Risk Management_Group 5_Section 2

8/10/2019 Risk Management_Group 5_Section 2

1/25

Risk Managem

Failures:What are they and When do th

Section 2 | Group 5

Jyoti Ranjan Behera (2013PGP086)|P. Sriram (2013PGP097)|Rohan Modi


2/25

Introduction

The concept of risk management failure is usually misunderstood

Often the blame for the 2007 Global Meltdown is thrust upon the farisk management at the financial institutions across the globe

An attempt is made to understand when the bad outcomes can be bon risk management and when they cannot


3/25

LTCM: Background

LTCM was founded in 1994 by John W. Meriwether, the former vicechairman and head of bond trading at Salomon Brothers. MemberLTCM's board of directors included Myron S. Scholes and Robert C. who shared the 1997 Nobel Memorial Prize in Economic Sciences f"new method to determine the value of derivatives

Trading strategy involved taking advantage of the arbitrage betwee

securities that were incorrectly priced relative to each other Due to the small spread in arbitrage opportunities, the fund had to

leverage itself highly to make money

LTCM: Long-Term Capital Management


4/25

Before its collapse, it had

Capital : close to $5 billion

Assets : over $100 billion and

Positions : total worth was over a $1 trillion

The fund held huge positions in the market, totaling roughly 5% the total global fixed-income market

LTCM: Background (Contd.)


5/25

Performance of the fund: Pre-Crisis

20%

43% 41%

17%

0%

10%

20%

30%

40%

50%

1994 1995 1996 1997

Interest

Interest


6/25

The Crisis

In 1998, the default of Russia on its rouble denominated debt (defaGovernment bonds), plunged the whole world capital markets into

Due to LTCMs highly leveraged nature, the fund sustained massiveand was in danger of defaulting on its loans

By September, 1998; the capital of the company had fallen by more$3.5 billion which made it difficult for the fund to cut its losses in itpositions

Had LTCM gone into default, it would have triggered a global financ

crisis, caused by the massive write-offs its creditors would have hamake

The Federal Reserve Bank of NY coordinated a rescue by private fininstitutions that injected $3.65 billion and thus a systematic meltdothe market was thus prevented

The 70% fall in the capital raised the question as to whether it wasbecause of the failure of risk management


7/25

Risk Management

Risk

Measure

RiskTolerance

Risk

Tolerance

Reduce the Risk Increase the

Manage &Monitor the

Risk

Communicatethe Risk

Assess theRisk


8/25

Analysis

The managers told the investors that there was a 99% probabili

generating a return of 25% and 1% chance of making a loss of 7thus, the expected return being 24.05%

In this case, the managers knew the true distribution of possibloutcomes of the fund

The risk managers knew what was at stake and hence it would bwrong to say that there was a failure of risk management


9/25

Large losses and Risk Management

1. Often large losses are a result of too much leverage

By increasing the leverage, the returns to the shareholders get a boothe expense of making more losses if things dont work out the wayplanned

2. Large losses also arise when the top management has a lot of incen

to take risk Financial economists argue that the incentives of the top manageme

are better aligned with those of the shareholders when the managehas a large stake in the firms equity


10/25

Thus, risk management does not prevent losses

Interestingly, even with good risk management, larglosses can occur when the decision makers conclude

taking large, well understood risks create a value fororganisation


11/25

Typology of Risk Management Failures

Measurement of known risks Failure to take risks into account

Failure in communicating the risks to top management

Failure in monitoring the risks

Failure in managing the risks

Failure to use appropriate risk metrics


12/25

Measurement of known risks

Mistake in assessing the probability of a large loss

Mistake in assessing the size of a large loss; if it occurs

Incorrect assessment of the relation between the returns acros

Misleading historical data


13/25

Failure to take risks into account

Ignoring the known risks

For e.g.: When Russia defaulted, it imposed a moratorium on these banmany collapsed, as a result, the hedge funds ended up having exchange rbecause their counterparties did not honour the hedges. So LTCM did ncounterparty risk in forwards properly into account.

Unknown risks - Other unknown risks may not matter simply becau

they have a trivially low probability.e.g.: There is some probability that a building will be hit by an asteroid. Tdoes not affect any management decisions. Ignoring that risk has no implifor risk management. Because of this, they have to conclude that they capture all risks in their models and therefore, some capital has to beavailable to cope with unknown risks.


14/25

Failure to take risks into account

Mistakes in information collection

For e.g.: In a Union Bank of Switzerland , group of traders was using dif

computers from the rest of the bank, so that integrating their systems in

bankssystems would have required them to change computers.

