Copyright © 2001 by Harcourt, Inc. All rights reserved.1 Chapter 16: Financial Risk Management...

Copyright © 2001 by Harcourt, Inc. All rights reserved.

1

Chapter 16: Financial Risk Management

Trying to control financial risk in this environment is like Trying to control financial risk in this environment is like trying to hammer down one corner of a tent in a gale. But trying to hammer down one corner of a tent in a gale. But that’s the nature of the business..that’s the nature of the business..

Stephen HodgeStephen Hodge

RiskRisk, March 1999, March 1999


2

Important Concepts in Chapter 16

The concept and practice of risk managementThe concept and practice of risk management The difference between end users and dealersThe difference between end users and dealers The difference between market and credit riskThe difference between market and credit risk How market risk is managed using delta, gamma, vega and How market risk is managed using delta, gamma, vega and

Value-at-RiskValue-at-Risk How credit risk is managed, including credit derivatives and How credit risk is managed, including credit derivatives and

nettingnetting Risks other than market and credit riskRisks other than market and credit risk Organizational considerations in risk managementOrganizational considerations in risk management Accounting for derivativesAccounting for derivatives


3

See See Figure 16.1, p. 684Figure 16.1, p. 684 for notional principal and for notional principal and Figure Figure 16.2, p. 68516.2, p. 685 for market value of global over-the-counter for market value of global over-the-counter derivatives marketderivatives market

Risk management: the practice of defining the risk level a Risk management: the practice of defining the risk level a firm desires, identifying the risk level a firm currently has, firm desires, identifying the risk level a firm currently has, and using derivatives or other financial instruments to and using derivatives or other financial instruments to adjust the actual level of risk to the desired level of risk.adjust the actual level of risk to the desired level of risk.


4

Why Practice Risk Management?

The Impetus for Risk ManagementThe Impetus for Risk Management Firms practice risk management for several reasonsFirms practice risk management for several reasons

Interest rates, exchange rates and stock prices are Interest rates, exchange rates and stock prices are more volatile today than in the past. more volatile today than in the past.

Significant losses incurred by firms that did not Significant losses incurred by firms that did not practice risk managementpractice risk management

Improvements in information technologyImprovements in information technology Favorable regulatory environmentFavorable regulatory environment


5

Why Practice Risk Management? (continued)

The Benefits of Risk ManagementThe Benefits of Risk Management What are the benefits of risk management, in light of the What are the benefits of risk management, in light of the

Modigliani-Miller principle that corporate financial Modigliani-Miller principle that corporate financial decisions provide no value because shareholders can decisions provide no value because shareholders can execute these transactions themselves?execute these transactions themselves? Firms can practice risk management more effectively.Firms can practice risk management more effectively. There may tax advantages brought on by the There may tax advantages brought on by the

progressive tax system.progressive tax system. Risk management reduces bankruptcy costs. Risk management reduces bankruptcy costs. Managers are trying to reduce their own risk.Managers are trying to reduce their own risk.


6

Why Practice Risk Management? (continued)

The Benefits of Risk Management (continued)The Benefits of Risk Management (continued) By protecting a firm’s cash flow, it increases the By protecting a firm’s cash flow, it increases the

likelihood that the firm will generate enough cash to likelihood that the firm will generate enough cash to allow it to engage in profitable investments.allow it to engage in profitable investments.

Some firms use risk management as an excuse to Some firms use risk management as an excuse to speculate.speculate.

Some firms believe that there are arbitrage Some firms believe that there are arbitrage opportunities in the financial markets.opportunities in the financial markets.

Note: The desire to lower risk is not a sufficient reason Note: The desire to lower risk is not a sufficient reason to practice risk management.to practice risk management.


7

The Structure of the Risk Management Industry

End UsersEnd Users Firms that engage in derivatives transactions to manage Firms that engage in derivatives transactions to manage

their risk.their risk. Mostly non-financial corporations, but also pension Mostly non-financial corporations, but also pension

funds, mutual funds, U.S. state and local governments, funds, mutual funds, U.S. state and local governments, foreign governments, endowments and other private foreign governments, endowments and other private organizations.organizations.

In corporations the treasury department is usually In corporations the treasury department is usually responsible for derivatives transactions.responsible for derivatives transactions.


8

The Structure of the Risk Management Industry (continued)

DealersDealers Financial institutions that make a market in derivatives.Financial institutions that make a market in derivatives. They typically hedge their risk and earn a profit off of They typically hedge their risk and earn a profit off of

the difference between their buying and selling prices.the difference between their buying and selling prices.


