market risk rev 12

8/13/2019 Market Risk Rev 12

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Market Risk

When you are willing to make sacrifices for agreat cause, you will never be alone.

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Market Risk Identification

Banks undertake transactions and hold positions with trading intent andwith the intention of benefiting in the short-term, from actual and/orexpected differences between their buying n selling prices or hedgingother elements in the trading book.

This results in market exposure. All such transactions reflect in the tradingbook.

A trading book consists of the banks proprietary positions in financialinstruments including:

Debt securities;

Equity;

Foreign Exchange; Commodities;

Derivatives held for trading.

They also include positions in financial instruments arising from matchedprincipal brokering n market making, or positions taken in order to hedge

other elements of the trading book. 2


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Market Risk Identification (Contd.)

A banks trading book exposure has the following risks, which arise dueto adverse changes in market variables such as interest rates, currencyexchange rate, commodity prices, market liquidity, etc., and theirvolatilities that impact the banks earnings n capital adversely.

1. Market Risk

Interest Rate Risk Equity Price Risk

Foreign Exchange Risk

Commodity Price Risk

2. Liquidity Risk Asset Liquidity Risk

Market Liquidity Risk

3. Credit n Counter party Risks

4. Model Risk

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Market Risk

Market risk is the risk of adverse movements of the mark to market valueof the trading portfolio, due to market changes/ movements, during theperiod required to liquidate the transactions.

The period of exit or length of holding period is critical to assess suchadverse deviations. If it gets longer, so do the deviations from the current

market value. Changes in market prices, if adverse, reduce the value of an instrument

or the portfolio.

Yield of a market portfolio is the profit or loss arising from the transaction.The profit between two dates is the variation of the market value of an

asset or a portfolio of assets. Any decline in value, results in a market loss. However, it is possible to liquidate tradable instruments or to hedge their

future changes of value at any time. This is the rationale for limitingmarket risk to the liquidation period.

Market risk does not refer to market losses due to causes other than

market movements. 4


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Interest Rate Risk

A fixed income security or a security with a predetermined cashflow would have interest rate risk. Market value of such securitiesis the discounted value of cash flow n as the interest ratechanges, the market value also changes.

Market value of these securities falls as interest rate rises n rises asthe interest rate falls.

Determining risk interest rate changes on such portfolio orportfolio risk exposure on account of interest rate change woulddepend on a combination of factors like maturities, reset dates nnominal values.

In case of financial instruments backed by hedge, basis risk maydevelop because of non-parallel adverse movement of theprice of an instrument n that of its hedge. The basis risk comes inas gap between the discounted cash flows of the portfolio n

that of hedging instrument, which gets created because of non-parallel shifts of yield curve. 5


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Equity Price Risk

Stock prices keep on changing with time. Volatility of stock prices results inequity risk as stock prices may move adversely as soon as it is purchased ntaken in the books.

While favourable movement adds to the profits, adverse movements results inaffecting profit & loss adversely.

Stock prices may move on account of market factors n also on account of firmspecific factors.

Movement of prices that can be attributed to market factors is called generalmarket risk of equity while the movement of prices on account of factorsspecific to the firm is called specific or idiosyncratic risk of equity.

General market risk of equity refers to stocks sensitivity to the change in broadmarket indices such as Sensex , Nifty, etc. For example, if a stocks pricemovement is twice that of market indices, then the stocks sensitivity is 2 n thatgives an indication of the general market risk associated with that stock.

While in case of a single stock both the risks are to be determined, in case of awell diversified portfolio of stock, only general market risk becomes relevant asin case of a well diversified portfolio the specific or idiosyncratic risk standseliminated substantially.

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Foreign Exchange Risk

Forex positions arise in the ordinary course of business n throughassuming a trading position in forex.

Volatility of exchange rates may result in adverse movements ofrates giving rise to forex risk. Favourable movements in rates giverise to profits.

Forex positions also include forward positions as well. Forex ratesare also time dependent. One month forward rate will be differentfrom two-month forward rate n they keep changing with time.

Usually, forex portfolio consists of pen positions n imperfectlyhedged positions. The open positions result in exchange rate risk n

it mainly depends upon movement of spot exchange rate of twocurrencies.

Imperfectly hedged position gives rise to gap risk. Gap riskdepends upon besides the movement of spot exchange rate oftwo currencies, interest rate differential o the two currencies.

