Why To Manage Risk - EDHEC 2021 v2

Why to Manage Risk ?
and
Michel Crouhy
Head of Research & Development
Best Practice Risk Management
NATIXIS
michel.crouhy@na:xis.com
Michel Crouhy and Dan Galai
Dan Galai
michel.crouhy@gmail.com dan@sigma-invest.co.il
Hebrew University and SIGMA
dan@sigma-‐invest.co.il
EDHEC – London
May, 2021
Moscow, October 2013
5/11/21
Agenda
I.  Historical Background

II.  What is Risk Management and Why Manage Risk?
III.  Best PracJce Risk Management
IV.  The Role of Models
V.  Concluding Remarks
5/11/21 Copyright © Michel Crouhy & Dan Galai, 2021 2

I.  Historical Background
-‐ Financial Markets and the Global Economy
-‐ The Banking Sector
-‐ Banking and Risk Management in the New Digital World


Milestones
§  1938 Macaulay’s bond duraCon
§  1944 BreFon-‐Woods agreement on fixed exchange rates
§  1952 Markowitz mean-‐variance framework
§  1964 Sharpe’s single factor beta model (CAPM)
§  1966 MulCple factor models
§  1971 End of BreFon-‐Woods (no longer converCbility of US$ to Gold)
§  1973 Black-‐Scholes opCon pricing model and the “Greeks”
§  1973 The CBOE starts trading in standardized opCons; end of fixed exchange rates;
first oil crisis (Yom Kippur war): oil price $4 to $10
§  1979 Second oil crisis (Iranian revoluCon) – oil price $10 to $40
§  1970s – 1983 – Period of high inflaCon (Vietnam war, oil shock) – Paul Volker 1979-‐1987 –
inflaCon peaked in March 1980 at 14.8% down to 3% in 1983. Fed fund rate 11.2% in 1979
to 20% in June 1981. Unemployment up to 10%.
§  1982 OpCons on FX are introduced
§  1983 OpCons on index are introduced
§  1987 Black Monday October – equity crash
§  1988 BIS Accord (Basel I) on credit risk is announced – fully implemented in 1992
§  1993 Value-‐at-‐Risk
§  1996 BIS Accord on market risk is introduced
§  1997 Asian crisis – July Thailand – abandon of the peg against US$: FX rate down 50% and stock market
down 50%. Start of the CDS market.
§  1998 Russian default – LTCM
§  2000 Dot-‐com bubble burst
§  2000 Enterprise-‐wide Risk Management (ERM)
§  2007 – 2009 – GFC (subprime crisis) – before 2007: 15,000 hedge funds with $1.5 trillion AUM – half collapsed
§  2011-‐2012 European Sovereign Debt crisis
Economic recessions in the USA
Recession is not necessarily a catastrophy - it’s also a beginning…
Last 10
years

150 year history of yields on LT Gov. Bonds

II. What is Risk Management and
Why Manage Risk ?

Why Manage Risk ?

Why Manage Risk?
§  EliminaCng risk?

§  Avoiding risk?
§  Imposing limits on risk acCviCes?
§  IdenCfying risk exposures?
§  Determining the strategy for risk management?

Why Manage Risk?
Reasons:
§  BeFer explore the alternaCves and uncertainCes.
§  OpCmize resources.
§  Make controlled decisions.
§  Make raConal decisions.
§  How risk exposures can affect our business?

Why Manage Risk?
It is a process leading to define what risks to assume

and what risks to avoid within the overall strategy of
the firm, and determining what should be the minimal
compensaCon for assuming the risk.

But-‐what is risk??


Why Manage Risk?
-‐ Process of selecCon.

-‐ Ex-‐ante decisions under condiCons of uncertainty.

-‐ Pricing of risks.

-‐ Controlling the process.

But-‐what is risk??


Corporate Risk Management
§  Why NOT to manage risk in theory (in perfect capital
markets)…
–  M&M: whatever the firm can accomplish in the financial
markets, the individual investor in the firm can also
accomplish or unwind on the same condiCons. (“Me
Too”)
–  CAPM: firms should not worry about specific risks
–  Reducing volaClity through hedging simply moves
earnings and cash-‐flows from one year to another.
–  RM requires skills, knowledge, infrastructure: not
carefully structured and monitored can lead to
disasters.

