Market Risks Building Blocks

• Market parameters (interest

Risk Drivers rates, equity indexes, foreign
exchange rates)
• Mark to Market values, Mapped
Risk Exposures to market parameters
• Valuation of adverse deviations
Standalone risk of market returns over liquidation
period
• Correlations between selected
market parameters mapped to
Correlations individual exposures
• Loss distributions aggregate
Portfolio Risk algebraically the individual asset
returns. The Delta Normal or
Monte Carlo Simulation
techniques serve for deriving the
individual and correlated asset
returns.
Capital • VaR is a loss percentile.
 The Mapping Process
• For Equity: beta( change in stock price to change in
market index for the same period)
• For Fixed Income Securities: (the sensitivity of bond
prices to interest rates shocks, shocks being parallel
shifts of the entire spectrum of rates is duration).
• If the duration of a bond is 5, it means the bond value will
change by 5% when all rates deviate by 1%).
• For options
• Value of underlying, horizon to maturity, the volatility of
the underlying, the risk free rate.
• For Foreign Exchange
 Scope of market risk
• Interest rate related instruments and equities in the trading book.
• Foreign exchange risk and commodities risk throughout the
bank.
• Approaches
– Standardised approach: measures four risks, using set of
forfeits allowing offsetting effects within portfolios of traded
instruments.
– Proprietary models: allows banks to use risk measures
derived from their own risk management models.
• The critical inputs include:
– The current valuation of exposures
– Their sensitivities to underlying market parameters
– Rules governing offsetting effects between opposing
exposures in similar instruments and eventually across entire
range of instruments.
 Standardized approach
• Offsetting the exact matches of instrument
characteristics or adding specific risk forfeits while
allowing limiting offsetting effects for general risks.
• Interest rate movements: capital charge adds
individual transaction forfeits, varying from 0% to 8% for
maturities over 24 months.
• Derivatives: Swaps and options
• Equity
• Foreign exchange
• Commodities
 Proprietary Models of Market Risk
VaR
• VaR may be used to define capital adequacy for market risks. The
Basle Committee has prescribed that VaR should be worked on
daily basis for market risk at a confidence level of 95% with a
holding period of 10 days. The historical data used to calculate
volatility should encompass data for atleast one year. Further, the
Capital Charge should be higher of the previous day’s VaR or three
times the average of daily VaR for the preceding sixty working days.
• Stress Testing : to see what happens under exceptional conditions.
• The process of validating the accuracy of VaR model is known as
backtesting.It verifies whether the actual losses are in line with the
losses projected by the model. The Basle Committee has also
defined the acceptable limits of exceptions on the results of VaR
model.
Value At Risk (VaR)
 Some statistical concepts
• Standard Deviation and volatility
• Probability Distribution and Normal Distribution : if we plot the
various price movements of an underlying and then draw a
mean of these numbers, it is said that the shape assumed is
that of a bell and such a distribution is called Normal
Distribution.
• It assumes that the distribution of data measured in terms of
the standard deviation is as per the following table:

Standard Deviation 1 1.65 2 3

Probability Distribution 68.3% 90% 95.5% 99.7%

Level of Confidence 84.15% 95% 97.75% 99.9%

 Some statistical concepts
• Covariance (A,B)= Correlation (A,B) X
Sq.rt. of (Variance A X Variance B)
• Variance of (A+B) = Var A+ Var B + 2
Covariance(A,B)
 The Idea behind VAR
• Volatility
• VAR answers the question, "What is my
worst-case scenario?"
• A VAR statistic has three components: a
time period, a confidence level and a loss
amount (or loss percentage). What is the
most I can - with a 95% or 99% level of
confidence -  expect to lose in dollars over
the next month?
 Definition of Value at Risk
• Value at Risk may be defined as an
estimate of maximum potential loss on a
given position for a given holding period at
a given level of confidence.
• Three methods of computation:
– Delta Normal Method or Variance-Covariance
Method
– Historical or Back Simulation Method
– Monte-Carlo Simulation
 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%.
 Historical Method
• 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%).
Parametric or Delta Normal Method
of Computing VaR
• This method assumes that stock returns are normally distributed.
• Therefore, 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:
Parametric or Delta Normal Method
of Computing VaR
• 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 :

• 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:
 Conversion of one time period into
another
• The standard deviation of stock returns tends to
increase with the square root of time.
• If the standard deviation of daily returns is 2.64%
and there are 20 trading days in a month (T =
20), then the monthly standard deviation is
represented by the following:

• Annualized volatility = Quarterly Volatility X

Sq.rt. Of 4 as there are 4 quarters in a year.
 Applying a VaR Method For
Stand alone Market Risk
• Map asset returns to market
parameters( interest rates, equity indexes,
foreign exchange rates etc)
• Relate asset returns to selected underlying
market parameters.
• Model the distribution of market parameter
returns.
 Applying a VaR Method For
Stand alone Market Risk
• Below we incorporate the time-conversion element into the variance-
covariance method for a single stock (or single investment):

