Derivatives and Risk Management

Bus Fin 829 Ren M. Stulz

stulz@cob.ohio-state.edu

292-1970 Office hours: Monday and Wednesday, 3:30 to 5 p.m., or by appointment. Registered students have access to handouts with the use of the class password.
This course is designed to train the participants in evaluating and managing risks using an enterprise-wide approach. The course starts with an analysis of how risk management contributes to firm value. A general framework for how to use risk management to create value is presented next. After making sure that the participants know how to measure risk, in particular how to compute value-at-risk (VaR) and cash-flow-at-risk (CaR), the course focuses on using derivatives to change a firms risks. The course shows how forwards and futures, equity, interest rate, exchange rate and commodity options, plain vanilla and exotic swaps, and exotic options can be used to manage financial risks and how the risks of these derivatives can be evaluated. After a discussion of credit risks and operational risks, the course turns to the implementation issues of enterprise-wide risk management, showing how to aggregate risks across the firm and how to use a firm-wide risk measure to make various corporate decisions and to evaluate performance within the firm. The emphasis of the course is on creating value with risk management rather than on the technical details of pricing derivatives. Risk management problems for financial intermediaries as well as for firms outside the financial sector are examined. Students will learn how to manage financial risks through lectures, exercises, cases, and guest lectures from practitioners. Course materials: Derivatives and risk management, by Ren M. Stulz, Southwestern, 2003; selected articles; cases; lecture slides. The cases are: The Enron Collapse, Orange County, Foreign Exchange Hedging Strategies at General Motors, and Integrated Risk Management. Cases are in the course packet except for Orange County and Integrated Risk Management. Orange County is available at http://www.gsm.uci.edu/~jorion/oc/case.html. Integrated Risk Management will be distributed in class. In addition to the case assignments, there will be an assignment that will be described in the first class. The Powerpoint slides for the lectures will be available on the course website prior to each class. The articles and book chapters marked with an asterisk are required readings; marked articles can be found in the course package. The other articles are given for reference purposes only. I will reference some of their results in class. They can be ignored unless you have a specific interest in a topic or when you need them later in your professional life. Course requirements: Students will be responsible for five assignments and a final examination. The assignments can be prepared in groups of no more than five students. The final examination and the assignments will count each for 125 points; class participation will count for 50 points.

1. Course introduction and overview.

*Risk Management and Derivatives, Chapter 1.

*Stulz, Ren, 1996, Rethinking Risk Management, Journal of Applied Corporate Finance, Vol. 9, No. 3 (Fall), pp. 824. *Stulz, Ren, Why risk management is not rocket science, Financial Times, Mastering Risk Series, June 27, 2000. *Cumming, Christine, and Beverly Hirtle, 2001, "The Challenges of Risk Management in Diversified Financial Companies," FRBNY Economic Policy Review (March), pp. 117. *Lam, James, Enterprise-wide risk management and the role of the chief management officer,

http://www.erisk.com/Learning/Research/011_lamriskoff.pdf 2. Integrated risk management and value creation. 2.1. What does value creation mean? - Measuring value creation: EVA and other approaches. 2.2. How can integrated risk management create value? - Reducing bankruptcy and distress costs. - Funding disruptions. - Taxes. - Stakeholder costs. - Managerial compensation and incentives. - Large shareholders. - Planning and renegotiation costs. 2.3. Mapping the risks corporations face. - Market risks. - Credit risks. - Operational risks. - Political and regulatory risks. 2.4. Is there an optimal risk level? - Marginal cost of bearing risk. - Determinant of this cost across firms. - Marginal cost of reducing risk with: - Derivatives. - Operations. - Investment policy. - Diversification. - Insurance. - Convergence products (contingent capital). - The optimal amount of risk for a corporation. 2.5. The ABC of integrated risk management: - Risk monitoring versus managing risk. - Strategic decisions. - Tactical decisions. - The role of risk measures. 2.6. How do we know that integrated risk management creates value?

- Empirical evidence. *Risk Management and Derivatives, Chapter 3.

