Market Risk (Concept, Measurement &

Capital Charge)

A . Nanda
Guest Faculty
INDIAN INSTITUTE OF BANKING & FINANCE
14th March 2019
Trading Book of a Bank covers

1. Debt securities
2. Equity
3. Foreign exchange
4. Commodities
5. Derivatives held for
trading
Bank’s trading book exposure is
subject to volatility in the
market variables

which can adversely impact Bank’s

1. Profitability & its
2. Net Worth
Market variables can have
major impact on the
Trading Book of a book
Bank are:
1. Market Risk
2. Liquidity Risk
RISK
3. Credit/ counterparty risk
4. Model risk
Market risk is the risk of adverse changes in the mark to market value of
the trading portfolio due to adverse changes in the market elements
such as interest rate and exchange rate during the period required to
liquidate the transaction

Adverse market
Value of trading movement Value of trading
portfolio portfolio
Sources of Market Risk
Interest
rate risk

Commod Market Equity

ity price price risk
Risk

Foreign
exchang
e risk
 Interest rate risk
1. Generally applicable to fixed income securities or
securities with predetermined cash flow

2. Market values of such instruments are

determined by discounting their future cash flows
by the current yield. As such, as interest rate or
the yield changes , their values also change.

3. There is a inverse relationship between change in

interest rate & change in securities price
 Bond Issue Price= Rs 1000
Period to Maturity = 2 years
Coupon rate = 8%
Coupon Payment = Semi annually
Current Yield = 8%
Rs 40 Rs 40 Rs 40 Rs 1040

0 0.5 yr 1yr 1.5 yrs 2 yrs

PV of Future Cash Flow
40/(1+0.04)= 38.4615
2
+
40/(1+0.04) = 36.9822
3
+
40/(1+0.04) = 35.5599
4
+
1040/(1+0.04) = 888.9964
=
TOTAL= 1000.00

If Current Yield is equal to Coupon rate the current price will be equal to
Issue Price and the Bond is said to be traded At Par
 Bond Issue Price= Rs 1000
Period to Maturity = 2 years
Coupon rate = 8%
Coupon Payment = Semi annually
Current Yield = 6%
Rs 40 Rs 40 Rs 40 Rs 1040

0 0.5 yr 1yr 1.5 yrs 2 yrs

PV of Future Cash Flow
40/(1+0.03)= 38.8350
2
+
40/(1+0.03) = 37.7038
3
+
40/(1+0.03) = 36.6057
4
+
1040/(1+0.03) = 924.0265
=
TOTAL= 1037.1710

If Current Yield is less than Coupon rate the current price will be higher
than Issue Price and the Bond is said to be traded At Premium
 Bond Issue Price= Rs 1000
Period to Maturity = 2 years
Coupon rate = 8%
Coupon Payment = Semi annually
Current Yield = 10%
Rs 40 Rs 40 Rs 40 Rs 1040

0 0.5 yr 1yr 1.5 yrs 2 yrs

PV of Future Cash Flow
40/(1+0.05)= 38.0952
2
+
40/(1+0.05) = 36.2812
3
+
40/(1+0.05) = 34.5535
4
+
1040/(1+0.05) = 855.6106
=
TOTAL= 964.5405

If Current Yield is greater than Coupon rate the current price will be less
than Issue Price and the Bond is said to be traded At Discount
 Equity price risk
1. Stock prices are volatile and changes with time
2. Stock prices change due to market factors as
well as factors specific to the issuer.
4. Movement of prices attributed to market factors Equity Risk
is called General Market Risk. Generally, this
refers to stock’s sensitivity to change in broad
market indices such as SENSEX General Specific
5. Movement of price on account of factors specific Market Risk Risk
to the firm is called Specific / Idiosyncratic Risk
like fall in market share, profit, change in
management
6. In case of a well diversified portfolio, specific risks
stand eliminated substantially.
 Foreign Exchange Risk
1. Foreign exchange positions arise in the
ordinary course of business and through
acquiring a trading position in foreign
exchange.
2. Usually, foreign exchange portfolio consists
of open positions as well as imperfectly
hedged positions in particular foreign
currency denominated assets and liabilities
giving rise to fluctuations in profit as
measured in domestic currency.
3. Open position is susceptible to exchange
rate risk which mainly depends on
movement of spot rates of two currencies.
Example
1. Let us presume that a Bank has a net long
position in USD to the extent of USD
1,00,000 which could not be covered
2.Current Exchange Rate + USD 1 = Rs
70.0000
3.Value of the exposure on account of open
position = Rs 70 00 000
4.Suppose the exchange rate changed to
USD 1 = Rs 69.0500 overnight
5. The value of the exposure on account of
open position goes down to Rs 69 05 000
6.Loss in the portfolio caused by adverse
movement in exchange rate = Rs 95000
 Commodity Price Risk
Commodity price risk differs from interest rate
risk, foreign exchange risk and equity risk and is
highly volatile because :

