FIN 430 – Risk Management

Market Risk I

Prof. Ramona Dagostino

 Recap of last classes
 The difference between maturity and duration

 Apply the duration model to measure interest rate exposure

 Applications & limitations of duration model

 Micro and Macro hedging

 Hedging interest rate risk exposure with derivative positions

 futures & forwards, options, interest rate swaps
 short or long?
 how many contracts to adopt?

 BancOne IRR in practice

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 Agenda for today
 Discuss nature of market risk

 Major approaches of measuring market risk

 Issues and practical concerns regarding VAR and other measurements

 Coming next class: Historical simulation & Montecarlo

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 Market Risk
 The risk of potential adverse change in trading
portfolio resulting from changes in market prices.
 Emphasizes the risks associated with actively trading
assets rather than holding them for long-term
investment.
 With securitization, FI’s trading income increasingly
replaced traditional earnings
 trading book: bond, equity, commodity, FX, derivative, MBS…
 liquid securities, marking to market daily

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 Where It Comes From

 Trading exposes firms and FI to large risks

 1995, Barings Bank, lost $1.3 billion in trading equity futures
 1996, Sumitomo Corp, lost $2.6 billion in trading copper futures
 2008, fall of big investment banks in trading MBS
 2012, JPMorgan’s “London Whale” lost $6.2 billion in synthetic credit index trading
 ……

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 Measure Market Risk

 Major approaches of measurement

 Value at Risk
 Expected Shortfall
 Historic or Back Simulation
 Monte Carlo Simulation

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 VAR
 Estimate potential loss under adverse circumstances: value at risk (VAR).

 “We are X percent sure that FI will not lose more than V dollars in the next T
days.”
 it can be measured over periods as short as one day.
 usually measured in terms of dollar exposure amount.

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 VAR

 JPMorgan helped make VAR a widely used measure.

 Its chairman, Dennis Weatherstone, was not satisfied with long risk reports containing
details on Greek letters for different exposures, but very little was useful for top
management.
 He asked for something simple that focuses on the bank’s total exposure over the next 24
hours.
 Eventually, they develop a VAR report, also known as the 4:15 report, because it was
placed on the chairman’s desk at 4:15pm everyday after trading closed.

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 Elements of VAR
(1) a statement of probability

 returns on portfolio or assets are assumed to follow

some statistical model;
 use this model to generate distribution of portfolio
return in the future;
 from the distribution, we can extract a number V
(potential portfolio loss) for a given confidence level X
percent (tail probabilities).

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 Elements of VAR
(2) concerns a specific forecast horizon

 length of horizon T chosen by management needs,

nature of business;
 assume hold the same portfolio over the entire
horizon

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 VAR Example
• Example: a portfolio’s five day payoff
distribution is

• Say -V is the 3rd percentile of the distribution.

• Let T= five days, X=97
• The VAR value in this example is V dollars.
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 Measure Market Risk

 Measure market risk

 first estimate daily potential loss under adverse circumstance: daily earning at risk
(DEAR).
 then transfer DEAR to longer term risk exposure under certain assumptions.

 DEAR = position value × potential daily loss per $

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 Normality

 Assume underlying risk (changes in interest rate,

foreign exchange, equity price etc.) is normally
distributed.

 Under normality, we can construct confidence

intervals for asset (portfolio) payoff.

 Then we can calculate potential loss and DEAR.

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 VAR Bond
 Market risk: interest rate change, ΔR
 Potential daily loss per $ then is ΔP
 Assume daily ΔR is normal with zero mean
 90% of the time, the change in yield will be within 1.65
standard deviations of the mean.
 5% of the extreme values greater than +1.65 standard
deviations and 5% of the extreme values less than -1.65
standard deviations.
 DEAR = Position Value  (-D) /(1+R)  ΔR
= Position Value  (-MD)  ΔR
 recall the duration model

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 VAR Bond: Example

 Suppose that we long $1,000,000 in 7-year zero-coupon

bonds
 Yield is 7.2%, and StdDev of daily yield change is 10bp.
 Under normality, 95% of the time yield changes will be
smaller than 1.65 standard deviations (16.5 bp).
 Concern is that yields will rise (worried of bond price
falling, right-tail of R distribution):

P(ΔR>=16.5bp)=5%

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VAR Bond: Example

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 VAR Bond: Example
 Potential loss per dollar
= (-MD)  (adverse change in yield)
= 7/1.072  0.00165 = -1.077%

 5% DEAR = position value  1.077%

= - $1,000,000  0.01077 = - $10,770

 This is total daily loss in value that will occur when interest rates go up by 16.5bp
(which will occur 5% of the time under normality).

