Private and Confidential: For discussion purposes only February 2011 Managing Market Risk for TMAC - Toronto

Private and Confidential: For discussion purposes only

February 2011

Managing Market Riskfor TMAC - Toronto

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James MacKinnon [email protected] Director, Risk Solutions Group 416-866-5443

Presenting today:

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Table of Contents

Section

1. Strategic Planning and Market Risk

2. Uses and Abuses of Forecasts

3. Measuring Market Risk

4. Event Risk and Black Swans

5. Solutions: Symmetrical and Asymmetrical

6. Managing Banks and Dealers

7. Assessing the Results


Strategic Planning and Market Risk

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Strategic Planning and Market Risk Management

• Strategy

Overall objectives, aligned with and supporting the organization’s goals

- SWOT analysis – internal and external

- Set enterprise objectives

- Develop strategic plan to achieve objectives

- Evaluation of plan: suitability (economic sense?), feasibility (break-even, budgeting),

acceptability: returns to stakeholders and their likely reaction, and risks

Risks

- Probability and consequences of failure of strategy

- Enterprise Risk Management process

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• Enterprise risk management steps:

Identify risks

- Pricing risk: commodity prices, interest rates

- Asset risk: financial securities

- Currency risk: translation risk

- Liquidity

Analyze and understand

- Quantify and assess materiality

- Integrate: identify any portfolio offsets

Respond

- Avoidance

- Reduction

- Insurance

- Accept

Monitor and review

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• Market Risk types:

Financial

- Pricing risk: cost of capital, interest rates

- Asset risk: liquidation values of real assets and financial securities

- Currency risk: translation risk for non-domestic obligations

- Liquidity: re-financing risk, cash flow risk

Commodity

- Pricing risk: cost of inputs

- Asset risk: value of inventory, reserves

- Liquidity: availability and security of supply

Currency

- Pricing risk: exchange risk impact on revenues and expenses

- Asset risk: balance sheet translation risk

- Liquidity: especially for non-G20 currencies, or countries with exchange controls

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• Market Risk Management

Best practice: integrated with the strategic planning process

- Not isolated in the Treasury or Purchasing functions

- Executive sponsorship

- Risk appetite/tolerance defined at Board level

- Liquidity: re-financing risk, cash flow risk

Best practice: integrated across functions, including audit

- Common risk language/metrics needed

- Risk inventory

- Prioritization

- Cross Functional Risk Committee

- Chief Risk Officer

- Clear accountability

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• Which market variables are material?

- Stress testing

- Potential impact on EBITDA, EPS, free cash flow

- Risk tolerance threshold

- Board-approved process

- Clear accountability

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• “What is our risk?”

Using forecasts as a risk management tool:

- Forecasts are a useful ‘base case’

- Implied forwards can also be used (“market consensus”)

- But forecasts and the market forwards change constantly with new information

- Random walk

- Also known as “the piper’s walk”


Uses and Abuses of Forecasts

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• On January 18th, the Bank of Canada (“BoC”) held its overnight target rate at 1.00%, and the market is forecasting the next rate hike to be on April 12th, 2011.

• Core inflation is projected to edge gradually to its 2% target by the end of 2012, as excess supply in the economy is slowly absorbed.

• What the BoC do over the next 18 months?

BoC Overnight Target Rate

BoC Update

Source: Bloomberg

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

Jan '08 Jan '09 Jan '10 Jan '11

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• By mid-2012, the BoC overnight rate will be between 1.25% and 3.25%, depending on which forecast you read.

• The BoC will begin hiking between May and October

Forecasts of BoC Overnight Target Rate

Market Consensus - BoC Overnight Target Rate

Source: Bloomberg

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• In October, 2009, the forecast for the BoC rate as at Q1 2011 was 2.2%

• It is currently 1.0%

Average Forecast - BoC Overnight Rate Q1 2011

Market Consensus - BoC Overnight Target Rate

Source: Bloomberg

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• In October, 2009, the average forecast for the 10 year GOC bond yield as at Q1 2011 was 4.25%, and the implied forward yield was 4.15%.

