Risk Management 101 PDF

Risk Management 101
Toronto Trading Risk Management Practice

Seminar Series 1
June 2013
Prerequisite Reviews
Seminar Series 1
June 2013
Contents
 Financial Markets
 Financial Products
 Business Functions – Trading & Trading Support
 Business Functions – Risk Management
 Business Functions – Finance, Technology & Audit
 Trade Life Cycle vs. Business Function
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© COPYRIGHT 2013 SAPIENT CORPORATION
Financial Markets
• Trade definition
 An agreement between two parties to exchange one “asset” to another “asset”
• Why People trade
 Make Profit
 Hedge
• Factors Affecting Trade
 Liquidity
 Risk Appetite
 Exposure Appetite
• Market Participants
 Producer
 Consumer
 Speculator
 Market Maker
• Means by which Trades are transacted
 Brokers
 Exchange
 OTC

Financial Markets (Cont’d)
• Remark:
 House Building Bank – a long/mid-term funding to house-build
 Bank go to CM - for hedging
 CM go to External - for hedging
 Bank and CM – accounting treatment ( accrual vs. present value)
 Bank and CM – Need to do FASB testing
Financial Products
• Common Asset Class
 Interest Rates
 Foreign Exchange
 Equity
 Bond and Credit
 Commodity
• Products
 Derivatives
• Any trade that derives from an underlying asset
• Linear: Forward
• Non-linear: Option
• Exotic Options: Any trade based around a vanilla option but modified in some way
 Structures and Hybrid
• A set of different trades bound together to produce a required set of exposure (most time in the same asset
class)
• A Hybrid is a structure but crossing different asset classes
 Cash Products
• Equity, Bond, Currency
 Credit Derivatives
• CDS-Credit Default Swap
 CLN-Credit Linked Note
• Notes linked to credit assets
Business Functions – Trading & Trading Support
• Trading and Trading Support
 Front Office
• Sales/Marketing
• Structurer/Origination
• Trading and Portfolio Management
• Trade Support – book/execute trades
 Legal
• Documentation
• Legal advice
• ISDA, CSA, GasEdi, …
 Middle Office
• Trade and trade proxy verifications
• Special trade tracking and monitoring
• Valuation data sourcing
• Valuation environment setup
• Static data setup
• Data management
• Cash and liquidity management
• Coordination of new business approval
• Intraday trade analysis

Business Functions–Trading & Trading Support (cont’d)
• Product Control
 Valuation data source policy
 On demand valuation data approval
 Independent Price Verification (IPV)
 Profit & Loss (P&L) Reporting
 Profit Attribute Analysis (PAA)
 Valuation adjustment calculation and approval
• Back Office/Operations
 Trade Confirmation/Affirmation
 Settlement
 Genera Leger (GL) entries
 Collateral Management
 Accounting

Business Functions (cont’d)–Risk Management
• Risk Management
 Market Risk
• Intro-day trade profit analysis
• Risk oversight (VaR, IRC, DSR, FS,…)
• Reserve calculation
• CVA calculation and monitoring
• Intro-day PAA
• New business approval
 Credit Risk
• Pre-trade credit checking
• Marginal exposure analysis
• ISDA & CSA… analytical support
• Margin calculation
• Collateral or pledging decision
• Credit limit approval
• New business approval
• Counterpart/Issuer credit quality monitoring

Business Functions (cont’d)–Risk Management
 Risk/Regulatory Reporting
• Desk level risk reporting
• Enterprise level risk reporting
• Economical/ Regulatory capital reporting
• Management dashboard reporting
 Infrastructure Development
• IT strategy and execution
• Architecture/infrastructure design
• New business capturing
• Business requirements
• New business initiatives
• Risk analytics and modeling
• Infrastructure implementation
• Risk measurement generation and reporting

Business Functions (cont’d)–Finance, Technology & Audit
• Finance
 Financial Reporting
• Technology
 Trading system development
 Operation system development
 Risk and MO system development
• Audit
 Exam Bank’s operations procedures

