Fluent Essays

Required textbook: Hull, J. (2018) “Risk Management and Financial Institutions” (5th edition).      FIN 562 Winter 2021 Final Project  The questions relate to chapters and respective lectures of 23, 24, 25, 27, 28, & 29 of the Hull book. If you have any calculations, please show them in your answers.    1)  Consider the following three events:  1)  An insurance company loses $5 billion due to an earthquake in California.   2)  An auto manufacturer loses $5 billion from a lawsuit relating to safety flaws of a new car design.   3)  A food processing firm loses $5 billion from a hedging trader speculating in the coffee and sugar markets.   You have equal investments in the three firms. Which loss or losses are you more concerned about? Why or why not are you concerned? Are there any risk management issues you can point to in these firms?  2)  A hedge fund wants to purchase 100 shares of company X. The bid = $70, offer = $80. They also want to purchase 200 shares of company Y. The bid = $15, offer = $25.  1)  What is the proportional bid–offer spread of each company?   2)  What is the midmarket total value of each position?   3)  What is the cost to the hedge fund to unwind the portfolio?   4)  If the bid–offer spreads are normally distributed with mean $10 and standard deviation $3, what is the 99\% worst-case cost of unwinding the position in the future?   3)  You are consulting to a financial institution that uses an imprecise model for pricing and hedging a particular type of structured product.  1)  Discuss how, if at all, it is likely to realize its mistake.   2)  As the risk management consultant, what procedures would you recommend mitigating the institution’s model risk?      4)  A funds risk appetite wants to be 90\% certain it will not lose more than 20\% in any one year. Based on the following variables, calculate the beta the fund should have.  R = -0.20, RF = 0.03, RM = 0.082, M = 0.15, and p = 0.9 5)  When thinking about the cycle of innovation, discuss the following items:  1)  What causes disintermediation?   2)  Name three fintech items and what is their impact on traditional intermediaries   3)  What is a common reason for financial institutions to reject fintech products and what can a fintech firm do to reduce rejection risk?   5) You are a risk consultant to a financial institution. Your client asks you to respond to the following two questions:  1)  What are the two common factors for firms to have large losses?   2)  List and discuss at least four actions you recommend the client to take to avoid risk management mistakes.FIN 562 Risk Management Professor Mark Shore DePaul University Week 7 Lecture Notes [email protected] Twitter @shorecap mailto:[email protected] Due Diligence • The examples are related to money managers • However, it can be applied to varying industries • What can go wrong? Dictionary Definition: Due Diligence 1) “law : the care that a reasonable person exercises to avoid harm to other persons or their property failed to exercise due diligence in trying to prevent the accident” 2) “business : research and analysis of a company or organization done in preparation for a business transaction (such as a corporate merger or purchase of securities)” “the care that a reasonable person takes to avoid harm to other persons or their property” The phrase can be traced back to the 1500s Can you relate this to your firm or industry? https://www.merriam-webster.com/dictionary/due\%20diligence#note-1 https://www.merriam-webster.com/dictionary/due\%20diligence#note-1 Due Diligence of a Fund Manager Front Office • Research – understand their research process • Strategy – understand their strategy & risk mgmt. (manage expectations) • Capacity Issues – estimate of limits to their AUM based on their strategy & markets traded • Track Record/ Metrics Back office • Operational / back office • Know the firm • Backup plan / disaster recovery • Key Personnel Risk • Background of senior management • Regulatory issues of firm & individuals –from NFA BASIC https://www.nfa.futures.org/BasicNet/basic-search- results.aspx?rnd=5618.661775151415 https://www.nfa.futures.org/BasicNet/basic-search-results.aspx?rnd=5618.661775151415 Due Diligence Process • Due diligence of a manager is analogous to analysis of a company or stock • Analysis of a company • Product / Service – (Portfolio/ Front office) • Understand the product (portfolio) • Examine portfolio metrics • How does it compare to their competitors (Peers) (Back Office / Operations) • Management – who are they? Backgrounds of mgmt? • Revenue – how is it generated? From AUM • Will the revenue support their operations? • Size of the firm/ Infrastructure / info on firm • Add up