2010 10-22 webb rym financial training examples

RYM Finanskonsult AB

How to Manage Financial Risks

Knowing Understanding

Analyzing Living

Organization and Culture

Business and Instruments

Risk measures and Pricing

Performance Measurements


Knowing Understanding Analyzing Living

How to Manage Financial Risks

Organization and Culture

Business and Instruments

Risk measures and Pricing

Performance Measurements

Markets

Loans/Dep.

FRA’s

Swaps

Bonds

Futures

Options

Culture

Organization

Policy

Limits

Processes

Risk taking

Risk control

Value-at-Risk

Forwards

R A P M Management

Market

Operational

Business

Credit

Risk Capital

Profit/Loss

Mark.values

Diversify

WACC

CAPM

Valuation

Cash flows

Hedging

Pricing


FX Markets

• Governments• Central banks• Financial institutions• Multinational corporations• Currency speculators / Arbitrageurs

In the Foreign Exchange (FX) markets are currencies traded for other currencies. Its by far the largest financial market in the world. Market participants are:


Loan

The loan giver ( a bank normally) issues a “loan” to a customer with a given amount, interest rate and term. Often does the loan giver require a “collateral” as a security for the loan.

3-year loanAmort type: Straight/QuarterlyLoan amount: 28 000 000Interest rate: 5,50%Coupon frequency: QuarterlyCoupon base: Actual/365Interest rate reset NoStart day 2007-10-01Maturity day: 2010-09-30

01 2 3 4 12


Gap analysis

DateInterest

paymentAmort

PaymentLoan

paymentSum

LoansCum.

Loans2008-01-01 0 0 1 000 000 1 000 000 1 000 0002008-03-31 -24 658 -83 333 0 -107 991 892 0092008-06-30 -47 511 -83 333 1 000 000 869 155 1 761 1642008-09-30 -46 210 -83 333 -129 543 1 631 6212008-12-31 -44 110 -83 333 -127 443 1 504 1782009-03-31 -41 096 -83 333 -1 000 000 -1 124 429 379 7492009-06-30 -14 543 -83 333 -97 877 281 8722009-09-30 -12 603 -83 333 -95 936 185 9362009-12-31 -10 502 -83 333 -93 836 92 1002010-03-31 -8 219 -83 333 -91 553 5482010-06-30 -6 233 -83 333 -89 566 -89 0182010-09-30 -4 201 -83 333 -87 534 -176 5532010-12-31 -2 100 -83 333 -85 434 -261 986


Gap analysis

-1 500 000

-1 000 000

-500 000

0

500 000

1 000 000

1 500 000

2 000 000

2008-01-01

2008-03-31

2008-06-30

2008-09-30

2008-12-31

2009-03-31

2009-06-30

2009-09-30

2009-12-31

2010-03-31

2010-06-30

2010-09-30

2010-12-31

Sum Loans Cum. Loans


Present ValueThe present value of a certain amount of money is greater than the right of receiving the same amount at time (t) in the future.

PV today > PV Future

PVt > PVt + 1

If you got 1.000 Dollars today what must the future amount in 1 year be if the Investment should be attractive? The Investors Hurdle rate is 10 %

1000 + (1000x10%) = 1 100

To get 1.100 Dollars in 1 year is equal with having 1.000 Dollars today


Bonds

• Bills – Normally less than 3 years• Notes – Smaller issues• Bonds – Long term securities issued to a wider public

A Bond is a debt security, in which the issuer (borrower) owes the holder a debt and is obliged to pay interest (coupon) and to repay the principal amount at a decided date.

A Bond is simply a loan that has been formed into a security and is tradable in the secondary market.


Bond Valuation

The market value of a ordinary straight Bond is determined by discounting the expected cash-flows of the bond to their present value using a appropriate discount rate (Zero Coupon rates).

P = Market Value or PriceC = CouponF = Face Value or Principal amountT = Time periods


Fixed rate BondA fixed rate Bond (also called straight bonds) gives a periodic interest payments (coupons) during the time to maturity.

Fixed Rate BondPrincipal amount 1 000 000Coupon 10,00%Coupon frequency YearlyCoupon base 360/360Issue date: 2008-01-01Maturity date: 2012-12-31


Period/ Year Cash-flow PV-factor

Present Value

PV-WeightDuration

1 100 000 0,90909 90 909 0,091 0,092 100 000 0,82645 82 645 0,083 0,173 100 000 0,75131 75 131 0,075 0,234 100 000 0,68301 68 301 0,068 0,275 1 100 000 0,62092 683 013 0,683 3,42