1. Commodity prices are strongly supply demand

dependent
2. Market liquidity or depth of trading market
are not uniform
3. Transaction cost vary widely
4. Commodities have different characteristics
 Liquidity Risk
1. Trading liquidity is the ability to freely transact in the
market at reasonable price
2. Liquidity Risk in trading book consists of
i) Asset Liquidation Risk
ii) Market Liquidation Risk
3. Asset Liquidation Risk refers to a situation where a specific
asset faces lack of trading liquidity.

4. Market Liquidity refers to a situation where there is

general liquidity crunch in the market and it affects trading
liquidity adversely
 Credit & Counterparty risk

1. Market values credit risk of issuers and

borrowers and is reflected in the price of
traded debts.
2. Credit rating indicates risk level
associated with the instruments.
3. Credit risk may arise due to default by the
issuer or because of risk migration
 Model Risk
1. Models are used to predict the value of
the variables for which they have been
designed
2. Value of a given variable would depend on
one or more parameters which influence
the value of the given variable.
3. However values predicted through model
may show deviation when compared with
actuals giving rise to Model Risk
4. Model risk can arise due to
i. Incorrect assumption
ii. Ignorance of vital parameter
iii. Errors of statistical technique
iv. Incorrect judgement
Measurement of market risk is critical for determination of risk
appetite, delegation structure and monitoring of risk exposure

Measurement of market risk 1. Sensitivity based Approach

2. Value at Risk Approach

 Sensitivity Based Approach
1. Sensitivity captures deviation of mark to
market value due to a unit movement of a
single market parameter
2. These market parameters are interest
rate, exchange rate, liquidity in the
market, inflation etc.
3. Sensitivity Based Approach makes use of
two popular tools namely :
I. Basis Point Value(BPV) Method
II. Duration Method
 Basis Point Value ( Delta DV01)

1. Basis Point Value denotes the change in price of the bond given
a basis point change in in the yield of the bond

2.It tells us how much money a portfolio or exposure will gain or

looses for a 0.01% parallel movement in the yield curve
3. BPV enables risk managers to manage interest rate risk exposure
4. This is done by allowing a max BPV limit for a dealer
5. Dealers adjust the BPV by altering the position they have
 Assessment of Basis Point Value
Bond Initial Price New Price BPV
(at 8% yield) (at 8.01%)
2 Yrs 8 % coupon 100.00 99.9819 (-)0.0181

5 Yrs 8% Coupon 100.00 99.9595 (-)0.0405

10 yrs 6% Coupon 86.4097 86.3478 (-)0.0619

10 Yrs 10% Coupon 113.5903 113.5164 (-)0.0739

Calculate how much loss will be suffered by 5Yrs 8% coupon Bond if Yield goes up from 8.00%
to 8.10 and what will be its new price.
Loss = BPV * 0.001/0.0001 =(-) 0.0405*10 =(-)0.4050 New Price=100-0.4050=99.5950
 McCauley Duration
Duration is the weighted average of
the times that interest payments and
the final return of capital are received.

The weights are the amount of the

payments discounted by the yield to
maturity.

Macaulay Duration is an average or

effective maturity
 Example : Computation of
Bond Issue Price= Rs 1000 Macaulay Duration
Period to Maturity = 2 years
Coupon rate = 8%
Coupon Payment = Semi annually
Current Yield = 10%
Term (Years) Cash Flow Present Value PV*t
(t) PV =CF/DF
0.50 40 38.0952 19.0476
1.00 40 36.2812 36.2812
1.50 40 34.5535 51.8303
2.00 1040 855.6106 1711.2212
964.5405 1818.3803
Duration σ 𝑷𝑽 ∗ 𝒕/σ 𝑷𝑽 1818.3803/964.5405= 1.8852 yrs
 Modified Duration & Price Sensitivity

