ISLAMIC RISK MANAGEMENT

Module 3:
Value at Risk

Lecturer : DR Muhammad Syarif Surbakti, CA,MSc

1

Syllabus
Class
Class Meeting
Meeting Pre-Mid Semester Test Session Session Pre-Mid Semester Test Session
Session

Risk Management in Islamic

1 8 Understanding value at risk
Perspective

2 Islamic risk management framework 9 Applied measuring financing risk

Risk management for Islamic profit

3 10 Applied measuring operational risk
sharing contracts
Risk management for Islamic buy &
4 11 Applied measuring market risk
sell contracts
Risk management for Islamic tabaruk
5 12 Applied measuring liquidity risk
contracts
Risk management for Islamic Financial
6 13 Group presentation
Institution
Mid‐semester test (group Mid‐semester test (group
7 14
presentation) presentation)

Islamic Risk Management

Lecturer: Dr. Muhammad Syarif Surbakti, SE.Ak., MSc
 Course Objectives

Definisi dan fungsi VAR

Metode mengukur VAR
Aplikasi Historical Simulation VAR calculation
Aplikasi Variance-Covariance VAR calculation
Aplikasi Monte Carlo Simulation VAR calculation

Islamic Risk Management

Lecturer: Dr. Muhammad Syarif Surbakti, SE.Ak., MSc 3

Risk Management Process

5 2

4 3

4
 Indicative Risk Spectrum Faced
By Islamic Financial Institution

1. 2. 3. 4.
FINANCIAL MARKET OPERATIONAL LIQUIDITY
RISK RISK RISK RISK

6. 7. 8.
5.
REPUTATIONAL STRATEGIC COMPLIANCE
LEGAL RISK
RISK RISK RISK

Group Discussion:
9. 10. Identifikasi risiko yang
RATE OF INVESTMENT paling signifikan
RETUN RISKS RISKS dihadapi Islamic
Banking.
Mengapa? 5

SCOPE RISK MANAGEMENT

No Partial Complete
Information Information information

Total General Specific Total

Uncertainty uncertainty Uncertainty Certainty

SCOPE OF RISK MANAGEMENT

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 A Deeper Sight on Operational Risk

DEFINITION OF
OPERATIONAL RISK ?

The risks of direct or indirect losses

resulting from inadequate or failed
internal process, people and systems
or from external events.

3.
OPERATIONAL
RISK
Operational Risk Management 6.
REPUTATIO-
NAL RISK
8.
Main factors of Operational Risk: COMPLIANCE
RISK

 Business strategy and policy

•People  Business process and risk management
•Internal Processes  People
•External Events  Management report
•Systems  Methodology
 System and Data
 External event
Financial Loss
Direct Loss The Effects of Operational Risk
1. Money Loss
2.
3.
Fine or Penalties
Compensation
FI Employee Stakeholder
4. Loss of Assets
5. High Operating Costs
6. Legal Costs, etc. Non Financial Loss
Indirect Loss  Value  Prosperity  Trustfulness
 Image  Moral  Satisfaction
P 1. Loss of Customer  Profit & Loss  Motivation  Security
2. Loss of Market Share
& 3. Customer Complaints
4. Opportunity Loss


Capital
E.t.c


Composure
PHK, dll


Public cost
E.t.c
L 5. Reputation
6. Loss of staffs, etc.

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 Typical Operational Risk Events
Event Types Categories
1. Internal Fraud Unauthorizeed activities
Theft & fraud
Theft & fraud (by external)
2. External Fraud
Systems security
Typical Operational Risk Events
Event Types Categories
3. Employment
Practices and Employee relations
Workplace Safety
Safe environment
Diversity &
discrimination
Activity Examples
Transaction not reported
Unauthorized transaction
Corruption
Misappropriation of asset
Forgery (pemalsuan)
Bribes/kickbacks (suap/komisi)
Theft/robbery
Forgery (insurance claim)
Hacking damage
Theft of information
(w/ monetary loss)
Activity Examples
Compentation, benefit,
termination issues
Organized labour activity
Corruption
Misappropriation of asset
Forgery (pemalsuan)
Bribes/kickbacks (on deposit)
All discrimation types
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 Operational Risk Events
Event Types
4. Clients, Products, &
Business Practices
Typical Operational Risk Events
Event Types
5. Damage to Physical
Assets (natural disaster or
other event)
6. Business Disruption
& System Failures
Categories Activity Examples
Fiduciary breaches
Suitability, disclosure, Guidelines violations
and fiduciary Breache of privacy
Misuse of confidential informtion
Antiturst
Improper business or Improper market/trade practices
market practices Market manipulation
Unlicensed activities
Failure to investigate clients
Selection, sponsoship, per guideines
and exposure Exceeding client exposure
limit
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Categories Activity Examples
Natural disaster losses
Human losses from external
Disaster or other event
sources (terrorism,
vandalism)
Hardware
Software
Systems
Telecommunications
Utility outage/disruptions
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 Typical Operational Risk Events

