Risk Management Assignment: Case Scenario of JP Morgan & BHP

Question

Task: You are supposed to prepare a risk management assignment answering the following question:

QUESTION 2
Describe the failure in risk management in JP Morgan during the London Whale episode .

(b) What risk management strategies would you recommend for JP Morgan moving forward?

QUESTION 3
The current stock price of BHP is $40. The Greeks for European options on BHP are as follows Delta
Gamma
Vega
Call
0.50
0.08
0.08

Put
-0.09
0.04
0.03
The Greeks in this table are for a long position in one call or put option. Assume that one call optiongives you the right to buy one share and one put option gives you to right to sell one share.

(a) You have sold (shorted) 2000 call options on BHP. What positions in the underlying and/or in the put option should you take to create a portfolio that is both delta neutral and gamma neutral? Clearly indicate whether the positions are long or short positions.

(b) By how much does the value of the delta- and gamma-hedged portfolio in question 3(a) change when the volatility of the BHP stock price goes down by 1%?

(c) Describe the following risks and explain to what extent these risks are handled by quantitative analysis.

List of risks:
Credit risk, reputational risk, market risk, and political risk.

Answer

Part a)
JP Morgan is one of the prominent companiesacross the world that is engaged in providing diversified financial services. Several US bank regulatory has been criticized to JP Morgan for failure is the risk management strategies of the company that assists towards significant loss on credit derivatives by a trader dubbed the London Whale. The primary reason behind this is, company was not paid emphasis on small group of trader that is working for chief investment unit of bank, which was predicted to be hedged or safeguarding against the future losses (Zeissler, and Metrick, 019). In reality, far from reducing the risk of bank, the London based traders amassed a bigger, comprehensive financial portfolio in the biased expectation that doing so will support the bank avoid a connectively moderate loss. There are several reasons by which company has suffered from these losses. It has been identified by JPM that bank is affected by several risk such as liquidity, market, interest rate, operational, legal and fiduciary, reputation and some others. Usually, risk managementframework of the JPM and its governance structure is consisting of qualitative as well as quantitative aspects.

For London Whale, the company has not considered the quantitative risk limits, models, and matrices that were assists towards measurement and monitoring of market risk they took (Bean, 2018). Along with this, traders also did not mark the fair value of some derivatives in the proper manner in order to hide their losses from the management of company, so that they could not understand about extent of losses they undertook. There it can be asserted that, there is failure of regulatory as well as corporate oversight, which assists towards speculative and risky derivatives that are not aligned with traditional investment tactics of the CIO of investment for long term period with credit derivatives for hedgingobjective only (Valine, 2018).

Further, risk management particularly, for credit derivatives portfolio of CIO unit does not recognize to have been priority, that shows risk management strategies has not been analyzed in adequate manner. Prior to this loss, risk management function has been overseen by the chief market officer that directly makes report to the CRO of bank, but company failed to take sufficient steps to power the risk and control framework. It can be said that, company failed to appoint skilled and qualified employees, by which risk could not be managed in appropriate manner.

Apart from this, another reason for such loss is implementation of new VaR model for the synthetic credit portfolio (Sargen, 2020). This new model has created impact on the extent of risk weighted assets that are being computed for CIO. The basis for application of new model was that the present model was very conservative that assists towards overstatement of risk, therefore leading in limit breached. There are several issues in the new model such as, requirement of manual updation, coding errors while computing hazard rates and correlation, and others. All these failure is risk management assists towards London Whale episodes.

Part b)
By considering the failure in risk management in JP Morgan during the London Whale episode, which resulted in the total loss of $ 6.2 billion? It has been evidenced that the both committed fraud by not disclosing the true extent of bank management losses(Zeissler and Metrick, 2019). It is very important for JP Morgan to consider effective risk management strategies to determine their risks early on so that their likelihood can be reduced to the highest extent a base for decision making is formed to prevent future risks. It is crucial for the company to comprise communication strategies and effective technological adaption in their business operations to effectively deal with data breaches, plus they are recommended to embrace inclusiveness of senior security leadership to discuss and define security issues with the external groups so that proper resolving techniques can be developed(Agwu, 2018). Along with this, the company must also encourage data transparency and usage of information, while keep on reevaluating and establishing policies enforcing unauthorized data accessibility. It is prevalent for the company to make proper compliance with the government regulation associated with data protection by enforcing internal auditing, setting minimum time and budget requirements and considering timely internal audit to ensure sufficient compliance.