Sum: 1 500 000 1 000 000 1,000 4,17

Macaulay Duration price sensitivity0,25% increase in yields

Period/ Year Cash-flow PV-factor

Present Value

PV-WeightDuration

1 100 000 0,90703 90 703 0,092 0,092 100 000 0,82270 82 270 0,083 0,173 100 000 0,74622 74 622 0,075 0,234 100 000 0,67684 67 684 0,068 0,275 1 100 000 0,61391 675 305 0,682 3,41

Sum: 1 500 000 990 583 1,000 4,17

990 583 – 1 000 000 = -9 417

To use Macaulay Duration as a tool for measuring price sensitivity was a good start but soon did the Market need more precise solutions

-4,17 x 1 000 000 x 0,25% = -10 425

With 0,25% increase in yields


Gap-analysis Business case 2 UAB Pinigus

-30 000 000

-20 000 000

-10 000 000

0

10 000 000

20 000 000

30 000 000

Cash changes Sum Deposit Bond Sum Loans Cumulative Gap


Forward Rate Agreement’s

• It’s a Notional contract with no exchange of principal (its netted) at settlement date

• The fixed rate (or the FRA rate) is the rate at which the contract is agreed on

• The reference rate (normally LIBOR) is the rate that will be decided at a future time

• The netted interest payments is paid on termination date• A combination of FRA´s is a Interest rate swap

The FRA is an interest rate contract. It locks in an interest rate (fixed rate), either a borrowing rate (buying) or a lending rate (selling) for a specific period in the future.


Interest Rate Swaps

A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

The “vanilla” IRS is a derivative in which one party’s exchanges a stream (legs) of fixed interest payments for an others party’s floating payments. Normally are no Principals exchanged!


Stocks /Shares

• Ordinary shares with full dividend rights and full voting right (A-share)

• Ordinary shares with full dividend rights but fractional or no voting rights (B-share)

• Preference shares with dividend priority

A share of stock represents a share of ownership in a corporation. The main types of shares are:


Futures Contracts

• Available on a wide range of underlyings• Exchange traded• Specifications need to be defined:

• What can be delivered,• Where it can be delivered, & • When it can be delivered

• Settled daily

A Future contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. The future gives the holder the obligation to buy or sell the underlying asset.


Stock loans

• Stock loans can be used to • Cover a delivery• Hedge a position• To go short in the market

The Stock loans product gives shareholders an opportunity to lend his shares to a borrower. The borrower has to return the same amount of shares to the lender after a certain time. The lender receives a premium for this.


Stock-options

• Insurance / hedge• Speculative or arbitrage

The option entitles the owner the right (but not obligation) to buy (call) or sell (put) an underlying asset (stock, bond etc.) at a predetermined price (exercise or strike) on a future day (European) or within a future period (American)

The options are used for following purposes:

The premium is normally paid as a flat fee and up front at the beginning of the option – which makes the options attractive for sellers


The Black-Scholes formulae

C = value of Call Option andS = Stock PriceK = Strike Prices = VolatilityT = Time to expirationr = Risk-Free Interest Rate

An Stock option value as shown by the Black-Scholes Option Pricing Formula is exposed to movement in several variables:

The pricing formula for stock options are adjusted for stock dividends, if they are expected until exercise.

C = ƒ(S, K, , T, r) s


Underlyingprice

IntrinsicValueTime

Value

Price at expiry

Price before expiry

The option price before expiry

Callprice

Strikeprice

Out-of-the-money In-the-money


Types of Strategies

• Take a position in the option and the underlying

• Take a position in 2 or more options of the same type (A spread)

• Combination: Take a position in a mixture of calls & puts (A combination)


Delta Hedging

• Delta (D) is the rate of change of the option price with respect to the underlying

Optionprice

A

BSlope = D

Stock price


Caps and Floors

• Cap is a protection for increasing Interest rates• Floor is a protection for decreasing Interest

rates• Caps/Floors are like a option on a series of

FRA’s• Caps = Calls• Floor = Puts• The issuer pays the difference (spread)

between the fixed rate and the reference rate• Buyer pays a premium


Swaptions

• Option on a Interest rate Swap• Gives the holder the right to buy or

sell a Swap• Is a insurance against low or high

interest yields• The buyer pays a premium


FX Outright

• Settlement (delivery) date• Exchange rate (forward price)• Currency pair and amounts• Payment instructions

An FX Outright (synonym Forward) is a trade made today but with delivery more than 2 days in the future. The conditions in the deal must consist of:

The Outright prices are decided by current existing FX spot-rates and MM interest rates


Yield curvesThe break-down of the Bretton woods system initiated an era of floating currency rates, which made life complicated for bond traders. Marty Liebowitz at Salomon Brothers (US Investment Bank) started in mid 1970s to draw a curve through all yields instead of think of each maturity as a separate market place.

