MANAGING MARKET

RISK IN BANKS
Contents:
Market Risk
Measuring Market Risk
Value at Risk (VaR)
Approaches to VaR
Basel Committee Recommendation
Indian Scenario
Conclusion
MARKET RISK
The risk that the value of on or
off balance sheet positions will be
adversely affected by movements in
equity, interest rate markets,
currency exchange rates and
commodity prices.
- BIS
An illustration:
Bharat Bank has raised a capital of Rs.10000
Invests the same in Shares of IBS ltd. Being quoted at Rs.100.
Bharat Bank buys 100 shares
Capital Scenario Investment Asset Value P/L
10000 Scenario-1:
Not allowed to
borrow
@Rs100 * 100 shares =Rs10000 0
9500 5% drop in share
price
@Rs.95 * 100
Shares
=Rs.9500 (-)500
Comments: The loss has directly affected the capital due to movement in market
price
10000 Scenario-2:
Allowed to borrow
9 times the
capital
Capital =10000+
Borrowings=90000
Total=1,00,000
=Rs100000 0
@Rs100*1000 shares =Rs100000 0
5000 5% drop in share
price
@Rs.95 * 1000
Shares
=Rs95000 (-)5000
Comments: The loss has affected the capital by 50%.(Transaction and borrowing
costs not taken into account in order to facilitate easy understanding)
Market Risks in Banks
Type of
Market Risks
Sub-Types What is it?
Market Risk Risk of adverse deviations of the mark-
to-market value of the trading portfolio,
due to market movements, during the
period required to liquidate the
transactions
Liquidation
Risk
Asset
Liquidity
Risk
Refers to a situation where a specific
asset faces lack of trading liquidity.
Market
Liquidity
Risk
Refers to a situation when there is a
general liquidity crunch in the market
and it affects trading liquidity adversely
Credit and
Counterparty
Risk
Refers to the risk on account of default
of the issuer/obligor or because of
rating migration
Sources of Market Risk
Related to Interest Rates and or
Prices
Interest Rates
Prices of foreign exchange
Prices of other financial products
Non-traded Interest Rate Risk
It is the direct consequence of banks role as
intermediary
Repricing risk due to change in fixed and
floating rates of its products
Interest rate sensitivity of balance sheet
Market Risk - Broader types
Market Risks
Specific Risk
The risk of an individual debt
or equity security moving by
more than or less than the
general market in day-to-day
trading
General Risk
This risk corresponds to the fraction of
market risk associated with the volatility
of positions or a portfolio that can be
explained in terms of general market
factors
Market Risk Measurement
Sensitivity
Sensitivity is
measured as the
change in the
market value due to
unit change in the
variable.
Example:
Where market value of a
portfolio of bonds changes
by Rs100000 for 1%
change in rate of interest,
interest rate sensitivity of
the portfolio isRs100000.
It gives us a measure of
risk associated with the
portfolio is vis-a-vis
change in rate of interest
Downside
Potential
It captures the
possible losses
ignoring profit
potential and
integrates
sensitivity and
volatility with
adverse affect of
uncertainty.
Example:
Measured by Value at
Risk (VaR)
VaR
VaR is a risk measurement and management
concept
It statistically estimates the potential loss in a
position over a given holding position at a given
level of certainty due to adverse movement in
market variables such as interest rates, exchange
rates, equity prices or commodity prices.
Mostly used for trading portfolios, and also for
strategic balance sheet management
VaR
VaR is an estimate of potential loss, always for a given
period, at a given confidencelevel..
Examples:
AVaR of 5pin USD/ INR rate for a 30- day periodat 95%
confidence level means that Rupee is likely to lose 5p
in exchange value with 5% probability, or in other
words, Rupee is likely to depreciate by maximum5p on
1.5 days of the period(30*5% ) .
A VaR of Rs. 100,000 at 99% confidence level for one
week for a investment portfolio of Rs. 1,00,00,000 (1
crore) similarly means that the market value of the
portfolio is most likely to drop by maximum Rs.
1,00,000 with 1% probability over one week, or , 99%
of the time the portfolio will stand at or above its
current value.
VaR The Definition
VaR summarizes the predicted maximum
loss (or worst loss) over a target horizon
within a given confidence interval.
Target horizon means the period till which
the portfolio is held. Ideally, the holding
period should correspond to the longest
period needed for an orderly (as opposed
to a `fire sale) portfolio liquidation.
Three crucial concepts in VaR
Confidence
coefficient
(95%, 99% or
99.9%)
Holding period
(period over
which portfolio
is assumed to
be held
constant).
Historical period
used for
estimating VaR
model
Value at Risk:
For e.g.., a set of portfolio having a
current value of say Rs.100,000- can
be described to have a daily value at
risk of Rs. 5000- at a 99% confidence
level, which means there is a 1/100
chance of the loss exceeding Rs.
5000/- considering no great paradigm
shifts in the underlying factors.
It is a probability of occurrence and
hence is a statistical measure of risk
exposure
Value-at-Risk
Value-at-Risk is a measure of Market Risk, which measures the
maximum loss in the market value of a portfolio with a given
confidence
VaR is denominated in units of a currency or as a percentage
of portfolio holdings
Features of VaR
JP Morgan popularized VaR in
1990s
VaR helps the banks to measure
risks in trading portfolios
VaR actually assigns a
Probability of happening of loss
VaR quantifies Market Risk
VaR is Prospective
Advantages of VaR
VaR provides an measure of total risk. VaR is useful
for monitoring and controlling risk within the portfolio.
It is easy to understand and explain the clientele.
It captures an important aspect of risk in a single
number
VaR can measure the risk of many types of financial
securities (i.e., stocks, bonds, commodities, foreign
exchange, off-balance-sheet derivatives such as
futures, forwards, swaps, and options, and etc.)
It asks the simple question: How bad can things get?
Weaknesses of VaR
Approach
Relies on simplifying statistical assumptions like normal
distribution, etc..
Past may not be a good approximation of future - volatilities and
correlations can change abruptly
VaR captures end-of-day rates and not intra-day rates which is
important for trading
Does not capture event risk
Approaches to Calculate
Value at Risk
Historical
Simulation Method
Monte Carlo
Simulation
Parametric VaR
Method
18
0.5 0.4 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 -0.5
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
Cumulative Distribution Function of Portfolio Return
p, % return
Probability that % return <p
-0.23
Probability
We see that there is a 5 % probability of the portfolio
returning less than -23%. If, say, the portfolios initial
value is $1 m, then
VaR(p=5%, h days) = 0.23x$1m = $230,000.
19
One approach to computing VaR is to assume that the portfolios
returns are normally distributed. Let the portfolios random rate of
return over a period of h days be r.
Its probability density function is
( )
2
~ , r N r

