09/04/2014

Chapter 10
Market Risk

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Overview
• This chapter discusses the nature of market risk
and appropriate measures

– Dollar exposure
– Risk Metrics
– Historic or back simulation
– Monte Carlo simulation
– Links between market risk and capital requirements

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Market Risk

• Risk related to the uncertainty of an FI’s

earnings on its Trading Portfolio caused by
changes in Market Conditions

• Trading Portfolio….????
• Market Conditions…???

Market Conditions
• Market conditions are the extreme changes in market
such as the prices of an Asset, Interest rates, Market
volatility, and Market liquidity.

• Thus, risks such as Interest Rate Risk and Foreign

Exchange Risk, Liquidity Risk affect market risk.

• However, market risk emphasizes the risks to FIs that

actively trade assets and liabilities (and derivatives)
rather than hold them for longer-term investment,
funding, or hedging purposes.

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Trading Portfolio
• The Trading Portfolio contains assets, liabilities, and
derivative contracts that can be quickly bought or sold
on organized financial markets.
• Such as
– Long and Short positions in Bonds,
– Commodities
– Foreign exchange,
– Equity securities,
– interest rate swaps, and options etc

• Further, with the increasing securitization of bank loans (e.g.,

mortgages), more and more assets have become liquid and
tradable (e.g., mortgage-backed securities).

Trading Portfolio

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Changing Income Trends

• With increasing global reach of FIs and introduction of new

financial engineering instrument.

• The Income from Trading activities is increasingly replacing

income from traditional FI activities of deposit taking and
lending.

• The changing Earning pattern of FIs has increased its market

exposure and uncertainty over the years.

• The uncertainty, or market risk, can be measured over

periods as short as a day or as long as a year

Trading Risks
• In recent years, market risk of FIs has raised
considerable concern among regulators
• Trading exposes banks to risks
o 1995 Barings Bank

o 1996 Sumitomo Corp. lost $2.6 billion in

commodity futures trading.

o AllFirst the U.S. subsidiary of Allied Irish Bank

$691 million losses in FX market.

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Importance of Market Risk Measurement

• Management information
– Management can compare this risk exposure to the FI’s
available capital resources.
• Setting limits.
– Risk/Return tradeoff for different traders and their portfolio.
• Resource allocation
– Risk/Return tradeoff in deferent geographic areas)
• Performance evaluation.
– Considers the return-risk ratio of traders
• Regulation
– BIS and Fed regulate Market Risk via Capital requirements
leading to potential for overpricing of risks by prudential
regulations.
– Thus use of internal models to calculate capital requirements
will reduce the chances of overpricing.

Calculating Market Risk Exposure

• Generally concerned with estimated Potential
Loss under Adverse Circumstances.

• Three major approaches of measurement

o JPM RiskMetrics (or Variance/Covariance
approach)
o Historic or Back Simulation
o Monte Carlo Simulation

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JP Morgan RiskMetrics Model

• “At close of business each day tell me what

the market risks are across all businesses and
locations.”

o Dennis Weatherstone, former Chairman of J. P. Morgan

(JPM), now J. P. Morgan Chase.

JP Morgan RiskMetrics Model

• When JPM developed its RiskMetrics Model in 1994 it had 14
active trading locations with 120 independent units across the
globe.
• Fixed-income securities • Foreign exchange
• Commodities • Derivatives
• Emerging-market securities • Proprietary assets

• As whole JP Morgan daily volume exceeding $50 billion.

• This is very typical for the major money canter banks, large
overseas banks (e.g., Deutsche Bank, Barclays ), and major
insurance companies and Investment Banks(Morgan Stanley,
Goldman Sashs ).

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RiskMetrics Model
• Here we will concentrate on measuring the Market
Risk Exposure of a FI on a daily basis.

