Lecture 5

Market Ris
k

Todays Topics
0 This Chapter discussess the nature of market and

appropriate measures:
0 Market risk
0 Value at risk
0 VaR parameters
0 Methods of Calculating VAR:
0 RiskMetrics
0 Historic or back simulation
0 Monte Carlo simulation
0 Stress testing
0 Methods of calculating VaR

0 Links between market risk and capital

requirements

Need for banks capital

0 To ensure the soundness of banks, regulators

specify minimum capital ratio that banks need to

maintain
0 If banks are not regulated, what will be the
tendency of banks towards capital-to-assets ratio?
0 Will deposit insurance solve the problem?
0 Deposit insurance will create moral hazard for

insurance companies,
0 Again for the solution of moral hazard problem,
banks should be required by an apex authority to
main enough capital

The pre-1988 period of

banks regulations
0 Prior to 1988, regulators in different countries

tended to regulate bank capital by setting minimum

level for the ratio of capital to total assets
0 However, definition of capital and ratios fluctuated

widely from country to country

0 Banks were competing globally and a bank in a

country with tight capital regulations was

considered to have competitive disadvantage as
compared to a bank in country with slack capital
requirements

0 At the same time, many banks were heavily involved in

derivative contracts, that do not appear on balance

sheet but increase the risk
0 These derivative contracts were not covered by the

capital-to-assets ratio
0 These problems led supervisory authorities in 12

countries to form a Basel committee on banking's

supervision
0 They met regularly in Basel, Switzerland, under the

patronage of the bank for International Settlements.

0 Assets to Capital must be less than 20. Assets includes off-

balance sheet items that are direct credit substitutes such

as letters of credit and guarantees
0 Cooke Ratio: Capital must be 8% of risk weighted amount. At

least 50% of capital must be Tier 1.

0 Tier 1 Capital: common equity, non-cumulative perpetual

preferred shares, minority interests in consolidated

subsidiaries less goodwill
0 Tier 2 Capital: cumulative preferred stock, certain types of

99-year debentures, subordinated debt with an original life

of more than 5 years

Risk-Weighted Capital
0 A risk weight is applied to each on-balance- sheet

asset according to its risk (e.g. 0% to cash and govt

bonds; 20% to claims on OECD banks; 50% to
residential mortgages; 100% to corporate loans,
corporate bonds, etc.)

0 For each off-balance-sheet item we first calculate a

credit equivalent amount and then apply a risk weight

0 Risk weighted amount (RWA) consists of:

0 sum of risk weight times asset amount for on-balance sheet

items
0 Sum of risk weight times credit equivalent amount for offbalance sheet items

1996 Amendment

Implemented in 1998

0 Requires banks to measure and hold capital for

market risk for all instruments in the trading book

including those off balance sheet (This is in
addition to the BIS Accord credit risk capital)

The Market Risk Capital

The

capital requirement is
k VaR SRC

0 Where k is a multiplicative factor chosen by

regulators (at least 3), VaR is the 99% 10day value at risk, and SRC is the specific
risk charge (primarily for debt securities
held in trading book)

Basel II
0In 1999 the Basel committee proposed new

rules that have become known as Basel II

0Expected to be implemented in 2007
Three pillars
1-New minimum capital requirements for credit
and operational risk
2-Supervisory review: more thorough and uniform
3-Market discipline: more disclosure

Soundness of FIs and Capital

Adequacy
0 Overview:
0 An important objective of government is to provide a

stable economic environment for businesses and

individuals
0 One of way of accomplishing this objective is to

provide stable and reliable banking system where

bank failures are rare and depositors are protected
0 Soundness of a bank mainly depends upon the

banks ability to absorb unexpected losses

0 This ability is critically dependent upon the banks

capital and other components of equity that the bank

holds

Soundness of cont
0 It is widely accepted that the capital a financial

institution requires should cover the difference

between the expected losses and worst-case
losses over some time horizon
0 The worst-case loss is the loss that is not expected
to be exceeded with some high degree of
confidence
0 The high degree of confidence might be 99%
0 Why only worst-cases losses?

