Financial Engineering (Professor Mahendra Mehta)
· Designing a product with various financial concepts to exactly meet the objectives of the investor
· Most products available are generic
What drives financial innovation
· Regulation & Taxes
· Changing Needs
· Greed
· Competition
Inflation is a very risky phenomenon – increases interest rates and hence all the asset prices drop. Govt has only 2 weapons
· Increase CRR
· Increase Interest Rates to suck liquidity
· Open Market operations – Sell government bonds
Tier1 Cap+Tier2 Cap/Risk weighted Capital –Capital to be maintained by banks
· What is Tier 1 & Tier 2 – Based on liquidity and risk
Annual Volatility of indices – 20-30%
Commodity volatility – 25-30%
Market makers – gives 2 way quotes and is ready to buy or sell. He hence provides a lot of liquidity in the market and is called a market maker
Hedging
It is the process of mitigating risk. Risks have to be first identified, measured/estimated, analyzed (to see if it is within your risk appetite) and finally risk control. Risk Control can be done by reducing exposure, eliminating risk completely or accept if it is within your appetite. The risk has to be reported at 3 levels – Regulators, BoD, Senior Management, Shareholders (through the balance sheet). These steps are followed under normal market conditions. These risks are measured everyday.
· Credit Risk
o Obligor Risk/Issuer Risk (Default Risk) – defaults entire payment..
§ hedged through CDS
§ Measured by probability of default
§ The function is exponential and as the PD increases, the premium increases rapidly
§ Minimum PD is 3bps
o Settlement Risk (mainly for spot transactions) – doesn’t pay the exact amount. This and default risk can be classified as counterparty risk. So it is advisable to not use this term. This is a huge risk when you sell and buy currency because of the time zones. Hedged through operational Insurance
o Pre-Settlement Risk- If i do a forward contract with a customer for 1 year of buying $ and selling yen. After 6 months, the contract is in the money for me and hence the customer is likely to default. So you make alternative means for that amount and assume that the customer will default so you still have 6 months to find alternate means of generating the amount.
o Cross Border Risk – If you have invested in some other country and that country is in trouble.
· Market Risk -
o Price Risk – All financial Engineering products have to hedge all these risks. For a single product, all of the following risks wont be applicable, some will be depending on the underlying. This is measured using ‘Factor Sensitivity’ and VAR
§ Equity price risk
§ Interest rate risk
§ FX risk
§ Commodity risk
§ Volatility Risk
o Liquidity Risk
§ Measured with the bid offer spread.
§ Done through a qualitative measurement
o Basis Risk
§ If the hedge is not perfect
§ If the change in the price of the underlying is not the same as the change in the price of the hedge instrument, it is called basis risk.
· Operational Risk
o People-25%
o Process-65%
o System-2%
o Legal- 1%
o External elements – 6-7%
Hedging Risk
· Market factor sensitivity- Change in the portfolio per percent change in the value of the change of one share
· So to hedge, i will pick up some instrument with a factor sensitivity of -10.5 so that my net exposure is 0. If it is not 0, you will run a basis risk.
On the Balance sheet, a FE has different taks
Asset Side
Asset Allocation – Markovitz MPT, by maximizing Sharpe ratio
· Sharpe ratio is Mu/Sd * sqrt (260)
· Numerator is multiplied by 260 and denominator by sqrt(260) and hence it will cancel out and become sqrt(260)
· If the Sharpe is 1, the risk is higher than the return expected. If it is 2, the risk is reduced by half. Hence, the higher the Sharpe ratio the better because the risk is getting reduced. Hence, anything more than 3 is an excellent Sharpe ratio.
· It is negative when the returns are negative
Liability Side
· Minimizing the cost of the liability
Risk & return
· Look at the overall impact of the balance sheet and invoke an instrument that reduces the overall impact
· You can take a bunch of financial instruments and derivatives and combine them in a way to give you cash flows exactly as desired.
