Risk Management: Introduction

Rangarajan K. Sundaram
Stern School of Business
New York University

TRIUM Global EMBA Program

New York: January 16-20, 2015

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An Overview

This is one of two segments in the module on risk management.

Deals mainly with the instruments for managing market risk and credit
risk, in particular, on
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The uses of these instruments.

The risks in these instruments.
The valuation of these instruments.

Professor Ed Altmans sessions focussing on credit risk complement this

material.

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Introduction

What is Risk?
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Potential that outcomes of an action may differ from those expected

or anticipated.

Ever-present in all economic activity.

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In normal market conditions.

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Changes in input prices, exchange rates, interest rates, etc.

Unexpected market dislocations:

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Financial bubbles, natural disasters, terrorist attacks, political events,

...

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The Management of Risk

From an organizational standpoint, the management of risk requires:

1. Identifying the sources of risks.
2. Where possible, measuring/quantifying these risks.
3. Managing the risks.
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Eliminating unnecessary risks.

Transferring risk to markets.
Managing the retained risk.

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The Sources of Risk

Market risk.
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Difficulty in getting in and out of positions.

Operational risk.
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Risk that promised payments fail to materialize.

Liquidity risk.
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Changes in prices in normal market times.

Credit risk.

Lack of proper controls to detect fraudulent activity.

Others:
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Political, terrorist, catastrophe, reputational, . . .

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Our Focus . . .

. . . is on instruments for managing market and credit risk.

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The effects of market risk can be exacerbated by the presence of

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As noted, Professor Altmans sessions develop the theme of credit

risk further.

Illiquidity.
Poor operational controls.

The case studies we examine will look at the interplay of these factors.

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2. Measuring Risks
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Involves specifying a probability distribution over outcomes:

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Set of possible outcomes.

Likelihoods of these outcomes.

What probability distribution should one use?

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Potential trade-off between using

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distributions that are easy to work with, and

those that fit the data better and/or are more appropriate for the
task at hand.

Common distribution in financial modeling: the Normal or Gaussian.

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Well understood and easy to work with . . .

. . . but, as we discuss below, some important shortcomings from a
risk-management standpoint.

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3. Managing the Risks

Involves:
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Eliminating unnecessary risks.

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Transferring risk to markets.

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For example, have minimum creditworthiness standards for advancing

credit.

Derivatives contracts: Futures/forwards, options, swaps, . . .

Hedging versus insurance.

Managing the retained risk.

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Capital to be held against retained risk.

Extent of liquid reserves.

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Potential Problems

Risk-management failures usually because either:

1. Risks are not properly identified.
or
2. Identified risks are inadequately measured.
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Usually mis-specified and/or excessively optimistic models.

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Risk-Management Failures: Famous Examples

Barings, Sumitomo, Societe Generale.

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Metallgesellschaft, Aracruz Cellulose.

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Risk of sharp market moves underestimated.

Amaranth.
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Unidentified operational risk: Rogue trading.

Market and liquidity risks underestimated.

Could not exit positions.

LTCM, AIG, Fannie Mae, Freddie Mac

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Systemic/correlation risk not captured.

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Comment 1: Unmodeled Features

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Models can only reflect what is put into them.

This can create illusory comfort levels with strategies.

Metallgesellschaft in 1995:
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Hedged long-term forward sales with short-term futures.

Cash flow consequences of sharp oil-price drop ignored.
Bankruptcy resulted.

AIG in 2008:
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Built sophisticated models to capture default risk.

Ignored collateral requirements from possible
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Market deterioration short of default.

AIGs own credit-rating deterioration.

Bankruptcy resulted.

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Comment 2: Unmodelable Features

Operational risk:
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Of course, not just a trading/financial markets issue:

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Nick Leeson and Barings: > $1 billion in losses.

Yasuo Hamanaka and Sumitomo: > $2.5 billion losses.
Jerome Kerviel and Soc Gen: e5 billion losses.
Kweku Adoboli and UBS: $2 billion losses

Enron.

Incentives matter! Where does Harvard Universitys $1 billion+ in

swap-related losses in 2009 fit in?

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Comment 3: The Normal Distribution

Key issue: Choosing a distribution that best represents the uncertainty

concerning future prices.

What is meant by best?

The most common starting point: Normal (a.k.a. Gaussian).

Instructive to understand the pros and cons of this choice.

Defined by two parameters:

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The mean : centers the distribution.

The standard deviation : measures dispersion around .

Distribution has the familiar bell-shape (hence bell curve).

