RM functions Zvi Wiener 02 588 3049 http

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 2

e g a Active Risk Management nt e m an e t a r g te In M k s i d. R Stress Market, Credit Va. R Monitor Identify and avoid Zvi Wiener Allocate capital RAROC Risk Analysis Limit Management FRM-3 3

RAROC • Risk Adjusted Rate of Return • Performance measurement • Marginal impact of any new transaction • Consistent pricing Zvi Wiener FRM-3 4

New Approach Three pillars A. Minimum Capital Requirement B. Supervisory Review Process C. Market Discipline Requirements Zvi Wiener FRM-3 5

Goals and Instruments • Risk Tolerance - “worst loss” • Stop losses • Capital allocation • Credit risk policy • Operational risk policy Zvi Wiener FRM-3 6

Risk Measurement • Consistent market based method • Old § limits § duration, ALM • Va. R + Stress • Backtesting Zvi Wiener FRM-3 7

Systems • Data bases § market § position § rules • Risk measuring tool • Reports and decision support Zvi Wiener FRM-3 8

IT - Information Technology • Unifying information from various units • Unifying information from various markets • Unifying information for various ownership • Back office and execution control Zvi Wiener FRM-3 9

Organizational structure • Front office • Middle office • Back office Zvi Wiener FRM-3 10

Front office • execution • risk taking • marketing Zvi Wiener FRM-3 11

Middle office • risk management • pricing • economic forecasts Zvi Wiener FRM-3 12

Back office • verification • booking • reporting • collection • settlement Zvi Wiener FRM-3 13

ALCO • Assets Liability management committee • responsible for § establishing § documenting § enforcing all policies involving market risk • FX • liquidity • interest rate Zvi Wiener FRM-3 14

Interdependence of RM Senior Management Trading Room Risk Management Operations Finance Zvi Wiener FRM-3 15

Senior management • Approves business plan and targets • Sets risk tolerance • Establishes policy • Ensures performance Zvi Wiener FRM-3 16

Trading Room Management • Establishes and manages risk exposure • Ensures timely and accurate deal capture • Signs off on official P&L Zvi Wiener FRM-3 17

Operations • Books and settles the trades • Reconciles front and back office positions • Prepares and decomposes daily P&L • Provides independent MTM • Supports business needs Zvi Wiener FRM-3 18

Finance • Develops valuation and finance policy • Ensures integrity of P&L • Manages business planning process • Supports business needs Zvi Wiener FRM-3 19

Risk Management • Develops risk policies • Monitors compliance to limits • Manages ALCO process • Vets models and spreadsheets • Provides independent view on risk • Supports business needs Zvi Wiener FRM-3 20

Risk Limits • Global risk limit • Risk limits for trading desks/units • Dynamic monitoring and adjustment Zvi Wiener FRM-3 21

Risk Approaches • Accounting - reported P&L • Economic - value • Liquidity needs Zvi Wiener FRM-3 22

Liquidity Rank • Based on forecasts and potential availability of funds. • Hot funds - can be withdrawn quickly. • Stable funds - typically to maturity. Zvi Wiener FRM-3 23

Israel 339 • Definitions of risk types • Relates to all banking institutions • Management structure • Exposure document • Directors and policy • Risk manager • Internal audit Zvi Wiener FRM-3 24

Israel 339 • IR risk • Market risk • Risk audit unit Zvi Wiener FRM-3 25

Israel 341 • Capital requirements against market risk • Risk measurement • Trading portfolio • Reporting • Examples of standard approach and Va. R Zvi Wiener FRM-3 26

Israel 341 • Capital requirements against market risk • Risk measurement • Trading portfolio • Reporting • Examples of standard approach and Va. R Zvi Wiener FRM-3 27

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 Zvi Wiener FRM-3 28

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 Zvi Wiener FRM-3 29

Types of Assets and Risks • Real projects - cashflow versus financing • Fixed Income • Optionality • Credit exposure • Legal, operational, authorities Zvi Wiener FRM-3 30

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 Zvi Wiener FRM-3 31

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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. Zvi Wiener FRM-3 35

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 Zvi Wiener FRM-3 36

value Forward/Futures Spot Zvi Wiener X $ FRM-3 37

Options • Put or Call • European or American • Underlying asset • Strike price • Premium • Time to maturity • Hedge ratio Zvi Wiener FRM-3 38

Call Option value premium X Zvi Wiener FRM-3 underlying 39

value Hedge Ratio X Zvi Wiener FRM-3 underlying 40

value Put Option X Zvi Wiener underlying FRM-3 41

Exotic Options • Asian • Path dependent • Digital • Bermudian • Knock-in, out • Exchange of assets • Swaptions Zvi Wiener FRM-3 42

Swap • currency or interest rate • two loans with swapped payments • low credit risk • changes exposure: § currency § duration Zvi Wiener FRM-3 43

Structured Note • tailor made solution • for example, IO, PO • higher priority obligations or junk • collar, IAS, ratchet, etc. Zvi Wiener FRM-3 44

Collar • Firm B has shares of firm C of value $200 M • 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? Zvi Wiener FRM-3 45

Collar. 1 Buy a protective Put option (3 y to maturity, strike = 90% of spot. (. 2 Sell an out-the-money Call option (3 y to maturity, strike above spot. (. 3 Take a “cheap” loan at 90% of the current value. Zvi Wiener FRM-3 46

Buy stock Result Buy put Sell call Zvi Wiener FRM-3 47

UPC example • Aug 98, a $90 M convertible loan to UPC • Feb 99, $49 M paid for 1. 55 M shares (10%( • The share price rose to $162 (5 times( • Four options were used to protect the value Zvi Wiener FRM-3 48

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 FRM-3 49

UPC 150 After tax capital gain is between $53 M and $80 M 108 212173153125 UPC share These options cover 800, 000 shares only. Zvi Wiener FRM-3 50

How much did it cost? • The results are not precise and very sensitive to volatility § if volatility is 10% $6. 5 M $10 M $13 M $15 M § if volatility is 20% § if volatility is 30% § if volatility is 40% This is the amount the bank should pay to DASKASCH! Zvi Wiener FRM-3 51

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 FRM-3 52

New proposals • BIS 2000 • Va. R based approach to credit risk. § Credit. Metrics §Credit. Risk+ § KMV § Merton. Zvi Wiener FRM-3 53

What is the current Risk? • Bonds • Stocks • Options • Credit • Forex • Total Zvi Wiener duration, convexity volatility delta, gamma, vega rating target zone ? FRM-3 54

Standard Approach Zvi Wiener FRM-3 55

Modern Approach Financial Institution Zvi Wiener FRM-3 56