1. FRM Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html Financial Risk Management

2. Zvi WienerFRM-2 slide 2

3. Zvi WienerFRM-2 slide 3 Lunch Breakfast $2$4 $5$7$9 $11$13$15 50%  = $11  = ?? 50%

4. Zvi WienerFRM-2 slide 4 Correlation  =+1 $2$4 $5$7$9 $11$13$15 Lunch Breakfast 50%  = $11  = $450%

5. Zvi WienerFRM-2 slide 5 Correlation  =-1 $2$4 $5$7$9 $11$13$15 Lunch Breakfast 50%  = $11  = $250%

6. Zvi WienerFRM-2 slide 6 Correlation  =0 $2$4 $5$7$9 $11$13$15 Lunch Breakfast 50%  = $11  = $3.1650%

7. Zvi WienerFRM-2 slide 7 Example We will receive n dollars where n is determined by a die. What would be a fair price for participation in this game?

8. Zvi WienerFRM-2 slide 8 Example 1 ScoreProbability 11/6 21/6 31/6 41/6 51/6 61/6 Fair price is 3.5 NIS. Assume that we can play the game for 3 NIS only.

9. Zvi WienerFRM-2 slide 9 Example If there is a pair of dice the mean is doubled. What is the probability to gain $5?

10. Zvi WienerFRM-2 slide 10 Example 1,12,13,14,15,16,1 1,22,23,24,25,26,2 1,32,33,34,35,36,3 1,42,43,44,45,46,4 1,52,53,54,55,56,5 1,62,63,64,65,66,6 All combinations: 36 combinations with equal probabilities

11. Zvi WienerFRM-2 slide 11 Example 1,12,13,14,15,16,1 1,22,23,24,25,26,2 1,32,33,34,35,36,3 1,42,43,44,45,46,4 1,52,53,54,55,56,5 1,62,63,64,65,66,6 All combinations: 4 out of 36 give $5, probability = 1/9

12. Zvi WienerFRM-2 slide 12 All combinations: 1 out of 9 give $5, probability = 1/9 Additional information: the first die gives 4. 1,12,13,14,15,16,1 1,22,23,24,25,26,2 1,32,33,34,35,36,3 1,42,43,44,45,46,4 1,52,53,54,55,56,5 1,62,63,64,65,66,6

13. Zvi WienerFRM-2 slide 13 All combinations: 4 out of 24 give $5, probability = 1/6 Additional information: the first die gives  4. 1,12,13,14,15,16,1 1,22,23,24,25,26,2 1,32,33,34,35,36,3 1,42,43,44,45,46,4 1,52,53,54,55,56,5 1,62,63,64,65,66,6

14. Zvi WienerFRM-2 slide 14 Example 1 -2 -1 0 1 2 3

15. Zvi WienerFRM-2 slide 15 Example 1 123456we pay 12345676 NIS. 2345678 3456789 45678910 567891011 6789101112

16. Zvi WienerFRM-2 slide 16 P&L 123456 1-4-3-2-101 2-3-2-1012 3-2-10123 4-101234 5012345 6123456

17. Zvi WienerFRM-2 slide 17 Example 1 (2 cubes)

18. Zvi WienerFRM-2 slide 18 Example 1 (5 cubes)

19. Zvi WienerFRM-2 slide 19 interest rates and dollar are NOT independent Value Interest Rate dollar

20. Zvi WienerFRM-2 slide 20 Regulation of Financial Intermediaries take deposits, give loans very small equity capital, big leverage FDIC, CDIC, Israel - implicit domino effect Minimal capital requirements (8-9%)

21. Zvi WienerFRM-2 slide 21 Banks major increase of off-balance sheet in 80s 1988 Basle accord (88 BIS Accord) - international minimum capital guidelines (credit risk). 1996 Amendment - market risk + VaR. Amendment = BIS 98

22. Zvi WienerFRM-2 slide 22 Accord + Amendment assets to capital  20 eligible capital/risk weighted assets  8% minimal capital charge for market risk concentration risk:  positions of 10% must be reported  positions of 25% need special permission

23. Zvi WienerFRM-2 slide 23 Accord + Amendment regulators encourage banks to develop models. Banks must implement a RM infrastructure in their daily RM - limits, monitoring, etc. G-30 report, 1993.