9

The Structure of the Risk Management Industry (continued)

Other Participants in the Risk Management IndustryOther Participants in the Risk Management Industry consultants, including accounting, management consultants, including accounting, management

consulting and personnel searchconsulting and personnel search software firmssoftware firms law firmslaw firms


10

Managing Market Risk Managing Market RiskManaging Market Risk

Market risk: the uncertainty associated with interest rates, Market risk: the uncertainty associated with interest rates, foreign exchange rates, stock prices or commodity prices.foreign exchange rates, stock prices or commodity prices.

Example: A dealer with the following positions:Example: A dealer with the following positions: A4-year interest rate swap with $10 million notional A4-year interest rate swap with $10 million notional

principal in which it pays fixed and receives a floating principal in which it pays fixed and receives a floating rate. rate.

A 3-year interest rate call with $8 million notional A 3-year interest rate call with $8 million notional principal. The dealer is short and the exercise rate is principal. The dealer is short and the exercise rate is 12%.12%.

See See Table 16.1, p. 691Table 16.1, p. 691 for current term structure. for current term structure.


11

Managing Market Risk (continued)

Managing Market Risk (continued)Managing Market Risk (continued) Swap rate is 11.85 percent based onSwap rate is 11.85 percent based on

.1185(1.10).1185(1.10)-1-1 + .1185(1.11) + .1185(1.11)-2-2 + .1185(1.116) + .1185(1.116)-3-3 + + 1.1185(1.12)1.1185(1.12)-4-4 = 1.00 = 1.00

Option data are F = .1321, r = ln(1.116) = .1098, Option data are F = .1321, r = ln(1.116) = .1098, = .08, T = .3. Plugging in Black model, the option is worth .009215, i.e., 92.15 basis points. Then $8,000,000(.009215) = $73,722.


12


Delta HedgingDelta Hedging We shall estimate the delta by repricing the swap and We shall estimate the delta by repricing the swap and

option with a one basis point move in all spot rates and option with a one basis point move in all spot rates and average the price change.average the price change. See See Table 16.2, p. 693Table 16.2, p. 693 for estimated swap and option for estimated swap and option

deltasdeltas• We are long the swap so we have a delta of We are long the swap so we have a delta of

$2,130.5.$2,130.5.• We are short the option so we have a delta of -We are short the option so we have a delta of -

$384.5.$384.5.• Our overall delta is $1,746.Our overall delta is $1,746.


13


Delta Hedging (continued)Delta Hedging (continued) We need a Eurodollar futures position that gains $1,746 We need a Eurodollar futures position that gains $1,746

if rates move down and loses that amount if rates move if rates move down and loses that amount if rates move up. Thus, we require a long position of $1,746/$25 = up. Thus, we require a long position of $1,746/$25 = 69.84 contracts. Round up to 70. Overall delta:69.84 contracts. Round up to 70. Overall delta: $2,130.5 (from swap)$2,130.5 (from swap) -$384.5 (from option)-$384.5 (from option) 70($25) (from futures)70($25) (from futures) = -$4 (overall)= -$4 (overall)


14


Gamma Hedging Gamma Hedging Here we deal with the risk of large price moves, which Here we deal with the risk of large price moves, which

are not fully captured by the delta.are not fully captured by the delta. See See Table 16.3, p. 695Table 16.3, p. 695 for the estimation of swap and for the estimation of swap and

option gammas.option gammas. The Eurodollar futures have zero gamma so we must The Eurodollar futures have zero gamma so we must

add another option position. We assume the add another option position. We assume the availability of a 4-year call with delta of $58 and availability of a 4-year call with delta of $58 and gamma of $10,500.gamma of $10,500.


15


Gamma Hedging (continued)Gamma Hedging (continued) We use xWe use x11 Eurodollar futures and x Eurodollar futures and x22 of the 4-year calls. of the 4-year calls.

The swap and option have a delta of $1,746 and gamma The swap and option have a delta of $1,746 and gamma of -$22,500. We solve the following equations:of -$22,500. We solve the following equations: $1,746 + x$1,746 + x11(-$25) + x(-$25) + x22($58) = $0 (zero delta)($58) = $0 (zero delta)

-$22,500 + x-$22,500 + x11($0) + x($0) + x22($10,500) = $0 (zero gamma)($10,500) = $0 (zero gamma)

Solving these gives xSolving these gives x11 = 74.8 (go long 74.8 = 74.8 (go long 74.8

Eurodollar futures) and xEurodollar futures) and x22 = 2.14 (go long 2.14 times = 2.14 (go long 2.14 times

$1,000,000 notional principal of 4-year option)$1,000,000 notional principal of 4-year option)


16


Vega HedgingVega Hedging Swaps and FRAs do not have vegas. Swaps and FRAs do not have vegas. We estimate the vegas of the optionsWe estimate the vegas of the options

On our 3-year option, if volatility increases On our 3-year option, if volatility increases (decreases) by .01, option will increase (decrease) (decreases) by .01, option will increase (decrease) by $35 (-$34). Average is $34.50. We are short this by $35 (-$34). Average is $34.50. We are short this option, so vega = -$34.50.option, so vega = -$34.50.