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Commodity Price Risk

Commodity market differs from interest rate market or equitymarket of forex market. The reasons are: Commodity prices are strongly demand supply dependent. Where

the market is dependent on fewer suppliers, price volatility is higher.

Market liquidity or depth of trading market varies frequently n that

adds to the commodity price volatility. Transaction cost in commodity market are not uniform as depends

on the ease n cost of storage, which varies across commodities.

Commodities have different characteristics. Some are perishable nhave short shelf life (agricultural n energy commodities). Some are

non-perishable with high-price to weight ratio like gold, silver orplatinum. Some are base metals with low price to weight ratio.

As a result of these factors, commodity prices have highvolatility n larger price discontinuities prices leap from onelevel to the another. Hence exposure on commodity market

carries relatively higher risk. 8


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Liquidity Risk

Trading liquidity is the ability to freely transact n markets at reasonableprices. Trading liquidity is ability to liquidate positions without:

1. Affecting market prices

2. Attracting the attention of other market participants

Liquidation risk arises from the lack of trading liquidity n results in:

1. Adverse changes in market prices

2. Inability to liquidate position at a fair market price

3. Liquidation of position causing large price change

4. Inability to liquidate position at any price.

Asset liquidation risk refers to a situation where a specific asset faceslack of trading liquidity.

Market liquidation risk refers to a situation when there is generalliquidity crunch in the market n it affects trading liquidity adversely.

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Model Risk

Models are designed to predict values of variables for which it is specificallydesigned. Value of a given variable would depend upon one or moreparameters, which influence the value of the given variable.

Models, with the help of parameters predict the value of a variable. Pricingmodels n risk measurement models are the most commonly used models inmarket risk management.

However, values predicted through models, when compared with actualobservation, may show deviation, i.e., gaps may exist between predictedvalue n actual values observed. This is called Model Risk.

Model risk arises because of following reasons:

Assumptions which have become irrelevant or found to be incorrect;

Ignoring one or more parameters usually for simplification or for somepractical reasons;

Errors of statistical techniques or insufficient data inputs;

Incorrect judgment in dealing with outliers, etc.

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Market Risk

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StresslossUnexpected loss

The relationship between frequency of loss,amount of loss, expected loss, stress loss,financial strength and economic capital can beseen in the following graph:


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Capital charge for Market Risk

Introduction Market risk is defined as the risk of losses in on-balance sheet

and off-balance sheet positions arising from movements inmarket prices. The market risk positions subject to capitalcharge requirement are:

(i) The risks pertaining to interest rate related instruments andequities in the trading book; and

(ii) Foreign exchange risk (including open position in preciousmetals) throughout the bank (both banking and trading

books).

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Measurement of Capital Charge forInterest Rate Risk

Capital Charge for Specific Risk : RBI guidelines prescribed astandardized capital charge for specific risk which depends onthe issuer, type of security n remaining maturity of security.

This varies from 0% for central n state government securities to100% for securities rated B n below or are unrated.

Capital Charge for General Risk : Capital charge for generalmarket risk is computed under standardized duration methodusing the following formula:

Capital Charge for General market Risk of a security = Modified

Duration of the Security x Market Value of the security xAssumed Change in Yield Where assumed change in yield is prescribed by regulator n that

varies from 60 basis points to 100 basis points depending upon thematurity of the security.

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A brief description of variouscomponents of market risk

General Market Risk: This is the risk arising from movements in the general level ofunderlying risk factors such as interest rates, exchange rates, equity prices, etc.

Specific Risk: This is the risk of adverse movement in the price of individual securityresulting from factors related to the securitys issuer. Specific risk is further divided intofour components explained below.

Default Risk: This means the potential for direct loss due to an obligors default as well as thepotential for indirect losses that may arise from a default event.

Credit Migration Risk: This is also called event risk or downgrade risk. This means the potentialfor direct loss due to an internal/external rating downgrade or upgrade as well as thepotential for indirect losses that may arise from a credit migration event.

Credit Spread Risk: Credit spread risk arises from the possibility that changes in creditspreads will affect the value of financial instruments. Credit spreads represent the credit riskpremiums required by market participants for a given credit quality, i.e., the additional yield

that a debt instrument issued by an AA rated entity must produce over a risk-freealternative (e.g., Government of India bond). For instance, widening of credit spread of agiven credit quality ( e.g. A rating) due to change in perception of the credit worthiness ofthe issuer or liquidity of the position would lead to mark to market losses for the long position.

Incremental Risk: This is the risk not captured by the VaR-based estimate of specific risk andthe Incremental Risk Charge (IRC) is intended to complement standards being applied tovalue-at-risk modelling framework. IRC represents an estimate of the default and migrationrisks to the extent these are not captured by the VaR-based measure incorporating specificrisk. 16


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Measurement of capital charge forEquity Risk

The capital charge for equities would apply on their currentmarket value in banks trading book.

Capital charge for banks capital market investments, includingthose exempted from CME norms, for specific risk (akin to creditrisk) will be 11.25 per cent or higher and specific risk iscomputed on banks gross equity positions.

The general market risk charge will be 9 per cent on the grossequity positions.

Specific Risk Capital Charge for banks investment in Security

Receipts will be 13.5 per cent (equivalent to 150 per cent riskweight). Since the Security Receipts are by and large illiquidand not traded in the secondary market, there will be noGeneral Market Risk Capital Charge on them.

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Measurement of Capital Charge forForeign Exchange Risk

The banks net open position in each currency should be calculatedby summing:

The net spot position (i.e. all asset items less all liability items, includingaccrued interest, denominated in the currency in question);

The net forward position (i.e. all amounts to be received less all amounts tobe paid under forward foreign exchange transactions, including currencyfutures and the principal on currency swaps not included in the spotposition);

Guarantees (and similar instruments) that are certain to be called and arelikely to be irrecoverable;

Net future income/expenses not yet accrued but already fully hedged (at

the discretion of the reporting bank); Depending on particular accounting conventions in different countries, any

other item representing a profit or loss in foreign currencies;

The net delta-based equivalent of the total book of foreign currencyoptions

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Measurement of Capital Charge forForeign Exchange Risk

Foreign exchange open positions and gold open positions areat present risk-weighted at 100 per cent. Thus, capital chargefor market risks in foreign exchange and gold open position is 9per cent. These open positions, limits or actual whichever ishigher, would continue to attract capital charge at 9 per cent.

This capital charge is in addition to the capital charge for creditrisk on the on-balance sheet and off-balance sheet itemspertaining to foreign exchange and gold transactions.

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Aggregation of the capital charge forMarket Risks

As seen above capital charges for specific risk and generalmarket risk are to be computed separately before aggregation.For computing the total capital charge for market risks, thecalculations may be plotted in the following table:

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Risk Category Capital ChargeI. Interest Rate (a+b)

a. General market risk

b. Specific risk

II.Equity (a+b)

a. General market risk

b. Specific risk

III.Foreign Exchange & Gold

IV.Total capital charge for market risks (I+II+III)


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Capital Charge for Market Risk:Internal Models Approach

At present, the SMM is applicable to both Held-For-Trading (HFT)and Available for Sale (AFS) portfolios.

Generally, the positions held in the AFS are more illiquid and themarket prices for them may not be available or may beavailable with a very low frequency due to low tradingvolumes.

Therefore, it would not be feasible to compute meaningful VaRmeasures for AFS portfolios.

Accordingly, the trading book for the purpose of these

guidelines will consist of only Held-For-Trading (HFT) portfolio,which will also include trading positions in derivatives and thederivatives transactions entered into for hedging trading bookexposures.

The AFS portfolio should continue to be under SMM for

computation of capital charge for market risk. 22


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VaRValue at Risk (VaR) is the most probable loss that we may incur innormal market conditions over a given period due to thevolatility of a factor, exchange rates, interest rates or commodityprices. The probability of loss is expressed as a percentage VaRat 95% confidence level, implies a 5% probability of incurring theloss; at 99% confidence level the VaR implies 1% probability of

the stated loss. The loss is generally stated in absolute amountsfor a given transaction value (or value of a investment portfolio).The VaR is an estimate of potential loss, always for a givenperiod, at a given confidence level.. A VaR of 5p in USD / INRrate for a 30- day period at 95% confidence level means thatRupee is likely to lose 5p in exchange value with 5% probability,or in other words, Rupee is likely to depreciate by maximum 5pon 1.5 days of the period (30*5% ) .A VaR of Rs. 100,000 at 99% confidence level for one week for ainvestment portfolio of Rs. 10,000,000 similarly means that themarket value of the portfolio is most likely to drop by maximum

Rs. 100,000 with 1% probability over one week, or , 99% of thetime the portfolio will stand at or above its current value.23


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VaR

Dennis Weatherstone, former chairman of J. P.Morgan (JPM):

"At close of business each day tell me what the marketrisks are across all businesses locations." In a nutshell, thechairman of J. P. Morgan wants a single dollar numberat 4:15 PM New York time that tells him J. P. Morgan'smarket risk exposure on that day.

For a Bank, it is concerned with how much itcould potentially lose should market conditionsmove adversely;

Market risk = Estimated potential loss under adversecircumstances

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VaR

VaR can be defined as the worst loss that might beexpected from holding a security or portfolio over a givenperiod of time, given a specific level of probability.

Example: A position has a daily VaR of $10m at the 99%confidence level means that the realized daily losses from theposition will, on average, be higher than $10m on only oneday every 100 trading days.

VaR is the answer to the following questions: What is the maximum loss over a given time period such

that there is a low probability that the actual loss over thegiven period will be larger (than the VaR )?

VaR is not the answer to: How much can I lose on my portfolio over a given period of time?

The answer to this question is everything.

VaR does not state by how much actual losses will exceed the VaRfigure.

It simply states how likely it is that the VaR figure will be exceeded. 25


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VaR Methodologies

VAR can be arrived as the expected loss on a position from anadverse movement in identified market risk parameter(s) with aspecified probability over a nominated period of time.

Volatility in financial markets is usually calculated as the standarddeviation of the percentage changes in the relevant asset price

over a specified asset period. The volatility for calculation of VaR isusually specified as the standard deviation of the percentagechange in the risk factor over the relevant risk horizon.

There are three main approaches to calculating value-at-risk: thecorrelation method, also known as the variance/covariance matrix

method; historical simulation and Monte Carlo simulation . All threemethods require a statement of three basic parameters: holdingperiod, confidence interval and the historical time horizon overwhich the asset prices are observed.

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VaR Methodologies

Under the correlation method , the change in the value of theposition is calculated by combining the sensitivity of eachcomponent to price changes in the underlying asset(s), with avariance/covariance matrix of the various components' volatilitiesand correlation. It is a deterministic approach.

The historical simulation approach calculates the change in thevalue of a position using the actual historical movements of theunderlying asset(s), but starting from the current value of the asset.The length of the historical period chosen does impact the resultsbecause if the period is too short, it may not capture the full variety

of events and relationships between the various assets and withineach asset class, and if it is too long, may be too stale to predictthe future. The advantage of this method is that it does not requirethe user to make any explicit assumptions about correlations andthe dynamics of the risk factors because the simulation follows

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VaR Methodologies

The Monte Carlo simulation method calculates the change in thevalue of a portfolio using a sample of randomly generated pricescenarios. Here the user has to make certain assumptions aboutmarket structures, correlations between risk factors and thevolatility of these factors. He is essentially imposing his views and

experience as opposed to the nave approach of the historicalsimulation method.

At the heart of all three methods is the model. The closer themodels fit economic reality, the more accurate the estimated VARnumbers and therefore the better they will be at predicting the true

VAR of the firm. There is no guarantee that the numbers returnedby each VAR method will be anywhere near each other.

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VaR

Three measurable components for the FI's daily earnings at risk: Daily earnings at risk (DEAR) = (Value of the position) * ( Price

sensitivity ) * (Potential adverse move in yield)

or

Daily earnings at risk (DEAR) = (Value of the position) * (Pricevolatility)

Suppose a Bank has a Rs1 million market value position in zero-coupon bonds of seven years to maturity with a face value ofRs1,631,483. Today's yield on these bonds is 7.243 percent per

annum. These bonds are held as part of the trading portfolio.Thus: Value of position = $1 million

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VaR

The Bank wants to know the potential exposure faced by thebank should a scenario occur resulting in an adverse orreasonably bad market move against the bank. How muchwill be lost depends on the price volatility of the bond. Fromthe duration model we know that:

Daily price volatility = (Price sensitivity to a small change inyield) * (Adverse daily yield move)

= (-MD) * (Adverse daily yield move) The modified duration (MD) of this bond is:

D 7 MD = --------- = -- ----------- = 6.5271+R (1.07243)

given the yield on the bond is R = 7.243 percent.

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VaR

Suppose we want to obtain maximum yield changes such thatthere is only a 5 percent chance the yield changes will begreater than this maximum in either direction.

Assuming that yield changes are normally distributed, then 90percent of the area under normal distribution is to be foundwithin 1.65 standard deviations from the mean-that is, 1.65 .

Suppose over the last year the mean change in daily yields onseven-year zeros was 0 percent while the standard deviationwas 10 basis points (or 0.1%), so 1.65 is 16.5 basis points (bp).

Then:

Price volatility = (-MD)* (Potential adverse move in yield)= (-6.527)* (.00165) = .01077 or 1.077% and

Daily earnings at risks = (Value of position) * (Price volatility)= (l,000,000)* (.01077) = Rs10,770

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VaR

Extend this analysis to calculate the potential loss over 2, 3, .....,N days. Assuming that yield shocks are independent, then theN-day market risk (VAR) is related to daily earnings at risk (DEAR)by:

VaR = DEAR x N

If N is 5 days, then:VaR = Rs10,770 x 5

= Rs24,082 If N is 10 days, then:

VaR = Rs10,770x 10= Rs34,057

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Limitations of VaR

Value At Risk can be misleading: false sense of security Looking at risk exposure in terms of Value At Risk can be very misleading. Many people

think of VAR as the most I can lose, especially when it is calculated with theconfidence parameter set to 99%. Even when you understand the true meaning of VARon a conscious level, subconsciously the 99% confidence may lull you into a false senseof security . Unfortunately, in reality 99% is very far from 100% and heres wherethe limitations of VAR and their incomplete understanding can be fatal.

VAR does not measure worst case loss 99% percent VAR really means that in 1% of cases (that would be 2-3 trading days in a

year with daily VAR) the loss is expected to be greater than the VAR amount. Value AtRisk does not say anything about the size of losses within this 1% of trading days and byno means does it say anything about the maximum possible loss .

The worst case loss might be only a few percent higher than the VAR, but it could also

be high enough to liquidate your company. Some of those 2 -3 trading days per yearcould be those with terrorist attacks, Kerviel detection, Lehman Brothers bankruptcy,and similar extraordinary high impact events.

You simply dont know your maximum possible loss by looking only at VAR. It is thesingle most important and most frequently ignored limitation of Value At Risk.

Besides this false-sense-of-security problem, there are other (perhaps less frequentlydiscussed but still valid) limitations of Value At Risk :

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Limitations of VaR

Value At Risk gets difficult to calculate with large portfolios When youre calculating Value At Risk of a portfolio , you need to measure

or estimate not only the return and volatility of individual assets, but alsothe correlations between them. With growing number and diversity ofpositions in the portfolio, the difficulty (and cost) of this task growsexponentially.

Value at Risk is not additive The fact that correlations between individual risk factors enter the VAR

calculation is also the reason why Value At Risk is not simply additive . TheVAR of a portfolio containing assets A and B does not equal the sum of VARof asset A and VAR of asset B.

The resulting VAR is only as good as the inputs and assumptions As with other quantitative tools in finance, the result and the usefulness of

VAR is only as good as your inputs . A common mistake with using theclassical variance-covariance Value At Risk method is assuming normaldistribution of returns for assets and portfolios with non-normal skewness.Using unrealistic return distributions as inputs can lead to underestimating

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Limitations of VaR

Different Value At Risk methods lead to different results There are several alternative and very different

approaches which all eventually lead to a number called ValueAt Risk: there is the classical variance-covariance parametricVAR, but also the Historical VAR method , or the Monte Carlo VARapproach (the latter two are more flexible with returndistributions, but they have other limitations). Having a widerange of choices is useful, as different approaches are suitablefor different types of situations. However, different approachescan also lead to very different results with the same portfolio , so

the representativeness of VAR can be questioned.

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The capital requirement under IMA would be a function ofthree components as indicated below :

Normal VaR Measure (for general market risk and specific risk)

Stressed VaR Measure (for general market risk and specific risk)

Incremental Risk Charge (IRC) (for positions subject to interest rate specific-risk capital charge).

Value-at-risk must be computed on a daily basis.

In calculating VaR, a 99th percentile, confidence interval is tobe used.

In calculating VaR, an instantaneous price shock equivalent toa 10-day movement in prices is to be used, i.e., the minimumholding period will be ten trading days.

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Calculation of VaR, Stressed VaR and Capital Requirement VaR Measures would be calculated, on a daily basis, as the sum of (a)

and (b) below:

a) Normal VaR , which is the higher of

(1) its previous days VaR number measured according to theparameters specified in this section (VaR t-1); and

(2) an average of the daily VaR measures on each of the precedingsixty business days (VaR avg ), multiplied by a multiplication factor (m c ).

b) Stressed VaR , which is the higher of

(1) its latest available stressed-VaR number (sVaR t-1); and (2) an average of the stressed VaR numbers over the preceding sixty

business days (sVaR avg ), multiplied by a multiplication factor (m s).

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Therefore, the capital requirement C is calculatedaccording to the following formula:

C = max {VaR t-1 ; (m c + p c )* VaR avg } + max {sVaR t-1 ; (m s+p s)* sVaR avg }

where:

m c and m s are the multiplication factors to be set by theRBIon the basis of their assessment of the quality of thebanks risk management system, subject to absoluteminimum of three for both the factors; and p c and p s isthe plus / add on factor, generally ranging from zero toone, to be decided by the bank based on the results of theback testing of its VaR model, as detailed below.

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Stress Testing

Stress Testing is a valuable risk management tool which tries to quantifythe size of potential losses under certain stress events. A stress event isan exceptional but credible event to which a banks portfolio isexposed. A stress event may involve subjecting the risk factors toshocks which itself is extreme but plausible movement of risk factor.

Stress testing to identify events or influences that could greatly impactbanks is a key component of a banks assessment of its capitalposition. A banks stress scenarios need to cover a range of factorsthat can create extraordinary losses or gains in trading portfolios, ormake the control of risk in those portfolios very difficult.

These factors include low-probability events in all major types of risks,including the various components of market, credit and operationalrisks. The market risk capital charge under IMA includes a stressed VaRmeasure . Banks would calculate Stressed VaR using the model inputscalibrated to historical data from a continuous 12-month period ofsignificant financial stress relevant to the banks portfolio andapproved by RBI. 41


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Stress Testing (Contd.): If a bank uses a 99% confidence level to calculate its value at

risk, it generally expects to suffer a loss exceeding the value atrisk on one day out of every 100.

What happens, however, on the one day when the value atrisk is exceeded?

How large is the loss on this day?

Could this be the one bad day required to break the bank?

Such possibilities are considered under stress testing.

Stress testing refers to techniques used by financial institutionsto analyze the effects of exceptional but plausible events inthe market on a portfolio's value.

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Stress Testing: (Contd.) Banks stress tests should be both of a quantitative and

qualitative nature, incorporating both market risk and liquidityrisk aspects of market disturbances.

Quantitative criteria should identify plausible stress scenarios towhich banks could be exposed. Qualitative criteria shouldemphasise that two major goals of stress testing are to evaluatethe capacity of the banks capital to absorb potential largelosses and to identify steps the bank can take to reduce its riskand conserve capital.

This assessment is integral to setting and evaluating the banksstrategy and the results of stress testing should be routinelycommunicated to senior management and, periodically, to thebanks board of directors.

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Stress tests help financial institutions to: overcome the shortfall of VAR models (as they deal with

tail events neglected by many such models)

communicate extreme scenarios throughout theinstitution, thereby enabling management to take thenecessary precautions (limit systems, additional capital,and so on)

manage risk better in more volatile and less liquid markets

bear in mind, during less volatile periods, that theprobability of disastrous events occurring should not beneglected

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Stress TestingSingle-Factor Stress Testing:

Sometimes referred to as sensitivity testing/ analysis

Single-factor stress testing involves applying a shift to a specific riskfactor affecting a portfolio .

Risk factors commonly used in sensitivity testing include changes in interest rates,

equity prices and

exchange rates .

Examples of single risk factors may include: A parallel shift in the yield curve of 100 basis points up and down

Yield curve steepening/flattening by 25 basis points

Stock index changes of 10% up and down

Movements of 6% up and down in major currencies (20% for othercurrencies) relative to the US dollar 45


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Limitations of Stress Tests

Stress testing can appear to be a straightforward technique. Inpractice, however, stress tests are often neither transparent norstraightforward.

They are based on a large number of practitioner choices as towhat risk factors to stress, how to combine factors stressed, what

range of values to consider, and what time frame to analyse. Even after such choices are made, a risk manager is faced with

the considerable tasks of sifting through results and identifyingwhat implications, if any, the stress test results might have forhow the bank should manage its risk-taking activities.

A well-understood limitation of stress testing is that there are noprobabilities attached to the outcomes. Stress tests help answerthe question How much could be lost? The lack of probabilitymeasures exacerbates the issue of transparency and theseeming arbitrariness of stress test design.

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Back testingStatistical testing that consist of checking whether actual tradinglosses are in line with the VAR forecasts

The Basel back testing framework consists in recording dailyexception of the 99% VAR over the last year

Even though capital requirements are based on 10 days VAR,back testing uses a daily interval, which entails moreobservations

On average, one would expect 1% of 250 or 2.5 instances ofexceptions over the last year

Too many exceptions indicate that either the model is understating VAR the Bank is unlucky How to decide ?

Statistical inference48


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Back Testing: RBI view

While back-testing of 1% VaR is required to establish theaccuracy of the model for the purpose of capital adequacy, inorder to dynamically verify model assumptions, banks may, inaddition, back-test VaR models based on 2%, 5% and 10% VaR.

A 95% daily confidence level is generally considered practical

for back-testing because one should observe roughly oneexcession a month (one in 20 trading days).

A 95% VaR represents a realistic and observable adverse move.

A higher confidence level, such as 99%, means that we wouldexpect to observe an exceedence only once in 100 days, orroughly 2.5 times a year.

Verifying higher confidence levels thus requires significantlymore data and time.

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Frequency of Back-Testing

Banks should perform back-testing of the VaR-models for each ofmajor risk categories separately wherever VaR for all major riskcategories is computed separately.

Banks should also perform back-testing of overall VaR, in case riskaggregation across all major risk categories has been done.

Banks should account for exceptions at least on a quarterly basis,but preferably on a monthly basis, using the most recent twelvemonths of data.

The implementation of the back-testing program should begin atleast six months before the date the bank makes an applicationto RBI for approval of the model.

In addition, the model should also be back-tested at least for twoquarters post-RBI approval, before it is actually used forcalculating regulatory capital.

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Reporting of Back-Testing Results to RBIn Supervisory Response

A bank should report to the RBI (Chief General Manager-in-Charge, Department of Banking Supervision, Central Office)the results of their back-testing exercise every quarter beforethe last day of the month following the close of reportingquarter. In addition to exceptions, the report should include:

i. The classification of exceptions and possible explanations forthe same.

ii. The proposed investigations, if not already completed.

iii. Action already taken or proposed to be taken to improvethe performance of the model.

iv. Number of exceptions observed during each of the lastthree back-testing results excluding the one under reporting.

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Supervisory Framework for the Interpretation ofthe Back-Testing Results

A bank will classify its back-testing outcomes into the followingthree zones depending on the number of exceptions arisingfrom back-testing:

If the back-testing results produce four or fewer exceptions, itfalls within the Green Zone and there may not be any increase

in the multiplication factor beyond minimum three for both VaRand stressed VaR.

If the back-testing results produce five to nine exceptions, it fallswithin the Yellow Zone and there would be an increase in themultiplication factors for both VaR and stressed VaR.

If the back-testing results produce ten or more exceptions, it fallswithin the Red Zone and the multiplication factors for both VaRand stressed VaR will be increased from three to four.

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Internal Model Approach - Benefits

Internal VaR system is more precise VaR account for correlations Market risk charge under IMA likely to be lower With improvements in risk measurement techniques, IMA will

enable capital charge to be more precise Market Risk charge needs to be computed and monitored daily Each day VaR is compared with the subsequent Trading profit or

loss Back Testing will help to refine the framework

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Internal Model Approach: Summary

Independent Risk Control Unit responsible for design andimplementation of Banks risk management systems Regular Back-Testing Initial and on-going Validation of Internal Model Banks Internal Risk Measurement Model must be integrated

into Management decisions Risk measurement system should be used in conjunction withTrading and Exposure Limits.

Stress Testing Risk measurement systems should be well documented

Independent review of risk measurement systems by internalaudit Board and senior management should be actively involved

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Market Risk Management: Summary

56

Know your risks Control Measures Allocate Capital

Measurement Techniques

Marking to Market

Duration, Convexity

Price Value of a Basis Point

VaR - Forex (Spot & Forward)

Stress Testing

Scenario Analysis

Duration Limits

VaR Limits

Stop Loss Limits

Counterparty ExposureLimits

Country Exposure Limits

StandardizedModel

Internal Model

Time

S o p h i s t i c a t i o n

Mark to Market

Duration

Value at Risk

Stress Testing

Use of Statistical

analysis todeterminemaximum losses

Use of What if scenarios to

determine lossesin extreme

events Cashflowanalysis tomeasure the

sensitivity of fixed incomeinstruments

Revaluation ofthe portfolio to

measure notional P/L

Time Time

S o p h i s t i c a t i o n

Mark to Market

Duration

Value at Risk

Stress Testing

Use of statistical

analysis todeterminemaximum losses

Use of What if scenarios to

determine lossesin extreme

events Cashflowanalysis tomeasure the

sensitivity of fixed incomeinstruments

Revaluation ofthe portfolio to

measure notional P/L

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Supporting Factors for RiskManagement

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Involve ofthe board of directors

and high level management

1

Formulate riskmanagement policies

and procedures

2

Establish a unit to operaterisk management

3

Set up riskmanagement system

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Limitations to Risk Management

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Limitations

Involve of the board of directorsand high level management

Not enough cooperation Low qualification Lack of independence to make a decision Not transparence

Formulate risk management policyand procedures

Policies/ procedures not match with risks

Underdevelopment Infrastructure Rigid to implement Communication failure

Establish a unit to operaterisk management

Lack of adequate structure Staff has less experience

Lack of independence

Set up risk managementsystem

No follow up and control system Not enough risk assessment/ management

instruments Database and IT system

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Organisation of Market Risk Functionof a bank

A typical organisational design of the market risk function of a bankconforming to standards of Basel II Framework for management andmeasurement of market risk would have the following independentelements:

(i) Front Office/Trading unit : This unit comprises the trading desks and theirimmediate supervisors.

(ii) Middle Office/Risk Control Unit : a) This unit is responsible for the design and implementation of the banks

market risk management system. The unit should produce and analysedaily reports on the output of the banks risk measurement model,including an evaluation of the relationship between measures of risk

exposure and trading limits. This unit must be independent from businesstrading units and should report directly to senior management of the bank.

b) The unit should conduct a regular back-testing programme, i.e. an ex-post comparison of the risk measure generated by the model againstactual daily changes in portfolio value over longer periods of time, as wellas hypothetical changes based on static positions.

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Organisation of Market Risk Functionof a bank (Contd.)

c) This unit should also conduct the initial and on-going validation of theinternal model. However, the responsibilities for model construction andmodel validation shall be clearly and formally defined. Further, the staffperforming model validation shall be independent of the staff whoconstructed the model (i.e. the bank shall ensure that there is no conflict ofinterest and that the staff performing the validation work can provideobjective and effective challenge to the staff who construct the model).

d) The unit will also be responsible for performing stress tests on the marketrisk exposures of the bank.

(iii) Model Construction Unit: If a bank decides to construct the market riskmodel(s) in-house, it should constitute the model construction teamcomprising staff who are later not involved in the validation and internalaudit of these models.

(iv) Model Validation Unit: This unit will comprise the suitably qualified staffwho were not involved in the model development process. However, theunit may be a part of the risk control unit.

(v) Back Office : This unit ensures the correct recording of transactions andfunds transfers. 60

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Organisation of Market Risk Functionof a bank (Contd.)

(vi) Internal Audit : An independent review of the risk measurement system shouldbe carried out regularly in the banks own internal auditing process. This reviewshould include both the activities of the business trading units and of theindependent risk control unit. A review of the overall risk management processshould take place at regular intervals (ideally not less than once a year) and shouldspecifically address, at a minimum:

The adequacy of the documentation of risk management system and process;

The organisation and functioning of the risk control unit; The integration of market risk measures into daily risk management;

The approval process for risk pricing models and valuation systems used by front and back-office personnel;

The validation of any significant change in the risk measurement process;

The scope of market risks captured by the risk measurement model;

The integrity of management information system;

The accuracy and completeness of position data;

The verification of the consistency, timeliness and reliability of data sources used to runinternal models, including the independence of such data sources;

The accuracy and appropriateness of volatility and correlation assumptions;

The accuracy of valuation and risk transformation calculation; The verification of the models accuracy through frequent back -testing

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market risk rev 12

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