UNDERSTANDING THE MARKET UNCERTAINTIES Andrea Loddo Associate Director, Financial Risk Advisory
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
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
Significant risk events are not infrequent anymore 1997 Asian crisis 1998 Russia/LTCM 2000 Bursting of dot - com bubble 2001 9/11, 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
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% 2008 2009 2010 2011 2012 2013 4
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% 2008 2009 2010 2011 2012 2013 Forward rates are bad predictors of interest rates 5
Do we learn from history? GBPUSD FX rate GBPUSD 1Y Forward rate 1 Year lag 2.2 2 1.8 1.6 1.4 1.2 1 2003 2005 2007 2009 2011 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
If market s expectations are unreliable, what now? 8.0 Historical Rate 8.0 % of times Current Level Rates GBP 3M LIBOR 6.0 4.0 2.0 0.0 2002 2004 2006 2008 2010 2012 GBP 3M LIBOR 6.0 4.0 2.0 0.0 0% 10% 20% 30% % of occurances 2.2 Historical Rate 2.2 % of times Current Level FX GBPUSD Rate 2.0 1.8 1.6 1.4 1.2 2002 2004 2006 2008 2010 2012 GBPUSD Rate 2.0 1.7 1.5 1.2 0% 10% 20% 30% % of occurances 7
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 2009 8
How do we look into the future? Trend + Volatility = Uncertainty Which trend? Forwards are bad predictors. Thus we will focus on uncertainty 9
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% 6.0 4.0% 4.0 2.0% 2.0 0.0% 2006 2009 2012 2015 2017 0.0 2007 2010 2012 2015 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
Quantifying market uncertainty GBPUSD FX rate projections Distribution in 5 years 4.00 Mean 5th 95th 25% GBPUSD FX Distribution 2017 1.1 1.7 2.6 3.00 2.00 1.00 % of occurrences 20% 15% 10% 5% 0.00 2012 2013 2014 2015 2016 2017 0% 0.3 1.0 1.6 2.3 2.9 3.6 4.2 4.9 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
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
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
Measuring correlation GBPUSD FX Rate GBPEUR FX rate GBPUSD Rate Historical Rate 2.2 2.0 1.8 1.6 1.4 1.2 2002 2004 2006 2008 2010 2012 GBPEUR Rate Historical Rate 1.7 1.5 1.3 1.1 0.9 2002 2004 2006 2008 2010 2012 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
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% 2003 2005 2007 2009 2011 60% Correlation was calculated by using weekly data on a rolling annual window 15
How does correlation impact projections? Positively correlated paths Negatively correlated paths GBPUSD FX path GBPEUR FX Path GBPUSD FX path GBPEUR FX Path 2.50 2.50 2.00 2.00 1.50 1.50 1.00 1.00 0.50 0.50 0.00 0.00 2012 2013 2014 2015 2016 2017 2012 2013 2014 2015 2016 2017 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
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 120 100 80 60 40 20 0 2013 2014 2015 2016 2017 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
How does correlation impact projections? Earnings - Positively correlated paths Earnings - Negatively correlated paths USD Earnings EUR Earnings USD Earnings EUR Earnings 150 150 Earnings ( m) 100 50 Earnings ( m) 100 50 0 2012 2013 2014 2015 2016 2017 0 2012 2013 2014 2015 2016 2017 The charts show the impact on the earnings under Positively correlated FX rates (40%) left chart Negatively correlated FX rates (-20%) right chart 18
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 250 29m Risk 200 150 100 50 0 2012 2013 2014 2015 2016 2017 19
How does correlation change the risk profile? Earnings at risk with 40% correlation Cash Flow At Risk ( m) 300 250 200 150 100 50 0 133.3 112.8 246.1 36.2 209.9 Earnings at risk with -20% correlation 300 250 200 150 100 50 0 GBP USD EUR Total Diversification Benefit Net Risk GBP USD EUR Total 133.3 112.8 246.1 78.6 167.5 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
Defining the right risk tolerance is important Earnings at risk with 40% correlation 300 250 300 250 133.3 246.1 209.9 112.8 36.2 200 150 100 50 0 300 250 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) 133.3 167.5 246.1 112.8 78.6 200 150 100 50 0 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) 133.3 246.1 209.9 112.8 36.2 200 150 100 50 0 Earning at risk with -20% correlation 300 250 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) 133.3 167.5 246.1 112.8 78.6 200 150 100 50 0 21 Medium Tolerance High Tolerance GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) Tolerance Tolerance
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% 2003 2005 2007 2009 2011 22
Low tolerance to risk Earnings at risk with 40% correlation Earnings at risk with -20% correlation 133.3 112.8 246.1 36.2 209.9 300 250 200 150 100 50 0 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk ( m) 133.3 112.8 246.1 78.6 167.5 300 250 200 150 100 50 0 23 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
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