Risk Management PDF

UNIT I
CHAPTER 1
RISK & ITS MANAGEMENT
LESSON 1:
INTRODUCTION TO RISK
Expected loss
Discuss different meanings of the term risk.
Uncertainty (vaiability around the expected loss)
Describe major types of business risk and personal risk.
One situation is riskier than other if it has greater
Explain and compare pure risk to other types of risk.

Outline the risk management process and describe major risk
Expected loss
Discuss organization of the risk management function within
Risk
Different Meanings Of Risk

The term risk has a variety of meanings in business and
everyday life. At its most general leve1, risk is used to describe
any situation where there is uncertainty about what outcome
will occur. Life is obviously very risky. Even the short-term
future is often highly uncer-tain. In probability and statistics,
financial management, and investment management, risk is
often used in a more specific sense to indicate possible
variability in outcomes around some expected value.
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We will develop the ideas of expected value and risk as reflecting

variability around the expected value in the next few chapters. For
now it is sufficient for you to think of the expected value as the
outcome that would occur on average if a person or business were
repeatedly exposed to the same type of risk. If you have not yet
encountered these concepts in statistics or fi-nance classes, the
following example from the sports world might help. Allen Iverson
has averaged about 30 points per game in his career in the National
Basketball Association. As we write this, he shows little sign of
slowing down. It is therefore reasonable to assume that the
expected value of his total points in any given game is about 30
points. Risk, in the sense of variability around the expected value,
is clearly present. He might score 50 points or even higher in a
particular game, or he might score as few as 10 points.
In other situations, the term risk may refer to the expected losses
associated with a situ-ation. In insurance markets, for example, it
is common to refer to high-risk policyholders. The meaning of
risk in this context is that the expected value of losses to be paid
by the in-surer (the expected loss) is high. As another example,
California often is described as hav-ing a high risk of earthquake.
While this statement might encompass the notion of variability
around the expected value, it usually simply means that Californias
expected loss from earthquakes is high relative to other states.
In summary, (see Figure 1.1) risk is sometimes used in a specific

sense to describe vari-ability around the expected value and other
times to describe the expected losses. We em-ploy each of these
meanings in this book because it is customary to do so in certain
types of risk management and in the insurance business. The
particular meaning usually will be obvious from the context.
One situation is riskier than other if it has greater
11D.571.3
1
Risk Is Costly
Regardless of the specific meaning of risk being used, greater
risk usually implies greater cost. To illustrate the cost of risk we
use a simple example: Suppose that two identical homes are in
different but equally attractive locations. The structures have the
same value, say $100,000, and initially there is no risk of damage
to either house. Then scientists announce that a meteor might
hit the earth in the coming week and that one house is in the
potential impact area. We would naturally say that one house
now has greater risk than the other.
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business.
Uncertainty (variability around the

expected loss)
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management methods.
Lets assume that everyone agrees that the probability of one

house being hit by the me-teor is 0.1 and that the probability of
the other house being hit is zero. Also assume that the house
woul9- be completely destroyed if it were hit (all $100,000 would
be lost). Then the expected property loss at one house is greater by
an amount equal to 0.1 times $100,000, or $10,000. If the owner
were to sell the house immediately following the release of news
about the meteor, potential buyers would naturally pay less than
$100,000 for the house. Ra-tional people would pay at least $10,000
less, because that is the expected loss from the me-teor. Thus,
greater risk-in the sense of higher expected losses-is costly to the
original homeowner. The value of the house would drop by at
least the expected loss.
In addition to greater expected losses, one homeowner has greater
uncertainty in the sense that potential outcomes have greater
variation. At the end of the week, one house will be worth $100,000
with certainty, but the other house could be worth zero or $100,000.
This greater uncertainty about the value of the house also is likely
to impose costs on the owner. Because of the greater uncertainty,
potential buyers might require a price decrease in ex-cess of the
expected loss ($10,000). Lets say the additional price drop is $5,000.
Thus, greater risk-in the sense of greater uncertainty-is also costly
to the original homeowner.
To summarize, this example illustrates that both meanings of
risk depicted in Figure 1.1 are costly. In this example, the value of
the house declined by the expected loss (the first meaning of risk)
plus an additional amount due to increased uncertainty (the second
mean-ing of risk). As you will see throughout this book, risk
management is concerned with de-creasing the cost of risk.
Direct versus Indirect Expected Losses
When considering the potential losses from a risky situation,
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11.5811
RISK MANAGEMENTFOR GLOBAL FINANCIAL SERVICES
Chapter Objectives
Price Risk
Credit Risk
Output Price Risk
Pure Risk
Input Price Risk
Damage to Assets
Legal Liability
Commodity Price Risk
Worker Injury
Exchange Rate Risk
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For businesses, indirect losses are extremely important. Indeed,

as we discuss in later chapters, the possibility of indirect losses is
one of the main reasons that businesses try to reduce risk. Figure
1.2 summarizes the major types of indirect losses that can arise
from the risks faced by businesses. For example, damage to
productive assets can produce an indirect loss by reducing or
eliminating the normal profit (net cash flow) that the asset would
have generated if the damage had not occurred. Large direct losses
also can lead to indirect losses if they threaten the viability of the
business and thereby reduce the willingness of customers and
suppliers to deal with the business or change the terms (prices) at
which they transact.
reductions in cash inflows or increases in cash outflows can

significantly reduce business value. The major business risks
that give rise to variation in cash flows and business value are
price risk, credit risk, and pure risk (see Figure 1.3).
Fig 1.3: Major Types of Business Risk
Employee Benefit
Interest Rate Risk
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you must consider indirect losses that arise in addition to direct

losses. In the previous example, if the meteor destroyed the
house, the direct loss would be $100,000. Indirect losses arise as
a consequence of direct losses. If the house were destroyed, the
owner would likely have additional expenses, such as hotel and
restaurant costs; these additional expenses would be indirect
losses. As another ex-ample, when a persons car is damaged,
the time spent getting it repaired is an indirect loss.
Moreover, if sales or production are reduced in response to direct

losses, certain types of normal operating expenses (known as
continuing expenses) may not decline in proportion to the
reduction in revenues, thus increasing indirect losses. If a long
interruption in pro-duction would cause many customers to switch
suppliers, or if a firm has binding contrac-tual commitments to
supply products, it also may be desirable for the firm to increase
operating costs above normal levels following direct losses. For
example, some businesses might find it desirable to maintain
production by leasing replacement equipment at a higher cost so
as to avoid loss of sales. The increased operating cost would create
an indirect loss. Similarly, a business that decides to recall defective
products that have produced liability claims will incur product
recall expenses and perhaps increased advertising costs to reduce
damage to the firms reputation.
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Other forms of indirect losses include the possibility that the

business will face a higher cost of obtaining funds from lenders
or from new equity issues following large direct losses. In some
cases, the higher costs of raising capital will cause the firm to forgo
making oth-erwise profitable investments. Finally, in the case of
severe direct and indirect losses, the firm might have to reorganize
or be liquidated through costly legal proceedings under bankruptcy law.
Loss of normal Profit
(net cash flow)
Extra operating
expenses
Higher cost of funds and

foregone investments
Bankruptcy costs
(Legal fees)
Types of Risks Facing Businesses & Individuals

Business Risk
Broadly defined, business risk management is concerned with
possible reductions in business value from any source. Business
value to shareholders, as reflected in the value of the firms
common stock, depends fundamentally on the expected size,
timing, and risk (variability) associated with the firms future net
cash flows (cash inflows less cash out-flows). Unexpected
changes in expected future net cash flows are a major source of
fluc-tuations in business value. In particular, unexpected
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Price Risk
Price risk refers to uncertainty over the magnitude of cash flows
due to possible changes in output and input prices. Output
price risk refers to the risk of changes in the prices that a firm
can demand for its goods and services. Input price risk refers to
the risk of changes in the prices that a firm must pay for labor,
materials, and other inputs to its production process. Analysis
of price risk associated with the sale and production of existing
and fu-ture products and services plays a central role in strategic
management.
Three specific types of price risk are commodity price risk, exchange
rate risk, and in-terest rate risk. Commodity price risk arises from
fluctuations in the prices of commodities, such as coal, copper,
oil, gas, and electricity, which are inputs for some firms and outputs
for others. Given the globalization of economic activity, output
and input prices for many firms also are affected by fluctuations in
foreign exchange rates. Output and input prices also can fluctuate
due to changes in interest rates. For example, increases in interest
rates may alter a firms revenues by affecting both the terms of
credit allowed and the speed with which customers pay for products
purchased on credit. Changes in interest rates also affect the firms
cost of borrowing funds to finance its operations.
Credit Risk
The risk that a firms customers and the parties to which it has lent
money will delay or fail to make promised payments is known as
credit risk. Most firms face some credit risk for account receivables.
The exposure to credit risk is particularly large for financial institutions, such as commercial banks, that routinely make loans that
are subject to risk of default by the borrower. When firms borrow
money, they in turn expose lenders to credit risk (i.e., the risk that
the firm will default on its promised payments). As a consequence,
borrowing exposes the firms owners to the risk that the firm will
be unable to pay its debts and thus be forced into bankruptcy, and
the firm generally will have to pay more to borrow money as credit
risk increases.
Pure Risk
The risk management function in medium-to-large corporations
(and the term risk man-agement) has traditionally focused on the
management of what is known as pure risk. As summarized in
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2. The risk of legal liability for damages for harm to customers,

suppliers, shareholders, and other parties.
3. Businesses commonly reduce uncertainty and finance losses

associated with pure risk by purchasing contracts from insurance
companies that specialize in evaluating and bearing pure risk.
The prevalence of insurance in part reflects the firm-specific
nature of losses caused by pure risk. The fact that events that
cause large losses to a given firm com-monly have little effect
on losses experienced by other firms facilitates risk reduction
by di-versification, which is accomplished with insurance
contracts (see Chapters 5 and 6). Insurance contracts generally
are not used to reduce uncertainty and finance losses associated with price risk (and many types of credit risk). Price risks
that can simultaneously pro-duce gains for many firms and
losses for many others are commonly reduced with financial
derivatives, such as forward and futures contracts, option
contracts, and swaps. With these contracts, much of the risk of
loss is often shifted to parties that have an opposite exposure
to the particular risk.
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3. The risk associated with paying benefits to injured workers

under workers compen-sation laws and the risk of legal liability
for injuries or other harms to employees that are not governed
by workers compensation laws. .
4. The risk of death, illness, and disability to employees (and
sometimes family mem-bers) for which businesses have agreed
to make payments under employee benefit plans, including
obligations to employees under pension and other retirement
savings plans.
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1. The risk of reduction in value of business assets due to physical

damage, theft, and expropriation (i.e., seizure of assets by
foreign governments).
ity of losses through actions that alter the underlying causes

(e.g., by taking steps to reduce the probability of fire or lawsuit).
In comparison, while firms can take a variety of steps to reduce
their exposure or vulnerability to price risk, the underlying causes
of some impor-tant types of price changes are largely beyond
the control of individual firms (e.g., eco-nomic factors that
cause changes in foreign exchange rates, market wide changes in
interest rates, or aggregate consumer demand).
Personal Risk
The risks faced by individuals and families can be classified in a
variety of ways. We classify personal risk into six categories:
earnings risk, medical expense risk, liability risk, physical asset
risk, financial asset risk, and longevity risk. Earnings risk refers
to the potential fluctuation in a familys earnings, which can
occur as a result of a decline in the value of an in-come earners
productivity due to death, disability, aging, or a change in
technology. A familys expenses also are uncertain. Health care
costs and liability suits, in particular, can cause large unexpected
expenses. A family also faces the risk of a loss in the value of
the phys-ical assets that it owns. Automobiles, homes, boats,
and computers can be lost, stolen, or dam-aged. Financial
assets values also are subject to fluctuation due to changes ill
inflation and changes in the real values of stocks and bonds.
Finally, longevity risk refers to the possibility that retired people
will outlive their financial resources. Often individuals obtain
advice about personal risk management from professionals,
such as insurance agents, accountants, lawyers, and financial
planners.
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Comparison of Pure Risk and Its Management with

Other Types of Risk
Common (but not necessarily distinctive) features
of pure risk include the following:
1. Losses nom destruction of property, legal liability, and

employee injuries or illness Often have the potential to be very
large relative to a businesss resources. While business value
can increase if losses nom pure risk turns out to be lower than
expected, the maximum possible gain in these cases is usually
relatively small. In contrast, the potential reduction in business
value from losses greater than the expected value can be very
large and even threaten the firms viability.
2. The underlying causes of losses associated with pure risk, such
as the destruction of a plant by the explosion of a steam boiler
or product liability suits from consumers injured by a particular
product, are often largely specific to a particular firm and depend
on the firms actions. As a result, the underlying causes of
these losses are often subject to a sig-nificant degree of control
by businesses; that is, firms can reduce the frequency and sever-
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4. Losses from pure risk usually are not associated with offsetting
gains for other par-ties. In contrast, losses to businesses that
arise from other types of risk often are associated with gains to
other parties. For example, an increase in input prices harms
the purchaser of the inputs but benefits the seller. Likewise, a
decline in the dollars value against foreign currencies can harm
domestic importers but benefit domestic exporters and foreign
im-porters of U S. goods. One implication of this difference
between pure risk and price risk is that losses from pure risk
reduce the total wealth in society, whereas fluctuations in output and input prices need not reduce total wealth. In addition,
and as we hinted above, the fact that price changes often produce
losses for some firms and gains for others in many cases allows
these firms to reduce risk by taking opposite positions in
derivative contracts.
While many of the details concerning pure risk and its management
differ from other types of risk, it is nonetheless important for you
to understand that pure risk and its man-agement are conceptually
similar, if not identical, to other types of risk and their management. To make this concrete, consider the case of a manufacturer
that uses oil in the production of consumer products. Such a firm
faces the risk of large losses from product liability lawsuits if its
products harm consumers, but it also faces the risk of potentially
large losses from oil price increases. The business can manage the
expected cost of product lia-bility settlements or judgments by
making the products design safer or by providing safety
instructions and warnings. While the business might not be able
to do anything to reduce the likelihood or size of increases in oil
prices, it might be able to reduce its exposure to losses from oil
price increases by adopting a flexible technology that allows low
cost con-version to other sources of energy. The business might
purchase product liability insurance to reduce its liability risk; it
Figure 1.3, the major types of pure risk that affect businesses
include:
Increases in business risk of all types and dramatic growth in the

use of financial deriv-atives for hedging price risks in recent years
have stimulated substantial growth in the scope and efforts
devoted to overall business risk management. It has become
increasingly im-portant for managers that focus on pure risk to
understand the management of other types of business risk.
Similarly, general managers and managers of other types of risk
need to understand how pure risk affects specific areas of activity
and the business as a whole.
Risk Management
The Risk Management Process

Regardless of the type of risk being considered, the risk
management process involves sev-eral key steps:
1. Identify all significant risks.
2. Evaluate the potential frequency and severity of losses.

3. Develop and select methods for managing risk.
4. Implement the risk management methods chosen.
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5. Monitor the performance and suitability of the risk

management methods and strategies on an ongoing basis.
The same general framework applies to business and
individual risk management. You will learn more about major
exposures to losses from pure risk, risk evaluation, and the selection and implementation of risk management methods in
subsequent chapters. Chapter 2 discusses risk management
objectives for businesses and individuals.
Risk Management Methods
Figure 1.5 summarizes the major methods of managing risk.
These methods, which _e not mutually exclusive, can be
broadly classified as (1) loss control, (2) loss financing, and (3)
internal risk reduction. Loss control and internal risk reduction
commonly involve de-cisions to invest (or forgo investing)
resources to reduce expected losses. They are concep-tually
equivalent to other investment decisions, such as a firms
decision to buy a new plant or an individuals decision to buy a
computer. Loss financing decisions refer to decisions about
how to pay for losses if they do occur.
Fig 1.5: Major Risk Management Methods
Internal Risk reduction

Loss Control
Retention & Self Insurance
Reduced Level of Risky Activity
Diversification
Insurance
Increased precautions
Other contractual Risk transfers
Hedging
Investments in Information
Loss Control
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While the concepts and broad risk management strategies are the
same for pure risk and other types of business risk, the specific
characteristics of pure risk and the significant re-liance on insurance
contracts as a method of managing these risks generally lead to
their management by personnel with specialized expertise. Major
areas of expertise needed for pure risk management include risk
analysis, safety management, insurance contracts, and other
methods of reducing pure risk, as well as broad financial and
managerial skills. The insurance business, with its principal
function of reducing pure risk for businesses and in-dividuals,
employs millions of people and is one of the largest industries
in the United States (and other developed countries). In addition,
pure risk management and insurance have a major effect on many
other sectors of the economy, such as the legal sector, medical
care, real estate lending, and consumer credit.
Loss Financing
Actions that reduce the expected cost of losses by reducing the

frequency of losses and/or the severity (size) of losses that occur
are known as loss control. Loss control also is some-times known
as risk control. 6 Actions that primarily affect the frequency of
losses are com-monly called loss prevention methods. Actions
that primarily influence the severity of losses that do occur are
often called loss reduction methods. An example of loss
prevention would be routine inspection of aircraft for mechanical
problems. These inspections help re-duce the frequency of crashes;
they have little impact on the magnitude of losses for crashes that
occur. An example of loss reduction is the installation of heat- or
smoke-activated sprin-kler systems that are designed to minimize
fire damage in the event of a fire.
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might hedge its risk of loss from oil price increases using oil
futures contracts.
Many types of loss control influence both the frequency and severity
of losses and can-not be readily classified as either loss prevention
or loss reduction. For example, thorough safety testing of
consumer products wi1l likely reduces the number of injuries,
but it also could affect the severity of injuries. Similarly, equipping
automobiles with airbags in most cases should reduce the severity
of injuries, but airbags also might influence the frequency of
injuries. Whether injuries increase or decrease depends on whether
the number of injuries that are completely prevented for accidents
that occur exceeds the number of injuries that might be caused by
airbags inflating at the wrong time or too forcefully, as well as any
in-crease in accidents and injuries that could occur if protection by
airbags causes some driv-ers to drive less safely.
Viewed from another perspective, there are two general approaches
to loss control: (1) reducing the level of risky activity, and (2)
increasing precautions against loss for ac-tivities that are undertaken.
First, exposure to loss can be reduced by reducing the level of risky
activities, for example, by cutting back production of risky products
or shifting atten-tion to less risky product lines. Limiting the level
of risky activity primarily affects the fre-quency of losses. The
main cost of this strategy is that it forgoes any benefits of the
risky activity that would have been achieved apart from the risk
involved. In the limit, exposure to losses can be completely
eliminated by reducing the level of activity to zero; that is, by not
engaging in the activity at all. This strategy is called risk avoidance.
As a specific example of limiting the level of risky activity, consider
a trucking firm that hauls toxic chemicals that might harm people
or the environment in the case of an accident and thereby produce
claims for damages. This firm could reduce the frequency of liability
11D.571.3
Concept Checks
1. Explain how the two major approaches to loss control (reducing

risky activity and in-creasing precautions) could be used to reduce
the risk of injury to construction firm employees.
2. How could these two approaches be used to reduce the risk of
contracting a sexually transmitted disease?
Loss Financing
Methods used to obtain funds to pay for or offset losses that

occur are known as loss fi-nancing (sometimes called risk
financing). There are four broad methods of financing losses:
(1) retention,
(2) insurance,
(3) hedging, and
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(4) other contractual risk transfers. These approaches are not

mutually exclusive; that is, they often are used in combination.
With retention, a business or individual retains the obligation to

pay for part or all of the losses. For example, a trucking company
might decide to retain the risk that cash flows will drop due to oil
price increases. When coupled with a formal plan to fund losses
for medium -to large businesses, retention often is called se1finsurance.
Firms can pay retained losses using either internal or external funds.
Internal funds in-clude cash flows from ongoing activities and
investments in liquid assets that are dedicated to financing losses.
External sources of funds include borrowing and issuing new
stock, but these approaches may be very costly following large
losses. Note that these approaches still involve retention even
though they employ external sources of funds. For example, the
firm must pay back any funds borrowed to finance losses. When
new stock is issued, the firm must share future profits with new
stockholders.
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The second major approach to loss control is to increase the

amount of precautions (level of care) for a given level of risky
activity. The goal here is to make the activity safer and thus reduce
the frequency and/or severity of losses. Thorough testing for
safety and instal-lation of safety equipment are examples of
increased precautions. The trucking firm in the example above
could give-its drivers extensive training in safety, limit the number
of hours driven by a driver in a day, and reinforce containers to
reduce the likelihood of leakage. In-creased precautions usually
involve direct expenditures or other costs (e.g., the increased time
and attention required to drive, an automobile more safely).
The second major method of financing losses is the purchase of

insurance contracts. As you most likely already know, the typical
insurance contract requires the insurer to provide funds to pay for
specified losses (thus financing these losses) in exchange for
receiving a premium from the purchaser at the inception of the
contract. Insurance contracts reduce risk for the buyer by
transferring some of the risk of loss to the insurer. Insurers in
turn reduce risk through diversification. For example, they sell
large numbers of contracts that provide coverage for a variety of
different losses.
The third broad method of loss financing is hedging. As
noted above, financial deriva-tives, such as forwards, futures,
options, and swaps, are used extensively to manage various
types of risk, most notably price risk. These contracts can be
used to hedge risk; that is, they may be used to offset losses
that can occur from changes in interest rates, commodity prices,
foreign exchange rates, and the like. Some derivatives have
begun to be used in the man-agement of pure risk, and it is
possible that their use in pure risk management will expand in
the future.
Individuals and small businesses do relatively little hedging
with derivatives. At this point, it is useful to illustrate hedging
with a very simple example. Firms that use oil in the production
process are subject to loss from unexpected increases in oil
prices; oil producers are subject to loss from unexpected
decreases in oil prices. Both types of firms can hedge their risk
by entering into a forward contract that requires the oil producer
to provide the oil user with a specified amount of oil on a
specified future delivery date at a predetermined price (known as
the forward price), regardless of the market price of oil on that
date. Because the forward price is agreed upon when the contract
is written, the oil user and the oil producer both reduce their
price risk.
The fourth major method of loss financing is to use one or
more of a variety of other con-tractual risk transfers that
allow businesses to transfer risk to another party. Like insurance
contracts and derivatives, the use of these contracts also is
pervasive in risk management.
For example, businesses that engage independent contractors to
perform some task routinely enter into contracts, commonly
known as hold harmless and indemnity agreements, that re-quire the
contractor to protect the business from losing money from
lawsuits that might arise if persons are injured by the
contractor.
Internal Risk Reduction
In addition to loss financing methods that allow businesses
and individuals to reduce risk by transferring it to another entity,
businesses can reduce risk internally. There are two ma-jor forms
of internal risk reduction:
1. diversification, and
2. investment in information. Regarding the first of these, firms
can reduce risk internally by diversifying their activities (i.e., not
putting all of their eggs in one basket). You will learn the
basics of how diversifi-cation reduces risk in Chapter 4.
Individuals also routinely diversify risk by investing their savings
in many different stocks. The ability of shareholders to reduce
claims by cutting back on the number of shipments that it hauls.

Alternatively, it could avoid the risk completely by not hauling
toxic chemicals and instead hauling nontoxic substances (such as
clothing or, apart from cholesterol, cheese). An example from
personal risk man-agement would be a person who flies less
frequently to reduce the probability of dying in a plane crash. This
risk could be completely avoided by never flying. Of course,
alternative transportation methods might be much riskier (e.g.,
driving down Interstate 95 from New York to Miami the day
before Thanksgiving-along with many long-haul trucks, including
those transporting toxic chemicals).
of scale in arranging loss financing. Moreover, many risk management decisions are strategic in nature, and centralization
facilitates effective interaction between the risk manager and senior
management.
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A possible limitation of a centralized risk management function

is that it can reduce con-cern for risk management among the
managers and employees of a firms various operat-ing units.
However, allocating the cost of risk or losses to particular units
often can improve incentives for unit managers to control costs
even if the overall risk management function is centralized. On
the other hand, there are advantages to decentralizing certain risk
man-agement activities, such as routine safety and environmental
issues. In these cases, operat-ing managers are close to the risk and
can deal effectively and directly with many issues.
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The second major method of reducing risk internally is to invest

in information to ob-tain superior forecasts of expected losses.
Investing in information can produce more ac-curate estimates or
forecasts of future cash flows, thus reducing variability of cash
flows around the predicted value. Examples abound, including
estimates of the frequency and severity of losses from pure risk,
marketing research on the potential demand for different products
to reduce output price risk, and forecasting future commodity
prices or interest rates. One way that insurance companies reduce
risk is by specializing in the analysis of data to obtain accurate
forecasts of losses. Medium-to-large businesses often find it
advan-tageous to reduce pure risk in this manner as well Given
the large demand for accurate fore-casts of key variables that affect
business value and determine the price of contracts that can be
used to reduce risk (such as insurance and derivatives), many firms
specialize in pro-viding information and forecasts to other firms
and parties.
Business Risk Management Organisation
Where does the risk management function fit within the overall
organizational structure of businesses? In general, the views of
senior management concerning the need for, scope, and
importance of risk management and possible administrative
efficiencies determine how the risk management function is
structured and the exact responsibilities of units devoted to risk
management. Most large companies have a specific department
responsible for managing pure risk that is headed by the risk
manager (or director of risk management). However, given that
losses can arise from numerous sources, the overall risk
management process ide-ally reflects a coordinated effort
between all of the corporations major departments and
business units, including production, marketing, finance, and
human resources.
Depending on a companys size, a typical risk management
department includes vari-ous staff specializing in areas such as
property-liability insurance. Workers compensa-tion, safety and
environmental hazards, claims management, and, in many
cases, employee benefits. Given the complexity of modem risk
management, most firms with significant exposure to price risk
related to the cost of raw materials, interest rate changes, or
changes in foreign exchange rates have separate departments or
staff members that deal with these risks. Whether there will be
more movement in the future toward combining the management of these risks with pure risk management within a unified
risk management depart-ment is uncertain.
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risk through portfo-lio diversification is an important factor

affecting insurance and hedging decisions of firms.
In most firms, the risk management function is subordinate to

and thus reports to the fi-nance (treasury) department. This is
because of the close relationships between protecting assets from
loss, financing losses, and the finance function. However, some
firms with sub-stantial liability exposures have the risk
management department report to the legal de-partment. A smaller
proportion of firms have the risk management unit report to the
human resources department.
The term risk broadly refers to situations where outcomes are
uncertain. Risk often refers specifi-cally to variability in outcomes

around the ex-pected value. In other cases, it refers to the
expected value (e.g., the expected value of losses). Regardless
of the specific notion of risk being used, risk is costly.
Major types of business risk that produce fluctu-ations in
business value include price risk, credit risk, and pure risk.
Pure risk encompasses risk of loss from (1) dam-age to and
theft or expropriation of business as-sets, (2) legal liability for

injuries to customers and other parties, (3) workplace injuries
to em-ployees, and (4) obligations assumed by busi-nesses
under employee benefit plans. Pure risk frequently is managed
in part by the purchase of insurance to finance losses and reduce
risk.
Risk management involves (1) identification of potential direct
and indirect losses, (2) evaluation of their potential frequency

and severity, (3) de-velopment and selection of methods for
manag-ing risk to maximize business value, (4) implementation of these methods, and (5) ongoing monitoring.
Major risk management methods include loss con-trol, loss
financing, and internal risk reduction.
Loss control reduces expected losses by lowering the level of
risky activity and/or increasing pre-cautions against loss for any

given level of risky activity.
Loss financing methods include retention (se1f-insurance),
insurance, hedging, and other con-tractual risk transfers.
Many businesses achieve internal risk reduction through
diversification and through investments in information to

improve forecasts of expected cash flows.
Most large corporations have a specific depart-ment, headed by
the risk manager, that is devoted to the management of pure
risk and, in some cases, other types of .
Notes:
Firms also vary in the extent to which the risk management function
is centralized, as opposed to having responsibility spread among
the operating units. Centralization may achieve possible economies
6
11D.571.3
UNIT I
CHAPTER 2
OBJECTIVE OF RISK MANAGEMENT
LESSON 2:
RISK MANAGEMENT OBJECTIVE &
COST OF RISK
Explain the cost of risk concept.

Explain how minimizing the cost of risk maximizes business
value.
Discuss possible conflicts between business and societal
objectives.
In addition to the component needed to pay losses, auto and

health insurance premiums must again include a loading for the
insurers administrative costs and provide a reasonable expected
return on the insurers capital. Even with insurance, you face some
uncertainty about the cost of losses that are less than your
deductible (or for liability losses greater than policy limits). You
also are exposed to uninsured indirect losses that arise from
accidents, such as the time lost in getting your car repaired and
submitting a claim to your insurer.
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The Need for a Risk Management objective

Risk refers to either variability around the expected value or, in
other contexts, the expected value of losses. Holding all else
equal, both types of risk-variability and expected losses are
costly (i.e., they generally reduce the value of engaging in various
activities). At a broad level, risk management seeks to mitigate
this re-duction in value and thus increase welfare. We begin this
chapter with two simple examples to illustrate how risk
management can increase value: (1) the risk of product liability
claims against a pharmaceutical company, and (2) the risk to
individuals associated with automo-bile accidents.
not equal. Safety equipment included in vehicles usu-ally increases

their price. Attempting to reduce the likelihood of injury by driving
less also can be costly. You either must stay home or take alternative
transportation that may not be as attractive as driving (apart from
the risk of accident). Driving more safely usually means taking
more time to get places, or it requires greater concentration, which
means you can-not think as much about other things while you
are behind the wheel.
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Define and explain the overall objective of risk management.
Consider first a pharmaceutical company that is developing a new

prescription drug for the treatment of rheumatoid arthritis, a
crippling disease of the joints. The risk of adverse health reactions
to the drug and thus legal liability claims by injured users could be
sub-stantial. The possibility of injuries, which cause the firm (and/
or its liability insurer) to de-fend lawsuits and pay damages, will
increase the businesss expected costs. Loss control, such as
expenditures on product development and safety testing that
reduce expected legal defense costs and expected damage payments
also would be costly.
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If the firm purchases liability insurance to finance part of the

potential losses, the pre-mium paid will include a loading to
cover the insurers administrative costs and provide a reasonable
expected return on the insurers capital. The possibility of uninsured
damage claims (self-insured losses or losses in excess of liability
insurance coverage limits) will create 1illcertainty about the amount
of costs that will be incurred in any given period.
Most and perhaps all of these factors can increase the price that the
firm will need to charge for the drug, thus reducing demand. For
a given price, the risk of injury also might discourage some doctors
from prescribing the drug. The risk of injury also might cause the
firm and the medical profession to distribute the drug only to the
most severe cases of the disease, or the firm might even decide
not to introduce the drug. As a result, from the com-panys
perspective, the risk of consumer injury could have a significant
effect on the value of introducing the drug.
Now consider the risk that you will be involved in an auto accident,
which could cause physical harm to you and your vehicle, as well as
exposing you to the risk of a lawsuit for harming someone else.
The possibility of being involved in an accident reduces the value
of driving. Other things being equal, people obviously would
prefer to have a lower likeli-hood of accident. But other things are
11D.571.3
Risk is costly and so is the management of risk. We therefore need

some guiding principles to de-termine how much and what types
of risk management should be pursued. That is, we need to
identify the underlying objective of risk management.
The guiding principle or fundamental objective of risk
management is to minimize the cost of risk. When we consider
business risk management decisions, the objective is to min-imize
the firms cost of risk. When we consider individual risk
management, the objective is to minimize the individuals cost of
risk. And, if we consider public policy risk manage-ment decisions,
the objective is to minimize societys cost of risk.
Understanding the Cost of Risk
Most risk management decisions must be made before losses are

known. The magnitude of actual losses during a given time period
can be determined after the fact (i.e., after the number and severity
of accidents are known). Before losses occur, the cost of direct and
indirect losses reflects the predicted or expected value of losses
during an upcoming time period. Thus, the cost of losses can be
determined ex post (after the fact) and estimated ex ante (before
the fact). Most risk management decisions must be based on ex
ante estimates of the cost of losses and thus the cost of risk.
Components of the Cost of Risk
Regardless of the type of risk being considered, the cost of risk
has five main components. For concreteness, we discuss these
components from a business perspective for the case of pure
risk. Using the ex ante perspective, the cost of pure risk
includes: (1) expected losses, (2) the cost of loss control, (3) the
cost of loss financing, (4) the cost of internal risk re-duction,
and (5) the cost of any residual uncertainty that remains after
loss control, loss fi-nancing, and internal risk reduction
methods have been implemented. Figure 2.1 summarizes these
five components.
Chapter Objective
Direct Losses
Increased
Precautions
Indirect
Losses
Reduces
Activity
Cost of Loss Financing
Retention & Self

Insurance Cost
Cost of Internal Risk

Reduction
Cost of Residual
Uncertainty
Div ersification
Effects on
Shareholders
Investments in
information
Effects on other
Stakeholders
Insurance
Hedging
Other Risk Transfers
Fig 2.1: Components of the cost of risk

Expected Cost of Losses
The expected cost of losses includes the expected cost of both
direct and indirect losses. As you learned in the last chapter,
major types of direct losses include the cost of repairing or
replacing damaged assets, the cost of paying workers
compensation claims to injured workers, and the cost of
defending against and settling liability claims. Indirect losses include reductions in net profits that occur as a consequence of
direct losses, such as the loss of normal profits and continuing
and extra expense when production is curtailed or stopped due
to direct damage to physical assets. In the case of large losses,
indirect losses can in-clude loss of profits from forgone
investment and, in the event of bankruptcy, legal expenses and
other costs associated with reorganizing or liquidating a
business.
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In the case of the pharmaceutical company discussed earlier, the

expected cost of direct losses would include the expected cost of
liability settlements and defense. The expected cost of indirect
losses would include items such as (1) the expected cost of lost
profit if sales had to be reduced due to adverse liability experience,
(2) the expected cost of product recall expenses, and (3) the expected
loss in profit on any investments that would not be under-taken
if large liability losses were to deplete the firms internal funds
available for invest-ment and increase the cost of borrowing or
raising new equity.
Cost of Loss Control
The cost of loss control reflects the cost of increased precautions

and limits on risky activ-ity designed to reduce the frequency and
severity of accidents. For example, the cost of loss control for the
pharmaceutical company would include the cost of testing the
product for safety prior to its introduction and any lost profit
from limiting distribution of the product in order to reduce
exposure to lawsuits.
Cost of Loss Financing
The cost of loss financing includes the cost of self-insurance,
the loading in insurance premiums, and the transaction costs in
arranging, negotiating, and enforcing hedging arrangements and
other contractual risk transfers. The cost of self-insurance
includes the cost of maintaining reserve funds to pay losses.
This cost in turn includes taxes on income from investing these
funds, as well as the possible opportunity cost that can occur if
main-taining reserve funds reduces the ability of a business to
undertake profitable investment opportunities.
Note that when losses are insured, the cost of loss financing
through insurance only re-flects the loading in the policys premium
for the insurers administrative expenses and re-quired expected
profit. The amount of premium required for the expected value
of insured losses is included in the firms expected cost of losses.
Cost of Internal Risk Reduction Methods
Insurance, hedging, other contractual risk transfers, and certain
types of loss control can re-duce the uncertainty associated with
losses; that is, these risk management methods can make the
cost of losses more predictable. Uncertainty also can be reduced
through diversification and investing in information to obtain
better forecasts of losses. The cost of internal risk reduction
includes transaction costs associated with achieving
diversification and the cost associated with managing a
diversified set of activi-ties. It also includes the cost of
obtaining and analyzing data and other types of information to
obtain more accurate cost forecasts. In some cases this may
involve paying another firm for this information; for example,
the pharmaceutical company may pay a risk management
consultant to estimate the firms expected liability costs.
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Cost of Loss
Control
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Expected
Loss
Cost of Residual Uncertainty

Uncertainty about the magnitude of losses seldom will be
completely eliminated through loss control, insurance, hedging,
other contractual risk transfers, and internal risk reduction. The
cost of uncertainty that remains (that is left over) once the
firm has selected and im-plemented loss control; loss financing,
and internal risk reduction is called the cost of resid-ual
uncertainty. This cost arises because uncertainty generally is
costly to risk-averse individuals and investors. For example,
residual uncertainty can affect the amount of com-pensation
that investors require to hold a firms stock.
Residual uncertainty also can reduce value through its effects on
expected net cash flows. For example, residual uncertainty
might reduce the price that customers are willing to pay for the
firms products or cause managers or employees to require
higher wages (e.g., the top managers of the pharmaceutical
company could require higher pay to com-pensate them for
uncertainty associated with product liability claims).
Cost Tradeoffs
A number of tradeoffs exist among the components of the
cost of risk. The three most im-portant cost tradeoffs are those
between: (1) the expected cost of direct/indirect losses and loss
control costs, (2) the cost of loss financing/internal risk
reduction and the expected cost of indirect losses, and (3) the
cost of loss financing/internal risk reduction and the cost of
residual uncertainty.
First, a tradeoff normally exists between expected losses (both
direct and indirect) and loss control costs. Increasing loss control
costs should reduce ex-pected losses. In the case of the
pharmaceutical company, for example, expenditures on developing a safer drug will reduce the expected cost of liability
suits. Ignoring for simplicity the possible effects of loss control
on other components of the cost of risk (such as the cost of
residual uncertainty), minimizing the cost of risk requires the
firm to invest in loss con-trol until the marginal benefit-in the
11D.571.3
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Even if it were technologically feasible to eliminate the risk of

harm, people would not want to live in such a world. It simply
would be too expensive. To use an absurd example to prove this
point, injuries from automobile accidents might be virtually
eliminated if auto-mobiles were simply tanks without weapons.
But very few people could afford to drive a tank, and those who
could would rather risk injury and get to their destination more
quickly with a pickup or luxury sports sedan. Because loss control
is costly, a point is reached where people prefer some risk of harm
to paying more for goods and services or incurring other costs to
reduce risk.
The second major tradeoff among the components of the cost

of risk is the tradeoff be-tween the costs of loss financing/internal
risk reduction and the expected cost of indirect losses. As more
money is spent on loss financing/internal risk reduction, variability
in the firms cash flows declines. Lower variability reduces the
probability of costly bankruptcy and the probability that the firm
will forgo profitable investments as a result of large unin-sured
losses. As a result, the expected cost of these indirect losses
declines. This tradeoff between the costs of loss financing/
internal risk reduction and the expected cost of indirect losses is
of central importance in understanding when firms with
diversified shareholders will purchase insurance or hedge.
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The third major tradeoff is that which often occurs between the
costs of loss financ-ing/internal risk reduction and the cost of
residual uncertainty. For example, if the firm in-curs higher loss
financing costs by purchasing insurance, residual uncertainty
declines. Greater and more costly internal risk reduction also reduces
residual uncertainty.
Concept Checks
1. For an airline, describe the most important components of

the cost of risk that arise from the risk of plane crashes.
2. How might the risk of crashes be eliminated by the airline, if
at all?
3. Assume that you want to fly across the country and that for a
price of $400 the proba-bility of a fatal crash is one in a million
trips. To reduce this probability to one in 1.5 mil-lion trips, the
price of a ticket would increase to $800. Would you be willing
to pay the extra $400?
Cost of Other Types of Risk
We illustrated the cost of risk concept using a business
perspective and analyzing pure risk. However, the cost of risk is
a general concept. With some modification, our discussion of
11D.571.3
From an ex ante perspective, the expected cost of oil is aalogous

to the expected cost of direct losses from pure risk, such as those
associated with product liability claims against the pharmaceutical
company. Ex post, the actual cost of oil price changes can differ
from what was expected, just as the actual costs from product
liability claims can differ from those expected. If costs are greater
than expected, then profits will be lower than expected in both
cases. However, because oil is an integral input to the production
process for which ongoing expenditures are routinely expected,
the expected cost of oil normally would not be considered as part
of the cost of risk. (Similarly, while wages paid to employees can
dif-fer from what is expected, the expected cost of wages normally
would not be considered as part of the cost of risk.)
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The amount of loss control that minimizes the cost of risk

generally will not involve eliminating the risk of loss. It will not
produce a world in which buildings never bum, workers are never
hurt, and products never harm cus-tomers because reducing the
probability of loss to zero would be too costly. Beyond some point, the
cost of additional loss control exceeds the reduction in the
expected cost of losses (that is, the marginal cost exceeds the
marginal benefit) so that additional loss control will increase the
cost of risk. Eliminating the risk of loss will not minimize the
cost of risk for either businesses or society.
the cost of pure risk is applicable to other types of risk. To

illustrate, we will briefly discuss the risk of input price changes,
using the specific example of a manufacturer that uses oil in its
production process. In this case, the prices charged for the firms
products generally would not immediately adjust to reflect
changes in the price of oil so that the firms profits will be
affected by oil price changes. Oil price increases will cause the
firms profits (or net cash flows) to decline in the short run, and
oil price decreases will lead to a short-run in-crease in profits.
Large increases in the price of oil could cause indirect costs if, for
example, production is reduced, alternative sources of energy need
to be arranged, or profitable investment is curtailed. The possibility
of indirect costs increases the expected cost of using oil in the production process. Expenditures on loss control, such as redesigning
the production process to allow for the substitution of other
sources of energy, would decrease the expected cost of oil use and
indirect losses.
With regard to loss financing, the manufacturer might choose to
reduce its exposure to the risk of oil price changes with futures
contracts. The ap-propriate use of futures will produce a profit if
oil prices increase, thus offsetting all or part of the loss to the
firm. (If oil prices drop, all or part of the gain that the firm
otherwise would experience will be offset by a loss on its futures
contracts.) However, the use of futures con-tracts involves
transaction costs that are analogous to the loading in insurance
premiums. The firm also might engage in internal risk reduction
by diversifying its activities to reduce the sensitivity of its profits
to oil price changes or by investing in information to obtain better forecasts of oil prices.
You can see from this simple example that the cost of risk concept
illustrated in Figure 2.1 is quite general. This concept provides a
useful way of thinking about and evaluating all types of risk
management decisions.
Firm Value Maximization and the Cost of Risk
Determinants of Value
A businesss value to shareholders depends fundamentally on
the expected magnitude, timing, and risk (variability) associated
with future net cash flows (cash inflows minus cash outflows)
that will be available to provide shareholder-s with a re-turn on
their investment.
Business value and the effects of risk on value reflect an ex ante
perspective: Value de-pends on expected future net cash flows and
risk associated with these cash flows. Cash in-flows primarily result
form of lower expected costs resulting from direct and indirect

lossesequals the marginal cost of loss control.
costs. We emphasize that this value is entirely hypothetical because

risk is in-herent in real-world business activities.
To illustrate the cost of risk, consider the product liability example
introduced earlier. For the pharmaceutical company, the value of
the firm without risk is the hypothetical value that would arise if
(1) it were impossible for the drug to hurt consumers and thus
produce lawsuits and (2) the firm did not have to incur any cost to
achieve this state of riskless bliss. The reality of injury risk and the
costs of loss control give rise to risk-related costs, thus re-ducing
the value of the business.
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Equation 2.2 implies that if the firm seeks to maximize value, it

can do so by minimiz-ing the cost of risk. It accomplishes this by
making the reduction in value due to risk as small as possible.
Thus, as long as costs are defined to include all the effects on value of risk
and risk management, minimizing the cost of risk is the same thing
as maximizing value.
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Because most investors are risk averse, the risk of cash flows
reduces the price that they are willing to pay for the firms stock
and thus its value (provided that this risk cannot be eliminated
by investors holding a diversified portfolio of investments). For
a given level of expected net cash flows, this reduction in the
firms stock price due to risk increases the expected return from
buying the stock. In other words, the variation in net cash flows
causes investors to pay less for the rights to future cash flows,
which increases the expected return on the amount that they
invest. Thus, a fun-damental principle of business valuation is
that risk reduces value and increases the ex-pected return required
by investors. The actual return to investors in any given period
will depend on realizations of net cash flows during the period
and new information about the expected future net cash flows
and risk.
Maximizing Value by Minimizing the Cost of Risk
Unexpected increases in losses that are not offset by cash
inflows from insurance con-tracts, hedging arrangements, or
other contractual risk transfers increase cash outflows and often
reduce cash inflows, thus reducing the value of a firms stock.
The effects of risk and risk management on firm value before
losses are known reflect their in-fluence on (1) the expected
value of net cash flows and (2) the compensation required by
shareholders to bear risk. Much of basic financial theory deals
with the kind of risk for which investors demand
compensation and the amount of compensation required. We
will have more to say about how risk affects expected cash
flows, risk, and required compen-sation in later chapters. For
now, it is sufficient for you to understand that making risk
man-agement decisions to maximize business value requires an
understanding of how risk and risk management methods
affect (1) expected net cash flows and (2) the compensation for
risk that is required by shareholders.
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from sales of goods and services. Cash outflows primarily arise

from the production of goods and services (e.g., wages and
salaries, the cost of raw materials, in-terest on borrowed funds,
and liability losses). Increases in the expected size of net cash
flows increase business value; decreases in expected net cash flows
reduce value. The tim-ing of cash flows affects value because a
dollar received today is worth more than a dollar received in the
future.
If the firms cost of risk is defined to include all risk-related costs

from the perspective of shareholders, a business can maximize its
value to shareholders by minimizing the cost of risk. To see this more
clearly, we define:
Cost of risk = Value without risk - Value with risk
(2.1)
Writing this expression in terms of the firms value to

shareholders in the presence of risk gives:
Value with risk = Value without risk - Cost of risk
(2.2)
The value of the firm without risk is a hypothetical and abstract

concept that is nonetheless very useful. It equals the hypothetical
value of the business in a world in which uncertainty associated
with net cash flows could be eliminated at zero cost. This
hypothetical value re-flects the magnitude and timing of future
net cash flows that would occur without risk and risk-related
10
Why bother introducing the cost of risk instead of just talking

about value maximiza-tion? First, the cost of risk concept helps
focus attention on and facilitates categorization of the major ways
that risk reduces value. Second, the concept is used extensively in
prac-tice (although its breadth is sometimes narrower, as is noted
below).
Measuring the Cost of Risk
In order to maximize business value by minimizing the cost of
risk, businesses ideally will estimate the size of the various
components of the cost of risk and consider how the firms
operating and risk management decisions will affect these costs.
However, in prac-tice, the necessary analysis is costly. Moreover,
some of the components are particularly difficult to measure.
Examples include the estimated cost of forgone activity (e.g.,
profits that would have been achieved but for risk and the
reduction inactivity), the impact of de-cisions on customers or
suppliers, and the cost of residual uncertainty.
As a result of these practical limitations, businesses often will not
attempt to quantify all of their costs precisely. Small businesses
especially are unlikely to measure costs with much precision because
the cost of analysis is usually large compared to the potential
benefit in the form of improved decisions. However, even when
quantifying the various components of the cost of risk is not
cost-effective, managers need to understand these components
and the general ways in which their magnitude will be affected by
risk management. This un-derstanding is necessary for making
informed decisions using intuitive and subjective as-sessments
of the effects of decisions on costs.
Subsidiary Goals
While the overall objective of risk management is to maximize
business value to share-holders by minimizing the cost of risk,
a variety of subsidiary goals is used to guide day to day decision
making. Examples of these subsidiary goals include making
insurance decisions to keep the realized cost of uninsured losses
below a specified percent of rev-enues, purchasing insurance
against any loss that could be large enough to seriously disrupt
operations, making decisions to comply with stipulations in
loan contracts on the types and amounts of insurance that
must be purchased, and spending money on loss control when
the savings on insurance premiums are sufficient to outweigh
11D.571.3
From a normative perspective (i.e., from the perspective of how

people or businesses should behave), managers are agents of
shareholders and therefore should seek to maximize value. As a
practical matter, a number of factors give managers strong
incentives not to deviate too much from value maximization,
thus re-ducing agency costs:
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1. Managers often are compensated in part with bonuses linked

to the firms profitability (and thus in-directly to its stock price),
or with stock or stock op-tions that directly increase managers
personal wealth when the firms stock price increases. These
performance-based compensation systems provide a direct
incentive for value maximization. Poor perfor-mance by
managers also can reduce their prospects for achieving
employment with other firms (it can re-duce. their value in the
managerial labor market).
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Objectives for Nonprofit Firms

How does the overall objective of risk management differ for
nonprofit or government en-tities that do not have
shareholders? Nonprofit firms can be viewed as attempting to
maxi-mize the value of products or services provided to
various customers and constituents (e.g., taxpayers or persons
that donate money to finance the firms operations), where
value de-pends on the preferences of these parties. If the cost
of risk is defined as the reduction in value of the nonprofit
firms activities due to risk, the appropriate goal of risk
management remains minimization of the cost of risk to those
constituents.
is needed on insurance, loss control, or other methods of reducing the likelihood of financial distress.
Minimizing the cost of risk for a nonprofit firm may involve

giving greater weight to certain factors than would be true for a
for-profit firm. A nonprofit hospital, for example, might place
greater emphasis on the adverse effects of large losses on its
customers than would a for-profit firm.
However, while the details may differ, the overall objective of risk
management and the key decisions that must be made by nonprofit
firms are similar to those for for-profit firms. Nonprofit firms
need to identify how risk reduces the net value of services provided
and make decisions with the goal of minimizing the cost of risk.
They have to consider the same basic components of the cost of
risk as for-profit firms. It is not clear whether the absence of
shareholders and the possibly fewer penalties for failing to
minimize costs make agency costs (see Article 2.1) greater for
nonprofit firms than for for-profit firms, or, if so, whether this
affects risk management.
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Article 2.1: Will Managers Maximize Value?

Owner-managers (e.g., sole proprietors, managing partners, and
owner-managers of corporations without publicly traded
common stock) have a clear incentive to operate their businesses
to achieve their own inter-ests. This generally will involve value
maximization pro-vided that value is appropriately defined to
reflect the owners attitude toward risk and their ability to diversify their risk of ownership.
One of the longest and most thoroughly debated subjects in

business economics and finance is whether managers of large
corporations with widely held common stock (i.e., with large
numbers of shareholders that are not involved in management)
will diligently strive to maximize value to shareholders. The
ownership and management functions are separated in businesses
with widely held common stock. Managers can be viewed as, agents
of shareholders. Managers may have incentives to take actions
that benefit themselves at a cost to share-holders, thus failing to
maximize shareholder wealth. The costs associated with these
actions, including the costs incurred by shareholders in monitoring
managerial behavior, are broadly referred to as agency costs.
Agency costs reduce business value. In the context of risk

management, managers being excessively cautious might manifest
agency costs. Because man-agers could be seriously harmed by
financial distress of the firm, they might spend more money than
11D.571.3
2. Failing to maximize the value of the firms stock makes it

more likely that another firm or parties that can then replace
current top management with managers that will take ac-tions
to increase firm value will acquire the firm.
3. If failure by managers to control costs, including the cost of
risk, increases the price or reduces the qual-ity of the firms
products, the firm will lose sales to firms with managers who
are more inclined to con-trol costs and increase value. This
outcome makes it more likely that managers will be replaced
and/or that the managers salaries will be lower than if they
maximized value.
4. Many firms have stockholders with large stakes and other
stakeholders (such as lenders) that routinely monitor managerial
performance.
5. Indian laws and the legal liability system impose fi-duciary
duties on managers. Failing to act in the in-terest of shareholders
can give rise to lawsuits against managers and potential legal
liability.
Individual Risk Management and the Cost of Risk
The cost of risk concept also applies to individual risk
management decisions. For exam-ple, when choosing how to
manage the risk of automobile accidents, an individual would
consider the expected losses (both direct and indirect) from
accidents, possible loss control activities (such as driving less at
night) and the cost of these activities, loss financing alter-natives
(amount of insurance coverage) and the cost of these
alternatives, and the cost and benefits of gathering information
(e.g., about the weather and road conditions). In addition, an
individual would consider the cost of any residual uncertainty,
which depends on that persons attitude toward risk
(uncertainty).
The amount of risk management undertaken by individuals
depends in part on their de-gree of risk aversion. A person is risk
averse if when having to decide between two risky alternatives
that have the same expected outcome, the person chooses the
alternative whose outcomes have less variability. This example
illustrates the concept of risk aversion: Sup-pose that you must
choose between the following alternatives. With alternative A,
you have a 50 percent chance of winning $100 and a 50 percent
11
the costs. These types of rules generally can be viewed as a

means to an end (i.e., as practical guides to increasing busi-ness
value). However, in each case, there should be a reasonably clear
link between the par-ticular goal and the increase in value.
It is reasonable to assume that individuals, acting privately, will

make risk management decisions that minimize their own cost of
risk. Similarly, businesses that seek to maximize value to
shareholders will make risk management decisions to minimize
the cost of risk to the business. The question arises: Will
minimizing the cost of risk to the business or indi-vidual minimize
the cost of risk to society?
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As mentioned earlier, most people are averse to risk. Risk-averse

people generally are willing to pay to reduce risk, or must be
compensated for taking on risk. For example, risk -averse people
buy insurance to reduce risk. Also, risk-averse people require higher
expected returns to invest in riskier securities. The degree of risk
aversion can vary across people. If Mary is more risk averse than
David, then Mary would likely purchase more insurance than
David, all else being equal.
Similar issues arise within the context of risk. An important

example is the effect of government regulations that cause insurance
premium rates for some buyers to differ from the expected costs
of providing them coverage. By changing how the total cost of
risk is divided (or how the total cost pie is sliced), these regulations
can alter incentives in ways that increase the total cost of risk (e.g.,
by encouraging too much risky activity by individuals whose
insurance premiums are subsidized). While many persons might
argue that these regulations produce a fairer distribution of costs,
they nonetheless involve some increase in cost.
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chance of losing $100. With alter-native B, you have a 50 percent

chance of winning $10,000 and a 50 percent chance of los-ing
$10,000. Both gambles have an expected value equal to zero, but
alternative As outcomes have less variability (i.e., they are closer to
the expected outcome). Stated more simply, most would agree
that alternative B is riskier than A. Thus, if you choose alterna-tive
A, you are risk averse. If you choose alternative B, you would be
called risk loving; and if you are indifferent between the two, you
are risk neutral.
Risk Management and Societal Welfare

From a societal perspective, the key question is how risky
activities and risk management by individuals and businesses
_an best be arranged to minimize the total cost of risk for society. This cost is the aggregate-for all members of society-of
the costs of losses, loss control, loss financing, internal risk
reduction, and residual uncertainty. Minimizing the to-tal cost
of risk in society would maximize the value of societal
resources.
Minimizing the total cost of risk for society produces an efficient

level of risk. Effi-ciency requires individuals and businesses to
pursue activities until the marginal benefit equals the marginal
cost, including risk-related costs. Expressed in terms of the cost
of pure risk, efficiency requires that loss control, loss financing, and
internal risk reduction be pursued until the marginal reduction in the
expected cost of losses and residual un-certainty equals the marginal cost
of these risk management methods. As was discussed earlier, however,
achieving the efficiency goal does not eliminate losses because it is
sim-ply too costly to do so.
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While the efficiency concept is abstract and the benefits and costs
of risk management are often difficult to measure, the efficiency
goal is nonetheless viewed as appropriate by many people
(especially economists). The main reason for this is that maximizing
the value of resources by minimizing the cost of risk makes the
total size of the economic pie as large as possible. Other things
being equal, this permits the greatest number of economic needs
to be met.
Greater total wealth allows greater opportunity for governments

to transfer income from parties that are able to pay taxes to parties
that need assistance. A fundamental problem that affects these
transfers, however, is that the size of the economic pie is not
invariant to how it is sliced (i.e., divided among the population).
High marginal tax rates, for example, dis-courage work effort
beyond some point, thus tending to reduce the size of the
economic pie. Thus, attempts to produce a more equal distribution
of income generally involve some re-duction in economic value.
The goal is to achieve the right balance between the amount of
total wealth and how it is distributed.
12
Note first that maximizing business value by minimizing the cost

of risk generally will involve some consideration of the effects of
risk management decisions on other major stakeholders in the
firm. As suggested above and explained in detail in later chapters,
the firms value to shareholders and the reduction in value due to
the cost of risk will depend in part on how risk and risk
management affect employees, customers, suppliers, and lenders.
The basic reason is that risk and its management affect the terms
at which these parties are willing to contract with the business. For
example, other things being equal, businesses that expose
employees to obvious safety hazards will have to pay higher wages
to attract employees. This provides some incentive for the firm to
improve safety conditions in order to save on wages (apart from
any legal requirement for the firm to pay for injuries).
Unfortunately, because we do not live in a perfect world, the goal
of making money for shareholders can lead to risk management
decisions that may not necessarily minimize the total cost of risk
to society. In order for business value maximization to minimize
the total cost of risk to society, the business must consider all
societal costs in its decisions. In other words, all social costs should
be internalized by the business so that its private costs equal social
costs. If the private cost of risk (the cost to the business) differs
from the social cost of risk (the total cost to society), business
value maximization generally will not minimize the total cost of
risk to society.
A few simple examples should help to illustrate the increase in the
social cost of risk that can arise when the private cost is less than
the social cost. To illustrate the point simply, as-sume that there is
no government regulation of safety, no workers compensation
law, and no legal liability system that allows persons to recover
damages from businesses that cause them harm. Under this
assumption, businesses that seek to maximize value to
shareholders may not consider possible harm to persons from
risky activity. It would be very likely that many businesses would
make decisions without fully reflecting upon their possible harm
to strangers (persons with no connection to the business).
In addition, businesses would tend to produce products that are
too risky and expose workers to an excessive risk of workplace
injury given the social cost if consumers and workers
underestimate the risk of injury. Note in contrast that if consumers
11D.571.3
and workers can accurately assess the risk of injury, they can influence
the business to consider the risk of harm by reducing the price
they are willing to pay for pr9ducts and increasing the wages
demanded in view of the risk of injury.
Summary
The overall objective of risk management is to minimize the
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cost of risk.
Components of the cost of risk include: (1) the expected cost
of losses, (2) the cost of loss con-trol, (3) the cost of loss
financing, (4) the cost of internal risk reduction, and (5) the
cost of any residual uncertainty that remains after loss con-trol,
loss financing, and internal risk reduction methods have been
implemented.
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For now, it is sufficient to note that a major function of li-ability

and workplace injury law is to get businesses to reflect more upon
the risk of harm to consumers, workers, and other parties in
making their decisions. If legal rules are de-signed so that private
costs are approximately equal to social costs, then valuemaximizing decisions by businesses will help to minimize the
total cost of risk. in society. Efficient le-gal rules are those that
achieve this goal. .
In the context of business risk management, maximizing firm
value is equivalent to minimizing the cost of risk.
Loss control reduces the expected cost of losses. Beyond some
point, the cost of additional loss control will exceed the

reduction in the expected cost of losses. As a result, minimizing
the cost of risk will not eliminate completely the risk of loss. If
it were feasible, eliminating the risk of loss would be excessively
costly to businesses and consumers alike.
Loss financing and internal risk reduction re-duce risk and
therefore can reduce both the ex-pected cost of indirect losses,

and the cost of residual uncertainty.
The overall objective of risk management for nonprofit firms
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also should be to minimize the cost of risk, provided that the

special objectives and circumstances of these firms are incorporated into the cost of risk.
The overall objective of risk management for indi-viduals can
be viewed as minimizing the cost of risk and thus maximizing

the welfare of individuals.
If businesses do not bear the full costs of their risky activities
(that is, if the private cost of risk is less than the social cost),
the total cost of risk in society will not be minimized when
businesses maximize value. A major function of business liability and workplace injury law is to align private costs with
social costs so that business value max-imization will minimize
the social cost of risk.
Notes:
11D.571.3
13
Understanding of Value Creation

How Integrated Risk Management creates Value?
Defining Optimal Risk Level
Implementing Integrated Risk Management
of its risk management. However, even when offering products

and services, banks deal in financial assets and are, therefore, by
definition in the financial risk business. Additionally, risk
management is also perceived in practice to be necessary and
critically important to ensure the long-term survival of banks.
Not only is a regulatory minimum capital-structure and riskmanagement approach required, but also the customers, who are
also liability holders, should and want to be protected against
default risk, because they deposit substantial stakes of their
personal wealth, for the most part with only one bank. The same
argument is used from an economy-wide perspective to avoid
bank runs and systemic repercussions of a globally intertwined
and fragile banking system.
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Introduction to Value Creation in Global Financial

Institutions
Increased (global) competition among banks1 and the threat of
(hostile) takeovers, as well as the increased pressure from
shareholders for superior returns has forced bankslike many
other companiesto focus on managing their value. It is now
universally accepted that a banks ultimate objective function is
value maximization. In general, banks can achieve this either by
restructuring from the inside, by divesting genuinely valuedestroying businesses, or by being forced into a restructuring
from the outside.
The approach typically applied to decide whether a firm creates

value is a variant of the traditional discounted cash flow (DCF)
analysis of financial theory, with which the value of any asset can
be determined. In principle, this multiperiod valuation framework
estimates a firms (free) cash flows and discounts them at the
appropriate rate of return to determine the overall firm value
from a purely economic perspective. However, since a banks liability
management does not only have a simple financing function as
in industrial corporationsbut is rather a part of a banks business
operations, it can create value by itself. Therefore, the common
valuation framework is slightly adjusted for banks. It estimates
the banks (free) cash flows to its shareholders and then discounts
these at the cost of equity capital, to derive the present value (PV)
of the banks equitywhich should equal (ideally) the
capitalization of its equity in the stock market.
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Chapter Objective:
UNIT I
CHAPTER 3
INTEGRATED RISK MANAGEMENT &
VALUE CREATION
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LESSON 3 :
INTRODUCTION TO INTEGRATED RISK
MANAGEMENT
This valuation approach is based on neoclassical finance theory

and, therefore, on very restrictive assumptions. Taken to the
extreme, in this worldsince only the covariance (i.e., so-called
systematic) risk with a broad market portfolio counts14the value
of a (new) transaction or business line would be the same for all
banks, and the capital-budgeting decision could be made
independently from the capital-structure decision. Additionally,
any risk-management action at the bank level would be irrelevant
for value creation, because it could be replicated/reversed by the
investors in efficient and perfect markets at the same terms and,
therefore, would have no impact on the banks value.
However, in practice, broadly categorized, banks do two things:
They offer (financial) products and provide services to their
clients.
They engage in financial intermediation and the management
of risk.
Therefore, a banks economic performance, and hence value,
depends on the quality of the provided services and the efficiency
14
Therefore, we find plenty of evidence that banks do run

sophisticated risk-management functions in practice (positive
theory for risk management). They perceive risk management to
be a critical (success) factor that is both used with the intention to
create value and because of the banks concern with lower tail
outcomes, that is, the concern with bankruptcy risk.
Moreover, banks evaluate (new) transactions and projects in the
light of their existing portfolio rather than (only) in the light of
the covariance risk with an overall market portfolio. In practice,
banks care about the contribution of these transactions to the
total risk of the bank when they make capital-budgeting decisions,
because of their concern with lower tail outcomes. Additionally,
we can also observe in practice that banks do care
Figure 1.1 Integrated view of value creation in banks

about their capital structurewhen making capital-budgeting and
risk management decisionsand that they perceive holding capital
as both costly and a substitute for conducting risk management.
Therefore, banks do not (completely) separate risk-management,
capital budgeting, and capital-structure decisions, but rather
determine the three components jointly and endogenously (as
depicted in Figure 1.1).
However, this integrated decision-making process in banks is not
reflected in the traditional valuation framework as determined by
the restrictive assumptions of the neoclassical world. And
11D.571.3
Developingbased on the theoretical foundations and the
implications from discussing the practical approachesmore

detailed instructions on how to conduct risk management and
how to measure value creation in banks in practice.
In order to achieve these goals, we will proceed in the following
way:
We will first lay the foundations for the further investigation of
the link between risk management and value creation by defining
and discussing value maximization as well as risk and its
management in a banking context, and establishing whether there
is empirical evidence of a link between the two.
We will then explore both the neoclassical and the neoinstitutional
finance theories on whether we can find rationales for risk
management at the corporate level in order to create value. Based
on the results of this discussion, we will try to deduce general
implications for a framework that encompasses both risk
management and value maximization in banks.
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To fill this gap, some of the leading banks have developed a set
of practical heuristics called Risk-Adjusted Performance Measures
(RAPM) or also better known, named after their most famous
representative, as RAROC (risk-adjusted return on capital). These
measures can be viewed as modified return on equity ratios and
take a purely economic perspective. Since banks are concerned about
unexpected losses and how they will affect their own credit rating,
they estimate the required amount of (economic or) risk capital
that they optimally need to hold and that is commensurate with
the (overall) riskiness of their (risk) positions. To do that, banks
employ a risk measure called value at risk (VaR), which has evolved
as the industrys standard measure for lower tail outcomes (by
choice or by regulation). VaR measures the (unexpected) risk
contribution of a transaction to the total risk of a banks existing
portfolio. The numerator of this modified ROE ratio is also
based on economic rather than accounting numbers and is,
therefore, adjusted, for example, for provisions made for credit
losses (so-called expected losses). Consequently, normal credit
losses do not affect a banks performance, whereas unexpected
credit losses do.
as they are currently applied in banks in the light of the results

of the prior theoretical discussion.
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Apparently, banks have already recognized this deficiency. Because

the traditional valuation framework is also often cumbersome to
apply in a banking context, many institutions employ a return on
equity (ROE) measure (based on book or regulatory capital)
instead. However, banks have also realized that such ROE
numbers do not have the economic focus of a valuation
framework for judging whether a transaction or the bank as a
whole contributes to value creation. They are too accountingdriven, the capital requirement is not closely enough linked to the
actual riskiness of the institution, and, additionally, they do not
adequately reflect the linkage between capital-budgeting, capitalstructure, and risk-management decisions.
Evaluating the practical heuristics RAROC and economic capital
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In order to judge whether a transaction creates or destroys value

for the bank, the current practice is to compare the (single-period)
RAPM to a hurdle rate or benchmark return. Following the
traditional valuation framework of neoclassical finance theory,
this opportunity cost is usually determined by the covariance or
systematic risk with a broad market portfolio.
However, the development and usage of RAROC, the practical
evidence for the existence of risk management in banks (positive
theory), and the fact that risk management is also used with the
intention to enhance value are phenomena unexplained by and
unconsidered in neoclassical finance theory.
It is, therefore, not surprising that there has been little consensus
in academia on whether there is also a normative theory for risk
management and as to whether risk management is useful for
banks, and why and how it can enhance value.
Therefore, the objective of this book is to diminish this discrepancy
between theory and practice by:
Deriving circumstances under which risk management at the
corporate level can create value in banks.

Laying the theoretical foundations for a normative approach
to risk management in banks.
11D.571.3
Using these results, we will outline the fundamentals for an

appropriate (total) risk measure that consistently determines the
adequate and economically driven capital amount a bank should
hold as well as its implications for the real capital structure in
banks. We will then discuss and evaluate the currently applied
measure economic capital and how it can be consistently
determined in the context of a valuation framework for the various
types of risk a bank faces.
Subsequently, we will investigate whether RAROC is an adequate
capital-budgeting tool to measure the economic performance of
and to identify value creation in banks. We do so because, on the
one hand, RAROC uses economic capital as the denominator
and, on the other hand, it is similar to the traditional valuation
framework in that it uses a comparison to a hurdle rate. When
exploring RAROC, we take a purely economic view and neglect
regulatory restrictions that undeniably have an impact on the
economic performance of banks. Moreover, we will focus on the
usage of RAPM in the context of value creation. We will not
evaluate its appropriateness for other uses such as limit setting
and capital allocation.
We close by evaluating the derived results with respect to their
ability to provide more detailed answers on whether and where
banks should restructure, concentrate on their competitive
advantages or divest, and whether they provide more detailed
instructions on why and when banks should conduct risk
management from a value creation perspective (normative theory).
Integrated Risk Management
There are three critical concepts that are cornerstones of the
Integrated Risk Management Framework: risk, risk
management and integrated risk management. These concepts
are elaborated on below.
Risk
Risk is unavoidable and present in virtually every human
situation. It is present in our daily lives, public and private
15
therefore it appears that some fundamental links to and concerns

about value creation in banks are neglected.
While this Framework recognizes the importance of the negative

connotation of outcomes associated with the description of risk
(i.e., risk is adverse), it is acknowledged that definitions are evolving.
Indeed, there is considerable debate and discussion on what would
be an acceptable generic definition of risk that would recognize
the fact that, when assessed and managed properly, risk can lead to
innovation and opportunity. This situation appears more prevalent
when dealing with operational risks and in the context of
technological risks. For example, Government On-Line (GOL)
represents an opportunity to significantly increase the efficiency of
public access to government services. It is acknowledged in advance
that the benefits of pursuing GOL would outweigh, in the long
term, potential negative outcomes, which are foreseen to be
manageable.
For the purposes of the Integrated Risk Management Framework:

Risk management is a systematic approach to setting the
best course of action under uncertainty by identifying,
assessing, understanding, acting on and communicating risk
issues.
In order to apply risk management effectively, it is vital that a risk
management culture be developed. The risk management culture
supports the overall vision, mission and objectives of an
organization. Limits and boundaries are established and
communicated concerning what are acceptable risk practices and
outcomes.
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The common concept in all definitions is uncertainty of outcomes.

Where they differ is in how they characterize outcomes. Some
describe risk as having only adverse consequences, while others are
neutral.
identification and assessment of risk, whereas others describe risk

management as the complete process, including risk identification,
assessment and decisions around risk issues. For example, the
Privy Council Offices report refers to risk management as the
process for dealing with uncertainty within a public policy
environment
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sector organizations. Depending on the context, there are many

accepted definitions of risk in use.
To date, no consensus has emerged, but after much research and

discussion, the following description of risk has been developed
for the federal Public Service in the context of the Integrated Risk
Management Framework:
Risk refers to the uncertainty that surrounds future events

and outcomes. It is the expression of the likelihood and
impact of an event with the potential to influence the
achievement of an organizations objectives.
The phrase the expression of the likelihood and impact of an

event implies that, as a minimum, some form of quantitative or
qualitative analysis is required for making decisions concerning
major risks or threats to the achievement of an organizations
objectives. For each risk, two calculations are required: its likelihood
or probability; and the extent of the impact or consequences.
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Finally, it is recognized that for some organizations, risk

management is applied to issues predetermined to result in adverse
or unwanted consequences. For these organizations, the definition
of risk in the Privy Council Office report 2, which refers to risk as a
function of the probability (chance, likelihood) of an adverse or
unwanted event, and the severity or magnitude of the
consequences of that event will be more relevant to their particular
public decision-making contexts. Although this definition of risk
refers to the negative impact of the issue, the report acknowledges
that there are also positive opportunities arising from responsible
risk-taking, and that innovation and risk co-exist frequently.
Since risk management is directed at uncertainty related to future

events and outcomes, it is implied that all planning exercises
encompass some form of risk management. There is also a clear
implication that risk management is everyones business, since
people at all levels can provide some insight into the nature,
likelihood and impacts of risk.
Risk management is about making decisions that contribute to
the achievement of an organizations objectives by applying it
both at the individual activity level and in functional areas. It
assists with decisions such as the reconciliation of science-based
evidence and other factors; costs with benefits and expectations in
investing limited public resources; and the governance and control
structures needed to support due diligence, responsible risk-taking,
innovation and accountability.
The current operating environment is demanding a more

integrated risk management approach. It is no longer sufficient to
manage risk at the individual activity level or in functional silos.
Organizations around the world are benefiting from a more
comprehensive approach to dealing with all their risks.
Today, organizations are faced with many different types of risk
(e.g., policy, program, operational, project, financial, human
resources, technological, health, safety, political). Risks that present
themselves on a number of fronts as well as high level, high impact risks demand a co-coordinated, systematic corporate
response.
Risk Management
Risk management is not new in the federal public sector. It is an

integral component of good management and decision-making
at all levels. All departments manage risk continuously whether
they realize it or notsometimes more rigorously and
systematically, sometimes less so. More rigorous risk management
occurs most visibly in departments whose core mandate is to
protect the environment and public health and safety.
Whatever name they put on itbusiness ... holistic ... strategic ...
enterpriseleading organizations around the world are breaking out of
the silo mentality and taking a comprehensive approach to dealing
with all the risks they face.
As with the definition of risk, there are equally many accepted

definitions of risk management in use. Some describe risk
management as the decision -making process, excluding the
16
-Towers Perrin
For the purposes of the Integrated Risk Management Framework:
Integrated risk management is a continuous, proactive and
systematic process to understand, manage and communicate
risk from an organization-wide perspective. It is about
11D.571.3
Element 4: Ensuring Continuous Risk Management

Learning
Integrated risk management requires an ongoing assessment of

potential risks for an organization at every level and then
aggregating the results at the corporate level to facilitate priority
setting and improved decision-making. Integrated risk
management should become embedded in the organizations
corporate strategy and shape the organizations risk management
culture. The identification, assessment and management of risk
across an organization helps reveal the importance of the whole,
the sum of the risks and the interdependence of the parts.
from experience is valued, lessons are shared;

Learning plans are built into an organizations risk management
practices;
An Integrated Risk Management Framework

The Integrated Risk Management Framework provides
guidance to adopt a more holistic approach to managing risk.
The application of the Framework is expected to enable
employees and organizations to better understand the nature
of risk, and to manage it more systematically.
Four Elements and Their Expected Results

The Integrated Risk Management Framework is comprised of
four related elements. The elements, and a synopsis of the
expected results for each, are presented below. Further details
on the conceptual and functional aspects of the Framework are
provided in subsequent sections of this document.
Element 1: Developing the Corporate Risk Profile
The organizations risks are identified through environmental
scanning;
Current status of risk management within the organization is
assessed; and
Results of risk management are evaluated to support
innovation, learning and continuous improvement; and

Experience and best practices are shared, internally and across
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government.
The four elements of the Integrated Risk Management
Framework are presented as they might be applied: looking
outward and across the organization as well as at individual
activities. This comprehensive approach to managing risk is
intended to establish the relationship between the organization
and its operating environment, revealing the interdependencies
of individual activities and the horizontal linkages.
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Integrated risk management does not focus only on the

minimization or mitigation of risks, but also supports activities
that foster innovation, so that the greatest returns can be achieved
with acceptable results, costs and risks. Integrated risk management
strives for the optimal balance at the corporate level.
A supportive work environment is established where learning
Element 1: Developing the Corporate Risk Profile

A broad understanding of the operating environment is an
important first step in developing the corporate risk profile.
Developing the risk profile at the corporate level is intended to
examine both threats and opportunities in the context of an
organizations mandate, objectives and available resources.
In building the corporate risk profile, information and knowledge
at both the corporate and operational levels is collected to assist
departments in understanding the range of risks they face, both
internally and externally, their likelihood and their potential
impacts. In addition, identifying and assessing the existing
departmental risk management capacity and capability is another
critical component of developing the corporate risk profile.
An organization can expect three key outcomes as a result of
developing the corporate risk profile:
Threats and opportunities are identified through ongoing
internal and external environmental scans, analysis and

adjustment.
The organizations risk profile is identified.
Current status of risk management within the organization is
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Element 2: Establishing an Integrated Risk

Management Function
Management direction on risk management is communicated,
understood and applied;
Approach to operationalized integrated risk management is
implemented through existing decision-making and reporting

structures; and
Capacity is built through development of learning plans and
tools.
Element 3: Practicing Integrated Risk Management

A common risk management process is consistently applied at
all levels;
Results of risk management practices at all levels are integrated
into informed decision-making and priority setting;
assessedchallenges/opportunities, capacity, practices,

culture and recognized in planning organization-wide
management of risk strategies.
The organizations risk profile is identifiedkey risk areas, risk
tolerance, ability and capacity to mitigate, learning needs.
External and Internal Environment
Through the environmental scan, key external and internal
factors and risks influencing an organizations policy and
management agenda are identified. Identifying major trends
and their variation over time is particularly relevant in providing
potential early warnings. Some external factors to be considered
for potential risks include:
Political: the influence of international governments and other
governing bodies;
Tools and methods are applied; and
Economic: international and national markets, globalization;
Consultation and communication with stakeholders is
Social: major demographic and social trends, level of citizen

engagement; and
ongoing.
Technological: new technologies.
11D.571.3
17
making strategic decisions that contribute to the

achievement of an organizations overall corporate
objectives.
Type of risk: technological, financial, human resources (capacity,

intellectual property), health, and safety;
Source of risk: external (political, economic, natural disasters);
internal (reputation, security, knowledge management,
information for decision making);
In the Public Service, citizens needs and expectations are

paramount. For example, most citizens would likely have a low
risk tolerance for public health and safety issues (injuries, fatalities),
or the loss of Canadas international reputation. Other risk
tolerances for issues such as project delays and slower service
delivery may be less obvious and may require more consultation.
In general, there is lower risk tolerance for the unknown, where
impacts are new, unobservable or delayed. There are higher risk
tolerances where people feel more in control (for example, there is
usually a higher risk tolerance for automobile travel than for air
travel).
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The environmental scan increases the organizations awareness

of the key characteristics and attributes of the risks it faces. These
include:
government departments will assist in developing a risk profile

and making decisions on what risks must be managed, how,
and to what extent. It will also help identify the challenges
associated with risk consultations and communication.
Risk tolerance can be determined through consultation with

affected parties, or by assessing stakeholders response or reaction
to varying levels of risk exposure. Risk tolerances may change
over time as new information and outcomes become available, as
societal expectations evolve and as a result of stakeholder
engagement on trade-offs. Before developing management
strategies, a common approach to the assessment of risk tolerance
needs to be understood organization-wide.
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Internally, the following factors are considered relevant to the

development of an organizations risk profile: the overall
management framework; governance and accountability structures;
values and ethics; operational work environment; individual and
corporate risk management culture and tolerances; existing risk
management expertise and practices; human resources capacity;
level of transparency required; and local and corporate policies,
procedures and processes.
What is at risk: area of impact/type of exposure (people,

reputation, program results, materiel, real property); and
Level of ability to control the risk: high (operational); moderate

(reputation); low (natural disasters).
An organizations risk profile identifies key risk areas that cut
across the organization (functions, programs, systems) as well as
individual events, activities or projects that could significantly
influence the overall management priorities, performance, and
realization of organizational objectives.
The environmental scan assists the department in establishing a

strategic direction for managing risk, making appropriate
adjustments in decisions and actions. It is an ongoing process
that reinforces existing management practices and supports the
attainment of overall management excellence.
Assessing Current Risk Management Capacity
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In assessing internal risk management capacity, the mandate,

governance and decision-making structures, planning processes,
infrastructure, and human and financial resources are examined
from the perspective of risk. The assessment requires an
examination of the prevailing risk management culture, risk
management processes and practices to determine if adjustments
are necessary to deal with the evolving risk environment.
Furthermore, the following factors are considered key in assessing

an organizations current risk management capacity: individual
factors (knowledge, skills, experience, risk tolerance, propensity to
take risk); group factors (the impact of individual risk tolerances
and willingness to manage risk); organizational factors (strategic
direction, stated or implied risk tolerance); as well as external factors
(elements that affect particular risk decisions or how risk is managed
in general).
Risk Tolerance
An awareness and understanding of the current risk tolerances
of various stakeholders is a key ingredient in establishing the
corporate risk profile. The environmental scan will identify
stakeholders affected by an organizations decisions and actions,
and their degree of comfort with various levels of risk.
Understanding the current state of risk tolerance of citizens,
parliamentarians, interest groups, suppliers, as well as other
Determining and communicating an organizations own risk

tolerance is also an essential part of managing risk. This process
identifies areas where minimal levels of risk are permissible, as
well as those that should be managed to higher, yet reasonable
levels of risk.
Element 2: Establishing an Integrated Risk Management Function
Establishing an integrated risk management function means
setting up the corporate infrastructure for risk management
that is designed to enhance understanding and communication
of risk issues internally, to provide clear direction and demonstrate
senior management support. The corporate risk profile provides
the necessary input to establish corporate risk management
objectives and strategies. To be effective, risk management needs
to be aligned with an organizations overall objectives, corporate
focus, strategic direction, operating practices and internal culture.
In order to ensure risk management is a consideration in priority
setting and revenue allocation, it needs to be integrated within
existing governance and decision-making structures at the
operational and strategic levels.
To ensure that risk management is integrated in a rational,
systematic and proactive manner, an organization should seek to
achieve three related outcomes:
Management direction on risk management is communicated,
understood and appliedvision, policies, operating principles.

Approach to operationalized integrated risk management is
implemented through existing decision-making structures:
governance, clear roles and responsibilities, and performance
reporting.
Building capacitylearning plans and tools are developed for
use throughout the organization.

