2. Outline
What is Risk?
2. Risk is Everywhere
3. Risk is Not Equal
4. Measuring Risk
5. Decision Making with Risk
6. Risk Management Systems
1.
3.
4. What is Risk?
The Chinese symbol for risk is a combination
of both danger and opportunity
Risk = P(undesired event) x Consequence
In finance, risk is the variability of actual
returns around the expected return
5. Market Risk
Risk that value of investment will decrease due to
changes in market factors
Common types of market risk
Interest Rate Risk
Equity Risk
Currency Risk
Measured with Value at Risk (VaR)
6. Credit Risk
Risk of loss due to default on payment
on a loan or other types of credit
Structured credit risk is measured with
the Merton Model or asset value model
Credit risk is commonly associated with
credit ratings.
7. Operational Risk
Differs from market and credit risk
“The risk of loss resulting from
inadequate or failed internal processes,
people and systems or from external
events”
8. Examples of Operational
Risk
Internal Fraud
External Fraud
Employment Practices and Workplace
Safety
Clients, Products, & Business
Damage to Physical Assets
Business Disruption & Systems Failures
Execution, Delivery, & Process
Management
9.
10. Decision Making with Risk
Decisions making in finance requires a
degree of risk taking with it these are
some of the areas where risk affects
decision making
Investment Choices
Corporate Finance
11. Investment Choices
Investment choices looks at the different
assets to come up with a portfolio
design for the risk aversion of an
investor
Asset Allocation
Asset Selection
Performance Evaluation
12. Corporate Finance
Corporate finance is related to decisions
that corporations make related to
running the business.
Investment decisions
Financing decisions
Dividend decisions
13.
14. Risk is Everywhere
Risks will come from places one would
least expect it and in a form that them to
come from and in unanticipated forms.
Good risk management is to be able to
adapt when confronted with the
unexpected.
15. Risk from Global Exposure
The Chinese Correction
27 February 2007
With rumors that China would raise the
interest rate to curb inflation, the
Shanghai Stock Exchange dropped 9%.
16. Result of the Chinese
Correction
DOW Jones Industrial Average (DJIA)
fell 416 points
This was the largest single day fall since
the 9/11 attack in 2001 where the DJIA
fell 684 points.
17. Risk from Different Businesses
Best example of this is with the sub-prime
mortgages and collateral debt obligations
(CDOs)
In 2000, Credit Suisse issued a $340.7
million CDO.
It was a mix of junk bonds and sub prime
home loans
By 2006, the CDO losses totaled $125
million
18. Credit Suisse CDO - 2000
Amount (in millions)
Tranche
Rating
$293.5
Senior
AAA
$13.0
Mezzanine
A
$17.0
Mezzanine
BBB-
$11.2
Equity
Not Rated
$6.0
Equity
Not Rated
19. Credit Suisse CDO - 2006
Amount (in millions)
Tranche
Rating
$220.5
Senior
AAA
$0
Mezzanine
A
$0
Mezzanine
BBB-
$0
Equity
Not Rated
$0
Equity
Not Rated
20. Subprime Primer
Banks were originally not allowed to
invest in mortgages because they were
not investment grade.
In the 1980s, banks started to package
mortgages into collateral debt
obligations through securitization.
Thus mortgages are now were able to
be traded and invested.
21.
Subprime mortgages are those from
buyers with weak credit and are usually
charged 2 percentage points higher than
those with good ratings
22.
Exotic mortgages such as no-doc loans
allowed people with bad credit to take
loans without documentation to show
evidence of income or savings
23.
Big banks buy the loans from the
lenders and small banks and securitize
the loans into CDOs with the help of
rating companies to achieve the desired
rating.
24.
By engineering products with high
ratings (AAA), investors liked CDOs
because of the high returns compared to
bonds of same rating.
25. To add noise to the confusion, CDOs
can be multiplied with CDO squareds
and CDO cubeds
This only hid the underlying assets even
more.
26.
As subprime mortgages defaulted by
people who had bad credit. The CDOs
began to default as well.
27.
28.
Due to the complex nature of CDOs it
was hard to see what was the
underlying assets.
We just believed the credit risk ratings
31. Who
Fitch Ratings (U.S.)
Moody's (U.S.)
Standard & Poor's (U.S.)
A. M. Best (U.S.)
Baycorp Advantage (Australia)
Dominion Bond Rating Service (Canada)
Pacific Credit Rating (Peru)
Egan-Jones Ratings Company (U.S.)
Capital Intelligence Ltd (Cyprus)
32.
33. Credit Ratings are Not
Equal
Ratings from one type of instrument do
not translate directly for comparison with
another instrument
“In CDO –land, there’s almost no
difference between Baa and Ba” –
Arturo Cifuentes, former Moody’s
executive
34.