§  …And some reasons FOR managing risk in pracCce:
–  Reduce the chance of default and the potenCal cost of financial
distress and bankruptcy.
–  Agency risk: managers may not be able to diversify their personal
wealth accumulated in the their company and have the incenCve to
reduce volaClity.
–  Signaling: not easy for shareholders to differenCate between volaClity
that’s healthy and volaClity that’s caused by management
incompetence.
–  Progressive taxaCon induce higher taxaCon for volaCle earnings.
–  Hedging allows a firm to stabilize its costs and hence its pricing policy
which could generate a compeCCve advantage.
–  Reduce the cost of capital and enhance the ability to finance growth.

§  QuesJon:
Why and how should a firm hedge financial risks that may
affect its business by means of financial contracts such as
derivaJves?
–  SEC insists on increased disclosures around risk management
policies and financial exposures;
–  Sarbanes-‐Oxley (SOX) requires internal cerCficaCon by CEOs
and CFOs that financial statements are “true and fair”.
–  Dodd-‐Frank and the Consumer ProtecCon Act calls for
stronger oversight on OTC derivaCves and the companies
that use them.

What is Risk Management
§  The future cannot be predicted: it is uncertain and hard to
forecast (stock market, interest rates, exchange rates,
commodity prices, systemic events,…)
§  But financial risk that arises from uncertainty can be
managed:
–  IdenCfy risk
–  Measure risk
–  Hedging, miCgaCng and transferring risk
§  Modern risk management:
–  Ability to price and ensure that risks are correctly
rewarded
§  Risk management in pracJce:

–  Determining the objecCve
•  Risk appeCte of the firm as the board defines it.
•  Which risk should be hedged, and which risks the company
should assume as part of its business strategy.
•  Hedging accounCng vs. economic profits, and short-‐term vs.
long-‐term profits.
–  Mapping the risks and esCmaCng their current and future
magnitudes.
–  Instruments for risk management.
–  ConstrucCng and implemenCng a strategy: staCc vs. dynamic
strategies (see Case study: Metallgesellschat).
–  CommunicaCon.
–  Performance evaluaCon.

What is Risk Management?
§  Back in 2002, Alan Greenspan, then chairman of the U.S. Federal
Reserve Board, made some opCmisCc remarks about the power
of risk management to improve the world, but the condiConality
aFached to his observaCons proved to be rather important:
“The development of our paradigms for containing risk has
emphasized dispersion of risk to those willing, and presumably
able, to bear it. If risk is properly dispersed, shocks to the overall
economic system will be be>er absorbed and less likely to create
cascading failures that could threaten financial stability.”
§  In the financial crisis of 2007-‐2009, risk turned out to have been
concentrated rather than dispersed!

DerivaJves are great hedging tools but…

What is Risk Management
§  Other failures or Risk management:

–  Long-‐Term Capital Management in 1998
–  Financial scandals at the turn of the millenium (Sarbanes-‐
Oxley (SOX)):
•  Enron, Worldcom, Parmalat,…
–  Financial engineering which played a role in obscuring the
true economic condiCon and risk-‐taking of financial
companies (e.g., Lehman with Repo 105, and Sovereigns,
e.g., Greece) in the run up to the 2007-‐2009 GFC.

What is Risk ?
Financial Risks Borne by CorporaJons

What is Risk ?

•  So far risk is vaguely defined; different people will have a
different percepCon of what is risk? Is it a potenCal
future loss? Even if the loss is very small, or, only a large
loss? Is it also the chance of a large gain?

•  In order to make the concept more pracCcal, we’ll define
it always in, at least, two words: e.g. market risk, credit
risk, etc.
•  Next, we engage in the typology of risk, or idenCfying
sources of risk at the corporaCon.

Typology of Risk Exposures
Not included
in Pillar 1 of
Basel III
framework


•  One can “slice and dice” these multiple dimensions of risk*
General
Market
Risk
Equity Risk Trading Risk
Market Risk
Interest Rate Risk Specific
Gap Risk Risk”
Currency Risk
Credit Risk
Commodity Risk
Counterparty
Operational Risk
Risk
Financial Transaction Risk
Risks Reputational Issuer Risk
Risk Portfolio
Concentration
Business and Risk Issue Risk
strategic risks
* For more details, see Chapter-1 – Appendix 1.1, “The Essentials of Risk Management”, second
edition, by Crouhy, Galai and Mark

