FIN 562

Brobst Winter 2017

Week 2 Slides

Class Overview

5:45 6:15

Market Risk

Review of Portfolio Volatility (Session 1)

6:15 7:00Value at Risk

7:00 7:15Other Market Risk Management Chapter 13

7:15 7:30

7:30 8:15Interest Rate Risk & Liquidity Risk

8:15

[Break]

Homework assignment #1 discussion

VaR

Worst loss that may be expected from holding a position

E.g., I am 99% confident my bond portfolio losses will not

exceed $1 million in a single day.

Does not state the loss amount (skew = tail risk, black swan)

Key Steps

Derive distributions of expected return

Select a confidence level (e.g., 95%)

Resulting value could be indicator of economic capital (i.e.,

reserve to cover position)

VaR Risk Factors

Selection based on portfolio

E.g., fixed income portfolio sensitive to overall interest rates and

credit spreads.

How to model:

Analytic variance-covariance approach

Log-normal returns to derive portfolio mean/variance

Historical simulation

Requires sufficient data history

Regulatory reporting requirement can differ from internal reporting

Monte Carlo
Simulation

of market prices/rates that affect portfolio

4

VaR Pros / Cons by Style

Variance - Covariance
Pros

Efficient

No pricing model/additional software

Easily handles incremental VaR

Cons

Normal distribution assumption

Trouble with fat tails

Need to estimate risk factors, correlations, variances

Trouble with derivative positions

5

VaR Pros / Cons by Style

Variance - Covariance

See Session 2 spreadsheet of V@R examples

A little matrix math

Covariance matrix

Calculate portfolio

variance

VaR Pros / Cons by Style

Variance Covariance
Portfolio variance

Makes no allowance for non-linear (conditional)

positions such as options
7

VaR Pros / Cons by Style (cont.)

Historical Simulation
Pros

No distribution assumptions

No need to estimate risk factors, correlations, variances

Can handle fat tails

Aggregation more straight forward

Can calculate confidence intervals

Cons

Past = future?

Difficult to handle changing market structures

Short data sets may be biased

Not always efficient

8

VaR Pros / Cons by Style

Monte Carlo
Pros

Can accommodate any distribution of risk factors (e.g., binary, normal)

Handles complexity

Can calculate confidence intervals

Allows for sensitivity analyses/stress testing

Cons

Computationally intensive

Garbage in/garbage out?

9

V@R Monte Carlo Example

MC Simulation
Generate random paths

Initial Asset Price

Drift

Normsinv()
Inverse of the standard normal cumulative
distribution

100
2.00%

Implied Volatility

12.00%

Year-end simulated value

Days

Random NormsInv
0

Mean = 0, Std Dev = 1

105.2341

Ending Value
100

See V@R-Session 2 spreadsheet for basic example of Monte Carlo

simulation1 0.322203 -1.81577 0.986446 98.64461
2 0.341339 -0.01191 0.999989 98.64356
3 0.913658 0.680769 1.005239 99.16037

10

VaR Example

Portfolio Size: $100 million

Expected 1-Day Return: 0.1%

Historical Daily Standard Deviation: $0.5 million (0.5%)

97.5% Confidence Interval, what is the 1-Day VaR of this

portfolio?

11

VaR Example - Solution

Portfolio Size: $100 million

Expected 1-Day Return: 0.1%

Historical Daily Standard Deviation: $0.5 million

97.5% Confidence Interval, what is the 1-Day VaR of this

portfolio?

Expected return = $100,000, Less $980,000 million (1.96

SDs), = $880,000.
I am 97.5% confident my portfolio will not lose more than
$880,000 in a single day.
12

VaR Example 2

Portfolio Size: $100 million

Expected 1-Day Return: 0.2%

Historical Daily Standard Deviation: $1.0 million (1%)

99% Confidence Interval, what is the 1-Day VaR of this

portfolio?

13

VaR Example 2 - Solution

Portfolio Size: $100 million

Expected 1-Day Return: 0.2%

Historical Daily Standard Deviation: $1 million

99% Confidence Interval, what is the 1-Day VaR of this

portfolio?