Strategic Risk Management Direction
18
11D.571.3
Seeking excellence in management practices, including risk
management;
Having senior managers champion risk management;
Encouraging innovation, while providing guidance and
assistance in situations that do not turn out favorably;

Encouraging managers to develop knowledge and skills in
risk management;
appraisals;
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Including risk management as part of employees performance

Introducing incentives and rewards; and
Recruiting on risk management ability as well as experience.
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It is essential that management provides a clear statement of its

commitment to risk management and determines the best way
to implement risk management in its organization. This includes
establishing a corporate focus and communicating internal
parameters, priorities, and practices for the implementation of
risk management. To reinforce the corporate focus on risk
management, organizations may dedicate a small number of
resources to provide both advisory and challenge functions, and
to specifically integrate these responsibilities into an existing unit
(for example, Corporate Planning and Policy, Comptrollership
Secretariat, Internal Audit).
The integration of risk management into decision-making is

supported by a corporate philosophy and culture that encourages
everyone to manage risks. This can be accomplished in a number
of ways, such as:
In establishing the strategic risk management direction, internal

and external concerns, perceptions and risk tolerances are taken
into account. It is also imperative to identify acceptable risk
tolerance levels so those unfavorable outcomes can be remedied
promptly and effectively. Clear communication of the
organizations strategic direction will help foster the creation and
promotion of a supportive corporate risk management culture.
Objectives and strategies for risk management are designed to
complement the organizations existing vision and goals. In
establishing an overall risk management direction, a clear vision
for risk management is articulated and supported by policies and
operating principles. The policy would guide employees by
describing the risk management process, establishing roles and
responsibilities, providing methods for managing risk, as well as
providing for the evaluation of both the objectives and results of
risk management practices.
Integrating Risk Management into Decision Making
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Effective risk management cannot be practiced in isolation, but

needs to be built into existing decision-making structures and
processes. As risk management is an essential component of good
management, integrating the risk management function into
existing strategic management and operational processes will
ensure that risk management is an integral part of day-to-day
activities. In addition, organizations can capitalize on existing
capacity and capabilities (e.g., communications, committee
structures, existing roles and responsibilities, etc.)
While each organization will find its own way to integrate risk
management into existing decision-making structures, the
following are factors that may be considered:
Aligning risk management with objectives at all levels of the
organization;
Introducing risk management components into existing
strategic planning and operational processes;

Communicating corporate directions on acceptable level of risk;
and
Improving control and accountability systems and processes
to take into account risk management and results.
11D.571.3
Reporting on Performance
The development of evaluation and reporting mechanisms for
risk management activities provides feedback to management
and other interested parties in the organization and
government-wide. The results of these activities ensure that
integrated risk management is effective in the long term. Some
of these activities could fall to functional groups in the
organization responsible for review and audit. Responsibility
may also be assigned to operational managers and employees
to ensure that information affecting risk that is collected as part
of local reporting or practices is incorporated into the
environmental scanning process. Reporting could take place
through normal management channels (performance reporting,
ongoing monitoring, appraisal) as part of the advisory and
challenge functions associated with risk management.
Reporting facilitates learning and improved decision-making by
assessing both successes and failures, monitoring the use of
resources, and disseminating information on best practices and
lessons learned. Organizations should evaluate the effectiveness
of their integrated risk management processes on a periodic basis.
In collaboration with departments, the Treasury Board of Canada
Secretariat will review the effectiveness of the Integrated Risk
Management Framework and make the necessary adjustments to
ensure sustained progress in building a risk-smart workforce and
environment.
Building Organizational Capacity
Building risk management capacity is an ongoing challenge even

after integrated risk management has become firmly entrenched.
Environmental scanning will continue to identify new areas and
activities that require attention, as well as the risk management
skills, processes, and practices that need to be developed and
strengthened.
Organizations need to develop their own capacity strategies based
on their specific situation and risk exposure. The implementation
of the Integrated Risk Management Framework will be further
supported by the Treasury Board of Canada Secretariat, which,
through a center of expertise, will provide overall guidance, advice
and share best practices.
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The establishment and communication of the organizations

risk management vision, objectives and operating principles are
vital to providing overall direction, and ensure the successful
integration of the risk management function into the
organization. Using these instruments can reinforce the notion
that risk management is everyones business.
Human Resources
Building awareness of risk management initiatives and culture;
Broadening skills base through formal training including
appropriate applications and tools;

Increasing knowledge base by sharing best practices and
experiences; and
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Building capacity, capabilities and skills to work in teams.
Tools and Processes

Developing and adopting corporate risk management tools,
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To build capacity for risk management, there needs to be a focus

on two key areas: human resources, and tools and processes at
both the corporate and local levels. The risk profile will identify
the organizations existing strengths and weaknesses vis--vis
capacity. Areas that may require attention include:
techniques, practices and processes;
Providing guidance on the application of tools and techniques;

Allowing for development and/or the use of alternative tools
and techniques that may be better suited to managing risk in

specialized applications; and
Adopting processes to ensure integration of risk management
across the organization.
Element 3: Practicing Integrated Risk Management
Implementing an integrated risk management approach requires

a management decision and sustained commitment, and is
designed to contribute to the realization of organizational
objectives. Integrated risk management builds on the results of
an environmental scan and is supported by appropriate corporate
infrastructure.
The following outcomes are expected for practicing integrated risk
management:
A departmental risk management process is consistently applied at all
levels, where risks are understood, managed and communicated.
Results of risk management practices at all levels are integrated into
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informed decision-making and priority settingstrategic, operational,

management and performance reporting.
Tools and methods are applied as aids to make decisions.
The common risk management process and related activities are:

Risk Identification
1. Identifying Issues, Setting Context
Defining the problems or opportunities, scope, context (social,
cultural, scientific evidence, etc.) and associated risk issues.
Deciding on necessary people, expertise, tools and techniques
(e.g., scenarios, brainstorming, checklists).

Performing a stakeholder analysis (determining risk tolerances,
stakeholder position, attitudes).
Risk Assessment
2. Assessing Key Risk Areas
Analyzing context/results of environmental scan and
Consultation and communication with stakeholders is ongoinginternal
and external.
Internal and external communication and continuous learning

improve understanding and skills for risk management practice
at all levels of an organization, from corporate through to
front-line operations. The process provides common language,
guides decision-making at all levels, and allows organizations to
tailor their activities at the local level. Documenting the rationale
for arriving at decisions strengthens accountability and
demonstrates due diligence.
determining types/categories of risk to be addressed, significant

organization-wide issues, and vital local issues.
A Common Process
A common, continuous risk management process assists an
organization in understanding, managing and communicating
risk. Continuous risk management has several steps. Emphasis
on various points in the process may vary, as may the type, rigor
or extent of actions considered, but the basic steps are similar.
In the exhibits that follow, Exhibit 1 illustrates an example of a
continuous risk management process that focuses on an
integrated approach to risk management, while Exhibit 2
presents a risk management decision-making process in the
context of public policy.
3. Measuring Likelihood and Impact
Exhibit 1: A Common Risk Management Process
Defining objectives and expected outcomes for ranked risks,
Determining degree of exposure, expressed as likelihood and
impact, of assessed risks, choosing tools.

Considering both the empirical/scientific evidence and public
context.
4. Ranking Risks
Ranking risks, considering risk tolerance, using existing or
developing new criteria and tools.

Responding to Risk
5. Setting Desired Results
short/long term.
6. Developing Options
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11D.571.3
and maximize opportunitiesapproaches, tools.
options; decision; implementation of the decision; and evaluation

and review of the decision.
7. Selecting a Strategy
Choosing a strategy, applying decision criteriaresults-oriented,
problem/opportunity driven.
In this model, several key elements were identified as influencing

the public policy environment surrounding risk management:
Applying, where appropriate, the precautionary approach/
8. Implementing the Strategy
making, and it is a central and legitimate input to the process.

Uncertainty in science, together with competing policy interests
(including international obligations) has led to increased focus
on the precautionary approach.
Developing and implementing a plan.
A decision-making process does not occur in isolationthe public
Monitoring and Evaluation
Integrating Results for Risk Management into

Practices at all Levels
The results of risk management are to be integrated both
horizontally and vertically into organizational policies, plans and
practices. Horizontally, it is important that results be considered
in developing organization-wide policies, plans and priorities.
Vertically, functional units, such as branches and divisions, need
to incorporate these results into programs and major initiatives.
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9. Monitoring, Evaluating and Adjusting

Learning, improving the decision-making/risk management
process locally and organization-wide, using effectiveness
criteria, reporting on performance and results.
nature and complexity of many government policy issues means

that certain factors, such as communications and consultation
activities, legal considerations, and ongoing operational activities,
require active consideration at each stage of the process.
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principle as a means of managing risks of serious or irreversible

harm in situations of scientific uncertainty.
There is a public element to virtually all government decision-
Organizations may vary the basic steps and supporting tasks most
suited to achieving common understanding and implementing
consistent, efficient and effective risk management. A focused,
systematic and integrated approach recognizes that all decisions
involve management of risk, whether in routine operations or
for major initiatives involving significant resources. It is important
that the risk management process be applied at all levels, from the
corporate level to programs and major projects to local systems
and operations. While the process allows tailoring for different
uses, having a consistent approach within an organization assists
in aggregating information to deal with risk issues at the corporate
level.
Exhibit 2: Risk Management in Public Policy: A
Decision-Making Process
In practice, the risk assessment and response to risk would be

considered in developing local business plans at the activity, division
or regional level. These plans would then be considered at the
corporate level, and significant risks (horizontal or high-impact
risks) would be incorporated into the appropriate corporate
business, functional or operational plan.
The responsibility centre providing the advisory and corporate
challenge functions can add value to this process, since new risks
might be identified and new risk management strategies required
after the roll-up. There needs to be a synergy between the overall
risk management strategy and the local risk management practices
of the organization.
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Each function or activity would have to be examined from three

standpoints:
Its purpose: risk management would look at decision-making,
planning, and accountability processes as well as opportunities

for innovation;
Its level: different approaches are required based on whether a
function or activity is strategic, management or operational;

and
The relevant discipline: the risks involved with technology,
Exhibit 2 presents the model, developed by the PCO-led ADM

Working Group on Risk Management, which addresses the
issue of risk management in the context of public policy
development. This model presents a basis for exploring issues
of interest to government policy-makers, and provides a
context in which to discuss, examine, and seek out
interrelationships between issues associated with public policy
decisions in an environment of uncertainty and risk (i.e., a
model of public risk management).
As in Exhibit 1, this model recognizes six basic steps: identification
of the issue; analysis or assessment of the issue; development of
11D.571.3
finance, human resources, and those regarding legal, scientific,

regulatory, and/or health and safety issues.
Tools and Methods
At a technical level, various tools and techniques can be used for
managing risk. The following are some examples:
Risk maps: summary charts and diagrams that help
organizations identify, discuss, understand and address risks

by portraying sources and types of risks and disciplines
involved/needed;
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Identifying and analyzing optionsways to minimize threats
Framework on the precautionary approach: a principle-
based framework that provides guidance on the precautionary

approach in order to improve the predictability, credibility and
consistency of its application across the federal government;
Qualitative techniques: such as workshops, questionnaires,
and self -assessment to identify and assess risks; and

Internet and organizational Intranets: promote risk
awareness and management by sharing information internally

and externally.
Exhibit 3 provides an example of a risk management model. In
this model, one can assess where a particular risk falls in terms of
likelihood and impact and establish the organizational strategy/
response to manage the risk.
Consultation and proactive citizen engagement will assist in

bridging gaps between statistical evidence and perceptions of risk.
It is also important that risk communication practices anticipate
and respond effectively to public concerns and expectations. A
citizens request for information presents an opportunity to
communicate about risk and the management of risk.
In the public sector context, some high-profile risk issues would
benefit from proactively involving parliamentarians in particular
forums of discussion thus creating opportunities for exchanging
different perspectives. In developing public policy, input from
both the empirical and public contexts ensures that a more
complete range of information is available, therefore, leading to
the development of more relevant and effective public policy
options. Internally, risk communication promotes action,
continuous learning, innovation and teamwork. It can demonstrate
how management of a localized risk contributes to the overall
achievement of corporate objectives.
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models to show the range of possibilities and to build scenarios

into contingency plans;
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Modelling tools: such as scenario analysis and forecasting
Exhibit 3: A Risk Management Model
Element 4: Ensuring Continuous Risk Management

Learning
Continuous learning is fundamental to more informed and
proactive decision-making. It contributes to better risk
management, strengthens organizational capacity and facilitates
integration of risk management into an organizational structure.
To ensure continuous risk management learning, pursue the
following outcomes:
Learning from experience is valued, lessons are shareda supportive
work environment.
Learning plans are built into organizations risk management practices.
Results of risk management are evaluated to support innovation, capacity
In developing methods to provide guidance on risk

management, the different levels of readiness and experience in
a department, as well as variations in available resources need to
be recognized. Therefore, methods need to be flexible and
simple using clear language to ensure open channels of
communication.
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Several practical methods that could be used to provide guidance

are:
A managers forum: where risks are identified, proposed
actions are discussed and best practices are shared;
An internal risk management advisory function: dedicated
to risk management, either as a special unit or associated with

an existing functional unit; and
Tool kits: a collection of effective risk management tools such
as checklists, questionnaires, best practices.
Experience and best practices are sharedinternally and across
government.
Creating a Supportive Work Environment

A supportive work environment is a key component of
continuous learning. Valuing learning from experience, sharing
best practices and lessons learned, and embracing innovation
and responsible risk-taking characterize an organization with a
supportive work environment. An organization with a
supportive work environment would be expected to:
Promote learning
By fostering an environment that motivates people to learn;

By valuing knowledge, new ideas and new relationships as vital
aspects of the creativity that leads to innovation; and
Communication and Consultation

Communication of risk and consultation with interested parties
are essential to supporting sound risk management decisions.
In fact, communication and consultation must be considered at
every stage of the risk management process.
A fundamental requirement for practicing integrated risk
management is the development of plans, processes and products
through ongoing consultation and communication with
stakeholders (both internal and external) who may be involved in
or affected by an organizations decisions and actions.
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building and continuous improvementindividual, team and

organization.
By including and emphasizing learning in strategic plans.

Learn from experience
By valuing experimentation, where opportunities are assessed
for benefits and consequences;

By sharing learning on past successes and failures; and
By using lessons learned and best practices in planning
exercises.
Demonstrate management leadership
By selecting leaders who are coaches, teachers and good stewards;
11D.571.3
By demonstrating commitment and support to employees
through the provision of opportunities, resources, and tools;

and
By making time, allotting resources and measuring success
through periodic reviews (e.g., learning audits).
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As part of a units learning strategy, learning plans provide for the

identification of training and development needs of each employee.
Effective learning plans, reflecting risk management learning
strategies, are linked to both operational and corporate strategies,
incorporate opportunities for managers to coach and mentor staff,
and address competency gaps (knowledge and skills) for individuals
and teams. The inclusion of risk management learning objectives
in performance appraisals is a useful approach to support
continuous risk management learning.
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Building Learning Plans in Practices

Since continuous learning contributes significantly to increasing
capacity to manage risk, the integration of learning plans into all
aspects of risk management is fundamental to building capacity
and supporting the strategic direction for managing risk.
Supporting Continuous Learning and Innovation

In implementing a continuous learning approach to risk
management, it is important to recognize that not all risks can
be foreseen or totally avoided. Procedures are paramount to
ensure due diligence and to maintain public confidence. Goals
will not always be met and innovations will not always lead to
expected outcomes. However, if risk management actions are
informed and lessons are learned, promotion of a continuous
learning approach will create incentives for innovation while still
respecting organizational risk tolerances. The critical challenge is
to show that risk is being well-managed and that accountability
is maintained while recognizing that learning from experience is
important for progress.
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In addition to demonstrating accountability, transparency and due

diligence, proper documentation may also be used as a learning
tool. Practicing integrated risk management should support
innovation, learning, and continuous improvement at the
individual, team and organization level.
An organization demonstrates continuous learning with respect
to risk management if:
An appropriate risk management culture is fostered;
Learning is linked to risk management strategy at many levels;
Responsible risk-taking and learning from experience is
encouraged and supported;
There is considerable information sharing as the basis for
decision-making;
Decision-making includes a range of perspectives including
the views of stakeholders, employees and citizens; and

Input and feedback are actively sought and are the basis for
further action.
Notes:
11D.571.3
23
Risks that corporations faces, can be classified into three

categories:
Price or Market Risk
Counter party or Credit risk
Operating Risk
Regulatory risk is the risk of doing a transaction, which is not as

per the prevailing rules and laws of the country.
Errors & Omissions
Errors and omissions are not uncommon in financial
operations. These may relate to price, amount, value date,
currency, buy/sell side or settlement instructions.
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Risks that Corporations Faces
Price or Market Risk

This is the risk of loss due to change in market prices. Price risk
can increase further due to Market Liquidity Risk, which arises
when large positions in individual instruments or exposures
reach more than a certain percentage of the market, instrument
or issue. Such a large position could be potentially illiquid and
not be capable of being replaced or hedged out at the current
market value and as a result may be assumed to carry extra risk.
Frauds
Some examples of frauds are:
Counter party or Credit Risk

Dealing Risk is the sum total of all unsettled transactions due
for all dates in future. If the Counter party goes bankrupt on
any day, all unsettled transactions would have to be redone in
the market at the current rates. The loss would be the difference
between the original contract rate and the current rates. Dealing
risk is therefore limited to only the movement in the prices and
is measured as a percentage of the total exposure.
Custodial
Custodial risk is the loss of prime documents due to theft, fire,
water, termites etc. This risk is enhanced when the documents
are in transit.
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LESSON 4:
DEFINING OPTIMAL RISK LEVEL
Settlement Risk
Settlement risk is the risk of Counter party defaulting on the
day of the settlement. The risk in this case would be 100% of
the exposure if the corporate gives value before receiving value
from the Counter party. In addition the transaction would have
to be redone at the current market rates.
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Operating Risk
Operational risk is the risk that the organization may be
exposed to financial loss either through human error,
misjudgment, negligence and malfeasance, or through
uncertainty, misunderstanding and confusion as to
responsibility and authority. Following are the different kinds
of operating risks:
Legal
Regulatory
Errors & Omissions

Frauds
Custodial
Systems
Legal
Legal risk is the risk that the organisation will suffer financial
loss either because contracts or individual provisions thereof are
unenforceable or inadequately documented, or because the
precise relationship with the counter party is unclear.
Regulatory
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Front running
Circular trading
Undisclosed Personal trading

Insider trading
Routing deals to select brokers
Systems
Systems risk is due to significant deficiencies in the design or
operation of supporting systems; or inability of systems to
develop quickly enough to meet rapidly evolving user
requirements; or establishment of a great many diverse,
incompatible system configurations, which cannot be effectively
linked by the automated transmission of data and which
require considerable manual intervention.
Determining Optimal Risk
Seasoned traders know the importance of risk management. If
you risk little, you win little. If you risk too much, you
eventually run to ruin. The optimum, of course, is somewhere
in the middle. Here, Ed Seykota of Galt Capital and Dave Druz
of Tactical Investment Management, present a method to
measure risk and return.
Placing a trade with a predetermined stop-loss point can be
compared to placing a bet: The more money risked, the larger the
bet. Conservative betting produces conservative performance, while
bold betting leads to spectacular ruin. A bold trader placing large
bets feels pressure or heat from the volatility of the portfolio.
A hot portfolio keeps more at risk than does a cold one. Portfolio
heat seems to be associated with personality preference; bold traders
prefer and are able to take more heat, while more conservative
traders generally avoid the circumstances that give rise to heat.
In portfolio management, we call the distributed bet size the heat
of the portfolio. A diversified portfolio risking 2% on each of five
instrument & has a total heat of 10%, as does a portfolio risking
5% on each of two instruments.
Our studies of heat show several factors, which are:
1. Trading systems have an inherent optimal heat.

11D.571.3
3. Many traders are unaware of both these factors.
The participants generally come up with some amazingly complex

ways to arrive at a solution. Overall, the simplest way is to notice
that:
In the long run, heads and tails balance.
The order of heads and tails doesnt matter to the outcome.
FIGURE 1: The percent bet is the percentage bet of the running

stake. The Win-on heads is always 200% of the bet. The Loseon tails is the bet The final total shows the result of one cycle.
Beyond a 25% bet (lower half of table) the final total begins to
suffer.
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The result after n sets of head/ tail cycles is just the result of
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Coin Flipping
One way to understand portfolio heat is to imagine a series of
coin flips. Heads, you win two; tails, you lose one is a fair
model of good trading. The heat question is: What fixed
fraction of your running total stake should you bet on a series
of flips?
one head/ tail cycle raised to the nth power.
So we can get our answer simply by making a table of results of

just one head/ tail cycle.
Figure 1 represents such a heat test. It shows an optimal bet size
of 25%, at which point one head/ tail cycle delivers 12.5% profit,
after a 50% gain and a 25% draw down. As is typical of heat tests,
at low heat, performance rises linearly with bet size. At high heat,
performance falls as losses dominate, because draw downs are
proportional to heat squared (see Figures 2 and 3). In practice, a
trader may prefer to bet the coin at less than optimal heat, say 15%
to 20%, taking a slightly smaller profit to avoid some draw downinduced stress.
The results of the 12-year simulation recall the coin Flips described
previously. Return initially rises with increasing heat and then falls
as draw downs Dominate.
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Heat tests show profitability and volatility over a range of bet

sizes. Heat tests can help traders communicate with their investors
about and ultimately align on betting strategy before trading
begins. Otherwise, investors may become disenchanted with traders
who trade well yet ultimately deliver either too little or too much
heat.
Actual Heat Test
To study actual portfolio betting strategies, we fired up our
system-testing engine and simulated a trading system over a
range of heats. The engine trades all instruments
simultaneously. The engine rolls deliveries forward to stay with
the most active deliveries. The results of the 12-year simulation
recall the coin flips described previously. Return initially rises
with increasing heat and then falls as drawdowns dominate.
This heat test shows optimal performance for heat around
140% (about 28% per each of five instruments), at which point
the system delivers about 55% return per annum with average
draw down around 40% per annum and maximum draw down
over 90%. In actual practice, few investors would have the
stomach for such an optimum. Most would prefer fewer draws
down and less gain. In any event, heat testing can provide a
focus for traders and their investors and help align on critical
issues of bet sizing, return and draw down before beginning
new trading relationships.
11D.571.3
FIGURE 2: Plotting the return versus the heat illustrates that the
optimal amount bet is 25% of the stake. The curve has a peak
(point of zeroslope) at 25%
FIGURE 3: The optimal level of heat is near 140%; then increasing

heat causes losses to dominate
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2. Setting the heat level is far and away more important than
fiddling with trade timing parameters.
SIDEBAR: COIN FLIPPING MATH

To find the optimal bet size for a coin that heads wins two
times the fraction bet, and tails loses the fraction bet of the
running total stake on tails:
Return = (Results of Heads)(Results of Tails)
= (1+ 2Bet)( 1-Bet)
The optimal return at the top of the curve in Article Figure 2 is the
point of zero slope of the curve. This is found by taking the first
derivative:
d( Return)/ d( Bet) = 0
0 + 1 -4Bet = 0
Bet = 0.25
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= 1 + Bet -2Bet 2
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FIGURE 4: As heat is increased, the size of the draw downs

reaches maximum of over 90%.
SIDEBAR: SYSTEM TEST

Portfolio
Five instruments: Soybean oil, live cattle, sugar, gold and Swiss
francs
Time span: December 19, 1979, through January 28, 1992
Trading system: Enter positions on stop close only, 2 ticks beyond

the 20-week price range, updated weekly. Exit on stop 2 ticks
beyond the three-week price range, also updated weekly.
Bet size upon entry: (Equity)( heat)/ number of instruments
Number of contracts per trade: (Bet size)/ entry risk based on

the three-week risk point at the time of entry.
For example, for equity = $100,000, heat = 10% and number of

instruments = 2:
Bet size = ($ 100,000)( 0. 10)/( 2)
= $5,000
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The number of contracts per trade incorporates the risk identified

by the three-week range at the time of an entry signal (2-tick
breakout of the 20-week range SCO). Say a buy signal occurred
and the three-week low is $2,500 per contract away. The number
of contracts is:
Number of contracts = (bet size)/( entry risk)
= $5,000/$ 2,500
= 2 contracts
Caution: For purposes of demonstrating heat testing, we chose

the 20-week and three-week box system for its simplicity. No
claims are made about future performance. Indeed, the profitable
results largely reflect having retrospectively placed some good trend
commodities in the portfolio. Further more, the results were best
in the early years and seemed to degenerate.
Notes:
26
11D.571.3
which STC is domiciled, have supported STCs operating

agreement with the contract drivers as being valid. The agreement
between STC and the drivers establishes them as independent
contractors, with the drivers leasing the trucks from STC for each
trip.
John Schmidt is also the President of Investors Trucking
Association (ITA), a trade group of independently owned trucking
companies. The purpose of this trade group is to support
beneficial actions in legislation, share solutions to mutual problems,
and to develop industry-wide operating standards for this segment
of the trucking industry.
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The objective of this case is to acquaint the student with the

basic financial considerations and processes employed in risk
management. It focuses on the financial risk management
principles underlying a sound risk management program. Use
of the trucking industry for this case is arbitrary, and does not
imply a risk management study for this industry per se.
Emphasis is directed to the risk financing function as contrasted
with identification, evaluation and control of risks. In practice
all of these are essential to achieving success in risk
management, and this lack of emphasis is not intended to
diminish their importance. ibis case is written from the
viewpoint of a beginning student of risk management, as
opposed to that of an experienced, professional risk manager
seeking to sharpen existing skills.
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Introduction
The Case
Mark Edwards has recently joined STC Trucking Corporation
(SIC) as Assistant Treasurer. In addition to other traditional
financial duties, Edwards new responsibilities involve the risk
management function, including purchase of insurance for the
corporation. This activity was formerly handled by Al Avery, the
present chief financial officer, a principal and cofounder of STC.
Mr. Avery has charged Edwards to ... get a handle on the
rising costs of property and liability insurance. Edwards
enthusiastically accepted the challenge; however, he knew this
would involve more than insurance alone.
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Background
STC has been in operation for four years. It is a closely held
corporation, owned by its President, John Schmidt (55%), Vice
President and Treasurer, Al Avery (25%), and two other
investors (10% each), who do not participate actively in the
management of STC.
STC has been very successful in its various operations during its
brief time in business. The principal business functions of SIC
are the operation; leasing and management of long- haul units
used in transportation of non-hazardous cargo, as a common
carrier. The companys operations are divided between its ownership
and operation of various tractor and trailer units, and the
management of other investor-owned trucking units. The trucking
units are either dispatched from one of the companys own two
terminals, or from one of the terminals of a large trucking/
transportation company which contracts with STC and other
similar trucking companies. STC presently owns some 100-truck
units. All remaining units are owned by other independent investor
syndicates, but are managed by STC under contract. Contract drivers
who are paid by the mile for operating the trucks drive all trucks.
Although these drivers are not considered to be employees of
STC, because of contract requirements with several of the shippers,
workers compensation coverage is carried voluntarily for these
drivers by STC. No other employee benefits are provided for the
contract drivers by STC. Recent court decisions in the state in
11D.571.3
Actions Already Taken

Before Edwards began his task of getting ...a handle on the
rising costs of property and liability insurance, it was necessary
for him to obtain various records and information from STCs
corporate files. Initially, the items he requested were STCs
current financial statements: (Balance Sheet and Income
Statement); (2) a Schedule of Insurance Costs; and (3) the
Claim and Loss Records, (sometimes referred to as Claim
Runs) supplied by each of STCs insurers.
In examining these records, Edwards also considered how to
approach controlling STCs cost of insurance. Until now, Edwards
had always considered premium cost to be the cost of insurance.
Now, as risk manager, he has a greater appreciation of the fact that
the premiums can be influenced by such basic factors as errors in
the information provided on the applications submitted to the
various companies, as well as errors in classification, rating, or
property valuation. Moreover, the ultimate cost can be determined
only after any retrospective rating or other premium adjustments,
including the audit, are completed, and the choice of the rating
plan may be crucial. Although his examination of the records
revealed no serious omissions, Edwards still was convinced there
had to be some ways (heretofore neglected) to reduce insurance
costs.
Edwards was eager to explore alternatives to the purchase of
commercial insurance to reduce STCs exposure to loss. He was
aware that the insurance industry follows cycles of alternating
tight and soft markets which may drive premiums up or down
at renewal. Indeed, in a tight market it might even be difficult for
insurance brokers to place some of STCs insurance coverage since
the trucking industry is generally considered a less than desirable
class of exposure in a restrictive insurance market. Finally, Edwards
knows that one of the most direct ways to cut insurance costs is
through a rigid program of loss prevention and control.
FINANCIAL STATEMENTS
Third-Year Abbreviated Balance Sheet (in thousands)
27
LESSON 5:
CASE STUDY OF STANDARD TRUCKING CORPORATION
ASSETS
LIABILITIES
Current Assets
Fixed Assets
$640 Current Liabilities
$299
10,400 Liabilities and Debt

Total Liabilities
7,900
8199
NUMBER & AMOUNT OF INCURRED LOSSES (Paid and Reserved)
SHAREHOLDERS EQUITY
Stock
Capital
1,841
1,000
Total S/H's Equity
2,841
lst Year
2nd Year
3rd Year
Amt.
Amt.
Amt.
Present Year
(Est.)
#
Amt.
WORKERS COMPENSATION
TOTAL ASSETS $11,040 TOTAL LIABILITY & S/H EQUITY $11,040
$ 100 - 500
(4) 700
(10) 2,500
(15) 3,100
(22)
3,600
501 - 2,000
(3) 3,100 ( 4) 3,600
( 6) 6,200
2,001 - 10,000
(2) 5,700 ( 3) 6,800
( 8)
8,100
( 5) 16,300 ( 7)
24,000
( 1) 12,500 ( 1) 28,000 ( 2)
38,100
(9) 9,500 (18) 25,400 (27) 53,600 (39)
73,800
$ 100 - 500
(1) 420
( 4) 1,610
( 6) 1,800
( 8)
2,800
501 - 2,000
(2) 1,200 ( 4) 4,800
(10) 7,800
10,001 & Above

TOTALS
(0) 0
FLEET LIABILITY
Third-Year Income Statement
2,001 - 10,000
10,000 & Above
Income from Owned Units $5,170,000
TOTALS
Income from Investor Units 2,940,000
(13)
14,300
(4) 9,100 ( 6) 18,700 (11) 39,800 (14)
32,340
(0) 0
167,5OO
( 2) 36,500 ( 3) 96,000 ( 2)
(7) 10,720 (16) 61,610 (30) 145,400 (37)
865,000
Gross Income
8,975,000
$ 100- 500
(2) 750
Cost of Operations
6,462,720
501-2,000
(3) 1,810 ( 4) 2,890
( 5) 3,110
(10)
7,090
Gross Profit
2,512,280
2,001- 5,000
(1) 2,800 ( 4) 8,200
( 6) 24,800 (11)
34,700
Other Expenses
1,307,425
5,001- 10,000
(3) 18,700 ( 9) 63,700 (12) 70,900 (19)
114,800
10,001- 20,000
(1) 15,700 ( 5) 72,000 ( 8) 105,700 ( 6)
77,200
Net Profit (Before Taxes)
1,204,855
20,001 & Above
(0) 0
79,400
FLEET PHYSICAL DAMAGE

( 6) 1,370
(12)
( 1) 60,200 ( 2) 101,700 ( 2)
GENERAL LIABILITY
Schedule of Insurance Costs

1st Year 2nd Year
Premium $ 750
750
3rd
2,000
3,970
$1,500,000 1,500,000 2,000,000 3,300,000
Premium $ 12,570
29,700
57,800
98,060
$ 601,400 1,340,400 2,001,400 3,100,900
GENERAL LIABILITY
($500,000 Combined Single Limit)

Premium $ 12,500
Sq. Ft.
22,000
13,750
16,500
29,000
22,000
22,000
22,000
FLEET LIAB. OWNED & MANAGED
(BI: $250,000 Per Pers./$500,000 Per Acc./ PD: $250,000)

Premium $ 50,000
Units
50
82,500
180,000
360,000
80
120
160
410,000
618,000
FLEET PHYSICAL DAMAGE

Premium $ 120,000 172,000
Value
$3,000,000 4,800,000 8,400,000 12,000,000
Deductible $ 1,000
UMBRELLA
1,000
2,500
2,500
36,000
75,000
($5,000,000 Excess of Primary)

Premium $ 12,500
16,000
PROPERTY
32,200
185,190
233,400
212,200
(0)
( 1) 714
(0) 0
( 1) 1,600
(0) 0
(0) 0
( 1) 850
(0)
Present Year (Est.)
WORKERS COMPENSATION
Payroll
316,870
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NET of Deductible s
PROPERTY
3,680
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( 5) 1,510
TOTAL (incldg deductibles) (10) 39,760 (28) 208,500 (39) 307,580 (60)
Value
216,940
Other Income
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LOSS INFORMATION SUMMARY
QUESTIONS FOR DISCUSSION
1. What information should Edwards be interested in obtaining

from the financial records requested, and how might he use
this information? Also, what other financial information might
be useful?
2. [A] What information can Edwards obtain from the Schedule
of Insurance Costs, and how might he use this information?
[B] What other insurance information might be useful?
3. [A] What information can be found in the Loss Runs, and
how might Edwards use this information?
[B] What other information might be helpful in reducing loss
costs?
4. What can Edwards do now to reduce the costs of insurance to

cover STCs exposures to loss?
5. Discuss the alternative risk financing methods Edwards might
consider, and their potential advantages and disadvantages.
In addition to the obvious areas of concern (fleet liability, fleet
physical damage, and workers compen
6. sation), what other areas of potential risk should concern
Edwards?
7. What should Edwards consider in determining the optimal
deductible decisions for his companys property insurance and
self insured retention (SIR) for liability insurance?
8. What other actions might Edwards take to reduce STCs costs
for fleet exposures, other than improved risk financing
methods?
Notes:
28
11D.571.3
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LESSON 6:
INTERACTIVE SESSION
11D.571.3
29
LESSON 7:
BASIC CONCEPT OF RISK
MEASUREMENT
UNIT I
CHAPTER 4
RISK IDENTIFICATION & MEASUREMENT
Discuss frameworks for identifying business and individual
risk exposures.
Review concepts from probability and statistics.
Apply mathematical concepts to understand the frequency and
exceed market value. Replacement cost new is the cost of

replacing the damaged property with new property. Due to
economic depreciation and improvements in quality,
replacement cost new often will exceed the market value of the
property.
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severity of losses.
Explain the concepts of maximum probable loss and value at
risk.
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Risk Identification
The five major steps in the risk management decision-making
process are: (1) identify all significant risks that can cause loss;
(2) evaluate the potential frequency and severity of losses; (3)
develop and select methods for managing risk; (4) implement
the risk management methods chosen; and (5) monitor the
suitability and performance of the chosen risk management
methods and strategies on an ongoing basis. This chapter
focuses on the first two steps of this process.
Identifying Business Risk Exposures

The first step in the risk management process is risk
identification: the identification of loss exposures.
Unidentified loss exposures most likely will result in an implicit
retention decision, which may not be optimal. There are various
methods of identifying exposures. For example,
comprehensive checklists of common business exposures can
be obtained from risk management consultants and other
sources. Loss exposures also can be identified through analysis
of the firms financial statements, discussions with managers
throughout the firm, surveys of employees, and discussions
with insurance agents and risk management consultants.
Regardless of the specific methods used, risk identification
requires an overall understanding of the business and the
specific economic, legal, and regulatory factors that affect the
business.
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Chapter Objective
Property Loss Exposure
Some of the major practical questions asked when identifying

property loss exposures for businesses are listed in Table 3.1. In
addition to identifying what property is exposed to loss and the
potential causes of loss, the firm must consider how property
should be valued for the purpose of making risk management
decisions. Several valuation methods are available. Book
valuethe purchase price minus accounting depreciationis
the method commonly used for financial reporting purposes.
However, since book value does not necessarily correspond to
economic value, it generally is not relevant for risk management
purposes . Market value is the value that the next-highestvalued user would pay for the property. Firm-specific value is
the value of the property to the current owner. If the property
does not provide firm-specific benefits, then firm-specific value
will equal market value. Otherwise, firm-specific value will
30
Indirect losses also can arise from damage to property that will
be repaired or replaced. For example, if a fire shuts down a
plant for four months, the firm not only incurs the cost of
replacing the damaged property, it also loses the profits from
not being able to produce. In addition, some operating
expenses might continue despite the shutdown (e.g., salaries for
certain managers and employees and advertising expenses).
These exposures are known as business income exposures
(or, sometimes, business interruption exposures), and they
frequently are insured with business interruption insurance. Note
that business interruption losses also might result from
property losses to a firms major customers or suppliers that
prevent them from transacting with the firm. This exposure can
be insured with contingent business interruption insurance.
Firms also may suffer losses after they resume operations if
previous customers that have switched to other sources of supply
do not return. In the event that a long-term loss of customers
would occur and/or a shutdown temporarily would impose large
11D.571.3
Liability Losses
As we analyze in detail in later chapters, firms face potential legal
liability losses as a result of relationships with many parties,
including suppliers, customers, employees, shareholders, and
members of the public. The settlements, judgments, and legal
costs associated with liability suits can impose substantial losses
on firms. Lawsuits also may harm firms by damaging their
reputation, and they may require expenditures to minimize the
costs of this damage. For example, in the case of liability to
customers for injuries arising out of the firms products, the
firm might incur product recall expenses and higher marketing
costs to rehabilitate a product.
One of the most important sources of risk for most individuals

and families is from medical expenses. The methods of dealing
with this risk vary across countries. Some countries, like the United
States, rely largely on the private medical and insurance industry to
provide or pay for services and insurance to deal with medical
expense risk. Other countries, such as Canada and the United
Kingdom, rely more on government provision of medical services
and insurance.
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insurance. The risk of a drop in earnings prior to retirement due

to external economic factors is also an important risk facing
households. Private methods for dealing with this risk, except for
perhaps investments in education, are limited. Some public
support often is available in the form of compulsory social
insurance and unemployment insurance programs.
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Another major source of expense risk is from personal liability

exposures. Individuals can be sued and held liable for damages
inflicted on others. The main sources of personal liability arise
from driving an automobile and owning property with potential
hazards.
Losses to Human Resources

Losses in firm value due to worker injuries, disabilities, death,
retirement, and turnover can be grouped into two categories.
First, as a result of contractual commitments and compulsory
benefits, firms often compensate employees (or their
beneficiaries) for injuries, disabilities, death, and retirement.
Second, worker injuries, disabilities, death, retirement, and
turnover can cause indirect losses when production is
interrupted and employees cannot be replaced at zero cost with
other employees of the same quality. In some cases, firms
purchase life insurance to compensate for the death or disability
of important employees.
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Losses from External Economic Forces

The final category of losses arises from factors that are outside
of the firm. Losses can arise because of changes in the prices of
inputs and outputs. For example, increases in the price of oil
can cause large losses to firms that use oil in the production
process. Large changes in the exchange rate between currencies
can increase a multinational firms costs or decrease its revenues.
As another example, an important supplier or purchaser can go
bankrupt, thus increasing costs or decreasing revenues.
Using loss control and purchasing liability insurance typically

manage these risks. Retirement often implies a large drop in
earnings. To continue to pay living expenses during retirement,
an individual needs to have saved substantial funds prior to
retirement and/or rely on public programs, such as social security.
The risk associated with pre-retirement savings and thus the risk
of not having sufficient assets during retirement to fund expenses
depends on how the assets are invested. The choice of assets, (for
example, between stocks, bonds, and real estate) is an important
risk management decision for all individuals and households.
Even after someone has retired with substantial assets, the person
faces the risk of living so long all savings are depleted prior to
death. This longevity risk can be managed using annuities,
including government mandated annuities, such as those
provided in the U.S. social security system.
Identifying Individual Exposures

One method of identifying individual/family exposures is to
analyze the sources and uses of funds in the present and
planned for the future. Potential events that cause decreases in
the availability of funds or increases in uses of funds represent

risk exposures (see Box 3.1). Because both physical and financial
assets represent potential future sources of funds, potential losses
in asset values also represent risk exposures. Just as business risk
management consultants can aid in the identification of business
risks, individual/family financial planners can help identify and
then manage personal risks.
An important risk for most families is a drop in earnings prior to
retirement due to the death or disability of a breadwinner. The
magnitude of this risk depends, among other factors, on the
number and age of dependents and on alternative sources of
income (e.g., a spouses income or investment income). The losses
due to death or disability can be managed with life and disability
11D.571.3
Basic Concepts from Statistics & Probability
31
costs on customers or suppliers, it might be optimal for the firm

to keep operating following a loss by arranging for the immediate
use of alternative facilities at higher operating costs. The resulting
exposure to higher costs is known as the extra expense exposure.
Insurance purchased to reimburse the firm for these higher costs
is known as extra expense coverage.
Random Variables and Probability Distributions

A random variable is a variable whose outcome is uncertain. For
example, suppose a coin is to be flipped and the variable X is
defined to be equal to $1 if heads appears and _$1 if tails appears.
Then prior to the coin flip, the value of X is unknown; that is, X
is a random variable. Once the coin has been flipped and the
outcome revealed, the uncertainty about X is resolved, because
the value of X is then known.
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Information about a random variable is summarized by the

random variables probability distribution. In particular, a
probability distribution identifies all the possible outcomes
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for the random variable and the probability of the outcomes. For
the coin flipping
example, Table 3.2 gives the probability distribution for X.
In addition to describing a probability distribution by listing the

outcomes and probabilities, we also can describe probability
distributions graphically. Figure 3.1 illustrates the probability
distribution for the coin flipping example. On the horizontal
axis, we graph the possible outcomes. On the vertical axis, we
graph the probability of a particular outcome. There are only two
possible outcomes in this very simple example: $1 and _$1, and
the probability of each is 0.5. When discussing random variables,
we use the term actual or observed outcome (or, sometimes realized
outcome) to refer to the outcome observed (realized) in a particular
case, as opposed to the possible outcomes that could have occurred.
In the coin flipping example, once the coin has been tossed we can
observe the actual outcome, which either must be $1 or _$1.
As emphasized in the first two chapters, risk management

decisions need to be made prior to knowing what the actual
(realized) outcomes of key variables will be. Managers do not
know beforehand which outcomes of the random variables
affecting the firms profits will occur. Nevertheless, they must
make decisions. Once the outcomes are observed, it usually is easy
to say what would have been the best decision. However, we
cannot evaluate decisions from this perspective, which is why
probability distributions are so important. Probability
distributions tell us all of the possible outcomes and the probability
of those outcomes. Information about probability distributions
is needed to make good risk management decisions.
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Risk assessment and measurement require a basic

understanding of several concepts from probability and
statistics. We review these concepts in this section.
As a second example of a probability distribution, we can

approximate the probability distribution for the dollar amount
of damages to your car during the coming year. For simplicity, our
approximation will assume only five possible levels of damages:
$0; $500; $1,000; $5,000; and $10,000. The probabilities of each
of these outcomes are listed in Table 3.3. The most likely outcome
is zero damages, and the least likely outcome is that damages
equal $10,000. Note that the sum of the probabilities equals 1;
this must always be the case. An alternative way of describing the
probability distribution is provided by Figure 3.2, where the height
of each dotted line gives the probability of each possible outcome
32
As a final example, consider an automaker. Two of the many

reasons why the automakers profits are uncertain are steel price
changes and labor conditions. In the language just introduced,
the automakers profits are a random variable. There are
numerous possible outcomes for the automakers profits. For
example, steel prices could increase so much that profits could be
negative. On the other hand, favorable outcomes for steel prices
and the economy could cause very high profits.
What is the probability distribution for the automakers profits?
Recall that a probability distribution identifies all of the possible
outcomes and associates a probability with each outcome. The
coin flipping example had only two possible outcomes and so
listing the probabilities was simple. In the automaker example,
however, we could spend hours listing all the possible outcomes
for profits and still not be finished, due to the large number of
possible outcomes. In these situations, it is useful to assume
that the possible outcomes can be any number between two
extremes (the minimum possible outcome and the maximum
possible outcome) and that the probability of the outcomes
between the extremes is represented by a specific mathematical
function.2 For example, assume that profits for the automaker
could be any number between _$20 million and $50 million. Just
as with the earlier graphs, we can identify the possible outcomes
for profits between these amounts on the horizontal axis of
Figure 3.3, which illustrates the probability distribution for the
automakers profits. Analogous to the earlier graphs, the vertical
axis will measure the probability of the possible outcomes. The
probabilities of the outcomes are illustrated in Figure 3.3 by a bell
shaped curve, which might appear familiar to you.
11D.571.3
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Expected Value
The expected value of a probability distribution provides

information about where the outcomes tend to occur, on
average. For example, if the expected value of the automakers
profits is $10 million, then profits should average about $10
million. Thus, a distribution with a higher expected value will
tend to have a higher outcome, on average.
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Recall that the sum of the probabilities of all the possible

outcomes must equal 1 (some outcome must occur). In the
coin flipping example and the automobile damage example,
this property is easy to verify because the number of possible
outcomes is small. Stating that the probabilities sum to 1 in
these examples is equivalent to stating that the heights of the
dotted lines in Figures 3.1 and 3.2 sum to 1. This is a useful
observation because it helps to illustrate the analogous
property in the automaker example, where any outcome
between _$20 million and $50 million is possible. You can
think of the curve in Figure 3.3 as a curve that connects the
tops of many thousands of bars that have very small widths,
and the sum of the heights of all these bars is equivalent to the
area under the curve.4 Thus, stating that the probabilities must
sum to 1 is equivalent to stating that the area under the curve
must equal 1.
Characteristics of Probability Distributions

In many applications, it is necessary to compare probability
distributions of different random variables. Indeed, most of
the material in this book is concerned with how decisions (e.g.,
whether to purchase insurance) change probability distributions.
Understanding how decisions affect probability distributions
will lead to better decisions. The problem is that most
probability distributions have many different outcomes and are
difficult to compare. It is therefore common to compare certain
key characteristics of probability distributions: the expected
value, variance or standard deviation, skew ness, and correlation.
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Since the area under the curve in Figure 3.3 equals 1, we can
graphically identify the probability that profits are within a certain
interval. For example, the probability that profits are greater than
$40 million is the area under the curve to the right of $40 million.
The probability that profits are less than $0 is the area under the
curve to the left of $0. The probability that profits are between
$10 and $30 million is the area under the curve between $10 and
$30 million. Thus, the bell-shaped curve in Figure 3.3 tells us that
for the automaker, there is a relatively high probability that profits
will be between $10 and $30 million. In contrast, while very low
profits and very high profits are possible, they do not have a high
probability of happening.
Concept Checks
1. What information is given by a probability distribution? What
are the two ways of describing a probability distribution?
2. Earthquakes are rare, but the property damage can be very large
when they occur. Illustrate these features by drawing a
11D.571.3
To calculate the expected value, you multiply each possible outcome

by its probability and then add up the results. In the coin flipping
example there are two possible outcomes for X, either $1 or $1.
The probability of each outcome is 0.5. Therefore, the expected
value of X is $0:
If one were to play the coin flipping game many times, the average
outcome would be approximately $0. This does not imply that
the actual value of X on any single toss will be $0; indeed, the
actual outcome for one toss is never $0.
To define expected value in general terms, let the possible outcomes
of a random variable, X, be denoted by x1, x2, x3, . . ., xM (these
correspond to _$1 and $1 in the coin flipping example) and let the
probability of the respective outcomes be denoted by p1, p2, p3, .
. . , pM (these correspond to the 0.5s in the coin flipping example).
Then, the expected value is defined mathematically as:
If we examine a probability distribution graphically, we often

can learn something about the expected value of the
distribution. For example, Figure 3.4 illustrates two probability
distributions. Since the distribution for A is shifted to the right
compared with B, distribution A has a higher expected value
than distribution B.
When distributions are symmetric, as in Figure 3.4, identifying
the expected value is relatively easy; it is the midpoint in the
range of possible outcomes. When the probability
distributions are not symmetric, identifying the expected value
by examining a diagram sometimes can be difficult.
Nevertheless, you often can compare the expected values of
different distributions visually. Consider, for example, the two
distributions illustrated in Figure 3.5. Distribution C has a
higher expected value than distribution D. Intuitively, the high
outcomes are more likely with distribution C than with D, and
the low outcomes are less likely with C than with D.
33
probability distribution for property losses due to an earthquake

for a business that has property valued at $50 million. Identify
on your graph the probability that losses will exceed $30 million.
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For each of the loss distributions in Table 3.4, the expected value
is $500 (you should verify this for yourself), but the variances of
the three distributions differ. Loss distribution 2 has a larger
variance than distribution 1, because the extreme outcomes for
distribution 2 are farther from the expected value than they are for
distribution 1. Distribution 3 has a larger variance than distribution
2, because even though the outcomes are the same for distributions
2 and 3, the extreme outcomes are more likely with distribution 3
than with distribution 2. That is, the probability of having a loss
far from the expected value ($500) is greater with distribution 3
than with distribution 2. The comparison of distributions 2 and
3 illustrates that the variance depends not only on the dispersion
of the possible outcomes but also on the probability of the
possible outcomes.
The mathematical definitions of variance and standard
deviation show precisely how the probabilities of the different
outcomes and the deviation of each outcome from the expected
value affect these measures of risk. The definitions are:
Concept Check
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Many risk management decisions depend on the probability

distribution of losses that can arise from lawsuits, worker injuries,
damage to property, and the like. When a probability distribution
is for possible losses that can occur, the distribution is called a loss
distribution. The expected value of the distribution is called the
expected loss.
3. What is the expected value of damages for the distribution

listed in Table 3.3?
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Variance and Standard Deviation

The variance of a probability distribution provides
information about the likelihood and magnitude by which a
particular outcome from the distribution will differ from the
expected value. In other words, variance measures the probable
variation in outcomes around the expected value. If a
distribution has low variance, then the actual outcome is likely
to be close to the expected value. Conversely, if the distribution
has high variance, then it is more likely that the actual (realized)
outcome from the distribution will be far from the expected
value. A high variance therefore implies that outcomes are
difficult to predict. For this reason, variance is a commonly used
measure of risk. In some instances, however, it is more
convenient to work with the square root of the variance, which
is known as the standard deviation.
To illustrate variance and standard deviation, consider three possible

probability distributions for accident losses. Each distribution
has three possible outcomes, but the outcomes and the
probabilities differ. The three probability distributions are shown
in Table 3.4.
34
Notice that the quantity in parentheses measures the deviation of

each outcome from the expected value. This difference is squared
so that positive differences do not offset negative differences.
Each squared difference is then multiplied by the probability of
the particular outcome so those outcomes that are more likely to
occur receive greater weight in the final sum than those outcomes
that have a low probability of occurrence.
Additional insights about these measures of risk can be gained by
going step-by-step through the calculations for distribution 1
introduced above. Table 3.5 provides this analysis. It indicates
that distribution 1 has a standard deviation equal to $204. Similar
calculations for distributions 2 and 3 (not shown) indicate that
their standard deviations equal $408 and $447, respectively.
As noted earlier, variance and standard deviation measure the
likelihood that and magnitude by which an outcome from the
probability distribution will deviate from the expected value. They
thus measure the predictability of the outcomes. As a consequence,
11D.571.3
when referring to risk as variability around the expected value, we

generally will measure risk using variance or standard deviation.5
Concept Checks
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Like expected values, standard deviations of distributions often

can be compared by visually inspecting the probability
distributions. For example, Figure 3.6 illustrates two distributions
for accident losses. Both have an expected value of $1,000, but
they differ in their standard deviations. There is a greater chance
that an outcome from distribution A will be close to the expected
value of $1,000 than with distribution B.
1. Explain why variance and standard deviation are useful

measures of risk.
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2. Without doing any calculations, can you compare the standard

deviations of the following distributions?
1. Compare the expected values and standard deviations of

distributions A and B illustrated in the following figure:
Notes:
11D.571.3
35
1. Recall the coin flipping game discussed earlier in the chapter

where you win $1 if heads appears and lose $1 if tails appears.
What is the expected value of the outcome from the game if
it is played only one time? Calculate the sample mean and
sample standard deviation if the game is played five times
with the following results: T, T, H, T, H.
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Skewness
Another statistical concept that is important in the practice of
risk management is the skewness of a probability distribution.
Skewness measures the symmetry of the distribution. If the
distribution is symmetric, it has no skewness. For example,
consider the two distributions for accident losses illustrated in
Figure 3.7. The distribution at the top of Figure 3.7 is
symmetric; it has zero skewness. However, the distribution at
the bottom is not symmetric; it has positive skewness. Many
of the loss distributions that are relevant to risk management
are skewed.
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Sample Mean and Sample Standard Deviation

Sometimes the expected value is called the mean of the
distribution. We avoid using this term because it leads to
confusion with another concept: the average value from a
sample of outcomes from a distribution, which also is known
as the sample mean. A simple illustration will help you
understand the difference between the average outcome from a
sample (the sample mean) and the expected value of the
probability distribution. Assume that there is a 0.5 probability
that the fertilization of an egg will produce a female, and there
is a 0.5 probability that the fertilization will produce a male.6
The group of babies born this month in the town where you
live can be viewed as a sample from this distribution. The
sample mean proportion of females is the number of females
in the sample divided by the total number of newborns in the
sample. The sample mean proportion generally will differ from
the expected value of 0.5 due to random fluctuations (unless
there are lots and lots of babies in the sample). Similarly, if the
expected loss from accidents for a large group of people is $500,
the sample mean loss or average loss during a given time
period for a sample of these people will differ from the
expected value due to random fluctuations.
The sample standard deviation (or, similarly, the sample variance)

reflects the variation in outcomes of a particular sample from a
distribution. It is calculated with the same formula that we used
above for the standard deviation but with three differences. First,
only the outcomes that occur in the sample are used. Second, the
sample mean is used instead of the expected value, which usually
is not known. Third, the squared deviations between the outcomes
and the sample mean are multiplied by the proportion of times
that the particular outcome actually occurs in the samplerather
than by the proportion of times that the outcome is likely to
occur, according to the probability distribution.
Note how the skewed distribution has a higher probability of

very low losses and a probability of very high losses when
compared to the symmetric distribution. Recognizing this
characteristic of skewed distributions is important when assessing
the likelihood of large losses. If you incorrectly assume that the
loss distribution is symmetric (you think that losses have
distribution 1 when they really have distribution 2 in Figure 3.7),
you will underestimate the likelihood of very large losses.
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LESSON 8:
BASIC CONCEPTS OF STATISTICS & PROBABILITY
It is useful to introduce the sample mean and sample standard

deviation at this point for several reasons. First, the probability
distributions for random variables that concern managers generally
are not known. The sample mean and sample standard deviation
sometimes can be used to estimate the unknown expected value
and standard deviation of a probability distribution. Thus,
estimation of the expected value and standard deviation of losses
is often very important in risk management. In addition, the
concept of the average loss for a group of people that pools its
risk (i.e., the sample mean loss for the group) and the standard
deviation of the average loss for the group (i.e., the sample standard
deviation) are to explain how pooling can reduce risk. Finally, you
will no doubt calculate sample means and sample standard
deviations if you take a statistics course. We dont want you to
confuse the expected value and standard deviation of the
underlying probability distribution with the sample mean and
sample standard deviation for a particular sample.
Concept Check
36
11D.571.3
1. Draw a distribution that might describe your automobile liability

losses for the coming year (i.e., the losses that you could cause
to other people for which you could be sued and held liable).
Maximum Probable Loss and Value-at-Risk
A frequently used measure of risk is maximum probable loss or
value-at-risk, Although used in different contexts, these terms
essentially mean the same thing. Maximum probable loss usually
describes a loss distribution, whereas value-at-risk describes the
probability distribution for the value of a portfolio or the value
of a firm subject to loss.
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Suppose that the probability distribution for annual liability losses

is described by the probability density function in Figure 3.8. Since
the random variable being described is losses, high values are bad
and low values are good. If $20 million is the maximum probable
loss (MPL) at the 5 percent level, the probability that losses will be
greater than $20 million is 5 percent. (That is, the area under the
probability density function to the right of $20 million is 0.05.) If
$30 million is the MPL at the 1 percent level, the probability that
losses will be greater than $30 million is 0.01.
Many large corporations estimate maximum probable losses

from different exposures to evaluate risk. Most large financial
institutions calculate a daily measure of value-at-risk.8 To
illustrate this concept, suppose that Mr. David, the risk
manager at First Babbel Corp., receives a report that the firms
daily value-at-risk at the 5 percent level is $50 million. This
number tells Mr. David that the firm has a 5 percent chance of
losing more than $50 million over the coming day. If Mr.
David determines that the firm should not take this much risk,
he might take actions to reduce the firms value-at-risk, such as
hedging or selling some risky assets. After taking these risk
management actions, presumably the firms value at risk would
drop to an acceptable level. See Box 3.2.
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These concepts are easily illustrated with simple examples.
To illustrate value-at-risk, consider the probability distribution

for the change in the value of an investment portfolio over a
month depicted in Figure 3.9. Since the random variable
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being described is portfolio value changes, high values are good

and low values are bad. If $5 million is the monthly value-at-risk
for this portfolio at the 5 percent level, the probability that the
portfolio will lose more than $5 million over the month is 5
percent. (The area under the density function to the left of _$5
million is 0.05.) If $7.5 million is the monthly value-at-risk at the
1 percent level, the probability that the portfolio will lose more
than $7.5 million over the month is 0.01.
11D.571.3
Correlation
To this point, we have limited our discussion to probability

distributions of a single random variable. Because businesses
and individuals are exposed to many types of risk, it is important
to identify the relationships among random variables. The
correlation between random variables measures how random
variables are related.
If the correlation between two random variables is zero, then the
random variables are not related. Intuitively, if two random
variables have zero correlation, then knowing the outcome of
one random variable will not give you information about the
outcome of the other random variable. For example, an automaker
has risk due to an uncertain number of product liability claims for
autos previously sold and also due to uncertain steel prices. There
is no reason to believe that these two variables will be related.
Knowing that steel prices are high will not imply anything about
the frequency or severity of liability claims for autos already sold.
Similarly, knowing that a large liability claim for damages has
occurred will not imply anything about steel prices. Thus, the
correlation between steel prices and product liability costs (for
past sales) is zero. When the correlation between random variables
is zero, we will say that the random variables are independent or
uncorrelated. These terms are used because they suggest that the
outcome observed for one distribution is unrelated to the outcome
observed for the other distribution.
37
Concept Check
c. Random variable 1: The property damage due to hurricanes in

Miami, Florida, in September 2003.
Random variable 2: The property damage due to hurricanes in
Miami, Florida, in September 2008.
d. Random variable 1: The number of people in New York who
die from AIDS in the year 2008.
Random variable 2: The number of people in London who die
from AIDS in the year 2008.
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Evaluating the Frequency and Severity of Losses

After identifying loss exposures, a risk manager ideally would
obtain information about the entire probability distribution of
losses and how different risk management methods affect this
distribution. Frequently, risk managers use summary measures
of probability distributions, such as frequency and severity
measures, as well as expected losses and the standard deviation
of losses during a given period. These measures help a risk
manager assess the costs and benefits of loss control and
retention versus insurance. We therefore illustrate how these
summary measures can be obtained in practice.
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Random variable 2: The property damage due to hurricanes in Ft.

Lauderdale, Florida, in September.
In many cases random variables will be correlated. For example,

a recession may decrease the demand for new cars and also
decrease steel prices. Thus, the demand for new cars and steel
prices both are affected by general economic conditions, and as a
result, the demand for new cars and steel prices are correlated.
When demand for new cars is high, steel prices also tend to be
high.
Positive correlation implies that the random variables tend to

move in the same direction. For example, the returns on common
stocks of different companies are positively correlated the return
on one stock tends to be high when the returns on other stocks
are high. Random variables can be negatively correlated as well.
Negative correlation implies that the random variables tend to
move in opposite directions. For example, sales of sunglasses
and sales of umbrellas on any given day in a given city are likely to
be negatively correlated.
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You should keep in mind that positive (negative) correlation does

not imply that the random variables will always move in the same
(opposite) direction. Positive correlation simply implies that when
the outcome of one random variablefor example, the demand
for carsis above (below) its expected value, the other random
variablefor example, steel coststends to be above (below) its
expected value. Similarly, negative correlation implies that when
one random variablefor example, sales of sunglassesis above
(below) its expected value, the other random variablefor example,
umbrella salestends to be below (above) its expected value.
Concept Check
1. For each scenario below, explain whether the correlation between

random variable 1 and random variable 2 is likely to be zero
(the random variables are uncorrelated), positive, or negative.
a. Random variable 1: Your automobile accident costs for the
coming year.
Random variable 2: The automobile accident costs of a student in
another country for the coming year.
b. Random variable 1: The property damage due to hurricanes in
Miami, Florida, in September.
38
Frequency
The frequency of loss measures the number of losses in a
given period of time. If historical data exist on a large number
of exposures, then the probability of a loss per exposure (or
the expected frequency per exposure) can be estimated by the
number of losses divided by the number of exposures. For
example, if Sharon Steel Corp. had 10,000 employees in each of
the past five years and over the five-year period there were 1,500
workers injured, and then an estimate of the probability of a
particular worker becoming injured would be 0.03 per year
(1,500 injuries/50,000 employee-years). When historical data do
not exist for a firm, frequency of losses can be difficult to
quantify. In this case, industry data might be used, or an
informed judgment would need to be made about the
frequency of losses.
Severity
The severity of loss measures the magnitude of loss per
occurrence. One way to estimate expected severity is to use the
average severity of loss per occurrence during a historical period.
If the 1,500 worker injuries for Sharon Steel cost $3 million in
total (adjusted for inflation), then the expected severity of
worker injuries would be estimated at $2,000 ($3,000,000/
1,500). That is, on average, each worker injury imposed a $2,000
loss on the firm. Again due to the lack of historical data and
the infrequency of losses, adequate data may not be available to
estimate precisely the expected severity per occurrence. With a
little effort, however, risk managers can estimate the range of
possible loss severity (minimum and maximum loss) for a
given exposure.
Expected Loss and Standard Deviation
When the frequency of losses is uncorrelated with the severity
of losses, the expected loss is simply the product of frequency
and severity. Thus, the expected loss per exposure in our
example can be estimated by taking expected loss severity per
11D.571.3
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To create an accurate categorization of a firms loss exposures (like

Table 3.6), considerable information, time, and expertise are needed.
For most companies, especially smaller ones and new ones, detailed
data on loss exposures do not exist. Nevertheless, the framework
of Table 3.6 still can be used. For example, each type of exposure
can be classified as having low, medium, or high frequency and
severity. Table 3.7 provides an example for Penn Steel Corp., a firm
that is engaged in the same activities and is of the same size as
Sharon Steel Corp.
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One way to summarize information about potential losses is to

create a table for various types of exposures (property, liability,
etc.) that provides characteristics of the probability distribution of
losses for the particular type of exposure. An example for Sharon
Steels property exposures is provided in Table 3.6.
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Tables 3.6 and 3.7 both show that the standard deviation of losses
for high frequency, low severity losses is low, while the standard
deviation is high for low frequency losses with high potential
severity. This relationship is fairly general: Infrequent but potentially
large losses are less predictable and pose greater risk than more
frequent, smaller losses. Using the type of information illustrated
in these tables, firms pay particular attention to exposures that can
produce potentially large, disruptive losses, either from a single
event or from the accumulation of a number of smaller but still
significant losses during a given period.
Identifying & Measuring Exposure
Risk Profile of a Financial Conglomerate: Measurement and

Management
The special problem of capital management in a conglomerate

stems from the need to aggregate risks across a diverse set of
businesses. This section seeks to size the magnitude of aggregation
effects by examining the risk profile of a banking-insurance
conglomerate. In effect, it asks just how big a problem risk
aggregation actually is: are aggregation effects so severe that a typical
conglomerate is over-capitalized to the point of inefficiency (in
particular to shareholders), or under-capitalized to the point where
it causes undue risk of insolvency to debt holders and
policyholders?
Capital Management of a Financial Conglomerate
11D.571.3
A financial conglomerate is, by definition, a combination of

diverse businesses operating under a common ownership
structure. As shown in Figure 1, the organization can be broken
down into major business lines, each of which has a distinct
risk profile. For example, the universal banking activities
consisting of retail, corporate, and investment banking are
dominated by credit risk. Life insurance activities are dominated
by market (investment) risk, and P&C activities by insurance
(CAT) risk. In addition, non-licensed subsidiaries may be part
of the conglomerate structure. While the common ownership
structure is typically in the form of a holding company, it need
not be. The analysis and results in this section are independent
of the specific legal structure of the conglomerate.
The capital management problem for a conglomerate is to
determine both within and across businesses how much
capital is required to support the level of risk taking. The problem
is of concern to different constituencies. On the one hand,
debtholders, policyholders, regulators and rating agencies are
primarily concerned with the solvency of the institution. For them,
the key issue is whether the institution holds sufficient capital to
absorb risk or the potential for loss under all but the most
extreme loss scenarios. Put another way, they are seeking capital to
backstop the organizations risk taking at a high degree of
confidence.
On the other hand, shareholders, participating policyholders, and
investment analysts are primarily concerned with the profitability
of the institution. For them, the key issue is whether the
institution is earning a sufficient return (at or above hurdle rate)
on the capital invested to support risk taking. While capital is the
common denominator that links the debtholders and
shareholders, their interests pull in different directions. Lower
capital for a given degree of risk taking will make an institution
less solvent, but more profitable, and vice versa. A conglomerate
poses special challenges for capital management: internally, for
managers charged with balancing the risk, capital, and return
equation, and externally, for regulators concerned with the safety
and soundness of the institution. The first challenge is to
determine the standalone risk of an activity within a business line
such as the credit risk in a commercial loan portfolio or the
catastrophe risk in a P&C insurers homeowners portfolio. A
number of techniques have been developed within banks and
insurance companies to assess risk at this level. The next challenge
39
occurrence times the expected frequency per exposure. Expected

loss obviously is an important element that affects business
value and insurance pricing. Thus, accurate estimates of expected
losses can help a manager determine whether insurance will
increase firm value. Continuing with the Sharon Steel example,
the annual expected loss per employee from worker injury is
0.03 X $2,000 = $60. With 10,000 employees, the annual
expected loss is $600,000. Ideally, many firms also will estimate
the standard deviation of losses for the total loss distribution
or for losses in different size ranges.
A typical approach is to tie the degree of capital protection to the

target debt rating of the institution. One convention is to adopt
a one-year time horizon. In the figure above, the economic capital
requirement is set to protect against losses over one year at the
99.9% level roughly equivalent to the default risk of an A rated
corporate bond. Put another way, a business that holds capital to
protect against one-year losses at the 99.9% confidence interval
would have a default risk consistent with a A debt rating. Setting
capital for the individual risks within a conglomerate at this
confidence interval assures that each of them, on a standalone
basis, is protected to a level consistent with the target rating.
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A further challenge for a conglomerate results from the presence

of unlicensed subsidiaries. They generally fall into two categories:
financial subsidiaries that engage in financial businesses such as
financing, insurance, and brokering outside of a licensed banking
group, insurance company or securities firm; and commercial
subsidiaries that are principally engaged in non-financial activities.
In both cases, unlicensed subsidiaries impose an incremental need
for capital, at a minimum to cover the incremental operating risks
(including both business and event risk) inherent in the business.
For a nonlicensed financial subsidiary such as a consumer finance
or leasing company the need for capital will be similar to that for
other regulated activities. For an unlicensed commercial subsidiary,
the incremental capital will be analogous to that held by a nonfinancial firm, and will be needed to cover operating risks, including
business and event risk.
economic capital sets a common standard for measuring the

degree of risk taking. The standard is defined in terms of a
confidence interval in the cumulative loss distribution, assessed
over a common time horizon. By setting capital for different
risks at the same confidence interval, the economic capital
requirements for different risk factors and types of activities can
be directly compared. Only by having such a common standard
can one meaningfully assess the risk for a complex conglomerate
with a diversity of business activities across the financial
spectrum.
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is to combine the different risk factors within a business line or

licensed subsidiary. Because risks are less than perfectly correlated,
they cannot be strictly added together. The licensed subsidiaries
include banks, insurance companies, and securities firms that are
subject to specific capital requirements. The potential for
diversification suggests that the whole will be less than the sum
of the parts.
At the same time, the top holding company within a conglomerate

structure may also be an unlicensed entity. Because of the scope of
activity, the holding company raises unique issues of aggregation.
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Economic Capital as a Common Currency for Risk

In order to assess capital requirements in a diverse
conglomerate, there needs to be a common currency for risk
that can equate risk taking in one activity or business line with
another. Economic capital is often used as that common
currency for risk measurement, irrespective of where the risk is
incurred. Under the economic capital approach, the risks of a
conglomerate or of the individual businesses within it can
be classified into primary components of asset risk, liability risk,
and operating risk. As shown in Figure 2, these risks can be
further decomposed. Asset risk is typically broken down into
credit risk and market/ALM (asset/liability mis-match or
management) risk. Insurance liability risks can be separated into
P&C catastrophe risk; P&C experience-based risks; and life risks.
Operating risks can be split into business risk and event risks.
Economic capital models are typically built up from the specific

analytical approaches for individual risk factors. Table 3 lists common
modeling approaches for the main risk types. While the specific
tools for risk factors such as credit, CAT, P&C experience and
market risks differ, the common denominator in an economic
capital framework is the attempt to describe the risk distribution
in probabilistic terms, and set capital at a common confidence
interval.
Although each of these risks has distinct statistical properties

as reflected in the stylized risk distributions shown for them
40
Risk Aggregation: The Building Block Approach

Just as risks can be decomposed into individual factors, they can
also be re-aggregated. The distribution drawn at the bottom of
11D.571.3
In practice, aggregating the various risk distributions in a complex

financial organization is a challenging task and somewhat arbitrary.
Ultimately, the total amount of economic risk at the top of an
organization is independent of how risks are aggregated within
it.27 One proposed method for constructing a composite risk
picture is to follow a building block approach that aggregates risk
at successive levels in an organization. There are three key levels,
corresponding to the levels at which risks are typically managed:
A3.
The correlation between the positions
In general, the diversification benefit increases with the number

of positions, decreases with greater concentration, and decreases
with greater correlation. These properties are depicted in Figure 3,
which shows the diversification benefits for a portfolio of equally
weighted assets or liabilities for two different levels of correlation.
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Level I: The first level aggregates the standalone risks within a

single risk factor in an individual business line. Examples include
aggregating the credit risk in a commercial loan portfolio; the
equity risks in a life insurance investment portfolio; and the
catastrophe risks in a P&C underwriting business.
Level II: The second level aggregates risk across different risk
factors within a single business line. Examples include aggregating
the credit, market/ALM, and operating risks in a bank; or
combining the asset, liability, and operating risks in P&C or life
insurance.
Level III: The third level aggregates risk across different business
lines, such as banking and insurance subsidiaries. This leads to the
composite picture or cumulative loss distribution at the top
(holding company) level.
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Our analysis adopts the building block approach because it allows

the risk profiles of each of the businesses within a conglomerate
to be considered separately, before introducing the cross-business
aggregation effects that are unique to a conglomerate. Put another way,
Level I and Level II aggregation effects are already present within
regulated banks and insurance companies. The unique problems
of a conglomerate are associated with Level III. Differences in
corporate structure, business line definitions, legal requirements,
or risk management philosophy may lead some organizations to
follow other hierarchies in aggregating risks than the three-level
building block approach. Although this should ultimately produce
the same amount of overall risk at the top of the organization,
alternative approaches to risk aggregation will yield different results
at lower levels.
Estimating Aggregation Effects: General Principles
The starting point for risk aggregation is to begin with standalone

estimates of the economic capital required for individual risk
factors. While the general concept of economic capital is explained
above, the specific techniques for calculating risk at this level are
beyond the scope of this paper.
Given estimates of standalone economic capital, one can aggregate

risks to a first-order approximation based on the relative
amounts of economic capital, and then consider correlations
between risk factors. As discussed in Appendix A, the
diversification benefits that accrue from aggregation are driven by
three main factors:
A1.
The number of risk positions (N)
A2.
The concentration of those risk positions, or their relative
weights in a portfolio
11D.571.3
As the number of positions28 increases for a given level of

correlation, the diversification ratio decreases i.e., there is an
increase in the diversification benefit. For a given number of
positions, as the correlation decreases the diversification benefit
increases. For a correlation level typically experienced in market
risk around 40% the full diversification benefit amounts to
about one-third; this is achieved fairly rapidly, after about 30
positions. For the much lower correlations typical of a credit
portfolio around 2% the diversification benefit is
significantly greater around 75%.
However, it takes longer to get there; this limit is achieved after
around 100 positions. Though the figure deals with equally
weighted positions, as concentration increases the diversification
benefit decreases. This is most easily seen at the extreme. The
diversification benefit obtained by one risk factor that is nine
times the size of another will be very small, even if the two risks
are completely uncorrelated (independent). At zero correlation,
the largest diversification benefit possible cannot exceed 10%.
There is a related point that can be illustrated in Figure 3. The
Capital Asset Pricing Model (CAPM) breaks total risk into specific
(or idiosyncratic) and systematic risk. While the two curves
represented in the graph show the systematic risk associated with
average correlations of 40% and 2%, respectively, it is possible to
conceive of different systematic risk curves for a given risk factor,
reflecting different average levels of correlation. For example, a
systematic risk curve for a domestic equities portfolio will have a
higher level of average correlation and lower diversification
benefit than a systematic risk curve for a globally diversified
equities portfolio. Similarly, the systematic risk curve for a regionally
concentrated credit portfolio will have a higher level of average
correlation than a systematic risk curve for a globally diversified
credit portfolio. Thus, the diversification benefit obtainable within
a given risk factor will vary with the scope of activity.
With these principles in mind, the general characteristics of the
three levels of aggregation can be stated as follows:
41
Figure 2 shows conceptually how the various risk distributions of

a financial conglomerate can be combined to yield a single,
cumulative loss distribution and economic capital requirement
for the institution.
that are neither strongly concentrated nor highly correlated. As

a result, there should be a high diversification benefit at Level I.
The achievable diversification benefit will be driven by the scope
of activity.
Level II has fewer risk factors, and they are likely to be more
concentrated and more correlated. Consequently, there should

be a lower diversification benefit at Level II than at Level I.
be much more highly concentrated than others, and correlations
will tend to be high. Level III should therefore yield the smallest
diversification effects of the three levels. These relationships
are examined empirically in the following sections.
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Notes:
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At Level III, there are only a few risk factors; some are likely to
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Level I has many risk factors (individual assets or liabilities)
42
11D.571.3
Before discussing risk measures and risk metrics, it is useful to

distinguish between the more basic notions of measure and
metric. A measure is an operation for assigning a number to
something. A metric is our interpretation of the assigned
number. When we apply a measure, the number obtained is a
measurement. Consider an example.
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We have someone take off his shoes and stand with his back
against a wall that is marked with a scale of inches. We note the
number of inches correspond to the top of the persons head.
This process is a measure. The number obtained is a measurement.
We interpret the number as the persons height. The
interpretation is a metric.
a probability distribution. With VaR, we summarize a portfolios

market risk by reporting some parameter of this distribution.
For example, we might report the 90%-quantile of the portfolios
single-period USD loss. This is called one-day 90% USD VaR. If
a portfolio has a one-day 90% USD VaR of, say, USD 5MM, it can
be expected to lose more than USD 5MM on one trading day our
of ten. This is illustrated in Exhibit 1.
Example: One-Day 90% USD VaR
Exhibit 1
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Risk Measure and Risk Metric
Measures are employed to quantify many things: height,

temperature, aptitude, speed, consumer confidence, etc. All of
these notions being quantified are metrics. The operations with
which we quantify them are measures. There are many metrics of
riskvolatility, delta, gamma, duration, convexity, beta, etc. We
call these risk metrics. A measure that supports a risk metric is
called a risk measure. The value obtained from applying a risk
measure is a risk measurement.
Risk measures tend to be categorized according to the risk metrics
they support. There are measures of duration, measures of delta,
etc. This is an important point. We do not categorize risk measures
according to the specific operations they entail. Operationally, there
are many different ways we might arrive at a measurement of a
portfolios volatility. Irrespective of the actual operations, all of
them are measures of volatility. All support a volatility risk metric.
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Value at Risk
Value-at-risk (VaR) is a category of risk measures that describe
probabilistically the market risk of a trading portfolio. VaR is
widely used by banks, securities firms, commodity and energy
merchants, and other trading organizations. Such firms could
track their portfolios market risk by using historical volatility as
a risk metric. They might do so by calculating the historical
volatility of their portfolios market value over a rolling 100
trading days. The problem with doing this is that it would
provide a retrospective indication of risk. The historical volatility
would illustrate how risky the portfolio had been over the
previous 100 days. It would say nothing about how much
market risk the portfolio was taking today.
For institutions to manage risk, they must know about risks
while they are being taken. If a trader mis-hedges a portfolio, his
employer needs to find out before a loss is incurred. VaR gives
institutions the ability to do so. Unlike retrospective risk metrics,
such as historical volatility, VaR is prospective. It quantifies market
risk while it is being taken.
Measure time in trading days. Let 0 be the current time. We know
a portfolios current market value . Its market value
in one
trading day is unknown. It is a random variable. We may ascribe it
11D.571.3
One-day 90% USD VaR is illustrated for a hypothetical portfolio.

Shown is the probability density function for the portfolios value
1
P one trading day from now. The portfolios current value 0p is
known. VaR equals the amount of money such that there is a
90% probability of the portfolio losing less than that amount
over the next trading day. This is indicated in the Exhibit.
VaR can be measured in other ways. For example, bank regulations
require that VaR be calculated as a 99%-quantile of loss over a
two-week horizon. Still other metrics are possible. We could
measure VaR as the standard deviation of portfolio value or the
standard deviation of portfolio return. Essentially, any parameter
of the distribution of a portfolios future value can be used to
measure VaR.
Lets formalize this. VaR is applicable to any liquid portfolio
that is, any portfolio that can reasonably be marked to market on
a regular basis. Value-at-risk is not applicable to illiquid assets,
such as real estate or fine art. VaR considers a portfolios
performance over a specific horizona trading day, two weeks, a
month, etc. We call this the VaR horizon. VaR is measured in a
particular currency, USD in the example above, but any currency
can be used. This is called the base currency. Finally, the portfolios
market risk is summarized with a single number. Informally, we
called this a parameter of the distribution of portfolio value.
More formally, it is any function of both the portfolios current
value and its (random) value at the end of the VaR horizon.
In our example, the function was the 90%-quantile of loss. As
we mentioned, other functions are possible. A VaR
measurement is the value obtained for that function for a specific
portfolio at a specific point in time.
We distinguish between a VaR measure and a VaR metric. A VaR
measure is the procedure by which we arrive at a VaR measurement.
It is some computational algorithm, which is typically coded on a
computer. A VaR metric is our interpretation of the VaR
43
LESSON 9:
MEASURING RISK AND VAR
One-year standard deviation of USD return

One-day semi-variance of JPY portfolio value
Value-at-risk became popular with trading organizations during

the 1990s. It was during this period that the name value-at-risk
entered the financial lexicon. However, VaR measures had been
used long before this.
An early user was Harry Markowitz. In his groundbreaking (1952)
paper Portfolio Selection, he adopted a VaR metric of single
period variance of return and used this to develop techniques of
portfolio optimization. In the early 1980s, the United States
Securities and Exchange Commission (SEC) adopted a crude VaR
measure for use in assessing the capital adequacy of broker-dealers
trading non-exempt securities. A few years later, Bankers Trust
implemented a VaR measure for use with its RAROC capital
allocation system. During the late 1980s and early 1990s, a number
of institutions implemented VaR measures to support capital
allocation or market risk limits.
As with its power, the challenge of VaR also stems from its
generality. In order to measure market risk in a portfolio using
VaR, some means must be found for determining the probability
distribution of that portfolios market value. Obviously, the more
complex a portfolio isthe more asset categories and sources of
market risk it is exposed tothe more challenging that task
becomes.
It is worth distinguishing between three concepts:
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Two-week 99% EUR VaR
uncertain market values, which can be characterized with probability

distributions. All sources of market risk contribute to those
probability distributions. Being applicable to all liquid assets and
encompassing, at least in theory, all sources of market risk, VaR is
an all-encompassing measure of market risk.
A VaR measure is an algorithm with which we calculate a

portfolios VaR.
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measurement. In our examples, the VaR metric was one-day 90%

USD VaR. Other examples of VaR metrics are:
In the early 1990s, three events popularized value-at-risk as a

practical tool for use on trading floors:
In 1993, the Group of 30 published a groundbreaking report on
derivatives practices. It was influential and helped shape the
emerging field of financial risk management. It promoted the
use of value-at-risk by derivatives dealers and appears to be the
first publication to use the phrase value-at-risk.
In 1994, JP Morgan launched its free Risk Metrics service. This
was intended to promote the use of value-at-risk among the
firms institutional clients. The service comprised a technical
document describing how to implement a VaR measure and a
covariance matrix for several hundred key factors updated daily on
the Internet.
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In 1995, the Basle Committee on Banking Supervision

implemented market risk capital requirements for banks. These
were based upon a crude VaR measure, but the committee also
approved, as an alternative, the use of banks own proprietary
VaR measures in certain circumstances.
These three initiatives came during a period of heightened concern
about systemic risks due to the emergingand largely
unregulatedOTC derivatives market. It was also a period when
a number of organizationsincluding Orange County, Barings
Bank, and Metallgesellschaftsuffered staggering losses due to
speculative trading, failed hedging programs or derivatives.
Financial risk management was a priority for firms, and value-atrisk was rapidly embraced as the tool of choice for quantifying
market risk. Financial firms, corporate treasuries, commodities
merchants, and energy merchants implemented it.
Measuring Value at Risk
Value-at-Risk (VaR) is a powerful tool for assessing market risk,

but it also poses a challenge. Its power is its generality. Unlike
market risk metrics such as the Greeks, duration and convexity, or
beta, which are applicable to only certain asset categories or certain
sources of market risk, VaR is general. It is based on the probability
distribution for a portfolios market value. All liquid assets have
44
A VaR model is the financial theory, mathematics, and logic that

motivate a VaR measure. It is the intellectual justification for the
computations that are the VaR measure.
A VaR metric is our interpretation for the output of the VaR
measure.
Examples of VaR metrics are one-day 95% USD VaR or one-week
standard deviation of return EUR VaR. A VaR measure is just a
bunch of computations. What justifies our interpreting the output
of those computations as, say, two-week 99% EUR VaR? The
answer is the VaR model. The VaR model is the intellectual link
between the computations of a VaR measure and the interpretation
of the output of those computations, which is the VaR metric.
This article focuses on VaR measures and VaR models.
Conveniently, these can be discussed without regard for specific
VaR metrics. The reason is that valuation of a VaR metric is the
final step of any VaR measure. The real work for a VaR measure is
to somehow characterize a probability distribution for a portfolios
market value. Valuing a specific VaR metric based on that
characterization is a final stepit is almost an afterthought. By
changing that final step of a VaR measure, we can alter the VaR
measure to support a different VaR metric. Accordingly, to a large
extent, any VaR measure can support any VaR metric, and we can
discuss VaR measures without considering the specific VaR metrics
they are to support.
Measure time in trading days. Let 0 be the current time. We know
a portfolios current market value . Its market value in one trading
day is unknown. It is a random variable. Out notation uses
preceding superscripts to denote time. We find it convenient to
indicate random quantities with capital letters and known constants
with lower case letters.
Our task is to ascribe to a probability distribution. One way that
we might simplify this task is to assume some standard
distribution. Doing so reduces the problem from one of
estimating an entire distribution to that of estimating the handful
of parameters necessary to specify that standard distribution.
Depending upon the standard distribution, which is assumed,
this simple approach may yield a closed formula for the portfolios
VaR.
For example, a normal distribution is fully described with two
parameters, its mean and standard deviation. If we assume is
normally distributed, then all we need do in order to measure VaR
11D.571.3
[1]
This formula is based on the fact that the 5%-quantile of a normal

distribution always occurs 1.645 standard deviations below its
mean. See Exhibit 1 to understand [1] or see the article linear
value-at-risk for a more detailed discussion.
[4]
Formula [4] is completely general. So long as Y is a linear

polynomial of the
, we can use [4]. We need no other
assumptions or information about the random variables .
We can apply [4] to estimate the standard deviation of our
portfolios market value. Suppose the portfolio has holdings in
m assets. The assets accumulated market values at time 1 are
random variables, which we denote . Then
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1.645 + ( )
Then the standard deviation of Y is given by
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Based on [5], we can apply [4] to obtain

. All we need as
inputs are standard deviations and correlations for the . These
might be inferred by applying methods of time series analysis to
historical price data for the assets. In some cases, this is feasible.
In others, it is not. Collecting historical price data for every asset
held by a portfolio may be a daunting task.
Example: One-Day 95% USD VaR

Exhibit 1
If we assume a portfolios value 1P is normally distributed, then
we can calculate its 95% VaR with formula [1]. The 5%-quantile
of a normal distribution occurs 1.645 standard deviations
below its mean. Of course, losses are measured relative to a
portfolios current value 0p and not its expected value
.
Accordingly, we must adjust
1.645
by the difference (
portfolios VaR.
A more manageable approach may be to model the portfolios

behavior, not in terms of individual assets, but in terms of specific
risk factors. Depending upon the composition of the portfolio,
risk factors might include exchange rates, interest rates, commodity
prices, spreads, implied volatilities, etc. We call the n modeled risk
factors key factors. We denote their values at time 1 as . The
key factors comprise an ordered set (or vector), which we call the
key vector. We denote it :
), as indicated in [1], to obtain the
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In practice, a portfolios expected value will often be close to its

current value . This is especially true over short VaR horizons,
such as the one trading day horizon of our example. In this
circumstance, it may be reasonable to set = . With this
simplification, our formula [1] for 95% VaR becomes
1.645 [2]
Based upon similar assumptions, formulas for 90%, 97.5% and
99% VaR are
90% VaR ~ 1.282
97.5% VaR ~ 1.960

99% VaR ~ 2.326
Estimating the standard deviation of the portfolios market value

is analogous to the task of estimating the standard deviation of
portfolio return, a task you may be familiar with from portfolio
theory. Except for the fact that VaR deals with market values instead
of returns, we may adopt this familiar mathematics of portfolio
theory for estimating VaR.
We use a general result from probability. Suppose are random
variables having standard deviations and correlations . Suppose
another random variable Y is defined as a linear polynomial of the
the
In all likelihood, the number n or key factors we need to model

will be substantially less than the number m of assets held by the
portfolio.
Selecting which key factors to model is as simpleor complex!
as choosing a set of market variables such that a pricing formula
for each asset held by the portfolio can be expressed in terms
of those variables. That is, for each asset, there must exist a
valuation function such that
= ( )
[6]
because the value of the portfolio is a linear polynomial of the
asset values , we can now express in terms of the key factors:
Y = b1X1 + b2X2 + + bmXm + a
11D.571.3
(7)
[3]
45
is estimate the mean and standard deviation of that distribution.