Market Risk is the risk that changes in financial markets prices and rates will impact the value of
the bank’s posiCons.
é Interest Rate Risk é Stock Market Risk é FX Risk
é  Commodity Risk é InflaCon Risk
–  Basis risk
–  General market risk
–  Specific risk

Credit Risk is the risk of an economic loss from the failure of a counterparty to fulfill its
contractual obligaCons, or from the increased risk of default during the term of the transacCon.
–  Default risk is the extreme case where the counterparty is unwilling or unable to fulfill
its contractual obligaCon (LGD – Loss Given Default)
–  Bankruptcy risk
–  Downgrade risk is the risk that a counterparty credit quality declines
–  SeFlement risk (HerstaF Bank 1974 – DM vs. US$ -‐ payment-‐versus-‐payment through
CLS Bank)
–  Counterparty credit risk (derivaCves transacCons)
–  Credit risk at the porwolio level (concentraCon risk)

Liquidity Risk:
–  Funding liquidity risk is the risk that the bank won’t be able to raise the necessary
cash to roll over its debt , to meet cash margins and collateral calls of
counterparCes, and to saCsfy cash withdrawals.
–  Trading liquidity risk is the risk of not being able to execute a transacCon at the
current prevailing market price.

OperaJonal Risk is the risk for potenCal losses resulCng from inadequate systems,
management failure, faulty controls, frauds, human errors, failure of technology.

Legal and Regulatory Risk (part of OR under Basel II Capital Accord):
–  A counterparty might lack the legal or regulatory authority to engage in a risky
transacCon
–  PotenCal impact of a change in the tax law on the market value of a posiCon (e.g.,
the BriCsh Government changed the tax code to remove a parCcular tax benefit
during the summer of 1997)



Business Risk is the risk stemming from the operaCons of the firm and is
reflected in the changes in the value of the firm.
It is related to the uncertainty about the demand for products, the price that
can be charged for those products, or the cost of producing and delivering
products.

Strategic Risk refers to the risk of significant investments for which there is a
high uncertainty about success and profitability.

ReputaJon Risk is related to:
–  The belief that a company can and will fulfill its promises to
counterparCes and creditors;
–  The belief that the company is a fair dealer and follows ethical
pracCces
–  Threat of false rumors propagated in the internet

Systemic Risk concerns the potenCal for the failure of one insCtuCon to
create a chain reacCon or domino effect on other insCtuCons and,
consequently, threaten the stability of the financial system and the global
economy (e.g., Lehman Brothers)


Financial Risk is the breakdown of the business risk among all claimholders
and thus is a funcCon of the capital structure of the firm.

Country Risk is the risk to which a firm is exposed due to operaCng in a
certain country, including poliCcal risk, changes in regulaCon or taxaCon:
–  Risk of naConalizaCon
–  Risk that a company could be prevented from making a payment
because of a sovereign debt moratorium (e.g., City of Moscow in
1998)
–  Risk for a company not to be allowed to repatriate cash.

and more… new non-‐financial risks are emerging

Cyber Risk
Model Risk
Contagion Risk

Typology of Risk Exposures-‐Economic vs AccounJng Risk

BIS:
Risky assets extend gains, but tail risks remain
•  With monetary policy remaining very easy, global equity markets rose in
response to indicaCons of stronger fiscal policy support, notably in the
United States, and a brightening earnings outlook.
•  The increase in stock prices was broad-‐based, but parCcularly strong in
EMEs other than China and in selected AEs such as Japan (Graph 1, first
panel).
•  Over Cme, equity indices waxed and waned in line with the prospect of a
major US fiscal package (verCcal lines). Later in the review period, the run-‐
up in US stock prices paused just as the reflaCon trade gained momentum
(see below).
•  In the background, earnings forecasts conCnued to improve in the United
States but stayed rather flat in Europe (second panel). Actual earnings also
largely surprised on the upside, with about three quarters of US
companies exceeding analysts’ esCmates for Q4 2020.