Event Types Categories Activity Examples

7. Execution, Miscommunication
Transaction capture,
Delivery, and Data entry, maintenance or
execution and
Process loading error
maintenance Accounting error
Management
Delivey failure

Failed mandatory reporting

obligation
Monitoring & reporting
Inaccurate external report
(loss incurred)

Unapproved access given to

Customer/client account accounts
management Incorrect client records (loss
incurred)

Outsourcing
Vendors & suppliers
Vendor dispute
13

Example of Casual Mapping

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 Frequency & Severity
Total Losses (IDR million) by Cause Amount for Period last 5 years

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Risk Maps
L
Certain/
.Sangat
Almost

Tinggi

I
K
Likely/
Tinggi

E
L
I
Possible/
Sedang

H
O
Unlikely/
Rendah

O
D
Rendah
Sangat
Rare/

Sangat Rendah Sedang Tinggi Sangat Tinggi

Rendah

I M P A C T/Consequences
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 OPERATIONAL
RISK
Unit Usaha : PT Semen Baturaja (Persero)

1/16/2021 17

VALUE AT RISK

VALUE AT RISK

• Definition :
– The expected maximum loss ( or worst loss ) over a target
horizon within a given confidence interval

• Evolved through the requirements of SEC to provide a

minimum capital requirement in provision for risks
taken by financial institutions

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VALUE AT RISK
The Idea Behind 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: stock can be volatile
because it suddenly jumps higher.

• For investors, the 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?"

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VALUE AT RISK
The Idea Behind VAR
• Now let's get specific. A VAR statistic has three
components:
a. time period,
b. confidence level and
c. 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 expect to lose in dollars over the next
month, with a 95% or 99% level of confidence?
 What is the maximum percentage I can expect to lose over
the next year with 95% or 99% confidence?

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VALUE AT RISK
The Idea Behind VAR
• You can see how the "VAR question" has three
elements:
a. relatively high level of confidence (typically either
95% or 99%),
b. time period (a day, a month or a year) and
c. estimate of investment loss (expressed either in
dollar or percentage terms).

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JENIS-JENIS LOSS
Expected Loss Unexpected Loss
Exceptional Loss
(EL) (UL)

Mode (most
frequent)
? EL EL + UL

Probability
of loss < EL Probability of loss < UL :
Probability

α (loss) = 0,9%
Confidence level
α (loss) = 0,1%
99%
confidence level Confidence level

Losses = 0 Losses (Rp)

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Expected Losses UL = VAR Exceptional loss
 EXPECTED LOSS
Definisi :
EXPECTED LOSS (UL) adalah kerugian rata-
rata (mean) yang diantisipasi terjadi pada
periode yang akan datang.
(informasi penting untuk menetapkan pricing dan reserve)

Rumus menghitung EL
EL   Loss
event i
i  p(L)

dimana :
EL = expected loss;
P(L) = probability of loss

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UNEXPECTED LOSS
Definisi :
UNEXPECTED LOSS (UL) adalah risiko kerugian yang
berpotensi diderita oleh suatu perusahaan dalam
jumlah yang besar.
(kerugian ini harus dibackup oleh ketersediaan modal yang cukup)

Rumus sederhana menghitung UL ?

UL   p(L)
event i
i  (Loss i - EL) 2

dimana :
UL = unexpected loss;
EL = expected loss

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Models to estimate VaR
• Historical Market Data
– assumption is that historical market data is our best
estimator for future changes and that
– asset returns in the future will have the same distribution as
they had in the past

• Variance – Covariance (VCV)

– assuming that risk factor returns are always (jointly)
normally distributed and that the change in portfolio value is
linearly dependent on all risk factor returns

• Monte Carlo Simulation

– future asset returns are more or less randomly simulated

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1. Historical Market Data

• involves running the current portfolio across a set of historical
price changes to yield a distribution of changes in portfolio value,
and computing a percentile (the VaR).

