Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling...
-
Upload
christine-horton -
Category
Documents
-
view
220 -
download
1
Transcript of Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling...
![Page 1: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/1.jpg)
1
Lotter Actuarial Partners
Pricing and Managing Derivative Risk
Risk Measurement and Modeling
Howard Zail, Partner
AVW10290293
![Page 2: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/2.jpg)
2
Risk Measurement and Modeling• Laying the Foundations
– Establish business-driven risk management goals– Identifying risks
• Risk Management Metrics– Value-at-Risk– Risk-Adjusted Performance Measurement– Others– Adjusting metrics designed for banking industry for use in the insurance industry
• Modeling Approach– Parametric Modeling, Distributional Approaches– Historic Simulation– Stress testing techniques
• Avoiding the Pitfalls– Stochastic vs. Parameter Risk– Correlation risk– Comparing the “Statistical” and “Market” price of risk– Communicating Results to Target Audiences
![Page 3: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/3.jpg)
3
Laying the Foundations
![Page 4: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/4.jpg)
4
Establish Business-DrivenRisk Management Goals• Modeling process must provide practical answers
to questions like:– How much capital is required to support business?
– Where should we be investing our equity?
– What risks should we keep and what risks should we pass to others?
– How do we compare different types of risks on a consistent basis?
– What instruments best hedge our risks?
![Page 5: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/5.jpg)
5
Identify The Key Risks• Financial Market Risk
– Interest rate risk– Equity– Liability option
• Credit Risk– Non financial market (fixed income, credit derivatives)– Counterparty risk (credit risk exposure to reinsurers,
OTC counterparty)
• Operational Risk– Underwriting
• Liquidity
![Page 6: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/6.jpg)
6
Risk Management Metrics
![Page 7: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/7.jpg)
7
Definition of Value-at-Risk• JP Morgan Definition:
Value at Risk is a measure of the maximum potential change in value of a portfolio of financial instruments over a pre-set horizon.
or
VaR answers the question:
How much can I lose with x% probability over a given time horizon?
![Page 8: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/8.jpg)
8
What is Value-at-Risk
![Page 9: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/9.jpg)
9
Uses of VaR• Risk reporting• Portfolio optimization• Component of performance measurement &
product pricing• Capital allocation• Limit setting• Deriving economic capital
![Page 10: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/10.jpg)
10
Example of VaR Risk Reporting• Goldman Sachs daily VaR (95% level)
Category Daily VaR ($ in millions)
Interest Rate Risk $ 39
Currency Rates 13
Equity Prices 21
Commodity Prices 12
Diversification effect (33)
Total $ 52
![Page 11: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/11.jpg)
11
Pros and Cons of VaR• Simple to understand
• Rating agencies are beginning to use the methodology
• Widely used in banking industry
• Accepted by banking regulators
• Requires a lot of work to implement firm-wide
• Relatively new to insurance industry
• Not yet accepted by insurance regulators
• Various technical problems
![Page 12: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/12.jpg)
12
VaR and Economic Capital• EC is the amount of capital that an institution
would devote to support its financial activities in the absence of regulatory constraints
• VaR can be used as a proxy for economic capital with some adjustments:– Time horizon
– Confidence level
– Targeted credit Rating
– Present Value
![Page 13: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/13.jpg)
13
Other Risk Measures• Variance / Standard Deviation• Downside variance• Maximum Possible Loss• Shortfall measures / tail outcomes
![Page 14: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/14.jpg)
14
Why Analyze Economic Capital• Regulatory capital (e.g. RBC) may be too high or
too low relative to an institutions risk profile• Actual capital held is rarely the most efficient
amount of capital
![Page 15: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/15.jpg)
15
Risk Adjusted Performance Measurement (RAPM)
(Single period model)
VaRAdjusted
Profit
CapitalEconomic
ProfitRAPM
![Page 16: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/16.jpg)
16
An Example of RAPM
Strategy Notional E[Profit] IRR Standard
Deviation
VaR
Unhedged $400 m $ 5 m 15% 8 16
Hedged $400 m $ 2 m 10% 2 4
Should we hedge a portfolio of 1-year GIC’s?
![Page 17: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/17.jpg)
17
An Example of RAPM (cont’d)• Traditional financial analysis suggests that we
should remain unhedged:
– IRRunhedged > IRRhedged
– NPVunhedged > NPVhedged
![Page 18: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/18.jpg)
18
An Example of RAPM (cont’d)• RAPM analysis suggests otherwise:
– RAPMunhedged = Profit / VaR = 5 / 16 = 31.25%
– RAPMhedged = Profit / VaR = 2 / 4 = 50%
• RAPMunhedged < RAPMhedged
![Page 19: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/19.jpg)
19
Adjusting Metrics for the Insurance Industry • The one day or week horizons used in banking
industry are not appropriate for insurance industry• Very difficult to measure correlations between risk
categories• Changes in volatility are important over longer
term horizons
![Page 20: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/20.jpg)
20
Modeling Approaches
![Page 21: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/21.jpg)
21
Types of models• Parametric Modeling
– Closed-form and monte-carlo simulation
• Historic modeling
![Page 22: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/22.jpg)
22
Stress Testing Techniques• Back-testing of model on historic data
– In sample and out-of-sample
• Scenario Analysis (or Dynamic Financial Analysis)
![Page 23: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/23.jpg)
23
VaR Difficulties • Determining:
– Confidence level
– Time interval
• Stochastic vs. Parameter Risk
• Correlation risk
• Comparing the “Statistical” and “Market” price of risk
• Communicating Results to Target Audiences
• Does not incorporate all types of risk
• Risk management is part art and not just science
![Page 24: Lotter Actuarial Partners 1 Pricing and Managing Derivative Risk Risk Measurement and Modeling Howard Zail, Partner AVW10290293.](https://reader036.fdocuments.us/reader036/viewer/2022062322/5697bff81a28abf838cbf099/html5/thumbnails/24.jpg)
24
Summary of Benefits• Provides managers with better understanding of:
– sources of risk
– interactions between different types of risks
• Enables comparison of different types of risk• Forms a basis for risk-return performance analysis