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On( e banks began hi face truly volatile foreignex hange markets, suddenly the halanr e sheetbecame inadequate as a communication tool, andcontrols on the balance sheet missed an importantpotential source of loss,,.

Best Practices in Risk Measurement: Why IncreasingDerivatives Activity Caused Banks to Turn to Value at Riskby Michelle McCarthy, Risk Product Managei IQ Financial Systems, Inc.

STAGE 1: BAI.ANCE SHEET CONTROLSIt was easier in the 60s. When the Bretton Woodsagreement was still in effect, when accountancy for bankswas dominated by accrual rather than mark-to-marketaccounting, and when the only derivatives in existencewere traded by speculators and commodities firms, bankmanagement was simpler. Without foreign exchange risk,duratan rk, or dervati-,e product risk, a balance $heetwas a very effective mechanism for communicating therisks a bank faced to management within the firm, and toinvestors and analysts outside the firm. Controls on theprincipal size of on-balance sheet assets controlled riskeffectively. With the addition of gap reporting, banks couldeasily grasp and control their risks. Balance sheetexposures could be easily attributed back to the businessgroups that generated them, in order to measure thosegroups’ return on capital.

However, once banks began to face truly volatile foreignexchange markets, suddenly the balance sheet becameinadequate as a communication tool, and controls on thebalance sheet missed an important potential source of loss.

In addition, when banks began to cease holding assets tomaturity, making them available for sale, they faced lossesbased on interest rate fluctuations. Once again, the balancesheet is a poor vehicle for expressing this risk it treats aone-year maturity asset identically to a 30-year maturityasset, even though the latter asset subjects its holder tomuch greater interest rate risk if it is sold before maturity.

Finally, once banks began entering into interest rate andcurrency swaps and options in the 1980s, they were posedwith another category of instrument which disappears froma balance sheet, yet poses real risk of loss.

STAGE 2: EXPOSURE CONTROLSIn the late 70s, managers at banks began to report and limitexposures to interest rate and foreign exchange risk.Without proper controls on these items, business people inthese firms would have very poor incentives — the so-called‘free option on wealth.’ The larger the foreign exchange or

interest rate risk positions they took, the greater thciiinstitution’s opportunity for gain or loss. If they werecompensated based on profits, they faced an asymmetricreturn: great financial gain if their position gained. hutlimited personal losses if the institution suffered asignificant loss. The incentives were there to create verylarge positions if these were not controlled. Bank managersdid not fail to note this, and took steps to manage it cnreporting and limiting the exposures taken.

Exposures (also known as sensitivities or positions)describe how long or short the institution is various kesegments of the market, usually by measuring how much aportfolio gains or loses for a small change in the price orrate of that market segment. Interest rates are normallyshifted by one basis point, foreign exchange rates by one percent, and all transactions repriced under such a change.Exposure measurement provides an elegant way to get apicture of what disappears from the balance sheetparticularly, for instrtiments which cost no cash upfront, buthave the ability to generate a loss if rates or prices change.

It is not easy, however, to judge whether a businesgroup’s profitability justifies its exposures, the same wayone might judge whether their profitability justifies theirbalance sheet usage; the figures are not comparable. Andsetting limits on exposures can be both insufficient and toocomplex to control the risks of certain types of portfolios.Multi-asset class portfolios, arbitrage portfolios, andhedged derivative portfolios cannot be controlled throughexposure measurement alone.

Multi asset class portfoliosLet’s posit two hypothetical portfolios, traded by twhypothetical New Zealand portfolio managers, employed bythe same bank. One trades the bonds of Australia and theUK. dabbles in convertible bonds and equities from thesecountries as well, and keeps open foreign exchangepositions. The other trades the money market instruments ofMexico and Argentina, and and also keeps some openforeign exchange and equity positions in these countries. It

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manager would have a difficult time determining who hadpros Ided the best return on equity, as not all of these

s are on the balance sheet, And even computing

equity for the on-balance sheet portions would heshould not the riskier Mexican and Argentinian

posiu require a higher return. een if their current valueis the same?

Arbitrage portfoliosWhen portfolio managers deliberately take low riskpositions, buying one asset and selling another that is sery5imlar, what should be the constraint on the strategy? I low

inager detei mine whether going long 100 million ofId short 100 million ofasset b is riskier or less riskyother arbitrage strategy. in which the portfolio

manager buss 1 billion of asset x and sells I billion of assetv Clearly, the less correl:ied ihe two assets in the pair, theriskier the strategy hut exposure measurements include noinformation about correlation.

Hedged derivative portfoliosSwaps traders ordinarily enter into swaps, then sell or buyduration weighted money market instruments or bonds toextinguish their risk. They may buy these at different pointsof the yield curve; they may rely more heavily ongovernment bonds rather than money market instruments,When they do this, they take risks that are difficult to assessjust by conducting exposure measurement. Their managersmight make use of a grid like this one to assess whethertheir risks are excessive. See table 1 above.