4-year option has estimated vega of $6.93. 4-year option has estimated vega of $6.93. Overall portfolio has vega of ($6.93)(2.14 million) Overall portfolio has vega of ($6.93)(2.14 million)

- $34.50 = -$19.67. - $34.50 = -$19.67.


17

Managing Market Risk (continued) Vega Hedging (continued)Vega Hedging (continued)

We add a Eurodollar futures option, which has delta of -We add a Eurodollar futures option, which has delta of -$12.75, gamma of -$500 and vega of $2.50 per $1MM.$12.75, gamma of -$500 and vega of $2.50 per $1MM.

Solve the following equationsSolve the following equations $1,746 + x$1,746 + x11(-$25) + x(-$25) + x22($58) + x($58) + x33(-$12.75) = 0 (delta)(-$12.75) = 0 (delta)

-$22,500 + x-$22,500 + x11($0) + x($0) + x22($10,500) + x($10,500) + x33(-$500) = 0 (gamma)(-$500) = 0 (gamma)

-$34.50 + x-$34.50 + x11($0) + x($0) + x22($6.93) + x($6.93) + x33($2.50) = 0 (vega)($2.50) = 0 (vega)

The coefficients are the multiples of $1,000,000 notional The coefficients are the multiples of $1,000,000 notional principal we need.principal we need.

Solutions are xSolutions are x11 = 72.02, x = 72.02, x22 = 2.47, x = 2.47, x33 = 6.95. = 6.95.


18


Vega Hedging (continued)Vega Hedging (continued) Any type of hedge (delta, delta-gamma, or delta-Any type of hedge (delta, delta-gamma, or delta-

gamma-vega) must be periodically adjusted.gamma-vega) must be periodically adjusted. Virtually impossible to have a perfect hedge.Virtually impossible to have a perfect hedge.


19


Value-at-Risk (VAR)Value-at-Risk (VAR) A dollar measure of the minimum loss that would be expected A dollar measure of the minimum loss that would be expected

over a given time with a given probability. Example:over a given time with a given probability. Example: VAR of $1 million for one day at .05 means that the firm VAR of $1 million for one day at .05 means that the firm

could expect to lose at least $1 million over a one day could expect to lose at least $1 million over a one day period 5% of the time.period 5% of the time.

Widely used by dealers and increasingly by end users.Widely used by dealers and increasingly by end users. See See Table 16.4, p. 700Table 16.4, p. 700 for example of discrete probability for example of discrete probability

distribution of change in value. VAR at 5 % is $3 million loss.distribution of change in value. VAR at 5 % is $3 million loss. See See Figure 16.3, p. 701Figure 16.3, p. 701 for continuous distribution. for continuous distribution.


20


Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued) VAR calculations require use of formulas for expected return and VAR calculations require use of formulas for expected return and

standard deviation of a portfolio:standard deviation of a portfolio:

where where E(RE(R11), E(R), E(R22) = expected returns of assets 1 and 2) = expected returns of assets 1 and 2

11, , 22 = standard deviations of assets 1 and 2 = standard deviations of assets 1 and 2 = correlation between assets 1 and 2= correlation between assets 1 and 2 ww11, w, w22 = % of one’s wealth invested in asset 1 or 2 = % of one’s wealth invested in asset 1 or 2

ρσσw2wσwσwσ

)E(Rw)E(Rw)E(R

112122

22

21

21p

2211p


21


Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued) Three methods of estimating VARThree methods of estimating VAR

Analytical method: Uses knowledge of the parameters Analytical method: Uses knowledge of the parameters (expected return and standard deviation) of the probability (expected return and standard deviation) of the probability distribution and assumes a normal distribution.distribution and assumes a normal distribution.

• Example: $20 million of S&P 500 with expected Example: $20 million of S&P 500 with expected return of .12 and volatility of .15 and $12 million of return of .12 and volatility of .15 and $12 million of Nikkei 300 with expected return of .105 and volatility Nikkei 300 with expected return of .105 and volatility of .18. Correlation is .55. Using the above formulas, of .18. Correlation is .55. Using the above formulas, the overall portfolio expected return is .1144 and the overall portfolio expected return is .1144 and volatility is .1425. volatility is .1425.


22


Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued)

• For a weekly VAR, convert these to weekly For a weekly VAR, convert these to weekly figures. figures.

– Expected return = .1144/52 = .0022Expected return = .1144/52 = .0022

– Volatility = .1425/Volatility = .1425/52 = .0198. .0198.

• With a normal distribution, we haveWith a normal distribution, we have

– VAR = .0022 - 1.65(.0198) = -.0305VAR = .0022 - 1.65(.0198) = -.0305

• So the VAR is $32,000,000(.0305) = $976,.000. So the VAR is $32,000,000(.0305) = $976,.000.


