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1.1

550.446Financial Risk

Measurement/Management

Introduction

Banks, Insurance Companies

and Asset ManagersWeeks of September 4 and

September 9, 2013

1.2

Principals

David R Audley, Ph.D.; Sr. Lecturer in AMS

[email protected]

Office: WH 212A; 410-516-7136

Office Hours: 4:30 5:30 Monday

Teaching Assistant(s)

Cheng, Wan-Schwin (Allen)

[email protected]

Office Hours: Wednesday, 10am - Noon

1.3

Schedule

Lecture Encounters

Monday & Wednesday, Noon -1:15pm,

Shaffer 202

Section

Section: Friday 12:00 - 12:50pm, Shaffer 202

1.4

Protocol

Attendance

Lecture Mandatory (default) for MSE FinMath majors

Quizzes

Section Strongly Advised/Recommended

Assignments

Due as Scheduled (for full credit)

Must be handed in to avoid incomplete

Exceptions need prior approval

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1.5

Resources

Textbooks

John C Hull: Risk Management and FinancialInstitutions; Prentice-Hall, 3e 2012

Recommended (On Reserve in Library): Philippe Jorion: Financial Risk Manager Handbook; Wiley, 6e 2011

Alexander McNeil, Frey & Embrechts: Quantitative Risk

Management; Princeton, 2005 Anthony Saunders & Cornett: Financial Institutions Management

A Risk Management Approach; McGraw-Hill, 7e 2011

1.6

Resources

Textbooks

Saunders: Chapters 1 7 : On Library ElectronicReserve

Registered Students may access their readings at theUniversitys Portal at http://my.jhu.edu

Text Resources http://www-2.rotman.utoronto.ca/~hull/riskman/rmlist.htm

1.7

Resources

Supplemental Material

As directed

AMS Website http://jesse.ams.jhu.edu/~daudley/446

Additional Subject Material Class Resources & Lecture Slides

Industry & Street Research (Optional) Consult at your leisure/risk

Interest can generate Special Topics sessions

Blackboard1.8

Measures of Performance

Mid Term Exam (~1/3 of grade)

Final Exam (~1/3 of grade)

Home work as assigned and designatedand Quizzes (~1/3 of grade)

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1.9

Assignment

For September 4th thru September 11th

Read: Hull Chapters 1-4 (Introduction) Read: Saunders, Chapter 1; Why are Financial

Institutions Special

Read: Saunders, Appendix 1A; The Financial Crisis:The Failure of Financial Institutions Specialness

Problems (Due September 16th

) Chapter 1: 1, 2, 11, 12; 18

Chapter 2: 3, 8; 16, 18

Chapter 3: 5, 9, 15

Chapter 4: 7, 14, 161.10

Assignment

For September 16th (Next)Read: Hull Chapters 5 & 7 (Trading, the

Markets & Managing Trading Risk)

Problems (Due September 23rd)Chapter 5: 3, 8, 10, 13, 21

Chapter 7: 1, 3, 6, 14; 16

1.11

Assets and Cash

Stock, Bond, Commodity, (Assets)

Risk vs. Return

Cash (or Currency)

Held, on Deposit or Borrowed

Terminology

Assets things we own (long)

Liabilities what we owe (short)

1.12

Risk vs. Return

There is a trade off between risk andexpected return

The higher the risk, the higher theexpected return

Attempts to understand the tradeoffs(required) between risk & expected returnwere pioneered by

Markowitz & Sharpe (MPT CAPM)

Ross (APT)

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1.13

Example

Suppose Treasuries yield 5% and the returnsfor an equity investment are expected to be:

Probability Return

0.05 +50%

0.25 +30%

0.40 +10%

0.25 10%

0.05 30%

1.14

Example continued

We can characterize investments by theirexpected return and standard deviation ofreturn (total risk)

For the equity investment:

Expected return =10%

Standard deviation of return =18.97%

22

52 2

1

and 0.10

0.046

18.97%

i i

i

E R E R E R

E R PR R

1.15

Risky Investments

Characterized by Risk & Expected Return

1.16

Combining Risky Investments

Lets combine 2 risky investments

2121

2

2

2

2

2

1

2

122112 wwwwww

PP

2.0

%24

%16%15

%10

2

1

2

1

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Combining Risky Investments

0

2

4

6

8

10

12

14

16

0 5 10 15 20 25 30

Standard Deviation

of Return (%)

Expected

Return (%)

1.18

Efficient Frontier of All Risky

Investments

Efficient

FrontierExpected

Return

S.D. of

Return

Investments

1.19

Efficient Frontier of All

Investments

Expected

Return

S.D. of Return

RF

E(RM)

M

Previous Efficient

Frontier (Risky only)F

M

I

J

New Efficient

Frontier (w/RF)

1 & 0 1I I F I M I

E R R R

1 & 1J J M J F J

E R R R

I M

J M 1.20

Systematic vs. Non-Systematic

Risk (total risk vs. systematic risk)

We can calculate the best fit linearrelationship between return frominvestment and return from market

Systematic Risk

(non-diversifiable)Non-systematic risk

(diversifiable)

M

RR

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1.25

Risk vs. Return for Companies

If shareholders care only about systematic riskshould the same be true of company managers?

In practice companies manage for total risk

They buy property insurance to protect against the riskof factory destruction due to fire, for example

Earnings stability and company survival are

important managerial objectives Bankruptcy costs arguments show that that

managers are acting in the best interests ofshareholders when they consider total risk

1.26

What Are Bankruptcy Costs?

Lost sales (There is a reluctance to buyfrom a bankrupt company.)

Key employees leave

Legal and accounting costs

Lost franchise value (intangibles)

3.27

Banking

Commercial Banking

Take Deposits, Make Loans, Provide Services

Retail: Individuals & Small Businesses

Wholesale: Larger Corporations & Funds

Investment Banking

Raise Capital Equity and Debt

Banking Services for Corporations

Financial Advice M&A, Corporate Finance

Sales and Trading1.28

Banking

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1.29

Capital

Capital is designed to provide protectionagainst extreme events that have a verylow (e.g. 0.1%) chance of occurring

Is a banks capital sufficient for it to maintainsolvency?

Lets see where Capital shows inconsidering Banks

1.30

Example of Simple Bank Balance

Sheet: End 2012 ($ millions)

Assets

Cash 5

Marketable Securities 10

Loans 80

Fixed Assets 5

Total 100

Liabilities & Net Worth

Deposits 90

Subord L.T. Debt 5

Equity Capital 5

Total 100

1.31

Income Statement: 2012

($ millions)

Net Interest Income 3.00

Loan Losses (0.80)

Non-Interest Income 0.90

Non-Interest Expense (2.50)

Pre-Tax Operating Income 0.60

Return on Equity (before tax) 12%

1.32

Year 2013 Is Capital Adequate

What happens in year 2013 if it is the sameas year 2012 except that loan losses are 4.0instead of 0.8? (rises by 3.2% of assets)

Other items on income statement are the same

There is an after-tax loss of 1.8% of assets(Operating Loss = 2.6%; Tax rate = 30%; & 2.6 x .7 = 1.8)

The equity capital would be diminished to 3.2%

Regulator might require an equity infusion torestore the 5% level

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1.33

What if Balance Sheet Had Been

More Aggressive? ($ millions)

Assets

Cash 5

Marketable Securities 10

Loans 80

Fixed Assets 5

Total 100

Liabilities

Deposits 94

Subord L.T. Debt 5

Equity Capital 1

Total 100

1.34

Regulation

Regulators set minimum levels for thecapital a bank is required to keep

Equity is an example of Tier I capital

Subordinated long term debt is an exampleof Tier II capital

What does tier I provide that tier II doesnt? Protection to maintain solvency; protection

against liquidation to pay bondholders

1.35

Investment Banking

Raising Capital

Private Placement vs. Public Offering

Public Offering

Best Efforts (fee)

Firm Commitment (own em)

IPO (Offering Price)

