market risk (1)

8/13/2019 Market Risk (1)

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A. Board practices

Boards overall responsibilities

Principle 1

The board has overal l respons ibi l i ty for thebank, includ ing approving and overseeing

the implementation of the banks strategicob ject ives, r isk strategy , co rpo rate

governance and co rpo rate values. The board

is also responsib le for prov id ing

overs ight o f senior management.


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Principle 2

Board members should be and remain

qual i fied, including th rough training ,

for their

posi t ions. They should have a clearunderstand ing o f their role in co rpo rate

governance and be able to exercise

sound and object ive judgment aboutthe affairs o f

the bank .


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Principle 3

The board should def ine app rop r iate

governance pract ices for i ts own work

and have

in p lace the means to ensu re that such

pract ices are fol lowed and per iodical ly

rev iewed for ongoing improvement .


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Principle 4

In a group structu re, the board o f the

parent company has the overal l

responsib i l ity for

adequate co rpo rate governance acrossthe group and ensur ing that there are

governance po l ic ies and mechanism s

app rop r iate to the stru ctu re, businessand r isks

of the group and i ts ent i t ies.


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Principle 6

Banks shou ld have an effect ive internal

con t ro ls system and a risk

management

funct ion (inc lud ing a chief r isk of f icer

or equ ivalent) with su ff ic ient author i ty,

stature, independence, resources and access to

the board.


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Principle 7

Risks should be ident i f ied and moni tored on

an ongo ing f i rm -w ide and ind iv idual

ent i ty basis, and the sophist icat ion o f the

banks risk management and internal control

in f rastruc tures should keep pace with any

changes to the banks risk profile (including

i ts g row th), and to the external r isklandscape.


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Effect ive r isk management requ ires

robust in ternal communicat ion w i th in

the bank

about r isk, bo th across the

organisat ion and through report ing to

the board and senior

management.


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Principle 9

Principle 9

The board and senio r management

shou ld effect ively u t i lise the wo rk

conducted by

internal aud it funct ions, external

aud i tors and in ternal contro l func t ions.


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Market Risk

Trading Book

Banks Proprietory positions in financialinstruments

Debt securitiesEquity

Foreign exchange

CommoditiesDerivatives held for trading


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Market Risk

Interest rate risk

Equity price risk foreign rate risk

Commodity price risk Liquidity risk

Asset Liquidity Risk

market liquidity riskModel risk


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Risk measurement

Nominal amount approach

Sensitivity based approach

Baisis point value


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BPV is a method that is used to measureinterest rate risk. It is sometimes referredto as a delta or DV01. It is often used to

measure the interest rate risk associatedwith swap trading books, bond tradingportfolios and money market books.


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What does it show?

BPV tells you how much money yourpositions will gain or lose for a 0.01%parallel movement in the yield curve. Ittherefore quantifies your interest rate riskfor small changes in interest rates.


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How does it work?

Let's suppose you own a $10m bond that has a price of 100%, a coupon of 5.00%and matures in 5 years time. Over the next 5 years you will receive 5 couponpayments and a principal repayment at maturity. You can value this bond by:

A. Using the current market price from a dealer quote, or B. Discounting the individual bond cash flows in order to find the sum of the present

values Let's assume you use the second method. You will use current market interest rates

and a robust method for calculating accurate discount factors. (Typically swap ratesare used with zero coupon methodology).

For the sake of simplicity we will use just one interest rate to discount the bond cashflows. That rate is 5.00%. Discounting the cash flows using this rate will give you avalue for the 5 year bond of $10,000,000. (How to do this using a financial calculatoris explained on the second page of this document).

We will now repeat the exercise using an interest rate of 5.01%, (rates haveincreased by 0.01%). The bond now has a value of $9,995,671.72.

There is a difference of $4,328.28. It shows that the 0.01% increase in interest rates has caused a fall in the value of the

bond. If you held that bond you would have lost $4,328.28 on a mark-to-market basis. This is the BPV of the bond.


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How do risk managers use this?

BPV is an estimate of the interest rate risk youhave. You can therefore use it to manage

interest rate exposure. Some firms do this by giving traders a maximum

BPV that they are permitted to run. For example,a limit where the portfolio BPV must not exceed

$20,000. The more interest rate risk you are prepared to

let dealers take the higher the limit


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How do traders use this?

Traders can use BPV in order to adjusttheir exposure to interest rate risk. If adealer expects interest rates to rise he will

reduce the BPV of the portfolio. If heexpects rates to fall the BPV will beincreased.


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Dealers adjust the BPV by altering the positions they have. Here isan example.

Let's suppose a dealer expects interest rates to rise and is long the$10m, 5 year bond from the previous example.

The dealer will want to reduce the BPV being run.

The BPV can be reduced by any of the following: Selling the $10m 5 year bond and investing in a 3 month deposit.

The BPV of a $10m 3 month deposit is approximately $250. Selling another bond so the value of the long and short positions

give a lower net BPV. Paying fixed interest on an interest rate swap so the BPV of the

swap and bond give a lower net BPV. Selling interest rate or bond futures, again to reduce the overall BPV

of the portfolio.