23


Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued)

• Example using options: 200 short 12-month calls on S&P Example using options: 200 short 12-month calls on S&P 500, which has volatility of .15 and price of $14.21. Total 500, which has volatility of .15 and price of $14.21. Total value of $1,421,000. value of $1,421,000.

– Based on monthly data, expected return is .0095 and Based on monthly data, expected return is .0095 and volatility is .0412. volatility is .0412.

– Upside 5 % is .0095 + 1.65(.0412) = .0775, which is Upside 5 % is .0095 + 1.65(.0412) = .0775, which is 720(1.0775) = 775.80. 720(1.0775) = 775.80.

– Option would be worth 775.80 - 720 = 55.80 so loss is Option would be worth 775.80 - 720 = 55.80 so loss is 55.80 - 14.21= 41.59 per option.55.80 - 14.21= 41.59 per option.

– Total loss = 200(500)(41.59) = $4.159 million. This is Total loss = 200(500)(41.59) = $4.159 million. This is the VAR.the VAR.


24


Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued)• One assumption often made is that the expected One assumption often made is that the expected

return is zero. This is not likely to be true.return is zero. This is not likely to be true.• Sometimes rather than use the precise option price Sometimes rather than use the precise option price

from a model, a delta is used to estimate the price. from a model, a delta is used to estimate the price. This makes the analytical method be sometimes This makes the analytical method be sometimes called the delta-normal method.called the delta-normal method.

• Volatility and correlation information is Volatility and correlation information is necessary. See the web site necessary. See the web site www.riskmetrics.com, where data of this sort is www.riskmetrics.com, where data of this sort is provided free.provided free.


25


Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued) Historical method: Uses historical information on the Historical method: Uses historical information on the

user’s portfolio to obtain the distribution.user’s portfolio to obtain the distribution.

• Example: See Example: See Figure 16.4, p. 704Figure 16.4, p. 704. For portfolio of . For portfolio of $15 million, VAR at 5% is approximately a loss of $15 million, VAR at 5% is approximately a loss of 10% or $15,000,000(.10) = -$1,500,000.10% or $15,000,000(.10) = -$1,500,000.

• Historical method is subject to limitation that the past Historical method is subject to limitation that the past holdings of the portfolio may not have the same holdings of the portfolio may not have the same distributional properties as the future holdings. It also distributional properties as the future holdings. It also is limited by the results of the chosen time period, is limited by the results of the chosen time period, which might not be representative of the future.which might not be representative of the future.


26


Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued) Monte Carlo Simulation method: Uses Monte Carlo Monte Carlo Simulation method: Uses Monte Carlo

method, as described in Chapter 15, to generate method, as described in Chapter 15, to generate random outcomes on the portfolio’s components.random outcomes on the portfolio’s components.


27


Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued) A Comprehensive Calculation of VARA Comprehensive Calculation of VAR

We do an example of a portfolio of $25 million in We do an example of a portfolio of $25 million in the S&P 500. We want a 5% 1-day VAR using each the S&P 500. We want a 5% 1-day VAR using each method. We collect a sample of daily returns on method. We collect a sample of daily returns on the S&P 500 for the past year and obtain the the S&P 500 for the past year and obtain the following parameter estimates: Average daily following parameter estimates: Average daily return = .0457% and daily standard deviation = return = .0457% and daily standard deviation = 1.3327%. These result in annual figures of1.3327%. These result in annual figures of

2120.2533327.1

1156.)253(0457.0


28

Managing Market Risk (continued) Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued)

A Comprehensive Calculation of VAR (continued)A Comprehensive Calculation of VAR (continued) Analytical method: We have 0.0457% - (1.65)1.3327% = -Analytical method: We have 0.0457% - (1.65)1.3327% = -

2.1533%. So the VAR is2.1533%. So the VAR is• .021533($25,000,000) = $538,325.021533($25,000,000) = $538,325• The .21 standard deviation is historically a bit high. Re-The .21 standard deviation is historically a bit high. Re-

estimating with a standard deviation of .15 gives us a daily estimating with a standard deviation of .15 gives us a daily standard deviation of 0.9430. Then we obtain 0.0474% - standard deviation of 0.9430. Then we obtain 0.0474% - (1.65(0.9430) = -1.5086% and a VAR of(1.65(0.9430) = -1.5086% and a VAR of

• .015086($25,000,000) = $377,150.015086($25,000,000) = $377,150• Are our data normally distributed? Observe Are our data normally distributed? Observe Figure 16.5, Figure 16.5,

p. 707p. 707..


