2013

ASSIGNMENT #1 FINANCIAL RISK MANAGEMENT

Submitted To: Dr. Kulbir Singh Assistant Professor Finance

Submitted By: Chetan Chawhan Roll No. 2012100

1. A Framework for Risk Management-Why Derivatives Don't Reduce FX Risk a) What should be the goal of a risk management in a firm: to reduce the volatility in the stock price, or to stabilize operating income, accounting earnings, ROE, or capital expenditures? The goal of risk management in a firm should be to stabilize operating income, accounting earnings, ROE, or capital expenditures. This helps a company to meet its strategic objectives by controlling excessive investment volatility. The stock-price volatility can be better managed by individual investors through their portfolio strategies. Also, the goal of risk management is to ensure that companies have the cash they need to create value by making good investments. A coherent risk-management strategy Understands the connection between a companys investment opportunities and key economic variables b) Should a firm hedge? What are the benefits and costs of hedging? Hedging is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you will have typically reduced the profit that you could have made, and if the investment loses money, your hedge, if successful, will reduce that loss. In Technical terms in order to hedge you would invest in two securities with negative correlation. A proper risk-management strategy ensures that companies have the cash when they need it for investment, but it does not seek to insulate them completely from risks of all kinds and also helps the managers whether there is need to hedge or not and in case of hedging how much to hedge. Risk Management also helps in controlling excessive investment volatility as it can threaten a companys ability to meet its strategic objectives. The major reason to hedge for a company is align their internal supply of funds with their demand for fund. If changes in exchange rates, commodity prices, and interest rates lead to large imbalances in the supply and demand for funds, then the company should hedge aggressively; if not, the company has a natural hedge, and it does not need to hedge as much. Benefits of Hedging Hedging using futures and options are very good short-term risk-minimizing strategy for long-term traders and investors. Hedging tools can also be used for locking the profit. Hedging enables traders to survive hard market periods. Successful hedging gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc. Hedging can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility. Hedging using options provide the trader an opportunity to practice complex options trading strategies to maximize his return.

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Costs of Hedging Hedging involves cost that can eat up the profit. Risk and reward are often proportional to one other; thus reducing risk means reducing profits. For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow. If the market is performing well or moving sidewise, then hedging offer little benefits. Trading of options or futures often demand higher account requirements like more capital or balance. Hedging is a precise trading strategy and successful hedging requires good trading skills and experience. c) Which risks should be hedged and which should be left unhedged? What kind of instruments and trading strategies are appropriate? Should risk management strategy be affected by what competitors are doing, and how? By hedging, the company reduces supply when there is excess supply and increases supply when there is a shortage. This aligns the internal supply of funds with the demand for funds. Of course, the average supply of funds doesnt change with hedging, because hedging is a zero-net-present-value investment: it does not create value by itself. But it ensures that the company has the funds precisely when it needs them. Because value is ultimately created by making sure the company undertakes the right investments, risk management adds real value. Thus, all risk should be hedged which leads to disequilibrium in the supply of internally generated funds and the investment demand for funds. Some key features of instruments that a company must keep in mind when evaluating which ones to use are: Cash-Flow Implications Linearity and Nonlinearity Money Down Customization All the following features will be explained in details in the latter part. The decision of which contract to use should be driven by the objective of aligning the demand for funds with the supply of internal funds. Also it is in favor of the company to stay away from most exotic, customized hedging instruments unless there is a very clear investment-side justification for their use. Companies should pay close attention to the Risk Management strategies of their competitors as there are some situations in which a company may have even greater reason to hedge if its competitors dont. The company should hedge to make sure it has enough cash for the investment. The investment opportunities depend on the overall structure of the industry and on the financial strength of its competitors. Thus, the same elements that go into formulating a competitive strategy should also be used to formulate a risk management strategy.