• Now let's apply these formulas to the QQQ. Recall that the daily standard
deviation for the QQQ since inception is 2.64%. But we want to calculate a
monthly VAR, and assuming 20 trading days in a month, we multiply by the
square root of 20:
 Historical or Back Simulation
Method
• Measure exposure
• Measure Sensitivity using delta (effect of
1% adverse change)
• Measure risk of today’s closing position
using exchange rates that existed on each
of the last 500 days
• Rank days by risk worst to best
• VAR is 25th worst day out of last 500
 VaR of a portfolio
• Importance of Correlation.
• Let us say we have two par bonds A and B and assign them equal
weights in a portfolio. Let the deviation of interest rate in respect of
bond A is 6 and bond B is 9 and the correlation between the two is
0.30. Let us also assume the holding period of the portfolio as one
year. The VaR of the portfolio at 99.9% confidence level may be
computed as:
• Covariance(A,B) = Correlation (A,B) X Sq.rt. of (Variance A X
Variance B)
= 0.30 X Sq.rt. (36 X 81)
= 0.30 X 6 X 9 = 16.2
• Variance of A+B= Var A+ Var B + 2 Covariance (A,B)
• = 36+ 81+ 2 X 16.2 = 149.4
• Std. deviation of A+B= 12.22
• If the two bonds were bought at Rs.100 each, the VaR of the
portfolio at 99.9% confidence level is 200x 3 X 0.1222= 73.32
 Factor Models
• High number of assets makes it unpractical to create a
matrix with all pair co variances between individual asset
returns.
• Therefore, it is more efficient to derive correlations from
the correlation of factors driving these returns.
• Prerequisites: since these are the value drivers of
individual assets within the portfolio, the perquisite is to
model the market parameter random deviations
complying with their correlation structure.
• Then derive individual asset return distributions from
market parameters to get all possible portfolio returns.
 Investment Management in Banks
• Banks’ Investment Classification: Classification based on
intention of the bank at the time of acquisition of investment.
Particulars Held to Maturity Held for Trading Available fir sale
(HTM) (HFT) (AFS)
Limit not to exceed 25% of No limit specified No limit specified
total investments
Realized appropriated to the taken in the taken in the
Profit/Loss capital reserve account income statement income statement
after being taken in the and transferred to and transferred to
income statement Investment Investment
Fluctuation Fluctuation
Reserve Reserve
Appreciation/ not marked to market Net appreciation, Net appreciation,
depreciation and carried at if any, that is not if any, that is not
acquisition cost or at an realised is realised is
amortized cost if ignored, while net ignored, while net
acquired at a premium depreciation is depreciation is
over the face value provided for provided for
 Banks’ Investment Classification
Particulars Held to Maturity Held for Available fir sale
(HTM) Trading (HFT) (AFS)

Shifting of done with the not permitted done with the

investments approval of the approval of the
Board of Directors board of Directors,
once a year the Asset Liability
Management
Committee or the
Investment
Committee
Duration Long-term To be sold Short-Term
within 90 days
Banking Book and Trading Book
• Securities acquired with the intention of Trading
have to be classified as Held for Trading and are
subject to regulatory prescriptions regarding
holding period, stop loss etc.
• A bank which has trading book is expected to
have in place proper risk management, trading
policies, delegation of powers, skills dealing
infrastructure etc.
• Securities other than trading book belong to
Banking book.
 Applications of VaR
• To measure maximum possible loss on any given trading or portfolio
position.
• As a benchmark for performance measurement of the treasury
operations.
• May be used to fix individual and dealing room limits.
• Enables the management to decide quickly on trading strategies.
• Applications in Banking
• VaR may be used to define capital adequacy for market risks. The
Basle Committee has prescribed that VaR should be worked on
daily basis for market risk at a confidence level of 95% with a
holding period of 10 days. The historical data used to calculate
volatility should encompass data for atleast one year. Further, the
Capital Charge should be either the previous day’s VaR or three
times the average of daily VaR for the preceding sixty working days.
• An Asset Liability Management tool. It may be used to calculate the
impact of interest rate changes on Net Interest Income and on
Market Value of equity.
 Backtesting
• The process of validating the accuracy of VaR model is
known as backtesting.
• It verifies whether the actual losses are in line with the
losses projected by the model.
• The Basle Committee has also defined the acceptable
limits of exceptions on the results of VaR model.
Number of Categorizations
Exceptions
0-4 Acceptable under Green Zone.
5-9 Acceptable but calls for improvements in
the model under Yellow Zone.
10 and above Serious defects in the model under Red
Zone.