(The preceding superscripts in our notation indicate that parameters
are for the portfolios time 1 value conditional on information
available at time 0.) Together with the normality assumption,
these two parameters provide all the information necessary to
value any other parameterVaR metricrelated to the
distribution of . For example, if our VaR metric is one-day 95%
USD VaR, we can calculate VaR as
Relationship [8] is called a portfolio mapping. The function is

called the portfolio mapping function.
As an example, suppose a portfolio comprises 100 shares of Dell
stock, 200 shares of IBM stock and a short position of 300 shares
of Microsoft stock. In this case, we would define
Consider Exhibit 2. It illustrates with two graphs the situation if

a portfolio mapping function is a linear polynomial. The graph
on the left is of . It shows how the price of the portfolio responds
linearly to changes in a single key factor . In that graph, evenly
spaced values for have been mapped into corresponding values
for . The resulting values of are also evenly spaced, indicating that
the mapping causes no distortions. If is normally distributed, so
will be . That normal distribution for is depicted in the graph on
the right.
Example: Linear Portolio
Exhibit 2
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[8]
These issues can be understood graphically.
[9]
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This is a functional relationship that specifies the portfolios market

value in terms of the key factors
. Shorthand notation for
the relationship is
Assuming none of the stocks goes ex-dividend during the VaR

horizon, the portfolio mapping is
[10]
This is a very simple portfolio mapping. A slightly more complex

example is a portfolio comprising a call option on a futures contract.
In this case, we define
[11]
and the portfolio mapping function is simply Blacks (1976)

pricing formula for options on futures. Obviously, if a portfolio
holds many complicated instruments, the portfolio mapping
function will be equally complicated.
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The portfolio mapping function maps the n-dimensional space

of the key factors to the one-dimensional space of the portfolios
market value. Given a realization for , gives us the corresponding
value of . That doesnt solve our problem. Were not interested in
one possible realization of . We need to characterize the entire
distribution of . Somehow, we need to apply the portfolio
mapping function to the entire joint distribution of to obtain the
entire distribution of . The question is: how? After all, beyond
purporting its existence, we know very little about the portfolio
mapping function . It could be some complex function with
discontinuities and other inconvenient properties.
A simple solution exists if is a linear polynomial, as is the case in

the above example of a portfolio with holdings in Dell, IBM, and
Microsoft stock. As indicated by [10], is a linear polynomial for
that example. If we assume that is normally distributed and that
= , then all we need to calculate is . Given standard deviations and
correlations for the , we can apply [4] to obtain .
But what if is not a linear polynomial? In our example of an
option portfolio, is given by Blacks (1976) option pricing formula.
That is decidedly non-linear, so we cannot use [4] to obtain .
Furthermore, we cannot reasonably assume that is normally
distributed. Because options limit downside risk, they skew the
probability distribution of . Normal distributions arent skewed.
46
A linear mapping function is applied to a key factor 1R1. This is

illustrated intuitively by mapping evenly spaced values for 1R 1
through the mapping function. The output values for 1P are also
evenly spaced, indicating that the mapping function causes no
distortion. Since 1R1 is conditionally normal, so is 1P.
If the portfolio price function is non-linear, may not be
normally distributed. This is illustrated in Exhibit 3 with a
portfolio consisting of a single call option in an underlier .
Example: Long Call Option
Exhibit 3
A non-linear mapping function is applied to a conditionally

normal key factor 1R1. The result is a conditionally non-normal
portfolio value 1P. This is illustrated intuitively by mapping evenly
spaced values for 1 R1 through the mapping function. The
corresponding values for 1P are not evenly spaced, reflecting how
the mapping function distorts the distribution of 1P.
The left graph of Exhibit 3 depicts the familiar hockey stick
price function for a call option. Evenly spaced values for
do
not map into evenly spaced values for
. If is normally
distributed, the resulting distribution of will not be normal. As
shown on the right, it will be skewed. That skewness reflects the
call options limited downside risk.
Portfolios can have more complex price distributions. For example,
a range forward is a long-short options position which, when
applied to a short position in an underlier , behaves as illustrated
in Exhibit 4.
11D.571.3
Example: Range Forward Hedging a Short Position

Exhibit 4
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A long-short options position can result in a bimodal distribution

for 1P.
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In the left graph of Exhibit 4, we see that values of cluster in

two regions, resulting in the dramatically non-normal price
distribution shown on the right.
These three examples illustrate how linearity of can simplify the

task of calculating a portfolios value-at-risk. Non-linear portfolios
often exhibit unusual price distributions. These can differ markedly
and in unpredictable ways from normal distributions. Such
portfolios require more sophisticated modeling techniques.
Here is the general problem we face in calculating value-at-risk. To
calculate VaR, we need to characterize the distribution of conditional
on information available at time 0. Our puzzle has two pieces
The first piece of the puzzle is the key factors . Because they are
observable financial variables, historical data should be available
for them. Based on this, we can characterize the joint distribution
of
. We may do so with standard deviations
and
correlations
for the , or we may do so in some other manner.
Our problem, then, is to convert that characterization of the
distribution of into a characterization of the distribution of . On
its own, our characterization of the distribution of is not enough
to do this. Because it is independent of the portfolios
composition, it cannot, on its own, tell us how risky the portfolio
is.
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The second piece of the puzzle is the portfolio mapping [8] that
relates to . That formula will change over time, evolving to reflect
the portfolios changing composition. Formula [8] contributes to
our analysis what the characterization of the distribution of does
not. It reflects the portfolios composition. On its own, however,
it cannot tell us how risky the portfolio is, for it contains no
information relating to market volatility.
We need to combine these two pieces of the puzzle in order to

estimate . Somehow we must filter the market information
contained in the characterization of the distribution of through
the portfolio information contained in the portfolio mapping
[8].
Every VaR measure must address this problem. Accordingly, all

VaR measures share certain common components related to
solving this problem. All must specify a portfolio mapping. All
must somehow characterize the joint distribution of . All must
somehow combine these two pieces to characterize the distribution
of . Exhibit 5 is a schematic summarizing these three processes
that are common to all practical VaR measures.
Schematic of How VaR Measures Work
Exhibit 5
11D.571.3
All practical VaR measures accept portfolio data and historical

market data as inputs. They process these with a mapping
procedure, inference procedure, and transformation procedure.
Output comprises the value of a VaR metric. That value is the
VaR measurement.
Any practical VaR measure must include three procedures:
Mapping procedure,
Inference procedure, and
Transformation procedure.
Recall that risk has two components:

Exposure, and
Uncertainty.
By specifying a portfolio mapping, a mapping procedure describes

exposure. By characterizing the joint distribution for , an inference
procedure describes uncertainty. A transformation procedure
combines exposure and uncertainty to describe the distribution
of , which it then summarizes with the value of some VaR
metric. In so doing, the transformation procedure describes risk.
A mapping procedure accepts a portfolios composition as an
input. Its output is a portfolio mapping function that defines as
a function of . Specifying is largely an exercise in financial
engineering. Since must value an entire portfolio, it can be
complicated. For example, if a portfolio holds 1000 exotic
derivatives will be extremely complicatedand may take hours to
value, even on a computer. For this reason, a mapping procedure
may employ certain approximations, called remappings, to simplify
The purpose of an inference procedure is to characterize the joint
probability distribution of the key vector conditional on
information available at time 0. It generally accepts historical market
47
Much research has focused on transformation procedures. Four

basic forms of transformations are used:
VaR Metric
It assumes familiarity with concepts described in the articles
value-at-risk and measuring VaR. It is worth distinguishing
between three concepts:
A VaR measure is an algorithm with which we calculate a portfolios
VaR.
A VaR model is the financial theory, mathematics, and logic that
motivate a VaR measure. It is the intellectual justification for the
computations that are the VaR measure.
A VaR metric is our interpretation for the output of the VaR
measure.
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A transformation procedure combines the outputs from the

mapping and inference procedures and uses them to characterize
the distribution of 1P, conditional on information available at
time 0. Based on that characterization, and perhaps the portfolios
current value 0 p, the transformation procedure (or
transformation) determines the value of the desired VaR metric.
The result is the VaR measurement.
and run on computers. An implemented VaR measure is a VaR

implementation.
Examples of VaR metrics are one-day 95% USD VaR or one-week

standard deviation of return EUR VaR. A VaR measure is just a
bunch of computations. What justifies our interpreting the output
of those computations as, say, two-week 99% EUR VaR? The
answer is the VaR model. The VaR model is the intellectual link
between the computations of a VaR measure and the interpretation
of the output of those computations, which is the VaR metric.
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data as an input and applies techniques of time series analysis to

characterize the joint distribution conditional on information
available at time 0. Techniques currently employed tend to be
crude. The most common are those of uniformly weighted
moving averages (UWMA) and exponentially weighted moving
averages (EWMA). What is needed is time-series methods that
can address conditional heteroskedasticity in high dimensions.
While research is ongoing, such methods are not yet perfected.
Linear transformations,
Quadratic transformations,
Monte Carlo transformations, and

Historical transformations.
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Linear transformations are simple and run in real time. Based on

[4], they apply only if a portfolio mapping function is a linear
polynomial. Quadratic transformations are slightly more
complicated, but also run in real time (or near-real time). They
apply only if a portfolio mapping function is a quadratic polynomial
and 1R is joint-normal. Monte Carlo and historical transformations
are widely applicable, but tend to run slowly (run times of an
hour or more are not uncommon). Both employ the Monte Carlo
method. They both generate a large number of realizations 1r [k]
for 1R and value 1P for each. The histogram of realizations 1p[k] for
1
P provides a discrete approximation for the conditional
distribution of 1P. From this, any VaR metric can be valued. Monte
Carlo and historical transformations differ only in how they
generate the realizations 1r [k]. Monte Carlo transformations generate
them with pseudorandom number generators. Historical
transformations draw them from historical market data.
Lets introduce some notation. We measure time in units equal to

the length of the VaR horizon. The present time is time 0. The
end of the VaR horizon is time 1.
To distinguish between known quantities and random quantities,
we denote the former with lowercase letters and the latter with
capital letters. With this convention, we denote the portfolios
current market value as 0p and its market value at the end of the
VaR horizon as 1P. The preceding superscripts 0 and 1 denote
time.
Formally, a VaR metric is a real-valued function of:
The distribution of 1P, conditional on information available at
time 0; and
The portfolios current value 0p.
Standard deviation of portfolio simple return 1Z, conditional on

information available at time 0, is a VaR metric
Traditionally, VaR measures have been categorized according to

the transformation procedures they employ. There are:
[1]
Linear VaR measures (other names include: parametric, variance-
covariance, closed form, or delta normal VaR measures)
Quadratic VaR measures (also called delta-gamma VaR
measures)
Monte Carlo VaR measures, and

Historical VaR measures.
This naming convention may have had unfortunate consequences.

By focusing attention on the role of transformation procedures,
the convention tends to downplay the important roles of
mapping and inference procedures. Over the past 10 years, most
VaR-related research has focused on transformations. Important
research on mapping and inference procedures has lagged.
Quantiles of portfolio loss, 1L = 0p 1P, make intuitively appealing

VaR metrics. If a portfolios conditional .95-quantile of1L is USD
12.5MM, then such a portfolio can be expected to lose less than
USD 12.5MM on 19 days out of 20.
An example of a risk metric that is not a VaR metric is standard
deviation of cash flow. Because this generally cannot be expressed
as a function of 0p and the conditional distribution of 1P, it is not
a VaR metric.
VaR metrics can be quite elaborate. Semi-variance of portfolio
return 1Z is one example. Define
To apply a VaR measure, it must be implemented in some manner.

For a very simple portfolioperhaps one comprising a single
asseta VaR measure might be implemented with pencil and
paper. In actual trading environments, they are coded as software
48
[2]
11D.571.3
Then the semi-variance of 1Z is simply the variance of 1Z .

Another VaR metric is expected tail loss (ETL), which is
sometimes called expected shortfall. This is the average portfolio
loss, assuming that the loss exceeds some quantile of loss. For
example, a 90% ETL VaR metric indicates the expected loss
conditional on that loss exceeding its own .90-quantile.
To fully specify a VaR metric, we must indicate three things:
Another VaR metric is expected tail loss (ETL), which is

sometimes called expected shortfall. This is the average portfolio
loss, assuming that the loss exceeds some quantile of loss. For
example, a 90% ETL VaR metric indicates the expected loss
conditional on that loss exceeding its own .90-quantile.
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To fully specify a VaR metric, we must indicate three things:
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Then the semi-variance of 1 Z is simply the variance of

1
Z.
The period of time1 day, 2 weeks, 1 month, etc.between
time 0 and time 1; this is the VaR horizon;
The function of 0p and the conditional distribution of 1P;
The currency in which 0p and 1P are denominated; this is the
base currency.
We adopt a convention for naming VaR metrics:

The metrics name is given as the horizon, function and currency,
in that order, followed by VaR.
If the horizon is expressed in days without qualification, these
are understood to be trading days.
If the function is a quantile of loss, it is indicated simply as a
percentage.
For example, we may speak of a portfolios
1-day standard deviation of simple return USD VaR,

2-week 95% JPY VaR, or
1-week 90% ETL GBP VaR, etc.
The period of time1 day, 2 weeks, 1 month, etc.between

time 0 and time 1; this is the VaR horizon;
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The function of 0p and the conditional distribution of 1P;
The currency in which 0p and 1P are denominated; this is the
base currency.
We adopt a convention for naming VaR metrics:
The metrics name is given as the horizon, function and currency,
in that order, followed by VaR.
If the horizon is expressed in days without qualification, these
are understood to be trading days.
If the function is a quantile of loss, it is indicated simply as a
percentage.
For example, we may speak of a portfolios
1-day standard deviation of simple return USD VaR,
2-week 95% JPY VaR, or
1-week 90% ETL GBP VaR, etc.
Notes:
11D.571.3
49
Extensions to Standard VaR
Liquidity - Adjusted VaR

Standard VaR measures the riskiness of a portfolio over a fixed
usually short holding period. Inherent is the implicit
assumption that the risk can be eliminated by the end of the
holding period, by liquidating or hedging the portfolio. In periods
of market illiquidity, the implicit assumption may not be valid.
Moreover, even in more normal periods, it is unlikely to be valid
for all instruments.
Algorithmics Mark to Future (MtF) represents a third step.

MtF is a scenario-based framework, encompassing both nonprobabilistic scenario analysis (by looking at a small set of
pre-specified scenarios) and Monte Carlo simulation (by assigning
probabilities to the scenarios).
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Here we are going to discuss the extensions to standard VaR and

the techniques that have been proposed as alternatives to VaR, as
well as the emergence of risk contribution measures.
MtF captures the passage of time by simulating the evolution of

market factors and portfolio values.This permits the computation
of VaR and other risk measures at various horizons. It also makes
it possible to incorporate path dependency of individual
instruments and portfolio values, as well as maturation of
instruments, prepayments, reinvestment of cash flows, and
dynamic portfolio strategies.
The ability to incorporate changes in portfolios is particularly
important when considering longer time horizons. Standard
VaR computations assume that the portfolio is constant over
time. This perspective remains relevant for derivatives dealers
a one-day VaR provides a useful summary measure of risk
assuming that the dealer doesnt liquidate any positions or
change any hedges. However, over the longer horizons relevant
for investment and portfolio management, the assumption of
no changes in the portfolio makes a standard VaR less useful.
Dynamic features of actual portfolios can only be captured by
Monte Carlo over multiple time points that allows the user to
specify rules for changing the positions as functions of factor
realizations, instrument or portfolio values, or other features
such as instrument deltas.
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LESSON 10:
BEYOND VAR & CASH AT RISK
Liquidity-adjusted VaR (LaVaR) addresses this issue by recognizing

that there are limits to the rate at which a portfolio can be liquidated.
To illustrate a simple LaVaR implementation, consider a situation
where only b units of an instrument can be sold each day a 100unit portfolio would require n = 100/b days to liquidate. If
liquidation of the position became necessary, a possible strategy
would be to liquidate b units each day and invest the proceeds at
the risk-free rate (rf ). (Any positions not liquidated would remain
exposed to market risk.) Under that trading strategy, b units would
be exposed to market risk for one day and then invested at the
risk-free rate rf for the remaining n 1 days; another b units would
be exposed to market risk for two days and then invested at rf for
n 2 days; another b units would be exposed to market risk for
three days and then invested at rf for n 3 days; and so on. If the
initial price per unit is P0 and the i th-day return is ri , the trading
strategy of liquidating b units on each of n days results in a
liquidated value (at the end of n days) of
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LaVaR is then obtained by estimating the distribution of this

liquidated value, similar to the way standard VaR is obtained by
estimating the distribution of the mark-to-market portfolio value.
Since LaVaR measures portfolio risk over an n-day horizon, it
follows that LaVaR will exceed a standard VaR over a one-day
horizon whenever n > 1 but will be less than standard VaR over
an n-day horizon.
LaVaR can be computed using a simulation of the evolution of

returns over n days and can be approximated with an analytic
variance-covariance (delta-normal) approach.
Mark to Future
Standard VaR can be viewed as the second step in the
evolution of risk measurement methodology.
50
This third step permits incorporation of credit risk, by including

credit spreads or indexes of credit quality as factors. And, at the
cost of introducing potentially large numbers of factors, credit
ratings of individual obligors could be included. The default and
transition probabilities can depend on other market factors,
allowing the approach to capture correlations between credit
migrations (including default) and other market factors, e.g.
wrong way exposures. Thus, in addition to generating VaR
estimates that combine market and credit risk, the MtF approach
can produce estimates of potential credit exposure that reflect
correlations.
Since this third step permits portfolio composition to depend
on market factors, MtF can also be used to examine liquidity risk.
Funding liquidity risk can be measured by tracking a cash
account. In the case of asset liquidity risk, including market
trading volumes as market factors and specifying portfolio
holdings as functions of the factors, makes it possible to simulate
illiquid scenarios i.e., scenarios where portfolio liquidation
requires n days. The additional risk is revealed by a VaR calculation
over an n-day horizon. Further, allowing trading volumes to
11D.571.3
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Incremental Decomposition
Incremental decomposition is similar to regression analysis.
Express the return r on a portfolio in terms of the changes in
(or returns to) K factors, i.e.
In interpreting the risk decomposition it is crucial to remember

that it is a marginal analysis. The marginal effects cannot be
extrapolated to large changes, because the partial derivatives change
as the position sizes change. In terms of correlations, changes in
the size of a position change the correlation between the portfolio
and that position. For example, if the i th position is uncorrelated
with the current portfolio, the risk contribution of a small increase
in the I th position is zero. However, if the size of the ith position
increases, that position comprises a larger fraction of the portfolio,
requiring that the correlation increase the risk contribution of
the ith position increases with the position size.
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Emergence of Risk Contribution Measures

As the use of VaR has expanded from a simple communication
device to play a role in managing the portfolios of banks and
other financial institutions, interest has naturally focused on the
decomposition of risk into its sources and to measures of the
risk contributions of instruments, asset classes, and market
factors. There are two main approaches to measuring risk
contributions, which we call incremental and marginal.
covariance (delta-normal) approach the term Var (w) / wi is

precisely the covariance. This is zero when the position is
uncorrelated with the existing portfolio, in which case the risk
contribution is zero. When the correlation is positive the risk
contribution is positive; when it is negative the position serves as
a hedge, and the risk contribution is negative.
Where DFK is the change in the kth factor, bK measures the

sensitivity of the portfolio return to the kth factor, and is a
residual (which may be zero). For any factor model, it is possible
to compute the proportion of the variance of r explained by the
K factors. Analogous to the R-squared of a multiple regression,
we denote this measure R2 k.
To compute the risk contribution of the kth factor, we would
consider the (K-1)-factor model
and compute the proportion of the variance of r explained by the

K-1 factors, R 2k-1. The risk contribution of the kth factor is then
R 2k R 2k-1
A limitation of incremental decomposition is that it depends on
the order in which the factors are considered. While some situations
might have a natural ordering of factors6, in most cases the order
is less apparent. In such cases, Golub and Tilman (2000) suggested
that at each step one should search over all of the remaining
factors (or groups of factors) to find the one with the largest risk
contribution.
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Marginal Decomposition
An important property of both the standard deviation and VaR

measures of a portfolio is that scaling all positions by a common
factor, k, has the effect of scaling the standard deviation and VaR
by the same factor, k. An implication of this scaling property of
the risk measures is that the portfolio VaR can be decomposed
into the risk contributions of the various positions. In particular,
letting w = (w1, w2, ., wN) denote the portfolio weights on the
N assets or instruments in the portfolio, the portfolio VaR can be
expressed as
Not surprisingly, the risk contribution of a position depends

crucially on the covariance of the return on that position with the
return on the existing portfolio. In fact, in the analytic variance-
11D.571.3
Alternatives to Standard VaR
VaR is being called on to perform functions not imagined when it

was first developed as a means of communication between trading
desks and senior management. Using VaR to determine of
economic or regulatory capital require the use of very high
confidence levels, thereby focusing attention on the tails of the
distributions of changes in market rates and prices. However, the
techniques behind the standard VaR measure perform best where
there is a lot of data (i.e. near the centers of distributions.) Not
surprisingly, alternatives to VaR have been proposed that perform
better in the tails.
Extreme Value Theory
It is well known that the actual distributions of changes in market

rates and prices have fat tails relative to the normal distribution,
implying that an appropriately fat-tailed distribution would
provide better VaR estimates for high confidence levels. However,
since the data contain relatively few extreme observations, we have
little information about the tails. So, selecting the right fat-tailed
parametric distribution and estimating its parameters are inherently
difficult tasks.
Extreme value theory (EVT) offers a potential solution. Loosely,
EVT tells us that the behavior of certain extreme values is the
same (i.e., described by a particular parametric family of
distributions), regardless of the distribution that generates the
data.
Two principal distributions appear in EVT. The Generalized
Extreme Value (GEV) distribution describes the limiting behavior
of the maximum of a sequence of random variables. The
Generalized Pareto Distribution (GPD) describes the tail of a
distribution above some large value and thus can be used to
compute the probabilities of extreme realizations exactly what
is required for VaR estimates at high confidence levels.
To indicate the usefulness of the GPD, suppose we were
considering a random variable X (e.g., a mark-to-market loss)
with distribution function F. Focusing on the upper tail, define a
threshold u. The conditional distribution function F(x | X > u)
gives the conditional probability that the excess loss (i.e., X u) is
less than x given that the loss exceeds u. EVT holds that, as the
51
depend on the other factors makes it possible to capture the

relation between liquidity risk and extreme market movements.
To indicate the usefulness of the GPD, suppose we were

considering a random variable X (e.g., a mark-to-market loss)
with distribution function F. Focusing on the upper tail, define a
threshold u. The conditional distribution function F(x | X > u)
gives the conditional probability that the excess loss (i.e., X u) is
less than x given that the loss exceeds u. EVT holds that, as the
threshold u gets large, the conditional distribution function
approaches the GPD given by
Artzner, Delbaen, Eber, and Heath (hereafter, ADEH) (1997, 1999)

argue that risk measures should be coherent i.e., they should
satisfy the following four properties (where the vectors X and Y
denote the possible state-contingent payoffs of two different
portfolios and (X) and (X) their risk measures):
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Two principal distributions appear in EVT. The Generalized

Extreme Value (GEV) distribution describes the limiting behavior
of the maximum of a sequence of random variables. The
Generalized Pareto Distribution (GPD) describes the tail of a
distribution above some large value and thus can be used to
compute the probabilities of extreme realizations exactly what
is required for VaR estimates at high confidence levels.
expiration equal to the VaR time horizon, and a premium of

$400,000. The 95 percent confidence VaR measures of the two
positions considered separately indicate no risk, because each suffers
a loss with a probability of only 4 percent. However, the 95 percent
VaR of the aggregate portfolio is $10 million - 2 $400,000 =
$9.2 million, and the VaR of the diversified portfolio composed
of one-half of each position is (1/2) ($10 million - 2 $400,000)
= $4.6 million.
A risk measure should reflect the impact of hedges or offsets; so,

the risk measure of an aggregate portfolio must be less than or
equal to the sum of the risk measures of the smaller portfolios
which comprise it
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threshold u gets large, the conditional distribution function

approaches the GPD given by
Where e and b are parameters that must be estimated. The

preceding equation implies that the conditional probability of an
excess loss greater than x is approximated by
From this, the unconditional probability of a loss can be obtained

as
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Evidence suggests that the GPD provides a good fit to the tails
of the distributions of changes in individual market rates and
prices (see, Neftci (2000)); and EVT appears to be useful in
measuring credit risk when there is a single important factor (Parisi
(2000)). However, the available empirical evidence does not bear
directly on the question of whether EVT is useful for measuring
the VaR of portfolios that depend (perhaps nonlinearly) on
multiple sources of risk. Classical EVT is univariate, i.e. it does
not characterize the joint distribution of multiple risk factors. To
apply EVT to portfolios that depend on multiple sources of risk
one must estimate the distribution of P/L by historical simulation,
and then fit the GPD to the tail of the distribution of P/L. We are
not aware of any results on the performance of this approach.
Coherent Measures of Risk
VaR was criticized from the outset because it says nothing about
the magnitude of losses greater than the VaR. A more subtle
criticism of VaR is that it does not correctly capture the effect of
diversification (even though capturing the benefits of
diversification is one of the commonly cited advantages of VaR).
To see this, suppose the portfolio contains short digital puts and
calls on the same underlying. Each option has a notional amount
of $10 million, a 4 percent probability of being exercised, time to
52
The risk measure is proportional to the scale of the portfolio, e.g.

halving the portfolio halves the risk measure.
Adding a risk-free instrument to a portfolio decreases the risk by

the size of the investment in the risk-free instrument. This
property ensures that coherent risk measures can be interpreted as
the amount of capital needed to support a position or portfolio.
Note that VaR is not a coherent risk measure, because the aggregate
portfolio of the digital put and call discussed above fails to satisfy
property (1) while the diversified portfolio fails to satisfy the
combination of (1) and (2) with a = 1/2.
ADEH show that all coherent risk measures can be represented in
terms of generalized scenarios. In particular, first construct a list
of K scenarios of future market factors and portfolio values, as
might be done in Monte Carlo simulation or deterministic scenario
analysis. Second, construct a set of M probability measures on the
K scenarios. These probability measures will determine how the
different scenarios are weighted in the risk measure, and need not
reflect the likelihood of the scenarios.10 For example, one measure
might say that the K scenarios are equally likely, while another
might say that the kth scenario occurs with probability one while
the other scenarios have probability zero. Third, for each of the M
probability measures, calculate the expected loss. Finally,
the risk measure is the largest of the M expected losses.

This seemingly abstract procedure corresponds to some widely
used risk measures. For example, ADEH show that the expected
shortfall measure defined by E[loss | loss < cutoff ] is a coherent
risk measure. And, the Chicago Mercantile Exchanges Standard
Portfolio Analysis (SPAN) methodology can be shown to be a
coherent risk measure. But, coherent risk measures do not appear
to be making inroads on VaR among banks and their regulators.
11D.571.3
But even if one can use standard VaR-like tools to model the
quantitative impact of Dells FX exposure, this risk is likely to be
second-order relative to, say, the risk that Dell does a poor job of
marketing and customer support and loses significant market
share to Gateway and Compaq. The bottom line is that while one
canand some consultants doattempt to implement a bottomup VaR analogue to companies like Dell, there is a danger that
such an approach will simply leave out some important sources
of risk, badly mis-measure others, and thus lead to a highly
inaccurate estimate of overall C-FaR.
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We define C-FaR (cash flow at risk) as the probability distribution

of a companys operating cash flows over some horizon in the
future, based on information available today. For example, if it is
December 31, 2000, a companys quarter-ahead C-FaR is the
probability distribution of operating cash flows over the quarter
ending March 31, 2001; and its year-ahead C-FaR is the probability
distribution of cash flows over the year ending December 31,
2001. These probability distributions can be used to generate a
variety of summary statistics such as five percent or one-percent
worst-case outcomes, thereby providing corporate CFOs with
answers to questions like the following: how much can my
companys operating cash flow be expected to decline over the
next year if we experience a downturn that turns out to be a fivepercent tail event?
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Cash (or Cash flow) at Risk
measurable) risks that a bank doesit has foreign exchange

exposure, for example.
While it is easy to define the concept of C-FaR, it is much more

difficult to come up with a reliable C-FaR estimate for any given
company. One way to see the challenges associated with
constructing a C-FaR measure is to compare it with the value-atrisk (VaR) measure commonly used by banks and other financial
institutions.1 Although there are some obvious differences
between the two (for example, C-FaR focuses on cash flows while
VaR focuses on asset values, and C-FaR looks out over a horizon
of a quarter or a year while the horizon for VaR is typically measured
in days or weeks), C-FaR is an attempt to create an analogue to
VaR that can be useful for non-financial firms. Thus one might
hope to be able to draw on the same basic methodological
approach.
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The standard approach to estimating VaR for a bank is what might

be termed a bottom up method. One begins by enumerating
each of the banks assetsevery loan, trading position, and so
forth. The risk exposures (to interest rate shocks, credit risk, foreign
exchange movements) of each of these assets are then quantified.
Finally, these risks are aggregated across the banks entire portfolio.
Although far from perfect, this VaR methodology works reasonably
well to the extent that (1) a bank can identify each of its main
sources of risk and (2) these sources of risk correspond (either
directly or indirectly) to traded assets for which there is good
historical data on price movements. The method is perhaps best
suited to evaluating the risks of a trading desk that deals in relatively
liquid instruments. Now imagine trying to apply this same bottom
up approach to a non-financial firm. For concreteness, consider
the case of the computer manufacturer Dell, an example to which
we will return repeatedly. How does one even begin to identify all
the individual risks to Dells cash flows? And once these risks have
been identified, how can they be accurately quantified? No doubt
Dell faces some of the same tradeable (and hence directly
11D.571.3
Given these difficulties with a bottom-up method, a natural

alternative is to approach matters from the top down. That is,
if the ultimate item of interest is the variability of Dells operating
cash flows, why not simply look directly at their historical cash
flow data? The obvious advantage of doing so is that this data
should summarize the combined effect of all the relevant risks
facing Dell, thereby avoiding the need to build a detailed model
of the business from the ground up. Simply put, if Dells C-FaR
is high, this should be manifested in a high volatility of its historical
cash flows.
Unfortunately, there is also a major problem with going this
routelack of data. The best one can do is to get quarterly data on
cash flows. Thus even if one is willing to go back say five years (it
is hard to imagine going back much further for Dell, given how
rapidly the company is evolving), this leaves us with only 20
observations of Dells cash flows. This is obviously an order of
magnitude too few, particularly given that the goal of a C-FaR
measure is to get a sense of the likelihood of extremely rare events.
But what if one could identify a group of companies that are
good comparables for Dell? With 25 such companies and five
years worth of quarterly data on each, we would be up to 500
observations. With 50 comparable companies, we would have
1,000 observations. At this point, it would become possible to
estimate five-percent (and even one-percent) tail probabilities with
some confidence.
As explained in detail below, we use a relatively sophisticated
benchmarking technique to find the best comparables for a given
target company, searching for those other companies that most
closely resemble our target on four dimensions: (1) market
capitalization, (2) profitability, (3) industry riskiness, and (4) stockprice volatility.]
One way to gauge the usefulness of this approach is to examine
the extent to which it produces plausibly different answers for
companies with different characteristics. In Figure 1, we plot the
one year- ahead C-FaR probability distributions for three
companies: Coca-Cola, Dell, and Cygnus. (Cygnus is a $400 million
market cap company engaged in the development and manufacture
53
A drawback of explicitly scenario-based approaches is that it is

unclear how reasonably to select scenarios and probability measures
on scenarios in situations in which portfolio values depend on
dozens or even hundreds of risk factors. This requires significant
thought, and probably knowledge of the portfolio.11 In situations
with many market factors, scenario-based approaches loose
intuitive appeal and can be difficult to explain to senior
management, boards of directors, regulators, and other
constituencies.
Capital Structure Policy

The classic debt-equity choice is usually framed as trading off the
benefits of debt (tax shields, increased discipline on managers)
against the potential costs associated with financial distress. To
operationalized this tradeoff, one needs a quantitative sense of
the probability of getting into distress, given a particular capital
structure. Perhaps the most important determinant of this
probability of distress is the variability of cash flowshence the
usefulness of C-FaR.
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To give a concrete example of how a C-FaR measure can be used

in thinking about capital structure policy, consider the case of the
electricity industry. This industry, which until a few years ago was
largely regulated, has been subject to enormous changes as the
result of rapid deregulation. Our estimates of C-FaR for the
electricity industry which we discuss in more detail below
suggest that the volatility of EBITDA for the typical firm has
roughly doubled from the early 1990s to the late 1990s. Against
the backdrop of these large increases in volatility, an important
question to ask is whether electricity companies capital structures
have adjusted appropriately.
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An obvious strength of this methodology is thatsince we are

looking directly at cash flow variabilityby definition it produces
the right answers on average. That is, if we run the analysis repeatedly
for a number of companies, on average we will generate C-FaR
estimates that are neither systematically too high nor too low.
This property is not shared by any bottom-up approach. For
example, if a bottom-up model ignores an important source of
risk, it will produce estimates that are generally too low, perhaps
substantially so. Of course, this comparables method is not
without its drawbacks. Chief among these is the fact that one
cannot capture company-level idiosyncrasies that might give rise
to differences in C-FaR. Thus if we create a peer group of 25
companies to estimate Dells C-FaR, and Dell is in some way
atypical of its peers (perhaps it has more overseas sales, and hence
more FX exposure), this will not be captured. Another limitation
of this approach is its inability to tell us much if anything about
the expected impact of changes in a companys strategy on its CFaR. For example, if Dell decides to move farther into overseas
markets, we cannot say by how much this might raise its C-FaR.
The ability to model these kinds of specific company-level effects
is the leading advantage of the bottom-up approach used in VaR
applications.
An analogy may help to bring the costs and benefits of our

methodology into sharper focus. Our approach to C-FaR is
analogous to the common practice of estimating the value of a
company by looking at the multiples (of market-to-book, price
to- earnings, price-to-cash flow) at which its peers trade in the
market. In contrast, the bottom-up approach used in VaR models
is analogous to valuing a company by forecasting the cash flows
from each of its operating assets, and then doing a discountedcash flow (DCF) calculation. Neither one of these valuation
approachescomparables or DCFcan be said to strictly
dominate the other; each has its strengths and weaknesses. In
particular, the comparables approach to valuation will be at a
comparative advantage in situations where there is not much
detailed company-specific data available to make cash flow forecasts,
but where there is a well-defined set of peer firms. Roughly the
same can be said of our comparables approach to measuring CFaR. Notably, in the valuation arena, comparables methods are
very widely used by practitioners; even when they are not relied on
exclusively, they are at a minimum seen as a useful complement to
bottom-up DCF methods.
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of diagnostic and drug delivery systems.) For comparability, all

the distributions are centered on zero and are scaled in units of
earnings before interest, taxes, depreciation and amortization
(EBITDA) per $100 of assets. As can be seen from the figure, the
distributions for the three companies are very different. For CocaCola a five- percent worst-case scenario involves EBITDA falling
short of expectations by $5.23 per $100 of assets; for Dell the
corresponding figure is $28.50; for Cygnus it is $47.31.3
The remainder of the article is organized as follows. We begin in

the next section by discussing why and how C-FaR can be useful
in informing variety of corporate finance decisions. We then go
on to describe the construction of our basic model in some detail,
as well as to sketch some specific extensions and applications.
WHY WOULD A COMPANY WANT TO KNOW ITS CFaR?
54
In 1992, the median electricity company had interest coverage,

defined as the ratio of earnings before interest and taxes (EBIT)
to interest expense, of 2.81. Moreover, using the results of our CFaR analysis for the early 90s, one can show that in a five percent
worst-case scenario, coverage would fall from 2.81 to 2.23a lower
number to be sure, but one that still would seem to indicate
more-than adequate cash flow relative to debt obligations. Thus it
appears that, prior to deregulation, the capital structure of the
typical electricity company did not pose a very high risk of financial
distress.
As of 1999, debt ratios for the industry as a whole had not changed
much from their levels earlier in the decade. Indeed, the median
coverage, at 2.82, was virtually identical to its value in 1992. But,
with the large increase in cash flow volatility, the five percent worstcase coverage had fallen to 1.65. This suggests that the risk of
financial distress in the electricity industry, though perhaps not
enormous by the standards of other industries, had become
significantly greater in the later part of the decade. The point here
is not to say that the electricity companies current capital structures
are right or wrong in any absolute sense. Rather, it is just to
illustrate how a C-FaR estimate can be used in conjunction with
capital structure data to help formulate debt-equity tradeoffs in a
more precise, quantifiable fashion. Clearly, the same apparatus can
be used to think about other closely related financial policy
questions such as the appropriate level of cash reserves and credit
lines.
Risk Management Policy
What is the value added by risk management strategies such as the
use of derivatives to hedge commodity-price exposures, or the
purchase of insurance policies? Do the costs of such risk
management exceed the benefits? Recent research in corporate
finance has shown that risk management can indeed be an
important tool for creating shareholder value. But this work also
stresses that the value of risk management is greater when there is
a higher probability that operating cash flows will fall to the point
that important strategic investments are compromised. Thus, in
11D.571.3
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In Scenario A, the operating cash flows of $120 are a sure thing. In

this case there is no reason for the company to buy insurance; even
if it is hit with the lawsuit, it will still have $110 left, which is
enough to do its planned investment. However, in Scenario B, the
forecast of $120 is subject to some volatility. In particular, actual
operating cash flows (before any product-liability suit) will either
be $150 or $90, each with probability 50%. Now insurance is
potentially valuable, because half of the time it kicks in when the
company has a cash shortfall relative to its investment needs, and
hence will be under investing. To be more specific, assume further
that each dollar invested yields an NPV of $1.40, so that a failure
to invest a dollar costs the company 40 cents in forgone value. In
this case the company would be willing to pay up to $1.20 for the
insurance policy.
We clean the data by eliminating firms with very tiny values of

book assets (those in the lowest five percent of the distribution
each quarter), so as to avoid situations where the ratio EBITDA/
Assets becomes unboundedly large. We also screen out firmquarters where property plant and equipment (PP&E) changes by
more than 50% in a quarter. The idea here is to eliminate large
mergers or other dramatic changes in a companys asset base, which
are not surprises from the companys point of view, but which
can potentially induce a great deal volatility in measured EBITDA/
Assets. We have experimented with setting this PP&E screen
different tolerances (e.g., 20%, 30%, and 40%) and our results are
essentially identical.
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This point can be illustrated with a simple example. Imagine a

company whose capital budget for the upcoming year is $100. The
company has no ability to raise finance externally, perhaps because
it is too highly leveraged to take on more debt, and is also reluctant
to issue new equity. The company forecasts operating cash flows
of $120. Aside from these operating cash flows, it also faces a 10%
probability of being hit with a product-liability suit that will cost
it $10. It can buy product liability insurance at a cost of $1.10,
which represents a 10% markup over the actuarially fair value. (Fair
value = 10% $10 = $1). Should it buy the insurance?
surprising given that there is very little unpredictable variation in

depreciation and amortization a quarter or a year ahead. To allow
for comparability across firms, we scale EBITDA by start-of-period
book assets.
The moral of the example is simple: Holding fixed the risks to be

hedged (the product liability risk, in the example), the greater are
the unhedgeable background risks, as measured by C-FaR, the
greater is the value of risk management.
Disclosure: Managing Investors Expectations About
Earnings Volatility
Do
cu
It is a fact of life that some investors, as well as analysts, are

extremely concerned about volatility in reported quarterly earnings,
and that this concern translates into pressure on management to
meet earnings targets. By disclosing the results of a comparablesbased C-FaR analysis to investors or analysts ahead of time, a
company may be able to help put earnings shocks into a credible,
objective, peer-benchmarked perspective. In particular, one could
make statements like the following: For other companies in our
peer group, an X% deviation of quarterly earnings from
expectations is not at all atypicalindeed, it occurs roughly Y%
of the time.
BUILDING THE MODEL
We begin by assembling quarterly income statement and balancesheet data from Compustat. In our baseline analysis, we pool
together data from firms in all non-financial industries. However,
our model can also be applied to individual well-defined industries
in which there are enough firms. Electricity companies represent
one such industry; we will review this industry-specific application
later.
The First-Step Forecasting Regression

In order to measure how much cash flow deviates from
expectations, one needs to have a forecast expected cash flow. In
our case, this means we need model to forecast cash flow both a
quarter into the future, as well as a year into the future. To do so,
we use a very simple autoregressive specification. For our quarterly
forecast, we regress EBITDA/Assets in quarter t against four lags
of itself: that is, against EBITDA/ Assets in quarters t1, t2, t
3, and t4. We also add the regression quarterly dummy variables
to account for possible seasonality in the data. In any quarter t, the
model is fit using the past five years worth of data. Panel A of
Table 1 gives an example of such regression, which is fit using
data from 1991 to 1995. As can be seen, the simple autoregressive
structure does a good job of forecasting the next quarters
EBITDA/Assets, attaining an R2 of 58%. Indeed, we have
experimented with a variety of more complicated models, and in
no case were we able to do significantly better on this score.
To forecast a year into the future, we use the same right-hand-side
variables as before: EBITDA/ Assets in quarters t1, t2, t3,
and t4, as well as the quarterly dummies. The only modification
is that now the dependent variable is the sum of EBITDA in
quarters t, t+1, t+2 and t+3, all divided by assets at the start of
quarter t. That is, we are now forecasting the next full years worth
of EBITDA. The results from this regression are shown in Panel
B of Table Again, the R2 is quite high, this time reaching 63%.
It is important to be clear as to the purpose these forecasting
regressions. Our ultimate goal not to make more accurate quarterahead or year ahead predictions of expected cash flow than could
be produced by, say, industry experts or well informed company
insiders. Rather, our interest is making statements about the entire
probability distribution of shocks to cash flow, particularly the
tails of this distribution.
Our basic measure of operating cash flow is earnings before

interest, taxes, depreciation, and amortization (EBITDA).
Alternatively, one can use earnings before interest and taxes (EBIT).
The results are virtually identical in either case, which is not
11D.571.3
55
order to quantify the benefits of risk management, one again

needs to have an accurate picture of the probability distribution
of cash flows.
Three then further subdivides these nine sub samples again,

according to a measure of industry cash flow risk. Finally, we
subdivide the resulting 27 sub samples once more, this time based
on their stock-price volatility. When all is said and done, we have
81 bins, corresponding to three-way splits on each of four
dimensions. In each of these 81 bins, there are approximately
1,000 forecast errors. The hope at this point is that within each of
The 81 bins, the forecast errors come from a relatively
homogeneous group of firms, matched on the characteristics that
matter most.
al
A concrete example may be helpful. Suppose we want to construct

the quarter-ahead forecast error for company XYZ for the first
quarter of 2000. We begin by taking the perspective of December
31, 1999. Using data from the prior five years (December 1994December 1999), we fit our model and make a forecast for XYZs
EBITDA/Assets for the first quarter of 2000. Lets say this forecast
is .05that is, our regression model predicts that XYZ will have
EBITDA of $5 for every $100 of assets in the first quarter of
2000. The forecast is then compared to the actual realized value of
EBITDA/Assets for XYZ in the first quarter of 2000, thereby
generating a forecast error. So if XYZs actual EBITDA/Assets in
the first quarter of 2000 turns out to be .04, we would say the
forecast error is .01 (actual of .04 minus forecast of .05). This is
the unanticipated shock to XYZs EBITDA/Assets. The
procedure for calculating year-ahead forecast errors is the same,
except in this case we would compare XYZs EBITDA/Assets
for the full year 2000 to the value forecast as of December 1999.
we further subdivide each market cap bucket into three sub-buckets

according to whether an observation corresponds to a firm in the
bottom, middle, or top one-third of the bucket by profitability.
At this point we have nine sub-samples.
To the extent that this homogeneity assumption holds true, we

now have a very powerful nonparametric way to assess C-FaR for
any given firm. Simply locate which of the 81 bins the firm in
question belongs to, based on its current values of market cap,
profitability, industry risk, and stock price volatility. Then the
roughly 1,000 forecast errors in that bin can be thought of as
describing the firms empirical C-FaR distribution. This procedure
is how we came up with the plots for Coca-Cola, Dell and Cygnus
shown in Figure 1 earlier. For example, Coca-Cola is in the top
one-third of the sample with respect to market cap. Within market
cap bucket 3, it is also in the top one third with respect to
profitability. On the other hand, it is in the lowest third of its sub
samples with respect to both industry risk and stock-price volatility.
Thus overall, Coca-Cola is assigned to the bin that we denote {3,
3, 1, 1}. The plot of Coca-Colas year-ahead C-FaR distribution in
Figure 1 is nothing more than the histogram of the year-ahead
forecast errors in bin {3, 3, 1, 1}. A similar logic applies for Dell
and Cygnus, which are assigned to bins {3, 3, 3, 3} and {2, 1, 3, 3}
respectively.
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But to define a shock, one needs a benchmark for what cash flow
is expected to be in the absence of a shock. In other words, our
shocks correspond to forecast errorsto deviations of cash flow
from their expected values. Thus the cash flow forecasts we
construct are not an end in and of themselves, but rather a necessary
ingredient to construct these forecast errors.
We repeat this procedure for every company quarter in our database.

This gives us a very large pool of forecast errors. For example,
even if we restrict ourselves to forecast errors from the most
recent six years (1994-1999), we have roughly 85,000 observations.
Sorting the Forecast Errors Based on Company
Characteristics
Do
cu
The big pool of 85,000 forecast errors represents a hodgepodge

of data from all different types of companies. In order to learn
something about the probability distribution of cash flows for a
particular company, we want to dip into this pool and extract only
those forecast errors that come from its peer group, suitably
defined. In other words, we need to subdivide the 85,000
observations into sub samples, where each sub sample is
composed of firms with roughly similar characteristics. To do so,
we need to have an idea of what the salient firm characteristics
arei.e., which characteristics matter for forecast error volatility.
After substantial experimentation, we have settled on four

characteristics that seem to be most strongly associated with
patterns in forecast-error volatility. The first of these is market
capitalization. There is a very strong, systematic tendency for larger
firms to have smaller forecast errors, most likely as a result of the
fact that larger firms are better diversified. The second key
characteristic is profitability, measured as the average value of
EBITDA/ Assets over the prior four quarters. The third is the
riskiness of industry cash low and the fourth is stock price volatility,
calculated using daily stock price data over the prior quarter.
We create sub samples based on these four characteristics as follows.
Beginning with the full pool of roughly 85,000 forecast errors, we
first sort firms into three buckets based on market capitalization.
All forecast errors coming from firms in the bottom one-third of
the sample by market cap in any given quarter are assigned to
market-cap bucket 1, those from the middle one-third of the
sample are assigned to market-cap bucket 2, and so forth. Next,
56
The empirical probability distributions of the sort shown in Figure

1 give us a great deal of flexibility. Since the data trace out the entire
distribution, we do not need to rely on any assumptions about
normality.10 Instead, to evaluate the five-percent tail for any given
company, we simply look at the fifth percentile of the empirical
distribution.
Table 2 is a grid that reports the five-percent values of the C-FaR
distribution, in units of EBITDA per $100 of assets, for each of
the 81 bins. Panel A looks at quarter-ahead shocks, while Panel B
looks at year-ahead shocks. The cells corresponding to our example
companiesCoca-Cola, Dell and Cygnus have been highlighted
in the table. Whether one looks at Panel A or Panel B of Table 2,
several distinct patterns emerge. Smaller firms, as well as those in
riskier industries or with higher stock-price volatility, all show
markedly more extreme tail values. These patterns are all what one
would expect, though it may be surprising just how strong they
are in some cases. The effect of profitability is a bit more subtle.
There is a general tendency for unprofitable firms to have riskier
cash flows, which one might interpret to be a consequence of
operating leverage. But this tendency does not hold across all the
cells in the grid.
Just to clarify the interpretation of the units in Table 2, consider
the {3, 3, 3, 3} cell in the lower right-hand corner of Panel B, where
11D.571.3
comparable companies that the model generates for Delli.e.,

some of Dells peers in bin {3, 3, 3, 3}. Many of the natural
suspects show up, such as Dells closest competitors Compaq,
Gateway, and Micron, as well as other large, profitable high-tech
companies like Cisco. But not all of the comparables are what one
might have expected. For example, retailers like Bed Bath & Beyond
and Williams-Sonoma make the list as well. Again, they are there
because they resemble Dell in terms of market cap, profitability,
and stock-price volatility. And even though they are in a quite
different industry, it is one that historically has had cash flow
volatility comparable to that of Dell and its high-tech brethren.
Variations on the Basic Model
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al
The basic comparables approach to C-FaR that we have described

can be modified in a number of ways. Here we briefly discuss a
couple of examples. Customized, centered peer groups. Consider
two firms, one in the 70th percentile of the market cap distribution,
and one in the 90th percentile. Our baseline methodology treats
these firms as identical for market-cap purposes, sticking them
both in the bucket corresponding to the top one-third of the
sample (i.e., the bucket for all firms above the 67th percentile). On
the other hand, the 70th percentile firm goes in a completely
different bucket than one in the 65th percentile, because they are
on opposite sides of the cutoff. This would seem to be an arbitrary
and unattractive feature.
Assuming that $2,419 was also the forecasted value of EBITDA

at the start of 1999, then we could say that in the five-percent
worst case, EBITDA would fall 43.5% below expectations 1,053/
2,419 = 43.5%).
Do
cu
Note that any statements that we make about EBITDA can be

easily translated into statements about EBIT, or about after-tax
net income. To the extent that Dell can perfectly forecast its
depreciation and amortization a year ahead, its unanticipated EBIT
shortfall is exactly the same as its EBITDA shortfall. And to get
its net income shortfall, all one has to do is multiply by one minus
the tax rate. Thus assuming a tax rate of 35%, the five-percent
worst case net income shortfall is $684 million (684 = .65 1,053),
which is equivalent to 41.1% of actual realized 1999 net income.
A Closer Look at Dells Peer Group

At this point, our four-characteristic sorting method of creating a
peer group for any company may seem like something of a black
box. What kind of comparables actually comes out of this
approach? As an illustration, Table 3 presents a partial list of the
11D.571.3
An alternative approach is to create customized, centered peer

groups for any given firm we study. For example, if we are looking
at a firm in the 70th percentile by market cap, we could create for it
a customized market-cap bucket, such that this firm fits right into
the middle of the bucket. In other words, the market-cap bucket
for our 70th percentile firm would include all firms with market
caps between approximately the 53rd percentile and the 87th
percentile. A similar approach can be used when we sort on the
other three characteristics. Although this involves re-running the
model each time we look at a new firmas opposed to just picking
firms out on a once-and-for-all grid of the sort shown in Table
2it arguably does a better job of creating representative peer
groups.
Single-industry analyses. In our baseline C-FaR model, we analyze
companies from all non-financial industries jointly. But this is not
necessary. Indeed, in some cases it may make more sense to look at
a single well-defined industry in isolation. This is particularly true
if (1) the industry has enough firms to create a decent-sized pool
of forecast errors and (2) there are specific questions about this
industry that cannot be answered if it is pooled together with
others.
Consider the case of the electricity industry. As noted above, this
industry has undergone rapid deregulation over the past several
years. In light of this deregulation, a natural question to ask is:
how has the C-FaR of the typical electricity company changed over
the course of the 1990s? To address this question, we begin by
taking the roughly 100 electricity companies in SIC codes 4911 and
4931 and creating a pool of forecast errors just for them. Given
that we want to see how things have changed over the past decade,
we now allow for 10 years worth of forecast errors, from 19901999. In total, this yields about 3,400 forecast errors for this
industry. Next, we divide our ten-year sample period into thirds
corresponding to the early, mid and late 1990sand examine
57
one finds the year-ahead number for Dell. This number is 28.50,
which should be read as saying that, in a five-percent worst-case
year, Dells EBITDA would fall short of expectations by $28.50
for every $100 of book assets that it has. For example, applying
the model at the start of Dells 1999 fiscal year, when its book
assets (net of cash and securities) stood at $3,696 million,11 the
conclusion is that a five-percent worst-case scenario for 1999 would
involve an EBITDA shortfall of $1,053 million (1,053 = 3696
.285) To get a sense of proportion, this figure can be compared to
Dells actual realized 1999 EBITDA of $2,419 million.
Another question that one might ask is: how do the C-FaR
distributions vary for electricity companies with different
characteristics? Naturally, we no longer have enough data to chop
this much-smaller pool of forecast errors into 81 separate bins.
But there is no longer any need to. Firstly, the observations are all
from firms in the same industry, so there is no need to do an
industry cut. Moreover, most are relatively large (as compared to
the overall Compustat sample), so there is less need to sort on
market cap as well. Instead, we streamline our sorting procedure
so that we just do a pair of two-way sortsone on profitability
and one on stock-price volatilitythereby dividing the pool of
forecast errors into four sub samples.
al
Notes:
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separate C-FaR distributions for each. Panel A of Table 4 shows

the year-ahead five-percent tails for each of the three sub-periods.
As can be seen, this value rises from 1.80 in the early 90s to 2.11
in the mid 90s, to 3.30 in the late 90si.e., it roughly doubles
over the course of the decade.
Panel B of Table 4 reports the results of this procedure

implemented only on the late-1990s data. As can be seen, the
general tendencies that we identified in the full Compustat sample
(higher cash flow volatility among firms with low profitability
and high stock-price volatility) hold true within the electricity sector
as well. In particular, those firms that land in the low-profitability/
high-stock-price-volatility bin have a year-ahead five-percent tail
that is roughly twice as large as the firms in any of the other bins.
CONCLUSIONS
Do
cu
We believe that our top-down, comparables based approach to

estimating C-FaR offers a number of practical advantages. First
and foremost, by looking directly at the ultimate item of interest
cash flow variabilitythe model naturally produces estimates that,
within any given peer group, are correct on average. In contrast,
with a bottom-up approach, one cannot be sure that the estimates
are not severely biased. Second, the model is non-parametric, and
thereby avoids imposing the highly unrealistic assumption
that shocks to cash flow are normally distributed. Finally, once the
model is built, it can be easily and at relatively low cost applied to
any number of non-financial companies.
Of course, none of this is to claim that our approach dominates
the alternative of building a company-specific C-FaR model from
the bottom up. Rather, the two approaches can be thought of as
complementary. For example, our model can be used to provide a
reality check on the results produced by an in-depth bottom-up
analysis. Again, the analogy to valuation practices is informative.
Comparables methods are widely (though not exclusively) used
by practitioners to value companies. And in spite of their inability
to factor in certain types of company-specific information, it would
be hard to argue that they do not represent an important part of
the pragmatic persons valuation toolkit. We hope that our
approach to estimating C-FaR will prove to be similarly useful.
58
11D.571.3
LESSON 11:
RISK REDUCTION THROUGH POOLING
LOSSES
risk.
Show how correlation in losses affects the amount of risk that
is reduced in a pooling arrangement.

Discuss how pooling arrangements provide the foundation
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for insurance transactions and how insurers are efficient

managers of pooling arrangements.
Discuss other examples of diversification including stock
markets.
The first column of Table 4.2 lists the possible outcomes for
Emily and Samantha with pooling. If neither woman has an
accident, total accident costs are zero and each woman pays zero. If
either of the women has an accident, total accident costs are $2,500
and each woman pays $1,250. If both women have an accident,
total accident costs equal $5,000 and each pays $2,500.
al
Show how pooling of independent loss exposures reduces
Note that the pooling arrangement changes the distribution of

costs paid by each person in Table 4.1; this is because the costs
paid by Emily now depend on the accident losses in-curred by
Samantha, and vice versa. Specifically, with pooling, the cost paid
by each per-son is the average loss of the two people. .
Risk Reduction through Polling Independent Losses

The most important risk management concept may be the
diversification of risk. Diversifi-cation is an essential aspect of
insurance and financial markets. We analyze diversification in
this chapter, highlighting the factors influencing the extent to
which risk can be and is di-versified. We illustrate diversification
in several different contexts, beginning with a sim-ple pooling
arrangement between two people and ending with
diversification among thousands of people or businesses
through insurance and financial markets.
Using the probability and statistics concept reviewed in the

previous chapter, we can now explain how pooling arrangements
reduce risk when losses are independent (uncorrelated).
Do
cu
Two people Pooling Arrangement

Suppose that Emily and Samantha each are exposed to the
possibility of an accident in the coming year. In particular,
assume that each person has a 20 percent chance of an accident
that will, cause a loss of $2,500 and an 80 percent chance of no
accident. The probability distribution for accident losses for each
woman is summarized in Table 4.1. Note that the distribution
is very skewed; that is, there is a high probability of zero loss
and a much smaller probability of a large loss. Also assume that
Emilys and Samanthas accident losses are uncorre1ated.
We want to examine what will happen if Emily and Samantha

agree to split evenly any accident costs that the two might incur. That is,
they agree to share losses equally, each pay-ing the average loss.
This arrangement often is called a pooling arrangement (or risk
pool-ing arrangement), because Emily and Samantha are pooling
their resources to pay the accident costs that may occur.
Because Emily and Samantha each have a 20 percent chance of

having an accident that causes $2,500 in losses, the expected costs
and the standard deviation for each person with-out a pooling
arrangement are as follows:
Expected cost = (0.80) ($0) + (0.20) ($2,500) = $500
Standard deviation = {O.8 ($0 - $500)2 + 0.2 ($2.500 - $500)2}1/2=
$1,000
Our goal is to determine how the pooling arrangement will affect
the expected cost and standard deviation for each person.
11D.571.3
Now lets find the probabilities of each of these outcomes (the

last column of Table 4.2). Since the losses incurred by Emily are
independent of the losses incurred by Samantha, the probability
that neither woman has an accident is simply the probability that
Emily does not have an accident times the probability that
Samantha does not have an accident. Thus, the probability of the
first outcome is (0.8)(0.8) = 0.64. An analogy might help reinforce
this result. Consider flipping a coin twice. The result of the second
coin flip is independent of the result of the first coin flip. The
probability of obtaining two heads is the probability of heads on
the first coin flip times the probability of heads on the second
coin flip, or (0.5)(0.5) = 0.25. You can convince yourself that this
is true by noting that there are four possible outcomes: headsheads, heads-tails, tails-heads, and tails-tails. Each of these
out-comes has a 0.25 probability of occurring.
Table 4.1: Probability distribution of accident losses for each person
without pooling
Outcomes
$ 0.0
$ 2.500
Probability
0.80
0.20
Table 4.2: Probability distribution of accident costs paid by each

woman with pooling
Possible Outcomes
1. Neither Samantha nor
Emily has an accident.
2. Samantha has an
accident but Emily does
not
3. Emily has an accident
but Samantha does no t
4. Both Samantha and
Emily has an accident
Total Cost
Average Loss
Probability
(0.8)(0.8) = 0.64
2500
1250
(0.2)(0.8) = 0.16
2500
1250
(0.2)(0.8) = 0.16
5000
2500
(0.2)(0.2) = 0.04
Returning to the accident costs example, lets find the probability

of the second and third outcomes shown in Table 4.2 (in which
only one of the two women has an accident). The probability that
Samantha has an accident, but Emily does not equals (0.2)(0.8) =
0.16. The probability that Emily has an accident, but Samantha
does not is also 0.16. Thus, the proba-bility that only one of the
women has an accident equals 0.16 + 0.16 = 0.32. The probabil-ity
of the fourth outcome (both Emily and Samantha have an accident)
is (0.2)(0.2) = 0.04.1
59
Chapter Objective:
UNIT I
CHAPTER 5
DIVERSIFICATION OF RISK
Standard deviation =
{0.64 X ($0 - $500)2 + 0.32 X ($1,250 - $500)2 + 0.04 X ($2,500 - $500)2}1/2 = $707
While both Samanthas and Emilys risk is reduced by pooling,

each persons expected accident cost is unchanged by pooling. It
still equals $500:
Expected cost = (0.64) ($0) + (0.32) ($1,250) + (0.04) ($2,500) =
$500
In summary, the pooling arrangement does not change either

persons expected cost, but it reduces the standard deviation of
costs from $1,000 to $707. Accident costs have become more
predictable. The pooling arrangement reduces risk (uncertainty)
for each individual.
Do
cu
Pooling arrangements provide a major example of how risk is

reduced through diversi-fication. Simply stated, diversification
means that you do not put all your eggs in one bas-ket. By
entering into a pooling arrangement, Emily and Samantha made
their accident costs for the year equal the average loss for the
participants. If they had not entered into the pooling arrangement,
their accident costs would equal their own losses. The key point is
that the average loss is much more predictable than each individuals
loss. Applying the egg analog) to the pooling arrangement, (1)
each woman puts half of her eggs into one basket and half into
another basket, and (2) Emily carries one basket and Samantha
carries the other. After reaching their destination, they divide the
surviving eggs equally.
Pooling Arrangement with Many People or
Businesses
Additional risk reduction can be obtained from pooling by
adding people (or businesses) to the arrangement. To illustrate,
suppose that Anne, who has the same probability distribu-tion
for accident costs as Samantha and Emily, joins the pooling
arrangement. At the end of the year, each woman will pay onethird of the total losses (the average loss). The addition of a
third person whose losses are independent of the other two
causes an additional reduc-tion in the probability of the extreme
outcomes. For example, in order for Samantha to pay $2,500 in
accident costs, all three individuals must experience a $2,500
loss. The probabil-ity of this occurring is (0.02) (0.02) (0.02) =
0.008. As a consequence, the standard devia-tion for each
individual decreases with the addition of another participant.
60
The probability distribution of each persons accident cost will

continue to change as more people are added. Figure 4.1 compares
the probability distribution for average acci-dent costs when there
are 4 and 20 participants in the pooling arrangement. Note that as
the number of participants in the pooling arrangement increases
the probability of the extreme outcomes (very high average losses
and very low average losses) go down. Stated differ-ently, the
probability that average losses (the amount paid by each
participant) will be close to $500, the expected loss, increases. Also,
as the number of participants increases, the probability
distribution of each persons cost (the average loss) becomes more
bell shaped, which is, less skewed. In summary, pooling makes
the amount of accident losses that each per-son must pay less
risky (more predictable), because pooling reduces the standard
deviation of the average loss for all the participants and thus the
standard deviation of the payment by each participant. The pooling
arrangement therefore reduces risk for each participant? As even
more participants are added, the probability distribution would
become more and more bell shaped (less skewed).
al
Because the pooling arrangement reduces the probabilities of the

extreme outcomes, the standard deviation (risk) of accident costs
paid by both Emily and Samantha is reduced. Re-call that, without
pooling, the standard deviation of accident costs in this example
is $1,000. With pooling, the standard deviation of accident costs
declines to $707:
While risk (standard deviation) decreases, each individuals

expected accident cost again remains con-stant at $500.
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As can be seen clearly from this example, the pooling arrangement

changes the proba-bility distribution of accident costs facing each person.
The probability that Emily will have accident costs equal to $2,500
is reduced from 0.20 to 0.04. This is because in order for Emily to
pay $2,500, both Emily and Samantha must experience an accident.
Given that ac-cidents are independent, the probability that both
Emily and Samantha will have an acci-dent is lower than the
probability that only Emily (or only Samantha) will have an
accident.
Notice in all of these examples that each participant is not simply

transferring risk to someone else. Instead, there is a reduction in
risk for each individual. This is the beauty of risk pooling
arrangements: Risk can be reduced substantially for the participants.
This point is extremely important and often is not fully appreciated
by students. Pooling arrange-ments reduce the amount of risk
that each participant has to bear.
To summarize, when losses are independent, pooling
arrangements have two important effects on the probability
distribution of the accident cost paid by each participant. First, the
standard deviation of the average loss is reduced. As a consequence,
the probability of ex-treme outcomes for participants both high
and low-is reduced. Second, the distribution of average losses
becomes more bell shaped.
In the extreme (i.e., as the number of people in the pooling
arrangement becomes very large), the standard deviation of each
participants cost becomes very close to zero and the risk thus
becomes negligible for each participant. This result reflects what is
known as the law of large numbers. In addition, as the number
of participants grows, the probability distribution of the average
loss (each participants cost)becomes more and more bell shaped
until it eventually equals the normal distribution, the most
famous distribu-tion in all of statistics. This result reflects what is
known as the central limit theorem.
Finally, our examples of risk reduction through pooling
arrangements have assumed that all participants have the same
probability distribution. This assumption is not essential. The
standard deviation of average loss also tends to decline when
more and more participants with different loss distributions are
added to a pooling arrangement. Furthermore, risk in principle
still becomes negligible as the number of participants becomes
infinitely large.
Concept Checks
11D.571.3
a.
There is one participant (i.e., no pooling)
b.
c.
There are 100 participants

There are 1,000 participants
Pooling Arrangement with correlated Losses
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Since in many instances losses will be positively correlated, we

need to examine risk re-duction through pooling in this case. We
will demonstrate that the essential point-that pooling
arrangements reduce risk for each participant-continues to hold
provided losses are not perfectly positively correlated. However,
the magnitude of risk reduction is lower when losses are positively correlated
than when they are independent (uncorrelated).
To illustrate, consider the effect of introducing positive correlation

between Emilys and Samanthas losses. Positive correlation does
not change Emilys or Samanthas initial prob-ability distribution
for accident costs. We start the year knowing that the probability
of an accident is 0.2 for both Emily and Samantha. Now suppose
you hear later that Emily has had an accident, but you do not
know whether Samantha has had an accident. What is your
assessment of the probability that Samantha will have an accident?
If the accidents are assumed to be independent, then your
assessment will not change; the probability of Saman-tha having
an accident still will be 0.2. However, if the accidents are assumed
to be positively correlated, then knowing Emily has had an accident
will raise your assessment of Samanthas accident probability above
0.2.
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2. Suppose that each participant in a pooling arrangement has

potential losses ranging from $0 to $4,000 and that each
participants expected loss is $1,000. Using Figure 4.2 as a guide,
sketch the probability distribution of average losses if the losses
across partici-pants are independent and if:
losses, and one persons unexpectedly high losses are less likely to
be offset by another persons unexpectedly low losses.
Losses across many different businesses or individuals may be

positively correlated for a number of reasons. The occurrence of a
loss is often due to events that are common to many people.
Catastrophes, such as hurricanes and earthquakes, are examples
of events that cause property losses to increase for many
individuals at the same time. Consequently, losses in certain
geographical regions during a given time period are positively
correlated. Similarly, since epidemics can cause medical costs to
increase for many people during a given time period, the medical
costs across people can be positively correlated.
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The severity or magnitude of losses also is often influenced by

common factors. For ex-ample, unexpected inflation can cause
everyone who needs health care to pay more than ex-pected. The
probability of receiving medical care may be independent across
people (in contrast to the epidemic example), but the magnitude
of the medical costs incurred by dif-ferent people is related to a
common underlying factor-inflation.
How do positively correlated losses affect pooling arrangements?
Intuitively, positively correlated losses imply that when one person
(or business) has a loss that is greater than the expected loss, and
then other people (or businesses) also will tend to have losses
that are above the expected loss. Similarly, when one person has a
loss that is less than the expected loss (e.g., no loss), then other
people also will tend to have losses below the expected value.
Thus, when losses are positively correlated, there is a greater chance
that lots of people will have high losses and a greater chance that
lots of people will have low losses, relative to the case of
uncorrelated losses. Consequently, pooling arrangements do not
decrease the stan-dard deviation of average losses as much when
losses are positively correlated. Stated dif-ferently, average losses
are more difficult to predict when losses are positively correlated.
To reinforce this idea, with uncorrelated losses, there is a relatively

high probability that unexpectedly high losses experienced by one
person will be offset by the unexpect-edly low losses of other
participants. Thus, the average loss becomes very predictable. When
losses are positively correlated, more participants incur similar
11D.571.3
Positive correlation between Emilys and Samanthas accident costs

implies that the prob-ability of both women having an accident is
greater than 0.04. Similarly, positive correlation implies that the
probability of neither woman having an accident is greater than
0.64. Un-less we make more assumptions, we cannot specify the
exact probabilities of the various outcomes. The critical point,
however, is that positive correlation between Emilys and
Samanthas accident costs implies that the probability of the
extreme outcomes (i.e., that ei-ther both or neither will have an
accident) is higher than if accident costs were independent.
The maximum degree of positive correlation is perfect positive
correlation. In this case, if Emily has an accident, so will Samantha,
and if Emily does not have an accident, neither will Samantha.
Perfect positive correlation implies that whatever happens to Emily
also happens to Samantha. As a result, the probability of both
women having an accident is the same as the probability that
either one of them will have an accident (0.2), and the proba-bility
that neither woman will have an accident is the same as the
probability that one of them will not have an accident (0.8).
The effect of positively correlated losses on the distribution of
average losses is sum-marized in Figure 4.3. Two cases are
presented. In both cases, there are 1,000 participants in the pooling
arrangement and each participant has an expected loss of$500. In
one case, the losses of each participant are uncorrelated; in the
other case, they are positively corre-lated. As illustrated, when losses
are positively correlated, the distribution of average losses has a
higher standard deviation so that average losses are less predictable.
Figure 4.4 further illustrates the effect of correlated losses on
pooling arrangements by examining how the standard deviation
of average losses changes as the number of partici-pants increases.
The vertical axis measures the standard deviation of average losses.
The horizontal, axis measures the number of participants in the
sharing arrangement. When losses are uncorrelated, the standard
deviation approaches zero as the number of partici-pants gets
large (recall the law of large numbers). When losses are perfectly
positively cor-related, the standard deviation of average losses
does not change as the number of participants increases. Intuitively,
when losses are perfectly positively correlated, there can be no risk
reduction from pooling, because whatever happens to one
participant happens to all other participants.
61
1. Explain how a pooling arrangement reduces risk for each

participant when losses are un-correlated. Does pooling reduce
the expected cost paid by each participant? Explain.
3. Sketch the probability distribution for average losses in a pooling

arrangement in each of the following cases. The appearance of
anyone distribution is not important; instead, the relative
appearance of the distribution matters.
a.
The expected loss for each participant is $500, and losses
for the 100 participants are independent.
When a participant in a pooling arrangement experiences a loss,

the person must inform and seek payment from the other
members. To prevent people from fraudulently claiming that a
loss has occurred or exaggerating loss amounts, the pooling
arrangement must mon-itor claims. The costs associated with
this process usually are called loss adjustment ex-penses (or claims
settlement expenses). Pooling arrangements also involve collection
costs. If, for example, a particular member has a valid claim of
$l0000, each participant will ul-timately have to be assessed the
specified share of the $10,000 loss (e.g., $10 each if there are 1,000
members that agree to share losses equally). Alternatively, each
member will have to be billed periodically for his or her share of
total claim costs since the last payment. In either case, the collection
of funds will involve costs in sending a bill to each member and
attempting to ensure that each member pays his or her assessment.
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Concept Check
pooling arrangement all have expected losses of $200. Then those

participants will be reluctant to allow a person with an expected
loss of $400 to join on the same terms. Thus, the pool members
will want to evaluate each potential participants expected loss.
The process of identifying (estimating) a potential participants
expected loss is known as underwriting, and the costs of doing so
are called underwriting expenses.
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Figure 4.4 also illustrates the intermediate case, where losses are
characterized by less than perfect positive correlation; As can be
seen, the standard deviation of average losses decreases as the
number of participants increases, but the standard deviation does
not ap-proach zero. The amount of risk (standard deviation)
cannot be reduced as much by adding participants when losses are
positively correlated; the greater the degree of correlation, the less
is the reduction in risk.
b.
The expected loss for each participant is $500, and losses
for the 100 participants are positively correlated.
c.
The expected loss for each participant is $1,500, and losses
for the 100 participants are independent.
d.
The expected loss for each participant is $1,500, and losses
for the 100 participants are positively correlated.
Insurers as Managers of Risk Pooling Arrangements
As we just learned, individuals or businesses can reduce their
risk by forming a pooling arrangement. As a result, risk-averse
individuals 1!Pd businesses that value lower risk would have
strong incentives to participate in pooling arrangements if they
could be organized at zero cost. However, risk-pooling
arrangements obviously are not costless to operate. Indeed, the
cost of organizing and operating pooling arrangements is the
main reason why insurance companies exist and why most
pooling arrangements take place indirectly through insurance
contracts. In essence, insurance contracts are a way of lowering
the costs of operating pool-ing arrangements.
Types of Contracting Costs
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Consider a risk pooling arrangement like the one introduced earlier,

in which Emily and Samantha agree to share losses equally. We
showed how this type of pooling arrangement reduces each
participants risk, as measured by the standard deviation of his or
her payment, provided that losses are not perfectly positively
correlated. The greater the number of peo-ple who participate in a
pooling arrangement, the greater is the reduction in risk. There
are, however, several important costs associated with writing and
enforcing contracts among participants, which in general are referred
to as contracting costs. To illustrate how insur-ance companies
economize on these costs, this section describes the major types
of con-tracting costs associated with pooling arrangements.
Consider first the costs associated with adding participants to risk

pools. In practice, risk-pooling arrangements incur substantial
costs in marketing and in specifying the terms of Agreement.
These costs often are called distribution costs. As discussed in
Box 4.2, insur-ers employ a variety of distribution systems,
including exclusive agents and independent agents and brokers.
Once a potential participant in a pooling arrangement has been
identi-fied, it must be decided whether to allow the individual to
participate. For example, suppose that existing participants in a
62
You can think of insurance companies as organizations that have

emerged to reduce the costs of operating pooling arrangements.
For example, without a central organization to re-cruit new
members and distribute contracts (marketing and distribution),
screen applicants (underwriting), monitor claims (loss adjustment),
and collect assessments, each member of a pooling arrangement
would need to contract with each of the other members. With
1,000 members, 499,500 separate contracts would be needed (1,000
members X 999 contracts per member -;- 2, since only one contract
per pair is needed). With a central organization, only 1,000 contracts
between the organization and the members are needed.
In addition, without a central organization, each member would
have to (1) become in-volved in underwriting each of the other
members, (2) investigate each claim, and (3) indi-vidually collect
assessments. These activities involve expertise that most people
do not have and require considerable amounts of time. The
existence of insurance companies that spe-cialize in these activities
typically is efficient (i.e., it lowers costs).
Ex Ante Premium Payments versus Ex Post
Assessments
In contrast to pure pooling arrangements, insurance companies
usually do not have the legal right to assess members of the
pooling arrangement (policyholders) for losses that have occurred. Instead, policyholders pay an ex ante premium-that is,
prior to knowing the magni-tude of losses-without giving the
insurer the right of assessment if more money is ultimately
needed to pay claims (ex post). One explanation for having
fixed ex ante premiums as opposed to ex post assessments is
that collecting assessments from people who do not have losses
is costly. Some people will attempt to delay and in some cases
avoid paying assessments.
Moreover, with a pure assessment system, funds might not be
available to pay losses quickly. The resulting delay in claim payments
would be costly to those participants that have experienced losses.
Finally, assessments impose risk on participants: They do not
11D.571.3
Other examples of Diversification: Stock Markets
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There are many ways that people and businesses diversify risk in
addition to pooling arrangements through insurance contracts.
Stock markets, for example, provide a mecha-nism for
entrepreneurs to share risk associated with new business ventures
with other peo-ple. A share of stock entitles the owner of the
share to a portion of a companys dividends. If the company
does well, then dividends and/or stock prices will increase, and
the owner will gain accordingly. If the company does poorly then
the dividends and/or stock prices will decline, and the owner of
the share will lose accordingly. Thus the owner of the share of
stock shares in risk of the venture.
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Fixed ex ante premiums imply that the insurer obtains revenue

(premium payments) prior to paying claims. As we elaborate in
the next chapter, insurers typically invest these funds in a variety
of financial assets. The resulting investment earnings can be used
to help pay claims when they come due. The insurers expected investment earnings reduce the premium that needs to be charged
to cover the insurers ex-pected costs, all else being equal.
know in advance how much they will have to contribute (although

the risk still is lower than if they were not members). For these
reasons, insurers commonly charge policyholders a fixed, ad-vance
premium without having the right to assess policyholders for
losses during the cover-age period if realized losses for the insured
group turn out to be higher than expected.
Most investors (including entrepreneurs) do not invest all of

their wealth into one companys stock; instead, they invest small
amounts of their wealth into many different stocks. This can be
accomplished at low cost using a mutual fund. In this way, their
wealth at the end of their investment horizon do not totally
depend on the fortunes of just one company. Investing in a
number of different stocks is an example of portfolio diversification, and it is recommended by almost all financial advisors.
Portfolio diversification re-duces the investors risk without
necessarily sacrificing expected return.
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The main message from the discussion of pooling arrangements

with correlated losses is that positive correlation. limits the amount
of risk that can be eliminated through pooling arrangements. An
analogous result holds for stock portfolio (investment)
diversification. Returns on different stocks are positively correlated,
because all firms are affected to some degree by common factors,
such as general economic conditions and interest rates. Consequently, some of the risk associated with holding stocks cannot
be diversified away. That is, the positive correlation in stock returns
limits the amount of risk that can be eliminated through portfolio
diversification. The risk that cannot be eliminated usually is called
sys-tematic risk or sometimes non-diversifiable or market risk.
Notes:
11D.571.3
63
UNIT I
CHAPTER 6
RISK DECISIONS
LESSON 12:
RISK REDUCTION DECISIONS
risk retention/reduction.
Summarize evidence indicating which types of firms are more
likely to reduce risk.

