Goldman Sachs had used proper risk management tools and good business sense to good use to avoid the financial crisis suffered by most of wall street such as Bear Stearns, Merrill Lynch and Lehman Brothers. According the the NY times article, managers at Goldman used risk management tools such as the VaR and the L&P to make the proper decisions to get rid of or hedge against mortgage-backed securities, thus saving them from the current financial crisis.
VaR is a Value at Risk model, developed by statistitions at JPMorgan and it is by far the most commonly used model to evaluate the boundaries of risk over a short duration in a normal market. VaR became so popular beacuase it could be used as a risk measure in any class of asset and it also takes into account many variables such as diversification, leverage and volatility. Since the big financial meltdown, Wall street started asking questions about the reliability of the VaR model and the fact that it did not take into account what would happen in the event of a financial meltdown. Several prominent risk managers stated that the VaR model is a useless measure and that it creates a false sense of security for the companies.
Goldman Sachs, however, used more than just the VaR model to evaluate the risk in their portfolio. CFO of Goldman Sachs, David Vinair says that they check their Profit and Loss (P&L) model on a daily basis to make sure that it is consistent with their risk models. In December 2006, Goldman's mortgage business had lost money for ten straight days and all the top managers sat down for a meeting with their risk managers as they looked over all their trading positions in the firm. During the meeting they looked over their VaR numbers and other risk management models and made the final decision to get rid of most of their mortgage-backed securities and hedged the rest of them.
Some argue that firms should have payed closer attention to their risk models and then maybe the meltdown could have been avoided and others argue again that it is the fault of models such as the VaR model that gave firms the false security and that these models were responsible for the entire meltdown. I feel that firms should not soley rely on one risk model, but have a few in place so that managers can be informed and ultimately make the correct decision as is in the case of Goldman Sachs.
Saturday, January 31, 2009
American Barrick
Since the case that we did on American Barrick was several years old, I did some research to find out whether their risk management policies have changed in the last couple of years. I found a few interesting articles in the NY times and I saw that they have changed quite dramatically. According to an article in the NY times, Barrick had suffered severe first quarter losses due to the company exiting hedge funds to take advandtage of the strong gold spot prices. Barrick was charged $557 million when they exited their hedge funds. By doing this, Barrick earnings were $398 million compared to the previous year of $263 million. Barrick said that they have completely eliminated their hedge book.
Barrick has always been very firm with their risk management plocies, but I agree with the recent changes that they have made. I looked at the gold price index over the last decade on goldprice.org and since January, 2001 where gold was trading at $260 an ounce, and it has been steadily increasing since then. Over the last 3 years gold prices have shot up from $450 an ounce in the beginning of 2006 up to $926 an ounce where it is today. The managers at Barrick had taken full advantage of this opportunity. If you take a look at Barrick's stock price chart on NY times, you will notice that its curve is very similar to that of the gold price chart.
I believe that Barrick should continue doing this until the market recovers and people stop buying gold as a fear of the weakeing dollar. Once the market recover, they should start hedging again to reduce the risk of gold price volatility.
Barrick has always been very firm with their risk management plocies, but I agree with the recent changes that they have made. I looked at the gold price index over the last decade on goldprice.org and since January, 2001 where gold was trading at $260 an ounce, and it has been steadily increasing since then. Over the last 3 years gold prices have shot up from $450 an ounce in the beginning of 2006 up to $926 an ounce where it is today. The managers at Barrick had taken full advantage of this opportunity. If you take a look at Barrick's stock price chart on NY times, you will notice that its curve is very similar to that of the gold price chart.
I believe that Barrick should continue doing this until the market recovers and people stop buying gold as a fear of the weakeing dollar. Once the market recover, they should start hedging again to reduce the risk of gold price volatility.
Monday, January 26, 2009
Forwards, Futures, Swaps and Options
I would like to continue with my last post about Derivatives and go into a little further detail about the main types of Derivatives and also explain how they relate to Risk Management.
A forward contract is a contractual agreement between two different parties. One of these parties agrees to buy a certain asset at a predetermined price and the other party agrees to deliver this asset at the same predetermined price. Both parties are required to honor this contract and there are no exceptions to this. Terms of the contract can be personalized since it is negotiated directly between two parties, however there is also a higher risk that one of the firms may default on their payments. I found a good example on Global Financial Management where a wheat farmer uses a forward contract to guarantee that he can sell 5000 bushels of wheat in 5 months time at 550 cents per bushel. This farmer is using proper risk management techniques from the start to guarantee that in the case of the market price for wheat drops dramatically for any reason, he will not be affected by it. This can however not work out since the farmer might have a terrible crop this season, and he will not be able to produce 5000 bushels of wheat to the buyer, thus defaulting on his contract.
A future contract is essentially the same as a forward contract, except it is exchanged in a formal, regulated exchange instead of directly between two parties. There are a few differences between the two, such as that future contracts guarantee against default, they are standardized and they are settled on a daily basis.
A swap contract is once again an agreement between two parties that to swap payments on regular future dates. Swaps are over the counter (OTC) derivatives that are just like forward contracts that have a risk that one side could default on their commitments. Swaps are generally used to hedge against risks created by volatile interest rates, currency exchange rates, commodity prices and share prices. Usually companies that borrow from banks with variable interest rates may reduce the cost of risk by entering into a swap to fix their cost of funding.
