RM functions

Zvi Wiener 02-588-3049

http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
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Structuring RM functions
Set firm-wide policies

Develop methodology
Set RM structure

Risk communication

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Active Risk Management

Allocate capital
Stress Market, Credit VaR Monitor Identify and avoid

RAROC

Risk Analysis

Limit Management

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RAROC
Risk Adjusted Rate of Return

Performance measurement
Marginal impact of any new transaction

Consistent pricing

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New Approach
Three pillars

A. Minimum Capital Requirement

B. Supervisory Review Process

C. Market Discipline Requirements

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Goals and Instruments

Risk Tolerance - worst loss Stop losses Capital allocation

Credit risk policy

Operational risk policy
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Risk Measurement
Consistent market based method Old
limits duration, ALM

VaR + Stress
Backtesting
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Systems
Data bases
market
position rules

Risk measuring tool

Reports and decision support

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IT - Information Technology
Unifying information from various units Unifying information from various markets Unifying information for various ownership

Back office and execution control

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Organizational structure
Front office
Middle office Back office

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Front office
execution risk taking marketing

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Middle office
risk management
pricing

economic forecasts

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Back office
verification
booking

reporting
collection

settlement

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ALCO
Assets Liability management committee responsible for
establishing
documenting enforcing all policies involving market risk FX liquidity interest rate

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Interdependence of RM
Senior Management
Trading Room

Risk Management

Operations

Finance

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Senior management
Approves business plan and targets

Sets risk tolerance

Establishes policy

Ensures performance

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Trading Room Management

Establishes and manages risk exposure

Ensures timely and accurate deal capture

Signs off on official P&L

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Operations
Books and settles the trades

Reconciles front and back office positions

Prepares and decomposes daily P&L

Provides independent MTM

Supports business needs

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Finance
Develops valuation and finance policy

Ensures integrity of P&L

Manages business planning process

Supports business needs

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Risk Management
Develops risk policies Monitors compliance to limits Manages ALCO process Vets models and spreadsheets Provides independent view on risk Supports business needs
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Risk Limits
Global risk limit Risk limits for trading desks/units Dynamic monitoring and adjustment

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Risk Approaches
Accounting - reported P&L

Economic - value
Liquidity needs

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Liquidity Rank
Based on forecasts and potential availability
of funds.

Hot funds - can be withdrawn quickly. Stable funds - typically to maturity.

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Israel 339
Definitions of risk types Relates to all banking institutions Management structure Exposure document Directors and policy Risk manager Internal audit
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Israel 339
IR risk

Market risk
Risk audit unit

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Israel 341
Capital requirements against market risk Risk measurement Trading portfolio

Reporting
Examples of standard approach and VaR

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Israel 341
Capital requirements against market risk Risk measurement Trading portfolio

Reporting
Examples of standard approach and VaR

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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

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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

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Types of Assets and Risks

Real projects - cashflow versus financing Fixed Income Optionality Credit exposure Legal, operational, authorities

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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

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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 banks strategy and risk limits.
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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

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value

Forward/Futures
1 rNIS X 1 r spot USD
T

Spot

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Options
Put or Call European or American Underlying asset

Strike price
Premium

Time to maturity
Hedge ratio
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value

Call Option

premium

underlying

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value

Hedge Ratio

underlying

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value

Put Option

underlying

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Exotic Options
Asian Path dependent Digital

Bermudian
Knock-in, out

Exchange of assets
Swaptions
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Swap
currency or interest rate two loans with swapped payments low credit risk changes exposure:
currency duration

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

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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?

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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.

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Buy stock Result

Buy put

Sell call
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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

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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

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UPC
150 After tax capital gain is between $53M and $80M 125 153 173 212 UPC share

108

These options cover 800,000 shares only.

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How much did it cost?

The results are not precise and very sensitive
to volatility
if volatility is 10%
if volatility is 20% if volatility is 30%

if volatility is 40%

$6.5M $10M $13M $15M

This is the amount the bank should pay to DASKASCH!

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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?

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New proposals
BIS 2000 VaR based approach to credit risk.
CreditMetrics CreditRisk+

KMV
Merton.

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What is the current Risk?

Bonds Stocks Options Credit Forex Total
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duration, convexity volatility delta, gamma, vega rating target zone ?

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Standard Approach

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Modern Approach

Financial Institution

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