Dutch Auction

1.36

Investment Banking

Creation & Exchange of Securities and Instruments

Investment Banking Creates for Capital Flows

Sales and Trading finds Capital & Makes Markets

CreateSecurities

MakeMarkets

ManageInvestedFunds

Collateral

New IssueSecurities

Securities &Contracts

Secondary Issues

Investment Banking Broker-Dealers &Exchanges

Institutional Investors

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1.37

Investment Banking

Raising Capital

Dutch Auction

1mm shares

Who gets (C, F, E, H, A & 2/3 of Ds order) and howmuch to pay (Ds 29.00)

1.38

Investment Banking

Securities Trading

Banks are often involved in securities trading

Brokerage Full Service: Research & Advice

Market Making (both bid & offer) OTC vs. Exchange

Conflicts of Interest (Glass-Steagall)Recommend the Axe

Access to non-public information

Research to please company for IB business

Risk transfer w/o full disclosure (loan/credit & CDS)

1.39

Todays Large Banks

Do Everything and more

Accounting Fees: Accrual Accounting

Assets: Banking Book (loans) & Trading Book(contracts & securities)

Mark to market vs. mark to model vs. banking book

Loans have troublesome credit exposure

Originate to Distribute (move loans out) Securitization

Got out of control post Glass-Steagall1.40

Categories of Risk

Market Risk (10-days) (Systematic)

Credit Risk (1-year) (Systematic)

Operational Risk (1-year) (Specific)

The Capital a bank is required to hold(regulatory capital) must be sufficient toaccommodate losses from these risks thereby precluding bank failure

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1.41

How Do Financial Institutions

Manage Risk

Risk Decomposition vs. Aggregation

Decomposition Identifies RiskFactors/Variables and levies a target for eachunit (trading desk)

Aggregation takes advantage of diversificationacross all units

Risk Manager allocates targets and assessesaggregation results

Capital Adequacy is the banks capital adequate tomeet the regulatory standard set by regulators

1.42

Management of Net Interest

Income Suppose that the markets best guess is that future

short term rates will equal todays rates

What would happen if a bank posted the followingrates?

How can the bank manage its risks?

Maturity (yrs.) Deposit Rate MortgageRate

1 3% 6%

5 3% 6%

1.43

Management of Net Interest

Income

The following might make more sense

A source of liquidity preference in higher rates w/longermaturities

Maturity (yrs) Deposit Rate MortgageRate

1 3% 6%

5 4% 7%

1.44

Expensive Failures of U.S. Financial

Institutions

Savings and Loans

Continental Illinois

IndyMac

Bear Stearns

FNMA/FHMC

Countrywide

Lehman

AIG?!

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1.45

Financial Institutions

Specialness of Financial Institutions

Banks, Insurance, Asset Managers, etc.

Transfer Capital: Sources to Users

Investors to Borrowers

Commonality of Risks

All Hold Assets as part of Services and Assume Credit Risk

Interest Rate Risk

1.46


Commonality of Risks (Continued)

Mediate a Mismatch of Asset & Liability Duration

Withdrawal/Liquidity Risk

Underwriting Risk / Credit Guarantees

Operating Risk

Because of Risks and Special Role in theFinancial System, Financial Institutions aresingled out for Regulatory Supervision

1.47


Specialness in Provision of Services Information Costs

Liquidity & Price Risk

Transaction Services Cost, Availability Maturity/Duration Intermediation

Transmission of Monetary Supply

Credit Allocation

Intergenerational Wealth Transfers

Payment Services check clearing, etc.

Denomination Intermediation 1.48


Specialness and Regulation

Safety & Soundness Borrowers & Depositors

Regulatory Capital Requirements

Guarantee Agents: FDIC, SIPC, ERISA (PBGC), etc.Monetary Policy Reserves & Leverage

Credit Allocation Mortgages, Consumer Loans

Consumer Protection Discrimination/Practices

Investor Protection Mutual Funds & Pensions

Entry / Chartering

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1.49


Changing Dynamics of Specialness

Shift Away from Risk Measurement / RiskManagement & Financial Crisis

See Appendix 1A in Saunders

Separation of Specialness since 1933 (G-S)

Financial Services Modernization Act 1999 Mega Holding Companies

From Originate & Hold to Originate & Distribute FIs fail to act as specialists in Risk Measurement & Mgmt.