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It is relatively simple to calculate. It is intuitively easy to understand and has gained

widespread acceptance with dealers. You can apply the same approach to financial

instruments that have known cash flows. This meansyou can calculate BPVs for money market products andswaps.

You can also amalgamate all the cash flows from aportfolio of transactions and calculate the portfolio BPV.

It can be used by dealers to calculate simple hedgeratios. (If you are long one bond and short another youcan calculate an approximate hedge ratio from the ratioof the two BPVs, more on this later).


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BPV has weaknesses, they are:

You may know the BPV but you do notknow how much the yield curve can moveon a day-to-day basis.

BPV assumes that the yield curve movesup or down in a parallel manner, this is notusually the case.


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Can anything be done to improve

BPV? Yes. Firms that use BPV recognise these

weaknesses and use additional risk limits. Someof these limits capture the risks that dealershave from a non-parallel shift in interest rates.Risk managers alter the shape of the yieldcurve. They make the yield curve steeper orflatter around a particular maturity and look atthe impact that would generate on the P&L.

Many firms have moved towards statisticaltechniques like value at risk. This provides aprobability of loss. BPV cannot do this


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In order to accurately calculate BPV you need a spreadsheet or frontoffice trading system that provides you with precise discount factorsfrom market interest rates. However if you want a quickapproximation of basis point value the following may help, you willneed a financial calculator.

Suppose you want to find the BPV of a $10m, 5 year bond with a

coupon of 5% when interest rates are 5%. Input the following into your calculator: N = 5.00

I = 5.00%PMT = 500,000FV = 10,000,000

Press PV and the calculator will give you 10,000,000 Repeat the exercise using 5.01% as the interest rate, I. The calculator now gives you $9,995,671.72 A difference of $4,328.28, the BPV of this bond.


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Use the following:

N = 3.00I = 5.00%PMT = 500,000

FV = 10,000,000 Press PV and the calculator will give you 10,000,000

Repeat the exercise using 5.01% as the interest rate, I.

The calculator gives you $9,997,277.26

A difference of $2,722.73, the BPV of this bond. You can now see that longer dated bonds, (or swaps),

give you higher BPVs and therefore greater interest raterisk.


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Hedge ratios Sometimes dealers construct trades that try to take advantage of

anticipated changes in shape of the yield curve. For example theymay expect short term interest rates to increase and longer termrates to fall.

Using the 3 year and 5 year bonds how could this trade beconstructed?

You sell the 3 year bond and buy the 5 year bond. Because the twobonds have different BPVs you would want to weight or ratio thetrade according to their relative risks.

So if you bought $10m of the 5 year bond you would sell:

4,328/2,722 (BPV 5 year/BPV 3 year )x $10m = 15.9m of the 3 year bond. The BPV of the two trades would be zero. You have hedged parallel

changes in the shape of the yield curve but are exposed to the non-parallel change you wanted.


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Finally is BPV constant? No. As interest rates increase, BPV falls. You can see this if you calculate

the BPV for the 5 year bond using interest rates of 10.00% and 10.01%respectively.

The BPV falls from 4,328.28, (using 5.00% and 5.01%), to $3,305.71. As interest rates rise the BPV falls. Sometimes this is referred to as

convexity. It can be important to traders because it can mean that the interest rate risk

they have changes as interest rates move and any hedges they are usingmay need to be rebalanced.

For risk managers this has important implications too. If you are usinginterest rates derived from swap rates to calculate the BPV of financialinstruments and those instruments trade with credit spreads over or under

swap rates then your BPV calculations will be approximations.


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Value at Risk tells you how much money you can loseover a given time period and for a given level ofconfidence from the positions you hold. But it is not aguaranteed maximum loss figure. Your positions could

lose you a lot more than VAR indicates. Sometimes markets move by huge amounts in very short

space of time. As a consequence your dealing positionscan give you losses much greater than the VAR youhave calculated.

It is this point that senior managers should be aware of.VAR is not a guaranteed maximum loss figure. Givingyour dealers a VAR limit will not mean they cannot losemore.


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Four main factors influence your VAR number, they are: Exposure: In general the larger the position you have the greater the risk.

Therefore large positions create greater VAR. Time: The longer you intend to hold the position the greater the VAR. As

you may expect 10 day VAR is greater than 1 day VAR. (But not by a factorof 10, only the square root of 10).

Confidence: If you want a VAR that is very unlikely to be exceeded you willneed to apply more stringent parameters. All things remaining constant thiswill increase your VAR and make it less likely to be exceeded.

Volatility: If you deal in risky things that have a history of going up and downin price, or if market conditions alter to make your positions move up anddown in price your VAR will tend to increase.

It is important to put any VAR number you see into context. This means that

if you are provided with a VAR number you should also know: What is the probability that it will be exceeded? What is the holding period? Without this information you will be unaware of the parameters that have

been used in the calculation of the VAR that you are working with.