3,50%

3,75%

4,00%

4,25%

4,50%

4,75%

5,00%


Upward-Sloping Yield Curve


The advantage for No-arbitrage models are that they reflect the actual market prices but their problem is badly behaving forward rates. This is a problem for economists.

Yield curves @ 1995-12-15by Boothstrapping

7,60

7,80

8,00

8,20

8,40

8,60

8,80

9,00

9,20

9,40

9,60

15-jun-94 28-okt-95 11-mar-97 24-jul-98 06-dec-99 19-apr-01 01-sep-02 14-jan-04 28-maj-05 10-okt-06

3M Forward Zeros

Spot Zeros

Curve from No-arbitrage model


Value-at-Risk

• Variance / Covariance method (Risk Metrics)• Historical Simulation• Stochastic Simulation (Monte Carlo)


Advantages of VaR

• It captures an important aspect of riskin a single number

• It is easy to understand• It asks the simple question: “How bad

can things get?”


Monte Carlo VaR

0

5

10

15

20

25

30

35

40

-5 -4.5 -4 -3.5 -3 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

P/L (MSEK)

Frequency

88

90

92

94

96

98

100

102

104

106

108

110

1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97

Tillgång 1 Tillgång 2

Tillgång 3 Tillgång 4

Simulated prices Price distribution


Stress Testing

• This involves testing how well a portfolio would perform under some of the most extreme market moves seen in the last 10 to 20 years


Credit Risk Measurement


Credit VaR

• Can be defined analogously to Market Risk VaR

• A one year credit VaR with a 99.9% confidence is the loss level that we are 99.9% confident will not be exceeded over one year


•Capital allocation

•Strategic Decision-Making

•Support for control environment

•Enhancement of risk finance and

• Insurance programs

•New business

Objectives of Operational Risk Capital


Histogram, Frequency of eventsFrequency

-∞Severity (log scale)0+∞

Internal data

External data from Peer companies

SAS Institute “Public” data (20 Years)

Loss data

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

0 500 1 000 1 500 2 000 2 500 3 000 3 500 4 000 4 500 5 000

Severity, MSEK

Pro

bab

ilit

y

Choice for data modelling the 99.9th percentile


Risk Adjusted Performance Measurements

Profit and Loss Risk adjusted Capital

= R A P M

How to transform our Risk Measurements into Capital?


Market Risk Capital

VaR Capital Multiplier

Economic Capital * =

Adjustment Factor *

A result from back testing is a calibration of

VaR to observed P&L

• Convert from daily to annual horizon

Calculated by a simulation model:

• Management intervention

• Solvency standard


Capital Asset Pricing Model

The formula also calculates the assets sensitivity for non-diversifiable market risk (Beta-value)

Determines the expected rate of return (Er) of an asset if it is to be added on an already well-diversified portfolio, given the assets non-diversifiable risk. It’s a model for pricing a singular asset or a portfolio

Government Long Bond Beta Value

Risk Premium

)( fmf rrrCoE = Er -+= b

CoE = Cost of Equity


The Weighted Average Cost of Capital WACC

• We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm.

• This “average” is the required return on our assets, based on the market’s perception of the risk of those assets

• The weights are determined by how much of each type of financing we use


Managing Operational risk

• Inadequate Information systems and technology

• Non-compliance with Laws and regulations

• Fraud and illegal acts from Management and staff

• Weak internal controls

• Environmental factors• Reputation• Suppliers failure• Natural disasters• Criminal acts

The risk that the following conditions or events result in losses or reduced confidence for the company:


Fraud

Société Genéral

e

Business-Interruption

Litigation

Nat West

LTCM

ReputationLoss

Baringsbank

SettlementLosses

SupplierFailure

Mispriced Portfolios

IneffectiveProcedures

Examples of Operational Threats


Tools for identifying and managing operational risks

• Self assessments • Operational risk self assessment• Rogue trading self assessment

• Incident management• Key risk indicators • New product approval procedure• Business process analysis• Audit findings • Business continuity planning • Employee attitude study

• Operational risk management information system


Handling of operational risks from a management perspective

• Build a culture in the organisation that promote operational risk management

• Make operational risk management a natural part of the business plan

• Focus on findings from tools used• Take action on identified risks• Yearly assessment and internal rating of units• Operational Development Processes (ODP)• “Governance” project


Driving a culture of operational risk into the business

• Management commitment• Common framework• Usage of common tools for identifying risks• Involvement and education of all staff

• open minded attitude• promote reporting

• Show benefits for the organisation – “What’s in it for me” • Action plans and follow up


Lessons from Leeson

2010 10-22 webb rym financial training examples

Documents

rym finanskonsult ab

market value

fixed rate bond principal

loan giver

risk control value

face value

straightquarterly loan

coupon rates