MAS Finance meets

Bank Julius Baer

Presentation of
B. Hodler/N. MacCabe
April 2, 2004

Agenda
Julius Baer Group
Risk management organisation
Risk landscape
Working with a MAS Finance intern: a case
study
Questions / Discussion

Julius Baer Group (figures in Mio CHF)

2003

1995

Assets under Mgt

115,500
49,400
Net operating income
1,020
525
Net profit
82
113
Equity
1,474
1,164
Capitalization
4,282
1,514
Headcount
1,766
1,470
ROE
5.3 %
10 %

Julius Baer Group

Private Banking
Asset Management and Funds
Trading
Corporate Center
Risk Management
Finance and Controlling
Legal and Compliance
IT and Operations
Communication
Human Resources
Investment Research

Risk management organisation

Board of Directors committees:
Risk committee of the board (quarterly)
Audit committee of the board (quarterly)
Executive Board committees:
Group ALM committee (monthly)
Group risk committee (weekly)
Group lead management committee (on request)

Risk management organisation

Group Risk Management
B. Hodler, CRO
A. Weber, Deputy

Risk Advisory
N. MacCabe

Support
M. Calpini
Private Banking
D. Mnchbach

Credit Risk
A. Weber

GRM NY
HR Wrgler

Relationship
Mgt
K. Schmid

Market Risk
S. Altner

Operational
Risk
B. Hodler

Asset Mgt &

Funds
B. Briner
Trading
R. Winkler
IT & Operations
U. Lderach /
Ph. Malherbe
J. Hsler

Julius Baer Group Risk Landscape

Strategic / Business Risk

Operational Risk

Market Risk
Funding / Liquidity Risk
Credit Risk

Clients & products

Execution, delivery & process

Fraud

Personnel

Legal & tax liability / default

System & physical risk

Reputational Risk

Six commandments of risk management

Foster risk and return awareness
Understand your profits
Be prepared to pay
Reconcile with diligence (and on time)
Track the cash
Watch your systems

Case study
Finance practitioners and academia working together
Project to model issuer specific risk on non-government
bonds at Julius Baer

What is issuer specific risk?

Key advantages of approach taken

The practitioners perspective

The interns perspective

What is issuer specific risk?

Risk from changes in price of a bond NOT due to
changes in the risk-free rate of interest

Issuer-specific risk (ISR) present in all non-govt bonds

Comparable magnitude to pure interest rate risk can

be much larger

Modelling pure IR risk fairly easy

Modelling ISR much harder

Problems with modelling ISR

Reliable historic prices are not available for most bonds

Even if they were available they would be of limited use because

time to maturity of a bond changes every day

Theoretically, problem 2 could be resolved by building a yield

curve (based on numerous bonds) for each issuer. Very difficult
in practice and very time consuming.

An approach based on the rating (S&P, Moodys) of a bond could

be used, but this presents numerous difficulties too

How did Enrique model ISR?

Measured spread of each bond (at current market price) over

risk free rate at same time to maturity (TTM)

Captured not only risk free yield curve for each currency, but also
various rating specific yield curves per currency (from
Bloomberg)

Took the interpolated spread over the risk free yield curve at
each TTM and for each rating specific curve

At each TTM calculated the historic volatility of these various

rating specific yield curves

Used discriminant analysis to determine probability that each

bonds spread would fall into a given rating category (usually
several probabilities, summing to one)

How did Enrique model ISR? (2)

Constructed an expected spread history for each bond (based

on historical spreads of each rating category and posterior
probabilities)

Once the expected spread history was calculated, GARCH was

used to find the best fit for the time series. These then drove
simulated paths for the expected spread history. This had effect
of rewarding diversification.

All of this was then automated in a routine using the SAS

statistical package

Key advantages of this approach

Rewards diversification

Backtesting against actual bonds (with reliable history) shows

model makes good estimates

No additional data on individual bonds needed

Can deal with any bond

Routine chooses best GARCH model for each bonds expected

spread history

Because main input is bonds current spread, model reacts

immediately to changes in market perception of an issues
credit quality.

Financial practitioners perspective

Assign one clearly defined task only to the intern

Task should require developing new approach to some problem

(e.g. a modelling problem)

If modelling involved, define an approach to backtesting early on

Recognise you are taking a risk

Encourage intern to attempt multiple approaches (unlikely to be

right first time)

Review progress regularly (at least once a week)

Be prepared to spend time helping the intern

Ensure intern has time to write thesis.

Interns perspective

Ensure task is clearly defined and that you understand it

Ask yourself seriously if you have what it takes to do the job

Try to gauge whether the task is doable in the time

Find out who your supervisor will be and make sure you spend
time talking to them about project. Can you work with them?

Ask how much time your supervisor will be able to spend with
you.

Ensure you have time for writing your thesis

Expected Spead History Calculation

Positions Rating may change during its lifetime. Thus, given
positions current YTM, a Discriminant Analysis was performed
using the simulated changes
Probabilities of membership into each Rating Category are
obtained and these are used to construct an Expected Spread
History (ESH) as follows:
ESHt = IssuerSpread + Current RFR*ExpChanget
C

PIssuerSpread Category * ChgCat

ExpChanget =
Bond:
TTM:
IS:
Group

i 1

3.75 Akademiska 06
2.09 years
19.17 bp
Probability

AAA

0.0000

AA

0.6224

0.3776

i, t

Monte Carlo Simulation and Risk Measures

Calculation
Using Monte Carlo, two bonds with exactly the same TTM and
YTM will have different simulated spreads. In this way, the ESH
of this simulated paths will not be perfectly correlated and
diversification reward is attained.
For each trading day, a random number from a (0, t ) is
drawn. The simulated pahts consider the volatilitys time
dependence.
Changes in the PV of the position is calculated using the
Simulated Spread.

Backtesting
Some bonds issue in CHF were selected with its price past
history, and a daily HSVaR was computed for the last 210
days.
Changes in bonds price due Issuer Spread is isolated and
compared with the HSVaRs.HSVaR99
HSVaR95
Exceptions Simulation
Rabobank

Hessen

General Motors

BP Amoco

Roche

Gemeenten

Electricite de
France

ExpSpread

Simulation

ExpSpread

# days

Observed
Expected
%
Observed
Expected
%
Observed
Expected
%
Observed
Expected
%
Observed
Expected
%
Observed
Expected
%

1
2
0.50%
1
2
0.50%
1
2
0.50%
1
2
0.50%
0
2
0.00%
0
2
0.00%

2
2
1.00%
2
2
1.00%
5
2
2.40%
2
2
1.00%
1
2
0.50%
0
2
0.00%

5
10
2.40%
3
10
1.40%
6
10
2.90%
3
10
1.40%
2
10
1.00%
0
8
0.00%

12
10
5.70%
8
10
3.80%
19
10
9.00%
10
10
4.80%
5
10
2.40%
1
8
0.60%

210

Observed
Expected
%

6
2
2.90%

7
2
3.30%

13
10
6.20%

24
10
11.40%

210

210

210

210

210

170