There are two types of options; call options and put options. A call option gives the owner the right to buy a certain underlying asset at a date and a fixed date, where as a put option gives the owner the right to sell the underlying asset at a certain date and a fixed price. Options are also an OTC derivative and is usually traded between a specialized dealer or in an organized exchange market, thus a premium needs to be paid by the buyer of the option as it provides so much flexibility.
A forward contract is a contractual agreement between two different parties. One of these parties agrees to buy a certain asset at a predetermined price and the other party agrees to deliver this asset at the same predetermined price. Both parties are required to honor this contract and there are no exceptions to this. Terms of the contract can be personalized since it is negotiated directly between two parties, however there is also a higher risk that one of the firms may default on their payments. I found a good example on Global Financial Management where a wheat farmer uses a forward contract to guarantee that he can sell 5000 bushels of wheat in 5 months time at 550 cents per bushel. This farmer is using proper risk management techniques from the start to guarantee that in the case of the market price for wheat drops dramatically for any reason, he will not be affected by it. This can however not work out since the farmer might have a terrible crop this season, and he will not be able to produce 5000 bushels of wheat to the buyer, thus defaulting on his contract.
A future contract is essentially the same as a forward contract, except it is exchanged in a formal, regulated exchange instead of directly between two parties. There are a few differences between the two, such as that future contracts guarantee against default, they are standardized and they are settled on a daily basis.
A swap contract is once again an agreement between two parties that to swap payments on regular future dates. Swaps are over the counter (OTC) derivatives that are just like forward contracts that have a risk that one side could default on their commitments. Swaps are generally used to hedge against risks created by volatile interest rates, currency exchange rates, commodity prices and share prices. Usually companies that borrow from banks with variable interest rates may reduce the cost of risk by entering into a swap to fix their cost of funding.
There are two types of options; call options and put options. A call option gives the owner the right to buy a certain underlying asset at a date and a fixed date, where as a put option gives the owner the right to sell the underlying asset at a certain date and a fixed price. Options are also an OTC derivative and is usually traded between a specialized dealer or in an organized exchange market, thus a premium needs to be paid by the buyer of the option as it provides so much flexibility.
Sunday, January 25, 2009
ERM Improves Business Performance
Enterprise risk management (ERM) is the process of planning, organizing, leading, and controlling the activities of an organization in order to minimize the effects of risk on an organization's capital and earnings. Enterprise risk management expands the process to include not just risks associated with accidental losses, but also financial, strategic, operational, and other risks.- SearchCIO.com
According to a post by Steven Minsky, founder and CEO of LogicManager, Inc, he has developed the RIMS Risk Maturity Model, which could be used by risk managers to meet the requirements of their company's ERM programs. Steven had assessed data over the last 14 months using this model to assess the ERM programs of 564 companies.
This study had four major findings, but I would like to highlight the first one; 93% of companies with an ERM program, make better risk management decisions than those without it. This model proves that when ERM programs are implemented properly according to the ERM guidelines, it could lower costs of capital and also improves business performance.
According to a post by Steven Minsky, founder and CEO of LogicManager, Inc, he has developed the RIMS Risk Maturity Model, which could be used by risk managers to meet the requirements of their company's ERM programs. Steven had assessed data over the last 14 months using this model to assess the ERM programs of 564 companies.
This study had four major findings, but I would like to highlight the first one; 93% of companies with an ERM program, make better risk management decisions than those without it. This model proves that when ERM programs are implemented properly according to the ERM guidelines, it could lower costs of capital and also improves business performance.
Derivatives Explained
So I was slightly confused on the first day of class when we discussed all the different financial contracts especially when it came to derivatives, so I decided to read up on it and try to understand it:
The Wikipedia defines derivatives as: Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions, or other derivatives).
There are three main types of derivatives, known as forwards or futures, options and swaps. Derivatives are used mainly in two ways, called hedging and speculation. During Hedging, these derivatives are used to reduce the risk of loss when the value of these underlying assets change. During Speculation, these derivatives may be used by investors to increase their profits if the value of the underlying assets change the way that they expected.
I found a good example on usafutures.com that shows a great example of how a soybean farmer uses future contracts to hedge against falling crop prices to reduce the risk of his economic loss.
According to the Washington Post, Pres. Obama sent out a proposal in June 2008 to reduce the speculation in the energy market. This proposal will attempt to increase federal oversight in these markets and also prohibit international trading in unregulated futures markets. As a result, soaring oil prices may be stabilized . It seems that if speculation is not regulated it can be used in a negative and unethical way. In contrast to this, several airline companies use hedging in oil prices to reduce their daily running costs.
Hope this helps, made things a little clearer for me...
The Wikipedia defines derivatives as: Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions, or other derivatives).
There are three main types of derivatives, known as forwards or futures, options and swaps. Derivatives are used mainly in two ways, called hedging and speculation. During Hedging, these derivatives are used to reduce the risk of loss when the value of these underlying assets change. During Speculation, these derivatives may be used by investors to increase their profits if the value of the underlying assets change the way that they expected.
I found a good example on usafutures.com that shows a great example of how a soybean farmer uses future contracts to hedge against falling crop prices to reduce the risk of his economic loss.
According to the Washington Post, Pres. Obama sent out a proposal in June 2008 to reduce the speculation in the energy market. This proposal will attempt to increase federal oversight in these markets and also prohibit international trading in unregulated futures markets. As a result, soaring oil prices may be stabilized . It seems that if speculation is not regulated it can be used in a negative and unethical way. In contrast to this, several airline companies use hedging in oil prices to reduce their daily running costs.
Hope this helps, made things a little clearer for me...
Wednesday, January 14, 2009
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