Copyright © Michel Crouhy & Dan Galai,
5/11/21 35
2021
Copyright © Michel Crouhy & Dan Galai,
5/11/21 36
2021
What is Risk?
§  Key concepts in modern risk management:

–  « Expected loss » vs. « unexpected loss »
•  Retail porwolio (e.g., credit card receivable) vs. corporate loan
porwolio (lumpy and concentrated porwolios)
–  Risk factors:
•  Stocks: underlying price, volaClity of returns
•  Interest rates: yield-‐to-‐maturity, forward rates, …
•  CorrelaCons
•  DistribuCon of the risk factors during normal market condiCons
and stressful condiCons
–  Risk appeJte

Financial Risks Borne by CorporaJons

§  All nonfinancial companies are exposed to business risk:

–  Earnings fluctuate due to changes in the business environment;
–  New compeCtors;
–  New producCon technologies;
–  Various factors affecCng suppliers.
§  Firms react in various ways:
–  Quality control;
–  Holding inventories of raw materials;
–  Storing finished products;
–  Signing long-‐term supply contracts at a fixed price;
–  Insurance contracts (e.g., cyber-‐aFacks,…)
–  ConducCng horizontal and verCcal integraCon with compeCtors, distributors and
suppliers (e.g., Delta Air Lines buying a refinery)

Merck
Financial Instruments Market Risk Disclosures

•  The Company manages the impact of foreign exchange rate movements and interest rate movements on its
earnings, cash flows and fair values of assets and liabiliCes through operaConal means and through the use of
various financial instruments, including derivaCve instruments.
•  A significant porCon of the Company’s revenues and earnings in foreign affiliates is exposed to changes in foreign
exchange rates. The objecCves and accounCng related to the Company’s foreign currency risk management
program, as well as its interest rate risk management acCviCes are discussed below.
Foreign Currency Risk Management
•  The Company has established revenue hedging, balance sheet risk management, and net
investment hedging programs to protect against volaClity of future foreign currency cash flows and
changes in fair value caused by volaClity in foreign exchange rates. The objecCve of the revenue
hedging program is to reduce the variability caused by changes in foreign exchange rates that
would affect the U.S. dollar value of future cash flows derived from foreign currency denominated
sales, primarily the euro and Japanese yen.
•  To achieve this objecCve, the Company will hedge a porCon of its forecasted foreign currency
denominated third-‐party and intercompany distributor enCty sales (forecasted sales) that are
expected to occur over its planning cycle, typically no more than two years into the future. The
Company will layer in hedges over Cme, increasing the porCon of forecasted sales hedged as it gets
closer to the expected date of the forecasted sales. The porCon of forecasted sales hedged is based
on assessments of cost-‐benefit profiles that consider natural offsezng exposures, revenue and
exchange rate volaCliCes and correlaCons, and the cost of hedging instruments. The Company
manages its anCcipated transacCon exposure principally with purchased local currency put opCons,
forward contracts, and purchased collar opCons.

Merck
Interest Rate Risk Management
•  The Company may use interest rate swap contracts on certain invesCng and borrowing
transacCons to manage its net exposure to interest rate changes and to reduce its
overall cost of borrowing. The Company does not use leveraged swaps and, in general,
does not leverage any of its investment acCviCes that would put principal capital at risk.
•  In May 2018, four interest rate swaps with noConal amounts aggregaCng $1.0
billion matured. These swaps effecCvely converted the Company’s $1.0
billion, 1.30% fixed-‐rate notes due 2018 to variable rate debt. In December 2018, in
connecCon with the early repayment of debt, the Company seFled three interest rate
swaps with noConal amounts aggregaCng $550 million. These swaps effecCvely
converted a porCon of the Company’s $1.25 billion, 5.00% notes due 2019 to variable
rate debt. At December 31, 2018, the Company was a party to 19 pay-‐floaCng, receive-‐
fixed interest rate swap contracts designated as fair value hedges of fixed-‐rate notes in
which the noConal amounts match the amount of the hedged fixed-‐rate notes

Merck
Analysis of Liquidity and Capital Resources
•  Merck’s strong financial profile enables it to fund research and development, focus on
external alliances, support in-‐line products and maximize upcoming launches while providing
significant cash returns to shareholders.
•  The decline in working capital in 2018 compared with 2017 reflects the uClizaCon of cash and
short-‐term borrowings to fund $5.0 billion of ASR agreements, a $1.25 billion payment to
redeem debt in connecCon with the exercise of a make-‐whole provision as discussed below,
as well as a $750 million upfront payment related to the formaCon of a collaboraCon with
Eisai discussed above. The decline in working capital in 2017 compared with 2016 primarily
reflects the reclassificaCon of $3.0 billion of notes due in the first half of 2018 from long-‐term
debt to short term debt, $1.85 billion of upfront and opCon payments related to the
formaCon of the AstraZeneca collaboraCon discussed above, as well as $810 million paid to
redeem debt in connecCon with tender offers discussed below.
•  Cash provided by operaCng acCviCes was $10.9 billion in 2018, $6.5 billion in 2017 and $10.4
billion in 2016. Cash provided by invesCng acCviCes was $4.3 billion in 2018 compared with
$2.7 billion in 2017. The increase in cash provided by invesCng acCviCes was driven primarily
by lower purchases of securiCes and other investments, parCally offset by higher capital
expenditures.

