UNIT-2

Measurement and Management of

Risk
 Value at Risk( VaR)
• VaR originated from a request made by
J.P.Morgan’s chairman, Dennis Weather Stone,
for a daily report regarding firm risk exposure.
• The proposal of implementing VaR is made by
BIS (Bank for International Settlements).
• VaR is the risk management concept which is
useful for the top level management, to know
short term price risk faced by the firm through a
single number.
 Computation of VaR
• Variance- covariance( Delta normal)
• Historical simulation.
Static simulation
Dynamic simulation
• Monte Carlo simulation [ Partial simlation]
 Measurement of VaR

• VaR can be calculated using two approaches

1. Model building approach
2. Linear model approach
 Calculation of VaR
• I. Estimating value at risk using the
probability confidence level:
i. At 5%(95%) probability VaR= 1.645* σp
ii. At 1% (99%) probability VaR =2.327* σp
• II. If in the problem he has given standard
deviation and mean
i. At 5% VaR=[1.645* σp]-mean
ii. At 1% VaR=[2.327* σp]-mean
• III. If in a problem amount invested with time period
and also standard deviation is given
i. Calculation of Number of working days in a year
Total number of days in a year= 365
(-) Number of Saturdays &Sundays(52*2)= 104
261
(-) Number of public holidays 7
(i.e compulsory holidays)
Number of trading days in a year 254
ii. At 5% VaR (1.645* σ)*√ (Number of
years*number of trading days in a
year)*Amount invested
iii. At 1% VaR (2.327* σ)* √ Number of
years*Number of trading days in a year *
(Amount invested)
• iv. Volatility = S.D*100
Mean
Volatility for a fortnight= S.D/ √Number of

fortnights
Fortnight means a period of 2 weeks
 Problems
P] Suppose a bank has deployed ₹200 crore in the call
market. Historical data records that average return on
overnight lending in a call market is 5% while the SD
is 0.5%.Assume that there are 300 working days in a
year. Calculate VaR for a fortnight.
Sol: Average rate of return =5%, SD=0.5% , No of wrkng
days=300
No of fortnights= No of working days in a year/months in a year
300/12=25
 Contd.,
• 1) Volatility= SD*100/mean
• 0.5*100/5= 10%
• 2) Volatility for a fortnight VaR=SD/√No of fortnights
• 0.5/ √25=0.5/5=0.1
 Stress testing
• Stress testing is used to assess market risk, and
that is the application this article focuses on.
• It is a simple form of scenario analysis.
• Stress testing has much in common with VaR
as both assess market risk.
• If stress testing is conducted with randomly
generated scenarios, the analysis would not be
called stress testing, instead it would be called as
Monte carlo VaR measure
 Uses of Stress Testing
• It allows the risk manager to rank the economic factors in
order of their influence on the portfolio value.
• Help to analyze the affects of the economic situation, except
that of price changes.
• Provides better and in depth identification of the risk and
takes necessary steps to protect the business from the risk.
• It helps in testing new products under extreme conditions
which allows the firm to examine the investment risk before
entering into new business.
• It can be used to test different types of risk like market risk,
derivative risk ,operational risk and credit risk.
 Approaches to stress testing
• Analyzing past events
• Scenario analysis
• Institutions scenario analysis
• Severe additional events and tail risk
• Quantitative analysis of tail events
 BACK TESTING

