UNDERSTANDING THE MARKET UNCERTAINTIES Andrea Loddo Associate - - PowerPoint PPT Presentation

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UNDERSTANDING THE MARKET UNCERTAINTIES Andrea Loddo Associate - - PowerPoint PPT Presentation

Dec 01, 2023 330 likes •589 views

UNDERSTANDING THE MARKET UNCERTAINTIES Andrea Loddo Associate Director, Financial Risk Advisory Executive Summary Markets are unpredictable: the implications on risk management Rethinking risk management: the importance of

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Andrea Loddo Associate Director, Financial Risk Advisory

UNDERSTANDING THE MARKET UNCERTAINTIES

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Executive Summary

  • Markets are unpredictable: the implications on risk management
  • Rethinking risk management: the importance of interpreting historical performances
  • From history to forecast: introducing market uncertainty
  • The risk management discussion shifts from what it is likely to happen to how profound

the impact can be

  • Introducing the idea of the future Economic Environment
  • Stress testing is the way
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2

Remember the Swan

  • The event is a surprise
  • The event has a major impact
  • After the fact, the event is rationalized by

hindsight, as if it had been expected

Always consider a Black Swan

Attempting to predict the future is not too helpful when trying to manage risks

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3

Significant risk events are not infrequent anymore

  • 1997 Asian crisis
  • 1998 Russia/LTCM
  • 2000 Bursting of dot -com bubble
  • 2001 9/11, US invades Afghanistan, Enron
  • 2003 Second Gulf War begins/collapse of world trade talks
  • 2004 Indonesia tsunami
  • 2005 Hurricane Katrina
  • 2006

US sub - prime housing market shows signs of stress

  • 2007 Global credit crisis
  • 2008 Lehman Brothers collapse; oil prices hit $140/barrel
  • 2009 Oil prices slump to under $40/barrel
  • 2010 EU peripheral sovereign debt concerns surface; Greece & Ireland

bailout

  • 2011 MENA unrest and Japan earthquake; Portugal bailout
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0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 2008 2009 2010 2011 2012 2013 3M GBP LIBOR ‐ Historic Rate Current Forward

Do we learn from history?

4

What was the market implied forward curve in 2008 & 2009?

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0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 2008 2009 2010 2011 2012 2013 3M GBP LIBOR ‐ Historic Rate Historic Forward Current Forward

Do we learn from history?

5

  • Forward rates are bad predictors of interest rates
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1 1.2 1.4 1.6 1.8 2 2.2 2003 2005 2007 2009 2011 GBPUSD FX rate GBPUSD 1Y Forward rate ‐ 1 Year lag

Do we learn from history?

6 FX forwards are a poor estimator of future spot levels given they are simply a spot rate adjusted by a realisation of interest rate differentials

  • Forward rates are bad predictors of FX rate as well
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If market’s expectations are unreliable, what now?

7 0% 10% 20% 30% 0.0 2.0 4.0 6.0 8.0 % of occurances GBP 3M LIBOR % of times Current Level 0% 10% 20% 30% 1.2 1.5 1.7 2.0 2.2 % of occurances GBPUSD Rate % of times Current Level Rates FX 0.0 2.0 4.0 6.0 8.0 2002 2004 2006 2008 2010 2012 GBP 3M LIBOR Historical Rate 1.2 1.4 1.6 1.8 2.0 2.2 2002 2004 2006 2008 2010 2012 GBPUSD Rate Historical Rate

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0% 10% 20% 30% 40% 50% ‐40% ‐33% ‐25% ‐18% ‐10% ‐3% 5% 13% % of occurrences GBPUSD Monthly changes % of times 0% 10% 20% 30% 40% ‐40% ‐33% ‐25% ‐18% ‐10% ‐3% 5% 13% % of occurrences GBP 3M LIBOR Monthly changes % of times

From historical performance to uncertainty

8 GBP 3M LIBOR - Historical changes GBPUSD FX - Historical changes

  • The charts above show the monthly changes for GBP 3M LIBOR and GBPUSD FX rate
  • ver the last 10 years
  • Historically LIBOR has been more volatile as a result of the strong and fast fall during

2008 and 2009 Vol = 31% Vol = 12%

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How do we look into the future?