Market risk
0 One source of risk for financial institution comes

from market variables

0 Market risk is the risk that the value of on and

off-balance sheet positions of a financial

institution will be adversely affected by
movements in market rates or prices such as
interest rates, foreign exchange rates, equity
prices, credit spreads and/or commodity
prices resulting in a loss to earnings and
capital

Why the focus on Market Risk Management ?

Convergence of Economies
Easy and faster flow of information
Skill Enhancement
Increasing Market activity
Leading to

Increased Volatility
Need for measuring and managing Market
Risks
Regulatory focus
Profiting from Risk

Value at Risk
0 To ensure the adequate capital is there to cover

losses above expected levels, financial institutions

need to know a single number that summarizes the
total risk in portfolio of financial assets
0 Value at Risk (VaR) is such measure which was

pioneered by J.P. Morgan

VaR Historical perspective

0 The chairman Dennis Weatherstone was dissatisfied

with the long risk reports

0 He asked for something simpler that focused on the

bank total exposure over the next 24 hours

0 This measure helped management to know the risk

being taken by the bank and were better able to

allocate capital within the bank

Definition of VaR
What loss level is such that we are X%
confident it will not be exceeded in N
business days?
Value at risk is a function of two
variables:
- The time horizon
- and the confidence level

VaR in Basel II
0 The VAR measure used by regulators for market risk

is the loss on the trading book that can be expected

to occur over a 10-day period 1% of the time
0 The value at risk is $1 million means that the bank

is 99% confident that there will not be a loss greater

than $1 million over the next 10 days.
0 The capital that it requires is a k times of the VaR

measure

Capital requirement for

VaR

0 K is chosen on a bank-by-bank basis by the

regulators and must be at least 3

0 It historical data shows that VaR measure did not

perform well in the last 250 trading days, k may be

set as high as 4

Example of Var (in %)

0 A percentage VaR is very simple
0 Value at risk is the worst expected loss over some

selected time period with some selected confidence

0 According to the above, Var is the product of
VaRa = za
0
0 Za is the chosen level of probability
0 If we set z value at 95% confidence, it will return
the value 1.65 of critical z which means that we are
95% confident that the worst negative change in
our given variable will be 1.65 times of the standard
deviation value
0 Similarly, 99% confidence returns the critical value
2.33 of z

0 The critical value of z at a given confidence level

can be calculated by the =normsinv function of

Excel
0 For 95% confidence, we shall input values like:
0 =normsinv(.05)
0 Example in excel sheet given (Var Parametric)

VaR Parameters
0 Time Horizon
0 VaR should be calculated over a horizon of how

many days?
0 An appropriate choice for the time horizon depends
on the application
0 For example, trading desks of banks calculate the
profit and loss daily
0 Their positions are usually fairly liquid and actively
managed
0 This is why daily VaR will be the right choice for
internal use
0 If VaR turns out to be beyond the acceptable limit,
composition of portfolio can be changed quickly

Choice of Parameters
0

Choice of Parameters
cont

The confidence interval

0 Basel committee has chosen a time horizon of 10days and a confidence level of 99% for market risks
in the trading books
0 The confidence interval is primarily dependent upon
the accuracy of VaR measures over time
0 If VaR threshold is breached several times in the
past, it can be suspected that the VaR is
underestimated
0 Should we increase or decrease confidence
level in such a scenario?

Dilema?
0 The higher the confidence level , the greater the

VAR measure
0 It is not clear, however, whether one should stop at

99%, 99.9%, 99.99% and so on. Each of these

values will create an increasingly larger loss, but
less likely.
0 Another problem is that, as confidence level

increases, the number of occurrences below VAR

shrinks, leading to poor measures of large but
unlikely losses.
0 The choice of the confidence level depends on the

use of VAR. For most applications, VAR is simply a

benchmark measure of downside risk. If so, what

Implications

0 Emphasizes importance of:

0 Measurement of exposure
0 Control mechanisms for direct market risk and
employee created risks
0 Hedging mechanisms
0 Of interest to regulators

