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Risk Management – Market Risk

Introduction to Market Risk:

Market Risk may be defined as the possibility of loss to bank caused by the changes in the market
variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements
in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the
bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign
exchange and equities, as well as the volatilities, of those prices. Market Risk Management provides a
comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate,
foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with
the bank’s business strategy.

Scenario analysis and stress testing is yet another tool used to assess areas of potential problems in a
given portfolio. Identification of future changes in economic conditions like – economic/industry overturns,
market risk events, liquidity conditions etc. that could have unfavorable effect on bank’s portfolio is a condition
precedent for carrying out stress testing. As the underlying assumption keep changing from time to time, output
of the test should be reviewed periodically as market risk management system should be responsive and
sensitive to the happenings in the market.

Market risk is typically measured using a Value at Risk methodology. Value at risk is well established as
a risk management technique, but it contains a number of limiting assumptions that constrain its accuracy. The
first assumption is that the composition of the portfolio measured remains unchanged over the single period of
the model. For short time horizons, this limiting assumption is often regarded as acceptable. For longer time
horizons, many of the transactions in the portfolio may mature during the modeling period. Intervening cash
flow, embedded options, changes in floating rate interest rates, and so on are ignored in this single period
modeling technique. Market risk can also be contrasted with Specific risk, which measures the risk of a
decrease in one’s investment due to a change in a specific industry or sector, as opposed to a market-wide
move.

Meaning of Market Risk: Market risk is the risk that the value of an investment will decrease due to moves in
market factors. Volatility frequently refers to the standard deviation of the change in value of a financial
instrument with a specific time horizon. It is often used to quantify the risk of the instrument over that time
period. Volatility is typically expressed in annualized terms, and it may either be an absolute number ($5) or a
fraction of the initial value (5%). The five standard market risk factors include:

1. Equity risk or the risk that stock prices will change.

2. Interest rate risk or the risk that interest rates will change.
3. Currency risk or the risk that foreign exchange rates will change.
4. Commodity risk or the risk that commodity prices (i.e. grains, metals, etc.) will change.
5. Equity index risk or the risk that stock or other index prices will change adversely.

Definition: ―The possibility for an investor to experience losses due to factors that affect the overall
performance of the financial markets‖, Market risk, also called "systematic risk," cannot be eliminated through
diversification, though it can be hedged against. The risk that a major natural disaster will cause a decline in the
market as a whole is an example of market risk. Other sources of market risk include recessions, political
turmoil, changes in interest rates and terrorist attacks.

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Types of Market Risk: There are four major types of market risk:

a. Interest Rate Risk

b. Equity Price Risk
c. Foreign Exchange Risk
d. Commodity Price Risk

a. Interest Rate Risk: Interest rate risk is the risk that the value of a security will fall as a result of increase in
interest rates. However, in complex portfolios, many different types of exposures can arise.
- Basis risk: Banks can face basis risk if the interest-bearing assets and liabilities have different bases
such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate, in Indian Context
Mumbai Interbank Offered Rate (MIBOR). In some circumstances different bases will move at different
rates or in different directions, which can cause erratic changes in revenues and expenses.
- Reprising risk: Banks can also face repricing risk, that is, the risk presented by assets and liabilities that
reprice at different times and rates. For instance, a loan with a variable rate will generate more interest
income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated
deposits, the bank’s interest margin will fluctuate.
- Yield Curve risk: Yield curve risk is presented by differences between short-term and long-term
interest rates. Under normal circumstances, the short-term rates are lower than long-term rates, and
banks earn profits by borrowing short-term money and investing in long-term assets. However, any
change in the yield curve can dramatically affect bank’s earnings.
- Options risk: The optionality embedded in some assets and liabilities gives rise to options risk. This can
be seen in the prepayment speeds of the mortgage loans, with changing interest rates. Falling interest
rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested
cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to
repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is
difficult to measure and control.

b. Equity Price Risk: Equity price risk refers to the risk arising from the volatility in the stock prices. While
talking about equity risk, it is important to differentiate between systematic risk and unsystematic risk.
Systematic risk refers to the risk due to general market factors and affects the entire industry. It cannot be
diversified away. Unsystematic risk is the risk specific to a company that arises due to the company specific
characteristics. According to portfolio theory, this risk can be eliminated through diversification.

