UNDERSTANDING THE MARKET UNCERTAINTIES Andrea Loddo Associate - PowerPoint PPT Presentation

UNDERSTANDING THE MARKET UNCERTAINTIES Andrea Loddo Associate Director, Financial Risk Advisory

Executive Summary ● Markets are unpredictable: the implications on risk management ● Rethinking risk management: the importance of interpreting historical performances ● From history to forecast: introducing market uncertainty ● The risk management discussion shifts from what it is likely to happen to how profound the impact can be ● Introducing the idea of the future Economic Environment ● Stress testing is the way

Remember the Swan Always consider ● The event is a surprise ● The event has a major impact ● After the fact, the event is rationalized by hindsight, as if it had been expected a Black Swan Attempting to predict the future is not too helpful when trying to manage risks 2

Significant risk events are not infrequent anymore • 1997 Asian crisis • 1998 Russia/LTCM • 2000 Bursting of dot -com bubble • 2001 9/11, US invades Afghanistan, Enron • 2003 Second Gulf War begins/collapse of world trade talks • 2004 Indonesia tsunami • 2005 Hurricane Katrina • 2006 US sub - prime housing market shows signs of stress • 2007 Global credit crisis • 2008 Lehman Brothers collapse; oil prices hit $140/barrel • 2009 Oil prices slump to under $40/barrel • 2010 EU peripheral sovereign debt concerns surface; Greece & Ireland bailout • 2011 MENA unrest and Japan earthquake; Portugal bailout 3

Do we learn from history? 3M GBP LIBOR ‐ Historic Rate Current Forward 7.0% 6.0% What was the market 5.0% implied forward curve in 2008 & 2009? 4.0% 3.0% 2.0% 1.0% 0.0% 2008 2009 2010 2011 2012 2013 4

Do we learn from history? 3M GBP LIBOR ‐ Historic Rate Historic Forward Current Forward 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 2008 2009 2010 2011 2012 2013 ● Forward rates are bad predictors of interest rates 5

Do we learn from history? GBPUSD FX rate GBPUSD 1Y Forward rate ‐ 1 Year lag 2.2 FX forwards are a 2 poor estimator of 1.8 future spot levels 1.6 given they are simply a spot rate adjusted by 1.4 a realisation of interest 1.2 rate differentials 1 2003 2005 2007 2009 2011 ● Forward rates are bad predictors of FX rate as well 6

If market’s expectations are unreliable, what now? Historical Rate % of times Current Level 8.0 8.0 6.0 6.0 GBP 3M LIBOR GBP 3M LIBOR Rates 4.0 4.0 2.0 2.0 0.0 0.0 2002 2004 2006 2008 2010 2012 0% 10% 20% 30% % of occurances Historical Rate % of times Current Level 2.2 2.2 2.0 GBPUSD Rate 2.0 GBPUSD Rate 1.8 1.7 FX 1.6 1.5 1.4 1.2 1.2 0% 10% 20% 30% 2002 2004 2006 2008 2010 2012 % of occurances 7

From historical performance to uncertainty GBP 3M LIBOR - Historical changes GBPUSD FX - Historical changes % of times % of times 40% 50% % of occurrences 40% % of occurrences 30% 30% Vol = 12% Vol = 31% 20% 20% 10% 10% 0% 0% 13% ‐ 40% ‐ 33% ‐ 25% ‐ 18% ‐ 10% ‐ 3% 5% ‐ 40% ‐ 33% ‐ 25% ‐ 18% ‐ 10% ‐ 3% 5% 13% GBP 3M LIBOR Monthly changes GBPUSD Monthly changes ● The charts above show the monthly changes for GBP 3M LIBOR and GBPUSD FX rate over the last 10 years ● Historically LIBOR has been more volatile as a result of the strong and fast fall during 2008 and 2009 8

How do we look into the future? Trend Volatility + = Uncertainty ● Which trend? ● Forwards are bad predictors. Thus we will focus on uncertainty 9

Introducing uncertainty GBP 3M LIBOR GBPUSD FX Rate Percentile(0.75) Percentile(0.95) Percentile(0.75) Percentile(0.95) Mean Percentile(0.05) Mean Percentile(0.05) Percentile(0.25) Historical Percentile(0.25) Historical 8.0% 8.0 6.0% 6.0 4.0% 4.0 2.0% 2.0 0.0% 0.0 2006 2009 2012 2015 2017 2007 2010 2012 2015 ● Uncertainty means projecting market factors based on market implied expectation of forward rates and historical volatility and correlation ● Uncertainty shifts the focus of the risk management discussion from what it is likely to happen to how profound the impact can be 10

Quantifying market uncertainty GBPUSD FX rate projections Distribution in 5 years Mean 5th 95th GBPUSD FX Distribution ‐ 2017 1.1 1.7 2.6 4.00 25% % of occurrences 20% 3.00 15% 2.00 10% 1.00 5% 0.00 0% 2012 2013 2014 2015 2016 2017 0.3 1.0 1.6 2.3 2.9 3.6 4.2 4.9 ● Thousands of simulations are generated which cover the entire spectrum of probable and extremely improbable events ● At each point in time, the distribution of potential outcome allows us to quantify the FX rate on a worst (95 th percentile), best (5 th percentile) and expected basis 11

