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Market Risk Management

April 8, 2015

Outline

Understanding Market Risk

Effective Risk Management Banks Perspective and Market Risk
Managers Perspective
Market Risk Metrics
VaR Models Parametric, Historical Simulation, Monte Carlo Simulation
Stress Testing
Extreme Values Theory

What Is Market Risk?

Basel Committee
the risk that the value of an investment will decrease due to moves in market factors
National Bank of Romania NBR Regulation No. 5/2013
the risk to incur losses corresponding to on-balance and off-balance positions due to adverse
market movements in prices and interest rates concerning the trading book business, as well as
from movements in foreign exchange rate and commodities prices for the whole business of the
credit institution (e.g. share prices, interest rate, foreign exchange rate)

Risk Management - Facilitator Vs. Hindrance

Indeed, better risk management may be the only truly

necessary element of success in banking. (Alan Greenspan, 2004)

Risk management does not attempt to eliminate risk, but it ensures that the level
and sources of risk are consistent with the risk appetite, risk profile, systemic
materiality and level of capitalization of the credit institution

Risk management does not represent a hindrance for a banks activity

It remains essential to value creation -> a bank with an effective risk management
system is more comfortable positioned to undertake higher risks (in line with its risk
tolerance) that should translate in time into higher return -> maximize the riskadjusted return on capital

Effective Risk Management Banks Perspective

Endow risk management with autonomy, empower risk management with control of
the oversight process, assure total management support

Ensure excellent reporting framework so that risk management always has accurate
information and disseminates timely to decision makers

Build/acquire powerful analytical tools that are easy to use, and that enable a
common risk language

High technical skills in the risk management team are a must, so that risk managers
understand in detail how the portfolio would perform under stressed market
conditions, recognizing that risk in the future is not necessarily the same as in the
past Next Page.

What Do You Need to Be a Market Risk Manager? Employee

Perspective

Master : linear
algebra &
probability
including
stochastic
calculus
statistics &
econometrics

Market Risk Manager

Be well versed
in regulations
and
understand
how they
affect the bank

To Remember

Overconfidence in numbers and quantitative techniques and in our ability to

represent extreme events should be subject to severe criticism because it lulls us
into a false sense of security. (Thomas Coleman)
Essentially, all models are wrong, but some are useful. (Box and Draper)

Market Risk Metrics

A market risk metric is a single number that captures the
uncertainty in a portfolios P&L, or in its return, summarizing
the portfolios potential for deviations from a target or expected
return
- Vol & Correl (only when
the returns/risk factor
returns have normal or
Student/ multivariate
elliptical distribution)
- Traditional risk metrics
measure only the
sensitivity to a risk factor

dur, KR dur, convexity, DV01,

Spread dur, CR01
beta of a stock /portfolio
delta and gamma of an option
portfolio

Aggregation of individual
exposure data on portfolio
level based on risk
factors multivariate
distribution: Value at
Risk, Expected Shortfall

Aggregation of individual
exposure data on
portfolio level based on
scenarios of risk factor
movements: Stress
Tests

Why Do I Need Risk Models

Purpose: disaggregate portfolio risk into components corresponding to different types of risk
factors
Steps:
1. Identify the risk factors Risk factor mapping rather than modeling the returns or P&L
distribution directly at the portfolio level
2. Calculate portfolio sensitivities to risk factors
3. Identify the risk factors distribution/conditional distribution (or empirical distribution)
4. Analyze the distribution is serial correlation present, long term dependence, time-varying
volatility, fat tails, asymmetry.
5. Analyze the dependence structure of risk factors.
Note:
All risk metrics, including VaR, should take account of portfolio diversification effects when
aggregating risks across different types of risk factors.

Risk Factor Mapping In Practice

Interest rate sensitive portfolios have interest rate risk factors and duration or
present value of basis point (PV01) sensitivities.

Equity portfolios usually have indices as risk factors and equity betas as
sensitivities.

Futures and forwards have interest rate risk factors with present value of basis
point sensitivities, in addition to the risk factors of the corresponding spot position.

Options portfolios have many risk factors, the main ones being the underlying assets
and the assets implied volatility surfaces. Sensitivities to risk factors are called the
portfolio Greeks.

