Introduction to Risk Management :

Michael Le
16 April 2008
Outline
What is Risk?
2. Risk is Everywhere
3. Risk is Not Equal
4. Measuring Risk
5. Decision Making with Risk
6. Risk Ma...
What is Risk?


The Chinese symbol for risk is a combination
of both danger and opportunity



Risk = P(undesired event)...
Market Risk


Risk that value of investment will decrease due to
changes in market factors



Common types of market ris...
Credit Risk


Risk of loss due to default on payment
on a loan or other types of credit



Structured credit risk is mea...
Operational Risk


Differs from market and credit risk



“The risk of loss resulting from
inadequate or failed internal...
Examples of Operational
Risk
Internal Fraud
 External Fraud
 Employment Practices and Workplace
Safety
 Clients, Produc...
Decision Making with Risk


Decisions making in finance requires a
degree of risk taking with it these are
some of the ar...
Investment Choices


Investment choices looks at the different
assets to come up with a portfolio
design for the risk ave...
Corporate Finance


Corporate finance is related to decisions
that corporations make related to
running the business.

In...
Risk is Everywhere


Risks will come from places one would
least expect it and in a form that them to
come from and in un...
Risk from Global Exposure


The Chinese Correction



27 February 2007



With rumors that China would raise the
intere...
Result of the Chinese
Correction


DOW Jones Industrial Average (DJIA)
fell 416 points



This was the largest single da...
Risk from Different Businesses


Best example of this is with the sub-prime
mortgages and collateral debt obligations
(CD...
Credit Suisse CDO - 2000
Amount (in millions)

Tranche

Rating

$293.5

Senior

AAA

$13.0

Mezzanine

A

$17.0

Mezzanine...
Credit Suisse CDO - 2006
Amount (in millions)

Tranche

Rating

$220.5

Senior

AAA

$0

Mezzanine

A

$0

Mezzanine

BBB-...
Subprime Primer
Banks were originally not allowed to
invest in mortgages because they were
not investment grade.
 In the ...


Subprime mortgages are those from
buyers with weak credit and are usually
charged 2 percentage points higher than
those...


Exotic mortgages such as no-doc loans
allowed people with bad credit to take
loans without documentation to show
eviden...


Big banks buy the loans from the
lenders and small banks and securitize
the loans into CDOs with the help of
rating com...


By engineering products with high
ratings (AAA), investors liked CDOs
because of the high returns compared to
bonds of ...
To add noise to the confusion, CDOs
can be multiplied with CDO squareds
and CDO cubeds
 This only hid the underlying asse...


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 ri...
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 ...
Credit Ratings are Not
Equal


Ratings from one type of instrument do
not translate directly for comparison with
another ...


Corporate bonds rated Baa (Moody’s)
from 1983 to 2005
 Default rate 2.2 percent over 5 year periods



CDOs rated Baa...
Rating agencies work with banks


In financial engineering for securitization,
rating agencies consult with banks on how
...
Analyze the Money


Revenue between rating bonds and
CDOs (S&P)
 Corporate bonds - $212,500
 CDOs - $600,000



Revenu...
Issues with CDO ratings
Garbage in, garbage out
 Due to complex nature (many moving
parts), must account for possibility ...


“The credit ratings and observations
contained herein are solely statements
of opinion and not statements of fact or
re...
Credit Ratings


The lack of transparency and potential
conflict of interest makes it hard for
ratings to be taken at fac...
Measuring Risk


Quantifying and measuring risk is one of
the key points of risk management



Focus will be on common r...
Value at Risk (VaR)
Focuses on volatility both up and down
 VaR statistic is made up of 3 parts


 Time Period
 Confid...
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 wor...
Investopedia
VaR: Variance Covariance
Method
 Assumes

that stock returns are
normally distributed

 Variance

measures how actual
re...
Normal Distribution

http://www.ifa.com/images/12steps/step8/f8-1.jpg
Variance
σP 2= wA2 σA2 + wB2 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%
Stand...
Investopedia
Putting it all together


Build normal distribution
 Variance = σP 2
 Standard Deviation = σP

 Mean (weighted average...
VaR: Monte Carlo
Simulations
Develop model for future stock prices
 Run multiple hypothetical trials
 Randomly generate ...
Investopedia
Comparison


Monte Carlo – Complex



Historical Method – Requires gathering
historical data and number crunching



Va...
What time is it?
To convert one VaR of one time period
to another time period
 Multiply standard deviation by square
root...
Profit and Loss (PnL)


Statement that summarizes
the revenues, costs and expenses
incurred during a specific period of t...