Ch 10-26

Market Risk

0 Market risk is the uncertainty resulting from

changes in market prices

0 Affected by other risks such as interest rate risk and

FX risk
0 Can be measured over periods as short as one day
0 Usually measured in terms of dollar exposure
amount or as a relative amount against some
benchmark

Ch 10-27

Market Risk
Measurement
0 Important in
terms of:
0 Management information
0 Setting limits
0 Resource allocation (risk/return tradeoff)
0 Performance evaluation
0 Regulation
0 BIS and Fed regulate market risk via capital
requirements leading to potential for overpricing of risks
0 Allowances for use of internal models to calculate
capital requirements

Ch 10-28

Calculating Market Risk

Exposure
0 Generally concerned with estimated potential

loss under adverse circumstances

0 Three major approaches of measurement:
0 JPM RiskMetrics (or variance/covariance

approach)
0 Historic or Back Simulation
0 Monte Carlo Simulation

Ch 10-29

RiskMetrics
Model
0 Idea is to determine the daily earnings at risk =
dollar value of position price sensitivity potential
adverse move in yield or,
DEAR = dollar market value of position price
volatility.

Where,
price volatility = price sensitivity of position
potential adverse move in yield

Ch 10-30

RiskMetrics
0 DEAR can be stated as:
DEAR = (MD) (potential adverse daily yield
move)
where,
MD = D/(1+R).
MD = Modified duration
D = Macaulay duration

Ch 10-31

Confidence
Intervals
0 If we assume that changes in the yield are normally
distributed, we can construct confidence intervals
around the projected DEAR (other distributions can
be accommodated but normal is generally sufficient)
0 Assuming normality, 90% of the time the disturbance
will be within 1.65 standard deviations of the mean
0 (5% of the extreme values remain in each tail of the

distribution)

Ch 10-32

Adverse 7-Year Rate

Move

Ch 10-33

Confidence
Intervals:
Example
0

Suppose that we are long in 7-year zero-coupon bonds

and we define bad yield changes such that there is
only a 5% chance of the yield change being exceeded in
either direction. Assuming normality, 90% of the time
yield changes will be within 1.65 standard deviations of
the mean. If the standard deviation is 10 basis points,
this corresponds to 16.5 basis points. Concern is that
yields will rise. Probability of yield increases greater than
16.5 basis points is 5%.

Ch 10-34

Confidence Intervals: Example

0 Yield on the bonds = 7.243%, so MD = 6.527

years
0 Price volatility = (MD) (Potential adverse
change in yield)
= (6.527) (0.00165) = 1.077%
DEAR = Market value of position (Price
volatility)
= ($1,000,000) (.01077) = $10,770

Ch 10-35

Confidence Intervals: Example

0 To calculate the potential loss for more

than one day:

Market value at risk
(VARN) = DEAR N
0 Example:

For a five-day period,

VAR5 = $10,770 5
= $24,082

Foreign Exchange
0 In the case of foreign exchange, DEAR is

computed in the same fashion we employed

for interest rate risk
0 DEAR = dollar value of position FX rate
volatility, where the FX rate volatility is taken
as 1.65 FX

Ch 10-37

Equities

0 For equities, total risk = systematic risk +

unsystematic risk
0 If the portfolio is well diversified, then
DEAR = dollar value of position stock market
return volatility, where
market volatility taken as 1.65 m
0 If not well diversified, a degree of error will be built
into the DEAR calculation

Ch 10-38

Aggregating DEAR Estimates

0 Cannot simply sum up individual DEARs

0 In order to aggregate the DEARs from individual

exposures we require the correlation matrix.

