Market Risk Management and its overlap with Credit (

1
Market Risk Managementand its overlap with
Credit(Convergence Risk)

• Dominic Wallace
• EMEA Head of Market Risk Management

Advanced Risk Issues Istanbul, March 2007
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Market Risk Management and Convergence Risk

• What is Market Risk Management?
• What is Market Risk?
• Market Risk Management techniques
• Policies and limit setting
• Hot topics
• When does it converge with Credit Risk
  Management?
• Traditional overlaps the liquidity crunch
• Current developments four examples
• The golden rules

3
Market Risk Management and Convergence Risk

• What is Market Risk Management?
• What is Market Risk?
• Market Risk Management techniques
• Policies and limit setting
• Hot topics
• When does it converge with Credit Risk
  Management?
• Traditional overlaps the liquidity crunch
• Current developments four examples
• The golden rules

4
Market Risk
Libor
JPY
Prepay

• Market Risk is the risk to earnings or capital
• due to changes in market variables
• (such as interest rates, foreign exchange,
  equity and
• commodities levels and volatilities)
• which affect the price of trading positions.

Citigroup Stock
US Interest Rates
Oil
EUR
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Market Risk The Greeks and other common terms
Delta Technically, the way that an option value
changes as the price of the underlying changes
(e.g. if an option value increases by 75c for a
1 increase in the underlying price the option
would be described as having delta of 75). Now
often used to describe any simple, linear
risk. Gamma Used to describe options
(originally) or, more generally, portfolios whose
value does not change in a linear fashion.
Negative gamma can lead to significant losses in
extreme market moves, which is why stress testing
is important, but in stable markets can be a
profitable strategy. Also known as
convexity. DV01 Simplest measure of interest rate
risk exposure to a one basis point move in
interest rates. Other organizations have
different names there is no one market
standard.
Also useful to know, for future
reference Theta The change in value of an option
portfolio as time passes, assuming nothing else
changes. Positions which are long gamma (i.e.
benefit from large market moves) are typically
short theta (i.e. they gradually bleed money
away if markets dont move) Vega The change in
value of an option portfolio as a function of
changes in implied volatilities. Volatility is a
measure of uncertainty in an assets future price
and is therefore one of the inputs used to
calculate option values (or, alternatively, is
implied by the quoted prices of options in the
market, hence the term implied
volatility). IRE Interest Rate Exposure used
in a specific sense at Citigroup to measure the
interest rate exposure of accrual, rather than
mark-to-market, portfolios. Cost to close The
difference between life-to-date accounting and
mark-to-market revenue for an accrual portfolio,
in other words the gain or loss that would be
incurred by liquidating the portfolio at market
value.
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Market Risk The Greeks and other common terms
Often a portfolios behaviour can be represented
accurately enough as a simple linear function of
market moves. At other times (especially for
options portfolios) it is necessary to include
the effects of convexity, especially if they are
negative (negative gamma).
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Market Risk Management

• Market Risk Management is three things
• Understanding managements risk appetite and
  expressing it in more specific terms
• Understanding trading desks exposure and
  communicating it upwards comprehensibly
• Acting as honest brokers in support of other
  control groups as required

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Market Risk Management - Techniques

• Three main techniques of Market Risk Management
• Value at Risk
• Stress Testing
• PL Attribution
• although none is as important as common sense.

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Market Risk Management Techniques Value at
Risk

• What is it?
• What happens on a bad day?
• Statistical estimate
• Simplest measure of market risk
• Expressed in terms of a confidence level and a
  holding period
• Various approaches, but all based on historical
  assumptions
• Advantages
• Simple, easy to understand
• Enables comparison between businesses
• Capital relief if you meet the Basel guidelines
• Drawbacks
• Doesnt address the worst case
• Can be opaque in some approaches
• Not a coherent risk measure

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Market Risk Management Techniques Value at
Risk
Probability
Revenue
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Market Risk Management Techniques Stress
Testing

• What is it?
• Tries to answer Whats the worst that could
  happen?
• Two reasons non-linear portfolios, extreme
  events
• Various scenarios historical,
  quasi-statistical, tailored
• Advantages
• Does address the worst case (at least in
  theory)
• Historical scenarios are very transparent
• Provides a measure of economic capital
• Drawbacks
• Significant judgmental input (correlation,
  liquidity)
• Can give false confidence
• Very dependent on trader/management behaviour

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Market Risk Management Techniques VaR, Stress
Testing

