Tools for risk management
Zvi Wiener
02-588-3049
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Jun-00
Risk Management
Options

Call, Put

European, American

Strike, volatility, time to maturity

In-the-money, Out-of-the-money

Black-Merton-Scholes

OTC and Exotic options
Risk Management Tools
Jun-2000
slide 2
Call Value before Expiration
E. Call
premium
X
Risk Management Tools
Jun-2000
Underlying
slide 3
Put Value before Expiration
E. Put
X
premium
X
Risk Management Tools
Jun-2000
Underlying
slide 4
Other Options

Callable bond

Warrants
 Asian,

Bermudian, Digital
Real options
– to start a new project
– to change prices
– to close some divisions
Risk Management Tools
Jun-2000
slide 5
Hedge Ratio = Delta

Delta measures sensitivity of a position
relative to a risk factor.

Similar to duration for bonds.

Delta of a call option is …

Delta of a put option is ...
Risk Management Tools
Jun-2000
slide 6
Call Delta
E. Call
C

S
current value
S
Risk Management Tools
Jun-2000
slide 7
Put Delta
E. Put
P

S
current value
S
Risk Management Tools
Jun-2000
slide 8
What type of risk protection would you
suggest for a pension fund?
payoff
Buy index
floor
Stock market
Buy put
Sell calls
Risk Management Tools
Jun-2000
slide 9
Buy stock
Result
Buy put
Sell call
Risk Management Tools
Jun-2000
slide 10
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
Risk Management Tools
Jun-2000
slide 11
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
Risk Management Tools
Jun-2000
slide 12
UPC
150
After tax
capital gain
is between
$53M and
$80M
108
125
153
173
212
UPC share
These options cover 800,000 shares only.
Risk Management Tools
Jun-2000
slide 13
How much did it cost?
The results are not precise and very sensitive
to volatility

– if volatility is 10%
– if volatility is 20%
– if volatility is 30%
– if volatility is 40%
$6.5M
$10M
$13M
$15M
This is the amount the bank should pay to DASKASCH!
Risk Management Tools
Jun-2000
slide 14
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?
Risk Management Tools
Jun-2000
slide 15
Butterfly
2*Call(550)-Call(540)-Call(560)
payoff
540
Risk Management Tools
550
Jun-2000
560
Stock market
slide 16
Hedge using Forward
Current exchange rate 4.00
USD interest rate
6%
NIS interest rate
10%
In a year you will receive $100 and will have
to pay 410 NIS.
Enter into a forward for 1 year for $100.
Forward price is 4.00*1.1/1.06=4.15.
The time match is important!
Risk Management Tools
Jun-2000
slide 17
After a year
$
3.9
4.0
4.1
4.2
4.3
Forward
25
15
5
-5
-15
Your balance
3.9*100-410+25= 5
4.0*100-410+15= 5
4.1*100-410+ 5 = 5
4.2*100-410- 5 = 5
4.3*100-410-15 = 5
Complete protection with no cost!
Risk Management Tools
Jun-2000
slide 18
What if there is no perfect time
match?
One can use shorter contracts and roll them
over. This will neutralize completely the
exchange rate risk, but you will have some
interest rate risk.


Do it very carefully!

Or better use OTC, but check prices.
Risk Management Tools
Jun-2000
slide 19
Hedge using Options
Current exchange rate 4.00
USD interest rate
6%
NIS interest rate
10%
In a year you will receive $100 and will have
to pay 410 NIS.
Buy a put option with strike 4.1 for $100.
The time match is important!
Risk Management Tools
Jun-2000
slide 20
After a year
$
Put Opt. Your balance
3.9 20
3.9*100 - 410 + 20= 0
4.0 10
4.0*100 - 410 + 10= 0
4.1 0
4.1*100 - 410 + 0 = 0
4.2 0
4.2*100 - 410 - 0 =10
4.3 0
4.3*100 - 410 - 0 =20
Protection with some cost!
The initial cost of options.
Risk Management Tools
Jun-2000
slide 21
Example
Your company has stable yearly income of
8M (shekels) a year and yearly costs of $1M
and 1M Euro. For simplicity assume that all
payments are on the end of ech calendar year.
How to measure and to manage this risk?
Risk Management Tools
Jun-2000
slide 22
Example
Time horizon – 1 year
Basic currency – SHEKELS
Major risk factors – exchange rates USD,
EUR and interest rates (for all 3 currencies).
The present value of the next cashflow is:
8
USD
EUR