*Tom Aabo, John R. S. Fraser, and Betty J. Simkins, Oklahoma State University, The rise and transformation of the chief risk officer: A success story on enterprise risk management, Journal of Applied Corporate Finance, Summer 2005. Froot, Kenneth A., David S. Scharfstein, and Jeremy C. Stein, 1993, Risk Management: Coordinating Corporate Investment and Financing Policies, Journal of Finance, Vol. 48 (December), pp. 162958. Carter, David, Daniel A. Rogers, and Betty J. Simkins, 2002, Does fuel hedging make economic sense? The case of the US airline industry, unpublished. Gibson, Michael S., 1998, The Implications of Risk Management Information Systems for the Organization of Financial Firms, International Finance Discussion Papers No. 632 (Washington: Board of Governors of the Federal Reserve System). Allayannis, George, and James P. Weston, The Use of Foreign Currency Derivatives and Firm Market Value, The Review of Financial Studies, Spring 2001, 243-276. Allayannis, G., U. Lel, and D.P. Miller, 2003, Corporate governance and the hedging premium around the world, unpublished working paper. Jin, Yanbo, and Philippe Jorion, 2005, Firm value and hedging: Evidence from U.S. oil and gas producers, Journal of Finance, forthcoming. Bartram, Soehnke, Gregory W. Brown, and Frank Fehle, 2004, International evidence on financial derivative usage, working paper, University of North Carolina, Chapel Hill, N.C. Geczy, Christopher, Bernadette Minton, and Catherine Schrand, Why Firms Use Currency Derivatives, Journal of Finance, September 1997, 1323-1348. Graham, John R. and Clifford W. Smith, Jr., 1999, "Tax Incentives To Hedge," Journal of Finance 54, 2241-2262. Leland, H., 1998, Agency costs, risk management, and capital structure, Journal of Finance 53, 1213-1243. Smith, Clifford W. and Ren M. Stulz. "The Determinants Of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, 1985, v20(4), 391-406. Schrand, Catherine and Haluk Unal. "Hedging And Coordinated Risk Management: Evidence From Thrift Conversions," Journal of Finance, 1998, v53(3,Jun), 979-1013. Tufano, Peter, Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry, Journal of Finance, September 1996, 1097-1125.

Diamond, Douglas W. and Robert E. Verrecchia. "Optimal Managerial Contracts And Equilibrium Security Prices," Journal of Finance, 1982, v37(2), 275-287. Diamond, Douglas W. "Financial Intermediation And Delegated Monitoring," Review of Economic Studies, 1984, v51(166), 393-414. DeMarzo, P., and D. Duffie, 1995, Corporate incentives for hedging and hedge accounting, Review of Financial Studies 8, 743-771. Chernenko, Sergey, Michael Faulkender, and Todd Milbourn, 2005, Why are firms using interest rate swaps to time the yield curve?, unpublished working paper. Charles Smithson and Betty Simkins, 2005, Does risk management add value? A survey of the evidence, Journal of Applied Corporate Finance, Summer 2005, 8-17.

3. Measuring risk. 3.1. Value-at-risk - Definition. - Riskmetrics approach. - Derivatives and VaR. - Delta VaR. - VaR and the collapse of Barings. - Full valuation Monte Carlo approach. - Full valuation historical approach. - Risk management at Chase Manhattan. - VaR and fat tails. - Empirical evidence on VaR. - VaR versus other risk measures for institutional investors. - Risk management at Goldman Sachs. - VaR and regulatory capital. - VaR in practice.
*Risk Management and Derivatives, Chapters 4 and 13. Andersen, Torben, Tim Bollerslev, Francis X. Diebold, and Peter Christoffersen, 2004, Practical volatility and correlation modeling for financial market risk management, in Mark Carey and Ren M. Stulz, The risks of financial firms, forthcoming. Artzner, Philippe, Freddy Delbaen, Jean-Marc Eber, and David Heath, 1999, Coherent measures of risk, Mathematical Finance 9, 208-223. Danielsson, Jon, and Casper de Vries, 1997, "Value-at-Risk and Extreme Returns," Discussion Paper No. 273, pp. 133 (London: School of Economics and Political Science). Ju, Xiongwei, and Neil Pearson, 1998, Using value-at-risk to control risk taking: how wrong can you be?, The Journal of Risk 1, 5-36.