c. Foreign Exchange Risk: Foreign exchange risk arises because of the fluctuations in the currency exchange
rates. Companies may be exposed to the foreign exchange risk in their normal course of business because of the
unhedged positions or because on imperfect hedges.

d. Commodity Price Risk: Commodity Price Risk refers to the risk of unexpected changes in a commodity
price, such as the price of oil. These commodities may be grains, metals, gas, electricity etc. Commodity risk
affects various sections of people:

- Producers (Farmers, plantation companies, and mining companies)

- Buyers (Cooperatives, commercial traders, etc.), Exporters and Governments.

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The Yield Curve: The yield curve is a graph which plots time (from shortest to longest maturity date) on the
horizontal access, and yield on the vertical access. It is used to show the relationship between yield and
maturity.

Yield curves work best when plotting different maturity dates for the same type of bond, meaning that the only
major difference in the securities is their maturity date. For example, a yield curve could plot maturities and the
corresponding yields for treasury bonds, corporate bonds with high credit ratings, municipal bonds from a
particular state, or any other type of bond. On the horizontal axis of the yield curve we have the time to maturity
going from 6 months to 30 years. On the yield curve’s Y axis, we have the yield to maturity going from 0 to as
high a percentage as needed to incorporate the yields of all the maturities plotted.

Types of Yield Curves:

A. The Normal Yield Curve: Normally the yield curve is upward sloping showing that, all else being
equal, a bond with a longer maturity pays a higher yield than the same bond with a shorter maturity.
Generally speaking, individuals and institutions prefer to lend money for shorter periods of time, rather
than longer periods of time. The risk that the lender will need the funds, or the borrower will be unable
to pay, increases with time. Another way of saying this is that the longer the term of the loan or bond,
the greater the chance something unexpected will happen. To compensate for the extra risks associated
with lending money for longer periods of time, lenders generally demand a higher rate of interest.

B. The Steep Yield Curve: When investors are expecting interest rates to rise in the future, it makes sense
that they are going to demand a higher rate of return when buying longer term bonds. If longer term
bonds did not pay a higher rate of interest in this situation, investors would simply buy shorter term
bonds; with the expectation that when the bonds mature, they would be able obtain a higher return on
the next purchase. Often times, when the economy is coming out of a recession, future interest rate
expectations will increase. This is because economic recoveries are normally accompanied by
corporations wanting to borrow more (for investment) which increases the demand for money, putting
upward pressure on interest rates. This results in the yield curve steepening as you can see in the graph
below:

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C. The Flat Yield Curve: The yield curve is flat when yields of all maturities are close to one another.
This happens when inflation expectations have decreased to the point where investors are demanding no
premium for tying their money up for longer periods of time. Like with the inverted yield curve, when
the yield curve moves from normal to flat, this is generally a sign of a pending, or ongoing economic
slowdown.

D. The Humped Yield Curve: The yield curve is humped when short and long term rates are closer to
each other than with medium term rates. This generally happens when there is either an increase in
demand, or decrease in supply of longer term bonds. In recent years there has been a larger increase in
demand for 30 year treasury bonds for example, than for 20 year treasury bonds, causing the yield curve
for treasuries to often form a humped shape.

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E. The Inverted Yield Curve: The yield curve inverts when longer term rates are actually lower than short
term interest rates. This happens rarely, but when it does, it is one of the surest sings of an oncoming
economic slowdown, as investors anticipate less future demand for money and therefore lower interest
rates.

The level and structure of bond yields and the yield curve based upon three principles. 1) Across different
maturities along the yield curve, bond yields change with the proportional change in the risk or potential
volatility of the bonds. 2) The incremental yield required as a bond's volatility increases by an infinitesimal
amount is determined by the riskless interest rate. 3) The relationship between the yield of a bond and the
riskless interest rate is governed by expectations of future riskless interest rates over the term of the bond.