1. Modified Duration (Mod D) measures how much a small

change in the yield to maturity can affect the price of the Bond
1
2. Modified Duration(Mod D) = Macaulay Duration x
1+𝑦

3. % Change in bond price = (-)Mod. Duration times the

change in yield to maturity. In other words,
∆𝑃
(%) = (-) Mod D x ∆ 𝑦
𝑃
4. Mod D of the Bond referred in previous slide (No 24) can
be worked out as = 1.8852*1/(1+0.05) = 1.7954
1. Calculate the change in the price of the Bond if the yield goes up from 10.00% to 10.05%
using Mod Duration

Ans: % Change in Price= (-)Mod D x ∆ 𝑦 = (-)1.7954 x 0.0005 =(-) 0.0008977 = (-)0.08977%

New Price = 964.54 – (0.08977% of 964.54)= 964.54-0.8659 = 963.67 (963.67)@

2. Calculate the change in the price of the Bond if the yield goes up from 10% to 12% using Mod
Duration

Ans: % Change in Price= (-)Mod D x ∆ 𝑦 = (-)1.7954 x 0.02 =(-) 0.0359 = (-)3.5908%

New Price = 964.54 – (3.5908 % of 964.54)= 964.54-34.6347 = 929.9053 (930.6979)@

3. Calculate the change in the price of the Bond if the yield goes down from 10.00% to 7.5%
using Mod Duration

Ans: % Change in Price= (-)Mod D x ∆ 𝑦 = (-)1.7954 x (-)0.025 =(+) 0.04488 = (+)4.488%

New Price = 964.54 + (4.488 % of 964.54)= 964.54+43.28 = 1007.82 (1009.1285)@
@ Figures given in the bracket are actual price arrived by using PV method)
1. Relationship between the % change in price and
duration works approximately. For very small change in
yield the formula gives exact result.

2. However, when there is a relatively large increase in the

market yield, the duration formula overestimates the %
drop in price. The opposite is true if the market yield
decreases.

3. For large increase the formula gives poor result

because it assumes a linear relationship between price
change and yield change
 Convexity
Convexity is the measure of
the curvature or 2nd derivative
of how the price of a bond
varies with interest rate i.e
how the duration of a
bond changes as the interest
rate changes
 (Years) Cash Flow Present Value PV*t*(t+1) Modified Duration and
(t) PV Convexity Measure
0.50 40 38.0952 28.5714 together gives more
accurate result to
1.00 40 36.2812 72.5624 measure the effect of
1.50 40 34.5535 129.5756 change in yield to Bond
Prices
2.00 1040 855.6106 5133.6636
964.5405 5364.3730 ∆𝑃
= (-) MD ∆𝑅 +
𝑃
Convexity 5364.3730/964.5405= 5.5616 1
𝐶𝑋 (∆R)2
2

Lets now recalculate the effect of change in yield from 10% to 7.5% on the bond Price
∆𝑃 1
= (-) MD ∆𝑅 + 𝐶𝑋 (∆R)2
𝑃 2
1
= (-) (1.7954 x (-)0.025) + 5.5616 (0.025)2
2
= (+) 0.0449+0.0017=0.0466 or 4.66%
New Price using Mod D & Convexity = 964.5405 + 4.66% of 964.5405 = 964.5405 + 44.9476 =
1009.49 ( 1009.13)@
 Interest Rate Risk Management- Immunization strategy
Suppose a Banker has to make a payment of Rs 1469 after 5 yrs towards a guaranteed
lumpsum payment equivalent to investing Rs1000 at an annually compound rate of
8% over 5 years

To immunize or protect against interest risk, the Banker will determine an investment
which would produce a cash flow of Rs1469 irrespective of what happens to the
interest rate in immediate future.

The Banker has two options

1. Invest in a five year maturity/ duration zero coupon bond which would produce a
cash flow of Rs 1469 irrespective of what happens to rate of interest.
or
2. Buy a five year duration coupon bond
A six year maturity Bond paying 8% yield to maturity has a duration of 4.993 or 5
years. If we buy this six year maturity and hold it for 5 years it will produce a cash flow
which would be Rs1469 whatever happens to interest rate
The cash flows received by the Banker on the bond if interest rates stay at 8 percent throughout the five
years would be

1. Coupons 5 × Rs 80 = Rs400
2. Reinvestment income = Rs 69
3. Proceeds from sale of bond at end of fifth year =Rs1000
TOTAL =Rs1469

