Market Risk & Liquidity

Management

Jawwad Farid

alchemya.com
FinanceTrainingCourse.com
jawwad@alchemya.com
 Agenda
Introductions

Challenges

Market Risk

Questions

Wrap up
Jawwad Intro

• Fellow Society of Actuaries, Investments

• MBA, Columbia Business School

• 21 years consulting: US, UK, MENA, Africa,

Pakistan & Far East.

• Risk Management, Product Development,

Regulatory Reporting, Actuarial Practice
• Prefers - Jawwad - (Pronounced Javaad)
http://FinanceTrainingCourse.com
http://www.alchemya.com
jawwad@alchemya.com

3
Models at work
 Market Risk

Why is risk broken?

 A survey of opinions

The governance structure is broken.

Market Risk and Middle Office function is dysfunctional.

The separation between Risk and business is not

working.

The best risk managers come from business.

 More opinions on risk

Risk is a dead end job. Can’t attract the right talent.

Is volatility the right measure?

Risk is the stupid trade that should have never

happened.

Pre-Trade limit enforcement.

 From hot to dead end.
Risk is broken.
Risk is a dead end job.

2014
Risk is hot.
Risk models are
2007
hot. Pricing models rule.

1996-
2000
 Top Questions
What drives the
Why is risk distrust towards
broken? risk in board
rooms?

What can we do to
fix it?
 Why is risk broken?

Non Models vs. Reconciling

Integrative Applications Decoding Risk and
Risk vs. Volatility Financial
Management Interpretation systems.
• Gap between • Reporting lines
practice and • Backseat driving
theory • Talent
• Validation of management
models

Real World
Governance
Models

Single Tracking
Source Data Volatility

• Reconciling data • Unstable

with financial correlations
source systems. • Cyclical volatility
• Credibility issues
 Capital & Distribution
Then
Distribution of Portfolio Value
Critical Expected
Barrier Value
Em ergency Norm al
Managem ent Operating
Conditions Conditions
Frequency

Econom ic
Capital

50 70 90 110 130 150

Now Portfolio Value
 Capital & Distribution
Regulator,
Shareholders

Depositors,
Counterparties, Distribution of Portfolio Value
Critical Expected
Barrier Value
Em ergency Norm al
Managem ent Operating

Rating Agencies
Conditions Conditions

Frequency
Econom ic
Capital

50 70 90 110 130 150

Portfolio Value
Real world models

Why is risk broken?

Thought experiment - One

Correlations
Distribution & Correlations
Correlations
The right blend - correlations
 Crude Oil Blends - Prices
120

105

90

75

Brent Abu Dhabi- Murban Dubai- Fateh Iran-Heavy Saudi Arabia- Light
 Correlation Abu Dhabi- Murban with Brent
1.00

0.60

0.20

(0.20)

(0.60)

(1.00)

Abu Dhabi- Murban with Brent

 Correlation - Saudi Arabia- Light with Brent
1.00

0.60

0.20

(0.20)

(0.60)

(1.00)
Thought experiments- Two

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24
 Interest Rates - Volatility
12%

8%

4%

0%
15/03/2008 08/07/2008 31/10/2008 23/02/2009 18/06/2009
7 Days 14 Days 1 Month 3 Months
 FX Rates - most
AUD-JPY Sterling-JPY USD-AUD EUR-JPY

3.6%

2.8%

2.0%

1.2%

0.4%
13/03/08 09/06/08 05/09/08 02/12/08 28/02/09 27/05/09
 FX Rates - least
USD-JPY USD-EUR Sterling-EUR EUR-CHF

1.4%

1.2%

1.0%

0.8%

0.6%

0.4%

0.2%
13/03/08 09/06/08 05/09/08 02/12/08 28/02/09 27/05/09
 FX Rates Volatility – Emerging
Markets
2.4%

1.6%

0.8%

0.0%
19/03/2003 29/03/2004 09/04/2005 20/04/2006 01/05/2007 11/05/2008 22/05/2009

Euro Sterling Japanese Yen US Dollar

Canadian Dollar Swiss Frank Australian Dollar
 Tracking volatility

Trailing volatility & correlations

 Trailing Vol - Trends
0.1

0.1

0.1

0.1

0.1

0.0

0.0

0.0

0.0

-
5-Jan-04 5-Jan-05 5-Jan-06 5-Jan-07 5-Jan-08 5-Jan-09 5-Jan-10 5-Jan-11 5-Jan-12

