2013

ASSIGNMENT #1 FINANCIAL RISK MANAGEMENT

Submitted To: Dr. Kulbir Singh Assistant Professor Finance

Submitted By: Chetan Chawhan Roll No. 2012100

and interest rates lead to large imbalances in the supply and demand for funds. the goal of risk management is to ensure that companies have the cash they need to create value by making good investments. In Technical terms in order to hedge you would invest in two securities with negative correlation. or capital expenditures. Risk Management also helps in controlling excessive investment volatility as it can threaten a company’s ability to meet its strategic objectives. inflation. If the investment you are hedging against makes money. commodity prices.  Successful hedging gives the trader protection against commodity price changes. and it does not need to hedge as much.1. etc. This helps a company to meet its strategic objectives by controlling excessive investment volatility. IMT/PGDM-2012066/FRM 1 . interest rate changes. 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. The major reason to hedge for a company is align their internal supply of funds with their demand for fund. if successful. will reduce that loss. ROE. then the company should hedge aggressively. A proper risk-management strategy ensures that companies have the cash when they need it for investment.  Hedging enables traders to survive hard market periods. A coherent risk-management strategy Understands the connection between a company’s 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 changes in exchange rates. 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. accounting earnings. the company has a natural hedge. The stock-price volatility can be better managed by individual investors through their portfolio strategies. if not. or capital expenditures?  The goal of risk management in a firm should be to stabilize operating income. Benefits of Hedging  Hedging using futures and options are very good short-term risk-minimizing strategy for long-term traders and investors. your hedge. you will have typically reduced the profit that you could have made. currency exchange rate changes.  Hedging can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility.  Hedging tools can also be used for locking the profit. and if the investment loses money.  Hedging using options provide the trader an opportunity to practice complex options trading strategies to maximize his return. accounting earnings. ROE. Also. or to stabilize operating income.

 Hedging is a precise trading strategy and successful hedging requires good trading skills and experience. 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 don’t. The investment opportunities depend on the overall structure of the industry and on the financial strength of its competitors. 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.  Risk and reward are often proportional to one other. the company reduces supply when there is excess supply and increases supply when there is a shortage. 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. e. all risk should be hedged which leads to disequilibrium in the supply of internally generated funds and the investment demand for funds. thus reducing risk means reducing profits. then hedging offer little benefits. Thus.  If the market is performing well or moving sidewise. the average supply of funds doesn’t change with hedging. 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.: for a day trader.g. 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.  Trading of options or futures often demand higher account requirements like more capital or balance. risk management adds real value. Also it is in favor of the company to stay away from most exotic. hedging is a difficult strategy to follow. This aligns the internal supply of funds with the demand for funds. the same elements that go into formulating a competitive strategy should also be used to formulate a risk management strategy.Costs of Hedging  Hedging involves cost that can eat up the profit.  For most short-term traders. Of course. The company should hedge to make sure it has enough cash for the investment. customized hedging instruments unless there is a very clear investment-side justification for their use. and how?  By hedging. Thus. because hedging is a zero-net-present-value investment: it does not create value by itself. IMT/PGDM-2012066/FRM 2 .

If there is a minimum amount of investment a company needs to maintain. 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.Based Contracts: Options. forwards. Broadly they are divided into two major heads Forwards and Options. they provide the flexibility to increase investment in good times.d) Compare and contrast hedging with forwards/futures/swaps to hedging with options  Few commonly used derivatives for hedging are futures. Options are settled when they are exercised. At the same time.  Customization:  Forward Contracts: As forwards are traded OTC there are high degrees of customization involved. etc. caps.e. Swaps Option. Forwards. options can allow it to lock in the necessary cash. in that they allow the company to put a floor on its losses without having to give up the potential for gains. the company has to put money to compensate for any short-term losses. floors. Caps. options. swaps.  Options: options are available both on exchanges and OTC. The further sub division is as follows: Forward-Based Contracts: Futures. These expenditures can cut into the cash a company needs to finance current investments. that is.  Forward Contracts: In future no money exchanges hands at the time of initiation  Options: Unlike Forward. Floors Some of the major differentiating factors are:  Cash Flow Implication: This means that whether an instrument is settled at maturity or before maturity.  Money Down: This means that when an instrument is initiated whether money changes hands or not.  Options are nonlinear. OTC offers great opportunity for customization IMT/PGDM-2012066/FRM 3 . 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.  Options: these are generally not mark to market.  Futures Contracts: These are traded on an exchange and require a company to mark to market on a daily basis.