• Coherent risk measures
• Various technical conditions must be satisfied
• Largely just means they make sense
• Critical condition is sub-additivity R(ab)
  lt R(a) R(b)
• When does this matter?
• Rarely if ever an issue for VaR within Market
  Risk
• Discontinuous risks
• High confidence levels
• In other words
• Stress testing
• Credit risk
• Operational risk

For more information P.Artzner, F.Delbaen,
J.M.Eber, and D. Heath (1999) Coherent Measures
of Risk, Mathematical Finance 9, 203-228.
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Market Risk Management Techniques PL
Attribution

• What is it?
• Two things, not one
• Detailed level to prove out the revenue
• High level to prove out the exposures
• Advantages
• If theres a problem, you find out about it early
• Drawbacks
• Overhead

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Market Risk Management Techniques PL
Attribution
Simple portfolio DV01 10mm SOAF 6 1/2
of 2014 _at_ 109.963 (6,872) 5 mm SOAF 7 3/8 of
2012 _at_ 113.183 (2,529) (15mm) UST 3 5/8 of
2013 _at_ 97-11 9,854
Prices and yields move as follows SOAF 2014
109.963 ? 109.695 (5.074 ? 5.113) SOAF
2012 113.183 ? 113.011 (5.016 ? 5.050) UST
2013 97-11 ? 96-24 (4.029 ? 4.117)
PL systems report a gain of 52,206
Is it right and where does it come from?
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Market Risk Management Techniques PL
Attribution

• Where does this come from?

• Financials answer
• 86,719 from UST 2013 (15mm) x (37/64) x
  1/100
• (26,800) from SOAF 2014 10mm x (0.268) x 1/100
• (8,600) from SOAF 2012 5mm x (0.172) x 1/100
• Total 51,319
• Risks answer is based on risk factors
• 47,000 from spreads narrowing (9,401)/bp x
  (5bp)
• 4,100 from rates rising 453/bp x 9bp
• Total 51,100

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Policies and Procedures
Market Risk Managements own policies cover areas
such as limits setting, model review and price
verification. Market Risk Managers also play a
key (formal or informal) role in implementation
of other policies including

• Policy on New Products, New Activities and
  Complex Transactions for CIB Global Markets
  The CMAC Policy to its friends.
• Off-Market Transaction Policy Loss-deferral
  trades are not permitted other trades where an
  up-front fee changes hands in exchange for
  off-market coupons are allowed only in tightly
  controlled circumstances.
• Structured Finance Policy All our customers
  must disclose any financing trades, even when
  accounting standards dont require it.
• Derivatives Sales Practices Policy Sale of
  exotic derivatives (or securities with them
  embedded) to non-professional customers needs
  specific approvals.

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Policies and Procedures quiz

• What do the following have in common?
• The UKs nuclear deterrent in the 1980s
• One half of a notorious US crime team
• Film starring Vin Diesel
• Character in Greek mythology, son of a legendary
  craftsman
• Popular term for an oil spillage at sea
• An ultra-dense astronomical body
• Characters from two films by Jay Roach

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Market Risk - Limit Setting

• Market Risk limits and exceptions are related to
  stress tests
• Stress tests exposure x worst case move
  stress loss
• Risk limits loss tolerance worst case move
  limit
• Loss tolerance depends on a number of factors
• Budgeted revenue
• Maturity/growth plans
• Nature of business (origination/facilitation/posit
  ioning)
• Limits are set at desk, division and CIB levels
  as appropriate
• All Market Risk Managers can approve exceptions
  at desk level (size depends on the seniority of
  the risk manager)
• Product and Regional Heads can approve exceptions
  at division level (including EM seniors for EM
  division)
• Only CIB Market Risk head can approve exceptions
  at CIB level

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Market Risk - other hot topics

• Model risk
• Impact on liquidity of a hedge fund dislocation
• Lack of market opportunities vs budget pressure
• Remote but outsized risks (the known unknowns)
• equity market collapse
• super-senior CDO tranches and related products
• The unknown unknowns
• Argentina - pesification
• euro breakdown??