Identify the variables on which a firm should focus its risk
Potential savings in profit loadings also can depend on the degree

of competition in in-surance markets. While most insurance
markets are competitively structured, the market for very large
limits of business insurance often involves negotiation between
the corporate buyer and a group of insurers that share the risk. In
these instances, it has been suggested that insurers may achieve
higher expected profits than is the case where many independent
insurers are competing to sell coverage.
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reduction activities.
Explain the advantages and disadvantages of following a
disaggregated approach to risk reduction.
services to the insured. Thus, the savings on premium loadings

depend on the insurers cost of providing these services rela-tive
to the firms own costs. The savings on premium loadings also
depend on the amount of profit loading that the firm can avoid
paying by retaining more risk, which in turn de-pends on the
insurers capital costs and ability to reduce risk through
diversification and reinsurance, relative to the firms capital costs
and ability to diversify risk.
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Identify firm characteristics that influence firm decisions about
Firm Characteristics Affecting Risk Retention

(Reduction) Decisions
The previous two chapters outlined conceptual reasons why
firms might find it advanta-geous to reduce risk even when the
firms owners can reduce risk on their own through port-folio
diversification. In short, firm-level risk affects the likelihood that
a firm not only will have to raise costly external capital but also
will en-counter financial distress, which in turn affects the terms
at which a firm contracts with lenders, employees, suppliers, and
customers. We explained that firms might reduce risk because
risk reduction is required by regulation or reduces expected tax
pay-ments. In this section, we use the conceptual arguments
from the previous two chapters to derive implications about
specific firm characteristics that are likely to influence risk reduction decisions.
Risk retention refers to the decision to accept the uncertainty

(variability) associated with a particular risk exposure. Conversely,
risk reduction refers to the decision to reduce uncertainty (variability).
Our discussion of the retention decision assumes that the alternative to retention is to reduce risk using an insurance contract.
However, the points general-ize to other risk reduction methods
that are discussed in subsequent chapters, such as risk reduction
using derivative contracts.
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Chapter Objectives
Benefits of Increased Retention
Potential savings to a firm from increasing retention include: (l)

savings on premium load-ings, (2) reducing exposure to insurance
market volatility, (3) reducing moral hazard, (4) avoiding high
premiums that may accompany asymmetric information, and (5)
avoid-ing implicit taxes that arise from insurance price regulation.
Savings on Premium Loadings
A key factor motivating additional retention is the ability to save
on some of the adminis-trative expense and profit loadings in
insurance premiums, thus reducing the expected cash outflows
for these loadings. Specific sources of savings include lower
commissions to in-surance brokers, possible savings in
underwriting expenses and administrative costs of claim
settlement, and savings in state premium taxes (typically 2
percent of the premium) and implicit taxes for expected
guaranty fund assessments. Recall, however, that part of an
insurers administrative costs are due to the provision of
64
Reducing Exposure to Insurance Market Volatility

Another motivation for some corporations to increase risk
retention has been the desire to re-duce their vulnerability to
annual swings in insurance prices due to the effects of shocks to
in-surer capital on the supply of insurance and/or the insurance
underwriting cycle. Loss financing decisions often are part of a
long-term business strategy or plan. Once a firm de-cides to
insure a particular exposure, it may be costly to change its
strategy in response to an insurance price increase. This is
because an immediate large increase in the amount of risk retained can increase the probability of financial distress, increase
the likelihood that the firm will not have sufficient internal
funds to adopt positive net present value projects, and damage
relationships with customers, suppliers, or lenders. Arranging
alternative loss financing, such as accumulating internal funds or
establishing a captive, also can take time.
As a result of these influences, the demand for insurance by
individual firms often is in-elastic in the short run (i.e., comparatively
unresponsive to a change in price in the short run). As a
consequence, the purchase of insurance can lead to the perverse
result: Even though a major purpose of purchasing insurance
generally is to reduce uncertainty in cash flows, the volatility in
insurance prices exposes the firm to uncertainty. When making
long-term loss financing decisions, therefore, risk man-agers often
view the volatility in insurance prices as a negative aspect of
insurance, which leads them to increase retention.
Reducing Moral Hazard
You learned in Chapter 10 that deductibles and other copayments reduce moral hazard. Without these contractual
provisions, expected claim costs would be higher and therefore
so would insurance premiums. Consequently, when moral
hazard is more of a potential problem, firms tend to retain
more risk.
11D.571.3
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Firms also can provide insurers with any available evidence that
their expected claim costs might be lower than predicted by the
insurer.
Costs of Increased Retention

Increased retention obviously exposes the firm to greater risk.
As you learned , increased risk can be costly for a number of
reasons. For example, the greater risk from increased retention
increases the probability of costly financial distress with
associated ad-verse effects on lenders, employees, suppliers, and
customers, which causes them to con-tract with the firm at less
favorable terms. Increased retention also may require the firm to
raise costly external funds and forgo some profitable
investment opportunities. Moreover, increased retention may
reduce expected tax shields and sacrifice possible advantages to
in-surance from bundling responsibility for claims payment
with claims settlement. Other things being equal, the costs
associated with increased retention will vary across firms depending on the nature of their ownership and operations.
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The inability of insurers to estimate claim costs precisely for all

potential buyers causes some buyers to face prices that are relatively
high compared to their true, unobservable ex-pected claim costs.
These buyers have an incentive to retain more risk. Higher risk
buyers would have the opposite incentive (i.e., they would retain
less risk to the extent that they face a lower price for insurance because they are pooled with lower risk firms). Note, however, that
the reasoning We have lower expected claim costs than what the
insurer thinks might be seductive and somewhat dangerous.
Recall that insurers have substantial incentives to forecast costs
accurately.
competitive insurance markets will provide some implicit return

for the expected average time lag between the payment of
premiums and claim costs.
Avoiding Implicit Taxes Due to Insurance Price

Regulation
In the case of workers compensation insurance, some states
periodically have had large residual markets characterized by
significant cross-subsidies from the voluntary market to the
residual market. To the extent that this occurs in workers compensation or other lines of business insurance that have
residual markets (e.g., commer-cial auto liability and some other
types of liability coverage), any higher premiums needed to
subsidize the residual market increase the incentives for firms
that would be insured in the voluntary market to self-insure or
otherwise increase their retention. Firms that can obtain
subsidized coverage in the residual market will tend to purchase
more coverage (re-tain less risk).
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Maintaining Use of Funds

It often is argued that another advantage of retention is that the
firm gets to maintain use of the funds that otherwise would be
paid in premiums until claim costs are paid. Given that
competitive insurance premiums will reflect the present value of
expected claim costs, it is not obvious that this argument is
valid. The reason is that discounting expected claim costs to
present value implicitly provides insurance buyers with a return
on funds paid in premi-ums until claims are paid. As explained
earlier, income tax rules for insurance ver-sus self-insurance
might even allow insurers to provide greater implicit after-tax
returns to insurance buyers than could be obtained if buyers
held the same amount of funds in similar assets to finance
retained losses.
It sometimes is argued that a firm should view its opportunity

cost of paying premiums as equal to its opportunity cost of
capital for general investment decisions, which will ex-ceed the
risk-free rate of interest due to the presence of non-diversifiable
risk, whereas in-surers will discount expected claim costs at the
risk-free rate (or something close to the risk-free rate). However,
this argument is problematic because theory generally suggests
that the rate used to discount losses should depend on the risk of
losses rather than whether the firm or the insurer pays the losses.
As a result, the appropriate discount rate for losses is the same for
the firm and the insurer (apart from any tax considerations). At a
minimum, it is important for you to recognize that premiums in
11D.571.3
Closely Held versus Publicly Traded Firms with

Widely Held Stock
The owners of closely held firms typically have a significant
proportion of their wealth in-vested in the firm and thus are
undiversified compared to shareholders of publicly traded firm
so with widely traded stock. Because the owners of closely held
firms are not diversi-fied, they have an incentive to retain less
risk (purchase more insurance) than publicly traded firms with
widely held stock. Similarly, firms that have managers who own
a large amount of stock and therefore are undiversified are more
likely to reduce risk.
Firm Size and Correlation among Losses
If a firm has a large number of independent exposures, then
the law of large numbers operates at the firm level, allowing the
firm to predict its average loss per exposure more ac-curately.
Consequently, one major benefit of insurance-the reduction in
the variability of the average loss per exposure-can also be
achieved by firms with a large number of un-correlated loss
exposures. Positive correlation among losses within a firm
reduces the ex-tent to which firms can diversify risk internally.
Consequently, other things being equal, positive correlation
increases the demand for insurance (provided that insurers are
able to achieve superior diversification). Larger firms with their
generally larger cash flows also are better able to readily finance
losses of any given size out of cash flow than are smaller firms,
and they often are able to raise external funds at lower cost.
Each of these influences reduces the demand for insurance by
large firms.
Investment Opportunities
Firms that are likely to have good investment opportunities will
need funds to finance those investment opportunities. These
firms will be more likely to reduce risk because an unex-pected
drop in cash flow can force the firm to either forgo the
investment project or raise costly external capital in under to
undertake the investment project. Firms that operate in growth
industries and firms that require continual investment in
research and development are likely to benefit from risk
reduction, all else equal.
65
Avoiding High Premiums Caused by Asymmetric

Information
d. A firm with a large amount of debt in its capital structure

versus a firm with no debt.
A Basic Guideline for Optimal Retention
The previous section highlights the basic trade-off between the
benefits of increased retention through savings on explicit and
implicit loadings in insurance premiums and the costs of increased uncertainty. A basic guideline for optimal retention
decisions in view of this trade-off is: Retain reasonably predictable
losses and insure potentially large, disruptive losses.
As noted above, potentially large losses that can cause financial
distress and interrupt planned investment can arise from a single
event, or they can arise from a series of smaller events during a
given period. For example, a company that transports chemicals
may face the possibility of very large liability claims from a single
accident (e.g., several hundred million dollars). It also may face
large aggregate claims in a given year if it has an unex-pectedly large
number of smaller claims (e.g., 50 claims averaging $3 million
each). These two possibilities help explain the demand for per
occurrence deductibles (or self-insured re-tentions) and stop loss
provisions.
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Correlation of Losses with Other Cash Flows and

with Investment Opportunities
Firms whose losses are positively correlated with other cash
inflows will have a lower stan-dard deviation of total cash
flows, other things being equal, and thus will tend to retain
more risk. In these cases, firms have a natural hedge: When
losses tend to be high, other cash flows also tend to be high,
thus reducing the likelihood of financial distress and the need
for external funds. For example, if a firm has more workplace
injuries when demand for its products is unexpectedly high, the
increased profits due to the increase in demand will at - least
partially offset the increase in worker injury costs.
c. A firm with operating profits positively correlated with claim

costs versus a firm with operating profits uncorrelated with
claim costs.
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Product Characteristics
When consumers expect future services from the provider of
products and services, then the demand for those products and
services will depend on con-sumers perceptions about the
likelihood that the provider will be able to provide the future
services. Of course, the likelihood that a firm will be able to
provide futures services is in-versely related to the likelihood of
bankruptcy. Consumer durables, such as electronic equipment
and cars, and financial services, such as insurance, are examples
of products and services for which consumer demand is likely
to be especially vulnerable to consumers per-ceptions about the
providers probability of bankruptcy. Thus, firms in industries
such as these tend to benefit more from risk reduction than
firms in industries that produce prod-ucts for which future
services are not expected.
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A related result is that a positive (negative) correlation between

losses and the rate of re-turn on new investment will reduce
(increase) the ability of the firm to pursue profitable in-vestments
without raising external funds, thus increasing (decreasing) the
demand for insurance. The reason is that the demand for funds
for new investment will tend to be high when losses are high and
available internal funds are low. This case often is more applica-ble
to hedging than insurance. For example, a reduction in oil prices is
likely to reduce the rate of return on new investment in the
exploration for oil. Firms in the oil industry will de-sire to invest
less money in exploration following an oil price decline, and they
will there-fore have less incentive to hedge the risk of lower oil
prices.
Financial Leverage
Firms with higher financial leverage (ratio of debt to equity) will
have a higher likelihood of financial distress, holding the
probability distribution of future asset values constant.
Consequently, firms with higher leverage are likely to find risk
reduction more advanta-geous (and vice versa).
Concept Check
1. Other factors held constant, which type of firm would be more
likely to fully retain (self insure) its workers compensation
losses?
a. A firm with an individual shareholder who owns 50
percent of the stock versus a firm in which no shareholder
owns more than 1 percent of the stock.
b.
A trucking firm with 5,000 drivers versus a manufacturing
firm with 5,000 workers at a single plant.
For individual firms, application of the guideline that firms should

retain predictable losses but insure potentially large, unpredictable,
and disruptive losses depends on the spe-cific magnitude of the
benefits and costs of increased retention, including managerial
judg-ment about the magnitude of losses that can be tolerated
without producing significant costs. For example, the point or
points at which losses cease to be reasonably predictable and
become potentially disruptive depends on many factors,
including firm size, the cost of raising external funds, and the
expected value and variability of cash flows apart from any losses.
Due to special circumstances (e.g., compulsory insurance rules),
retention strategies adopted by particular firms may vary
substantially from this basic guideline.
You also should recognize that while the underlying motives for
buying insurance differ, this guideline also is applicable to risk
management decisions by individuals and closely held businesses.
For example, auto owners routinely choose per occurrence
deductibles for automobile collision coverage by considering the
trade-off between increased risk and lower premiums for policies
with larger deductibles. Moreover, risk management decisions by
small, closely held businesses often reflect this trade-off.
Evidence on Business Risk Reduction Decisions
A number of studies have examined whether various firms
decisions regarding risk re-duction correspond to the factors
that have been outlined above. This type of research is dif-ficult
because most firms do not disclose details of their risk
reduction decisions. For example, relatively few firms disclose
the types and amounts of insurance they purchase. An
interesting exception comes from the insurance industry. For
regulatory reasons, US in-surers disclose information about
their use of reinsurance. One study examined reinsurance
purchases by insurers and found that insurers with owners that
were not well diversified purchase more reinsurance. 1 It also
Many of the arguments for why firms should reduce risk suggest
a more aggregate fo-cus. For example, the progressive tax rate
argument implies that firms should focus on tax-able income,
which depends on many sources of risk, including property losses,
exchange rates, and so on. If a more aggregate approach is adopted,
then firms need to consider in-teractions between the various
sources of risk. This section has two objectives: First, we highlight
the level at which risk reduction would take place under each of
the arguments we outlined in the previous chapters for why firms
should reduce risk. Second, we discuss the advantages and
disadvantages of the disaggregated versus aggregated approach
to risk reduction.
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Although firms rarely disclose specific information about their

insurance purchases, they are required to disclose specific
information about their use of derivative contract, which are
generally used to hedge price risk. Thus, a number of studies have
examined whether the use of derivative contracts corresponds to
the factors outlined above. These studies generally find that larger
firms are more likely to use derivatives. The most likely explanation
relates to the relatively large investment in computers and
knowledgeable personnel that is necessary to have a derivatives
trading operation. Smaller firms are likely to find that the fixed
cost of setting up an internal hedging operation exceed the benefits
of reducing price risk.
such as earnings, which depends on each separate risk exposure,

as well as the relationships between the various risk exposures?
Traditionally, risk management has taken a disaggregated
approach. Pure risk managers focused their atten-tion on
individual sources of risk, such property losses, liability losses,
and workers com-pensation losses. Financial risk managers
focused their attention on other sources of risk, such as
exchange rate risk or commodity price risk. The respective
managers would attempt to reduce risk from individual
exposures, without considering the interactions among the
various sources of risk.
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found that smaller insurers, which tend to have greater financial

distress costs and greater costs of raising external capital,
purchase more reinsur-ance. Thus, evidence on reinsurance is
consistent with several of the reasons given in the previous
chapters for why firms should reduce risk.
Some studies have found that firms with relatively greater research
and development expenses are more likely to use derivatives. This
finding is consistent with one of the reasons for reducing risk
(hedging) discussed earlier. Firms that make large investments in
research and development need funds on a consistent basis. If
internal funds are not available, then these firms will have to either
raise costly external capital or forgo some research and development expenditures. To ensure that internal funds are
available, firms with greater re-search and development are more
likely to hedge.
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Other research provides interesting findings about the hedging

practices of gold min-ing companies operating in the United States
and Canada. The primary risk faced by gold mining companies is
the price of gold. When the price of gold increases, gold mining
com-panies can sell their output for higher prices and thus make
greater profits. Conversely, a drop in gold prices can reduce cash
flows substantially and even threaten the viability of a company.
This gold price risk can be hedged using derivative contracts. There
is wide vari-ation in the degree to which gold mining companies
actually hedge gold price risk. Some companies hedge a large
proportion of their risk and others do not hedge at all. Interestingly, gold mining companies are more likely to hedge gold price
risk as the managers stock ownership of the company increases.
One interpretation is that managers with large undiversified
ownership interests are more likely to hedge than managers with
more di-versified portfolios.
There is also evidence that firms are more likely to hedge as their
financial leverage increases. One study examined the hedging
practices of oil and gas producers. The output of these firms is
subject to oil and gas price risk. If the price of gas decreases, then
all else equal, revenues decrease. Fortunately, this risk can be hedged
with derivative contracts. Among oil and gas producers that use
derivatives, the extent of hedging (the proportion of expected
output) increases as the firms financial leverage ratio increases.
Aggregated or Disaggregated Risk Management?
Assuming risk reduction is appropriate, firms must decide
where to focus their risk reduc-tion activities. Should firms take
a disaggregated or micro approach and hedge (insure) each
individual risk exposure separately? Or, should firms hedge
(insure) some aggregate or macro measure of performance,
Advantages and Disadvantages of Disaggregation

Even though many of the arguments for business risk
reduction imply that the uncertainty associated with some
aggregate financial variable, such as earnings, cash flow, or equity
value, is ultimately what matters, uncertainty associated with
these aggregate variables could be reduced by reducing the risk
associated with one or more of the disaggregated vari-ables that
comprise the aggregate variable. For example, earnings
uncertainty might be de-creased by reducing the risk associated
with any or all of the individual components of earnings (sales,
raw material costs, interest, taxes, property losses, workers
compensation losses, etc.). The issue addressed in this
subsection is whether there are advantages of hedg-ing the
aggregate variable versus a disaggregated approach; that is,
hedging all the individ-ual components of the aggregate
variable.
A Disaggregated Approach Can Increase Transaction
Costs
The main disadvantage of insuring / hedging each individual
risk exposure separately is that the use of separate contracts can
increase transactions costs. Negotiating, writing, and purchasing insurance and derivative contracts involve transaction
costs for both the supplier and the purchaser. Because there are
fixed costs associated with this process, using a sin-gle contract
that covers multiple sources of risk can reduce transaction costs.
Bundling exposures for risk transfer purposes also can reduce
proportional transaction costs, although the argument is slightly
more complex than the previous argument. Suppose that a firms
cash flows are subject to two sources of variability-liability risk
and property risk-which are uncorrelated. The distribution for
liability losses is
Liability Loss =
$ 50 million
$ 25 mi llion
0 million
With probability of 0.02

$ 50 million
$ 25 million
0 million

To capture the idea that firms often want to avoid large losses,
assume that the managers do not want total retained losses to
exceed some critical value, say $40 -million (perhaps be-cause the
firm would then be forced to raise costly external capital or violate
a debt covenant). The firm can insure each loss exposure to achieve
its objective, but assume that contracts are priced so that the firm
must pay 120 percent of the contracts expected pay-out, implying
a 20 percent loading or transaction cost. As you will see below, this
propor-tional transaction cost can make the cost of managing
each exposure separately greater than the cost of managing the
bundled exposure.
Recall that the firm was willing to retain losses up to $40 million.
The important point to notice is that in some cases the coverage
provided by the separate contracts results in a pay-out from the
insurer even though retained losses are less than $40 million. In
these cases, the firm has purchased coverage that, ex post, it did
not really need. We refer to this extra cover-age as unnecessary
coverage, and report it in the final column. The problem with
purchasing unnecessary coverage under these assumptions is that
there is a positive loading associated with purchasing coverage.
Thus, the unnecessary coverage is costly for the firms owners.
Now suppose that the firm was able to purchase an insurance
policy that would indem-nify the firm based on total losses. To
achieve its objective of not having retained losses ex-ceed $40
million, the firm could use one policy under which the insurer
would pay aggregate (sum of property and liability) losses in
excess Of $40 million. We refer to a policy like this that bundles
multiple exposures as a bundled policy. The outcomes with the
bundled policy are summarized in Panel B of above table. The
important point is that with the bundled policy, there is no
unnecessary coverage.
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Liability Loss =
would pay $5 million of the liability loss and the insured

would pay $20 million.
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For simplicity, assume that property losses have the same

distribution:
If the firm hedges each exposure separately, it can achieve its

objective (total retained losses less than $40 million) by retaining
$20 million of each exposure. In other words, the firm could
purchase a liability insurance policy under which it would be
reimbursed for li-ability losses in excess of $20 million and a
property insurance policy under which it would be reimbursed for
property losses in excess of $20 million.7 The expected claim cost
on each policy equals
($30 million X 0.02) + ($5 million X 0.04) = $600,000 + $200,000
= $800,000
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With a 20 percent loading, the premium on each policy would

equal $800,000 in expected claim costs plus $160,000($800,000 X
0:2) in loading. Because two policies are purchased, the total loading
paid by the firm would equal $320000.
As indicated in the final row of Panel B, the expected claim cost

for the bundled policy is $472,000, which implies a loading cost
equal to $94,400 (0.2 X $472,000). This policy achieves the firms
objective of not having retained losses above $40 million, but at
a lower loading cost ($94,400 versus $320,000) compared to
purchasing separate policies.
The advantage of bundling can be illustrated using below figure.
The horizontal axis in-dicates the property loss and the vertical
axis indicates the liability loss. Using the same as-sumptions as
the numerical example, suppose that the firm can retain losses up
to $40 million, but would like coverage for aggregate losses in
excess of $40 million. One way to achieve this objective is to
purchase separate property and liability insurance policies, with
each policy having a $20 million self-insured retention. The
property policy would pay losses whenever property losses exceed
$20 million, which is illustrated in Figure as the shaded area to the
right of the vertical line labeled P. The liability policy would pay
losses whenever losses exceed $20 million, which is illustrated in
Figure as the shaded area above the horizontal line labeled L.
Panel A of above table summarizes the results of purchasing

separate policies on each ex-posure. The first four columns list
all the possible outcomes and the associated probabilities. For
example, row two indicates that one possible outcome is that
the liability loss equals $25 million and the property loss equals
zero; this outcome occurs with probability 0.0376 (0,94 X 0.04).
The later columns indicate the coverage provided by the separate
con-tracts. For example, row two indicates that the insurer
68
11D.571.3
Several of the reasons for reducing risk imply that a firm should
focus its risk reduction activities on an aggregate financial

variable, such as earnings, cash flow, or taxable income.
The risk of an aggregate financial variable can be reduced either
by focusing risk reduction activi-ties on the aggregate variable

or by focusing on the risk of each individual component of
the ag-gregate financial variable
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Notes:
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Moral Hazard
A completely bundled policy would only have an aggregate
retention level and an aggregate limit; consequently, the source
of a loss would not matter for the contracts payoff. The
problem with such a policy is that once a firms aggregate
retention level was reached, an additional loss (up to the
aggregate limit) would be covered. Such a policy therefore
would greatly reduce the insureds incentive to reduce additional
losses once the retention level was reached. To mitigate this
moral hazard problem, per occurrence deductibles for each type
of loss exposure would likely be included in any bundled policy.
large losses that could cause financial distress or cause the firm
to raise costly external capital.
Costs Associated with a More Complex Contract

A disadvantage of bundling multiple exposures into one
contract is that the parties need to have an understanding of all
of the risk exposures and their correlations. The cost associ-ated
with performing this analysis can increase the transaction costs
relative to those that would be incurred on separate contracts for
each type of exposure. In the example above, we assumed a 20
percent loading regardless of whether each exposure was
insured sepa-rately or bundled together under one insurance
contract. If the proportional transaction costs were higher for
the bundled policy, then the benefit of bundling illustrated
above would be reduced (or even eliminated).
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Since the number of counter-parties that will have the expertise to

price a complicated bundled contract might be limited, the market
for such policies could be relatively thin and less liquid. Also,
those institutions that possess the modeling expertise needed to
price a complicated bundled policy may not have expertise in other
areas, such as loss control and claims processing, that are demanded
by firms. A bundled policy therefore could result in lower quality
of services. Finally, a large body of insurance contract law exists,
which low-ers the transaction cost of settling coverage disputes
and claims for standard policies. Un-til a similar body of law is
developed for bundled policies, these transaction costs could be
higher for bundled policies.
Summary
Optimal risk retention/reduction decisions would consider the
costs and benefits of reducing risk.

Some of the firm characteristics that influence the benefits of
reducing risk include firm size, the correlation among loss

exposures, investment opportunities, whether future services
are ex-pected from the product or services produced, the
correlation between losses and cash flows, and fi-nancial leverage.
A basic rule of thumb for retention decisions is to retain
relatively small, predictable loss exposures and insure against
11D.571.3
69
A bundled policy that would achieve the firms objective would

pay losses whenever the sum. of property and liability losses
exceeds $40 million, which is illustrated in Figure 22.1B as the area
above the line labeled B. The important point to notice is that the
losses paid by the bundled policy (the shaded area in Figure) are a
subset of the losses paid by the separate policies (the shaded areas
in Figure). The difference in the shaded ar-eas is the sum of the
triangles labeled Un. Cov. (for unnecessary coverage) in Figure.
Because of proportional loading costs, the purchase of unnecessary
insurance cov-erage is costly to the firms owners.
The Portfolio
The purpose of this case is to explain how a municipality can

lose $1.6 billion in financial markets. The case also introduces
the concept of Value at Risk (VAR), which is a simple
method to express the risk of a portfolio. After the string of
recent derivatives disasters, financial institutions, end-users,
regulators, and central bankers are now turning to VAR as a
method to foster stability in financial markets. The case
illustrates how VAR could have been applied to the Orange
County portfolio to warn investors of the risks they were
incurring.
In fact, Bob Citron was implementing a big bet that interest rates
would fall or stay low. The $7.5 billion of investor equity was
leveraged into a $20.5 billion portfolio. Through reverse repurchase
agreements, Citron pledged his securities as collateral and reinvested
the cash in new securities, mostly 5-year notes issued by
government-sponsored agencies. One such agency is the Federal
National Mortgage Association, affectionately known as Fannie
Mae. The portfolio leverage magnified the effect of movements
in interest rates. This interest rate sensitivity is also known as
duration.
Introduction
In December 1994, Orange County stunned the markets by
announcing that its investment pool had suffered a loss of $1.6
billion. This was the largest loss ever recorded by a local
government investment pool, and led to the bankruptcy of the
county shortly thereafter.
The duration was further amplified by the use of structured notes.

These are securities whose coupon, instead of being fixed, evolves
according to some pre-specified formula. These notes, also called
derivatives, were initially blamed for the loss but were in fact
consistent with the overall strategy.
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Summary
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LESSON 13:
CASE STUDYORANGE COUNTY CASE:
USING VALUE AT RISK TO CONTROL FINANCIAL RISK
This loss was the result of unsupervised investment activity of

Bob Citron, the County Treasurer, who was entrusted with a $7.5
billion portfolio belonging to county schools, cities, special districts
and the county itself. In times of fiscal restraints, Citron was
viewed as a wizard who could painlessly deliver greater returns to
investors. Indeed, Citron delivered returns about 2% higher than
the comparable State pool. See track record (Figure 1).
Citrons main purpose was to increase current income by exploiting

the fact that medium-term maturities had higher yields than shortterm investments. On December 1993, for instance, short-term
yields were less than 3%, while 5-year yields were around 5.2%.
With such a positively sloped term structure of interest rates, the
tendency may be to increase the duration of the investment to
pick up an extra yield. This boost, of course, comes at the expense
of greater risk.
Do
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The strategy worked fine as long as interest rates went down. In

February 1994, however, the Federal Reserve Bank started a series
of six consecutive interest rate increases, which led to a bloodbath
in the bond market. The large duration led to a $1.6 billion loss.
Citron was able to increase returns on the pool by investing in

derivatives securities and leveraging the portfolio to the hilt. The
pool was in such demand due to its track record that Citron had
to turn down investments by agencies outside Orange County.
Some local school districts and cities even issued short-term
taxable notes to reinvest in the pool (thereby increasing their
leverage even further). This was in spite of repeated public
warnings, notably by John Moorlach, who ran for Treasurer in
1994, that the pool was too risky. Unfortunately, he was widely
ignored and Bob Citron was re-elected.
The investment strategy worked excellently until 1994, when the

Fed started a series of interest rate hikes that caused severe losses
to the pool. Initially, this was announced as a paper loss. Shortly
thereafter, the county declared bankruptcy and decided to liquidate
the portfolio, thereby realizing the paper loss. How could this
disaster have been avoided?
70
Value at Risk
What is VAR? VAR is a method of assessing risk that uses
standard statistical techniques routinely used in other technical
fields. Formally,
VAR is the maximum loss over a target horizon such that there
is a low, prespecified probability that the actual loss will be
larger. Based on firm scientific foundations, VAR provides users
with a summary measure of market risk. For instance, a bank
might say that the daily VAR of its trading portfolio is $35 the
11D.571.3
Really Advanced (Optional)

The historical simulation approach assumes that changes in
monthly yields have an independent, identical distribution
(i.i.d.) The issue is whether this assumption is appropriate:
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1. Duration approximation.
The state auditor reported the effective duration of the pool as
7.4 years in December 1994. This high duration is the result of
two factors: the average duration of individual securities of 2.74
years (most of the securities had a maturity below 5 years), and
the leverage of the portfolio, which was 2.7 at the time. In 1994,
interest rates went up by about 3%. Compute the loss predicted
by the duration approximation and compare your result with
the actual loss of $1.64 billion.
Advanced (2)
Next, we check whether the assumption of a conditional
normal distribution seems adequate for changes in yields.
Compute the number of exceptions at the 1-tailed 95% level,
using the monthly volatility forecast just computed and the
actual increase in yield. Test whether the number of exceptions
is in line with what was expected.
(For the exception test, you can use the normal approximation
to the binomial distribution. Also, be careful to match the
volatility forecast with the subsequent change in yield.)
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Questions
Let us place ourselves in the position of the county
Supervisors, who had to decide in December of 1994 whether
to liquidate the portfolio or maintain the strategy (obviously,
based on past information only). At that time, interest rates
were still on an upward path. A Federal Open Market
Committee meeting was looming on December 20, and it was
feared that the Fed would raise rates further. To assess the
possibility of future gains and losses, VAR provides a simple
measure of risk in terms that anybody can understanddollars.
Compute the monthly volatility forecast (the square root of

Var[dy(t)]) and discuss whether recent interest rates swings are
explained by elevated volatility.
2. Computation of portfolio VAR.

The yields data file contains 5-year yields from 1953 to 1994.
Using this information and the duration approximation,
compute the portfolio VAR as of December 1994. Risk should
be measured over a month at the 95% level. Report the
distribution and compute the VAR:
using a normal distribution for yield changes (Delta-Norma

method),and
using the actual distribution for yield changes (HistoricalSimulation method). Compare the VAR obtained using the
two methods.
Consider now a model with mean-reversion in the mean, such
as the Vasicek model (if seen in the fixed-income course).

Estimate the model, test whether mean reversion seems
significant, and evaluate VAR in the context of this new model.
Does monthly VAR change? What about annual VAR?
1. Hedging.
On December 31, 1994, the portfolio manager decides not to

liquidate the portfolio, but simply to hedge its interest rate
exposure. Develop a strategy for hedging the portfolio, using
(i) interest rate futures, (ii) interest rate swaps, and (iii) interest
rate caps or floors. For each strategy, describe the instrument
and whether you should take a long or short position.
On that day, the March T-bond futures contract closed at 9905. The contract has notional amount of $100,000. Its duration
duration can be measured by that of the Cheapest-To-Deliver
(CTD) bond, which is assumed to be 9.2 years. Compute the
number of contracts to buy or sell to hedge the Orange County
portfolio.
(3) Interpretation of VAR.
Convert the monthly VAR into an annual figure. Is the latter

number consistent with the $1.6 billion loss?
From December 1994 to December 1995, interest rates fell from
7.8% to 5.25%. Compute the probability of such an event.
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It seems that both in 1994 and 1995, interest rate swings were
particularly large relative to the historical distribution. Suggest

two interpretations for this observation.
Estimate a GARCH model for the change in yield and compare

the forecasts to that of the EWMA model.
This contract has typical trading volume of 300,000-400,000

contracts daily. Verify with recent volume data at the NSE.
Would it have been possible to put a hedge in place in one day?
Assuming that futures can be sold in the required amount,
would the resulting portfolio be totally riskless?
Notes:
Advanced (1)
Compute a time-varying volatility of changes in yields using the
Risk Metrics approach to see if the recent volatility is abnormally
high. The exponential model (as used in Risk metrics) is:
Var[dy(t)] = Var[dy(t-1)] * k + [dy(t-1)*dy(t-1)]*(1-k)
where Var[dy(t)] is the conditional, predicted variance for time t
and k is the decay factor, usually selected as 0.97 for monthly
data. The model states that the variance forecast is a combination
of the previous month forecast and of the latest squared
innovation. For the starting value of the variance (at time t=0),
use the average variance over the whole period.
11D.571.3
71
same units as the banks bottom linedollars. Shareholders

and managers can then decide whether they feel comfortable
with this level of risk. If the answer is no, the process that led
to the computation of VAR can be used to decide where to
trim risk.
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Notes:
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LESSON 14:
INTERACTIVE SESSION
72
11D.571.3
UNIT I
CHAPTER 7
HEDGING WITH DERIVATIVES
LESSON 15:
EXPOSURE MANAGEMENT OVERVIEW
insolvent or even become bankruptcy. He will then not be able to

fulfil the contract condition causing the sellers expected income to
go into uncertainty. That risk is usually called insolvency risk or
credit risk, and will last until the final payment for that particular
transaction in the specific foreign currency be made.
Overview of Financial risks management

Hedging with Derivatives
Option Pricing Models
Hedging with Future / Forward Contracts
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Other Derivatives Contracts
Introduction
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Financial risk faced by the companies
Today, the economic environment in which most firms operate is

highly volatile and uncertain. One of the main factors effecting
this process is the increasing market globalisation and
internationalization, which is reflected in increased exchange,
interest, inflation rates fluctuations as well as in high competition,
demand levels etc. Consequently, the firm will be exposed to the
risks, which Duma (1978) identifies as what one has on risk or,
in other words, as the amount which is exposed. firms may act as
buyers and sellers simultaneously on the international market. We
shall begin by seeing how the above-mentioned factors influence
the firms on going business, before talking about different types
of risk exposure concepts.
Figure No.1 (Eiteman 1995, p. 186) gives us a clear picture of how
different kinds of risk are associated with the firms business
transactions, based on the life span of the firms transaction
from the sellers point of view.
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The firm is already exposed to risk, in terms of quotation risk,

before this particular business transaction begins. Quotation risk
exposure is created at the moment Time 1, when the seller quotes
the price, for the buyer is presented in written or verbal form. In
the case of the unfavorable / favorable exchange rate change, sellers
inflows in the home currency might decrease/increase. The other
important point is the competitors price level, which might change
as well. Both these factors might cause the tender cancellation risk.
The tender price might be changed before the contract is signed
resulting in a cancellation of the tender, and anticipated foreign
currency inflows. This risk is usually called antenatal risk, which
may not be reflected in the firms accounting numbers. At this
moment, the exposure will only be estimation; neither the size,
nor the time of the exposure may be known at this time. If the
price, and all the other transactions conditions, fit the buyer, they
will then set an order to the seller at the price agreed at Time 1. At
that moment (Time 2) the backlog exposure appears and this will
last until the moment when the seller ships the product to the
buyer (Time 3). The risk is not usually shown at this stage in
accounting numbers, but the firm already starts to include lots of
costs and funds in order to generate that product. Thus, the later
periods risk may influence the firms future cash flow. Then, coming
up to Time 3, which is usually the point in time when most firms
begin appropriate accounting records, this becomes billing
exposure, which means that the customer may become insolvent
11D.571.3
Another example is to have a detailed look on how one specific

factor, such as exchange rate change, influences the firms
accounting record. Oxelheim and Wihlborg (1997) have
designed a model to test the effect of exchange rate change on a
firms cash flow. The following example (example no. 1), based
on the scenario analysis showed in their book, gives us a clear
picture of how the exchange rate change might affect the firms
sales volume, prices and costs, resulting in the cash flow
exposure measurement explanation.
Example No.1: How exchange rate change effects a firms
accounting record
Data: a Swedish company, which produces 100 units products in
Sweden, while selling its products both in Sweden and United
States, each with 50 units respectively. They have major competitors
in the United States and Germany. The firm uses a marking-up
pricing strategy. Ignore taxes. Basic case:
Sales, 100 units
Unit price=2*(COGS imported + COGS domestic + wages)
73
Chapter Objectives
In the second case, if no sales volume takes place, then, in

comparison with the first case, the cash flow will change SEK
1,250. (41,250- 40,000). However, in reality it does not always
happen like this. The exchange rate change might increase the
Swedish firms sales price only in cases where competitors wont
change their price, but, if they do, the Swedish firms sales volume
will be effected, assuming moderate price sensitivity (price elasticity
= 1), cash flow will fall by another SEK 2,062.5 (41,250*5%) and
result in reduction of sales. So the total cash flow change will be
SEK 812.5. (41,250-40,0002,062.5).
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From above analysis, we can say that todays economic environment

sets much higher requirements for the financial managers than it
did ten years ago. Todays financer should have excellent
qualifications in order to manage market dictated risks in an
appropriate way. More and more firms have to take macroeconomic
environment fluctuation challenge, and try to solve such critical
problems as:
How to manage risks associated with exchange rate, interest
rate, and inflation rate changes?
How to build effective links between firms financial strategy
and its microeconomic environments?
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Exposure management overview
Financial Risks
A companys activities face different kinds of risks. In order to
be able to introduce financial risks, a general definition of risk
conception is needed. Risk, according to Oxelheim and
Wihlborg (1997, p.18), is a measure of unanticipated changes.
In our paper, we brake down every type of risk that a company
might face into two groups: financial and non-financial. We will
leave non-financial risks, as we are not concern with them, and
concentrate on financial ones. Financial risk is the likelihood and
magnitude of unanticipated changes in interest, exchange and
inflation rate risks. As one might expect, financial risk might be
broken down into the interest rate, exchange rate and inflations
rate risks. According to Oxelheim and Wihlborg (1997, p.27- 28)
the above-mentioned risks are defined in the following way:
Interest rate risk refers to the magnitude and likelihood of
unanticipated changes in interest rates that influence both the

costs of different capital sources in a particular currency
denomination and the demand for the product.
Exchange rate risk refers to the magnitude and likelihood of
unanticipated changes in exchange rate.
Inflation rate risk refers to the magnitude and likelihood of
unanticipated changes in inflation rate.

Inflation and exchange rate risk taken together gives currency
risk.
Exchange, interest and inflation changes in the market are very
interrelated and usually have a high degree of correlation. The
main reason why these three factors recently became of major
concern is the effect they were having on the firms value. The
above mentioned factors are the main causes of the companys
financial risk exposure and value volatility. In other words, they
might influence the companys value in a positive way, when the
company is worth more than expected (upside risk), or in the
74
11D.571.3
One of the pioneers in financial risks definition process was

Ankrom (1974), who first used the expressions translation,
transaction and economic risks, defined as follows:
Translation risk recognize only items already on an accounting
balance sheet,
Transaction risk comes from future sales and purchases certain
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to take place, but before the company will be able to adjust

prices in line with exchange rate movements,
Economic risk, Ankrom defines as, the sum of 1 and 2 after
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Exchange, interest and inflation rates changes lead to the exchange,

interest and inflation rates risks respectively, which aggregated form
financial risk. Each of the financial risk additive parts is handled
using a certain financial or commercial instruments. Exchange rate
risk could be managed using financial (futures, forwards, options)
or commercial (foreign currency cash flows maturities and amounts
matching) instruments and pricing strategy. Interest rate risk is
usually manageable using interest rate swaps or assets and liabilities
management (ALM). The later tool might be used for the inflation
rate risk management, but in the long run we believe it can be
offset by the exchange and interest rate change.
Overview of existing classifications and

terminologies of financial risks
In order to give a reasonable basis for our choice, as well as to
provide the reader with an appropriate grasp of the topic, we
will now give an overview of the existing classification and
terminology of financial risks.
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The reader may wonder why instead of a decisive beginning using

the exchange rate risk, we include such a long introduction
describing all kinds of financial risks. The point is that the consisting
parts of financial risk are very correlated among themselves, and
often offset each other. If we had perfectly efficient markets then,
according to the International Fisher Parity (IFP), exchange rates
would just reflect the changes in interest rates among different
currencies and exchange rate risk would be zero. In the real life, we
have a lot of shifts from IFP that induce exchange rate risk. All of
the above-described financial risks, currency risk and,
specifically, exchange rate risk have received the most attention. As
noted, most current approaches in managing these risk presume
implicitly or explicitly that exchange rate variability is independent
of variability of other macroeconomic factors(Oxelheim and
Wilhborg, 1997, p. 28). In general, the majority of our viewed
theoretical sources presumes, and believes, that every single financial
risk is independent, though one should be very careful separating
and calculating them. Just imagine the situation when the exchange
rate between USD and SEK changed because of the lift in SEK
interest rates. The negligence of interdependence between interest
rate changes and exchange rate changes would cause the same
exposure being measured twice. Therefore, the measurement of
the effect of financial risks on companys cash flows should be
made in recognition of the interdependence among them.
One more reason why exchange rate risk has received particular
attention is that it, more than any other financial risk, follows
changes in the market and, less than the others, depends on nonmarket economy factors such as government or central bank
interference. In other words, exchange rate risk is more predictable
than others and therefore more manageable. Although we should
emphasis that it is predictable and manageable approximately as
much as the market by itself.
11D.571.3
eliminating double counting in inventory. The author does

not cover real exchange rate movements threats.
Shapiro (1996), whose concepts we used a lot in our work, gives a

series of definitions that form a good starting point. He describes:
Currency risk, in general, as the degree to which a company is
affected by exchange rate changes,
Accounting exposure is a measure of currency risk arising from
the need to convert the financial statements of foreign

operations from local currencies to home currency; the
restatement of assets, liabilities, revenues and expenses at new
exchange rates will result in exchange gains and losses,
Economic exposure is another measure of currency risk based on
the extent to which the value of the company as measured by

the present value of its expected future cash flows will change
when exchange rates change.
Shapiro subdivides economic exposure into:

Transaction exposure, which is the possibility of incurring gains
or losses, upon settlement at a future date, on transactions

already entered into and denominated in a foreign currency,
and
Real operating exposure, which arises because currency fluctuations
together with price changes can alter the amounts and riskiness
of a companys future revenue and cost streams, i.e. operating
cash flows.
Another economist who tried to penetrate the same field was

Buckley (1986), who classifies currency risk into:
Transaction exposure,
Translation (=accounting) exposure,

Economic exposure.
Buckley defines the three concepts in terms similar to Shapiros

with the difference in terms economic exposure, which Shapiro
called operating exposure. Both authors relate economic and
transaction exposure with cash flows. Though Buckley does not
go as far as did Shapiro in identifying economic exposure in respect
to deviations from purchasing power parity.
Other writers such as Walker (1978) and Wihlborg (1980) used
definitions broadly similar to those used by Shapiro and Buckley.
The main difference between Kenyons (1981) and previous writers
definitions is the way in which he defined financial currency risk.
75
negative way - the amount the companys value decreasing more

than it was expected (downside risk). Not mentioning the
downside risk, which lacking the right management strategy might
cause financial distress, the smoothening of the upside risk gives
the company value in the terms of lower taxation. Most countries
have a convex corporate taxation system (Dhanini, 2000, p. 33) the higher the profit, the higher the tax percentage applicable.
Therefore, during the periods when the company earns high profit,
it pays higher taxes, although at times when low or even negative
profit are generated no compensation is given. The main danger is
the financial distress, which is very costly, and according to
Copeland study: the average indirect bankruptcy cost were 17,5%
(Copeland, 1999, p. 69) of the companys value one year prior to
bankruptcy.
sale,
Balance sheet risk= mismatch between assets and liabilities in a
given currency.
Kenyon (1990) was citing his previous book as follows: Kenyon
further suggested that any of these financial risks could be viewed
and managed either in accounting terms, i.e. as accounting or
translation risk, or in cash terms, i.e. as transaction risks, but that
these two concepts referred to different ways in which management
looks at the same risks, rather than two different risks.
One contrast between Shapiro and Kenyons (1981) classifications
stands out: Shapiro regards the main division as being between
the accounting model and the economic or cash flow model,
whereas Kenyon (1981) gives primacy to the contrast between
risks from the real and nominal exchange rates, a contrast also
stressed by Shapiro.
Different firms have different targets to achieve, such as profit,

economic value, shareholders wealth, book value. In turn, the
personal managers risk attitude causes a different choice of targets.
For example, if the firms target is to maximize the profit, then
the manager may be more concerned about the level of profit over
a particular time period. On the other hand, if the target is
shareholders wealth maximization, then the manager might be
more concerned about the probability of bankruptcy, in this case
he might be more willing to sacrifice some level of profit in order
to reduce the variability of companys value and cash flows. Since
shareholders are the owners of joint venture companies, their
interests should be of primary concern. This is the attitude that
recently received a lot of attention in risk management literature,
as well as in the joint venture companies annual reports. Since,
according to financial theory, the firms value is the net present
value of its future cash flow, it is emphasized much more in the
firms economic value, so our exchange rate exposure analysis will
be based on economic exposure calculation and management,
presuming that the management is risk averse.
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Trading risk = mismatch between currencies of cost and of
outsourcing trends, even these types of firm find themselves

more and more related to their exchange rate risk exposure partners.
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Changes in nominal exchange rate will influence the values of the

companys existing assets, liabilities and other commercial
commitments. Financial risks were subdivided into:
We found that Shapiros point of view of currency risks was

mainly grounded in the following reasons:
Appropriate reasoning of his deep belief in to purchasing power
parity in respect to economic exposure and;

Grounded explanations showing why none of the existing
accounting systems were able to reflect economic or cash flow
streams;
Best grasp of the connection between the transaction exposure
and operating exposure, both of which are the key issues in

exchange rate exposure calculation.
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Problem Discussion
Among the above-mentioned financial exposures, it is especially
the exchange rate risk exposure that becomes more and more
important in light of world markets globalisation and
internationalization. Foreign exchange exposure (FEE) comes
from the international trade and financial activities, such as
foreign loans, guarantees etc. As an example, one big
multinational company buys its raw material in the domestic
market and sells its final product in both domestic and foreign
markets. Assume that the situation in the markets changes, and
as a consequence the foreign currency becomes cheaper in
relation to the domestic one. What will happen to such a
company? If the company cant increase the price, its products
to be sold in the foreign market, will generate less income than
earlier, because the domestic currency as well as the final product,
will become more expensive in comparison with the foreign
currency and prices level. Following the same logic, it is not
difficult to realize, that the foreign competitors of our company
will get the competitive advantage, being able to offer the lower
price for the same product in our domestic market. Therefore,
the company will incur double losses: it will lose part of the
domestic market and part of the foreign market.
Not only big multinational companies, but also small firms having
only domestic trade operations, become increasingly dependant
on the world market main currencies fluctuations. With common
76
Exchange rate exposure
Lets start with a simple example, which hopefully will make the
introduction of some main concepts clearer. One Swedish
company that buys raw material in Germany pay in DEM, and has
90 days deferred payment. The companys main activity is in
Sweden, and the biggest part of its cash inflows is in SEK. It is
not difficult to realize that if the DEM suddenly and unexpectedly
increases in price just before the maturity of the payment to the
German supplier, the company incurs losses, as it is forced to pay
more SEK than was expected for the same amount of DEM. In
other words, the company is exposed to DEM price changes. We
arrive at the main definition in this chapter, i.e. exchange rate exposure,
which according to A.C.Shapiro (1996, p. 277) is the degree to
which a company is affected by exchange rate change.
Following the Shapiro way of exchange rate exposure classification
in the coming chapters, we will present it, describing accounting
versus economic exposure and then breaking down exchange rate
exposure into translation, transaction and operating exposures
providing the description of every single one of them.
Accounting practice and economic reality
Accounting exposure arises from the need, for purpose of
reporting and consolidation, to convert the financial statements
of foreign operations from local currencies (LC) involved to the
home currency (HC) (Shapiro, 1996, p. 237). Big multinational
companies usually have foreign subsidiaries and a lot of foreign
operations. As a consequence, foreign currency denominated
assets and liabilities as well as revenues and expenses take place
in their values. However, the investors and the other interested
part of society need values expressed in one currency in order to
get a clear understanding about the companys overall financial
results. Therefore, in accordance with accounting standards at
the end of accounting period (quarter, year) all foreign
subsidiaries values are translated in to HC. Assets and liabilities
might be translated in current (post change) exchange rate and
are considered to be exposed, or at historical (pre-exchange) rate,
11D.571.3
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Under the monetary/non-monetary method, monetary balance

sheet items (cash, bank-holdings, most claims and debts) are
translated at the closing date, non-monetary balance sheet items
(inventories, machine, real estate) at historical (the rate applying
when the asset was acquired). According to this method only
monetary items are supposed to be exchange rate exposed. Under
the current method all assets and liabilities on the balance sheet are
translated at the closing of the accounts rate. Under current method
all asset position are supposed to be exchange rate exposed.
According to the third current/non-current method current
assets and short-term debt of the balance sheet of foreign
subsidiaries are translated at the closing rate, while fixed assets and
ling term debt at historical rate.
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Economic exposure is based on the extent to which the value of the

firm - as measured by the present value of its expected future cash
flows - will change when exchange rates change (Shapiro, 1996, p.
277). Economic exposure measurement is based on the companys
all future cash flows while accounting contains only part of them.
Moreover, accounting numbers are not adjusted to reflect the
distorting effect of inflation and relative price changes on their
associated future cash flows. Economic exposure, in turn, might
be able to be separated into operating and transaction exposures.
Among the translation methods, the most popular internationally

are monetary/non-monetary, current and current/non-current
methods.
Accounting measures of exposure focus on the effect of currency

changes on previous decisions of the firm, as reflected in the book
values of assets acquired and liabilities incurred in the past.
However, book values (which represent historical cost) and market
values (which reflect future cash flows) of assets and liabilities
typically differ. Therefore, retrospective accounting techniques, no
matter how refined, cannot truly account for the economic (that is,
cash flow) effects of a devaluation or revaluation in the value of a
firm because these effects are primarily prospective in nature.
Basing on this, more and more companies are starting to rely on
economic exposure measurement. Although it is hard work to
persuade the person, who may have been basing his decisions on
accounting numbers for the past 30 years, that there is a better way
of doing the same things, but that is the objective, and hopefully
with our thesis we will also contribute to it.
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Translation Exposure
The best definition of Translation exposure we found in
Eitemans book (1997, p. 187). The later follows Shapiros point
of view and states that translation exposure also called accounting
exposure, is the potential for accounting derived changes in
owners equity to occur because of the need to translate
foreign currency financial statements of foreign affiliated into a
single reporting currency to prepare worldwide consolidated
financial statements.
Translation exposure can be seen as a measure of a latent risk. In

the short term, translation gains or losses on exposure have no
cash flows effects, i.e. they are not realized over the reporting
period. Cash flow gains and losses occur, however, if the company
is liquidated, or in the future when assets and liabilities produce
cash flows. Thus, ideally, translation exposure should capture the
sensitivity of economic value, in a form of either liquidation value
or present value of future cash flows, to exchange rate changes.
11D.571.3
One should take into account that different translation methods

result in different translation exposure. For example, the
monetary/nonmonetary method always yields a more positive
result that the current method in any year during which a foreign
currency has been devaluated.
Looking from the economic point of view, translation exposure
is less important in comparison with the other two mentioned,
because translation losses are only book losses while operating
and transaction are expected and real cash losses respectively.
Operating exposure
Operating exposure, in some sources of literature also called as
economic exposure, competitive exposure, or strategic
exposure, measures the change in the present value of the firm
resulting from any change in the future operating cash flows of
the firm caused by an unexpected change in the exchange rates.
So, sometimes it might be called cash flow exposure. The
changed value depends on the effect of the exchange rate change
of future sales volume, prices, or costs. Although in order to
have a clear distinction between operating and economic
exposures in our paper, we define operating and transaction
exposures we define as consisting parts of economic exposure.
Operating exposure of the firm requires forecasting and analysing
all of the firms future individual transaction exposures together
with the future exposures of all of the firms competitors and
potential competitors worldwide.
Cash flow
Usually, from accounting point of view, cash flow or net cash

flow means the difference between contracted cash inflows and
cash outflows, although accounting cash flow definitions varies as
follows:
The total receipts minus payments.
Net profit before depreciation within some specific periods.
A measure of the companys ability to fund its capital
expenditure and debt repayment out of its own resources which

equal the net profit adding back the depreciation then plus or
minus changes in inventories, receivables and payables.
From the economic point of the view cash flow was defined in a
following way:
77
and are regarded as not exposed. In some literature accounting

exposure is named as translation exposure, thats why we
would like to stress that that it is the same thing and we are
introducing both terms, not to confuse the reader, but to give
the full overview of the terminology used in the different
sourcesoftheliterature.Translation
exposure is simply the

difference between exposed assets and exposed liabilities
(Shapiro, 1996, p. 238). The difference between exposed assets
and exposed liabilities are increasing or decreasing companys
earnings and are reposted as foreign exchange gains or losses.
There are four different translation methods: current/non
current, monetary/non-monetary, temporal and current rate
methods.
Any available cash for stockholders i.e. earnings before
depreciation minus capital expenditure minus increases in

working capital.
The future earnings of the firm including the overseas
subsidiaries. It is much more similar to the accounting concept

2, when we speak about the cash flow later, it always will be
referred to this concept.
Cash flow exposure
Cash flow exposure, might be defined as the extent to which the
present value of a firms future cash flow is changed by a given
currency appreciation or depreciation. In general, it arises because
of currency fluctuations, in combination with price changes, which
alter the amounts and riskiness of a companys future revenue
and cost streams. As we can see, the cash flow exposure has a
multidimensional effect, involving the interaction among the firms
strategy in financing, marketing and production. The firms cash
flow in the future will depend on its competitive ability. The later
exposure computation requires a long term prospective, viewing
the firm as an ongoing concern with operations whose cost and
price competitiveness could be affected by exchange rate change.
Let us take a look what firms cash flow statement looks like from
the economic point of view.
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Usually, a multinational firms cash flow statement is divided into

two parts, i.e. operating cash flow and financial cash flow. Example
No.2 shows what the firms cash flow statement looks like.
Operating cash flow results from accounts receivable, accounts
payable, rent, lease payment for the use of facilities and equipment,
royalties and license fees for the use of technology and intellectual
property, as well as assorted management fees for services
provided, which could appear between unrelated company and
subsidiary of the firm. Financial cash flows are payments for the
use of loans (principal and interest), stockholder equity (new equity
investment and dividends) and firms financial instruments such
as forward contract, option swap etc. Each of these cash flows can
occur at different time intervals, in different amounts, in different
currencies of denomination, and may have a different predictability
of occurrence.
Example No.2 Firms cash flow statement
Commercial cash flows:
+/- Income from financial instruments such as: forward, swap,

option.
Usually, there are two ways to examine the firms cash flow
exposure, scenario analysis and regression analysis. The scenario
analysis is more related to the fundamental factors such as sales
volumes, prices, and costs effect on the firms cash flow. Another
method is to use historical data to forecast future effects, which is
termed regression analysis. Two different variables need to be
taken into account. One is an independent variable, which can be
the exchange rate, interest rate values during a certain period or any
other that is likely to affect the companys cash flows. Another one
is dependent variable, which could be anything that the company
is concerned about, such as revenues, book value, market value
and so on. Oxelheim and Wihlborg (1997) have presented a good
example to show how the effect of exchange rate change on a
firms cash flow.
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over future years.
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The total net dividends, which can be paid to the stockholders
Transaction exposure
In his excellent book, Currency risk management, Alfred Kenyon

uses the metaphors conception, birth, anniversaries, death to
describe the life cycle of transaction exposure. Conception
concerns the major price quotation problem area - when we
commit ourselves to the mismatch. Birth is the moment when
the contract is signed and the exposure becomes certain; when
the commitment becomes a commercial or contractual reality, it
has ceased to be unilateral. Anniversaries refer to the covering
of the risk; any annual reporting dates at which interim gains or
losses may be ascertained. Death refers to when settlement is
made - the end of the exposure when we are free to convert the
receipt or payment into the other currency and thus measure the
final cash gain or loss. So, using Donaldson (1980)s words,
transaction exposure can be explained as revenues in nature and
exist for relative short periods. He says that a sale from seller to
buyer in another currency must be in the currency of, at best, one
of them, and the another one has an exposure, but only when
there is a period of delay in payment for the goods, and most
transaction exposure arise from the granting of credit. Therefore,
summing up, transaction exposure arises from:
Purchasing or selling goods or services whose prices are stated
in foreign currencies in credit,

Borrowing or lending funds when repayment is to be made in
foreign currency,
Being a party to an unperformed foreign exchange forward
+ Sales revenues (domestic and foreign subsidiaries)
contract, and
- Costs of goods (domestic and foreign subsidiaries)
Otherwise acquiring or incurring liabilities denominated in
- Wages and salaries (domestic and foreign subsidiaries)

- Rent, lease payment etc. administration expenses (domestic and
foreign Subsidiaries)
- Depreciation (domestic and foreign subsidiaries)
+/- Change in accounts receivable
+/- Change accounts payable
foreign currencies.
Now we will go back to the example that we present in the
beginning of this chapter to explain how those exposures fit into
the firms transaction life span. Below (figure No. 2), we present
a basic framework of one business transaction, which starting at
Time 1 ends at Time 4, repeating the cycle again.
Financial cash flows:

+/- Change in loan amount (principal and interest)
+/- Change in stockholder equity value (new investment and
dividends)
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11D.571.3
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From the above analysis, we can see that both the transaction
exposure and economic exposure focus on the aggregate effect of
both the direct effect and indirect effect. Direct exposure, captured
by transaction and translation exposure, potentially exists whenever
a firm sells or buys its productions or sources in a foreign currency.
Indirect exposure exists when a firm has a supplier, customer or
competitor that is exposed. (Pringle J.1995). The following table
(table 1) shows the effect of the home country currency appreciation
or depreciation. From the table we can see the exchange rate change
impact on the company.
Before the buyer signs the contract with the seller (Time 1), the
seller is already exposed to the risk, even though, in this period,
the exposure is not reflected in the accounting numbers and, at
this moment, the exposure will only be an estimation. Neither
size nor time of the exposure may be known at this time. From
this point of view, some companies will identify the estimated
sales volumes as a transaction exposure, others may treat it as
economic exposure. Usually, firms can estimate their sales volume
on the base of the historical performance. Basic on the transactions
from long-term contracts with permanent customers, companies
forecast the future sales volumes, keeping in mind possible
deviations. The transaction will start in Time 1 and will not end
until the transaction cycle is finished (Time 4). The economic
exposure for one transaction is equal to the transaction exposure,
though from the whole companys value point of view economic
exposure can be broken down into transaction and translation
exposures.
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In Time 2, the risk is not shown in accounting numbers as well,

but it is at this point that the firms began to put into lots of costs
and funds to generate that product, so this period risk may
influence the firms future cash flow. Therefore, from this period,
operating exposure will occur until the transaction end up in Time
4. Consequently, these will follow the translation exposure. Still,
during Time 2 to Time 4, in order to fulfill the contract, the firm
may need short term financing; they may get a loan from a bank at
Time 2 with a certain interest rate, and then repay the loan at Time
4 with another interest rate. So, during this period they may have
interest rate exposure. Consequently, they may have credit exposure
as we mentioned before.
Again we will go back to the example of how the exchange rate
change effected the firms accounting record and look at how
different exposure fits into that process. Firstly, the basic idea
behind that example is operating cash flow=Sales-COGS (cost
of goods sold), since both the sales amount and COGS will be
changed because of the changed exchange rate, even though in
the first case we assume there have no simultaneous change of
the sales amount. So in this case, the firm may have operating
exposure. Secondly, if we cancel the first assumption and leave
valid only the second one, that is with moderate price sensitivity
11D.571.3
The following figure (figure no. 3) will give us a clear picture of the
relationship between transaction, translation and operating
exposures.
Transaction exposure
Impact of having outstanding obligations, that were set before
change in exchange rates, but to be settled after change in
exchange rate change.
Another important concept of FEE is the time horizon. FEE
might be broken down into short and long-term exposures. Shortterm exposure is related to the cash flow management, while long
79
(price elasticity = 1), we get the estimate that the cash flow will fall
by another SEK 2,037.5. In this case, since we can only estimate
future sales volume and sales amount, it appears that the firm are
faced with the economic exposure and transaction exposure.
Assuming that the transaction exposure management is the
most important one among the above-mentioned concepts,

how do the firms actually manage transaction exposure?
Since transaction exposure goes through the whole life span of
firms business transaction, is there a general strategy that every
firm can use in transaction exposure management?
When the firms are managing FEE, how do they choose the
time horizon? Does there exist any general rule to find an

optimal time horizon?
One of the main things, in measuring the companys transaction

exposure, is to assess if and to which extent the companys
business transactions are exposed. The key concept at this stage is
how to define the exposure problem that depends on the firms
target set. One way to meet the purpose is to find out what kind
of exposure management the companies are using. In our analysis,
we will also answer the questions of whether the companies we
picked up are hedging the transaction exposure and, if so, how
they are doing it.
Another important issue is how to choose an appropriate strategy
to manage transaction exposure. While more and more firms
realize that they should manage transaction exposure, not all of
them have come up with the appropriate management strategy.
The complexity of foreign exchange rate changes appears in the
following way: it influences not only a firms existing financial
position, but also sales and prices which in turn will effect the
firms future value. Therefore, the choice of an appropriate
transaction exposure management strategy is another task we are
going to work out in our thesis. We are going to review the chosen
companies transaction exposure management strategies, compare
them with the theoretical framework, and make observations and
notations on the differences between theory and practice. Finally,
we are going to come up with our suggestions on improvements
of the companies exchange rate exposure strategies.
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So, summing up the above problem discussion, we would like to

stress the following issues:
order to help them to improve transaction exposure management

strategies.
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term to capital investment management. In our paper, we focus

on the short-term exposure management, since we believe that
during long run purchasing power parity offsets exchange rate
exposure.
Purpose
Based on the above problem analysis, we found out that both
transaction and operating exposures measure the exchange rate
change effect on the firms cash flows. The main differences
between operating and transaction exposures are the following:
Operating exposure is more focused on accounting cash flows,
while transaction exposure focused on expected cash flows;
Operating exposure is usually related to the near future, while
transaction is with more farseeing strategies.
Thus, transaction exposure is the one we are going to concentrate

on, since it best represents the real companys value FEE. Though,
at the same time, its effect on the companys cash flows, sales
volume and pricing strategies is very controversial. At the same
time, transaction exposure is the most uncertain one, due to the
following reasons:
The sales volumes effect is related to the transaction or economic
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exposures, because of insolvency (credit) risk of the counter

party,
Estimated sales volumes effect is related to the transaction or
economic exposures, because of the possibility that tender price
might be changed before the contract will be singed causing
cancellation of tender, and, finally, no anticipated foreign
currency inflows (ante natal risk),
Uncertain sales volumes might cause the commercial risk or the
economic exposure, due to sales volume uncertainty and,

consequently, foreign currency inflows uncertainty,
Another important reason why we have chosen this particular

subject is the applicability of the topic in our future work. The
knowledge gained in this subject will be very useful due to the fact
that in recent years almost all companies are more or less exposed
to this type of financial risk.
Thus we aim at to present the companies transaction management
strategies in the following way:
To present the real companies transaction exposure
management systems and compare them with the theoretical

framework.
To make observations on the differences between the theory
and practice along with possible reasons, and to come up with

the suggestions on the transaction management strategies
improvements.
Notes:
Expected currency inflow might be exposed to the price risk,
which generates economic exposure in a way that the listed

prices might be changed due to the changed in cost or
competition level.
Due to the above-mentioned grounding, we think that the

exchange rate risk is the most critical among financial risks
exposures. At the same time transaction exposure management is
the key issue among different exposures management.
Therefore, the purpose of our thesis is two fold. First, we aim to
give a full overview of the existing classifications of exchange rate
exposures, focusing on the one that is the most useful, i.e.
Transaction exposure life span. Secondly, we would like to apply
it to a couple of real companies and compare these applications in
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11D.571.3
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81
11D.571.3
Why hedge?
Hedging will stabilize the cost accounting and price setting.
Firms with smoother value position can gain business

opportunities and improve the planning capability so as to
gain competitive advantage over other companies in their
industry. For example, if the firm can more accurately predict
future cash flows, it may be able to undertake specific investment
or maintain the R&D budgeting. Thus they can introduce the
new products and take an advantage of it.
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Today, more and more firms try to manage the exposure through
hedging. Hedging is the taking of a position either acquiring a
cash flow or an asset or a contract (including a forward contract)
that will rise (fall) in value and offset a drop (rise) in value of an
existing position. Therefore, the main purpose of a hedge is to
reduce the volatility of existing position risks caused by the exchange
rate movement (smoother effect). Figure No.4 shows how the
firms expected value E [V] in the home currency looks before and
after hedging. Hedging narrows the distribution of the firms
value about the mean of the distribution. From the figure, we can
see that unless the hedging shifts the mean of distribution to the
right it cant increase the firms value, what means that the hedging
not only protects the purchaser against loss, but also eliminates
any gain that might result from changes in exchange rates. At the
same time hedging is not free; the firm must use their resources to
undertake hedging activity. In order to add value through hedging,
the result must not only shift the mean to the right, but also
needs a net right hand shift given
costs are 17,5% (Altman, 1984) of the companys value oneyear prior the bankruptcy.
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The risk management decision is the final phase of a 3-step

process. The first step is to recognize if there is an exposure, the
second is to measure it, and the third is to decide whether, and
in which way, to manage it. Since we already know about the
existence of exposure in our example, and even measured it,
now the question is how to manage it?
the expenses related to hedging activities. So it is much more

important to explain that the purpose of hedging is to reduce the
exposure, even though some companies not only try to reduce
exposure, but also try to beat the market in order to make profit.
In our paper, we are following the idea that under the efficient
market condition, there should be no opportunity for speculation.
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LESSON 16:
EXPOSURE MANAGEMENT STRATEGIES
Firms with smoother value position can reduce the amount of
taxes they pay since most countries have convex corporate

taxation system, the higher the profit the higher the tax
percentage applicable. Therefore, for the periods the company
earns a high amount of profit, it will pay higher taxes, although
the periods it generate low or even negative profit, no
compensation will be given.
Firms with smooth value position can increase their debt
capacity. Lenders are more willing to lend to the companies that

have stable cash flows and enough guarantee funds. When the
firms financial position is stable and cash flow predictable, it
has better borrowing and investment options.
Compared to individual stockholders, the firms manager has
an advantage in accessing different kinds of information. The
depth and the width of knowledge concerning the companys
real risks and returns gives the manager the ability more precisely
than anybody else decide to hedge or not to hedge.
Compared to individual stockholders, the firms manager has
an advantage in tracing market disequilibria, which could be

caused by structural and institutional imperfections, as well as
unexpected external shocks (oil crisis, war). Thus, the manager
is in a better position than stockholders recognizing market
disequilibria and, therefore, has an advantage in decisionmaking ability concerning the firms value protection through
selective hedging.
Hedging opponents provide the following reasons for not

hedging:
The stockholders can diversify currency risk in their portfolio in
accordance with their personal risk attitude. Therefore, the

managers activity spending companys resources for hedging is
useless.
As mentioned before, hedging is not a tool with which you
Thereby, to hedge or not to hedge is a continuously debatable

topic in multinational financial management. The proponents
of the hedging reason it in the following way:
As we mentioned before, firms with a smoother value position
can reduce the probability of business disruption costs.

According to Altman study, the average indirect bankruptcy
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could increase the firms value. In other words, hedging not

only protects against loss, but also eliminates the possibility to
earn from it. Additionally, we should not forget that hedging
is not free; the firm must use their resources to undertake
hedging activity.
Usually, the manager is more risk averse than stockholders
because he concerned about his career and reputation. Therefore,
11D.571.3
a market is in equilibrium with respect to parity conditions, the

expected net present value of the hedging is zero. Thereby,
managers mistakes in forecasting could result in unnecessary
hedging.
One reason that leads the firms manager to hedging is the
First of all we have to define what are financial derivatives. Generally

speaking, a derivative is a financial instrument whose value is
derived from the price of a more basic asset called the underlying.
The underlying may not necessarily be a tradable product. Examples
of underlyings are shares, commodities, currencies, credits, stock
market indices, weather temperatures, sunshine, results of sport
matches, wind speed and so on. Basically, anything, which may
have to a certain degree an unpredictable effect on any business
activity, can be considered as an underlying of a certain derivative.
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account veil, because, in the income statement, foreign

exchange loss is a separate line, which is highly visible, while the
hedging costs are hidden in operating or interest expenses.
Thats why manager prefer some additional hedging costs
instead of having foreign exchange losses.
Banks use derivatives as a powerful instrument to generate profits

and hedge their risks. Businesses use derivatives as sources of
additional investments and also as risk management instruments.
The derivatives users base is extremely large. It even includes
pensioners who can now buy options on places at retirement
houses.
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Managers cannot forecast the market perfectly. Therefore, when
institutions have their own derivatives analysts. For example oil

companies spend quite a lot of money on derivatives research,
which may seem as an odd activity unrelated to the industrys
main business. Why then derivatives are so popular among so
many? It turns out that different businesses love derivatives for
different reasons.
Financial instruments used in hedging
Forward rate contracts

Forward contract is the most common instrument used in
hedging, mostly related to the transaction exposure. For
example, if a Swedish firm is expecting to receive US$10,000 in
six months and during this time US$ is depreciating, then the
expected receivable is decreasing in value and vice versa.
Therefore, in order to reduce this kind of exposure, the firm can
go into the forward market and take a short position to sell US
dollar 10,000 forward in six months, then there will show up
minus US$10,000 which will balance the firms US dollar cash
inflow and cash outflow.
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Interest rate contracts

Money market instruments are quite similar to the forward
contract; they also involve a contract and a source of funds to
fulfill that contract. The firm can borrow money in one currency
and then exchange them to another one. After that, it can use
the money generated from its business operations to repay the
loan. The difference between forward
and money market contracts is that the money market contract
cost is predetermined by the different interest rate, while the
forward contract cost is predetermined by the forward rate
quotation. In efficient markets, interest rate parity should ensure
that these costs remain nearly the same, but not all markets are
efficient at all times.
Options contracts
A foreign currency option is a contract, which gives the
purchaser (buyer) an option (right), but not an obligation, to
buy or to sell a certain amount of foreign currency or other
securities at a fixed price per unit on a specific date or during a
certain time period (Eiteman, 1997, p. 150). During past years,
more and more firms started to use options as a tool to hedge.
We also noticed this trend from the later surveys results. A
number of banks in the United States and other capital markets
offer flexible foreign currency options on transactions of 1
million USD or more (Eiteman, 1997, p. 151).
Why Derivatives?
There is not a single investment bank, which does not have a
derivatives desk. Moreover, now even some non-financial
11D.571.3
All derivatives can be divided into two big classes:

Linear
Non-linear
Linear are derivatives whose values depend linearly on the

underlyings value. This includes
Forwards and Futures
Swaps
Non-linear are derivatives whose value is a non-linear function

of the underlying. This includes
Options
Convertibles
Equity Linked Bonds

Reinsurances
One can add some other instruments to both of the two classes.
For example, bonds can be viewed as non-linear derivatives with
the interest rate being a non-tradable underlying. During the course
we will talk about each of the listed above types of derivative
products. Although the main goal of my course is not to teach
how to use various derivatives, but rather how to price them, I
will try to explain the most common applications of some of the
derivatives.
Forwards and Futures
Forward is a contract between two parties agreeing that at
certain time in the future one party will deliver a pre-agreed
quantity of some underlying asset (or its cash equivalent in the
case of non-tradable underlyings) and the other party will pay a
pre-agreed amount of money for it. This amount of money is
called the forward price. Once the contract is signed, the two
parties are legally bound by its conditions: the time of delivery,
the quantity of the underlying and the forward price.
While the delivery time and the delivery quantity of the underlying
asset can be fixed without any problem, the question is how the
parties can agree on the future price of the underlying when the
83
the manager can conduct hedging activity at the stockholders

expense, while it is beneficial only for him, but not for
stockholders. So, if the firms target is only stockholder wealth
maximization (which may not be the case), then part of hedging
activity might be not in the stockholders interests.
At the end of the year, we will deliver the asset to the buyer of the
forward contract who will pay us the forward price n X F. From
this amount we have to repay the bank our loan which obviously
grew to (1 + r) X S, where r is the one-year interest rate quoted by
our bank. Thus, at the end of the year our cash flow is]
F (1+r) X S
Since we started with no money, we have to end with no money.
Otherwise, by selling or buying forward contracts we would be
able to make unlimited profit without taking any risk. This is not
possible in practice. Therefore, we have to impose the following
constrain
F (1+r) X S = 0
Futures are standardized forwards which are traded on exchanges.

All futures positions are marked to the market at the end of every
working day. To illustrate this procedure let us suppose that we
bought a three months futures contract on crude oil for 30 per
barrel. The next day the futures closing price for the same delivery
date is 31 per barrel. This means that our contract has gained one
Euro, because at the maturity we still have to pay only 30. In this
case, the seller of the futures contract immediately pays 1 into
our account. Suppose that one day after, the futures closing price
dropped to 29. Now we have to pay two Euros to the sellers
account. By this time our contract lost one Euro. This process
continues to the maturity date. Because of the specific mechanism
adopted by futures exchanges, contracts are settled in cash and
only in some special cases the seller has to physically deliver the
asset (especially, in commodities markets).
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Suppose we sell a one-year forward contract meaning that we take

aresponsibilitytodeliverinoneyearacertainquantity,n,saof
y
the underlying asset whose current market price is S. In order to
avoid any expose to the market risk, we can borrow from a friendly
bank the amount n X S and buy the necessary quantity of the
underlying. In other words, we sell a covered forward.
The Forward Price=(1+0.0684) X 334.25=357.11
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latter can change randomly due to market price fluctuations. It

turns that in the case of forward contracts there exists what is
called the fair future price of the asset. This can be found as follows.
We can draw the following table:
This gives us the forward price

F = (1+r) X S
If any other price is written in the forward contract, one of the

parties will be able to make a risk-less profit by selling or buying
the contracts in large (theoretically unlimited) quantities. The
considered above example shows us how all specifications of a
forward contract can be fixed by the parties to their mutual
satisfaction. The argument, which helped us to discover the forward
price was that there, must be no trading strategy allowing for a
risk-free profit. This is called the no-arbitrage principle.
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There is another requirement, which has to be fulfilled when we

look for the forward price. This is that the cash flow must remain
equal to zero at any time to expiration of the forward contract. We
only showed that our cash flow is zero at the starting and ending
points of the contract. However, we did not consider what is
happening to the cash flow at intermediate moments. In order to
investigate this problem, we need to know the model describing
the behaviour of the underlying asset. We will return to this
question when we will talk about random motion of share prices.
For the time being we will assume that in the example considered
the cash flow does vanish at all times before the maturity. We will
prove this assumption later on.
Another assumption is that the interest rate r does not change in

time. This might be true for short periods of time. However, for
one year it will be most certainly a wrong conjecture. However, the
effects of changing interest rates are quite negligible and can be
ignored in many cases. Let us consider a specific example based on
real data taken from the Financial Times
Example:
The underlying =British Airways
The spot price=334.25 (31 August 2000)
The time to maturity=Six months (0.5 a year)
At the end of the third day, the seller of the futures contract is
better off by 2.
Forwards and futures are designed to reduce risks related to the
uncertainty of future market prices for both sellers and buyers of
underlying assets. By entering this type of contracts, both sides
achieve complete certainty about their future positions, which may
help them to have a better control over their financial resources.
However, many traders take futures positions for purely speculative
reasons. For instance, if we sell an uncovered futures contract (i.e.,
when we do not have a long position in the underlying asset),
then when the asset price goes down, our futures position will
gain a profit and vice versa.
In what follows we will be using the following definitions. A
long position in an asset is a position that benefits from price
increases in that security (an investor who buys a share has a long
position, but an equivalent long position can also be established
with derivatives). A short position benefits from price decreases
in the security. A short position is often established through a
short sale. To sell a security short, one borrows the security and
sells it. When one unwinds the short sale, one has to buy the
security back in the market to return it to the lender. One then
benefits from the short sale if the assets price is lower when one
buys it back than it was when one sold it.
Swaps
Swaps, as the name suggests, are instruments, which allow a
swap holder to receive a floating interest rate from and pay a
fixed interest rate to a swap seller for a certain period of time.
The interest rates are paid on the same fixed notional principal.
The six-month risk -free interest rate =6.84%
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11D.571.3
Put options give the right to sell the underlying asset. Calls give
the right to buy the underlying assets. There exist also chooser
options, when the option holder has the right to chose between
call and put payoffs.
There are hundreds of different types of options, which differ in
their payoff structures, path-dependence, and payoff trigger and
termination conditions.
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Bonds
Bonds are securities, which pay a certain fixed amount on a
certain fixed date in the future. Since we know how much we
will get on some future date, we can find the present value of
the notional by discounting this amount to the present time
with respect to a certain interest rate. If the rate was known in
advance, the price of the bond would be very easy to calculate.
For example, if the rate is fixed and equal to 5% per annum,
then the one-year bond with the notional value 1000 should
now cost
There are three main categories of options: European,

American and Bermudan. European options can be exercised
only at expiration time. American options can be exercised at
any moment prior to maturity. Bermudan options can be
exercised prior to maturity but on certain pre-determined days.
Operating management hedging strategies

Matching
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Matching, also called natural hedging, is a way to decrease

currency exposure by covering cash outflows by inflow in the
same currency. The firm can use natural hedging in several ways.
In the above example, where Swedish firm has expected USD
cash inflow, if it would acquire the same amount in debts
(including interest) in the United States market for the same
period. In order to have US dollar outflows on inflow day, it
would have had an opportunity to pay its debt, including the
principal and interest, without any hedging need. It is similar to
the money market hedge mentioned before.
However, in reality interest rates are not known in advance, at

least, not for very long periods of time. Therefore, the pricing
of bonds represents a challenging problem, which involves
various assumptions about the behaviour of interest rates.
Swaps can be priced in terms of bonds. Let us consider a swap

with N payments at times Ti. The outgoing fixed-rate part of the
swap is given by
The incoming floating-rate part can be presented as follows
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Indeed, the bond B (t, T i ) can be expressed in terms of the bond

B (t, T i1) as follows
Where
is the interest earned from the time T i 1 to T i
discounted to the present time.
Obviously, coincides with the incoming floating-rate contribution

into the swap.
Taking into account that B (t, T 0) = 1, we find All in all, the value
of the swap is given by We can now see that a swap from the
floating-rate receiver side can be presented as a combination of
short positions in bonds with different maturities. Normally, the
fixed rate is chosen so that the swap present value is equal to zero.
Swaps are extremely liquid instruments and, therefore, their market
values can be used to price bonds.
Options
Options are the most flexible of all derivatives because they give
an option holder a multiple choice at various moments during
the lifetime of the option contract. However, an option seller
does not have such flexibility and always has to fulfill the
option holders requests. For this reason, the option buyer has
to pay a premium to the option seller.
11D.571.3
Another way is based on the operating strategy changes. The

company can set a foreign subsidiaries basing on the market
concentration. Lets say that the Swedish firm from the previous
example, which has a lot of cash inflows in USD, can open a
manufacturing subsidiary in USA, which would incur cash outflows
in USD (subsidiarys cost). The Swedish companys exposure to
USD dollars would thereby be effectively covered. In the later case
study, we found out that one of the companies (SKF) is trying to
follows the later pattern. This activity is relatively effective in
eliminating currency exposure when the firms cash flow can be
constantly predicted over time.
Thus, the main advantage of natural hedging is that transaction
exposure can be effectively covered without any transaction cost.
Another advantage is that the matching strategy offers a particular
advantage to companies, which are subject to exchange rate control
regulation that constrains their activities in the foreign exchange
market. For example, it provides an acceptable solution to the
problem where it is apparent that an exposure exists but there is
no coverable exposure as such defined for purposes of exchange
control. Even though the concept of matching is simple, there are
a number of complexities associated with using the technique.
For example, the time periods used by companies in the
management of their exposures will vary with the nature of their
business. If a chosen period is too short, then the number of
time periods will quickly escalate, adding work to the data collectors
and increasing the number of specific decisions. It is likely,
therefore, that the exposures being matched out will be those
arising over a period as long as a month, or even more.
Risk sharing
Risk sharing means that the seller and buyer agree to share the
currency risk in order to keep the long term relationship based
on the product quality and supplier reliability, so they will not
85
Swaps can be arranged in various ways. For example, there are

swaps between different currencies, in which case the parties swap
domestic and foreign rates. A swap can be priced as a combination
of bonds.
Practical strategies
Pricing strategy
The case that we presented in chapter one explained how the
exchange rate change affect the firms cash flow. Pricing strategy
and demand sensitivity to competitors price are two important
factors, which affect the firms exchange exposure. Therefore, it
would be logical to presume that if we set a flexible pricing
strategy, then the firm can handle the exchange rate exposure
easily. However thats not always the case. As a matter of fact,
some industries such as chemical, petroleum and mining
businesses have few pricing decisions to make relative to the
currency risk, since those industries are very large depend on
economies of scale which means they are pricing taker instead
of pricing setter. For example, in the SKF case, the company
whose activity we are going to analyze later, the buyer not the
seller dictates the price. Additionally, there still exists some costs
associated with pricing changing policy; such as: long term
customer relationship, the customers loyalty to the firm, and so
on.
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Netting
An alternative method to the previous one is to use a netting
system. This system is often based on a re-invoice center
establishment, where each separate subsidiary deals only with its
own currency, leaving all the transaction exposure to re-invoicing
center. There are some advantages of re-invoice center:
simple version of netting strategy, based on assumption that

the accounts receivable and accounts payable are all due on the
same period. However thats not always the case. If the firm
have a large number of transactions due in the different period,
when the measure and the hedging of netting exposure
depends on each transaction time horizon, on a separate or
aggregate contracts specificity ect, then the calculation of the
best netting period as well as hedging amount becomes quite
complicated.
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destroy the long term relationship just because of the

unpredicted exchange rate change. Following our previous
example, if the spot rate is SEK 8.5/US$, six months later, the
spot rate turns to be SEK 9/US$, then the Swedish firm, which
expected to receive SEK 8500 will get SEK 9000. In this case, if
both contract parties agree to sharing the risk, for example, each
party offer half, then Swedish firm can agree to receive $10,000*
(8,5+(9-8,5)/2)= SEK8750. So, the risk sharing arrangement is
intended to smooth the impact on both parties, of volatile and
unpredictable exchange rate movements, and the firms can still
use this strategy to manage the cash flow exposure.
It is easy to control the overall firms activity when all the currency
exposure is netted in one place, thus ensure that the firm as a

whole follows a consistent policy.
Lower transaction cost because of the centralized netting system.
Each subsidiary can concentrate on what they are specialized in.
There still exist some drawbacks to the re-invoice center. For

example, the netting system insulates the internal suppliers from
their ultimate external customer market, which will mislead the
firm to set sub optimal pricing and other commercial decisions.
A firms re-invoice center can measure the transaction exposure on
daily, monthly or even quarterly basis depending on the firms
exposure management policy. As we mentioned before, most
firms act simultaneously as buyers and sellers on the international
markets for commodities (so they have to manage both the
accounts payable and accounts receivable in a single foreign currency)
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The following example (example no. 3) will explain how the

reinvoice centers measure transaction exposure based on the weekly
data with respect to different foreign currency. In the following
case, we see that the transaction exposure is basically gap between
the firms accounts receivable and accounts payable. However,
different companies can use different information based on the
firms special condition, such as the call, order or import and
export data to measure exposure.
Example No.3 Netting transaction exposure
Diversification
From above mentioned Pringles analysis, we may get an
impression that the firms can manage the currency exposure
through diversification of both operating and financial policies.
From the first sight, we may say that diversification of both
strategies gives a lot of choices. The firm can diversify its
operations through, such branches of its activity as, sales,
location of production facilities, raw material sources, while
financial policy diversification can be done using funds in more
than one capital market and in more than one currency.
However, its not always an easy way. Some industry may require
large economies of scale that it are not feasible to diversify its
production location, maybe some firm are too small to be
known by the international investors or lenders. Thereby,
especially operating strategys diversification can be used mostly
depend on the firms characteristic. In the later case study, we
will look if this kind of strategy is feasible.
Notes:
This kind of transaction exposure management can very quickly

provide the firm with an overview of the short period exchange
rate risk. So, if one currency appreciated (depreciated) at a certain
percentage than the net exposure before hedge will appreciated
(depreciated) at the same percentage. Thus, the firm can, based
on this information, to find the way out in the financial market.
On the other hand, the above mentioned example is the most
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11D.571.3
LESSON 17:
CASE STUDY IN SKF
Overview of SKF
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SKF is a company with a long history behind. It was founded

in 1907. It started as a manufacturing company and soon
became the leading manufacturer in the bearing industry and
has maintained this position ever since. Recently, service
business is also becoming an increasingly important part of the
SKF Groups operations. SKFs central office is in Gothenburg.
The company has a network made up of its own sales
companies in some 50 countries, plus more than 7000
independent distributors and dealers worldwide. SKF
manufactures its products at some 80-production sites in 22
countries.
The SKF business is organized in six Divisions and one area

covering operations related to the aviation industry. SKF is a one
of the biggest joint ventures in Sweden. Nearly 44,3 % shares
representing 22,6% of voting rights were owned by foreigners
(30/12/1999). The biggest Swedish shareholder is Investor AB
having 14,2% of the shares representing 28,8 voting rights.
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Main products, suppliers, customers, competitors

and net sales distribution
The main products of the company are bearings, seals, and
special steel and steel components. SKF has 15-17% of the
world market and 30% of Europes market for ball bearings.
Principal competitors have the greater part of their production
capacity in the following regions: four competitors in Japan
(about 25-30% of the worlds market), two competitors in USA
and two competitors in Europe. SKFs main raw material is
steel, and 50% of the steel the company uses, is making by SKF
itself. SKFs manufacturing is widely spread geographically, but
with a concentration to continental Europe, USA and Sweden.
Though especially during the latest 10-15 the situation changed
from the manufacturing being concentrated in continental
Europe to almost evenly spread among European, USA and
emerging Asian markets. The company is quite successfully
trying to reach that the subsidiaries would have less difference
between export and import or, in other words, that most of
cash outflows would be covered by cash inflows in foreign
currency. This, as it will be explained later is a very favourable
condition for the natural hedging strategy. During the latest 1015 years the difference between import and export in the main
USA, European and Asian markets from being 25-30 %
decreased to 20%.
Overview of the companys latest years activity and future plans

As an introduction, we would like to give some key data on the
size and performance of the company, as follows (table 2):
Table No.2 SKF key data on size and performance
The following figures (figure 5&6) describe the net sales

distribution by geographical areas and customer segments.
Figure No.5 SKF net sales by customer segment 1999
All above given and the other numbers presented in this chapter
are taken from the companys Annual Report of 1999.

