Tools for risk management Zvi Wiener 02 588

Tools for risk management Zvi Wiener 02 -588 -3049 http: //pluto. mscc. huji. ac. il/~mswiener/zvi. html Jun-00 Risk Management

Tools F Measurement tools F Financial tools – options – forwards, futures – swaps – insurance F Risk Management Tools Outsourcing Jun-2000 2

Senior Management Marketing Finance Supply Cashflow Capital Risk Management Tools Jun-2000 3

Important Principles Distinction between risk taking and risk control. Backtesting. Transparent reporting. Timing is more important then precision ! Risk Management Tools Jun-2000 4

Basic decisions F Goal of Risk Management F Base currency F Time horizon (embedded options( F Economic or Accounting approach F Admissible risk F Stop losses or other actions Risk Management Tools Jun-2000 5

Risk Management System Can NOT Predict future F Identify business opportunities F Be always right! F Risk Management System Can Predict loss, given event F Identify most dangerous scenarios F Recommend how to change risk profile F Risk Management Tools Jun-2000 6

Measurement Tools CATS, CARMA F Algorithmics, Risk Watch F Infinity F J. P. Morgan, Four. Fifteen $25 K/yr F FEA, Outlook F Risk Manager, RMG F Theoretics, TARGA F Bankers Trust, RAROC INSSINC, Orchestra Jun-2000 Risk. F Management Tools F $400 K/yr >$1 M $18 K $30 K/yr $75 K $50 K/run $25 -75 K 7

Definition Va. R is defined as the predicted worst-case loss at a specific confidence level (e. g. 99%) over a certain period of time. Risk Management Tools Jun-2000 8

Va. R 1% Profit/Loss Risk Management Tools Jun-2000 9

Benchmarking F Financial assets – create an imaginary portfolio and measure performance relative to this portfolio. F Industry – measure relative to competitors. Risk Management Tools Jun-2000 10

Financial Tools Risk Management Tools F Options F Futures/Forwards F SWAP F FRA F Insurance Jun-2000 11

Derivatives Contracts that are priced according to underlying variables (prices are derived from underlying). Options, Futures, Forwards, Swaps, Warrants, etc. Risk Management Tools Jun-2000 12

Derivatives Contingent claims gold shipped KTUBA insurance an option not to undertake a project an option to leave an option to change price Risk Management Tools Jun-2000 13

Financial Tools Risk Management Tools F Options F Futures/Forwards F SWAP F FRA F Insurance Jun-2000 14

Forward and Futures F Forward agreement F Futures - standard traded contracts – margin – mark to market F Final result is very similar – settlement risk Risk Management Tools Jun-2000 15

Forward payoff Forward at maturity Underlying asset Risk Management Tools Jun-2000 16

Forward Price F Note that forward price is not a price Forward price does NOT depend on the expected exchange rate. It depends on the current exchange rate and interest rates only! F It is important to chose appropriate time horizon! F Risk Management Tools Jun-2000 17

Forward Price Consider a NIS/USD forward contract for 10, 000 USD to be exchanged in 6 months to NIS according to the forward price. F F Current exchange rate is $1=4 NIS, – USD interest rate is 6% – NIS interest rate is 10% F How to define the forward rate? Risk Management Tools Jun-2000 18

Forward Price Buy 6 month T-bill, $10, 000 nominal, it will cost 10, 000*4/1. 03= 38, 835 NIS F F Sell 6 month MAKAM, for 38, 835 NIS This will guarantee that in 6 months you will receive $10, 000 and pay 38, 835*1. 05 NIS. Risk Management Tools Jun-2000 19

Forward Price Risk Management Tools Jun-2000 20

Hedge using Forward Current exchange rate 4. 00 USD interest rate 6% NIS interest rate 10% In a year you will receive $100 and will have to pay 410 NIS. Enter into a forward for 1 year for $100. Forward price is 4. 00*1. 1/1. 06=4. 15. The time match is important! Risk Management Tools Jun-2000 21

After a year $ Forward Your balance 100 -410+25= 5*3. 9253. 9 100 -410+15= 5*4. 0154. 0 100 -410+ 5 = 5*4. 15 4. 1 100 -410 - 5 = 5*4. 25 -4. 2 100 -410 -15 = 5*4. 315 -4. 3 Complete protection with no cost! Risk Management Tools Jun-2000 22

What if there is no perfect time match? One can use shorter contracts and roll them over. This will neutralize completely the exchange rate risk, but you will have some interest rate risk. F F Do it very carefully! F Or better use OTC, but check prices. Risk Management Tools Jun-2000 23

Marking to Market Your balance Initial margin Maint. margin call Risk Management Tools Jun-2000 time 24