1  rNIS 1  rUSD 1  rEUR
Risk Management Tools
Jun-2000
slide 23
Example
8
USD
EUR


1  rNIS 1  rUSD 1  rEUR
Assume that now
USD = 4 SHEKELS
EUR = 3.5 SHEKELS
rNIS = 10%
rUSD= 6%
rEUR = 5%
Risk Management Tools
Jun-2000
slide 24
Example
8
USD
EUR


1  rNIS 1  rUSD 1  rEUR
The current value of the position is 165,809 NIS.
But this number is subject to the risk factors.
We ignore in this example the interest rates for
simplicity.
Risk Management Tools
Jun-2000
slide 25
Example
8
USD
EUR


1  rNIS 1  rUSD 1  rEUR
Each time the USD/NIS rate increases by 1
AGORA, our position loses 9,434 NIS.
Each AGORA in Euro exchange rate causes
a loss of 9,524 NIS.
Assume that yearly volatility of USD/NIS is
10%, and EUR/NIS is 20%.
Correlation between them -0.1.
Risk Management Tools
Jun-2000
slide 26
Example
8
USD
EUR


1  rNIS 1  rUSD 1  rEUR
  (9,434  400  0.1)  (9,524  350  0.2)
2
P
2
2
 2  0.1 9,434  400  0.1 9,524  350  0.2
 P  732,482
VaR5%  1,208,595
Risk Management Tools
Jun-2000
slide 27
Example
The best way to hedge this risk is by forward
contracts that will allow you to exchange the
appropriate amount of foreign currency to
SHEKELS at the rate fixed in advance.
Another alternative is to use static (or better
dynamic) hedge with options.
Risk Management Tools
Jun-2000
slide 28
Example
 Assume
that for the following 7 years you
have to pay each year $1M and you will get
each year 5M NIS.

How one can hedge this cash flow?

What if amounts or timing is not precise?
Risk Management Tools
Jun-2000
slide 29
How to hedge financial risk?
Static hedge
Forwards agreements that fix the price
Futures
Options static hedge
 Dynamic delta or vega hedge, with a
variable amount of options held. It is
applicable if there is a very liquid market and
low transaction costs.

Risk Management Tools
Jun-2000
slide 30
Risk Management resources

Useful Internet sites

Regulators

Insurance Companies

Risk Management in SEC reports
pluto.mscc.huji.ac.il/~mswiener/
Risk Management Tools
Jun-2000
slide 31
RMG

http://www.riskmetrics.com/

http://www.pictureofrisk.com/

http://www.riskmetrics.com/rm/splash.html

rmgaccess
Risk Management Tools
Jun-2000
slide 32
Consulting
Risk Management Tools

Oliver, Wyman and Co.

Willis Corroon

Richard Scora

Ernst and Young

Enterprise Advisors

Kamakura
Jun-2000
slide 33
Examples of Risk Reports
http://www.pictureofrisk.com
http://www.mbrm.com/
http://www.riskmetrics.com/rm/splash.html
Risk Management Tools
Jun-2000
slide 34
Regulators










BIS
G-30
FSA
SEC
market risk disclosure rules
market risk reporting
FED, FRB
our GARP report
Swiss Central Bank
Financial Accounting Standards Board
Risk Management Tools
Jun-2000
slide 35
Who manages risk?
Citibank
AIG
Nike
Bank of England
General Re
Sony
CIBC
Swiss Re
Dell Computers
J. P. Morgan
Aetna
Philip Morris
Bankers Trust
Zurich
Ford Motor
Risk Management Tools
Jun-2000
slide 36
SEC reports