• Benefits
– Simple to implement
– does not assume a normal distribution of asset returns

• Drawbacks
– requires a large market database
– computationally intensive calculation.

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1. Historical Market Data
• 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.

• As a historical example, let's look at the Nasdaq 100 ETF, which

trades under the symbol QQQ (sometimes called the "cubes"),
and which started trading in March of 1999. If we calculate each
daily return, we produce a rich data set of more than 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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1. Historical Market Data

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1. Historical Market Data
• 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%).

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1. Historical Market Data

• We 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

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VALUE AT RISK (VAR)

Market Value
x
Risk Variability
x
time horizon in year
x
Confidence Level
=
Worst Loss

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DEFINITION :

• Market Value :
– Current market value of the respective transaction to be
managed
– Mark to market at the end of time horizon

• Risk variability :
– Usually the standard deviation of the risk to be managed
– The higher the variability the higher is VAR

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DEFINITION :

• Time Horizon :
– Time period to be considered correspond to time required for
corrective actions as losses starts to develop
– Annualized
– The longer the time horizon the higher is VAR

• Confidence Level :
– Confidence level of loss occurring
– The higher the confidence level the higher is VAR

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Example :
• Current market value of transaction USD 100,000 paid by 3
months usance L/C

• Standard deviation of Rp/USD is 10%

• Time horizon is 3 months

• Confidence level is 95%

• VAR = 100,000 X 0.10 X X 0.95

3
12

= USD 4,750.00  Maximum expected loss

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WEAKNESSES OF HISTORICAL SIMULATION

• Past is not prologue, history does not always

repeat it selves

• Trends in the data, since all data are treated

equal, despite the fact that some periods
might experience higher volatility

• For new assets or market risks no historical

data available

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MODIFICATIONS OF HISTORICAL SIMULATION

• Weighting the recent past more, assuming that
the recent past is a better predictor of the immediate
future than the distant past ( can be using indexes to
adjust each return based on its timeline)

• Combining historical simulation with time

series models, by fitting a time series models
through the historical data

• Volatility updating, by comparing past volatility

with recent volatility and then adjusting the past return
accordingly e.g. past volatility = 0.5, recent volatility
0.75, past return 10%, recent predicted return is
0.75/0.5* 10%=15%

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2. Variance – Covariance (VCV)
• This method assumes that stock returns are
normally distributed. In other words, it requires
that we estimate only two factors:
 EXPECTED (or average) return, and
 STANDARD DEVIATION, which allow us to plot
a normal distribution curve.
Here we plot the normal curve against the same
actual return data:

• Hence are the returns also normally distributed

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2. Variance – Covariance (VCV)

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2. Variance – Covariance (VCV)
• 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.
Confidence # of Standard
Deviations (σ)
95% (high) - 1.65 x σ
99% (really high) - 2.33 x σ

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2. Variance – Covariance (VCV)

• 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 Standard Calculation Equals
Deviations (σ)
95% (high) - 1.65 x σ - 1.65 x (2.64%) = -4.36%
99% (really high) - 2.33 x σ - 2.33 x (2.64%) = -6.15%

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2. Variance – Covariance (VCV)
VAR formula for VCV :

VaR   * sigma of confidence level

σ = standard deviation of the risk

 Sigma for 95% confidence level is 1.645
 Sigma for 99% confidence level is 2.33

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EXAMPLE :
Exchange Loss / Probability 2 2
rate (USD/Rp) Gain () 
9.600 -400 0.025 4.000

9.700 -300 0.025 2.250

9.800 -200 0.050 2.000

9.900 -100 0.200 2.000

10.000 0 0.400 0

10.100 100 0.200 2.000

10.200 200 0.050 2.000

10.300 300 0.025 2.250

10.400 400 0.025 4.000

Average = 0  2 = 20.500

 = 143.18

With 95% confidence interval the VAR = 1.645 * Rp. 143.18= Rp. 235.53
 The maximum potential loss for exchange rate risk is Rp. 235.53

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ASSESMENT OF V-CV METHOD
• Strength :
simple to compute after making assumptions about the distribution of
returns and inputted the means, variances and covariances or returns

• Weaknesses :
Wrong distributional assumptions, if it turns out that the returns a re not
normally distributed and the outliers are higher, computed VaR can be lower
that actual VaR

Input error, if data used to calculate are for example based on historical
data, which is not reflecting the current situation

Nonstationary variables, happens if the underlying assumed correlation

does not hold anymore, e.g. interest rate is adjusted by FED

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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, probabilistic 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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3. Monte Carlo Simulation
• To summarize, we ran 100 hypothetical trials of monthly returns
for the QQQ:
 Among them, two outcomes were between -15% and -20%;
 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.