Trade Life Cycle vs. Business Function

Risk Management 101
Seminar Series 1
June 2013
Table of Contents
 What is Risk Management
 Risk Factor Determination
 Return Versus Price Changes
 Types of Risks Financial Institutions face
 (Quantitative) Risk Management – an organization example
 Market Risk
 Credit Risk
 Liquidity Risk
 Operational Risk
 Models for Risk Measurement Ingredients
 How Risks are Managed
 How Do Traders Manage Their Exposures – Greeks
 Value at Risk (VaR)
 Specific Risk
 Volatility as a Measurement of Market Risk
 Scenario Analysis/Stress Test
Table of Contents
• Back Test / Model Validation
• Not All Risks Are the Same
• A Closer Look at Market Risk and Credit Risk
• Regulatory Capital and Economic Capital
• Risk Capital and Its Allocation
• Risk Reporting and Its Platform Development
• Integration of Market and Credit Risks
• Risk Management Future Topics
• Risk Management Data Architecture

What is Risk Management
• Risk management
 Risk - a state of unexpected change or loss of your portfolios
 Risk Management – a process of the identification, assessment, and prioritization of risks
• Risk management activities
 Measure the extent and sources of exposure
 Charge each position a cost of capital appropriate to its risk
 Allocate scare risk capital to traders and to profit centers
 Provide information on the bank’s financial integrity to outside parties, such as investors,
rating agencies, and regulators
 Evaluate the performance of profit centers in light of the risks taken to achieve profits –
optimal decision between risk and reward
 Mitigate risk, by various means and policies – “Hedge”
 Assign and enforce market and counterparty credit limits

Risk Factor Determination
• Credit
 Rating/Score
 Recovery/LGD
• Market
 Spread
 IR
 FX
 Commodity/Energy
 Equity
 Inflation
 Correlation
 Volatility/Smile
 Calibrated Parameters

Return Versus Price Changes
• To analyze market risks of a portfolio, we are ultimately interested in
the changes in value of the portfolio over some horizon. Risk
manager study either its value changes or its returns.
• If we know P(t) and continuously compounded return between t and t+1, x,
so P(t+1) = P(t)*exp(x).
• Make returns to be the object of study in risk measurement:
 The statistical distributions of returns have been studied widely in both academic
and industry practitioner literatures, so this research can be directly adapted to
risk management systems.
 Working with yields leads naturally to a common language between risk managers
and traders (e.g., returns and return volatility, etc.)

Geometric Brownian Motion
• Geometric Brownian Motion:
 X(t) = 𝑧0 exp(μt + 𝜎 𝐵(t))
 where B(t) is standard Brownian Motion.
• The mean of Geometric Brownian Motion:
• 𝑧0 exp(µt + ½ 𝜎 2 t)
• The variance of Geometric Brownian Motion:
• z0 2 exp(2μt + σ2 t)(exp(σ2 t) −1)
• If dx = a(x, t)dt + b(x, t)dB(t), Ito’s Lemma for Brownian Motion:
𝟏
df(x, t) = (ft + a(x, t)fx + 𝒃(𝒙, 𝒕)𝟐 fxx)dt + b(x, t)fxdB(t)
𝟐
 If Stock Price process is dS = μSdt + σSdB(t), the Ito’s Lemma :
1
df(S, t) = (ft + µS fs + σ2 𝑆 2 fss)dt + σS fsdB(t)
2
𝟏
 dln(S) = (µ - 𝝈𝟐 )𝒅𝒕 + σdB(t), if f(S, t) = ln (S)
𝟐
 In other words, at any time t the stock-price random variable St is log-normal
 The above means that we assume that the continuously compounded returns are modeled
by a normally distributed random variable.

The Ornstein-Uhlenbeck Process
• Along with the processes we discussed so far, consider a stochastic

• process {Xt} which satisfies
 dX(t) = [α − xt ] dt + σB(t),
• where α and σ are given constants and {B(t)} is a standard Brownian
motion.
• The process above is called the mean reverting process. With setting α = 0,
the resulting process is called the Ornstein-Uhlenbeck process

Types of Risks Financial Institutions face
• Market Risk - the risk that the value of an investment will decrease due to
moves in market factors
• Credit Risk - the risk that borrowers, bond issuers and counterparties may
default
• Liquidity Risk – the risk that an asset can not be traded quickly enough or
“cash shortage” to meet the payment obligation
• Operational risk – the risk of loss resulting from inadequate or failed
internal processes, people and systems or from external events
• Model Risk – the risk of using incorrect model or parameters, model gives
incorrect price
• Systemic risk – breakdown in market-wide liquidity, chain reaction defaults

