Earlier this academic term, a team of graduate students from the Department of Economics, Mathematics, and Statistics took part in the PRMIA Risk Management Challenge. The Challenge is hosted every year in Europe and North America by the Professional Risk Managers’ International Association (PRMIA), the global professional and standard-setting body for the financial risk management industry.
This competition, which included teams from leading universities and business schools, was based on a exotic interest rate derivatives case. Birkbeck students successfully competed in three rounds, and advanced as one of the 6 teams (was 7 but 1 team dropped out due to an exam clash) to the final round. Beside the team from Birkbeck College, the final round included aspiring quants, financial engineers, and risk managers from University of Naples, Frankfurt School of Finance & Management, Imperial College Business School, University of Aberdeen, and London School of Economics.
What follows below is a brief summary of the proceedings, challenges in connection with the case study, and the solutions that have been implemented in order to progress to the final round. If you are a student or a faculty member interested in further details about this competition then please do get in touch.
The case study can be summarised as follows. In 2003, an interest rate swap was contracted by Metro do Porto (MdP), a Portuguese transport utility serving the city of Porto, and was related to an operational leasing contract originally signed in 2002. The contract, traded with Banco Comercial Portugues, was initially designed to cover a floating 20-year loan, which was an adequate hedging strategy at the time, considering the interest-rate risk. In 2005, Portuguese government auditors urged it to find a way of reducing MdP’s fixed-rate of 4.76% semi-annually relative to a straightforward 20-year fixed-for-floating swap.
In 2007, after considering the proposals from various banks, MdP entered into a more complex swap arrangement with Banco Santader Totta, with an underlying of EUR 89 Million, in which the bank agreed to pay a fixed coupon of 4.76% semi-annually. The swaps incorporated a “memory” feature, whereby the fixed rate was calculated as the last fixed rate plus the new fixed rate. If the reference interest rate (Euribor) moved outside upper or lower region, the fixed rate payable by the MdP had a “spread” added to it. The spread was cumulative at each payment date. The swap was also subject to leverage, hence the “snowball” effect. The swaps provided attractive initial rates, well below the rates obtainable on “vanilla” interest rate swaps. The swap provided positive cash flows for MdP: Euribor was between 2% and 6%, so the spread stayed at zero and Santander kept paying MdP 3%.
In 2009, following the financial crisis and the resulting sustained near-zero interest rates, the spread was activated. The leverage and the memory feature helped to increase substantially the interest rates payable by MdP under the swaps. According to the terms, the spread payable for that quarter be added to the spread for the previous quarter, giving it a cumulative “snowball” effect. In March 2009, the spread of the previous coupon period was 0%. But, by June of the same year, with Euribor standing at 1.28%, MdP’s coupon became 1.44% + 0.68% from the previous quarter, or a cumulative 2.12%. On September 11, 2009, with Euribor at 0.77%, it became 2.46% + 2.12%, or a compounded 4.58%. The contract did not have any reset clauses or caps: the bank safeguarded itself against the spread going negative.
So, for every quarter that Euribor is below the 2% mark, the cumulative coupon rises by a corresponding amount. By way of illustration, if Euribor remained at around 0.5%, MdP would be paying Santander a coupon in excess of 100% in late 2017 or early 2018. MdP ceased to make payments under the swaps in 2013, and as at 1 October 2015, the total unpaid amount of MdP and other three transport companies to be EUR 272.6 million. At the time of the competition, the rate stood at -0.327%.
Challenges and opportunities
In terms of our strategy when tackling this case, two things warrant immediate mention. First, this is not a “derivatives mis-selling” case. MdP did not assert that Santander wrongly advised them to enter into swaps, or misrepresented the swaps to them. The authorities did not argue that they had been mis-sold the swaps or that the bank had breached any advisory duty. Instead, the authorities’ arguments as to why they were not bound by the swaps turned on Portuguese, rather than English, law. The authorities argued that they had no capacity to enter into the swaps, that the swaps breached Portuguese mandatory law and that, in selling the swaps, the bank had acted in breach of Portuguese Securities Code. Indeed, Justice Blair ruled that English law applied to nine swaps that MdP and other Portuguese transport companies (eg Metropolitano de Lisboa) – signed with Banco Santander, meaning that the transit operators could not have the contracts invalidated.
