Price Risk Value. Risk Management. Jawwad Intro. Alchemy Intro What is this course about. Fellow Society of Actuaries, Investments

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1 Jawwad Intro Fellow Society of Actuaries, Investments June 2012 Risk Management Ideas, Products, Risks, Limits MBA, Columbia Business School 19 years consulting: US, UK, ME & Pakistan Risk Management, Product Development, Regulatory Reporting, Actuarial Practice Prefers - Jawwad jawwad@alchemya.com 2 Alchemy Intro What is this course about Actuarial & Risk Advisory firm 8 years, 4 Markets Derivative & Risk Management models, ALM, ICAAP, Stress Testing, Financial Product Development, Training workshops 120th workshop trained professionals Price Risk Value Products Limits 3 1

2 Price Volatility Models Relative Value 2

3 Relative Value - II Products & Payoffs 9 Limits Action Plan Day One Volatility Data & Trends Value at Risk Calculating VaR Trailing volatility Review of trends Understanding & Calculating Value at Risk. Hands on practice 3

4 Action Plan Day Two Working with Oil & Gold Air Canada GM Fundamental models Oil FX Distribution & Volatility Measuring Exposure What would you recommend? Volatility Sigma Variance ==> expectations not met >Std-deviation ==> square root (Variance) >Dispersion, Diffusion >Volatility >Vol >Trading Vol >Implied Vol Optionality - Volatility - Convexity 4

5 Exchange Rate Volatility against the US Dollar of Selected Crisis and Non-Crisis Currencies, 1990: :05 (Daily) - Source Ronald Mckinnon, Stanford University Chinese Yuan Hong Kong Dollar Thai Baht 8% 8% 8% 6% 6% 6% 4% 4% 4% 2% 2% 2% Exchange Rate Volatility against the US Dollar of Selected Crisis and Non-Crisis Currencies, 1990: :05 (Daily) - Source Ronald Mckinnon, Stanford University 0% -2% -4% -6% -8% Malaysian Ringgit 8% 6% 4% 0% -2% -4% -6% -8% Philippine Peso 8% 6% 4% 0% -2% -4% -6% -8% Japanese Yen 8% 6% 4% 2% 2% 2% 0% 0% 0% -2% -2% -2% -4% -4% -4% -6% -6% -6% -8% % % (Continued), Exchange Rate Volatility against the US Dollar, 1990: :05 (Daily) Standard Deviations of Monthly Exchange Rate Fluctuations against the Dollar Indonesian Rupiah Korean Won Euro (German Mark) 8% 8% 8% 6% 6% 6% 4% 4% 4% 2% 2% 2% 0% 0% 0% -2% -2% -2% -4% -4% -4% -6% -6% -6% -8% -8% -8% Singapore Dollar New Taiwan Dollar Swiss Franc 8% 8% 8% 6% 6% 6% 4% 4% 4% 2% 2% 2% 0% 0% 0% -2% -2% -2% -4% -4% -4% -6% -6% -6% -8% -8% -8% Chinese Yuan Hong Kong Dollar Indonesian Rupiah Korean Won Malaysian Ringgit Philippine Peso Singapore Dollar New Taiwan Dollar Thai Baht Japanese Yen Euro (Deutsche Mark) Swiss Franc Pre-crisis Crisis Data source: IMF: IFS, Ronald Mckinnon, Stanford University Post-crisis

6 Vol Trend 10% 8% 6% 4% 2% 0% 28/03/ /06/ /09/ /01/ /04/2009 Crude Oil Refined Products Precious Metal Other Metals Fibers and Textiles Grains and Feeds Foods Fats and Oils 21 Lagged effects Flight to Safety cycle AUD-JPY Sterling-JPY USD-AUD EUR-JPY Reduce Vol; Park Capital Safe Assets US$ 3.6% 2.8% Risk Limit Hit Low Yield Safe havens CHF Yen 2.0% 1.2% Change in Risk Profile Yield & Vol Pickup trades 0.4% 13/03/08 29/05/08 14/08/08 30/10/08 15/01/09 02/04/09 Risk Assets 6

7 Flight to Safety - II Thought Experiments? Volatility Drag? Vol =?, r =? 7

8 8 Vol = 0, r = 0 tz t t r t e S S ) ( tz t t r t e S S ) ( Vol = 0, r = 1 tz t t r t e S S ) ( Vol = 0, r =? tz t t r t e S S ) (

9 Vol =?, r =1 Vol =?, r =0 S t S e 1 2 ( r ) t tz 2 t 0 S t S e 1 2 ( r ) t tz 2 t 0 Trailing Volatilites Thought experiment - PSR Process Vol VaR Worst Case Move PSR Default Impact Pricing Model 9

