FRM

Zvi Wiener
02-588-3049
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Financial Risk Management
Zvi Wiener FRM-1 slide 2
Risk
Business Risk
Operational Risk
Financial Risk
credit risk
market risk
liquidity risk
Legal Risk
Zvi Wiener FRM-1 slide 3
Crouhy, Galai, Mark, Risk Management, McGraw Hill,
2000.
Golub, Tilman, Risk Management Approaches for Fixed
Income Markets, Wiley, 2000.
Jorion, Value at Risk, McGraw Hill, 1997.

http://www.gloriamundi.org
http://www.riskmetrics.com
http://www.bis.org
http://www.garp.com
Zvi Wiener FRM-1 slide 4
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
Zvi Wiener FRM-1 slide 5
Barings
February 26, 1995
233 year old bank
28 year old Nick Leeson
$1,300,000,000 loss
bought by ING for $1.5
Zvi Wiener FRM-1 slide 6
Public Funds
($ million)
Orange County 1,640
San Diego 357
West Virginia 279
Florida State Treasury 200
Cuyahoga County 137
Texas State 55
Zvi Wiener FRM-1 slide 7
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
Zvi Wiener FRM-1 slide 8
Barings $1.3B
Bank Negara, Malaysia 92 $3B
Banesto, Spain $4.7B
Credit Lyonnais $10B
S&L, U.S.A. $150B
Japan $500B
Financial Losses
Zvi Wiener FRM-1 slide 9
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
Zvi Wiener FRM-1 slide 10
Zvi Wiener FRM-1 slide 11
Risk Management and
Risk Measurement
Zvi Wiener FRM-1 slide 12
Basic Statistics
Certainty and uncertainty
Probabilities, distribution, PDF, CDF
Mean, variance
Multivariable distributions
Covariance, correlation, beta
Quantile
Zvi Wiener FRM-1 slide 13
A 100 km. B
100 km/hr
50 km/hr
1 100 2 50 3 50
(100+50+50)/3 = 66.67 km/hr.
Zvi Wiener FRM-1 slide 14
1. +40%
2. +10%
3. -50%
4. +20%
1. -2%
2. +1%
3. -1%
4. +1%
1.4*1.1*0.5*1.2 =
0.924
0.98*1.01*0.99*1.01 =
0.9897
Zvi Wiener FRM-1 slide 15
Probabilities
Certainty
Uncertainty
Probabilities
Zvi Wiener FRM-1 slide 16
Probabilities
Mean
Variance
Zvi Wiener FRM-1 slide 17
Probabilities
1 2 3 4 5
0.2
0.3
0.1
20%
30% 30%
10% 10%

=
i
i
p 1
Zvi Wiener FRM-1 slide 18
Probabilities
1 2 3 4 5
0.2
0.3
0.1
1
0
=
}

dp
Zvi Wiener FRM-1 slide 19
Probabilities

=
= =
N
i
i i
p X X mean
1

=
= =
N
i
i i
p X X X Variance
1
2 2
) ( ) ( o
Zvi Wiener FRM-1 slide 20
Probabilities
}
+

= = Xdp X mean
}
+

= = dp X X X Variance
2 2
) ( ) ( o
) ( X Variance o =
Zvi Wiener FRM-1 slide 21
Sample Estimates
Sometimes one can use weights
( )

=
=

=
=
N
i
i
N
i
i
X X
N
X
X
N
X
1
2
2
1

1
1
) (

o
Zvi Wiener FRM-1 slide 22
Normal Distribution N(, o)
Zvi Wiener FRM-1 slide 23
Normal Distribution N(, o)

o
Zvi Wiener FRM-1 slide 24
Normal Distribution

quantile
1%
Zvi Wiener FRM-1 slide 25
Lognormal Distribution
1 2 3 4
0.1
0.2
0.3
0.4
0.5
0.6
Zvi Wiener FRM-1 slide 26
Covariance
Shows how two random variables are connected
For example:
independent
move together
move in opposite directions

covariance(X,Y) =
( )( ) Y Y X X E
Zvi Wiener FRM-1 slide 27
Correlation
-1 s s 1
= 0 independent
= 1 perfectly positively correlated
= -1 perfectly negatively correlated
( )( )
) ( ) ( Y X
Y Y X X E
XY
o o

=
Zvi Wiener FRM-1 slide 28
Properties
) ( ) ( ) ( B E A E B A E | o | o + = +
) , ( 2 ) ( ) (
) (
2 2 2 2
2
B A Cov B A
B A
o| o | o o
| o o
+ +
= +
o o|o o | o o
| o o
) ( ) ( 2 ) ( ) (
) (
2 2 2 2
2
B A B A
B A
+ +
= +
Zvi Wiener FRM-1 slide 29
Time Aggregation
Assuming normality
T
T
annual T
annual T
o o

