Measurement of Market Risk

Market Risk

• Directional risk

• Relative value risk

• Price risk

• Liquidity risk

Type of measurements

– scenario analysis

– statistical analysis
 Scenario Analysis

• A scenario analysis measures the change in market

value that would result if market factors were changed
from their current levels, in a specified way. No
assumption about probability of changes is made.

• A stress test is a measurement of the change in the

market value of a portfolio that would occur for a
specified unusually large change in a set of market
factors.
 Value at Risk
• A single number that summarizes the likely loss in
value of a portfolio over a given time horizon with
specified probability.
• C-VaR states expected loss conditional on change in
value in the left tail of the distribution.
• Three approaches
– Historical simulation
– Model-building approach
– Monte Carlo simulation
 Historical Simulation
• Identify market variables that determine the portfolio
value
• Collect data on movements in these variables for a
reasonable number of historical days
• Build scenarios that mimic changes over the
historical period
• For each scenario calculate the change in value of
the portfolio over the specified time horizon
• From this empirical distribution of value changes
calculate VaR
 Model Building Approach

• Portfolio of n-assets

• Calculate mean and standard deviation of change in

the value of portfolio for one day

• Assume normality

• Calculate VaR
 Monte Carlo Simulation

• Value of the portfolio today

• Draw samples from the probability distribution of

changes of the market variables

• Using the sampled changes calculate the new portfolio

value and its change

• From the simulated probability distribution of changes

in portfolio value calculate VaR

 Pitfalls of Normal Distribution Based VaR

• Normality assumption may not be valid for tail part of the

distribution

• VaR of a portfolio is not less than weighted sum of VaR

of individual assets (not sub-additive)

• Expected shortfall conditional on the fact that loss is

more than VaR is a sub-additive measure of risk

 Pitfalls of Value-at-Risk

• VaR is a statistical measurement of price risk

• VaR assumes a static portfolio. It does not take into

account

– Structural change in the portfolio that would

contractually occur during the period

– Dynamic hedging of the portfolio

• VaR calculation has two basic components

– Simulation of changes in market rates

– Calculation of resultant changes in the portfolio value

 Value-at-Risk
VaR (Value-at-Risk) is a measure of the risk in a portfolio over
time.

Quoted in terms of a time horizon and a confidence level.

Example: 10 day 95% VaR is the size of loss X that will not
happen 95% of the time over the next 10 days.

Value-at-Risk
X 95%
5%

(Profit/Loss Distribution)
 Value-at-Risk Levels

Two standard VaR levels are 95% and 99%.

95% is 1.645 standard deviations from the mean

99% is 2.33 standard deviations from the mean

mean
 Value-at-Risk Assumptions

1) Percentage change (return) of assets is Gaussian:

dS
dS  Sdt  Sdz or  dt  dz
S

S
  t   z
S
Normal Distribution
 Value-at-Risk Assumptions

2) Mean return m is zero:

S
  t   z
S
Mean of t is.
t ~ O(t )
Standard deviation of ∆t is.
z ~ O(t1/ 2 )
Time is measured in years, hence t or change in
time is insignificant. Hence the mean μ is not taken
into consideration and the mean return is stated as:
S  Sz
 VaR and Regulatory Capital

Regulators require banks to keep capital for market risk

equal to the average of VaR estimates for past 60

trading days using confidence level of 99% and number

of days (N) =10, times a multiplication factor

(multiplication factor equals 3).

 Advantages of VaR

• Captures an important aspect of risk in a single number

• Easy to understand

• Indicates the worst loss that could happen

 Daily Volatilities

• Option pricing (volatility is express as volatility per year)

• aR calculations (volatility is express as volatility per day)

 year
 day   0.063   year  6%   year
252
 Daily Volatility

• day is defined as the standard deviation of the

continuously compounded return in one day

• In practice it is also assumed that it is the standard

deviation of the proportional change in one day

 Example
• Based on 60 days prior trading data the following
computations have been made
• Volatility of a bank is 2% per day (about 32% per year)
• Assume N=10 and confidence level is 99 %
• Standard deviation of the change in the market price (₹
60,000) in 1 day is ₹ 1,200 (2% x 60,000)
• Standard deviation of the change in 10 days is
1,200 x V10 = 3,794.733 (1,200 x 10 )
 Example (continued)

• Assume that the expected change in the value of the

bank’s share is zero

• Assume that the change in the value of the bank’s share

is normally distributed

• Since N(0.01)= -2.33, ({Z<-2.33}=0.01)

the VaR is

2.33 x 3,794.733 = ₹ 8,846.728.

 Example (continued)

• VaR for one year (252 days) = ₹ 44,385.12

• Bank’s Gross Income = ₹ 1,869,906

• 15% of Gross Income = ₹ 280,485.

• Capital charge for operational risk = ₹ 280,097.

• Bank’s current share capital will be related to risk weights

assessed by the capital charge.

