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 interpretation 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% 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 exercise

• $10,000 cash on bank account

• 3 month $20,000 deposit• 100 shares of Apple• 100 shares of • 10 US T-bond• option• $1m gold forward

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

LTCM profile

• a hedge fund created in 1993 by John Meriwether, former Salomon Brothers vice-chairman

• hired many experienced traders and specialists in mathematical finance as well as two Nobel prize economist: Myron Scholes and Robert C. Merton

• trading with leading banks on high-quality instruments avoiding 'emerging markets'

• capital provided by top class institutional investors• $1,1b capital raised at start

LTCM investment strategy

• investment based on carefully researched mathematical models of the markets

• seeking small pricing anomalies from which it could profit (arbitrage or temporary correlations)

• this complex investment strategies were using high leverage

LTCM success story

• very high returns: 43% in 1995 and 41% in 1996• by this time fund proven to be well managed and

successful• high profits brings huge money from investors

interested in its share• in 1995 investment capital raised to $7,5b and fund

was closed for investors• in 1997 redemption of $2.7b back to investors• return still respectable 17%

LTCM risks at the horizon

• due to investment strategies big exposure to instruments volatility risk

• using highly complex models brings big model risk• pressure on attractive returns - style drift from original

investment methods• other funds started to use similar strategies which decrease

its efficiency• redemption of investment capital but without closing

adequate risk positions - increased leverage• huge leverage brings increasing liquidity risk

LCTM downturn (I)

• 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 - liquidity risk effects hit the fund

forced liquidation trade example

• 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

LCTM downturn (II)

• 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 almost all Wall St big players they

there was move to prevent fund form collapse

LTCM performance

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LCTM rescue

• 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

LTCM failure summary

• market risk management model brakes when VaR level reached

• far too much credit from involved banks - too huge leverage

• poor market liquidity risk management• poor public and industry wide disclosure of its ‐

activities and exposures• model risk - there is no sure way of profit