Six Sigma

This chapter is about Six Sigma to introduce the concepts and functions. The chapter makes a brief description of the Six Sigma methods. In addition, Six Sigma references are provided to the reader that allow them to read more about the subject.

Managing Liquidity Risk

This chapter describes the liquidity risk management in retail banking. The chapter elaborates how to determine an optimal cash management strategy to provide for liquidity of a retail bank which maximises profit by using the Miller-Orr Cash Management Model: 1) Stochastic Optimisation is used to construct the Efficient Frontier of optimal cash management policies with maximal profit determining the Daily Target Cash Balance and Daily Upper Cash Limit in order to maintain liquidity; 2) Monte Carlo simulation is used to stochastically calculate and measure the Profit, Variance, Standard Deviation and VAR of the cash management policies; 3) Six Sigma process capability metrics are also stochastically calculated, against the bank's specified target limits, for Profit and VAR of the Efficient Frontier cash management policies; 4) Simulation results are analysed and the optimal cash management strategy is selected from the Efficient Frontier based on the criteria of minimal VAR.

Managing Foreign Exchange Risk

This chapter discusses the method's application to foreign exchange risk management by elaborating how to use foreign exchange options for hedging the interest rate risk. The problem is to determine how many European Put options to purchase for optimal hedging of the foreign exchange risk: 1) Stochastic Optimisation is used to construct Efficient Frontier of optimal hedging strategies of the foreign exchange risk with minimal Standard Deviation; 2) Monte Carlo simulation is utilised to stochastically calculate and measure the Total Amount Hedged (US $), Variance, Standard Deviation and VAR of Efficient Frontier optimal hedging strategies; 3) Six Sigma process capability metrics are also stochastically calculated against desired specified target limits for Total Amount Hedged and associated VAR of Efficient Frontier optimal hedging strategies; 4) Simulation results are analysed and the optimal hedging strategy is selected based on the criteria of minimal VAR.

Managing Interest Rate Risk

This chapter discusses the method's application to interest rate risk. The method uses interest rate derivatives elaborating how to value the two-year inverse floater derivative in order to manage interest rate risk. The chapter presents a model for the interest rate risk associated with two-year Inverse Floater Derivative as follows: 1) Monte Carlo simulation is used to stochastically calculate the total Net Present Value (NPV) of the two-year Inverse Floater Derivative, the associated Variance, Standard Deviation and VAR; 2) Six Sigma process capability metrics are also stochastically calculated against desired specified target limits for the total NPV, as well as relating VAR of two-year Inverse Floater Derivative; 3) Simulation results are presented and analysed.

Measuring and Analysing Credit Risk

This chapter discusses the measurement and analysis of credit risk. A factory plans to accomplish a project and applies for credit to a bank to finance the project. The bank considers a loan to finance the factory project and assesses the credit risk. The chapter presents the analysis and measurement of different aspects of credit risk in order to answer how much should be lent to the factory project and for how long considering the risk inherent in the transaction. Credit risk is assessed considering: 1) Cash flow projection; 2) Count of negative cash flow; 3) Maximum negative cash flow; 4) Net Present Value (NPV) based on dividends; 5) Internal Rate of Return (IRR) based on dividends; 6) Capital asset NPV and IRR; 7) Solvency loan; 8) Risk of bankruptcy; 9) Financial Analysis Measures such as Gross Margin, Interest Coverage, Financial Coverage, Return on Investment, Return on Assets and Net Worth.

The Global Financial Crisis 2007/2008 and Financial Risk Management

This chapter covers the global financial crisis of 2007/2008 and outlines the real issues involved at that time specifically considering Financial Risk Management. The chapter highlights what has (or has not) been done to ensure such an event does not occur again. In particular, it elaborates how the Six Sigma DMAIC approach might have averted such a disaster.

Managing Market Risk and Controlling VAR

The market risk management in a portfolio selection of correlated assets is considered in this chapter. The chapter elaborates how to construct and select an optimal portfolio of correlated assets in order to control VAR considering the risk associated limits. Stochastic optimisation is used to construct the efficient frontier of minimal mean variance investment portfolios with maximal return and a minimal acceptable risk. Monte Carlo simulation is utilised to stochastically calculate and measure the portfolio return, Variance, Standard Deviation, VAR and Sharpe Ratio of the efficient frontier portfolios. Six Sigma process capability metrics are also stochastically calculated against desired specified target limits for VAR and Sharpe Ratio of the Efficient Frontier portfolios. Simulation results are analysed and the optimal portfolio is selected from the Efficient Frontier based on the criteria of maximum Sharpe Ratio.

Managing Credit Risk in Bank Loan Portfolio

In this chapter, the Six Sigma DMAIC approach is applied to improve credit risk management in banking loan portfolio selection. The objective is to select the optimal loan portfolio which achieves the bank's investment objectives with an acceptable credit risk according to their predefined limits. Stochastic optimisation constructs an efficient frontier of optimal loan portfolios in banking with maximal profit and minimising loan losses, i.e. credit risk. Simulation stochastically calculates and measures mean gross profit, loan losses, variance, standard deviation and the Sharpe ratio. The Six Sigma capability metrics determines if the loan portfolio complies with the bank's limits regarding the gross profit; loan losses, which quantifies the credit risk; and Sharpe ratio, i.e. a risk adjusted measure. Also, the bank regulation limits are applied based on the bank's capital to control the maximum loan amount per loan investment grade. Analysis allows for selection of the best Efficient Frontier loan portfolio with the maximum Sharpe ratio.