Expected return = $200,000, Less $2.33 million (2.33 SDs),

= -$2,130,000.

I am 99% confident my portfolio will not lose more than

$2,130,000 in a single day.
14

Converting from Daily VaR / Volatility to

10 Day

VaR
10 Day (i.e., loss level certainty over a 10 day trading period)
= VaR 1 Day *

Same principal holds for volatility (standard deviation)

E.g., VaR 1 Day = $1 million, VaR 10 Day = $3.16 million

E.g., Volatility (1 Day) = 1%, Volatility (10 Day) = 3.16%

Explanation

Variance of Brownian motion is proportional to time, T, as follows

Volatility is a standard deviation (which is the square root of variance), so

when we take the standard deviation of Brownian motion defined by , we
get

==

15

Types of Market Risk

Basis
Risk
16

Market Risk Management Policies

Define

Roles and Responsibilities

Delegation
Risk

of Authority

Measuring and Reporting

Valuation
Hedging

and Back Testing

Policy

Liquidity

Policy (Funding)

Exception

Management

17

Stress Testing
Extreme
Key

market events w/o probabilities assigned

Steps

Stress
Which

market variables to test the impact on exposures

variables?

Assumptions
Interest

rates

Assume

parallel shift?

Assume

different changes per bucket?

Exchange
All

rates

currencies against USD?

Percent

Price

Impact

change in value?

correlations

of the stress test

Develop

potential strategies

Cost/benefit

analysis

18

Scenario Testing
Extreme
Like

market events w/o probabilities assigned

stress test, but formulated differently

What

scenarios?

Mexican

Peso Crisis 94

Asian

contagion 97

LTCM

collapse / Russian default 98

9/11/2001
Financial

crisis 2008
19

Bond Basics
Debt

obligation

Zero-coupon
Coupon

bonds

bonds

Payment

frequency: semi-annual, quarterly, etc.

Rates
Coupon

rate

Yield
Annual,

Bond Equivalent, Continuously compounded

Yield-to-maturity
20

Yield Curve 12-31-06

21

Yield Curve Risks

Twists

or shifts in the yield curve

Problems
E.g.,

of mismatched assets and liabilities

Bank

22

Eurodollar Futures
Futures

contract that allows for hedging of interest

rate movements in LIBOR
Long

position in a Eurodollar contract is short

interest rates (i.e., decreasing interest rates results
in a profit).

Short

position in a Eurodollar contract is long

interest rates (i.e., increasing interest rates results
in a profit).

Contract

multiplier = $25 per basis point (0.01%).

23

Eurodollar Futures Continued

Traded
Cash

on CME
settled

Settlement

dates up to 10 years out

Settlement

based on the current 3 month LIBOR for the

NEXT three months (i.e., not historical)
Prices

quoted relative to a price of 100, where a 0% LIBOR

rate = a price of 100

Example:
3-month
Rates

$1

Dec 2016 contract price of 99.165

LIBOR as of Dec: (100-99.165)/100 = 0.835%

derived from prices are annual rates

million notional value

24

Eurodollars Futures Example 1

Long Position in 10 June15 Eurodollars at 99.
Notional
What
For

amount = $10,000,000 (10* $1 million)

is the implied 3 month LIBOR rate?

which time period?

25

Eurodollars Futures Example 1

Long Position in 10 June15 Eurodollars at 99.
Notional
What
1%

amount = $10,000,000 (10* $1 million)

is the implied 3 month LIBOR rate?

annual

(100-99)/100

For
3

= 1%

which time period?

month forward LIBOR at June 2015 (June Sept).

26

Eurodollars Futures Example 1

Long Position in 10 June 15 Eurodollars at 99.
Notional
If

amount = $10,000,000 (10* $1 million)

3 month LIBOR in June is 1.08%, what is the P/L?

