Black Scholes Pricing Model

Earlier in the semester we looked briefly at the Black Schoels pricing model and how it is used for pricing options. We also discussed this model in my finance class, so I thought it would be interesting to look at it in a bit more depth and do some actual calculations to see exactly how different options are priced. For example, it is very interesting to see how much the price of an option can change simply due to a change in maturity, volatility, or price of the stock.

I created a fairly simple Excel spreadsheet that computes the prices of puts and calls based on changes in different variables. It is able to change the variables: standard deviation, risk free rate, exercise price, price until maturity, stock price, and dividend yield. The blog does not have the capability to attach files, so here are a few screenshots of the Excel sheet and the prices that resulted. I used the respective formulas for determining the price of puts and calls for this model and input them based on the set of factors used in the equations. I think this is a very helpful exercise to do because it showed me how easily the prices of these options are affected. For example, by only changing the time to maturity on a stock, from 1 year to 5 years, the call price increased from under $2 to almost $7.

Additionally, as part of this spreadsheet I priced the option using both the Black Schoeles model as well as using the Put-Call Parity, I thought this was very helpful because it directly showed that these are always equal.

The following depict the price changes due to a change in maturity (all other factors held constant):

The following depict the price changes due to a change in volatility (all other factors held constant):



This shows the large change in options pricing that can result from an increase in volatility. For example, as seen in the images above, from an increase in the standard deviation (from 20% to 70%), the price of a call increased from $2.77 to $13.59, and the price of a put increased from $7.03 to $17.85.

Overall, I think the Black Schoels pricing model is a great way to view the pricing of calls and puts and how changing different variables affects these prices. However, in using this model, individuals definitely need to be careful, as it does have a large number of assumptions within its formulas. For example, in order to use this model the risk free rate must be constant, there must be no transaction costs, the stock does not pay a dividend, are securities are perfectly divisible, and there are no restrictions on short selling (among other things). But, I do feel like this model is a great way to see the interaction between all the different variables in pricing options.

Black-Schoels Model – Wikipedia

Info and Equations for the Black Schoels Model

Critique: Retirement Plans

In a post by Zach, he discusses retirement plans and how it is still necessary to save for retirement despite the current problems in the economy. Zach explains that many employees are often worried about problems with their retirement funds supplied by employers and now that fear seems to be happening. He gives details about some companies that are now liquidating their retirement funds to maintain operations in the current economic climate. Zach also notes that Fidelity Investments still seems to be doing fine, with only a 1% drop in overall retirement funds.

Zach’s Blog

I found his blog to be quite interesting because I had the opportunity to intern at Mercer consulting this past summer as an actuarial intern within the pension/retirement department. I was able to see the variety of different retirement plans available – and worked with defined benefit and defined contribution plans. However, in reading the article Zach mentions, it notes that the changes being made are simply to the matching of funds by employers. With an ever increasing switch from defined benefit plans to defined contribution plans, where employees are more liable for their own investments, employer contributions are a key thing. Therefore I agree with Zach that this is definitely a problem and I am not surprised at the fear this causes employees.

DB vs. DC Retirement Plans

However, on the other hand there are a vast amount of laws protecting employees from unfair changes in retirement plans. The Employee Retirement Income Security Act has been implemented since 1974. ERISA does a great job at protecting the assets of millions of Americans so that funds placed in retirement plans during their working lives will be there when they retire. ERISA does set limits for employees such as how long the must be employed to become a participant or what rights their spouses have for being a part of their 401K plan, among many other things. However, it also requires that those employers who establish 401K plans meet certain minimum standards, so employees are well protected.

401K Regulations

I also strongly agree with Zach’s suggestion that individuals should prepare for their retirement outside of one’s employer and the government. In looking at statistics about retirement savings, it is quite shocking and unnerving to see some of the numbers. For example, two in five workers say they are not too willing or not at all willing to cut back on their spending in order to save for retirement. Additionally, four out of ten people aged 55 or older have less than $100,000 saved toward their retirement. The problem is that many people don’t view retirement saving as an important enough thing and are more focused on their current situation, often times saying that they are willing to work longer if they have to. But, pair this with the fact that four in ten retirees end up having to leave the work force earlier than expected due to health problems, disability or company downsizing. So, even though an individual feels that they don’t need to save up, and will just work more years, this doesn’t always work out like planned. People need to view retirement saving as a more important thing, as it determines what their quality of life will be once they finish working.

Retirement Statistics

Overall, I think that people need to be more aware of saving for retirement at an early age. I realize that there are many other aspects of an individual’s life that may seem more vital at the current time, especially given the current economic circumstances, but this is definitely something that should not be ignored. Often times individuals rely too much on government and employer aid, and this is not right. Though I think it is unfortunate that some employers are lowering their matching contribution for defined contribution retirement plans, it almost seems necessary given current circumstances. Given the choice of layoffs to save money, or lowering retirement plan funds, I think most employees would choose the later. Especially given the fact that there are many laws protecting employee defined contribution plans, and a great deal of this is also set in employees contract upon their hire. So, with a little more savings on the part of individuals for their retirement, they will be much better off.

Ford and Government Bailout Money

In Keval’s post from April 6th, he discusses the fact that despite huge bailout requests from major competitors, Ford has not requested or received any bailout money. Instead, Ford has decided to take action themselves – working on a variety of aspects of their company to survive on their own through these rough financial and economic times. Keval explains that they have already reduced their debt by $9.9 billion and increased their share price by 16%. Keval believes that this strategy Ford has, to survive and increase value on their own, is a great one, because it pleases shareholders and consumers. He says that if consumers see that Ford required no assistance (unlike its competitors), managed themselves efficiently, and still increased value, that they would be extremely happy and pleased with the company. This suggests that these consumers would be more loyal to Ford, rather than its competitors.

Keval's Post

For the most part I do agree with the points that Keval makes about Ford. I think it is quite admirable that they are going through these rough times on their own. This is especially true given how much Ford’s competitors – GM and Chrysler – have accepted in government bailout money. In fact these two companies just recently asked for $22 billion more in bailout money. An article I found from MSNBC describes in detail Ford and its strategy to avoid government assistance. The article mentions good things Ford is doing such as standardizing its products globally, improving the efficiency of management, and moving towards more fuel-efficient vehicles, which are helping it succeed within the market. However, Ford is also doing other things to decrease costs, which aren’t necessarily good for everyone. For example, they have had to shut down a number of manufacturing plants (causing layoffs), and have worked with United Auto Workers to make large pay cuts across the company. So, although the company is not accepting government bailout money, it doesn’t mean everything is going great for the company. Additionally, the article explains that they feel it is just a matter of time until Ford does succumb and accept government money. One main reason for this is because Ford has been quite overoptimistic on their sales, and if these sales goals are not met, Ford will be in trouble. For example, its assumptions for sales are 1 million more than its competitors and they have not correctly accounted for different costs associated with sedans verses trucks verses SUVs, which can greatly affect their cost structure and profit.

MSNBC Article: How Long Until Ford Also Needs a Bailout?

Additionally, it seems as though Ford isn’t in as great of a position as it portrays. For example, Ford recently underwent its worst loss ever at over $5.9 billion, and burned through over 40% of its cash on hand. Though it will definitely look great to consumers if Ford can survive without government assistance, the problem is they most likely won’t be able to do so. Therefore, it seems as though they are unnecessarily making themselves worse off, and simply postponing the inevitable. Additionally, the article mentions that Ford has already asked for a $9 billion line of credit from the government, but has said they have enough cash to make it through 2009, and won’t use government loans unless economic conditions worsen. But, many fear that Ford will need the money eventually and is simply trying to slip under the public radar. John Wolkonowicz (an analyst at IHS Global Insight) explains that “They’ll need money from the government by mid-year. But when they do put their hand out, it won’t captivate the media nearly as much, and it will go by with less fanfare.”