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d) Compare and contrast hedging with forwards/futures/swaps to hedging with options Few commonly used derivatives for hedging are futures, forwards, swaps, options, caps, floors, etc. Broadly they are divided into two major heads Forwards and Options. The further sub division is as follows: Forward-Based Contracts: Futures, Forwards, Swaps Option- Based Contracts: Options, Caps, Floors Some of the major differentiating factors are: Cash Flow Implication: This means that whether an instrument is settled at maturity or before maturity. Futures Contracts: These are traded on an exchange and require a company to mark to market on a daily basis, that is, the company has to put money to compensate for any short-term losses. These expenditures can cut into the cash a company needs to finance current investments. Options: these are generally not mark to market. Options are settled when they are exercised. Money Down: This means that when an instrument is initiated whether money changes hands or not. Forward Contracts: In future no money exchanges hands at the time of initiation Options: Unlike Forward, the options require some initial payment in the form of premium in order to earn a right to walk away later on Linearity: it tells whether a particular contract is linear or non-linear Futures and forwards are essentially linear contracts i.e. for every dollar the company gains when the underlying variable moves in one direction and it loses a dollar when the underlying variable moves in the other direction. Options are nonlinear, in that they allow the company to put a floor on its losses without having to give up the potential for gains. If there is a minimum amount of investment a company needs to maintain, options can allow it to lock in the necessary cash. At the same time, they provide the flexibility to increase investment in good times. Customization: Forward Contracts: As forwards are traded OTC there are high degrees of customization involved. Options: options are available both on exchanges and OTC. OTC offers great opportunity for customization

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2. Forgetting Lehman: VaR: Seductive but Dangerous-Beyond VaR, The Risk of Value at Risk a) What is VaR? Explain its relevance for a financial institution. VaR is a statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. Value at risk is used by risk managers in order to measure and control the level of risk which the firm undertakes. The risk manager's job is to ensure that risks are not taken beyond the level at which the firm can absorb the losses of a probable worst outcome. VaR is considered as a standard measure of market risk and is widely implemented by financial institutions. The VaR of a market position is a single number attempting to summarize the risk of that position. It is defined as the worst expected loss of that position, over a given period of time at a given confidence level. Originally VaR was intended to measure the risks in derivatives markets, but it became widely applied in financial institutions to measure all kinds of financial risks, primarily market and credit risks. b) What is relevance of confidence interval and horizon in computation of VaR. Time horizon is a crucial factor in VaR. Firms select different time periods to view risk depending on the capital exposure and the expected profits, whether in the short term or long term. Although a model may produce adequate views of capital risk on an overnight or weekly basis, it may produce inadequate risk views over time horizons of several months, years. VaR is calculated within a given confidence interval, typically 95% or 99%; it seeks to measure the possible losses from a position or portfolio under normal circumstances. The definition of normality is critical and is essentially a statistical concept that varies by firm and by risk management system. Put simply however, the most commonly used VaR models assume that the prices of assets in the financial markets follow a normal distribution.

c) What are the shorting comings of VaR? Is there any better model instead of VaR? Shortcomings: VaR does not provide certainty or confidence of outcomes but rather an expectation of outcomes that the firm based on a specific set of assumptions. Under certain circumstances VaR does not give an appropriate risk measure, its estimation is subject to large estimation errors, and a downward bias in the estimation can easily be exploited by employees or the entire company to their own benefit. Focused on the manageable risks near the center of the distribution and ignored the tails

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BVaR is used to take into consideration the profile of losses beyond VaR. BVaR incorporates both, the frequency of losses beyond VaR and the size of the losses beyond the VaR by taking into account the first moment of the distribution of the losses exceeding the VaR. d) Explain stressed VaR. What relevance of horizon in the stressed VaR? The stressed VAR charge is designed to have an impact on capital levels, but its not the most efficient way of doing it, says Simon Gurney, London-based chief risk officer for the UK and Europe at Standard Chartered Bank. Not only is there no clear philosophy behind the decision to add together capital charges derived from normal VAR and stressed VAR, but it is also too broad a response, he says. For the structured credit market, VAR clearly didnt work, but it was fine for other areas. For the business areas that stayed liquid, banks found VAR still worked. They should fix the specific problem.