ALIBABA
Market Risk
Interest Rate Risk
Our main interest rate exposure relates to bank borrowings. We also have interest-‐bearing
assets, including cash and cash equivalents, short-‐term investments and restricted cash. We
manage our interest rate exposure with a focus on reducing our overall cost of debt and
exposure to changes in interest rates. When considered appropriate, we use derivaCves, such
as interest rate swaps, to manage our interest rate exposure.
Foreign Exchange Risk
Foreign currency risk arises from future commercial transacCons, recognized assets and
liabiliCes and net investments in foreign operaCons. Although we operate businesses in
different countries, most of our revenue-‐generaCng transacCons, and a majority of our
expense-‐related transacCons, are denominated in Renminbi, which is the funcConal currency
of our major operaCng subsidiaries and the reporCng currency of our financial statements.
When considered appropriate, we enter into hedging acCviCes with regard to exchange rate
risk.
Market Price Risk
We are exposed to market price risk primarily with respect to investment securiCes, to a
lesser extent interest rate swaps and forward exchange contracts, held by us which are
reported at fair value. A substanCal porCon of our investments in equity investees are all
held for long-‐term appreciaCon or for strategic purposes. All of these are accounted for
under cost or equity method and not subject to market price risk. We are not exposed to
commodity
5/11/21 price risk Copyright © Michel Crouhy & Dan Galai, 2021 47
BAIDU
Item 11. QuanJtaJve and QualitaJve Disclosures about Market Risk
Interest Rate Risk
Our exposure to interest rate risk primarily relates to excess cash invested in short-‐term instruments with original
maturiJes of less than a year and bank borrowings that have a floaJng rate of interest. Investments in both fixed rate
and floaCng rate interest earning instruments carry a degree of interest rate risk. Fixed rate securiCes may have their
fair market value adversely impacted due to a rise in interest rates, while floaCng rate securiCes may produce less
income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of
expectaCons due to changes in interest rates, or we may suffer losses in principal if we have to sell securiCes which have
declined in market value due to changes in interest rates. For example, as of December 31, 2017, we had RMB78.7 billion
(US$12.1 billion) fixed-‐income short-‐term investments, with a weighted average duraCon of approximately 0.4 years. A
hypotheCcal one percentage point (100 basis-‐point) increase in interest rates would have resulted in a decrease of
approximately RMB393 million (US$60 million) in the fair value of our fixed-‐income short-‐term investments as of
December 31, 2017. We have not been, and do not expect to be, exposed to material interest rate risks relaCng to our
investment in short-‐term instruments, and therefore have not used any derivaJve financial instruments to manage
such interest risk exposure.
Our exposure to interest rate risk also arises from our bank borrowings that have a floaJng rate of interest. The costs
of floaCng rate borrowings may be affected by the fluctuaCons in the interest rates. We manage this risk by maintaining
an appropriate mix between fixed and floaCng rate borrowings and through the use of interest rate swap contracts.
Foreign Exchange Risk
Most of our revenues and costs are denominated in RMB, while a porCon of our cash and cash equivalents, short-‐term
financial assets, long-‐term investments, long-‐term loans payable and notes payable are denominated in U.S. dollars. We
have not used any derivaJve financial instruments to hedge exposure to foreign exchange risk.

