Financial Risk Management

Futures - Options - Swaps - Forwards - Default Risk - AIRS - Legal

Because risk is a fundamental element of business, it is important that managers properly assess and manage it.

Are derivative products mathematical monsters?

About the Author

Mark Glitto is a financial risk strategist at First Union National Bank. In managing the $5.6 billion credit card portfolio, Mr. Glitto's risk assessment includes revenue and loss forecasting, underwriting, acquisition & securitization issues as well as economic evaluation.

At the University of Florida, Mr. Glitto researched financial issues including spreadsheet-hedging analysis and the use of liner programming and computer simulation in financial decision making and portfolio management. His seminar lectures covered financial risk management issues and his thesis, Derivatives: Merging Legal Treatment and Financial Risk Management, examines the legal aspects of derivatives and the use of risk management in advancing corporate objective.

Mr. Glitto is a member of the Florida Bar and practiced law in Tampa, Florida. He received his BA, Cum Laude, from the University of Iowa, his JD from the of Illinois College of Law and MBA from the University of Florida. His law practice centered on commercial litigation and lender representation in state court and creditor representation in Federal Bankruptcy Court.

Introduction to Risk Management

Risk is pervasive. Corporations face currency exchange fluctuations, developers rise and fall with interest rates, and transports are subject to the daily changes in the price of oil. All businesses are subject to business cycle and everyone fears higher taxes. Because uncertainty is so prevalent in business, managers must learn to cope with it.

Risk management is a broad discipline. In order to be effective, risk management must be a core part of the overall management of a system. A risk manager must deal with insurance, technological systems, regulatory and legal issues, political exposures, and both micro and macroeconomic fluctuations. For example, in assessing a communication system, a manager must be aware that the system failure can caused by failure of the hardware, the software, the organization, or the staff members.

My lectures start by providing a basic understanding of a firm's risk profile. I emphasize understanding, and then managing, the risk. My hope is that the lectures will provide insight into the great latitude of modern risk management

Risk Management Lectures

My risk management lectures and papers are outlined below. I gave these lectures at the University of Florida during the summer of 1997. They are largely based on Managing Financial Risk by Smithson and Smith with Wilford. The lectures provide a basic introduction to the goals of risk management and the tools (derivative products) which are used. Special thanks to Professor Mark Flannery, Barnett Banks Eminent Scholar of Finance, at the University of Florida, for his patience and insight in reviewing these lectures.

Measuring a Firm's Exposure to Financial Price Risk. This lecture introduces the concept of firm risk profiles. It goes on to illustrate how to assess risk profiles from financial statements and annual reports.
Using Forwards to Manage Financial Price Risk. This lecture addresses forward-rate agreements (FRAs) in the context how banks manage maturity gaps. It also examines a corporation's use of forwards to lock in windfall profits from foreign exchange rates. Finally, it addresses the issue of coffee prices rising to a historic high during 1997. The question is posed as to whether a firm that successfully hedges a commodity would pass those profits on to consumers.
Futures and Risk. This lecture covers futures pricing and the cost of carry model. It also briefly covers bases risk and then explores the concepts of contango and backwardation in futures markets.
Options Risks: Curvature and Time Decay. This lecture is based on chapter six of Managing Derivative Risk: the Use and Abuse of Leverage by Lillian Chew. The lecture focuses on Gamma (convexity) risk. Understanding this second order effect is vital in dealing with options or derivatives that contain embedded options. The lecture briefly addresses the the issue of hedging gamma risk.
Using Swaps to Manage Financial Price Risks. This lecture has an excellent example of how firms can use swaps to increase debt capacity. Three typical problems are addressed: political risk; credit risk; and conversion of floating to fix rate funding. The example utilizes a forward contract, a commodity swap and an interest rate swap to resolve the issues. The result is a stabilized value and an increase in the corporation's ability to borrow funds.
Measuring and Managing Default Risk. This lecture addresses the important issue of credit risk inherent in certain derivative contracts. Changes in the level of credit exposure over the life of the contract is explored along with the implication of amortization and diffusion effects. Finally the paper examines measuring portfolio exposure with an illustration comparing a swap with a loan.
The Impact of Risk Management. This lecture reviews the three basic reasons to hedge and addresses the issue of derivative's influence on market price volitilities. Two examples of firm's using derivatives are explored. First, the market's use of collateralized mortgage obligations (CMOs) to transfer demonstrating a firms comparative advantage. Second, an oil companies use of derivatives to hedge commodity exposure, to illustrate the concept of firm specialization.
Case Study: Banc One Corporation: An Analysis of their Hedging Strategy. This document addresses Banc One's asset sensitive position and traditional methods of adjusting this balance sheet position. The paper investigates the bank's use of mortgage backed securities including collateralized mortgage obligations. Finally it explores Amortized Index Rate Swaps (AIRS), synthetic replications of CMOs. The paper was written with Gajendra Tulsian, PhD and Captain Robert J. Young, U.S. Army. Dr. Tulsian holds a PhD in mathematical physics and his mathematical insight was indispensable. Captain Young is an engineer whose "intuition" was vital to the paper's completion.

Derivative Quotes

"Never have I seen a subject about which people know so little" -George Salem, bank analyst, Prudential Securities as quoted by Steven Lipen "Heard on the Street," WSJ Dec. 1 1993, page C1.

