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"Confessions of a Risk Manager,” The Economist, 8/7/08
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 1
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Important Concepts in Chapter 15
The concept and practice of risk management
The benefits of risk management
The difference between market and credit risk
How market risk is managed using delta, gamma, vega,
and Value-at-Risk
How credit risk is managed, including credit derivatives
Risks other than market and credit risk
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 2
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Definition of risk management: the practice of defining the
risk level a firm desires, identifying the risk level it
currently has, and using derivatives or other financial
instruments to adjust the actual risk level to the desired
risk level.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 3
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Why Practice Risk Management?
The Impetus for Risk Management
Firms practice risk management for several reasons:
Interest rates, exchange rates and stock prices are
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 4
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Why Practice Risk Management? (continued)
The Benefits of Risk Management
What are the benefits of risk management, in light of
the Modigliani-Miller principle that corporate financial
decisions provide no value because shareholders can
execute these transactions themselves?
Firms can practice risk management more
effectively.
There may tax advantages from the progressive tax
system.
Risk management reduces bankruptcy costs.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 5
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Why Practice Risk Management? (continued)
The Benefits of Risk Management (continued)
By protecting a firm’s cash flow, it increases the
likelihood that the firm will generate enough cash to
allow it to engage in profitable investments.
Some firms use risk management as an excuse to
speculate.
Some firms believe that there are arbitrage
opportunities in the financial markets.
Note: The desire to lower risk is not a sufficient reason
to practice risk management.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 6
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk
Market risk: the uncertainty associated with interest rates,
foreign exchange rates, stock prices, or commodity prices.
Example: A dealer with the following positions:
A four-year interest rate swap with $10 million
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 7
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Delta Hedging
We estimate the delta by repricing the swap and option
with a one basis point move in all spot rates and
average the price change.
See Table 15.2 for estimated swap and option deltas.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 8
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Delta Hedging (continued)
We need a Eurodollar futures position that gains $1,887
if rates move down and loses that amount if rates move
up. Thus, we require a long position of
$1,887/$25 = 75.48 contracts. Round to 75. Overall
delta:
$2,131 (from swap)
= $12 (overall)
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 9
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Gamma Hedging
Here we deal with the risk of large price moves, which
are not fully captured by the delta.
See Table 15.3 for the estimation of swap and option
gammas. Swap gamma is -$12,500, and option gamma
is $5,000. Being short the option, the total gamma is -
$17,500.
Eurodollar futures have zero gamma so we must add
another option position to offset the gamma. We
assume the availability of a one-year call with delta of
$43 and gamma of $2,500.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 10
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Gamma Hedging (continued)
We use x1 Eurodollar futures and x2 of the one-year
calls. The swap and option have a delta of $1,887 and
gamma of -$17,500. We solve the following equations:
$1,887 + x (-$25) + x ($43) = $0 (zero delta)
1 2
-$17,500 + x ($0) + x ($2,500) = $0 (zero gamma)
1 2
Solving these gives x1 = 87.52 (go long 88
Eurodollar futures) and x2 = 7 (go long 7 times
$1,000,000 notional principal of one-year option)
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 11
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Vega Hedging
Swaps, futures, and FRAs do not have vegas.
We estimate the vegas of the options
On our 3-year option, if volatility increases
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 12
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Vega Hedging (continued)
We add a Eurodollar futures option, which has delta of
-$12.75, gamma of -$500, and vega of $2.50 per
$1MM.
Solve the following equations
$1,887 + x (-$25) + x ($43) + x (-$12.75) = 0
1 2 3
(delta)
-$17,500 + x ($0) + x ($2,500) + x (-$500) = 0
1 2 3
(gamma)
-$42 + x ($0) + x ($3.50) + x ($2.50) = 0 (vega)
1 2 3
The coefficients are the multiples of $1,000,000
notional principal we need.
Solutions are x1 = 86.61, x2 = 8.09375, x3 = 5.46875.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 13
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Vega Hedging (continued)
Any type of hedge (delta, delta-gamma, or delta-
gamma-vega) must be periodically adjusted.
Virtually impossible to have a perfect hedge.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 14
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR)
A dollar measure of the minimum loss that would be
expected over a given time with a given probability.
Example:
VAR of $1 million for one day at 0.05 means that
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 15
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
VAR calculations require use of formulas for expected return and
standard deviation of a portfolio:
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 16
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
Three methods of estimating VAR
Analytical method: Uses knowledge of the parameters
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 17
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
For a weekly VAR, convert these to weekly figures.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 18
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
volatility is 0.0412.
Upside 5 % is 0.0095 + 1.65(0.0412) = 0.0775, which is
720(1.0775) = 775.80.