III. Best PracJce Risk Management

Recent Events and Emerging Trends
Development of Internal Models which measure IntersecJon
of Market Risk, Credit Risk and Liquidity Risk in the Trading
Book and Asset Porcolios
PRICE RISK IN THE TRADING BOOK
Market Credit
Risk Risk
Liquidity
Risk

Recent Events and Emerging Trends
AcCve porwolio = Active

management as a key Portfolio
component of first class Management
proacCve Risk
}
+ Facilitate Pricing
Management + Assign Reserves & RAROC
Allocate Economic Capital
}
+ Stress Test &
Scenario Analysis Risk Analysis
+ Measure (e.g. MVaR & CVaR)
+ Monitor
Identify & Avoid } Limit Management
First Class Risk Management

Typical dynamics of a financial crisis-‐The Asian
Contagion of July 1997
Trading Market Liquidity Trading Credit
Risk Risk Risk
Market
Asian Credit
Liquidity
Currencies Spreads
Dried
Declined Widened
Up
Enterprise Declining
Equities
Liquidity Credit
Fell
Dried Up Quality
Interest Financial
Defaults
Rates System
Increased
Unstable Under Stress
Market Risks and the World of DerivaJves

Global OTC DerivaJves Markets

Gross Market Value and NoJonal Value

Central clearing rates trend upwards, especially for CDS

Interest rate derivaJves drive rise in
gross market value


Global DerivaJves Markets

OTC Foreign Exchange DerivaJves

OTC Interest Rate DerivaJves

How to EsJmate/Measure Risk/Uncertainty ?

How to Measure Risk?
-‐ Standard DeviaCon?

-‐ Beta?
-‐ VaR?
-‐ RAROC?
-‐ Tail Risk ?
-‐ Worse case scenario?

III. The Roles of Models, or
Why Do We Need Models for Risk Management ?

Why Do We Need Models For Risk Assessments ?

Why Do We Need models?
-‐Disciplined analysis.

-‐Focusing on important factors.

-‐To get “Ball Park” figures.

-‐To price risks (against benchmarks).

Theory of Risk Measurement
Researcher Theory Risk Measurement

Markowitz (1951) Portfolio Selection σ p2
Modigliani-Miller Business risk/ rs = rf + (rv − rf )
v
(1958) Financial Risk s
Sharpe (1964) CAPM β
Lintner (1965)
Black-Scholes/ OPM σs =σv ⋅
∂s v
⋅
Merton (1973) ∂v s
J.P. Morgan (1995) VaR, RAROC
Bankers Trust (1987)

Risk RelaJonships
Equity Real Estate

Risk Risk
Interest Rate Commodity Foreign

Risk Risk Exchange Risk
Default risk of
debt of firm i
σ Bi , β Bi , N(−d2 )
Business risk of
Market Risk firm i
σ M2 σ vi , β vi Financial risk of
equity of firm i
σ si , β si ,η s ,v

Did The Models Fail?
(LTCM, Metallgesellschah, CiJ, Merrill Lynch etc.)

1.  Is the role of models to forecast?

2.  Is the role of models to reduce uncertainty?

3.  Can we blame the models for failing the banks and the hedge
funds?

1. IS THE ROLE OF MODELS TO FORECAST?
§  MODELS ARE BASED ON ASSUMPTIONS.
§  ECONOMIC MODEL ARE BASED OF STATISTICAL PARAMETERS.
§  MODELS USE PARAMETERS AS INPUTS AND DO NOT TELL US, HOW TO
ESTIMATE PARAMETERS.
§  MODELS SHOULD TELL US HOW TO MAKE RATIONAL DECISIONS AT
PRESENT TIME, FACING FUTURE UNCERTAINTY.

2. IS THE ROLE OF MODELS TO REDUCE UNCERTAINTY?
§  MODEL CANNOT CANCEL OUT UNCERTAINTY.
§  UNCERTAINTY IS A FACT OF LIFE.
§  ECONOMIC MODELS CAN BE USED TO DEFINE AND PRICE RISKS.
§  MODELS CAN BE USED TO SET RATIONAL STRATEGY TO REDUCE RISKS OR
SELL / BUY RISKS.

3. CAN WE BLAME THE MODELS FOR FAILING BANKS & HEDGE
FUNDS?
§  HEDGE FUNDS ARE USUALLY LEVERED FUNDS WITH LONG AND SHORT
POSITIONS IN MANY FINANCIAL INSTRUMENTS.
§  NOT ALL POSITIONS IN HEDGED FUNDS ARE FULLY HEDGED.
§  SOME POSITIONS ARE HEDGED VIA CORRELATIONS.
§  SOME POSITIONS ARE IN ILIQUID, NONTRADED INSTRUMENTS.
§  ALL MODELS ARE BASED ON THE ASSUMPTION OF PERFECT CAPITAL
MARKETS.
§  SOME PARAMETERS (ESPECIALLY CORRELATIONS) WERE WRONGLY

ESTIMATED.

