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Financial Risk Management 4/9/2020

Fina nc ia l Risk
M a na ge m e nt
VAR

Philippe Jorion
University of California at Irvine
2020
© 2020 P. Jorion – All rights reserved E-mail: pjorion@uci.edu
This content is protected and may not be shared, uploaded, or distributed

Philippe Jorion 1
Financial Risk Management 4/9/2020

Interest Rate and Currency Swaps

Notional amount outstanding (billions of dollars)
$500,000

$450,000 Currency swaps Interest rate swaps

$400,000

$350,000

$300,000

$250,000

$200,000

$150,000

$100,000

$50,000

$0
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
P.Jorion - Source: ISDA, BIS
\course\spec\market.xls

Size of Derivatives Markets

(Billion of Dollars)
2018 OTC OTC Exchange
Notional Market Notional
Amounts Values Amounts
Foreign exchange 90,662 2,257 396
Interest rates 436,837 6,401 94,368
Equities 6,417 571
Commodities 1,898 220
Credit 8,373 191
Others, gaps - -
TOTAL 544,187 9,640 94,764
Source: May 2019 BIS Survey

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Financial Risk Management 4/9/2020

Losses Attributed to Derivatives

Cumulative, $ billions
30

20

10

0
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Source: © Capital Market Risk Advisors, Inc.

Losses Attributed to Derivatives:

1993-2004
Entity Date Instrument Loss ($m)
Orange County, CA Dec-1994 Reverse repos 1,810
Showa Shell Sekiyu, Japan Feb-1993 Currency forwards 1,580
Kashima Oil, Japan Apr-1994 Currency forwards 1,450
Metallgesellschaft, Germ. Jan-1994 Oil futures 1,340
Barings, U.K. Feb-1995 Stock index futures 1,330
Allfirst (AIB), U.S. Feb-2001 Yen trades 691
Ashanti, Ghana Oct-1999 Gold "exotics'' 570
China Aviation Oil Dec-2004 Oil derivatives 550
Yakult Honsha, Japan Mar-1998 Stock index derivt. 523
Nat’l Australia Bank Jan-2004 Currency options 262
Codelco, Chile Jan-1994 Copper futures 200
Procter & Gamble, U.S. Apr-1994 Differential swaps 157
NatWest, U.K. Feb-1997 Swaptions 127
Risk Management--Philippe Jorion SocGen, Feb08, $7b

Philippe Jorion 3
Financial Risk Management 4/9/2020

“Financial Insanity”
Ken Lay, Jeff Skilling: “Did not know
what was going on at the company”
(Forbes)

Peter Baring, chairman; Peter Norris, head of investment

banking: “none of the company's top managers actually
understood the intricacies of derivatives trading"
Bob Citron, OC treasurer: “However in
retrospect, I wish I had more education and
training in complex government securities”
Richard Fuld: “Mr. Fuld did not know what those
transactions were”… “did not use a computer…”
Risk Management-Philippe Jorion

Toward Better Risk Management:

Regulators

“High-tech banking and finance has its place, but

it's not all it's cracked up to be. I hope this
sounds like a warning, because it is.”

Gerald Corrigan, president, Federal Reserve Bank

of New York, January 1992 speech

Risk Management-Philippe Jorion

Philippe Jorion 4
Financial Risk Management 4/9/2020

Toward Better Risk Management:

Corporate Regulations
 Basel Committee for Banking Supervision (1998)
requires commercial banks to hold capital reserves
to cover market risk, based on internal Value at
Risk (VAR) models; expanded to risk-sensitive
charges for credit and operational risk
 Securities and Exchange Commission (1997)
requires public corporations to disclose quantitative
information about derivatives risk using VAR as a
possible method
 Solvency II (2010) requires insurance companies to
have capital to cover worst loss at high confidence
level
Risk Management-Philippe Jorion

Toward Better Risk Management:

Asset Management
 Specific risk requirements for derivatives
 EU Investment Funds, UCITS Directive IV (Jul 1, 2011)
» Allows either simple leverage approach, or VAR
approach for sophisticated users
» Requires risk management program
» VAR (99%, 1-mo) limit: 20% of fund NAV
 US Mutual Funds, SEC proposal (Nov 2019) for
using derivatives
» Requires risk management program
» Relative VAR limit: 150% of reference index
» Absolute VAR (99%, 20-day) limit: 15% of NAV
Risk Management-Philippe Jorion