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

Why correlation matters? Positively Correlated Risks Combined Risk Factor 1 Risk Factor 2 Effect = + Negatively Correlated Risks Combined Risk Factor 1 Risk Factor 2 Effect = + 13

Measuring correlation GBPUSD FX Rate GBPEUR FX rate Historical Rate Historical Rate 2.2 1.7 2.0 GBPUSD Rate 1.5 GBPEUR Rate 1.8 1.3 1.6 1.1 1.4 1.2 0.9 2002 2004 2006 2008 2010 2012 2002 2004 2006 2008 2010 2012 ● Weekly data shows that GBPUSD and GBPEUR rates are negatively correlated (- 11.1%) over the past year ● Should this be the assumption to be used when projecting GBPEUR and GBPUSD FX rates? 14

Correlation patterns can change over time GBPEUR & GBPUSD correlation Correlation 100% ● Only recently GBPUSD and GBPEUR FX rates exhibit negative correlation 60% ● Historically, they have been positively 20% correlated, particularly in 2009 and 2010 ‐ 20% ● What are the implications of using different correlation measures? ‐ 60% 2003 2005 2007 2009 2011 15 Correlation was calculated by using weekly data on a rolling annual window

How does correlation impact projections? Positively correlated paths Negatively correlated paths GBPUSD FX path GBPEUR FX Path GBPUSD FX path GBPEUR FX Path 2.50 2.50 2.00 2.00 1.50 1.50 1.00 1.00 0.50 0.50 0.00 0.00 2012 2013 2014 2015 2016 2017 2012 2013 2014 2015 2016 2017 ● The chart on the left shows the simulated paths for positively correlated GBPUSD and GBPEUR FX rates (correlation at +40%) ● The chart on the right show the simulated paths assuming a negative correlation of - 20% 16

An example: a UK Company with Earnings in GBP, USD and EUR Current Earnings Earning profile over the next 5 years USD EUR Currency Earnings 120 100 Earnings (£m) USD £100m 80 60 EUR £100m 40 20 Total £200m 0 2013 2014 2015 2016 2017 ● We assume earnings stay constant over time ● The company is exposed to FX risk related to the earnings in USD and EUR ● We will show how we quantify the impact of FX risk on earnings by projecting the FX rates around spot 17

How does correlation impact projections? Earnings - Positively correlated paths Earnings - Negatively correlated paths USD Earnings EUR Earnings USD Earnings EUR Earnings 150 150 Earnings (£m) Earnings (£m) 100 100 50 50 0 0 2012 2013 2014 2015 2016 2017 2012 2013 2014 2015 2016 2017 ● The charts show the impact on the earnings under ● Positively correlated FX rates (40%) – left chart ● Negatively correlated FX rates (-20%) – right chart 18

What is the impact on total earnings? Total Earnings Total Earnings ‐ Negative Correlation ● The chart shows total earnings under Total Earnings ‐ Positive Correlation ● The positive correlation scenario 250 £29m Risk (40%) 200 Earnings (£m) 150 ● The negative correlation scenario (- 100 20%) 50 ● In 2017, the earning risk associated to 0 positively correlated FX rates is £29m 2012 2013 2014 2015 2016 2017 19

How does correlation change the risk profile? Earnings at risk with 40% correlation Earnings at risk with -20% correlation 300 300 Cash Flow At Risk (£m) Cash Flow At Risk (£m) 250 250 36.2 78.6 112.8 112.8 200 200 150 150 246.1 246.1 209.9 167.5 100 100 133.3 133.3 50 50 0 0 Diversification Diversification GBP USD EUR Total GBP USD EUR Total Net Risk Net Risk Benefit Benefit ● The charts show how the FX uncertainty translates into earning risk, on a cumulative basis over 5 years and on a worst case basis (95 th percentile) ● The net risk is lower than the total risk as a result of the diversification benefit ● Negative correlation implies higher diversification benefit and lower overall risk 20

Medium Tolerance High Tolerance Cash Flow At Risk (£m) Cash Flow At Risk (£m) Defining the right risk tolerance is important Earnings at risk with 40% correlation 100 150 200 250 300 100 150 200 250 300 50 50 0 0 GBP GBP USD 133.3 USD 133.3 EUR 112.8 EUR 112.8 Total 246.1 Total 246.1 Diversification Diversification 36.2 36.2 Benefit Benefit Net Risk 209.9 Net Risk 209.9 Tolerance Tolerance Earning at risk with -20% correlation Cash Flow At Risk (£m) Cash Flow At Risk (£m) 100 150 200 250 300 100 150 200 250 300 50 50 0 0 GBP GBP USD 133.3 USD 133.3 EUR 112.8 EUR 112.8 Total 246.1 Total 246.1 Diversification Diversification 78.6 78.6 Benefit Benefit Net Risk 167.5 Net Risk 167.5 21