• Back testing is a key component of effective

trading system development.
• The underlying theory is that any strategy that
worked well in the past is likely to work well in
the future ,and conversely, any strategy that
performed poorly in the past is likely to
perform poorly in the future.
 DATA AND TOOLS
• Net profit or loss
• Time frame
• Volatility measures
• Averages
• Exposure
• Ratios
• Annualized return
• Risk adjusted return
 Important things to remember while Back
testing
• The broad market trends in the time frame in which
a given strategy was tested.
• Volatility measures are extremely important to
consider in developing a trading system.
• Most back testing software includes commission
costs in the final calculations.
• Exposure is double edged sword. Increased exposure
leads to higher profit or higher losses and vice versa.
 Important things to remember while Back
testing
• The average gain/loss statistic, combined with
the wins-to- losses ratio can be useful for
determining optimal position.
• Traders can take larger positions and reduce
commission costs by increasing their average
gains and increasing their wins-to-losses ratio.
• Annualized return is important because it is
used as a tool to benchmark a systems returns
against other investment venues
 Cash Flow at Risk(CaR):VaR& CaR to make
investment decisions
• Cash flow risk is due to uncertainty in future
reported cash flows.
• Cash flow is the life blood of a firm.
• Cash flow can also be manipulated and steady
cash flows may hide corporate decline.
• Draw heavily on techniques of ALM –
especially scenario and simulation analysis.
Managing risk when risk is measured by VaR
& CaR

• Decreasing the cost of risk for a given level of

VaR & CaR.
• Lower risk through project selection
• Derivatives and financial instruments to
manage risk.
Non-Insurance methods of Risk Management

 Risk Avoidance
• Risk Transfer
• Risk Aversion
 Loss Control
• Severity Reduction
• Separation
• Duplication
 Risk Retention
 Asset–Liability Management
• ALM deals with effective long term
management of financial statement ,that
involves risk faced by the variations in interest
and exchange rates and the liquidity position
of banks and financial institutions.
• The importance of ALM has been highlighted
after the decade of 1990’s due to the
occurrence and remarkable changes in the
financial sector.
 Concept and evolution of ALM

• Volatility
• Introduction to new products
• Regulatory environment
• Awareness of the top management
 RBI guidelines for ALM
• Commercial banks are to distribute the
outflows/inflows in different residual maturity period
known as time buckets.
• The assets and liabilities were earlier divided into 8
maturity buckets.
• All the liability figures are outflows and all the asset
figures are inflows.
• The banks may adopt a more granular approach to
measurement of liquidity risk by splitting the first time
bucket i.e., 1-14 days.
• Within each time bucket there could be mismatches
depending on cash inflows and outflows.
• Mismatch position, creates liquidity surplus or
liquidity crunch position depending upon interest
rate movement, such situation may turnout to be
risky for the bank.
• The net cumulative negative mismatches during the
next day,2-7 days,8-14 days and 15-28 days buckets
should not exceed 5%, 10%, 15% &20% of the
cumulative cash flows.
• The board’s of the banks have been entrusted
with the overall responsibility for the
management of risks and is required to decide
the risk management policy& set limits for
liquidity, interest rate and foreign exchange.
• Asset-Liability committee(ALCO) is the top
most committee to oversee the
implementation of ALM system and is to be
headed by CMD
 Capital Adequacy- Management of Interest Rate Risk

• The changes in the interest rates have an

immediate impact on the earnings of the
banks.
• Variation in market rates affects Off-balance
sheet position and the changing interest rates
on banks
Various methods of measurement of Interest
rate risk
• The banks uses the following approaches for
measuring ALM Interest rate risk:
 Gap Analysis
 Rate- shift scenario
 Simulation method
 Static simulation
 Dynamic simulation
 Duration analysis
 Hedging with derivatives.
 Management of Interest Rate Risk
• The various types of interest rate risk caused
in an organization offering financial services:
• Rate level risk
• Volatility risk
• Prepayment risk
• Call/Put risk
• Reinvestment risk
• Real interest rate risk
 MANAGEMENT OF LIQUIDITY RATE RISK

• Fundamental approach
 Asset management
 Liability management
• Technical approach
 Working funds approach
 Owned funds
 Deposits – Volatile, Vulnerable & Stable
 Float funds-Cheques,DD’s
 Credit risk and Exchange rate risk
• Effectively managed through the micro and macro
level approach.
• Micro-single credit transaction
• Evaluation-clients proposal must be assessed
• Pricing-expected return
• Monitoring-Past, performance of the client, Delay
in payment of installments
• Macro- completely focuses in the risk faced by
bank.
 Exchange rate risk
• Transaction exposure
• Translation exposure
• Operating exposure