamma, vega rating target zone What is the current Risk? • Bonds • Stocks • Options • Credit • Forex • Total ? FRM-2

  39. Standard Approach FRM-2

  40. Modern Approach Financial Institution FRM-2

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