Download Value-at-Risk (VaR)

RM functions
Zvi Wiener
02-588-3049
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
FRM-3
Structuring RM functions
• Set firm-wide policies
• Develop methodology
• Set RM structure
• Risk communication
Zvi Wiener
FRM-3
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Active Risk
Management
Allocate capital
Stress
Market, Credit VaR
Monitor
Identify and avoid
Zvi Wiener
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
Zvi Wiener
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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
Zvi Wiener
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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
bank’s 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
T
 1  rNIS 
 spot
X  
 1  rUSD 
Spot
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X
$
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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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Call Option
value
premium
X
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underlying
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value
Hedge Ratio
X
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underlying
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value
Put Option
X
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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
Zvi Wiener
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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.
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How much did it cost?
• The results are not precise and very sensitive
to volatility
 if volatility is 10%
$6.5M
$10M
$13M
$15M
 if volatility is 20%
 if volatility is 30%
 if volatility is 40%
This is the amount the bank should pay to DASKASCH!
Zvi Wiener
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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?
Zvi Wiener
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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
Zvi Wiener
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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