Market factor Sensitivity
Anything that is not in your control is a market factor
· Equity prices
· Commodity prices
· Interest rates
· FX rates etc
There are 100s of market factors in the market – each scrip will have a market factor.
Current portfolio : 1 reliance share of value 1050
· If i have a reliance share for 1050, my portfolio increases by 10.50rs for every +1% change in the reliance prices.
· Hence now the value becomes = 1050+10.5=1060.5
· MFS= Final value- Initial value
· VaR= Defeasance factor* MFS
· For a sd of 30, for 1 day
· VaR=10.5*normsinv(99%)*30*sqrt(1/260)=32.13299
· To hedge this
o You can buy a put on reliance. Either reliance or an underlying which is highly correlated with the underlying (>.8) with a strike = current spot of 1050. The upside is reduced parallel to the extent of the premium paid. However, if the stock price doesn’t increase by an amount greater than the premium, you will lose. Hence it is not a perfect hedge. Additional exposures have been created. With the stock, there is only one MFS. Here, you are exposing to more factors like volatility, interest rates etc
o You can sell a future. This is like shorting the stock, the upside on one is exactly compensated by the downside of the other. Although there is small exposure to interest rates, this makes for a good hedge and is perfectly hedged
o For banks, if the VAR is calculated, according to Basel, the bank has to show more than 3-4 times the VaR as capital to be able to take that much risk. This is the deciding factor of the confidence level that the bank takes to decide the VaR. The lower CL they take, the greater the probability of them needing to show 3 times rather than 4 times because they have more space to make mistakes in their back testing process. Also, at 99%, the dist is at the tail and the tail is never accurate. So it is safer to limit the confidence at a 95% where the results are more accurate.
o Expected Shortfall – you find the normsinv for 1%
Policy
· Appetite
o How do you decide the risk appetite ??
o Risk Appetite depends on
· Revenue
· Margin
· Debt
· USD/INR Volatility
· Quality of people
· Cash flows, liquid assets
o Generally start with a stringent number and then review it every 3 months
o It is generally a % of the revenue (PAT)
· Risk Identification
o Direct
o Indirect
· Risk measurement
o FS & VaR
o VaR is calculated for each currency by adding the separate VaRs and then portfolio VAR is calculated for different currencies
· Risk control
Some shit that i was absent for
Interest rate risk management
· FRA
o Risks : Interest rate risk, counter party risk
· IRS
o Risks : Interest rate risk, counter party risk
· STIR
· Bond futures
o Exchange traded, only IRR
· Interest rate options – cap (call) and floor (put)
o OTC
o Series of caplets, every 6 months so if the interest rate goes above the strike interest
· Swaptions
o Swap+Option
o Option period must be less than the swap
o Once the strike price is breached, you can exercise the swaption and convert it into a swap contract
o Once it is converted to a swap, the strike will be the fixed rate and you are converting your obligation to floating
· Range Accrual
o It is an exotic product built using options
o The seller tells the buyer that he has to pay interest only if it remains between an agreed range (the actual rate in that case) or else, he doenst have to pay any interest
o This is calculated daily and amount to be paid is accrued and paid during settlement
Exotic Options
· Asian Options
o Average price option – payoff is average spot-strike
§ Volatility is much lower and hence the premium is also lower, profits are also lower
§ Exotic options aim to reduce the cost to customers rather than maximize the profit
§ Applied in ESOPs
§ It is easier to delta hedge. Delta approaches 0 as the option approaches maturity.
§ Similarly an average spot put
o Average strike call
§ Payoff : Spot on expiration – average spot of the asset
§ Similarly average strike put, where strike = average of spot
§ Average can be AM or GM
· Knock in/out and double knock in/out
o Becomes a vanilla option after breaching the barrier
o Objective is to again reduce the premium
· Lookback option
o Lookback call
§ Strike = minimum price of the asset
§ Payoff= spot at maturity-minimum stock value
o Lookback put
§ Strike=maximum price of the asset
§ Payoff=spot at maturity-maximum stock value
§ Premium will be very high
No comments:
Post a Comment