(Quantitative) Risk Management – an organization example
• Balance sheet level – Asset & Liability risk management
• Lending risk management
• ….
• Trading risk management
 Enterprise level
 Desk level

Market Risk
• Market risk is the risk that the value of an investment will
decrease due to moves in market factors.
• Types of Market Risk
 Interest Rate Risk
 Currency Risk
 Commodity Risk
 Equity Risk
 Volatility Risk
 …
• Market Risk Management
 A sound and well informed strategy to manage market risk
 Determine the level of market risk the institution is prepared to assume
 A strategy that balances its business goals with its market risk appetite

Credit Risk
• Credit Risk: the risk that borrowers, bond issuers and counterparties may
default
• Types of Credit Risk

 Credit Spread risk
 Default risk
 Downgrade risk
• Key Credit Risk Factors

 Credit Ratings
 Default Probabilities
 Recovery Rates
 CDS Spread
 Bond Credit Spread

Operational Risk
• Operational Risk: the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events.
• Types of Operational Risk

 Internal and external Fraud
 Employment practices and workplace health and safety
 Clients, products, and business practices
 Physical assets damage and loss
 Business disruption and system failures
 Execution, delivery and process management
• Measurement and Allocation of Operational Risk

 Scorecard approach
 Statistical approach

Liquidity Risk
• Liquidity Risk: the risk that an asset can not be traded quickly enough or
shortage of cash to meet payment obligation
• Types of liquidity risk
 Liquidity trading risk
 Liquidity funding risk
• Main sources of liquidity for a financial institutions

 Sell liquid assets
 Liquidate positions in trading books
 Borrow money in the wholesale market
 Attract retail deposits
 Securitize assets
 Borrow from the central bank
• Liquidity Black Hole

 Equilibrium price vs Liquidity Black Hole
 Most serious liquidity risk which drives all traders on to the same side of the market and dries up liquidity

Models for Risk Measurement Ingredients
• A model of random changes in the prices of the underlying instruments
(equity indices, interest rates, foreign exchange rates, and so on)
• A model for computing the sensitivity of the prices of the derivatives to the
underlying prices.
• A model for the PDs, random changes in PDs, and losses at default.
• Estimating Market Risk Measures
 Simulate the change in market value of the portfolio for each of many independently
generated scenarios, over the give time horizon.
 Estimate the desired risk measurements. For example, the 99%-expected tail loss is the
average of the losses of those scenarios with the highest 1% of losses.

Risk Measurements
• Desired properties of measurements
 Is closely related to the key economic costs of market risks
 Can be estimated at a reasonable cost and within a reasonable accuracy.
 Can be easily communicated to users.
• Time Horizon for Risk Measurements

 The accuracy of the measurement declines with the time horizon.
 The time required for a replacement of capital, or extension of lines of credits, and the
reconstruction with proper risk appetite, is relevant.
• Question: Is an estimate of market risk over the next year helpful risk-management for a
derivative trading portfolio?
• Answer: No, because the estimation will be highly imprecise, and because capital can be
replaced at low cost in much less than one year (Most of Canadian Banks uses 1Day VaR).

How Risks are Managed
• Two main risk management strategies used by financial institutions
 Risk Decomposition
• Identify risks one by one and handle each one separately.
• Hedge risks to ensure exposures to individual market variables are within limits specified by the bank.
 Risk Aggregation
• Reduce risks by being well diversified.
• Calculating at the end of the day the total risk faced by the bank from movements in all market variables.
• An integrated firm wide risk management framework should include

 An integrated approach to enterprise risk management
 Aligning risk appetite and business strategy
 Board and senior management oversight
 Internal documentation such as organizational policies and procedures
 Risk measurement, monitoring and reporting systems and processes
 Internal controls, internal audits and compliance checkpoints
 Develop integrated risk infrastructure

How Do Traders Manage Their Exposures - Greeks
• Delta
 The rate of change of the portfolio value with respect to the changes in the underlying
market variable
• Gamma
 The rate of change of the portfolio’s delta with respect to the value of the underlying market
variable.
• Vega
 The rate of change of the value of the portfolio with respect to the volatility of the
underlying market variable.
• Theta
 The rate of change of the value of the portfolio with respect to the passage of time with all
else remaining the same.
• Rho / IR Delta
 The rate of change of a portfolio with respect to the level of interest rate.