Corporate bonds rated Baa (Moody’s)
from 1983 to 2005
Default rate 2.2 percent over 5 year periods
CDOs rated Baa (Moody’s) from 1983 to
2005
Default rate 24 percent over 5 year periods
35. Rating agencies work with banks
In financial engineering for securitization,
rating agencies consult with banks on how
to structure the CDO
CDOs aren’t regulated like bonds. They are
sold in private placements and current
values are not posted
Financial regulators effectively outsourced
the monitoring of CDOs to rating agencies
36. Analyze the Money
Revenue between rating bonds and
CDOs (S&P)
Corporate bonds - $212,500
CDOs - $600,000
Revenue from analyzing CDOs in 2006
Moodys - $204 million
Fitch Ratings - $480.5 million
37.
38. Issues with CDO ratings
Garbage in, garbage out
Due to complex nature (many moving
parts), must account for possibility of
many things going wrong.
Financial products are being more
complex for current methodologies.
39.
“The credit ratings and observations
contained herein are solely statements
of opinion and not statements of fact or
recommendations to purchase, hold, or
sell any securities or make any other
investment decisions.
Accordingly, any user of the information
contained herein should not rely on any
credit rating or other opinion contained
herein in making any investment
decision.” – S&P
40. Credit Ratings
The lack of transparency and potential
conflict of interest makes it hard for
ratings to be taken at face value.
Good risk management would involve
understanding how the products were
rated.
41.
42. Measuring Risk
Quantifying and measuring risk is one of
the key points of risk management
Focus will be on common risk
measurements
Value at Risk (VaR)
Profit and Loss (PnL)
43. Value at Risk (VaR)
Focuses on volatility both up and down
VaR statistic is made up of 3 parts
Time Period
Confidence Interval
Loss amount (percentage)
“What is the most I can lose with 95%
confidence in the next month?”
47. VaR: Variance Covariance
Method
Assumes
that stock returns are
normally distributed
Variance
measures how actual
returns vary around the expected
return
Covariance
tells us how two assets
are correlated
50.
Portfolio with 2 assets A and B
70% invested in A
30% invested in B
Standard Deviation of A (σA) is 10%
Standard Deviation of B (σB) is 20%
Correlation coefficient (ρAB) is 0.5
σP 2= (0.7) 2(10) 2 + (0.3) 2(20) 2 +
2(0.7)(0.3)(10)(20)(.05) = 127
Portfolio Std. Dev = σP = 11.27%
52. Putting it all together
Build normal distribution
Variance = σP 2
Standard Deviation = σP
Mean (weighted average rate of return)
Confidence
Std. Dev.
Calculation
Result
95%
2.64%
1.65 x 2.64
4.36%
99%
2.64%
2.33 x 2.64
6.16%
53. VaR: Monte Carlo
Simulations
Develop model for future stock prices
Run multiple hypothetical trials
Randomly generate trials (random
inputs)
55. Comparison
Monte Carlo – Complex
Historical Method – Requires gathering
historical data and number crunching
Variance Covariance – Easiest because
number are on readily available
56.
57. What time is it?
To convert one VaR of one time period
to another time period
Multiply standard deviation by square
root of the time period.
Recalculate
Ex. σDaily = 2.5%
σmonthly = σDaily x √20 = 11.18%
58. Profit and Loss (PnL)
Statement that summarizes
the revenues, costs and expenses
incurred during a specific period of time.
DAILY PnL
Market Moves
Swap Rates
FX Changes
Rates resets
Trading
Amendments
$9,000
$25,000
-$100,000
$5,000
$80,000
-$1,000
59.
It’s market close time, suddenly you
hear
“How’s my PnL?”
“Let me check”
Now we will look at how it put all
together in a bank
61. Basic Flow
System reads security positions for book
Read the closing values
Reads the individual trades in the book
Calculate the mark to market value of
the trade
Calculate PnL,VaR, Sensitivities
Done
62. Reality
There are thousands of books, hundreds of
trading desks and different business units
Different ways of storing and sending data.
Different close times for data
Must be calculated for next morning
(T+1PnL)
Reports generated within one hour of
market close is called T+0PnL
Risk versus probability - The probability of the event occurring and the consequences of the event. Thus, the probability of a severe earthquake may be small, but the consequences are so catastrophic that it would be categorized as a high-risk event.Risk versus threat - A threat is a low-probability event with large negative consequences, where analysts may be unable to assess the probability. A risk, on the other hand, is defined to be a higher probability event, where there is enough information to assess both the probability and the consequences.All outcomes versus negative outcomes— Some definitions of risk tend to focus only on the downside scenarios, whereas others are more expansive and consider all variability as risk. The engineering definition of risk is defined as the product of the probability of an event occurring, that is viewed as undesirable, and an assessment of the expected harm from the event occurring.