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The Normal Distribution

Probability of observa7on < x

Xc
x

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The Normal Distribution

The Mean: Centering the Distribution

MEAN = 0
STD DEV = 1

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MEAN = 2
STD DEV = 1

-2

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The Normal Distribution

The Standard Deviation: Dispersion Around the Mean

MEAN = 0
STD DEV = 1.0

MEAN = 0
STD DEV = 1.50

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The Normal Distribution: Properties

Distribution is symmetric around the mean.

Likelihood of an observation depends solely on its distance from the mean

(measured in standard deviations):
Distance from mean

1 standard deviation
1.96 standard deviations
2.58 standard deviation
3 standard deviation

% of all observations
68%
95%
99%
99.73%

Thus, for example, if observations are normally distributed only around 1

in 370 observations should be more than three standard deviations from
the mean.

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The Normal Distribution: Properties

One Standard Deviation from the Mean

16%

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16%

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m

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The Normal Distribution: Properties

1.96 Standard Deviations from the Mean

2.5%

2.5%

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m --2 1.96s

0
m

-1

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m + 12 .96 s

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Are Financial Markets Normal ?

Normal distributions have found widespread applications in the physical

and natural sciences.

How well do they fit financial market data?

The main problem: In virtually every financial market, they underestimate

significantly the likelihood of extreme or tail observations.

Example Observations more than 3 standard deviations from the mean

should occur only about 0.27% of the time (roughly once every 370
observations).
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In practice, they occur far more frequently (see the next several
slides).

Normality is of limited use in estimating tail risk.

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S&P 500 Returns: 1950-2015

No of Observations: 16,360
Actual No. Beyond
Theoretical No. Beyond
Actual/Theoretical

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Period: 3-Jan-1950 to 8-Jan-2015

3 Std Dev
4 Std Dev
5 Std Dev
6 Std Dev
225

93 44 26
44.2

1.04

0.009

0.00003
5.09

89.74

4,691.2 805,424

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S&P 500 Returns: 1950-2015

No of Observations: 16,360
Actual No. Beyond
Theoretical No. Beyond
Actual/Theoretical

Period: 3-Jan-1950 to 8-Jan-2015

3 Std Dev
4 Std Dev
5 Std Dev
6 Std Dev
225

93 44 26
44.2

1.04

0.009

0.00003
5.09

89.74

4,691.2 805,424

No of Observations: 16,360
Actual Freq (Days)
Theoretical Freq (Days)
Theoretical/Actual

Period: 3-Jan-1950 to 8-Jan-2015

3 Std Dev
4 Std Dev
5 Std Dev
6 Std Dev
73 176

372

629

370.4

15,787.2

1,744,278

506,797,317
5.09

89.74

4,691.2 805,424

I Thus, for example, observations 4 standard deviations from the mean occurred

roughly once every seven months, 89.7 times more frequently than predicted by
normality of once every 62.6 years.

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6,081
No. of Observations: 14,463

Period: 33-Jan-1950
-Jan-1950 to
to 330-Jun-2007
-Dec-2013
Period:
3 Std Devs
4 Std Devs
5 Std Devs
6 Std Devs
223 41
90
43
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129

19

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43.4 0.92
1.02 0.008
0.009 0.00003
39.0
5.14 44.8
88.3 2,291
4,664 350,410
819,397
3.30

S&P 500
Returns: 1950-2007
Actual No. Beyond
Theoretical No. Beyond
Actual/Theoretical

4,463
Period:
No. of Observations: 16,081
Period: 33-Jan-1950
-Jan-1950 tto o 330-Jun-2007
-Dec-2013
Frequency (Days)
3 Std Devs
4 Std Devs
5 Std Devs
6 Std Devs
o. Beyond(days)
129 178.68


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Actual fNrequency
72.11
41
373.98
19
618.50
o. Beyond(days) 370.4
39.0 15,787.19
0.92 1,744,278
0.008 506,797,332
0.00003
Theoretical fNrequency
Actual/Theoretical
3.30 88.4
44.8 4,664
2,291 819,397
350,410
Theoretical/Actual
5.14

6,081
No. of Observations: 14,463
Period: 3-Jan-1950 to 3-Dec-2013
Frequency (Days)
3 Std Devs
4 Std Devs
5 Std Devs
6 Std Devs
618.50
Actual frequency (days)
112.12
72.11 352.76
178.68 761.21
373.98 1,446.30
Theoretical frequency (days) 370.4 15,787.19 1,744,278 506,797,332
5.14 44.8
88.4 2,291
4,664 350,410
819,397
Theoretical/Actual
3.30