Determinants of Yield Curve Shape:

1. Pure Expectation of the Investors.

2. Liquidity Preference given by Investors.
3. Preference and will of an Investors.

Generally speaking the expectation of the investors is always to make high amount of returns on their
investment and they would like to go for higher rate of returns. They also prefer to convert their securities into
cash with a short span of time with a minimum loss and they may prefer short term market. Talking about
preference they give preference of shorter term investment with highest returns as well as less risk. Generally
the investors are risk averse in nature.

Introduction to VAR Model:

In financial mathematics and financial risk management, value at risk (VaR) is a widely used risk measure of
the risk of loss on a specific portfolio of financial assets. For a given portfolio, time horizon, and probability p,
the 100% VaR is defined as a threshold loss value, such that the probability that the loss on the portfolio over
the given time horizon exceeds this value is p. This assumes mark-to-market pricing, normal markets, and no
trading in the portfolio.

For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 0.05 probability that the
portfolio will fall in value by more than $1 million over a one day period if there is no trading. Informally, a
loss of $1 million or more on this portfolio is expected on 1 day out of 20 days (because of 5% probability). A
loss which exceeds the VaR threshold is termed a "VaR break."

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VaR has four main uses in finance: risk management, financial control, financial reporting and computing
regulatory capital. VaR is sometimes used in non-financial applications as well. Important related ideas are
economic capital, back testing, stress testing, expected shortfall, and tail conditional expectation.

VAR Model:

A statistical technique used to measure and quantify the level of financial risk within a firm or
investment portfolio over a specific time frame. Value at risk is used by risk managers in order to measure and
control the level of risk which the firm undertakes. The risk manager's job is to ensure that risks are not taken
beyond the level at which the firm can absorb the losses of a probable worst outcome.

Value at Risk is measured in three variables: the amount of potential loss, the probability of that amount of loss,
and the time frame. For example, a financial firm may determine that it has a 5% one month value at risk of
$100 million. This means that there is a 5% chance that the firm could lose more than $100 million in any given
month. Therefore, a $100 million loss should be expected to occur once every 20 months.

Value at Risk Advantages: Why Use VAR in Risk Management:

1. Value at Risk is easy to understand: VAR is just one number giving you a rough idea about the extent
of risk in the portfolio. Value at Risk is measured in price units (dollars, euros) or as percentage of
portfolio value. This makes VAR very easy to interpret and to further use in analyses, which is one of
the biggest advantages of Value at Risk.
2. Comparing VAR of different assets and portfolios: You can measure and compare VAR of different
types of assets and various portfolios. Value at Risk is applicable to stocks, bonds, currencies,
derivatives, or any other assets with price. This is why banks and financial institutions like it so much –
they can compare profitability and risk of different units and allocate risk based on VAR (this approach
is called risk budgeting). The limitation of Value at Risk as a risk budgeting tool is the fact that VAR is
not easily additive. VAR of a portfolio of two assets does not necessarily equal the sum of the single
asset VARs, as the correlations must also be taken into consideration.
3. VAR is often available in financial software: Value at Risk is a frequent part of various types of
financial software. For example, you can quickly calculate Value at Risk of your portfolio on
Bloomberg after entering holdings and setting a few parameters. You don’t have to be a statistics wizard
to do this, as the software takes historical data of securities in the portfolio and performs all calculations
for you. Availability is a big advantage of VAR.
4. Everybody else uses VAR: Though there are different opinions regarding whether its popularity is
justified (see limitations), Value at Risk is considered the gold standard, the part of risk management
101 in financial institutions. Of course, when your competitors use it, your clients require it, and
regulators recommend it, you have big reasons for using VAR too.

Value at Risk (VAR) Limitations:

