Market Risk Petar Marković May 2013. Lecture Topics This session will cover: 1.Basics of financial markets and financial risk 2.Market risk concepts:

Market RiskPetar Marković

May 2013

Lecture Topics

This session will cover:

1. Basics of financial markets and financial risk

2. Market risk concepts:

a) Risk factors

b) Risk measures: Greeks, VaR, stress tests

c) Hedging

3. Role of regulation

Basics of Financial Markets

Basics of Financial Markets

Participants:

• Corporations – to raise capital, buy/sell their inputs/outputs, acquire assets or competitors, hedge their risks

• Governments – to raise capital, stabilize and stimulate the markets

• Banks – to facilitate transactions between other participants at a profit

• Pension funds and insurance companies – for long term investments

• Other funds and individuals – usually for speculation

Basics of Financial Markets (2)

Main markets and products:

• Equity – stocks, options

• Interest Rate Products (IRP) – government bonds, forward rate agreements, swaps

• Credit – corporate bonds, credit default swaps, collateralized debt obligations

• Foreign Exchange (FX) – spot currency, forwards, options

• Commodities – futures, forwards, swaps, options

Basics of Financial Markets (3)

Methods of trading:

• Exchanges – rules of trade are defined and contracts are standardized; prices are public for all contracts

• Over the Counter (OTC) – rules depend on the agreement between the counterparties and contracts do not have to be standardized; prices are not disclosed

Financial Risk

Basics of Financial Risk

Financial Risk

Liquidity Risk

Market Risk

Credit RiskOperational Risk

Reputational Risk

Basics of Financial Risk - Liquidity

• Liquidity Risk - is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss or make the required profit

• Major reason why banks and financial institutions fail (default or go bankrupt) is because they run out of liquid assets (cash, government bonds) and are unable to meet the current obligations. Failure to pay leads to a default.

• A corporation can have a positive net worth and still default

Total Assets Total Liabilities Current Cash Current LiabilitiesTime

Value

DEFAULT

Basics of Financial Risk – Market Risk

• Market Risk - is the risk of losses in positions arising from movements in market prices

Basics of Financial Risk - Credit

• Credit Risk – is the risk of a borrower failing to make obligated payments on time and the risk of a borrower reducing ability to make payments in the future

• Credit ratings are the most basic form of credit risk assessment. Companies providing credit ratings like Standard & Poor’s, Moody’s and Fitch use historical default statistics with balance sheet analysis. This is backward looking approach.

• Using information from the CDS market (if available) is forward looking and represents what market participants think is the probability of default on debt for a particular company.

Basics of Financial Risk – Operational Risk • Operational Risk - the risk of loss resulting from inadequate or

failed internal processes, people and systems, or from external events

Event Categories

Internal Fraud

External Fraud

Employment Practices

Clients, Products and

Business Practices Damage to

Physical Assets

Business Disruption &

System Failures

Execution, Delivery and

Process Management

Basics of Financial Risk – Reputational Risk

• Reputational Risk - risk related to the trustworthiness of business and ability to keep existing and attract new clients

Basics of Financial Risk – Example

• You are an EUR-based investor.

• You buy an at-the-money European call option on BP (British Petroleum) on NYSE

• You sell an at-the-money European put option on BP to CitiBank over the counter

• What risks are you running?

• Market:

• Equity – on BP spot price moves

• Interest Rates – option is priced using discounting of cash flows, so interest rates move the option price

• Commodity (indirect) – BP spot price is highly correlated to oil prices

• Credit – CitiBank may not be able to pay on expiry if your option is in the money and they are in default

• Liquidity – you need to fund your position

• Operational – always present with any transaction

• Reputational – Depends on the situation. Why are you buying BP?

Market Risk

Who is exposed to Market Risk?

• Every investor, producer and consumer is exposed to market risk (to a different degree)

• Example:

• You are a Serbian producer of X using local resources and local labour.

• Your major competitor is in China, and he produces X at a 50% lower price including transport.

• You are competing in the Serbian market and your competitor starts taking over market share.

• What do you do?

a) Price war – you lower your prices and sell at a loss until you drive the competition out, but you may go bankrupt in the process

b) Buy your competitor – you will put on a large amount of debt or risk your own funds

c) Try to negotiate – competitor must agree for you to be the distributor; you can start a monopoly or price fixing which causes legal issues

d) Sell your business and close the shop – the last resort of any entrepreneur

e) Alternatives?

Market Risk - Background

• Why do we care about market risk?

• We want to know how much money we can lose each day

• so we can hedge the exposures we are not comfortable with

• (and hope that our calculations are right!)

• Evolution of market risk:

• Exposure

• Greeks (Delta, Gamma, Vega, Theta...)

• VaR and Stress test

• Major assumptions:

• Historical moves are a good indicator of future moves

• Markets are efficient and pricing instruments correctly

Main Risk Factors – Spot and Forward Price

• Spot Price: The current price at which a particular security can be bought or sold at a specified time and place.

• Forward Price: The predetermined delivery price for an underlying commodity, currency or financial asset decided upon by the buyer and the seller to be paid at predetermined date in the future.

