UNDERSTANDING THE MARKET UNCERTAINTIES. Andrea Loddo Associate Director, Financial Risk Advisory

Transcription

1 UNDERSTANDING THE MARKET UNCERTAINTIES Andrea Loddo Associate Director, Financial Risk Advisory

2 Executive Summary Markets are unpredictable: the implications on risk management Rethinking risk management: the importance of interpreting historical performances From history to forecast: introducing market uncertainty The risk management discussion shifts from what it is likely to happen to how profound the impact can be Introducing the idea of the future Economic Environment Stress testing is the way

3 Remember the Swan Always consider The event is a surprise The event has a major impact After the fact, the event is rationalized by hindsight, as if it had been expected a Black Swan Attempting to predict the future is not too helpful when trying to manage risks 2

4 Significant risk events are not infrequent anymore 1997 Asian crisis 1998 Russia/LTCM 2000 Bursting of dot - com bubble /11, US invades Afghanistan, Enron 2003 Second Gulf War begins/collapse of world trade talks 2004 Indonesia tsunami 2005 Hurricane Katrina 2006 US sub - prime housing market shows signs of stress 2007 Global credit crisis 2008 Lehman Brothers collapse; oil prices hit $140/barrel 2009 Oil prices slump to under $40/barrel 2010 EU peripheral sovereign debt concerns surface; Greece & Ireland bailout 2011 MENA unrest and Japan earthquake; Portugal bailout 3

5 Do we learn from history? 7.0% 6.0% 3M GBP LIBOR Historic Rate Current Forward 5.0% 4.0% What was the market implied forward curve in 2008 & 2009? 3.0% 2.0% 1.0% 0.0%

6 Do we learn from history? 7.0% 3M GBP LIBOR Historic Rate Historic Forward Current Forward 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Forward rates are bad predictors of interest rates 5

7 Do we learn from history? GBPUSD FX rate GBPUSD 1Y Forward rate 1 Year lag FX forwards are a poor estimator of future spot levels given they are simply a spot rate adjusted by a realisation of interest rate differentials Forward rates are bad predictors of FX rate as well 6

8 If market s expectations are unreliable, what now? 8.0 Historical Rate 8.0 % of times Current Level Rates GBP 3M LIBOR GBP 3M LIBOR % 10% 20% 30% % of occurances 2.2 Historical Rate 2.2 % of times Current Level FX GBPUSD Rate GBPUSD Rate % 10% 20% 30% % of occurances 7

9 From historical performance to uncertainty GBP 3M LIBOR - Historical changes % of times 40% % of occurrences 30% 20% 10% 0% 40% 33% % of occurrences GBPUSD FX - Historical changes % of times 50% 40% Vol = 31% 30% Vol = 12% 25% 18% 10% 3% 5% 13% GBP 3M LIBOR Monthly changes 20% 10% 0% 40% 33% 25% 18% 10% 3% 5% 13% GBPUSD Monthly changes The charts above show the monthly changes for GBP 3M LIBOR and GBPUSD FX rate over the last 10 years Historically LIBOR has been more volatile as a result of the strong and fast fall during 2008 and

10 How do we look into the future? Trend + Volatility = Uncertainty Which trend? Forwards are bad predictors. Thus we will focus on uncertainty 9

11 Introducing uncertainty GBP 3M LIBOR GBPUSD FX Rate Percentile(0.75) Mean Percentile(0.95) Percentile(0.05) Percentile(0.75) Mean Percentile(0.95) Percentile(0.05) Percentile(0.25) 8.0% Historical 8.0 Percentile(0.25) Historical 6.0% % % % Uncertainty means projecting market factors based on market implied expectation of forward rates and historical volatility and correlation Uncertainty shifts the focus of the risk management discussion from what it is likely to happen to how profound the impact can be 10

12 Quantifying market uncertainty GBPUSD FX rate projections Distribution in 5 years 4.00 Mean 5th 95th 25% GBPUSD FX Distribution % of occurrences 20% 15% 10% 5% % Thousands of simulations are generated which cover the entire spectrum of probable and extremely improbable events At each point in time, the distribution of potential outcome allows us to quantify the FX rate on a worst (95 th percentile), best (5 th percentile) and expected basis 11