r
1.65 r
Probability density function
Rate of return, r

2.33 r
5 % of area
under curve
1 % of area
under curve
VaR with Normally Distributed Portfolio Returns
20
This implies that there is a 5 % probability of a return
less than
and a 1 % probability of a return less than
VaR is usually calculated over a measurement horizon of
a small number of days. For this short horizon, a
portfolios standard deviation is typically much greater
than its expected return. Hence, the practice is to ignore
the expected return and set
If this is done, then we have
VaR(p=5 %, h days) =1.65x x(Portfolio Value)
VaR(p=1 %, h days) =2.33x x(Portfolio Value)
1.65 r
2.33 . r
0. r =
Computing VaR ..
An Example:
A portfolios 1 day standard deviation is
10%, and its initial value is $1mn.
Then,
P = Probability =1%,
H = Holding Period = 1 day
S.D = Standard Deviation = 10% = 0.10
VaR(p=1%, h=1 day) = 2.33x(0.10)x1mn
= $233,000.
Computing VaR ..
22
What should be the time horizon (h days) over which to
calculate VaR? If a FI can measure its risk and change it
once a day, a one-day VaR is most useful. This would
be relevant when a FIs portfolio consists of liquid
securities that can be bought or sold quickly.
However, if a FI holds a portfolio of illiquid assets that
cannot be sold quickly, a longer horizon would be
relevant. The FI should choose the VaRs h to be the
number of days over which it could change its portfolio.
If the return on a portfolio is estimated to have a one-day
standard deviation of , then, assuming the portfolios
composition stays the same over h days, its h-day
standard deviation can be estimated as
. h
Computing VaR ..
23
Example: A bank holds a $20 m. portfolio of syndicated
loans that would likely take 5 days to arrange for a sale.
The daily standard deviation of the portfolios value is
0.3 %. Therefore,
Suppose a portfolio consists of n different assets. Its
standard deviation depends on the standard deviations
and correlations of the individual assets composing the
portfolio.
Let
i
be the proportion of the portfolios total value
that is invested in asset i, and let
i
asset is standard
deviation of return. Further, let
ij
be the correlation
between the returns on asset i and asset j. Then, the
portfolio returns variance is
( )
VaR 5%,5 days 1.65x0.003x 5x$20m=$221,371 p = =
2
1 1
n n
i j i j ij
i j