Second, when submitting the case analysis, our team paid particular attention to MdP’s position, performance, business model, strategy, principal risks, and ethical considerations. The Birkbeck team argued that the most critical issue, taking the weight of evidence into account, is the fact that reporting standards in Portugal were normalised in line with a common European system only in 2010. These changes took into consideration the International Financial Reporting Standards (IFRS) and, more importantly, the IAS 39 guidelines, which relate to Hedge Accounting standards. In this sense, Portuguese companies, in general, were not obliged to report derivatives contracts and their fair value, unless they were publicly traded in other markets, such as some companies do through instruments. In the case of the Portuguese SOEs, such reporting was made mandatory by the DGTF – the Portuguese ownership authority – only in 2009. The necessary provisions were made in Portuguese law only in 2010.
In order to further put this case in proper context, one must flag other types of complex contracts traded by MdP. Whilst specific information about these contracts remains classified, some of these contracts were unveiled by the international press, particularly the Snowball with Santander, and the Index Swap renegotiated with Goldman Sachs, which was later renegotiated with Nomura. No points for guessing who benefitted most from these highly complex structures. It is also worth noting that MdP bought these products as a result of a “request for proposals” i.e. a formal tender process inviting banks to pitch. The finance team at MdP had an appetite for taking on aggressive risk.
Why is this important, you may ask? Economic developments and some high profile failures of risk management in recent years have reminded boards of the need to ensure that a company’s approach to risk has been properly considered in setting the company’s strategy and managing its risks. By way of example, the default of Lehmann Brothers in late 2008 arguably requires a broader statement about the reasonable expectation of the interest rates than before. One can expect that derivatives traded with previous interest rate expectations, either for hedging or speculative reasons, should be realising losses from 2009 onward.
Images: First page of Nomura MDP swap, and sample MATLAB code.
The team’s recommendations and supporting remarks aimed to bring together elements of best practice for risk management; prompt others to consider how to discharge their ethical responsibilities in relation to the existing and emerging risks faced by the company; reflect sound business practice, whereby risk management and internal control are embedded in the business process by which a company pursues its objectives; and highlight related reporting responsibilities. Although the case study examined on a particular situation in Portugal, lessons learned can be applied to a number of state-owned European entities. Indeed, the team felt confident to issue a number of recommendations.
MdP, and other Portuguese state-owned companies, should have adopted appropriate reporting standards in line with IAS 39 and prepare its financial statements accordingly. We argue that disclosures on risk management were the critical issue. If the appropriate reporting standards were implemented when needed, a clear risk picture would have emerged sooner and a determined hedge effectiveness would have been correctly assessed. Ernst & Young, MdP’s external auditor at the time, confirm this view in a note in the 2007 report. The external auditors highlight the fact that there were five swap contracts effective at the time, and that they should be considered in line with with IAS 39, even if the legal framework did not explicitly require this at the time.
Just as importantly, the risk management function for complex instruments for similar entities should be centralized, with a proper oversight mechanism. An organisation’s corporate treasury function manages a full portfolio of funding arrangements supporting all of its business operations. In the private sector, if things go wrong then it is the organisation’s parent company that absorbs the risk within its treasury function. But with State-owned enterprises, it is the tax-payer, by virtue of involvement of the central government! The best approach would be to centralize the risk management function for complex instruments and refer any such transactions to an appropriate and competent central authority, eg the Portuguese Treasury.
Guidance issued by the IGCP – Portuguese Treasury and Government Debt Agency – on potentially toxic financial products was ignored. The metrics of potential toxicity set out in the IGCP guidance should be used coherently. The irony is that when done properly, the pricing of financial instruments and the management of the component risks by modern statistical methods have the potential to produce a more efficient allocation of financial risks and to enhance the safety and soundness of financial institutions. However, the methods involved are can be complex as the derivative instruments themselves. And we should not forget that for some market participants pricing new exotic options can be a fool’s errand: they trade in small amounts. Why? Because buyers know that any contract is full of adverse selection. What we can see in the MdP case there is a clear deviation from sound hedging, while moving unnecessarily beyond keeping simple hedging strategies and structures.