Edgar
 Yahoo
– find symbol
– profile
– raw SEC reports

Risk Management Tools
market risk in 10K 7A
Jun-2000
slide 37
3 methods

Sensitivity
– requires a deep understanding of positions

Tabular
– when there are 1-2 major risk factors

Value-at-Risk
– for active risk management
Risk Management Tools
Jun-2000
slide 38
KPMG report
Survey of disclosures: SEC Market Risk, 1999
SEC:
http://www.sec.gov/smbus/forms/regsk.htm#quan
http://www.sec.gov/rules/othern/derivfaq.htm
GARP
http://www.garp.com/
Risk Management Tools
Jun-2000
slide 39
World Experience

Bankers Trust, J.P. Morgan, investment banks

Bank regulators, commercial banks

Insurance, dealers

Investment funds (LTCM)

Real companies

Investors learn to read risk information!
Risk Management Tools
Jun-2000
slide 40
Agriculture
www.cfonet.com/html/Articles/CFO/1999/99APkita.html
1998 revenues $1.25B
consulting Willis Corroon
Risk Management Tools
Jun-2000
slide 41
Nike

Salaries are paid in Asia

Shoes are sold worldwide

Financing comes from USA

Marketing, storing, shipping worldwide
use VaR since 1998.
Risk Management Tools
Jun-2000
slide 42
Merck
http://www.palisade-europe.com/html/Articles/merck.html
http://www.sec.gov/Archives/edgar/data/64978/000095012
3-99-005573-index.html see “sensitivity”
Risk Management Tools
Jun-2000
slide 43
Articles
Value at Risk as a Diagnostic Tool for Corporates:
The Airline Industry
http://netec.mcc.ac.uk/WoPEc/data/Papers/dgruvati
n19990023.html
Agricultural Applications of Value-at-Risk
Analysis: A Perspective
http://netec.mcc.ac.uk/WoPEc/data/Papers/wpawu
wpfi9805002.html
Risk Management Tools
Jun-2000
slide 44
Publications
“The New Risk Management: the Good, the Bad,
and the Ugly”, P. Dybvig, W. Marshall
http://dybfin.olin.wustl.edu/research/papers/riskma
n_fed.pdf
Association for Investment Management and
Research
http://www.aimr.org/
Risk Management Tools
Jun-2000
slide 45
Web tour
ZW, students, VaR and risk management
 Gloriamundy
 GARP
 SEC reports
 Google

Risk Management Tools
Jun-2000
slide 46
What is more risky and why?
A. 1 year bond
B. 10 year bond
Risk Management Tools
Jun-2000
slide 47
What is more risky and why?
A. An in-the-money option?
B. An out-of-the-money option?
Risk Management Tools
Jun-2000
slide 48
Call Value before Expiration
Call
In-the-money option
Out-of-the-money option
X
Risk Management Tools
Jun-2000
Underlying
slide 49
What is more risky and why?
A. A fixed interest loan?
B. A floater (variable interest rate)?
Risk Management Tools
Jun-2000
slide 50
The End
Risk Management Tools
Jun-2000
slide 51
Tools

Measurement tools

Financial tools
– options
– forwards, futures
– swaps
– insurance

Risk Management Tools
Outsourcing
Jun-2000
slide 52
Senior Management
Marketing
Finance
Supply
Cashflow
Capital
Risk Management Tools
Jun-2000
slide 53
Important Principles
Distinction between risk taking and risk control.
Backtesting.
Transparent reporting.
Timing is more important then precision!
Risk Management Tools
Jun-2000
slide 54
Basic decisions

Goal of Risk Management

Base currency

Time horizon (embedded options)

Economic or Accounting approach
 Admissible

Risk Management Tools
risk
Stop losses or other actions
Jun-2000
slide 55
Risk Management System Can NOT
Predict future
 Identify business opportunities
 Be always right!

Risk Management System Can
Predict loss, given event
 Identify most dangerous scenarios
 Recommend how to change risk profile

Risk Management Tools
Jun-2000
slide 56
Definition
VaR is defined as the predicted worst-case
loss at a specific confidence level (e.g. 99%)
over a certain period of time.
Risk Management Tools
Jun-2000
slide 57
VaR
1
0.8
0.6
0.4
VaR1%
1%
0.2
Profit/Loss
-3
Risk Management Tools
-2
-1
1
Jun-2000
2
3
slide 58