3. CAN WE BLAME THE MODELS FOR FAILING BANKS &
HEDGE FUNDS?

§  Banks in recent years were highly levered effecCvely through
securiCzaCon and structured products.
§  Banks were let oten with the residual credit risk.
§  Banks failed to tell their clients about the risks inherent in
some instruments, e.g., aucCon rates.
§  Investment banks were not regulated by Basel requirements.

IV. Concluding Remarks

A Few RecommendaJons for Risk Management
§  Pay aFenCon to assumpCons and esCmaCon procedures.
§  Define the “Risk AppeCte” of the organizaCon and its
willingness to take risks.
§  Understand that for higher average yield the organizaCon must
assume greater risks in general.
§  Avoid complicated financial instruments or schemes, that you

don’t comprehend

§  Always remember-‐you cannot create something from nothing

-‐ check always against the benchmark.
§  During economic crisis the importance of risk management

increases.
§  The importance of transparency.

§  DerivaCves pricing models require a compromise between

realism and tractability.
§  Try to locate where model inaccuracies may lead to the
biggest losses.
§  Stress test the model structure, and not only the
parameter values.
§  Control model drit.
§  IT system is a necessary condiCon to all risk management.

Appendices
-‐The banking sector

-‐The new digital world
-‐More interesJng informaJon


The Banking Sector


–  The banking industry is far more concentrated, complex and
government dependent than at any other Cme in recent
history (Thomas Hoening – Vice Chairman of the FDIC)
1990 – the five largest banks controlled 20% of total assets
2014 – the five largest banks controlled 55% of total assets
JP Morgan assets: $4 trillion (25% of GDP)
The 8 largest G-‐SIBs assets (Global SystemaVcall Important Banks) :
$15 trillion (90% of GDP)


Risk Management in the
New Digital World


Context
Source: CiCgroup

A New Environment: Some Examples

More interesJng informaJon


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Why to Manage Risk ?

I. Historical Background

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§ EliminaCng risk?

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It is a process leading to deﬁne what risks to assume

5/11/21 Copyright © Michel Crouhy & Dan Galai, 2021 13

-­‐ Process of selecCon.

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§ Risk management in pracJce:

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§ Other failures or Risk management:

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5/11/21 Copyright © Michel Crouhy & Dan Galai, 2021 34

§ Key concepts in modern risk management:

5/11/21 Copyright © Michel Crouhy & Dan Galai, 2021 41

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§ All nonﬁnancial companies are exposed to business risk:

5/11/21 Copyright © Michel Crouhy & Dan Galai, 2021 43

Financial Instruments Market Risk Disclosures

5/11/21 Copyright © Michel Crouhy & Dan Galai, 2021 44

Interest Rate Risk Management

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PRICE RISK IN THE TRADING BOOK

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AcCve porwolio = Active

First Class Risk Management

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-­‐ Standard DeviaCon?

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Researcher Theory Risk Measurement

I.  Historical Background

§  EliminaCng risk?

-‐ Process of selecCon.

§  Risk management in pracJce:

§  Other failures or Risk management:

§  Key concepts in modern risk management:

§  All nonﬁnancial companies are exposed to business risk:

-‐ Standard DeviaCon?

§  MODELS ARE BASED ON ASSUMPTIONS.

§  ECONOMIC MODEL ARE BASED OF STATISTICAL PARAMETERS.

§  MODEL CANNOT CANCEL OUT UNCERTAINTY.

§  UNCERTAINTY IS A FACT OF LIFE.

§  SOME POSITIONS ARE HEDGED VIA CORRELATIONS.

§  SOME POSITIONS ARE IN ILIQUID, NONTRADED INSTRUMENTS.

§  SOME PARAMETERS (ESPECIALLY CORRELATIONS) WERE WRONGLY

§  Pay aFenCon to assumpCons and esCmaCon procedures.

§  Avoid complicated ﬁnancial instruments or schemes, that you

§  Always remember-‐you cannot create something from nothing

§  During economic crisis the importance of risk management

§  The importance of transparency.

§  DerivaCves pricing models require a compromise between

-‐The banking sector