over a given period of time at a given confidence level. its estimation is subject to large estimation errors. The definition of normality is critical and is essentially a statistical concept that varies by firm and by risk management system. VaR is considered as a standard measure of market risk and is widely implemented by financial institutions.  Time horizon is a crucial factor in VaR. The Risk of Value at Risk a) What is VaR? Explain its relevance for a financial institution. typically 95% or 99%. whether in the short term or long term. Value at risk is used by risk managers in order to measure and control the level of risk which the firm undertakes. and a downward bias in the estimation can easily be exploited by employees or the entire company to their own benefit. but it became widely applied in financial institutions to measure all kinds of financial risks. Forgetting Lehman: VaR: Seductive but Dangerous-Beyond VaR. 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.2. Firms select different time periods to view risk depending on the capital exposure and the expected profits. Originally VaR was intended to measure the risks in derivatives markets. it seeks to measure the possible losses from a position or portfolio under “normal” circumstances.  Focused on the manageable risks near the center of the distribution and ignored the tails IMT/PGDM-2012066/FRM 4 . 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.  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.  Under certain circumstances VaR does not give an appropriate risk measure. the most commonly used VaR models assume that the prices of assets in the financial markets follow a normal distribution. primarily market and credit risks. it may produce inadequate risk views over time horizons of several months. Put simply however. b) What is relevance of confidence interval and horizon in computation of VaR. years. It is defined as the worst expected loss of that position. The VaR of a market position is a single number attempting to summarize the risk of that position. Although a model may produce adequate views of capital risk on an overnight or weekly basis. VaR is calculated within a given confidence interval.

VAR clearly didn’t work. d) Explain stressed VaR. making them more accurate and reducing the risk of unexpected losses. For the business areas that stayed liquid. Not only is there no clear philosophy behind the decision to add together capital charges derived from normal VAR and stressed VAR. VAR models should not automatically be viewed as unreliable. Exceptions to the rule a. The results of the Back testing can be used to refine the models used for the VaR predictions.  In these circumstances. What is Back testing? Explain its relevance to financial institutions. This identifies instances where VaR has been underestimated. 3. They should fix the specific problem. but it was fine for other areas. banks found VAR still worked. but it’s not the most efficient way of doing it. It’s a technique used to compare the predicted losses from VaR with the actual losses realized at the end of the period of time. he says. and extreme market moves not taken into account in past historical data used to calibrate the parameters of the models. For the structured credit market. A more discretionary interpretation similar to the yellow zone could be considered. BVaR incorporates both. as a high number of VAR exceptions can hint at either weaknesses in the model or a major regime shift in markets. meaning a portfolio has experienced a loss greater or than the original VaR estimate. but risk of a poor interpretation remains. the green zone corresponds to back testing results that suggest there are no issues with the accuracy of the bank’s model. IMT/PGDM-2012066/FRM 5 . 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. Theoretically.BVaR is used to take into consideration the profile of losses beyond VaR. 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. What relevance of horizon in the stressed VaR?  The stressed VAR charge is designed to have an impact on capital levels. but it is also too broad a response.  Back testing is a set of statistical procedures designed to check if the real losses are in line with VaR forecasts. London-based chief risk officer for the UK and Europe at Standard Chartered Bank.” says Simon Gurney.

as illustrated by Lehman Brothers. the supervisor may impose a penalty corresponding to an increase in market risk capital via the scaling factor. But Lehman’s ranking in the green zone raises questions about the Ability of VAR exceptions to indicate banks’ health. and so appear to have better VAR models.Goldman Sachs and Lehman Brothers fell into the green zone over the observation period. 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. They should be interpreted taking into account the VAR methodology of each bank and the market context when the VAR exceptions took place. which reported few exceptions prior to its collapse. one may draw the tentative conclusion that the firm massively increased its risk taking without selling risky assets or putting as ide enough capital. Although Lehman was facing Funding problems. c. 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. it is difficult to see the predictive value of VAR exceptions since methodological differences may hide differences in performance and behavior. the Basel Committee introduced a three-zone framework related to the number of exceptions recorded. What is the Basel requirement for back testing for banks?  In 1996. From these findings. IMT/PGDM-2012066/FRM 6 . VAR exceptions cannot by themselves predict bank failures or distress. To help supervisors interpret back testing results. Depending on the results. VAR exceptions are just one instrument in a comprehensive toolkit available to regulators to assess potential risk management failures within banks.

IMT/PGDM-2012066/FRM 7 . 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 is considered an acceptable back testing result. 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. The supervisor would try to find out what caused the VAR exceptions and decide if the bank should be penalized. 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. Yellow zone: between five and nine exceptions. with an increase in the scaling factor of 1. There is no concern over the models of banks and therefore no penalty.Green zone: between zero and four exceptions.S. even in period of stress. whereas the supervisor may use its judgment in interpreting the back testing results if they fall within the yellow zone. This raises questions. (250 days trading a year) Most U. The red zone leads to an automatic presumption of weakness in the model. This indicates a major modeling problem and generates an automatic penalty.