Topics covered The concept and practice of risk management Types of risks An Introduction to Risk Management Financial Risks: definition Basic stat review Value at Risk (VaR): Basics Value at Risk (VaR): Motivation & Definition Financial Risk Management Nattawut Jenwittayaroje, Ph.D., CFA Value at Risk (VaR): Three methods of VaR calculation NIDA Business School National Institute of Development Administration Benefits and extensions of VaR 1 2 Why Practice Risk Management? Definition of risk management: the practice of defining the The Motivation for Risk Management risk level a firm desires, identifying the risk level it currently Firms practice risk management for several reasons: has, and using derivatives or other financial instruments to Interest rates, exchange rates and stock prices are more volatile today than in the past. These factors create risks over which most businesses have little adjust the actual risk level to the desired risk level. expertise. Therefore, it makes sense for a business to manage and largely eliminate these risks. Significant losses incurred by firms that did not practice risk management Improvements in information technology – without enormous developments in computing power, it would not have been possible to do the complex calculations necessary for pricing derivatives and for keeping track of positions taken. Favorable regulatory environment – the growth of derivatives (i.e., main tools for managing risks) was fueled by the favorable regulatory environment. 3 4 Risks of Financial Intermediation Risks of Financial Institutions Interest rate risk resulting from intermediation: Mismatch in maturities of assets and liabilities. The risks associated with financial intermediation: Interest rate sensitivity difference exposes equity to changes in Interest rate risk interest rates Market risk Financial Risk Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs. Credit risk Inconsistent with asset transformation role Operational risk Refinancing risk Liquidity risk The risk that the cost of rolling over or reborrowing funds (e.g., deposits) will rise above the returns being earned on asset investments Legal and regulatory risk (e.g., loans) Reinvestment risk. The risk that the returns on funds to be reinvested (e.g., making loans) will fall below the cost of funds (e.g., deposits) 5 6 Market Risk Credit Risk Incurred in trading of assets and liabilities (and derivatives). Examples: Barings & decline in ruble. Risk that promised cash flows are not paid in full. 1995 Barings Bank, forced into insolvency due to losses on its Firm specific credit risk trading in Japanese stock index futures Systematic credit risk 1996 Sumitomo Corp. lost $2.6 billion in commodity futures trading 1997 market volatility in Eastern Europe and Asia Credit risk is the oldest form of risk in the financial 1998 losses on Russian bonds and Ruble currency: Big US banks institutions. have to write off hundreds of millions of dollars in losses on their holdings of Russian government securities DJIA dropped 12.5 percent in two-week period July, 2002. Heavier focus on trading income over traditional activities increases market exposure. 7 8 Operational Risk Liquidity Risk Liquidity risk is the risk that a sudden surge in liability BIS definition: Risk of losses resulting from inadequate or failed internal processes, people, and systems or from withdrawals may leave a bank in a position of having to external events. liquidate assets in a very short period of time and at low prices. Operational risk is the risk that existing technology or support systems may malfunction or break down. May generate runs. Power failures, computer problems such as viruses, the failure Runs may turn liquidity problem into solvency problem. of staff personnel to monitor and record transactions properly, Risk of systematic bank panics. etc.. However, operational risk losses do not occur often (but can lead to tremendous losses), so it is difficult to do the analysis. 