The rules that would be required to control the mix ofcurse, spread and outright duration risks in a swap booklike this could be very complex and yet not necessarilysufficient. For example, we might make a rule that. for thisparticular currency. (I) total sensitivity to a one basis pointmove could not be greater than 500 overall, and (2) thatsensitivity to the first third of the yield curse could notdiffer from the second third of the yield curve by more than30 per cent, while the difference between the sensitivity of

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Risk and Compliance

3ger for thcse indis iditals hadimits as his only control, he would TAt3I F 1: P(l) SENSITIVITY TO + 1 BP MOVEMENT, CURRENCY ABC

d time determining v hat balance Im 3m 6m 9m lyr 3yr 5yr 7yr lOyr Totalwould control risk for both books. SWAP 80 . 4 4(3 (31 (34 (34 (759) 309

while still leaving room Ihr protit, and being VT .1w 31 1 (13 (701 9 67 (304) 448 (110)somewhat equitable across the two Net 40 (180) 4,1 (11) (30) 70 34 139 (311) 200portfolios. Moreover, II’ both portfolio

__________ _________________________

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Risk and Compliance

the second third and the third third could not exceed 25 percent. and 13) that government interest rate risk could notaccount for more than 40 per cent of total sensitivity.Without obser ing the historical correlation of thesesectors, and their volatility, to measure how much losscould be sustained through duration, curve and spreadchanges. it would be hard to assess whether this long-winded rule controls risk appropriately, excessively, or notat all. And once we have gone to the trouble of conductinga volatility and correlation analysis, we have done almostall the work required for a measurement and control systemthat is at once more simple and more capable Value atRisk, or VaR.

STAGE 3: VALUE AT RISK CONTROLSIn the mid- to late I 980s, a few banks began to put in placeVaR measures and controls. ‘1 hcs included Bankers Trustand Citibank; US commercial banks were keen todemonstrate appropriate risk controls as they began to runlarge deriatives operations. In the late 70s Bankers Trust

There are a variety of VaR models. Some, such as

the Monte Carlo simulation and historical

simulation models, are better for portfolios

containing options (including convertibles and

mortgages) and convex interest rate instruments

had begun to assess the potential loss of its lending book,and to attribute capital to these lending activities in order tobetter measure return on equity: the extension of thisphilosophy to market risks was a natural one.

Under VaR measurement, banks use systems thatassemble their exposures to hundreds, or even thousands ofkey risk factors, such as foreign exchange rates, interestrates, equity and commodity prices. These exposures comefrom their on- as well as off-balance sheet instruments.Their systems store historical information about these riskfactors, to show how volatile their price of yield movementshave been historically, and how highly correlated they havebeen to the other factors.

VaR models all run a bank’s current exposures in onefashion or another in order to determine what kind of worst-case losses these exposures could have generated had theybeen held in the past. This measure provides a numberbenefits. Instead of trying to place limits on many singletypes of assets, as was shown in the examples above, a VaRsystem instead limits how much loss they are capable ofgenerating together — a single, simpler figure. Further, aportfolio’s potential loss can be thought of as the amount ofcapital which is supporting that portfolio, allowing forreturn on capital calculation for that activity.

Because of the regulatory requirements in GlOcountries, banks in these countries commonly measure thepotential losses of their market risks if these risks were held

for two weeks, and the 99 per cent worst case two-weekperiod occurred.

There are a variety of’ VaR models. Some, such as thMonte Carlo simulation and historical simulation model’are better for portfolios containing options (includinconvertibles and mortgages) and convex interest rateinstruments. For portfolios with significant positions inemerging or illiquid markets, many prefer the historicalsimulation method as it better represents the higherincidence of extreme price changes in these models than doparametric methods.

Beyond Value at Risk: a suitable risk frameworkVaR provides an excellent way to communicate. compar.and limit risks in a hank, and to view returns in light of thurisks taken to earn them, It is superior to relying onbalance sheets or exposures alone to limit risk-taking

— butit is not perfect. Firstly, because VaR relies on historicaldata to estimate risk, it will be inaccurate when the futuredoes not much resemble history. Secondly. if banks takevery large risk positions, larger than the standard tradingvolume in the market, VaR will underestimate riskThirdly, it does not adjust for the chance that an individurholding might not behave like a broad market risk factorie. that there can be losses on single issues which are notmarket wide. This type of risk is classic credit risk, orspecific equity risk.Good risk frameworks contain a number of elements:

VaR & Exposure Limits: Limits on the VaR of portfolios,as well as on selected exposures

• Stress Testing: Conducting scenario analysis — ignoringthe historically-based VaR analysis, and instea’subjecting their an institution’s portfolio to hypotheticimarket shocks (or replays of well-known historical onesto see whether they are overexposed to shocks that theybelieve to be possible

• Liquidity and Credit Limits: Constraining position sizeacross many assets, to ensure that they are notoverconcentrated in credit or market risks, helping toavoid unexpected and destabilizing loss from individualissuers or being too large for the marketplace

• Backtesting the VaR model: Predicting tomorrow’s 9(per cent confidence potential loss using the VaR modeithen comparing it the next day to the actual mark-tomarket of the portfolio. If the model is a good one, 99 percent of the time losses will be less than were predicted.However, one per cent of the time, losses will exceed thisnumber — and they may do it in grand style

Where VaR models have let institutions down, one of thesesteps has usually not been followed. VaR is not an ironcladprediction of potential future loss, but it is an excellent useof historical information blended with portfolhinformation, in limiting and rewarding risk-taking. m

Forfurther information, contact:IQ Financial Si’stemsTel: 44-] 71-549-1000Web: www iq.financial. corn

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