Francois M. Longin, From value at risk to stress testing: The extreme value approach, Journal of Banking and Finance 24, 1097-1130. Duffie, Darrell, and Jun Pan, 1997, An overview of value at risk, The Journal of Derivatives, Vol. 4, No. 3 (Spring) pp. 749. *Litterman, Robert, 1996, Hot SpotTM and Hedges, Journal of Portfolio Management, Special Issues, 5275. Committee on the Global Financial System, Basel, 2001, A Survey of Stress Tests and Current Practice at Major Financial Institutions, (Switzerland: Bank for International Settlements). Hull, John, and Alan White, 1998, Value at Risk When Daily Changes in Market Variables are Not Normally Distributed, The Journal of Derivatives, Vol 5, No 3 (Spring) pp. 919. *Berkowitz, Jeremy and James OBrien, How Accurate are Value-at-Risk Models at Commercial Banks?, Journal of Finance 57, No 3, 10931111. Jorion, Philippe, Risk Management Lessons From Long-Term Capital Management, European financial Management, Vol.6, No.3, 2000, 277-300. J. R. Aragones, C. Blanco, and K. Dowd, 2001, Incorporating Stress Tests into Market Risk Modeling, Derivatives Quarterly, Spring, 44-49. Kiesel, Rudiger, William Perraudin, and Alex Taylor, 2000, An extremes analysis of VaRs for emerging market benchmark bonds, working paper, Birkbeck College, London, England. Bams, Dennis, Thorsten Lehnert, and Christian C. Wolff, 2003, An evaluation framework for Alternative VaR models, working paper, Masstricht University. Anil Bangia, Francis X. Diebold, Til Schurmann, and John Stroughair, 1999, Modeling liquidity risk, with implications for traditional market risk measurement and management, Financial Institutions Center, The Wharton School, University of Pennsylvania. Embrechts, Paul, 2000, Extreme value theory: Potential and limitations as an integrated risk management tool, working paper, ETH Zurich. Koedijk, Kees, Ronald Huisman, and Rachel Pownall, 1998, VaR-x: fat tails in financial risk management, The Journal of Risk 1, 47-63. Grammig, Joachim and Pierre Giot, 2002, "How Large is Liquidity Risk in an Automated Auction Market?" Discussion paper 2002-23, University of St. Gallen, Swiss Institute of Banking and Finance. Brown, K., Fiedler, R., and J. Moloney, 2001, Liquidity in a dry climate, eRisk. Roy, Sunando, 2005, Liquidity adjustment in value at risk(VAR) model: Evidence from Indian debt market, unpublished working paper, Indian Central Bank.

4. Measuring and hedging exposures. 4.1. Cash flow at risk (CaR). - Definition of CaR. - Forecasting cash flow using the exposures approach. - CorporateMetrics. - An alternative to CorporateMetrics. 4.2. The pro forma approach. 4.3. The regression approach. 4.4. The simulation approach. 4.5. Delta exposures. 4.6. Using futures and forwards. - Problems with futures. 4.7. Using options. - A general approach to hedging with options. 4.8. Using exotics. *Risk Management and Derivatives, Chapters 5-10. A guide to using these chapters will be given in class.
*Stein, Jeremy, Stephen Usher, Daniel LaGattuta, and Jeff Youngen, 2001, A Comparables Approach to Measuring Cashflow-at-Risk for Non-financial Times, Journal of Applied Corporate Finance, Winter, 100-109. Ahn, Dong-Hyun, Jacob Boudoukh, Matthew Richardson and Robert F. Whitelaw. "Optimal Risk Management Using Options," Journal of Finance, 1999, v54(1,Feb), 359-375. Brown, Gregory W. "Managing Foreign Exchange Risk With Derivatives," Journal of Financial Economics, 2001, v60(2-3,May), 401-448. Brown, Gregory W., and K. B. Toft, 2002, How should firms hedge?, Review of Financial Studies 15, 1283-1324. Culp, Christopher, and Merton Miller, 1995, Metallgesellschaft and the economics of synthetic storage, Journal of Applied Corporate Finance 6, 33-41. Edwards, Franklin R. and Michael S. Canter. "The Collapse Of Metallgesellschaft: Unhedgeable Risks, Poor Hedging Strategy, Or Just Bad Luck?," Journal of Futures Markets, 1995, v15(3), 211-264. Mello, A., and J.E. Parsons, 1995, Maturity structure of a hedge matters: lessons from the Metallgesellschaft debacle, Journal of Applied Corporate Finance 8, 106-120. Petersen, M.A., and S.R. Thiagarajan, 2000, Risk measurement and hedging: with and without derivatives, Financial Management 29, 5-30. Schwartz, E., 1997, The stochastic behavior of commodity prices: implications for valuation and hedging, Journal of Finance 52, 923-973.