WTI_Volatility EUR_Volatility Gold_Volatility Silver_Volatility

Volatility - Distribution
Governance Structure
 The Framework

Marginal
Exposure Trend Capital
Impact
 Connections

Price Risk Value

Products Limits
Price
Volatility
Models
Relative Value
 Relative Value - II

40
Transaction & Exposure Limits
Within a Trade • Max Ticket size

Within a security • Max Product limit

Within an operating cycle • Max Daily limits

Within a tenor or maturity

• Max Tenor Exposure
bucket
Within a risk classification
• Max Ticket Size
or grade
 Sensitivity Limits
• Change in USD Equivalent Exposure
To Exchange Rates • Change in Position value per PiP

To Interest Rates • Duration, PVBP, Gaps, Interest Rate Mismatch

To Volatility • Vega, Change in value, Change in projected P&L, Gamma

• Change in projected earning, Net Interest Income or Earnings

Earnings at Risk

Shareholder Value • Change in Income, Market Value of Equity or NPV

Equity or Capital • Maximum Loss, Impact of ALM choices on Capital

Limit Management

Sensitivity Limit
limits Management

Exposure Counterparty
Limits Limits

Transaction
Limits
 Governance

Reporting
Business Risk
Lines

Looking up,
Conflicts
at or down?
Products & Payoffs
Limits
Reconciliation

Single Source of data

 Volatility

Approaching volatility
Monthly Crude Oil Change
 Crude oil price changes - daily
250 120.00%

100.00%
200

80.00%
150
60.00%
100
40.00%

50
20.00%

0 0.00%

Frequency Cumulative %
Volatility - Distribution
Gold
Oil
Silver
EUR-USD
More Thought experiments

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Model price vs. Market price vs.
liquidity

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Swap Points - A
Swap Points - B
Swap Points - C
Swap Points - D
Swap Points - E
 Four relationships
(1  rlocal) /(1  r $) E(1  ilocal) / E(1  i$)

Interest Rate Expected Inflation

Differential Rate Differential

( forwardlocal / $) /(Spotlocal / $)

Forward &
 E(Spotlocal / $) /(Spotlocal / $)

Expected change in
Spot spot rates
Differential
Thought Experiement
Is Gold safe now?
Is Gold safe now?
Bubble and after
 What is Risk?

A framework for risk management

 Four Questions

Marginal Capital /
Exposure Trend
Impact Appetite
 Exposure
2,000
1,500
1,000
500
0

Lease Finance Long Term Short Term Finance Medium Term

 Trend

300
250
200
150
100
50
0
1 2 3 4 5 6 7 8 9 10 11 12
February March April May June
 Exposure, Risk, Target Accounts

Exposures Risk Target Accounts

• Gross • Probability • Sit

Numbers that we may somewhere
• Book Size lose in the middle
• Driven by something at the
Internal • Driven by intersection
choices external of exposure
factors and risk
 What is exposure?

Volatile

Financial
Uncertain
Impact

Exposure
 What is a Target Account?

Measurable/ Sensitive/ Explainable/

Reportable Relevant Understandable
 Exposure, Risk, Target Accounts

Exposures Risk Target Accounts

• Gross • Probability • Sit

Numbers that we may somewhere
• Book Size lose in the middle
• Driven by something at the
Internal • Driven by intersection
choices external of exposure
factors and risk
Target Accounts & Impact

P&L

Risk &
Capital

Benchmark
Governance revisited

Governance challenges
 Who is the regulator?

• Central Bank, Securities regulator

Local • FMA & ACI Code of conduct

• OCC, Federal Reserve, FSA

International • North American and EU regulations

• Broadest definition.
Morality • How do you teach morality to smart people?
 The Gambit – Rational thinking

Expected Payoff > Penalty

Expected Payoff < Penalty

 In an imperfect world?
• Impact
Social Costs • Group behavior

• Recognition
Personal Costs • The desire to get caught

The cost of • Direct

being caught • In Direct

Regulatory • Paradigm shift

compensation • Make an example – The bite & teeth
 Cases & Messages

Misrepresentation • The slide in security prices

Collusion
• FSA Libor Crisis, FX
Exchange rate crisis

Client • Front Running, Insider

Confidentiality Trading, Gouging
 Consequence
Bank wide • Fines, penalties
• Loss of license
impact • Civil Suit, Class Action Suit

• Suspension & Termination

Management • Negative lists
• Future prospects

• Suspension & Termination

Dealers • Negative lists
Q&A
 Alchemy Intro
• Actuarial & Risk Advisory firm

• 11 years, 4 Markets

• Banking and Insurance Risk, Capital Adequacy Focus

• Derivative & Risk Management models, Treasury Management

• ALM, ICAAP, Stress Testing, Financial Product Development

• More than 3,000 trained participants across 150 workshops

FinanceTrainingCourse.com
Jawwad Ahmed Farid

alchemya.com
FinanceTrainingCourse.com
jawwad@alchemya.com