27

Eurodollars Futures Example 1

Long Position in 10 June15 Eurodollars at 99.
Notional
If

amount = $10,000,000 (10* $1 million)

3 month LIBOR in June is 1.08%, what is the P/L?

Price = 100 1.08%*100 or 98.92.

Forward Price long at 99.

98.92
$25

99 = -.08

* -8 basis points * 10 contracts = -$2,000

28

Duration

Measurement of the sensitivity of the bond price (i.e., value

of the bond) to interest rates.

Change in the value of the bond for a change in the yield by one
basis point

A.K.A. PV weighted average maturity of cash flows of a bond

Typically expressed in terms of % impact on bond price:

Macaulay Duration and Modified Duration

29

Impact on Duration
Bond Attribute

Relationship to
Duration

Coupon Rate

Negative

Maturity

Positive

Yield to Maturity

Negative

Frequency of Coupon
Payments

Negative

30

Issues with Duration

Duration is not constant

Changes as interest rates change

E.g., the change in price (or % change in price) is not the same as yield
goes from say 5.01% to 5.00% as 4.01% to 4.00%.

Not accurate for large changes in interest rates.

Convexity

Also changes as time passes

Uses a single discount rate

Falls short of VaR in determining price risk of a fixed

income portfolio
31

Convexity Illustration

32

Macaulay Duration

Weighted average life by timing of the present value of

expected payments

Refer to Excel File Interest Rate Examples Session 2

33

Duration Example

Calculate the Macaulay Duration on a Bond with the

following attributes:

Coupon Rate 5%

Yield to Maturity of 4.5%

Annual payments (one year from today)

Maturity 2 years from today

Par Value = $1,000

34

Duration Example

Calculation the Macaulay Duration on a Bond with the

following attributes:

Coupon Rate 5%

Yield to Maturity of 4.5%

Annual payments

Maturity 2 years from today

Par Value = $1,000

35

Modified Duration

Equal to the Macaulay Duration divided by one plus yield to

maturity:

Mac. Duration / ( 1 + YTM/Compounding Frequency)

36

Duration Example

Calculate the Modified Duration on a Bond with the

following attributes:

Coupon Rate 5%

Yield to Maturity of 4.5%

Annual payments (one year from today)

Maturity 2 years from today

Par Value = $1,000

37

Duration Example

Calculation the Modified Duration on a Bond with the

following attributes:

Coupon Rate 5%

Yield to Maturity of 4.5%

Annual payments

Maturity 2 years from today

Par Value = $1,000

38

Duration Example Continued

Using the Duration calculations from above, estimate the

value of the bond after a 25 BP increase in the yield:

New Value = Prior Value * (1 - Duration * Yield Change )

$1,004.65 = $1,009.36 * (1 - 1.87 * .0025)

Actual price of the bond: $1,004.67 (repriced using 4.75% as the

yield)

39

Duration Applied

Base Case

Note that duration declines as the yield increases. Why?

Years to Maturity

Coupon Frequency (per year)

Coupon Rate
Maturity Value

Modified Duration at
Coupon = Yield

5.845

5.00%
1,000,000

40

Duration Applied

Lower Coupon Case

Years to Maturity

Coupon Frequency (per year)

Coupon Rate
Maturity Value

Modified Duration at
Coupon = Yield

6.272

3.00%
1,000,000

41

Duration Applied

Longer Maturity Case

Years to Maturity

10

Coupon Frequency (per year)

Coupon Rate
Maturity Value

Modified Duration at
Coupon = Yield

7.795

2
5.00%
1,000,000

42

Duration of a Portfolio

Equal to weighted average duration of the bonds in a

portfolio

For example, a portfolio holds the following two bonds

Bond 1, Value $3 million, duration of 5.

Bond 2, Value $2 million, duration of 10.

What is the duration of the portfolio?