How Do Traders Manage Their Exposures - Greeks
• Sticky Delta Rule
 For each strike K and expiry T the implied volatility of any option
is dependent on he level of its Δ and consequently on the movements
of the underlying asset (and on the elapsing of time.
• Sticky Strike Rule

 For each strike K and expiry T the implied volatility of any option
is independent of the movements of the underlying asset.
 Matrices with different implied volatility for different levels of strike show that the constant
volatility assumption of the Black-Scholes model is not realistic.
 The two rules can be considered just as two convention for quoting volatility surfaces and they
are respectively chosen according to their suitability to different markets.
• X (Vanna or DvegaDspot)
• W (Volga or DvegaDvol)
• Dynamic Hedge and Static Hedge?

Value at Risk (VaR)
• Value at Risk (VaR)
 Value at Risk is an attempt to provide a single number that summarizes the total risk in a
portfolio
 VaR: The loss that is exceeded with a given probability (Most Canadian Banks: 1%) over a
give time horizon (Most Canadian Banks: 1Day). This is the 99% 1-day VaR or there is 1%
chance of 1 day loss will be over VaR!
 Three major components: the amount of potential loss, the probability of that amount of
loss, and the time frame
• Limitation of VaR
 VaR does not capture the likelihood of losses in excess of VaR.
 Conventionally, VaR measures may not capture “low Probability” events like market crashes.
We need to use stress test and scenario analysis to capture these events.
 VaR, normally, does not capture the Intra-Day risks.
 VaR does not measure worst case loss

Value at Risk (VaR)
• Visualization of VaR
 The simple question: ”How bad can things get?”
 An attempt to provide a single number that summarizes the total risk in a portfolio.

Value at Risk (VaR) (Cont.)
• Validating VaR
 If the fraction of days on which actual losses exceed the 95%-VaR is not roughly 5%, something may be
wrong.
 Example: We have 500 days of daily P/Ls. Only 2.5% of these days had losses in excess of the 95% VaR
estimate for that day. Perhaps the VaR model is over-estimating risk!
• Two main approaches to calculating VaR for market risk

 Historical Simulation Approach
 Model-Building Approach
• VaR and Capital

 Capital Required for Market Risk is a multiple of the VaR calculated using a ten day time horizon and a
99% confidence level
 Capital Required for credit risk and operational risk as the VaR using a one year time horizon and a 99.9%
confidence level

Specific Risk
• Desk level risk measure: CS01
• Enterprise level risk measure: SR VaR (Canadian Banks use 10 Day VaR)
• Hedge: Trade “credit” sensitive instruments
• Question: What type of portfolios has Specific Risk?

Volatility as a Measurement of Market Risk
• The language of volatility is well understood in the financial industry, and
statistical measures of volatility are more reliable, and more readily
validated from historical experience, than is VaR.
• Some firms estimate VaR simply as a multiple of volatility
• Financial institutions monitor the volatilities of the market variables on
which the value of its portfolio depends.
• Volatilities are either estimated from historical data or implied from option
prices.
• The daily volatility of a market variable is defined as the standard deviation
of the percentage daily change in the market variable.

Scenario Analysis
• Scenario Analysis and Stress Test
 Risk fact based: Real world scenarios and hypothetic scenario
 Portfolio based: Special purpose portfolio analysis
 Legal agreement based: CSA type analysis
 ….

Back Test
• Back Test – Model Validation
 Methodology for VaR_1Day calculation (Canadian Banks): P&Ls for the Constant
portfolio are computed on a set of scenarios (500 Business-Days)
 Back Test: VaR(i) > P&L (i), i = 1, …, 250
 Count how many breaches to decide if the VaR model passes the validation

Not All Risks Are the Same
• Measure risk during “normal” times may be useful for strategic planning
(e.g., market risk VaR)
• Manage “company” specific risks by exposures to specific risk factors. (e.g.,
stress test and scenario analysis)

A Closer Look at Market Risk and Credit Risk
• Credit risk is one source of market risks.
• Some forms of credit risk are captured in traditional market risk systems,
e.g., Corp bonds are marketed at a spread that may be tracked by VaR.
• VaR rarely captures OTC derivative credit risk in current practice.
• Exposure limits are often used to control credit risks.
• Market risks over short horizons may be approximated through its “risk-
neutral” probability distribution, whereas measurement of OTC derivative
potential exposure requires models of the “actual” distribution.
• Market risk can be re-marked each day, and can offset over relatively short
time windows.
• Credit risk offsets are not as easily or cheaply arranged. The credit risk on a
given position frequently accumulates over counterparties and over long
time horizon such as the maturity of an interest rate swap.