It’s market close time, suddenly you
hear



“How’s my PnL?”



“Let me check”



Now we will look at how it put all...
Risk Management Systems


What is it trying to achieve



Generate risk number and figures
 VaR

 PnL



Produce repo...
Basic Flow
System reads security positions for book
 Read the closing values
 Reads the individual trades in the book
 ...
Reality


There are thousands of books, hundreds of
trading desks and different business units

Different ways of storing...
Thank you


This concludes the presentation 
Risky business: Guide to Risk Management
Risky business: Guide to Risk Management
Risky business: Guide to Risk Management
Risky business: Guide to Risk Management
Risky business: Guide to Risk Management
Risky business: Guide to Risk Management
Risky business: Guide to Risk Management
Risky business: Guide to Risk Management
Risky business: Guide to Risk Management
Risky business: Guide to Risk Management
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  • 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.
  • T+1 has overnight interest (carry)
  • Risky business: Guide to Risk Management

    1. 1. Introduction to Risk Management : Michael Le 16 April 2008
    2. 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. 3. 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
    4. 4. 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)
    5. 5. 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.
    6. 6. 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”
    7. 7. 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 
    8. 8. 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 
    9. 9. 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 
    10. 10. Corporate Finance  Corporate finance is related to decisions that corporations make related to running the business. Investment decisions  Financing decisions  Dividend decisions 
    11. 11. 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.
    12. 12. 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%.
    13. 13. 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.
    14. 14. 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 
    15. 15. 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
    16. 16. 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
    17. 17. 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. 
    18. 18.  Subprime mortgages are those from buyers with weak credit and are usually charged 2 percentage points higher than those with good ratings
    19. 19.  Exotic mortgages such as no-doc loans allowed people with bad credit to take loans without documentation to show evidence of income or savings
    20. 20.  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.
    21. 21.  By engineering products with high ratings (AAA), investors liked CDOs because of the high returns compared to bonds of same rating.
    22. 22. To add noise to the confusion, CDOs can be multiplied with CDO squareds and CDO cubeds  This only hid the underlying assets even more. 
    23. 23.  As subprime mortgages defaulted by people who had bad credit. The CDOs began to default as well.
    24. 24.  Due to the complex nature of CDOs it was hard to see what was the underlying assets.  We just believed the credit risk ratings
    25. 25. Credit Ratings  Common terms  Issue Rating  Issuer Rating
    26. 26. 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)
    27. 27. 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
    28. 28.  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
    29. 29. 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
    30. 30. 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
    31. 31. 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.
    32. 32.  “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
    33. 33. 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.
    34. 34. 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)
    35. 35. 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?”
    36. 36. VaR Calculation 3 ways of calculating:  Historical  Variance Covariance  Monte Carlo Simulation
    37. 37. VaR: Historical Model  Assumes history will repeat itself  Arranges historical returns into buckets from order of worst to best returns
    38. 38. Investopedia
    39. 39. 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
    40. 40. Normal Distribution http://www.ifa.com/images/12steps/step8/f8-1.jpg
    41. 41. Variance σP 2= wA2 σA2 + wB2 σB2 + 2wAwB σAσBρAB Correlation Coefficient ρAB = COVAB σAσB
    42. 42.       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%
    43. 43. Investopedia
    44. 44. 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%
    45. 45. VaR: Monte Carlo Simulations Develop model for future stock prices  Run multiple hypothetical trials  Randomly generate trials (random inputs) 
    46. 46. Investopedia
    47. 47. Comparison  Monte Carlo – Complex  Historical Method – Requires gathering historical data and number crunching  Variance Covariance – Easiest because number are on readily available
    48. 48. 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%
    49. 49. 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
    50. 50.  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
    51. 51. Risk Management Systems  What is it trying to achieve  Generate risk number and figures  VaR  PnL  Produce reports
    52. 52. 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 
    53. 53. 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 
    54. 54. Thank you  This concludes the presentation 
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