Value at Risk

Currently the most widely applied risk management measure

It can be measured at any level, from an individual trade or portfolio, to a single
enterprise-wide VaR measure covering all risks in the firm as a whole
It is an universal metric that applies to all activities and to all types of risk

Under the Basel II Accord, banks using internal VaR models to assess their market risk
capital requirement should measure VaR at the 1% significance level,
Value at Risk (VaR) is an estimate of the
loss from a fixed set of trading positions
over a fixed time horizon that would be
equaled or exceeded with a
specific probability.
Parameters:
- time horizon
- confidence level

To calculate VaR:
Need to know the MTM of your portfolio / position

What is the 1-day 95% VaR for Triangle Asset Management?

The pdf for daily profits at TAM can be described by the following function:



1
1

 ,
10 100

1
1



 ,
10 100

10

0
0  
10

What is the one-day 95% VaR for TAM?

R: 6.84

12

Expected Shortfall/Expected Tail Loss/Conditional VaR

ETL is the loss we can expect to make if we get a loss in excess of VaR.

VaR is already pass (Kevin Dowd Measuring Market Risk)

The current frameworks reliance on VaR as a quantitative risk metric raises a

number of issues, most notably the inability of the measure to capture the tail risk of
the loss distribution. [] ES accounts for the tail risk in a more comprehensive
manner, considering both the size and likelihood of losses above a certain threshold.
(BCBS -Fundamental review of the trading book: A revised market risk
framework, October 2013)

ETL

To define ES, let L be a random variable density f and distribution FL ; a confidence level
(close to 1).

Average loss beyond -quantile

of FL:
ES 1- =E[L|L>VaR1- ]




ES 1- =      

ETL is a coherent risk measure.

What is the ES of TAM?

R: 7.89

15

VaR Models and Risk Factor Returns/Asset Returns Distribution

Parametric
Linear VaR
(Analytical/
Delta-normal)

The distribution of risk factor returns is multivariate normal

(each risk factor is i.i.d. and normal)
Not adequate for non-linear instruments with asymmetric
payoffs

Historical
Simulation VaR

Does not make any assumption about the parametric form

of the distribution
Historical simulated distribution is identical to the returns
distribution over the forward looking risk horizon

Monte Carlo
Simulation VaR

Different assumptions about the multivariate distribution of

risk factor returns can be accommodated use copula to
model the dependence and specify any type of marginal
risk factors return distribution we want

Parametric Linear VaR (1)

holding period returns (h-days returns) are

i.i.d. and normally distributed: ~ (!,"2)
portfolio is currently worth S

h-day VaR at the confidence

level (1-)% is given by:
,= 
(where  is the lower - quantile

return of the distribution

R< )=)

(!,"2) -> P(

Using the standard

normal distribution
Z score
corresponding to
, we get :
 =Z"+!

,=(#
#"+!
! )


Parametric Linear VaR (2)

The parametric linear VaR model is applicable to all portfolios except those
containing options, or any other instruments with non-linear price functions.
-> all portfolio whose returns or P&L is a linear function of its risk factors
returns or its asset returns

Example 1
For the price of a bond, using only the first derivative from the Taylor series:
%  %01 '()*+, -) .
, -) /-0' '-+0/
VaR 1-day, = 1(1) PV01 * Daily Yield (bps)
( Assumptions: mean of daily yield changes approximately zero, daily yield
changes i.i.d. and standard normal distributed, quantile of a standard normal
distribution )

Parametric Linear Example (3)

Reminder VaR formula:

,=(#"+! )

You look at a portfolio with daily returns that are normally and identically distributed with
expectation 0% and standard deviation of 1.5%. What is 1% 1-day VaR, under the
assumption that daily excess returns are independent?
VaR 1, 0.01 = 2.33*0.015=0.0349
We can use the square root of time rule:
VaR 1, 0.99 = 10 3.49%=11.035%

Parametric Linear VaR (4)

Risk factor returns are normally distributed and their joint distribution is
multivariate normal, therefore the covariance matrix of risk factors returns is
all that is required to capture the dependency between risk factors returns