Regulatory Capital and Economic Capital
• Regulatory Capital
 The minimum amount of capital a financial institution must hold as required by the regulator. The
purpose is to protect the financial institution, its customers and the economy by ensuring the financial
institution has enough capital to sustain operating losses while still honoring withdrawals.
 BASEL requires the total required capital is the capital for credit risk + market risk + operational risk.
 Tier 1 and Tier 2 Capital
 Regulatory Capital and Capital Adequacy Ratios
• Economic Capital
 Bank’s internal estimate of the capital it needs for the risks it is taking. Economic Capital gives the
financial institution the ability to allocate capital within itself, encourage risk management and risk based
business decision making
 Components of Economic Capital
• Market Risk Economic Capital
• Credit Risk Economic Capital
• Operational Risk Economic Capital
• Business Risk Economic Capital

Risk Capital and Its Allocations
• Risk Capitals and Capital Charges
• Remark: please see seminar deck “Counterparty Credit Risk Pricing,
Hedging and Risk Transferring”

Risk Reporting and Platform Development
• Risk Reporting and Report Designs
 Dynamically configurable reporting hierarch
 Drill-down feature to trade/security level
 Visualization
 Timely risk aggregation
• Integrated Risk Infrastructure Design

 Efficient: • Minimize redundant functionality in computing, storing and reporting risks
• Eliminate the need for reconciliation
 Flexible: • Allow for the easy and quick addition of new products, risk factors, organization changes,
and new scenarios
 Timely:
• EOD reporting before SOD, T+1
• Real time On Demand/what-if analysis
• Remark: Motivate a single production source, valuation and risk measure.

Integration of Market and Credit Risks
Financial Engineering/Analytics Framework
Client Migration
(ISDA & Gas EDI &
CSAs) Agreements
Current Market and Calibrated Model Market Risk Factor

Historical & Stress Parameters Historical Simulations MC &
Data & Implied Historical & Stress
Valuation Aggregations Reporting

Models
Current Client Data Calibrated Model Credit Risk Factor
and Historical & Parameters Historical Simulations MC &
Stress Client Data & Implied Historical & Stress
Contracts

Risk Management Future Topics
• Capital management
• Capital allocation
• Capital charge
• CVA and FVA
• Hedge Credit Risk
• Remark: please see seminar deck “Counterparty Credit Risk Pricing,
Hedging and Risk Transferring”

Risk Management Data Architecture
In Memory
Cache
Traders
Traders Risk Calculations Engine
· VaR
Execute Trades · Scenario Analysis
· Counterparty Credit Risk
Reference Centralized Data Warehouse
Data · Regulatory Capital
· Sensitivity · Regulatory Reporting
· Pricing
Real Time · Capital Adequacy Risk
ETL · P&L · …...
Risk Management
Management
· P&L Decomposition Professional
Professional
· CVA
Market FO
FO Trading
Trading
Data · ... Market Credit Liquidity
Systems
Systems Risk Risk Risk
Other Back Office ...

Data P&L
P&L Decomposition
Adjustment
Reports
Reports
...
Data Finance
Management
P&L Risk
Adjustment Finance Data Management
... Warehouse Data
Warehouse

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Risk Management 101

Toronto Trading Risk Management Practice

© COPYRIGHT 2012 SAPIENT CORPORATION | CONFIDENTIAL 3

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• Along with the processes we discussed so far, consider a stochastic

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• Types of Credit Risk

• Key Credit Risk Factors

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• Types of Operational Risk

• Measurement and Allocation of Operational Risk

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• Main sources of liquidity for a financial institutions

• Liquidity Black Hole

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• Time Horizon for Risk Measurements

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• An integrated firm wide risk management framework should include

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• Sticky Strike Rule

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• Two main approaches to calculating VaR for market risk

• VaR and Capital

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• Credit Risk Economic Capital

• Operational Risk Economic Capital

• Business Risk Economic Capital

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• Integrated Risk Infrastructure Design

• Remark: Motivate a single production source, valuation and risk measure.

© COPYRIGHT 2012 SAPIENT CORPORATION | CONFIDENTIAL 43

Financial Engineering/Analytics Framework

Current Market and Calibrated Model Market Risk Factor