Risk ManagementUniversity of Economics, Kraków, 2012

Tomasz Aleksandrowicz

market risk management

measuring 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 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

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

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:

portfolio A return 10 years time ($m)2527 observations (trading days)

portfolio A return distribution

The 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 of 100• Q: 95% dialy VaR of $50m• A: 95 days out of 100 there should be lose no more

than $50 million

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

liquidity risk management

asset and funding liquidity riskLTCM collapse case-study

liquidity

• liquidity (accounting) - ability of a organization to pay his debts as and when they fall due

• liquidity (asset) - asset's 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

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

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

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

asset liquidity measurement

• tightness - which is a measure of the divergence between actual transaction pricesand quoted mid-market pricesdepth - which is a measure of the volume of trades possible without affectingprices too much (e.g. at the bid/offer prices), and is in contrast toresiliency - which is a measure of the speed at which price fluctuations from tradesare dissipated

• illiquid markets are those where transactions can quickly affect prices.

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

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

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

• payables, short-term notes, repurchase agreements, commercial paper, deposits, long-term bonds, convertiblesecurities, bank loans

funding liquidity management

• liability maturity profile management• managing funding source concentration• credit rating changes awareness • using liquid collateral (adequate haircut)

Long Term Capital Managementmarket and liquidity risk

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

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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

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

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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

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LTCM performance

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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

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LTCM downturn (III)

• company has performed a flight-to-liquidity• Sep 1998 LTCM's 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

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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

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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