5. Risk management, credit, and interest rate risks. 5.1. Measuring interest rate risks. - Duration and convexity. - Duration VaR. - Using interest rate models. 5.2. Hedging interest rate risks. - Using swaps. - Using caps and floors. 5.3. Measuring credit risks. - Mertons model. - KMV, CreditMetrics and CreditRisk+. 5.4. Hedging with credit derivatives. 5.5. Integrating market and credit risk management. Risk Management and Derivatives, Chapters 9 and 18.
Duffie, Darrell, and Kenneth Singleton, 1999, Modeling term structures of defaultable bonds, Review of Financial Studies 12, 687-720. Breeden, Douglas T. "Complexities Of Hedging Mortgages," Journal of Fixed Income, 1994, v4(3), 6-41. Erturk, Erkan, 2000, "Default Correlation Among Investment-Grade Borrowers," The Journal of Fixed Income, Vol. 9, No. 4 (March), pp. 5559. *Jackson, Patricia, and William Perraudin, 1999, The nature of credit risk, Financial Stability Review (November), 128-140. Kiesel, Rudiger, William Perraudin, and Alex Taylor, 2001, "The Structure of Credit Risk, Working Paper No. 131 (London: Bank of England). Nickell, P., William Perraudin, S. Varotta, 1998, Ratings- Versus Equity-Based Credit Risk Models: An Empirical Investigation, unpublished Bank of England mimeo., London, England. Gersbach, Hans, and Alexander Lipponer, 1999, Default correlations, macroeconomic risk and credit portfolio management, working paper, University of Heidelberg. Kupiec, Paul, 2001, Why Basel must brush-up on credit, Risk, June, 74-77. Altman, Edward, Andrea Resit, and Andrea Sironi, 2002, The link between default and recovery rates: effects on the pro-cyclicality of regulatory capital ratios, BIS working paper No 113, BIS. Carey, Mark, and Mark Hricay, 2001, Parameterizing credit risk models with rating data, Journal of Banking and Finance 25, 197-270. Bangia, Anil, Francis X. Diebold, Andre Kronimus, Christian Schagen, and Til Schuermann, 2002, Ratings migration and the business cycle, with application to credit portfolio stress testing, Journal of Banking and Finance 26, 445-474.

Duffie, Darrell, Lasse Pedersen and Kenneth Singleton, 2003, Modeling Sovereign Yield Spreads: A Case Study of Russian Debt,'' Journal of Finance Vol. 58, pp. 119-160. Eduardo Canaberro and Darrell Duffie, Credit risk for OTC derivatives portfolios: Exposure and valuation, in ALM of Financial Institutions, edited by Leo Tilman, Institutional Investor Books, 2004.