29


Value-at-Risk (VAR) (continued)Value-at-Risk (VAR) (continued) A Comprehensive Calculation of VAR (continued)A Comprehensive Calculation of VAR (continued)

Historical method: Here we rank the returns from Historical method: Here we rank the returns from worst to best. For 253 returns we obtain the 5% worst to best. For 253 returns we obtain the 5% worst by observing the .05(253) = 12.65 worst worst by observing the .05(253) = 12.65 worst return. We shall make it the 13return. We shall make it the 13thth worst. This would worst. This would be -2.0969%. Thus, the VAR isbe -2.0969%. Thus, the VAR is

• .020969($25,000,000) = $524,225.020969($25,000,000) = $524,225


30



Monte Carlo simulation method: We shall use an Monte Carlo simulation method: We shall use an expected return of 12% and standard deviation of 15% expected return of 12% and standard deviation of 15% and a normal distribution.and a normal distribution.

• We generate 253 random returns (this number is We generate 253 random returns (this number is arbitrary and should actually be much larger) by the arbitrary and should actually be much larger) by the following method:following method:

• where where is a standard normal random number. is a standard normal random number.1/253*deviation) (Standard

53)Return(1/2 (Expected Return


31



Monte Carlo simulation method (continued): We do Monte Carlo simulation method (continued): We do this 253 times, rank the returns from worst to best this 253 times, rank the returns from worst to best and obtain the 13th worst return, which is -1.3942%. and obtain the 13th worst return, which is -1.3942%. Then the VAR is Then the VAR is

• .013942($25,000,000) = $348,550.013942($25,000,000) = $348,550


32



So VAR is estimated at eitherSo VAR is estimated at either• $538,325$538,325• $377,150$377,150• $524,225$524,225• $348,550$348,550

Key considerations: wide ranges such as this are Key considerations: wide ranges such as this are common, real-world portfolios are more complicated common, real-world portfolios are more complicated than this, ex post evaluation should be donethan this, ex post evaluation should be done


33



Features of VARFeatures of VAR

• Widely usedWidely used

• Facilitates communication with senior Facilitates communication with senior managementmanagement

• Widely used in banking regulationWidely used in banking regulation

• Used to allocate capital within firmsUsed to allocate capital within firms

• Used in performance evaluationUsed in performance evaluation

• Should be supplemented with stress testsShould be supplemented with stress tests


34

Managing Credit Risk Credit risk or default riskCredit risk or default risk is the risk that the counterparty is the risk that the counterparty

will not pay off losses incurred on a financial transaction.will not pay off losses incurred on a financial transaction. Credit ratings are widely used to assess credit risk.Credit ratings are widely used to assess credit risk. Current credit risk is the risk to one party that the other will Current credit risk is the risk to one party that the other will

be unable to make payments that are currently due.be unable to make payments that are currently due. Potential credit risk is the risk to one party that the Potential credit risk is the risk to one party that the

counterparty will default in the future.counterparty will default in the future. In options, only the buyer faces credit risk.In options, only the buyer faces credit risk. FRAs and swaps have two-way credit risk but at a given FRAs and swaps have two-way credit risk but at a given

point in time, the risk is faced by only one of the two parties.point in time, the risk is faced by only one of the two parties.


35

Managing Credit Risk (continued) Potential credit risk is largest during the middle of an interest Potential credit risk is largest during the middle of an interest

rate swap’s life but due to principal repayment, potential credit rate swap’s life but due to principal repayment, potential credit risk is larger during the latter part of a currency swap’s life.risk is larger during the latter part of a currency swap’s life.

Typically all parties pay the same price on a derivative, Typically all parties pay the same price on a derivative, regardless of their credit standing. Credit risk is managed regardless of their credit standing. Credit risk is managed throughthrough limiting exposure to any one partylimiting exposure to any one party collateralcollateral periodic marking-to-marketperiodic marking-to-market (by dealers) captive derivatives subsidiaries(by dealers) captive derivatives subsidiaries netting (see next) netting (see next)


36

Managing Credit Risk (continued) NettingNetting

Netting: several similar processes in which the amount of cash Netting: several similar processes in which the amount of cash owed by one party to the other is reduced by the amount owed by owed by one party to the other is reduced by the amount owed by the latter to the former.the latter to the former. Bilateral netting: netting between two parties. Bilateral netting: netting between two parties. Multilateral netting: netting between more than two parties; Multilateral netting: netting between more than two parties;

essentially the same as a clearinghouse.essentially the same as a clearinghouse. Payment netting: Only the net amount of a payment owed Payment netting: Only the net amount of a payment owed

from one party to the other is paid.from one party to the other is paid. Cross-product netting: payments from one type of transaction Cross-product netting: payments from one type of transaction

are netted against payments for another type of transaction.are netted against payments for another type of transaction.


37

Managing Credit Risk (continued) Netting (continued)Netting (continued)

Netting by novation: net value of two parties’ mutual Netting by novation: net value of two parties’ mutual obligations is replaced by a single transaction; often used obligations is replaced by a single transaction; often used in FX markets.in FX markets.

