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BFM MODULE-B
Chapt
er8:
RISKANDBASI
CRISK
MANAGEMENTFRAMEWORK(PARTII
I)
Whatwewi
llst
udy?
Whati
sri
skmeasur
ement
?
Howr
iskmeasur
ementi
sdone?
Whati
ssensi
ti
vi
ty?
Whati
sVol
ati
li
ty?
Whati
sri
skpr
ici
ng?
Ri
skMeasur
ement
:
Ri
sk management r
eli
es on t
he quant
it
ati
ve
measur
esofr
isk.
Ther
iskmeasur
esseekt
ocapt
urev
ari
ati
onsi
n
Ear
nings/
Mar
ketv
alue/Lossesduet
odef
aul
tet
c.
(r
efer
red t
o as tar
getv ar
iables),ar
isi
ng outof
uncer
tai
nti
esassoci
atedwit
hv ariousr
iskel
ement
s.
 Joi
nCAI
IBWI
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Quant
it
ati
vemeasur
esofr
isks:
BasedonSensi
ti
vi
ty
BasedonVol
ati
li
ty
BasedonDownsi
dePot
ent
ial
.
1-
Sensi
ti
vi
ty:
Sensi
ti
vi
tycapt
uresdevi
ati
onofat ar
getvar
iabl
e
duetouni
tmovementofasingl
emar
ketpar
ameter.
Onl
yt hose market par
ameter
s,which dr
ivet
he
val
ue ofthe targetv
ari
abl
e ar
erelevantfort
he
pur
pose.
Forexamplechangein marketv
alueduet o 1%
changeini
nter
estr
atewoul
dbeasensit
ivi
ty-
based
measure.
Exampl
e:3y
ear
sBondwi
th
Facev
alue=1000Rsand
CouponRat
e=6%
Whatwi
llbepr
esentv
alue?
 Joi
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FaceVal
ue I
nter
est Pr
esentVal
ueof
Rate Bond
1000 9% 924
1000 10% 900
1000 11% 878

OtherExamples ofmar
ketparamet
ers coul
d be
exchanger
atesandst
ockpr
ices.
*
Theint
erestr
ategapissensit
ivi
tyoft
hei
nter
est
r
atemar
ginofthebanki
ngbook.
*Dur
ati
onisthesensi
ti
vi
tyofi
nvest
mentpor
tfol
io
oftr
adi
ngbook.
Dr
awbackofSensi
ti
vi
tyanal
ysi
s:
1-I
tisonl
ywithref
erencet
oonemar ketparameter
and doesn'
t consider the impact of ot her
par
ameter
s,whichmayalsochangesi
multaneously
.
2-Theanaly
sisdependsontheprevai
li
ngcondi
tions
anditchangesasthemarketenv
ironmentchanges.
 Joi
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2-
Vol
ati
li
ty:
I
tis possibl
e to combine sensi
ti
vi
ty oftarget
var
iabl
es wit
hthe inst
abil
it
y of the under
lying
par
amet er
s.
Thevol
ati
li
tycharact
eri
est
hest
abi
li
tyori
nst
abi
li
ty
ofanyr
andom var
iabl
e.
Volati
li
tyi
sthestandar
ddev
iat
ionoft
hev
aluesof
thesevari
abl
es.
Iti
sfeasi
blet ocalculate hi
stori
calvol
ati
li
tyusi
ng
anysetofhist
oricaldata,whetherornott
heyfoll
ow
anormaldistr
ibuti
on.
The calcul
ati
on ofhist
ori
calmean and v
olat
il
it
y
requi
restimeser
ies.
Defi
ning a time ser
ies r
equir
es the per
iod of
observat
ionandfr
equencyofobser
vati
on.