It is recommended to JP Morgan to take on adequate control procedures and implement proper security controls with making use of Flags to alert the management about any system break that take place. It is to be suggested that the company must mainly focus on communication and set up regular meeting along with taking feedbacks and providing training sessions to share information regarding compliance procedures(Stulz, 2016). Furthermore, the company must also conduct frequent training and education sessions to make employees alter about the policies, and classify reliable data management, risk management and controlling strategies to foster ethical and fair practices. For moving forward, the company needs to gain the goodwill of authorities and their support by sharing their achievements related to the security of their information assets, for this aspect they need to inform core governmental stakeholders regarding the success and proficiency of information security measures. It has been evidenced that the financial industry poses a significant challenge due to the volatile environment of assest market and the possible imapct of decisions considered by decentralized investment managers as well as traders(Callahan and Soileau, 2017). The risk profile of an investment bank can dramatically fluctuate with a single deal or a main market movement. In regards with this aspect, JP Morgan’s risk management must embedd experts so that they can constantly monitor and impact the risk profile and work with line managers to closely evaluate risks and generate new innovation, ideas and profits. In a nutshell, the invetsment bank is reccomended to carry out regularly schedules detailed assessment, and consider a risk based approach along with contributing more time and resources on high risk areas so as to successfully manage risks. The high risk areas of JPM comprise of; credit, opertaional, market, staretgic and liquidity risk for this aspect the bank must initially consider task segregation, strenghten the organizational ethics, monitor and evaluate activities and opertions at regular intervals and conduct periodic risk assessment. It is important that the bank attempt to resolve opertaional risks by complying with strict rules for delegation of duties and roles among and in the business and promote functions by pursuing an internal control system and strict supervision. To this note, the bank must mitigate the risks in future by proper planning, and considering which risks are of highest pirority and need urgent resolvance, while they must also consider constant development as well as updation of strategic information and communication system (Carretta, Fiordelisi and Schwizer, 2017). The situation of JP Morgan case offers an unfortunate remind of the signficance of setting and manaing a suitable risk culture in which the voice of managemennt is taken into account and secured. By considering this aspect, JPM needs to place utmost investment on training employees and management to understand how educated and informed risk related decisions can be made to ensure constant risk behaviour in the business (Adrian, 2017).

Answer 3
Part a)
Delta-Gamma hedging is referred as option strategy that includes delta hedging and gamma hedging by which risk could be mitigated in relation to the change in the underlying assets and in delta as well. In case of option trading, delta is referred to a change in the price of option contract in relation to changes in the price of underlying assets. Further, rate of change in delta is known as gamma. It can be said that, delta as well as gamma support to gauge changes in the price of option relative to in-the-money and out-of-the money option. Investor enter into delta hedging to restrict the risk of minute movement in the prices in the underlying security, and hedge gamma in order to obtain security from remaining exposure built by use of delta hedge. In other words, it can be said that, hedging of gamma creates impact on protection of position of trader from movement in the delta of option. Moreover, movement in delta lies from -1 and +1. The delta of call option lies between 0 and 1, and in contrary to this, delta of put option lies from 0 and -1.

Delta neutral is considered as portfolio strategy applying several positions with aligning positive as well as negative deltas by which overall delta of the security in questions totals zero. By use of delta extent of change in prices of option could be identified when the prices of underlying security changes (Xiong, and Yong, 2017). As per changes in the value of underlying assets, the position of Greek would shift between being positive, negative, and neutral. It is required by the investor to adjust their portfolio if they want to maintain data neutrality (De Spiegeleer et.al 2018). Data-neutral strategy is used by the option traders to gain profit from implied volatility or from delay in time of the option. For the purpose of hedging, data neutrality strategies are used. Since, investor owns 2000 shares in the company. The option contract provides right to sell or right to purchase shares at the strike price.

In the given case, investor has sold 2000 call option. In order to obtain data-neutral position, it is required to enter into position that has delta of -2000. Since, the delta of underlying stock is 0.5; therefore, it is required to enter into two long call option by which one short future contract could be hedged. As, -

2 call option *0.5 = 1, which is equivalent with one short future.

Further, the gamma neutral option storey consists of creation of option position that assists towards overall value of Gamma zero, or very near to the zero. The primary standard for this is to ensure that value of delta of such proposition remains constant notwithstanding off how the underlying security moves (Kim, and Kim, 2016). Further, Gamma neutral portfolio could be cerate through offset Gamma position. This would provide support to decrease variation because of changes in the market situation. Therefore, in the given case, it is required by investor to have zero long call option in order to hedge one short future contract.

Part b)
In case, if the option has delta one, and the price of underlying stock is increased by $1, then in such case, option price also increased by $1. This could be noticed in the call options that are in-the-money. Similarly, if the delta of option is zero, and the price of underlying stock is increased by $1, then in such case, there is not any change in the price of option, this type of behavior could be observed in the out-of-money call option. Moreover, if the delta of option is 0.5, its price would increase by 0.5 for every increment in the $1 value of the underlying stock (Florianová, and Dráb, 2016).

In the present case, there is requirement of two call hedge option in order to hedge one short future contract. This suggest, one percent increment in the S&P future, a loss of $250, which investor has short position would be aligned by one point profit in the value of two call option. Therefore, in the given case, it can be said that, investor are in position of delta neutrality.