6. Operational risk. 6.1. Definitions. 6.2. The top-down approach. 6.3. The bottom-up approach. 6.4. Modeling operational risks.
De Fontnouvelle, Patrick, Eric Rosengren, and John S. Jordan, 2005, Implications of alternative operational risk modeling techniques in Mark Carey and Ren M. Stulz, The risks of financial firms, forthcoming. Cole, Roger, and Christine M. Cumming, 1998, Operational Risk Management, Basle Committee on Banking Supervision, Basle (September). *Ceske, Robert, and Jos Hernandez, 1999, "Where Theory Meets Practice," Operational Risk Special Report, Risk Magazine (November), pp. 1720. *Pagett, Tim, J. Chris Karow, and Julianne Duncan. Top Down or Bottom Up?, Operational Risk Management, 9-23. *Risk Magazine, 2000, Measuring Op Risk, (March), pp. 5861. Oliver Bennett, 2000, Data trouble, Risk, June, 62-64. Crouhy, Michel, Dan Galai, and Robert Mark, 2000, Managing Operational Risk, in Risk Management (New York: McGraw Hill). Ebnther, Silvan, Paolo Vanini, Alexander McNeil, and Pierre Antolinez-Fehr, 2001, Modeling operational risk, working paper. Silvian Ebnother, McNeil, Alexander, Paolo Vanini, and Pierre Antolinez, 2003, Operational risk: A practitioners perspective, Journal of Risk. Cruz, Marcelo, Rodney Coleman, and Gerry Salken, 1998, Modeling and Measuring Operational Risk, Journal of Risk, Vol. 1, No. 1, Fall. BIS, 2002, Sounds practices for the management and supervision of operational risk.

7. The practice of integrated risk management. 7.1. Using a risk measure to set the optimal amount of capital. 7.2. Measuring risk at the firm level. 7.3. Marginal VaR: Measuring the impact of a trade. 7.4. Managing a trading desk with VaR.

7.5. Risk measures and investment policy. 7.6. Risk measures and performance evaluation. 7.7. Risk measures and compensation. 7.8. Risk measures and intra-firm capital allocation. 7.9. Evaluating strategic risks. 7.10. Is Raroc right?
Risk Management and Derivatives, Chapter 4. *Deloitte, 2004, Global Risk Management Survey. Crouhy, Michel, Dan Galai, and Robert Mark, Risk Management, McGraw Hill, Chapter 14. Rosenberg, J. V., and T. Schuermann, 2004, A general approach to integrated risk management with skewed, fat-tailed risk, Federal Reserve Bank of New York, Staff Reports. Basel Committee on Banking Supervision, Joint Forum, Trends in risk integration and aggregation, August 2003. Crouhy, Michel, Stuart M. Turnbull, and Lee M. Wakeman, 1999, Measuring risk-adjusted performance, The Journal of Risk 2 (1), 5-36. Froot, Kenneth A., and Jeremy C. Stein, 1998, Risk management, capital budgeting, and capital structure policy for financial institutions: An integrated approach, Journal of Financial Economics 47 (January), 5582. Merton, Robert, and Andr Perold, 1993, Management of risk capital in financial firms, in Financial Services: Perspectives and Challenges, S. Hayes, editor, Harvard Business School Press, 215-245. *Merton, Robert, and Andr Perold, 1993, Theory of risk capital in financial firms, Journal of Applied Corporate Finance 6 (No. 3), 16-32. Matten, C., 2000, Managing bank capital, Second edition, Wiley. Perold, Andr, 2001, Capital Allocation in Financial Firms, Working Paper No. 98072, (Cambridge: Harvard Business School). Kupiec, Paul H., 1999, Risk capital and VaR, The Journal of Derivatives (Winter), 41-52. Kupiec, Paul H., 2004, Estimating economic capital allocations for market and credit risk, Journal of Risk, Summer. *Capital Market Risk Advisors, 2001, Economic Capital Survey. Shepheard-Walwyn, Tim, and Robert Litterman, 1998, Building a coherent risk measurement and capital optimization model for financial firms, Economic Policy Review 4, 171-182. Andrew Kuritzkes, Til Schuermann, and Scott M. Weiner, Risk measurement, risk management and capital adequacy in financial conglomerates, Wharton, Financial Institutions Center, 03-02.

Jeffrey Wallace, Derivative accounting and hedging under FASB 133, http://www.greenwichtreasury.com/download/Derivative_Accounting.pdf Peter Nakada, Hemant Shah, H. Ugur Koyluoglu, and Olivier Collignon, P&C Raroc: A catalyst for improved capital management in the property and casualty insurance industry, The Journal of Risk Finance, Fall 1999. Reprint available at http://www.erisk.com/Learning/Research/201_USIndustryStudy.pdf