Daily Markets Article: “Ford Says ‘No Bailout Funds’ Despite Worst Loss Ever”

The CEO of Ford, Alan Mulally, has also been quite vocal over the government bailouts within the market recently. Mulally is quite sturdy on his stance regarding the government bailouts, explaining that Ford has not changed and most likely will not change its mind about needing a bailout. Mulally said it would take an “event such as the bankruptcy of a major competitor,” which would also drag down some of Ford’s suppliers, to force Ford to ask for government loans. Mulally also makes very vague statements in this article, such as “Ford doesn’t need a bailout — unless conditions get a lot worse.” However, he fails to give specific statistics or numbers on what he means by “much worse” within the market and economy. The article also mentions that a major reason why Ford has not required government bailouts up to this point is because it did a huge refinancing back in 2006, and recently has drawn down/borrowed last remaining $10.1 billion it had available from that refinancing.

BNET Auto Article: “Ford CEO Mulally says No Bailout Needed – Unless It Is”

Overall, I think that Ford is doing as well as it can to avoid government bailouts given the economy. I think it is admirable that they are looking towards alternatives instead of simply giving in and asking for assistance like their competitors have. It will be a great thing for the company if they are able to make it through, without any government assistance. However, from these articles I’ve read it seems that that might not be the case. Ford has seen a great deal of losses and may end up in the same position as its competitors soon. However, the thing that worries me most is if Ford deceptively takes money from the government without disclosing it, thus deceiving customers. This seems like it could be possible given the fact that Ford already has asked for loan money, but has not actively taken it yet – making it much easier for them to actually accept the money soon, without others knowing it.

Credit Rating Agencies and the Mortgage Crisis

Recently in class we have been discussing a lot about credit rating agencies and the role they play. These companies are responsible for assigning credit ratings for issuers of certain types of debt obligations as well as debt instruments themselves. A credit rating assigned takes into consideration a variety of aspects about the issuer’s credit worthiness, and thus affects the interest rate applied to the particular security being issued. Some of the main credit rating agencies within the U.S. include Moody’s, Standard and Poor’s, and A.M. Best.

With the current crisis going on in the U.S. economy, a great deal of attention has been focused upon the loans given to subprime borrowers for mortgages. Recently many people have been most concerned with who is really responsible for all the mortgage problems in the economy today. Some have argued that mortgage brokers are to blame, for pursuing predatory lending practices. While others have blamed the mortgage problems on the actual home owners who accepted loans they could not afford. Still others have pointed the finger at the SEC for easing lending regulations and investment banks for creating defaulting securities. Though, it seems like the most common answer for who to blame is now the credit rating agencies, who have been irresponsible in giving ratings to borrowers.

I was interested in this topic, so I researched a little more about it and came upon an article by the Business Times Online, titled “Credit Rating Agencies Admit Ranking Many Mortgage-Related Securities Too High.” This article goes into detail about how the CRAs have now accepted some responsibility for the mortgage crisis, and have said that they have assigned ratings on many mortgage-related securities that are far too high. The article also explains that one of the main problems was that many assumptions used in preparing the ratings on mortgage-backed securities did not work because of the extreme economic and financial situation the United States is in. The CRAs are now looking for a new way to create these ratings, since it is evident that the current system is quite inefficient. In fact, the article mentions that recently the three big agencies agreed to work with New York attorney-general to overhaul how they evaluate investments backed by high-risk debt. This is a start to fixing the current problems in this system.

I agree with the article that something needs to be done to make changes to the way the ratings are currently being done by the CRAs. Clearly, many ratings have been too high as seen by the high level of default. I think that they definitely need to look a little bit deeper into the borrowers they are assigning ratings for, and they need to better determine what aspects affect the repayment of the debt. Also, I think another major problem, which was briefly brought up in the article, is the whole idea of this system. The credit ratings agencies are competing for their business and being paid by the debt issuers. This is a major problem, considering it prevents the analysts from putting the investors’ interests first. I think it may be a poor idea to place the blame for the whole mortgage crisis upon one entity, but I do think that it is clear that the credit ratings agencies did play some role in this whole mortgage disaster we currently face.

The Subprime Mortgage Crisis Info

Wikipedia Definition of Credit Rating Agencies

Business Times Online CRA Article

Critique of Ceiling on Credit Card Fees

In a recent blog post by Yu, he discusses his thoughts on the recent legislation considering credit card fees. The article he discusses explains that the senate is considering putting a limit on the fees charged to consumers by major credit card companies. This measure is aimed at “punishing credit card companies that raise their interest rates to a high level and at giving consumers who may be on the verge of bankruptcy greater leverage to negotiate better deals with those lenders.” Yu suggests that this measure is a bad thing, because it undermines the credit system. He explains that individuals know what fees they are being charged and should take this into consideration in evaluating their use of their credit cards. Yu also gives examples of those who use credit cards properly such as those building up their credit history, and college students who use credit cards. Additionally, he explains that these fees help give credit card companies revenues, and individuals need to take responsibility for their own actions rather than always requiring government intervention.

Yu's Blog

I agree with many of the points Yu makes within his blog. I think that too often, people depend on the government to bail them out of the financial situation they get themselves into, and this is not right. I found another article that further detailed this plan by the government. It explained that this new bill is called the Consumer Credit Fairness Act. It would prevent companies from raising their interest rates higher than 15%, plus the current yield on a 30-year treasury bond (18.5% total). The article also explained that though these changes could be positive for consumers, they could really affect the whole credit industry, causing a reworking of “credit card industry’s internal operations, pricing models, and functioning mechanisms.” And in fact, these new laws could be imposed in as soon as 90 days if it is passed.

Credit Card Fee Limit (Fox News)

The first thing I looked into after reading this article was looking at some of the statistics about credit card usage. It seems like so many people make unwise credit decisions, purchase beyond their means, and don’t consider the consequences they will face when they can’t repay all their debt. For example, in 2008 the total balance of bank-issued credit cards per consumer was $5,710. And, total U.S. consumer credit card debt reached $2.56 trillion at the end of 2008. These amounts are quite high and show the lack of consideration on the part of consumer. Though I do believe credit card companies do charge high, unreasonable fees in some circumstances, that is the industry. It is not the responsibility of the credit card companies to limit their fees to help out those consumers who have made unreasonable risks and poor decisions in accumulating debt they can’t repay.

Credit Card Statistics

Additionally, I feel like this is a poor thing for the government to do because it just shows people that they don’t have to be responsible for their own actions. For many years before I even had my own credit card I was taught how to make good decisions regarding credit cards and purchasing. There are so many resources out there to teach people how to handle credit properly, and how to get out of debt if they do make poor decisions with their credit cards. I do feel bad for those that are struggling with their mortgage payments, and bills, and now the additional fees that they face from these credit card companies, but that is simply not a problem that the government should control. When an individual gets a credit card they are presented with all the information on fees and rates they will be charged on their cards, and it is their responsibility to go over this and base decisions based on this information. It is required that credit card companies disclose this information, and it is something that consumers clearly need to pay more attention to. There are already many regulations on credit card companies that ban unfair and deceptive practices, and this would be yet another thing imposed on them. Credit card companies need a way to profit, and putting more and more regulations on them will limit their ability to do so. The following site I found gives great advice to individuals with credit cards. They offer may suggestions on how to avoid costs of going over one’s credit limit. These include knowing your credit limit, not expecting your creditor to stop you, enrolling in balance alerts, keeping your balance low, and remembering to consistently check your balance if you aren’t sure what it is. Many websites such as this exist which will help individuals better manage their finances and the costs they assume by using credit cards.