1. Value at Risk can be misleading: false sense of security: Looking at risk exposure in terms of Value
at Risk can be very misleading. Many people think of VAR as ―the most I can lose‖, especially when it
is calculated with the confidence parameter set to 99%. Even when you understand the true meaning of
VAR on a conscious level, subconsciously the 99% confidence may lull you into a false sense of
security. Unfortunately, in reality 99% is very far from 100% and here’s where the limitations of VAR
and their incomplete understanding can be fatal.
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2. Value at Risk gets difficult to calculate with large portfolios: When you’re calculating Value at Risk
of a portfolio, you need to measure or estimate not only the return and volatility of individual assets, but
also the correlations between them. With growing number and diversity of positions in the portfolio, the
difficulty (and cost) of this task grows exponentially.
3. Value at Risk is not preservative: The fact that correlations between individual risk factors enter the
VAR calculation is also the reason why Value at Risk is not simply preservative. The VAR of a
portfolio containing assets A and B does not equal the sum of VAR of asset A and VAR of asset B.
4. The resulting VAR is only as good as the inputs and assumptions: As with other quantitative tools in
finance, the result and the usefulness of VAR are only as good as your inputs. A common mistake with
using the classical variance-covariance Value at Risk method is assuming normal distribution of returns
for assets and portfolios with non-normal skewness or excess kurtosis. Using unrealistic return
distributions as inputs can lead to underestimating the real risk with VAR.
5. Different Value At Risk methods lead to different results: There are several alternative and very
different approaches which all eventually lead to a number called Value At Risk: there is the classical
variance-covariance parametric VAR, but also the Historical VAR method, or the Monte Carlo VAR
approach (the latter two are more flexible with return distributions, but they have other limitations).
Having a wide range of choices is useful, as different approaches are suitable for different types of
situations. However, different approaches can also lead to very different results with the same portfolio,
so the representativeness of VAR can be questioned.
6. VAR does not measure worst case loss: 99% percent VAR really means that in 1% of cases (that
would be 2-3 trading days in a year with daily VAR) the loss is expected to be greater than the VAR
amount. Value at Risk does not say anything about the size of losses within this 1% of trading days and
by no means does it say anything about the maximum possible loss. The worst case loss might be only a
few percent higher than the VAR, but it could also be high enough to liquidate your company. Some of
those ―2-3 trading days per year‖ could be those with terrorist attacks, Kerviel detection, Lehman
Brothers bankruptcy, and similar extraordinary high impact events. You simply don’t know your
maximum possible loss by looking only at VAR. It is the single most important and most frequently
ignored limitation of Value at Risk.

How to calculate VaR: The power of value-at-risk lies in its generality. Unlike market risk metrics such as the
Greeks, duration and convexity, or beta, which are applicable to only certain asset categories or certain sources
of market risk, value-at-risk is general. It is based on the probability distribution for a portfolio’s market value.
All liquid assets have uncertain market values, which can be characterized with probability distributions. All
sources of market risk contribute to those probability distributions. Being applicable to all liquid assets and
encompassing, at least in theory, all sources of market risk, value-at-risk is a broad metric of market risk.

The generality of value-at-risk poses a computational challenge. In order to measure market risk in a portfolio
using value-at-risk, some means must be found for determining the probability distribution of that portfolio’s
market value. Obviously, the more complex a portfolio is the more asset categories and sources of market risk it
is exposed to the more challenging that task becomes.

It is worth distinguishing two concepts:

1. A value-at-risk measure is an algorithm with which we calculate a portfolio’s value-at-risk.
2. A value-at-risk metric is our interpretation of the output of the value-at-risk measure.

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A value-at-risk metric, such as one-day 90% USD VaR, is specified with three items:
a. A time horizon;
b. A probability;
c. A currency.

A value-at-risk measure calculates an amount of money, measured in that currency, such that there is that
probability of the portfolio not losing that amount of money over that horizon. In the terminology of
mathematics, this is called a quantile, so one-day 90% USD VaR is just the .90-quantile of a portfolio’s one day
loss.

This is worth emphasizing: value-at-risk is a quantile of loss. The task of a value-at-risk measure is to calculate
such a quantile. For a given value-at-risk metric, measure time in units of the value-at-risk horizon. Let time 0
be now, so time 1 represents the end of the horizon. We know a portfolio’s current market value 0p. Its
market value 1P at the end of the horizon is unknown. Define portfolio loss 1L as
1
L = 0p – 1P

If 0p exceeds 1P, the loss will be positive. If 0p is less than 1P, the loss will be negative, which is another way of
saying the portfolio makes a profit.

Because we don’t know the portfolio’s future value 1P, we don’t know its loss 1L. Both are random variables,
and we can assign them probability distributions. That is exactly what a value-at-risk measure does—in assigns
a distribution to 1P and/or 1L, so it can calculate the desired quantile of 1L. Most typically, value-at-risk
measures work directly with the distribution of 1P and use that to infer the quantile of 1L. This is illustrated in
Exhibit 1 for a 90% VaR metric.