During 1999, SKF increased its earnings due to the inventory, real
estate and employees reduction carried out in the context of weak
market demand. The Groups net sales decreased by 2,6 % owning
11D.571.3
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Capacity utilization to the low demand and inventory reduction

was unsatisfactory last year. In the future, the company is going to
pay more attention to the new technologies and to use them as an
instrument to create more profitable business for the Group. The
Group is now focusing on expanding its activities in several
different areas especially emphasizing service and maintenance.
The latest two areas have high priority and are growing both
organically and by acquisitions. The company is also going to go
on with the reshaping program, selling out unprofitable business
and looking for new perspective areas.
Financial objectives
The financial objective the company set itself, as it was indicated
in annual report, is value creation for its shareholders. The
financial risk management objective, the representative of the
company defined as: not to have any unexpected surprises or
in other words cash flows smoothing.
In the Annual Report of the year 1999, we found the following

notation regarding the type of the exchange rate risk the company
is focusing on: The most important currency risk to which the
Group exposed is changes in the exchange rates, which affect the
future flows of payments. The main aim managing the currency
risk is made on transaction exposure.
The Groups financial policy defines currency, interest rate and

credit risks, establishes responsibility and authority for managing
these risks. The policy states that the objective is to eliminate or
minimize risk and to contribute to a better return through an
active management of risks.
The companys exposure measurement starting point is the

moment when the billing exposure appears in the companys
accounting record representing goods shipment and invoice for
these goods presentation to the buyer. The accounting records
representing described transactions during the month are made in
the subsidiaries and at the last day of the month are send to the
Treasury center. For example (example no. 4), on the last day of
July 1999, SKF Treasury center received from the Austrian subsidiary
the following report:
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to volume (5%), currency effects (+2%) and price/mix (+0,5%).

The improvements in the price/mix factor, and part of the decline
in volume; are attributed to the new strategy initiated in 1998,
which prioritized profitability and discontinued unprofitable
business.
SKFs financing policy is that the financing of the Groups

operations should be long term (maturities exceeding three years).
As of December 1999, the average maturity of SKFs loan was 4.5
years. SKF should have an additional payment capacity in the
form of surplus liquidity and/or long term credit facilities,
amounting to approximately MUSD 350. The group has been
assigned BBB+ rating for long term credits by Standard & Poors
and Baa2 rating by Moodys Investors Service.
An analysis of SKFs financial risk management
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The management of the financial risk, and the responsibility for

all treasury operations, are largely centralized in the SKF Treasury
Center (see figure7.), the Groups internal bank. This means that
all the currency exchange operations inside the company or with
the other companies, exposure measurement (partly), hedging
and financing operations are made there. For example, if SKF
subsidiary in France sells something to the German buyer (if we
exclude the possibility of settling the payment in EUR), then the
buyer might set a requirement of settling the payment in DEM.
If the payment is deferred, the subsidiary informs the center about
the currency exposure and at the payment day makes the DED/
FRF currency exchanges in the internal bank. If the payment is
made at sight, then only the currency exchange takes place. Thereby
the French unit of the company all the payments get in FRF.
Thereby the subsidiaries (as shown below) have no currency risk.
Every unit of the company pays and gets payments only in its
local currency.
Export and import are expressed on the base of
subsidiarys sent and received invoices amounts
Based on the information received from the foreign subsidiaries

and Swedish units of the company, Treasury center makes the
overall companys exchange rate exposure report by each currency.
The company has a special internal rule regarding the companys
exchange rate exposure period, saying that the companys billing
exposure period (representing the trade transaction within the
Europe) can not be longer than 10 days. For the trade transactions
among different continents, the period should not exceed 40 days.
Therefore, the companys exchange rate exposure for one transaction
does not exceed 40 days.
Since 90% of the trading transactions are made in Europe, 90%
of the payments for goods are settled within 10 days. The period
of the majority of trading transactions is 3-6 months. The
companys exchange rate exposure measurement is made on the
monthly basis (as described above) at the last day of the month.
The Companys exposure hedging horizon is three months. The
hedging activity takes place four times a year as follows: in the
88
11D.571.3
Example No.5 Prognos

Companys exposure is US dollars:
The performance for last year:
(January+February+March+April+December)= 200 000
The performance for last month (December)=20 000*12=240
000
in mind the latest 10-15 years companys strategy of foreign

currencies inflows and outflows balance, more and more natural
hedging is taking place. Forwards are the main instruments the
company uses for exposure hedging. Options are sometimes used
as well, but only in the cases when it is big probability that the
particular currency will increase (decrease) below (above) certain
limit. Options are used more widely for currency trading purposes.
Though, as we can see below, the trading portfolio in the company
is comparatively small.
For the better grasp of the magnitude of financial derivative
instruments the company use, the following numbers in MSEK
are given (table 3):
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The performance for last three months:
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(October+November+December)=(13000+12000+20000)*4=170
000
The performance for last six months:(July,August,,December)
=(9000+17000+18000+13000+12000+20000)*2=178 000
Prognos=180 000 (roughly equal to last years US dollars net

position and might be adjusted to the coming years companys
strategy; for example, shutting down part of the production or
signing a big long lasting contract with the new customer in a
particular subsidiary).
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Prognos, or the forecast, is made for the one-year period and

might be adjusted if any significant deviations from the forecast
in the real invoicing amount take place. Otherwise, according to
our example, the Prognos for the first quarter the company is
going to have 45 000 USD excess inflows than outflows. Then the
company, at the beginning of January, will sell 45 000 USD three
months forward. To the question if the company is looking back
and checking if the forecast was right, the representative answered
positively, not identifying the real numbers. To the question how
often the Prognos needs to be adjusted, the representative
answered, that not often. Due to the fact that approximately 50 %
of the companys customers are permanent and the business cycles
are comparatively predictable, it seems quite reasonable to presume
that the invoicing forecast for the coming quarters might be quite
accurate. The companys objective is to have zero currency risk and
according to the representative they are close to it. As we can
observe, the company is hedging 100% of its exposure. The
currency of denomination is Swedish Krona.
Speaking about the hedging, the season of the year should be
taken in to account. During summer or Christmas holiday less
attention to the hedging position adjustment needed. Talking
about the exposure hedging time period, we should point out
that the companys hedging period policy changed due to Swedish
Krona devaluation, which was in the end of 1992. Before, the
company was hedging on the yearly basis, but starting from 1994
changed to quarterly.
One more important thing to mention is transaction costs. SKF
treasury department is costs center and, to our knowledge, is not
accounting or anyhow recording transactions cost.
The main companys exposure management strategy is netting.
Companys exposure management system, as it is today hasnt
been changed in the last 5-6 years. The representative of the
company expressed his full satisfaction with it. Although, keeping
11D.571.3
One more specific factor related to the SKF business exchange

rate exposure management should be mentioned; SKF has a
comparatively mall pricing strategy changing capability based on
its specific consumer situation. The biggest part of SKF prices
is locked in the big volumes, long-term contracts with the car
industries, original equipment manufacturers (30% of
productions), or the paper industry (26% of production). Only
44% of the SKF productions are sold to distributors selling
bearings for replacement. The latter cluster of the customers is
the only one SKF could use its pricing strategy on, in the case of
drastic exchange rates changes.
Lets take the companys most common business transaction and
try to fit it into the transaction life span as it was described in the
89
beginning of January for the first quarter, in the beginning of

April for the second, etc. The hedging volume is based on so
called Prognos, which is the forecast of invoicing amount for
the coming quarter basing on the last years performance. The
forecast is calculated in the following way:
pot. Forward contracts are the financial instruments are mostly

used for the hedging companys exposure position. In the example
given in the beginning of the chapter, the Austrian subsidiary is
exporting 40.569 ATS more than importing; therefore the whole
SKF is exposed to ATS. To hedge that exposure, 40.569 ATS
forward had to be sold to insure the company against the exchange
rate risk on the same amount of ATS inflow.
Observations and suggestions for SKF
After the analysis of the SKFs actual transaction exposure
management system, we made the following observations and
suggestions.
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Starting moment of the exposure management

Observation: The first one is concerned with the starting
moment of the transaction exposure hedging, in respect to the
theoretical transaction life span. In the case of SKF, we found
out that SKF start to hedge transaction exposure from Time 3,
even though they have signed the contracts with the customers
in the second period.
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Expenses are made and the risk of incurring losses appears, creating
the credit risk, in the case the buyer wont pay the bill. To our
knowledge, during Time 1-Time 2, SKF is making only some
kind of interest and credit exposures management, but since
interest rate and credit risk exposure are out of our concern we are
not going to go deeper into that topic. At Time 3 SKF ships the
goods and bills the buyer. Starting from that moment the amount
of cash flow receivables appears in the SKF accounting books. All
above described exposures, which appeared at Time 1 and Time 2
increase by shipment and any Other cost related with the
transporting (in the case the SKF is paying).
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figure no.1. A majority of SKF transactions take place according to

the long term contracts, meaning that the same transactions follows
each other for 5- 6 years under already signed contracts. But, for
the very first one, transaction life span starts exactly as it was
described in the figure, when SKF quotes the price for the buyer.
It is clear that, starting from that moment; the company already
starts to have exchange rate exposure. In other words, if, after that
moment, the exchange rate would drastically change, the company
would risk incurring losses if it follows the tender price or might
lose the buyer in the case it would decide to increase prices.
Therefore, the company is already exposed to the Quotation
exposure or part of the transaction exposure, though still without
any effects on the cash flows. SKF is not measuring or managing
Quotation exposure. Backlog exposure starts from the contract
signing moment. From that moment SKF starts to produce steel
and bearings and the expenses starts to increase. One important
thing to mention is that almost all the bearings are produced in
Sweden from steel, which the company is producing by itself as
well in Sweden. Therefore, only cash inflows for the production
sold are exchange rate exposed and almost no costs are exposed.
In the case of unfavorable exchange rate changes, the company
will generate less cash inflow than expected, while the fixed costs
are already made, creating cash flow exposure (part of the
transaction exposure). Under the transactions, financed from the
external sources (bank loans etc.) in order to buy the raw materials
and start the production, if unfavorable interest rate change would
take place (drop down) the company would have to pay the higher
than in the market interest rate. Thereby, from Time 2 the interest
rate exposure starts. The more expenses made (raw material, steel
production, bearing production) the more loan or credit line from
the bank is used, the higher interest rate exposure incurred. Meaning
that the interest rate exposure increases during Time 1-Time 2.
During Time 2-Time 4 the company produces and sends the
production along with the bill to the buyer. The accounting record
is made showing the amount of the bill as account receivable.
SKF is measuring only part of transaction exposure within Time

3- Time 4.
In 1998, the company stopped the hedging of the translations
exposure. In 1994, the company was hedging the translation
exposure for 100 %, although during the 1995-1997 the company
was decreasing the percentage hedged and starting from 1998
stopped to hedge translation exposure. The reason for leaving the
translation exposure unhedged, according to the representative
of the company, was the single EURO currency system.
At the beginning of every month, subsidiaries net currency
position (the excess of import of export) are pooled into one
90
Suggestions: Based on the knowledge we received, we recommend

that the company should at least start to hedge during the period
when they signed the contract. In Kenyons book, he said we can
take action to hedge the risks as soon as we are sure to have landed
out contract, this is usually at signature, sometimes later
sometimes earlier(Kenyon, 1981, p. 82), otherwise they are bearing
the currency risk during that period. It is obvious that once a
quotation has been submitted, the exposure appears and the firm
needs to consider how to manage that exposure. Another
interesting things is that, being a big international manufacturing
companies, SKF, have a large percentage of long-term contracts
and permanent customers. Therefore, a big part of SKF prices are
locked in the big volume, long term contracts with the car industries
original equipment manufacturers (30% of productions) or paper
industry (26% of production). Whether or not to hedge the
potential exposure during the period of quotation is an important
issue. From the moment the firm starts to be exposed, hedging
decision will be accompanied with transaction cost. Prior to that
point, the evaluation of the contract signing probability should
be made. If the chances of winning the contract were low, then
attempting to cover the risk would seem more like speculation
than hedging. At this point, the firms need to consider theirs
historical performance carefully. So summing up above mentioned
problem, we would like to make the following suggestions:
The company could evaluate the customers and set them into
different clusters depending on the historical performance, which
is the performance of theirs contracts fulfilling: permanent, less
permanent and un-permanent. Depending on the cluster the
customer belongs, to set different hedging percentage. For example,
for those customers, whom belong to the permanent customer
category, the firm can hedge 100% expected transaction exposure
at the quotation period. For those customers who belong to the
less permanent customer category, 80% hedging of the contracts
volume after the moment that contract has been signed; and finally
those customers, who belong to the un-permanent category, 50%
hedging. We think that the latter way of customer grouping would
help the company to avoid big fluctuations resulted from different
types of customers.
11D.571.3
Risk sharing
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Observation: as was mentioned above, about 50 % of the

companys contracts are long term (3-5 years) with the permanent
contractual parties. Production prices in such contracts are based
on tender prices and usually are fixed. The company is not using
any exchange rates clauses in the contracts, but takes all the risk on
theirs behalf or some kind of exchange rate changes expectation
includes in to the price.
Suggestion: Lets take an example and presume that the company

is signing a contract for selling 1 million bearings in 5 years for
fixed price based on the tender. The contract is in US dollars. It
means that during that period, if the exchange rate changes, in the
way that USD value will increase in comparison with SEK, then
the Swedish company will incur losses. Another important point
is that the longer the validity period of the contract the bigger the
uncertainty about the exchange rate changes. In our example, it is
5 years plus tender period. Since the companys financial risk
objective is to have zero exchange rate risk, we think that the best
solution of this problem is to share the exchange rate changes risk
using so called currency clauses or pricing strategy element, such as:
11D.571.3
meaning that if USD/SEK (following our example) exchange

rate changes the contractual party, which are getting advantage
of that change compensating half of the advantage to the
other party;
To set a floating production price, which would float in
accordance with the exchange rate changes.

Hedging period and transactions cost balancing
Observation: SKFs Treasury department is the cost center unit.
The company is not accounting or recording hedging transactions
cost. Suggestion: As we know from the basic economic theory,
forward price is about 3% of the transaction amount. Therefore
the bigger the amount, the higher the transaction costs. SKF is
big multinational company operating with big exposed amounts,
therefore it would be reasonable to presume that the transactions
costs compose a significant amount. The more seldom exposure
is hedged, the less transactions and consequently less transaction
costs will incur. Since SKF is hedging four times a year, if any
unexpected exchange rate changes take place, the transactions cost
might seem not be so significant. On the other hand, in our
turbulent word of changes, one should be very careful making a
decision about the hedging period, since the longer the period,
the bigger the probability of unexpected exchange rate changes.
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Suggestions: In fact, if we look deeper into SKF groups internal

transactions, we might find that there exists currency exposure in
subsidiaries. From the representative of the treasury department,
we found out that the company has set an internal forward rate
usage for next quarter invoices rule. Since we have not received any
other information from the subsidiaries, we will set up an example
to explain how the exchange rate change effect the groups internal
transactions. Assume that the director of the United States decides
the final price of the subsidiarys production in the United States
market subsidiary (it is common that the pricing decision is taken
at the country where the goods are sold to outside customers).
The forward rate is 1US$=8 SEK, and the inter-companys price is
280 SEK/unit, which costs the United States subsidiary 35US$/
unit, with a minimum gross margin of 12,5% of selling price,
which means the final price in the United States markets is 40US$/
unit. Now with the exchange rate change, say that the forward rate
change to 1US$=8,75 SEK, then the costs for the United States
subsidiary will turn to be 32US$/unit, still the final price is 40US$/
unit, then the united states subsidiary will have a gross margin of
20%. It seems to be well enough, though on the other hand the
United States subsidiary have an alternative to use the windfall
cost reduction in selling price reduction in order to get extra sales
and market shares. The third alternative is to adopt a halfway
position in terms of usage of part of the saving for a price reduction
and part for the profit margin enlargement. As we can see from
the example, the exposure, which SKF probably didnt consider,
still exist in the subsidiaries. Thus, theoretically, if the intercompany price between SKF and its subsidiary in United States
were fixed to the US dollar, then above mentioned exposure would
not happen.
To share the exchange rate risk by so called currency clause,
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Observation: The second observation is about the inter-company

indirect sales transaction risk. As we described before, SKFs treasury
department dealing with the companys whole financial exposure
management, while the subsidiaries do not take any exchange rate
risk at all.
floating price setting. The mentioned ways of risk sharing usually

are used as follows:
Depending on the hedging transactions volume and frequency,

the transactions cost might reach a level from which it might be
more costly than useful to hedge. Therefore, due to the abovementioned reasons as well as for the further possible surveys, we
think that it would be very useful if the company would start to
record transactions costs.
The other crucial issue is transaction costs and hedging period
balance. As was discussed above, the more often and the bigger
amounts one hedges, the more transaction costs one will have
and the other way round. Though the more frequent exposure is
hedged, the less variability in cash flows and the less probability
of unexpected exchange rate changes will occur. Therefore, the
appropriate balance of the hedging period and transactions costs
should be made. For that kind of balance the transaction costs
and the hedging period should be known. Unfortunately the
company has no transaction costs records. Thus, the only thing
we can suggest is to start to record transaction costs and then have
both transaction costs and hedging frequency try to find out if the
hedging costs are not getting higher than the level and when
hedging starts to be more expensive than useful.
Hedging horizon and financial risk
Observation: SKFs hedging period is three months. Hedging
volume is determined by the forecast (Prognos), which on its turn
is based on the historical performance. Forecast is adjusted during
that period, if any changes appear.
Suggestion: The length of the hedging period is a debatable
question, although one of the factors that affect it is hedging
transaction cost and period balance. Another factor is the firms
readiness to take a certain amount of risk. As it was mentioned
before, SKF is hedging its transaction exposure every three months.
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Inter-company indirect transaction risk
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Notes:
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For example, at the beginning of January, they are hedging for

January, February and March. At the beginning of April, they are
hedging for April, May and June. If any big fluctuations in the
first quarters exchange rate appears or significant deviations from
the billing forecast would takes place, the forecast amount would
be adjusted in the second quarter accordingly. However, if any
changes would take place in the first quarter no action is going to
be made. For example, if in the middle of January a big change in
the main currencies exchange rate occurs, adjustment to the forecast
would be made only in the beginning of April. Thereby, it might
result in a comparatively large, 2,5 month unhedged period, that
might dramatically deteriorate SKFs net position. Thus, we think,
that in order to avoid such kind of un-hedged periods,
adjustments should be made every month. For example, at the
beginning of January, they can hedge for one quarter, that is January,
February and March and in the beginning of February, they can
hedge for another three months, that is February, March and April.
In this way, they can avoid unexpected fluctuation caused by the
short period exchange rate changes.
92
11D.571.3
LESSON 18:
CASE STUDY IN ELOF HANSSO
Overview of Elof Hansson
Elof Hansson is a trading company with an even longer history
than the SKFs one. The company was founded by the
merchant Elof Hansson in 1897. The Board of Directors and
Managing Director gives the following presentation of the
company (in annual report of the fiscal year 1999):
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Elof Hansson, whose registered office is in Gothenburg, is the

parent company of the Elof Hansson Group. The company
undertakes international trading in three business areas Forest,
Industrial and Consumer Products. Sales are handled via
subsidiaries, branch officers and agents in more than one hundred
countries. Elof-Hanson AB is owned to 99.9 % by Elof Hanssons
Stiftelse (The Elof Hnasson Foundation) or, in other words, is
family owned business.
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Main business areas, suppliers, customers,

competitors and sales distribution
Forest products area accounts for the largest proportion of the
business operations of the Group, which is explained by the
fact that merchant Elof Hansson, who founded the company,
did his first deals in paper and pulp. The largest customers of
the paper products are found in Latin America, several African
countries, Asia, the Middle East and the Far East. The
suppliers are primarily located in Scandinavia and North
America, but also in Russia and South America. Traditionally,
paper pulp suppliers are found in Scandinavia and North
America, however the incidence of new suppliers for companys
customers in Asia, the Middle East and North Africa, has risen.
The industrial area is the second largest, comprising of steel,
pipes, forgings and castings. Industrial Products Division
supplies mentioned products mostly within Sweden. The
customers of the industrial products are found in Central
America, the Caribbean and Mexico. Customers products are
the third largest field of business activity and the consumers of
these products are settled in some fifteen European countries,
primarily in Scandinavia and the Baltic region. The main
suppliers countries are China, India, Pakistan, Rumania, Taiwan,
Hong Kong and Turkey.
Due to the specificity of the business competitors might be not

only the other trading houses, but also companys suppliers and
customers. Since Elof Hansson is the middleman, the cases when
the previous suppliers stars to sell their production directly to the
previous customers, makes the latter a competitor. According to
the representative of the company, Mr.Henrik Jerner, the main
competitors in Sweden are the following trading houses: Ekman
and Co., Cellmark. One of the main foreign competitors is
Japaneses trading house Sumitomo.
The following figures, No.8 and No.9, describe the net sales
distribution by geographical areas and customer segments.
Figure No.8 Elof Hansson business volume by products 1999
11D.571.3
Overview of the companys latest years activity and

future plans
Following the SKFs data presentation order, an introduction
some key figures on the size and performance of the company
will be presented in the following table:
Table No.5 Elof Hansson key data on size and performance
All above given and the other numbers presented in this chapter
are taken from the companys annual report of 1999.

Operating profit, as well as the business volume of the company
in 1999, was the lowest during the last five years. The Chairman
of the Board of Directors in the companys annual report explained
it through weak demand and subsequent shortage of quantities
during the latter half a year. Though taking into account several
strategically important activities were undertaken the financial results
93
The companys nearest future activity is going to be concentrated

on the main forest products area, since the trend in this area remains
positive. The trade in forest products in future will also have a
dominant role within the company. Demand for paper is evaluated
as remaining high with the world consumption rising annually by
1-2%, that is, by five-seven million tons. Among forest products,
timber and downgraded paper has a strong standing on this
market, and will be further reinforced in the current year.
Downgraded paper through a continuing expansion in Asia. In
the coming years, marketing will intensify and include non-Swedish
markets, primarily the rest of Scandinavia and the Baltic region.
As opposite to SKF, a majority of EH contracts are short or

middle terms, and majority of suppliers and customers are
temporal. That requires a stricter management attitude. Therefore,
EH measures and manages exchange rate exposure on the daily
basis. Every day the treasury center measures exchange rate risk
exposure in the similar way as the SKF does in the end of the
month. The main companys exposure management strategy is
netting. Basing on the during the day received foreign exchange
orders from the subsidiarys, treasury department net the numbers
and buys on the spot or forward markets the required amounts.
At the end of the day all the exchange rates orders are added
together and the one-days exposure is calculated. As with SKF,
EH hedges 100% of the currency exposure. Internally, for every
currency it is set 2,5 % value at risk (VAT) factor, representing the
foreign currency transaction magnitude allowed during the day.
Trading, loans and commercial portfolios reports are made
representing all the foreign currencies transactions made during
the day in the case the 2,5 % per day value at risk requirement is
exceeded.
Elof Hanssons financial objectives

Since the company is basically owned by one family, the
representative of the company indicated that the main financial
operating objective is as it usually is for private business
enterprises: profit. Financial risk management objective was
defined as cash flows smoothing as well as the advantage of the
exchange rate changes taking speculating with the available liquid
assests. Financial policy of the Group defines exchange rates,
interest and credit risks. The company is managing them
actively.
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companies is organized in the same way as in SKF; every unit of

the company pays and gets payments only in its local currency.
Exchange is made in the internal bank (Treasury Department).
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COE found acceptable. The representative of the company on the

interview as the main factor, which diminished business volume
and income for 1999, indicated Asian crisis.
Groups financial policy regarding companys operations financing

is predetermined by the specificity of the operations, which mostly
are short term. Thereby the biggest part of the loans the company
has is from 6 months to 1 year.
An analysis of Elof Hanssons financial risk
management
The organization of the exchange rate risk management is
based on the centralization principle and is fully centralized for
the Swedish divisions of the company. The most important
currency risk to which the Group is exposed is exchange rate
exposure. Transaction exposure was defined as one of the
highest concerns.
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As well as in SKF, in Elof Hansson (EH) in all the currency

exchange operations inside the company or with the other
companies, exposure measurement (European), hedging and
financing operations are made in the internal bank, although there
are some significant differences. One of the main ones is that EH
is measuring and managing its exposure every day, while at SKF is
once a month. EH hedges forevery single contracts (orders) period,
SKF for 90 days. The specificity of EH commercial operations no manufacturing, just trading - causes the difference in the treasury
departments structure and main activities. EH being a mostly
profit seeking middleman has much bigger trading portfolio.
Unfortunately, due to the confidentiality of the information, both
companies refused to give any real numbers describing trading
portfolio. The only information we received was that the portfolio
is comparatively big, while in SKF it is comparatively small. The
treasury departments main concern in EH is commercial and
trading portfolio management, while in SKF just commercial
transactions hedging. No trading transactions among subsidiaries
are taking place in EH and, therefore, no exchange operations
among them are needed. Otherwise the trade with the other
94
The companys exposure management system, as it is today, hasnt

been changed for latest 4 years. The representative of the company
expressed his full satisfaction with it. Forwards are the main
instruments the company uses for exposure hedging. Though
the representative expresses his willingness to introduce options
in to subsidiarys hedging activity more widely. The companys
subsidiaries commercial activity within Europe is hedged in the
same way as the companys units in Sweden. The Treasury
department nets and hedges the exposed amounts according to
the received exchange rate orders. The North American and Latin
American subsidiaries, due to the big time difference, net and
hedge their exposed cash flows in the local financial markets by
themselves, providing the center with the financial reports at the
end of the month. The currency of denomination is Swedish
Krona.The Treasury Department in EH, as well as in SKF, is the
cost center. Although in EF the Treasury Departments dealers are
sometimes having so called realised and unrealized profit,
which appears due to the fact that quite often the exposure bought
from the subsidiary for one price (for example in the morning) is
hedged later (in the afternoon) for another one. 70% of the
companys sales are in foreign currency. The main currencies are
USD and EUR.
The yearly currency flows for 1999 are shown in the following
table:
Table No.6 Elof Hansson currency flows
11D.571.3
and, thereby, the most fitting exposure managing moment for

one does not necessary means the same for other. Elof Hansson,
in comparison with SKF, has a small percentage of long-term
customer relationship cases, thus, it turns to be difficult for them
to forecast the number of contract signed or deals set.
Thereby, we suggest that they should start to hedge starting
from the Time 1 for a lower percentage in the quotation period
basing on the customers historical performance and hedge
100% after the contracts have been signed, which is in Time 2.
Since the company has no historical hedging transactions costs,
we were unable to come up with a hedging percentage
suggestion.
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Different approaches for the choice of hedging

period and transactions cost
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Observation: Both companies Treasury departments are cost

centers. They are not accounting or recording hedging transactions
cost.
The company does not consider translation risk as important

and, therefore, does not hedge it.
Observations and suggestions for Elof Hansson
Different approaches for the initial moment of the exposure
management
Observation: In the case of Elof Hansson, we found that they

start to hedge the contracts in the Time 2. This means they hedge
the contracts (orders) after the contracts (orders) have been
confirmed.
Suggestion: we have mentioned transactions exposure starting
moment in our paper for several times in order to emphasize its
importance. An interesting coincidence is that the Elof Hansson
transaction exposure hedging starting point is exactly at the same
Time 2 that we have suggested for SKF. Although we should
keep in mind that the companies are from different industry clusters
11D.571.3
Suggestion: The first observation suggests that EH is more

exposed to the exchange rate changes than SKF. Therefore, EHs
exposure should be hedged more frequently. Thats the way it
actually is. The exposure is measured and managed every day,
while in SKF it was once a month. Thus, EH should have much
more hedging transactions and as a result higher transactions costs.
But, the more frequent the exposure is hedged, the less variability
in cash flows and the less probability of unexpected exchange rate
changes should occur, which is critical issue for EH. Since, as it was
mentioned earlier, EH is more exposed, meaning higher risk of
cash flows variability resulted from the exchange rates changes.
However the amounts the company are hedging are comparatively
smaller than in SKF and that factor should reduce the transactions
costs. But, is it the best hedging frequency for the company? It
might be possible to get some kind of guidance if we would have
historical performance records of hedging transaction costs.
Unfortunately, thats not the case. In order to be able to come up
with the best fitting hedging period, reasonable basis for the
calculation is needed. Therefore, we suggest that the company
should start to record their hedging transactions costs.
Hedging period and netting strategy
Observation: Elof Hansson is hedging on a daily basis.
Suggestion: As it was mentioned, EH is hedging every day and is
using a netting strategy to manage the transaction exposure. As
we know from the basic theory the biggest use of the netting
strategy is when there are a lot of opposite way exchange rate
transactions; e.i. when one subsidiary requires to sell the same
amount and currency the other needs to buy. The longer the period,
the bigger the probability of opposite exchange rate transactions
and the bigger the use of netting strategy. As was mentioned
earlier, the more often we hedge, the more hedging transactions
costs we will have. Thus, is it really necessary to hedge transaction
exposure every day? In order to get the answer to the question,
one would need to measure and compare hedging transactions
costs spent with the possible transactions cost if it were hedged
just once a week or once a month, and the gain from the avoided
transactions costs on the opposite way exchange rate transactions.
Especially in cases where a lot of opposite way transactions take
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The pricing strategy the company uses is currency clauses,

according to which, in the majority of cases, contractual parties
sharing the exchange rate changes risk. No quantity affect strategy
takes place. Lets take the companys most common business
transaction and try to fit it into the transaction life span as it was
described in the figure no.1. EH finds the supplier, which is willing
to sell the product for the lower price and the final buyer willing to
buy the product for the higher price. Usually, EH is provided with
1-3 month deferred payment and is giving 3-9 month deferred
payment to the final buyer. The subsidiary gets the order from the
buyer and the same day has to send it to the internal bank for
hedging. The quotation exposure starts. Due to the same reasons
described in the SKF case, at that moment exchange rate exposure
or transaction risk starts. EH, as SKF, is not measuring or
managing that risk. If all the parties are satisfied with the business
transaction conditions, the final buyer places an order with EH
and the Backlog exposure starts. Starting from this moment, cash
flow, interest rate and credit risk exposure starts. At this point, we
should mention one significant difference between SKF and EH;
EHs both cash outflows for imported production as well as cash
inflows for the exported production are exchange rate exposed.
This means that if the exchange rate changes unfavourably and
the company will get less for the production sold, the amount
EH has to pay for the supplier should decrease as well, if the time
lag between the moments when productions was bought and
sold is small and the currency is the same. Thereby, in the described
case, EH is naturally hedged. Although if time lag is big (6-9
months) and the currencies EH buying and selling the production
are different then if the exchange rate change appears the cash
inflow might be smaller and the outflow bigger than expected.
Therefore the expected profit might be squeezed to unexpected
loss. At the same time, in SKF only cash inflows for production
are exposed, because the bigger part of raw material (steel) the
company produces by themselves. As we see, EH has to be more
attentive and careful with exchange rate risk, since it is exposed to
the higher exchange rate risk. EH starts to measure transaction
exposure starting from the Time 2 basing on the historical
performance. EH is exposed to interest rate risk in the same way
as it was described in SKF, therefore, we are not going to describe
it. In summary, we could say that EH starts to measure and manage
their exchange rate exposure form Time 2 to Time 4 though is not
measuring or managing for Time 1.
exposure since it deals with business transactions, the most

fundamental issue in the profit seeking companies activity.
After the analysis of the chosen companies we can conclude that
there are no general rules for setting the hedging period. Each
companys specific characteristics dictate the hedging period
requirements.
Two big Swedish multinational companies with large open
currency positions were chosen in order to fulfill the second part
of the purpose. First we overviewed the main characteristics of
the companies exchange rate risk management systems in order to
be able to apply the theoretical transaction life span on the specific
company business transaction.
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Risk sharing, billing currency, VAT

Since the risk sharing EH does in the right way we could
suggest and the billing currency question does not exist for EH
at all, we just will make a summary comparison of the later
issues between the companies.The biggest part of the EH
contracts are short or medium term for comparatively small
amounts and the opposite is at SKF. Production prices in such
kind of contracts in EH are floating depending on the changes
in the market, while SKF uses mostly fixed prices. EH is widely
using currency clauses while SKF is not. Therefore, to our point
of view, EH is exploring available pricing strategy, while SKF is
not so active in this sphere. Although we should keep in mind
that due to the specificity of the SKFs industry, the company
has small pricing setting capability, meaning, that there are small
chances that the buyers would accept currency clauses or
especially floating prices. Since EF is the middleman and does
not have any manufacturing the billing currency question is not
so important, while in SKF that is one more thing to be
improved. The last issue worth to be mentioned is VAT. To
our knowledge, only EH is using VAT exchange rate deals
limits, which we found an appropriate exchange rate deal for
one-day control tool.
Transactions exposure covers the biggest part of the companys
One was SKF, belonging to the ball bearing manufacturing

industry, while the other was Elof Hansson (EH), representing
the trading sector. Differences between the companies result in
different levels of exchange rate risk and, thus, differences in
exchange rate management strategies. The industries that the
companies belong to predetermine the following differences:
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place, hedging frequency decreasing might be an important issue

to think about.
Hedging frequency related to different industries
Observation: Elof Hanson as a trading company is taking the

role of the middleman, both buying and selling at the same time.
That will consequently incur double exposure in terms of import,
as well as export exposures, while at SKF, most of the raw materials
are produced by the company themselves and, therefore, most
exposure happens in the export section.
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Suggestion: For Elof Hanson, it IS more important to control

the exposure, since they are exposed from both sides. The company
needs more intensive and careful management of the exchange
rate risk. Elof Hansson measures the exposure daily,
demonstrating that they are paying a great deal of attention to the
exchange rate exposure. While, on the other hand, most of the
merchandise the company is buying and selling at the same time.
As we know, if the company is buying and selling in the same
currency and at the same time, then it might appear in the situation
of natural hedging. In that case, the frequency of hedging should
decrease, since we know that the hedging is not costless.
Conclusion
In the final part of our work we would like to make a short
summary of the main issues we have analyzed and the results
we have achieved. In order to fulfill the first part of our
purpose we overviewed the existing classifications and
terminologies of financial risk and its consisting parts,
emphasizing the one we found most useful, i.e. transaction
exposure life span. We think that transactions exposure is the
most important one for the companies due to the following
reasons:
Transaction exposure observes the whole life span of the
companies business transactions from pricing quotation to

the final settlement.
96
In SKF the biggest part of the bearings are produced from the
self-made Swedish steel. Thereby, it is exchange rate exposed

only from the sales, but not costs side, while EH is exposed
from both sides;
About 50% of SKFs contracts are long term with long standing
customers, while this is the opposite for EH;
SKF, in comparison with EH, has small price setting capability.
Nevertheless the companies have some significant similarities

concerning exchange rate exposure management:
Both companies financial risk management policy defines
exchange rate risk exposure as the main; managing the exchange
rate exposure main focus is made on the transaction exposure
management;
In both companies, exchange rate risk exposure management
is centralized in the headquarters treasury department, so called

internal bank, where all the currency exchange operations take
place. Subsidiaries deal only with their local currency and dont
have any currency risk;
The companies use exposed amounts netting strategy and not
record their hedging transactions costs.
Forward contract is both companies main hedging instrument;
However, there are more differences than similarities between the

companies exchange rate management systems such as:
SKFs exchange rate exposure hedges every three months, while
EH does it every day

SKF does not have any limits for the exchange rate deals, while
EH has 2,5 % per day value at risk (VAT) requirement;

SKF, signing long-term big contracts, does not use any kind of
pricing strategy elements, while EH uses currency clauses and

floating prices strategies.
The companies real transactions exposure management strategies
are compared with the theoretical framework. According to the
theory, both companies start to hedge their transactions later than
the origin of the transaction risk. In theory, transaction risk appears
when the seller quotes price for the buyer (Time 1) while SKF
11D.571.3
A short summary of the companies above described financial risk

management characteristics is given in the following table (table
no. 7).
EH hedges transaction exposure every day using the netting

strategy. Too high hedging frequency might result in a loss of
netting system advantage. Therefore, we think that EH should
consider the hedging period revision, especially if one day oneway foreign exchange deals are requited and the second day the
backwards streams are coming. One more important thing to
mention is the one-day currency exchange deals limit in order to
avoid the big fluctuation in firms cash outflow and inflow. In
EHs value at risk (VAT) one day limit, we have a very good
example of how a firms speculative currency position might be
controlled. On the other hand, it will raise other question as to
how to set such a limit, which might be an interesting question
for further research in this field.
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Table No.7 Summary of companies financial risk management
The hedging period, especially for SKF, has one more aspect. The
company is hedging every three-months. So, at the end on the
hedged period they are faced with the big risk of being exposed to
exchange rate changes, if any. Therefore, the conclusion and
suggestion at the same time is that, in the case of SKF, they
would have less risk if they were to hedge every month.
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At this stage, the first important step for the firm is to confirm
the starting moment of the hedging strategy, based on the
firms operating characteristics. Since SKF has a big percentage
of long-term contracted relationship, it becomes very important
to set a certain hedging percentage in the quotation period and
use 100 percent hedging after the contract signing. Otherwise,
they are exposed to exchange rate risk during these periods.
Since EH has small percentage of fixed long term contracted
relationships, the hedging after the contract (order) has been
confirmed is the most important one. The possibility to
forecast future cash flows before that moment is very small.
Thats why the hedging before the contract is placed might
turned out to be more costly then useful, although in theory
the company is incurring risk from Time 1 to Time 2. So in this
sense, different firms might have different most fitting starting
moment of hedging depending on this net of specific features.
Last conclusion is about the pricing strategy. Even if it is difficult

for the firm (SKF) to implement pricing strategy elements, from
the theoretical point of view, it is a useful tool to decrease
transaction exposure. Such pricing strategys elements as risk sharing
or floating price clauses might be very useful when the firms
planning to enter a new market in developing countries, where the
risk is very high. Therefore, at least a trial to implement mentioned
pricing strategy tools might end up with a significant exchange
rate risk decrease. Finally, we would like to point out the main
knowledge we gained from this work is that there is no general
transaction exposure management rule that could be applicable to
all the companies. Every company has its own specific characteristic,
which depends on a lot of different macroeconomic factors.
The comparison of the companies transaction management
strategies provides the companies with the exceptional opportunity
to get a clear and detailed picture of the other companys transaction
management strategy. Such information is usually not publicly
announced; therefore, the companies have an excellent chance to
learn from each other.
Notes:
One more important conclusion we made is about natural hedging

possibilities. EH can reach a natural hedge of transaction exposure,
as a middleman if it buys and sells in the same currency at the
same time, while SKF can reach it through the operations
diversification among foreign subsidiaries.
The third important conclusion concerns the hedging period and

the transaction cost balancing. Neither SKF nor EH recognized
the importance of transaction cost recording. Since the longer the
hedging period, the less transaction cost will incur; while on the
other hand, there will appear a bigger possibility of the firms cash
flows fluctuation, which, as a consequence, will effect the firms
future value. So, it is very important to keep a record of transaction
costs, because that gives the possibility to compare different periods
hedging transactions costs in order to find the breakeven point
for the most fitful hedging period.
11D.571.3
97
starts to hedge when the seller ships products and bills the buyer
(Time 3) and EHs starting point is when the buyer places a contract
(order) with the seller (Time 2).
Underlying stock or index price

Exercise price of the option
Expiry date of the option
Expected dividends (in cents for a stock, or as a yield for an
index) to be paid over the life of the option

Expected risk free interest rate over the life of the option
Expected volatility of the underlying stock or index over the
life of the option
When the formula is applied to these variables, the resulting figure

is called the theoretical fair value of the option.
PRICING MODELS USED BY THE MARKET
There are two main models used in the market for pricing
equity options:
the Binomial model and the Black Scholes model.
THE BINOMIAL OPTION-PRICING MODEL
Introduction
For calls at expiration, we already know the answer: C* = max [0,

S* - K]; and similarly for puts, P* = max [0, K - S*]. The
unanswered question is what formula to use prior to expiration.
Simple arbitrage arguments tell us at least that, prior to expiration,
an American call value C must be less than the asset price S, but
more than the calls current exercisable value max [0, S - K] and
also more than its present value max [0, Sd -t - Kr-t] when volatility
is zero. In summary,
S C max [0, S - K, Sd -t - Kr-t]
For example, if S = K = 100, r = 1.08, d = 1.03, and t = 1, this

places only very loose bounds on the call value, 100 C 4.49.
Similarly, for an American put:
Thus far, we have only been able to place a lower and upper
bound around the value of an option prior to its expiration. To
produce an exact formula, we will need to make specific
assumptions about the way the underlying asset price and
riskless return evolve over time.
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We begin by making the simplest possible, but still interesting,

assumption governing this uncertainty: the option expires after a
single period (of known but arbitrary duration) in which the
underlying asset price moves either up to a single level or down to
a single level. In addition to being able to invest in a European
option, we can also invest in its underlying asset and cash. This
approach, when generalized to accommodate many periods is
known as the standard binomial option-pricing model.
We assume that there are no riskless arbitrage opportunities, first

between the underlying asset and cash; and second between the
option and the underlying asset. In that case, the prices of these
three securities must be set as if their payoffs were discounted
back to the present using the same two state-contingent prices.
Expressed mathematically, we have three equations (one for the
asset, one for cash, and one for the option) in two unknowns. As
a result, we can solve the first two equations for the two statecontingent prices. Finally, knowing these state-contingent prices
and using the third equation, we can write down a formula for the
current option value as a function of its current underlying asset
price and the riskless return.
Option Pricing Formula
The option-pricing problem we now address is to find an exact
formula or method, which transforms the current underlying
asset price S and the current time-to-expiration t into a standard
options current value. Among the six fundamental
98
determinants of option values asset price, strike price (K),

time-to-expiration, riskless return (r), volatility (s), and payout
return (d) these two are singled out because they must
necessarily change as the expiration date approaches. In brief,
we search for a function f of S and t, where the other
determinants enter as fixed parameters, which equal the
concurrent option value C or P.
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An option-pricing model is a mathematical formula or model

into which you insert the following parameters:
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LESSON 19:
OPTION PRICING MODELS
K P max [0, K - S, Kr-t - Sd -t]
For European calls and puts, while the lower bounds must be
loosened, the upper bounds can be tightened:
Sd -t C max [0, Sd -t - Kr-t]
Kr-t P max [0, Kr-t - Sd -t]
Single Period Model

Black and Scholes used a replicating portfolio argument to
derive their option pricing formula. To mimic that argument
with a binomial model, we form a portfolio consisting of delta
units of the underlying asset and an investment in cash, such
that the portfolio has payoffs equal to the value of the option
in each of the two possible states at the end of the period. In
this analysis, we also account for payouts, allowing for the
option not to be payout-protected. If there are no riskless
arbitrage opportunities, the current cost of constructing the
replicating portfolio must equal the cost of the option. This
leads to a simple single-period formula for the current value of
the option indeed, the very same formula that was derived
earlier via state-contingent prices.
This satisfies our goal of finding an exact option pricing formula
prior to expiration under conditions of uncertainty. Despite its
simplicity, it reveals many of the economic ideas that lie behind
modern option pricing theory. First, the current value of the
option is given by a formula that depends on the concurrent
underlying asset price, the strike price, the volatility (as proxied
for by the sizes of the up and down moves of the underlying
asset), the riskless return and the payout return. Second, investors
are assumed only to act in the market to eliminate riskless arbitrage
opportunities. They need not be risk-averse or even rational.
11D.571.3
Binomial Formula Interpretation

C = [p Cu + (1 - p) Cd ] / r
Where, p = [{(r / d) d} / (u - d)]

Assumptions:
1. Exact formula for the value of an option prior to expiration.

2. Option value depends only on S, K, u, d, r and d.
3. Option value depend only on one random variable: underlying

asset price.
4. Investor motivation: eliminate arbitrage opportunities, neither

rationality nor risk aversion required.
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Several comments are in order. It was easy to write down the

formula for the value of a call at expiration (max [0, S* - K]); now
we have the formula for the value of a call prior to expiration in
terms of its possible values C u and Cd one period later. If this were
exactly one period before expiration, this formula clearly depends
only on S, K, u, d, r and d (S and K through payoffs Cu = max [0,
uS - K] and Cd = max[0, dS - K]). Interpreting the spread between
u and d as a proxy for asset volatility, these variables, along with the
time-to-expiration, are the fundamental determinants of option
prices.
In any model in the social sciences, it is prudent to ask what is

being assumed about human behavior and psychology. In this
case, we only assume that investors price securities so that there are no
riskless arbitrage opportunities. This arose in our derivation when we
assumed that the riskless return was bracketed by the total return
of the underlying asset and when we assumed that the current
cost of the option and its replicating portfolio must be the same.
Interestingly, we have not assumed (as is common in many models
of pricing in financial economics) that investors are risk-averse, or
indeed that they are even rational in the economists sense of
making transitive choices (if an investor prefers A to B and B to C,
then he prefers A to C).
Multi Period Model
The principal defect of the single-period binomial optionpricing model is overcome by extending it to many periods by
constructing a recombining binomial tree of asset prices
working forward from the present. One path through the tree
represents a sample drawn from the universe of possible future
histories. Inverting this process and working backward from the
11D.571.3
We then discuss some curious properties of binomial trees based

on the ideas of sample paths and path-independence. It is fortunate
that the binomial option pricing model is based on recombining
trees, otherwise the computational burden would quickly become
overwhelming as the number of moves in the tree is increased.
All sample paths that lead to the same node in the tree have the
same risk-neutral probability. The types of volatility objective,
subjective and realized which in real life are usually different, are
indistinguishable in our recombining binomial tree. Finally, in the
continuous-time limit, as the number of moves in the tree (for a
fixed time-to-expiration) becomes infinite, the sample path,
though itself continuous, has no first derivative at any point.
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The simplicity of the analysis seems to depend on the assumption

of binomial underlying asset price movements. If, instead, the
asset price could move to three possible levels, no replicating
portfolio (involving solely the underlying asset and cash) could
match the future values of the option. However, most of the
force of this objection can be removed, as we shall see, by
generalizing the model to many periods.
We use a series of examples to illustrate this combination of

working forward to construct the binomial tree of asset prices and
then working backward to derive the current option value for
European and American calls and puts, with and without payouts.
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If the option is American, the valuation formula is only slightly

more complex: the option is worth either its current exercisable
value or its holding value, whichever is greater.
end of the tree, being careful at each node, for American

options, to consider the possibility of early exercise, then
calculate the current option value. For a European option, using
the risk-neutral valuation principle, a shortcut is available. We
simply calculate its discounted risk-neutral expected expirationdate payoff. With a little algebra, we can derive a single-line
formula for the current value of a European option even
though it expires an arbitrarily large number of periods later.
We showed earlier that the term structure of spot and forward

returns could be inferred from the concurrent prices of otherwise
identical bonds of different maturities. In a similar manner, the
inverse problem for binomial trees can also be solved; that is, we
can infer a binomial tree from the concurrent prices of otherwise
identical European options with different strike prices. This is
called an implied binomial tree.
Volatility in Binomial Trees
In most economic situations involving a random variable, there
are three types of volatility:
1. The objective population volatility: the true volatility of
the random variable true in the sense that if history could be
rerun many times, on average the realized volatility of the
random variable would tend to converge to this volatility.
2. The subjective population volatility: the volatility believed
by the relevant agents to govern the random variable that is,
their best guess about the objective population volatility.
3. The realized sample volatility: the historically measured
volatility of the realized outcomes of the random variable along
its realized sample path.
In the standard binomial option pricing model, these three are
identical. It is assumed that all investors believe in the same
binomial tree. That is, they all believe that the underlying asset
price follows a binomial movement. They all believe that the
resulting tree is recombining, so that an up followed by a down
move leads to the same outcome as a down move followed by an
up move. And they have the same estimate of the possible up
and down moves at every point in the tree. Indeed, were this not
the case, then two investors would value an option differently, so
that whatever the market price of the option, at least one of them
would believe there were a riskless arbitrage opportunity. Since we
99
Significantly, the formula says the option should be priced by

discounting its risk-neutral expected value at the end of the
period, where the discount rate is the riskless return, and where
the risk-neutral probabilities have a simple well-defined form,
determined solely by the riskless return, payout return, and the
up and down move sizes.
[(log u)2 + (log d)2 + (log u)2 + (log u)2 + (log d)2]/5 = (log u)2
The sample variance of the second path is:
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[(log d)2 + (log d)2 + (log d)2 + (log u)2 + (log u)2]/5 = (log u)2
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This is an extraordinary situation. In real life, realized history can

be interpreted as a sample from a population of possible histories.
It would be strange indeed if each sample were guaranteed to
have the same volatility computed from its time-series of events.
Hedging
We can use binomial trees not only to value options, but also to
determine the sensitivity of these values to key determining
variables: underlying asset price, time-to-expiration, volatility,
riskless return and payout return.
Assumptions of the Black and Scholes Model:
Delta is the sensitivity of current option value to its current

underlying asset price. It is easily calculated from a binomial tree.
While working backward, stop one move before reaching the
beginning of the tree and collect the two nodal values. The delta is
their difference divided by the corresponding difference in
underlying asset prices including payouts.
The stock pays no dividends during the options life: Most

companies pay dividends to their shareholders, so this might
seem a serious limitation to the model considering the observation
that higher dividend yields elicit lower call premiums. A common
way of adjusting the model for this situation is to subtract the
discounted value of a future dividend from the stock price.
Gamma measures the rate at which the delta changes as the

underlying asset price changes. This is also easily calculated from a
binomial tree, but by stopping two periods before the beginning.
It indicates at which points during the life of an option replication
will be particularly difficult in practice.
European exercise terms are used: European exercise terms dictate

that the option can only be exercised on the expiration date.
American exercise term allow the option to be exercised at any
time during the life of the option, making American options
more valuable due to their greater flexibility. This limitation is not
a major concern because very few calls are ever exercised before the
last few days of their life. This is true because when you exercise a
call early, you forfeit the remaining time value on the call and
collect the intrinsic value. Towards the end of the life of a call, the
remaining time value is very small, but the intrinsic value is the
same.
Theta measures the sensitivity of the current option value to a

reduction in time-to-expiration. Again, it is also easily calculated
from a binomial tree by comparing two adjacent option values
computed when the underlying asset price is the same. Vega, rho
and lambda measure the sensitivity of current option value to
changes in volatility, the riskless return and the payout return,
respectively. To calculate these, two current option values are
compared from two otherwise identical binomial trees, except
that they are based on slightly different volatilities, riskless or
payout returns.
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rule this out, in effect, we are assuming that volatilities (1) and (2)
are the same.
Moreover, investors all think the next up and down moves at
every node in the tree will be the same everywhere in the tree,
and that u = 1/d. Thus log u = - log d, so that (log u)2 = (log
d)2. This means that along any path in the tree the sampled
(logarithmic) volatility around a zero mean will be the same. For
example, consider two paths in a five move tree: u, d, d, u, d and
d, d, u, u, u. The sample variance of the first path is:
Similar to bond duration, fugit measures the risk-neutral expected

life of an option, accounting for reduction in its life from early
exercise. This too can be calculated by working backward in the
binomial tree.
THE BLACK SCHOLES MODEL
The Black and Scholes Option Pricing Model involved
calculating a derivative to measure how the discount rate of a
warrant varies with time and stock price.
Markets are efficient: This assumption suggests that people cannot

consistently predict the direction of the market or an individual
stock. The market operates continuously with share prices following
a continuous It process. To understand what a continuous It
process is, you must first know that a Markov process is one
where the observation in time period t depends only on the
preceding observation. An It process is simply a Markov process
in continuous time. If you were to draw a continuous process
you would do so without picking the pen up from the piece of
paper.
No commissions are charged: Usually market participants do have
to pay a commission to buy or sell options. Even floor traders pay
some kind of fee, but it is usually very small. The fees that
Individual investors pay is more substantial and can often distort
the output of the model.
Interest rates remain constant and known: The Black and Scholes
model uses the risk-free rate to represent this constant and known
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11D.571.3
Returns are log normally distributed: This assumption suggests,

returns on the underlying stock are normally distributed, which is
reasonable for most assets that offer options.
Greeks
Gamma
Gamma is a measure of the calculated deltas sensitivity to small

changes in share price.
Theta
The following 5 graphs show the impact of diminishing time

remaining on a call with:
S = $48
E = $50
r = 6%
sigma = 40%
Graph # 1, t = 3 months
Graph # 2, t = 2 months
Graph # 3, t = 1 month
Graph # 4, t = .5 months
Graph # 5, t = .25 months
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Delta is a measure of the sensitivity the calculated option value

has to small changes in the share price.
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Delta
Graph #1
Theta measures the calculated option values sensitivity to small

changes in time till maturity.
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Vega
Vega measures the calculated option values sensitivity to small

changes in volatility.
Rho
Graph #2
Relationship between Call Premium & Underlying

Stocks Prices
These following graphs show the relationship between a calls
premium and the underlying stocks price.
The first graph identifies the Intrinsic Value, Speculative Value,
Maximum Value, and the Actual premium for a call.
11D.571.3
101
rate. In reality there is no such thing as the risk-free rate, but the
discount rate on U.S. Government Treasury Bills with 30 days left
until maturity is usually used to represent it. During periods of
rapidly changing interest rates, these 30-day rates are often subject
to change, thereby violating one of the assumptions of the model.
Graph #6
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Graph #3
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Graph #4
Graph #7
Graph #5
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Graph #8
Graphs # 6 - 9, show the effects of a changing Sigma on the

relationship between Call premium and Security Price.
S = $48, E = $50, r = 6%, sigma = 40%
Graph # 6, sigma = 80%,
Graph # 7, sigma = 40%
Graph # 8, sigma = 20%,
Graph # 9, sigma = 10%
102
11D.571.3
Although the fair value may be close to where the market is

trading, other pricing factors in the marketplace mean fair value
is used mostly as an estimate of the options value.
Moreover, fair value will depend on the assumptions regarding
volatility levels, dividend payments and so on that are made by
the person using the pricing model. Different expectations of
volatility or dividends will alter the fair value result. This means
that at any one time there may be many views held
simultaneously on what the fair value of a particular option is.
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In practice, supply and demand will often dictate at what level an

option is priced in the marketplace. Traders may calculate fair value
on a option to get an indication of whether the current market
price is higher or lower than fair value, as part of the process of
making a judgement about the market value of the option.
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Volatility
The volatility figure input into an option-pricing model reflects
the assumptions of the person using the pricing model.
Volatility is defined technically in various ways, depending on
assumptions made about the underlying assets price
distribution. For the regular option trader it is sufficient to
know that the volatility a trader assigns to a stock reflects
expectations of how the stock price will fluctuate over a given
period of time.
Hedging
Delta measures the sensitivity of an option value, ceteris
paribus, to a small change in its underlying asset price. So it
makes sense to calculate the delta by taking the first partial
derivative of the option value, as expressed by the Black-Scholes
formula, with respect to the underlying asset price. Other
hedging parameters including gamma and vega, can also be
derived from the Black-Scholes formula by taking the
appropriate partial derivatives.
We can also use the Black-Scholes formula to measure the local

risk of an option as measured by its own volatility or its beta. To
do this, we apply the simple result that the local option volatility
or beta equals the volatility or beta of its underlying asset scaled by
the option omega.
For some purposes, we may also want to measure global
properties of an option that apply on average over its remaining
life. As an example, we show that the expected return of an option
over all or some portion of its life can be easily calculated by
reinterpreting the Black-Scholes formula.
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Commonly, several different options but with the same

underlying asset are simultaneously held in a portfolio. The
delta of such a portfolio measures the amount by which its value
changes for a small increase in the underlying asset price.
Fortunately, having calculated the deltas of the individual options
in the portfolio, the delta of the portfolio as a whole is calculated
from a simple weighted average of the constituent option deltas.
A similar additivity property also applies to gamma.
Volatility is usually expressed in two ways: historical and implied.

Historical volatility describes volatility observed in a stock over
a given period of time. Price movements in the stock (or underlying
asset) are recorded at fixed time intervals (for example every day,
every week, or every month) over a given period. More data generally
leads to more accuracy. Be aware that a stocks past volatility may
not necessarily be reproduced in the future. Caution should be
used in basing estimates of future volatility on historical volatility.
In estimating future volatility, a frequently used compromise is to
assume that volatility over a coming period of time will be the
same as measured/historical volatility for that period of time just
finished. Thus if you want to price a three month option, you
may use three month historical volatility.
Implied volatility relates to the current market for an option.
Volatility is implied from the options current price, using a standard
option-pricing model. Keeping all other inputs constant, you can
put the current market price of an option into any theoretical
option price calculator and it will calculate the volatility implied by
that option price.
Notes:
One application of portfolio deltas is to the construction of option

portfolios, which are almost insensitive to movements in its
underlying asset price. Such delta-neutral portfolios are useful for
option market makers, who must take positions in options but
do not want to risk losses because of unfavorable asset price
changes. Investors who believe they can identify options which
are mispriced relative to each other but who have no opinion
about the direction of changes in the underlying asset price also
use them.
The relationship between fair value and market
price
11D.571.3
103
Graph #9
This is the cost involved in holding a physical quantity of the

commodity. For wheat the cost of carry is a storage cost, for live
hogs it consists of storage and feed costs, and for gold it consists
of storage and security costs. Some commodities have a negative
cost of carry. For example, holding a stock index provides the
benefit of receiving dividends. In forward markets it is common
to express the cost of carry as a continuously compounded annual
rate, payable at inception. For example, if the cost of carry for
wheat is reported to be 5%, this would mean that the cost of
storing $100 of wheat for six months is
$100 (e0.05(0.5)-1) = $2.53, payable immediately.
This module focuses on the mechanics of forward and futures

contracts. There is a particular emphasis on the interrelationship
between the various contracts and the spot price of the underlying
asset. The spot price is the price of an asset where the sale transaction
and settlement is to occur immediately.
We use the following notation, which is common in forward

markets:
Forward Contracts
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Introduction
Despite the recent adverse press they have received, derivative
securities provide a number of useful functions in the areas of
risk management and investments. In fact, derivatives were
originally designed to enable market participants to eliminate
risk. A wheat farmer, for example, can fix a price for his crop
even before it is planted, eliminating price risk. An exporter can
fix a foreign exchange rate even before beginning to
manufacture the product, eliminating foreign exchange risk. If
misused, however, derivative securities are also capable of
dramatically increasing risk.
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LESSON 20:
HEDGING WITH FORWARD / FUTURE CONTRACTS
The Mechanics of Forward Contracts
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A Forward Contract is a contract made today for delivery of an

asset at a prespecified time in the future at a price agreed upon
today. The buyer of a forward contract agrees to take delivery of an
underlying asset at a future time, T, at a price agreed upon today.
No money changes hands until time T. The seller agrees to deliver
the underlying asset at a future time, T, at a price agreed upon
today. Again, no money changes hands until time T.
A forward contract, therefore, simply amounts to setting a price
today for a trade that will occur in the future. Example 4.4
illustrates the mechanics of a forward contract. Since forward
contracts are traded over-the-counter rather than on exchanges,
the example illustrates a contract between a user and a producer
of the underlying commodity.
St The spot price of the underlying commodity at time t

S0 the spot price now, which is known.
ST The spot price at maturity of the contract and is not known

when the contract is entered into.
r The riskless rate of interest from now until maturity of the
contract,
q The cost of carry of the underlying commodity
F The forward price for delivery at time T.
Both r and q are expressed as continuously compounded annual

rates. Consider the strategy of:
Borrowing enough money to buy one unit of a commodity
and to pay for the associated carrying costs through time T,

and
Entering into a forward contract to sell the commodity at time
T. The value of this position in terms of the initial (time 0)

and terminal (time T) cash flows is tabulated in the following
table.
Example: Forward contract mechanics.

A wheat farmer has just planted a crop that is expected to yield
5000 bushels. To eliminate the risk of a decline in the price of
wheat before the harvest, the farmer can sell the 5000 bushels
of wheat forward. A miller may be willing to take the other side
of the contract. The two parties agree today on a forward price
of 550 cents per bushel, for delivery five months from now
when the crop is harvested. No money changes hands now. In
five months, the farmer delivers the 5000 bushels to the miller
in exchange for $27,500. Note that this price is fixed and does
not depend upon the spot price of wheat at the time of
delivery and payment.
Arbitrage relationship between spot and forward

contracts
Valuation of Forward Contracts
F = S0 e(q+r)T
Forward contracts can be valued by recognizing that, in many

cases, forward markets are redundant. This occurs when the payoff
from a forward contract can be replicated by a position in (1) the
underlying asset and (2) riskless bonds. Before illustrating this
concept, we define the cost of carry of the underlying commodity.
104
Position
Initial Cash Flo w Terminal Cash Flow
Buy one unit of commodity
-S 0
ST
Pay Cost of Carry
-S0 (eqT - 1 )
Borrow
S 0 eqT
-S0 e(q+r)T
Enter 6-month forward sale
F - ST
Net Portfolio Value
F - S 0 e (q+r)T
Since this portfolio requires no initial cash outlay, the absence of

arbitrage opportunities will ensure that the terminal payoff is
also zero. Therefore, the futures contract can be valued as
The following example shows how arbitrage is possible if this
pricing relation is violated.
Example: Forward arbitrage.
Suppose the spot price of wheat is 550 cents per bushel, the sixmonth forward price is 600, the riskless rate of interest is 5% p.a.,
11D.571.3
Initial Cash Flow
Buy one unit of commodity -550

Pay
Cost
of
Carry -550
Borrow
550
Enter 6-month forward sale
0
Net Portfolio Value
(e0.06x0.5
Terminal Cash Flow

ST
1) 0
e0.06x0.5 -550
600 - ST
e(0.06+0.05)T
600-550 e(0.06+0.05)0.5 = 18.90
That is, it is possible to lock in a sure profit that requires no initial

cash outlay.
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Hedging With Forward Contracts

The primary motivation for the use of forward contracts is risk
management. The wheat farmer in above example was able to
eliminate price risk by selling his crop forward. Example
contains a more comprehensive example concerning foreign
exchange risk management.
Above Example illustrates the marking to market mechanics of

the All Ordinaries Share Price Index (SPI) futures contract on the
Sydney Futures Exchange. The SPI contract is similar to the Chicago
Mercantile Exchange (CME) S&P 500 contract and the London
International Financial Futures Exchange (LIFFE) FTSE 100
contract. The mechanics are the same for all of these contracts.
Stock index futures were introduced in Australia in 1983 in the
form of Share Price Index (SPI) futures which are based on the
Australian Stock Exchanges (ASX) All Ordinaries Index which is
the benchmark indicator of the Australian stock market. Users of
SPI futures include major international and Australian banks,
fund managers and other large investment institutions. SFE locals
and private investors are also active participants in the market.
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Position
A futures contract is similar to a forward contract except for two

important differences. First, intermediate gains or losses are posted
each day during the life of the futures contract. This feature is
known as marking to market. The intermediate gains or losses
are given by the difference between todays futures price and
yesterdays futures price. Second, futures contracts are traded on
organized exchanges with standardized terms whereas forward
contracts are traded over-the-counter (customized one-off
transactions between a buyer and a seller).
Example: Forward contacts and risk management.

XYZ is a multinational corporation based in the US. Its
manufacturing facilities are located in Pittsburgh and hence its
labor and manufacturing costs are incurred in US dollars (USD).
A large fraction of its sales, however, are made to German
customers who pay for the goods in Deutschemarks (GDM).
There is a six-month lead-time between the placement of a

customer order and delivery of the product. XYZs cost of
production is 80% of the sale price. Suppose XYZ receives a
$1MM GDM order and that the current USD/GDM exchange
rate is 0.60 (i.e. 1 GDM = 0.60 USD). The cost of production of
this order is $480,000 (0.60 x $1MM x 0.80). The exchange rate six
months from now is, of course, uncertain in which case XYZ is
exposed to exchange rate risk.
If the exchange rate stays at 0.60, then XYZ will convert the 1MM
GDM to $600,000 and earn a 25% profit on the $480,000 cost of
production. If, however, the exchange rate falls to 0.40 six months
from now, XYZ will convert the 1MM GDM to only $400,000,
registering a loss on the sale.
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Conversely, if the exchange rate rises to 0.80 six months from

now, XYZ will convert the 1MM GDM to $800,000, registering a
very large profit on the sale. Whereas XYZ are very good at
manufacturing and marketing their product, they have no expertise
in forecasting exchange rate movements. Therefore, they want to
avoid the exchange rate risk inherent in this transaction (i.e., the
risk that they do everything right and then lose money on the sale,
solely because exchange rates move against them). They can do
this by selling forward 1MM GDM. This involves entering a
contract today with, say, an investment bank under which XYZ
agrees to deliver 1MM GDM six months from now in exchange
for a fixed number of US dollars. This rate of exchange is the sixmonth forward rate. Suppose the six-month forward rate is 0.62
(which is set according to market expectations and relative interest
rates as described below). Then, when XYZ receives 1m GDM
from its customer, they deliver it to the investment bank in exchange
for $620,000 (locking in a profit) regardless of whether the
exchange rate happens to be 0.40 or 0.80 at that time.
Futures Contracts
The Mechanics of Futures Contracts
11D.571.3
SPI futures have an underlying of A$25 x Index (i.e., a SPI futures

contract with a price of 2000.00 will have a contract value of
A$50,000). The All Ordinaries Share Price Index (AOI) is a
capitalization weighted index and is calculated using the market
prices of approximately 318 of the largest companies listed on the
Australian Stock Exchange (ASX). The aggregate market value of
these companies totals over 95% of the value of the 1,186
domestic stocks listed.
Example: Marking to market.
Suppose an Australian futures speculator buys one SPI futures
contract on the Sydney Futures Exchange (SFE) at 11:00am
on June 6. At that time, the futures price is 2300. At the close
of trading on June 6, the futures price has fallen to 2290 (what
causes futures prices to move is discussed below).
Underlying one futures contract is $25 x Index, so the buyers
position has changed by $25(2290-2300)=-$250. Since the buyer
has bought the futures contract and the price has gone down, he
has lost money on the day and his broker will immediately take
$250 out of his account. This immediate reflection of the gain or
loss is known as marking to market.
Where does the $250 go? On the opposite side of the buyers buy
order, there was a seller, who has made a gain of $250 (note that
futures trading is a zero-sum game - whatever one party loses, the
counter party gains). The $250 is credited to the sellers account.
Suppose that at the close of trading the following day, the futures
price is 2310. Since the buyer has bought the futures and the price
has gone up, he makes money. In particular, $25(23102290)=+$500 is credited to his account. This money, of course,
comes from the sellers account.
This concept of marking to market is standard across all major
futures contracts. Contracts are marked to market at the close of
trading each day until the contract expires. At expiration, there are
two different mechanisms for settlement. Most financial futures
(such as stock index, foreign exchange, and interest rate futures)
105
and the cost of carry is 6% p.a. To execute an arbitrage, you borrow

money, buy a bushel of wheat, pay to store it, and sell it forward.
The cash flows are:
Margin
Although futures contracts require no initial investment, futures
exchanges require both the buyer and seller to post a security
deposit known as margin. Margin is typically set at an amount
that is larger than usual one-day moves in the futures price. This
is done to ensure that both parties will have sufficient funds
available to mark to market. Residual credit risk exists only to
the extent that (1) futures prices move so dramatically that the
amount required to mark to market is larger than the balance of
an individuals margin account, and (2) the individual defaults
on payment of the balance. In this case, the exchange bears the
loss so that participants in futures markets bear essentially zero
credit risk. Margin rules are stated in terms of initial margin
(which must be posted when entering the contract) and
maintenance margin (which is the minimum acceptable
balance in the margin account). If the balance of the account
falls below the maintenance level, the exchange makes a margin
call upon the individual, who must then restore the account to
the level of initial margin before the start of trading the
following day. Below Example illustrates the margining
procedure.
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An alternative to cash settlement is physical delivery. Consider the

SFE wool futures contract, which requires delivery of 2500 kg of
wool when the contract matures. Of course, there are different
grades of wool, so a set of rules governing deliverable quality is
required. These are detailed rules that govern the standard quality
of the underlying commodity and a schedule of discounts and
premiums for delivery of lower and higher quality respectively.
Below Example illustrates the rules governing deliverable quality
for the SFE greasy wool futures contract.
and he has the option to choose what quality he will deliver,

subject to the schedule of discounts and premiums.
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Example: Cash settlement.

Suppose the SPI futures contact price was 2350 at the close of
trading on the day before expiration and 2360 at the close of
trading on the expiration day. Settlement simply involves a
payment of $25(2360-2350) = $250 from the sellers account to
the buyers account. The expiration day is treated just like any
other day in terms of standard marking to market.
Example: Deliverable quality: Greasy wool futures.

Delivery must be made at approved warehouses in the major
wool selling centers throughout Australia. For wool to be
deliverable, it must possess the relevant measurement
certificates issued by the Australian Wool Testing Authority
(AWTA) and appraisal certificates issued by the Australian Wool
Exchange Limited (AWEX). In particular, it must be good top
making merino fleece with average fibre diameter of 21.0
microns, with measured mean staple strength of 35 n / ktx,
mean staple length of 90mm, of good color with less than
1.0% vegetable matter. Because any particular bale of wool is
unlikely to exactly match these specifications, wool within some
prespecified tolerance is deliverable. In particular, 2,400 to 2,600
clean weight kilograms of merino fleece wool, of good top
making style or better, good colour, with average micron
between 19.6 and 22.5 micron, measured staple length between
80mm and 100mm, measured staple strength greater than 30
n/ktx, less than 2.0% vegetable matter is deliverable. Premiums
and discounts for delivery that does not match the exact
specifications of the underlying contract are fixed on the Friday
prior to the last day of trading for all deliverable wools above
and below the standard, quoted in cents per kilogram clean.
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are cash settled, whereas most physical futures (agricultural, metal,

and energy futures) are settled by delivery of the physical
commodity. Below Example illustrates cash settlement.
Below Example illustrates the process of physical delivery for the

SFE greasy wool futures contract. The process is similar for most
commodity futures contracts.
Example: Physical delivery.
Suppose the greasy wool futures contact price was 700 cents at
the close of trading on the expiration day. Settlement involves
physical delivery, from the seller of the futures contract to the
buyer, of the underlying quantity of wool (2,500 kilograms) on
the business day following the expiration day. Delivery,
therefore, involves the seller delivering 2,500 kg of wool to the
buyer, in return for a payment of A$17,500.
The wool must be within the tolerance described above. If the
wool is of better quality than is specified in the contract, a premium
must be paid. Conversely wool of lower quality involves a discount.
It is the seller of the futures who must make delivery of the wool
106
Example: Margin
Suppose a contract requires initial margin of $7,000 and maintenance margin of $5,000. The following table
illustrates the margining procedure and the cash flows required for the buyer of a futures contract.
Value
Time Futures
Contract
of Margin
Margin
Balance before
Call
Calls
Margin
Balance after
Calls
25,000
7,000
7,000
24,000
6,000
6,000
22,000
4,000
3,000
7,000
24,500
7,000
7,000
Note that when the margin balance falls below the maintenance margin, it must be restored to the initial level.
Note also that when the future moves favorably (as at time 3) the marking to market cash inflow can be
immediately withdrawn - it need not remain in the margin account.
Valuation of Futures Contracts

Whereas the valuation of forward contracts is relatively
straightforward, the marking to market feature complicates the
valuation of futures contracts. The cash flows associated with
forward and futures contracts are illustrated in the following
table.
Cash Flows of Forward and Futures Contracts
Time
0 1
... T
Forward Cash Flow
0 0
... S T-FO 0
Futures Cash Flow
0 FU1 -FU 0
FU 2-FU1
... F UT - FUT- 1
For both contracts, no money changes hands at the time the

contract is initiated (time 0). For the forward contract, no money
changes hand until the contract matures (time T). For the futures
contract, money changes hands daily depending upon movements
in the futures price.
In some circumstances, however, a futures contract is perfectly
equivalent to a forward contract in which case the two contracts
must have the same value. Since forward contracts are relatively
easy to value using a no-arbitrage argument, this provides a
convenient way of valuing a futures contract. In particular, if interest
11D.571.3
At time 1 he increases his holding to e contracts. At time 2 the

profit (possibly negative) on this position is e2r(FU2-FU1), which
he invests (or borrows) until maturity. At maturity, this has grown
to er(T-2)e2r(FU2-FU1) = e rT(FU2-FU1). At time 2 he increases his holding
to e3r and so on. At maturity, the total payoff on the futures
position is:
e rT [(FU1 - FU0) + (FU2 - FU1) + ... + (FUT - FUT-1)] = e rT (S T - FU0)
where we note that FUT = S T. The payoff on the bond is FU0 e rT.
Therefore, the overall initial investment required for this strategy
is $FU0 and the overall payoff at time T is S 0erT.
Now consider the strategy of buying erT forward contracts on day
o and investing $FO 0 in a riskless bond (where FO represents the
price of a forward contract). The overall initial investment required
for this strategy is $FO 0 and the overall payoff at time T is:
erT(ST - FO0) + FO0 erT = S0 erT
Since both of these strategies have the same payoff, they must
cost the same. That is FO0 = FU0. The following table illustrates
the cash flows associated with the two strategies.
Forward-Futures Equivalent
Time
Net Cash Flow
r
The interest rate (annual continuously compounded TBill rate)
d
The dividend yield on the index (continuously
compounded annual rate)
T
The time to maturity of the contract
This is the same as equation (1) except that +q has been replaced
by -d as the cost of carry (storing wheat) has been replaced by a
benefit (dividends). To see why this relationship must hold,
consider the strategy of (1) borrowing e-dTS0 through time T, (2)
using this to purchase e-dT units of the index and reinvesting all
dividends back into the index, and (3) selling a futures contract
that matures at time T. If interest rates are constant, the futures
contract is equivalent to a forward contract, which simplifies the
analysis. In particular, the (equivalent) cash flows associated with
this strategy are tabulated in the following table. Note that
reinvestment of the dividends has resulted in the initial investment
of e-dT units of the index growing at a rate of d to amount to one
unit by maturity.
Two Examples given below illustrate how to execute a riskless
arbitrage if this equality does not hold.
Arbitrage Relationship Between Spot and Futures Contract
Position
Time 0
Time T
Borrow
e-dTS0
erT e-d TS0
Buy e-dT units of index
-e-dTS0
ST
Sell one Futures Contract
F - ST
Net Position
F - S0e( r- dT)
e2r
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STer T
er
T
Contract erT (ST
FO 0erT
FU 1-FU0
-(FU1-FU0 )
Net Cash Flow
er(t- 1)
FO0) erT(S T
FU 0)
erT[FU0 + (FU 1 - F U0) + ... + (FUT-1 - F UT- 2)]
S TerT
Arbitrage Relationships
For the remainder of this module, we assume that interest rates
are indeed constant over the period of the contract and hence
the futures price equals the forward price. That is, we can
consider the price and payoffs of a futures contract to be
identical to those of a forward contract. This simplifies things
because a forward contract has only a single payoff at maturity.
Consider, for example, the valuation of a futures contract on
the S&P 500 stock index. This contract, which trades on the
Chicago Mercantile Exchange (CME) entitles the buyer to receive
the cash value of the S&P 500 stock index at the end of the
contract period. There are always four contracts in effect at any
one time expiring in March, June, September, and December. In
11D.571.3
The current value of the S&P 500 stock index
-FU 0
er t
FU t-FU t-1
-(FUt-FU t- 1)
Net Cash Flow
The Futures price
S0
-FO 0
Time:
t
Number of Contracts Purchased 0
Cash Flow from Contract 0
Investment in Bonds
0
Time:
Cash Flow from
Payoff from Bonds
Forward Position Futures Position
Time:
1
Number of Contracts Purchased 0
Cash Flow from Contract 0
Investment in Bonds
0
Net Cash Flow
where
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2r
F = S 0 e (r-d)T
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This equivalence can be established by considering a roll-over

strategy whereby at time 0 an investor purchases er futures contracts
and invests FU0 in a riskless bond where FU represents the futures
price). At time 1 the profit (possibly negative) on the futures
position is er(FU1-FU0) , which he invests (or borrows) until
maturity. At maturity, this has grown to er(T-1)er[FU1-FU0)] = e rT(FU1FU0).
contrast to the previous examples that involved a cost of carry,

holding the S&P 500 index yields a benefit, in the form of
dividends received, rather than a cost of carry. The result is that
the value of an S&P 500 futures contract can be expressed as
Once again, since this strategy requires no initial cash outlay, the
cash flow at maturity must also be zero or an arbitrage opportunity
exists. In particular, if F > S 0 e(r-dT) the strategy of buying the index
and selling the futures generates an arbitrage profit. Conversely, if
F < S 0 e(r-dT) the strategy of selling the index and buying the futures
generates an arbitrage profit.
Two Examples given below illustrate how to execute a riskless
arbitrage if this equality does not hold.
Example: Futures arbitrage: Buy index - Sell futures
Suppose the S&P 500 stock index is at $295 and the six-month
futures contract on that index is at $300. If the prevailing T-Bill
rate is 7% and the dividend rate is 5%, an arbitrage opportunity
exists because F=300 > S e(r-d)T = 297.96. The arbitrage can be
executed by buying low and selling high. In this case, the futures
contract is relatively overvalued, so we sell the futures and buy the
index.
In particular, the strategy is to
Borrow e-dTS0 = $287.72 at 7% repayable in 6 months.
107
rates are constant (at a continuously compounded annual rate of

r) over the life of the contract then the prices of the futures contract
and the forward contract are identical.
Position
Time 0
Time T
Borrow
287.72
-297.96
Buy e - dT units of index
-287.72
ST
Sell one futures contract
300 - S T
Net Position
2.04
Hence this strategy generates an arbitrage profit of $2.04 six months

from now.
Example: Futures arbitrage: Sell index - Buy futures
Suppose the S&P 500 stock index is at $300 and the six-month
futures contract on that index is at $300. If the prevailing T-Bill
rate is 7% and the dividend rate is 5%, an arbitrage opportunity
exists because F = 300 < S e(r-d)T = 303.02. The arbitrage can be
executed by buying low and selling high. In this case, the futures
contract is relatively undervalued, so we buy the futures and sell
the index.
In particular, the strategy is to
Short sell e-dT units of the S&P index generating Se-dT = 292.59.
Lend the $292.59 proceeds of the short sale at 7% repayable in 6

months.
Buy a futures contract for delivery of the index in six months.
This generates the following cash flows:
Position
Sell e -dT units of index
Lend
Buy one futures contract
Net Position
Example 4.22: LIBOR Conventions.

If 3-month (90 actual days) LIBOR is quoted as 8%, the interest payable on a $1 million loan at the end of the
3- month borrowing period is
(.08)(90/360) $1,000,000 = ((.08)/4) $1,000,000 = $20,000
The Eurodollar futures contract is based on a 3-month $1

million Eurodollar time deposit. It is cash settled, so no actual
delivery of the time deposit occurs when the contract expires.
Delivery months are March, June, September, and December.
The minimum price move is $25 per contract which is
equivalent to 1 basis point: (.0001/4)1,000,000=25. The futures
price at expiration (time T) is determined as FT = 100-LIBOR.
Prior to expiration, the futures price implies the interest rate
that can be effectively locked in for a 3-month loan that begins
on the day the contract matures.
Settlement of the Eurodollar futures contract is illustrated in
Example given below.
Example: Settlement of Eurodollar Futures Contract.
Time 0
Time T
292.59
-S T
-292.59
303.02
ST -300
3.02
Suppose you purchased 1 December Eurodollar futures contract

on November 15 when the price was 94.86. If interest rates fall
100 basis points between November 15 and expiration of the
futures contract in December, what is your total gain or loss on
the contract at settlement?
Hence this strategy generates an arbitrage profit of $3.02 six months

from now.
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Hedging with Futures

In this section, we examine how three common business risks interest rate risk, stock market risk, and foreign exchange risk can be hedged in a practical setting. In each case, we describe the
nature of the risk and illustrate, through a series of practical
examples, how the risk can be managed.
Hedging Interest Rate Risk
There are two primary interest rate futures contracts that trade
on US exchanges. The Eurodollar Futures Contract trades on
the Chicago Mercantile Exchange and the US T-Bill Futures
Contract trades on the Chicago Board of Trade.
The Eurodollar contract is the more successful and heavily traded

contract. At any point in time, the notional loan amount
underlying outstanding Eurodollar futures contracts is in excess
of $4 trillion. This contract is based on LIBOR (London Interbank
Offer Rate), which is an interest rate payable on Eurodollar Time
Deposits. This rate is the benchmark for many US borrowers and
lenders. For example, a corporate borrower may be quoted a rate
of LIBOR+200 basis points on a short-term loan. Eurodollar
time deposits are non-negotiable, fixed rate US dollar deposits in
banks that are not subject to US banking regulations. These banks
108
Example given below demonstrates how interest is calculated on

a LIBOR loan according to the conventions.
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This generates the following cash flows:
may be located in Europe, the Carribean, Asia, or South America.

