Introduction to Risk Management :

Michael Le

16 April 2008

Outline

1. What is Risk?

2. Risk is Everywhere

3. Risk is Not Equal

4. Measuring Risk

5. Decision Making with Risk

6. Risk Management Systems

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

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)

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.

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”

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

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

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

Corporate Finance

Corporate finance is related to decisions

that corporations make related to

running the business.

Investment decisions

Financing decisions

Dividend decisions

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.

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%.

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.

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

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

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

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.

Subprime mortgages are those from

buyers with weak credit and are usually

charged 2 percentage points higher than

those with good ratings

Exotic mortgages such as no-doc loans

allowed people with bad credit to take

loans without documentation to show

evidence of income or savings

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.

By engineering products with high

ratings (AAA), investors liked CDOs

because of the high returns compared to

bonds of same rating.

To add noise to the confusion, CDOs

can be multiplied with CDO squareds

and CDO cubeds

This only hid the underlying assets even

more.

As subprime mortgages defaulted by

people who had bad credit. The CDOs

began to default as well.

Due to the complex nature of CDOs it

was hard to see what was the

underlying assets.

We just believed the credit risk ratings

Credit Ratings

Common terms

Issue Rating

Issuer Rating

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)

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

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

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

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

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.

“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

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.

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)

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?”

VaR Calculation

3 ways of calculating:

Historical

Variance Covariance

Monte Carlo Simulation

VaR: Historical Model

Assumes history will repeat itself

Arranges historical returns into buckets

from order of worst to best returns

Investopedia

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

Normal Distribution

http://www.ifa.com/images/12steps/step8/f8-1.jpg

Variance

σP2= wA

2 σA2 + wB

2 σB2 + 2wAwB σAσBρAB

Correlation Coefficient

ρAB = COVAB

σAσB

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

σP2= (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%

Investopedia

Putting it all together

Build normal distribution

Variance = σP2

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%

VaR: Monte Carlo

Simulations Develop model for future stock prices

Run multiple hypothetical trials

Randomly generate trials (random

inputs)

Investopedia

Comparison

Monte Carlo – Complex

Historical Method – Requires gathering

historical data and number crunching

Variance Covariance – Easiest because

number are on readily available

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%

Profit and Loss (PnL)

Statement that summarizes

the revenues, costs and expenses

incurred during a specific period of time.

DAILY PnL $9,000

Market Moves

Swap Rates $25,000

FX Changes -$100,000

Rates resets $5,000

Trading $80,000

Amendments -$1,000

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

Risk Management Systems

What is it trying to achieve

Generate risk number and figures

VaR

PnL

Produce reports

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

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

Thank you

This concludes the presentation