Derivatives mavens who've spent the summer in front of the tube dreaming of Olympic triumphs need dream no longer. Australia-based Risk Technology is sponsoring what it calls the first "Risk Olympics" on the Internet.

Prospective competitors need simply point their browsers at http://www.ristek.com.au~ristek and register. You'll then get a series of multiple-choice questions you must answer within three days. The questions are designed to test and develop risk intuition and, the company claims, "can be answered intuitively; you don't need to be a rocket scientist to win."

The first heat, reproduced below, was faxed to 100 treasury professionals in July. The promoters say the results "demonstrated that risk intuition is often misleading and that risk holes are more prevalent than commonly believed. The "correct" answer to most of the questions appeared obvious-but the obvious was usually wrong. Many seasoned treasury executives answered fewer than half the questions correctly and may have scored better by guessing at random. Four participants scored very highly. No one scored 100 percent.

Winners were Mike Shilling of Record Treasury Management, London, who captured a gold medal, and Chris Plater and Steve Davy of Bankers Trust Australia, who won the silver and bronze. There's no charge to compete, but it costs $15 to get a copy of the correct answers and explanations.

Question 1: The humble cash flow

A positive cash flow has a fixed face value. A sensitivity analysis is performed to measure the increase in its present value from a sudden 1 percent decrease in yields. The same analysis is performed on a second cash flow, which is identical in all respects except that it has a longer duration. Assume a flat yield curve at, say, 10 percent semiannual. The change in present value of the longer-term cash flow:

A. Is necessarily greater than that of the shorter-term cash flow.

B. Is necessarily less than that of the shorter-term cash flow.

C. May be greater or less than that of the shorter-term cash flow.

D The present values actually decrease, not increase.

Answer: The correct answer is C.

Players' selections

63 percent A, 6 percent B, 23 percent C, 8 percent D.

Question 2: The age of VAR

A risk manager is presented with a value-at-risk (VAR) measure of a complex diversified derivatives portfolio. The VAR is a single statistic intended to express the maximum one-day loss within a 99 percent confidence limit. The VAR indicates the potential for loss is too high. The risk manager must formulate directly an effective hedge or hedges to reduce the portfolio's market risk exposure.

A. The risk manager can do this simply by knowing the VAR.

B. The asset types, not specific instrument details, in the portfolio must also be known.

C. The asset types, spot and forward market rates must also be known.

D. The risk manager cannot determine the required hedge(s) given only the VAR, the relevant asset types and market data.

Answer: The correct answer is D.

Players' selection

6 percent A, 18 percent B, 18 percent C, 58 percent D.

Question 3: Exposed to what?

A corporate enters into a long-term FX forward to hedge a contingent liability. The hedge may need to be closed and settled at any time. The present value of the profit or loss on the hedge is, in general, exposed to:

A. Changes in the spot (exchange) rate only.

B. Changes in the spot rate and the domestic interest rate only.

C. Changes in the spot rate and the interest rates of both currencies only.

D. Changes in the spot rate, both interest rates as well as time lapse.

E. No market rates once a reverse FX forward with equal face value and maturity is entered into.

Answer: The best answer is D.

Players' selection

6 percent A, 4 percent B, 18 percent C, 61 percent D, 11 percent E.

Question 4: Is this real?

A trader performs a stress test on an interest-rate-related derivatives portfolio using uniform yield shifts with time and all other economic parameters unchanged. The portfolio seems to profit when yields increase. It also appears to profit when yields decrease.

A. This suggests the net delta is zero and gamma is zero or positive.

B. This suggests the stress analysis software is defective-the result violates arbitrage theory.

C. This suggests the portfolio will tend to gain value as time lapses.

D. This effect can occur only if options are present in the portfolio.

Answer: The correct answer is A.

Players' selection

45 percent A, 1 percent B, 10 percent C, 44 percent D.

Question 5: Does it matter?

An exporter can use either FX futures or forwards to hedge a long-dated FX exposure. Both futures and forwards are available with expiries coinciding with the payment date. Domestic and foreign currency interest rates exceed 10 percent. To achieve near risk equivalence, the face value of the futures contracts:

A. Should be greater than an equivalent forward contract.

B. Should be less than a forward contract.

C. Should be the same as a forward contract.

D. May be greater or less than a forward, depending on which currency has the higher interest rate.

Answer: The correct answer is B.

Players' selection

10 percent A, 36 percent B, 30 percent C, 24 percent D.

Question 6: A fundamental thing

The critical dimension, that is, the fundamental unit of measure, of a simple interest rate is:

A. A unit of the currency of the underlying instrument (for example, dollars of U.S. dollar­based instruments).

B. It has no dimension; interest rates are dimensionless numbers.

C. 1/Time.

D. Time.

E. Percent.

Answer: The correct answer is C.

