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1.1
550.446
Financial Risk
Measurement/Management
Introduction
Banks, Insurance Companies
and Asset Managers
Weeks of September 4 and
September 9, 2013
1.2
Principals
David R Audley, Ph.D.; Sr. Lecturer in AMS
david.audley@jhu.edu
Office: WH 212A; 410-516-7136
Office Hours: 4:30 5:30 Monday
Teaching Assistant(s)
Cheng, Wan-Schwin (Allen)
wcheng14@jhu.edu
Office Hours: Wednesday, 10am - Noon
1.3
Schedule
Lecture Encounters
Monday & Wednesday, Noon -1:15pm,
Shaffer 202
Section
Section: Friday 12:00 - 12:50pm, Shaffer 202
1.4
Protocol
Attendance
Lecture Mandatory (default) for MSE Fin
Math majors
Quizzes
Section Strongly Advised/Recommended
Assignments
Due as Scheduled (for full credit)
Must be handed in to avoid incomplete
Exceptions need prior approval
2
1.5
Resources
Textbooks
John C Hull: Risk Management and Financial
Institutions; Prentice-Hall, 3e 2012
Recommended (On Reserve in Library):
Philippe Jorion: Financial Risk Manager Handbook; Wiley, 6e 2011
Alexander McNeil, Frey & Embrechts: Quantitative Risk
Management; Princeton, 2005
Anthony Saunders & Cornett: Financial Institutions Management
A Risk Management Approach; McGraw-Hill, 7e 2011
1.6
Resources
Textbooks
Saunders: Chapters 1 7 : On Library Electronic
Reserve
Registered Students may access their readings at the
Universitys Portal at http://my.jhu.edu
Text Resources
http://www-2.rotman.utoronto.ca/~hull/riskman/rmlist.htm
1.7
Resources
Supplemental Material
As directed
AMS Website
http://jesse.ams.jhu.edu/~daudley/446
Additional Subject Material
Class Resources & Lecture Slides
Industry & Street Research (Optional)
Consult at your leisure/risk
Interest can generate Special Topics sessions
Blackboard
1.8
Measures of Performance
Mid Term Exam (~1/3 of grade)
Final Exam (~1/3 of grade)
Home work as assigned and designated
and Quizzes (~1/3 of grade)
3
1.9
Assignment
For September 4
th
thru September 11
th
Read: Hull Chapters 1-4 (Introduction)
Read: Saunders, Chapter 1; Why are Financial
Institutions Special
Read: Saunders, Appendix 1A; The Financial Crisis:
The Failure of Financial Institutions Specialness
Problems (Due September 16
th
)
Chapter 1: 1, 2, 11, 12; 18
Chapter 2: 3, 8; 16, 18
Chapter 3: 5, 9, 15
Chapter 4: 7, 14, 16
1.10
Assignment
For September 16
th
(Next)
Read: Hull Chapters 5 & 7 (Trading, the
Markets & Managing Trading Risk)
Problems (Due September 23
rd
)
Chapter 5: 3, 8, 10, 13, 21
Chapter 7: 1, 3, 6, 14; 16
1.11
Assets and Cash
Stock, Bond, Commodity, (Assets)
Risk vs. Return
Cash (or Currency)
Held, on Deposit or Borrowed
Terminology
Assets things we own (long)
Liabilities what we owe (short)
1.12
Risk vs. Return
There is a trade off between risk and
expected return
The higher the risk, the higher the
expected return
Attempts to understand the tradeoffs
(required) between risk & expected return
were pioneered by
Markowitz & Sharpe (MPT CAPM)
Ross (APT)
4
1.13
Example
Suppose Treasuries yield 5% and the returns
for an equity investment are expected to be:
Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 10%
0.05 30%
1.14
Example continued
We can characterize investments by their
expected return and standard deviation of
return (total risk)
For the equity investment:
Expected return =10%
Standard deviation of return =18.97%
( ) ( ) ( )
( )
2
2
5
2 2
1
and 0.10
0.046
18.97%
i i
i
E R E R E R
E R PR R
o
o
=
= =
= =
=

1.15
Risky Investments
Characterized by Risk & Expected Return
1.16
Combining Risky Investments
Lets combine 2 risky investments
2 1 2 1
2
2
2
2
2
1
2
1 2 2 1 1
2 o o + o + o = o + = w w w w w w
P P
2 . 0
% 24
% 16
% 15
% 10
2
1
2
1
=
= o
= o
=
=
5
1.17
Combining Risky Investments
0
2
4
6
8
10
12
14
16
0 5 10 15 20 25 30
Standard Deviation
of Return (%)
Expected
Return (%)
1.18
Efficient Frontier of All Risky
Investments
Efficient
Frontier
Expected
Return
S.D. of
Return
Investments
1.19
Efficient Frontier of All
Investments
Expected
Return
S.D. of Return
R
F
E(R
M