The housing bubble

Other Considerations 1.50


Changing Dynamics of Specialness

Shift Away from Risk Measurement / RiskManagement & Financial Crisis

Other Considerations S&L Crisis and subsequent liquidity for mortgage lending

9/11 Accommodation

Removal of Accommodation in 2006 Borrower Squeeze

Bear Stearns Hedge Fund failure

AIG Insurance for Distribution

Merrill Lynch / BofA / Lehman

Federal Reserve Saves the World

2.51

Insurance Companies

Life vs. Property & Casualty vs. Health

Life Insurance

Whole Life vs. Term

An investment vehicle for premiums

Annuity Contracts from Life Insurers

Fixed Annuity lump sum into payments

Mortality Tables

Longevity Risk & Mortality Risk

2.52

Insurance Companies

a Mortality Table

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2.53

Insurance Companies

a Mortality Table

Some entries can be calculated

from others - consistency

Probability of death 90-910.15722 0.12986 = 0.02736

Conditional on reaching 90 Death in next year is

0.02736/0.15722 = 0.1740

which is consistent with the entry in column 2

Death in 2nd year (91-92)

(1 0.174013) x 0.191354 = 0.158056

2.54

Insurance Companies

Insurance Premiums

Like for a Credit Default Swap

Need to find breakeven value of premium so the PV ofexpected pay-outs equals PV of expected premiums

Suppose a male 90-year old wants to buy a 2-year termlife policy; term structure is 4% and flat; pay-outs midwayin any year and premiums are paid at the beginning ofeach year

PV of expected payoff:PV[.174x100K] + PV[.158x100K] = 17,060 + 14,894 = 31,954

PV of Premiums:

1 x X + (1-.174) x X = 1.79 x X

Breakeven: 1.79X = 31,954 => X = 17,812

2.55

Insurance Companies

Property & Casualty

Loss to property (fire, theft, home & auto, etc.)

Legal Liability

singular events and legacy risk

Ratios (of payouts to premiums)

2.56

Insurance Companies

Health Insurance

Attributes of Life and P&C

Premiums can go up, but only with prevailing costs

Dont increase as a function of the health of individual

Moral Hazard & Adverse Selection

Moral Hazard P&C Insurance can promoteimprudent behavior

Adverse Selection Insurance attracts bad risks

Reinsurance against large losses

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2.57

Insurance Companies

The Balance Sheet (Life vs. P&C)

Risks ? Inadequate Reserves

Liquidity Duration

Hedges: Longevity Derivative & CAT bonds

2.58

Insurance Companies

Regulation of Insurance Companies

States and the NAIC

Pension Plans

Defined Contribution

Defined Benefit

Are defined benefit plans viable?

2.59

Investment Companies

Mutual Funds & Hedge Funds

Mutual Funds

Small Investor Diversification

Big Business - $10 trillion in US

Open End vs. Closed End

Index Funds

2.60


Mutual Funds

Cost Structure

Load: Front End vs. Back End

Annual Expense FeeOnce a day

NAV

Purchase and Redemption

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2.61


ETFs

Created by Institutions

Traded as a security on Exchanges(continuous trading)

Exchangeable: ETF and Underlying Assets

Insures no arbitrage in pricing/valuation

Mutual Funds and ETFs are regulated bythe SEC

2.62


Hedge Funds

Unregulated

Can use short positions and leverage

Limited Disclosure (including NAV)

Restrictions on Deposits and Redemptions

Fees

Management Fee plus Performance Fee

Hurdle Rate, High Water mark, & Clawback (% offees go to recovery account vs. future losses)

Prime Brokers (de facto regulator)

2.63


Hedge Fund Strategies Long/Short Equity

Dedicated Short

Distressed Situations Merger Arbitrage / Event Driven

Convertible Arbitrage

Fixed Income Arbitrage

Emerging Markets

Global Macro

Managed Futures

2.64


Documents

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