• The only concern of FI is how to preserve its Equity if

market conditions move Adversely tomorrow

• Market risk = Estimated potential loss under

Adverse Circumstances

RiskMetrics Model
• More specifically, the market risk is measured in
terms of the FI’s Daily Earnings At Risk (DEAR)

• Components of Dear:
1. Dollar value of position
2. Price Sensitivity
3. Potential Adverse move in yield

• Daily Earnings at Risk = (Dollar value of position) ×

(Price sensitivity) × (Potential adverse move in
yield)

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RiskMetrics Model
• Since

• (Price Sensitivity) X (Adverse yield move) = Degree of

price volatility of an asset.

• we can also write this equation as:

RiskMetrics Model
• We concentrate on how the RiskMetrics model
calculates daily earnings at risk in three trading
areas

1. Fixed income
2. Foreign exchange (FX)
3. Equities

• And then on how it estimates the Aggregate

Risk of the Entire Trading Portfolio

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The Market Risk of Fixed-Income Securities

• Suppose an FI has a $1 million market value position in zero-
coupon bonds of 7 years to maturity with a face value of
$1,631,483.

• Today’s Yield on these bonds is 7.243% per year.

• These bonds are held as part of the trading portfolio. Thus

• Dollar market value of position = $1 million

1,631,483
– ళ = $1,000,000
(1.07243)

The Market Risk of Fixed-Income Securities

• The potential exposure the FI faces should interest rates move
against the FI as the result of bad market move the next day.

• How much the FI will lose…..????

• Depends on the bond’s price volatility…..!!!

• From the duration model in Chapter 9 we know that

• Daily Price Volatility = (MD) x (Adverse daily yield move)

• The modified duration (MD) of this bond is

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Confidence Intervals
• Suppose we define “bad” yield changes such that there is only 5%
chance of the yield change being exceeded in either direction.

• From statistics, we know that (the middle) 90 percent of the area

under the normal distribution is to be found within ±1.65 standard
deviations(σ) from the mean. That is, 1.65σ

• And 10 percent of the area under the normal distribution is found

beyond ±1.65 (5% under each tail, −1.65σ and +1.65σ,
respectively).

• Our concern is only that yields will Rise.

• Which is the Probability of yield Increases greater than 16.5σ Basis

Points is 5%.

Adverse 7-Year Rate Move

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Adverse 7-Year Rate Move

• In other words, over the last year, daily yields on 7-
year, zero-coupon bonds have fluctuated (either + or -)
by more than 16.5σ bp only 10% of the time.

• Adverse moves in yields are those that decrease the

value of the security (i.e., the yield increases).

• These occurred 5% of the time, or 1 in 20 days.

Confidence Intervals
• Suppose the standard deviation of the bond was 10 Bb
(or 0.001).

• Thus, 1.65σ is equal to 16.5 basis points (bp).

• 1.65σ => 1.65 x (.001) => 0.00165

• => 0.00165 = 16.5 basis points

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The Market Risk of Fixed-Income Securities

• Now we can calculate the potential Daily Price Volatility on 7-
year discount bonds using Equation.

• 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

• The potential daily loss in earnings on the $1 million position

is $10,770 if the 1 bad day in 20 occurs tomorrow.

The Market Risk of Fixed-Income Securities

• To calculate the potential loss for more than one
day:

Market value at risk (VARN) = DEAR × N

• Example:
For a five-day period
VAR5 = $10,770 × 5
= $24,082

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DEAR for Foreign Exchange

• In the case of Foreign Exchange, DEAR is
computed in the same fashion we employed
for Interest Rate Risk.

• DEAR = Dollar Value Of Position × FX rate volatility

• where the FX rate volatility is taken as 1.65 σFX

DEAR for Foreign Exchange

Suppose the FI had a £1.6 million trading position in spot Pound
at the close of business on a particular day.