Suggestions to Avoid Credit Card Fees

Overall, I feel that the government should not need to limit the fees and rates charged by credit card companies so stringently. These companies already have so many regulations and limitations upon them and this would just be one more. People need to take responsibility for their own choices, and their buying decisions using credit cards. I realize that the economy is hard right now and it is causing more people to use their credit cards more often. The reality of it is that people need to assess the levels of risk they are assuming in their financial decisions, and using credit cards is one of them. Simply bailing individuals out all the time and being so strict on credit card companies does not teach individuals to have any responsibility.

Short Selling for Homeowners

Recently in class we had been discussing all sorts of different options, forwards, and combinations of these. As I was looking up more information about these topics, in particular about short sales, I came upon a very interesting article about a new trend in selling short. This is for the mortgage/housing industry, as individuals are beginning to sell their property and houses short within the market.

Because so many families nowadays are having trouble keeping up with their mortgage payments, they are looking for any way possible to get out of their difficult circumstances. This is how selling short comes about for homeowners. In a short sale, the lender allows the house/property to be sold for less than the total amount due on the loan, and in some cases the lender forgives the remaining debt. The process was not even heard of by most before the whole housing mortgage crisis, but now it is helping many people avoid foreclosure on their houses.

Overall, it seems to me that short selling for homeowners can be a really great helpful thing for those with financial hardship. Given the high levels of unemployment, increasing layoffs, declining sales, and struggling stock market that we have in the economy today, it is inevitable that people will have problems paying their mortgages. This is especially true given the unreasonable loans many individuals were given, making it very difficult for them to make such high payments in the first place. Short selling is very helpful for these people because it gives them an option besides foreclosure. Foreclosure would leave a long-lasting mark on one’s credit history and can take a very long time, costing them even more in the long run. On the other hand, short selling can be a faster and less expensive process. Additionally, it is helpful because short selling does not look as horrible on one’s credit report.

However, I definitely don’t think short selling is perfect on all levels. One problem could be that it is difficult to convince a lender to short sell a property. Also, another major problem is that in the case that some amount of the loan is forgiven by the lender, it still will most likely be subject to taxes, that the borrower has to pay. Though, I think this might be a good thing, as it still makes the borrower somewhat accountable for their insufficient payments made.

Overall, it seems that there are positive and negative aspects to short selling for homeowners. It’s great that it offers struggling homeowners an option besides simply foreclosure. However, both positives and negatives need to be considered. As this new strategy becomes increasingly popular, there are a growing number of websites that explain the process and provide resources for those that might be interested in short selling their homes.

The New Exit Strategy: A Short Sale

How To Do a Short Sale

Assessing Risk Tolerance

In class we have been discussing risk tolerance little bit, with respect to industries as a whole, as well as particular companies, and individuals’ portfolios. So I decided to learn a little bit more about how risk tolerance is assessed, and find some instances to view risk tolerance. One thing I find interesting is how individuals assess their own risk tolerance in deciding what investments to choose and how to keep their finances on track.

First of all risk tolerance, like discussed in class is the degree of uncertainty that an investor can handle in regard to a negative change in the value of his or her portfolio. I read an article from Consumer Reports Money Advisor that had very detailed information for investors on how to assess their personal risk tolerance on a variety of levels. I feel like this is a really important thing for investors to do on a frequent basis, especially given the high level of volatility in the market today. Assessing one’s risk tolerance helps plan for the future, and like the article stated “Determining your risk tolerance is essential.
You don’t want to react emotionally when the market tumbles.”

An additional aspect of the article that I found interesting was it offered resources for people to learn more about the risk and rewards associated with their investing activities. I think that often times people simply listen to the media when making financial decisions, and end up selling low, and then get back in when the media say that the market is starting to run up, even though it may not always work out like planned. By being better informed and educated about the market, people will be able to make better decisions in the diversification of their portfolios. One great resource the article gives readers is www.vanguard.com. Vanguard’s website offers an online risk-tolerance questionnaire, with relevant suggestions on how to apportion one’s money between stocks, bonds, and cash. This is very helpful so that investors can calculate how risk tolerant they are, and how much they could lose given their investment choices.

Additionally, the article also discussed other need’s one has in order to protect themselves from risks in life. One of the main issues discussed was life and health insurance. The article explains that most people do not buy nearly enough coverage to protect themselves. For life insurance in particular, “They rely on old rules of thumb, like buying coverage equal to six times their annual income. This method doesn’t take into account your financial goals, like putting your children through college or providing a comfortable retirement income for your surviving spouse.” I feel like it is very important for people to be well insurance, especially with regard to health insurance (and life insurance depending on age). I have a few friends that don’t have health insurance at all, and it is a scary thought that they may get very sick, and not have access to the medical treatment that they need. I feel like this is another level of measuring one’s risk tolerance. Sometimes, it seems that individuals view themselves as completely free of risk. But, individuals need to take a step back and see all that they could possibly lose, and all that is at risk.

From the article, I gained an even better understanding of risk tolerance and the importance of it in an individual perspective. I think that is clearly shows that it is beneficial to really consider one’s risk tolerance before entering into investments for a portfolio, or other risky aspects of life. This can help an individual personalize the correct portfolio for themselves based on their particular risk tolerance and how much uncertainty and possibility of losses they can handle.

Consumer Reports Money Advisor

Vanguard

Problems with the Public Education System in the U.S.

In Dwayne W.’s post from March 10th, he analyzes the U.S. public education system and the problems it has caused in the country. He asserts that our poor education system is much to blame for the economic crisis that we are currently in. Dwayne explains how many teachers nowadays simply pass all the kids in their classes, despite the fact that some really should be held back to ensure they have fully grasped important concepts. He explains that these poorly educated individuals often times grow up, and have a very poor understanding of finances and how to manage financial decisions within their lives – such as when entering into a mortgage. Dwayne argues that in order to fix the economy, we need to look are more than just money, and truly understand the underlying aspects behind the country’s problems. One of these main problems is the public school system. With more funding and focus on education, the U.S. will be able to see positive results, as our labor force becomes better educated and prepared for more advanced careers.Dwayne's Blog

Dwayne's Blog

I agree with the points that Dwayne brings up about the education system in the United States. Like him, I saw lack of concern for some students at my college, as teachers passed them, despite the fact that they really should have been held back. It seems to me that many times this occurs because teachers are highly reprimanded and questioned for failing a student in a class, particularly if it hinders the student from an on schedule graduation. Or, the teachers simply don’t want to deal with the student in their class anymore. This is a very poor way to look at education – if a student is struggling and fails to understand the material of the class, they should be held back until they fully understand it. Although holding them back may cause short term frustration for the student, it is undoubtedly worth it in the long run, as it will allow the student the opportunity to learn more and eventually achieve more success in life and their career. This will ultimately help the U.S. get out of the economic crisis, by increasing the pool of skilled, educated individuals in the country in the work force.