• The average closing yield on this bond for the month of January was 3.25%.

Average Forecast and Implied Forward - 10 Year GOC Bond Yield Q1 2011

Market Consensus – Bond Yields

Source: Bloomberg

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Unknown: Will US Consumers Save Or Spend Stimulus?

Consumers are paying down debt and avoiding risky investments.

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Unknown: Will US Consumers Spend Some Liquidity?


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Unknown: When Will US Companies Redeploy Excess Cash?


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Unknown: Will The US Raise Its Debt Ceiling and What Then?


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Unknown: When Will US House Prices Begin to Recover?

Total US net borrowing declined despite large fiscal deficits, as businesses and households

paid down debt. Net borrowing has been increasing as the economy recovers.

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Unknown: How Will Bonds React As Demand For Capital Heats Up?



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Unknown: Can Global Markets Take Down Sovereign Rollover?



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Unknown: How Will China React To Policy Tightening, Currency Wars?



Forecasts are not a replacement for a prudent risk management strategy.


Measuring Market Risk

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• If forecasts are not useful, then how do you measure risk?

• Two basic approaches:

Subjective judgment about the future – “guesstimation”

Quantification based on historical patterns

- Cash-Flow-at-Risk

- Value-at-Risk

Subjective judgment

- Susceptible to influence by recent news

- Biases harder to spot

- “Rule of thumb” errors

- Can be helpful in generating scenarios: “What If?”

How could markets react to a specific event?

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• Cash-flow-At-Risk models

Forecast income, expenses can be drawn from the budget spread sheet

Interest rates, currency exchange rates, raw materials prices

- Vary the market variable to gauge potential impact

Stress-testing: market variables

- Use historic high and low

- Use theoretical equilibrium level (eg., CAD/USD PPP approx. US$ 0.80)

- Use historical data: one or two Standard Deviations

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• Value-At-Risk: the preferred measure of market risk

Emerged in late 1980s after the 1987 stock market crash

Extreme market movements can exceed expected (historical) ranges

VaR

- Initially, individual desks calculated VaR independently

- Later was made firm wide in most banks, and was incorporated in Basle II Accord

Highly statistical

- Provides a structure for thinking about risk

- Not widely understood by decision-makers

- Can create the illusion of certainty

- 1-3x VaR is not unusual

- Stress testing should be done outside of these VaR ranges

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• VaR models

Widely used risk measure of the risk of loss on a portfolio of assets

Risk is defined as a mark to market (fair value) loss over a specified time span

How much money could we lose today?

You need a time period, a confidence level, and a loss amount

What is possibility that a portfolio could lose a certain amount of money over the next

24 hours with a 95% probability?

- Example: a portfolio with a one-day 95% VaR of $ 1 MM: there is a 0.05 probability

that the portfolio will fall in value by more than $ 1 MM over a one day period

(a loss of $ 1 MM or more is expected on 1 day in 20)

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• Three methods of calculating VaR:

Historical method

- If in the last 5 years, the worst 5% of all one-day results was a loss of 5 to 10%

- then with 95% confidence: our worst one-day loss will be less than 5%

Variance-covariance method

- assumes results are normally distributed

- requires that we measure expected (average) return, and standard deviation

- then we repeat the process used in Historical method, but use the binomial curve

rather than actual data

Monte Carlo simulation

- randomly generate future paths based on historical patterns

- then repeat the process used above using the resulting data rather than actual data

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• What’s wrong with VaR?:

Results are probabilistic

Assumes that history will repeat itself

Can be complex and hard to understand

Can create an illusion of certainty and false sense of security

Making VaR control the focus of risk management:

- Can result in bias to focus on manageable risks near the centre of the

distribution and ignores the tails

- Ignores risk of extreme losses – can lead to excessive risk taking

- Does not measure liquidity risk

- Does not fully reflect leverage risk

“Lies, damn lies, and statistics”

- Based on historical data over limited time periods

- “Garbage in, garbage out”

- “It’s like the historical data only has rain storms and then a tornado hits”

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• Applying VaR in an enterprise setting