Players' selection

4 percent A, 10 percent B, 41 percent C, 17 percent D, 28 percent E.

Question 7: The business of banking

A banker uses interest rate derivatives to manage a fixed rate mortgage portfolio. The bank's board views exposure management based on rate forecasts as speculative and prohibits it. A careful stress analysis indicates that the portfolio contains risk holes; it is exposed to yield curve changes. The risk manager then formulates and executes a hedge parcel that reduces market risk exposure significantly. With less market risk the expected or average profit to the bank:

A. Increases.

B. Decreases, but only by the amount of the hedge parcel transaction costs.

C. Decreases significantly since less risk means less return.

D. Stays the same.

E. May increase or decrease.

Answer: The correct answer is B.

Players' selection

4 percent A, 38 percent B, 17 percent C, 8 percent D, 33 percent E.

A number of dealers have been gearing up to offer clients services based on value-at-risk in recent months, but Chase has entered the field with what appears to be a distinctly different approach. The bank is developing pilot projects for CHARISMA, an umbrella term for a new collection of risk management services and methodologies including products that offer a variety of alternatives to standard value-at-risk analysis.

Although the CHARISMA (Chase Risk Management Analytics) products emphasize value-at-risk (VAR) techniques, they include stress testing, hedge optimization, performance evaluation and other statistical analysis. The goal, explains Chase managing director James MeVay, is to help clients develop the customized risk management framework appropriate for their unique operations. "We believe risk management should include a mosaic of different techniques, and we help our clients find the best methods and combinations of measurements," he says.

CHARISMA's approach to VAR, which was developed at Chase for internal risk management about eight years ago, has a number of attractive features compared to the variance-covariance methods that have gained popularity elsewhere. First is the accuracy of its method. Variance-covariance VAR methods-of which JP Morgan's RiskMetrics is perhaps the best known-generate a matrix of market factors, standard deviation and correlation estimates. This matrix is then used to estimate the potential loss of instruments held and their portfolio groupings at a predetermined confidence level over a given period of time-that is, VAR. The implicit assumption of this method is that the market factors are normally distributed, which is usually not the case. Another weakness of these models is the fact that they can measure the risk of only those instruments with a linear payout, that is, instruments that have no optionality.

CHARISMA's methodology, however, uses an historical simulation approach. This means that actual changes in historical values of relevant market factors are used to determine potential future losses in risk positions and their portfolios. If you wish to determine the VAR of a position with a 95 percent confidence level, this approach identifies the loss corresponding to the 95th percentile of potential changes in its market value produced by historical changes in the corresponding market factor. There is no attempt-in fact, no need-to define the shape of the distribution, normal or otherwise.

This fact makes it very easy to understand the results of risk evaluation, since risk exposure can be related to specific instruments and their positions, and to specific market and economic events.

MeVay believes that this historical approach has many advantages. First, it's extremely flexible. "Using the CHARISMA method, you can find a VAR for almost any exposure, provided that you can assemble enough historical data," he says. For example, he recalls one client asking if CHARISMA could handle Turkish lire. After a rapid check of available data sources, MeVay was able to answer quickly in the affirmative. The implication is that this method can handle an unlimited number of risk factors, which allows the practitioner to include those risk exposures that are of greatest importance for any given situation. This would not be the case with many covariance approaches, which are limited to a variance-covariance matrix of a certain size.

Because CHARISMA does not require explicit correlation figures, you eliminate the substantial worry of whether or not your correlation numbers are indeed a correct representation of actual market behavior. Instead, with CHARISMA, correlations are effectively embedded into the historical prices of each instrument in the portfolio. Thus, unlike covariance VAR, CHARISMA/VAR makes it easy to calculate the risks of individual positions as well as the resulting portfolio risk when they are aggregated. Says MeVay, "If you are looking at your portfolio, and let's say you want to add another instrument, all you really have to do is simply add another column to your spreadsheet."

So, then, is there anything that CHARISMA/VAR can't handle? "Of course," says MeVay, "if the instrument can't be priced, then you're going to run into problems. Otherwise, all other instruments can be included." MeVay is confident that CHARISMA's take on VAR is flexible enough to handle most client needs without resorting to a lot of assumptions. "We also emphasize that companies and financial institutions should not be just looking at VAR," he says. "It is necessary to include a number of different measurements in order to get a balanced picture of all your risks." For companies that want a fully comprehensive and flexible approach to risk management, CHARISMA/VAR is definitely worth a look.