One article about this issue I read was published by Stanford University, and focused a great deal on how this education crisis is a cause of so many issues in the U.S., and contributes to the economic problems we face. New York City Schools Chancellor Joel Klein said that “The greatest domestic issue we as Americans face is failing to prepare students to compete globally in the 21st century.” I feel that this relates well to Dwayne’s article, because of the fact that without this, the U.S. will not be competitive with other countries labor around the world. The quality of public schools in the United States is embarrassing and upsetting compared to those of Asian and European countries, especially with regard to math and science. The problem is that without proper education, these individuals are unable to contribute much to the work force of the U.S. and employers look elsewhere to fill positions. This is causing companies to draw in more experienced, educated individuals from other countries, rather than looking within the country, causing a problem of diminishing jobs available.

"Public Education Crisis ‘The Greatest Domestic Issue’ Americans Face Today" by Lisa Trei

Additionally, another article I found placed the blame more on lack of math education, rather than just the U.S. public school system in general. This article, by James Bowers, gave some alarming statistics about the majority of the population. For example, “65 percent of respondents could not identify what remained if you subtracted 25 percent from eight. Another question revealed that 1 in 3 adults could not calculate 1 percent of 50,000.” If individuals can’t even do simple math such as this, how could they possibly calculate how much a mortgage would cost them, and if they were financially able to afford it based on their income. Clearly, the public education system did not do an adequate job at preparing these individuals for real world situations, such as a mortgage. Simple fees get translated into confusing annual percentage rates, and it's a lack of understanding on these issues that results in many people taking on car and home loans they can't afford, and overdrawing their bank accounts. In fact, a new FDIC study showed that banks make billions of dollars in overdraft fees - an expense that disproportionately targets low-income and uneducated Americans.

"Financial Mess Stems From Poor Math Education" by James Bowers

The problem is that the United States needs to be much more focused on education, starting from lower grade level children all the way through college aged students. More education and hard work from Americans ultimately leads to more economic freedom and will greatly help out the economy. Human capital is the most important resource, and it is something that the United States nowadays is clearly behind in. The problem is that there are few well educated individuals that can compete for high power, high paying positions in many companies, and a multitude of uneducated or poorly educated individuals with very little to offer. For example, in an article by Nicolle Girolamo and Helen Siaxabanis they explain the market now “consists of a few skilled labors that command high wages, while there is a flooded market of unskilled labor that ‘have little bargaining power.’” By focusing more on education, the U.S. will be able to increase the pool of talent, thus minimizing the effect of poor education on the economy.

"Lack of Education Driving Force of Poor Economy in U.S." by Nicolle Girolamo and Helen Siaxabanis

Overall, it is evident that the U.S. needs to do something to greatly improve the quality of the public school system. It seems that more and more, we are falling behind other countries, who consistently better prepare students for the future. If something isn’t done then individuals will continue to lack the knowledge necessary to lead a fulfilling life with a good career, and will continue to make mistakes, such as those that caused the whole mortgage crisis we are in. Additionally, if the education system is not improved, our level of human capital will continue to fall below that of other countries, and more and more employers will look to other countries for possible employees. By increasing our pool of educated, skilled labor, it will undoubtedly make a big difference for the U.S. economy.

AIG Executive Bonuses

In Yu Y.’s post from March 16, 2009 he argues that the AIG bonus payments to executives are a bad thing and that the company needs to be restructured, especially with regard to their risk management techniques in place. He explains that by accepting such huge bailouts from the government, AIG is not only ruining their public reputation, but they are also putting a huge burden upon taxpayers, who are now expected to pay for these executive’s bonuses. He believes that by redesigning AIG, they will slowly but surely regain a positive reputation and respect from the public.

Yu's Blog

Though I do agree with some parts of Yu’s post, I feel that he is not taking enough factors into consideration when looking at this bailout for AIG’s executives. The media seems to be portraying these AIG executives automatically in a very negative light, and this is simply not fair to them, since none of us really know anything about these executives. Though some of the fault for the failure of the company may be based on their actions, that’s not something we can really determine. There are many reasons why these bonuses may be quite needed, a good thing, and help AIG begin on the path to recovering and regaining their reputation. The reality of it is that they were promised these bonuses, they will cost $165 million, and it could have been avoided if specific bills were signed as listed in this article by the Associated Press, such as signing a provision on the economic stimulus bill that would have denied such payments being made.

AIG Executive Bonuses - Yahoo News

First of all, many AIG executives either would not take the bonus money in the first place, or have since given back the money received. In fact, many of them had even already given a great deal of their regular salary to AIG to help the company get through this crisis. If you think about it, these executives want to help AIG as much as they can, this is the company they work for, and if AIG fails, they are out of a job and looking for new work elsewhere. The below article details specifics on executives that have given back, or plan to give back their bonuses. One particular executive listed is Jon Liebergall, who was the co-head of North American marketing for AIG's financial products.

AIG Executive Give Back Bonuses

Another thing is that AIG executives were promised bonuses in their contracts. So many contracts lately have been completely thrown out and disregarded, but this is not a fair thing to do at all. If a contract is made and is then not something that has to be followed up with, why would anyone ever want to enter into a contract anymore? If one thinks about this from a risk management standpoint, consider things such as forward contracts. If an individual could enter into a forward contract and then not fulfill it – either by not paying as they had promised, or not delivering a set amount of goods, then no one would ever enter into this sort of contract again. Yes, it is unfortunate that AIG failed, and yes it is partially the fault of some employees, but it isn’t right to deny an executive a bonus, when most likely they were working hard all year in expectation of that bonus, as promised in their contract. The below article explains that these bonuses are necessary due to this contractual obligation, stating “an individual employee of AIG, who entered into a good faith contractual relationship with his employer requiring the employer to pay a bonus to the employee who has not broken the law or breached the employment contract, has a right to receive the benefit of the bargain – just like you and I do in our contractual relationships.”

AIG Contractual Obligation

Additionally, because AIG is going through such a rough time right now, the last thing they want to do is lose valuable, hard working employees. Though it is just speculation whether these executives were really hard working or not, we cannot simply just assume that they are responsible for the problems of the company. AIG needs to keep their talented workers right now, and if giving these executives bonuses is the way to do it, then at least that’s a start. If these executives were really great at their job, and didn’t receive the compensation they deserved, they would immediately be out looking for a new job, which is going to harm AIG even more.

I think that everyone needs to take a deeper look at the role these executive bonuses pay for AIG as a whole. It is not right to simply assume the worst about these executives, when that simply may not be the case. There are many reasons showing that these bonuses may really be needed to help out AIG, though it is unfortunate that such a huge bailout is required for them.

Weather Derivatives

Recently in class we have been discussing derivatives and the role these play within risk management. We also specifically looked at weather derivatives and the affect these have on particular industries. I found this interesting so I found an article on a specific instance of a weather contract being used. The weather derivative contract in this article was entered into by Swiss Re and the International Development Association (IDA). The IDA is the arm of the World Bank that helps the world’s poorest countries.

I thought this was quite interesting, because usually individuals associate poorer, less developed countries with a higher agricultural industry, which seems to be true in this case. For this particular weather derivative that they entered into, Swiss Re will pay out up to $5,000,000 in the event that Malawi’s farmers suffer drought-related shortfall in maize production.

What was interesting about this contract was that it is structured on a rainfall index. Rainfall and maize production are highly correlated, so this worked well as a factor to base it upon. So, if the rainfall falls below a certain amount, Swiss Re will pay out an amount based on the projected loss. The article states that the maximum payout is reached if maize production drops to 10% below the historical average.