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 VAR Bond
 If we have to hold the asset for N days, what’s the
potential loss?
 If we assume daily yield shocks are i.i.d., then
VARN = DEAR × N

 in the previous example: for a five-day period,

VAR5 = - $10,770 × 5 = - $24,082

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 N-Day VAR
 How to determine N?
 divide position by median daily trading volume over recent days.
 Intuition: how long to sell it off given current trading mkt size
 Or use the BIS capital requirement indications

 Why the square-root?

 Assumption is shocks are i.i.d, meaning independent and identically
distributed
 This implies no autocorrelation in shocks (strong, unrealistic assumption)
 Under i.i.d, the N-day variance of the asset return will be 𝜎𝑁2 = 𝜎12 𝑥 𝑁
 The St.Dev is the sqr root of the variance, so the N-day st.dev is 𝜎1 𝑁

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 VAR Foreign Exchange

 DEAR is computed in the same fashion as we did

for interest rate risk.
 Assume daily forex shocks are normal with zero mean,
st.dev 𝜎, and i.i.d.
 DEAR
= position value × foreign currency daily loss per $

• VAR = DEAR × N

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 VAR Foreign Exchange
 Lloyds bank has a $200mln trading position in forex spot contracts.
 current exchange rate is $1.7029=£1.
 look back for the last 30 days, stdev of daily FX is 61bps.
 suppose Lloyds has to hold the position for 5 days.

 Lloyds is a UK financial. Home currency is £.

 £ Value of position £1/$1.7029= £ x/$200mln
 £ x = 200mln/1.7029 = £117.447mln

 What is the potential daily loss per £ (need it for DEAR)?

 With 5% prob, forex will change by more than Д
 Д = 1.65*s = 100.65 bps.
 With 5% prob, $/ £ goes up more than 100.65bp ($ depreciates, lose money £)
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 VAR Foreign Exchange
 Lloyds bank has a $200mln trading position in forex spot contracts.
 current exchange rate is $1.7029=£1.
 look back for the last 30 days, stdev of daily FX is 61bps.
 suppose Lloyds has to hold the position for 5 days.

 What is the 5% DEAR and the relevant VAR?

 DEAR = £117.447mln * 0.010065 = £1.182mln

 VAR(5) = DEAR*SQRT(5) = £2.643mln

 Lloyds makes or loses money according to how $ moves against £

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 VAR Equity
 Equity positions as in shares/stocks

 There are two types of risks in equity positions

 systematic or idiosyncratic

 From CAPM: s it2 = bi2 ´ s 2mt + s eit

2

 If the portfolio is well diversified, then s eit

2
= 0 (the
idiosyncratic risk is diversified away).
 If a portfolio replicates the market return or directly holds the
market index, then beta of the portfolio is 1.

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 VAR Equity
 Warren holds a market portfolio in the S&P500 worth
$25bln.
 stdev of daily S&P500 return = 1.95% over last year.
 for the same period, median volume of daily trade on S&P
is $4,167,435,000.
 What is 5% DEAR & VAR, assuming the market return
is normal with mean zero and i.i.d. shocks?
 DEAR = position value × equity daily loss per $

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 VAR Equity
 Warren holds a market portfolio in the S&P500 worth $25bln.
 stdev of daily S&P500 return = 1.95% over last year.
 for the same period, median volume of daily trade on S&P is
$4,167,435,000.
 What is 5% DEAR & VAR, assuming the market return is
normal with mean zero and i.i.d.?
 equity daily loss per $ with 5% prob. S&P will go down by
more than 1.95%

 DEAR = $25bln*1.65*(-0.0195) = -$804.3mln.

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 VAR Equity

 Warren holds a market portfolio in the S&P500 worth $25bln.

 stdev of daily S&P500 return = 1.95% over last year.
 for the same period, median volume of daily trade on S&P is
$4,167,435,000.
 What is 5% DEAR & VAR, assuming the market return is
normal with mean zero and i.i.d.?

 Days to unwind (N) = $25b/$4.167b ~=6 days.

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 VAR Equity

 Warren holds a market portfolio in the S&P500 worth

$25bln.
 stdev of daily S&P500 return = 1.95% over last year.
 for the same period, median volume of daily trade on S&P
is $4,167,435,000.
 What is 5% DEAR & VAR, assuming the market return
is normal with mean zero and i.i.d.?

 VAR = - $804.3mln*SQRT(6) = - $1.97bln.