)
o
M
Previous Efficient
Frontier (Risky only)
F
M
I
J
New Efficient
Frontier (w/RF)
( ) ( ) 1 & 0 1
I I F I M I
E R R R | | | = + s s
( ) ( ) 1 & 1
J J M J F J
E R R R | | | = s
I M
| o
J M
| o
1.20
Systematic vs. Non-Systematic
Risk (total risk vs. systematic risk)
We can calculate the best fit linear
relationship between return from
investment and return from market
Systematic Risk
(non-diversifiable)
Non-systematic risk
(diversifiable)
c | o + + =
M
R R
6
1.21
The Capital Asset Pricing Model
Expected
Return E(R)
Beta
R
F
E(R
M
)
1.0 o
M
When we include a
risk free investment,
the efficient frontier
is a straight line
] ) ( [ ) (
F M F
R R E R R E = |
/
M
| o o =
1.22
The Capital Asset Pricing Model
Assumptions
Normal Distribution of Returns
Company Specific Risk () is Independent
Common: 1-period returns for all
Borrow & Lend at risk-free rate
No taxes
Homogeneous return expectations
1.23
The Capital Asset Pricing Model
Alpha
For a PF manager, his return expectation is
If in fact
Then he has yielded positive ; where
Thats Good!
( ) [ ( ) ]
P F P M F
E R R E R R | =
[ ( ) ]
P F P M F
R R E R R | > +
[ ( ) ]
P F P M F
R R E R R o |
1.24
Arbitrage Pricing Theory
Returns depend on several factors
We can form portfolios to eliminate the
dependence on the factors
Leads to result that expected return is
linearly dependent on the realization of the
factors
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1.25
Risk vs. Return for Companies
If shareholders care only about systematic risk
should the same be true of company managers?
In practice companies manage for total risk
They buy property insurance to protect against the risk
of factory destruction due to fire, for example
Earnings stability and company survival are
important managerial objectives
Bankruptcy costs arguments show that that
managers are acting in the best interests of
shareholders when they consider total risk
1.26
What Are Bankruptcy Costs?
Lost sales (There is a reluctance to buy
from a bankrupt company.)
Key employees leave
Legal and accounting costs
Lost franchise value (intangibles)
3.27
Banking
Commercial Banking
Take Deposits, Make Loans, Provide Services
Retail: Individuals & Small Businesses
Wholesale: Larger Corporations & Funds
Investment Banking
Raise Capital Equity and Debt
Banking Services for Corporations
Financial Advice M&A, Corporate Finance
Sales and Trading
1.28
Banking
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1.29
Capital
Capital is designed to provide protection
against extreme events that have a very
low (e.g. 0.1%) chance of occurring
Is a banks capital sufficient for it to maintain
solvency?
Lets see where Capital shows in
considering Banks
1.30
Example of Simple Bank Balance
Sheet: End 2012 ($ millions)
Assets
Cash 5
Marketable Securities 10
Loans 80
Fixed Assets 5
Total 100
Liabilities & Net Worth
Deposits 90
Subord L.T. Debt 5
Equity Capital 5
Total 100
1.31
Income Statement: 2012
($ millions)
Net Interest Income 3.00
Loan Losses (0.80)
Non-Interest Income 0.90
Non-Interest Expense (2.50)
Pre-Tax Operating Income 0.60
Return on Equity (before tax) 12%
1.32
Year 2013 Is Capital Adequate
What happens in year 2013 if it is the same
as year 2012 except that loan losses are 4.0
instead of 0.8? (rises by 3.2% of assets)
Other items on income statement are the same
There is an after-tax loss of 1.8% of assets
(Operating Loss = 2.6%; Tax rate = 30%; & 2.6 x .7 = 1.8)
The equity capital would be diminished to 3.2%
Regulator might require an equity infusion to
restore the 5% level
9
1.33
What if Balance Sheet Had Been
More Aggressive? ($ millions)
Assets
Cash 5
Marketable Securities 10
Loans 80
Fixed Assets 5
Total 100
Liabilities
Deposits 94
Subord L.T. Debt 5
Equity Capital 1
Total 100
1.34
Regulation
Regulators set minimum levels for the
capital a bank is required to keep
Equity is an example of Tier I capital
Subordinated long term debt is an example
of Tier II capital
What does tier I provide that tier II doesnt?