the pros and cons and decide to allocate or not (quantitative and qualitative information) Importance of Operational Due Diligence • After 9/11 (2001) - Does the firm have a disaster recovery plan? • After Madoff (2008) $65 billion stolen from investors & $18 billion in investor losses (Ponzi scheme) -Who are the auditors and administrators of the fund? -Potential conflicts of interest? - Are items handled internally or by third parties? • After MF Global bankruptcy (2011/2012) about $1.6 billion in customer losses -Does the fund have backup brokerage firms? • Operational due diligence has become as important or more important than front office due diligence Feffer & Kundro (2003): -Studied over 100 fund liquidations over 20 years: At least 50\% of hedge fund failures are due to operational FIN 562 Risk Management Professor Mark Shore DePaul University Week 8 Lecture Notes [email protected] Twitter @shorecap mailto:[email protected] Liquidity Risk 2 Types of Liquidity Risk • Liquidity Trading Risk ➢Relates to ability to enter and exit the market • Liquidity Funding Risk ➢Relates to ability to pay obiligations Liquidity Trading Risk • More liquid = smaller bid – ask spread ➢Less slippage = lower cost to enter or exit the position ➢Less costly to enter and exit a market position Liquidity Trading Risk • Factors for Price depends on: • The mid market price • Quantity = How much is to be sold • Time = How quickly it is to be sold • The economic environment • Financial Crisis transparency is also a factor that affects liquidity: Mortgages: • More transparency = greater understanding of involved risk • Unacceptable risks = reduced demand= less volume = wider bid- ask spreads = costlier to enter and exit the market • 2007 investors were using credit ratings in place of understanding the risks • When confidence declines; liquidity declines • Sellers market • Buyers market • Predatory trading Bid-Offer Spread As a Function of Quantity (Figure 24.1, page 539) Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 Offer Price Bid Price Quantity 100 units 500 or 1,000 units Having many small positions instead of one large position, may reduce liquidity risk Bid-Offer Spread (page 540-541) Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 .instrumentth for the spreadoffer -bid alproportion theis and ,instrumentth in the position theis positions, ofnumber theis where 2 1 markets normalin n liquidatio ofCost pricemarket -Mid price BidpriceOffer spread,offer -Bid alProportion price Bid priceOffer spread,offer -bidDollar 1 i si n αs s p i i n i ii  − = −=  = Bid-Ask Spread p=20-15 = 5 S= (20-15)/17.5 = 29\% Unwinding a Position Optimally • Relative to a large position: ➢Unwound quickly = large bid-ask spreads ➢But the loss from a mid-market price is small Or ➢Unwind the position over several days = smaller bid-ask spread ➢But the potential loss of mid-market price increases Other Measures of Trading Liquidity • Volume of trading per day = less liquidity: smaller volume • Price impact of the size of a trade • Absolute value of daily return divided by daily dollar volume (suggested by Amihud in 2002) Research shows that an asset’s expected return increases as its liquidity decreases Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 Liquidity Black Holes Risk Management and Financial Institutions 5e, Chapter 24, Copyright © John C. Hull 2018 Liquidity Black Holes • A liquidity black hole occurs when most market participants want to take one side of the market and liquidity dries up • ExamplesFIN 562 Risk Management Professor Mark Shore DePaul University Week 9 Lecture Notes [email protected] Twitter @shorecap mailto:[email protected] Model Risk Management Uses of Models • Credit decisions and credit exposures • Liquidity management • Derivatives valuation • Calculation of VaR, Expected shortfall and other risk measures • Asset management • Fraud detection • etc Risk Management and Financial Institutions 5e, Chapter 25, Copyright © John C. Hull 2018 Models • Models approximate reality ➢Ideally try to keep the models simple ➢Assumptions are built into the models • Models are considered part of operational risk • Models need to be: • Documented • Validated • Used the way its intended • Monitored Regulatory Requirements • April 2011 SR11-7 was published from the Fed to provide guidance to banks on model risk management • Model risk: “ the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports” • A systematic approach to managing model risk • Model risk can arise from ➢fundamental errors involving data, calculations, numerical procedures, and assumptions ➢Inappropriate use of the model ➢Not understanding the limitations of a model SR 11-7 continued • SR11-7 contains