1. Coupons. The Rs400 from coupons is simply the annual coupon of Rs80 received in each of the five
years.
2. Reinvestment income. Because the coupons are received annually, they can be reinvested at 8
percent as they are received, generating an additional cash flow of Rs69. 13
(1+𝑅)𝑛−1 1.085 −1
FVAFn,R= = =5.867x80= Rs469
𝑅 0.08
3. Bond sale proceeds. The proceeds from the sale are calculated by recognizing that the six year bond
has just one year left to maturity when it is sold by the Bank at the end of the fifth year.
What fair market price can the insurer expect to get when selling the bond at the end of the fifth year
with one year left to maturity? A buyer would be willing to pay the present value of the Rs1,080—final
coupon plus face value—to be received at the end of the one remaining year or:1080/1.08= 1000. Thus,
the insurer would be able to sell the one remaining cash flow of Rs 1,080, to be received in the bond’s
Interest Rate falls to 7%

1. Coupons, 5 × Rs80 = Rs400

5
1.07 −1
2. Reinvestment income= 80x = 80x5.75=460-400= Rs 60
0.07
3. Bond sale proceeds = 1080/1.07 = Rs 1009
Total = Rs 1469

Interest Rate rises to 9%

1. Coupon 5xRs80 = Rs400
1.095−1
2. Reinvestment Income=80x =80x5.9847=478-400= Rs 78
0.09
3. Bond Sale Proceeds= 1080/1.09 = Rs 991
4. Total = Rs 1469
VaR is defined as the predicted worst Value at Risk (VaR)
case loss at a specified confidence level
over a certain period of time assuming
normal trading condition

Assuming 95% confidence level and a 1-

day horizon, a VaR of Rs 10 million means
that, on average, only 1 day in 20 would
you expect to lose more than Rs10 million
due to market movements.

Here we would anticipate that losses

exceeding the VaR amount would occur
5% of the time (or losses less than the VaR
amount would occur 95% of the time).
What goes into the estimation of VaR :
1. Exposure
2. Time
3. Confidence
4. Volatility

1. The main assumption underpinning VaR model is that the

distribution of future price and rate changes will follow a past
variation
2. It measures potential losses from a position or portfolio under
normal circumstances. Most commonly used VaR model assumes
that the prices of assets in the market follow a normal distribution
3. It measures potential loss in the market value of a portfolio using
estimated volatility and correlation
Tools used for calculation of VaR

1. Variance/co-variance Approach
2. Historical Simulation
3. Monte Carlo Simulation
 Calculation Of VaR by Variance/ Co variance Method
Standard deviations can be used to estimate
probabilities of loss when the parametric
approach to measuring risk is used.
Because returns tend to cluster around the
mean, larger standard deviation moves have a
lower probability of occurring.

To arrive at the tail probability of loss levels and

implied VaR confidence levels, we use standard
deviations (confidence level scaling factors).

Probability value
0.10 (-)1.282* SD
0.05 (-)1.645* SD
0.01 (-)2.326* SD
 Example of calculation of VaR
A portfolio having daily standard deviation of 1.7% and a current
market value of say Rs 1 million , calculate daily VaR at 95%
confidence level

Ans: 5% probability is represented by (-) 1.65 *SD

= (-)1.65*1.7
= (-) 2.805 %
Daily VaR at 95% Confidence level = (-)2.805% of Market value
= Rs 1000000*(-)2.805%
=(-)Rs 28050
 Historical Simulation Method
Historical simulation method calculates the change in the value of a position
using the actual historical movement of the risk factors of underlying assets
Lets find out the VaR in respect of a position in 10 ye G-sec securities having a market value
of Rs 10 cr

Step 1 : Tabulate daily changes in the rate of return of 10 yr G-sec Bonds for say last 100 days
Step 2 : Plot the distribution value in descending order
Step 3 : Identify the required VaR measured at required confidence level
95% confidence level means the VaR so determined hold in 95 out of 100 days
This corresponds to the 95th percentile. In our example, this would correspond to Sl
No 95 worst scenario out of 100. (Sl No 475 worst scenario if we have returns for
500 days).
Step 5 :If the worst case scenario at sl no 95 gives a return of ( -) 4.1% from the table, then
the VaR in case of our portfolio would be 4.1% of Rs 10 cr = 10 x 0.041=0.41Cr
Forward Return on Portfolio Portfolio Return arranged in descending order
Outcome No % Return Sl No Outcome
1 - - 4.56
2 0.41 86 -3.48
3 4.32 87 -3.6
4 0.81 88 -3.82
5 -3.82 89 -3.97
6 0.98 90 -4.38
7 -1.71 91 -4.39
8 -4.38 92 -4.46
9 4.27 93 -4.56
10 -2.43 94 -4.63
…………. ………… 95 -4.64
96 -4.67 96 -4.67
97 -4.95 97 -4.67
98 4.6 98 -4.74
99 0.86 99 -4.76
100 4.65 100 -4.95
 Monte Carlo simulation