9 Trend

+ =

Uncertainty Volatility

  • Which trend?
  • Forwards are bad predictors. Thus we will focus on uncertainty
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Introducing uncertainty

10 GBP 3M LIBOR GBPUSD FX Rate

  • Uncertainty means projecting market factors based on market implied expectation of

forward rates and historical volatility and correlation

  • Uncertainty shifts the focus of the risk management discussion from what it is likely to

happen to how profound the impact can be 0.0% 2.0% 4.0% 6.0% 8.0% 2006 2009 2012 2015 2017 Percentile(0.75) Percentile(0.95) Mean Percentile(0.05) Percentile(0.25) Historical 0.0 2.0 4.0 6.0 8.0 2007 2010 2012 2015 Percentile(0.75) Percentile(0.95) Mean Percentile(0.05) Percentile(0.25) Historical

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0.00 1.00 2.00 3.00 4.00 2012 2013 2014 2015 2016 2017 0% 5% 10% 15% 20% 25% 0.3 1.0 1.6 2.3 2.9 3.6 4.2 4.9 % of occurrences GBPUSD FX Distribution ‐ 2017

Quantifying market uncertainty

11 5th 95th Mean GBPUSD FX rate projections Distribution in 5 years

  • Thousands of simulations are generated which cover the entire spectrum of probable

and extremely improbable events

  • At each point in time, the distribution of potential outcome allows us to quantify the FX

rate on a worst (95th percentile), best (5th percentile) and expected basis 1.1 1.7 2.6

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Generating the Economic Environment

Risk Factor 1 Risk Factor 2 Risk Factor 3 Impact Risk factor 1 Impact Risk factor 2 Impact Risk factor 3 Overall Impact The Economic Environment Simple standard approach Risk Factor 1 Risk Factor 2 Risk Factor 3

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= +

13

Positively Correlated Risks

= +

Negatively Correlated Risks

Why correlation matters?

Risk Factor 2 Combined Effect Risk Factor 1 Combined Effect Risk Factor 2 Risk Factor 1

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Measuring correlation

14 GBPEUR FX rate GBPUSD FX Rate

  • Weekly data shows that GBPUSD and GBPEUR rates are negatively correlated (-

11.1%) over the past year

  • Should this be the assumption to be used when projecting GBPEUR and GBPUSD FX

rates? 1.2 1.4 1.6 1.8 2.0 2.2 2002 2004 2006 2008 2010 2012 GBPUSD Rate Historical Rate 0.9 1.1 1.3 1.5 1.7 2002 2004 2006 2008 2010 2012 GBPEUR Rate Historical Rate

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Correlation patterns can change over time

15 GBPEUR & GBPUSD correlation

  • Only recently GBPUSD and GBPEUR

FX rates exhibit negative correlation

  • Historically, they have been positively

correlated, particularly in 2009 and 2010

  • What are the implications of using

different correlation measures? ‐60% ‐20% 20% 60% 100% 2003 2005 2007 2009 2011 Correlation

Correlation was calculated by using weekly data on a rolling annual window

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How does correlation impact projections?

16 Positively correlated paths Negatively correlated paths

  • The chart on the left shows the simulated paths for positively correlated GBPUSD and

GBPEUR FX rates (correlation at +40%)

  • The chart on the right show the simulated paths assuming a negative correlation of -

20% 0.00 0.50 1.00 1.50 2.00 2.50 2012 2013 2014 2015 2016 2017 GBPUSD FX path GBPEUR FX Path 0.00 0.50 1.00 1.50 2.00 2.50 2012 2013 2014 2015 2016 2017 GBPUSD FX path GBPEUR FX Path

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Earning profile over the next 5 years

An example: a UK Company with Earnings in GBP, USD and EUR

Currency Earnings USD £100m EUR £100m Total £200m Current Earnings

  • We assume earnings stay constant over time
  • The company is exposed to FX risk related to the earnings in USD

and EUR

  • We will show how we quantify the impact of FX risk on earnings by projecting the FX

rates around spot 20 40 60 80 100 120 2013 2014 2015 2016 2017 Earnings (£m) USD EUR

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50 100 150 2012 2013 2014 2015 2016 2017 Earnings (£m)

USD Earnings EUR Earnings

How does correlation impact projections?