EXXONMOBIL CORPORATION (NYSE:XOM) STOCK PRICE MAY 2012 – MAY 2013

Main Risk Factors – Volatility

• Volatility is commonly expressed through standard deviation of returns assuming Normal Distribution. It is used for pricing options using Black-Sholes and other pricing models and for pricing other derivatives.

• Historical volatility takes the actual returns of an asset during a defined period (i.e. a year) and it is backward-looking.

• Implied volatility is taken from the markets by using market option prices and back-solving for volatility. It is forward-looking from market expectation.

Black-Scholes pricing formula of a European call option premium:

Main Risk Factors – Correlations

• “Don’t put all eggs in one basket”

• Diversification helps improve portfolio performance by reducing the risk on same expected returns

• Correlations are not constant. They change the risk and return of portfolio.

• Correlations increase in the times of financial stress and crises.

Risk Measures - Exposure

• Quantity: Knowing the quantities of each financial instrument in the portfolio is the first step in the valuation.

• Price: Price of each instrument can be determined from the published market prices where these are available (i.e. Price of IBM stock can be read from the exchange) or by using the pricing model to determine the theoretical price.

• Total portfolio value is determined by calculating Price * Quantity for each instrument in the portfolio

Risk Measures - Greeks

• Risk measures that describe how much a portfolio value changes when the underlying risk factor changes by a set value. They are used by traders to asses their positions (exposures) and risk.

• Delta: Change in portfolio value if a stock increases price by 1$.

• Gama: Change in Delta if a stock increases price by 1$.

• Vega: Change in portfolio value for a 1 percentage point increase in Volatility

• Theta: Change in portfolio value for a 1 day change in time.

• Greeks give a good linear approximation of changes in portfolio value for linear instruments and for smaller market moves.

Risk Measures - VaR

Value at Risk or VaR is a statistical measure of how much money can be lost on a portfolio in given period of time with a given confidence level.

• What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next month?

• If 95% 1-day VaR of your portfolio is $100k, it means that:

• statistically in the next 95 out of 100 days your losses will be limited to $100k

• statistically in the next 5 out of 100 days you will lose more than $100k

Simple formula to calculate linear VaR based on the Normal distribution:

•σ is the standard deviation of portfolio returns•MV is the market value of portfolio

Risk Measures – VaR (2)

• VaR can be back-tested to measure the quality of profit and loss (PnL) estimation.

• The number of VaR breaches is compared to the confidence level on the period:

• I.e. You expect to have 5 breaches in any 100-day period for the below graph

02/11/201217/09/201231/07/201213/06/201224/04/201205/03/201212/01/201222/11/201105/10/201118/08/201101/07/201116/05/2011

-500,000.00

-400,000.00

-300,000.00

-200,000.00

-100,000.00

0.00

100,000.00

200,000.00

300,000.00

400,000.00

500,000.00

Šajkaška fabrika šećera a.d. - Linear 1-day 95% VaR brackets with PnL

Profits and Losses Upside VaR Downside VaR

Risk Measures – Stress Testing

• Stress tests are ‘what-if’ analysis tools which show the impact of changes in risk factors to the value of the portfolio

• Typically, there are two types of stress tests that financial institutions run:

• Sensitivity test: focuses on a single risk factor and explains pre-defined movements. I.e. How much does portfolio value change if USD/EUR changes +5%, -5%, +10%, -10%, etc.

• Scenario test: focuses on multiple risk factors and explains custom movements. I.e. How much does portfolio value change if market crash of 2008 would happen again in the next month

Hedging Market Risk

Ways to change market risk exposure:

• Change exposure – buy or sell the assets to change the risk. Selling your portfolio in the market and converting it into cash removes almost all market risk.

• Hedge – you pay (or receive) the premium for hedging the risk. Typical instruments used are options for Equities, FX, Commodities and IRP and credit default swaps in Credit

• Convert – enter into a swap, go into a structured trade which removes one exposure and replaces it with another one (long and short) or make an opposite position in a correlated asset

A bank will always run market risk as a nature of the business. The efficiency and cost of hedges will determine the profitability.

A corporation should hold only the market risk related to it’s operations.

Role of Regulators

• Market stability and (de)stimulation – regulations are put in place to reduce excessive risk taking and prevent large company failures; regulations can stimulate or de-stimulate the markets

• Disclosure of positions and risks – companies are mandated by law to disclose significant and large investments to the public

• Enforcement of risk limits – companies pay penalties and publicly disclose breaches of risk limits (loss of reputation)

• Bureaucracy – the cost of regulation to the companies significant

Popular Media

Movies:

• Margin Call (2011)

• Too Big to Fail (2011)

• Wall Street (1987, 2010)

• Inside Job (2010)

Books:

• “The Big Short: Inside the Doomsday Machine “, Michael Lewis (2010),

• “When Genius Failed: The Rise and Fall of Long-Term Capital Management”, Roger Lowenstein (2001)

• “Liar’s Poker”, Michael Lewis (1989)

Professional Literature

Market risk:

• “Market Risk Management”, David C. Shimko, Peter Went, GARP (2010)

• “Risk Management and Financial Institutions”, John Hull (2012)

• “Elements of Financial Risk Management”, Peter F. Christoffersen (2011)

Financial basics:

• “Options, Futures, and Other Derivatives “, John C. Hull, (2011)

Questions