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Market Risk Management and Convergence Risk

• What is Market Risk Management?
• What is Market Risk?
• Market Risk Management techniques
• Policies and limit setting
• Hot topics
• When does it converge with Credit Risk
  Management?
• Traditional overlaps the liquidity crunch
• Current developments four examples
• The golden rules

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In the Beginning it was simple
Loans Letters of Credit
Sovereigns
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Even now, stable markets mean largely discrete
risks
High Grade Corporates EM FX and Securities
Agencies
High Yield Corporates Distressed Debt

• Sovereigns
• Supranationals

Loans Letters of Credit Counterparty Risk
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The Fashion has always been to convert Credit to
Market Risk
High Grade Corporates EM FX and Securities
Agencies
High Yield Corporates Distressed Debt

• Sovereigns
• Supranationals

Loans Letters of Credit Counterparty Risk
Risk transfer instruments
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But as Liquidity Evaporates
High Grade Corporates EM FX and Securities
Agencies
High Yield Corporates Distressed Debt

• Sovereigns
• Supranationals

Loans Letters of Credit Counterparty Risk
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It Moves the Other Way
Sovereigns Supranationals
High Yield Corporates
Loans
Letters of Credit
Agencies
EM FX and Securities
High Grade Corporates
Distressed Debt
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Commercial Paper Liquid or Cement?
In recent years, Commercial Paper issuers have
come under the spotlight Commercial paper (CP)
issuers could routinely arbitrage funding
sources to reduce the costs of funds between bank
borrowings, debt borrowings and CP issuances.
Many companies used CP funding for long term uses
of cash such as acquisitions. The current credit
environment has resulted in investors looking
more closely at CP leverage ratios (e.g., General
Electric) and credit rating migrations (e.g.,
Sprint, Tyco, Quest, WorldCom, Nortel). ABB Asea
Brown Boveri Ltd. had 2.1BB of CP outstanding in
February 2001. On March 25, Moodys downgraded
ABBs CP from P1 to P3, resulting in a split
rating of A1/P3. On April 23, ABBs CP
outstanding had fallen to 500MM and SP
downgraded the company to A2. There were no bids
in the market. CIB was holding 116MM at the
Moodys downgrade and had no realistic out
except to wait until maturity and hope to be
repaid. (We were).
Previously
Current
Example
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Government Intervention is a Time-Bomb.
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When It Explodes, All Risks Converge
Sovereign
Liquidity
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Market or Credit Risk? AFS portfolio

• Available for sale portfolios
• Marked to market, but through equity not income
• Historically treated as credit exposures and
  using credit lines
• Argument to reclassify as market risk is based on
  liquidity
• which makes sense in normal circumstances, but
  beware
• Ability of some markets to turn illiquid suddenly
• Implications on expected behaviour in a downturn
• Credit risk approach hold/workout, maximise
  value
• Market risk approach sell, limit downside

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Market Risk Management and Convergence Risk

• What is Market Risk Management?
• What is Market Risk?
• Market Risk Management techniques
• Policies and limit setting
• Hot topics
• When does it converge with Credit Risk
  Management?
• Traditional overlaps the liquidity crunch
• Current developments four examples
• The golden rules

31
Recent developments in Convergence (1)
Extinguishing swaps
Start with a vanilla interest rate or currency
swap
Citi is clearly taking counterparty risk to
ABC Traditional strategy for mitigating this risk
is to buy credit protection (how much depends on
the current and projected mark-to-market value of
the swap) This has a number of disadvantages

• Basis risk derivatives claims are not normally
  deliverable into a CDS
• Possible accounting mismatch and likely capital
  mismatch
• Still a creditor in default
• Possible solution is the extinguishing swap

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Recent developments in Convergence (1)
Extinguishing swaps
Extinguishing swap is identical to a vanilla swap
except that all obligations are cancelled on a
credit event. Do we still have counterparty risk
with an extinguisher?
Yes, because Economically we lose the same money
in the same circumstances
No, because Credit risk is the risk that someone
defaults and owes you money

• Advantages of the extinguishing swap
• Full mark-to-market accounting even without Fair
  Value Option
• Easier to monetise right-way exposure
• No messy creditor meetings and no exposure to
  recovery rates
• Drawbacks
• Legal enforceability if deal is in the money to
  the customer
• Reputational association with self-referenced
  products
• Moral hazard customers may have an incentive to
  default

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Recent developments in Convergence (1)
Extinguishing swaps

• Variations
• Isda Method 1
• Third-party extinguishers
• Legal/credit risk separation with this structure

• Bank B has the legal risk
• Bank A has the credit risk

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Extinguishing swaps - application
A Philippines corporate is raising funds in the
offshore market in dollars. Their customer
revenues are in pesos so a currency swap is the
natural hedge.
Banks have limited credit appetite for the name,
even though the likely/projected mark-to-market
of the swap is negative
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Extinguishing swaps - application
An extinguishing swap is a natural solution to
everyones problem