Eventually, the bank decided, at the top level, that it was more important

the traders make money than disrupt what they were doing thchanges of computers. Soon thereafter, this group of traders lost a

amount of money for the bank. The loss was partly responsible for the

having to merge with another Swiss bank.


15/25


16/25

Failure in monitoring/managing risk

Risks can change sharply even when the firm

takes no decision / position

Contingency hedging plans

Heisenberg Principle: chain reaction ofadjustments

X


17/25


Use of daily VaR measure for trading activities implications ofexceedances

VaR doesnt capture huge losses that have small probability ofoccurring so it should be complemented with risk measures likeexpected shortfall which give the expected value of loss X

Whether large gains , small exceedances or large exceedances and

small gains.(Latter casedetrimental to the firm).

VaR is not sub additive , hence not a coherent risk measure. In some

cases where return distributions are non elliptical , there may be

situations when portfolio aggregate VaR is greater than the sum of

individual VaR of the assets of the portfolio.


18/25

Daily VaR assumes that assets can be sold quickly, howeverthere might be scenarios where the markets may become

suddenly illiquid . For e.g.: Russian crisis of 1998

So if a firm sits on assets not tradable using daily VaR doesntserve the purpose as firm is stuck for a longer time horizon

Existing risk models are not designed to capture risksassociated with crisis and help firms manage them they usehistorical data and with short horizons they may not capturethe crisis.


X


19/25

Leverage at LTCM

LTCM didnt want to manage a business earning 17% return, ins

wanted similar higher returns seen in 1995 and 1996

Capital Base expanded to $ 7.4 bn, but decided to return 36% ocapital back to investors

So, it had to borrow(take leverage) to provide the targeted retuthe investors.

Had off-balance sheet derivative positions with a notional valueapproximately $1.25 trillion


20/25

Repercussions of Leverage

As a result of these losses, LTCM had to liquidate a number positions at a highly unfavourable moment and suffer further losse

LTCM established an arbitrage position in the dual-listed compan"DLC") Royal Dutch Shell. Royal Dutch traded at an 8%-10% premrelative to Shell.

In total $2.3 billion was invested, half of which was "long" in Shethe other half was "short" in Royal Dutch betting that the share pwould converge

The premium of Royal Dutch had increased to about 22%, which imthat LTCM incurred a large loss on this arbitrage strategy. LTCM$286 million in equity pairs trading and more than half of this laccounted for by the Royal Dutch Shell trade


21/25

Why do hedge funds leverage?

Hedge-Funds usually aim to provide high returns through trading mothe derivatives market and sometimes use arbitrage opportunities t

smaller profits

For LTCM, increasing leverage was a positive NPV decision when it wmade, but obviously ex post it was a costly decision as it meant thatassets fell in value, the funds equity fell in value faster than it wouldwith less leverage.

In order to generate higher returns and provide better shareholder managers take the view that the gains related with leverage are muchigher that the associated downside costs in the normal course of thbusiness


22/25

Short Term vs Long Term Risk Managem

Short term risk measures like VaR simply risk measures and focus onthe immediate loss the company could bear. Also there are helpful in

devising simplified hedging strategies

Short-term Risk measures like VaR do not consider contagious risks, a situation of crisis where one days loss would significantly change trisk characteristics for the second day

Short term risk management doesnt focus on crisis-risk as the

possibility of a crisis happening in the short term is very low, wherealong term risk management considers this and hence considers therelated risks like liquidity risk and chain reactions with mark-to-marklosses that come along with a crisis


23/25

Crises may involve a dramatic withdrawal of liquidity from the mark

The withdrawal of liquidity means that firms are stuck with positions

they never expected to hold for a long time because price pressure c

involved in trading out of these positions are extremely high

Positions whose risk was evaluated over one day because the firm

thought it could trade out of these positions suddenly became

positions that had to be held for weeks or months

Also , firms will make multiple losses that exceed their daily VaRs an

these losses can be large enough to substantially weaken them. As a

result, risk measures have to contemplate the distribution of large lo

over time rather than over one day

Using Long Term horizon for evaluating Risk


24/25

Conclusion There are many ways that risk management failures can occur, but not

loss reflects a risk management failure

However, risk management practice can be improved by taking into a

the lessons from financial crises

These crises happen often enough that they have to be carefully modelle

institutions have to focus on scenario analyses that assess the impli

of crises for their financial health and survival

Scenario analyses should not be built from quantitative models usin

data, but instead they must use economic analysis to evaluate the impact

withdrawal of liquidity and the feedback effects that are common in fi

crises

To successfully impact firm strategy, such analyses have to be

rooted in a firms culture and in the strategic thinking of top managem


25/25

Documents

Risk Management_Group 5_Section 2