 Value-at-Risk

• An estimate of potential loss in a

– Position

– Asset

– Liability

– Portfolio of assets

– Portfolio of liabilities

• During a given holding period at a given level of certainty

 Value-at-Risk

• Probability of the unexpected happening

• Probability of suffering a loss

• Estimate of loss likely to be suffered

• VaR is not the actual loss

• VaR measures potential loss and not potential gain

• VaR measures the probability of loss for a given time

period over which the position is held

 Bank for International Settlement (BIS)
• VaR is a measurement of market risk
• Provision of capital adequacy for market risk, subject to
approval by banks' supervisory authorities
• Computation of VaR changes based on the estimated
time period
– One day
– One week
– One month
– One year
 Bank for International Settlement (BIS)

• Holding period for an instrument will depend on liquidity

of the instrument

• Varying degrees of certainty changes potential loss

• VaR estimates that the loss will not exceed a certain

amount

• VaR will change with different levels of certainty

 VaR Methodology

• Computed as the expected loss on a position from an

adverse movement in identified market risk parameter(s)

• Specified probability over a nominated period of time

• Volatility in financial markets is calculated as the

standard deviation of the percentage changes in the
relevant asset price over a specified asset period

• Volatility for calculation of VaR is specified as the

standard deviation of the percentage change in the risk
factor over the relevant risk horizon
 VaR Computation Method

• Correlation Method

– Variance – covariance method

– Deterministic approach

– Change in value of the position computed by combining

the sensitivity of each component to price changes in

the underlying assets

 VaR Computation Method
• Historical Simulation

– Change in the value of a position using the actual

historical movements of the underlying assets

– Historical period has to be adequately long to capture

all possible events and relationships between the
various assets and within each asset class

– Dynamics of the risk factors captured since simulation

follows every historical move
 VaR Computation Method
• Monte Carlo Simulation

– Calculates the change in the value of a portfolio using a

sample of randomly generated price scenarios

– Assumptions on market structures, correlations

between risk factors and the volatility of these factors
 VaR Application

• Basic parameters

– Holding period

– Confidence interval

– Historical time period (observed asset prices)

• Closer the models fit economic reality, more accurate the

estimated

• There is no guarantee that the numbers returned by

each VaR method will be near each other

 VaR Application

• VaR is used as a Management Information System (MIS)

tool in the trading portfolio
• Risk by levels

• Products

• Geography

• Level of organisation

• VaR is used to set risk limits

• VaR is used to decide the next business

 VaR Limitation

• VaR does not substitute

– Management judgement

– Internal control

• VaR measures market risk

– Trading portfolio

– Investment portfolio

• VaR is helpful subject to the extent of

– Measurement parameters
 Back Testing

• Backtests compare realized trading results with model

generated risk measures

• Evaluate a new model

• Reassess the accuracy of existing models

• Banks using internal VaR models for market risk capital

requirements must backtest their models on a regular

basis
 Back Testing
• Banks back test risk models on a monthly or quarterly
basis to verify accuracy
• Observe whether trading results fall within pre-specified
confidence bands as predicted by the VaR models
• If the models perform poorly establish cause for poor
performance
– Check integrity of position
– Check market data
– Check model parameters
– Check methodology
 Stress Testing

• Banks gauge their potential vulnerability to exceptional,

but plausible, events

• Stress testing addresses the large moves in key market

variables that lie beyond day to day risk monitoring but

that could potentially occur

 Stress Testing
• Process of stress testing involves
– Identifying potential movements
– Market variables to stress
– How much to stress them
– What time frame to run the stress analysis
– Shocks are applied to the portfolio
• Revaluing the portfolios
– Effect of a particular market movement on the value of
the portfolio
– Profit and Loss
– Effects of different shocks of different magnitudes
 Stress Testing Technique

• Scenario analysis

• Evaluating the portfolios

– under various expectations

– evaluating the impact

• changing evaluation models

• volatilities and correlations

• Scenarios requiring no simulations

– analyzing large past losses

 Stress Testing Technique

• Scenarios requiring simulations

– Running simulations of the current portfolio subject to

large historical shocks

• Bank specific scenario

– Driven by the current position of the bank rather than

historical simulation

• Subjective than VaR

• Identify undetected weakness in the bank's portfolio

 Efficiency of a Stress Test

• Relevant to the current market position

• Consider changes in all relevant market rates

• Examine potential regime shifts (whether the current risk

parameters will hold or break down)

• Consider market illiquidity

• Consider the interrelationship between market and credit

risk
 Application of Stress Tests
• Stress tests produce information summarising the bank’s
exposure to extreme but possible circumstances
• Role of risk managers in the bank is gathering and
summarising information to enable senior management
to understand the strategic relationship between the
bank’s risk taking
– Extent and character of financial leverage employed
– Risk appetite
– Stress scenarios created on a regular basis
– Stress scenarios monitored over time
 Application of Stress Tests

• Influence decision-making

• Manage funding risk

• Provide a check on modelling assumptions

• Set limits for traders

• Determine capital charges on trading desks’ positions

 Limitations of Stress Test

• Stress tests are often neither transparent nor

straightforward

• Depends on a large number of practitioner choices

• Choice of risk factors to stress

• Methods of combining factors stressed

• Range of values considered

 Limitations of Stress Test

• Time frame to analyse

• Risk manager is faced with the considerable tasks of

analyzing the results and identifying implications

• Stress test results interpretation for the bank is based on

qualitative criteria

• Manage bank’s risk-taking activities is subject to

interpretations