0 Three-asset case:
DEAR portfolio = [DEARa2 + DEARb2 +
DEARc2 + 2ab DEARa DEARb + 2ac
DEARa DEARc + 2bc DEARb DEARc]1/2

Ch 10-39

DEAR: Large US Banks 2005 &

2008

Ch 10-40

Estimation of VAR:
Example
0 Convert todays FX positions into dollar equivalents at
todays FX rates
0 Measure sensitivity of each position
0 Calculate its delta

0 Measure risk
0 Actual percentage changes in FX rates for each of past
500 days
0 Rank days by risk from worst to best

Ch 10-41

Other methods of finding

VaR

0 There are other two approaches to calculate VaR

0 Historical simulation
0 Monte Carlo simulation

0 Historical Simulation
0 HS involves using past data as a guide to what will

happen in the future

Historic or Back
Simulation
0 Basic idea: Revalue portfolio based on actual

prices (returns) on the assets that existed

yesterday, the day before that, etc. (usually
previous 500 days)
0 Then calculate 5% worst-case (25th lowest
value of 500 days) outcomes
0 Only 5% of the outcomes were lower

Ch 10-43

Estimation of VAR:
Example
0 Convert todays FX positions into dollar equivalents at
todays FX rates
0 Measure sensitivity of each position
0 Calculate its delta

0 Measure risk
0 Actual percentage changes in FX rates for each of past
500 days
0 Rank days by risk from worst to best

Ch 10-44

Historic or Back
Simulation
0 Advantages:
0 Simplicity
0 Does not need correlations or standard deviations
of individual asset returns
0 Does not require normal distribution of returns
(which is a critical assumption for RiskMetrics)
0 Directly provides a worst case value

Ch 10-45

HS - Methodology

vni1

0 Suppose we wan to calculate VaR for a portfolio

using 1-day horizon, a 99% confidence level, and

500 days of data
0 Collect data on the daily movements in the given
market variables
0 Conduct 500 trials assuming as if todays prices will
change at a past rate of change in each of the 500
days
0 This way forecasted value for tomorrow will be:
0 Where Vn is todays value of the variable
0 Vi is the variable value in past days

0 Vi-1 is the variable value one-day before the vi value

HS - Methodology
0 After that, calcualte the value of portfolio based on

the trial values of each variable

0 Find the difference between the forecasted values
and todays value of the portfolio in all 500 trials
0 Find the given percentile of these differences, and
that will be the VaR estimate

Percentile
0 The 1st percentile in 500 observations mean the 5th

worst loss in all 500 observations

0 In Excel, we do this by:
0 =percentile(range, .01) if it is for 1st percentile

Weaknesses
0 Disadvantage: 500 observations is not very

many from a statistical standpoint

0 Increasing number of observations by going
back further in time is not desirable
0 Could weight recent observations more
heavily and go further back

Ch 10-49

Monte Carlo Simulation

0 To overcome problem of limited number of

observations, synthesize additional observations

0 Perhaps 10,000 real and synthetic observations

0 Employ historic covariance matrix and random

number generator to synthesize observations

0 Objective is to replicate the distribution of observed

outcomes with synthetic data

Ch 10-50

Accuracy
0 Past may not be accurate estimate of the future,

Kendall and Stuart describ how to calculate a

confidence for the percentile of the probability
distribution when it is esitmated from a sample data
0 Suppose that x is the qth percentileof the loss
distribution when it is estimated from n
observations. The standard error of x is

where f(x) is an estimate of the probability

density of the loss at the qth percentile calculated
by assuming a probability distribution for the loss

Regulatory Models

0 BIS (including Federal Reserve) approach:

0 Market risk may be calculated using standard BIS
model
0 Specific risk charge
0 General market risk charge
0 Offsets

0 Subject to regulatory permission, large banks may be

allowed to use their internal models as the basis for

determining capital requirements

Ch 10-52

BIS Model
0 Specific risk charge:
0 Risk weights absolute dollar values of long and
short positions
0 General market risk charge:
0 reflect modified durations expected interest rate
shocks for each maturity
0 Vertical offsets:
0 Adjust for basis risk
0 Horizontal offsets within/between time zones

Ch 10-53

0 q= NORMINV(0.01, mean, Stdev)

0 f(x) = NORMDIST(q, mean, stdev, false)
0 Error is the +/- in the value of VaR