Option would be worth 775.80 - 720 = 55.80 so loss is
VAR.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 19
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
One assumption often made is that the expected return
is zero. This is not likely to be true.
Sometimes rather than use the precise option price from
a model, a delta is used to estimate the price. This
makes the analytical method be sometimes called the
delta-normal method.
Volatility and correlation information is necessary. See
the web site www.riskmetrics.com, where data of this
sort are provided free.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 20
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
Historical method: Uses historical information on the
user’s portfolio to obtain the distribution.
Example: See Figure 15.2. For portfolio of $15
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 21
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
Monte Carlo Simulation method: Uses Monte Carlo
method, as described in Appendix 14, to generate
random outcomes on the portfolio’s components.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 22
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
A Comprehensive Calculation of VAR
We do an example of a portfolio of $25 million in
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 23
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
A Comprehensive Calculation of VAR (continued)
Analytical method: We have 0.0457% − (1.65)1.3327%
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 24
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
A Comprehensive Calculation of VAR (continued)
Historical method: Here we rank the returns from
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 25
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
A Comprehensive Calculation of VAR (continued)
Monte Carlo simulation method: We shall use an
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 26
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
A Comprehensive Calculation of VAR (continued)
Monte Carlo simulation method (continued): We do
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 27
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
A Comprehensive Calculation of VAR (continued)
So VAR is estimated to be either
• $538,325
• $377,150
• $524,225
• $348,550
Key considerations: wide ranges such as this are
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 28
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
Benefits and Criticisms of VAR
Widely used
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 29
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Market Risk (continued)
Value-at-Risk (VAR) (continued)
Extensions of VAR
Stress testing
Conditional VAR: expected loss, given that loss exceeds VAR. In S&P
with assets that generate cash but for which a market value cannot easily
be assigned.
• Example: expected cash flow of $10 million with standard deviation
of $2 million. CAR at .05 would be 1.65($2 million) = $3.3 million
because
Prob[$10 million − $3.3 million > Actual Cash Flow]
= 0.05.
– Note: CAR is a shortfall measure.
Earnings at Risk (EAR): measures earnings shortfall.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 30
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 31
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk (continued)
Option Pricing Theory and Credit Risk
Here we use option pricing theory to understand the
nature of credit risk. Consider a firm with assets with
market value A0, and debt with face value of F due at T.
The market value of the debt is B0. The market value
of the stock is S0.
See Table 15.5 for the payoffs to the suppliers of
capital. Note how the stock is like a call option on the
assets. Its payoff is
Max(0,A – F)
T
Using put-call parity, we have
P = S – A + F(1 + r)-T
0 0 0
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 32
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk (continued)
Option Pricing Theory and Credit Risk (continued)
This put is the value of limited liability to the stockholders.
Rearranging, we obtain S0 = A0 + P0 – F(1 + r)-T. But, by definition,
S0 = A0 – B0. Setting these equal, we obtain
B = F(1 + r)-T – P .
0 0
Thus, the bond subject to default risk is equivalent to a risk-free
bond and a put option written by the bondholders to the
stockholders.
The Black-Scholes-Merton formula adapted to price the stock as a
call would be rc T
S0 A 0 N(d1 ) Fe N(d 2 )
Using B0 = A0 – S0, we can obtain the value of the bonds.
B0 Fe rcT N(d 2 ) A 0 (1 N(d 2 ))
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 33
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk (continued)
Credit Risk of Derivatives
Current credit risk is the risk to one party that the other
will be unable to make payments that are currently due.
Potential credit risk is the risk to one party that the
counterparty will default in the future.
In options, only the buyer faces credit risk.
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.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 34
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk (continued)
The Credit Risk of Derivatives (continued)
Potential credit risk is largest during the middle of an
interest rate swap’s life but due to principal repayment,
potential credit risk is largest during the latter part of a
currency swap’s life.
Typically all parties pay the same price on a derivative,
regardless of their credit standing. Credit risk is
managed through
limiting exposure to any one party (primary method)
collateral
periodic marking-to-market
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 35
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk (continued)
Netting
Netting: several similar processes in which the amount of cash
owed by one party to the other is reduced by the amount owed by
the latter to the former.
Bilateral netting: netting between two parties.
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 36
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk (continued)
Netting (continued)
Netting by novation: net value of two parties’
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 37
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk (continued)
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 38
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk (continued)
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 39
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Managing Credit Risk (continued)
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 40
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Synthetic CDO
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 41
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Other Types of Risks
operational risk (including inadequate controls)
model risk
liquidity risk
accounting risk
legal risk
tax risk
regulatory risk
settlement risk
systemic risk
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 42
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Summary
Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 15: 43
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