10 Framing the problem What is long term? Framing the problem What is long term? 38 Framing the problem What is long term? Distributions - Simulations 39 10

11 Mindset Distributions - Models ALL MODELS ARE WRONG SOME MODELS ARE MORE USEFUL THAN OTHERS Sigma a,b 41 Questions What is the probability that margins will decrease in any month over the next quarter, the next half year, or the next full year? What is the range of these projected reductions? What is the worst case reduction in any month over the next 12 Risk months? What is the likely reduction in any month over the next 12 months? 44 11

12 Monthly Crude Oil Change The Oil Refinery Case VaR and Margins Application Questions Questions What is the probability that margins will decrease in any month over the next quarter, the next half year, or the next full year? What is the range of these projected reductions? 12

13 Questions What is the worst case reduction in any month over the next 12 months? What is the likely reduction in any month over the next 12 months? More questions? More questions? What is the probability that gross margins will shrink below the minimum profitability threshold? What is the likely expected gross margin number at current price volatility levels? How will this number change if volatility moves by a percentage point? What is the probability that gross margins will turn negative? By how much does a dollar change in prices change the expected margin number? 13

14 Monthly Crude Oil Change Integration - Example Crude Volatility Input Input Inventory Inventory Price Price Losses Losses Odds Percentile Shock-low Shock-high Low High 99% ,310,771 30,885,105 1% 99% ,310,771 30,885,105 11% 90% ,781,826 17,014,160 18% 85% ,484,689 13,759,917 25% 80% ,453,765 11,173,548 33% 75% ,569,324 8,954,674 43% 70% ,775,068 6,962,056 52% 66% ,182,708 5,475,951 67% 60% ,340,684 3,363,492 82% 55% ,986 1,668,308 96% 51% , ,820 14

15 Frequency VaR AUD/USD Exchange Rate Most severe 5% losses Levelof tolerance -5.8% -5.1% -4.4% -3.7% -3.0% -2.3% -1.6% -0.9% -0.2% 0.5% 1.2% 1.9% 2.6% 3.3% 4.0% 4.7% 5.4% 6.1% % 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Portfolio A VaR Case 60 15

16 Portfolio B Portfolio D Portfolio J Portfolio N 16

17 Portfolio P Histogram Source A B D Bin FreqCumulative % Bin Freq Cumulative %Bin Freq Cumulative % -20% % -25% % -5.0% % -18% % -23% % -4.3% % -17% % -22% % -3.7% % -15% % -20% % -3.0% % -14% % -18% % -2.3% % -12% % -16% % -1.6% % -11% % -14% % -1.0% % -9% % -13% % -0.3% % -8% % -11% % 0.4% % -6% % -9% % 1.1% % -5% % -7% % 1.8% % -3% % -5% % 2.4% % -2% % -4% % 3.1% % 0% % -2% % 3.8% % 1% % 0% % 4.5% % 3% % 2% % 5.1% % 4% % 4% % 5.8% % 6% % 5% % 6.5% % More % More % More % Histogram Source J N P Bin Freq Cumulative %Bin Freq Cumulative %Bin Freq Cumulative % -1.44% % -0.80% % -3.4% % -1.25% % -0.70% % -2.9% % -1.06% % -0.60% % -2.5% % -0.87% % -0.50% % -2.0% % -0.68% % -0.40% % -1.5% % -0.48% % -0.30% % -1.0% % -0.29% % -0.20% % -0.6% % -0.10% % -0.10% % -0.1% % 0.09% % 0.00% % 0.4% % 0.28% % 0.10% % 0.8% % 0.47% % 0.20% % 1.3% % 0.67% % 0.30% % 1.8% % 0.86% % 0.40% % 2.3% % 1.05% % 0.50% % 2.7% % 1.24% % 0.60% % 3.2% % 1.43% % 0.70% % 3.7% % 1.63% % 0.80% % 4.1% % 1.82% % 0.90% % 4.6% % More % More % More % What is exposure? Uncertain Volatile Exposure Financial Impact 17

18 Issues What is exposure? Air Canada GM Rising Jet Fuel Prices Rising Canadian Dollar Process and Control Policy Data Banc One Interest Rates Limits Models LTCM Volatility Metrics Limit Management Stop Loss Limit Process Limit Management Counterparty Limits Transaction Limits Exposure Limits Sensitivity limits Risk appetite Target Stop loss limit Book Size Actual stop loss limits Loss Capital Amount depends on Expected and Minimum Rates of Return, Capital Amount applicable for given period Allocation of book size to individual business/ investment lines individual lines for given period 18