Protection to maintain solvency; protection
against liquidation to pay bondholders
1.35
Investment Banking
Raising Capital
Private Placement vs. Public Offering
Public Offering
Best Efforts (fee)
Firm Commitment (own em)
IPO (Offering Price)
Dutch Auction
1.36
Investment Banking
Creation & Exchange of Securities and Instruments
Investment Banking Creates for Capital Flows
Sales and Trading finds Capital & Makes Markets
Create
Securities
Make
Markets
Manage
Invested
Funds
Collateral
New Issue
Securities
Securities &
Contracts
Secondary Issues
Investment Banking
Broker-Dealers &
Exchanges
Institutional Investors
10
1.37
Investment Banking
Raising Capital
Dutch Auction
1mm shares
Who gets (C, F, E, H, A & 2/3 of Ds order) and how
much to pay (Ds 29.00)
1.38
Investment Banking
Securities Trading
Banks are often involved in securities trading
Brokerage
Full Service: Research & Advice
Market Making (both bid & offer) OTC vs. Exchange
Conflicts of Interest (Glass-Steagall)
Recommend the Axe
Access to non-public information
Research to please company for IB business
Risk transfer w/o full disclosure (loan/credit & CDS)
1.39
Todays Large Banks
Do Everything and more
Accounting
Fees: Accrual Accounting
Assets: Banking Book (loans) & Trading Book
(contracts & securities)
Mark to market vs. mark to model vs. banking book
Loans have troublesome credit exposure
Originate to Distribute (move loans out)
Securitization
Got out of control post Glass-Steagall
1.40
Categories of Risk
Market Risk (10-days) (Systematic)
Credit Risk (1-year) (Systematic)
Operational Risk (1-year) (Specific)
The Capital a bank is required to hold
(regulatory capital) must be sufficient to
accommodate losses from these risks
thereby precluding bank failure
11
1.41
How Do Financial Institutions
Manage Risk
Risk Decomposition vs. Aggregation
Decomposition Identifies Risk
Factors/Variables and levies a target for each
unit (trading desk)
Aggregation takes advantage of diversification
across all units
Risk Manager allocates targets and assesses
aggregation results
Capital Adequacy is the banks capital adequate to
meet the regulatory standard set by regulators
1.42
Management of Net Interest
Income
Suppose that the markets best guess is that future
short term rates will equal todays rates
What would happen if a bank posted the following
rates?
How can the bank manage its risks?
Maturity (yrs.) Deposit Rate Mortgage
Rate
1 3% 6%
5 3% 6%
1.43
Management of Net Interest
Income
The following might make more sense
A source of liquidity preference in higher rates w/longer
maturities
Maturity (yrs) Deposit Rate Mortgage
Rate
1 3% 6%
5 4% 7%
1.44
Expensive Failures of U.S. Financial
Institutions
Savings and Loans
Continental Illinois
IndyMac
Bear Stearns
FNMA/FHMC
Countrywide
Lehman
AIG?!
12
1.45
Financial Institutions
Specialness of Financial Institutions
Banks, Insurance, Asset Managers, etc.
Transfer Capital: Sources to Users
Investors to Borrowers
Commonality of Risks
All Hold Assets as part of Services and Assume
Credit Risk
Interest Rate Risk
1.46
Financial Institutions
Commonality of Risks (Continued)
Mediate a Mismatch of Asset & Liability Duration
Withdrawal/Liquidity Risk
Underwriting Risk / Credit Guarantees
Operating Risk
Because of Risks and Special Role in the
Financial System, Financial Institutions are
singled out for Regulatory Supervision
1.47
Financial Institutions
Specialness in Provision of Services
Information Costs
Liquidity & Price Risk
Transaction Services Cost, Availability
Maturity/Duration Intermediation
Transmission of Monetary Supply
Credit Allocation
Intergenerational Wealth Transfers
Payment Services check clearing, etc.
Denomination Intermediation
1.48
Financial Institutions
Specialness and Regulation
Safety & Soundness Borrowers & Depositors
Regulatory Capital Requirements
Guarantee Agents: FDIC, SIPC, ERISA (PBGC), etc.
