FIN 40450, Fall 2013

Lesson 05A Risk Measurement Overview

Risk measurement is a very complex topic and appropriate risk measurement strategies are highly dependent on the context of the analysis.

How Do We Measure Identified Risk Exposures?

(1) Expected Loss Calculations given calibrated probability estimates for the possible outcomes, compute the expected value of the loss. Gap Analysis measuring the mismatch between the factor sensitivity of assets and liabilities (or between revenues/inflows and expenses/outflows). Traditionally used by financial institutions in maturity/duration matching of assets/liabilities, it can also be applied to industrial firms matching inflows and outflows in a given currency or fixed/floating rate characteristics of customer credit and short-term borrowing. (3) Instrument Sensitivity duration, convexity (the rate of change of duration), DV01 (the change in value of a security after a one basis point change in the interest rate), and option deltas and gammas are all used to measure the risk exposure of a particular financial instrument (i.e., security).

(2)

DV01 = - 0.0001 @P D*

Duration gives only a first-order approximation of the expected price change due to a given change in the yield. These approximations only work well for small, shape-preserving shifts of the yield curve. A more accurate estimate requires a second-order adjustment the convexity adjustment. Convexity is the rate of change of the duration. See Figure 64 of Crouhy, Galai & Mark, The Essentials of Risk Management]:

05A-1

FIN 40450, Fall 2013

For options, you can describe various aspects of the riskiness of the position using the Greeks: Delta (price risk) Delta measures the degree to which an options value changes in response to a small change in the price of the underlying security. Gamma (convexity risk) Gamma measures the degree to which an options delta changes in response to a small change in the price of the underlying security. For European call options, higher gamma means the option is more valuable (when the underlying price increases, the delta also increases, so the option appreciates even more in value than a gamma-neutral position and when the underlying price falls, the delta also declines, so the option loses less value than a gamma-neutral position). Vega (volatility risk) Vega measures the sensitivity of the option value to changes in the volatility of the underlying security.

05A-2

FIN 40450, Fall 2013

Theta (time decay risk) Theta measures how much the value of the option changes as it moves closer to its expiration date. Rho (discount rate risk) Rho measure the change in the value of an option in response to a change in the interest rate. W hile the Greek measures provide complementary information about the riskiness of the option position, they cannot be aggregated into an overall measure of risk (e.g., you cant sum the delta and gamma risk of an option) and you cant aggregate them across markets (e.g., you cant add the delta of a euro/dollar call and the delta of a stock index call). This means they cant be used as a comprehensive measure of the risk of a portfolio. (4) Value-at-Risk (VaR) VaR is the V in the following statement: W e are X percent certain that we will not lose more than V dollars in the next N days. The required inputs are the confidence level of interest (what is X?) and the time horizon (what is N?). In practice, banks in particular consider the 99% confidence level and 10-day horizons since those are the parameters established by bank regulators in the determination of capital requirements. (5) Scale or scoring methods subjective rank ordering of risks on a scale of say, 1-to-5, or ranking probabilities and impact with categories such as high/medium/low. Scales are subject to: a) range compression (only a few points on a multi-point scale are generally chosen and more extreme scores are more likely to be used at the end of a long list of evaluations); b) presumption of regular intervals (the incremental impact between a low and medium risk project is assumed equal to the incremental impact between a medium and high risk project); c) presumption of independence of the different risks and risk factors being ranked (two medium-probability risks would be treated as independent even if they are much more likely to happen in tandem than in isolation

05A-3

FIN 40450, Fall 2013

(6)

Regressions coefficients of the regression of stock returns (or cash flows or earnings) on various risk variables. W e talked about this approach in a cross-sectional context (i.e, using large samples of different firms) when we discussed empirical evidence regarding whether risk management creates shareholder value, but it can also be used in time-series approach by a given firm to measure its own sensitivity to various risk factors. Estimate a market model of expected returns, and add risk variables to test for sensitivity of returns to those risk variables:

To test for interest rate risk, X might be the return on a constant maturity default-free bond, or change in interest rate, r/r. To test for exchange rate risk, this added term might be the rate of change in FX rate, P FX,t /P FX,t W e can also use the same basic approach with changes in firm value or changes in operating income as the dependent variable (omitting the market return variable in that case). Limitations/concerns: a) Measures of this type only make sense if the firm has been in its current business for a sufficient time to estimate the regressions AND it expects to remain in the same business for the foreseeable future. Firms that engage in significant M&A or other asset restructurings are not good candidates. b) Small sample sizes often lead to insignificant regression estimates particularly with the firm size variable since market capitalization (and hence firm value) is generally more volatile than operating income. In this case, we might want to use data aggregated across all firms in a particular sector and use the sector betas to infer the betas for your specific firm.

05A-4

FIN 40450, Fall 2013

c) The firms FX exposure might be more strongly associated with particular currencies. In this case, we might use changes in the FX rate for a given currency, or use a weighted basket of currencies that specifically fits with the firms mix of foreign currency cash flows rather than an index such as the trade-weighted dollar. (7) Scenario/Simulation Analysis and Stress Testing building models of security/portfolio value or of firm-level cash flows as a function of various risk exposures and then testing various scenarios or conducting simulations of possible results. Risk exposure might be defined as the probability of failing to meet a particular cash flow target. This is probably the most comprehensive and potentially powerful approach to measuring risk exposures. The same models that are developed for measuring exposures can subsequently be used to compare costs/benefits of alternative risk management strategies. As discussed in Smithson (Managing Financial Risk ), the likely starting place is the firms existing budgeting or planning model. This model captures the relationships between input costs, product prices, foreign and domestic operations, budgeting investments in R&D, capital expenditures, and contractual commitments. To move from a budgeting model to a cash flow sensitivity model requires two steps: a) the model must formalize the relationship between financial prices (commodity prices, FX, interest rates) and changes in the firms operating cash flows. This may be quite complex. For example, a change in FX rate may not only affect the immediate value of existing orders and also affect the firms market share in the long run as competitive advantages shift between domestic and foreign producers. Sensitivities from historical regressions may help to model these relationships. b) The deterministic financial prices in the budget model must be replaced with stochastic financial prices. Changes in the financial prices can be simulated over time.

05A-5

FIN 40450, Fall 2013

Limitations/Drawbacks: GIGO distributions chosen for inputs must be based on analysis and data, rather than guesswork; the output can look very concrete and unambiguous, so decision makers need to be aware of the underlying assumptions and limitations. Real data may not fit known statistical distributions. Distributions may be non-stationary historical data (even if it fits well with a given distributional assumption) may not be a good predictor of the future. Correlations across inputs may change over time.

05A-6