Closeout netting: netting in the event of default, where all Closeout netting: netting in the event of default, where all transactions between two parties are netted against each transactions between two parties are netted against each other; see example in text.other; see example in text.

The OTC derivatives market has an excellent record of The OTC derivatives market has an excellent record of default. Note the Hammersmith and Fulham default where default. Note the Hammersmith and Fulham default where it was found that a town had no legal authority to engage in it was found that a town had no legal authority to engage in swaps. The town was able to get out of paying up on swaps. The town was able to get out of paying up on losses.losses.


38

Managing Credit Risk (continued)

Credit Derivatives: These are a family of derivative Credit Derivatives: These are a family of derivative instruments that have payoffs contingent on the credit instruments that have payoffs contingent on the credit quality of a particular party. Types includequality of a particular party. Types include Total return swaps: See Total return swaps: See Figure 16.6, p. 715Figure 16.6, p. 715. Credit . Credit

derivative buyer purchases swap from credit derivative derivative buyer purchases swap from credit derivative seller in which it pays the total return on a specific seller in which it pays the total return on a specific bond. If that return is reduced by some credit event, bond. If that return is reduced by some credit event, this loss is passed through automatically in the swap.this loss is passed through automatically in the swap.


39


Credit Derivatives (continued)Credit Derivatives (continued) Credit swap: A swap in which the credit derivatives Credit swap: A swap in which the credit derivatives

buyer pays a periodic fee to a credit derivatives seller. buyer pays a periodic fee to a credit derivatives seller. If the buyer sustains a credit loss from a third party, it If the buyer sustains a credit loss from a third party, it then receives payments from the credit derivatives then receives payments from the credit derivatives seller to compensate. See seller to compensate. See Figure 16.7, p. 716Figure 16.7, p. 716. This is . This is really more like an option.really more like an option.


40


Credit Derivatives (continued)Credit Derivatives (continued) Credit linked security: This is a bond or note that pays Credit linked security: This is a bond or note that pays

off less than its face value if a credit event occurs on a off less than its face value if a credit event occurs on a third party.third party.

The credit derivatives market is small but growing The credit derivatives market is small but growing rapidly. The notional principal of credit derivatives at rapidly. The notional principal of credit derivatives at U. S. banks grew from $55 billion in 1997 to $287 U. S. banks grew from $55 billion in 1997 to $287 billion in 1999 but the global market is much larger billion in 1999 but the global market is much larger than this.than this.


41

Other Types of Risks

operational risk (including inadequate controls)operational risk (including inadequate controls) model riskmodel risk liquidity riskliquidity risk accounting riskaccounting risk legal risklegal risk tax risktax risk regulatory riskregulatory risk settlement risksettlement risk systemic risksystemic risk


42

Organizational and Accounting Issues in Risk Management

Derivatives in the OrganizationDerivatives in the Organization Good risk management requires a sound organization Good risk management requires a sound organization

structure that begins with responsibility at the top.structure that begins with responsibility at the top. Dealers usually have an independent risk manager who Dealers usually have an independent risk manager who

reports to the CEO, has access to relevant information reports to the CEO, has access to relevant information and authority to block or initiate certain transactions.and authority to block or initiate certain transactions.

Corporate risk management should also be centralized Corporate risk management should also be centralized but is often decentralized.but is often decentralized.

Many corporations run the treasury as a profit center, Many corporations run the treasury as a profit center, which is not conducive to sound risk management.which is not conducive to sound risk management.


43

Organizational and Accounting Issues in Risk Management (continued)

Derivatives in the Organization (continued)Derivatives in the Organization (continued) Should be separation of front office from back office.Should be separation of front office from back office. Legal counsel, accounting and auditing are critical but Legal counsel, accounting and auditing are critical but

accounting and auditing do not substitute for risk accounting and auditing do not substitute for risk management.management.

Risk management is a continuous process requiring Risk management is a continuous process requiring regular evaluation and comparison to objectives.regular evaluation and comparison to objectives.

See See Figures 16.8, p. 724Figures 16.8, p. 724 and and 16.9, p. 72516.9, p. 725 for examples for examples of dealer and corporate risk management organization of dealer and corporate risk management organization charts.charts.


44


Accounting for DerivativesAccounting for Derivatives The concept of hedge accounting: accounting in which The concept of hedge accounting: accounting in which

gains and losses on derivatives are tied to gains and gains and losses on derivatives are tied to gains and losses on hedged instruments.losses on hedged instruments.

