Market Risk Measurement

Market Risk
• Losses due to change in market price of an asset. 5 main market risk
categories
• Exchange Rate Risk
• Interest Rate Risk;
• Equity Risk;
• Commodity Risk
• Volatility Risk (associated with positions in derivatises portfolio)
• Common Approaches to measure market risk
• Sensitivity Analysis;
• Stress Testing;
• Scenario Test;
• VAR
• Expected Shortfall
Market Risk Measurement
• Sensitivity Analysis
• Quick and useful measure to show how changes in market could affect the value of the
portfolio(V);
• Such analysis provides a description of how V will change if there is a small change in one of
the market-risk factors;
• Sensitivity={V(f+ e)-V(f)}/ e;
• Ex: Bonds sensitivity with respect to interest rate measured in duration dollar;
• Stress Testing
• For changes in a risk /market factor is large(such as in crisis), linear sensitivity will not be an
appropriate estimate of the downside.
• In stress testing large changes are made in the factors and full non-linear pricing is used to
revalue the portfolio and evaluate the loss.
• Typical outcome: "If interest rates move up by 2%, we would lose USD 15 mn. If they move
by 4%,would lose USD 32 mn.”
• The changes in risk factors applied for testing are usually uniform and objective;
Market Risk Measurement
• Scenario Analysis
• The changes are tailored ,subjectively;
• Informed opinion/expert judgement is used to create specific inputs based on
perceived ‘worst case’.
• The scenarios are chosen based on previous crisis, bank’s current portfolio
and opinion of experts such as head trader, chief economist and risk
management group.
• Then based on these inputs full non linear models are run to revaluate
portfolio value to estimate the loss
Market Risk Measurement
• Value at Risk(VAR)
• It is a measure of market risk that tries objectively to combine the sensitivity
of the portfolio to market changes and the ‘probability’ of a given market
change.
It asks the simple question: “How bad can things get?”
It captures an important aspect of risk in a single number
“What loss level is such that we are X% confident it will not be exceeded in N business
days?”
• The ease of aggregating risk in various exposure , simplicity of the concept
and ease in communicating risk of positions are its strength
• VAR has significant limitations that require the continued use of stress and
scenario tests as a back up.
VAR
• Among the most popular and well researched risk measurement
technique and adopted by Basel Committee for market risk
measurement.
• The market-risk capital is k times the 10-day 99% VaR where k is at
least 3.0
• Under Basel II, capital for credit risk and operational risk is based on a
one-year 99.9% VaR
Expected Shortfall
• VaR is the loss level that will not be exceeded with a specified
probability
• Expected shortfall is the expected loss given that the loss is greater
than the VaR level (also called C-VaR and Tail Loss)
• Two portfolios with the same VaR can have very different expected
shortfalls
 Which is the Most appropriate measure of risk?
• Determined by Coherent Risk Measure
• Properties of coherent risk measure
1. Monotonicity :If one portfolio always produces a worse outcome than another its risk
measure should be greater
2. Translation Invariance: If we add an amount of cash K to a portfolio its risk measure should
go down by K
3. Homogeneity: Changing the size of a portfolio by l should result in the risk measure being
multiplied by l
4. Subadditivity: The risk measures for two portfolios after they have been merged should be
no greater than the sum of their risk measures before they were merged
Spectral Risk Measures

• A risk measure is also characterised by the weights it assigns to

quintiles/percentile of loss distribution.
• VAR gives full weight to the Xth(99 or 99.9) percentile and nothing to
others.
• Expected Shortfall gives equal weight to all percentile above the Xth
and zero weight to all percentile below Xth.
• This is known as spectral measure of risk, which is fully coherent if the
weight assigned to the qth percentile is a non-decreasing function of
q.
 VAR Example 1
• A one-year project has a 98% chance of leading to a gain of $2 million, a 1.5%
chance of a loss of $4 million, and a 0.5% chance of a loss of $10 million
• The VaR with a 99% confidence level is $4 million
• What if the confidence level is 99.9%?
• What if it is 99.5%?
VAR Example 2
• Two independent projects can each lose USD 10mn with a probability of 0.02 and can
each lose USD1 mn with a probability of 0.98 over a one year period.
• The One Year 97.5 %bVAR for each project is USD 1.0 mn
• Thus:
• 0.02X0.02(=0.004) is the probability of a USD 20 mn loss;
• 2X0.02X0.98(=0.0392) is the probability of a USD 11 mn loss;
• 0.98X0.98(=0.9604) is the probability of loss USD 2 mn
• What is the 97.5% VAR for the portfolio consisting of these two projects?
• The full loss distribution is as follows:
• Upto 0.96 (cumulative) the loss is 2 MN
• Upto 0.9996(cumulative) the loss is 11 MN
• 1.0( cumulative) is 20MN
• 97.5 % VAR would fall between 2MN and 11 MN; the exact amount may ve estimated pro-rata/distance weighed
Volatility

• Suppose that Si is the value of a variable on day i. The volatility per

day is the standard deviation of ln(Si /Si-1)
• Normally days when markets are closed are ignored in volatility
calculations
• The volatility per year is times the daily volatility
• Variance rate is the square of volatility
VAR Adjustment For Autocorrelation

• When daily changes in a portfolio are identically distributed and

independent the variance over T days is T times the variance over one
day
• When there is autocorrelation equal to r the multiplier is increased
from T to
VAR Adjustment For Autocorrelation

T=1 T=2 T=5 T=10 T=50 T=250

r=0 1.0 1.41 2.24 3.16 7.07 15.81

r=0.05 1.0 1.45 2.33 3.31 7.43 16.62

r=0.1 1.0 1.48 2.42 3.46 7.80 17.47

r=0.2 1.0 1.55 2.62 3.79 8.62 19.35

Real Life and ‘Normal’ Distributions
Fat Tailed Distributions
• Daily exchange rate changes are not normally distributed
• The distribution has heavier tails than the normal distribution
• It is more peaked than the normal distribution
• This means that small changes and large changes are more likely than
the normal distribution would suggest
• Many market variables have this property, known as excess kurtosis
Power Law
Prob(v > x) = Kx-a

This seems to fit the behavior of the returns on many market variables better
than the normal distribution
• Approach:
• Take the actual fat tail data.
• In reference to previous slide X refers to the standard deviation; Prob(v > x) refers to the
observed /actual frequency of the occurrence.
• Linearise the power equation by taking Ln of both sides.
• Plot the observations and run a linear regression/ find a best fit line;
• The parameter estimates would correspond to the K and a;
• Here lnK will be the intercept and will be the a slope
Power Law
Using Exponential Weighing to Calculate
VAR
• Let weights assigned to observations decline exponentially as we go
back in time
• Rank observations from worst to best
• Starting at worst observation sum weights until the required quantile
is reached