Example 2
For a portfolio of fixed income securities, with 1 the vector of PV01s (key rate
DV01) and the covariance matrix of risk factor returns (bps changes in yields):
Interest Rate VaR 1-day, = 1(1) 1 2 1

Parametric Linear VaR Flavours

Analytical formula for linear VaR can be obtained also for risk factor returns with other
distribution than normal:
-Student t distribution (accommodate a leptokurtic distribution)
-Normal mixture when market display regime-specific behavior (variance mixture
same mean, normal mixture especially when I identify asymmetry in data)
Principal components can be used as risk factors, especially for Interest Rate VaR as
the first 3 components have an intuitive interpretation: level, slope, curvature.
Interest Rate PC VaR 1-day, = 1(1) 1 2 3 4 3 2 1
Where W* is the matrix whose columns are the first 3 eigenvectors of the
covariance matrix of absolute changes in yields and D = diag (first 3
eigenvalues).
Stress tests are very easy to be applied on PC representations of changes in yields.

EWMA Parametric Linear VaR

Exponentially weighted model - places exponentially declining weights on past observations
such as:

Most recent observations are given higher weights

Todays variance will be positively correlated with yesterdays variance, which captures
the idea of volatility clustering

Estimate volatility:

Parameters
- - persistence parameter - the higher the , the bigger
the impact of t1 on t
- (1) reflects the intensity of reaction.
Unfortunately, these two are not independent in EWMA model (they are in GARCH).

Obtaining the EWMA Covariance Matrix

EWMA Parametric Linear VaR

Advantages over the equally weighted model:

Volatility reacts faster to shocks in the market as recent data carry more weight

Following a shock, volatility declines rapidly as the weight of the shock observation falls
(hence, ghost effect from moving window disappears)

RiskMetrics: 6=0.94 produces good forecast for one-day volatility, and 6=0.97 results in
good estimates for one-month volatility)
Note:
EWMA produces a constant volatility for any future forecast, which is equal to todays
volatility calculated by EWMA. Hence, EWMA fails to capture the key characteristic of
volatility time variability and is not appropriate for estimating the market evolution of
volatility over longer time horizon.

Scaling VaR to Different Risk Horizon

When is it rational to apply square root of time rule?

Returns are normal and i.i.d Yes or No?

Returns are not normal but are i.i.d. (with finite variance) Yes or No?
Thing about Central Limit Theorem

Returns are normal but not independent volatility clustering Yes or No?
Correction for serial correlation when daily log returns follow a AR(1):
V(789 ) 8 
<CD  79;<  2 <BA >?@ 79;< , 79;A

There is linear long term dependence in the time series

(detection : Rescaled Range analysis, Hurst exponent) Yes or No?
Rule based on Hurst Exponent.

There is non-linear dependence (BDS test) - Yes or No?

What Happens If Returns are Heavy-Tailed?

Leptokurtosis: the density function has a

higher peak and greater mass in the tails
than the normal density with the same
variance stylized fact of empirical
distribution of financial assets returns.
Solution: attempt to fit a Student t
distribution to the data.

A fat tailed distribution requires the tails to be regularly varying - Pareto distributionlike
power expansion at infinity. The thickness of the tails is indicated by the tail index . The lower
the tail index, the fatter the tails.
For most financial assets the tail index is between three and five, (see e.g. Jansen and de
Vries, 1991; Danelsson and de Vries, 1997, 2000)
When risk factor changes are heavy-tailed, VaR is underestimated at relatively high confidence
levels.

Historical Simulation VaR

Calculation
Reconstructs a hypothetical P/L series for our current portfolio over the specified historical
period, by holding the portfolio characteristics constant
Takes the value in the P/L series at the significance level as VaR.
Advantages
Uses empirical return distribution, does not make any assumption on the parametric form of
the distribution of the risk factor returns
Not limited to linear portfolios as analytical VaR
Criticisms
It is unrealistic to assume that we would have held the current portfolio when market
conditions were different from those prevalent today
Requires a large set of historical observations over the recent past (3-5 years of daily data)
Slow to reflect major events, such as sudden market turbulence
Difficult to identify the scaling rule

Why Do We Like Stable Distributions?

