1. FRM-3 Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html RM functions

2. Zvi WienerFRM-3 slide 2 Structuring RM functions Set firm-wide policies Develop methodology Set RM structure Risk communication

3. Zvi WienerFRM-3 slide 3 Integrated Risk Management Identify and avoid Monitor Limit Management Stress Market, Credit VaR Risk Analysis Allocate capital RAROC Active Risk Management

4. Zvi WienerFRM-3 slide 4 RAROC Risk Adjusted Rate of Return Performance measurement Marginal impact of any new transaction Consistent pricing

5. Zvi WienerFRM-3 slide 5 New Approach Three pillars A. Minimum Capital Requirement B. Supervisory Review Process C. Market Discipline Requirements

6. Zvi WienerFRM-3 slide 6 Goals and Instruments Risk Tolerance - “worst loss” Stop losses Capital allocation Credit risk policy Operational risk policy

7. Zvi WienerFRM-3 slide 7 Risk Measurement Consistent market based method Old  limits  duration, ALM VaR + Stress Backtesting

8. Zvi WienerFRM-3 slide 8 Systems Data bases  market  position  rules Risk measuring tool Reports and decision support

9. Zvi WienerFRM-3 slide 9 IT - Information Technology Unifying information from various units Unifying information from various markets Unifying information for various ownership Back office and execution control

10. Zvi WienerFRM-3 slide 10 Organizational structure Front office Middle office Back office

11. Zvi WienerFRM-3 slide 11 Front office execution risk taking marketing

12. Zvi WienerFRM-3 slide 12 Middle office risk management pricing economic forecasts

13. Zvi WienerFRM-3 slide 13 Back office verification booking reporting collection settlement

14. Zvi WienerFRM-3 slide 14 ALCO Assets Liability management committee responsible for  establishing  documenting  enforcing all policies involving market risk FX liquidity interest rate

15. Zvi WienerFRM-3 slide 15 Interdependence of RM Senior Management Risk Management Operations Trading Room Finance

16. Zvi WienerFRM-3 slide 16 Senior management Approves business plan and targets Sets risk tolerance Establishes policy Ensures performance

17. Zvi WienerFRM-3 slide 17 Trading Room Management Establishes and manages risk exposure Ensures timely and accurate deal capture Signs off on official P&L

18. Zvi WienerFRM-3 slide 18 Operations Books and settles the trades Reconciles front and back office positions Prepares and decomposes daily P&L Provides independent MTM Supports business needs

19. Zvi WienerFRM-3 slide 19 Finance Develops valuation and finance policy Ensures integrity of P&L Manages business planning process Supports business needs

20. Zvi WienerFRM-3 slide 20 Risk Management Develops risk policies Monitors compliance to limits Manages ALCO process Vets models and spreadsheets Provides independent view on risk Supports business needs

21. Zvi WienerFRM-3 slide 21 Risk Limits Global risk limit Risk limits for trading desks/units Dynamic monitoring and adjustment

22. Zvi WienerFRM-3 slide 22 Risk Approaches Accounting - reported P&L Economic - value Liquidity needs

23. Zvi WienerFRM-3 slide 23 Liquidity Rank Based on forecasts and potential availability of funds. Hot funds - can be withdrawn quickly. Stable funds - typically to maturity.

24. Zvi WienerFRM-3 slide 24 Israel 339 Definitions of risk types Relates to all banking institutions Management structure Exposure document Directors and policy Risk manager Internal audit

25. Zvi WienerFRM-3 slide 25 Israel 339 IR risk Market risk Risk audit unit

26. Zvi WienerFRM-3 slide 26 Israel 341 Capital requirements against market risk Risk measurement Trading portfolio Reporting Examples of standard approach and VaR

27. Zvi WienerFRM-3 slide 27 Israel 341 Capital requirements against market risk Risk measurement Trading portfolio Reporting Examples of standard approach and VaR

28. Zvi WienerFRM-3 slide 28 Qualitative Requirements An independent risk management unit Board of directors involvement Internal model as an integral part Internal controller and risk model Backtesting Stress test

29. Zvi WienerFRM-3 slide 29 Quantitative Requirements 99% confidence interval 10 business days horizon At least one year of historic data Data base revised at least every quarter All types of risk exposure Derivatives