43

Liquidity Risk
Liquidity

risk is either

Funding

Risk - Represents the risk of liquidity from

financing operations (e.g., refinancing long-term
notes as they come due)

Market

Risk - Represents the risk that the market

for assets or liabilities becomes illiquid (e.g.,
widening bid/ask spreads)

44

Liquidity in Securities Markets

Market liquidity is difference between the transaction

price and the fundamental value

Funding liquidity is a dealers scarcity (or shadow cost) of

capital
As

long as dealer capital is abundant, market liquidity

is at its highest level and insensitive to marginal
changes in capital and margins

However, when

dealers hit their capital constraints

or risk hitting their capital constraints over the life of a
trade they are forced to reduce their positions and
market liquidity is reduced
45

Liquidity in Securities Markets Cont.

Funds (e.g., hedge funds) and investment banks often

borrow against assets held.

E.g., repos, margin posting, etc.

Haircuts or margin requirements result in increasing drain

on capital

When market liquidity declines, the drain on capital

increases

This causes investors to shy away from highly volatile assets

46

Examples of Liquidity Issues in Markets

Auction

Rate Securities 2007/2008

For

example, student loan ARS often traded at 80% of

par (or less) even when federally guaranteed

Flight

to Safety Treasury Securities in 2008/2009

Interest

rate on short-term treasuries traded in the

negative in early 2009 (e.g., someone was willing to
pay $1.01 today for $1.00 in the future)

London Whale
Large

position in credit derivatives which turned

illiquid

Ultimately

cost JP Morgan $7 billion+

47

Level 1, 2, 3 Assets on Balance Sheet

Level 1 - observable market prices

Level 2 no observable direct price, but rely on inputs

solely from market prices (e.g., LIBOR based swap)

Level 3 - one or more of inputs do not have observable

prices; reliant on management estimates

Represents highest risk in terms of model risk and illiquidity

48

Levels of Assets - Examples

Level 1

Level 2

Level 3

NYSE Stock

Libor/Currency
Swap

Private Equity Int.

T-Bills

Forward
Contract

Venture Cap. Inv.

Exchange Traded
Derivatives

OTC Derivative

Real Estate

Actively Traded
Corp. Bonds

Thinly Traded Corp.

Bonds

Complex Derivatives

Commodity

Restricted Stock

Commercial
Loans
49

Levels of Assets - Examples

Asset

Level 1, 2, or 3?

Restricted Apple
Stock
Forward Contract
on Corn
Apple Corp. Bonds
Investment in
Uber
Oil Futures
Pink Sheets Stock,
Thinly Traded
Forward Rate
Agreement

50

Level 1, 2, 3 Assets on Balance Sheet

Level 1 - observable market prices

Level 2 no observable direct price, but rely on inputs

solely from market prices (e.g., LIBOR based swap)

Level 3 - one or more of inputs do not have observable

prices; reliant on management estimates

Represents highest risk in terms of model risk and illiquidity

51

Microsoft Risk Management in Practice

Key reason for continued success is risk management

practice

Risk culture driven

Bill Gates the chief risk officer

Investment in technology and people

Intranet site where BUs share risk information

Risk management group meets face-to-face with business

units to gain better understanding of risk

52

Microsoft Risk Management in Practice

Business risk management

Practices financial risk management as a form of business risk

management
Protects

Risk management group may undertake risk financing

View
Do

sales in areas with unstable currencies

of current risk profile so that it can validate risk financing plans

plans accommodate the risk profile that exists?

Validate conclusions of business managers

Quantitative

resource

What do you think they mean by risk financing?

53

Microsoft Risk Management in Practice

Business risk management

Identify business risk through scenario analysis

What if?...If X occurred

Initial

thoughts address the most obvious, immediate impact

Earthquake = property damage

Obvious result = property insurance

Further

thought addresses the business implication of the immediate

impact

Key personnel

Loss of market share

R&D risk / disruption

54

Microsoft Risk Management in Practice

Been using VaR since mid-90s

Applies multiple systems to estimate risk

1 in-house program, 2 third party software programs

Use of Stress Testing and Scenario Analyses

Gibraltar systematically integrates MSFTs treasury function

Data warehouse

Performance measurement

Transactions

Financial risk analysis/reporting

55