Scaling rule of HS VaR Scaling rule for the quantiles of

the empirical distribution
A random variable X has a stable distribution if the sum of N independent copies of X is a
random variable that has the same type of distribution.

More precise, a random variable X with zero expectation has a stable distribution if :
8<C F< G  X
where the notation G stands for has the same distribution as and X1 Xh are
independent copies of X. is the tail index of heavy tailed distribution and 1 is the scale
exponent => the quantiles also scale with 1 !

Scaling rule for HS VaR

We assume that returns have a stable distribution.

Let x h, denote the -quantile of the h-day log returns. We seek such that
x h, =h1/ * x 1,
Taking logs:
= ln(h)/(ln(x h, )ln(x 1, ))
could be estimated as the slope of graph with ln(x h, )ln(x 1, ) on the horizontal axis
and ln(h) on the vertical axis if:

The graph is a straight line

does not depend on

Scaling Rule for HS VaR

Example for S&P 500 index

a
5%
h

(Carol Alexander, Market Risk Analysis, vol IV)

R1
R20
R18
R16
R14
R12
R10
R8
R6
R4
R2
-0.0138033 -0.06583 -0.0555666 -0.0552353 -0.0543466 -0.0468391 -0.0453141 -0.0396846 -0.0347942 -0.0294032 -0.0200063
1
20
18
16
14
12
10
8
6
4
2

ln(percentile ratio))
ln(h)
Scale exponent

0 1.5621663 1.3926729 1.3866921 1.3704715 1.2218092 1.1887073 1.0560534 0.9245418 0.7561946 0.3711385
0 2.9957323 2.8903718 2.7725887 2.6390573 2.4849066 2.3025851 2.0794415 1.7917595 1.3862944 0.6931472

1950 -2007
1970-2007
1990-2007

0.5001

4
3

0.1%
0.4662
0.5134
0.4015

1%
0.5186
0.5074
0.4596

5%
0.5001
0.4937
0.4522

Estimated value of scale exponent for S&P 500 index

2
1
0
0

0.5

1.5

Log plot of holding period versus 5% quantile ratio

10%
0.4853
0.4639
0.4268

Monte Carlo Simulation VaR

Calculation
Paths for risk factors are generated from stochastic processes finding a realistic risk
factor return model
Portfolio is valued for each path
VaR is measured based on the distributions of simulated portfolio profit/loss (P/L).
Advantages
Powerful method, may account for fat tails, non-linearity, complicated payoff functions
Not limited to linear portfolios as analytical VaR.
Criticism
Computationally expensive and time consuming
Highly dependent on finding a suitable realistic risk factors return model
It is difficult to find an appropriate scaling rule.

Stress Testing
The analysis of portfolio performance under conditions of extreme price/rate movements

Examine the vulnerability of the

institution in unlikely but plausible
extreme market conditions
-> Asses the extend of large
portfolio losses

Steps in Stress Testing

Identify risk
factors to be
stressed

Select the type

of the stress
test (factor push
or scenario) and
the magnitude
of shocks

Apply shocks
to risk factors

Evaluate the
impact on
portfolio
return

Types of Stress Testing

Scenario Analysis - examines

portfolios response to
simultaneous changes in a
combination of risk factors

Hypothetical Scenarios:
consider plausible future
developments of current
event

Historical Scenarios:
based on significant
events that happened in
the past

Sensitivity Analysis examines portfolios response

to the change in a single risk
factor core risk factor

Simple: assume no
change in other risk
factors

Predictive: estimate the

changes in peripheral risk
factor given the shocks
in core risk factors, based
on estimates of volatility
and correlations

Popular Historical Scenarios

Black Monday 1987

Gulf War 1 1991
Rate Rise 1994
Peso Crisis 1995
Asian Crisis 1997
Russia/LTCM 1998
Tech Wreck 2000
Rate Cut 2001
Sept.11th 2001

Equity Sell-Off 2002

Equity Rally 2002
Gulf War 2 (March 1-23, 2003)
Bond Rally 2003
Bond Sell-Off 2003
Emerging Market Sell-Off 2006
Subprime Debacle 2007
Bank Meltdown 2008

What If We Want to Focus on The Tails?