24. Zvi WienerFRM-2 slide 24 G-30 policy recommendations The Role of senior management Marking to market Market valuation methods Identifying revenue sources Measuring market risk (VaR) Stress simulation Investing and funding forecasts

25. Zvi WienerFRM-2 slide 25 G-30 policy recommendations Independent risk management Practices by end-user Measuring credit exposure Master agreements Credit enhancements Promoting enforceability Professional expertise

26. Zvi WienerFRM-2 slide 26 G-30 policy recommendations Systems Authority Accounting practices Disclosures Recognizing netting Legal and regulatory uncertainty Tax treatment Accounting standards

27. Zvi WienerFRM-2 slide 27 1988 BIS Accord Developed by Basle committee Accepted by G-10: Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, UK, USA. minimum asset to capital multiple risk based capital ratio

28. Zvi WienerFRM-2 slide 28 1988 BIS Accord risk based capital ratio - solvency ratio (Cooke ratio). Capital divided by risk weighted on- balance-sheet assets plus off-balance- sheet exposures. Weights are based on credit risk. No netting or portfolio effects! No market risk.

29. Zvi WienerFRM-2 slide 29 1988 BIS Accord The Assets-to-capital multiple  20 Bank’s total assets divided by its total capital. Some off-balance-sheet items, like letters of credit are accounted at nominal.

30. Zvi WienerFRM-2 slide 30 Weights in Cooke ratio On-balance-sheet items: 0%Cash, gold, OECD government claims, insured mortgages. 20%OECD banks, OECD public sector entities. 50%Uninsured residential mortgages. 100% All other claims.

31. Zvi WienerFRM-2 slide 31 Cooke ratio Off-balance-sheet credit equivalent. 1. Nonderivative exposure - conversion factor is set by regulators between 0 and 1. 2. Derivative exposure = Current replacement cost + Add-on amount Risk weighted amount =  Assets*W+  Credit equivalent*W

32. Zvi WienerFRM-2 slide 32 Cooke ratio Banks are required to maintain capital equal to at least 8% of their total risk weighted assets. (In Israel 9%.)

33. Zvi WienerFRM-2 slide 33 Capital Tier 1. Stock equity, preferred stock, minority equity interest in consolidated subsidiaries, less goodwill and other deductions. Tier 2. Cumulative perpetual preferred shares, 99 year debentures, some subordinated debt (  5y). Tier 3. Can be used to cover market risk only. Short term subordinated debt (  2y). Tier 1 + Tier 2  8%, and Tier 1 must be at least 50% of this amount.

34. Zvi WienerFRM-2 slide 34 Models Standard model. Internal models (based on VaR). (3*marketVaR 10d +4*creditVaR 10d )*trigger/8 trigger = 8 in North America and between 8 and 25 in the UK

35. Zvi WienerFRM-2 slide 35 Problems with the current approach No distinction between a loan of $100 and 100 loans of $1 each one. Turkish bank has lower capital requirements than General Electric. A loan to AA rated firm is treated as a loan to a B rated firm. Some similar contracts are treated differently.

36. Zvi WienerFRM-2 slide 36 New proposals BIS 2000 VaR based approach to credit risk.  CreditMetrics  CreditRisk+  KMV  Merton.

37. Zvi WienerFRM-2 slide 37 New Approach Three pillars A. Minimum Capital Requirement B. Supervisory Review Process C. Market Discipline Requirements

38. Zvi WienerFRM-2 slide 38 What is the current Risk? duration, convexity volatility delta, gamma, vega rating target zone Bonds Stocks Options Credit Forex Total?

39. Zvi WienerFRM-2 slide 39 Standard Approach

40. Zvi WienerFRM-2 slide 40 Modern Approach Financial Institution