= =
=

Computing VaR ..
24
Example: A portfolio has three assets held in proportions

1
= 0.2,
2
= 0.5, and
3
= 0.3. The assets h-day
standard deviations are
1
= 0.3,
2
= 0.2, and
3
= 0.4.
Their correlations are
12
= 0.1,
13
= 0.6,
23
= -0.1.
The portfolios h-day return variance is then
( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
2
1 1
2 2 2 2 2 2
1 1 2 2 3 3 1 2 1 2 12
1 3 1 3 13 2 3 2 3 23
2 2 2 2 2 2
2
2 2
.2 .3 .5 .2 .3 .4 2 .2 .5 .3 .2 .1
2 .2 .3 .3 .4 .6 2 .5 .3 .2 .4 .1
=0.03544
n n
i j i j ij
i j



= =
=
= + + +
+ +
= + + +
+ +

Computing VaR ..
25
Then, the portfolio returns standard deviation is
If the three-asset portfolio was initially worth $50m, then, for
example,
VaR(p=5%, h days) =1.65x0.188 x$50 m = $15.5 m.
Under the approach outlined thus far, implementing VaR for
a portfolio of many different assets requires estimates of
each asset returns standard deviation and the correlations
between all of the assets returns.
A consulting firm, RiskMetrics, provides daily estimates
of standard deviations and correlations for different types of
assets in many different countries. Of course, an individual
FI could compute these estimates on its own using
historical data.
0.03544 0.188 = =
Computing VaR ..
26
The historic or back simulation approach uses the
historical returns on the individual assets contained in
the FIs current portfolio.
It then simulates what would have been the losses on
the current portfolio if this portfolio had been held
during the historical period, say the last 250 or 500
trading days.
Specifically, this approach involves the following
steps:
VaR Using Back Simulation
27
1.Consider each of the asset/liability positions in the FIs current portfolio.
Suppose, as before, that there are n different assets and
i
is the
proportion of the portfolios total value that is invested in asset i.
Obtain data on the returns of these assets and liabilities for, say, the last
500trading days.
2.Let r
it
is the return on asset/liability i on prior day t. Then if the portfolio
had been held on that day, its return would have been
3 Next, rank the portfolio returns, R
t
, for previous t = 1, , 500 days
from the lowest return to the highest. Let R
5
be the fifth worst
return over the last 500 days and let R
25
be the 25
th
worst return over
the last 500 days. Most likely, both of these returns are negative
(losses).
4 Then we would compute VaR as;
1
n
t i it
i
R r
=
=

( ) ( )
( ) ( )
25
5
VaR 5%,1 day x portfolio value
VaR 1%,1 day x portfolio value
p R
p R
= =
= =
Computing VaR .. Historic or Back Simulation Approach
28
Asimilar procedure using historical returns over, say,
h=5 day intervals could be used to calculate
VaR(p, h=5 days).
The advantage of this historical simulation approach is that it
uses the sample frequency (histogram) of actual returns.
There is evidence that empirical distributions of asset returns
display large losses more frequently than would be predicted
by the thin-tailed normal distribution, and the back simulation
method could account for this.
One disadvantage is that the historical period may not be
representative of the near future. It may have been an
unusually quiet (lowvolatility) period, and volatility is nowlikely
to be greater. One correction for this is to give more recent
observations a greater weight.
Computing VaR .. Historic or Back Simulation Approach..
29
VaR is the basis for setting minimum capital (net worth) requirements
for large international banks.
In 1996, an amendment to the 1988 Basel Capital Accord created a
rule for bank capital requirements to cover their liquid securities (non-
loan) portfolios, so-called trading accounts:
Required capital for day t+1 =
where SR
t
is additional capital to cover idiosyncratic risks. The
terms in brackets are the banks current VaR estimate and an
average of VaR estimates over the last 60 days.
The multiplier S
t
depends on the accuracy of the banks VaR model.
( ) ( )
59
0
max VaR 1%,10days , VaR 1%,10days
60
t
t t i t
i
S
p p SR

=
(
= = +
(

Risk-Based Capital Requirements Using VaR

30
S
t
is computed by back-testingthe banks VaR model estimates over
the last 250 days. If the banks daily trading portfolio losses
exceeded VaR(p=1%, h= 1 day) on x days over the last 250 days,
then
Thus, a bank with a less accurate internal VaR model has a
higher multiplier, S
t
, and must have more capital.
3 if 4
3.4 if 5
3.5 if 6
3.65 if 7
3.75 if 8
3.85 if 9
4 if 10
t
x
x
x
S x
x
x
x