13 Generating the Economic Environment Simple standard approach The Economic Environment Risk Factor 1 Impact Risk factor 1 Risk Factor 1 Risk Factor 2 Impact Risk factor 2 Risk Factor 2 Overall Impact Risk Factor 3 Impact Risk factor 3 Risk Factor 3

14 Why correlation matters? Positively Correlated Risks Risk Factor 1 Risk Factor 2 Combined Effect + = Negatively Correlated Risks Risk Factor 1 Risk Factor 2 Combined Effect + = 13

15 Measuring correlation GBPUSD FX Rate GBPEUR FX rate GBPUSD Rate Historical Rate GBPEUR Rate Historical Rate Weekly data shows that GBPUSD and GBPEUR rates are negatively correlated (- 11.1%) over the past year Should this be the assumption to be used when projecting GBPEUR and GBPUSD FX rates? 14

16 Correlation patterns can change over time Only recently GBPUSD and GBPEUR FX rates exhibit negative correlation GBPEUR & GBPUSD correlation Correlation 100% Historically, they have been positively correlated, particularly in 2009 and 2010 What are the implications of using different correlation measures? 20% 20% 60% % Correlation was calculated by using weekly data on a rolling annual window 15

17 How does correlation impact projections? Positively correlated paths Negatively correlated paths GBPUSD FX path GBPEUR FX Path GBPUSD FX path GBPEUR FX Path The chart on the left shows the simulated paths for positively correlated GBPUSD and GBPEUR FX rates (correlation at +40%) The chart on the right show the simulated paths assuming a negative correlation of - 20% 16

18 An example: a UK Company with Earnings in GBP, USD and EUR Current Earnings Currency Earnings USD 100m EUR 100m Total 200m Earnings ( m) Earning profile over the next 5 years USD EUR We assume earnings stay constant over time The company is exposed to FX risk related to the earnings in USD and EUR We will show how we quantify the impact of FX risk on earnings by projecting the FX rates around spot 17

19 How does correlation impact projections? Earnings - Positively correlated paths Earnings - Negatively correlated paths USD Earnings EUR Earnings USD Earnings EUR Earnings Earnings ( m) Earnings ( m) The charts show the impact on the earnings under Positively correlated FX rates (40%) left chart Negatively correlated FX rates (-20%) right chart 18

20 What is the impact on total earnings? The chart shows total earnings under The positive correlation scenario (40%) The negative correlation scenario (- 20%) In 2017, the earning risk associated to positively correlated FX rates is 29m Total Earnings Earnings ( m) Total Earnings Negative Correlation Total Earnings Positive Correlation m Risk

21 How does correlation change the risk profile? Earnings at risk with 40% correlation Cash Flow At Risk ( m) Earnings at risk with -20% correlation GBP USD EUR Total Diversification Benefit Net Risk GBP USD EUR Total Diversification Benefit Cash Flow At Risk ( m) Net Risk The charts show how the FX uncertainty translates into earning risk, on a cumulative basis over 5 years and on a worst case basis (95 th percentile) The net risk is lower than the total risk as a result of the diversification benefit Negative correlation implies higher diversification benefit and lower overall risk 20

22 Defining the right risk tolerance is important Earnings at risk with 40% correlation GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) Earning at risk with -20% correlation GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) Medium Tolerance High Tolerance GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) Tolerance Tolerance

23 Medium tolerance: what to do? Further investigating the historical correlation patterns by Changing the frequency of observation Looking at different time horizons Understand the motivations behind inversion of trends Running different stress cases, evaluating the impact on the earnings profile and potentially exploring hedging strategies GBPEUR & GBPUSD FX correlation Correlation 100% 60% 20% 20% 60%

24 Low tolerance to risk Earnings at risk with 40% correlation Earnings at risk with -20% correlation GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) Low tolerance GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) Tolerance If under any scenarios, the risk is not within the desired tolerance band, then an appropriate hedging strategy should be defined We can help in quantifying the risk and define the appropriate tolerance levels

25 What is then the right strategic decision? Tolerance to Risk Risk analysis Strategy Lower Neutral Higher The risk quantified under different scenarios is not within the tolerance level The risk quantified under different scenarios is partially within the tolerance level The risk quantified under different scenarios is within the tolerance level Definition of an optimal hedging strategy Additional stress testing required. Considerations around an optimal hedging strategy are beneficial No hedging 24