Simulations in Financial Risk Management

Use of Simulations in Financial Risk
Management
Rolf van der Meer
Crystal Ball Finance Workshop
Frankfurt am Main, 6 November 2006
Page 2 Frankfurt am Main, 6 November 2006
Introduction
Use of Simulations in Financial Risk Management
We will focus on the practical use of Monte Carlo
Simulations
A (fictional) case study will serve as background
Theory vs. practice?

Rolf van der Meer
Studies in Rotterdam (HES) and Durham, NC (Duke
University - Fuqua School of Business)
Leader of a team of consultants who advise corporations
and public sector entities on risk management issues
Projected P&L of Berliner Maschinen AG over 2006
(numbers in Mio ; today is 31 December 2005)
Turnover
Aluminium cost
Other raw materials
1,002.30
304.59
175.00
Gross margin 522.71
Personnel cost
Other costs
Depreciation and amortization
Interest
200.00
175.00
70.00
17.64
Target profit before taxes 60.07
Market price risks:
Charge to reflect aluminium forward curve
Hedging
-20.41
0.00
Operational risks:
Loss of an important customer
Compensation for loss of an important customer
Damage to reputation
Machine breakdown
0.00
0.00
0.00
0.00
Earnings (before taxes) 39.66
Taxes 13.88
Net earnings 25.78
Return on equity 13.2%
Case Study: Berliner Maschinen AG
fictional German supplier of
components for car
manufacturers
Sales in Asia / Latin
America (10%/), US
(20%/$), Europe (70%/)
Main raw materials input is
aluminium (175,000t p.a.)
Total assets on the balance
sheet are 1bn , of which
300m equity and 300m
interest-bearing debt.
The Risk Management Process
1. Fundamental
risk strategy
2. Identification of
risk exposures
5. Aggregation
3. Measuring risk
exposures &
building a
risk model
4. Definition of risk taking and
risk retention strategies
6. Effectiveness
testing
7. Risk
monitoring
1. Fundamental Risk Strategy
Objectives
should fit into overall
strategy
create value (e.g. by
preventing bankruptcy)
eliminate costly lower-tail
outcomes while preserving
as much of the upside as
possible