= =

Historical
Simulation
Method
1. Focuses more on the historical
aspects of the financial instruments
2. It considers the actual historical rates
and revalues the positions for each
change in the market
3. It calculates the change in the value
of a position using the actual
historical movements of the
underlying asset(s) but starting form
the current value of the asset
4. It does not need a variance /
covariance matrix.
5. No need to make any explicit
assumptions
Monte
Carlo
Simulation
1. Relies on estimation of VaR by
simulating random scenarios and
revaluing positions in the portfolio
2. It is appropriate for both linear and
non- linear derivative instruments.
3. It calculates the change in the value
of a of a portfolio using a sample of
randomly generated price structures,
correlations between risk factors and
the volatility of these factors.
4. There is a need to make certain
assumptions about the market
structures.
Parametric
VaR
Method
1. It involves the estimation of VaR
by using equations that specify
parameters such as volatility,
correlations, delta and gamma.
2. It is a deterministic approach
3. It yields usually accurate results
for traditional assets and linear
derivatives
4. It gives less accurate results for
non-linear derivative products.
Estimation of VaR The Three Approaches
Methodology Description Applications
Variance/ Covariance
(Parametric)
Estimates VaR with
equation that specifies
parameters such as
Volatility, Correlation,
Delta and Gama
Accurate for
traditional assets and
linear derivatives, but
less accurate for non-
linear Derivatives
Monte Carlo
Simulation
Estimates VaR by
simulating random
scenarios and revaluing
positions in the portfolio
Appropriate for all
types of instruments,
linear and non-linear
Historical Simulation Estimates VaR by
reliving history; takes
actual historical rates
and revalues positions
for each change in the
market
Back Testing
Is a process where model based VaR
is compared with the actual
performance of the portfolio. This is
carried out for evaluating a new
model or to assess the accuracy of
the existing model
Stress Testing
Stress Testing essentially seeks to determine
possible changes in the market value of a
portfolio that could arise due to non-normal
movement in one or more market parameters.
Stress Testing covers many different techniques.
Some of important ones are:
1. Simple Sensitivity Test
2. Scenario Analysis
3. Maximum Loss
4. Extreme Value Theory
The New Basel Capital Accord
Market Risk:
(a) Standardised Method
(i) Maturity Method
(ii) Duration Method
(b) Internal Models Method
New Basel Accord II:
Market Discipline
Disclosure requirements that
allow market participants to
assess key information about a
banks risk profile and level of
capitalisation.
Pillar-III
Market Risk: Standardized Approach
1. Two alternative approaches
1. Standardized Approach
2. Internal Rating Based (IRB) Approach
2. Standardized Approach
5 distinct sources of market risk are identified viz., interest rate
risk, equity position risk, forex risk, commodities risk, options
trading risk.
3. Illustration of capital charges for interest rate risk
1. Specific interest rate risk (adverse movements in the
price of an individual security owing to factors related to
individual issues)
2. General risk (arising from movements in market interest
rates).
4. Specific interest rate risk.
Three types of securities
1. Government
2. Qualifying (securities of multilateral development banks, PSEs,
securities rated as investment grade by at least 2 rating agencies)
3. Others.
Market Risk: IRB Approach
1. Concept of Value-at-Risk (VaR)
2. Three crucial concepts in a VaR
(i) Confidence coefficient (95%, 99% or 99.9%)
(ii) Historical period used for estimating VaR model
(iii) Holding period (period over which portfolio is assumed to be
held constant).
A VaR estimate is simply an appropriate percentile of the banks
portfolio loss distribution, e.g., If 99% VaR estimate of a bank is Rs.50
lakhs, it means that there is only 1% chance that the banks portfolio
loss will exceed Rs.50 lakhs.
Basel II proposes a confidence coefficient of 99%, a holding period of 10 days
and a historical observation period of at least 1 year.
Capital Requirement (Daily) = Max {Previous day VaR estimate; (Average of VaR
of preceding 60 working days) x m}
m (multiplication factor) = 3 +
Minimum value of = 0 (bank performance good)
Maximum value of = 1 (poor bank performance)
Risk Monitoring & Control
Risk Monitoring and Control calls for
implementation of risk and business policies
simultaneously. This is achieved through the
following:
1. Policy guidelines limiting roles and authority
2. Limits structure and approval process
3. System and procedures to unbundle products
and transactions to capture all risks
4. Guidelines on portfolio size and mix
5. Defined policy for market to market
6. Limit monitoring and reporting
7. Performance Measurement and Resource
allocation
Managing Market Risk
Board and Senior Management
Oversight
Organizational Structure
Risk Management Committee
Asset-Liability Committee
Middle Office
Risk Measurement
Interest Rate, Foreign Exchange, Equity
Managing Market Risk
Risk Measurement
Repricing Gap Models
Measuring Risk to Economic Value
Value at Risk
Risk Limits
Gap Limits
Factor Sensitivity Limits