Like we discussed in class, it seemed that this derivative contract was well planned out as it is based on geography. Therefore, an individual farm owner must still do their work and it averages out for a certain geographic location within Malawi, since it depends upon the rainfall. This also works well because it reduces possible moral hazard. The contract is based upon historical maize production, and depends upon the rainfall which an individual cannot control, so it is definitely still in their best interest to farm as efficiently as possible. This is especially true since an easy comparison could be made between various farms within similar locations in Malawi with respect to their maize production.

Additionally, I found it interesting how heavily Swiss Re is involved in weather derivatives. From the article it seems as though they have been a huge member in dealing with weather risk transfer instruments. For example, they started with these risk instruments in India, reaching over 350,000 smallholder farmers. First looking at this, it seems like Swiss Re may have a lot of stake in weather derivatives, and is possibly not as diversified as they should be, given that there may unfortunate weather conditions around the world. However, I assume Swiss Re is a very large company and has significant stake in other industries and areas as well. Additionally, because Swiss Re has these types of contracts in areas around the world, it will most likely balance out in the end. For example, India may face very bad weather one year, harming their agricultural industry and costing Swiss Re money, but Malawi may have great weather and create a profit for Swiss Re since they won’t have to pay out any money to that specific country.

Swiss Re Weather Derivative

Economic Crisis: GM and Chrysler Bailout

In the post by Keval P. from February 21st, he discusses the problems that GM and Chrysler are facing within this difficult economy. He explains the possible merger that will occur between the two companies that has been discussed for some time now. He also explains that both GM and Chrysler feel like they are better off on their own, and will reduce costs by shutting down excess factories. Keval argues that the job loss from these two companies would be quite detrimental. Therefore, he feels like the 26 billion dollars that each of the companies have requested is reasonable and should be complied with by the US government. Keval feels that this is the best solution to protect these companies from further loss, and possible layoffs coming.

Keval's Blog

Although I do think that the jobs lost by the layoffs of GM and Chrysler would be quite unfortunate, it would not have a huge affect in the general scope of the current economy. If the statistics Keval is giving are accurate, then only 23,000 jobs would be lost from these two companies if the government doesn't keep stepping in to fund these companies. CNN reports that 2.6 million jobs have been lost in 2008, making unemployment rise to 7.2%. Therefore, although these additional layoffs would raise these numbers even higher, it is not a substantial amount compared to many other companies facing layoffs, especially at the cost of 26 billion per company to keep them funded.

CNN: Jobs Lost

Additionally, although the government could continue to help out with funding GM and Chrysler, it is just going to cause the government and the United States to go further into debt, and will cause more and more companies to request monetary assistance. I found an article that specifically deals with the GM bailout and ideas for how it should be approached. The article makes a good point, arguing that the government should not just hand over money to GM and Chrysler, but implement a plan to help out these companies while at the same time making sure they take the effort to restructure and that it doesn’t hurt tax payers. They suggest a “DIP (Debtor-in-Possession)” loan, which will cause less layoffs, let them restructure over 18-24 months, and minimize costs to tax payers since the DIP loan is provided financing directly, or through private financial institutions, and is well protected. I think this plan also seems like it will work well because it will make GM and Chrysler work to improve, and will force them to reorganize so that bad management is not rewarded and it will minimize moral hazard.

GM Bailout Information and Advice

I also feel like if the government simply keeps agreeing to bail out and fund all these companies, then it will just continue to cause more problems, as more companies start to request funding, and the government surges further into debt. I feel like the market is designed to work itself out, and those companies that have been managed well will find ways to survive without such massive assistance from the government. It is the fault of these companies if they didn’t have proper risk management strategies in place to protect themselves from uncertain outcomes. Had a company managed their assets properly and had efficient management, it would most likely be in a much better place in the economy, and would not require $26 billion dollars assistance from the government, like GM and Chrysler are requesting. I found an article focusing on this bailout effort, which did a great job of analyzing the current steps that the government is taking, as well as what it is likely to do in the future. Most likely, the government will continue to help out some, but not all companies, especially given the fact that we do not know how much longer the current crisis is going to last for. It is undoubtedly being felt globally, and it is something that taxpayers are eventually going to have to pay for.

US Bailout Information and Risk

Insurance Contracts: Price and Quality

Recently in class we have discussed insurance contracts at depth, including influences of such things as deductibles, limits, and coinsurance. The one aspect I found most interesting is the fact that most people focus all their attention on price in deciding upon an insurance contract. Most people don’t realize that the quality of an insurance contract is a huge factor that needs to be considered, as it has a strong influence upon them.

For example, I found an article discussing how much time and effort it takes for insurance companies to determine the pricing for their various plans. Insurance companies take a great deal of time to put together these contracts because they have quite complex legal provisions and contractual terms within them. They also often spend millions and millions of dollars on lawyer’s fees and many of them have groups of professionals who are analyzing and amending terms of their contracts to cover any possible outcome.

Therefore, I think that overall people need to be more aware of the details involved in the insurance contracts they are becoming involved in. Many times people simply focus too much on the price and make a quick decision. Most individuals don’t have a great deal of time to get familiar with the contents of an insurance contract and simply glance over a contract before going with it.

Though many insurance contracts one may be looking at will be quite similar – whether this be car, medical, mortgage, life insurance, etc. There are differences between companies, and one should especially pay attention to the quality of them companies – in terms of their financial data, such as the assets they hold, and their investment grade. One also should pay close attention to what exactly is covered in the insurance plan. Many times insurance contracts are drawn up with certain exclusions, and one needs to read closely to see what they really cover. For example, a person may need coverage on something that is excluded, which they could get if they only paid a little bit extra. This is something that needs to be determined before a problem or claim arises. In some insurance contracts there are also some exclusions and conditions that one must meet to keep the policy valid, so this needs to be taken into consideration as well.

I feel like another thing that needs to be taken into consideration more by individuals, is to purchase insurance in the first place. I personally have several friends that don’t have medical insurance, or even car insurance (which is not only dangerous, but also illegal). I found another article that examined the importance of purchasing insurance. This article focused on five groups: health insurance, life insurance, car insurance, property insurance, and casualty insurance. Life is quite unpredictable, and one can’t simply hope that unfortunate events will not occur to them; therefore purchasing insurance provides protection from these things. Though insurance may cost money in the short run, the money it will save in the long run, and the security and peace of mind it provides are certainly worth it.


Necessary Insurance

Understanding Insurance Contracts

Risk Mapping and ExposureView

After discussing the idea of risk mapping in class I decided to research a bit more about it. I came upon an article about a new software program which completely does this risk mapping process for companies. Including providing them with visual "risk maps" as the ones we viewed in class.

I was thinking about the fact that a company's risks and exposures are constantly changing, so it seems that as soon as they would be able to come up with an appropriate risk map and plan, things could change. A company often will experience unexpected events which could completely reshape and transform their risks. This is especially true given how unstable and unusual the market is in today's economy.

Well, this new software is called ExposureView and it is in particular designed for insurance companies. It lets them visualize the impact of catastrophic events on their portfolios before, during, and after an event. The software is used with range of data including personal and commercial property, workers compensation, and offshore platforms.

ExposureView includes feature called ExposureCube that allows the companies to interact with their data to build and deliver reports instantaneously. Functionality includes "summarizing, filtering, drill-down, roll-up, and standard pivot table features to enable users to quickly create all possible reports from one dataset."

I think what seems great about this program is the company can change the information and data in the system and get instantaneous results. It also seems great that they can enter information to forecast what will happen given certain risks that may happen in the future. It seems like all these things would be much more difficult and time consuming without such a software product.