Thecal
cul
ati
onofhistor
icalVol
ati
li
tybasedont
ime
ser
iesi
sgi
venintable:
 Joi
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Mont
h Shar
e Mean Dev
iat
ion Squar
e
Pri
ce ofDev
1 100 114 -
14 196
2 110 114 -
4 16
3 90 114 -
24 576
4 120 114 +6 36
5 150 114 +36 1296
Tot
al= 570 Tot
al= 2120
Av
g: 424
Sqr
t 20.
59
 Joi
nCAI
IBWI
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Computat
ion of Hi
stor
ical Vol
ati
li
ty Based on
Def
inedTi
meSeries:
Defi
ningatimeser
iesrequi
resdefi
ningt
heperiod
ofobserv
ati
onandthef
requencyofobser
vat
ion.
Forinst
anceifwehav etodeterminevol
ati
li
tyofa
givenstockpri
ceperiodofobser vat
ioncouldbe
takenasoney earand fr
equencyofobser v
ati
on
couldbedail
ycl
osingpri
ceofstock.
Wecanal socomputedail
yv ol
ati
li
tybychangi ng
thef
requencyofobser
vat
ionfrom weeklytodai l
y
orcan computethemonthlyv ol
ati
li
ty,based on
monthl
yobserv
ati
on.
Conver
sionofdai
lyv
olat
il
it
yint
oweekl
yormont
hly
vol
ati
li
ty:
Weusesquar
erootoft
imer
ule.
Theequat
ioni
sgi
venbel
ow.
Vol
ati
li
tyov
erat
imehor
izon"
T"=
Dai
lyVol
ati
li
tyxSquar
erootof'
T'
 Joi
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Forexample,i
fthedail
yv ol
atil
it
yofast
ockwere,
say1.5%,t
hemont hl
yvolati
li
tywoul
dbe1.5x5.
48
(Squar
erootof30)or8.
22.
Her
eTi
s30day
sast
het
imehor
izoni
sonemont
h.
I
tmaybenotedthatv
olat
il
it
y woul
dbehigher
,if
t
het
imehor
izoni
smorethanonemonth.
Volati
li
tyhelpsusto capt
urepossi
blevari
ati
ons
aroundt heaver
ageoftar
getvar
iabl
e,bot
hupside
anddownSi de.
Usinghistori
calobserv
ati
onsonthet ar
getv ar
iable,
i
ti s possibl
et o esti
mate upsi
de and downsi de
potenti
aloft hetargetvari
abl
ewi t
har easonable
accuracy.
 Joi
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3-
Downsi
dePot
ent
ial
:
Risk material
ise onl
y when ear ni
ngs dev
iat
e
adver
sely. Volat
il
it
y capt
ures bot
h upsi
de and
downsidedev i
ati
on.
Downsidepot
ent
ialonlycaptur
espossi
blel
osses
i
gnori
ngthepr
ofi
tpotenti
al.
I
tist
headv
ersedev
iat
ionofat
argetv
ari
abl
e.
The downsi
de potenti
al has two component
s
pot
enti
all
ossesandprobabi
li
tyofoccur
rence.
Potent
iall
ossesmaybeesti
mat edbutt
hedi
ff
icul
ty
l
iesinesti
matingt
hepr
obabil
it
ies.
Hencet hedownsi
der i
skmeasur esrequi
repri
or
modell
ingofthepr
obabi
li
tydi
str
ibuti
onofpotent
ial
l
osses.
Worstcasescenar
io ser
vesto quanti
fyextr
eme
l
ossesbuthasl
owprobabil
it
yofoccur
rence.
Downside pot
enti
ali sthe mostcompr ehensive
measure ofrisk as i
ti nt
egrates sensi
tiv
ity and
vol
ati
li
tywitht
headv er
seeffectsofuncertai
nties.
 Joi
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Thisisthemeasur
ethatismostreli
eduponby
banki
ngandfi
nanci
alser
vicei
ndust
ryasalsot
he
regul
ator
s.

Ri
skPr
ici
ng:
Ri
sksinbanki
ngt
ransact
ionsi
mpactbanksi
ntwo
ways.
Fi
rst
ly,bankshavetomaintai
nnecessar
y capi
tal
,
atl
eastasperregul
ator
yrequi
rement
s.
Thecapi
talr
equi
redi
snotwi
thoutcost
s.
Thecostofcapi talari
sesfr
om theneedt opay
i
nvestor
sinbanks equityint
heform ofdivi
dends
andforint
ernalgener
ati
onofcapi
talnecessaryf
or
busi
nessgrowth.
Each banking tr
ansact
ion shoul
d be able t
o
gener
atenecessar
ysurpl
ustomeetthi
scost
s.
Theprici
ngort r
ansact
ionmustt
akei
ntoaccount
fact
orsdi
scussedinthi
spar
a.
 Joi
nCAI
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Secondl
y,ther
eisapr
obabi
li
tyofl
ossassoci
ated
wit
hallr
isks.
Thi
sal
soneedst
obef
act
oredi
ntopr
ici
ng.

Toexplaint
his,l
etustakethecaseofabankthat
has 100 cr
editaccount
s with sayLev
el2 r
isks
accordi
ngtosomemeasur e.
Say,hi
storicalobser
vat
ioni
ndicat
esthatther
eisan
aver
agel ossof10%onLev el2accounts.
Thi
slossi
sthecostassoci
atedwi
thsuchr
isk.
Thisi
stobef actor
edintothepr i
cing,
Thei nt
enti
on
i
st o defr
ay the possi
blelosses acr oss si
mil
ar
tr
ansact
ions.I
nthiscase,r
iskpremi um of10%may
beaddedinpri
cing.
Risk pri
cing i
mplies f
actori
ng r
isks i
nto pri
cing
throughcapit
alchargeandlosspr
obabil
it
ies.
Thi
s woul
d be i
n additi
on t
othe act
ualcost
s
i
ncurr
edi
nthet
ransact
ion.
 Joi
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Theactualcostsincurr
edwilli
ncludecostoffunds
thathasgonei ntot hetr
ansacti
onandt hecosts
i
ncurredingivi
ngt heservi
ces,whicharei ncur
red
bywayofmai ntai
ningtheinf
rastr
uctur
e,employees
andotherrel
evantexpenses.
Pri
cing,ther
efor
e,shoul
dtake i
nto accountt
he
fol
lowing:
1.CostofDepl
oyabl
eFunds
2.Oper
ati
ngExpenses
3.LossPr
obabi
li
ti
es
4.Capi
talChar
ge
5.Pr
ofi
tMar
ginorRet
urnonnetwor
th.

I
tshoul dal
sobement i
onedher
ethatthecostof
fundsshoul
dcor
respondtothet
ermforwhi
chitis
deploy
ed.
Thisis because fi
v e-
year f
unds may havea
dif
fer
entcostt han one-y
earfunds due t
oti
me
val
ueofmoney .
 Joi
nCAI
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I
tmaybenot
edt
hatpr
ici
ngi
str
ansact
ion-
based.

Thi
s is one of t he key reasons f
or r
isk
measur
ementatt
ransact
ionl
evel
.

Joi
nCAI
IBWI
THASHOKonYouTube