=
=
Zvi Wiener FRM-1 slide 30
Time Aggregation
Assume that yearly parameters of CPI are:
mean = 5%, standard deviation (SD) = 2%.
Then daily mean and SD of CPI changes are:
% 1265 . 0
250
1
% 02 . 0
250
1
= =
= =
y d
y d
o o

Zvi Wiener FRM-1 slide 31
Portfolio
o
2
(A+B) = o
2
(A) + o
2
(B) + 2o(A)o(B)

o
r
f

A
B
Zvi Wiener FRM-1 slide 32
$


o
$

o

o
$

$

$
Zvi Wiener FRM-1 slide 33
u Cos X X X X X
2 1
2
2
2
1
2
12
2 + =
12 2 1
2
2
2
1
2
12
2 o o o o o + =
u Cos ~
12

o
12

o
1

o
2

John Zerolis
"Triangulating Risk",
Risk v.9 n.12, Dec. 1996
Zvi Wiener FRM-1 slide 34
Useful Books
Duffie D., Dynamic Asset Pricing Theory.
Duffie D., Security Markets, Stochastic Models.
Shimko D. Finance in Continuous Time, A
Primer. Kolb Publishing Company, 1992.
Zvi Wiener FRM-1 slide 35
Binomial Tree
1.0
0.5
0.5
0.25
0.25
0.5
0.125
0.125
0.375
0.375
Zvi Wiener FRM-1 slide 36
Zvi Wiener FRM-1 slide 37
Example
We will receive n dollars where
n is determined by a die.

What would be a fair price for
participation in this game?
Zvi Wiener FRM-1 slide 38
Example 1
Score Probability
1 1/6
2 1/6
3 1/6
4 1/6
5 1/6
6 1/6
5 . 3
6
6
6
5
6
4
6
3
6
2
6
1
= + + + + +
Fair price is 3.5 NIS.
Assume that we can play
the game for 3 NIS only.
Zvi Wiener FRM-1 slide 39
Example
If there is a pair of dice the
mean is doubled.

What is the probability to
gain $5?
Zvi Wiener FRM-1 slide 40
Example
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
All combinations:
36 combinations with equal probabilities
Zvi Wiener FRM-1 slide 41
Example
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
All combinations:
4 out of 36 give $5, probability = 1/9
Zvi Wiener FRM-1 slide 42
All combinations:
1 out of 9 give $5, probability = 1/9
Additional information:
the first die gives 4.
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
Zvi Wiener FRM-1 slide 43
All combinations:
4 out of 24 give $5, probability = 1/6
Additional information:
the first die gives s4.
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
Zvi Wiener FRM-1 slide 44
Example 1
-2 -1 0 1 2 3
% 67 . 16
6
1
=
Zvi Wiener FRM-1 slide 45
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
Zvi Wiener FRM-1 slide 46
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
6 1 2 3 4 5 6
Zvi Wiener FRM-1 slide 47
-4 -3 -2 -1 0 1 2 3 4 5 6
0.025
0.05
0.075
0.1
0.125
0.15
Example 1 (2 cubes)
Zvi Wiener FRM-1 slide 48
-10-9-8-7-6-5-4-3-2-10 1 2 3 4 5 6 7 8 9101112131415
0.02
0.04
0.06
0.08
0.1
Example 1 (5 cubes)
Zvi Wiener FRM-1 slide 49
Breakfast
$2 $4
50% 50%
Zvi Wiener FRM-1 slide 50
Lunch
$5 $11
50% 50%
Zvi Wiener FRM-1 slide 51
Zvi Wiener FRM-1 slide 52
Lunch
Breakfast
$2 $4
$5 $7 $9
$11 $13 $15
50% 50%
= $11 o = ??
50%
50%
Zvi Wiener FRM-1 slide 53
Correlation =+1
$2 $4
$5 $7 $9
$11 $13 $15

Lunch
Breakfast
50%
50%
= $11 o = $4
50% 50%
Zvi Wiener FRM-1 slide 54
Correlation =-1
$2 $4
$5 $7 $9
$11 $13 $15

Lunch
Breakfast
50%
50%
= $11 o = $2
50% 50%
Zvi Wiener FRM-1 slide 55
Correlation =0
$2 $4
$5 $7 $9
$11 $13 $15

Lunch
Breakfast
50%
50%
= $11 o = $3.16
50% 50%
Zvi Wiener FRM-1 slide 56
How much can we lose?
Everything

correct, but useless answer.

How much can we lose realistically?
Zvi Wiener FRM-1 slide 57
What is the current Risk?
duration, convexity
volatility
delta, gamma, vega
rating
target zone
Bonds
Stocks
Options
Credit
Forex
Total ?
Zvi Wiener FRM-1 slide 58
Standard Approach
Zvi Wiener FRM-1 slide 59
Modern Approach
Financial Institution
Zvi Wiener FRM-1 slide 60
10
11
12
13
14
4.1
4.15
4.2
4.25
4.3
7.25
7.5
7.75
8
8.25
10
11
12
13
14
interest rates and dollar are
NOT independent
Value
Interest Rate
dollar