In the U. S. the Financial Accounting Standards Board In the U. S. the Financial Accounting Standards Board (FASB) has prescribed the appropriate methods of (FASB) has prescribed the appropriate methods of accounting for derivatives with FAS 133, accounting for derivatives with FAS 133, Accounting Accounting for Derivative Instruments and Hedging Activitiesfor Derivative Instruments and Hedging Activities. In . In general, derivatives are marked to market and must general, derivatives are marked to market and must appear on the financial statementsappear on the financial statements


45


Accounting for Derivatives (continued)Accounting for Derivatives (continued) Fair Value Hedge: The firm is hedging the market Fair Value Hedge: The firm is hedging the market

value of an asset or liability. The gain/loss on the value of an asset or liability. The gain/loss on the derivative as well as the instrument being hedged is derivative as well as the instrument being hedged is recorded and reflected in current earnings.recorded and reflected in current earnings.

Example: Firm holds security and hedges with a Example: Firm holds security and hedges with a derivative. Before the end of the hedge, the security derivative. Before the end of the hedge, the security loses $100,000 in value and the derivative gains loses $100,000 in value and the derivative gains $96,000. It does the following entries:$96,000. It does the following entries:


46


Accounting for Derivatives (continued)Accounting for Derivatives (continued) Debit DerivativeDebit Derivative 96,000 96,000 Credit Unrealized Gain on DerivativeCredit Unrealized Gain on Derivative 96,000 96,000

Debit Unrealized Loss on SecurityDebit Unrealized Loss on Security 100,000100,000 Credit SecurityCredit Security 100,000100,000

This affects net income as well as the balance sheet. This affects net income as well as the balance sheet. These hedges must be properly justified, and carefully These hedges must be properly justified, and carefully documented to be eligible for accounting this way.documented to be eligible for accounting this way.


47


Accounting for Derivatives (continued)Accounting for Derivatives (continued) Cash Flow Hedge: The firm is hedging the risk of a Cash Flow Hedge: The firm is hedging the risk of a

future cash flow. The derivative is marked to market future cash flow. The derivative is marked to market and shows on the balance sheet but the gain/loss shows and shows on the balance sheet but the gain/loss shows up in a temporary account, Other Comprehensive up in a temporary account, Other Comprehensive Income (OCI), which is an equity account. At the end Income (OCI), which is an equity account. At the end of the hedge, OCI is closed out and any balance adjusts of the hedge, OCI is closed out and any balance adjusts the amount recorded to the cash flow being hedged. the amount recorded to the cash flow being hedged. Also gains/losses must be separated into “effective” Also gains/losses must be separated into “effective” and “ineffective” components.and “ineffective” components.


48

Organizational and Accounting Issues in Risk Management (continued) Accounting for Derivatives (continued)Accounting for Derivatives (continued)

Cash Flow Hedge (continued) Cash Flow Hedge (continued) A firm plans to borrow $1 million in six months by A firm plans to borrow $1 million in six months by

issuing a discount note. It buys an FRA to hedge. issuing a discount note. It buys an FRA to hedge. Rates go down and it incurs a loss on the FRA of Rates go down and it incurs a loss on the FRA of $10,000. Eventually the FRA expires with a loss of $10,000. Eventually the FRA expires with a loss of $12,000 and the note is issued at 7%, generating a $12,000 and the note is issued at 7%, generating a cash inflow of (1 - .07)$1,000,000 = $930,000. cash inflow of (1 - .07)$1,000,000 = $930,000. During the interim, you would enterDuring the interim, you would enter

• Debit OCIDebit OCI 10,00010,000• Credit FRACredit FRA 10,00010,000


49


Cash Flow Hedge (continued) Cash Flow Hedge (continued) When it takes out the loan, it enters the following:When it takes out the loan, it enters the following:

• Debit CashDebit Cash 930,000930,000

• Credit Notes PayableCredit Notes Payable 930,000930,000

• Debit FRADebit FRA 10,000 10,000

• Debit OCIDebit OCI 2,000 2,000

• Credit CashCredit Cash 12,000 12,000


50


Cash Flow Hedge (continued) Cash Flow Hedge (continued) • Debit Notes PayableDebit Notes Payable 12,00012,000• Credit OCICredit OCI 12,00012,000

What has happened is that it received $930,000 in What has happened is that it received $930,000 in cash and set up a liability of $930,000. It removed the cash and set up a liability of $930,000. It removed the FRA from the books and recorded a $2,000 further FRA from the books and recorded a $2,000 further loss in OCI. It paid out $12,000 to cover the FRA loss loss in OCI. It paid out $12,000 to cover the FRA loss and zeroed out OCI. It reduced the note balance to and zeroed out OCI. It reduced the note balance to $918,000, reflecting the net amount of cash it $918,000, reflecting the net amount of cash it received.received.


