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FRM-3
Zvi Wiener
02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
RM functions
Zvi Wiener FRM-3 slide 2
Structuring RM functions
• Set firm-wide policies
• Develop methodology
• Set RM structure
• Risk communication
Zvi Wiener FRM-3 slide 3
Integrated
Risk M
anagemen
t
Identify and avoid
MonitorLimit Management
StressMarket, Credit VaR
Risk Analysis
Allocate capital RAROC
Active RiskManagement
Zvi Wiener FRM-3 slide 4
RAROC
• Risk Adjusted Rate of Return
• Performance measurement
• Marginal impact of any new transaction
• Consistent pricing
Zvi Wiener FRM-3 slide 5
New Approach
Three pillars
A. Minimum Capital Requirement
B. Supervisory Review Process
C. Market Discipline Requirements
Zvi Wiener FRM-3 slide 6
Goals and Instruments
• Risk Tolerance - “worst loss”
• Stop losses
• Capital allocation
• Credit risk policy
• Operational risk policy
Zvi Wiener FRM-3 slide 7
Risk Measurement
• Consistent market based method
• Old limits duration, ALM
• VaR + Stress
• Backtesting
Zvi Wiener FRM-3 slide 8
Systems
• Data bases market position rules
• Risk measuring tool
• Reports and decision support
Zvi Wiener FRM-3 slide 9
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 slide 10
Organizational structure
• Front office
• Middle office
• Back office
Zvi Wiener FRM-3 slide 11
Front office
• execution
• risk taking
• marketing
Zvi Wiener FRM-3 slide 12
Middle office
• risk management
• pricing
• economic forecasts
Zvi Wiener FRM-3 slide 13
Back office
• verification
• booking
• reporting
• collection
• settlement
Zvi Wiener FRM-3 slide 14
ALCO
• Assets Liability management committee
• responsible for establishing documenting enforcing all policies involving market risk
• FX
• liquidity
• interest rate
Zvi Wiener FRM-3 slide 15
Interdependence of RM
Senior Management
Risk Management Operations
Trading Room
Finance
Zvi Wiener FRM-3 slide 16
Senior management
• Approves business plan and targets
• Sets risk tolerance
• Establishes policy
• Ensures performance
Zvi Wiener FRM-3 slide 17
Trading Room Management
• Establishes and manages risk exposure
• Ensures timely and accurate deal capture
• Signs off on official P&L
Zvi Wiener FRM-3 slide 18
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 slide 19
Finance
• Develops valuation and finance policy
• Ensures integrity of P&L
• Manages business planning process
• Supports business needs
Zvi Wiener FRM-3 slide 20
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 slide 21
Risk Limits
• Global risk limit
• Risk limits for trading desks/units
• Dynamic monitoring and adjustment
Zvi Wiener FRM-3 slide 22
Risk Approaches
• Accounting - reported P&L
• Economic - value
• Liquidity needs
Zvi Wiener FRM-3 slide 23
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 slide 24
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 slide 25
Israel 339
• IR risk
• Market risk
• Risk audit unit
Zvi Wiener FRM-3 slide 26
Israel 341
• Capital requirements against market risk
• Risk measurement
• Trading portfolio
• Reporting
• Examples of standard approach and VaR
Zvi Wiener FRM-3 slide 27
Israel 341
• Capital requirements against market risk
• Risk measurement
• Trading portfolio
• Reporting
• Examples of standard approach and VaR
Zvi Wiener FRM-3 slide 28
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 slide 29
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 slide 30
Types of Assets and Risks
• Real projects - cashflow versus financing
• Fixed Income
• Optionality
• Credit exposure
• Legal, operational, authorities
Zvi Wiener FRM-3 slide 31
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 slide 32
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Zvi Wiener FRM-3 slide 35
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 slide 36
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 slide 37
Forward/Futuresvalue
spotr
rX
T
USD
NIS
1
1
Spot X $
Zvi Wiener FRM-3 slide 38
Options
• Put or Call
• European or American
• Underlying asset
• Strike price
• Premium
• Time to maturity
• Hedge ratio
Zvi Wiener FRM-3 slide 39
Call Option
X underlying
premium
value
Zvi Wiener FRM-3 slide 40
Hedge Ratio
X underlying
value
Zvi Wiener FRM-3 slide 41
Put Option
X underlying
value
Zvi Wiener FRM-3 slide 42
Exotic Options
• Asian
• Path dependent
• Digital
• Bermudian
• Knock-in, out
• Exchange of assets
• Swaptions
Zvi Wiener FRM-3 slide 43
Swap
• currency or interest rate
• two loans with swapped payments
• low credit risk
• changes exposure:
currency
duration
Zvi Wiener FRM-3 slide 44
Structured Note
• tailor made solution
• for example, IO, PO
• higher priority obligations or junk
• collar, IAS, ratchet, etc.
Zvi Wiener FRM-3 slide 45
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?
Zvi Wiener FRM-3 slide 46
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.
Zvi Wiener FRM-3 slide 47
Buy stock
Sell call
Result
Buy put
Zvi Wiener FRM-3 slide 48
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
Zvi Wiener FRM-3 slide 49
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 slide 50
UPC
125 153 173 212 UPC share
108
150
After tax capital gainis between $53M and$80M
These options cover 800,000 shares only.
Zvi Wiener FRM-3 slide 51
How much did it cost?
• The results are not precise and very sensitive to volatility
if volatility is 10% $6.5M if volatility is 20% $10M if volatility is 30% $13M if volatility is 40% $15M
This is the amount the bank should pay to DASKASCH!
Zvi Wiener FRM-3 slide 52
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 slide 53
New proposals
• BIS 2000
• VaR based approach to credit risk. CreditMetrics
CreditRisk+
KMV
Merton.
Zvi Wiener FRM-3 slide 54
What is the current Risk?
duration, convexity
volatility
delta, gamma, vega
rating
target zone
• Bonds
• Stocks
• Options
• Credit
• Forex• Total ?
Zvi Wiener FRM-3 slide 55
Standard Approach
Zvi Wiener FRM-3 slide 56
Modern Approach
Financial Institution