The so-called snowball contract had a high degree of complexity and potential toxicity. It was recommended in the team report that any transactions above the most simple ones – IGCP defines these as the 1st degree – are subject to scrutiny at a national level by an appropriate central authority. In addition, from an ethical standpoint, in considering communication systems, the board should also consider the company’s whistle-blowing procedures.
Calculus of modern finance
Disputes between banks and public authorities over interest rate swaps are not new. English, Italian, Norwegian, and German public authorities are among those that have come before the English courts, with variable success, to argue that they are not bound by swaps that have turned out to be expensive.
Both the calculus and regulatory aspects of such deals may reflect concern and, in some quarters, alarm about the implications of the rapid growth of derivatives. To the uninitiated, discussion of semi-martingales, Markovian structures, modelling the term structure of multiplicative spreads, compounded risk-free forward rates may seem alien. Yet, this is the calculus of modern finance, an industry where risk management and hedging are part of normal business practice. All companies need to raise and manage its financing, and state-owned rail companies are certainly no exception, especially as markets have been transformed by the forces of securitization and globalization.
The growth of derivatives activities undeniably poses challenges to financial institutions, end-users and regulators. However, as the industry landscape moves forward, we must not lose sign of the fact that derivatives are important instruments to hedge risk and, subject to appropriate risk management, can be very useful. The Birkbeck team successfully argued that swap restructuring, as the type carried out by MdP in 2007, and the accompanying lack of transparency, resulted in the warehousing of tail risk, and would therefore not be effective without being subject to specific risk controls presented in the team’s report.
Although Birkbeck did not win (University of Naples did), the competition was valuable in many ways. First, it allowed Birkbeck students the opportunity to study a company’s industry, risk position, financing capacity, targeted financial statistics, and long term goals. Second, the team calibrated and simulated term structure models in MATLAB using Markov Chain Monte Carlo methods to advise on corporate debt refinancing. Short and long risk horizons were integrated in a consistent framework. And finally, the Birkbeck team successfully created a thorough and detailed risk methodology to provide financial market participants with accurate risk measures to improve their bottom line.
This competition and others like it help fine-tune the skills that any good quant needs to excel on the job market: technical acumen, problem-solving and decision-making abilities, analytical skills and a good eye for detail, the ability to cope under pressure, planning and organisation skills, negotiation skills and the ability to influence people, and good communication and presentation skills.
Special thanks to the School of BEI and the Students’ Union for funding the team this year, to the Birkbeck Economics + Finance Society for facilitating the entry and composition of the team, and to Konstantinos Dagklis for mentorship throughout the competition.
The Birkbeck team consisted of: Charles Shaw, Tim Poon, and Mayundo Mwenze. All three are graduate students in the Department of Economics, Mathematics and Statistics.
Find out more:
Financial Risk Management (MSc):
Q: Should I register for a competition as part of EFS?
A: Registration as part of a society team, rather than entering your own team, is optional but has many benefits:
– The society infrastructure (members, connections, access to faculty etc) means that there is much likely to be a wider pool of applicants, making the final selection stronger
– EFS entered around 10 competitions in last three years and has the experience and resources, inter alia, to: facilitate entry, secure academic support, and obtain practitioner expertise.
– Ability to include team participation details and, if obtained, awards on your CV and LinkedIn profile – Meanwhile, students benefit from the resources, experiences, and reputation of a strong research department like EMS.
Q: I have heard of a particular competition and I want EFS to enter it. What do I do?
A: Speak to the relevant committee member. If it is felt that the minimum standard for team quality is not reached, then it is likely that the society will not enter a team into that competition.
Q: I do not study economics, I’m a student in another field, a lawyer, etc. Am I welcome to take part in competitions?
A: Yes of course you are. In any case, nobody can stop you from applying. Yes, the primary purpose of the society is to facilitate discussion among economists with (or close to obtaining) degrees, particularly those who are committed to a career in the field. And if you do not have a background or ambitions of this type, then you will probably need to state clearly on your application the reasons for your application. But on the other hand, EFS is a broad church and different backgrounds can only compliment and augment the society. For example, the society was extremely lucky to have secured the involvement of a law graduate student with forensic accounting experience for last year’s Venture Capital Investment Challenge, and other activities.
A few notes on previous competitions…
- Venture Capital Investment Competition:
- University Trading Challenge 2015:
- University Trading Challenge 2014: