Measurement of Market Risk - Bank Management - Lecture Slides, Slides of Banking and Finance

Download Measurement of Market Risk - Bank Management - Lecture Slides and more Slides Banking and Finance in PDF only on Docsity! Measurement of Market Risk Docsity.com Market Risk • Directional risk • Relative value risk • Price risk • Liquidity risk Type of measurements – scenario analysis – statistical analysis Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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. (Profit/Loss Distribution) 5% 95%X Value-at-Risk Docsity.com 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 Docsity.com Value-at-Risk Assumptions 1) Percentage change (return) of assets is Gaussian: SdzSdtdS   dzdt S dS  or zt S S    Normal Distribution Docsity.com Advantages of VaR • Captures an important aspect of risk in a single number • Easy to understand • Indicates the worst loss that could happen Docsity.com Daily Volatilities • Option pricing (volatility is express as volatility per year) • aR calculations (volatility is express as volatility per day) yearyear year day     %6063.0 252 Docsity.com 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 Docsity.com 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. Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com