From searching I did it appears that there are many other risk mapping software programs that have similar functions to ExposureView, including Sobedi and RISK-MAP. Additionally, it appears that many consulting firms take on this role themselves and consult companies on their risks and provide them with similar visuals to physically show them their risks. However, it seems to me like this would be much more expensive for the company. Additionally, this doesn't give them the same benefit as the software does, to have instantaneous results for different sets of data.

Overall, it seems that the process of risk mapping, to identify risks and determine what specific actions should be taken towards these risks, is a very important technique. With constant advancements in technology that we continue to see over time, it appears that this process will continue to get easier and more accurate for companies. This is seen by the creation of the risk mapping software ExposureView, and various other helpful software programs for risk management.

ExposureView Product Information

Beta (KO vs. S&P 500 Index)

We have discussed the idea of beta and systematic risk a great deal in class thus far. So I decided to put together an example of this using a certain stock and see if I could analyze a bit about the firm and its beta value.

I decided to go with the stock KO (Coca Cola) and using Yahoo Finance was able to find historical returns of the stock over a period of time. I chose to go with September 1, 2008-February 28, 2009 (since this is the most recent 6 month period). I first found the information on a weekly basis for the adjusted closing prices. I did the same with the S&P 500 Index to use this as my comparison for the market values. I found the % change in the closing price for each of the stocks for each week. Below is the Excel sheet I created:




I then put the S&P 500 data vs. the KO data on a scatter plot to try to see the correlation between the stock and the market during this current time period. Below is the scatter plot that I created. I also inserted a trendline to further show this correlation. Excel came up with the equation y=0.6777x + 0.0054 for the line.

From looking at the graph, it shows the equation for the trendline, and since beta is the slope of the line that means the beta for KO for this time period is .6777. Because KO’s beta is less than one, KO is seen to be less volatile than the market (S&P 500).

I also did the above process on a monthly basis for the same time period to see if the results would come out the same or similar for less data points. For that one the equation turned out to be y=0.7568x + 0.0196. So the beta appeared to be larger since it didn't have as many data points to see all the fluctuations that had occurred over the specified time period.

Overall, I think this was a very interesting process to go through. I compared my results to the beta listed on the Yahoo Finance website for KO, and they list beta as .61, so it appears that the beta is pretty close to that in the recent 6 month period. I suppose I thought this was just an interesting thing to see right now given all the unusual circumstances of the market and the US economy as a whole. It was really interesting to be able to work through this and see where that beta value comes from, since it is something we've been discussing in class so much this semester.


Yahoo Finance KO


Yahoo Finance S&P 500 Index

Risk Assessment and Looking for Exposures

Recently in class we have been discussing a lot of things regarding risk assessment of exposures for a company. Therefore I decided to research more about this process of risk management and see exactly how companies go about it. I found a PowerPoint Presentation from the University of Illinois that had a lot of great information.

One of the first things I found interesting was the following chart:

This was interesting to me because it gives a clear picture of a formal process companies go about for analyzing their risks and determining if they are acceptable or not. As you can see some risks may be acceptable for the time being (since no company can be completely risk free), but these exposures definitely need to be reevaluated to insure they are still acceptable over time. Other exposures may be unacceptable and therefore require control in the form of various risk management techniques.

As discussed in class, some ways that it can be determined if these exposures are acceptable, uncertain, or unacceptable is through various processes. This can include looking through financial statements, analyzing internal company pro forma statements, looking at organizational charts, or even risk mapping.

Another interesting thing I read in this UIC PowerPoint Presentation was the view that risk assessment and management is “not an objective scientific process; facts and values frequently merge when we deal with issues of high uncertainty; cultural factors affect the way people assess risk.” This is definitely something we have touched on in class, and I think it is a very important thing to remember in looking at how different companies deal with different risks. Though there are many mathematical and scientific approaches to understanding why companies may view some exposures as more important than others, a great deal of it also has to do with the individual values and culture of the company. Many companies are different and value different things, so as much as none of them are going to like losing cash flows due to a risk factor, they will be accepting of it to different degrees based on the foundation of the company.


UIC PowerPoint Presentation on Risk Assessment and Exposure

Efficient Diversification

Recently in class it seems that we have been talking quite a bit about effective diversification and how it can increase/decrease risks and returns. I thought this was interesting as well because it also ties into what I am learning in several other classes this semester, including my finance class. I think diversification is quite an important concept, so I decided to find some articles and learn a bit more about it. In class, we have been talking a lot about diversification through adding new projects, but I decided to look more in depth at diversification of a portfolio.


I found the following chart, which I think is quite interesting, as it shows the correlation between the risk one takes and the rewards/profits one receives. As you can see, small company stocks have the highest risk, but also the highest reward. Whereas, T-bills do not have a very high return, but they also have the lowest standard deviation in the chart, and are therefore the least risky.

The following picture was quite interesting to me, as it clearly shows the differences between all these different types of investments a company or person can make, and the risks and rewards associated with each.

Additionally, I found charts showing the benefits from efficient diversification of one's portfolio. For example, it seems that most people nowadays do not create well diversified portfolios for themselves. Many invest too heavily in just one company or stock, while others try to diversify their portfolios more so, but still confine themselves too much into one market segment, such as technology. By being more prudent, and investing in a variety of different market segments, in some risky and some less risky investments, one's portfolio will be much more well diversified and profitable.

The following chart gives a good example of how diversifying one's portfolio can be more profitable. Investing in some risky stocks, or projects (like we have talked about in class) can sometimes be a good thing, but this needs to be balanced out with investments, or projects that provide a more stable return.

From this you can see the effect of diversification, that a prudent investor can get great returns by balancing out their portfolio in both risky and less risky investments/projects. I think this connects well to a lot of the aspects we previously talked about in class about diversification, as well as our new topic talking about whether new projects should be undertaken or not, depending on their risk level.

Essentials of Investments


Diversification Benefits

Currency Hedging

After reading the case about Aspen Technology I decided to research and try to learn a bit more about currency hedging and some ways that companies that might engage in this strategy.

A simple way to describe currency hedging is that it is a strategy used by companies when engaging is some sort of foreign investment. Basically, the process compensates for any possible shifts in the relative value of the currency types used within the investment. This way, even if there are unfavorable shifts in the money market, a positive return on the investment will still likely be achieved.

Using currency hedging seems to be a great way to keep the amount of loss at a minimum when dealing with international investments. However, the strategy is quite useful because it doesn't diminish the ability of a firm to make large profits. By using currency hedging, the firm might even be able to become involved in great investment opportunities that otherwise would have been considered far too volatile and risky.

Currency Hedging Definition

I was interested in what other companies may engage in some sort of foreign exchange risk management and found an article about GM. GM seems similar to Aspen Technology in some ways as far as how they manage this risk. Like Aspen Technologies, GM does a lot of buying, selling, and financing in currencies other than the US Dollar. Therefore, they too face risk from the volatility of other currencies. In particular, GM has to deal a lot with financing, since most cars are purchased with some sort of financing contract, much like the ones in place for Aspen's software.

I also thought it was interesting, because I remember reading in the case that Aspen Technology has difficulties finding any counterparts willing to enter into long-dated forward contracts. Therefore, they typically only entered into one or two year forward contracts to protect them from the foreign exchange rate risks. GM is very similar to this, in the article it states that for transactions denominated in foreign currencies, GM typically hedges forecasted and firm commitment exposures up to three years in the future.

It seems that foreign exchange risk is hedged out a great deal among companies. Even some large companies, many people are familiar with, such as GM. Overall, I think it was just very interesting to see all the parallels between the risk management policy of Aspen Technology and that of GM in regard to this foreign exchange risk.

GM Foreign Exchange Risks

Homework Exercise

• Suppose the firm's new expected revenue was 106
• Cost of Capital is 0.05
• And we want to use the 99% confidence level for CaR (hint: use the Zc=2.326)
• Assume everything else is the same, should the Pharmaceutical company invest in the new drug?

The Cash Flow at Risk for this new drug needs to be calculated using the 99% (1%) level:

• 2.326*20=46.52 for new
• 2.326*25=58.15 for current
• 2.326*35=81.41 for combined (calculated by finding the variance of the cash flows, taking the square root, and then multiplying by Zc=2.326)

Then, the present value of cash flows for the new drug is found as follows:

• New Drug=106/(1+0.05)-100=0.9524

However, we also need to account for the fact that the new drug increases firm risk:

• 106/1.05-100-0.11*(change in CaR from new to old)
• =106/1.05-100-0.11*(81.41-58.15)
• = -1.6062

Even without accounting for the increased risk to the firm, the NPV of adding this new drug was barely greater than zero.

By including this factor of added risk, it puts the NPV of this new project less than zero.

Therefore, since adding the new drug would increase risk and result in a negative NPV, we should not engage in this project and should not add this new drug for the pharmaceutical company.

"Beyond the Normal Distribution"

Since we have recently been discussing the normal distribution in class, and its application in risk management, I thought it would be interesting to find an article and learn a bit more about it, beyond what I have learned in other classes thus far.

I found a great article titled "Beyond the Normal Distribution" by Ben Fehr about the normal distribution, and some new ways mathematicians are beginning to use this model and others, as well as possible problems it poses.

The article was really interesting because it explained that the normal distribution is a great tool for many situations, but for the true picture of the financial market as a whole, the normal distribution doesn't really do that great of a job. For example, using the normal distribution big shocks to the stock market would occur much less often than they do in reality. Like the crash in 1987, it should technically only happen every 10^87 years, but in reality it happens about every 38 years. So, by using the normal distribution one is really underestimating risk in this case.

I think this is quite interesting to think about, especially given the economy nowadays. Given the fact that we have never really seen an economy like the one of today, it would be very difficult to use such a mathematical model to predict what is going to happen, when everything is so volatile and unpredictable.

Another interesting thing the article discussed was the fact that they are replacing common risk measures such as "standard deviation," and "value at risk," with a new measure they call "expected tail loss." The traditional estimates we have learned about so far in class give an answer that for example, the daily loss of a particular company will not exceed $40 million with a probability of 99%. But this new approach answers the question about that remaining 1%, about what happens in that tail, which actually seems like a very interesting question to me. I think it would be interesting for example, so see how high this 1% likelihood of losses could get.

"Beyond the Normal Distribution"

"Personalizing Risk Management"

An article I read titled "Personalizing Risk Management" by Julian Birkinshaw and Huw Jenkins, gives a unique view into risk management, somewhat similar to what we have discussed in class thus far.

The article described risk management for a large firm with three complementary approaches, each with positive and negative aspects:

• The first is called formalization, which is basically just following all the formal procedures, rules, formulas, etc. to evaluate and decide what risks should be taken within the company.
• The second is called externalization, which is depending on the expertise and skills of third parties (such as auditors, regulators, credit ratings agencies, etc.). I discussed possible problems with this approach in my previous post.
• The third is called personalization, which involves giving the responsibility for evaluating and judging risk to those individuals who are making the decisions within a company.

I think that the switch of a company's risk management approach back to focusing on personalization is a great idea to make risks more effectively understood and controlled. For example, if you think about a company's management, it doesn't make sense for them to have sole control over risk management decisions, like they would get if the company followed formalization. Management doesn't always know all the information about what is going on in a company, and by getting input from lower level employees, or employees from various divisions in a company, they would have a wider view and be able to make better decisions. Personalization would allow this to occur, by giving more people input on risk management decisions and providing as much information as possible to make good decisions.

Personalization is also a good thing, because sometimes managers may be too focused on personal goals and not the overall good of the company. They may get bonuses or benefits for short term profits, so they will focus on this, rather than the long term status and future of the company. Making risk management decisions in this manner could be detrimental for the future long term good of the company simply due to a greedy manager. Personalization would reduce the sole power of these managers, and also refine their personal accountability. It seems to me that reorganizing their rewards would be a great way to fix part of the problem. It should be more focused on long-term behavior, rather than short-term profits. Companies need to make sure that those people who are making the key decisions are genuinely responsibility, and not too far removed to see what is really going on.

To me it seems that a supportive culture would also help out with this personalization of risk management. For example, if you look at those few companies that have been successful even during these difficult economic times, such as JP Morgan Chase and Goldman Sachs, you will see that they have a high level of team-based decision processes, open debates, intellectual honesty, and sufficient self confidence to make decisions. This way information is not hidden from any level of management or employees. It also helps manage risks better because employees see how their actions impact others, and have a clearer picture of the company, and everyone looks out for each other.

Though I think it is evident that all three types of risk management - formalization, externalization, and personalization - can be beneficial at times, but after reading this article I see the many benefits that come from personalization. It seems like a pretty intuitive thing that responsibility for evaluating and making a judgment on risks should be given to those individuals making the decisions, rather than pushing it solely upon top company managers or outside organizations with no real accountability.

Financial Times - "Personalizing Risk Managment"

"Do Not Destroy the Essential Catalyst of Risk"

I recently read the article "Do Not Destroy the Essential Catalyst of Risk" by Lloyd Blankfein, which seemed to tie in with many themes of risk management we have discussed in class so far this semester.

The article explained that the deterioration of risk management and finance practices was a large portion of this global economic crisis we are currently undergoing. One of the main points made in the article was that we cannot base risk management decisions on just historical data. I thought this was quite interesting insight, as it is exactly what we talked about in class this past week. Given the current state of our economy, there isn't really a "normal" historical time period that we can relate it to. These times of low stocks, failing companies, and layoffs are certainly the norm for this time period, but no time periods of the past had the same circumstances occurring. Therefore, to look back and base our risk management decisions on how things used to be, or how things nowadays were predicted to be 20 years ago, is certainly not a beneficial thing to be doing.

The article also discussed the problems with over-dependence on credit rating agencies. We have discussed the significance of these credit ratings many times in class. An AAA rating is the best, with investment quality going all the way down until BBB. Where BB down to CCC is considered high yield or "junk." During this time period the problems faced by risk management officials were more severe because they outsourced so much of their risk and depended too much on these credit rating agencies - many of which were over inflating ratings. For example, the article states that at this time there were over 64,000 structured finance instruments rated AAA. Clearly, the companies should have seen the problems with the credit agencies ratings and tried to evaluate some of the risk on their own, rather than completely relying on others. Therefore, personally I feel like a lot of the blame should be put on the credit agencies, but also some blame does belong to those financial institutions that did nothing to take on any responsibility for their own risk.

Another interesting thing this article brought up was the idea that "many risk models incorrectly assumed that positions could be fully hedged." Many new products to hedge had been created, such as basket indices and credit default swaps. However, they did not properly think through the fact that "liquidity would dry up, making it difficult to apply effective hedges." I think this is an interesting point, because we have talked a great deal about hedging in class, from examples we have seen in class it does sometimes seem that companies depend a great deal upon hedging to protect themselves from any risk possible. I think this brings up a good point, that though hedging is a great risk management tool, it isn't something that should be used in all instances for every risk management problem a company of institution faces.

And lastly, the article brought up the problem of risks in off-balance sheet activities. The management for these companies with huge risk off their balance sheet did not take necessary precautions and even worry about the great risks they faced. I think this also seems to relate to things we have talked about in class. This is one of those things that as investors, ordinary people can look through every financial document available, but some things, such as these huge off balance-sheet risks will still not be able to be seen. This is why reliable, responsible management, that won't get tied up with greed is a huge thing for a company. Management has great control over the risks of a company, and sometimes all these risks aren't as evident to lower level employees or the public as we would like them to be.

Overall, I think this article brought up a lot of great points about the economic problems institutions and companies currently face, and some risk management errors that are tied to these problems. It was really intersting to see how these tie to many things we have discussed in class already this semester. I think by realizing where these problems stem from is the first major step towards fixing them. However, it is evident that it is going to take time to "mend our financial system to restore stability and vitality."

Financial Times - "Do Not Destroy the Essential Catalyst of Risk"

Value at Risk and Beta

Professor Grace recently gave us a practice exam question, dealing with two firms with varying values for their value at risk, and their Beta.

Firm 1 had a Beta=1, and VaR of $2 billion
Firm 2 had a Beta=2 and VaR of $2 million

As discussed in class, these firms are both risky, as seen by these two different risk measures. Like Professor Grace taught us in class, a higher Beta, like that seen in Firm 2, shows that the firm is much more susceptible to changes in the market, making it quite risky. However, Firm 1 has a HUGE VaR of $2 billion, showing that it has a great deal of money on the line to lose.

The question got me thinking about which of these risk measures is actually better to look at, and is a better estimate of the true risk at hand.

I found a presentation by Oklahoma State University, which further expands upon ideas about Beta and VaR that we discussed in class. The expanded information in this presentation helped me further analyze the benefits of each of these risk management techniques, and try to figure out which one I feel is most beneficial.

Like we learned in class, beta shows the fluctuations of the firm (stock) in comparison to market changes. Beta=1 moves exactly with the market, Beta<1>1 is more sensitive to changes than the market. After some more research about beta, I determined that it seems to be a good determiner of just systematic/non-diversifiable risk, but not any other type of risk (diversifiable).

Therefore, it seems to me that VaR is a much better determination of overall risk. VaR gives an estimate of the worst possible loss an investment could realize over a given time period, under normal market conditions. To me, there seem to be many more advantages of using VaR than Beta. For example, the best thing about VaR seems to be that it gives a measure of total risk (diversifiable and non-diversifiable risk), that Beta is unable to analyze. Also, VaR is an easier number to explain to clients trying to understand the risks they face, since it translates portfolio volatility into a clear dollar value. Whereas, Beta would be much more difficult to explain to the clients. Another advantage of VaR is that it can measure the risk of many types of financial securities (stocks, bonds, foreign exchange, derivatives such as futures, forwards, options, etc.). And lastly, VaR is useful for comparing a portfolio with the market portfolio (S&P500).

From all these different qualities, personally I feel that VaR is a better risk measure than Beta. It seems that it has many advantages over Beta. Though I do agree that in the above problem, both firms are definitely risky, I would argue that Firm 1 is riskier due to its very high VaR, and to all the information that comes along with knowing this value.

Oklahoma State University Presentation on Beta and VaR

Ross: Company Analysis

Most days in class we seem to choose a company and analyze their current state, such as their revenues, costs, beta, risk management activities, etc. Well, we had done a variety of different types of businesses, but one we had not yet done was something discount clothing related. Given rough financial times, it seems as though people are moving away from expensive retail stores, to stores where they can purchase items much cheaper.

I think one great example of this is Ross clothing stores. Rather than going to more expensive regular department stores at the mall, such as Dillards, Macys, or Sears, it seems like people are making the switch over to companies which offer items at discounted prices. For example, Ross sells mostly closeout merchandise, including men's, women's, and children's clothing, at prices far below those of department stores, traditionally seen at the mall. Apparel does account for a lot of the sales for Ross (over 50%), but they also sell a wide variety of other things including some furniture, toys, kitchen items and accessories, and miscellaneous office supplies, among other things. Their motto is "Dress for Less," and "the chain targets 18- to 54-year-old white-collar shoppers from primarily middle-income households."

Like we discussed in class, the Beta of a company says a lot about it. For Ross, the beta is .77 according to Yahoo finance. So, according to what we talked about in class, this means that Ross' stock is less sensitive to market changes, since its beta is less than 1. Therefore, even though the market is doing very poorly recently, Ross is not doing quite as bad. A lot of this probably does have to do with the fact that Ross is a discount store, so people are switching over to shopping there, since it is still something they can afford even with decreases in their income.

Ross' main competitors include Kohls, Gottschalks, and TJX Corporations. Ross and its competitors are expected to have "medium growth" in coming years. This is due to the fact that these companies to have good merchandising, and are discount stores, the slowing economy still affects them. That is, the economy limits spending on non-essentials, like many of the products in these stores are.

Ross does face some risks, such as foreign exchange rate risk, since some of their clothing items, toys, and other products are from foreign countries. They also have pure risk of their buildings being damaged and their goods being destroyed. And they also have a large risk of theft from their stores. All these risks can be managed using effective risk management procedures - such as insurance, security personnel, etc. By reducing the cost of their risks, Ross will be able to stay above their competitors and be successful within their market.

ROSS Profile/Overview
Hoovers: Ross

Did Risk Management Cause the Crisis?

I recently read the article posted on the RMI course website entitled "Did Risk Management Cause the Crisis?" by RIMS.

From reading the article I learned that a variety of factors were at play in this crisis. For example, it was a failure to enact appropriate enterprise risk management behaviors, and also failure to develop and reward internal risk management competencies.

The one thing I found most interesting was that the article mentioned the main problem was that there was a "failure to use enterprise risk management to inform management’s decision making for both risk-taking and risk-avoiding decisions." In class we discussed the fact that risk management is very important and that it provides great information for reducing the cost of risk for a company. However, we also discussed the fact that this risk management ONLY adds value IF it is enacted and used to make better management decisions. Clearly, this article is trying to show that the risk management procedures in place didn't do this at all, they did not help the management add value, because they did not help make better risk-taking and risk-avoiding decisions. Therefore, risk management for them was not value added.

Another thing I found interesting about this article was that it takes time to examine different risk management approaches. It explains the difference between "risk management," "enterprise risk management," and "financial risk management." I thought this was interesting because our class is titled "RMI 4350: Enterprise Risk Management," and we had spent a great deal of time in class discussing the process of enterprise risk management. In the article it describes risk management and financial risk management as limitations of ERM, whereas ERM is more all-encompassing. It describes ERM as involving more than just physical and financial exposures, it takes into consideration other things too, such as long-term strategy, competitors, human capital, operations, etc. It seemed to be describing ERM just as we did in class, as a process in which all the steps must be completed: (1) Figure out risk tolerance (2) Identify and measure risk (3) Develop a risk portfolio (4) Finance risks.

I also found it interesting how how article discussed the necessity of taking risks, just like we have discussed in class. It explained that though ERM is a great thing, "ERM can potentially identify situations in which risk can be a competitive advantage instead of only a threat. ERM encompasses all aspects of an organization in managing risks and seizing opportunities related to the achievement of the organization’s objectives." This shows, that just like stated in class, it takes some risks to be rewarded, and making a profit is all about a company being better than all its competitors at managing its risks - reducing the costs of its risks as much as possible.

RIMS: Did Risk Management Cause the Crisis?