RISK MANAGEMENT

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FIN562Week10LectureNotesFinal.pdf

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FIN 562 Risk Management

Professor Mark Shore

DePaul University

Week 10 Lecture Notes

mshore1@Depaul.edu

Twitter @shorecap

mailto:mshore1@Depaul.edu

Financial Innovation

• Cash markets to forwards, futures, options, other derivatives for commodities & financial, private equity and public equity = innovation

• Choices of insurance policies = innovation

• Increased choices of credit and lending = innovation

• Information & data transfer from printed books, letters, railroad, telegraph, telephone, radio, airplanes, television to the internet and high-speed digital transfer = innovation ➢Data & information is critical to financial services

• Fintech

The Cycle of Innovation

• Intermediaries = the function between two parties ➢“The middleman”

• Disintermediation = removal of the traditional intermediary ➢Bank Teller

➢Stockbroker

• Reintermediation = new technology intermediaries appear ➢ATM

➢Online trading

Fintech

Machine Learning (page 622-623) • Branch of artificial intelligence that allows

computers to learn without being explicitly programmed ➢Supervised Learning: builds rules to map inputs to

outputs ➢Unsupervised Learning: seeks patterns in the data ➢Reinforcement Learning: Has a goal/ task and learns the

task

• Uses tools to search for patterns. Some are traditional statistical tools such as linear regression, logistic regression and PCA

• An important tools that mirrors the way humans recognize patterns are neural networks

Examples of Applications • Translation from one language to another

• Fraud recognition

• Lending decisions

• Driving a car

• Also used for: ➢Market trading patterns

➢Customer behavior

➢Algos for online behavior

Blockchain • A distributed ledger (spreadsheet)

• When updated a new block is added = a chain of blocks

• A community of users can update it

• Hacking and fraud are extremely unlikely

• It is the technology behind bitcoin ➢Has other applications in finance, supply chain

management, law (smart contracts), regulation

• Permission = Private blockchains where people tend to know and trust each other

• Permissionless = Non-restrictive on users and people may not know or trust each other

Hashing 1

• Hashing converts text to a 64 string of numbers and letters

• Cannot be reversed

• Hashing is an important part of blockchain security systems

• Blockchain records are made tamper proof with a hash where one of the inputs is the hash of the immediately preceding block

Hashing 2

Hashing “Risk Management and Financial Institutions” (without quotation marks) using SHA gives:

1dcc48387a27cd95378b08ab26261b161a97c51a7c9146f3d3f f73710d656a3f

Adding the edition number so that ``Risk Management and Financial Institutions 5'' is input (again without quotation marks) produces a totally different hash:

117e1e23121f8db4b75d3e2a63d37ef052b11a63cf448721825 aadb882492c6b

Payment Systems (page 625)

• Many innovations already: credit cards, debit cards, mobile wallets

• Future use of biometric authorization

• Data collection and privacy issues

• Increasing use of digital currencies

• Will central banks use digital currencies?

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9/30/2013 9/30/2014 9/30/2015 9/30/2016 9/30/2017 9/30/2018 9/30/2019 9/30/2020

Bitcoin

Source: Coindesk, 11/12/20. Look at www.coinmarketcap.com

Lending Innovations • P2P lending is example of disintermediation

followed by re-intermediation ➢Aka Marketplace Lending

• Lending Club statistics published June 2017:

Grade A B C D E F&G

Ave Interest Rate

7.26 10.79 14.01 17.20 19.94 24.04

Ave Net Ann Return

4.86 6.29 6.69 6.32 5.59 4.52

Crowdfunding (page 631)

• Raising funding for projects on line • Donation based

• Debt based

• Equity-based

• Initial Coin Offerings (ICOs) are an alternative to IPOs where a company issues a new digital currency, usually in return for a digital currency such as bitcoin

Regulation

• Regulation is a barrier to entry for FinTechs

• Regulators do not want to stifle innovation and have come up with some plans that provide some regulatory relief for innovators

• But regulating FinTechs is a challenge (e.g., HFTs have caused problems for regulators)

• Can a computer program be regulated in the same way as the systems in a large bank?

RegTech

• RegTech is the word used to describe the use of technology to improve compliance with regulations. Examples: • Screen customers and transactions in real time for

money laundering, terrorist financing, and sanctions

• Monitor staff communications using machine learning to determine outliers

• Use a library of global regulatory requirements

Risk Management Mistakes to Avoid

Risk Management and Financial

Institutions 5e, Chapter 29,

Big Losses (Business Snapshot 29.1, page 644-645) • Allied Irish Bank ($700 million)

• Barings ($1 billion)

• Enron’s Counterparties ($ billions in lawsuits)

• Hammersmith and Fulham ($600 million)

• Kidder Peabody ($350 million)

• LTCM ($4 billion)

• National Westminster Bank ($130 million)

• Orange County ($2 billion)

• Procter and Gamble ($90 million)

• Soc Gen ($7 billion)

• Subprime Mortgage Losses ($ tens of billions)

• UBS (2.3 billion)

Related to a single individual = internal controls

Risk Management and Financial

Institutions 5e, Chapter 29,

Risk Limits (page 643-645) • Risk must be quantified, and risk limits set

➢Procedures in places to control the risks

• Exceeding risk limits not acceptable even when profits result

• Do not assume that you can outguess the market

• Be diversified

• Scenario analysis and stress testing is important

Risk Management and Financial

Institutions 5e, Chapter 29,

Managing the Trading Room (page 647-649)

• Do not give too much independence to star traders

• Separate the front, middle, and back office

• Do not blindly trust models

• Be conservative in recognizing inception profits

• Do not sell clients inappropriate products

• Beware easy profits ➢Are there potential operational, credit, or market risks?

Risk Management and Financial

Institutions 5e, Chapter 29,

Liquidity Risk (page 649-651)

• The credit crisis of 2007 has emphasized the importance of liquidity risk

• Need to ensure that liquidity funding needs can be met in stressed market conditions

• Beware when many are following the same strategy ➢Will slippage occur to enter and exit the positions?

➢Liquidity Black Holes?

• Do not make excessive use of short-term borrowings for long-term needs

• Market transparency is important

Risk Management and Financial

Institutions 5e, Chapter 29,

Lessons for Non-Financial Corporations (page 651-653)

• It is important to fully understand the products you trade

• Beware of hedgers becoming speculators

• It can be dangerous to make the Treasurer’s department a profit center

A Final Point (page 653-654)

• Three types of risk • Known

• Unknown

• Unknowable

• Flexibility is important ➢Avoid excessive leverage

➢Diversify across products and sectors

Risk Management and Financial

Institutions 5e, Chapter 29,

Thank You