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 VAR Multiple Risks

 A US investor long £100m of a 10 year zero coupon

bond. Faces both interest rate risk and FX risk
- current interest rate is 3%, exchange rate £/$ = 1.4
- interest rate daily volatility is 0.1%
- FX (£/$) daily volatility is 1%
- interest rate and FX fluctuations exhibit correlation

 What is the 5% DEAR, assuming normal

distribution on daily change of IR and FX?

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 VAR Multiple Risks

 Dollar position: £100m×1.4 = $140m

 IR risk: (MD = 10/1.03 = 9.709)
 $140m × -MD × 1.65 × 0.1% = -$2.243m
 FX risk (lose if £ depreciates) :
 $140m × 1.65 × -1% = -$2.310m
 What is the total VAR?
 is it $4.553m = $2.243m + $2.310m ?

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 VAR Multiple Risks

 Is this correct? What do we miss?

 correlations among risks may not be zero.
 so changes in asset values may offset each other.

 Cannot simply sum up individual DEARs

 we have to correct the volatility by including the correlation
among risks or assets.

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 VAR Multiple Risks
 X, Y are two random variables
 a, b are two constants
Remember the variance of aX+bY is :
 Var[aX+bY] = 𝑎2 Var[X] + 𝑏 2 Var[Y] + 2abCov[X, Y]

 The standard deviation of aX+bY is

StdDev[aX + bY ] = a2s 2X + b2s Y2 + 2abr XY s Xs Y

 The correlation between aX and bY is
Cov(aX, bY ) ab
r (aX, bY ) = = r XY
s aXs bY ab
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 VAR Multiple Risks
 From previous example, two shocks X=IR, Y=FX
 Cannot simply sum up individual DEARs
 Remember DEAR is tracing the (joint) distribution of the shocks (given their st.dev
and mean), and estimating potential losses within confidence intervals
 we have to correct the volatility by including the correlation among risks or assets
direct application of the portfolio theory:

StdDev[aX + bY ] = a2s 2X + b2s Y2 + 2abr XY s Xs Y

 Consider a n-asset case. Let 𝜌𝑖𝑗 be the pairwise correlation between asset i and asset j.

 Portfolio DEAR is:

𝐷𝐸𝐴𝑅12 + 𝐷𝐸𝐴𝑅22 +. . +𝐷𝐸𝐴𝑅𝑛2 + ෍ ෍ 2 𝜌𝑖𝑗 𝐷𝐸𝐴𝑅𝑖 𝐷𝐸𝐴𝑅𝑗

𝑖 𝑗

 Use the correlation matrix to determine 𝜌𝑖𝑗

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 VAR Multiple Risks
 Example: consider the following correlation matrix
Asset DEARa Bond Spot euro S&P500

10 year US bond $10,770 1 -0.2 0.4

Spot euro contracts $9,320 1 0.1

S&P 500 index portfolio $33,000 1

 DEAR = [10.772 + 9.322 + 332 +

+2(-0.2)*10.77*9.32+2(0.4)*10.77*33 + 2(0.1)*9.32*33]1/2
=$39.969K
 This is less than $53.09K = (33+9.32+10.77)

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 VAR Drawbacks
 Just as we studied with duration (eg. convexity), also VAR makes simplifying
assumptions
 Two problems:
 Distribution might not be normal – in presence of fat (left) tails, we
underestimate the probability/density of losses
We think 99% VAR in a week is $10m, but the actual VAR is
much bigger if we use to true probability distribution

 VAR says nothing about losses in the left tail. Just the probability of such big
losses occurring. Not how big!

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 Expected Shortfall
 So VAR says nothing about how big losses can be in the left tail.
 Expected shortfall addresses this issue

 Expected shortfall (ES) asks the question: if things gets bad, what is the expected
loss?
 ES is the expected loss over horizon T conditional on loss greater than X percentile of the
distribution.
 It’s also called conditional VAR.

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 Expected Shortfall: Example
 Two portfolios have the following payoff distributions over a five day period.
 portfolio A:
50% chance of $100m,
49% chance of $80m,
1% chance of -$920m.
 portfolio B:
50% chance of $100m,
49% chance of $92m,
0.25% chance of -$920m,
0.75% chance of -$1704m.
 Expected payoff of portfolio A = B = $80m.
 99% VAR of portfolio A = B = -$920m.
 99% ES of portfolio A = -$920m, of portfolio B = -$1508m.

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 Takeaways
 Discuss nature of market risk
 Where it comes from
 Why it matters

 Major approaches of measuring market risk

 Measuring VAR
 Role of correlations

 Limitations of VAR

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