US banks can take deposits on an unregulated basis through their
international banking facilities. LIBOR is the rate at which major
money center banks are willing to place Eurodollar time deposits
at other major money center banks. Corporations usually borrow
at a spread above LIBOR since a corporations credit risk is greater
than that of a major money center bank. By convention, LIBOR
is quoted as an annualized rate based on an actual/360-day year
(i.e., interest is paid for each day at the annual rate/360).
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Use this $287.72 to buy e-dT = 0.975 units of the S&P index, and
reinvest all dividends in the index. Sell a futures contract for delivery
of the index in six months.
First note that no money changes hands at the time you buy the
contract. This is the nature of all futures contracts. The November
15 price of 94.86 implies that the LIBOR rate of interest was 10094.86=5.14% at that time. If LIBOR falls 100 basis points by the
time the December contract expires, LIBOR will then be 4.14%.
Therefore, the expiration futures price will be 100-4.14=95.86.
The total gain is therefore:
0.25 (1,000,000)(Ft-F0) = 0.25 (1,000,000)(0.9586-0.9486) = $2,500
That is, to settle the contract, your counter party will give you
$2,500.
Example given below contains a detailed illustration of how the
Eurodollar futures contract can be used to hedge interest rate risk.
Example: Hedging with the Eurodollar Futures Contract.
It is currently November 15 and your company is aware that it
needs to borrow $1 million on December 16 to pay a liability,
which falls due on that day. The loan can be repaid on March 16
when an account receivable will be collected. The current LIBOR
rate is 5.14%. Your company is concerned that interest rates will
rise between now and December 16, in which case you will pay a
higher rate of interest on your loan. How can your company lock
in the current rate of 5.14%?
11D.571.3
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If we could lock in the rate of 5.14%, the total interest on the loan
would be 0.0514($1 million)/4 = $12,850.
First, suppose that on December, 16 LIBOR is 6.14%. Interest
on the loan will be
0.0614($1 million)/4 = $15,350, and the gain on the futures
position will be -10000(93.86-94.86)/4 = $2,500. This yields a
net cash outflow of -$15,350+$2,500 = -$12,850, which is the
same as 3-months interest on $1 million at 5.14%.
Now suppose that on December, 16 LIBOR is 4.14%. Interest
on the loan will be
0.0414($1 million)/4 = $10,350, and the gain on the futures
position will be -10000(95.86-94.86)/4 = -$2,500. This yields a
net cash outflow of -$10,350-$2,500 = -$12,850, which is the
same as 3-months interest on $1 million at 5.14%.
First note that at the December futures price of 383.50, the return
on the index, since the beginning of the year, is 383.5/306.80-1 =
25%. If the manager is able to lock in this return on his fund, the
value of the fund will be 1.25($76.7 million) = $95.875 million.
Since the notional amount underlying an S&P 500 futures contract
is 500(383.50) = $191,750, the manager can lock in the 25% return
by selling 95,875,000/191,750=500 contracts. To illustrate that
this position does indeed form a perfect hedge, we examine the
net value of the hedged position under two scenarios.
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From the construction of the Eurodollar futures contract, we

know that if the interest rate rises, the futures price will fall.
Therefore, you will sell 1 December Eurodollar futures contract at
94.86. Underlying this contract is a notional 3-month $1 million
dollar loan to be entered into on December 16 (the day the contract
expires).
at 382.62. The December S&P 500 futures price is currently 383.50.

The managers fund was valued at $76.7 million at the beginning
of the year. Since the fund has already generated a handsome
return for the year, the manager wishes to lock in its current value.
That is, he is willing to give up potential increases in order to
ensure that the value of the fund does not decrease. How does he
lock in the current value of the fund?
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Hedging Market Risk

Another source of risk that an individual or organization may
wish to hedge is stock market risk. For example, a person
nearing retirement may wish to hedge the value of the equities
component of his retirement fund against a stock market crash
before he retires. A fund manager, who believes he can pick
winners among individual stocks, may wish to hedge marketwide movements. The dominant stock market index futures
contract is the S&P 500 futures contract. This contract trades
on the Chicago Mercantile Exchange and has delivery months
March, June, September, and December. The underlying
quantity is $500 times the level of the S&P 500 index. The
minimum price move is 0.05 index points, which is $25 per
contract. Example given below illustrates the settlement
mechanics for the S&P 500 contract.
Example: Settlement of the S&P 500 Futures Contract.
It is currently November 15 and the S&P 500 index is at 382.62.

The December S&P 500 futures price is 383.50. If you buy 1
December S&P 500 futures contract, how much will you gain if
the futures price at expiration is $393.50?
First, suppose the value of the S&P 500 index is 303.50 at the end
of December. In this case, the value of the fund will be (303.50/
383.50)95.875 million = 75.875 million. The gain on the futures
position will be -500(500)(303.50-383.50) = 20 million. Hence the
total value of the hedged position is 75.875+ 20 = 95.875 million,
locking in a 25% return for the year.
Now suppose that the value of the S&P 500 index is 403.50 at the
end of December. In this case, the value of the fund will be
403.50/383.50(95.875 million) = 100.875 million. The gain on the
futures position will be -$500(500)(403.50-383.50) = -5 million.
Hence the total value of the hedged position is 100.875-5=95.875
million, again locking in a 25% return for the year.
Hedging Foreign Exchange Risk
Another source of risk that an individual or organization may
wish to hedge is foreign exchange risk. For example, a person
who will be traveling overseas in the coming months may wish
to hedge the value of the amount of money he intends to
spend abroad against a devaluation of his domestic currency
relative to the foreign currency. An exporter who sells goods
overseas on credit may wish to hedge against a devaluation of
the foreign currency in which payment occurs.
A number of foreign currency futures contracts trade on the
International Monetary Market division of the Chicago Mercantile
Exchange. The currencies on which contracts are based, and the
underlying notional amount are listed in the following Table.
Delivery months for all contracts are March, June, September, and
December. Prices are quoted as US dollars per unit of foreign
currency. For example, if one Swiss franc buys 69.15 US cents, the
price will be quoted as 0.6915.
Denomination of Foreign Currency Futures Contracts
The gain on your futures position is $500(Ft-F0) = $500(393.50383.50)=$5,000. That is, to settle the contract, your counter party
will give you $5,000.
Example given below contains a detailed illustration of how the
S&P 500 futures contract can be used to hedge stock market risk.
Example: Hedging with the S&P 500 Futures Contract.
Currency
Underlying Amounts
British Pound
62,500 L
Canadian Dollar
100,000 C$
German Mark
125,000 DM
Japanese Yen
12,500,000 Y
Swiss Franc
125,000 SF
French Franc
250,000 FF
Australian Dollar
125,000 A$
A portfolio manager holds a portfolio that mimics the S&P 500

index. The S&P 500 index started the year at 306.8 and is currently
11D.571.3
109
Your company stands to lose if interest rates increase. Therefore,

you want enter a futures position that increases in value if interest
rates rise. Then, if interest rates rise, your company loses by paying
higher interest charges on the loan, but your company gains by
profiting on the futures position. Conversely, if interest rates fall,
your company gains by paying lower interest charges on the loan,
but your company loses on the futures position. Ideally, the loss
and the gain would exactly cancel, whether interest rates rise or fall.
with Treasury bond futures; basis risk arises due to the uncertainty
of the yield differential at the time the hedge is lifted.
Example: Hedging with the Swiss Franc Futures Contract.
Second, in commodity futures, there is basis risk due to locational

differentials. For example, a cattle farmer in Texas who hedges
with a cattle futures contract that calls for delivery in Omaha has
the uncertainty of the closeout differential between the Texas steer
price and the Omaha steer price. This is called locational basis risk.
This is usually an important factor in agricultural contracts. The
risk is compounded by the fact that the seller usually has the
option of where delivery is made.
The third type of basis risk arises because the seller of the futures
contract often has the option to choose the quality of the goods or
financial instrument delivered. For example, the Treasury bond
futures market calls for delivery of any U.S. Treasury bond that is
not callable within 15 years. Since there are many instruments that
are candidates for delivery, the hedge has the risk of fluctuations in
the yield spread between the instrument hedged and the
instrument ultimately delivered.
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Note that since (1) the total exposure is one million Swiss Francs
and (2) each futures contract is for 125, 000 Francs, eight contracts
are required to hedge the exposure. Further, since (1) the company
stands to lose if the Swiss Franc depreciates (each Swiss Franc can
be converted back into a smaller number of Dollars) and (2) the
futures contracts decrease in value if the Swiss Franc depreciates
(since the basis of the contract is Swiss Francs per Dollar), the
contracts should be sold.
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Your company sells 10 machines to a Swiss company. The sale

price is 100,000 Swiss Francs each and payment is to be made at
the end of the calendar year. The December futures price for
Swiss Francs is 0.6915. You are worried that the Swiss Franc will
depreciate against the US Dollar between now and the end of the
year. How can you hedge this exchange rate risk?
To illustrate that selling eight futures contracts provides an

adequate hedge, first suppose that the value of the Swiss Franc is
0.30 at the end of December. In this case, the US Dollar value of
the payment for the machines will be 0.30(10)(100,000) =
$300,000. The gain on the futures position will be 8(125,000)(0.30-0.6915) = $391,500. Hence the total income is
$691,500, which equals the unhedged income in dollars if the
exchange rate does not fluctuate.
Basis Risk
There is no such thing as a perfect hedge. You can never
completely eliminate a cash positions risk. Consider a holder
of Q Treasury bonds maturing in 2004 with a coupon rate of
8%. Assume that the holder of bonds believes that bond
prices are going to fall. To hedge his risk, the person shorts an
equivalent amount of futures contracts for Treasury bonds. At
a later date, the person will close out both its bond and futures
positions. At the close, the firm will receive BT per bond sold in
the regular spot or cash market. The futures price is F0 at the time
the futures are sold short, and its price at the closeout is FT.
Prior to the closeout, both BT and FT are uncertain, although F0
is known. The usual computation of the funds that the
person will have at closeout is:
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Example given below contains a detailed illustration of hedging

exchange risk.
Net Revenue(bond sale plus futures) = Q[BT + (FT - F0)] =QF0 +

Q[BT - FT]
From the above equation, the net revenue from the hedge position
is composed of (1) a certain component that depends upon the
futures price at the time of the hedge (F0) and (2) an uncertain
component that depends upon the difference between the price
received for bonds in the spot market and the futures price at
closeout (BT-FT). The difference between the spot and the futures
price is called the basis. Thus, uncertainty about the net-hedged
revenue arises if there is uncertainty about the basis. To quote
Holbrook Working, hedging is speculation in the basis.
There are many reasons for the basis to be
uncertain.
First, the good or instrument being hedged may be different
from the good or instrument for which there is a futures contract.
This would be the case if a corporate bond offering is hedged
110
Fourthly, with most futures contracts, the seller has the choice of
the date of delivery within the delivery month. This choice is an
uncertain value and thus contributes to basis risk.
Finally, the mark to market aspect of futures results in hedging
risk. The uncertainty is about the amount of interest earned or
forfeited due to the daily transfers of profits and losses. In fact,
the equations for net revenue are not exactly right due to the
omission of interest earned (lost) on futures profits (losses).
The Volatility of Futures
A common mistake made is to assume that futures are much
more volatile than stocks. Percentage changes of futures prices
are generally less volatile than the percentage changes of a typical
stock. Annualized standard deviations for most futures
contracts are in the 15-20% range whereas a typical stocks is
about 30%.
There is no reason that the futures should be played in a high-risk
manner by a large investor. Of course, if the futures investor does
not have enough capital (5-8 times margin), then he is required to
play with considerable leverage or not at all. Before taking great
leverage, the small investor should consider looking at a smaller
contract (grain on CBT is 5,000 bushels whereas Mid-America
contract is 1,000 bushels).
The effect of leverage is to increase volatility. Borrowing to meet
the margin requirements will increase gains but also increase losses.
Setting aside larger amounts of capital, which are invested, in a
safe asset will decrease the volatility.
Risk in the Futures Markets
As we have already seen, one the most important applications
of the futures is for hedging. Futures contracts were initially
introduced to help farmers that did not want to bear the risk of
price fluctuations. The farmer could short hedge in March (agree
to sell his crop) for a September delivery. This effectively locks in
the price that the farmer receives. On the other side, a cereal
company may want to guarantee in March the price that it will
pay for grain in September. The cereal company will enter into a
long hedge.
11D.571.3
F = S0 e(r-d)T
The price of a forward contract when there is a dividend benefit d.
When interest rates are constant, the same relationship holds for
a futures contract.
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Notes:
The second important insight had to do with hedging with futures

contracts. The concept of basis risk was introduced. It is extremely
unlikely that you can create a perfect hedge. A perfect hedge is
when the loss on your cash position is exactly offset by the gain in
the futures position. We suggested some reasons why it is unlikely
that we can construct a perfect hedge.
The most obvious case is when you are trying to hedge a cash
position with futures positions in different instruments. This is
the case that we introduced in one of the first lectures when we
hold the Ginnie Mae security and want to hedge this security with
a combination of T-Bonds and Euros. It is unlikely, however,
that at the expiration of the futures contract, the cash price of the
T-Bond and Euros will equal the Ginnie Mae. This is the basis
risk.
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A second type of basis risk arises out of the quality option. We

discussed this in terms of food and financial instruments. If you
are a farmer and want to lock in the price for your crop of wheat,
you may use a futures contract that may call for delivery of a
number of different types of wheat. Similarly, in the T-Bond and
T-Note contracts, there are whole ranges of instruments that are
available for delivery. This difference will induce basis risk.
Third, there is a timing option. The futures contract is different
from an options contract. Most futures call for delivery within the
contract month. It is unclear when the short will deliver the goods.
This uncertainty leads to basis risk.
The fourth type of risk is locational basis risk. This is mainly

applicable to agricultural commodities. There could be a difference
the cash price of the good that you are selling (cattle) and the
futures price at a different location.
The last type of uncertainty is linked to the uncertain interest rate
flows from the money you make in excess of the margin.
Summary of Important Formulas
F = S 0 e(r+q)T
The price of a forward contract when there is a cost of carry q.
When interest rates are constant, the same relationship holds for
a futures contract.
11D.571.3
111
There are a number of important insights that should be reviewed.

The first is that we should be careful about what we consider the
investment in a futures contract. It is unlikely that the margin is the
investment for most traders. It is rare that somebody plays the
futures with a total equity equal to the margin. It is more common
to invest some of your capital in a money market fund and draw
money out of that account as you need it for margin and add to
that account as you gain on the futures contract. It is also
uncommon to put the full value of the underlying contract in the
money market fund. It is more likely that the futures investor will
put a portion of the value of the futures contract into a money
market fund. The ratio of the value of the underlying contract to
the equity invested in the money market fund is known as the
leverage. The leverage is a key determinant of both the return on
investment and on the volatility of the investment. The higher
the leverage the more volatile are the returns on your portfolio
of money market funds and futures. The most extreme leverage
is to include no money in the money market fund only commit
your margin.
We have introduced call options, put options, and forward

contracts. Futures contracts are essentially the same as forward
contracts at this introductory level of analysis. Call and put
options give asymmetric payoffs and forward and futures
contracts give symmetric payoffs. While there are many other
types of derivative contracts, they generally can be constructed
from the basic contracts we have already described. For this
reason, many practitioners and academics find it useful to view
options and forwards as building blocks that can be used to
construct other derivative contracts. The building block
approach starts with the basic payoffs summarized in Figure
given below.
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Constructing Other Derivatives
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LESSON 21:
OTHER DERIVATIVES CONTRACTS
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To illustrate the usefulness of the building block approach, suppose

that NeedOil decides that it wants protection from high oil prices,
but that it does not believe oil prices will rise above $18 a barrel. If
NeedOil hedged by buying a call option with an exercise price of
$15 (as was described earlier), it would be buying protection against
any increase in oil prices -
- above $15, including protection against oil prices above $18.

Since it does not believe oil prices will rise above $18, it is
buying protection that it deems as having little or no value.
NeedOil therefore would like to have a derivative contract with
a payoff that increases with prices between $15 and $18, but
that does not increase when oil prices are above $18. The solid
line in Figure given below illustrates the payoff NeedOil wants
(ignoring the cost of obtain-ing protection).
NeedOil can obtain its desired payoff by buying a call option with
an exercise price of $15 and selling a call option with an exercise
price of$18. To see this, you simply need to graph the payoff on
each option separately and then vertically add the payoffs. Figure
given below illustrates the payoffs from the two options with
dashed lines.
112
A huge variety of other types of derivative securities exist for a

number of purposes, including hedging, speculating and arbitrage.
One important type of derivative, a swap contract, provides for
the exchange of one set of cash flows for another set of cash
flows. The amounts of these cash flows are usually tied to cash
flows associated with other assets or portfolios. Swap contracts
are specified for commodities, currencies, debt and equity securities,
interest rates and a large number of other types of assets as well.
These swap contracts have a number of uses. For instance, swap
contracts enable financial market participants to synthesize other
securities, which are either unavailable or inappropriately priced.
For example, Japanese regulations have restricted investment in
many types of securities; in particular, Japanese institutions have
been restricted with respect to non-yen bond purchases. Suppose
that a firm wished to borrow dollars to purchase American
products. Japanese tax code often makes borrowing less expensive
in Japan. The borrower could sell to a Japanese institution a yen
denominated bond (resulting in an attractive interest rate due to
preferential tax treatment of Japanese zero coupon notes) then
execute a dollar/yen currency swap such that its initial loan receipts
and loan repayments are denominated in dollars. Thus, all of the
borrowers net cash flows are denominated in dollars (it has
synthesized a dollar loan) and the Japanese institution fulfills
regulatory requirements by issuing a yen denominated note.
Swap Contracts
The final type of derivative contract that we will highlight is
called a swap contract. Swap contracts have payoffs like a series
of forward contracts. That is, instead of having just one payoff
at the contracts expiration (or when the option is exercised), a
swap contract has a series of payoffs over time. Each payoff
depends on the difference between the market price of the
underlying asset and a predetermined price, called the swap
price.
11D.571.3
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To illustrate a swap contract, we will again use the example of

Need Oil. In this example, NeedOil plans to purchase oil every six
months for the next two years and it wants protec-tion against
high oil prices at each date. It therefore purchases a swap contract
from SWAPCO with the payoffs described in Table given below.
Notice that at each date, the payoff to NeedOil is just like the
payoff from buying a forward contract. Thus, swap contracts can
be viewed as a series of forward contracts.
Equity Swaps
An equity swap is a contract providing for the delivery of cash
flows associated with shares of equity (or an equity index) in
exchange for the cash flows associated with another asset (such
as a debt or index instrument). For example, an investor
wishing to relieve himself of risk associated with shares he is
currently holding, without selling and exposing himself to
capital gains tax liability, may agree to deliver to another investor
the cash flows (dividends and capital gains for a specified
period) associated with his shares. The second investor, in turn,
agrees to deliver cash flows associated with a treasury bond to
the stock investor. Equity swaps are used to exploit apparent
mis-pricing in equity markets, to manage risks associated with
domestic or foreign equity investment, to circumvent dividend
withholding tax requirements in foreign countries and to
speculate in foreign equity markets when direct ownership is not
permitted.
The term swap is used because these transactions allow parties to

reduce risk by swap-ping payments. Without hedging, NeedOils
payments for oil every six months would be un-certain; the
payment would equal 250,000 times the price of oil at that time
(Pt). By transacting with SWAPCO, NeedOil swaps its uncertain
payment for oil for a certain oil payment. Specifically, SWAPCO
gives NeedOil the funds needed to make its uncertain oil payment
(250,000 times Pt) and NeedOil gives SWAPCO $15 times 250,000.
By swapping its uncertain payments for certain payments, NeedOil
reduces its risk.
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In this example, the difference between the price of oil at a given

date and $ 15 is always multiplied by 250000. This is a common
feature of swap contracts (and many other derivative contracts)
the difference between two prices is multiplied by some number,
called the notional principal (in this case 250,000), to determine the
dollar payoff.
While notional principal often is used to measure the value of

outstanding swap con-tracts, notional principal usually is a flawed
measure of how much money the parties could potentially gain
or lose because potential swap payments depend on the units
used for quot-ing prices and the volatility of prices, as well as the
notional principal. For example, if oil prices could vary between
$13 and $17 during the time period covered by NeedOils swap
contract, then the payments made by NeedOil could vary between
-$500,000 and $500,000. In this particular case, the notional
principal understates the potential gain or loss in any given sixmonth period.
For other types of swaps, like interest rate swaps, the notional
principal greatly overstates the amount of money at risk. Table
24.5 gives an example of an interest rate swap. Here, the notional
principal is $1 million and SWAPCO pays NeedOil the prevailing
one-year T-bill rate minus 5 percent. For example, if the one-year
T-bill rate in 12 months equals 6 percent, then SWAPCO pays
NeedOi11 percent times $1 million, or $10,000. If the one-year Tbill rate in two years equals 4.5 percent, then NeedOil pays
11D.571.3
Equity swaps permit investors to reduce their risk in an equity

investment without actually selling shares. One type of participant
in this market have been corporate managers. Corporate managers
have used the executive equity swap to reduce their personal exposure
in the shares of their employers stock. In a well-publicized case
involving Autotote Company, at the time, a NASDAQ listed
manufacturer of wagering equipment, the CEO Lorne Weil
arranged to deliver dividends and any capital gains (which would
be negative in the event of a capital loss) associated with Autotote
stock in exchange for certain cash flows associated with treasury
securities. Thus, technically, the CEO did not sell his shares, though
he divested himself of any of the return risk associated with share
ownership. By engaging this equity swap, the CEO has reduced
his risk in the employing company without having to report a sale
of shares (though, Weil did voluntarily report this transaction,
and the SEC currently requires reporting). This means that the
CEO is not subject to capital gains taxes at the time of the
transaction.1 The CEO is not likely to bear the selling price
consequences associated with an insider sell transaction.
Furthermore, the CEO maintains his level of voting control in
the companys shares. Thus, in a sense, the equity swap permits
the CEO the opportunity to, in effect, execute a sale of shares
without bearing most of the undesirable consequences associated
with the sale.
Exotic Options
An Asian Option (average rate) is based on the average price (or
exchange rate) of the underlying asset (or currency). For
example, an Asian call on currency permits its owner to receive
the difference between the average currency exchange rate over
the life of the option (AT) and the exercise price (E) associated
with the option:
A potential user of the Asian option might be an exporter who
sells to a particular country the same number of units of its
product each day. Since the exchange rate will vary daily, the revenues
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SWAPCO 0.5 percent times $1 mil-lion, or $5,000. Even though

the notional principal is $1 million, the likely payments are only a
fraction of the notional principal. Thus, for interest rate swaps,
the notional princi-pal greatly overstates the amount of money at
risk.
A Barrier Option is similar to a plain vanilla option except that

it expires or is activated (in the case of a down-and-out option, or,
in the case of down-and-in options can only be activated) once the
underlying asset value reaches a pre-specified price.
These are often referred to as either knock out or knock in options.
In addition to the ability to tailor contracts, there are other

differences between the OTC and exchange markets. One difference
is liquidity, the ability to buy or sell without making a large price
concession. When the OTC market creates a contract that is tailored
to one par-ticipants needs, this contract tends to be illiquid. In
contrast, if the contract were a stan-dardized exchange-traded
futures contract, there would likely be more liquidity. The greater
liquidity arises in part because the standardized exchange contracts
attract many traders.
The greater liquidity also is due in part to the method of ensuring
that the parties who trade derivatives uphold their agreements.
OTC contracts are bilateral contracts. That is, a buyer and seller are
specified on the contract and if one party cannot fulfill its part of
the contract, the other party becomes a creditor. As a result, when
trading OTC contracts, firms assess the default risk (or credit risk)
of the parties with whom they transact. In addition, if a firm
wishes to reverse its position, the firm must negotiate with the
specific counter party to the contract. These features make OTC
contracts less liquid.
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A Lookback Option enables its owner to purchase (or sell in the

case of a put) the underlying security at the lowest price (or highest
price in the case of a put) realized over the life of the option.
either by engaging in an offsetting transaction with someone else

in the OTC market or by using exchange-traded options and futures
contracts.
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received by the exporter will vary. The Asian option enables the
exporter to stabilize its cash flows without entering the derivatives
market on a daily basis. The cash flow structures of these options
vary from contract to contract. For example, some contracts call for
the payoff to be related to the difference between the time T spot
rate and the average exchange rate realized during the life of the
option.
A Compound Option is simply an option on an option.

Rainbow Options are written on two or more assets.
A Zero Cost Collar is a package of options designed to require

zero net investment. For example, the Range Forward Contract
enables (and obliges) its owner to purchase the underlying security
with a time T value for the following price:
An Interest Rate Cap pays its owner a value based on the difference
between the market rate and the cap strike rate if the market rate
rises above the strike rate. A Swaption gives its owner the right
(but not the obligation) to enter into a swap arrangement at a later
date.
Markets for Derivatives
Over-the-counter versus Exchange-traded Derivatives
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Earlier we mentioned that the payoffs from forward and futures

contracts are similar. One difference in the two contracts is that
forward contracts are traded in the over-the-counter (OTC) market
and futures contracts are traded at exchanges like the Chicago Board
of Trade. Call and put option contracts trade on exchanges as well
as in the over-the-counter market. Swap contracts are traded overthe-counter.
An over-the-counter (OTC) derivative contract resembles a privately

negotiated contract between two firms. For example, if NeedOil
wanted to purchase an option contract to hedge its oil price risk,
NeedOil could contact a financial institution in the OTC market,
which could then tailor a contract to NeedOils hedging needs.
Exchange-traded derivatives are stan-dardized contracts with the
terms established by the exchanges. Since specific details are not
subject to negotiation, contracting costs tend to be lower with
exchange-traded derivatives than with OTC derivatives. While
exchanges try to create standardized contracts that appeal to many
participants, the standardization often implies that exchange-traded
derivatives have greater basis risk than OTC derivatives.
Initially, financial institutions operating in the OTC market acted
as brokers who would identify another firm that would transact
with a party such as NeedOil. Today, fi-nancial institutions operate
more like dealers, taking positions directly with each firm. Thus,
NeedOil could buy the option directly from the financial institution.
Having sold a call option, the dealer would be exposed to oil price
risk and thus the dealer probably would try to hedge this risk
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Default risk is handled differently with exchange-traded contracts.

When taking a fu-tures position, a trader must post a performance
bond,calleda
margin. The bond equals some percentage of the
value of the contracts and must be posted either in the form of
cash, letters of credit, or government bonds. The purpose of the
bond is to ensure the solvency of the trader over the corning day
of trading. Thus, at the end of each day, the margin account is
monitored to see if there are sufficient funds to ensure solvency
over the subsequent day.
As an example, suppose that the required margin is always 20
percent of the value of the contract and that Ms. Weiss takes a
long position in (buys) one contract when the futures price equals
$1,000. Then, Ms. Weiss must post margin equal to $200. Now
suppose that over the course of the following day, the futures
price falls to $900. Ms. Weiss has lost $100 ($1,000 - $900), which
is subtracted from her margin account, leaving only $100. Since
Ms. Weisss position now is worth $900, she needs to (have margin
equal to $180 (20% of $900). Consequently, Ms. Weiss must add
$80 to the margin account. If she does not add this amount, then
her position will be closed; that is, she will have to take an offsetting
short position in (sell) one contract.
The other important difference between OTC markets and
exchange markets is that ex-changes have a clearinghouse that acts
as an intermediary in every transaction. As stated above, with an
OTC contract, the buyer knows the identity of the seller. With
exchange-traded contracts, a buyer is not matched with a particular
seller. Instead, each transaction is with the clearinghouse. The
number of contracts purchased by the clearinghouse must always equal the number that it has sold, but buyers and sellers are
not explicitly matched. Thus, if a trader wants to reverse a position
(sell the derivative the trader had previously pur-chased or buy the
derivative contract the trader had previously sold), a specific counter
party does not have to be notified. Any counter party willing to
take the other side of the transac-tion may be used. The
11D.571.3
clearinghouse, along with the daily settlement and margin system

for ensuring performance, helps create a liquid market.
Common Risks That Are Hedged with Derivatives
Although OTC contracts can be tailored to meet the specific
hedging needs of individual firms, the types of risk that are
most often hedged with derivatives are: (1) foreign exchange
rates, (2) interest rates, (3) commodity prices, and (4) equity
prices.
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With the increasing amount of trade among foreign countries

and the increased volatility in exchange rates due to the
breakdown in 1973 of the previous system of fixed foreign exchange rates, firms have become more interested in hedging
against changes in foreign ex-change rates. Most multinational
companies utilize derivatives to manage their foreign exchange
exposures. The most commonly used currency derivatives are
swap and forward contracts, which had notional principal of
over $1.46 trillion in 2002.
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Foreign Exchange Derivatives
Interest Rate Derivatives

Several factors have contributed to the use of interest rate
derivatives to hedge against changes in value due to interest rate
changes. One factor is the high level and volatility of interest
rates in the 1970s and 1980s, which resulted from high levels of
expected inflation as well as changes in expected inflation. Also,
in 1979 the Federal Reserve changed its pol-icy of trying to
stabilize interest rates directly and instead started targeting
monetary ag-gregates. The consequence of this change in policy
was to increase interest rate volatility substantially. Interest rate
futures, options, and swaps are frequently used to hedge
interest rate risk. The notional principal in 2002 of interest rate
derivatives was close to $90 trillion.
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Commodity Derivatives
Derivative contracts on agricultural commodities have existed
for a long time. For example, the Chicago Board of Trade has
traded futures contracts since 1865, and forwards and op-tions
on agricultural products date back several centuries. Users and
producers of com-modities such as metals and oil also
frequently trade both OTC and exchange-traded derivatives. The
use of electricity derivatives also has grown significantly in recent
years due in part to deregulation of the industry.
Equity Derivatives
Equity derivatives are contracts derived from stock market
indexes like the Standard & Poors 500. Futures contracts exist
that are based on US stock market indexes and on for-eign stock
market indexes, such as the Nikkei index for the Japanese stock
market. In ad-dition, options have traded on individual stocks
for some time. The notional principal on futures and options
in 2002 equaled about $2.2 trillion.
Notes:
11D.571.3
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LESSON 22:
MEASURING & HEDGING INTEREST
RATE RISK IN BANKS
Hedging Interest Rate Risk in Banks

Measuring credit Risk
Hedging with Credit Derivatives
Integrating Market & Credit Risk Management
Introduction
Interest rate risk is the risk to earnings or capital arising from
movement of interest rates. It arises from differences between
the timing of rate changes and the timing of cash flows (re
pricing risk); from changing rate relationships among yield
curves that affect bank activities (basis risk); from changing rate
relationships across the spectrum of maturities (yield curve
risk); and from interest-rate-related options embedded in bank
products (option risk). The evaluation of interest rate risk must
consider the impact of complex, illiquid hedging strategies or
products, and also the potential impact on fee income that is
sensitive to changes in interest rates.
The movement of interest rates affects a banks reported earnings

and book capital by changing
Net interest income,
The market value of trading accounts (and other instruments
accounted for by market value), and
Other interest sensitive income and expenses, such as mortgage
servicing fees.
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Changes in interest rates also affect a banks underlying economic

value. The value of a banks assets, liabilities, and interest-raterelated, off-balance-sheet contracts is affected by a change in rates
because the present value of future cash flows, and in some cases
the cash flows themselves, is changed. In banks that manage
trading activities separately, the exposure of earnings and capital
to those activities because of changes in market factors is referred
to as price risk. Price risk is the risk to earnings or capital arising
from changes in the value of portfolios of financial instruments.
This risk arises from market making, dealing, and position-taking
activities for interest rate, foreign exchange, equity, and commodity
markets. The same fundamental principles of risk management
apply to both interest rate risk and price risk.
Risk Identification
The systems and processes by which a bank identifies and
measures risk should be appropriate to the nature and
complexity of the banks operations. Such systems must
provide adequate, timely, and accurate information if the bank is
to identify and control interest rate risk exposures.
Interest rate risk may arise from a variety of sources, and
measurement systems vary in how thoroughly they capture each
type of interest rate exposure. To find the measurement systems
that are most appropriate, bank management should first consider
116
the nature and mix of its products and activities. Management

should understand the banks business mix and the risk
characteristics of these businesses before it attempts to identify
the major sources of the banks interest rate risk exposure and the
relative contribution of each source to the banks overall interest
rate risk profile. Various risk measurement systems can then be
evaluated by how well they identify and quantify the banks major
sources of risk exposure.
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Measuring Interest Rate risk in Banks
Re-pricing or Maturity Mismatch Risk

The interest rate risk exposure of banks can be broken down
into four broad categories: re-pricing or maturity mismatch risk,
basis risk, yield curve risk, and option risk. Re-pricing risk
results from differences in the timing of rate changes and the
timing of cash flows that occur in the pricing and maturity of a
banks assets, liabilities, and off-balance-sheet instruments. Repricing risk is often the most apparent source of interest rate
risk for a bank and is often gauged by comparing the volume
of a banks assets that mature or re-price within a given time
period with the volume of liabilities that do so. Some banks
intentionally take re-pricing risk in their balance sheet structure
in an attempt to improve earnings. Because the yield curve is
generally upward sloping (long-term rates are higher than
short-term rates), banks can often earn a positive spread by
funding long-term assets with short-term liabilities. The
earnings of such banks, however, are vulnerable to an increase
in interest rates that raises its cost of funds.
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Chapter Objective
UNIT I
CHAPTER 8
CREDIT & INTEREST RATE RISKS
Banks whose re-pricing asset maturities are longer than their repricing liability maturities are said to be liability sensitive, because
their liabilities will re-price more quickly. The earnings of a liabilitysensitive bank generally increase when interest rates fall and decrease
when they rise. Conversely, an asset sensitive bank (asset re-pricings
shorter than liability re-pricings) will generally benefit from a rise
in rates and be hurt by a fall in rates.
Re-pricing risk is often, but not always, reflected in a banks current
earnings performance. A bank may be creating re-pricing imbalances
that will not be manifested in earnings until sometime into the
future. A bank that focuses only on short-term re-pricing
imbalances may be induced to take on increased interest rate risk
by extending maturities to improve yield. When evaluating repricing risk, therefore, it is essential that the bank consider not
only near term imbalances but also long-term ones. Failure to
measure and manage material long-term re-pricing imbalances
can leave a banks future earnings significantly exposed to interest
rate movements.
Basis Risk
Basis risk arises from a shift in the relationship of the rates in
different financial markets or on different financial instruments.
Basis risk occurs when market rates for different financial
instruments, or the indices used to price assets and liabilities,
change at different times or by different amounts. For example,
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Basis risk can also be said to include changes in the relationship

between managed rates, or rates established by the bank, and
external rates. For example, basis risk may arise because of
differences in the prime rate and a banks offering rates on various
liability products, such as money market deposits and savings
accounts. Because consumer deposit rates tend to lag behind
increases in market interest rates, many retail banks may see an
initial improvement in their net interest margins when rates are
rising. As rates stabilize, however, this benefit may be offset by repricing imbalances and unfavorable spreads in other key market
interest rate relationships; and deposit rates gradually catch up to
the market. (Many bankers view this lagged and asymmetric pricing
behavior as a form of option risk. Whether this behavior is
categorized as basis or option risk is not important so long as
bank management understands the implications that this pricing
behavior will have on the banks interest rate risk exposure.)
balance-sheet positions needs to consider how the off-balancesheet contracts cash flows may change with changes in interest
rates and in relation to the positions being hedged or altered.
Derivative strategies designed to hedge or offset the risk in a
balance sheet position will typically use derivative contracts
whose cash flow characteristics have a strong correlation with the
instrument or position being hedged. The bank will also need
to consider the relative liquidity and cost of various contracts,
selecting the product that offers the best mix of correlation,
liquidity, and relative cost. Even if there is a high degree of
correlation between the derivative contract and the position
being hedged, the bank may be left with residual basis risk
because cash and derivative prices do not always move in
tandem. Banks holding large derivative portfolios or actively
trading derivative contracts should determine whether the
potential exposure presents material risk to the banks earnings
or capital.
Certain pricing indices have a built-in lag feature such that the
index will respond more slowly to changes in market interest
rates. Such lags may either accentuate or moderate the banks shortterm interest rate exposure. One common index with this feature
is the 11th District Federal Home Loan Bank Cost of Funds
Index (COFI) used in certain adjustable rate residential mortgage
products (ARMs). The COFI index, which is based upon the
monthly average interest costs of liabilities for thrifts in the 11th
District (California, Arizona, and Nevada), is a composite index
containing both short and long-term liabilities. Because current
market interest rates will not be reflected in the index until the
long-term liabilities have been re-priced, the index generally will
lag market interest rate movements.
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A bank that holds COFI ARMs funded with three-month

consumer deposits may find that, in a rising rate environment, its
liability costs are rising faster than the repricing rate on the ARMs.
In a falling rate environment, the COFI lag will tend to work in
the banks favor, because the interest received from ARMs adjusts
downward more slowly than the banks liabilities.
Hedging with Derivative Contracts
Some banks use off-balance-sheet derivatives as an alternative to
other investments; others use them to manage their earnings or
capital exposures. Banks can use off-balance-sheet derivatives to
achieve any or all of the following objectives: limit downside
earnings exposures, preserve upside earnings potential, increase
yield, and minimize income or capital volatility. Although
derivatives can be used to hedge interest rate risk, they expose a
bank to basis risk because the spread relationship between cash
and derivative instruments may change. For example, a bank
using interest rate swaps (priced off Libor) to hedge its Treasury
note portfolio may face basis risk because the spread between
the swap rate and Treasuries may change. A bank using offbalance-sheet instruments such as futures, swaps, and options
to hedge or alter the interest rate risk characteristics of on11D.571.3
Yield Curve Risk

Yield-curve risk arises from variations in the movement of
interest rates across the maturity spectrum. It involves changes
in the relationship between interest rates of different maturities
of the same index or market (e.g., a three-month Treasury
versus a five-year Treasury). The relationships change when the
shape of the yield curve for a given market flattens, steepens, or
becomes negatively sloped (inverted) during an interest rate
cycle. Yield curve variation can accentuate the risk of a banks
position by amplifying the effect of maturity mismatches.
Certain types of structured notes can be particularly vulnerable to
changes in the shape of the yield curve. For example, the
performance of certain types of structured note products, such as
dual index notes, is directly linked to basis and yield curve
relationships. These bonds have coupon rates that are determined
by the difference between market indices, such as the constant
maturity Treasury rate (CMT) and Libor. An example would be a
coupon whose rate is based on the following formula: coupon
equals 10-year CMT plus 300 basis points less three-month Libor.
Since the coupon on this bond adjusts as interest rates change, a
bank may incorrectly assume that it will always benefit if interest
rates increase. If, however, the increase in three month Libor exceeds
the increase in the 10-year CMT rate, the coupon on this instrument
will fall, even if both Libor and Treasury rates are increasing. Banks
holding these types of instruments should evaluate how their
performance may vary under different yield curve shapes.
Option Risk
Option risk arises when a bank or a banks customer has the
right (not the obligation) to alter the level and timing of the
cash flows of an asset, liability, or off-balance-sheet instrument.
An option gives the option holder the right to buy (call option)
or sell (put option) a financial instrument at a specified price
(strike price) over a specified period of time. For the seller (or
writer) of an option, there is an obligation to perform if the
option holder exercises the option.
The option holders ability to choose whether to exercise the option
creates an asymmetry in an options performance. Generally, option
holders will exercise their right only when it is to their benefit. As
a result, an option holder faces limited downside risk (the premium
or amount paid for the option) and unlimited upside reward.
117
basis risk occurs when the spread between the three-month

Treasury and the three-month London inter-bank offered rate
(Libor) changes. This change affects a banks current net interest
margin through changes in the earned/paid spreads of
instruments that are being re-priced. It also affects the
anticipated future cash flows from such instruments, which in
turn affects the underlying net economic value of the bank.
Risk Measurement
Accurate and timely measurement of interest rate risk is
necessary for proper risk management and control. A banks risk
measurement system should be able to identify and quantify
the major sources of the banks interest rate risk exposure. The
system also should enable management to identify risks arising
from the banks customary activities and new businesses. The
nature and mix of a banks business lines and the interest rate
risk characteristics of its activities will dictate the type of
measurement system required. Such systems will vary from
bank to bank.
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Some banks buy and sell options on a stand-alone basis. The

option has an explicit price at which it is bought or sold and may
or may not be linked with another bank product. A bank does not
have to buy and sell explicitly priced options to incur option risk,
however. Indeed, almost all banks incur option risk from options
that are embedded or incorporated into retail bank products.
the loan, renegotiate the loan to a lower rate, or face a default on

the loan. A banks non-maturity deposits, such as money market
demand accounts (MMDAs), negotiable order of withdrawal
(NOW) accounts, and savings accounts also may have implicit
caps and floors on the rates of interest that the bank is willing to
pay.
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Options often result in an asymmetrical risk/reward profile for

the bank. If the bank has written (sold) options to its customers,
the amount of earnings or capital value that a bank may lose from
an unfavorable movement in interest rates may exceed the amount
that the bank may gain if rates move in a favorable direction. As a
result, the bank may have more downside exposure than upside
reward. For many banks, their written options positions leave
them exposed to losses from both rising and falling interest rates.
These options are found on both sides of the balance sheet. On

the asset side, prepayment options are the most prevalent
embedded option. Most residential mortgage and consumer loans
give the consumer an option to prepay with little or no prepayment
penalty. Banks may also permit the prepayment of commercial
loans by not enforcing prepayment penalties (perhaps to remain
competitive in certain markets). A prepayment option is equivalent
to having written a call option to the customer. When rates decline,
customers will exercise the calls by prepaying loans, and the banks
asset maturities will shorten just when the bank would like to be
extending them. And when rates rise, customers will keep their
mortgages, making it difficult for the bank to shorten asset
maturities just when it would like to be doing so.
On the deposit side of the balance sheet, the most prevalent

option given to customers is the right of early withdrawal. Early
withdrawal rights are like put options on deposits. When rates
increase, the market value of the customers deposit declines, and
the customer has the right to put the deposit back to the bank.
This option is to the depositors advantage. As previously noted,
bank managements discretion in pricing such retail products as
non-maturity deposits can also be viewed as a type of option.
This option usually works in the banks favor. For example, the
bank may peg its deposits at rates that lag market rates when
interest rates are increasing and that lead market rates when they
are decreasing.
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The option seller faces unlimited downside risk (an option is

usually exercised at a disadvantageous time for the option seller)
and limited upside reward (if the holder does not exercise the
option and the seller retains the premium).
Bank products that contain interest caps or floors are other

sources of option risk. Such products are often loans and may
have a significant effect on a banks rate exposure. For the bank, a
loan cap is like selling a put option on a fixed income security, and
a floor is like owning a call. The cap or floor rate of interest is the
strike price. When market interest rates exceed the cap rate, the
borrowers option moves in the money because the borrower is
paying interest at a rate lower than market. When market interest
rates decline below the floor, the banks option moves in the
money because the rate paid on the loan is higher than the market
rate.
Floating rate loans that do not have an explicit cap may have an
implicit one at the highest rate that the borrower can afford to pay.
In high rate environments, the bank may have to cap the rate on
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Every risk measurement system has limitations, and systems vary

in the degree to which they capture various components of interest
rate exposure. Many well-managed banks will use a variety of
systems to fully capture all of their sources of interest rate exposure.
The three most common risk measurement systems used to
quantify a banks interest rate risk exposure are re-pricing maturity
gap reports, net income simulation models, and economic
valuation or duration models. The following table summarizes
the types of interest rate exposures that these measurement
techniques address.
Banks with significant option risk may supplement these models

with option pricing or Monte Carlo models. But for many banks,
especially smaller ones, the expense of developing options pricing
models would outweigh the benefits. Such banks should be able
to use their data and measurement systems to identify and track,
in a timely and meaningful manner, products that may create
significant option risk. Such products may include non-maturity
deposits, loans and securities with prepayment and extension
risk, and explicit and embedded caps on adjustable rate loans.
Bank management should understand how such options may
alter the banks interest rate exposure under various interest rate
environments. Regardless of the type and level of complexity of
a banks measurement system, management should ensure that
the system is adequate to the task. All measurement systems require
a bank to gather and input position data, make assumptions
about possible future interest rate environments and customer
behavior, and compute and quantify risk exposure. To assess the
11D.571.3
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Aggregation
The amount of data aggregated from transaction systems for
the interest rate risk model will vary from bank to bank and
from portfolio to portfolio within a bank. Some banks may
input each specific instrument for certain portfolios. For
example, the cash flow characteristics of certain complex CMO
or structured notes may be so transaction-specific that a bank
elects to model or input each transaction separately. More
typically, the bank will perform some preliminary data
aggregation before putting the data into its interest rate risk
model. This ensures ease of use and computing efficiency.
Although most bank models can handle hundreds of
accounts or transactions, every model has its limit. Because
some portfolios contain numerous variables that can affect their
interest rate risk, additional categories of information or less
aggregated information may be required. For example, banks
with significant holdings of adjustable rate mortgages will need
to differentiate balances by periodic and lifetime caps, the reset
frequency of mortgages, and the market index used for rate
resets. Banks with significant holdings of fixed rate mortgages
will need to stratify balances by coupon levels to reflect
differences in prepayment behaviors.
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Gathering Data
The first step in a banks risk measurement process is to gather
data to describe the banks current financial position. Every
measurement system, whether it is a gap report or a complex
economic value simulation model, requires information on the
composition of the banks current balance sheet. In modeling
terms, gathering financial data is sometimes called providing
the current position inputs. This data must be reliable for the
risk measurement system to be useful. The bank should have
sufficient management information systems (MIS) to allow it
to retrieve appropriate and accurate information in a timely
manner. The MIS systems should capture interest rate risk data
on all of the banks material positions, and there should be
sufficient documentation of the major data sources used in the
banks risk measurement process. Bank management should be
alert to the following common data problems of interest rate
risk measurement systems:
To obtain the detailed information necessary to measure interest

rate risk, banks need to be able to tap or extract data from
numerous and diverse transaction systems the base systems
that keep the records of each transactions maturity, pricing, and
payment terms. This means that the bank will need to access
information from a variety of systems, including its commercial
and consumer loan, investment, and deposit systems. The
banks general ledger may also be used to check the integrity of
balance information pulled from these transaction systems.
Information from the general ledger system by itself, however,
generally will not contain sufficient information on the maturity
and repricing characteristics of the banks portfolios.
Incomplete data on the banks operations, portfolios, or
branches.
Lack of information on off-balance-sheet positions and on
caps and floors incorporated into bank loan and deposit
products.
Inappropriate levels of data aggregation.
Information to Be Collected
To describe the interest rate risk inherent in the banks current
position, the bank should have, for every material type of
financial instrument or portfolio, information on:
The current balance and contractual rate of interest associated
with the instrument or portfolio.
The scheduled or contractual terms of the instrument or
portfolio in terms of principal payments, interest reset dates,

and maturities.
For adjustable rate items, the rate index used for repricing (such
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as prime, Libor, or CD) as well as whether the instruments

have contractual interest rate ceilings or floors.
A bank may need to collect additional information on certain

products to provide a more complete picture of the banks interest
rate risk exposure. For example, because the age or seasoning
of certain loans, such as mortgages, may affect their prepayment
speeds, the bank may need to obtain information on the
origination date and interest rate of the instruments. The
geographic location of the loan or deposit may also help the bank
evaluate prepayment or withdrawal speeds. Some banks may use
a tiered pricing structure for certain products such as consumer
deposits. Under such pricing structures, the level and
responsiveness of the rates offered for deposits will vary by the
size of the deposit account. If the bank uses this type of pricing,
it may need to stratify certain portfolios by account size.
Since a banks interest rate risk exposure extends beyond its onbalance-sheet positions to include off-balance-sheet interest
contracts and rate-sensitive fee income, the bank should include
these items in its interest rate risk measurement process.
Developing Scenarios and Assumptions

The second step in a banks interest rate risk measurement
process is to project future interest rate environments and to
measure the risk to the bank in these environments by
determining how certain influences (cash flows, market and
product interest rates) will act together to change prices and
earnings. Unlike the first step, in which one can be certain
about data inputs, here the bank must make assumptions
about future events. For the risk measurement system to be
reliable, these assumptions must be sound. A banks interest
rate risk exposure is largely a function of (1) the sensitivity of
the banks instruments to a given change in market interest rates
and (2) the magnitude and direction of this change in market
interest rates. The assumptions and interest rate scenarios
developed by the bank in this step are usually shaped by these
two variables.
Some common problems in this step of the risk measurement
process include:
Failing to assess potential risk exposures over a sufficiently
wide range of interest rate movements to identify vulnerabilities

and stress points.
Sources of Information
11D.571.3
119
adequacy of a banks interest rate risk measurement process,

examiners should review and evaluate each of these steps.
Basing assumptions solely on past customer behavior and
performance without considering how the banks competitive

market and customer base may change in the future.
Failing to periodically reassess the reasonableness and accuracy
of assumptions.
From these specifications, the bank develops interest rate scenarios

over which exposures will be measured. The complexity of the
actual scenarios used may range from a simple assumption that all
rates move simultaneously in a parallel fashion to more complex
rate scenarios involving multiple yield curves. Banks will generally
use one of two methods to develop interest rate scenarios:
The deterministic approach. Using this common method, the
bank specifies the amount and timing of the rate changes to be

evaluated. The risk modeler is determining in advance the range
of potential rate movements. Banks using this approach will
typically establish standard scenarios for their risk analysis and
reporting, based on estimates of the likelihood of adverse
interest rate movements. The bank may also include an analysis
of its exposure under a most likely or flat rate scenario for
comparative purposes. These standard rate scenarios are then
supplemented periodically with stress test scenarios. The
number of scenarios used may range from three (flat, up, down)
to 40 or more. These scenarios may include rate shocks, in
which rates are assumed to move instantaneously to a new
level, and rate ramps, where rates move more gradually. Banks
may use parallel and nonparallel yield curve shifts, with tests
for yield curve twists or inversions. Models using deterministic
rate scenarios generate an indicator of risk exposure for each
rate scenario by highlighting the difference in net income
between the base case and other scenarios. For example, the
model may estimate the level of net income over the next 12
months for each rate scenario. Results often are displayed in a
matrix-type table with exposures for base, high, and low rate
scenarios.
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Future Interest Rate Assumptions

A bank must determine the range of potential interest rate
movements over which it will measure its exposure. Bank
management should ensure that risk is measured over a
reasonable range of potential rate changes, including
meaningful stress situations. In developing appropriate rate
scenarios, bank management should consider a variety of
factors such as the shape and level of the current term structure
of interest rates and the historical and implied volatility of
interest rates. The bank should also consider the nature and
sources of its risk exposure, the time it would realistically need
to take actions to reduce or unwind unfavorable risk positions,
and bank managements willingness to recognize losses in order
to reposition its risk profile. Banks should select scenarios that
provide meaningful estimates of risk and include sufficiently
wide ranges to allow management to understand the risk
inherent in the banks products and activities.
often move more slowly than market rates, including rates such as
the banks prime rate, and rates it pays on consumer deposits.
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embedded options to be consistent with individual rate

scenarios.
Banks should use interest rate scenarios with at least a 200-basispoint change-taking place in one year. Since 1984, rates have twice
changed that much or more in that period of time. The OCC
encourages banks to assess the impact of both immediate and
gradual changes in market rates as well as changes in the shape of
the yield curve when evaluating their risk exposure. The OCC also
encourages banks to employ stress tests that consider changes
of 400 basis points or more over a one-year horizon. Although
such a shock is at the upper end of post-1984 experience, it was
typical between 1979 and 1984. Banks with significant option risk
should include scenarios that capture the exercise of such options.
For example, banks that have products with caps or floors should
include scenarios that assess how the banks risk profile would
change should those caps or floors become binding. Some banks
write large, explicitly priced interest rate options. Since the market
value of options fluctuates with changes in the volatility of rates
as well as with changes in the level of rates, such banks should
also develop interest rate risk assumptions to measure their
exposure to changes in volatility.
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Failing to modify or vary assumptions for products with
Developing Rate Scenarios

The method used to develop specific rate scenarios will vary
from bank to bank. In building a rate scenario, the bank will
need to specify:
The term structure of interest rates that will be incorporated in
its rate scenario.

The basis relationships between yield curves and rate indices
for example, the spreads between Treasury, Libor, and CD
rates.
The bank also must estimate how rates that are administered or
managed by bank management (as opposed to those that are
purely market driven) might change. Administered rates, which
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The stochastic approach. Developed out of options and
mortgage pricing applications, this method employs a model

to randomly generate interest rate scenarios, and thousands of
individual interest rate scenarios or paths are evaluated. Models
using this approach generate a distribution of outcomes or
exposures. Banks use these distributions to estimate the
probabilities of a certain range of outcomes. For example, the
bank may want to have 95 percent confidence that the banks
net income over the next 12 months will not decline by more
than a certain amount.
Behavioral and Pricing Assumptions

When assessing its interest rate risk exposure, a bank also must
make judgments and assumptions about how an instruments
actual maturity or repricing behavior may vary from the
instruments contractual terms. For example, customers can
change the contractual terms of an instrument by prepaying
loans, making various deposit withdrawals, or closing deposit
accounts (deposit runoffs). The bank must assess the likelihood
that customers will elect to exercise these options. These
likelihoods will generally vary with each interest rate scenario. In
addition, a banks vulnerability to customers exercising
embedded options in retail assets and liabilities will vary from
bank to bank because of differences in customer bases and
demographics, competition, pricing, and business philosophies.
Assumptions are especially important for products that have
unspecified repricing dates, such as demand deposits, savings,
11D.571.3
Historical trend analysis of past portfolio and individual account
behavior.
Bank- or vendor-developed prepayment models.

Dealer or vendor estimates.
Managerial and business unit input about business and pricing
strategies.
Bank management should ensure that key assumptions are

evaluated at least annually for reasonableness. Market conditions,
competitive environments, and strategies change over time, causing
assumptions to lose their validity. For example, if the banks
competitive market has changed such that consumers now face
lower transaction costs for refinancing their residential mortgages,
prepayments may be triggered by smaller reductions in market
interest rates than in the past. Similarly, as bank products go
through their life cycle, bank managements business and pricing
strategies for the product may change.
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A banks review of key assumptions should include an assessment

of the impact of those assumptions on the banks measured
exposure. This type of assessment can be done by performing
what-if or sensitivity analyses that examine what the banks
exposure would be under a different set of assumptions. By
conducting such analyses, bank management can determine which
assumptions are most critical and deserve more frequent
monitoring or more rigorous methods to ensure their
reasonableness. These analyses also serve as a type of stress test
that can help management to ensure that the banks safety and
soundness would not be impaired if future events vary from
managements expectations.
Management should document the types of analyses underlying

key assumptions. Such documents, which usually briefly describe
the types of analyses, facilitate the periodic review of assumptions.
It also helps to ensure that more than one person in the
organization understands how assumptions are derived. The
volume and detail of that documentation should be consistent
with the significance of the risk and the complexity of analysis.
For a small bank, the documentation typically will include an analysis
of historical account behavior and comments about pricing
strategies, competitor considerations, and relevant economic
factors. Larger banks often use more rigorous and statistically
11D.571.3
Computing Risk Levels

The third step in a banks risk measurement process is the
calculation of risk exposure. Data on the banks current position
is used in conjunction with its assumptions about future
interest rates, customer behavior, and business activities to
generate expected maturities, cash flows, or earnings estimates,
or all three. The manner in which risk is quantified will depend
on the methods of measuring risk.
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Some banks encounter the following problems when using risk

measurement systems:
The model no longer captures all material sources of a banks
interest rate risk exposure. Banks that have not updated risk
measurement techniques for changes in business strategies and
products or acquisition and merger activities can experience this
problem.
Bank management does not understand the models methods
and assumptions. Banks that purchase a vendor model and
fail to obtain current user gudes and source documents that
describe the models implied assumptions and calculation
methods may misinterpret model results or have difficulties
with the measurement system.
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A banks assumptions need to be consistent and reasonable for

each interest rate scenario used. For example, assumptions about
mortgage prepayments should vary with the rate scenario and
reflect a customers economic incentives to prepay the mortgage in
that interest rate environment. A bank should avoid selecting
assumptions that are arbitrary and not verified by experience and
performance. Typical information sources used to help formulate
assumptions include:
based analyses. The banks key assumptions and their impact

should be reviewed by the board, or a committee thereof, at least
annually.
Only one person in the bank is able to run and maintain the
risk measurement system. Should that person leave the bank,

the institution may not be able to generate timely and accurate
estimates of its risk exposure. More than one person, when
possible, should have detailed knowledge of the measurement
system.
Calculating Risk to Reported Earnings

The OCC expects all national banks to have systems that enable
them to measure the amount of earnings that may be at risk
from changes in interest rates. Calculating a banks reported
earnings-at-risk is the focus of many commonly used interest
rate risk models. When measuring risk to earnings, these
models typically focus on:
Net interest income, or the risk to earnings arising from accrual
accounts. This part of a banks interest rate risk model is similar

to a budget or forecasting model. The model multiplies
projected average rates by projected average balances. The
projected average rates and balances are derived from the banks
current positions and its assumptions about future interest
rates, maturities and repricings of existing positions, and new
business assumptions.
Mark-to-market gains or losses on trading or dealing positions
(i.e., price risk). This calculation is often performed in a separate

market valuation model or subsystem of the interest rate risk
model. In essence, these models project all expected future
cash flows and then discount them back to a present value. The
model measures exposure by calculating the change in net
present values under different interest rate scenarios.
Rate-sensitive fee income, or the risk to earnings arising from
interest sensitive fee income or operating expenses. Examples

include mortgage servicing fees and income arising from credit
card securitization.
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NOW and MMDA accounts (nonmaturity deposits), and credit

card loans. Management must estimate the date on which these
balances will reprice, migrate to other bank products, or run off.
In doing so, bank management needs to consider many factors
such as the current level of market interest rates and the spread
between the banks offering rate and market rates; its
competition from banks and other firms; its geographic
location and the demographic characteristics of its customer
base.
Risk Monitoring
Interest rate risk management is a dynamic process. Measuring
the interest rate exposure of current business is not enough; a
bank should also estimate the effect of new business on its
exposure. Periodically, institutions should reevaluate whether
current strategies are appropriate for the banks desired risk
profile. Senior management and the board should have
reporting systems that enable them to monitor the banks
current and potential risk exposure and to ensure that those
levels are consistent with their stated objectives.
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To determine whether a bank needs a system that measures the

impact of long-term positions on capital, examiners should
consider the banks balance sheet structure and its exposure to
option risk. For example, a bank with more than 25 percent of
total assets in long-term, fixed rate securities and comparatively
little in nonmaturity deposits or long-term funding may need to
measure the long-term impact on the economic value of equity. If
a bank is invested mainly in short-term securities and working
capital loans and funded chiefly by short-term deposits, it probably
would not.
Deterministic models, in contrast, view an option unrealistically

as riskless until the predetermined rate path rises above the strike
price, at which point the exposure estimate suddenly becomes
very large.
Evaluating and Implementing Strategies

Well-managed banks look not only at the risk arising from their
existing business but also at exposures that could arise from
expected business growth. In their risk-to-earnings analyses,
they may make assumptions about the type and mix of
activities and businesses as well as the volume, pricing, and
maturities of future business. Typically, strategic business plans,
marketing strategies, annual budgets, and historical trend
analyses help banks to formulate these assumptions. Some
banks may also include new business assumptions in analyzing
the risk to the banks economic value. To do so, a bank first
quantifies the sensitivity of its economic value of equity (EVE)
to the risks posed by its current positions. Then it recomputes
its EVE sensitivity as of a future date, under a projected or pro
forma balance sheet.
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Calculating Risk to Capital

Banks that have significant medium- and long-term positions
should be able to assess the long-term impact of changes in
interest rates on the earnings and capital of the bank. Such an
assessment affords the economic perspective or EVE. The
appropriate method for assessing a banks long-term exposures
will depend on the maturity and complexity of the banks
assets, liabilities, and of balancesheet activities. That method
could be a gap report covering the full maturity range of the
banks activities, a system measuring the economic value of
equity, or a simulation model.
Banks can measure the volatility of long-term interest rate risk

exposures using a variety of methods. For example, a bank that is
considerably exposed to intermediate-term (three to five years)
interest rate risk may elect to expand its earnings-at-risk analysis
beyond the traditional one- to two-year time period. Gap reports
that reflect a variety of rate scenarios and that provide sufficient
detail in the timing of long-term mismatches may also be used to
measure long-term interest rate risk.
The OCC encourages banks with significant interest rate risk

exposures to augment their earnings-at-risk measures with systems
that can quantify the potential effect of changes in interest rates on
their economic value of equity. With few exceptions, larger national
banks engaging in complex on- and of balancesheet activities
need such measurement systems.
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To quantify its economic value of equity exposure, a bank generally

will use either duration-based models (where duration is a proxy
for market value sensitivity) or market (economic) valuation
models. These models are essentially a collection of present value
calculations that discount the cash flows derived from the current
position and assumptions for a specified interest rate scenario.
Static discounted cash flow models are associated with deterministic

models. In deterministic models, the user designates an interest
rate scenario, and the model generates an exposure estimate for
the scenario. Stochastic models use rate scenarios that are randomly
generated. Exposure estimates are then generated for each scenario,
and an estimate of expected value can be calculated from the
distribution of estimates.
Although stochastic models require more expertise and computing
power than deterministic models, they provide more accurate risk
estimates. Specifically, stochastic models produce more accurate
estimates for options and products with embedded options. The
value of most options increases continually as interest rates
approach the options strike rates, and the probability of the option
going into the money likewise increases continually. Stochastic
models capture this effect because they calculate an expected value
of future cash flows derived from a distribution of rate paths.
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Although new business assumptions introduce yet another

subjective factor to the risk measurement process, they help bank
management to anticipate future risk exposures. When
incorporating assumptions about new and changing business mix,
bank management should ensure that those assumptions are
realistic for the rate scenario being evaluated and are attainable
given the banks competition and overall business strategies. In
particular, bank management should avoid overly optimistic
assumptions that serve to mask the banks interest rate exposure
arising from its existing business mix. For example, to improve
its earnings under a rising interest rate scenario, bank management
may want to increase the volume of its floating rate loans and
decrease its fixed rate loans. Such a restructuring, however, may
take considerable time and effort, given the banks overall lending
strategies, customer base, and customer preferences.
Larger banks typically monitor their interest rate risk exposure
frequently and develop strategies to adjust their risk exposures.
These adjustments may be decisions to buy or sell specific
instruments or from certain portfolios, strategic decisions for
business lines, maturity or pricing strategies, and hedging or risk
transformation strategies using derivative instruments. The banks
interest rate risk model may be used to test or evaluate strategies
before implementation.
Special subsystems or models may be employed to analyze specific
instruments or strategies, such as derivative transactions. The
results from these models are entered into the overall interest rate
risk model. Examiners should review and discuss with bank
management how the bank evaluates potential interest rate risk
11D.571.3
exposure.
Evaluate the sensitivity of key assumptions, such as those
dealing with changes in the shape of the yield curve or in the

speed of anticipated loan prepayments or deposit withdrawals.
Evaluate the trade-offs between risk levels and performance.
When management considers major interest rate strategies

(including no action), they should assess the impact of potential
risk (an adverse rate movement) against that of the potential
reward (a favorable rate movement).
Verify compliance with the boards established risk tolerance
levels and limits and identify any policy exceptions.
Determine whether the bank holds sufficient capital for the
level of interest rate risk being taken.
The reports provided to the board and senior management should

be clear, concise, and timely and provide the information needed
for making decisions. Reports to the board should also cover
control activities. Such reports include (but are not limited to)
audit reports, independent valuations of products used for interest
rate risk management (e.g., derivatives, investment securities), and
model validations comparing model predictions to performance.
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Risk Control
A banks internal control structure ensures the safe and sound
functioning of the organization generally and of its interest rate
risk management process in particular. Establishing and
maintaining an effective system of controls, including the
enforcement of official lines of authority and appropriate
separation of duties, is one of managements more important
responsibilities. Persons responsible for evaluating risk
monitoring and control procedures should be independent of
the function they review. Key elements of the control process
include internal review and audit and an effective risk limit
structure.
Auditing the Interest Rate Risk Measurement
Process
Banks need to review and validate each step of the interest rate
risk measurement process for integrity and reasonableness. This
review is often performed by a number of different units in the
organization, including ALCO or treasury staff (regularly and
routinely), and a risk control unit that has oversight
11D.571.3
Among the items that an audit should review and validate are:
The appropriateness of the banks risk measurement system(s)
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Evaluate the level and trends of aggregate interest rate risk
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Interest Rate Risk Reporting

Banks should have an adequate system for reporting risk
exposures. A banks senior management and its board or a
board committee should receive reports on the banks interest
rate risk profile at least quarterly. More frequent reporting may
be appropriate depending on the banks level of risk and the
likelihood of its level of risk changing significantly. These
reports should allow senior management and the board or
committee to do the following:
responsibility for interest rate risk modeling. Internal and

external auditors also can periodically review a banks process. At
smaller banks, external auditors or consultants often perform
this function. Examiners should identify the units or
individuals responsible for auditing important steps in the
interest rate risk measurement process. The examiner should
review recent internal or external audit work papers and assess
the sufficiency of audit review and coverage. The examiner
should determine in particular whether an appropriate level of
senior management or staff periodically reviews and validates
the assumptions and structure of the banks interest rate risk
measurement process. Management or staff performing these
reviews should be sufficiently independent from the line units
or individuals who take or create interest rate risk.
given the nature, scope, and complexity of its activities.
The accuracy and completeness of the data inputs into the
model. This includes verifying that balances and contractual

terms are correctly specified and that all major instruments,
portfolios, and business units are captured in the model. The
review also should investigate whether data extracts and model
inputs have been reconciled with transactions and general ledger
systems. It is acceptable for parts of the reconcilement to be
automated; e.g, routines may be programmed to investigate
whether the balances being extracted from various transaction
systems match the balances recorded on the banks general ledger.
Similarly, the model itself often contains various audit checks
to ensure, for example, that maturing balances do not exceed
original balances. ALCO, audit staffs, or both may also perform
more detailed, periodic audit tests of specific portfolios.
The reasonableness and validity of scenarios and assumptions.
The audit function should review the appropriateness of the

interest rate scenarios as well as customer behaviors and pricing/
volume relationships to ensure that these assumptions are
reasonable and internally consistent. For example, the level of
projected mortgage prepayments within a scenario should be
consistent with the level of interest rates used in that scenario.
Generally this will mean using faster prepayment rates in
declining interest rates scenarios and slower prepayment rates
in rising rate scenarios. An audit should review the statistical
methods that were used to generate scenarios and assumptions
(if applicable), and whether senior management reviewed and
approved key assumptions.
The audit or review also should compare actual pricing spreads

and balance sheet behavior to model assumptions. For some
instruments, such as residential mortgage loans, estimates of value
changes can be compared with market value changes. Unfavorable
results may lead the bank to revise model relationships such as
prepayment and pricing behaviors.
The validity of the risk measurement calculations. The validity
of the model calculations is often tested by comparing actual
with forecasted results. When doing so, banks will typically
compare projected net income results with actual earnings.
Reconciling the results of economic valuation systems can be
more difficult because market prices for all instruments are not
always readily available, and the bank does not routinely mark
123
exposures of new products or future business plans. Examiners

should assess whether the banks assumptions about new business
are realistic and attainable. In addition, examiners should review
the banks interest rate risk strategies to determine whether they
meet or are consistent with the stated goals and objectives of
senior management and the board.
Risk Limits
The banks board of directors should set the banks tolerance
for interest rate risk and communicate that tolerance to senior
management. Based on these tolerances, senior management
should establish appropriate risk limits that maintain a banks
exposure within the boards risk tolerances over a range of
possible changes in interest rates. Limit controls should ensure
that positions that exceed predetermined levels receive prompt
management attention. A banks limits should be consistent
with its overall approach to measuring interest rate risk and
should be based on its capital levels, earnings performance, and
risk tolerance. The limits should be appropriate to the size,
complexity, and capital adequacy of the bank and address the
potential impact of changes in market interest rates on both
reported earnings and the banks economic value of equity
(EVE).
The appropriate target account may vary and generally depends

upon the nature and sources of the banks earnings exposure. For
some banks, most if not all of their earnings volatility will occur
in their net interest margin. For these banks, NII may be an
appropriate target. In constructing a limit based on NII, however,
bank management should consider and understand how variations
in its margin may affect its bottom-line earnings performance. A
bank with substantial overhead expenses, for example, may find
that relatively small variations in its margin result in significant
changes to its net income. Banks with significant non-interest
income and expense items that are sensitive to interest rates
generally should consider a more bottom-line-oriented targeted
account, such as NI or EPS.
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The scope and formality of the measurement validation will

depend on the size and complexity of the bank. At large banks,
internal and external auditors may have their own models against
which the banks model is tested. Larger banks and banks with
more complex risk profiles and measurement systems should
have the model or calculations audited or validated by an
independent source either an internal risk control unit of the
bank, auditors, or consultants. At smaller and less complex banks,
periodic comparisons of actual performance with forecasts may
be sufficient.
earnings (in dollars or percent) over a specified time horizon

and rate scenario. Banks typically compute their earnings-at-risk
limits relative to one of the following target accounts: net
interest income (NII), pre-provision net income (PPNI), net
income (NI), or earnings per share (EPS).
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all of its balance sheet to market. For instruments or portfolios

with market prices, these prices are often used to benchmark or
check model assumptions.
Many banks will use a combination of limits to control their

interest rate risk exposures. These limits include primary limits on
the level of reported earnings at risk and economic value at risk
(for example, the amount by which net income and economic
value may change for a given interest rate scenario) as well as
secondary limits. These secondary limits form a second line of
defense and include more traditional volume limits for maturities,
coupons, markets, or instruments.
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Pricing policies may also control the creation of interest rate risk
exposures and internal funds transfer pricing systems. Funds
transfer systems typically require line units to obtain funding prices
from the banks treasury unit for large transactions. Those funding
prices generally reflect the cost that the bank would incur to hedge
or match-fund the transaction.
Examiners should identify and evaluate the types of limits the
bank uses to control the risk to earnings and capital from changes
in interest rates. In particular, the examiner should determine
whether the risk limits are effective methods for controlling the
banks exposure and complying with the boards expressed risk
tolerances. The examiner also should assess the appropriateness
of the level of risk allowed under the banks risk limits in view of
the banks financial condition, the quality of its risk management
practices and managerial expertise, and its capital base.
Earnings-At-Risk Limits
Earnings-at-risk limits are designed to control the exposure of a
banks projected future reported earnings in specified rate
scenarios. A limit is usually expressed as a change in projected
124
Capital-At-Risk (EVE) Limits

A banks EVE limits should reflect the size and complexity of
its underlying positions. For banks with few holdings of
complex instruments and low risk profiles, simple limits on
permissible holdings or allowable repricing mismatches in
intermediate- and long-term instruments may be adequate. At
more complex institutions, more extensive limit structures may
be necessary. Banks that have significant intermediate- and longterm mismatches or complex options positions should
establish limits to restrict possible losses of economic value or
capital.
Gap Limits
Gap (maturity or repricing) limits are designed to reduce the
potential exposure to a banks earnings or capital from changes
in interest rates. The limits control the volume or amount of
repricing imbalances in a given time period.
These limits often are expressed by the ratio of rate-sensitive
assets (RSA) to rate-sensitive liabilities (RSL) in a given time period.
A ratio greater than one suggests that the bank is asset-sensitive
and has more assets than liabilities subject to repricing. All other
factors being constant, falling interest rates generally will reduce
the earnings of such a bank. An RSA/RSL ratio less than one
means that the bank is liability-sensitive and that rising interest
rates may reduce its earnings. Other gap limits that banks use to
control exposure include gap-to-assets ratios, gap-to-equity ratios,
and dollar limits on the net gap.
Although gap ratios may be a useful way to limit the volume of a
banks repricing exposures, the OCC does not believe that, by
themselves, they are an adequate or effective method of
communicating the banks risk profile to senior management or
the board. Gap limits are not estimates of the earnings (net interest
income) that the bank has at risk. A bank that relies solely on gap
measures to control its interest rate exposure should explain to its
senior management and board the level of earnings and capital at
risk that are implied by its gap exposures (imbalances).
11D.571.3
LESSON 23:
INTEREST RATE RISK MODELS
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Gap Reports
Gap reports are commonly used to assess and manage interest
rate risk exposure specifically, a banks repricing and maturity
imbalances. However, as explained later in this appendix, a basic
gap report can be an unreliable indicator of a banks overall
interest rate risk exposure. Although a simple gap report does
not identify and quantify basis risk, yield curve risk, and option
risk, bankers have modified gap reports to do so. Gap reports
stratify all of a banks assets, liabilities, and off-balance-sheet
instruments into maturity segments (time bands) based on the
instruments next repricing or maturity date. Balances within a
time band are then summed (assets are reported as positive
amounts and liabilities as negative amounts) to produce a net
gap position for each time band. Risk is measured by the size
of the gap (the amount of net imbalance within a time band)
and the length of time the gap is open.
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Common Interest Rate Risk Models
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Using properly prepared gap reports, a bank can identify and

measure short and long-term repricing imbalances. With this
information, a bank can estimate its earnings and economic risks
within certain constraints. Gap reports can be particularly useful in
identifying the repricing risk of a banks current balance sheet
structure before assumptions are made about new business or
how to effectively reinvest maturing balances. Within a given time
band, a bank may have a positive, negative, or neutral gap. A bank
will have a positive gap when more assets reprice or mature than
liabilities. Because this bank has more assets than liabilities subject
to repricing, the bank is said to be asset sensitive for that time
band. An asset sensitive bank is generally expected to benefit from
rising interest rates because its assets are expected to reprice more
quickly than its liabilities.
A bank has a negative gap and is liability sensitive when more
liabilities reprice within a given time band than assets. A bank that
is liability-sensitive, such as the bank described in the gap report in
table 1, usually benefits from falling interest rates. (The gap report
in table 1 is a simplified example. In practice, most gap reports will
contain many more line items and additional time bands.)
A bank whose assets equal liabilities within a time band is said to

have a neutral gap position. A bank in a neutral gap position
is not free of exposure to changes in interest rates, however.
Although the banks repricing risk may be small, it can still be
exposed to basis risk or changes in rate relationships.
Traditionally, most bankers have used gap report information to
evaluate how a banks repricing imbalances will affect the sensitivity
of its net interest income for a given change in interest rates. The
same repricing information, however, can be used to assess the
sensitivity of a banks net economic value to a change in interest
rates
11D.571.3
Construction of a Gap Report

As a general rule, all assets, liabilities, and off-balance-sheet
items should be included in a banks gap report. Less complex
banks should, at a minimum, include all earning assets and
interest-paying liabilities in their gap reports. A bank also
should consider including potential repricings or maturities of
all non-earning assets and non-interest-bearing liabilities in its
reports. Non-earning assets such as non-accrual loans, for
example, may at some point be collected or renegotiated, and
then become repriceable. Non-interest-bearing liabilities
(demand deposit account balances) also should be included in a
banks gap report even though such deposits do not bear an
explicit rate of interest. Such deposits are included because their
maturity or run-off exposes the bank to interest rate risk. (The
bank may need to replace the deposits with interest bearing
sources of funds such as NOW accounts, certificates of
deposits, or federal funds purchased.)
If the bank operates significant books in currencies other than the
dollar, it should prepare a separate gap report for each book. Why?
Interest rates in different countries can move in different directions,
and the volatility of such interest rates can differ considerably as
well. A significant currency book would be one that represents at
least 10 percent of total business. Many banks avoid open positions
or repricing imbalances in their foreign currency books. If this is
the banks policy, gap reports for those currencies may not be
needed. Number of Time Bands A bank must decide how many
time bands it will use in its gap report. In general, the narrower the
time bands, the more accurate the risk measures. To measure risk
to earnings, the report should have at least monthly detail over
the first year and quarterly over the second. If a gap report is used
to capture long-term exposures and risk to economic value, the
time bands should extend to the maturity of the last asset or
liability.
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In a product with an embedded option, the cash flows will depend

on the path of interest rates; different interest rate paths need to
be considered because the dates of the options exercise will change
accordingly, affecting cash flows. A single gap report gives an
incomplete picture of products with embedded options because
it allows for only one repricing date. Three methods of
incorporating options exposures into gap reports are popular
with banks. An examiner encountering a bank using another
method should analyze the approach to determine whether it
properly incorporates the asymmetrical impact of options on
future net interest income and economic value.
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Reporting of Off-Balance-Sheet Items

A gap report that does not include off-balance-sheet interest rate
positions does not fully measure a banks interest rate risk
profile. All material positions in off-balance-sheet instruments
whose value can be affected by interest rates should be captured
in a gap report. Such instruments include interest rate contracts,
such as swaps, futures, and forwards; option contracts, such as
caps, floors, and options on futures; and firm forward
commitments to buy or sell loans, securities, or other financial
instruments. Off-balance-sheet instruments are often reported
in a gap report using two entries to reflect how the instruments
alter the timing of cash flows. The two entries of the contract
are offsetting: one entry is the notional principal amount of the
contract reported as a positive dollar value, and the other is an
offsetting negative entry. If the off-balance-sheet position
generally increases in value when interest rates fall (e.g., long
futures, pay-floating swap, long call option, and short put
option positions), the first entry is reported with a negative
value and the second entry is reported with a positive value.
contract or to act when warranted by market conditions. When a

customer exercises the option, the bank loses a valuable asset
that will no longer pay interest. Since these products are
germane to a banks interest rate risk exposure, institutions
should incorporate them into their gap reports.
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Time bands for distant time periods, say, beyond 10 years, may be
relatively wide five years, for example. These wider time frames
are justified because the change in interest rate sensitivity is small
for maturities beyond 10 years. In other words, a banks use of
wide time bands beyond 10 years will not usually cause it to
misestimate its interest rate risk exposure for items in those time
bands.
Conversely, if the position generally increases in value when interest

rates rise (e.g., short futures, pay-fixed swap, short call option, and
long put option positions), the first entry is positive and the
second is negative. This slotting reflects the impact of an offbalance-sheet instrument on the effective maturity of an asset on
the balance sheet.
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For example, if a bank has a $100 million five-year interest swap in

which it receives a fixed rate and pays three-month Libor, the bank
would report a positive $100 million in the five-year time band
and a negative $100 million in the three-month time band. This
treatment reflects the fact that the bank is long a fixed rate
payment (as if it owned a fixed rate asset) and short a floatingrate payment (as if it had a floating-rate liability).
A long futures position would increase a banks asset maturity,

while a short futures position would decrease its asset maturity.
Hence, a long position in a 10-year Treasury note future that expires
in five months would be reported as a negative entry in the time
band that covers five-month maturities and a positive entry in the
time band that covers a 10-year instrument. As discussed in the
next section, option instruments such as caps and floors pose
special problems for gap reports. Because most gap reports usually
assume a static interest rate environment at the current level of
interest rates, they ignore caps and floors until the strike rate is hit.
Suppose a bank has a long position in a 10-year interest rate cap.
Before the strike rate is hit, the report would show the position as
a floating rate liability and would ignore the cap; after the strike
rate is hit, the position becomes a 10-year fixed rate liability.
Reporting of Options-Related Positions
Many consumer products have embedded options in them
because the customer has the right to change the terms of a
126
The first method either recognizes that the cap is in full effect for
the remaining life of the product or ignores it for that same period.
The following example illustrates this all-or-nothing approach to
a cap on a floating rate loan: The bank has a 10-year $100,000
floating rate loan that reprices every six months but is subject to a
12 percent lifetime cap (the rate on the loan cannot exceed 12
percent). The all-or-nothing approach would consider the loan a
six-month floating rate loan when rates are below 12 percent. If
rates equal or exceed 12 percent, the loan becomes a fixed rate loan
with a 10-year repricing maturity. This approach has several
weaknesses. First, the method does not correctly reflect the
exposure of net interest income to future changes in interest rates.
For example, when the loan is slotted as a six-month repricing
asset and funded with a six-month CD, the gap report would not
indicate any interest rate risk. If interest rates were to rise above 12
percent, however, the loan could not reprice further but the funding
costs on the CD could continue to rise, and interest rate margins
would decline. Second, this treatment does not suggest how this
exposure may be hedged. Neither hedging the asset as a six-month
floating rate asset nor hedging it as a 10-year fixed rate asset would
be appropriate.
A better approach would be for the bank to prepare two gap
reports, one for a high-rate scenario and the other for a low-rate
scenario. Under the high-rate scenario, the cap would be binding
and the gap report would show the capped loans as fixed rate
assets. Under the low-rate scenario, the gap report would show
the loan as a floating rate asset.
A bank could use similar approaches to measure prepayment
option risks associated with fixed rate residential mortgage loans.
Under the high-rate scenario, the weighted average lives of the
fixed rate mortgages would be extended in the gap report, reflecting
the effect of slower prepayments.
Under the low-rate scenario, the weighted lives would be
shortened, reflecting faster prepayments. Comparing the gaps
between the two schedules provides an indication of the amount
of option risk the bank faces. Although this second method
provides a way to assess how embedded options may alter a banks
repricing imbalances under alternative interest rate scenarios, it
also has limitations. Like the all-or-nothing approach, this method
suggests that an option has value only when it becomes binding
11D.571.3
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It is important to stress that this method of measuring a banks

net interest income at risk is very crude and employs numerous
simplifying assumptions, including the following:
All repricing and maturities within a time band occur
simultaneously (as in the above formula), typically at the
beginning, middle, or end of the period.
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In the illustration of the loan with the 12 percent lifetime cap

described above, the bank could strip the cap from the loan and
treat the cap and loan as two separate instruments. The bank
would report the loan as a six-month floating rate loan and the
cap as an off-balance-sheet instrument, based on the caps deltaequivalent value. The delta-equivalent value would equal the delta
of the cap times the notional value of the cap (in this case, the
principal amount of the loan, or $100,000).
The cap in this example would have a delta between 50 percent
and 100 percent when rates are greater than 12 percent. The high
level of the delta indicates a high probability of the cap being
effective over the life of the loan. If market rates were at 8 percent,
however, the delta would be much lower, reflecting a lower
probability that the cap will be effective over the life of the loan.
The delta approach also has limitations. The delta of an option

changes in a nonlinear fashion with the passage of time and with
the level of interest rates. As a result, the delta value of an option
is valid only for small changes in interest rates, and this value
changes over time.
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Measuring Risk to Net Interest Income

After a bank has stratified the banks assets, liabilities, and offbalance-sheet instruments into time bands and determined
how it will treat embedded options, it must measure net
interest income (NII) at risk. The formula to translate gaps into
the amount of net interest income at risk, measuring exposure
over several periods, is:
(Periodic gap) x (change in rate) x (time over which the periodic

gap is in effect) = change in NII
Applying it to the sample gap report shown in table 1 and
calculating the change in the banks net interest income for an
immediate 200-basis-point increase in rates can illustrate this
formula. For example, the bank has a negative gap of $20 million
in the one-month to three-month time band. This means that
more liabilities than assets will reprice or mature during this time
frame. Hence, for the remaining 10 months of the banks 12month time horizon, the bank will have $20 million more of
liabilities than assets that have reprised at higher (200 basis points
higher) rates. As shown in table 2, the increase in rates reduces the
banks earnings for the 10-month period by approximately
$333,000. The cumulative earnings effect of the banks repricing
imbalances over the 12-month horizon is a reduction in net interest
income of approximately $362,500.
11D.571.3
All maturing assets and liabilities are reinvested at overnight
rates.
No other new business is booked.
There is an instantaneous change in the overnight rate to a new
and constant level.
All interest rates move the same amount. Using simulation
models can test the sensitivity of the results to these

assumptions.
Measuring Risk to Economic Value

Gap reports may be used to measure the exposure of a banks
net economic value to a change in interest rates. To do so, a
bank multiplies the balances in each time band by a price
sensitivity factor that approximates, for a given change in
interest rates, the percentage change in the present value of an
instrument with similar cash flow and maturity characteristics.
For example, consider a bank that has $10 million of two-year
Treasury notes slotted in the time band covering from two years
to three years in its gap report. To estimate the market value
sensitivity of those balances to a 200-basis-point increase in
market interest rates, a banker would multiply those balances by
a factor that approximates the change in the present value of a
two-year Treasury note for a 200-basis-point movement in rates.
The present value of a note with a 7.5 percent coupon would
decline 3.6 percent for such a rate movement. Hence, the
estimated decline in the market value of the banks $10 million
two-year Treasury note would be approximately $360,000 ($10
million times negative 3.6 percent). Similar price sensitivity
factors can be applied to other types of instruments and time
bands. The exposure of the banks net economic value would
be the sum of the weighted balances.
Limitations of Gap Reports
Basis Risk
The focus of a gap report is on the level of net repricings. The
assumption is that within a given time band, assets and
liabilities fully offset or hedge each other. In practice, however,
assets and liabilities price off different yield curves or indices
and do not move at all points together. To facilitate an
127
or is in the money. In reality, an option has value throughout its

life. The value of the option will depend on such factors as the
time to expiration of the option, the distance from the strike
price, and the volatility of interest rates. A third approach for
incorporating options into gap reports varies the value of the
option according to the change in the value of the underlying
instrument. Incorporating the delta-equivalent value of the option
into the gap report does this. The delta-equivalent value of an
option, a mathematically derived weighting between 0 percent
and 100 percent, reflects the probability that the option will go in
the money.
Intra-Period Gaps
Although gap reports rely on stratifying balances into broad
time bands, they do not detect imbalances within those bands.
Some bankers have partly overcome this weakness by reporting
the weighted average repricing maturity within each time band.
Another method is to reduce the width of the bands.
New Business
Many gap reports used by banks consider only the banks
current financial positions. These reports are called static
reports because they capture only the risk that arises from the
banks existing balance sheet structure and do not incorporate
any assumptions about new business. Some banks may also
prepare dynamic gap reports. Typically, these reports are
generated from the banks earnings simulation models and
show how the banks gap would appear at some point in the
future, after new business assumptions are incorporated into
the risk measure.
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Alternatively, some banks prepare beta-adjusted gap reports in an

attempt to measure basis risk. In this type of report, the repricing
balance for each account type is multiplied by a factor that
approximates the correlation between that accounts pricing
behavior and a benchmark market interest rate. For example, the
report could compare the pricing behavior for all accounts to the
federal funds rate. If the analysis revealed that the banks pricing
on money market deposit accounts moves 50 basis points for
every 100-basis-point movement in the federal funds rate, 50 percent
of such balances would be shown as short-term rate-sensitive,
and the remaining balances would be assigned a longer maturity.
these weaknesses, they are unable to fully capture all of the

dimensions of option risk. To do so, a bank that has significant
option risk must supplement its gap reports with simulation or
option pricing models.
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interpretation of basis risk, some bankers group instruments

with similar basis relationships into separate line items within
the report and report average rates and yields on those groups.
For example, within a 30- to 60-day time band, the repricing
imbalance for accounts tied to CD rates could be reported as
one line item, followed by balances tied to the Treasury curve.
This approach provides a rough approximation of the degree
of basis risk present in the balance sheet.
Even beta-adjusted gap reports, however, do not always provide

a complete picture of a banks basis risk because the correlation
between account pricing and market interest rates may not be the
same for rising and declining interest rate environments or even
for similar rate environments at different points in time. In such
cases, a bank may need to formulate different correlations or beta
factors for each rate scenario it develops. Given the limitations of
gap reports, intuition and judgment are required when using them
to quantify the exposure of earnings to changes in interest rates.
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Yield Curve Risk

To measure a banks cumulative repricing risk over several
periods or time bands, most users of gap reports simply sum
the gaps across each time band to produce a net cumulative gap
position. Implicit in this act is an assumption that movements
in interest rates will be perfectly correlated across the time bands
and will move in a parallel fashion. Applying different weights
to each time band can amend this assumption. For example,
gaps in the shorter time bands could be weighted more heavily
than those in the longer time bands because short-term interest
rates are usually more volatile and usually move by larger
amounts than long-term rates.
The pattern of a banks repricing gaps across the various time

bands can provide an indication of the banks exposure to changes
in yield curve shapes. Suppose a bank that is liability sensitive (has
negative gaps) in the short- and long-term time bands and asset
sensitive in the intermediate time bands is exposed to a flattening
of the yield curve when short-term rates go up and long-term
rates remain stable. The banks net interest margin deteriorates as
the rates on its short-term liabilities increase. Because long-term
rates remain stable, however, the market value of its long-term
liabilities remains constant. Hence, the bank will not benefit from
a decline in the expected future value of its long-term obligations.
Option Risks
As noted in earlier discussions, it is difficult to capture option
risks with gap reports. Options introduce an asymmetrical and
nonlinear element to a banks risk profile. Although techniques
such as preparing multiple gap reports and reporting options by
their delta-equivalent values attempt to overcome some of
128
Bank Simulation Models

Simulation models may be used for measuring interest rate risk
arising from current and future business scenarios. They can be
used to measure risk from either an earnings or economic
perspective. The models simulate or project a banks risk
exposure under a variety of assumptions and scenarios and,
thus, can be used to isolate sources of a banks risk exposure or
quantify certain types of risk. To do so, a bank performs a series
of simulations and applies different assumptions and scenarios
to each simulation.
In general, earnings simulation models are more dynamic than
gap analyses and market valuation simulations. Whereas gap and
market valuation models generally take a snapshot of the risk
inherent in a banks balance sheet structure at a particular point in
time, most earnings simulation models evaluate risk exposure
over a period of time, taking into account projected changes in
balance sheet structures, pricing, and maturity relationships, and
assumptions about new business.
Banks often use simulation models to analyze alternative business
decisions and to test the effect of those decisions on a banks risk
profile before implementation. Banks also use simulation models
in budgeting and profit planning processes.
Construction of a Simulation Model
Most simulation models are computer-based models that
perform a series of calculations under a range of scenarios and
assumptions. From data on the banks current position and
managerial assumptions about future interest rate movements,
customer behavior, and new business, a simulation model
projects future cash flows, income, and expenses. These
assumptions include different loan growth and funding plan
scenarios and other assumptions about how a banks assets and
liabilities will be replaced. The main components of a
simulation model are presented in the table below.
Data from a banks general ledger and transaction systems generally
provide information on the banks current position for each
11D.571.3
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A bank might have risk limits that restrict losses in the account at
risk for a defined interest rate scenario over a certain period of
time. For example, the bank in the table above might limit losses
in annual net interest income from a 200 basis point change in
rates to 10 percent of its base net interest income.
The banks potential exposure is estimated by calculating how a

change in rates will affect the value, income, and expense of the
banks current and forecasted financial positions.
The output of a typical simulation model consists of: 1) future
balance sheet and income statements under a number of interest
rate and business-mix scenarios; 2) an analysis of the impact of
the different scenarios on the value of the target account; and 3)
graphical representations of the analysis that are often used to
communicate results to senior management and the board.
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Measurement of Risk
The greater the interest rate risk, the greater the change in the
value of a targeted account under different interest rate
scenarios. The target account is usually net interest income or
net income. Many simulation models also are capable of
measuring changes in the market value of equity. Several
business mix and rate scenarios usually are run. Rate scenarios
often include rising, flat, and declining rates, as well as a most
probable scenario.
Table 3 illustrates the type of summary report that may be

generated by an earnings simulation model. The report shows
variation in net interest income under alternative interest rate
scenarios using a flat rate scenario as a base. Similar reports are
often developed to show how net interest income might vary
with alternative business mixes and strategies.
Advantages of Simulation Models

Simulation models allow some of the assumptions underlying
gap reports to be amended. For instance, gap reports assume a
one-time shift in interest rates. Simulation models can handle
varying interest rate paths, including variations in the shape of
the yield curve. Gap reports usually assume the improbable
that all current assets and liabilities run off and are reinvested
overnight. Simulation models can be more realistic. A
simulation model can accommodate various business forecasts
and allow flexibility in running sensitivity analyses. For instance,
basis risk can be evaluated by varying the spreads between the
indices the bank uses to price its products. Perhaps the
strongest advantage of simulation models is that they can
present risk in terms that are meaningful and clear to senior
management and boards of directors. The results of
simulation models present risk and reward under alternative
rate scenarios in terms of net interest income, net income, and
present value (economic value of equity). These terms are basic
financial fundamentals that are readily understood by bank
management. Simulation models can vary greatly in their
complexity and accuracy. As the cost of computing technology
has declined, simulation models have improved. Some
simulation models can:
Handle the intermediate principal amortizations of products
such as installment loans.