Philippe Jorion 5
Financial Risk Management 4/9/2020

Principle for Bank

Capital Charge
Assets Liabilities
Bank loans: Debt:
$100m $92m

Equity: $8m
 Banks are required to maintain a level of book
equity higher than a “minimum risk charge,”
initially with simple rules to cover credit risk
 Capital ratio must exceed 8%, or $8mm
Risk Management - Philippe Jorion

Bank Regulatory Requirements:

RWAs
 If fact, the capital ratios apply not to assets,
but rather “risk weighted assets” (RWA),
which roughly account for their credit risk
» Assets with no credit risk are given a weight=0%
» For instance, if 25% of the $100 assets are held
in Treasury bonds and the rest in bank loans,
RWAs = $25x0% + $75x100% = $75mm
» The capital charge is then 8% of $75mm, which
is less than $8mm
 This is more realistic, and has been refined
over time to account for risk better
Risk Management - Philippe Jorion

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Financial Risk Management 4/9/2020

Bank Regulatory Requirements:

Leverage Ratio
 However, banks can exploit rules to try to
minimize their capital requirements, e.g. not
enough capital during the GFC
 Regulators added a measure of risk that is
more robust, the “leverage ratio,” defined as
the ratio of equity to total assets (not RWA),
with a minimum of 3% (and 5% in US)
 Leverage is more conventionally measured
as the inverse, or ratio of assets to equity,
with a maximum of 33% (20% in US)
Risk Management - Philippe Jorion

Toward Better Risk Management:

Private Sector
 Group or Thirty G-30 (1993) issued landmark “best
practice” report for managing derivatives
 Risk management industry has developed new
tools to measure VAR (JPMorgan)
 “Risk standards” developed for U.S. institutional
investors (1996) extend G-30 recommendations to
fiduciary responsibility and all assets classes
 By now, nearly all banks describe their market risk
using VAR-type measures
 Such position-based risk measures have become
widespread in the financial industry
Risk Management-Philippe Jorion

Philippe Jorion 7
Financial Risk Management 4/9/2020

The Field of Risk Management

Statistics
Finance Insurance

Corporate Investments
Finance

Equities Bonds Currencies

Derivatives
Capital structure Capital structure
Aggregation of risks

Risk Management
Risk Management-Philippe Jorion

Firm-wide risks
Business risk Non-business risk

Other risks Financial risk

Strategic risk
Reputational Market risk
Product risk risk (inc. liquidity risk)
(market, technology…)
Regulatory,
Credit risk
Macro- political risk
economic risk Operational risk
(inc. legal, disaster)

Risk Management-Philippe Jorion

Philippe Jorion 8
Financial Risk Management 4/9/2020

Recent Operational Losses

($ Billion)
Event Type 2017 2018 2019 Examples, 2019
Mitsubishi, rogue trader, 
Internal fraud $7.9 $25.6 $5.2 $320MM loss
Punjab Bank, account 
External fraud $4.3 $2.2 $3.6 fraud, $556MM loss

Employee practices and workpl.safety $0.5 $0.2 $0.2

GE settlement, mortgage 
Clients, products and bus. practices $14.4 $13.4 $7.8 secs., $1.5B loss

Natural disasters and public safety $0.4
Technology and infrastructure failure $0.5
Execution, delivery and process mgt $0.6 $0.1 $0.7
Total $28.2 $42.1 $17.4

Risk Management--Philippe Jorion Source: RISK (Jan 2020), Top 2019 Operational Losses

Risk Management: The Old

Price

Valuation
problem

Sensitivity
analysis

Scenario
analysis

Yield
Risk Management-Philippe Jorion

Philippe Jorion 9
Financial Risk Management 4/9/2020

Risk Management: The New

Distribution of value Price Value function

Price
Frequency

Yield
Frequency
Distribution
of risk factor

Risk Management-Philippe Jorion

Yield

Option Distribution

ERM-risk.swf
Risk Management - Philippe Jorion

Philippe Jorion 10
Financial Risk Management 4/9/2020

Global Association of
Risk Professionals
 Established in 1996 as a non-profit association
 MISSION STATEMENT: “To be the leading
professional association for risk managers, managed by
and for its members dedicated to the advancement of
the risk profession through education, training and the
promotion of best practices globally.”
 Now: more than 230,000 members

Risk Management-Philippe Jorion As of Dec 2018

GARP: Financial Risk Manager

(FRM) Certificate
 FRM certificate provides industry standard of
minimum professional competence in the field
of risk management
 FRM exam administered twice a year:
(May, November)
 Until November 2009, single exam
 Now separated into Level 1 and Level 2
 Total of 50,000 FRM holders worldwide (Dec2018)