19 What is a Target Account? Target Accounts Air Canada P&L Shortfall Measurable/ Reportable Sensitive/ Relevant Explainable/ Understandable GM Banc One FX Factor Sensitivity Interest Rate Impact on Earnings LTCM Volatility, Value at Risk Exposure, Risk, Target Accounts Duration / Convexity Exposures Gross Numbers Book Size Driven by Internal choices Risk Probability that we may lose something Driven by external factors Target Accounts Sit somewhere in the middle at the intersection of exposure and risk 19

20 Convexity Convexity Alternate Convexity Convexity long bond YTM Perptuity 30 year 3.00% % % % % %

21 Case Study One Crude Oil Refinery Measuring Exposure Oil Refinery Case Study Lag between crude oil purchase and product arrival for distribution Retail price sensitive to pricing set by market price regulator Market regulator link pricing to international crude prices There is a 30 day lag in every price reset Crude Oil Oil Refiner Assumption Price Fix Manufacturing Process Time lag Potential Exposure P&L Impact HSFO NAPHTHA MOGAS HOBC KERO Aviat Fuels HSD LDO % 0.00% 19.03% 0.29% 2.67% 10.50% 33.84% 0.39% 21

22 Crude Oil - input Refined products Margin Impact Crude Oil Refiner Exposure Assessment >Understand Manufacturing Process >Estimate time lag between input price fix and retail product delivery >Breakdown between fixed and variable pricing >Estimate dollar sensitivity to unit change in input price >Estimate projected impact on P&L 22

23 Questions & Answers Questions & Answers Input Input Margin Margin Price Price shortfall shortfall Odds Percentile Shock-low Shock-high Low High 99% % 63.4% 1% 99% % 63.4% 11% 90% % 34.7% 18% 85% % 28.0% 25% 80% % 22.7% 33% 75% % 18.1% 43% 70% % 14.0% 52% 66% % 10.9% 67% 60% % 6.6% 82% 55% % 3.1% 96% 51% % 0.3% Input Input Inventory Inventory Price Price Losses Losses Odds Percentile Shock-low Shock-high Low High 99% ,310,771 30,885,105 1% 99% ,310,771 30,885,105 11% 90% ,781,826 17,014,160 18% 85% ,484,689 13,759,917 25% 80% ,453,765 11,173,548 33% 75% ,569,324 8,954,674 43% 70% ,775,068 6,962,056 52% 66% ,182,708 5,475,951 67% 60% ,340,684 3,363,492 82% 55% ,986 1,668,308 96% 51% , ,820 Questions More questions? What is the probability that margins will decrease in any month over the next quarter, the next half year, or the next full year? What is the probability that gross margins will shrink below the minimum profitability threshold? What is the range of these projected reductions? What is the worst case reduction in any month over the next 12 What is the probability that gross margins will turn negative? months? What is the likely reduction in any month over the next 12 months? 23

24 More questions? Questions for Air Canada & GM What is the likely expected gross margin number at current price volatility levels? What is the probability that margins will decrease in any month over the next quarter, the next half year, or the next full year? How will this number change if volatility moves by a percentage point? What is the range of these projected reductions? By how much does a dollar change in crude prices change the expected margin number? What is the worst case reduction in any month over the next 12 months? What is the likely reduction in any month over the next 12 months? As a board member what % of hedging do you recommend and why? Crude Oil 24

25 Price Volatility Integrated Future spreads Brent Relative Price in USD, EUR, AUD, JPY 25

26 Brent, WTI Correlation Correlation with EUR-USD ALM at a glance Interest Rates Repricing ALM Banc One Case Maturities Value/ Income Funding 26

27 A tale of two banks Risk - Return Bank A A 100 M L 90 M E 10 M Assets? Maturity? Bank B A 100 M L 90 M E 10 M Risk Return Sensitivity Liquidity? Funding? Metric or Target Account Driver Setting Change in Interest Income Change in Interest Rate Balance Sheet Change in Market Value Income Statement Concepts ALM Framework - II Sigma Duration Convexity Value at Risk Simulation ALM Portfolio Review Capital Asset Sensitive Liability Sensitive Value at Risk Hedging Tools 27

28 Concepts Liquidity Funding Liquidity Market (Tbills) Liquidity Assumptions Earnings at Risk Limit Management Counterparty Limits Banc one Questions? How does Banc One measure its interest rate exposure? Given Banc One s exposure should they worry about rising rates or declining rates environment? Can you optimize Earning at risk and NPV at risk at the same time? How would you go about it? Take Banc One s example and show through numbers. Transaction Limits Limit Management How do derivatives and other non-funded instrument help with capital optimization. Show through numbers. Exposure Limits Sensitivity limits Review the annexure on pages If you look at these numbers as an analyst, what are your conclusions? Your recommendations to Banc One? 6/28/