LUQUIDITY QUESTIONS AND ANSWERS

1. Steps involved when calculating VAR using Historical Simulation Approach (10)

SOLUTION

- Historical data is used (A time series of Assets returns)

- Dig deep into the past data, applying current weights to a time series of assets returns.
- For example, going back in time like 200 days, applying current weights to the data of that
time.

STEP1

- Identify market variable with risk factors that affect portfolio such as interest rates, inflation
rate, price volatility and inflation rate.

STEP 2

- Collect data on the market movement of that market variable for the most recent number of
days say 200 days, with possible scenarios that can happen between now and tomorrow.

STEP 3
- calculate value change of a portfolio which can happen between now and tomorrow for all
the 200 scenarios which describes probability distribution of daily changes in the value of
portfolio.

STEP 4

- Rank the changes values from best to worst changes. From the worst daily changes and take
first percentile of the distribution. After this, estimate VAR.

Advantages

- Easy to explain to a non-technical person,

- Very objective and cannot be criticized.
- Flexibility

Disadvantages

- It cannot be applied to newly introduced companies,

- New securities with no past data
- It assumes there is no risk factor, but there might be risk.
 2. Advantages and Disadvantages of Var as a risk measure

ADVANTAGES

• VaR is a single number, expressed as a percentage or in price units, and is

easily interpreted and widely used by financial industry professionals.
• VaR computations can be compared across different types of assets—
shares, bonds, derivatives, currencies, and more—or portfolios.
• VaR is measured in price units (dollars, euros) or as a percentage of
portfolio value, making it easy to interpret and use in analyses.

Disadvantages
1. It gets difficult to calculate with large portifolios
- When calculating VAR of a portfolio we need volatility, returns and correlation of assets, So
as the portfolio grows bigger, it becomes difficult to calculate their correlation.
2. It is not additive
Correlation of individual risk factors does not enter VAR calculation of portfolio.
- VAR of Asset A and B is not equal to VAR of assets B are not the same as VAR of AB
-
3. VAR resulting is as good as inputs and assumptions,
- With Variance – covariance VAR method, assets normal distribution returns are assumed,
therefore the result will be misleading. It leads to the underestimation of VAR.
4. Different VAR methods lead to different results,
- This shows the weakness of VAR. Monte Carlo, variance – covariance method, historical var
method, all lead to different results.
5. It does not measure worst case losses
- In 99% con interval, it means 1% of cases losses is higher than VAR amount. The amount
could be higher enough to liquidate company but it does not provide realistic estimates.

Operational Risks identified by Basel Committee on banking supervision.

DEPOSIT INSURANCE OF DEVELOPING COUNTRIES AND OF
DEVELOPED COUNTRIES

What is A deposit Insurance

Deposit insurance or deposit protection is a measure implemented in many countries to protect
bank depositors, in full or in part, from losses caused by a bank's inability to pay its debts when
due, thereby reducing their incentive to make a "run" on the bank.

Parameters to be specified before calculation of VAR (12)

Value at risk (VaR) is a measure of the potential loss that an asset,

portfolio, or firm might experience over a given period of time.

1. Time Horizon
- It is defined as the maximum dollar amount expected to be lost over a given time
horizon, at a pre-defined confidence level. For example, if the 95% one-month VAR is
$1 million, there is 95% confidence that over the next month the portfolio will not lose
more than $1 million.
An appropriate choice for time horizon depends on the application of what to put for VaR:
a. When their positions are fairly liquid and actively managed it therefore make sense to
calculate VaR over the time horizon for 1 day.
b. For an investment portfolio held by Pension fund the time is traded less often or less
actively, some of the portfolio is measured monthly.

2. Confidence Level
-The confidence level determines how sure a risk manager can
be when they are calculating the VAR. The confidence level is
expressed as a percentage, and it indicates how often the VaR
falls within the confidence interval.

The confidence level chosen for VaR is likely to depend on a number of reasons; it follows that
a VaR with a confidence level of x can be calculated from VaR with the lower confidence level
of x

3. Size of possible Loss

 This one is calculated using the two above parameters. When the two parameters are
identified then, size of possible loss can be computed.

Qsn. Explain all operational risk approaches identified by the Bsel Framework.

1. Internal Fraud – Cash embezzlement and misappropriation of company’s assets by

employees.
2. External Fraud – Disclosure of proprietary information by traders and other third
parties.
3. Employment practises and workplace safety
- Workplace lawsuits my lead to operational risk for example if a bank or firm has not
condoned the behavior ot its erring employees, the company may be held liable and
pay monetary charges as penalty fees,
- Operational risks may also arise from company’s non compliance with policies
regarding health and safety of its employees at work.
4. Clients, Products and Business practises
- A company maybe penalized if found dealing with clients in cahoots with perpetrators,
- Penalized for non compliance with duties towards client,
- Penalized for selling defective products that is products that dosen’t workas intented.
-
5. Losses to physical assets,
- These assets require a significant amount of money to build such as factories,
machinery and vehicles.
- If the assets get lost through for examples by the acts of God, war, this leads to
operational risk as operations are disrupted.
6. Business disruptions
- Nowadays business are depending on technology, data is stored in computers.
- If deficiencies between a computer and its components arises. This may lead to
operational risks.