Handle caps and floors on adjustable rate loans and
prepayments of mortgages or mortgage-backed securities under

various interest rate scenarios (embedded options).
Handle nonstandard swaps and futures contracts.
Change spread relationships to capture basis risk.
Model a variety of interest rate movements and yield curve
shapes.
Test for internal consistency among assumptions.
11D.571.3
129
portfolio in the models chart of accounts. This information is

similar to that used for a gap report and includes current balances,
rates, and repricing and maturity schedules. New business and
reinvestment plans, which are generally more subjective, are based
on managements assumptions. Those assumptions might be
derived from historical trends, business plans, or econometrics
models. Both market interest rates and business mix are forecasted.
Forecasts of interest rates involve forecasts of their direction, the
future shape of the yield curve, and the relationship between the
various indices that the bank uses for pricing products.
Limitations of Simulation Models

Although offering greater versatility than the alternatives,
simulation is not always objective. A simulation can
misrepresent the banks current risk position because it relies on
managements assumptions about the banks future business.
The myriad of assumptions that underlie most simulation models
can make it difficult to determine how much a variable contributes
to changes in the value of the target account. For this reason,
many banks supplement their earnings simulation measures by
isolating the risk inherent in the existing balance sheet using gap
reports or measurements of risk to the economic value of equity.
In measuring their earnings at risk, many bankers limit the
evaluation of their risk exposures to the following two years because
interest rate and business assumptions that project further are
considered unreliable. As a result, banks that use simulation models
with horizons of only one or two years do not fully capture their
long-term exposure. A bank that uses a simulation model to
measure the risk solely to near-term earnings should supplement
its model with gap reports or economic value of equity models
that measure the amount of long-term repricing exposures.
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income.
Table 4 illustrates the type of output that is generated by economic

value sensitivity models. In this example, the economic value of
the banks equity would be adversely affected by a rise in interest
rates. For example, if rates rose by 200 basis points, the present
value of the banks assets would decline by $2.5 million, whereas
the present value of the banks liabilities would decline by only
$1.5 million. As a result, the banks net economic value would
decline by $1 million from the base scenario.
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Analyze market or economic risk as well as risk to interest
Economic Value Sensitivity and Duration Models

Techniques that measure economic value sensitivity can capture
the interest rate risk of the banks business mix across the
spectrum of maturities. Economic value sensitivity systems
generally compute and measure changes in the present value of
the banks assets, liabilities, and off-balance-sheet accounts
under alternative interest rate scenarios.
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Construction of Economic Value Models

Most economic value measurement systems are a form of
simulation model. Typically, these models first estimate the
current or base case present value of all of the banks assets,
liabilities, and off-balance-sheet accounts. The model projects
the amount and timing of the cash flows that are expected to
be generated by the banks financial instruments under the
base case interest rate scenario. These cash flows are then
discounted by an appropriate discount factor to arrive at a net
present value. For the base case scenario, the banks net
economic value equals the present value of expected cash flows
from the banks assets, minus the present value of expected
cash flows from the banks liabilities, plus or minus the present
value of expected cash inflows from the banks off-balancesheet positions.
To measure the sensitivity of the banks economic exposure to

changes in interest rates, the model then performs similar
calculations of expected discounted cash flows for alternative
interest rate scenarios. The level and timing of cash flows for
products with option features will often vary with each rate scenario
being evaluated. For example, the rate of mortgage prepayments
increases as interest rates decrease.
Measurement of Risk
For alternative scenarios, the change in net economic value from
the base case represents the interest rate sensitivity of the banks
net economic value. The greater the change in net economic
value, the greater the potential risk exposure of the bank.
130
Duration
Many economic sensitivity models also compute the duration
of a banks financial instruments. Duration is a measure of the
sensitivity of market values to small changes in interest rates. If
interest rates increase, the market value of a fixed income
instrument will decline. Duration indicates by how much. The
duration of a fixed income instrument that has no option
features is the percentage change in the market value of the
instrument from a change in market rates. For instance, the
market value of a bond with duration of five will decline by
roughly 0.5 percent if interest rates increase by 10 basis points.
Before advances in computing technology made simulations of
net present values under multiple interest rate scenarios feasible,
some bankers used duration as a proxy for estimating the net
economic value of their institution. Duration is still used by
many bank managers as a basis for evaluating the relative risks
of different financial instruments, portfolios, or investment
strategies.
Duration incorporates an instruments remaining time to maturity,
the level of interest rates, and intermediate cash flows. If a fixed
income instrument has only one cash flow, as a zero coupon
bond does, duration will equal the maturity of the instrument: a
zero coupon bond with five years remaining to maturity has a
duration of five years. If coupon payments are received before
maturity, the duration of the bond declines, reflecting the fact that
some cash is received before final maturity. For example, a fiveyear 10 percent coupon bond has duration of 4.2 years in a 10
percent interest rate environment. Duration is calculated by
weighting the present value of an instruments cash flows by the
time to receipt of those cash flows. Table 5 illustrates the calculation
of the Macaulay and modified durations of a $100,000 two-year
note that pays interest semiannually, has a 7.5 percent coupon,
and was purchased at par to yield 7.5 percent. This note has a
modified duration of 1.82. If rates were to increase 100 basis
11D.571.3
Duration can measure the exposure of the economic value of a

single contract or a portfolio of contracts carried at market value.
The duration of a portfolio of contracts can be calculated by
computing the weighted average maturity of all the cash flows
in the portfolio individually. However, because the duration of
individual instruments is usually readily available, most banks
estimate the duration of a portfolio of contracts by weighting
the durations of the individual contracts and summing them.
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Many banks use duration to measure and limit the risk of a

portfolio of fixed income contracts. This measurement is much
more precise than simply limiting the amount of securities with
certain maturities a bank may hold. Duration also allows portfolio
managers to combine the risks of different contracts based on
their price sensitivity and to hedge the net risk of the portfolio.
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Table 6 illustrates how duration may be used to calculate the interest

rate risk of a portfolio of fixed income contracts.
The calculations in table 5 do not adjust the expected cash flows

of the bond to changes in interest rates. Hence, this calculation
(modified duration) is not valid for instruments, such as callable
bonds and mortgage-backed securities, whose options will change
their cash flows as interest rates move. To correct for this problem,
many banks use what has become known as effective duration.
Effective duration is derived by using simulation techniques to
calculate the change in price of an instrument for a given change in
interest rates. The concepts of effective duration and convexity are
discussed in more detail in a later section.
Properties of Duration
In general, duration exhibits the following characteristics:
The higher the duration, the greater the price sensitivity of the
instrument to changes in market interest rates.
For two instruments with the same maturity, a high-coupon
instrument will have a lower duration than a low-coupon

instrument and will also be less price sensitive. A larger
proportion of a high coupons cash flows will be received sooner
and thus the average time to receipt of the cash flows will be
less.
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A given fixed income instrument will have a higher duration in
a low interest rate environment than in a high interest rate

environment.
Duration may be positive or negative. A fixed rate instrument
would have a positive duration, and an increase in interest rates

would generally decrease the market value of the instrument.
Mortgage servicing rights and interest-only (IO) mortgagebacked securities generally have a negative duration, since an
increase in interest rates would decrease the prepayment speed
of the underlying mortgages, increasing the market value of
the instruments.
Durations are additive when weighted by the amount of the
contract. For example, if a portfolio consists of two bonds of

equal market value, one with a duration of six and the other
with a duration of two, the duration of the portfolio would
be four.
Duration Can Measure the Exposure of a Portfolio of
Instruments
11D.571.3
The weighted duration of the portfolio is 4.04. If interest rates

were to increase by 1 percent, the market value of the portfolio
would decline by about approximately 4.04 percent or $11,629.
Duration Can Measure the Economic Value of Equity
Some banks use duration to measure or hedge the sensitivity of
the economic value of their portfolio equity to changes in
interest rates. The duration of equity is derived from the
duration of all assets, liabilities, and off-balance sheet contracts.
To understand how the duration of equity measures risk, the
economic value of portfolio equity may be viewed as a net bond
position. Assets are analogous to long bond positions with
positive durations, and liabilities are analogous to short bond
positions with negative durations. Duration indicates whether
the economic value of the net bond position or portfolio
equity will increase or decrease with a change in rates.
A bank with long-term assets funded by short-term liabilities will
generally have a duration of equity that is positive. The economic
value of portfolio equity of this bank will decline as interest rates
rise. A bank with short-term assets funded with long-term liabilities
will generally have a negative duration of equity. The economic
value of this bank will increase as interest rates rise. The higher the
duration of a banks equity (whether the number is positive or
negative), the more sensitive is its economic value to changes in
rates.
Advantages of Duration
Duration is a useful tool for setting risk limits either on the net
economic value of the bank or for selected portfolios, such as
investment portfolios. Some banks attempt to limit their
economic exposures through simple position limits, which are
131
points, the value of this note would be expected to decline by

approximately 1.82 percent.
Limitations of Duration
Duration as a measure of the sensitivity of economic value also
has limitations:
Macaulay and modified duration accurately measure changes in
value for small and generally parallel changes in interest rates.

However, modified duration can not measure changes in value
for nonparallel changes in interest rates, and there is no practical
method by which effective duration can measure nonparallel
shifts. The margin of error, which increases with the size of
the interest rate change, is called convexity.
The present value at 8 percent (PV +) is $94. Then the bank estimates
the present value at 6 percent (PV -), taking into account the decrease
in cash flows because the rate of prepayment is higher. The present
value at 6 percent (PV -) is $104. The bonds effective duration
[($104 - $94 / 2 (100) - (.01)] is 5. In other words, the bonds value
will decline by approximately 5 percent for the 100-basis-point
increase in interest rates.
Monte Carlo Simulation
Monte Carlo simulation measures the probable outcomes of
events, such as a movement in interest rates that have a random
or stochastic element. The simulation models discussed
previously measure the value of the bank under a limited
number of interest rate scenarios. Such approaches are
deterministic because the possible interest rate paths are
predetermined and controlled by the model user. Although
deterministic models are valuable, their outcomes depend on
the interest rate scenarios. If actual interest rates differ from
assumptions, the risk to the bank may be substantially different
from the measured risk. The outcome of a Monte Carlo
simulation is less preordained than that of a deterministic
simulation because its statistical modeling technique generates
thousands of randomly determined interest rate paths. These
interest rate paths result in a distribution of possible interest
rate scenarios. The value of the bank or the banks portfolios is
then evaluated for each of the possible interest rate paths,
yielding a range of possible values or outcomes.
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Limits based on duration analysis are best expressed in terms of

dollar changes in market or economic value. Duration measures
the percentage change in value rather than the actual dollar change.
To calculate exposure of the account at risk (the economic value of
equity), a bank must weight the durations of assets, liabilities,
and off-balance-sheet accounts by their economic values.
the cash flows of this security will increase because prepayments

will slow.
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usually based on maturity. Such limits, however, do not

precisely assess the sensitivity of market values to changes in
rates, something limits based on duration can do.
The duration of different instruments will change at different
rates as time passes (duration drift). In other words, in a

portfolio hedged for duration the effectiveness of the hedge
will diminish over time.
Macaulay and modified duration assume that the expected cash
flows of a fixed income instrument will not change with interest

rate movement.
Hence, these duration measures are not accurate for instruments
with embedded options, which often grow more sensitive to
interest rates as rates rise. In other words, an instrument that
declines in value by 1 percent for a 100-basis-point increase in
interest rates might decline by 3 percent for a 200-basis-point
increase and by 6 percent for a 300-basis-point increase.
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Convexity and Effective Duration

Banks can adjust modified duration to overcome some of the
problems of convexity. Effective duration incorporates changes
in cash flow that occur in instruments with options. (Convexity
reflects a nonlinear shift in the price/yield relationships of
instruments with and without options.) However, effective
duration is useful only for a specific interest rate change. To
obtain an instruments effective duration, calculate its present
values at two different market yields and obtain the percentage
change in price (PV + and PV -). Divide the absolute difference
between the two present values by the bonds original (basecase) market price (PV) times the assumed change in yield (y)
times two:
The resulting number is the instruments effective duration. For

example, a bank can calculate the effective duration of a
Government National Mortgage Association security after a 100basis-point rise in interest rates. Assume the security is currently
trading at par to yield 7 percent. The bank first estimates the
present value of the security if interest rates increase to 8 percent.
In calculating this present value the bank takes into account that
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Construction of a Monte Carlo Simulation

Formulating the average Monte Carlo model is quite complex:
1. The first step is to develop the underlying probability
distribution for interest rates that will generate the random
interest rate paths. Typically, the current forward yield curve is
used to anchor the probability distribution.
2. A model generates a multitude of random interest rate paths
(typically several thousand). However, certain properties are
usually built into this process to ensure that the mean (average)
interest rate generated is consistent with the current structure
of interest rates and that the dispersion (distribution) of
possible interest rates is consistent with observed volatility.
These properties are important to ensure that the model does
not introduce the possibility of risk-free arbitrage. Essentially,
the properties assume that markets efficiently and fairly price
securities, such that one cannot construct instruments with
equivalent risk and higher returns than what the market
commands.
3. The cash flows corresponding to each of the randomly
developed interest rate paths are calculated. That is, the bank
specifies the relationships between the interest rates and the
cash flows of the banks portfolios. For example, the bank
would develop a prepayment function that relates mortgage
prepayments with each interest rate path. Once adjusted for
prepayments and other interest-rate effects, the cash flows are
said to be option-adjusted.
4. The option-adjusted cash flows for each rate path are discounted
by the risk-free rate to obtain their net present value. All of
11D.571.3
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Technical Note: Calculating Convexity

The convexity of an option-free fixed income instrument is
measured by the following formula:
One can estimate how much, in percent, convexity can change the
price of an option-free instrument:
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5. After obtaining the base-case price in step 4, the current forward

yield curve is shocked for each of the interest rate scenarios
that banks consider in their risk analysis. For example, if the
bank is evaluating its risk for a parallel 200-basis-point increase
in rates, it would shift the underlying distribution of interest
rates (developed in step 1) by 200 basis points such that the
expected mean (average) is 200 basis points higher across the
maturity spectrum. Steps 2,3, and 4 are then repeated, except
that the market price that results represents the price that
would result if interest rates were to change as assumed for
that rate scenario. The resulting estimates are used to fill in a
report such as the one illustrated in table 4.
example, they evaluate an insufficient number of paths, in the

process sacrificing accuracy for the sake of speed. When
designers fail to provide adequate documentation, they increase
the possibility that future changes to the model will result in
errors.
Advantages of Monte Carlo Simulation

Monte Carlo simulation is a powerful risk analysis tool because
it alone, of the tools discussed in this booklet, can accurately
and clearly adjust risk estimates for optionality and convexity.
The capital markets employ Monte Carlo techniques to price
interest rate derivative products and residential mortgage
products using OAS analysis. Banks can employ Monte Carlo
techniques to understand and evaluate current market pricing as
well as their economic value at risk.
Table 7 calculates the convexity of the 7.5 percent coupon bond

shown in table 5 and how much, in percent, this convexity will
change the bonds price.
The total change in price, in percent, of the 7.5 coupon bond after
a 100- basis point move can now be estimated by summing the
changes caused by modified duration and convexity. (For optionfree bonds, convexity will always have a positive effect on price,
and duration will have a negative effect.) Thus, the 7.5 coupon
bond is estimated to decline by 1.80 percent (duration of minus
1.82 percent plus convexity of 0.02 percent) after a 100- basispoint increase in rates. If rates decrease by 100 basis points, the
bond is estimated to increase in price by 1.84 percent (duration of
1.82 percent plus convexity of 0.02 percent).
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Limitations of Monte Carlo Simulation
Monte Carlo simulations, like all interest rate risk measurement

systems, are only as good as the data and assumptions underlying
the analysis. Two critical assumptions in Monte Carlo analysis are
the process used to derive the interest rate paths and the cash flow
relationships developed for each interest rate path. If these
assumptions are faulty, the results of the simulation will be suspect.
Monte Carlo simulations are complicated to develop and require
substantial computing technology. To correctly derive and apply
this modeling process, a bank must have staff members with
considerable expertise in financial and statistical theory.
Notes:
Model Exposure
Regardless of the type of model used, banks should take care
to minimize model exposure. Financial models fall into error
for many reasons. Users may make incorrect assumptions about
deposit behavior or about changes in the spread between
interest rates. They may select a model that is not appropriate
for all parameters. A model that provides reasonable results for
a certain range of inputs may fail to do so for extreme
assumptions. Some model users misuse good models; for
11D.571.3
133
these outcomes are summed, and the total is divided by the

total number of rate paths evaluated to produce an expected
net present value for the distribution. If the cash flows have
been adjusted correctly and the interest rate paths correctly reflect
market expectations about the distribution of possible future
interest rates outcomes, this expected net present value
represents the base-case market price. If the models
assumptions are accurate, the cash flows have been adjusted
for all risks, and the market for the instrument under
consideration operates according to the underlying theory (which
assumes risk neutral valuation), this base-case price should be
within a few basis points of observable market prices. If the
net present value does not match the market price, common
practice is to add a fixed spread known as the option-adjusted
spread (OAS) to the risk-free rate.
A first step in the measurement of credit risk is to determine

the exposure to counterparties in each portfolio and across
portfolios (firm-wide exposure). These exposures may exist in
securities or derivatives positions, or they may arise from
pending settlements of contracts, positions executed with a
financial institution, or letters of credit issued by an institution
for another counterparty. The purpose of ex posure calculation
is to support the assessment of portfolio and firm compliance
with policies and guidelines and to assess credit concentrations.
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Investment management firms face a constant challenge in

maximizing returns. As markets become more liquid and arbitrage
opportunities decrease, portfolio managers must seek additional
sources of risk to enhance portfolio returns. One way in which
managers can do this is to increase credit risk in security positions.
A second approach is to use derivatives, which, for over-the-counter
derivatives, also results in additional credit risk. Both of these
methods allow portfolio managers to take on measurable risk
that may be compared to returns to determine the efficiency of the
portfolio strategy. With the intensified pressure to deliver riskadjusted performance, the ability of investment management firms
to measure and monitor the credit risk in security and derivatives
positions has taken on increased importance.
For security positions, exposure is straightforward (i.e., equal to

the value of the security). For derivatives positions and security
transactions that have not yet settled, exposure measurement must
consider not only the value of the position today, but also the
potential change in value of the position over its life (or until
security settlement) that could lead to a larger exposure on the
position. This maximum potential exposure estimates the
degree of credit risk in the position and is analogous to the credit
exposure on the value of a security position. This exposure also
allows for aggregation across all portfolio positions and is necessary
for the determination of expected and unexpected losses. Data
requirements for credit exposure calculations go well beyond those
required for market risk measures. In order to measure the current
and potential exposure of portfolio positions, investment
managers need appropriate valuation methodologies to determine
the current value of positions. In addition, they need the ability
to:
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LESSON 24:
MEASURING CREDIT RISK
We will define credit risk for investment management firms as the

risk that credit-related events will cause investments to
underperform benchmarks or realize losses. Traditionally,
investment managers have managed credit risk by establishing
and complying with credit concentration guidelines usually
expressed in nominal terms. These measures, however, fail to
take into account the complexities of measurement across
portfolios and measurement of credit exposures other than in
security positions. Traditional measures also fail to support the
active management of credit risk taken in a portfolio because they
do not provide return analyses for credit risks taken. Active credit
risk portfolio management techniques allow investment managers
to measure returns gained for credit risks taken and to fine-tune
portfolios to match credit risk appetites and optimize risk and
return. Use of these measures of return/risk trade-off result in
maximizing the efficiency of risk-taking.
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Management and measurement of credit risk pose challenges even

greater than those required for market risk. Investment
management firms must define the credit exposure of different
types of positions and establish measures that allow for
aggregation across positions and across multiple time horizons.
Firms must also obtain information about counterparties in
addition to information about positions. They need to evaluate
credit mitigation methods as part of the overall credit risk
management process and incorporate the effects of credit
mitigation into credit risk measures.
Finally, firms need to develop portfolio-level measures of credit
performance to account for diversification effects and to allow for
the active management of credit risks taken. Current best practice
in credit risk measurement consists of expected and unexpected
loss measures and portfolio management measures, which require
current and potential exposure calculations. Each of these types
of measures serves a different purpose in credit risk management.
Each also represents a different objective and level of sophistication
in the credit risk management process, as further discussed below.
Current and Potential Exposure Calculations
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Aggregate positions by counterparty:

To properly aggregate exposures, the investment manager must
first identify all of its counterparties, then link each of its
positions to the appropriate counterparty, and link each
counterparty to the appropriate parent obligor. As part of this
process, the investment manager must specify the level at which
a counterparty will be defined. For example, a firm may define
counterparties at a parent or subsidiary level, or both. Generally,
the firm should have the ability to identify where exposures
may be linked through corporate ownership.
Simulate future market values:
Firms must have the ability to model estimated changes in the
value of a financial instrument position over its life. Generally,
this is done by randomly drawing a large number of market
moves and calculating the value of the position under each
market move, generating a distribution of potential market
values. Potential credit exposure on the position is then defined
as an extreme (99 percent confidence interval, for example) value
of the positions creating credit exposure to the firm.
Net exposure where netting agreements allowed: After
counterparties are defined, any netting and collateral agreements
with those counterparties should be noted and exposure for
those positions covered by netting and/or collateral agreements
calculated accordingly. Consequently, systems used to measure
11D.571.3
Credit Derivatives Market

Markets in credit risk transfer have the potential to contribute to
a more efficient allocation of credit risk in the economy. They
could enable banks to reduce concentrations of exposure and
diversify risk beyond their customer base. Liquid markets could
also provide valuable price information, helping banks to price
loans and other credit exposures. They might allow institutions
other than banks to take on more credit risk, so that the
immediate relationship banks have with end-borrowers need
not mean they are excessively exposed to them.
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Expected and Unexpected Loss Measurement

Once current and potential credit exposures are calculated,
expected and unexpected losses may be determined using
estimated default probabilities and recovery rates. Expected
credit losses are defined as the mean of the credit loss
distribution based on the distribution of credit exposures, the
default probability of the counterparty, and the expected
recovery rate if a counterparty were to default. Unexpected credit
losses are defined as an extreme (e.g., 99 percent confidence
interval) level of loss derived from the credit loss distribution
determined. Expected credit loss calculations are used to
determine expected net returns to the portfolio, and unexpected
credit losses are used to determine extreme potential credit
losses to the portfolio, similar to the market risk losses
estimated by value at risk.
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Incorporate collateral held to mitigate exposure:

Systems should also have the ability to incorporate any collateral
held into the exposure calculation.
monitored. Monitoring many different credit guidelines

presents both financial and compliance risk, and places a huge
reliance on systems to accurately reflect the many investments in
the portfolios. Finally, the complexity and computational
intensity of credit risk measures place increased reliance on
systems as well.
Expected and unexpected loss measurement requires even more

data about the counterpartyspecifically default probabilities and
recovery rates. Historic default probabilities are available from public
rating agencies, such as Standard & Poors and Moodys. Default
probabilities may also be determined using vendor methodologies,
such as KMVs Credit Monitor, the RiskMetrics Groups Credit
Manager, Credit Suisse First Bostons Credit Risk +, and Moodys
RiskCalc. Where default probability methodologies rely on historic
data, questions about applicability exist due to the small number
of data points available. Other methodologies that do not rely on
historic default data rely on certain assumptions about firms and
markets that must be considered. Historic recovery rates on senior
securities are available from Standard & Poors and Moodys.
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Portfolio Management Measures

In the context of portfolio measurement, credit risk
management has advanced from an exposure limitation and
loss avoidance process to a process of active management and
fine-tuning of credit risks taken in the portfolio. Active
portfolio management results in not only measuring and
limiting credit risks taken but in optimizing the return gained
for a given level of credit risk. Portfolio management concepts
related to market risk are fundamental and well developed
within the investment management industry. Credit risk
portfolio measures, though not as well developed in the
industry, are simply an extension of this. For example, a
portfolio manager may use measures of credit risk-adjusted
return on capital to optimize the overall asset mix. A manager
may also use portfolio weighted-average risk grades to monitor
the overall credit quality of a portfolio.
Other Issues to be considered

Measurement and monitoring of credit risk by investment
managers pose specific issues not faced by other types of
institutions. For example, investment management firms must
measure and monitor credit risk at both the firm and portfolio
level. This is complicated by the fact that each portfolio may
have specific credit guidelines against which it must be
11D.571.3
A number of primary and secondary markets in debt instruments

bearing credit risk are well established. Investment grade and,
increasingly in North America and Europe, sub-investment grade
borrowers are able to issue debt securities directly through
international and domestic bond markets. Bank loans to companies
are distributed through initial syndication and can be sold through
the secondary loan market, including to non-banks. The
development of securitisation techniques has allowed banks to
sell portfolios of all kinds of loans (eg mortgage, credit card,
automobile) provided investors can be shown that the aggregate
cashflows behave in a reasonably predictable manner.
All of these markets, however, require the taker of credit risk to
provide funding, either directly to the borrower or to the bank
selling the debt, in order to buy an underlying claim on the
borrower. Credit derivatives differ because credit risk is transferred
without the funding obligation. The taker of credit risk provides
funds ex post only if a credit event occurs. Credit derivatives
therefore allow banks to manage credit risk separately from funding.
They are an example of the way modern financial markets unbundle
financial claims into their constituent elements (credit, interest
rate, funding etc), allowing them to be traded in standardized
wholesale markets and rebundled into new composite products
that better meet the needs of investors. In the case of credit
derivatives, the standardized wholesale market is in single-name
credit default swaps and the new composite products include
portfolio default swaps, basket default swaps, synthetic
collateralized debt obligations (CDOs) and credit-linked notes.
Hedging with Credit derivatives instruments
135
exposure should have the ability to identify where netting may

be performed and then net appropriately.
same way as a single-name CDS. But transactions can be

distinguished according to three characteristics.
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1. Whether protection is funded or unfunded and sold directly or

via an SPV?
The original CDO structure involved the transfer of the underlying
bonds or loans to an SPV, which then issued CDOs backed by the
cashflows on this portfolio. Most CDOs are still funded
transactions of this type. Increasingly, however, CDSs are used to
transfer the credit risk to the SPV leading to so-called synthetic
CDOs. Alternatively, the protection buyer enters into a portfolio
CDS a CDS referenced to a portfolio of companies or sovereigns
rather than a single name directly with the seller, or embeds a
portfolio CDS in a so-called credit-linked note (CLN) issued directly
to the seller, avoiding the use of an
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A CDS is similar, in economic substance, to a guarantee or credit

insurance policy, to the extent that the protection seller receives a
fee ex ante for agreeing to compensate the protection buyer ex post,
but provides no funding. Being a derivative, however, makes a
CDS different. Both guarantees and credit insurance are designed
to compensate a particular protection buyer for its losses if a credit
event occurs. The contract depends on both the state of the world
(has a credit event occurred or not?) and the outcome for the buyer
(has it suffered losses or not?). A CDS, by contrast, is statedependent but outcome-independent. Cashflows are triggered
by defined credit events regardless of the exposures or actions of
the protection buyer. For this reason, credit derivatives can be
traded on standardized terms amongst any counterparties2. The
single name CDS market allows a protection buyer to strip out the
credit risk from what may be a variety of different exposures to a
company or country loans, bonds, trade credit, counterparty
exposures etc and transfer it using a single, standardized
commodity instrument. Equally, market participants can buy or
sell positions for reasons of speculation, arbitrage or hedging
even if they have no direct exposure to the reference entity. For
example, it is straightforward to go short of credit risk by buying
protection using CDS. Standardization, in turn, facilitates hedging
and allows intermediaries to make markets by buying and selling
protection, running a matched book.
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There is no universally accepted definition of a credit derivative.

The focus in this article is on single-name credit default swaps
and the structured portfolio transactions put together using
them. Single-name credit default swaps In a credit default swap
(CDS), one counterparty (known as the protection seller)
agrees to compensate another counterparty (the protection
buyer) if a particular company or sovereign (the reference
entity) experiences one of a number of defined events (credit
events) that indicate it is unable or may be unable to service its
debts (see Diagram 1). The protection seller is paid a fee or
premium, typically expressed as an annualized percentage of the
notional value of the transaction in basis points and paid
quarterly over the life of the transaction. Box 1 describes single
name CDS in more detail.
Portfolio transactions
Just as CDS can be used to unbundle credit risk, they can also
be combined to create new portfolio instruments with risk and
return characteristics designed to meet the demands of
particular protection buyers and sellers. This use of CDS to
construct portfolio instruments is part of the evolution of the
market in collateralised debt obligations (CDOs). In its simplest
form, a CDO is a debt security issued by a special purpose
vehicle (SPV) and backed by a diversified loan or bond portfolio
(see Diagram 2). The diversification of the portfolio
distinguishes CDO transactions from asset-backed
securitisation (ABS) of homogenous pools of assets such as
mortgages or credit card receivables, a more established
technique. The economics of CDOs is that the aggregate
cashflows on a diversified portfolio have a lower variance than
the cashflows on each individual credit; the lower risk enabling
CDOs to be issued at a lower average yield. Because these are
structured deals, they do not have standardised features in the
SPV altogether. These variants are summarised in the table below:
Entering into a portfolio default swap directly with the protection

buyer is the simplest of these structures. But it exposes both
parties to potential counterparty risk and, if the protection buyer
is a bank, it will only obtain a lower regulatory capital requirement
if the protection seller is also a bank (see Box 2). A CLN protects
the buyer against counterparty risk on the seller but not vice versa.
It can be an attractive option if the protection buyer (issuer) is, for
example, a highly rated bank and the seller (investor) is a pension
or mutual fund, with funds to invest. Some investors may also
have regulatory or contractual restrictions on their use of derivatives
but not purchases of securities such as CLNs.
CLNs, however, still involve the protection seller taking
counterparty risk on the buyer4. Partly for this reason, most CDOs
continue to involve an SPV. In a typical synthetic structure, the
SPV issues CDOs to the end-sellers of protection and invests
the proceeds in high-quality collateral securities, such as G7
government bonds, bonds issued by government-sponsored
agencies, mortgage bonds (Pf and brief) or highly-rated assetbacked securities (see Diagram 3). The end-sellers receive the return
on the collateral, often swapped into a floating rate, together with
the premium on the default swap. Principal and/or interest
payments are reduced if credit events occur on the reference
portfolio. In this case, the bank/sponsor has a claim on the SPV
under the CDS, backed by the collateral, which is typically cashsettled. This structure has advantages for the protection buyer and
the end-sellers:
It reduces counterparty credit risk for both parties. Both have
potential claims on the SPV that are at least partly backed by the
136
11D.571.3
the principal is protected by the value of the collateral securities

(principal-protected notes). Some insurance companies find
this type investment attractive (see below).
If a bank has bought protection against its loanbook, some
regulators may allow a lower regulatory capital requirement on

the underlying loans if the counterparty is an SPV that is
restricted to holding OECD government bonds.
1. How the risk and return on the portfolio is tranched to give
different protection sellers obligations with varying degrees of
leverage?
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The risk on portfolio transactions is usually divided into at least

three tranches. For example, a US$100 million portfolio may have
US$10 million first loss, US$20 million mezzanine and US$70
million senior pieces. If there is a US$15 million loss on the
portfolio following a series of credit events, the seller of protection
on the first loss tranche loses US$10 million and the seller on the
mezzanine US$5 million. In effect, the holder of the first loss (or
equity) tranche has leveraged the credit risk on the underlying
portfolio by ten times whereas the holder of the senior piece may
have a much lower risk security. Typical market practice at present is
to tranche the risk so that the senior position is Aaa/AAA-rated
and the mezzanine position Baa2/BBB-rated.
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The CDOs can be structured so that they are high yielding but
(see below) are said to be important sellers of protection on supersenior tranches, often via back-to-back transactions with another
bank or securities firm in order to obtain a reduced capital
requirement for the bank protection buyer5. Super-senior tranches
are intended to be almost free of credit risk they rank higher
than senior tranches, which are often AAA-rated. Annual premia
are correspondingly low, ranging between 6-12 basis points,
depending on market conditions. But the notional value of the
exposures can be very large. For example, super-senior tranches
on large diversified portfolios of investment grade credits may
cover the last 90% of losses on transactions of US$ billions in
size.
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Tranching can be achieved in different ways depending on the

structure of the transaction. If the risk on the entire portfolio is
transferred to an SPV (whether through sales of the underlying
asset or a series of CDSs), it can issue securities with varying
degrees of seniority. If, however, protection is purchased directly
from sellers, tranching must be included within the contractual
terms of the portfolio CDS or credit-linked note.
More senior tranches of CDOs are more likely, in practice, to be

unfunded than first loss or mezzanine tranches. This is partly
because the amounts involved are larger and partly because
protection buyers prefer to avoid counterparty risk on equity and
mezzanine tranches because of the greater likelihood that these
tranches will bear losses. Recently, a hybrid structure has been
popular with European banks. It involves an SPV selling
protection to a bank on the mezzanine/senior tranche of risk on
a portfolio against issuance of tranched CDOs. The bank separately
buys protection directly on a so-called super-senior tranche using
a portfolio CDS. This might specify, for example, that the
protection seller will compensate the buyer if credit events on the
reference portfolio lead to losses in excess of 20% of the portfolio
value over the life of the transaction (Diagram 4). Monoline insurers
11D.571.3
Basket default swaps allow protection sellers to take leverage in a

slightly different way. A first-to-default basket is a CDS that is
triggered if any reference entity within a defined group experiences
a credit event. Typically the transaction is settled through physical
delivery of obligations of the entity that experienced the credit
event. For example, an investor might enter into a US$100 million
first-to-default basket on five European telecoms, receiving a
spread significantly higher than that for a single-name CDS on any
one of the names in the basket; although less than selling US$100
million protection on each company individually because the
exposure is capped at US$100 million. The more risk averse can
sell protection on second or even third-to default baskets, which
are triggered only if a credit event occurs on more than one name
in the basket over the life of the transaction.
3 The nature of the reference portfolio
Commercial banks can use the CDO structure to transfer the
credit risk on loans that they have originated. These are known
as collateralised loan obligations (CLOs) or sometimes balance
sheet ransactions because the primary motivation is to remove
risk from the balance sheet of the commercial bank. For
example, it may want to reduce particular concentrations in its
loanbook or to lower its regulatory capital requirements or to
free up lines to counterparties. CLOs are generally large
transactions often billions of dollars. Reference portfolios are
usually loans to large, rated companies but recent transactions
have included loans to mid-sized companies. Growth of CLOs
began in 1997, following JP Morgans BISTRO programme.
Another use of the structure is by fund managers to gain leverage
for high-yield, managed investment portfolios. Such transactions
known as collateralised bond obligations (CBOs) or sometimes
arbitrage CDOs are much more common in the US, where
sub-investment grade bond and secondary loan markets are more
developed, than in Europe. Typically, an investment bank will
137
collateral securities. The SPV should be remote from the

bankruptcy of either party.
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markets in terms of notional principal were those related to

interest rates (US$65 trillion); foreign exchange rates
(US$16 trillion); and equities (nearly US$2 trillion). According to

the OCC data, credit derivative exposures comprised less than 1%
of US commercial banks and trust companies notional derivative
exposures at end-March 2001. Although notional principal is only
a loose guide, these figures suggest that using derivatives to trade
credit risk remains small relative to their use to trade interest rate,
foreign exchange and equity risk. The notional value of credit
exposure being transferred through the market is also only a
fraction of the debt held by US and European banks and by
bondholders in the international and US domestic bond markets.
Because one or more transactions with intermediaries will often
occur between an initial protection buyer and a final protection
seller, the figure of US$1 trillion is an upper bound on the actual
value of exposure being transferred through the market. For
comparison, the value of non-government debt outstanding in
the international bond market was nearly US$5 trillion and in the
US domestic bond market US$61/2 trillion at end-December
2000; and bank balance sheets totalled around US$5 trillion for
US banks and 12 trillion for euro area banks at end-December
200011.
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A third use of CDOs also known as arbitrage transactions is

to repackage static portfolios of illiquid or high yielding securities
purchased in the secondary market. Examples of securities that
have been repackaged in this way include asset-backed securities,
mortgage-backed securities, high-yield corporate bonds, EME
bonds, bank preferred shares and even existing CDOs.
Intermediaries have also used CDS to create entirely synthetic
tranches of exposure to reference portfolios (see below). For
example, an intermediary might buy protection from a customer
using a portfolio CDS designed to replicate the mezzanine tranche
of a CDO referenced to a portfolio of European companies. It
then hedges its position in the single name CDS market.
Market size
The credit derivative market has been growing rapidly but is
probably still small relative to other OTC derivative and
securities markets. Comprehensive, global data do not exist.
The best sources are the British Bankers Associations 2000
survey6 of its members and the quarterly statistics on
outstanding derivatives positions of US commercial banks and
trust companies published by the Office of the Comptroller of
the Currency (OCC)7. The BBA survey suggests that the global
credit derivatives market increased in size (measured by notional
amount outstanding) from around US$151 billion in 1997 to
US$514 billion in 1999, with the market expected to continue
growing over 2001 and 2002. Market participants estimate that
the market continues to double in size each year. The OCC
data show that US commercial banks and trust companies had
notional credit derivatives outstanding world-wide of US$352
billion at end-March 2001. Based on market participants
estimates of their market share compared to securities dealers
and European banks, this is consistent with an overall market
size of around US$1 trillion. According to the BBA survey,
around half the market was in single name CDS (Chart 1).
Another source of data on portfolio transactions is the volume
of transactions rated globally by the major agencies. Moodys
rated 38 CBOs in 2000, of which 12 were synthetic, and 51
CLOs, of which 32 were synthetic. The value of CBOs was
around US$48 billion and of CLOs US$72 billion, suggesting
that around US$50 billion of portfolio default swaps were
agreed in 20009. By contrast, data from the Bank for
International Settlements (BIS)10 show the largest derivatives
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find investors willing to purchase mezzanine and senior tranches

and the fund manager (known as the collateral manager) will
retain a share of the first loss risk and so the equity. Whereas
CLOs are not actively managed portfolios are typically static
other than the replacement of maturing loans with others of
similar characteristics collateral managers are permitted to trade
managed CBO portfolios in order to maximise yield for the equity
investors. The exception is if the CBO breaches defined covenants
such as interest cover or ratings requirements. In this case, any
excess return on the portfolio is redirected from the equity holders
to pay down the higher ranking tranches in order of seniority.
CBO tranches are more likely to be fully funded than CLOs because
the collateral manager typically needs cash to invest. But collateral
managers are nonetheless often permitted to buy and sell
protection using CDS as part of a CBO portfolio.
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Market participants say that about 500 to 1000 corporate names

are traded actively in the single-name CDS market, although trades
have occurred on up to 2000 names. Most of these companies are
rated by the major agencies. Markets in single name CDS on
sovereigns are typically more liquid than companies, but only about
10-12 sovereigns are traded mostly emerging market economies
with less frequent trades in some G7 sovereigns such as Italy
and Japan. The BBA survey found that 20% of reference entities
were sovereigns and 80% companies. Market participants suggest
that the proportion of emerging market sovereign trades was
higher in 1997-98 at the time of the Asian crisis. Demand to buy
protection on sovereigns is often from banks or other investors
willing to extend credit to borrowers in a particular country but
not to increase their country exposure beyond a certain limit
known as line buying. The BBA survey reveals that in 1999 just
under half of global trading was taking place in London. New
York accounted for about the same proportion, with the remainder
trading of local names in regional centres, principally Tokyo and
Sydney.
Market Participants
A stylized structure of the credit derivatives market includes
end-buyers of protection, seeking to hedge credit risk taken in
11D.571.3
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systems and other ancillary services such as foreign exchange and

derivatives. The use of credit derivatives is part of a wider trend
among some of the largest banks to separate out these services
so that they can be priced appropriately. Any credit risk is, in
principle, valued according to its marginal contribution to the
risk and return on the banks overall credit portfolio. If the
credit risk does not fit with the portfolio, any additional cost of
selling the debt or purchasing protection using credit derivatives
must be recouped from the banks other business with the
customer. Banks may also purchase credit derivatives, alongside
purchases of loans and bonds in the secondary markets, to
manage their portfolio actively. For example, they might sell
protection where they can bear the risk at a lower cost than the
market price because it diversifies their portfolio across industry
sectors or regions in which they do not have many customers.
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In spite of these potential advantages, the OCC data for US banks

show that only the largest appear to use credit derivatives on any
scale at present. In the data, it is impossible to separate the activities
of commercial banks as intermediaries from their purchases of
protection to hedge risk on their loanbooks. For example, the
notional credit derivatives exposures of JP MorganChase, an
important intermediary, comprised 64% (around US$227 billion)
of the aggregate for all 400 US banks and trust companies at endMarch 2001. But outside JP MorganChase, Citibank and Bank of
America, the notional exposures of the remaining 396 US banks
that use derivatives was only US$18.4 billion. This suggests that
regional US banks are making only modest use of credit derivatives,
whether purchasing protection on their loanbooks or selling
protection to diversify their credit portfolios. It may be that the
European banks are more significant end-buyers of protection.
For example, 29 of the 51 CLOs and 21 of the 32 synthetic CLOs
rated by Moodys in 2000 involved European banking portfolios.
The total value of risk transferred was US$48 billion, of which
90% was through credit default swaps. An important motivation
for banks has been regulatory. The 8% Basel minimum regulatory
capital requirement on corporate exposures is higher than the
economic capital requirement on many investment grade
exposures, giving banks an incentive to transfer the risk to entities
not subject to the same regime. This may help to explain why
most CLOs to date have referenced portfolios of loans to
companies of relatively high credit quality. The proposals to reform
the Basel Accord announced in January 2001 may have important
consequences for the market (see Box 2). The intention is that, by
aligning capital requirements more closely with economic risk, the
proposals will reduce the purely regulatory motive for portfolio
transactions so that transfers of high quality corporate loans might
decrease. But, importantly, the Basel Committee on Banking
Supervision decided that credit risk modelling has not progressed
far enough to recognise default correlations in setting bank capital
requirements. Banks may still therefore have an incentive to transfer
the risk on portfolios to protection sellers able to adjust their
capital requirements to reflect greater diversification.
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concentrated among a number of large intermediaries mainly

US and European wholesale banks and securities houses. And
the market appears to be facilitating a net transfer of credit risk
from the banking sector to insurance companies and investment
funds, mostly through portfolio transactions. What motivates
these different groups of market participants?
Commercial banks
Compared to loan sales and securitisation, credit derivatives can
be an attractive way for commercial banks to transfer credit risk
because they do not require the loan to be sold unless and until
a credit event occurs. This makes it easier to preserve the
relationship with the borrower and is simpler administratively,
especially in some European countries where loan transfers are
complex, although the borrowers consent may still be needed
to transfer the loan if physical settlement is agreed following a
credit event. Use of credit derivatives also allows a bank to
manage credit risk separately from decisions about funding.
Securitisation can be an expensive source of funds for banks
with large retail deposit bases, although market participants say
that buying protection using CDS is often more expensive than
selling loans in the secondary market, perhaps reflecting
concerns about moral hazard (see below). Lending to customers
is typically one of a bundle of banking services including
deposit taking and liquidity management, access to payment
11D.571.3
Non-financial companies
Judging from the Banks regular contacts with UK companies
and market intermediaries, corporate involvement in the credit
derivatives market remains limited to a handful of large
multinationals. Intermediaries do, however, see potential for a
139
other parts of their business; end-sellers of protection, usually

looking to diversify an existing portfolio; and, in the middle,
intermediaries, which provide liquidity to end-users of CDS,
trade for their own account and put together and manage
structured portfolio products. The BBA survey gives some idea
of which institutions fall into these three categories (Chart 2).
By far the biggest players are the intermediaries, including
investment banking arms of commercial banks and securities
houses and therefore split between these two categories in Chart
2. They are thought to run a relatively matched book but are
probably, in aggregate, net buyers. OCC data show that this is
the case for the large US banks (Chart 3). End-sellers include
commercial banks, insurance companies, collateral managers of
CBOs, pension funds and mutual funds. End-buyers are
mainly commercial banks but also hedge funds and, to a lesser
extent, non-financial companies.Participants suggest that the
market has continued to grow and develop rapidly since the
BBA survey. It is difficult to draw any firm conclusions yet
about how it will work in a steady state. At present, however,
the single name CDS market appears to be relatively
Insurance companies also provide financial guarantees on the

senior tranches of CDOs, a practice which is long established in
the asset-backed and US municipal bond markets. Such credit
wrappers are used to improve the rating of the tranche (credit
enhancement) in order to meet the needs of investors. They
typically provide an unconditional and irrevocable guarantee that
principal and interest payments will be made on the original due
dates. But they do not provide cover for accelerated payment
following default. A few AAA-rated insurers, known as
monolines because they specialise in credit insurance, dominate
the market, although some of the major property and casualty
insurers have also begun to offer such policies. Monolines are also
said to be the largest sellers of protection on super-senior tranches
of CLOs. Annual accounts suggest that they, in turn, reinsure
around 15-25% of their exposures.
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The greater prominence of insurers is clearly an important

explanation for the increasing volume of portfolio transactions.
Many insurance companies have regulatory or legal restrictions on
their ability to enter into derivatives contracts. But most life and
general insurance companies can invest in credit-linked notes and
CDOs alongside equities, bonds and other asset classes. EU
insurance companies, in particular, are said to have been significant
investors in CDO tranches in order to gain greater exposure to the
US high yield market as part of the diversification of their
portfolios since European Monetary Union. These are often
structured as principal-protected notes in order to meet the
requirements of some insurance regulators to treat them as bonds
rather than equities for capital adequacy purposes. For example,
contacts say that German insurance companies have been major
investors in principal-protected equity and mezzanine tranches of
CDOs. Some insurance companies are said to have begun by
investing in senior tranches of CDOs and then added higher
yielding mezzanine tranches as they became more familiar with
the asset class.
portfolio of single-name default swaps. A few are active traders

and intermediaries. More typically, insurance companies are looking
to put together a large and relatively static book of portfolio and
perhaps single-name positions, using credit modelling and/or
actuarial techniques to price the risk. Until recently, non-banks
have found it difficult to put together such portfolios because
they have been limited to acquiring (on the asset side of their
balance sheets) bonds that companies decide to issue. Credit
derivatives, in effect, reduce the transaction costs for non-banks
of constructing a diversified credit book. Some large insurers appear
to have focussed on super-senior or senior tranches, making use
of their high credit ratings. Other companies, such as the
Bermudan-based reinsurers, have reportedly been sellers of
protection on mezzanine tranches of CDOs, baskets and on single
names.
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Insurance companies
Insurance companies are net sellers of protection and their
participation in the market seems to be increasing. An insurance
company can sell protection both through investment in
securities such as CDOs or credit-linked notes on the asset side
of its balance sheet and, on the liabilities side of its balance
sheet, by entering into single-name or portfolio default swaps,
writing credit insurance or providing guarantees.
Significant participation on the liabilities side of the balance sheet

appears currently limited to a relatively small number of large,
international property and casualty insurers and reinsurers, together
with specialists such as monolines and Bermudan reinsurers. US
insurance regulators agreed in 2000 to treat transactions using
derivatives that replicate the cashflows on a security, such as a
corporate bond, in the same way as the replicated asset. The
agreement has been implemented in a number of states, including
New York, where insurance companies have been allowed to hold
up to 10% of their investments in replicated assets since January
2001. This may give US insurance companies greater scope to sell
protection using credit derivatives.
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number of applications as the market matures. For example,

companies could use CDS to buy protection against credit
extended to customers or suppliers an example might be the
extension of so-called vendor finance to telecom operators by
telecom equipment manufacturers, where CDS might usefully
be used to reduce the size and/or concentration of the resulting
credit exposures.
But some property and casualty and reinsurance companies clearly

have entered the market on a relatively large scale since 1998/9.
Their motivations are said to have included low premiums in
their traditional property and casualty businesses, apparent
opportunities because they are not subject to the same regulatory
capital requirements as banks and the possibility that credit risk
might further diversify portfolios. Portfolio default swaps and
baskets are potentially attractive to these insurers because they are
based on diversified portfolios and offer the potential for differing
degrees of leverage depending on the tranche held. Some have
gone beyond portfolio transactions and sought to put together a
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Pension/investment funds and hedge funds

Similarly to insurance companies, pension and investment
funds are also important investors in CDO tranches and creditlinked notes. The nature of the fund tends to determine the
seniority of the investment. For example, leveraged debt funds
might buy higher-risk, mezzanine tranches whereas senior
tranches might be sold to pension funds. A few hedge funds
are also said to specialise in investing in the first loss and
mezzanine tranches of CDOs. But hedge fund participation in
credit markets appears to remain relatively small compared to,
for example, equity markets. In particular, hedge funds are
thought to be little involved in arbitraging CDS, loan and bond
markets.
Hedge funds are, however, active users of single-name CDS in
order to hedge other trades. Probably the most significant example
is convertible bond arbitrage, where hedge funds use CDS to
hedge the credit risk on the issuer of the bond. Traders say that
CDS premia can spike upwards if a company issues convertible
bonds, as funds seek to buy protection. They can, it is suggested,
be relatively insensitive to the cost of hedging the credit risk, as
their goal is to isolate the embedded equity option. Over the past
year, hedge funds have become large end-buyers of protection on
some entities that have issued convertible bonds, typically lowerrated US companies.
A particular category of investment fund manager is the collateral
managers of CBO funds. Typically they invest in the first loss,
11D.571.3
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Intermediaries
Most of the large global investment banks and securities
houses have developed the capacity to buy and sell protection in
the single name CDS market in order to provide liquidity to
customers and trade for their own account. Many are bringing
together their CDS and corporate bond trading desks with a
view to encouraging traders to identify arbitrage opportunities
between the two markets. This parallels moves to integrate, to a
greater or lesser degree, government bond, swap and repo desks
during the 1990s. Intermediaries also use CDSs to manage
credit risk in their other activities. In particular, they buy
protection against counterparty risk arising in other OTC
derivative transactions, such as interest rate swaps (line
buying). In this context, CDSs are now established as an
alternative to collateralisation. For example, an intermediary may
prefer to buy protection from a third party than request
collateral from a counterparty if it is a valuable corporate
customer. The first collateralised debt obligation with credit
events linked to payments by counterparties on a portfolio of
OTC transactions was issued at the end of 2000. One role of
the intermediaries is to bridge the different needs of protection
sellers and buyers. An example is the legal or regulatory
restriction in a number of countries against insurance
companies using derivatives (except to hedge insurance
business), so that these insurers cannot sell protection directly
using ISDA documentation. They can, however, sell insurance
to other insurance companies against their credit exposures on
nearly identical terms. Some intermediaries have therefore
established captive insurance companies (known as
transformers) in financial centres such as Bermuda that do
allow insurers to enter into derivatives. The transformers
typically sell protection to banks using
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attracting protection sellers for the mezzanine and senior tranches.
but seventeen in Q1 2001 alone. Traders say that demand from

banks and securities houses to sell protection in order to hedge
portfolio default swaps was one explanation for the general
downward trend in premia in the single name CDS market in Q1
2001. Intermediaries might still be left net short of credit risk ie
protection bought exceeds protection sold. But it is possible that
they will welcome this position as an offset to the inventory of
corporate bonds that they typically carry from their primary and
secondary market activities. It might also be a natural hedge to the
pro-cyclicality of investment banking revenues for example, IPO
and M&A activity tends to fall off during economic slowdowns
when credit risk typically crystallises. A greater concern would be if
an investment bank was unexpectedly net long of credit risk: for
example, if it had constructed the hedges for a CDO before placing
the transaction. Because of this balance of risks, portfolio
transactions are typically only hedged after completion.
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CDS and simultaneously purchase back-to-back protection from

insurers under insurance policies (Diagram 5).
Another, probably more significant, function of intermediaries is

the bundling of single credits to create portfolios. As explained
earlier, demand by insurance companies to sell protection on
portfolios and investment funds to purchase CDOs and creditlinked notes has increased recently. It is apparently outstripping
the supply from commercial banks looking to buy protection on
their loanbooks. Intermediaries have responded by putting
together synthetic CDOs and portfolio default swaps in which
the sellers/investors specify the mix of credits that they want to
hold. Moodys rated thirteen such synthetic transactions in 2000
11D.571.3
Pricing, liquidity and relationship with other credit

markets
A single-name CDS is similar to an option exercisable if a credit
event occurs. The pay-off is the notional value of the CDS less
the market value of the reference entitys debt following the
credit event. Although the inclusion of credit events other than
default complicates pricing somewhat, the key variables are the
expected probability that the reference entity will default over the
life of the CDS, the expected recovery rate on the debt and the
required return on any economic or regulatory capital held by the
protection seller against the risk of unexpected losses on the
transaction. In this sense, pricing single name CDS is little
different to pricing loans or bonds. Most would be settled
physically, so that the protection seller steps into the shoes of
the protection buyer following a credit event. In principle,
therefore, the premium on a CDS should be similar to the
credit spread on the reference entitys debt trading at par or,
more precisely, the spread over LIBOR if the fixed return on
that debt is exchanged for a floating rate return in an asset swap.
An important characteristic of the market is that counterparty
exposures on outstanding CDSs could increase sharply if credit
quality within the corporate sector were to deteriorate and large
numbers of companies were to move close to default. The
development of the CDS market is bringing closer together
different credit markets that have previously been segmented.
For example, contacts say that in 1998 loans to the Republic of
Turkey were priced about 150 basis points above LIBOR,
bonds were about 500 basis points over LIBOR, political
insurance cost 300 basis points, and CDS were priced at 550
basis points. Prices on these different instruments are unlikely
to converge completely. For example, loans may contain
covenants and clausing that allow lenders to take pre-emptive
action to protect their positions more easily than bondholders;
or banks may under-price loans in order to develop a
relationship with the borrower in pursuit of other ancillary
business. Both factors may mean loans still trade at lower credit
spreads than bonds. But CDS have the potential to encourage
arbitrage and increase transparency for three reasons:
CDS offer a relatively pure exposure to credit risk, which, in
principle, makes them an attractive instrument to hedge credit

risk embedded in other instruments; and may make their prices
141
equity tranches of the CBOs that they manage. The track record of
the collateral manager is said to be a key consideration in
loan markets, it is more standardised. CDS trading is

concentrated at certain maturities, principally five years, whereas
bonds and loans have different maturities and coupons. This
may make it easier for intermediaries to hedge CDS positions
and encourage tighter bid: offer spreads, and so foster liquidity.
Liquidity in the CDS market is less constrained by whether the
reference entity decides to issue debt or whether existing debt

holders are prepared to sell or lend securities although these
are needed for physical settlement following a credit event.
Some market participants (eg insurance companies or hedge
funds) may not always have ready access to financing and prefer
to take credit risk though an unfunded CDS than by purchasing
a bond. Financing a bond position exposes the investor to
some liquidity risk if its source of funding becomes more
expensive or dries up. Demand to sell protection by such
investors may reduce CDS premia relative to credit spreads on
bonds.
CDS may expose protection sellers to a little more risk than
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Market structure and liquidity

A number of large intermediaries publish indicative two-way
CDS prices for the most-traded companies and sovereigns on
their websites and on electronic data vendor screens. Trading in
the inter-dealer market occurs through voice and internet-based
brokers. Services exist to provide reference prices for markingto-market existing transactions, based on averages of prices
supplied by dealers and/or on trade prices in the inter-dealer
market. Traders say that liquidity in the single-name CDS
market varies, with different entities and sectors having more
activity at different times. In general, activity is said to increase
when assessments of creditworthiness are changing, as banks
look to hedge their risks and traders take positions. For
example, telecoms reportedly became more liquid during 2000
H2. The corporate bond market is typically more liquid if a
borrower has large, recent bond issues but CDS may be if the
company is an infrequent issuer and/or long-term investors
hold most of its debt.
for corporate bonds can mean CDS premia move higher relative
to credit spreads on bonds if demand to buy protection
increases. This reflects the cost of taking a short position in
bonds in order to arbitrage the two markets. Box 3 shows that
this seemed to happen in the telecom sector in the second half
of 2000.
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Although the CDS market remains smaller than the bond and
Illiquidity in the term reverse repo (or stock borrowing) markets
The CDS market may also have greater liquidity for those looking
to take a short position in a particular credit. In the bond market
this means selling the bond short and borrowing it through reverse
repo or stock borrowing. Especially in Europe, liquidity in the
term stock borrowing (or repo) market for corporate bonds can
be unpredictable, partly because not all holders are willing or able
to lend securities. Taking a short position by buying protection
using CDS can be more straightforward. Market participants say
that the CDS market has had greater two-way liquidity than the
bond market in some recent cases when a companys
creditworthiness deteriorated sharply, such as Xerox and Pacific
Gas and Electric. Certainly market participants have been sufficiently
confident in market liquidity that they have used CDS to take
views on changes in creditworthiness, expecting to be able to close
out the position and realise any mark-to-market profit by entering
into an opposite trade in the future. A typical trade might be to
take a view on the shape of the term structure of credit spreads.
For example, a speculator may believe that the forward credit
spreads implied by current premia on term CDS are too high or
low. Such trading increases market liquidity for those buying
protection to hedge credit exposures or selling protection as part
of an investment portfolio.
bondholders if they believe there is value in the option for the

protection buyer to deliver various obligations of the reference
entity following a restructuring. They may therefore require
CDS premia to be a little higher.
Compared to bondholders, protection sellers under CDS may
require a premium because they have no contractual rights,

such as covenants or information requirements, vis--vis the
reference entity allowing them to monitor its creditworthiness
or influence its decision-making.
Protection sellers under CDS may be subject to different
marginal tax rates than bondholders.
Compared with bondholders, participants in the CDS market
may require different liquidity premia against the cost of trading

out of positions.
Notes:
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a benchmark against which those of other credit instruments

can be compared.
In practice, market prices for CDS can be lower than, close to or

higher than credit spreads on corporate bonds (the so-called
default-cash basis), both across different reference entities and
for the same entity over time. Market participants say explanations
for changes in this relationship include:
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11D.571.3
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The measurement and aggregation of risk continue to play an

increasingly important role in the overall risk management
process. Whether it be from senior management, the board, or
regulators, information on the risk that firms are taking
through their trading activity is in demand. As the
measurement of market risk using Value-at-Risk (VaR) has
become a standard tool, stakeholders have begun to look
towards conquering the measurement of the next step along
the risk continuum in trading activities, credit risk. The pricing
and measurement of this risk component have taken on
increased importance with the rapid spread of credit derivatives.
As recent market events have shown, however, there is an
important interplay between market and credit risk. The ability
to measure market and credit risk for trading activities together
in an integrated model allows for a more complete picture of
the underlying risk.
the specification of a stochastic process for firm value. In these

models, default occurs when the value of the firm reaches an
exogenously specified barrier. In both models, when the firm
reaches default, the credit exposure is impacted by the recovery
rate. In this framework, we will be working with the second of
these methodologies, the firm value model. While there are
advantages and disadvantages of each method, the firm value
model allows for a development of an integrated model that is
linked not only through correlation but also through the impact
of common stochastic variables, as will be seen.
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The Integration of Market and Credit

Risk Measurement
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Market Risk Measurement through VaR

VaR measures the expected loss for a portfolio over a given
holding period for a specified confidence level. There are a
number of methodologies available for the measurement of
VaR. In all cases, however, there is a requirement for the
estimation of a distribution of portfolio returns at the end of
the holding period. In some cases, this distribution is assumed
to be normal which may allow for analytical solutions to be
developed. The distribution may also be estimated using
historical returns. Finally, a Monte-Carlo simulation can be used
to create a distribution based on the assumption of certain
stochastic processes for the underlying variables. In each
method, based on the specified confidence level, a particular
point on the distribution is taken as the VaR measure. For the
measurement of market risk, the choice of methodology is
often dependent on the characteristics of the underlying
portfolio as well as other factors. For example, factors that may
be considered include the degree of leptokurtosis in the
underlying asset returns distribution, the availability of
historical data or the desire to specify a more complicated
stochastic process for the underlying assets. In our framework,
we will focus on the use of Monte-Carlo simulation. While this
is the most computationally intensive of the available
methodologies, it allows the most flexibility for the
specification of an integrated market and credit model.
Credit Risk Measurement using the Value Process

As new models for the measurement of credit risk are
developed, they generally fall into two categories. The first
category includes models that specify an underlying process for
the default process. In these models, firms are assumed to
randomly move from one credit rating to another with specified
probabilities. One of the potential states that a firm could
transition to is default. The second category of models requires
11D.571.3
The Integrated Market and Credit Risk Framework

The integration of market and credit risk measurement requires
the ability to interweave the concept of VaR with a credit risk
model. Overall, our goal is the same as that for a VaR measure:
estimate the distribution of portfolio values at the end of a
holding period. In the integrated framework, however, the
distribution is driven by both market risk and credit risk. Using
the firm value model, the credit quality of a particular firm will
be measured by the value of the firm relative to the bankruptcy
barrier. In this integrated framework, we separate the simulation
of the underlying stochastic processes over the holding period
and the valuation of the portfolio at the end of holding period.
This bifurcation minimizes the computational burden of the
methodology while maintaining the flexibility of valuation
across a wide range of products.
The underlying credit valuation model follows that of Joon,
Ramaswamy and Sundaresan (1993). For the sake of brevity, we
will only specify the stochastic processes. For a complete
specification of the underlying assumptions in the model, the
reader is referred to Joon (1993).
The following processes are assumed:
where Vi is the value of firm I, r is the short rate,

is the
volatility of the value process for firm I,
is the volatility of the
short rate, k is the speed of mean reversion, q is the long term
mean-reversion rate and b is the payout rate of the firm. Zi and
Z1 are standard Brownian motions with
Note that, for simplicity, a Vasicek process has been used. The
model can be specified with any model for the short rate. This
allows the use a model that can be calibrated to the term structure
of interest rates such as a Hull-White model. Also note that the
stochastic short rate r is found in the drift for the value process.
This allows for the interplay of market and credit risk beyond
correlation effects.
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LESSON 25:
INTEGRATING MARKET AND CREDIT RISK MANAGEMENT
For the bankruptcy barrier, V*,

the following boundary condition is applied when V = V*:
The estimation of V* is a critical issue. In this framework, we will

continue to follow Joon(1993) who assume that default occurs
when the firm is unable to make coupon payments. Assuming
that the firm has only a single issue of debt, V* is then specified as
follows:
All that is left is to utilize the stochastic process to generate a

Monte-Carlo simulation over the holding period and then to
solve the PDE at the end of the holding period to provide a
valuation that includes the credit risk of the contingent claim.
An Example
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where d(t) is the recovery rate, C is the coupon and B(r,t;c) is the
value of an comparable Treasury. Additional boundary conditions
will be applied based on the contingent claim being valued. This
emphasizes another advantage of this framework which is the
ability to incorporate a wide range of products by simply changing
the boundary conditions.
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With these processes, the following PDE can be written for the
valuation of a contingent claim, P.
The implementation of the model was done in MATLAB. The

PDE was numerically solved using an Alternating Direction
Implicit (ADI) Finite Difference Scheme. The use of an ADI
scheme was chosen since it maintains tridiagonal matrices which
allow for efficient computation using sparse matrices. Using
MATLABs functionality to handle sparse matrices, maximizes
the inherent matrix nature of the problem. The Monte-Carlo
simulation was implemented in MATLAB based on above
specified stochastic process.
Figure 1 - Bond Value Sensitivity to Issuer Credit Quality and Interest

Rates
As a first analysis, the valuation model was run across a range of
short rates and V*. The results are shown in figure 1. The graph
shows the sensitivity of the bond value to the credit quality of the
issuer. The bond value falls quickly towards zero as V* increases
indicating a higher likelihood of default. On the interest rate side,
the bond shows the expected sensitivity to interest rates.
Interestingly, the bond value seems be more sensitive to interest
rates when the credit quality is lowest. This confirms our intuition
that firms with low credit quality should have more market risk
than firms with high credit quality. Firms with higher credit quality
are those which we expect will have only a base level of interest rate
exposure.
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Before calculating the distribution for the risk calculation, it helps

to investigate the valuation component to gain insight into what
factors will impact the integrated market and credit risk measure.
As an example, a 3-year bond with a 5% coupon was chosen.
Later, when the simulation is run, the holding period will be set
to one year leaving a bond with 2-years to maturity at that time.
The initial short rate is set to 5%, the mean reversion rate is set to
0.1 and the long-term mean rate is set to 6%, and the initial firm
value is 200. The interest rate volatility is set at 2.5% and the firms
volatility is set to 15%.
Figure 2 - Bond Value Sensitivity to Firm Value Volatility and Net Cash
Payout Rate
As second level of analysis, the bond valuation was performed
for a range of firm net cash outflow payments and firm value
volatilities. Noting that V* changes as beta, the payout rate,
changes, we find the expected results. Joon (1993) note that firms
with higher net cash flows are more likely to meet their coupon
obligations and should, therefore, have lower credit yield spreads,
as is highlighted in this valuation analysis. As shown in figure 2,
when the payout rate is low, the bond valuation is highly sensitive
144
11D.571.3
derivative. The methodology provides a flexible way to develop a

risk measure that integrates market and credit risk.
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Finally, we run the simulation to obtain an integrated market and

credit risk distributions. The distributions are shown below. As
can be seen, the lower credit-quality bond has an integrated
distribution very different from the stand-alone market
distribution of the same bond. On the other hand, the highgrade bond distribution highlights the marginal effect of the credit
risk component. Results such as these highlight the value of an
integrated market and credit risk. Although the credit quality of
the bond has a clear impact on the risk measure, it impacts the
overall risk of higher grade bonds by a significantly lesser amount.
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Notes:
Figure 3: Market and Credit Risk Distributions

The framework developed can be extended to multiple products
across multiple issuers and counterparties. In addition, the ADI
scheme can be extended to three dimensions to allows the inclusion
of products where two different underlying firm values processes
will impact the contingent claim valuation, as in the case of a credit
11D.571.3
145
to the firm value volatility. However, as the payout rate increases,

and the firm is more likely to make coupon payments, the volatility
of the firm value process has less of an effect on the bond valuation.
Overall, this analysis confirms our intuition with regard to lowgrade bonds and their sensitivity to underlying firm and market
factors.
Nature & Scope of Operational Risk

The need to manage and mitigate Credit Risk and Market Risk
has long been recognised by Banks and Financial Institutions.
In fact efficient management of financial risk can give a Bank /
FI a decisive competitive edge over rivals. With scams like the
collapse of the Barings Bank, the LTCM crisis, the P&G
Bankers Trust litigation, etc., the finance industry became
painfully aware of the significant threat posed by operational
risk. 9/11 and its aftermath has only served to highlight the
importance of operational risk management.
The New Capital Accord, (Basel II), published by the Basel

Committee of the Bank of International Settlements (BIS), defines
Operational Risk as: The risk of loss resulting from inadequate
or failed internal processes, people and systems or from external
events. This definition includes legal risk, but excludes strategic
and reputational risk. By its very definition then, Operational
Risk extends to all activities, business functions and organizational
units of a firm. Any Risk Management activity must constitute
four steps viz:
1. Risk Identification
2. Risk Measurement
3. Risk Control
4. Integrated Risk-Return Management
Unlike market and credit risk the measurement and management

of operational risk is not a theoretically straightforward exercise.
This very disparate and wide scope of Operational Risk poses
ssignificant conceptual issues exist in all the steps of the risk
management process. These are:
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1. Definition: At the very basic level, differences still exist on the

definition of Operational Risk. Definitions have ranged from
extremely narrow ones focussing only on transaction processing
risks, to sweepingly broad definitions that include all risks faced
by a Bank/FI other than Credit and Market Risk. Both these
extremes are clearly of little use. The BIS definition attempts to
evolve a broad consensus.
2. Isolation: Operational Risk, Market Risk and Credit Risk are

not mutually exclusive. Often, one risk event has repercussions
on all three risk domains. However, quantification requires
isolating the risk effects of each event. While convenient thumb
rules exist for demarcating credit and market risk, operational
risk poses specific problems.
3. Risk Factors: Unlike Credit and Market risk, the risk factors
that contribute to Operational Risk are often subject to internal
control by a bank. Furthermore, the causal linkage between a
risk factor and the associated loss severity & likelihood is
often difficult to establish.
For instance, the linkage between market yields and the value of a
bond portfolio are direct and measurable. However, Operational
146
Risk factors, like a people risk event raised by a rogue trader cannot
be traced to a directly quantifiable exposure and / or probability
of loss.
4. Quantification: There are two schools of thought concerning
quantification of Operational Risk. One believes that
Operational Risk is an inherently subjective domain and
quantification would rely too much on human judgement to
be reliable. The other school believes that quantitative
measurement presents our only hope of managing operational
risk and hence advocates building up of loss event databases
to provide the requisite statistical foundations for quantification.
However the fact that Operational Risk events do not represent
any notional amounts, contract values or payoffs, makes
quantification of exposure particularly tricky.
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Introduction
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LESSON 26:
OPERATIONAL RISK
5. Modelling: Market and Credit Risk rest on solid academic

foundations. Modern Portfolio Theory and the Efficient
Markets Hypothesis provide the conceptual framework within
which stochastic calculus and analytical methods provide elegant
mathematical models for credit and market risks. These models
can work on several decades of historical data for credit risk and
near continuous pricing data on exchange traded instruments
for market risks, to generate meaningful results. Operational
Risk on the other hand lacks such academic underpinnings as
yet. The quantification issue, mentioned above, has bearing on
the nature of operational risk modelling. While statistical models
like Operational VaR, loss distributions, etc., can be used,
validating and fine tuning the assumptions becomes difficult
owing to the lack of data. Given these issues, a pure quantitative
approach to Operational Risk may be inadequate. Industry
consensus thus seems to be evolving towards using both
qualitative and quantitative means. Combining the two into
an integrated Operational Risk view presents further modelling
challenges.
6. Controlling: Risks are typically controlled by reducing exposures
or hedging positions. Operational Risks cannot be controlled
by these means. Some Operational Risks require process
modifications that would minimize / eliminate a particular
kind of loss event. Some can be insured against. Some have to
be lived with. Determining which of these remedies is suitable
in a given circumstance may seem straightforward, but
quantifying the effectiveness of these mitigation strategies poses
further challenges.
7. Capital Allocation: The single largest innovation in the New
Capital Accord is that it requires Banks and FIs to allocate
capital against risk of Operational Losses.
8. Risk Aggregation: In the case of market and credit risk,
aggregation, while practically complex, is conceptually clear aggregated Credit Risk is essentially the risk to a Credit Portfolio.
The absence of an Operational Portfolio relates to the absence
of an explicitly quantified Operational Exposure. However
11D.571.3
1. People: These consist of events like employee fraud, human

error, etc
2. Relationship: These pertain to risks arising out of client
interfaces, viz., product liability, pricing negotiation, contract
default, etc
Qualitative & Quantitative Approaches

The operational risk associated with any event has two
components, loss severity and loss probability. Loss, in itself
consists of expected and unexpected components. The
unexpected loss component could be severe or catastrophic.
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3. Technology & Process: These pertain to process failures or

transaction errors. E.g., Downtime for a trading system or errors
in settlement processing.
The accord encourages banks to move along the spectrum of

available approaches as they develop more sophisticated
operational risk measurement systems and practices.
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Classification of Operational Risks

To facilitate assessment of Operational Risks, they are often
categorized into the following broad risk classes. While several
such categorizations have been proposed, the classification
suggested by Hoffman is placed below.
Under the AMA, the regulatory capital requirement will equal the
risk measure generated by the banks internal operational risk
measurement system using the quantitative and qualitative criteria
specified in the Capital Accord. Use of AMA is subject to
supervisory approval by the central bank. Banks adopting the
AMA will be required to calculate their capital requirement using
the Advanced measurement Approach as well as as per the existing
Accord for a year prior to implementation of the New Accord at
year-end 2006.
4. Physical Asset: These errors pertain to physical loss or damage

owing to fire, theft, etc
5. Other External: These pertain to risks arising out of activities
of, or failures at external agencies. E.g., failure of a bank payment
gateway, human error at counterparty, etc.
Separating risks into classes facilitates loss event identification and
is a very important tool for qualitative assessment techniques
discussed below.
In addition, it is also useful to think of Operational Risk events in
terms of their locale in an organisation; giving rise to the following
process dimensions for Operational Risk.
1. Origination: These are risks of failure at transaction origination

2. Execution & performance: These pertain to risks of failure
while executing orders, processing transactions, or fulfilling
contractual obligations.
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3. Managing Business lines: These risks arise from organisational

management activities at he business unite level. E.g., technology
implementation, work-force management risks, etc.
4. Corporate level: These are enterprise level risks. Damages due
to natural causes or terrorism, loss owing to improper security
and access controls in the organisation, etc. ]
Basel II Requirement for Operational Risk
Requirement for banks to allocate regulatory capital for Operational

Risk is a significant innovation in the New Capital Accord, or
Basel II. The accord has outlined three methods for calculating
operational risk capital charges in a continuum of increasing
sophistication and risk sensitivity, namely:
Basic Indicator Approach;
Banks using the Basic Indicator Approach must hold capital for
operational risk equal to a fixed percentage of average annual
gross income over the previous three years.
Advanced Measurement Approaches (AMA).
11D.571.3
Usually, expected losses are adjusted for in pricing or in reserve

allocation. Unexpected losses require capital allocation. Given that
operational risk events are most often subject to internal control,
any Operational Risk system that passively measures Operational
Risk would clearly be inadequate. Once risk factors are identified as
likely causes of Operational Risk losses, mitigating steps need to
be initiated. While quantification would indicate risk magnitude
and capital charges, it may not by itself suggest mitigating steps.
This makes it advisable for banks to combine qualitative and
quantitative approaches to Operational Risk. The broad steps
involved here would be:
i. Determine the types of operational losses that could occur
ii. Identify the causal risk factors
iii. Estimate the size and likelihood of losses
iv. Mitigate associated risks
Approaches for measuring Operational Risk can be seen along
two dimensions.
1. Qualitative versus Quantitative approaches: Whether the
approach relies on quantitative methods like Bayesian networks
or actuarial analysis or on qualitative techniques like audits and
self-assessments
2. Bottom-up versus Top-down analysis: Depending on whether
firm-wide risk is aggregated from unit level risks, or whether
unit level risks are drilled-down to from firm-wide risks.
147
there is general agreement that intuitively, operational loss events

are correlated.
Risk Audit
Employing the services of external (or internal) auditors to
review the business processes of a business unit is another
approach. This process not only helps identify risks but also
helps put in place the oversight organisation for Operational
Risk.
Techniques like Monte Carlo simulation can be used to fill up

gaps in the loss distribution occurring on account of lack of data.
Furthermore, with developments in extreme value theories, more
accurate estimations of the tail distributions can be made. The
operational VaR would help quantify unexpected loss for which
capital can be allocated.
Causal / Factor based Approaches
Bayesian Network is one of the commonest causal approaches
used to quantify Operational Risk. In this approach, process
workflows are mapped to a probability tree where each node
represents a loss event or indicator and has an associated
probability. Once all the initial nodes of the probability tree are
assigned probabilities, the probability of all subsequent nodes
can be calculated and the Bayesian Network is complete. Monte
Carlo simulations can be run on the network starting with the
initial variables to arrive at the required loss distributions.
This analysis can allow highly granular risk events / indicators
that are specific to a business process to be used.
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Critical Self-Assessment: (CSA)

This is one of the common qualitative bottom-up approaches
where line managers are asked to critically analyse their business
processes given specific scenarios to identify potential risks and
gaps in their risk management processes. Tools like
questionnaires, checklists and workshops are used to help the
managers analyse the risk profile of their business units. The
key idea behind this method is that business managers are in
the best position identify and manage the Operational Risks
pertaining to their business units.
given time interval, with loss severity distributions, which

describe the severity of the loss. The loss distribution can then
be used to quantify Expected Operational Loss and a suitable
quantile (95% or 99% confidence interval) can be used to arrive
at an operational VaR.
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Qualitative Approaches
Qualitative approaches involve audits, self-assesments and
expert / collective judgement.
Key Risk Indicators (KRI)

The KRI approach tries to blend the qualitative and quantitative
aspects of Operational Risk management. The focus in
identifying KRIs is on predictive rather than causal factors.
Factors that have predictive value and that can be easily
measured with minimum time lag can serve as risk indicators.
Some risk indicators inherently carry risk related information, for
instance, indicators like transaction volumes, trade size,
portfolio size, etc. Others are indirect indicators, for instance, IT
budgets, transaction lifecycle durations, appraisal completion
rates, etc. Key indicators are identified from several potential
factors and are tracked over time. The predictive capabilities of
the indicators are tested through regression analysis on historical
loss data and indicator measurements. Based on such analysis,
the set of indicators being tracked may be modified suitably.
Over time, as the model gets refined, the set of indicators can
provide early warning signals for operational losses.
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Quantitative Approaches
Loss Scenario Modelling

This approach attempts to translate a qualitative operational risk
assessment into a risk quantification mechanism. They make
use of methods similar to the Critical Self-Assessment
approach in that business managers analyse business processes
to identify potential risks arising out of various loss scenarios.
Quantification is achieved by assessing the loss frequency
(number of losses expected over a fixed period) and the loss
severity, which are combined to arrive at a loss distribution.
Since this approach requires the active involvement of business

managers, it leads to proactive risk identification. However, the
quantification arrived at is highly subjective and the correlations
between the loss scenarios are difficult to gauge, posing problems
for risk aggregation.
Loss Distribution / Actuarial Approaches
This quantification approach, widely used by the insurance
industry, uses loss distributions derived from historical. Loss
distributions are derived by combining loss frequency
distribution, which describes the frequency of losses over a
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Modelling Operational Risks
The case for quantification

A number of approaches have developed for modelling
operational risk. Niall OBrien, Barry Smith and Morton Allen
outline the options and discuss how they relate to risk
management objectives such as performance measurement and
capital allocation
The time to quantify has arrived. Following the publication of
the Basle Committees report on operational risk in September
1998 and last months consultative paper on a new capital
adequacy framework, the industry is on notice that it has to step
up its thinking about how to measure and not simply
manage operational risk.
The benefits of measuring and streamlining the flow of capital,
people and information into and out of the enterprise were realised
long ago outside the financial sector, as evidenced by the
management programmes Total Quality Management, Six Sigma
and Shareholder Value Added introduced at companies like US
conglomerate General Electric and communications firm
Motorola. With the search for value by customers and shareholders,
deregulation and global competition transforming the financial
services industry, there should be no need to wait for the Basle
Committee to claim its operational risk claw-back before acting.
Of course, quantifying operational risk is a challenge, if it means
supporting enterprise-wide performance measurement and
capital allocation. But this is not the only possible objective.
Simpler models, delivering relative or subjective measures risk
indicators, ratings, or impact measures are widely used already.
These are intended to
improve the quality of workflow;
reduce losses caused by process failure;
change risk culture; and
11D.571.3
management.
Having fitted the daily mishandling event data to a distribution, it

is possible, using maximum likelihood analysis, to derive a
consistent set of critical event count thresholds for each day of the
week. Based on the same confidence intervals applied to the daily
distributions, these can provide dynamic triggering of rules, such
as alarms or manual drill-down. For modelling the continuous
variable describing the severity of transaction mishandling events
(for example, penalty payments in the case of settlement failure),
the usual choice is the Weibull distribution (see figure 2).
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The current tendency among modellers is to look outside the

enterprise and fit external data from comparable organisations.
By this means, one could attempt to set aside enough risk capital
to ride out the rogue trader event, if it were to occur. But then the
business lines returns and competitiveness in the market are tied
to that of the organisations used for benchmarking, leaving no
incentive for investment in the kind of management controls that
might have prevented or tempered the event in the first place. The
lesson is that statistical models based on external data must be
leavened with some form of internal marking-to-operations.
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Most of the major publicised losses at financial institutions of

the past few years were due wholly or partly to operational risk, for
example, the losses sustained last year by investors in hedge fund
Long-Term Capital Management, and by Sumitomo, Daiwa,
NatWest and Barings. In such cases it seems far-fetched to suppose
that quantification and risk capital attribution alone can help. For
such low-frequency, high-impact events as rogue trader syndrome,
internal data will probably never be statistically valid.
Operational risk can be divided into operational leverage risk (also

known as business or strategic risk) and operational failure risk.
Operational leverage risk is the risk that the organisations
operations will not generate the expected returns as a result of
external factors, such as changes in the tax regime, in the political,
regulatory or legal environment, or in the nature or behaviour of
the competition. Modelling this kind of risk is best carried out
using scenario analysis. Operational failure risk is the risk that
losses will be sustained, or earnings foregone, as a result of failures
in processes, information systems or people. In contrast to leverage
risk, the risk factors in failure risk are primarily internal.
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Modelling losses
In the sections that follow, we show how to combine
distributional assumptions for event frequency and severity to
derive loss estimates, using the familiar example of transaction
processing errors.
Although it would be possible to model total transaction
handling losses as a single distribution, it is preferable to
combine separate distributions for the mishandling event
process and the severity. This has a number of advantages.
These include better drill-down into the causes and effects of
losses, and the improved ability to set trigger thresholds for
implementing dynamic control processes as part of the
workflow and to see the effects of those controls.
The event process for transaction handling errors is best

approximated as a Poisson process, in which the frequency of
error events per unit of time is distributed as a Poisson variable
(although in theory, the exponential distribution could also be
used to model the distribution of the time between errors).
In general, Mondays and Fridays have a higher proportion of
mishandled transactions than other days (see figure 1). The number
of transaction mishandling events on different days of the week
follow different poisson processes with respective parameters.
For example, on Mondays the number of mishandled transactions
are distributed as P, on Tuesdays as P and so on.
11D.571.3
The shape of the Weibull distribution is governed by its

parameters and , and its probability density function is given
by:
where 0<x, 0<, and 0<.