"[Derivatives are] simply another Wall Street-developed house of cards." -Representative Joseph Kennedy as quoted by Barbara A. Rehm, regulators Try to Reassure Lawmakers on Swaps," American Banker, October 29,1993, page 3.

"You can call it [the use of derivatives] whatever you want, but in my book it's gambling." -Representative Henry Gonzalez, Chairman, House Banking Committee, Ibid.

"Futures and options are the tail wagging the dog. They have also escalated the leverage and volatility of the markets to precipitous, unacceptable levels." - John Shad, former Chairman SEC and current CNBC news commentator, Managing Financial Risk, Smithson and Smith with Wilford.

Legal Writings

My legal practice focused on state-wide representation of lenders. Representation included commercial and residential foreclosures, closings, document preparation, bankruptcy, eviction, real estate litigation and all related matters. Legal services were rendered in accordance with FHA/VA/PMI requirements. I have provided expert testimony to the City of Tampa, Board of County Commissioners, on condemnation and foreclosure issues. I have tried over ten cases to final conclusion. Some of my legal writing is listed below along with an appeal I wrote to Florida's First District Court of Appeals. I included Judge Feikens' opinion in the Proctor & Gamble case, which is must reading for anyone interested in the legal aspects of derivatives.

The following documents do not constitute legal advice or opinion. Mr. Glitto gives legal advice or opinion only with respect to particular facts and only after conflicts of interest have been cleared and/or waved and after being retained as counsel.

LENDER REPRESENTATION: Florida's Bankruptcy Courts and Adequate Protection of Mortgagees. This article reviews the mortgagee's concerns when bankruptcy is filed by a mortgagor. It explores the implications of the automatic stay imposed by the Federal Bankruptcy Code and addresses the issue of adequate protection. Finally I compare the bankruptcy court procedures in the northern, middle and southern districts of Florida.
MORTGAGE FORECLOSURE: Special Problems with Federal Tax Liens. Title 28,section 2410 of the United States Code sets out specific requirements regarding foreclosing on federal tax liens. This article reviews the specific statutory and case law governing foreclosing out these liens. The article explains removal and outlines the governments redemption right.
A Summary of Florida's 1993 Mortgage Foreclosure Act. In 1993 the Florida legislature made sweeping amendments to the Florida Statutes governing mortgage foreclosure. In this article I review the ten major changes. Special attention is given to the retroactive vs. prospective aspects of the Act.
Mills v. Walden - Sparkman, Inc., 493 So. 2d 64 (Fla. App. 1 Dist. 1986). I represented Walden - Sparkman threw their insured, the Florida Farm Bureau in this worker's compensation matter. The appellate issue was whether a family member should be reimbursed for wages lost when he drove his wife, the claimant, to obtain authorized medical treatment. The case was reversed and remanded to determine: whether the manner of travel was the most economical and reasonable method of transport; whether the husband's wages were actually lost; and for determination of the reasonable amount of compensation for the transport service.
Proctor & Gamble Co.v. Bankers Trust Co., 925 F. Supp. 1270 (S. D. Ohio 1996). The trial court applied the Supreme Court's Howey and Reves tests to the swap transactions involved and concluded that they were not securities as defined by the Securities Act's of 1933 and 1934. As such the plaintiff had no private cause of action under the antifraud provisions of the Acts. Furthermore, the court held that Banker's Trust was not a "commodity trading adviser" to the plaintiff. Instead, the court found that the litigants were counterparties in a "bilateral contractual arrangement." As such the bank did not own a fiduciary duty to the plaintiff. Note that the losses, approximately 200 million dollars, stemmed from embedded options.

Personal Notes

Across Italy on a Bicycle

In 1992 I toured Italy on bicycle. My journey started at the southern most tip of the mainland in the small town of Villa San Giovanni. I bicycled north along the Mediterranean sea through Salerno and Naples. My route then went inland threw Assisi, Spolito, Perugia and north to Florence. My "Giro de Italia" ended just north of Florence.

During my travels I pushed my bicycle up to the top of Mount Vesuvius, camped out on Anzio beach, were the Americans landed in World War II, saw the ruins of Pompeii and ate a lot of linguini.

My Italian vocabulary improved to the point were I could understand which road lead to Rome. It was always "Sempre Diritto" straight ahead! As the saying goes, "all roads lead to Rome." One warning, if you ever bicycle through Italy watch out for the long, dark, tunnels.

1000 miles on the Appalachian Trail

The Appalachian Trail trail is a continuous path that runs from Maine to Georgia following the spine of the Appalachian Mountains. I have hiked sections of the trail from the rugged, exposed peaks, of Maine's Mahoosuc Mountains through the old growth forests of the Nantahala Mountains in North Carolina. During my hikes I experienced life at a monastery in New York, a primitive farm in Virginia and watched 4th of July fireworks from a mountain top in Connecticut. The trail is very accessible and hiking it is like walking through history. Even a couple hours on the trail is a tranquil, rewarding experience.

"Remote for detachment, narrow for chosen company, winding for leisure, lonely for contemplation, it beckons not merely north and south, but upward to the body, mind, and soul of man." -Harold Allen, on the Appalachian Trail.

Futures - Options - Swaps - Forwards - Default Risk - AIRS - Legal