Risk ManagementUniversity of Economics, Kraków, 2012              Tomasz Aleksandrowicz
market risk managementmeasuring market risk – value at risk (VaR)
measuring risk: value at risk
value at risk (VaR) (I)• VAR is the maximum loss over a target horizon   such that there is a low, pre-specified probabili...
value at risk (VaR) (II)• the most commonly used measure of market risk• useful because of its ability to distill a great ...
value at risk (VaR) (III)• creates a distribution of potential outcomes at a  specified confidence interval• confidence in...
portfolio A return 10 years time ($m)2527 observations (trading days)
portfolio A return distributionThe maximum loss over one day is about $47m at the 95% confidence level
VaR examples:• Q: $3m overnight VAR with 99% confidence level• A: the loss will be worst than $3m in on average 1  day out...
VaR issues• VAR does not tell how big the loss might be on the  95th/97th/100th day• it is based on historical correlation...
liquidity risk management       asset and funding liquidity risk            LTCM collapse case-study
liquidity• liquidity (accounting) - ability of a organization to  pay his debts as and when they fall due• liquidity (asse...
liquidity risk• it is less amenable to formal analysis than traditional  market risk• there is still no commonly accepted ...
asset liquidity risk• risk of loss due to an inability to sell an asset at  expected value• asset liquidity to be a crucia...
why an asset liquidity issue?• asset might be too large in relation to the market and  cannot be sold without moving it• m...
asset liquidity measurement• tightness - which is a measure of the divergence between  actual transaction prices  and quot...
asset liquidity exercise                     • $10,000 cash on bank                       account                     • 3 ...
asset liquidity management•   asset maturity profile management•   portfolio credit quality mix (high/low quality assets)•...
funding liquidity risk• risk of loss due to an inability to fund assets,  payments and other obligations when required   –...
• payables, short-term  notes, repurchase  agreements,  commercial paper,  deposits, long-term  bonds, convertible  securi...
funding liquidity management•   liability maturity profile management•   managing funding source concentration•   credit r...
Long Term Capital Management       market and liquidity risk
Long term capital management• Long Term Capital Management fund• a hedge fund created by Salomon Brothers in 1994• hired t...
LTCM investment strategies• fixed-income arbitrage    – inefficiencies in the pricing of bonds    – using derivatives as I...
LTCM downturn (I)• high profits brings huge money from investors interested in its  share• others start to use similar str...
LTCM downturn (II)• portfolio under pressure of markets after East Asian crisis  (1997)• returns down to -6,42% in May 199...
LTCM performance                   27
LTCM deal loss exampleRoyal Dutch Shell• Royall Dutch Shell – dual-listed at Euronext (Royal Dutch) and  LSE (Shell)• stoc...
LTCM downturn (III)• company has performed a flight-to-liquidity• Sep 1998 LTCMs equity down from $2.3b to $400m• total li...
LTCM downturn (IV)• 23 Sep 1998 Goldman Sachs, AIG and Warren Buffet offered  $200m for acquisition (compared to $4.7b sta...
LTCM lessons•   failures in:•   1. Model risk•   2. Breakdown in historical correlations•   3. The need for stress-testing...
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Rm 09

  1. 1. Risk ManagementUniversity of Economics, Kraków, 2012 Tomasz Aleksandrowicz
  2. 2. market risk managementmeasuring market risk – value at risk (VaR)
  3. 3. measuring risk: value at risk
  4. 4. value at risk (VaR) (I)• VAR is the maximum loss over a target horizon such that there is a low, pre-specified probability that the actual loss will be larger• the answer to: How much money might I lose?‘• provides an estimate of the riskiness of a portfolio based on statistical methodology to quantify potential financial loss
  5. 5. value at risk (VaR) (II)• the most commonly used measure of market risk• useful because of its ability to distill a great deal of information into a single number• based on probabilities and within parameters set by the risk manager• based on one of several different methods
  6. 6. value at risk (VaR) (III)• creates a distribution of potential outcomes at a specified confidence interval• confidence intervals are typically 95, 97.5, or 99 percent• time horizon might be 1 or more days• largest loss outcome using the confidence level as the cut-off is the amount reported as value-at risk• an example using historical data method:
  7. 7. portfolio A return 10 years time ($m)2527 observations (trading days)
  8. 8. portfolio A return distributionThe maximum loss over one day is about $47m at the 95% confidence level
  9. 9. VaR examples:• Q: $3m overnight VAR with 99% confidence level• A: the loss will be worst than $3m in on average 1 day out of 100• Q: 95% dialy VaR of $50m• A: 95 days out of 100 there should be lose no more than $50 million
  10. 10. VaR issues• VAR does not tell how big the loss might be on the 95th/97th/100th day• it is based on historical correlations which can break down in times of market stress• it is based on statistical assumptions - it is estimation• VAR can really only be used for marked-to-market portfolios (revalued every day)• criticized as unable to forecast real value at risk as well as its existence encouraged extensive investment 10
  11. 11. liquidity risk management asset and funding liquidity risk LTCM collapse case-study
  12. 12. liquidity• liquidity (accounting) - ability of a organization to pay his debts as and when they fall due• liquidity (asset) - assets ability to be sold with minimum price movement/loss of value• liquidity risk is underestimated by many organizations• loss of liquidity the reason for most bankruptcies or liquidations in the financial industry
  13. 13. liquidity risk• it is less amenable to formal analysis than traditional market risk• there is still no commonly accepted measurement / solution• two types of liquidity risk: – asset liquidity (also called market/product liquidity risk) – funding liquidity risk (also called cash-flow risk)• these two types of risk interact with each other
  14. 14. asset liquidity risk• risk of loss due to an inability to sell an asset at expected value• asset liquidity to be a crucial factor• can be managed by setting limits on certain markets or products and by means of diversification
  15. 15. why an asset liquidity issue?• asset might be too large in relation to the market and cannot be sold without moving it• market might be unable to absorb an asset sale of that size• asset may be so exotic/complex - attracts few buyers• asset might not be readily transferable without some legal effort• asset might be restricted on convertibility, capital withdrawal or regulatory approval
  16. 16. asset liquidity measurement• tightness - which is a measure of the divergence between actual transaction prices and quoted mid-market prices depth - which is a measure of the volume of trades possible without affecting prices too much (e.g. at the bid/offer prices), and is in contrast to resiliency - which is a measure of the speed at which price fluctuations from trades are dissipated• illiquid markets are those where transactions can quickly affect prices.