E.g theft of financial data due improper functions of a computer.

7. Delivery and Process management

- Companies enter into contracts with their business partners.
- They promise to deliver the products,
- Failure to do so this my lead to penalties of contract breaches thereby causing
operational risk.

Qsns. Identify Proactive approaches used to prevent Operational Risks

1. Basic indicator approach

- This was suggested by BIS.
- It helps banks to calculate amount of money that needs to be set aside to meet operational
risk requirements in 3 steps as follows.

a. Step 1
- Calculate fixed percentage known as alpha that is always 15%
b. Step 2
- Calculate firm’s positive gross income for the past 3 years.
c. Step 3
 - Multiply positive growth income and alpha to get amount that needs to be set aside to meet
operational risk requirements.
2. Standardized Approach
- Suggested by BIS.
- Divide firm’s operations into multiple operations or lines of business including commercial,
retail banking and corporate finance.
- Revenue earned for that year is split into these lines of business,
- Each line of business act as a proxy to operational riks that might arise,
- Calculate beta for each line of business that is a fixed percentage,
- Multiply beta with revenue of each line of business,
- Aggregate revenue of each line of business to get total amount of capital that needs to be set
aside for operational risk requirements.
- These lines of business might not have same risks.

3. Advanced Measurement approach

- Suggested by BIS and is currently used.
- Pre-requisites to be done before using this approach like;
a. Senior management should be more active in this type of operational risk management,
b. Risk and Audit department should be established to oversee the process,

This is carried out in three steps, collection of data, risk identification, risk analysis and control factors.

The bottom line here is that, this approach calculates amount of money to be set aside to meet
operational risk requirements.

Qsns. Identify, explain and critique any four (4) sources of scenarios that can be used to stress test
banks. [20 marks)

Stress test - Risk management tool used to evaluate potential impact of an event, movement on the
asset quality , profitability and other financial variables. In short it is a tool used to assess stability of
banking systems as they focus on a forward looking analysis by adopting a uniform approach in
identifying potential risks for the banking system as a whole.

Plausibility

A plausible scenario is a realistic event that could disrupt the delivery of important
business services, leading to unacceptable impacts. They must be realistic,and having a
reasonable probability of actually occurring.

Consistency
Stress test scenarios should be designed to capture material and relevant risks identified in
the risk identification process and key variables within each scenario should be internally
consistent with existing quantitative frameworks.

Adaptivity
 - Stress testing scenarios should be specifically designed for a given portfolio.

Reportability

They should provide information that can be translated into concrete action.

Depending on the scenario, the results of the stress test may

significantly misrepresent the risks to which a bank is actually
exposed to, because the scenario may not be severe enough or
plausible, or because it does not address important aspects.

Qsn. Explain steps and methods that are useful in designing a

comprehensive risk management framework.
There are five crucial components to be considered when designing
RMF. They include Identification, risk measurement and
assessment, risk mitigation, risk reporting and monitoring and risk
governance.

1. Establish the context

- The risk management objectives and align then with overall
strategic goals.

2. Risk Identification
- Start by defining risk universe that is a list of all risks a firm is
exposed to such as IT, Operational, Financial, Political and
Legal risks.
- Group risks into core and non core risks, core being those that
a firm must deal with frstly to increase its performance and to
meet its future goals, core being the vice-versa and can be
eliminated completely.
-
3. Risk measurement
- This provides information on a risk exposure or aggregate risk
exposures, or amount of loss that could occur as a result of
risk exposure identified.
- When measuring risk exposure the effect of a risk exposure
should be measured on the overall risk profile of a company.
- This helps companies to see which risk is core and which is
not based on the effects.
-
4. Risk Mitigation
- Having risks identified and measured, the company can now
decide on how to mitigate them. Either by elimination or
reduction. This can be done by buying insurance to protect
investments, outright sale of assets, hedging with derivatves,
diversification.
-
5. Risk Reporting and Monitoring
- Reports must be made on specific and aggregate risk
measures to make sure that risks remain at optimal level.
- Depending on the company operations, reports can be made
everyday or weekly.
- Sending the reports to the authority to adjust risk exposures.
-
6. Risk Governance
- Company have to make sure that their employee comply with
RMF.
- Defining roles of employees and authority for approval of core
risks, risk limits and risk reports.
-

Steps.
1. Prepare
- To prepare an organization to adopt formalized risk
management strategies including risk identification and
determination of key risk management roles.
2. Categorize,
 - Identified risks may need to be assessed and categorize them
into core and non core risks. Priotise core and non core later.
3. Select
- Selection of controls that will be used to protect affected
systems to minize or mitigate risks.
4. Implement
- This is the implementation of controls that have been
selected.

5. Assess
- This step assesses the implemented controls to see if the
were implemented correctly.
- If they are yielding desired results without bringing new risks.
6. Authorize.
- Authorization of mechanisms that have been identified and put
in place . This is done by management who oversees risk
management process.
7. Monitor
- This one provides situational awareness on an ongoing basis.
- Evaluation of risk mitigation strategies to make sure they are
working.

Qsns. Explain the role of asset and liability management in

commercial bank operations.