Philippe Jorion 11
Financial Risk Management 4/9/2020

FRM Exam Topics

 Part I
» Foundations – 20%
» Quantitative risk analysis – 20%
» Financial markets and products – 30%
» Valuation and risk models – 30%
 Part II
» Market risk – 20%
» Credit risk – 20%
» Operational risk and resiliency – 20%
» Liquidity risk – 15%
» Investment risk – 15%
» Current issues – 10%
As of 2020

FRM Exam Registrations

70,000 68,397

60,000 57,044

50,000 47,349
42,968
40,278
40,000 36,471
32,166
30,000 26,527
23,39123,324

20,000
13,682
10,135
10,000 8,078
5,7266,760
4,369
2,9583,584
108 262 769 1,238
0 1997199819992000200120022003200420052006200720082009201020112012201320142015201620172018

FRM-ExamData.xls at 80%

Philippe Jorion 12
Financial Risk Management 4/9/2020

FRM Exam Pass Rates

100%

90% Full Exam Level 1 Level 2

80%

70%

60%

50%

40%

30%

20%

10%

0% 97 99 01 03 05 07 09 F'10 F'11 F'12 F'13 F'14 F'15 F'16 F'17 F'18

Chartered Financial Analysts

(CFA) Association
 CFA exams:
Level I twice a year (June, Dec.)
Level II, III once a year (June)
 “… program that takes a generalist approach
to investment analysis and valuation, and
portfolio management, and emphasizes the
highest ethical and professional standards”
 Over 150,000 charterholders (as of 2019)
 41%-44%-56% pass rates in June 2019

https://www.cfainstitute.org/en/programs/cfa/exam/results-info

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Financial Risk Management 4/9/2020

Example: JP Morgan Chase

2019 Annual Report (1)
Market Risk Management
Tools used to measure risks:
... “the Firm uses various metrics, both
statistical and nonstatistical, … including:”
• Statistical risk measures:
– Value-at-Risk (“VaR”)
• Nonstatistical risk measures:
– Stress tests
– Measures of position size and sensitivity
Risk Management - P.Jorion JPM, AR 2018, p.124

Example: JP Morgan Chase

2019 Annual Report (2)
Value-at-Risk
“JPMorgan Chase utilizes VaR, a statistical risk
measure, to estimate the potential loss from adverse
market moves in the current market environment”
VAR provides a consistent framework to measure risk
profiles and levels of diversification across product
types and is used for aggregating risks across
businesses and monitoring limits

Risk Management - P.Jorion JPM, AR 2018, p.126

Philippe Jorion 14
Financial Risk Management 4/9/2020

Example: JP Morgan Chase

2019 Annual Report

Risk Management - P.Jorion JPM, AR 2019

VAR Book: Plan

Part I. MOTIVATION 1. The Need for Risk Management
2. Lessons from Financial Disasters
3. VAR-Based Regulatory Capital
Part II. BUILDING BLOCKS 4. Sources of Financial Risk
5. Computing VAR
6. Backtesting VAR
7. Portfolio Risk: Analytical Methods
8. Multivariate Models
9. Forecasting Risks and Correlations
Part III. VAR SYSTEMS 10. VAR Methods
11. VAR Mapping
12. Monte Carlo Methods
13. Liquidity Risk
14. Stress Testing
Part IV. APPLICATIONS 15. Using VAR to Measure and Control Risk
16. Using VAR for Active Risk Management
17. VAR and Risk Budgeting in Investment Management
Part V. EXTENSIONS 18. Credit Risk Management
19. Operational Risk Management
20. Integrated Risk Management
Part VI. RM PROFESSION 21. Risk Management: Guidelines and Pitfalls
22. Conclusions

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Financial Risk Management 4/9/2020

References
• Philippe Jorion is Professor of Finance at the School
of Business at the University of California at Irvine
• Author of “Value at Risk,” first published by McGraw-
Hill in 1997, which has become an “industry
standard,” translated into 7 other languages; third
edition published in October 2006
• Author of the “Financial Risk Manager Handbook,”
published by Wiley and exclusive review text for the
FRM exam; sixth edition in 2010

Phone: (949) 824-5245 E-Mail: pjorion@uci.edu

FAX: (949) 824-8469 Web: www.merage.uci.edu/~jorion

Philippe Jorion 16