Why Index-Collar-Type Hedges May Rebound

Goldman Sachs' equity derivatives group has addressed a recurring problem for portfolio managers: how to weigh the cost of reducing risk with put and collar-type option hedges. Three years ago Goldman did a study on this subject, which it replicated for the three-year interval ended in mid-July. The study focused on hedging costs for the S&P 500 index for a generic five percent three-month out-of-the-money put option and a zero-premium collar.

The timing of the new research has been shrewd, insofar as the equity market drop this summer may cause some institutional investors who've shunned collar strategies to reconsider. Goldman finds that in the last three years, a third of the time the collar return cap was breached, while the put floor was hit only four percent of the time. "Although hedging costs were low recently because of low index volatility," the report observes, "they were also not very valuable retrospectively because only in rare cases were they needed."

This state of affairs could very well change. If the downside frequency of the S&P 500 reverts to a more normal pattern, Goldman reckons that put floors would be breached 16 percent of the time, not the actual four percent for 1993­1996. The findings support the "idea that the upside behavior of U.S. equities in 1995 was not nearly as unusual as was the lack of downside volatility. Therefore, if history is any guide, investors may find hedging much more valuable in the future than they have in the past."

Among the firm's institutional clients there is a marked tendency for a strong interest in hedging to surface after an unusual steep index decline or rapid market rally that may not be sustained. There is also a seasonal demand pattern: very few investors are interested in hedging early in the calendar year. The peak of enthusiasm comes between summer and October.

The study-authored by Joanne M. Hill, Mark Eisner and Todor Mitev-concludes with a look at 1996 costs. It notes that the cost of the generic five percent OTM three-month put strategy has been at the high end of the last three-year interval, but below the levels of 1990­1993-consistent with the index return volatility that has snapped out of the doldrums of recent years. This year's cost of an OTM collar, on the other hand, has been consistently low. The report concludes with the following forecast: "With most investors expecting stable to rising short-term interest rates, and more modest upside gains than we saw last year, we can expect these collar-type hedges to gain favor as risk reduction vehicles in the next year."

Critical Looks at Tactical Asset Allocation

Two recent studies have shed some much-needed light on the effectiveness of tactical asset allocation techniques. According to the theory, using a tactical asset allocation (TAA) manager should provide better returns with lower volatility. But a study by pension consultants Rogers Casey suggests that market conditions have a profound effect on how well the strategy works.

Market conditions since 1988 have not been propitious for TAA, the study concludes. In particular, the low volatility, high correlations and similar returns from different asset classes make it difficult for TAA managers to add value. Dramatic underperformance of TAA occurred in the period 1988­1989.

Rogers Casey consultants Thomas K. Philips, Greg T. Rogers and Robert E. Capaldi examined the investment results of 11 money managers who collectively manage over 95 percent of the institutional assets allocated to domestic TAA strategies. One interesting observation the trio make is that there is little dampening of volatility. In each of the two time periods, only one manager of the 11 had volatility at least 100 basis points lower than its benchmark.

In conclusion, the consultants offer four pearls of wisdom. They suggest that unless there are institutional issues that TAA addresses, plans should not commit additional assets to TAA. Plans should use TAA as an overlay strategy to minimize transaction costs, should negotiate performance-based fees and, perhaps most important, should establish an appropriate passive benchmark for the program. All in all, the Rogers Casey study is no ringing endorsement for domestic TAA.

Salomon Brothers' Global Derivatives Review recently made its own study of the subject and reached the following conclusion: "Other things being equal, the payoff to an active allocation strategy will increase as the volatilities of the asset classes increase and their correlation falls. The ideal environment for a TAA manager is one of significant decoupling and high volatility-for example, 1987."

The report, entitled "Asset Allocation: Cost and Value," looked at its subject through the prism of option pricing theory and advised clients that they could get the same results with a spread option that paid the return differential between two asset classes.

US commercial banks are still doing a land-office business in derivatives, according to the latest survey from the Office of the Comptroller of the Currency. The survey, published on June 10, calculated the total outstandings to be $17.85 trillion in the first quarter.

Chemical led the list of bank holding companies, followed by JP Morgan, Citicorp, Bankers Trust, BankAmerica and NationsBank. The survey also broke down exposures at individual banks by the maturity of their interest rate and FX contracts. Trading revenues from derivatives totalled $2 billion in the first quarter, of which fully one third was attributable to Morgan Guaranty. It made $637 million, compared to the next best of $281 million at Citibank.

Another recent survey by the International Swaps and Derivatives Association reported a whopping growth rate in 1995. Overall outstanding transactions in interest rate swaps, currency swaps and interest rate options were valued at $17.713 trillion, fully 56.7 percent higher than the $11.303 trillion at the end of 1994.