1. Risk Management
University of Economics, Kraków, 2012
Tomasz Aleksandrowicz

2. market risk management
measuring market risk – value at risk (VaR)

3. measuring risk: value at risk

4. value at risk (VaR) (I)
• VAR is the maximum loss over a target horizon
such that there is a low, pre-specified probability
that the actual loss will be larger
• the answer to: 'How much money might I lose?‘
• provides an estimate of the riskiness of a portfolio
based on statistical methodology to quantify
potential financial loss

5. value at risk (VaR) (II)
• the most commonly used measure of market risk
• useful because of its ability to distill a great deal of
information into a single number
• based on probabilities and within parameters set by
the risk manager
• based on one of several different methods

6. value at risk (VaR) (III)
• creates a distribution of potential outcomes at a
specified confidence interval
• confidence intervals are typically 95, 97.5, or 99
percent
• time horizon might be 1 or more days
• largest loss outcome using the confidence level as
the cut-off is the amount reported as value-at risk
• an example using historical data method:

7. portfolio A return 10 years time ($m)
2527 observations (trading days)

8. portfolio A return distribution
The maximum loss over one day is about $47m at the 95% confidence level

9. VaR examples:
• Q: $3m overnight VAR with 99% confidence level
• A: the loss will be worst than $3m in on average 1
day out of 100
• Q: 95% dialy VaR of $50m
• A: 95 days out of 100 there should be lose no more
than $50 million

10. VaR issues
• VAR does not tell how big the loss might be on the
95th/97th/100th day
• it is based on historical correlations which can break
down in times of market stress
• it is based on statistical assumptions - it is estimation
• VAR can really only be used for marked-to-market
portfolios (revalued every day)
• criticized as unable to forecast real value at risk as
well as its existence encouraged extensive
investment 10

11. liquidity risk management
asset and funding liquidity risk
LTCM collapse case-study

12. liquidity
• liquidity (accounting) - ability of a organization to
pay his debts as and when they fall due
• liquidity (asset) - asset's ability to be sold with
minimum price movement/loss of value
• liquidity risk is underestimated by many
organizations
• loss of liquidity the reason for most bankruptcies or
liquidations in the financial industry

13. liquidity risk
• it is less amenable to formal analysis than traditional
market risk
• there is still no commonly accepted measurement /
solution
• two types of liquidity risk:
– asset liquidity (also called market/product liquidity risk)
– funding liquidity risk (also called cash-flow risk)
• these two types of risk interact with each other

14. asset liquidity risk
• risk of loss due to an inability to sell an asset at
expected value
• asset liquidity to be a crucial factor
• can be managed by setting limits on certain markets
or products and by means of diversification

15. why an asset liquidity issue?
• asset might be too large in relation to the market and
cannot be sold without moving it
• market might be unable to absorb an asset sale of
that size
• asset may be so exotic/complex - attracts few buyers
• asset might not be readily transferable without some
legal effort
• asset might be restricted on convertibility, capital
withdrawal or regulatory approval

16. asset liquidity measurement
• tightness - which is a measure of the divergence between
actual transaction prices
and quoted mid-market prices
depth - which is a measure of the volume of trades possible
without affecting
prices too much (e.g. at the bid/offer prices), and is in contrast
to
resiliency - which is a measure of the speed at which price
fluctuations from trades
are dissipated
• illiquid markets are those where transactions can quickly
affect prices.

17. asset liquidity exercise
• $10,000 cash on bank
account
• 3 month $20,000 deposit
• 100 shares of Apple
• 100 shares of
• 10 US T-bond
• option
• OCT structure

18. asset liquidity management
• asset maturity profile management
• portfolio credit quality mix (high/low quality assets)
• aged assets management (long-term assets)
• concentrated (large) positions monitoring

19. funding liquidity risk
• risk of loss due to an inability to fund assets,
payments and other obligations when required
– inability to rollover, or renew, maturing financing when
required
– inability to access new funding when needed
• can be managed by proper
– planning of cash-flow needs
– by setting limits on cash flow gaps
– by having a robust plan in place for raising fresh funds

20. • payables, short-term
notes, repurchase
agreements,
commercial paper,
deposits, long-term
bonds, convertible
securities, bank loans

21. funding liquidity management
• liability maturity profile management
• managing funding source concentration
• credit rating changes awareness
• using liquid collateral (adequate haircut)

22. Long Term Capital Management
market and liquidity risk

23. Long term capital management
• Long Term Capital Management fund
• a hedge fund created by Salomon Brothers in 1994
• hired two Nobel prize economist: Myron Scholes and Robert
C. Merton
• using high leverage and complex investment strategies
• has very good returns – on level of 40% annually
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24. LTCM investment strategies
• fixed-income arbitrage
– inefficiencies in the pricing of bonds
– using derivatives as IRS (interest rate swaps), MBS (mortgage backed
securities) and forwards
• statistical arbitrage
– a heavily quantitative and computational approach to equity trading
– looking for statistical mispricing of one or more assets based on the
expected value of these assets
• pairs trading strategies
– using temporary correlation changes between pair of stocks
• The problem: these strategies brings model risk and short term
volatility risk
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25. LTCM downturn (I)
• high profits brings huge money from investors interested in its
share
• others start to use similar strategies for investment which
decrease its efficiency
• fund closed for new investors in 1996
• in 1997 huge dividend to remove unmanageable money from
the fund – but without closing
• adequate risk positions
• style drift from original investment methods
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26. LTCM downturn (II)
• portfolio under pressure of markets after East Asian crisis
(1997)
• returns down to -6,42% in May 1998 and -10,14% in June –
total loss of $461m
• in Aug 1998 Russian financial crisis – default of the
government put pressure on bonds market
• further losses $1,85b which forced liquidation of assets
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27. LTCM performance
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28. LTCM deal loss example
Royal Dutch Shell
• Royall Dutch Shell – dual-listed at Euronext (Royal Dutch) and
LSE (Shell)
• stock price premium of 8-10% observed at Royal Dutch
• $2,3b invested: half in long position at Shell, half in short on
Royal Dutch
• expectation was premium will be gone and 8-10% profit from
Royal Dutch re-purchase collected
• strategy was cut by forced liquidation – Royal Dutch was re-
purchase under 22% premium
• deal created $286m loss
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29. LTCM downturn (III)
• company has performed a flight-to-liquidity
• Sep 1998 LTCM's equity down from $2.3b to $400m
• total liabilities still over $100 billion
• this translated to an effective leverage ratio of more than
250:1
• due to deals with almos all Wall St big players they there was
move to prevent fund form collapse
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30. LTCM downturn (IV)
• 23 Sep 1998 Goldman Sachs, AIG and Warren Buffet offered
$200m for acquisition (compared to $4.7b starting capital) -
deal was not done,
• FED organized an bailout and injected $3.65b capital for
operation form consortium of banks
• by 2000 fund was liquidated and and rescuers paid back
• total loss estimated at $4.6b
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31. LTCM lessons
• failures in:
• 1. Model risk
• 2. Breakdown in historical correlations
• 3. The need for stress-testing
• The value of disclosure 4. and transparency
• 5. The danger of over-generous extension of
• trading credit
• 6. The woes of investing in star quality