9 10 Legal and Regulatory Risks Financial Risks Market risk is the uncertainty of a firm’s value or cash flow that is Legal risk is the risk that the legal system will fail to enforce associated with movements in an underlying source of risk (e.g., interest a contract. rates, foreign exchange rates, stock prices, or commodity prices). E.g., interest rate risk faced by financial intermediary, FX risks faced For example, suppose a dealer enters into a swap with a by FX dealers, oil price risks faced by oil distributors, and stock price counterparty that, upon incurring a loss, then refuses to pay risk faced by equity fund managers. the dealer, arguing that the dealer misled it or that the However, because many sources of risk are partially correlated, the counterparty had no legal authority to enter the swap. combined effects of all sources of risk must be considered. Credit risk is the uncertainty and potential for loss due to a failure to pay on the part of a counterparty. It is the risk that promised cash flows Regulatory risk is the risk that regulations will change. are not paid in full. Regulatory risk means that certain existing or contemplated Credit risk (or default risk) of loans faced by any lender, and credit transactions can become illegal or regulated. risk of derivatives, i.e., the risk of default faced by any party that may receive obligation payments from another party. 11 12 Basic Stat Review Basic Stat Review (Con’t) Want to know the height of Thai population Want to know the height of Thai population (con’t) Sort from the lowest to the highest Randomly select 100 people and measure each person’s height What is the average height of Thai people? What is the standard deviation of height of Thai people? How many people have height below 161? 15 people What is the percentage of people having height below 161? How many people have height below 161? 15 from 100 people 15% What is the percentage of people having height below 161? 13 14 Basic Stat Review (Con’t) Value at Risk (VaR) Basics Want to know the height of Thai population (con’t) Want to know the risk of my stock portfolio…. How many people have height above 185? For example, I now have 100,000 shares of AA stock @$10 What is the percentage of people having height above 185? each. So my portfolio is now worth $1,000,000. How many people have height between 161 and 185? What is the percentage of people having height between 161 What is the probability that tomorrow (i.e, one day later) my and 185? portfolio will be worth below $930,000? About 5% of people have height below………………? There is 5% chance that tomorrow (i.e, one day later) my About 95% of people have height at least………………? portfolio will be worth below $xxxxxx? 15 16 Value at Risk (VaR) Basics (Con’t) Value at Risk (VaR) Basics (Con’t) Want to know the risk of my stock portfolio…A Better Way Want to know the risk of my stock portfolio…. Collect data of AA share price over the recent past 100 days; Collect data of AA share price over the recent past 100 days as follows.. Compute daily return of AA share price over the recent 100 days.. Sort the data from the smallest price to the highest price.. (price at 4Jun – price at 3Jun)/price at 3 Jun = (9.57-9.33)/9.33 What is the probability that tomorrow (i.e, one day later) my portfolio will be worth below $930,000? Sort the 100 daily returns from the smallest to the highest.. There is 5% chance that tomorrow (i.e, one day later) my portfolio will be worth below $xxxxxx? 17 18 Value at Risk (VaR) Basics (Con’t) Value at Risk (VaR): Motivation Want to know the risk of my stock portfolio…. Starting Point: “At close of business each day, tell me There is 5% chance that tomorrow (i.e, one day later) my what the market risk are across all business and portfolio will be worth ? $993,000 below $xxxxxx locations” In a nutshell, A chairman wants a single amount Equivalently, there is 5% chance that tomorrow (i.e, one day dollar later) my portfolio will lose more than $7,000 at 4.15pm that tells him JPM’s market risk exposure over the next day – especially if that day turns out to be Value at Risk - VaR a “bad” day. If tomorrow turns out to be a bad day, how much will we make loss? 19 20 Value at Risk (VaR) defined Value at Risk (VaR) defined (Con’t) A dollar measure of the minimum loss that would be Equivalently, Value at Risk can be defined as the expected over a given time with a given probability. maximum loss that might be expected from holding a security or portfolio over a given period of time (say, a Example: single day), given a specified confidence level. for at means that the firm VAR of $30,000 one day 5% VAR of $30,000 for one day at 95% confidence level could expect to lose at least $30,000 over a one day means that the firm could expect to lose no more than period 5% of the time. $30,000 over a one day 95% of the time. 21 22 Calculating VaR (I) Historical method Historical method: Uses actual data from a recent historical Three methods of estimating VAR period to determine the VaR. (I): Historical Method (or Back Simulation approach) Specifically, the historical method estimates the distribution of the portfolio’s performance by collecting data on the past (II): Analytical Method (or Variance/Covariance approach) performance of the portfolio and using it to estimate the future probability distribution.