directives on • Model development, testing, and documentation • The role of model validation groups • The use of vendor models Risk Management and Financial Institutions 5e, Chapter 25, Copyright © John C. Hull 2018 Vendor Model • Subject to the same validation as internal models • Have a process to choose vendor models • Does the vendor conduct ongoing monitoring of their models? • Have information on data used to develop the model • Contingency plan if the vendor stops supporting the model or goes out of business? ➢Vendor should make available proprietary data Risk Management and Financial Institutions 5e, Chapter 25, Copyright © John C. Hull 2018 Finance vs Physics (page 572) • The models of physics describe physical processes and are highly accurate. Their parameters do not change through time. • The models of finance describe human behavior. They are at best approximations. Parameters do change through time Developing & Testing Models • Marking to Market ➢Valuation based on market prices • Marking to Model ➢Valuation based on model pricing ➢Are assumptions built into the model? • Stochastic Model ➢Model will have some randomness to the results; results can vary • Deterministic Model ➢Model will have greater consistency (constant) of results Marking the Prices of an Instrument to Market • Use prices quoted by market maker • Use price at which financial institution has traded product • Use prices from SEFs (Swap Execution Facilities) or interdealer brokers • Use price indications • Use model (marking to model) Risk Management and Financial Institutions 5e, Chapter 25, Copyright © John C. Hull 2018 FIN 562 Risk Management Professor Mark Shore DePaul University Week 10 Lecture Notes [email protected] Twitter @shorecap mailto:[email protected] Financial Innovation • Cash markets to forwards, futures, options, other derivatives for commodities & financial, private equity and public equity = innovation • Choices of insurance policies = innovation • Increased choices of credit and lending = innovation • Information & data transfer from printed books, letters, railroad, telegraph, telephone, radio, airplanes, television to the internet and high-speed digital transfer = innovation ➢Data & information is critical to financial services • Fintech The Cycle of Innovation • Intermediaries = the function between two parties ➢“The middleman” • Disintermediation = removal of the traditional intermediary ➢Bank Teller ➢Stockbroker • Reintermediation = new technology intermediaries appear ➢ATM ➢Online trading Fintech Machine Learning (page 622-623) • Branch of artificial intelligence that allows computers to learn without being explicitly programmed ➢Supervised Learning: builds rules to map inputs to outputs ➢Unsupervised Learning: seeks patterns in the data ➢Reinforcement Learning: Has a goal/ task and learns the task • Uses tools to search for patterns. Some are traditional statistical tools such as linear regression, logistic regression and PCA • An important tools that mirrors the way humans recognize patterns are neural networks Risk Management and Financial Institutions 5e, Chapter 28, Copyright © John C. Hull 2018 Examples of Applications • Translation from one language to another • Fraud recognition • Lending decisions • Driving a car • Also used for: ➢Market trading patterns ➢Customer behavior ➢Algos for online behavior Risk Management and Financial Institutions 5e, Chapter 28, Copyright © John C. Hull 2018 Blockchain • A distributed ledger (spreadsheet) • When updated a new block is added = a chain of blocks • A community of users can update it • Hacking and fraud are extremely unlikely • It is the technology behind bitcoin ➢Has other applications in finance, supply chain management, law (smart contracts), regulation • Permission = Private blockchains where people tend to know and trust each other • Permissionless = Non-restrictive on users and people may not know or trust each other Hashing 1 • Hashing converts text to a 64 string of numbers and letters • Cannot be reversed • Hashing is an important part of blockchain security systems • Blockchain records are made tamper proof with a hash where one of the inputs is the hash of the immediately preceding block Risk Management and Financial Institutions 5e, Chapter 28, Copyright © John C. Hull 2018 Hashing 2 Hashing “Risk Management and Financial Institutions” (without quotation marks) using SHA gives: 1dcc48387a27cd95378b08ab26261b161a97c51a7c9146f3d3f f73710d656a3f Adding the edition numbRisk Management and Financial Institutions Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment pro- fessionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. 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