In order to model the total losses, a mixture of the poisson and
Weibull distributions must be formulated. The mixture
distribution is formulated as a compound poisson process. The
total loss due to mishandled transactions, or severity amount,
S(t), for some time interval (0,t) forms a compound poisson
process if:
1. The frequency of mishandled transaction events forms a
poisson process;
2. The individual loss amounts are independent, and identically
distributed; and
149
provide early warning of deterioration in systems or
some time to come, the greatest gains will be found in

instrumenting and improving the organisations core workflows.
If the mishandled transaction events occur in accordance with a

poisson process with rate and the moment generating function
(MGF) of the individual loss amounts (random variable x) is
Mx(u), then the MGF of S(t), the mixture distribution is:
The ups and downs of operational risk models

Fully-fledged models of operational failure risk fall into two
broad categories: top-down and bottom-up. Top-down models
integrate loss or earnings volatility data at the business unit or
enterprise-wide level, independently of the actual workflow, to
arrive at an implied estimate of the risk in the business unit as a
whole. These models are easier to implement than bottom-up
models, but are not inherently sensitive to the actual business
process implementations.
E(S(t))=tm1
and
V(s(t))=tm2
where m1 is the mean of the Weibull distribution and m2 its
variance.
Thus, we can calculate the mean and variances of the total losses
due to mishandling.
One top-down approach is to use the Capital Asset Pricing Model

(CAPM) to benchmark against comparable institutions. Model
inputs include equity prices, betas, debt leverage and benchmark
equity price movements due to major operational failures. CAPMbased models attempt to strip away the components of the firms
specific risk that are due to balance sheet leverage and portfolio
risk, and provide an overview of the firms operational risk capital.
The CAPM methodology is easy to implement, but inadequate
by itself because it is tied to an enterprise-wide view. It cannot
help with capital allocation or improvement in business processes.
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It can be shown that
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3. The individual loss amounts are independent of the number

of events N(t).
The final step is to take the overall loss distribution and use it to
attribute risk capital to the overall transaction workflow. The
distribution must be scaled from the daily total severity distribution
to the appropriate horizon and confidence interval dictated by the
firms capital allocation policy. Simulation can be used to aggregate
loss distributions across multiple operational risk categories.
A similar methodology can be applied to address the important
area of model risk. Model risk is a function of input data quality
and inherent model applicability and accuracy. The valuation model
risk resulting from data quality problems should be considered.
The lifecycle of a transaction may be characterised in terms of
canonical events and the types of data quality problems typically
associated with those events, including errors in market data; failure
to capture initially all relevant trade attributes; and failure to capture
lifecycle events such as resets, changes in collateral values,
dividends or corporate actions correctly.
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For these purposes, the portfolio can be sampled periodically. The

frequency of errors should be assessed, as well as the severity,
measured in dollar terms. To gather data for the model, a favoured
technique is dollar-unit sampling, which gives more weight to
the big transactions without overlooking the small transactions.
Using this method, sampled transactions are checked and corrected
where indicated, then revalued. Comparison of this result against
the original valuation provides an estimate of the severity the
model error for this transaction. Extrapolation of these results
from the sample to the overall population then provides an
estimate of the frequency, severity and total model error in the
portfolio. As before, it is possible to fit the frequency and severity
distributions, and define critical values using confidence intervals,
which in turn can be used to control the sampling process.
Depending on the point in the lifecycle at which the error occurs
for example, deal pricing a causal model must then be used to
translate this error into a true loss estimate.
Modelling operational risk in financial institutions is still in its
infancy. But the process is sure to develop, and the trend is likely to
be towards bottom-up or hybrid models that, wherever possible,
model the real workflows despite the fact that it is harder to
arrive at a full and consistent operational value-at-risk and capital
allocation methodology by this means. Quantification is not an
end in itself, but a step towards better management and for
150
Focusing directly on operational loss data at business unit level

leads to a simple top-down model that addresses this issue. Risk
is expressed as the absolute value of the observed volatility of
current budgeted (expected) expenses due to operational failures.
This simple approach includes costs such as penalties for settlement
failure, but ignores indirect effects on revenue such as foregone
income. A more sophisticated model takes overall earnings
volatility and attempts to strip away the components due to market
and credit risk.
Bottom-up models involve mapping the workflows in which
failure may occur. In estimating risk, they make use of actual
causal relationships between failures and resulting losses. They are
sensitive to process improvement, but hard to implement and
may never get off the bottom to support consistent enterprisewide capital allocation.
Bottom-up risk profiling starts from a mapping of the workflow
in each business unit. At every point where operational failures
can occur, profiling attempts to estimate the frequency of loss
events, taking into account the controls that are in place. It then
estimates the severity of the potential losses, accounting for any
risk transfers, such as insurance. A simplistic implementation
would attribute risk capital based on the product of the event
probabilities and severities over the chosen horizon, summing
the resulting operational value-at-risk for each different type of
loss event. Despite its simplicity, such a method would still have
the advantage of introducing model sensitivity to the workflow
itself and to the quality of controls that are in place.
A more sophisticated implementation builds on this approach by
introducing statistical/actuarial methods, noting that both the
event frequency and the severity should be modelled as probability
distributions. The granularity of the unit of workflow used for
analysis can be chosen pragmatically.
For most types of failure event, it will be necessary to use severity
data gathered over time, and it may, therefore, be necessary to
include a model of inflation in order to scale losses into a time-
11D.571.3
independent unit. Because of the complementary strengths and

weaknesses of top-down and bottom-up profiling, some
institutions have attempted to create hybrid models. New models
appearing on the market such as PricewaterhouseCoopers
OpVaR or NetRisks RiskOps tend to adopt either the bottomup approach or a hybrid approach integrating external loss event
datasets.
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Notes:
11D.571.3
151
The LTCM fiasco is full of lessons about:

1. Model risk
2.
Unexpected correlation or the breakdown of historical

correlations
3. The need for stress-testing
4. The value of disclosure and transparency
5. The danger of over-generous extension of trading credit

6. The woes of investing in star quality
7. And investing too little in game theory.
The latter because LTCMs partners were playing a game up to hilt.
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John Meriwether, who founded Long-Term Capital Partners in

1993, had been head of fixed income trading at Salomon Brothers.
Even when forced to leave Salomon in 1991, in the wake of the
firms treasury auction rigging scandal (another marker buoy),
Meriwether continued to command huge loyalty from a team of
highly cerebral relative-value fixed income traders, and considerable
respect from the street. Teamed up with a handful of these traders,
two Nobel laureates, Robert Merton and Myron Scholes, and
former regulator David Mullins, Meriwether and LTCM had more
credibility than the average broker/dealer on Wall Street.
It was a game, in that LTCM was unregulated, free to operate in
any market, without capital charges and only light reporting
requirements to the US Securities & Exchange Commission (SEC).
It traded on its good name with many respectable counterparties
as if it was a member of the same club. That meant an ability to
put on interest rate swaps at the market rate for no initial margin
- an essential part of its strategy. It meant being able to borrow
100% of the value of any top-grade collateral, and with that cash
to buy more securities and post them as collateral for further
borrowing: in theory it could leverage itself to infinity. In LTCMs
first two full years of operation it produced 43% and 41% return
on equity and had amassed an investment capital of $7 billion.
Meriwether was renowned as a relative-value trader. Relative value

means (in theory) taking little outright market risk, since a long
position in one instrument is offset by a short position in a
similar instrument or its derivative. It means betting on small
price differences which are likely to converge over time as the
arbitrage is spotted by the rest of the market and eroded. Trades
152
typical of early LTCM were, for example, to buy Italian government

bonds and sell German Bund futures; to buy theoretically
underpriced off-the-run US treasury bonds (because they are less
liquid) and go short on-the-run (more liquid) treasuries. It played
the same arbitrage in the interest-rate swap market, betting that
the spread between swap rates and the most liquid treasury bonds
would narrow. It played long-dated callable Bunds against Dm
swaptions. It was one of the biggest players on the worlds futures
exchanges, not only in debt but also equity products.
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Lessons From the Collapse of Hedge Fund, Longterm Capital Management

Barings, the Russian meltdown, Metallgesellschaft, Procter &
Gamble, LTCM. These are all events in the financial markets
which have become marker buoys to show us where we went
wrong, in the hope that we wont allow quite the same thing to
happen again. The common weakness, in these cases, was the
misguided assumption that our counterparty and the market it
was operating in, were performing within manageable limits.
But once those limits were crossed for whatever reason, disaster
was difficult to head off.
To make 40% return on capital, however, leverage had to be applied.

In theory, market risk isnt increased by stepping up volume,
provided you stick to liquid instruments and dont get so big that
you yourself become the market.
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LESSON 27:
CASE STUDY ON CREDIT RISK
Some of the big macro hedge funds had encountered this problem
and reduced their size by giving money back to their investors.
When, in the last quarter of 1997 LTCM returned $2.7 billion to
investors, it was assumed to be for the same reason: a prudent
reduction in its positions relative to the market.
But it seems the positions werent reduced relative to the capital
reduction, so the leverage increased. Moreover, other risks had
been added to the equation. LTCM played the credit spread between
mortgage-backed securities (including Danish mortgages) or
double-A corporate bonds and the government bond markets.
Then it ventured into equity trades. It sold equity index options,
taking big premium in 1997. It took speculative positions in
takeover stocks, according to press reports. One such was Tellabs
whose share price fell over 40% when it failed to take over Ciena,
says one account. A filing with the SEC for June 30 1998 showed
that LTCM had equity stakes in 77 companies, worth $541 million.
It also got into emerging markets, including Russia. One report
said Russia was 8% of its book which would come to $10
billion!
Some of LTCMs biggest competitors, the investment banks,
had been clamouring to buy into the fund. Meriwether applied a
formula which brought in new investment, as well as providing
him and his partners with a virtual put option on the performance
of the fund. During 1997, under this formula [see separate section
below, titled UBS Fiasco], UBS put in $800 million in the form of
a loan and $266 million in straight equity. Credit Suisse Financial
Products put in a $100 million loan and $33 million in equity.
Other loans may have been secured in this way, but they havent
been made public. Investors in LTCM were pledged to keep in
their money for at least two years.
LTCM entered 1998 with its capital reduced to $4.8 billion.
A New York Sunday Times article says the big trouble for LTCM
started on July 17 when Salomon Smith Barney announced it was
liquidating its dollar interest arbitrage positions: For the rest of
the that month, the fund dropped about 10% because Salomon
Brothers was selling all the things that Long-Term owned. [The
article was written by Michael Lewis, former Salomon bond trader
11D.571.3
Most of LTCMs bets had been variations on the same theme,

convergence between liquid treasuries and more complex
instruments that commanded a credit or liquidity premium.
Unfortunately convergence turned into dramatic divergence.
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LTCMs counterparties, marking their LTCM exposure to market

at least once a day, began to call for more collateral to cover the
divergence. On one single day, August 21, the LTCM portfolio
lost $550 million, writes Lewis. Meriwether and his team, still
convinced of the logic behind their trades, believed all they needed
was more capital to see them through a distorted market.
Peter Fisher, executive vice president at the NY Fed, decided to

take a look at the LTCM portfolio. On Sunday September 20,
1998, he and two Fed colleagues, assistant treasury secretary Gary
Gensler, and bankers from Goldman and JP Morgan, visited
LTCMs offices at Greenwich, Connecticut. They were all surprised
by what they saw. It was clear that, although LTCMs major
counterparties had closely monitored their bilateral positions, they
had no inkling of LTCMs total off balance sheet leverage. LTCM
had done swap upon swap with 36 different counterparties. In
many cases it had put on a new swap to reverse a position rather
than unwind the first swap, which would have required a markto-market cash payment in one direction or the other. LTCMs on
balance sheet assets totalled around $125 billion, on a capital base
of $4 billion, a leverage of about 30 times. But that leverage was
increased tenfold by LTCMs off balance sheet business whose
notional principal ran to around $1 trillion.
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On August 17,1998 Russia declared a moratorium on its rouble

debt and domestic dollar debt. Hot money, already jittery because
of the Asian crisis, fled into high quality instruments. Top
preference was for the most liquid US and G-10 government bonds.
Spreads widened even between on- and off-the-run US treasuries.
from its constituent banks. In the third week of September, Bear

Stearns, which was LTCMs clearing agent, said it wanted another
$500 million in collateral to continue clearing LTCMs trades. On
Friday September 18, 1998, New York Fed chairman Bill
McDonough made a series of calls to senior Wall Street officials
to discuss overall market conditions, he told the House
Committee on Banking and Financial Services on October 1.
Everyone I spoke to that day volunteered concern about the
serious effect the deteriorating situation of Long-Term could have
on world markets.
Perhaps they were right. But several factors were against LTCM.
1. Who could predict the time-frame within which rates would

converge again?
2. Counterparties had lost confidence in themselves and LTCM.
3. Many counterparties had put on the same convergence trades,

some of them as disciples of LTCM.
4. Some counterparties saw an opportunity to trade against
LTCMs known or imagined positions.
In these circumstances, leverage is not welcome. LTCM was being

forced to liquidate to meet margin calls.
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On September 2, 1998 Meriwether sent a letter to his investors

saying that the fund had lost $2.5 billion or 52% of its value that
year, $2.1 billion in August alone. Its capital base had shrunk to
$2.3 billion. Meriwether was looking for fresh investment of
around $1.5 billion to carry the fund through. He approached
those known to have such investible capital, including George
Soros, Julian Robertson and Warren Buffett, chairman of
Berkshire Hathaway and previously an investor in Salomon
Brothers [LTCM incidentally had a $14 million equity stake in
Berkshire Hathaway], and Jon Corzine, then co-chairman and cochief executive officer at Goldman Sachs, an erstwhile classmate at
the University of Chicago. Goldman and JP Morgan were also
asked to scour the market for capital. But offers of new capital
werent forthcoming. Perhaps these big players were waiting for
the price of an equity stake in LTCM to fall further. Or they were
making money just trading against LTCMs positions. Under these
circumstances, if true, it was difficult and dangerous for LTCM to
show potential buyers more details of its portfolio. Two Merrill
executives visited LTCM headquarters on September 9, 1998for a
due diligence meeting, according to a later Financial Times report
(on October 30, 1998). They were provided with general
information about the funds portfolio, its strategies, the losses
to date and the intention to reduce risk. But LTCM didnt disclose
its trading positions, books or documents of any kind, Merrill is
quoted as saying.
The US Federal Reserve system, particularly the New York Fed
which is closest to Wall Street, began to hear concerns about LTCM
11D.571.3
The off balance sheet contracts were mostly nettable under bilateral
Isda (International Swaps & Derivatives Association) master
agreements. Most of them were also collateralized. Unfortunately
the value of the collateral had taken a dive since August 17.
Surely LTCM, with two of the original masters of derivatives and
option valuation among its partners, would have put its portfolio
through stress tests to match recent market turmoil. But, like
many other value-at-risk (Var) modellers on the street, their worstcase scenarios had been outplayed by the horribly correlated
behaviour of the market since August 17. Such a flight to quality
hadnt been predicted, probably because it was so clearly irrational.
According to LTCM managers their stress tests had involved
looking at the 12 biggest deals with each of their top 20
counterparties. That produced a worst-case loss of around $3
billion. But on that Sunday evening it seemed the mark-to-market
loss, just on those 240-or-so deals, might reach $5 billion. And
that was ignoring all the other trades, some of them in highly
speculative and illiquid instruments.
The next day, Monday September 21, 1998, bankers from Merrill,
Goldman and JP Morgan continued to review the problem. It
was still hoped that a single buyer for the portfolio could be
found - the cleanest solution.
According to Lewiss article LTCMs portfolio had its second
biggest loss that day, of $500 million. Half of that, says Lewis,
was lost on a short position in five-year equity options. Lewis
records brokers opinion that AIG had intervened in thin markets
to drive up the option price to profit from LTCMs weakness. At
that time, as was learned later, AIG was part of a consortium
negotiating to buy LTCMs portfolio. By this time LTCMs capital
base had dwindled to a mere $600 million. That evening, UBS,
with its particular exposure on a $800 million credit, with $266
153
and author of Liars Poker. Lewis visited his former colleagues at

LTCM after the crisis and describes some of the trades on the
firms books]
But any action had to be taken swiftly. The danger was a single
default by LTCM would trigger cross-default clauses in its Isda
master agreements precipitating a mass close-out in the over-thecounter derivatives markets. Banks terminating their positions
with LTCM would have to rebalance any hedge they might have
on the other side. The market would quickly get wind of their
need to rebalance and move against them. Mark-to-market values
would descend in a vicious spiral. In the case of the French equity
index, the CAC 40, LTCM had apparently sold short up to 30%
of the volatility of the entire underlying market. The Banque de
France was worried that a rapid close-out would severely hit French
equities. There was a wider concern that an unknown number of
market players had convergence positions similar or identical to
those of LTCM. In such a one-way market there could be a panic
rush for the door.
The meeting resumed at 9.30 the next morning. Goldman Sachs

had a surprise: its client, Warren Buffett, was offering to buy the
LTCM portfolio for $250 million, and recapitalize it with $3 billion
from his Berkshire Hathaway group, $700 million from AIG and
$300 million from Goldman. There would be no management
role for Meriwether and his team. None of LTCMs existing
liabilities would be picked up, yet all current financing had to stay
in place. Meriwether had until 12.30 to decide. By 1pm it was clear
that Meriwether had rejected the offer, either because he didnt like
it, or, according to his lawyers, because he couldnt do so without
consulting his investors, which would have taken him over the
deadline.
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The Feds Peter Fischer invited those three banks and UBS to
breakfast at the Fed headquarters in Liberty Street the following
day. The bankers decided to form working groups to study possible
market solutions to the problem, given the absence of a single
buyer. Proposals included buying LTCMs fixed income positions,
and lifting the equity positions (which were a mixture of index
spread trades and total return swaps, and the takeover bets). During
the day a third option emerged as the most promising: seeking
recapitalization of the portfolio by a consortium of creditors.
But what incentive would they have if they no longer had an

interest in the profits? Chase insisted that any bailout would first
have to return the $470 million drawn down on the syndicated
standby facility. But nothing could be finalized that night since
few of the representatives present could pledge $250 million or
more of their firms money.
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million invested as a hedge, sent a team to Greenwich to study the

portfolio.
A meltdown of developed markets on top of the panic in

emerging markets seemed a real possibility. LTCMs clearing agent
Bear Stearns was threatening to foreclose the next day if it didnt
see $500 million more collateral. Until now, LTCM had resisted
the temptation to draw on a $900 million standby facility that had
been syndicated by Chase Manhattan Bank, because it knew that
the action would panic its counterparties. But the situation was
now desperate. LTCM asked Chase for $500 million. It received
only $470 million since two syndicate members refused to chip in.
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To take the consortium plan further, the biggest banks,

either big creditors to LTCM, or big players in the overthe-counter markets, were asked to a meeting at the
Fed that evening. The plan was to get 16 of them to chip
in $250 million each to recapitalize LTCM at $4 billion.
The four core banks met at 7pm and reviewed a term sheet which
had been drafted by Merrill Lynch. Then at 8.30 bankers from nine
more institutions showed. They represented: Bankers Trust,
Barclays, Bear Stearns, Chase, Credit Suisse First Boston, Deutsche
Bank, Lehman Brothers, Morgan Stanley, Credit Agricole, Banque
Paribas, Salomon Smith Barney, Societe Generale. David Pflug,
head of global credit risk at Chase warned that nothing would be
gained a) by raking over the mistakes that had got them in this
room, and b) by arguing about who had the biggest exposure:
they were all in this equally and together.
The delicate question was how to preserve value in the LTCM
portfolio, given that banks around the room would be equity
investors, and yet, at the same time, they would be seeking to
liquidate their own positions with LTCM to maximum advantage.
It was clear that John Meriwether and his partners would have to
be involved in keeping such a complex portfolio a going concern.
154
The bankers were somewhat flabbergasted by Goldmans dual

role. Despite frequent requests for information about other
possible bidders, Goldman had dropped no hint at previous
meetings that there was something in the pipeline. Now the banks
were back to the consortium solution. Since there were only 13
banks, not 16, theyd have to put in more than $250 million each.
Bear Stearns offered nothing, feeling that it had enough risk as
LTCMs clearing agent. [Their special relationship may have been
the source of some acrimony: LTCM had an $18 million equity
stake in Bear Stearns, matched by investments in LTCM of $10
million each by Bear Stearns principals James Cayne and Warren
Spector]. Lehman Brothers also declined to participate . In the end
11 banks put in $300 million each, Societe Generale $125 million,
and Credit Agricole and Paribas $100 million each, reaching a total
fresh equity of $3.625 billion. Meriwether and his team would
retain a stake of 10% in the company. They would run the portfolio
under the scrutiny of an oversight committee representing the
new shareholding consortium.
The message to the market was that there would be no fire-sale of
assets. The LTCM portfolio would be managed as a going concern.
In the first two weeks after the bail-out, LTCM continued to lose
value, particularly on its dollar/yen trades, according to press reports
which put the loss at $200 million to $300 million. There were
more attempts to sell the portfolio to a single buyer. According to
press reports the new LTCM shareholders had further talks with
Buffett, and with Saudi prince Alwaleed bin talal bin Abdelaziz.
But there was no sale. By mid-December, 1998 the fund was
reporting a profit of $400 million, net of fees to LTCM partners
and staff.
In early February, 1999 there were press reports of divisions
between banks in the bailout consortium, some wishing to get
their money out by the end of the year, others happy to stay for
the ride of at least three years. There was also a dispute about
how much Chase was charging for a funding facility to LTCM.
Within six months there were reports that Meriwether and some
of his team wanted to buy out the banks, with a little help from
their friend Jon Corzine, who was due to leave Goldman Sachs
after its flotation in May, 1999.
11D.571.3
The LTCM fiasco naturally inspired a hunt for scapegoats:
They believed that the first-class collateral they held was sufficient
to mitigate their loss if LTCM disappeared. It may have been over
time, but their margin calls to top up deteriorating positions
simply pushed LTCM further towards the brink.
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1. First in line were Meriwether and his crew of market professors.

2. Second were the banks which conspired to give LTCM far
more credit, in aggregate, than theyd give a medium-size
developing country. Particularly distasteful was the combination
of credit exposure by the institutions themselves, and personal
investment exposure by the individuals who ran them.
2. Risk management by LTCM counterparties

Practically the whole street had a blind spot when it came to
LTCM. They forgot the useful discipline of charging non-bank
counterparties initial margin on swap and repo transactions.
Collectively they were responsible for allowing LTCM to build
up layer upon layer of swap and repo positions.
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Post mortem
LTCM sources apparently complain that the market started trading

against its known positions. That seems like special pleading.
Meriwether et al must have been in the markets long enough to
know they are merciless, and to have been just as merciless
themselves. All they that take the sword shall perish with the
sword. [Matthew, xxvi, 52]
Merrill Lynch protested that a $22 million investment on behalf

of its employees was not sinister. LTCM was one of four
investment vehicles which employees could opt to have their
deferred payments invested in. Nevertheless, that rather cosy
relationship may have made it more difficult for credit officers to
ask tough questions of LTCM. There were accusations of croney
capitalism as Wall Street firms undertook to bail out, with
shareholders money, a firm in which their officers had invested,
or were thought to have invested, part of their personal wealth.
3. Third in line was the US Federal Reserve system. Although no

public money was spent - apart from hosting the odd breakfast
- there was the implication that the Fed was standing behind
the banks, ready to provide liquidity until the markets became
less jittery and more rational. Wouldnt this simply encourage
other hedge funds and lenders to hedge funds to be as reckless
in future?
Their credit assessment of LTCM didnt include a global view of

its leverage and its relationship with other counterparties.
A working group on highly leveraged institutions set up by the
Basle Committee on Banking Supervision reported its findings
in January, 1999 drawing many lessons from the LTCM case. It
criticized the banks for building up such exposures to such an
opaque institution. They had placed a heavy reliance on
collateralization of direct mark-to-market exposures the report
said. This in turn made it possible for banks to compromise
other critical elements of effective credit risk management,
including upfront due diligence, exposure measurement
methodologies, the limit setting process, and ongoing monitoring
of counterparty exposure, especially concentrations and leverage.
5. Fifth was sloppy market practice, such as allowing a non-bank

counterparty to write swaps and pledge collateral for no initial
margin as if it were part of a peer-group top-tier banks.
The working group also noted that banks covenants with LTCM
did not require the posting of, or increase in, initial margin as the
risk profile of the counterparty changed, for instance as leverage
increased.(Forfullreports,seSound
e
Practices for Banks
Interactions with Highly Leveraged Institutions, and Banks
Interactions with Highly Leveraged Institutions.) Another report
in June, 1999 by the Counterparty Risk Management Policy Group,
a group of 12 leading investment banks, suggested many ways in
which information-sharing and transparency could be improved.
It noted the importance of measuring liquidity risk, and
improving market conventions and market practices, such as
charging initial margin.
LTCMs risk management.
3. Supervision
Despite the presence of Nobel laureates closely identified with

option theory it seems LTCM relied too much on theoretical
market-risk models and not enough on stress-testing, gap risk
and liquidity risk. There was an assumption that the portfolio was
sufficiently diversified across world markets to produce low
correlation. But in most markets LTCM was replicating basically
the same credit spread trade. In August and September 1998 credit
spreads widened in practically every market at the same time.
Supervisors themselves showed a certain blinkered view when it

came to banks and securities firms relationships with hedge funds,
and a huge fund like LTCM in particular. The US Securities &
Exchange Commission (SEC) appears to assess the risk run by
individual broker dealers, without having enough regard for what
is happening in the sector as a whole, or in the firms unregulated
subsidiaries.
In testimony to the House Committee on Banking and
Financial Services on October 1, 1998, Richard Lindsey, director
of the SECs market regulation division recalled the following:
When the commission learned of LTCMs financial difficulties
in August, the commission staff and the New York Stock
Exchange surveyed major broker-dealers known to have credit
exposure to one or more large hedge funds. The results of our
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4. Fourth culprit was poor information. Scant disclosure of its

activities and exposures, by LTCM, as with many hedge funds,
was a major factor in allowing it to put on such leverage. There
was also no mechanism whereby counterparties could learn
how far LTCM was exposed to other counterparties.
LTCM risk managers kidded themselves that the resultant net

position of LTCMs derivatives transactions bore no relations to
the billions of dollars of notional underlying instruments. Each
of those instruments and its derivative has a market price which
can shift independently, each is subject to liquidity risk.
11D.571.3
155
By June 30, 1999 the fund was up 14.1%, net of fees, from last
September. Meriwethers plan approved by the consortium, was
apparently to redeem the fund, now valued at around $4.7 billion,
and to start another fund concentrating on buyouts and mortgages.
On July 6, 1999, LTCM repaid $300 million to its original investors
who had a residual stake in the fund of around 9%. It also paid
out $1 billion to the 14 consortium members. It seemed
Meriwether was bouncing back.
4. Was there truly a systemic risk?

Since there was no global meltdown it is difficult to prove that
there was a real danger of such a thing last September. But if
the officers at the US Federal Reserve had waited to see what
happened no-one would have thanked them after the event. In
the judgment of this writer, the world financial system owes a
lot to the prompt action of Greenspan, McDonough, Fisher
and others at the Fed for their willingness to meet the problem
fair and square. One shudders to think what the Bank of
England (FSA) might have done, given its constructive
ambiguity during the Barings crisis.
But the counter-argument is also valid. Those Wall Street firms,
once they knew the size of the problem, had only one sensible
course of action, to bankroll a co-ordinated rescue. They had the
resources to prevent a meltdown and it took only a night and a
day to pool them. Mutual self-interest concentrates the mind
wonderfully.
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As the situation at LTCM continued to deteriorate, we learned

that although significant amounts of credit were extended to
LTCM by US securities firms, this lending was on a secured basis,
with collateral collected and marked-to-the-market daily. Thus,
broker-dealers lending to LTCM was done in a manner that was
consistent with the firms normal lending activity. The collateral
collected from LTCM consisted primarily of highly liquid asseets,
such as US treasury securities or G-7 country sovereign debt. Any
shortfalls in collateral were met by margin calls to LTCM. As of
the date of the rescue plan, it appears that LTCM had met all of its
margin calls by US securities firms. Moreover, our review of the
risk assessment information submitted to the commission
suggests that any exposure to LTCM existed outside the US brokerdealer, either in the holding company or its unregistered affiliates.
The true test of moral hazard is whether the Fed would be expected
to intervene in the same way next time. Greenspan pointed to a
unique set of circumstances which made an LTCM solution
particularly pressing. It seems questionable whether the Fed would
act as broker for another fund bailout unless there were also such
wide systemic uncertainties.
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initial survey indicated that no individual broker-dealer had

exposure to LTCM that jeopardized its required regulatory
capital or its financial stability.
The sad truth revealed by this testimony is that the SEC and the
NYSE were concerned only with the risk ratios of their registered
firms and were ignorant and unconcerned, as were the firms
themselves, about the markets aggregate exposure to LTCM.
Bank of England experts note the absence of any covenant
between LTCM and its counterparties that would have obliged
LTCM to disclose its overall gearing. UK banks have long been in
the habit of demanding covenants from non-bank counterparties
concerning their overall gearing, the Bank of England says.
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3. Was there moral hazard?

The simple answer is yes, since the bailout of LTCM gave
comfort that the Fed will come in and broker a solution, even if
it doesnt commit funds. The Feds intervention also arguably
tempted Meriwether not to accept the offer from Buffett, AIG
and Goldman. The offer, heavily conditional though it was,
shows that the LTCM portfolio had a perceived market value. A
price might have been reached in negotiations between Buffett
and Meriwether. Meriwethers argument [and the Feds] is that
Buffetts deadline of 1230 didnt give Meriwether time to
consult with LTCMs investors: he was legally unable to accept
the offer.
It is possible to argue that a market solution was found. Fourteen

banks put up their own money, regarding it as a medium-term
investment from which they expected to make a profit. From a
value-preservation point of view it was an enlightened solution,
even if it did seem to reward those whose recklessness had created
the problem. Federal Reserve chairman Alan Greenspan defended
the Feds action at the October 1 hearing in the House Committee
on Banking and Financial Services as follows: This agreement
[by the rescuing banks] was not a government bailout, in that
Federal Reserve funds were neither provided nor ever even
suggested. Agreements were not forced upon unwilling market
participants. Credits and counterparties calculated that LTCM and,
accordingly, their claims, would be worth more over time if the
liquidation of LTCMs portfolio was orderly as opposed to being
subject to a fire sale. And with markets currently volatile and
investors skittish, putting a special premium on the timely
resoluton of LTCMs problems seemed entirely appropriate as a
matter of public policy.
156
It seems that in the developed world, since the early 1990s, financial
firms have built up enough capital to meet most disasters the
world can throw at them. Their mistakes in emerging markets
were costly both for them and for the countries concerned, but
they havent threatened the life of the world financial system. It
seems the mechanisms for restructuring and acquisition are so
swift that the demise of a financial firm simply means it will be
stripped of the trash and carved up. In a down-cycle, however, the
outcome could be very different. Moreover, the social costs of this
financial overreach, followed by cannibalism, could be considerable.
Systemic, no; ripe for concerted private and public intervention,
yes.
On September 29, 1999, six days after the LTCM bailout, US
Federal Reserve chairman Alan Greenspan cut Fed fund rates by
25 basis points to 5.25%. On October 15, 1999 he cut them by
another quarter. His critics associate these cuts directly with the
bail-out of LTCM: it was an extra dose of medicine to make sure
the recovery worked. Some sources attribute the cut to rumours
that another hedge fund was in trouble.
The more generous view is that, if the financial markets were in
disarray, we aint seen nothing yet. Bruce Jacobs, who has followed
the systemic implications of the 1929, 1987 and subsequent minicrashes, fearful of the dangers of globally traded derivatives, writes
in a new book: Had LTC not been bailed out, the immediate
liquidation of its highly leveraged bond, equity, and derivatives
positions may have had effects, particularly on the bond market,
rivaling the effects on the equity market of the forced liquidations
of insured stocks in 1987 and margined stocks in 1929. Given the
links between LTC and investment and commercial banks, and
between its positions in different asset markets and different
countries markets, the systemic risk much talked about in
connection with the growth of derivatives markets may have
become a reality. [Capital ideas and market realities, Blackwell,
1999, page 293]
11D.571.3
For a premium of $300 million UBS sold LTCM a seven-year

European call option on 1 million of LTCMs own shares, valued
then at $800 million. To hedge the position - the only way it could
be done - UBS bought $800 million worth of LTCM shares. UBS
also invested $300 million (most of the $266 million premium
income) directly in LTCM. Such an investment had to be held for
a minimum of three years. This transaction was completed in
three tranches in June, August and October 1997.
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The deal was calculated so that the $300 million premium was
equivalent to a coupon of Libor plus 50 basis points over the
seven years.
Assuming that LTCM performed well the deal provided UBS
with steady, tax-efficient, return plus a share in the upside, through
its $266 million stake.
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The losers
Among the investors who lost their capital in LTCM (according
to press reports) were:
LTCM partners - $1.1 billion ($1.5 billion at the beginning of

1998, offset by their $400 million stake in the rescued fund)
Liechtenstein Global Trust - $30 million
Bank of Italy - $100 million
Credit Suisse - $55 million
UBS - $690 million
sweetener for UBS was a structure that looked more like an

option than a loan, turning any income into a capital gain, and
an opportunity to invest directly in LTCM.
Merrill Lynch (employees deferred payment) - $22 million

Donald Marron, chairman, PaineWebber - $10 million
Sandy Weill, co-ceo, Citigroup - $10 million
McKinsey executives - $10 million
Bear Stearns executives - $20 million

Dresdner Bank - $145 million
Sumitomo Bank - $100 million
Nick Leeson enjoyed at Barings before March 1995).
But it is clear now that UBS risk managers never faced the possibility
of a collapse of LTCM which would have left them with $766
million exposure ($800 million hedge, $266 million investment,
less $300 million option premium). That is, they didnt wake up
to it, apparently, until around April 1998, in a post-merger review,
when it was too late to do much about it. Credit Suisse Financial
Products, which did a similar deal for $100 million, set that as the
maximum it was prepared to lose.
An interesting aspect of the UBS deal is to consider it from LTCMs
point of view. LTCM secured $800 million new investment capital
at Libor plus 50 basis points. It had a call on all returns above that
level. UBSs obligation, to convert any shares it wanted to sell into
a loan, provided LTCM with a synthetic seven-year put on its own
performance. Was this an added incentive to roll the dice? It was a
cheap gambling stake
Notes:
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Prudential Life Corp - $5.43 million

There were no reported numbers for the following
organisations:
Bank Julius Baer (for clients)
Republic National Bank
St Johns University endowment fund

University of Pittsburgh
UBS fiasco
The biggest single loser in the LTCM debacle was UBS, which
was forced to write off Sfr950 million ($682 million) of its
exposure. The UBS involvement with LTCM pre-dated the
merger of Union Bank of Switzerland and Swiss Bank
Corporation in December 1998. Various heads rolled, including
that of chairman Mathis Cabiallavetta (formerly chief executive
of Union Bank of Switzerland), Werner Bonadurer, chief
operating officer, Felix Fischer, chief risk officer, and Andy
Siciliano, head of fixed income (who had been with SBC).
UBSs deal with LTCM was a variation on other attempts to
turn hedge funds into a securitized asset class with a protected
downside. However in this case UBS was protecting the
downside and LTCM was taking a good deal of the upside. The
11D.571.3
157
Corrective response
The Basle Committee on Banking Supervisions report on
highly leveraged institutions (HLIs) in January 1999 suggests
that supervisors demand higher capital charges for exposure to
highly leveraged institutions where there is no limit to overall
leverage: Possibly all exposures to all counterparties not
covered by covenants on leverage should carry a higher weight.
It further considers the possibility of extending a credit register
for bank loans in the context of HLIs. The register would
entail collecting, in a centralized place, information on the
exposures of international financial intermediaries to single
counterparties that have the potential to create systemic risk (ie
major HLIs). Exposures would cover both on and off-balancesheet positions. Counterparties, supervisors and central banks
could then obtain information about the overall indebtedness
of the single counterparty.
an aggressive buying programme, which culminated in a high of

19,094 contracts reached about a month later on February 17.
I. How Leeson Broke Barings

The activities of Nick Leeson on the Japanese and Singapore
futures exchanges, which led to the downfall of his employer,
Barings, are well-documented. The main points are recounted
here to serve as a backdrop to the main topic of this chapter the policies, procedures and systems necessary for the prudent
management of derivative activities. Barings collapsed because it
could not meet the enormous trading obligations, which
Leeson established in the name of the bank. When it went into
receivership on February 27, 1995, Barings, via Leeson, had
outstanding notional futures positions on Japanese equities
and interest rates of US$27 billion: US$7 billion on the Nikkei
225 equity contract and US$20 billion on Japanese government
bond (JGB) and Euroyen contracts. Leeson also sold 70, 892
Nikkei put and call options with a nominal value of $6.68
billion. The nominal size of these positions is breathtaking;
their enormity is all the more astounding when compared with
the banks reported capital of about $615 million. The size of
the positions can also be underlined by the fact that in January
and February 1995, Barings Tokyo and London transferred
US$835 million to its Singapore office to enable the latter the
meet its margin obligations on the Singapore International
Monetary Exchange (SIMEX).
Reported activities (Fantasy)
But Leesons Osaka position, which was public knowledge since

the OSE publishes weekly data, reflected only half of his sanctioned
trades. If Leeson was long on the OSE, he had to be short twice
the number of contracts on SIMEX. Why? Because Leesons
official trading strategy was to take advantage of temporary price
differences between the SIMEX and OSE Nikkei 225 contracts.
This arbitrage, which Barings called switching, required Leeson
to buy the cheaper contract and to sell simultaneously the more
expensive one, reversing the trade when the price difference had
narrowed or disappeared. This kind of arbitrage activity has little
market risk because positions are always matched.
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The chain of events, which led to the collapse of Barings,

Britains oldest merchant bank, is a demonstration of how not
to manage a derivatives operation. The control and risk
management lessons to be learnt from the collapse of this 200
year-old institution apply as much to cash positions as they do
to derivative ones, but the pure leverage of derivatives makes it
imperative that proper controls are in place. Since only a small
amount of money (called a margin) is needed to establish a
position, a firm could find it facing financial obligations way
beyond its means. The leverage and liquidity offered by major
futures contracts - such as the Nikkei 225, the S&P 500 or
Eurodollars - means that these obligations, once in place,
mount very quickly; thus bringing down an institution with
lightning speed. This is in stark contrast to bad loans or cash
investments whose ill-effects takes years to ruin an institution as
demonstrated by the cases of British & Commonwealth Bank
or Bank of Credit and Commerce International (BCCI).
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LESSON 28:
CASE STUDY
The build-up of the Nikkei positions took off after the Kobe
earthquake of January 17. This is reflected in Figure 10.1 - the
chart shows that Lessons positions went in the opposite direction
to the Nikkei - as the Japanese stock market fell, Leesons position
increased. Before the Kobe earthquake, with the Nikkei trading in
a range of 19,000 to 19,500, Leeson had long futures positions of
approximately 3,000 contracts on the Osaka Stock Exchange. (The
equivalent number of contracts on the Singapore International
Monetary Exchange is 6000 because SIMEX contracts are half the
size of the OSE.) A few days after the earthquake Leeson started
158
Barings Long Positions against the Nikkei 225 Average.

Source: Datastream and Osaka Securities Exchanges
But Leeson was not short on SIMEX, infact he was long

approximately the number of contracts he was supposed to be
short. These were unauthorised trades which he hid in an account
named Error Account 88888. He also used this account to execute
all his unauthorised trades in Japanese Government Bond and
Euroyen futures and Nikkei 225 options: together these trades
were so large that they ultimately broke Barings. Table 10.1 gives a
snapshot of Leesons unauthorised trades versus the trades that
he reported.
For the rest of the chapter, contracts will be discussed or converted
into SIMEX contract sizes.
Unreported positions (Fact)
The most striking point of Table 10.1 is the fact that Leeson
sold 70,892 Nikkei 225 options worth about $7 billion without
the knowledge of Barings London. His activity peaked in
November and December 1994 when in those two months
alone,
11D.571.3
Fantasy versus Fact: Leeson's

Positions as at End February 1995.
Number of contracts1
nominal value in US$
amounts
Reported 3
Actual4
he sold 34, 400 options. In industry parlance, Leeson sold straddles.

i.e. he sold put and call options with the same strikes and maturities.
Leeson earned premium income from selling well over 37,000
straddles over a fourteen month period. Such trades are very
profitable provided the Nikkei 225 is trading at the options strike
on expiry date since both the puts and calls would expire worthless.
The seller then enjoys the full premium earned from selling the
options. (see Fig 10.2 for a graphical presentation of the profit
and loss profile of a straddle.) If the Nikkei is trading near the
options strike on expiry, it could still be profitable because the
earned premium more than offsets the small loss experienced on
either the call (if the Tokyo market had risen) or the put (if the
Nikkei had fallen.).
Actual
position in
terms of
open
interest of
relevant
contract 2
Futures
JGB
15940
$8980
million
601
Euroyen $26.5
million
85% of
March
1995
short 28034
contract
$19650
and 88%
million
of June
1995
contract.
short 6845
$350
million
Nikkei
225
Nil
5% of
June 1995
contract,
1% of
September
1995
contract
and 1% of
December
1995
contract.
Figure 10.2
37925 calls
$3580
million
32967 puts
$3100
million
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Options
long 61039
$7000
million
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30112
$2809
million
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Nikkei
225
49% of
March
1995
contract
and 24%
of June
1995
contract.
1. Expressed in terms of SIMEX contract sizes which are half

the size of those of the OSE and the TSE. For Euroyen,
SIMEX and TIFFE contracts are of similar size.2. Open interest
figures for each contract month of each listed contract. For the
Nikkei 225, JGB and Euroyen contracts, the contract months
are March, June, September and December.3. Leesons reported
futures positions were supposedly matched because they were
part of Barings switching activity, i.e. the number of contracts
on either the Osaka Stock Exchange, the Singapore
International Monetary Exchange or the Tokyo Stock
Exchange.4. The actual positions refer to those unauthorized
trades held in error account 8888. Source: The Report of the
Board of Banking Supervision Inquiry into the Circumstances
11D.571.3
Payoff Profile of a Straddle. The strike prices of most of Leesons

straddle positions ranged from 18,500 to 20,000. He thus needed
the Nikkei 225 to continue to trade in its pre-Kobe earthquake
range of 19,000 - 20,000 if he was to make money on his option
trades. The Kobe earthquake shattered Leesons options strategy.
On the day of the quake, January 17, the Nikkei 225 was at 19,350.
It ended that week slightly lower at 18,950 so Leesons straddle
positions were starting to look shaky. The call options Leeson had
sold were beginning to look worthless but the put options would
become very valuable to their buyers if the Nikkei continued to
decline. Leesons losses on these puts were unlimited and totally
dependent on the level of the Nikkei at expiry, while the profits
on the calls were limited to the premium earned.
This point is key to understanding Leesons actions because prior
to the Kobe earthquake, his unauthorized book, i.e. account
88888& showed a flat position in Nikkei 225 futures. Yet on
Friday 20 January, three days after the earthquake, Leeson bought
10,814 March 1995 contracts. No one is sure whether he bought
these contracts because he thought the market had over-reacted to
the Kobe shock or because he wanted to shore up the Nikkei to
protect the long position which arose from the option straddles.
(Leeson did not hedge his option positions prior to the earthquake
and his Nikkei 225 futures purchases after the quake cannot be
construed as part of a belated hedging programme since he should
have been selling rather than buying.)
159
Table
10.1
of the Collapse of Barings, Ordered by the House of

Commons, Her Majestys Stationery Office, 1995
After executing these cross-trades, Leeson would instruct the

settlements staff to break down the total number of contracts
into several different trades, and to change the trade prices thereon
to cause profits to be credited to switching accounts referred to
above and losses to be charged to account 88888. Thus while the
cross trades on the Exchange appeared on the face of it to be
genuine and within the rules of the Exchange, the books and
records of BFS, maintained in the Contac system, a settlement
system used extensively by SIMEX members, reflected pairs of
transactions adding up to the same number of lots at prices bearing
no relation to those executed on the floor. Alternatively, Leeson
would enter into cross trades of smaller size than the above but
when these were entered into the Contac system he would arrange
for the price to be amended, again enabling profit to be credited to
the switching account and losses to be charged to account 88888.
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The large falls in Japanese equities, post-earthquake, also made

the market more volatile. This did not help Leesons short option
position either - a seller of options wants volatility to decline so
that the value of the options decrease. With volatility on the rise,
Leesons short options would have shown losses even if the
Tokyo stock market had not plunged.
both his client accounts. However he can only do this after he

has declared the bid and offer price in the pit and no other
member has taken it up. Under SIMEX rules, the Member
must declare the prices three times. A cross-trade must be
executed at market-price. Leeson entered into a significant
volume of cross transactions between account 88888 and
account 92000 (Barings Securities Japan - Nikkei and JGB
Arbitrage), account 98007 (Barings London - JGB Arbitrage)
and account 98008 (Barings London - Euroyen Arbitrage).
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When the Nikkei dropped 1000 points to 17,950 on Monday

January 23, 1995, Leeson found himself showing losses on his
two-day old long futures position and facing unlimited damage
from selling put options. There was no turning back. Leeson,
tried single-handedly to reverse the negative post-Kobe sentiment
that swamped the Japanese stock market. On 27 January, account
88888 showed a long position of 27,158 March 1995 contracts.
Over the next three weeks, Leeson doubled this long position to
reach a high on 22nd February of 55,206 March 1995 contracts and
5640 June 1995 contracts.
Leeson engaged in unauthorized activities almost as soon as he

started trading in Singapore in 1992. He took proprietary positions
on SIMEX on both futures and options contracts. (His mandate
from London allowed him to take positions only if they were
part of switching and to execute client orders. He was never
allowed to sell options.) Leeson lost money from his unauthorized
trades almost from day one. Yet he was perceived in London as
the wonder boy and turbo-arbitrageur who single-handedly
contributed to half of Barings Singapores 1993 profits and half
of the entire firms 1994 profits. The wide gap between fact and
fantasy is illustrated in table 10.2 which not only shows the
magnitude of Leesons recent losses but the fact that he always
lost money. In 1994 alone, Leeson lost Barings US$296 million;
his bosses thought he made them US$46 million, so they
proposed paying him a bonus of US$720,000.
Price per
SIMEX
Average
Value per
Price per
SIMEX
CONTACT JPY
millions
Value per
Profit/(Loss)
CONTACT to '92000'
JPY millions JPY millions
20
6984
January
18950
19019
66173
66413
240
23
3000
January
17810
18815
26715
28223
1508
Table
10.3
No. of
contracts in
account
'88888' 2
Buy
23
January
FactsversusFantasy:Profitability of Leeson's Trading Activities.
Period
Reported (milion)
Actual (milion)
Cumulativeactual1 (milion)
1Jan1993to31Dec1993
+GBP8.83
-GBP21
-GBP23
1Jan1994to31Dec1994
+GBP28.529
-GBP185
-GBP208
1Jan1995to31Dec1995
+GBP18.567
-GBP619
-GBP827
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Table10.2
1.The cumulative actual represents Leeson's cumulative losses carried forward.

Source: Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings,
Ordered by the House of Commons, Her Majesty'sStationeryOffice,1995.
The cross-trade
How was Leeson able to deceive everyone around him? How
was he able to post profits on his switching activity when he
was actually losing? How was he able to show a flat book when
he was taking huge long positions on the Nikkei and short
positions on Japanese interest rates? The Board of Banking
Supervision (BoBS) of the Bank of England which conducted
an investigation into the collapse of Barings believes that the
vehicle used to effect this deception was the cross trade.1 A
cross trade is a transaction executed on the floor of an Exchange
by just one Member who is both buyer and seller. If a Member
has matching buy and sell orders from two different customer
accounts for the same contract and at the same price, he is
allowed to cross the transaction (execute the deal) by matching
160
Sell
8082 17810
18147
(71970)
(73332)
(1362)
25
10047
January
18220
18318
91528
92020
492
26
16276
January
18210
18378
148193
149560
1367
2245
Table 10.3 below is an example of how Leeson manipulated his

books to show a profit on Barings switching activity.
1. This table is Figure 5.2 of Report of the Board of Banking
Supervision Inquiry into the Circumstances of the Collapse of
Barings, Ordered by the House of Common, Her Majestys
Stationery Office, 1995.2. This column represents the size of
Nikkei 225 cross-trades traded on the floor of SIMEX for the
dates shown, with the other side being in account 92000.
The BoBS report notes In each instance, the entries in the Contac
system reflected a number of spurious contract amounts at prices
different to those transacted on the floor, reconciling to the total
lot size originally traded. This had the effect of giving the
impression from a review of the reported trades in account 92000&
that these had taken place at different times during the day. This
was necessary to deceive Barings Securities Japan into believing the
reported profitability in account 92000 was a result of authorised
arbitrage activity. The effect of this manipulation was to inflate
reported profits in account 92000& at the expense of account
88888, which was also incurring substantial losses from the
unauthorised trading positions taken by Leeson. In addition to
11D.571.3
Figure 10.3 , below, shows the number of cross-trades executed

by Leeson. It is the difference between the solid line which
represents all the Nikkei trades of account 92000 not crossed
into account 88888 and the broken line which reflects the position
Leeson reported to Barings management. The figure graphically
illustrates the chasm between reported and actual positions. For
example, Barings management thought the firm had a short
position of 30,112 contracts on SIMEX on 24 February; in fact it
was long 21,928 contracts after ignoring the trades crossed with
account 88888.
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Figure 10.3
Graph to show the Nikkei Position of Account 92000.
Reproduced by permission from the Report of the Board of
Banking Supervision Inquiry into the Circumstances of the
Collapse of Barings.
II. Lessons from Leeson

Numerous reports have come out over the last three years with
recommendations on best practices in risk management. (see key
risk concepts - risk control.) Barings violated almost every
recommendation. Because its management singularly failed to
institute a proper managerial, financial and operational control
system, the firm did not catch on, in time, to what Leeson was
up to. Since the foundations for effective controls were weak, it
is not surprising that the firms flimsy system of checks and
balances failed at a number of operational and management
levels and in more than one location. The lessons from the
Barings collapse can be divided into five main headings:
11D.571.3
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a. Segregation of front and back-office

b. Senior management involvement
c. Adequate capital
d. Poor control procedures
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The bottom line of all these cross-trades was that Barings was
counterparty to many of its own trades. Leeson bought from one
hand and sold to the other, and in so doing did not lay off any of
the firms market risk. Barings was thus not arbitraging between
SIMEX and the Japanese exchanges but taking open (and very
substantial) positions, which were buried in account 88888. It
was the profit and loss statement of this account which correctly
represented the revenue earned (or not earned) by Leeson. Details
of this account were never transmitted to the treasury or risk
control offices in London, an omission which ultimately had
catastrophic consequences for Barings shareholders and
bondholders.
II. Lessons from Leeson

Numerous reports have come out over the last three years with
recommendations on best practices in risk management. (see key
risk concepts - risk control.) Barings violated almost every
recommendation. Because its management singularly failed to
institute a proper managerial, financial and operational control
system, the firm did not catch on, in time, to what Leeson was
up to. Since the foundations for effective controls were weak, it
is not surprising that the firms flimsy system of checks and
balances failed at a number of operational and management
levels and in more than one location. The lessons from the
Barings collapse can be divided into five main headings:
e. Lack of supervision
a. Segregation of front and back-office

The management of Barings broke a cardinal rule of any
trading operation - they effectively let Leeson settle his own
trades by putting him in charge of both the dealing desk and
the back office. This is tantamount to allowing the person who
works a cash-till to bank in the days takings without an
independent third party checking whether the amount banked it
at the end of the day reconciles with the till receipts. The backoffice records, confirms and settles trades transacted by the front
office, reconciles them with details sent by the banks
counterparties and assesses the accuracy of prices used for its
internal valuations. It also accepts/releases securities and
payments for trades. Some back offices also provide the
regulatory reports and management accounting. In a nutshell,
the back office provides the necessary checks to prevent
unauthorised trading and minimise the potential for fraud and
embezzlement. Since Leeson was in charge of the back office, he
had the final say on payments, ingoing and outgoing
confirmations and contracts, reconciliation statements,
accounting entries and position reports. He was perfectly placed
to relay false information back to London. Abusing his
position as head of the back-office, Leeson suppressed
information on account 88888. This account was set up in July
1992 - it was designated an error account in Barings Futures
Singapore system but as a Barings London client account in
Simexs system. But Barings London did not know of its
existence since Leeson had asked a systems consultant, Dr
Edmund Wong, to remove error account 88888 from the daily
reports which BFS sent electronically to London. This state of
affairs existed from on or around 8 July 1992 to the collapse of
Barings on 26 February 1995. (Information on account 88888
was however still contained in the margin file sent to London.)
Error accounts are set up to accommodate trades that cannot be
reconciled immediately. A compliance officer investigates the
trade, records them on the firms books and analyses how it
affects the firms market risk and profit and loss. Reports of
error accounts are normally sent to senior officers of the firm.
Barings management compounded their initial mistake of not
segregating Leesons duties by ignoring warnings that
prolonging the status quo would be dangerous. An internal
161
crossing trades on SIMEX between account 88888& and the

switching accounts, Leeson also entered fictitious trades between
these accounts which were never crossed on the floor of the
Exchange. The effect of these [off-market trades, which were not
permitted by SIMEX], was again to credit the switching accounts
with profits whilst charging account 88888 with losses.
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position?.... Senior management naively accepted that this

business was a goldmine with little risk. Of Ron Baker (head of
the Financial Products Group) and Mary Walz (Global head of
Equity Financial Products), two of Barings most senior
derivatives staff and Leesons bosses, the BoBS report
concluded, Neither were familiar with the operations of the
SIMEX floor. Both claim that they thought that the significant
and large profits were possible from a competitive advantage
that BFS had arising out of its good inter-office
communications and its large client order flow. As the
exchanges were open and competitive markets, this suggests a
lack of understanding of the nature of the business and the
risks (including compliance risks) inherent in combining agency
and proprietary trading. Given the huge amounts of cash that
Barings had to borrow to meet the margin demands of
SIMEX, senior managers were almost negligent in their duties
when they did not press Leeson for more details of his
positions or/and the Credit department for client details.
Members of the Asset and Liability Committee (ALCO), which
monitored the banks market risk, expressed concern at the size
of the position, but took comfort in the thought that the
firms exposure to directional moves in the Nikkei was
negligible since they were arbitrage (and hedged) positions. This
same misplaced belief led management to ignore market
concerns about Barings large positions, even when queries came
from high level and reputable sources including a query on
January 27 1995 from the Bank for International Settlements in
Basle. The bank was haemorrhaging cash and still London took
no steps to investigate Singapores requests for funds - partly
because senior management assumed that a proportion of
these funds represented advances to clients. Even then the
complacency is still baffling. BFS had only one third-party client
of its own - Banque Nationale de Paris in Tokyo. The rest were
clients of the London and Tokyo offices. Either London or
Tokyos existing customers had suddenly become very active or
Leeson had recently gone out and won some very lucrative
accounts or Tokyo or London had a new supersalesman who
had brought new business with him. Yet no enquiries were
made on this front, which displays a blas attitude about a
potentially important source of revenue.
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b. Senior management involvement

The crux of the Barings collapse lay in senior managements
lackadaisical attitude to its derivative operations in Singapore.
Every major report on managing derivative risks has stressed
the need for senior management to understand the risks of the
business; to help articulate the firms risk appetite and draft
strategies and control procedures needed to achieve these
objectives. Senior managers at Barings can be found wanting in
all these areas. For example, while they were happy to enjoy the
fruits of the success of the Singapore branch, they were not so
keen on providing adequate resources to ensure a sound risk
management system for a unit that alone ostensibly accounted
for one-fifth of its 1993 profits and almost half of its 1994profits. The senior managements response to the internal
auditors report for a suitably experienced person to run
Singapores back office was that there was not enough work for
a full-time treasury and risk manager even if the role
incorporated some compliance duties. No senior managers in
London checked on whether key internal audit
recommendations on the Singapore backoffice had been
followed up. Barings senior management had a very superficial
knowledge of derivatives and did not want to probe too deeply
into an area that was bringing in the profits. Arbitraging the
price differences between two futures contracts is a low-risk
strategy. How could it then generate such high profits if the
central axiom of modern finance theory is low risk-low return,
high risk-high return? And if such a low-risk and relatively
simple arbitrage could yield so much profits, why were Barings
better-capitalised rivals (all with much larger proprietary trading
teams) not pursuing the same strategy? The profitability of the
business was marvelled at by all senior managers, but never
analysed or properly assessed at Management Committee
meetings. Senior managers did not even know the breakdown
of Leesons reported profits. They erroneously assumed that
most of the switching profit came from Nikkei 225 arbitrage,
which actually only generated profits of US$7.36 million for
1994, compared with US$37.5 million for JGB arbitrage. No
wonder Peter Baring, ex-chairman of Barings, told the bobs
that he found the earnings pleasantly surprising since he did
not even know the breakdown. Andrew Tuckey, ex-deputy
chairman, when asked whether there had ever been any
discussion about the long term sustainability of the business,
told the same investigation, Yes...in very general terms. We
seemed to be making money out of this business and if we can
do it, cant somebody else do it? How can we protect our
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auditors report in August 1994 concluded that his dual

responsibility for both the front and back offices was an
excessive concentration of powers. The report warned that
there was a significant general risk that the general manager (Mr
Nick Leeson) could override the controls. The audit team
recommended that Leeson be relieved of four duties:
supervision of the back-office team, cheque-signing, signingoff SIMEX reconciliations and bank reconciliations. Leeson
never gave up any of these duties even though Simon Jones,
regional operations manager South Asia and chief operating
officer of Barings Securities Singapore, had told the internal
audit team that Leeson will with immediate effect cease to
perform the[se] functions.
162
c. Adequate capital
There are two aspects to this issue - an institution must have
sufficient capital to withstand the impact of adverse market
moves on its outstanding positions as well as enough money
to keep these positions going. Barings management thought
that Leesons positions were market neutral and were thus quite
happy to fund margin requirements till the contracts expired. In
the end, these collateral calls from SIMEX and OSE proved too
much to bear (as was pointed out earlier, they were larger than
Barings capital base) and the 200-year old institution was forced
to call in the receivers. It was funding risk that seriously
wounded Barings but the terminal shot came from the
discovery that the enormous positions were unhedged.
Funding risk also nearly sank Metallgesellschaft, a German
industrial company, in 1993. In that year alone,
Metallgesellschafts US subsidiary paid out $900 million in
margins for its crude oil hedges on NYMEX. When the
American subsidiary asked for a cash infusion to meet further
11D.571.3
ii. Credit risk

iii. Market risk
iv. No limits
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i. Funding
Barings control procedures were sloppy. No where is this point
better illustrated than in the way it funded BFS (or more
accurately Leesons unauthorised positions). Barings did not
require Leeson, to distinguish between variation margin needed
to cover proprietary and customer trades; neither did it have a
system to reconcile the funds Leeson requested to his reported
positions and/or that of its client positions. (The London
office for example could have used the Standard Portfolio
Analysis of Risk (SPAN) margining programme to calculate
margins and would then have realised that the amount of
money Leeson was requesting was significantly more than that
called for under Simexs margining rules.) London simply,
automatically, remitted to Leeson the sum of money he asked
for, despite misgivings felt by many senior operational staff
about the accuracy of his data. The fact that no one even asked
Leeson to justify his requests is all the more astounding given
the size of his demands. At the end of Dec 1994, the
cumulative funding of BFS by Barings London and Tokyo
stood at US$354 million. In the first two months of 1995, this
figure increased by US$835 million to US$1.2 billion. The BoBS
11D.571.3
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d. Poor control procedures

In many trading houses, not only is there a separation of
operational duties between the front and back-office (absent in
Barings), but there is also a unit independent of both to
provide an additional layer of checks and balances.
i. Funding
inquiry team notes, We described...how [Tony] Railton

[Futures and option settlements senior clerk] discovered in
February 1995 that the breakdown of the total US Dollar
request was meaningless, and that the BFS clerk knew the total
funding requirement for that day and made up the individual
figures in the breakdown to add up to the required total. From
November 1994, BFS usually requested a round sum number
split equally between US dollars for client accounts and
proprietary positions. The BoBS team notes, Tony Hawes
[group treasurer] confirmed that he identified this feature of the
requests: That was one of the main reasons why during
February 1995 I paid two visits to Singapore. If the US Dollar
requests had been in relation to genuine positions taken by
clients and house [Barings itself], on any one day we consider it
unlikely for the margin requests for these two sets of positions
to be identical; as for having the requests split 50:50 most days,
this is in our view is beyond all possibility. Tony Hawes appears
to agree with this view. He told us that: It was just one of the
factors that made me distrust this information... It was quite
too much of a coincidence. ...Throughout I put it down to
poor book-keeping and sloppy treasury management in Barings
Futures [BFS]. David Hughes [Treasury Department manager]
also told us that the 50:50 split: was a cause for concern...we
said, this cannot be right. He explained that: I do not think we
could have house positions and client positions running totally
in tandem. [Brenda] Granger [manager, futures and options
settlements] confirmed that she would have spoken to Hughes
about the split. She added: We would joke about Singapore, Why dont we send somebodys mother [anyone] out there to
run the department since Nick is so busy now?. Staff in
London could not reconcile funds remitted to Singapore to
both proprietary in-house and individual client positions. But
no remedial action was taken. Their cavalier attitude to
reconciliation is illustrated by Figure 10.43 which shows total
funds remitted to Singapore ostensibly to pay customer
margins. place fig 10.4 here The solid line in Figure 10.4 shows
the total funds sent to BFS by Barings Securities London (BSL)
- the entity to which all customer trades of London were
booked; the broken line the amount of money funded by
Barings Securities Group Treasury in London, this funding was
known in the firm as the top-up balance. The Group Treasury
advanced this money, on behalf of clients, because it was not
always possible for clients to transfer money to Barings in time
to meet SIMEX intra-day margin calls. (The bank was expected
to recover from clients these advances as quickly as possible.)
Figure 10.4 shows that BSGT had to consistently advance a
substantial portion of the funds earmarked for margins for
client positions. The graph shows that from 1 January to 24
February 1995, the proportion of genuine client moneys which
were transferred to BFS fell as a proportion of the total funding
Indeed on 21 February 1995, BSGT had to advance all the client
margins of some US$440 million. On 24 February, only US$50
million of the US$540 million sent to Singapore to cover client
positions had been recovered from individual clients (i.e. the
difference between the solid and broken lines). Barings control
did not reconcile the top-up payments to individual client
balances - if it did it would have discovered that it was sending
163
margin obligations, the parent refused and closed out the

NYMEX contracts at a loss. The latter only survived because a
consortium of German banks quickly put together a rescue
package of $2 billion. Both the Barings and Metallgesellschaft
stories highlight the need for institutions to pay more attention
to the interim funding needs of hedged and semi-hedged
positions. But the parallel ends here. Barings senior managers
continued to fund Leesons activities because they thought they
were paying margins on hedged positions (as well as those of
their clients) whereas they were actually losing money on
outright bets on the Tokyo stock market. Metallgesellschaft, on
the other hand, refused to grant any more interim finance
because they thought they were losing money on contracts
which were infact bona fide hedges for the companys long-term
obligations. Both incidents illustrate the need for senior
managers to be more knowledgeable about hedged positions
because the issues facing them are complex in many cases. As it
turned out Barings had significant market risk from its naked
positions so even if it had managed to borrow enough money
to cover its margin costs till the contracts expired, it would have
been unable to withstand the substantial losses it would suffer
on expiry. Agents appointed by Barings administrators closed
out the contracts at losses totalling US$1.4 billion, so Barings
inability to meet its margin obligations at the end of February
just hastened its demise. Its fate had been sealed at the end of
January when Leeson had an unauthorised Nikkei exposure of
about 30,000 contracts.
different markets have different settlement systems, creating

liquidity and funding risk.
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e. Lack of supervision
Theoretically Leeson had lots of supervisors; in reality none
exercised any real control over him. Barings operated a matrix
management system, where managers who are based overseas
report to local administrators and to a product head (usually
based at head office or the regional headquarters).Leesons
Singapore supervisors were James Bax, regional manager South
Asia and a director of BFS, and Simon Jones, regional
operations manager South Asia, also a director of BFS and
chief operating officer of Barings Securities Singapore. Jones
and the heads of the support functions in Singapore also had
reporting lines to the Group-wide support functions in
London. Yet both Bax and Jones told the BoBS inquiry that
they did not feel operationally responsible for Leeson. Bax felt
Leeson reported directly to Baker or Walz on trading matters
and to Settlements/Treasury in London for backoffice matters.
Jones felt his role in BFS was limited only to administrative
matters and concentrated on the securities side of Barings
activities in South Asia. Leesons reporting lines for product
profitability are not clear cut since his supervisors have disputed
who was directly responsible for him from January 1, 1994. His
ultimate boss was Ron Baker, head of the financial products
group. But who had day-to-day control over him? Mary Walz,
global head of equity financial products, insists that she
thought Fernando Gueler, head of equity derivatives proprietary
trading in Tokyo was in charge of Leesons intra-day activities
since the latters switching activities were booked in Tokyo.
However, Gueler insists that in October 1994, Baker told him
that Leeson would report to London and not Tokyo. He thus
assumed that Walz would be in charge of Leeson. Walz herself
still disputes this claim. Tapes of telephone conversations show
that Leeson spoke frequently to both Gueler and Walz. (The
bottom line however is that Gueler reported to Walz.) Two
important incidents vividly illustrate the cavalier attitude Barings
had towards supervising Leeson. The first involves two letters
to BFS from SIMEX. In a letter dated 11 January, 1995; SIMEX
senior vice-president for audit and compliance Yu Chuan Soo,
complained about a margin shortfall of about US$116 million
in account 88888 and that Barings had appeared to break
SIMEX rule 822 by previously financing the margin
requirements of this account, (which appeared in SIMEXs
system as a customer account.) SIMEX also noted that the
initial margin requirement of this account was in excess of
US$342 million. BFS was asked to provide a written
explanation of the margin difference on account 88888 and of
its inability to account for the problem in the absence of
Leeson. No warning lights went off in Singapore. No one
investigated who this customer really was and why he was
having difficulties in meeting margin payments or why he had
such a huge position; or the credit risk Barings faced if this
customer defaulted on the margins that Barings had paid on
its behalf. A copy of the letter was not sent to operational heads
in London. Simon Jones did not press Leeson for an
explanation; indeed he dealt with the matter by allowing Leeson
to draft Barings response to SIMEX. The second incident did
come to the attention of London but again was dealt with
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Figure 10.4
Top-up Funding from BSGT to BSL and Margin Balances from
BFS from 1 January 1995. Reproduced be permission from the
Report of the Board of Banking Supervision Inquiry into the
Circumstances of the Collapse of Barings
ii. Credit risk

The credit risk implication of the client advances represented by
the top-up balances was significant if the total funds remitted
to Singapore was to meet genuine client margin calls. Yet the
Credit risk department did not question why Barings was
lending over US$500 million to its clients to trade on SIMEX,
and collecting only 10% in return. It did not seem to have an
idea of who these clients were, yet Barings financial losses would
have been significant if some of these clients defaulted. The
Credit Committee under George Maclean insists that it was
Barings policy to finance client margins until they could be
collected. But no limit per client or on the total top-up funds
was set. Indeed clients who were advanced money this way
appear not to have undergone any credit approval process. The
Credit Committee never formally considered the credit aspects of
the top-up balance although they could see the growth of these
advances as recorded on the balance sheets. Plainly put, the credit
risk controls of Barings Securities were shambolic.
iii. Market risk
Because Leeson controlled the back office and because Barings
had no independent unit checking the accuracy of his reports, the
market risk reports generated by Barings risk management unit
and passed on to ALCO were inaccurate. Leesons futures
positions showed no market risk because trades were supposedly
offset by opposite transactions on another exchange. Peter
Baring and Baring shareholders have learnt too painfully the
meaning of garbage-in, garbage-out because a system is only as
good as the data it receives
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out far too much money just to cover the margin calls of clients.
iv. No limits
Barings did not impose any gross position limits on Leesons
proprietary trading activities because it felt that there was little
market risk attached to arbitrage trades since at the close of
business, the position must be flat. But the Barings collapse has
shown that placing gross position limits on each side of an
arbitrage book is perhaps not such a bad idea after all. While it is
true that an arbitrage book has little price (directional ) risk, it has
basis and settlement risk. The former arises because prices in two
markets do not always move in tandem and the latter because
164
11D.571.3
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unsatisfactorily, perhaps because Barings personnel themselves

are unsure about what really happened. At the beginning of
February 1995, Coopers & Lybrand brought to the attention of
London and Simon Jones the fact that US$83 million
apparently due from Spear, Leeds & Kellogg, a US investment
group, had not been received. No one is sure how this multimillion dollar receivable came about. One version of events is
that BFS, through Leeson, had traded or broked an over-thecounter deal between Spear, Leeds & Kellogg, and BNP, Tokyo.
The transaction involved 200 50,000 call options, resulting in a
premium of 7.778 billion (US$83 million). The second version
was that an operational error had occurred; i.e. a payment had
been made to a wrong third-party in December 1994. Both
versions had very serious control implications for Barings. If
Leeson had sold or broked an OTC option, then he had
engaged in an unauthorised activity. Yet he was not
admonished for doing so; nor is there any record of Barings
management taking any steps to ensure that it did not happen
again. If the SLK receivable was an operational error, Barings
had to tighten up its back-office procedures.
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Conclusion
The Nikkei 225 and JGB futures contracts traded by Leeson
were the simplest of derivative instruments. They were also the
most transparent - since they were listed contracts, Leeson was
required to pay (or receive) daily margins and so needed funds
from London. In January and February 1995 alone, he asked for
US$835 million. His could not hide his build-up of positions
on the OSE because the exchange publishes weekly numbers.
All his rivals could see his enormous positions, and many
assumed that the positions were hedged because such naked
positions were out of all proportion to the firms capital base or
even those of other players. His senior managers also assumed
Leesons were hedged. But unlike outsiders who had to assume
that these positions were hedged, Barings management did
not. They could have done something about it - they could
have probed Leeson, they could have tried to obtain more
information from their internal information systems, and most
of all they could have heeded the warning signals available in
late 1994 and throughout January and February of 1995. But
although Barings fate was only sealed in the final weeks of
February, the seeds of its destruction were sown when senior
management entered new businesses without ensuring
adequate support and control systems. The collapse of Britains
oldest merchant bank was an extreme example of operations
risk, i.e. the risk that deficiencies in information systems or
internal controls result in unexpected loss. Will it happen again?
Certainly, if senior managers of firms continue to disregard
rules and recommendations which have been drawn up to
ensure prudent risk-taking.
Notes:
11D.571.3
165

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UNIT I

Discuss different meanings of the term risk.

Uncertainty (vaiability around the expected loss)

Describe major types of business risk and personal risk.

One situation is riskier than other if it has greater

Explain and compare pure risk to other types of risk.

Discuss organization of the risk management function within

Different Meanings Of Risk

We will develop the ideas of expected value and risk as reflecting

In summary, (see Figure 1.1) risk is sometimes used in a specific

Uncertainty (variability around the

Lets assume that everyone agrees that the probability of one

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RISK MANAGEMENTFOR GLOBAL FINANCIAL SERVICES

Output Price Risk

Input Price Risk

Exchange Rate Risk

For businesses, indirect losses are extremely important. Indeed,

reductions in cash inflows or increases in cash outflows can

Interest Rate Risk

RISK MANAGEMENTFOR GLOBAL FINANCIAL SERVICES

you must consider indirect losses that arise in addition to direct

Moreover, if sales or production are reduced in response to direct

Other forms of indirect losses include the possibility that the

Higher cost of funds and

Types of Risks Facing Businesses & Individuals

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2. The risk of legal liability for damages for harm to customers,

3. Businesses commonly reduce uncertainty and finance losses

3. The risk associated with paying benefits to injured workers

1. The risk of reduction in value of business assets due to physical

ity of losses through actions that alter the underlying causes

Comparison of Pure Risk and Its Management with

1. Losses nom destruction of property, legal liability, and

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RISK MANAGEMENTFOR GLOBAL FINANCIAL SERVICES

Increases in business risk of all types and dramatic growth in the

The Risk Management Process

2. Evaluate the potential frequency and severity of losses.

5. Monitor the performance and suitability of the risk

Internal Risk reduction

Actions that reduce the expected cost of losses by reducing the

RISK MANAGEMENTFOR GLOBAL FINANCIAL SERVICES

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1. Explain how the two major approaches to loss control (reducing

Methods used to obtain funds to pay for or offset losses that

(4) other contractual risk transfers. These approaches are not

With retention, a business or individual retains the obligation to

The second major approach to loss control is to increase the

The second major method of financing losses is the purchase of

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RISK MANAGEMENTFOR GLOBAL FINANCIAL SERVICES

claims by cutting back on the number of shipments that it hauls.

A possible limitation of a centralized risk management function

The second major method of reducing risk internally is to invest

RISK MANAGEMENTFOR GLOBAL FINANCIAL SERVICES

risk through portfo-lio diversification is an important factor

In most firms, the risk management function is subordinate to

The term risk broadly refers to situations where outcomes are

uncertain. Risk often refers specifi-cally to variability in outcomes

theft or expropriation of business as-sets, (2) legal liability for

Risk management involves (1) identification of potential direct

and indirect losses, (2) evaluation of their potential frequency