Exhibit 1 shows how the .90-quantile of 1L (the portfolio’s value-at-risk) can be obtained as the .10-quantile
of 1P minus the portfolio’s current value 0p. Other value-at-risk metrics can be valued similarly. So if we know
the distribution for 1P, calculating value-at-risk is easy. The challenge for any value-at-risk measure is
constructing that distribution of 1P. Value-at-risk measures do so in various ways, but all practical value-at-risk
measures share certain features described below.

Because value-at-risk measures are probabilistic, they deal with various random financial variables. Three types
are particularly significant and are given standard notation:

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 Portfolio value 1P;

 Asset values 1Si; and
 Key factors 1Ri.

We have already discussed portfolio value 1P, which is the portfolio’s market value at time 1—the end of the
value-at-risk horizon. It has current value 0p. Mathematically, a portfolio is defined as an ordered pair (0p, 1P).

Asset values 1Si represent the accumulated value at time 1 of individual assets held by the portfolio. Individual
assets might be stocks, bonds, futures, options or other instruments. Current asset values are denoted 0si.
Mathematically, we define an asset as an ordered pair (0si,1Si). The m asset values 1Si comprise an ordered set
(or ―vector‖) called the asset vector, which we denote 1S. Its current value 0s is the ordered set of asset current
values 0si.

Key factors 1Ri represent values at time 1 of financial variables that can be used to value the assets. Depending
on the composition of the portfolio, key factors might represent exchange rates, interest rates, commodity
prices, spreads, implied volatilities, etc. The n key factors 1Ri comprise an ordered set called the key vector,
which we denote 1R. Value-at-risk measures utilize not only the current value 0r for the key vector but also
other historical values –1r, –2r, –3r, … , –αr:

Where are we going with this? The quantities 1P, 1Si and 1Ri are all random. But the portfolio’s value 1P is a
function of the values 1Si of the assets it holds. Those in turn are a function of the key factors 1Ri. For example, a
bond portfolio’s value 1P is a function of the values 1Si of the individual bonds it holds. Their values are in turn
functions of applicable interest rates 1Ri. Because a function of a function is a function, 1P is a function θ of 1R:
1
P = θ (1R)

Value-at-risk measures apply time series analysis to historical data 0r, –1r, –2r, …, –αr to construct a joint
probability distribution for 1R. They then exploit the functional relationship θ between 1P and1R to convert that
joint distribution into a distribution for 1P. From that distribution for 1P, value-at-risk is calculated, as illustrated
in Exhibit 1 above.

Let’s formalize this. Exhibit 2 summarizes the components common to all practical value-at-risk measures:

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Exhibit 2: All practical value-at-risk measures accept portfolio holdings and historical market data as inputs.
They process these with a mapping procedure, inference procedure, and transformation procedure. Output
comprises the value of a value-at-risk metric. That value is the value-at-risk measurement.

Note: Exhibit 2 is in next page:-

A value-at-risk measure accepts two inputs:

 historical data 0r, –1r, –2r, … , –αr for 1R, and

 The portfolio’s holdings ω.

The portfolio holdings comprise a row vector ω whose components indicate the number of units held of each
asset. For example, if a portfolio holds 1000 shares of IBM stock, 5000 shares of Google stock and a short
position of 3000 shares of Microsoft stock, its holdings are

ω = (1000 5000 3000)

The two inputs—historical data and portfolio holdings—are processed separately by two procedures within the
value-at-risk measure:

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 An inference procedure applies methods of time series analysis to the historical data 0r, –1r, –2r, … , –
α
r to construct a joint distribution for 1R.

 A mapping procedure uses the portfolio’s holdings ω to construct a function θ such that 1P = θ (1R).

The mapping procedure uses a set of pricing functions φi that value each asset 1Si in terms of 1R:
1
Si = φi(1R)

A transformation procedure accepts as inputs

 a joint distribution for 1R, and

 a portfolio mapping θ, which can be either a primary mapping or a remapping.

It uses these to construct a distribution for 1P from which it calculates the portfolio’s value-at-risk.