Part c)
Credit Risk: It is the possibility of loss taking place from the failure of borrower to make repayment of loan or meeting the contractual agreements. It is termed as the risk that the lender might not derive the outstanding interest which leads to cash flow fluctuations and interruption thereby can cause enhanced costs for collection(Bülbül, Hakenes and Lambert, 2019). The best tools for credit risk management comprise of traditional techniques like financial analysis, or making use of support tools like credit scoring as well as risk grading. Credit risks scorecards can be used to manage these risks as these are the mathematical models that seek to offer a quantitative assumption of the probability that a consumer will reflect a defined behavior for example, loan default etc in regards to their current credit position.

Reputational risks: These risks are referred to the potential for negative public perspective, public perceptions or uncertain or risky events that can create a harmful influence over the reputation of company, sales and revenue(Walter, 2016). These risks take place without indications and any shift in the corporate environment; it also injects an adverse narrative into corporate search results which can affect customer perspectives and overall profitability. The reputational risks are quantitatively handled by protecting business against data breaches, and being mindful regarding ethical conduct. However, these processes are not under the control of organizations these are measures in terms of regulatory costs, operating costs, revenue loss or reducing shareholder value.

Market risk: It is the risk that the investment value will fall because of the changing market forces, and these forces will create an unfavourable impact on the financial market’s performance and activities and can only be addressed by asset diversification that are not correlated with the market like some alternative asset classes(Beltrame, Previtali and Sclip, 2018). These risks are also known as systematic risks as they are related to factors like recession that can affect every single aspect of market. These risks are unavoidable and thus are of utmost concerns and these can mainly take place due to market variables such as inflation, exchange rates and risk of interest rate. The extent by which credit risks are handled by quantitative analysis is that derivatives are used herein as financial instruments such as swaps, future as well as forwards that obtain their value from references rates, underlying assets or indices or a mixture of these factors. These financial instruments are used in accordance with board policies for hedging market risks for mitigating market risks, volatility and minimizing risk of loss.

Political risk: It is the risk that the returns of investments can suffer due to political changes or unstable country situations. This unstable and inconsistent environment can be a big threat to investment returns and can stem from governmental changes, foreign policy marker decision changes and legislative body changes(Ashraf, 2017). These risks are faced by firm when they incur strategic, personnel, or financial loss due to non market factors (macro-economic, societal policies i.e. labour, fiscal, investment, income, trade and political instability).

Political risks cannot be completely mitigated, but their impact can be lowered by gaining goodwill from government authorities by presenting achievements and considering better compliance, ethical conduct, regular auditing etc. The assessment tools of scenario planning can be used to mitigate political risks as it assist in perceiving risks and opportunities and taking a broader view into future uncertainty. This helps in making strategic decisions for plausible futures and uncertain events and allow in imagining different scenarios that might challenge business assumptions and to spot risk sources that might otherwise go undetected(Grafova and et al. 2017). One more tool of war-gaming is used to by firms to create, evaluate, rehearse and refine strategies and improvise decision making during uncertainty. Furthermore, both of these are vital tools for political risk management as well as risk governance, portfolio optimization and risk sensing are the core divers of the risk intelligent enterprise. ?

References
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Agwu, P.E., 2018. Credit risk management: Implications on bank performance and lending growth. Available at SSRN 3122501.

Ashraf, B.N., 2017. Political institutions and bank risk-taking behavior. Journal of Financial Stability, 29, pp.13-35.

Bean, E.J., 2018. Beaching the London Whale. In Financial Exposure (pp. 371-400). Palgrave Macmillan, Cham.

Beltrame, F., Previtali, D. and Sclip, A., 2018. Systematic risk and banks leverage: The role of asset quality. Finance Research Letters, 27, pp.113-117.

Bülbül, D., Hakenes, H. and Lambert, C., 2019. What influences banks’ choice of credit risk management practices? Theory and evidence. Journal of Financial Stability, 40, pp.1-14.

Callahan, C. and Soileau, J., 2017. Does enterprise risk management enhance operating performance?. Advances in accounting, 37, pp.122-139.

Carretta, A., Fiordelisi, F. and Schwizer, P., 2017. Risk culture in banking. Springer International Publishing.

De Spiegeleer, J., Madan, D.B., Reyners, S. and Schoutens, W., 2018. Machine learning for quantitative finance: fast derivative pricing, hedging and fitting. Quantitative Finance, 18(10), pp.1635-1643.

Florianová, H. and Dráb, T., 2016. Hedging of Portfolios and Transaction costs. European Financial Systems 2016, p.157.

Grafova, T.O., Skorev, M.M., Andreeva, L.Y. and Kirischeeva, I.R., 2017. Tools of financial management of reputational risks.

Kim, D. and Kim, S., 2016. Delta-hedged gains and risk-neutral moments. Journal of Risk, Forthcoming.

Sargen, N.P., 2020. Why Morgan Matters. In JPMorgan’s Fall and Revival (pp. 217-230). Palgrave Macmillan, Cham.

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