No. of before
Observations:
4,463
Period: deviations
3-Jan-1950 tfrom
o 3-Dec-2013
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2007, 1changes
of more than 4 standard
the mean
Frequency
(Days) more likely in
3 Sreality
td Devs than
4 Spredicted
td Devs
5 Std
Devs
6 Std Devs
were
45 times
by
normality.
Actual frequency (days)
112.12

352.76

761.21

1,446.30
Theoretical frequency (days) 370.4 15,787.19 1,744,278 506,797,332
Theoretical/Actual
3.30 44.8 2,291 350,410

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USD-EUR Exchange Rates: 2004-2011

No of observations: 2085
Actual Number Beyond
Theo Number Beyond
Actual/Theoretical
No of observations: 1042
Actual Number Beyond
Theo Number Beyond
Actual/Theoretical
No of observations: 1043
Actual Number Beyond
Theo Number Beyond
Actual/Theoretical

Period: 1-Jan-2004 to 31-Dec-2011

3 Std Dev 4 Std Dev
5 Std Dev
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4
1
5.6
0.13
0.0012
4.3
30.3
836.6
Period: 1-Jan-2004 to 31-Dec-2007
3 Std Dev 4 Std Dev
5 Std Dev
1
0
0
2.8
0.07
0.0006
0.36
0
0
Period: 1-Jan-2008 to 31-Dec-2011
3 Std Dev 4 Std Dev
5 Std Dev
23
4
1
2.8
0.07
0.0006
8.17
60.5
1672.4

I Changes of > 4 standard deviations from the mean are 30 times more likely than

predicted by normality.
I But . . .

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Crude Oil Changes: WTI

WTI crude: 2005-2015

No of observations: 2,518
3 Std Dev
43
6.80
6.32

Actual No. Outside

Theoretical No. Outside
Actual/Theoretical

Period: Jan 3, 2005 to Jan 5, 2015

4 Std Dev
5 Std Dev
22
7
0.16
0.001
137.5
4,861

WTI crude: 2012-15

No of observations: 757
3 Std Dev
11
2.04
5.39

Actual No. Outside

Theoretical No. Outside
Actual/Theoretical

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Period: Jan 3, 2012 to Jan 5, 2015

4 Std Dev
5 Std Dev
2
2
0.05
0.0004
41.7
4,608

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Others

Copper: 2008-13
No of Observations: 1515
Actual Number Beyond
Theo Number Beyond
Actual/Theoretical

Period: 1-Jan-2008 to 31-Dec-2013

3 Std Dev 4 Std Dev 5 Std Dev
17
4
1
4.09
0.1
0.0009
4.2
41.7
1151.3

Brent crude: 2006-2012

No of Observations: 756

Period: 1-Jan-2011 to 31-Dec-2013

No of Observations: 1798 3 SPeriod:

o 18-Dec-2012
td Dev1-Jan-2006
4 Std Dtev
5 Std Dev
3 Std Dev3 4 Std Dev 05 Std Dev
Actual Number Beyond
0
Actual no beyond
17
7
1
Theo
Number Beyond
2.04
0.1
0.0004
Theoretical no beyond
4.9
0.114
0.001
Actual/Theoretical
1.5
0.0 970.1 0.0
Actual/Theoretical
3.5
61.5

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Non-Normality

The non-normality of equity returns has been documented at least since

1965.

Non-normality is also reflected in implied volatilities obtained from option

prices.

Normality is mainly useful as a benchmark; other distributions may

capture tail-risk better:
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Students t.
Jump-diffusions.
Cornish-Fisher.
Others.

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Comment 4: Historical Behavior

500.00
450.00

Tech: CSCO + INTC + MSFT

Fin: C + JPM + MS

400.00
350.00
Tech Stocks
Fin Stocks

300.00
250.00
200.00
150.00
100.00
50.00
-
1/2/98

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1/3/04

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1/3/07

1/3/10

1/3/13

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The Material to Follow

Derivatives and their role in risk-management:

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Futures & Forwards.

Options.
Swaps.
Credit derivatives.

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Si tacuisses, philosophus mansisses

or: Beware of geeks bearing formulae. (Warren Buffet, 2009)

Alan Greenspan, Federal Reserve Chairman, in 2004:

Not only have individual financial institutions become less
vulnerable to shocks from underlying risk factors, but also the
financial system as a whole has become more resilient.

Joseph Cassano of AIG Financial Products in August 2007:

It is hard for us, without being flippant, to even see a scenario
within any kind of realm of reason that would see us losing $1
in any of those transactions,

Robert Lucas, Nobel Laureate in Economics, in 2003:

The central problem of depression-prevention has been solved.

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