Approaches or Methods of VaR:

The most popular and traditional measure of risk is volatility. The main problem with volatility, however, is that
it does not care about the direction of an investment's movement: a stock can be volatile because it suddenly
jumps higher. Of course, investors are not distressed by gains!

For investors, risk is about the odds of losing money, and VAR is based on that common-sense fact. By
assuming investors care about the odds of a really big loss, VAR answers the question, "What is my worst-case
scenario?" or "How much could I lose in a really bad month?"

Now let's get specific. A VAR statistic has three components: a time period, a confidence level and a loss
amount (or loss percentage). Keep these three parts in mind as we give some examples of variations of the
question that VAR answers:

 What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next
month?

 What is the maximum percentage I can - with 95% or 99% confidence - expect to lose over the next
year?

You can see how the "VAR question" has three elements: a relatively high level of confidence (typically either
95% or 99%), a time period (a day, a month or a year) and an estimate of investment loss (expressed either in
dollar or percentage terms). There are three normal methods of calculating VAR: the historical method, the
variance-covariance method and the Monte Carlo simulation.

1. Historical Method: The historical method simply re-organizes actual historical returns, putting them in
order from worst to best. It then assumes that history will repeat itself, from a risk perspective. The
QQQ started trading in Mar 1999, and if we calculate each daily return, we produce a rich data set of
almost 1,400 points. Let's put them in a histogram that compares the frequency of return "buckets". For
example, at the highest point of the histogram (the highest bar), there were more than 250 days when the
daily return was between 0% and 1%. At the far right, you can barely see a tiny bar at 13%; it represents
the one single day (in Jan 2000) within a period of five-plus years when the daily return for the QQQ
was a stunning 12.4%!
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Notice the red bars that compose the "left tail" of the histogram. These are the lowest 5% of daily returns (since
the returns are ordered from left to right, the worst are always the "left tail"). The red bars run from daily losses
of 4% to 8%. Because these are the worst 5% of all daily returns, we can say with 95% confidence that the
worst daily loss will not exceed 4%. Put another way, we expect with 95% confidence that our gain will exceed
-4%. That is VAR in a nutshell. Let's re-phrase the statistic into both percentage and dollar terms:

 With 95% confidence, we expect that our worst daily loss will not exceed 4%.
 If we invest $100, we are 95% confident that our worst daily loss will not exceed $4 ($100 x -4%).
You can see that VAR indeed allows for an outcome that is worse than a return of -4%. It does not express
absolute certainty but instead makes a probabilistic estimate. If we want to increase our confidence, we need
only to "move to the left" on the same histogram, to where the first two red bars, at -8% and -7% represent the
worst 1% of daily returns:

 With 99% confidence, we expect that the worst daily loss will not exceed 7%.
 Or, if we invest $100, we are 99% confident that our worst daily loss will not exceed $7.

2. The Variance-Covariance Method: The variance-covariance, or delta-normal, model was popularized

by J.P Morgan (now J.P. Morgan Chase) in the early 1990s when they published the Risk Metrics
Technical Document. In the following, we will take the simple case, where the only risk factor for the
portfolio is the value of the assets themselves. This method assumes that stock returns are normally
distributed. In other words, it requires that we estimate only two factors - an expected (or average) return
and a standard deviation - which allow us to plot a normal distribution curve. Here we plot the normal
curve against the same actual return data:

The idea behind the variance-covariance is similar to the ideas behind the historical method - except that we use
the familiar curve instead of actual data. The advantage of the normal curve is that we automatically know
where the worst 5% and 1% lie on the curve. They are a function of our desired confidence and the standard
deviation ( ):
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Confidence # of Standard Deviations (σ)

95% (high) - 1.96 x σ

99% (really high) - 2.58 x σ

The blue curve above is based on the actual daily standard deviation of the QQQ, which is 2.64%. The average
daily return happened to be fairly close to zero, so we will assume an average return of zero for illustrative
purposes. Here are the results of plugging the actual standard deviation into the formulas above:

Confidence # of σ Calculation Equals

95% (high) - 1.96 x σ - 1.96 x (2.64%) = -5.17%

99% (really high) - 2.58 x σ - 2.58 x (2.64%) = -6.81%

3. Monte Carlo Simulation: The third method involves developing a model for future stock price returns
and running multiple hypothetical trials through the model. A Monte Carlo simulation refers to any
method that randomly generates trials, but by itself does not tell us anything about the underlying
methodology.

