risk management jan röman om technology securities systems ab
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Types of Risk
Credit risk Market risk Liquidity risk
Settlement risk Operation risk Legal risk
The risk that the counterpart will fail to fulfill his
obligation.
The risk that movement in prices will result in loss.
One part may not be able to transfer a position quick
enough at a reasonable price. Unable to hedge.
The risk that the counterpart can´t deliver the
instruments at the expected time.
The risk for losses due to human or system errors.
The risk for losses due to the contracts are not
legally enforceable or documented correctly.
Technology Risk Credit Risk Regulatory Risk
Basis Risk Market Risk Tax Risk
Political Risk Accounting Risk Interest Rate Risk
Suitability Risk Prepayment Risk Legal Risk
Optional Risk Volatility Risk Capital Risk
Personnel Risk Reinvestment Risk Daylight Risk
Concentration Risk Netting Risk Liquidity Risk
Contract Risk Currency FX Risk Bankruptcy Risk
Systems Risk Commodity Risk Collateral Risk
Limit Risk Equity Risk Modelling Risk
Rollover Risk Call Risk Cross-market Risk
Hedging Risk Yield Curve Risk Systemic Risk
Interpolation Risk Curve Fitting Risk Time Lag Risk
Extrapolation Risk Raw Data Risk Knowledge Risk
Derivatives and Risk
Derivatives = Financial instruments/contracts with values derived from the price of the underlying instrument. Designed to transfer and isolate risk. They play a valuable rule for users at the marketplace.
Sources of Financial Risk
Unexpected Underlying price changes Unexpected Exchange rate changes Unexpected Interest rate changes Unexpected Share value changes
In all cases the changes are unexpected!
Techniques for Managing Risk
On-balance-sheet transactions
loans, bonds, stocks and deposits.
Forecasting
Diversification
holding many non-correlated instruments.
Hedging with derivatives
Hedging with derivatives
Call option = C(S, K, T, r, ) Models
Put option = P(S, K, T, r, ) Binomial or Black-Scholes
SC
2
2
S
C
TC
rC
C
Hedge parameters:
Formal Analysis
-1 = number of units of the derivative product x = number of units of the underlying S = today´s stock price T = today’s time to mature
Value of the portfolio: SxTSCV ),(1
A delta hedge is characterized by: 0SV
1
0 dNSCxx
SC
The delta hedge must be rebalanced over time.
Formal Analysis
n = number of units of the derivative product n m = number of units of the derivative product m x = number of units of the underlying S = today´s stock price T = today’s time
Value of the portfolio: SxTSmCmTS
nCnV ),(),(
A delta gamma hedge is characterized by: 0,02
2
S
VSV
0
0
mn
mn
mn
xmn Gives n and m with known x.
VaR: Value at Risk
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
GainsLosses
•Portfolio measure of risk
•Potential loss in a portfolio over a specified period of time
•Based on historyvolatilitycorrelation
change in value
Three Key Questions
ExposureWhat risk?How much?
Volatility &Correlation
How much couldprices change?
SensitivityHow much will P&L
change per unit?¨
How much can Ilose?
What is VaR
VaR is the maximum loss a portfolio can incur over aspecified time period, with a specified probability.
VaR is a vital component of current “best” practices inrisk measurement
VaR is used by practitioners and academics
VaR is valuable as a probabilistic measure of potentiallosses
What VaR is NOT
VaR is NOT the worst case scenario
VaR does NOT measure losses under any particular market condition
VaR -- by itself -- is NOT sufficient for riskmeasurement
Typical Uses of VaR
Translate portfolio exposures into potential P&L
Aggregate and reports multi-product, multi-marketexposure into one number
Uses risk factors and correlations to create a riskweighted index e.g. what is my equivalent risk position
How VaR is calculated
Sensitivity Estimate Model -- use sensitivity factors such as duration to estimate the change in value of the portfolio to changes in market rates and prices.
Full Revaluation Models -- use pricing algorithms such as bond formulae or option pricing models to estimate the the change in value of the portfolio to changes in market rates and prices.
Sensitivity vs. Revaluation
10 YearRate
SensitivityEstimated
P&L
Revaluation(Actual)
P&LDifference
8.0% -1 900 000 -1 698 493 201 507 12%
6.0% -380 500 -371 864 8 636 2%
5.5% 0 0 0 0
5.0% 380 500 389 684 9 184 2%
3.0% 1 900 000 2 145 584 245 584 11%
Why is the VaR Different?
The sensitivity VaR assumed that the bond’s value would change by some basis point.
But, as interest rates changes, bond price become more sensitive to changes in interest rates.
The change in sensitivity at different interest rate levels is nonlinear.
VaR Sensitivity vs. Revaluation
Sensitivity Models
Fast
Don’t require model library
Easy to understand
Implemented in less time
Revaluation models
Gives more accurate P&L results
Are price-based
Can handle complex products
VaR Inputs
Position Size -- the size of the instruments in the portfolio
Price/Yield Volatility -- The magnitude of the underlying prices and yield changes
Price/Yield Correlation -- Degree to which price and yield changes move together
VaR Estimation Period -- The time over which P/L in estimated
Confidence Level -- The frequency which actual losses
Monte Carlo Simulation
Scenario Generation -- produce a large number offuture price scenarios
Portfolio valuation -- for each scenario, compute aportfolio value
Summary -- report the result of the simulation, eitheras a portfolio distribution or as a risk measure
Monte Carlo is most helpful when some or all asserts in aportfolio are not amenable to analytical treatment