Current Topics in Risk Management
In this chapter, we discuss several currently important risk management topics: value at risk (VaR), credit derivatives, options on debt instruments, swaptions, and exotic options.
One goal of active risk management is to reduce the variability of uncertain cash flows. As you have seen, however, risk management cannot eliminate this variability. Further, many examples that we have presented in this textbook have presented risk management vehicles dealing with a single risk, such as interest rate risk, foreign currency risk, commodity price risk, or stock market risk. However, the modern corporation could have hundreds, or thousands, of sources of uncertainty that are being hedged (or not being hedged).
Value at risk (VaR) is the name of a risk management concept by means of which senior management can be informed, via a single number, of the short-term price risk faced by the firm. The origin of “value at risk” stems from a request by J. P. Morgan's chairman, Dennis Weatherstone, for a simple report, to be made available to him every day, concerning the firm's risk exposure. Since then, VaR has rapidly become the financial industry's standard for measuring exposure to financial price risks. Today, few financial firms fail to make VaR part of their daily reporting to senior management.
Use of the VaR concept has become pervasive.1 The Bank for International Settlements (BIS), which is essentially the central bank of the world's major central banks, proposed in April 1995 that major banks use VaR to determine their capital adequacy requirements. These requirements became effective January 1, 1998. The U.S. Federal Reserve Bank and the International Swaps and Derivatives Association (ISDA) basically endorsed the BIS's recommendations about VaR. In December 1995, the U.S. Securities and Exchange Commission (SEC) proposed rules that would require corporations to disclose information concerning their use of derivatives. Firms would be directed to use one of three methods that would provide information about the risk exposure of their portfolios of financial assets and derivatives. One of the methods was VaR.2 In April 1996, eleven individuals from the institutional investment community formed the Risk Standards Working Group (1996) and charged themselves to “create a set of risk standards for institutional investment managers and institutional investors.” Risk Standard 12 states that money managers “should regularly measure relevant risks and quantify the key drivers of risk and return.” The standard proceeds to suggest VaR as one possible method for measurement of risk.3