51


Cash Flow Hedge (continued) Cash Flow Hedge (continued) This was a perfect hedge. Suppose in the interim This was a perfect hedge. Suppose in the interim

period the loss was $11,000 but the effective part period the loss was $11,000 but the effective part was $10,000. Thus, the gain/loss on the derivative was $10,000. Thus, the gain/loss on the derivative does not perfectly match the gain/loss on the hedged does not perfectly match the gain/loss on the hedged instrument. It would do the followinginstrument. It would do the following

• Debit Current IncomeDebit Current Income 1,000 1,000

• Debit OCIDebit OCI 10,00010,000

• Credit FRACredit FRA 11,00011,000


52


Cash Flow Hedge (continued) Cash Flow Hedge (continued) At expiration let the loss on the FRA be $15,000, of which At expiration let the loss on the FRA be $15,000, of which

only $12,000 is effective. Then we only $12,000 is effective. Then we

• Debit FRADebit FRA 11,00011,000

• Credit OCICredit OCI 11,00011,000

• Debit Current IncomeDebit Current Income 2,000 2,000

• Debit OCIDebit OCI 1,000 1,000

• Debit Notes PayableDebit Notes Payable 12,00012,000

• Credit CashCredit Cash 15,00015,000


53


Cash Flow Hedge (continued) Cash Flow Hedge (continued) We remove the FRA from liabilities and all but $1,000 We remove the FRA from liabilities and all but $1,000

from OCI. We zero out OCI and reduce Current Income from OCI. We zero out OCI and reduce Current Income by $2,000. Notes payable goes from $930,000 to $918,000 by $2,000. Notes payable goes from $930,000 to $918,000 (the Notes Payable entry above is the same), reflecting a (the Notes Payable entry above is the same), reflecting a loss of $12,000. Of the $12,000 loss, the ineffective part is loss of $12,000. Of the $12,000 loss, the ineffective part is $2,000, which goes into Current Income and combines $2,000, which goes into Current Income and combines with the $1,000 loss already in Current Income.with the $1,000 loss already in Current Income.

There is still some uncertainty about how firms are to There is still some uncertainty about how firms are to identify effective and ineffective parts of hedges.identify effective and ineffective parts of hedges.


54


Foreign Investment Hedges: Procedures for these had Foreign Investment Hedges: Procedures for these had been established a few years ago. Certain transactions been established a few years ago. Certain transactions qualify for Fair Value and Cash Flow hedge qualify for Fair Value and Cash Flow hedge accounting.accounting.

Speculation: Gains/losses are marked to market and Speculation: Gains/losses are marked to market and recorded in current income.recorded in current income.


55


Problems in the Application of FAS 133Problems in the Application of FAS 133 Only the intrinsic value of purchased options qualifies for Only the intrinsic value of purchased options qualifies for

hedge accountinghedge accounting No clear prescription for what constitutes No clear prescription for what constitutes

effective/ineffective hedgingeffective/ineffective hedging Embedded derivatives must be separatedEmbedded derivatives must be separated No hedge accounting for bonds held to maturityNo hedge accounting for bonds held to maturity Difficulty of arriving at derivatives valuesDifficulty of arriving at derivatives values Does not permit macro (firm-wide) hedgesDoes not permit macro (firm-wide) hedges Covered calls do not qualify for hedge accountingCovered calls do not qualify for hedge accounting


56


Disclosure: The U. S. SEC requires that firms using Disclosure: The U. S. SEC requires that firms using derivatives present eitherderivatives present either Tabular information on market values and contract Tabular information on market values and contract

terms, orterms, or Sensitivity analysis of potential losses, orSensitivity analysis of potential losses, or Value-at-RiskValue-at-Risk


57

Avoiding Derivatives Losses

See See Table 16.5, p. 735Table 16.5, p. 735 for a partial list of organizations for a partial list of organizations reporting derivatives losses.reporting derivatives losses.

See See Table 16.6, p. 737Table 16.6, p. 737 for the G-30 recommendations for for the G-30 recommendations for best practices for end users and dealers.best practices for end users and dealers.

See See Table 16.7, p. 741Table 16.7, p. 741 for Risk Standards Working Group for Risk Standards Working Group recommendations for best practices for institutional recommendations for best practices for institutional investors.investors.


58

Summary


59

Appendix 16: Some Lessons in Risk Management

Metallgesellschaft: to Hedge or Not to Hedge?Metallgesellschaft: to Hedge or Not to Hedge? Orange County, California: Playing the OddsOrange County, California: Playing the Odds Barings PLC: How One Man Blew up a BankBarings PLC: How One Man Blew up a Bank Procter & Gamble: Going up in SudsProcter & Gamble: Going up in Suds


60

People are not apologizing anymore for using derivatives. They’ve realized that they are not the evil instruments they have been made out to be.

Sarah Orsay

Derivatives Strategy, April 1997

Copyright © 2001 by Harcourt, Inc. All rights reserved.1 Chapter 16: Financial Risk Management...

Documents

Transcript of Copyright © 2001 by Harcourt, Inc. All rights reserved.1 Chapter 16: Financial Risk Management...