18 Earnings - Positively correlated paths Earnings - Negatively correlated paths

  • The charts show the impact on the earnings under
  • Positively correlated FX rates (40%) –

left chart

  • Negatively correlated FX rates (-20%) –

right chart 50 100 150 2012 2013 2014 2015 2016 2017 Earnings (£m)

USD Earnings EUR Earnings

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50 100 150 200 250 2012 2013 2014 2015 2016 2017 Earnings (£m)

Total Earnings ‐ Negative Correlation Total Earnings ‐ Positive Correlation

What is the impact on total earnings?

19 Total Earnings

  • The chart shows total earnings under
  • The positive correlation scenario

(40%)

  • The negative correlation scenario (-

20%)

  • In 2017, the earning risk associated to

positively correlated FX rates is £29m £29m Risk

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133.3 112.8 246.1 36.2 209.9 50 100 150 200 250 300 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk (£m)

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Earnings at risk with -20% correlation

How does correlation change the risk profile?

Earnings at risk with 40% correlation

  • The charts show how the FX uncertainty translates into earning risk, on a cumulative

basis over 5 years and on a worst case basis (95th percentile)

  • The net risk is lower than the total risk as a result of the diversification benefit
  • Negative correlation implies higher diversification benefit and lower overall risk

133.3 112.8 246.1 78.6 167.5 50 100 150 200 250 300 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk (£m)

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133.3 112.8 246.1 36.2 209.9 50 100 150 200 250 300 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk (£m) 133.3 112.8 246.1 78.6 167.5 50 100 150 200 250 300 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk (£m) 133.3 112.8 246.1 36.2 209.9 50 100 150 200 250 300 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk (£m) 133.3 112.8 246.1 78.6 167.5 50 100 150 200 250 300 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk (£m)

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Defining the right risk tolerance is important

High Tolerance Medium Tolerance Earning at risk with -20% correlation Earnings at risk with 40% correlation Tolerance Tolerance

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Medium tolerance: what to do?

  • Further investigating the historical

correlation patterns by

  • Changing the frequency of
  • bservation
  • Looking at different time horizons
  • Understand the motivations behind

inversion of trends

  • Running different stress cases,

evaluating the impact on the earnings profile and potentially exploring hedging strategies GBPEUR & GBPUSD FX correlation ‐60% ‐20% 20% 60% 100% 2003 2005 2007 2009 2011 Correlation

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133.3 112.8 246.1 36.2 209.9 50 100 150 200 250 300 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk (£m) 133.3 112.8 246.1 78.6 167.5 50 100 150 200 250 300 GBP USD EUR Total Diversification Benefit Net Risk Cash Flow At Risk (£m)

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Low tolerance to risk

Low tolerance Earnings at risk with -20% correlation Earnings at risk with 40% correlation

  • If under any scenarios, the risk is not within the desired tolerance band, then an

appropriate hedging strategy should be defined

  • We can help in quantifying the risk and define the appropriate tolerance levels

Tolerance

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What is then the right strategic decision?

Tolerance to Risk Risk analysis Strategy Lower The risk quantified under different scenarios is not within the tolerance level Definition of an optimal hedging strategy Neutral The risk quantified under different scenarios is partially within the tolerance level Additional stress testing

  • required. Considerations

around an optimal hedging strategy are beneficial Higher The risk quantified under different scenarios is within the tolerance level No hedging