3. Exceptions to the rule a. What is Back testing? Explain its relevance to financial institutions. Back testing is a set of statistical procedures designed to check if the real losses are in line with VaR forecasts. Its a technique used to compare the predicted losses from VaR with the actual losses realized at the end of the period of time. This identifies instances where VaR has been underestimated, meaning a portfolio has experienced a loss greater or than the original VaR estimate. The results of the Back testing can be used to refine the models used for the VaR predictions, making them more accurate and reducing the risk of unexpected losses. Relevance to FI Automated algorithms for regular back testing on a daily basis A portfolio of statistical tests can detect specific problems with your VaR model Awareness of weaknesses of the applied VaR model and thus a more efficient control of risks b. How back testing would have saved the financial institutions as mentioned in the article during financial crisis of 2007-2008? The answer is complicated and lies in a combination of factors primarily the failure of models to capture the risks of some exotic products, and extreme market moves not taken into account in past historical data used to calibrate the parameters of the models. In these circumstances, VAR models should not automatically be viewed as unreliable, as a high number of VAR exceptions can hint at either weaknesses in the model or a major regime shift in markets. A more discretionary interpretation similar to the yellow zone could be considered, but risk of a poor interpretation remains. Theoretically, the green zone corresponds to back testing results that suggest there are no issues with the accuracy of the banks model.
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Goldman Sachs and Lehman Brothers fell into the green zone over the observation period, and so appear to have better VAR models. But Lehmans ranking in the green zone raises questions about the Ability of VAR exceptions to indicate banks health.

Although Lehman was facing Funding problems, one may draw the tentative conclusion that the firm massively increased its risk taking without selling risky assets or putting as ide enough capital. From these findings, it is difficult to see the predictive value of VAR exceptions since methodological differences may hide differences in performance and behavior. It may be concluded that VAR exceptions are by no means an early warning indicator because they do not reflect the health of banks in a fair way. VAR exceptions cannot by themselves predict bank failures or distress, as illustrated by Lehman Brothers, which reported few exceptions prior to its collapse. VAR exceptions are just one instrument in a comprehensive toolkit available to regulators to assess potential risk management failures within banks. They should be interpreted taking into account the VAR methodology of each bank and the market context when the VAR exceptions took place. c. What is the Basel requirement for back testing for banks? In 1996, the Basel Committee on Banking Supervision developed a back testing frame-work based on the number of exceptions over 250 daily observations generated by bank VAR models with a 99% confidence level. Depending on the results, the supervisor may impose a penalty corresponding to an increase in market risk capital via the scaling factor. To help supervisors interpret back testing results, the Basel Committee introduced a three-zone framework related to the number of exceptions recorded.

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Green zone: between zero and four exceptions. This is considered an acceptable back testing result. There is no concern over the models of banks and therefore no penalty. Yellow zone: between five and nine exceptions. This raises questions. The supervisor would try to find out what caused the VAR exceptions and decide if the bank should be penalized. The categories are: a) Basic integrity of the model b) Deficient model accuracy c) Intraday trading d)Bad luck Red zone: 10 or more exceptions. This indicates a major modeling problem and generates an automatic penalty, with an increase in the scaling factor of 1. The red zone leads to an automatic presumption of weakness in the model, whereas the supervisor may use its judgment in interpreting the back testing results if they fall within the yellow zone. The penalty applied is based on a table linking the number of exceptions to an increase in the scaling factor (see figure 1) European banks calculate VAR at 99% confidence level 2-3 days of exceptions a year. (250 days trading a year) Most U.S. banks calculate VAR at 95% confidence interval 12-13 days of exceptions a year According to Basel Model, an accurate model should generate more than 10 exceptions, even in period of stress.

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