Extreme events: lowprobability, high impact

such as large market falls,
the failure of major
institutions, the outbreak of
financial crises, natural
disasters

Extreme
Value
Theory

EVT distributions can

be used to improve a VaR
estimate that has a very
high confidence level

EVT tells us what distributions

we should fit to our extremes
data, and guide us on how we
should estimate the parameters
involved. EV distributions are
quite
different
from
the
distributions of central tendency
statistics.

Generalized Extreme Value (GEV) distributions

Can be used to fit any set of data; is derived as the distributions of the maximal
loss/profit over a certain interval of time.

The GEV distribution depends on the location and scale parameters and a
parameter which is called the tail index because it defines the shape of the tail of
the GEV distribution.

=> three types of GEV, depending on the : Gumbel, Weibull, Frchet.

37

Generalized Extreme Value (GEV) distributions

If =0 =>Gumbel distribution. The corresponding density function has a mode at

0, positive skew and declines exponentially in the tails.

If <0 =>Weibull distribution. The density converges to a mass at .

If >0 we have the Frchet distribution. The density converges to a mass at ,

but it converges more slowly than the Weibull density since the tail in the Frchet
declines by a power law.

38

Generalized Pareto Distribution (GPD)

applies only to a specific tail, i.e. to excesses over a pre-defined threshold -peaks-overthreshold (POT) model.

- scale parameter and is the tail index

How do I compute VaR?

Correlation is a minefield for the unwary(Embrechts at all 2002)

When returns are not assumed to have elliptical distributions Pearsons linear correlation is
an inaccurate and misleading measure of association between two returns series.

Why ?

- Correlation is not invariant under transformation of variables.

- Feasible values for correlation depend on the marginal distributions.

- Perfect positive dependence does not imply a correlation of one.
- Zero correlation does not imply independence.
- Variances must be finite: this is often not true with heavy-tailed
distribution e.g.Cauchy distribution

Correlation Misleading Indicator of Non-Linear Dependence

Source: Wikipedia
Several sets of (x, y) points, with the Pearson correlation coefficient of x and y for each set. Note that the correlation
reflects the noisiness and direction of a linear relationship (top row), but not the slope of that relationship (middle), nor
many aspects of nonlinear relationships (bottom). N.B.: the figure in the center has a slope of 0 but in that case the
correlation coefficient is undefined because the variance of Y is zero.

How To Model Dependence in a Multivariate Setting

Volatility and correlation are portfolio risk metrics but they are only sufficient
(in the sense that these metrics alone define the shape of a portfolios return or P&L
distribution) when asset or risk factor returns have a multivariate normal distribution. When
these returns are not multivariate normal (or multivariate Student t) it is inappropriate and
misleading to use volatility and correlation to summarize uncertainty in the future value of a
portfolio. (Carol Alexander Market Risk Analysis, Vol II)

Questions
- What is the multivariate distribution of r.v. with different marginal distributions?
- How can I capture the dependence structure in such a multivariate distribution?

Answer
- Copula theory
A copula is a function that joins a multivariate distribution function to a collection of
univariate marginal distributions function. The construction of a joint distribution entails
estimating the parameters of both the marginal distributions and the copula. different
copulas produce different joint distributions when applied to the same marginals.

Copula Theory

Two random variables X1 and X2 with continuous marginal distribution functions F1(x1)
and F2 (x2) and set u i= Fi(xi) , i= 1, 2.
The bivariate form of Sklars theorem : given any joint distribution
function F(x1,x2) there is a unique copula function C : [0,1][0,1][0,1] such that:

F(x1,x2) =C(F1(x1) , F2 (x2) )

Why does this help?
Step 1: Choose a copula to represent the dependence structure
Step 2: Estimate the parameters involved
Step 3: Apply the copula to the marginals
Step 4: Use the joint distribution function to estimate any risk measures.
43

Examples of Copulas(1)

44

Examples of Copulas (2)

A bivariate normal mixture copula density

Bivariate Gumbel copula density for

=1.25

45