  17. 17. asset liquidity exercise • $10,000 cash on bank account • 3 month $20,000 deposit • 100 shares of Apple • 100 shares of • 10 US T-bond • option • OCT structure
  18. 18. asset liquidity management• asset maturity profile management• portfolio credit quality mix (high/low quality assets)• aged assets management (long-term assets)• concentrated (large) positions monitoring
  19. 19. funding liquidity risk• risk of loss due to an inability to fund assets, payments and other obligations when required – inability to rollover, or renew, maturing financing when required – inability to access new funding when needed• can be managed by proper – planning of cash-flow needs – by setting limits on cash flow gaps – by having a robust plan in place for raising fresh funds
  20. 20. • payables, short-term notes, repurchase agreements, commercial paper, deposits, long-term bonds, convertible securities, bank loans
  21. 21. funding liquidity management• liability maturity profile management• managing funding source concentration• credit rating changes awareness• using liquid collateral (adequate haircut)
  22. 22. Long Term Capital Management market and liquidity risk
  23. 23. Long term capital management• Long Term Capital Management fund• a hedge fund created by Salomon Brothers in 1994• hired two Nobel prize economist: Myron Scholes and Robert C. Merton• using high leverage and complex investment strategies• has very good returns – on level of 40% annually 23
  24. 24. LTCM investment strategies• fixed-income arbitrage – inefficiencies in the pricing of bonds – using derivatives as IRS (interest rate swaps), MBS (mortgage backed securities) and forwards• statistical arbitrage – a heavily quantitative and computational approach to equity trading – looking for statistical mispricing of one or more assets based on the expected value of these assets• pairs trading strategies – using temporary correlation changes between pair of stocks• The problem: these strategies brings model risk and short term volatility risk 24
  25. 25. LTCM downturn (I)• high profits brings huge money from investors interested in its share• others start to use similar strategies for investment which decrease its efficiency• fund closed for new investors in 1996• in 1997 huge dividend to remove unmanageable money from the fund – but without closing• adequate risk positions• style drift from original investment methods 25
  26. 26. LTCM downturn (II)• portfolio under pressure of markets after East Asian crisis (1997)• returns down to -6,42% in May 1998 and -10,14% in June – total loss of $461m• in Aug 1998 Russian financial crisis – default of the government put pressure on bonds market• further losses $1,85b which forced liquidation of assets 26
  27. 27. LTCM performance 27
  28. 28. LTCM deal loss exampleRoyal Dutch Shell• Royall Dutch Shell – dual-listed at Euronext (Royal Dutch) and LSE (Shell)• stock price premium of 8-10% observed at Royal Dutch• $2,3b invested: half in long position at Shell, half in short on Royal Dutch• expectation was premium will be gone and 8-10% profit from Royal Dutch re-purchase collected• strategy was cut by forced liquidation – Royal Dutch was re- purchase under 22% premium• deal created $286m loss 28
  29. 29. LTCM downturn (III)• company has performed a flight-to-liquidity• Sep 1998 LTCMs equity down from $2.3b to $400m• total liabilities still over $100 billion• this translated to an effective leverage ratio of more than 250:1• due to deals with almos all Wall St big players they there was move to prevent fund form collapse 29
  30. 30. LTCM downturn (IV)• 23 Sep 1998 Goldman Sachs, AIG and Warren Buffet offered $200m for acquisition (compared to $4.7b starting capital) - deal was not done,• FED organized an bailout and injected $3.65b capital for operation form consortium of banks• by 2000 fund was liquidated and and rescuers paid back• total loss estimated at $4.6b 30
  31. 31. LTCM lessons• failures in:• 1. Model risk• 2. Breakdown in historical correlations• 3. The need for stress-testing• The value of disclosure 4. and transparency• 5. The danger of over-generous extension of• trading credit• 6. The woes of investing in star quality
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