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3. Monte Carlo Simulation

• Decide on N, the number of iterations to perform.
• For each iteration:
– Generate a random scenario of market moves using some market
model.
– Revalue the portfolio under the simulated market scenario.
– Compute the portfolio profit or loss (PnL) under the simulated
scenario. (i.e., subtract the current market value of the portfolio
from the market value of the portfolio computed in the previous
step).
• Sort the resulting PnLs to give us the simulated PnL distribution
for the portfolio.
• VaR at a particular confidence level is calculated using the
percentile function.
• For example, if we computed 5000 simulations, our estimate of
the 95% percentile would correspond to the 250th largest loss;
i.e., (1 - 0.95) * 5000.

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STRENGTH OF MONTE CARLO SIMULATION

• Does not need to rely on historical data, those historical data

can still be used as benchmark and then adjust accordingly

• Does not need to assume normal distribution for the returns

• Can be used for any type of portfolio including options or

option like securities

WEAKNESSES OF MONTE CARLO SIMULATION

• Needs to estimate the probability distribution for all the

market risk variables that we want to consider

• Number of simulations that need to be run on the model will

be substantially large
MODIFICATION ON MONTE CARLO SIMULATION
• Scenario simulation, only likely combination are run through
the model

• Monte Carlo simulation with Variance-Covariance

method modification, assuming normal distribution for the
returns

Indications on method to use

• For Value at Risk for portfolios, that do not include options, over
very short time periods (a day or a week) and normality can be
assumed, the variance-covariance approach does a reasonably
good job.

• If the risk source is stable and there is substantial historical data

(commodity prices, for instance), historical simulations provide
good estimates.

• In the most general case of computing VaR for nonlinear portfolios

(which include options) over longer time periods, where the
historical data is volatile and non-stationary and the normality
assumption is questionable, Monte Carlo simulations do best.
LIMITATIONS OF VaR :

• Return distributions cannot always be

correctly predicted
• History may not be a good predictor
• Nonstationary correlations
• Only looking at the downside risk (negative
side of risk)
• Best for calculating short term risk
• Difficult to use for comparing different
investments

VaR can lead to suboptimal decision

• Overexposure to risk, managers will tend to be more bold in
making risky investments while actually the rest of 5-10%
probability of incurring risk might be huge

• Agency problem, because VaR usually uses past data,

managers who knows about irregularity in the volatility can misuse
them for his own advantage.
Convert VAR To Different Time Periods
Converting One Time Period to Another

• We had calculated VAR for the Nasdaq 100 index (ticker: QQQ)
and establish that VAR answers a three-part question: "What is
the worst loss that I can expect during a specified time period
with a certain confidence level?"

• Since the time period is a variable, different calculations may

specify different time periods - there is no "correct" time
period. Commercial banks, for example, typically calculate
a daily VAR, asking themselves how much they can
lose in a day; pension funds, on the other hand, often
calculate a monthly VAR.

Convert VAR To Different Time Periods

Converting One Time Period to Another
• To recap briefly, let's look again at our calculations of three VARs in part
1 using three different methods for the same "QQQ" investment:
Inves VAR Daily  Time Calc. VAR 250 days
tment Method Period VAR
 95% CL 99% CL

-1.65x2.5%x√250 -2.33x2.5%x√250
QQQ Historical 2.50% Daily -4% = -65% = -92%
- -
Variance- -
QQQ 2.64% Daily 1.65x2.64%x√250 2.33x2.64%x√250
Covariance 6.16% = -69% = -97%
Monte
-1.65x3.75%x√12 -2.33x2.64%x√12
QQQ Carlo 3.75% Monthly -15% = -21% = -30%
Simulation
Discussion Corner: Islamic Perspective -

 Menurut Anda, Teknik:

 Historical Simulation VAR calculation
 Aplikasi Variance-Covariance VAR calculation
 Aplikasi Monte Carlo Simulation VAR calculation
Bertentangan Syariah atau Syariah Compliant?
Jika bertentangan, tunjukkan dan jelaskan rujukan
ayat Al-Quran dan/atau hadist yang dilanggar.
Jika Syariah compliant, tunjukkan dan jelaskan
ayat Al-Quran dan/atau hadist yang mendukung.

Continued to the next course