The first step is to calculate the dollar value of the position:

• Suppose for simplicity

• The exchange rate is £1.60/$1 or $0.625/: at the daily close;
then:

• Dollar value of position (£1.6 million) x ($0.625/ ) = $1 million

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DEAR for Foreign Exchange

• We find that the volatility, or Standard Deviation (σ), of daily
changes in the Spot exchange rate was 56.5 bp.

• Suppose that the FI is interested in adverse move of not more

than 5 % of the time, or 1 day in every 20.

• Statistically speaking, if changes in exchange rates are

historically “normally” distributed,
• The exchange rate must change in the adverse direction by
1.65 σ

• FX volatility 1.65 x 56.5 bp = 93.2 bp

• In other words, during the last year, the euro declined in value
against the dollar by 93.2 bp just 5% of the time

DEAR for Foreign Exchange

• As result

DEAR = (Dollar value of position) x (FX volatility)

= ($1 million) x(.00932)
= $9,320

• This is the potential Daily Earnings Exposure to

adverse Pound to Dollar exchange rate changes for
the FI from the £1.6 million spot currency holdings.

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DEAR for Equities

• Many large FIs also take positions in equities.

• As we known from the Capital Asset Pricing Model

(CAPM), there are two types of risk to an equity
position in an individual stock

• Total risk = Systematic risk + Unsystematic risk

• Beta: Systematic risk reflects the co-movement of

that stock with the market portfolio reflected.

DEAR for Equities

• In a very well diversified portfolio, unsystematic risk can be
largely diversified away (i.e., will equal zero)

• Leaving behind Systematic (undiversifiable) Market Risk.

• If the FI’s trading portfolio follows (replicates) the returns on

the stock market index, the Beta of that portfolio will be 1

• Since the movement of returns on the FI’s portfolio will be

one to one with the market.

• And the standard deviation of the portfolio, will be equal to

the standard deviation of the stock market index.

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DEAR for Equities

• Suppose the FI holds a $1 million trading position in stocks that
reflect a U.S. stock market index (e.g., the Wilshire 5000).
• Then Beta ß= 1 and
• The DEAR for well diversified portfolio is

DEAR = (Dollar value of position) × (Stock market return volatility)

Dear= ($1,000,000) x (1.65 σM )

• If over the last year, the σM of the daily returns on the stock
market index was 200 bp.
• Then 1.65 σM = 330 bp (i.e., the adverse change daily return on
the stock market index exceeded 330 bp only 5% of the time).

DEAR for Equities

• So in this case

• Dear= ($1,000,000) x (1.65 σM )

• Dear= ($1,000,000) x (0.033)
• Dear = $33,000

• That is, the FI stands to lose at least $33,000 in earnings if

adverse stock market returns materialize tomorrow.

• In less well diversified portfolios or portfolios of individual

stocks, the effect of Unsystematic Risk on the value of the
trading position would need to be added.

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Aggregating DEAR Estimates

• So the individual DEARs were:
1. Seven-year zero-coupon bonds = $10,770
2. Euro spot = $9,320
3. U.S. equities = $33,000
• Senior management wants to know the aggregate risk of the entire
trading position.
• So we cannot simply sum the three DEARs ($10,770 + $9,320 +
$33,000) = $53,090…..!!!
• Why…????
• Because that ignores any degree of offsetting covariance or correlation
among different trading positions.
• In particular, some of these asset shocks may be negatively correlated.
• As is well known from Modern Portfolio Theory, negative correlations
among asset shocks will reduce the degree of portfolio risk.

Aggregating DEAR Estimates

• In order to aggregate the DEARs from individual
exposures we require the correlation matrix.

• Three-asset case:

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Aggregating DEAR Estimates

• Suppose the Correlation between the 7-year zero-coupon bonds
and £ /$ exchange rates, is negative (-0.2),
• While the 7-year zero coupon yield changes with, respectively,
U.S. stock returns (0.4)
• And £ /$ shocks, U.S stock index are positively correlated (0.1)

• Substituting value in DEARs equation (in thousands of dollars)

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