Calculates the change in the portfolio

using a sample of randomly selected
price scenario

It involves the following steps

1. Listing risk factors & parameters

like volatility correlation etc.
2. Constructing time path
3. There will be several paths to show
distribution
Computation of capital charge for Market Risk

1. Market risks are required to be managed on an ongoing basis and Bank has to
ensure that the capital requirement of market risk is maintained on
continuous basis at the close of each business day
2. Banks in India have adopted Standardised Method for computation of capital
charge for market risk
3. Under the standardised method there are two principal methods of measuring
market risk i.e. (i)Maturity method and (ii) Duration method
4. As duration method is more accurate way of measuring interest rate risk, banks
have been advised to adopt Standardised Duration Method to arrive at capital
charge
Computation of capital charge for Market Risk

Capital for market risk is required for abnormal losses that may arise
on account of adverse movements in the market prices which in turn
depends upon adverse movements in interest rates and adverse
changes in factors relating to individual issuer

Capital for Capital for Capital for

= risk
market = General Risk Specific Risk
Computation of capital charge for Market Risk
1. The capital charge for specific risk is designed to protect
against an adverse movement in the price of an individual
security owing to factors related to individual issuer
2. Extant guidelines of RBI prescribe a standardized capital
charge for specific risk which depends upon the issuer, type of
security and remaining maturity of security. This varies from
0% in case of central and state govt securities to 100% for
securities rated B or below or are unrated
3. Capital charge for general market risk is charge towards
interest rate risk in the portfolio where long and short
positions in different securities and instruments can be set off.
 Capital Charge for General Market Risk

1. Capital charge for general market risk is computed under

standardised duration method using the formula

Capital charge for a security = Modified duration of the

security X Market value of security X Assumed change in yield

2. Here assumed change in yield is prescribed by the regulator

(RBI)and varies from 60 basis points to 100 point basis
depending on the remaining period of maturity
3. Capital charge for general risk of all securities in a portfolio would
equal sum of the capital charge calculated in the above manner
Sequential path to calculate capital charge for General Market
Risk
(i) First calculate the price sensitivity (modified duration) of each instrument;
(ii) Next apply the assumed change in yield to the modified duration of each
instrument between 0.6 and 1.0 percentage points depending on the maturity of
the instrument (As prescribed by RBI);
(iii) slot the resulting capital charge measures into a maturity ladder with the
fifteen time bands as set out in RBI guideline;
(iv) subject long and short positions (which is not allowed in India except in
derivatives) in each time band to a 5 per cent vertical disallowance designed to
capture basis risk; and
(v) carry forward the net positions in each time-band for horizontal offsetting
subject to the disallowances set out in RBI circular
Mod DxIntt
Shock
1. In case of shares, capital charge for specific risk is 11.25% of the market value
and capital charge for general market risk is also 9% of market value. Hence
capital charge for market risk for shares is taken as 20.25% of market value of
shares held
2. Capital charge for open position in foreign exchange and gold is 9% of limit or
actual whichever is higher.
3. Capital charge for market risk of derivatives is computed after converting in to
into positions in the relevant underlying in the same manner as securities
Proforma for consolidation of capital charge for market risk is
given below

Risk Category Capital charge1

1 Interest Rate
General Market Risk
- Net Position
- Vertical Allowance
- Horizontal Allowance
- Options
Specific Risk
2 Equity
General Market Risk
Specific Risk
3 Foreign Exchange & Gold
Total Capital Charge for Market Risk ( 1+2+3)
References:

 Risk Management An overview : IIBF

 Financial Institution Management : Risk Management Approach
By Anthony Saunders & Marcia Cornett
 The Essentials of Risk Management : 2nd edition
By Crouhy , Galai, Mark
 Thanks
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