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What are the advantages?

VAR is just one number and in that sense becomes a loteasier to understand and monitor.

VAR provides you with a statistical measure of theprobability of loss. Risk measures like duration and basispoint value, (DV01), do not provide a statistical measure

of the likelihood of loss. They just give you an absoluterisk figure rather than a probability of such a loss arising.Therefore VAR is an improvement on these techniques.

VAR can be calculated for all types of assets. Thismeans you can calculate VAR for interest rate risk,

foreign exchange risk, credit risk and commodity pricerisk. Some firms add these individual VARs together toarrive at an overall VAR. You cannot do this with otherrisk measures.


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What are the disadvantages of

Value at Risk? There are some weaknesses you should know about, they are: VAR is not a maximum loss figure. From time-to-time you may find that the

actual amount of money lost exceeds the VAR. If you experience a loss greater than your VAR there is no guarantee that

you will not experience another loss that exceeds your VAR the followingday as well.

Many IT systems find the calculation of VAR challenging. Sometimes banksrely on spreadsheets to do this. Calculation errors and stale data can leadto inaccurate VAR reports.

Inaccuracy and doubts in the validity of VAR can also lead to it being usedas a "soft limit". The breaking of a risk limit based on VAR is then treatedwith less seriousness than would otherwise have been the case.

Banks using VAR for the first time may be tempted to set a VAR limit much

higher than the risk they have. The limit is so far from being breached thatno one pays attention to VAR as a risk measure. VAR does not deal with option positions very well. It also does not measure

operational risks. This means that you can have losses that arise from poorcontrols and fraud.


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Is there anything we can do to

improve the situation? Yes. Many firms do not solely rely on VAR to

manage market risk. They use a variety ofmeasures that may include traditionaltechniques like basis point value and stress

testing. Stress testing shows what can happenwhen extreme market moves arise. It focusesattention to what can happen when marketsmove abnormally. You can see what a bad daycould really cost you. By using several measures

banks are looking for consistency in thereporting of risk. It is like having a second, thirdand fourth check on VAR.


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VAR & regulators Regulators will not tell you how to calculate your VAR. But they are

known to probe the methodology that is being used, question howappropriate it is and also assess senior manager's understanding ofthe risk measures the firm is using.

In general regulators are supportive of firms using VAR. Many firmshave agreed with the regulator the use of VAR in order to calculatemarket risk and therefore the amount of regulatory capital requiredto support it.

If you agree to use VAR then the VAR model needs to be anaccurate assessment of the risks you run. Therefore if you expectyour VAR to be exceeded only 1 day in 100 days your regulator will

not appreciate a frequency that exceeds this. It would indicate thatyour VAR model is inaccurate and your regulator may decide toincrease the amount of regulatory capital you are holding.


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Finally a few numbers

By way of illustration the following provides a simplified VAR calculation. Supposeyou own a bond that has a price of 100% and you have calculated that the daily pricevolatility is 0.5%*.

Using statistics, (standard deviation, SD), there is an 84.1%, (1 SD), chance, that theprice tomorrow will not fall below 100%-0.5%= 99.50%, a 97.7%, (2 SD), chance thatthe price tomorrow will not fall below 100%-1%= 99.00% and a 99.8%, (3 SD),chance that the price tomorrow will not fall below 100%-1.5%= 98.50%.

Put another way you are 99.8% certain that in normal market conditions your loss onholding this asset for one day will not exceed 1.5%, ($150,000 on a $10m position),this is the VAR**.

If you pick a more risky security, say one with a daily volatility of 1% your one dayVAR for a 99.8% confidence interval is 3%, $300,000 on a $10m position. Increasedvolatility increases VAR.

This also means that if volatility changes your VAR can increase or decrease evenwhen you positions remain unchanged.

What confidence interval and holding period should be used? That is entirely up toyou. In determining the time horizon you may wish to consider how long it could taketo liquidate positions. Many banks use between 5 and 10 days with a 2 or 3 standarddeviation confidence interval. It just depends on how conservative you want your riskmeasure to be. ***


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Valye at Risk uses standard deviation; this is sometimes referred toby traders as volatility. A standard statistical text book will explainstandard deviation; it can also be calculated using spreadsheet add-in functions. It is a measure of the historic or implied price fluctuationof dealing positions and requires observing and collecting dailyasset prices. Put simply the more an asset goes up and down in

price the more volatile it is and the greater the perceived market risk.High price volatility equals high risk. **Because financial markets do not strictly conform to normal or

lognormal distribution the probability of a loss exceeding the VAR isgreater than would be indicated. In real life the "tail" under thedistribution curve is fatter than expected.

***As a rule of thumb, VAR increases with the square root of time.So if you want to calculate the VAR with a 99.8% confidence intervalfor a 10 day holding period for the asset with a 0.5% daily volatilitythe 10 day VAR will be 3.16 (square root 10) x 1.5 = 4.74% or$474,000 for a $10,000,000 position.

market risk (1)

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