Methodologies
VaR, CaR, EaR, .
MCS at their best when it
comes to aggregating risks
of different kinds (for
instance, market price risks
and business or operational
risks)
Berliner Maschinen AG:
Main objective: preserve equity base, avoid negative earnings
Methodologies: EaR, Monte Carlo Simulation
2. Identification of risk exposures
comprehensive risk landscape
collect risks in structured and systematic manner
Tools:
risk assessment workshop
classification of risks in a probability/impact graph
brainstorming sessions
ask experts (inside & outside)
SWOT
Porters Five Forces
checklists
Risk Landscape of Berliner Maschinen AG
Category Risk factor Description
Market risk Aluminium
price
Higher raw materials costs due to aluminium price rise on LME.
Market risk $/ rate Value of exports in US depends on the $/ rate.
Aluminium price on LME is transferred into via the $/ rate.
Market risk Interest rate Possibly higher interest rate for debt after April 2006.
Credit risk Bad debts Not a major focus, because customers are large corporations that
have long business relationships with the company.
Operational
risk
Machine
breakdown
If an important machine breaks down, the company incurs costs
for repairs and production delays.
Operational
risk
Reputation
damage
Risk that deliveries are held up by a wastewater pipeline issue. If
customers receive their components too late, the companys
reputation as a reliable supplier suffers.
Operational
risk
Personnel
cost
Personnel costs can fluctuate by about 2% due to uncertainties
regarding remuneration and working times.
Business-
volume risk
Loss of an
important
customer
Sales contracts are long-term, but a customer may stop producing
a car model for which the company supplies components.
3. Measuring Exposures & Building a Model
market prices
Markov process, random walk
does distribution fit empirically
observed market data?
relevant time horizon
fat tails
estimation by experts
errors
heuristic biases
distinguish between
probability and impact
Unstable
30-days correlation between price changes
for 3-month aluminium contract (LME) and
dollar/euro exchange rate
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
4
-
J
a
n
-
2
0
0
5
4
-
F
e
b
-
2
0
0
5
4
-
M
a
r
-
2
0
0
5
4
-
A
p
r
-
2
0
0
5
4
-
M
a
y
-
2
0
0
5
4
-
J
u
n
-
2
0
0
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4
-
J
u
l
-
2
0
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4
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A
u
g
-
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S
e
p
-
2
0
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-
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4
-
N
o
v
-
2
0
0
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-
D
e
c
-
2
0
0
5
4. Risk Aggregation
Statistic Forecast
values
Trials
Mean
Median
Mode
Standard Deviation
Variance
Skewness
Kurtosis
Coeff. of Variability
Minimum
Maximum
Mean Std. Error
10,000
17.41
23.22
---
31.83
1,013.08
-2.54
12.96
1.83
-227.34
84.02
0.32
85% blue columns (positive net earnings)
Relative importance of risk factors depends
on risk measure employed
Sensitivity chart
Contribution to variance of net earnings forecast.
c) = correlated; * = proceeds from goods originally destined for
lost customer
59%
13%
12%
10%
4%
2%
0%
0%
0%
Aluminium (1Q, 2Q, 3Q)
Loss of important customer (c)
Damage to reputation (c)
Machine breakdown (c)
Dollar/euro
Other raw materials
Personnel cost
Interest rate
Discount on open market*
Sensitivity chart
Contribution to variance of profit-or-loss forecast.
c) = correlated; * = proceeds from goods originally destined for
lost customer
36%
32%
18%
13%
1%
0%
0%
0%
0%
Loss of important customer (c)
Damage to reputation (c)
Aluminium (1Q, 2Q, 3Q)
Machine breakdown (c)
Dollar/euro
Other raw materials
Personnel cost
Interest rate
Discount on open market*
5. Risk Strategies
Risk-taking
strategy
Explanation Example for Berliner Maschinen AG
Risk avoidance Renounce from risky
operations
Sell in Latin America, but bill only in US dollars
and euros (and not in Latin American currencies).
Deliberate risk
taking
Accept risks (possibly in
combination with pricing
or diversification
strategy)
Let US customers pay in US dollars (and use the
resulting net hedge from long and short dollar
position see Hedging below).
Risk
minimization
Minimize the likelihood
or impact of a risk factor
(e.g. quality
management)
Repair wastewater system.
Ensure standby credit facilities.
Risk transfer Transfer risks to third
parties (insurers, banks,
suppliers, customers,
etc.)
Insure against machine breakdown.
Hedge aluminium price risk.
6. Effectiveness Testing
aluminium price hedge
hedge proposal of bank:
use natural hedge
opportunities, enter into
aluminium swap
left tail of the distribution is
relatively unchanged
repair wastewater system
reduce probability and
potential impact
higher expected value of
net earnings
EaR decreases by 12.7m

Base Case Repair
Expected value
(mean)
Probability of loss
Earnings at Risk
17.4 Mio

15%
61.3 Mio
20.0 Mio

13%
48.6 Mio

ensure standby credit
facilities
need for standby credit to
prevent liquidity shortage in
worst case scenarios
simulation results show how
much credit is needed in
different percentiles
7. Risk Monitoring
Risk Reporting
gives precise view of the
risk structure of the
company
shows deviations between
the firms actual risk
exposures and risk
tolerances (limits)
are targeted to readers
Risk Controlling
critical ongoing appraisal of
the risk management
process
needs a risk management
function in the organization
that lives
systematic approach
adequate measures are
taken shortly after a
warning level has been
reached
closed loop

The good news
1. Adequate use of MCS improves forecasting quality
and provides better background for management
decisions.
2. Inclusion of all risks (market prices, operational
risks, event risks, etc.).
3. Systematic approach to value-oriented corporate
planning and controlling.
4. Thinking in ranges and probability distributions
enhances the acceptance of risk management.
5. Pragmatic risk models.
Caveats & Side Effects
1. False impression of accuracy.
2. Dependence on the model used.
Models cannot reflect the high level of complexity
inherent in economic reality.
Models are prone to errors (e.g. in Excel formulas).
3. Expert opinions are prone to errors, and may also
be influenced by such psychological factors as
biases and company culture.
4. Historical data may give false impressions.
5. Market prices are not normally distributed.
Critical appraisal
MCS can greatly help a
company to cope with
uncertainty.
Quantitative methods do not
make the future any more
certain, but they enable
managers to make well-
informed decisions.
Beware of unjustified sense
of control over uncertainty
(reality is more complex).
For Berliner Maschinen AG
Uncertainties can be better
measured
Transparent view of net
earnings forecast, risk
factors
what-if analysis of risk
strategies proved very
worthwhile
better informational basis
upon which to base risk
management decisions.

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