For most users, a Monte Carlo simulation amounts to a "black box" generator of random outcomes.
Without going into further details, we ran a Monte Carlo simulation on the QQQ based on its historical
trading pattern. In our simulation, 100 trials were conducted. If we ran it again, we would get a different
result--although it is highly likely that the differences would be narrow. Here is the result arranged into a
histogram (please note that while the previous graphs have shown daily returns, this graph displays
monthly returns):

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To summarize, we ran 100 hypothetical trials of monthly returns for the QQQ. Among them, two outcomes
were between -15% and -20%; and three were between -20% and 25%. That means the worst five outcomes
(that is, the worst 5%) were less than -15%. The Monte Carlo simulation therefore leads to the following VAR-
type conclusion: with 95% confidence, we do not expect to lose more than 15% during any given month.

If the VAR is systematically ―too low‖, the model is underestimating the risk and you tend to have too many
occasions where the loss in the portfolio exceeds the VAR. This can lead to an increase in the ―multiplier‖ for
the capital calculation.

If the VAR is systematically ―too high‖, the model is over estimating the risk and your regulatory capital charge
will be too high

Stress Testing: Stress testing is the process of determining the ability of a computer, network, program or
device to maintain a certain level of effectiveness under unfavorable conditions...

Stress testing (sometimes called torture testing) is a form of deliberately intense or thorough testing used to
determine the stability of a given system or entity. It involves testing beyond normal operational capacity, often
to a breaking point, in order to observe the results. Reasons can include:
- To determine breaking points or safe usage limits.
- To confirm intended specifications are being met.
- To determine modes of failure (how exactly a system fails)
- To test stable operation of a part or system outside standard usage

Reliability engineers often test items under expected stress or even under accelerated stress in order to
determine the operating life of the item or to determine modes of failure. The term "stress" may have a more
specific meaning in certain industries, such as material sciences, and therefore stress testing may sometimes
have a technical meaning – one example is in fatigue testing for materials.

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Techniques of Stress Testing:

1. Simple Sensitivity Test: Short term impact on portfolio. Ex: +2 or -2 changes in prices.
2. Scenario Analysis: Based on historical event or a hypothetical event.
3. Maximum Loss: Most potentially damaging combination of moves of market risk.
4. Extreme Value Theory: Extreme possible circumstances & works on ―tails‖.(High/Low)

Essentials of Good Stress Testing:

1. Be relevant to the Current Position

2. Consider changes in all relevant market rates.
3. Examine potential regime shifts (whether the current risk parameters will hold or breakdown).
4. Stress tests should spur discussion.
5. Consider market illiquidity.
6. Consider the interplay of market and credit risk.

Steps of Stress Testing:

A. Generate Scenarios:
B. Revalue Portfolio:
C. Summaries Results:

Introduction to Back Testing:

The process of testing a trading strategy on prior time periods. Instead of applying a strategy for the time period
forward, which could take years, a trader can do a simulation of his or her trading strategy on relevant past data
in order to gauge its effectiveness.

When you back test a theory, the results achieved are highly dependent on the movements of the tested period.
Back testing a theory assumes that what happens in the past will happen in the future, and this assumption can
cause potential risks for the strategy.

For example, say you want to test a strategy based on the notion that Internet IPOs outperform the overall
market. If you were to test this strategy during the dotcom boom years in the late 90s, the strategy would
outperform the market significantly. However, trying the same strategy after the bubble burst would result in
dismal returns.

Back testing is a valuable tool available in most trading platforms. Dividing historical data into multiple sets to
provide for in-sample and out-of-sample testing can provide traders a practical and efficient means for
evaluating a trading idea and system. Since most traders employ optimization techniques in back testing, it is
important to then evaluate the system on clean data to determine its viability. Continuing the out-of-sample
testing with forward performance testing provides another layer of safety before putting a system in the market
risking real cash. Positive results and good correlation between in-sample and out-of-sample back testing and
forward performance testing increases the probability that a system will perform well in actual trading.

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