Monetary Policy Reserves & Leverage
Credit Allocation Mortgages, Consumer Loans
Consumer Protection Discrimination/Practices
Investor Protection Mutual Funds & Pensions
Entry / Chartering
13
1.49
Financial Institutions
Changing Dynamics of Specialness
Shift Away from Risk Measurement / Risk
Management & Financial Crisis
See Appendix 1A in Saunders
Separation of Specialness since 1933 (G-S)
Financial Services Modernization Act 1999
Mega Holding Companies
From Originate & Hold to Originate & Distribute
FIs fail to act as specialists in Risk Measurement & Mgmt.
The housing bubble
Other Considerations
1.50
Financial Institutions
Changing Dynamics of Specialness
Shift Away from Risk Measurement / Risk
Management & Financial Crisis
Other Considerations
S&L Crisis and subsequent liquidity for mortgage lending
9/11 Accommodation
Removal of Accommodation in 2006
Borrower Squeeze
Bear Stearns Hedge Fund failure
AIG Insurance for Distribution
Merrill Lynch / BofA / Lehman
Federal Reserve Saves the World
2.51
Insurance Companies
Life vs. Property & Casualty vs. Health
Life Insurance
Whole Life vs. Term
An investment vehicle for premiums
Annuity Contracts from Life Insurers
Fixed Annuity lump sum into payments
Mortality Tables
Longevity Risk & Mortality Risk
2.52
Insurance Companies
a Mortality Table
14
2.53
Insurance Companies
a Mortality Table
Some entries can be calculated
from others - consistency
Probability of death 90-91
0.15722 0.12986 = 0.02736
Conditional on reaching 90
Death in next year is
0.02736/0.15722 = 0.1740
which is consistent with the entry in column 2
Death in 2
nd
year (91-92)
(1 0.174013) x 0.191354 = 0.158056
2.54
Insurance Companies
Insurance Premiums
Like for a Credit Default Swap
Need to find breakeven value of premium so the PV of
expected pay-outs equals PV of expected premiums
Suppose a male 90-year old wants to buy a 2-year term
life policy; term structure is 4% and flat; pay-outs midway
in any year and premiums are paid at the beginning of
each year
PV of expected payoff:
PV[.174x100K] + PV[.158x100K] = 17,060 + 14,894 = 31,954
PV of Premiums:
1 x X + (1-.174) x X = 1.79 x X
Breakeven: 1.79X = 31,954 => X = 17,812
2.55
Insurance Companies
Property & Casualty
Loss to property (fire, theft, home & auto, etc.)
Legal Liability
singular events and legacy risk
Ratios (of payouts to premiums)
2.56
Insurance Companies
Health Insurance
Attributes of Life and P&C
Premiums can go up, but only with prevailing costs
Dont increase as a function of the health of individual
Moral Hazard & Adverse Selection
Moral Hazard P&C Insurance can promote
imprudent behavior
Adverse Selection Insurance attracts bad risks
Reinsurance against large losses
15
2.57
Insurance Companies
The Balance Sheet (Life vs. P&C)
Risks ?
Inadequate Reserves
Liquidity Duration
Hedges: Longevity Derivative & CAT bonds
2.58
Insurance Companies
Regulation of Insurance Companies
States and the NAIC
Pension Plans
Defined Contribution
Defined Benefit
Are defined benefit plans viable?
2.59
Investment Companies
Mutual Funds & Hedge Funds
Mutual Funds
Small Investor Diversification
Big Business - $10 trillion in US
Open End vs. Closed End
Index Funds
2.60
Investment Companies
Mutual Funds
Cost Structure
Load: Front End vs. Back End
Annual Expense Fee
Once a day
NAV
Purchase and Redemption
16
2.61
Investment Companies
ETFs
Created by Institutions
Traded as a security on Exchanges
(continuous trading)
Exchangeable: ETF and Underlying Assets
Insures no arbitrage in pricing/valuation
Mutual Funds and ETFs are regulated by
the SEC
2.62
Investment Companies
Hedge Funds
Unregulated
Can use short positions and leverage
Limited Disclosure (including NAV)
Restrictions on Deposits and Redemptions
Fees
Management Fee plus Performance Fee
Hurdle Rate, High Water mark, & Clawback (% of
fees go to recovery account vs. future losses)
Prime Brokers (de facto regulator)
2.63
Investment Companies
Hedge Fund Strategies
Long/Short Equity
Dedicated Short
Distressed Situations
Merger Arbitrage / Event Driven
Convertible Arbitrage
Fixed Income Arbitrage
Emerging Markets
Global Macro
Managed Futures
2.64
Investment Companies