Start with the budget spread sheet

Key revenues/expenses driven by market variables

Vary the variables by specified amount

- historical high and low

- VaR amount

Assess potential impact on key bogey:

- Free cash flow

- EPS

Consider risk of extreme moves:

- Black Swans


Event Risk and Black Swans

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The Allegory of the Black Swan

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• Popularized by Nassim Nicholas Taleb, NYU

• Rare, high-impact events that have a disproportionate impact on markets

• Examples of past Black Swans:

World War 1

9/11

the internet

• The probability of such events cannot be calculated using statistical methods

It may be possible to predict ‘known unknowns’, where we know the ‘frame’

It is impossible to predict ‘unknown unknowns’, where there is no precedent

• Market participants tend to ignore a probability if it is low, and they after the fact

they tend to develop retrospective explanations which make them look predictable

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• We cannot predict extreme events, but we can reduce our vulnerability to them

Property insurance

Insurance is not an option

• We can’t drive looking in a rear-view mirror: past events are not predictive

• Approaches to risk mitigation:

Balance complexity with simplicity

Diversification

Risk Management

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• Examples of Black Swan risks:

Hyperinflation (rising government debt)

Geopolitical crisis (Middle East, Korean Peninsula, South Asia)

Instability in China: double digit economic growth and property value inflation

Internet event: cyber attack

Natural disaster

Prolonged period of limited economic growth

• We can’t drive looking in a rear-view mirror: past events are not predictive

• Interest in protection against “tail risks”, is increasing

May 6 stock market drop: Dow fell almost 1,000 points

Sovereign debt crisis may increase hyperinflation risk

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“It ain’t what you don’t know that gets you into trouble.

It’s what you know for sure that just ain’t so.”

- Mark Twain


Solutions: Symmetrical and Asymmetrical

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Hedges: Symmetrical and Asymmetrical

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Symmetrical Hedges

• Interest Rates:

> Interest Rate Swaps

• Currencies:

FX Forwards

FX Swaps

• Commodities:

Commodity Forwards

Commodity Price Swaps

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Operations:

• Let us assume that an enterprise was to execute a swap today to fix the underlying interest rate of its Term Facility for 5 years, at a fixed rate of Y%. Borrower’s all-in fixed rate would be:

On Swap: Borrower Pays Fixed Y% Monthly (paid in arrears)Borrower Receives Floating 3-month BA rate (paid in arrears)

On Debt: Borrower Pays Floating 3-month BA rate (reset in advance, paid in arrears)Borrower Pays Loan Credit Spread (paid in arrears)

Result: Borrower Net Cost of Debt Y% + Loan Credit Spread

Symmetrical: Interest Rate Swap

BorrowerBorrower

3-mth BA

Y% Swap Fixed Rate

3-mth BA + Credit Spread

Interest Rate Swap Underlying Bank Debt

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Asymmetrical Hedges

• Interest Rates:

> Interest Rate Caps

> Swaptions

• Currencies:

FX Puts and Calls

FX Binaries

• Commodities:

Commodity Puts and Calls

Commodity Price Swap Options

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Cap Mechanics:

• Let us assume that an enterprise was to purchase a cap today to protect the underlying interest rate of its credit facility for 5 years. For the specified cap strike rate, the amount and term, the cap premium would be a dollar amount due on the trade date.

• In this case, Borrower’s borrowing costs would be as follow:

Loan: Pays BA rate

Loan: Pays Loan Credit Spread

Cap: Pays premium

Cap: Receives BA rate less cap rate, if positive

Lesser of BA rate or cap rate + Loan Credit Spread (+ Cap Premium)

Asymmetrical: Interest Rate Cap

3-mth BA less Cap Rate, if positive

Cap Premium ($)

3-mth BA + Spread

Interest Rate Cap Underlying Bank Debt

BorrowerBorrower

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• Symmetrical hedges tend to look less costly:

No premium

All critical terms can be easily made to match

Comparing Symmetrical and Asymmetrical Hedges

• Symmetrical hedges tend to track market expectations

> Market expectations usually are reflected in current forecasts


Managing Banks and Dealers

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• Supplier and customer form a system – you are buying his/her knowledge:

End the practice of awarding business on the basis of price alone

This assumes that the end product is totally commoditized – “we’re not in that world”

Instead, minimize the total cost

Move towards a single supplier for any one item, on a long-term relationship of loyalty and trust

Managing Relationships

• Old School errors:

> Total cost = purchase price + price of use

> Jump-ball supplier system is wrong:

- no loyalty and trust

- “just meet specifications and keep quiet”

- no incentive to improve or add value

• Suppliers:

> Competition is needed, but in the right place – let suppliers compete, then work with

the selected one

> Select a supplier based on capability, evidence of quality, record, history, reputation,

training, burning desire to work with you

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Possible Risks Associated with Hedge Transactions:

• Symmetrical OTC hedge transactions are typically credit-intensive, bilateral contracts

• Execution of such transactions poses unique challenges when there are multiple credit providers. These include:

Market Liquidity Risk: Simultaneous dealer activity can adversely affect market rates

Pricing Risk: Hedge providers require a capital charge on hedging transactions, to cover the cost of regulatory capital. Capital charges for hedge transactions tend to be broadly consistent between banks, which are generally subject to regulatory regimes based on the Basle accords. However, if the process is not carefully managed, there can be information discrepancies which may result in non-uniformity of pricing.

Structuring Risk: an enterprise can end up with multiple transactions between several dealers each with its own terms (i.e., credit mitigation, interest rate & daycount differences)

Documentation Risk: an enterprise can end up with multiple legal documents, each with its own terms (i.e., credit appendices, etc.), and associated legal costs

Credit Management: secured creditors effectively bear a pro rata proportion of the credit risk through the dilution of security resulting from an interest rate swap, and will require a commensurate return on this additional risk.

• All of these risks need to be considered as they will ultimately impact the process, price, and structure an enterprise receives on its hedge


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Risk Mitigation:

• To mitigate these risks, it is common market practice to select one hedge advisor to facilitate the deal process for hedge transactions

• The hedge advisor is responsible for:

Assisting in the determination of an optimal hedging strategy by an enterprise

Hedging the entire transaction – to reduce transaction costs

Syndicating the hedge to prospective hedge providers - allocations determined by the enterprise

Working with the hedge providers to ensure uniformity of:

i. pricing,

ii. documentation, and

iii. deal structure.

• Using a hedge advisor can reduce market and pricing risk, and ensure that all dealers are providing the company with a uniform hedge


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Typical Execution Timeline:


Enterprise selects Lead Hedge Advisor

Hedge Advisor provides relevant analysis, research and market colour

Identify credit conditions, security and capital charge requirements for hedging program

Documentation and/or security package completed

Hedge Advisor executes hedges

Hedges are Syndicated


Assessing the Results

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• Repeat the process on a regular basis

• Bring in your risk management advisors/dealers for periodic reviews

Assessing the Results

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• Scotia Capital has had the pleasure of leading a number of large and successful risk management programs

Cineplex Entertainment L.P.

Interest Rate Risk Management

$235,000,000

Lead Hedge Advisor

April 2008

Rogers Communications Inc.

Interest Rate Risk ManagementCurrency Risk Management

$1,000,000,000

Lead Hedge AdvisorSole Hedge Provider

July 2008

Galleon Energy Inc.


$100,000,000


January 2009

Scotia Capital’s Qualifications

Videotron Ltee

$260,000,000

Lead Hedge Advisor

March 2009


Videotron Ltee


$455,000,000

Lead Hedge Advisor

April 2008

Quebecor Media Inc.

$350,000,000

Lead Hedge Advisor

October 2007


McCain Capital Corporation


$100,000,000

Lead Hedge Advisor

January 2010

Willbros Group, Inc.


$150,000,000

Lead Hedge Advisor

September 2010

Comber Wind Financial Corp.


$350,000,000

Lead Hedge Advisor

October 2010

$1,500,000,000


December 2010


Teranet Inc.

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The Canadian Market Leader in Corporate Risk Management

Documents

Private and Confidential: For discussion purposes only February 2011 Managing Market Risk for TMAC - Toronto