30. Zvi WienerFRM-3 slide 30 Types of Assets and Risks Real projects - cashflow versus financing Fixed Income Optionality Credit exposure Legal, operational, authorities

31. Zvi WienerFRM-3 slide 31 Risk Factors There are many bonds, stocks and currencies. The idea is to choose a small set of relevant economic factors and to map everything on these factors. Exchange rates Interest rates (for each maturity and indexation) Spreads Stock indices

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35. Zvi WienerFRM-3 slide 35 Board of Directors (Basle, September 1998) periodic discussions with management concerning the effectiveness of the internal control system a timely review of evaluations of internal controls made by management, internal and external auditors periodic efforts to ensure that management has promptly followed up on recommendations and concerns expressed by auditors and supervisory authorities on internal control weaknesses a periodic review of the appropriateness of the bank’s strategy and risk limits.

36. Zvi WienerFRM-3 slide 36 Forward agreement Is an obligation on both sides No initial money transfer Final price is fixed in advance Typical cash settlement Margin account and mark to market

37. Zvi WienerFRM-3 slide 37 Forward/Futures value SpotX $

38. Zvi WienerFRM-3 slide 38 Options Put or Call European or American Underlying asset Strike price Premium Time to maturity Hedge ratio

39. Zvi WienerFRM-3 slide 39 Call Option Xunderlying premium value

40. Zvi WienerFRM-3 slide 40 Hedge Ratio Xunderlying value

41. Zvi WienerFRM-3 slide 41 Put Option Xunderlying value

42. Zvi WienerFRM-3 slide 42 Exotic Options Asian Path dependent Digital Bermudian Knock-in, out Exchange of assets Swaptions

43. Zvi WienerFRM-3 slide 43 Swap currency or interest rate two loans with swapped payments low credit risk changes exposure:  currency  duration

44. Zvi WienerFRM-3 slide 44 Structured Note tailor made solution for example, IO, PO higher priority obligations or junk collar, IAS, ratchet, etc.

45. Zvi WienerFRM-3 slide 45 Collar Firm B has shares of firm C of value $200M They do not want to sell the shares, but need money. Moreover they would like to decrease the exposure to financial risk. How to get it done?

46. Zvi WienerFRM-3 slide 46 Collar 1. Buy a protective Put option (3y to maturity, strike = 90% of spot). 2. Sell an out-the-money Call option (3y to maturity, strike above spot). 3. Take a “cheap” loan at 90% of the current value.

47. Zvi WienerFRM-3 slide 47 Buy stock Sell call Result Buy put

48. Zvi WienerFRM-3 slide 48 UPC example Aug 98, a $90M convertible loan to UPC Feb 99, $49M paid for 1.55M shares (10%) The share price rose to $162 (5 times) Four options were used to protect the value

49. Zvi WienerFRM-3 slide 49 UPC example Buy 2 put options maturing 06-Feb-2002  put option for 500,000 shares, strike $125  put option for 300,000 shares, strike $153 Sell 2 call options maturing 06-Feb-2002  call option for 500,000 shares, strike $173  call option for 300,000 shares, strike $212

50. Zvi WienerFRM-3 slide 50 UPC 125153173212UPC share 108 150 After tax capital gain is between $53M and $80M These options cover 800,000 shares only.

51. Zvi WienerFRM-3 slide 51 How much did it cost? The results are not precise and very sensitive to volatility  if volatility is 10%$6.5M  if volatility is 20%$10M  if volatility is 30%$13M  if volatility is 40%$15M This is the amount the bank should pay to DASKASCH!

52. Zvi WienerFRM-3 slide 52 Risk Management Issues Why only half of the bond was called? Why only 800,000 shares were protected? How to choose the protection level? When does it make sense to hedge?

53. Zvi WienerFRM-3 slide 53 New proposals BIS 2000 VaR based approach to credit risk.  CreditMetrics  CreditRisk+  KMV  Merton.

54. Zvi WienerFRM-3 slide 54 What is the current Risk? duration, convexity volatility delta, gamma, vega rating target zone Bonds Stocks Options Credit Forex Total?

55. Zvi WienerFRM-3 slide 55 Standard Approach

56. Zvi WienerFRM-3 slide 56 Modern Approach Financial Institution