• Customer gets a hedge that would otherwise be
  unavailable
• Citi has the opportunity to monetise the expected
  value by buying bonds
• Creditors in default dont have the uncertainty
  of a potential currency swap claim

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Recent developments in Convergence (2) Hedge
Fund leverage

• Funds and fund investors both looking for
  leverage
• Investors increased upside, non-recourse
  structure
• Funds fees depend on assets under management
• Leverage now available in a range of flavours
• Generic FoF product offered to risk-tolerant
  investors
• Bespoke leverage for single investor
• Single-fund product

Credit or market risk?
Citi lends 252mm for three years at 6 to
Rosetta Leveraged Master Fund Ltd., whose only
assets are holdings in each of eight third-party
hedge funds, with current value 50mm each. Citi
takes a charge over the fund units.
James King, founder and managing partner of
Kings Road Capital LLP, pays 148mm for a call
option giving him the right to buy a basket of 50
units in each of eight Kings Road funds, in
three years time, at a cost (strike) of 300mm.
Each unit is currently valued at 1mm.
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Recent developments in Convergence (2) Hedge
Fund leverage
These are basically the same deal
Kings Road
Rosetta
and if you combine the related parties you get
something even simpler
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Recent developments in Convergence (3) EMCT
loan program
Simple in concept Citibank lends to an EM
borrower (usually corporate) and simultaneously
sells the risk to the market in CDS or CLN form

• A customer-based product on both sides
• Borrowers raise finance by tapping a broader
  investor base
• Investors take exposure to previously
  inaccessible credits

Citigroup should be uniquely well positioned for
this business given its access to both borrower
and investor markets

• Closely related to four existing and mature
  businesses
• Loan syndication Citibank lends to an EM
  borrower and simultaneously distributes to the
  bank market (Credit/underwriting risk)
• Bond syndication Citigroup underwrites issuance
  of securities to the general investor market
  (Market/underwriting risk)
• EMCT secondary business Citigroup purchases a
  corporate loan (or security) and simultaneously
  sells the risk to the market in CDS or CLN form
  (Market risk)
• Portfolio Optimisation Citibank lends to an EM
  borrower and later may sell the risk to the
  market in CDS or CLN form (Credit risk)

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Recent developments in Convergence (3) EMCT
loan program

• So
• Is this market risk or credit risk?
• Is there anything else we need to think about?

• The short answers
• Mainly credit/underwriting risk as long as EMCT
  do habitually defease it as planned once
  defeased, it becomes market risk. If EMCT start
  to hold positions routinely, the answer changes.
• YES! There are key differences to each of the
  existing businesses (all now addressed in the
  program, although US distribution remains
  sensitive)

Difference compared to Disclosure Bank regulation Accounting
Loan syndication Investors are public side Hedge MtM
Bond syndication No prospectus Citibank lender Ongoing
EMCT secondary New money Citi is private side Citibank lender Loan accrued
Portfolio optimisation Level of diligence Trader involvement
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Recent developments in Convergence (4)
Non-recourse lending
Not strictly recent, but a big growth area as
hedge funds and private equity sponsors look for
more leverage and to monetise perceived
gains. Citigroup is increasingly asked to lend
money with recourse only to specified assets (or
to lend money to an SPV with no other
assets). Regulation requires that Credit Policy
be followed (assuming a bank-chain vehicle
lends) but when should we use market risk
techniques and when should we try to use
traditional credit analysis? Rarely a hard and
fast rule try these examples (most of which are
real)

1. Lend 100mm for one year to European bank X,
   secured by shares representing a 5 stake in
   large corporate company A and valued at 150mm
   extra margin required if LTV exceeds 80, or we
   liquidate the portfolio
2. Same as (1) but with no extra margin requirement
   pure term deal
3. Same as (1) but where 150mm is spread across a
   large number of liquid equities
4. Same as (3) but where customer is a hedge fund
   and this is the bulk of their portfolio
5. Same as (3) but where the security is private
   equity valued at 300mm
6. Lend 100mm to Canadian corporate Y, secured by
   shares representing a 95 stake in subsidiary Z
   and valued at 300mm
7. Same as (6) but Y is a financial sponsor, not a
   corporate

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Convergence the golden rules

• Talk to each other and know who the point people
  are

• It is better for you to tread on someones toes
  than for both of you to miss something

• Dont wait to be asked

But of course

• Respect the public/private divide

• Be responsive Convergence shouldnt mean
  approvals take twice as long (dont ask for all
  the details and then say not my job)