Internal Fraud - misappropriation of assets, tax evasion, intentional mismarking of positions, briberyExternal Fraud - theft of information, hacking damage, third-party theft and forgeryEmployment Practices and Workplace Safety - discrimination, workers compensation, employee health and safetyClients, Products, & Business Practice - market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churningDamage to Physical Assets - natural disasters, terrorism, vandalismBusiness Disruption & Systems Failures - utility disruptions, software failures, hardware failuresExecution, Delivery, & Process Management - data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets
Investment ChoicesOur views of risk have consequences for how and where we invest. In fact, the risk aversion of an investor affects every aspect of portfolio design, from allocating across different asset classes to selecting assets within each asset class to performance evaluation.Asset allocation— Asset allocation is the first and perhaps the most important step in portfolio management, where investors determine which asset classes to invest their wealth in. The allocation of assets across different asset classes will depend on how risk averse an investor is, with less risk-averse investors generally allocating a greater proportion of their portfolios to riskier assets. Using the most general categorization of stocks, bonds, and cash as asset classes, this would imply that less risk-averse investors will have more invested in stocks than more risk-averse investors, and the most risk-averse investors will not stray far from the safest asset class, which is cash.[16][16] Cash includes savings accounts and money market accounts, where the interest rates are guaranteed and there is no or close to no risk of losing principal.Asset selection— Within each asset class, we have to choose specific assets to hold. Having decided to allocate specific proportions of a portfolio to stocks and bonds, the investor has to decide which stocks and bonds to hold. This decision is often made less complex by the existence of mutual funds of varying types, from sector funds to diversified index funds to bond funds. Investors who are less risk averse may allocate more of their equity investment to riskier stocks and funds, although they may pay a price in terms of less than complete diversification.Performance evaluation— Ultimately, our judgments on whether the investments we made in prior periods (in individual securities) delivered reasonable returns (and were therefore good investments) will depend on how we measure risk and what trade-off we demand in terms of higher returns.
Corporate FinanceJust as risk affects how we make portfolio decisions as investors, it also affects decisions that we make when running businesses. In fact, if we categorize corporate financial decisions into investment, financing and dividend decisions, the risk aversion of decision makers feeds into each of these decisions:Investment decisions— Few investments made by a business offer guaranteed returns. In fact, almost every investment comes with a full plate of risks, some of which are specific to the company and sector and some of which are macro risks. We have to decide whether to invest in these projects, given the risks and our expectations of the cash flows.Financing decisions— When determining how much debt and equity we should use in funding a business, we have to confront fundamental questions about risk and return again. Specifically, borrowing more to fund a business may increase the potential upside to equity investors but also increase the potential downside and put the firm at risk of default. The way we view this risk and its consequences will be central to how much we borrow.Dividend decisions— As the cash comes in from existing investments, we face the question of whether to return some or a lot of this cash to the owners of the business or hold on to it as a cash balance. Because one motive for holding onto cash is to meet contingencies in the future (an economic downturn, a need for new investment), how much we choose to hold as a cash balance will be determined by how we perceive the risk of these contingencies.
Chinese economic authorities were going to raise interest rates in an attempt to curb inflation and that they planned to clamp down on speculative trading with borrowed money8.8% to be exact
Investment grade
Buy this investment and you will get up to 10 percent return.
Fitch court case
Histogram – allows comparison of returns by looking at frequencyLeft tail is the worstWe can say with 95% confidence that worst daily lost won’t exceed 4%
Variance measures the variability of realized returns around anaverage level. The larger the variance the higher the risk in the portfolioCovariance essentially tells uswhether or not two securities returns are correlated.We can see how two securites interact with each other via the correlation coefficent
Symmetric, only two parameters to describe it standard deviation and meanFrom the 68-95-99.7 rule we know that for a variable with the standard normal distribution, 68% of the observations fall between -1 and 1 (within 1 standard deviation of the mean of 0), 95% fall between -2 and 2 (within 2 standard deviations of the mean) and 99.7% fall between -3 and 3 (within 3 standard deviations of the mean).This can be converted to the relative frequency 1.65, 2.33 for 95,99%
A correlation of +1 means that the returns of the two securities always move inthe same direction; they are perfectly positively correlated.• A correlation of zero means the two securities are uncorrelated and have norelationship to each other.
This can be converted to the relative frequency 1.65, 2.33 for 95% and 99% of observations
Commercial banks, for example, typically calculate a daily VAR, asking themselves how much they can lose in a day; pension funds, on the other hand, often calculate a monthly VAR.