Instrument Sensitivity1) Basically, any asset purchased by an investor can be considered a financial instrument. Antique furniture, wheat and corporate bonds are all equally considered investing instruments; they can all be bought and sold as things that hold and produce value. Instruments can be debt or equity, representing a share of liability (a future repayment of debt) or ownership. 2) Commonly, policymakers and central banks adjust economic instruments such as interest rates to achieve and maintain desired levels of other economic indicators such as inflation or unemployment rates. 3) Some examples of legal instruments include insurance contracts, debt covenants, purchase agreements or mortgages. These documents lay out the parties involved, triggering events and terms of the contract, communicating the intended purpose and scope. Scenario AnalysisThere are many different ways to approach scenario analysis, but a common method is to determine what the standard deviation of daily or monthly security returns are, and then compute what value would be expected for the portfolio if each security generated returns two or three standard deviations above and below the average return.In this way, an analyst can have reasonable certainty that the value of a portfolio is unlikely to fall below (or rise above) a specific value during a given time period.
Stress testing is a useful method for determining how a portfolio will fare during a period of financial crisis. The Monte Carlo simulation is one of the most widely used methods of stress testing. A stress test is also used to evaluate the strength of institutions. For example, the Treasury Department could run stress tests on banks to determine their financial condition. Banks often run these tests on themselves. Changing factors could include interest rates, lending requirements or unemployment. Financial CrisesA financial crisis can come as a result of institutions or assets being overvalued, and can be exacerbated by investor behavior. A rapid string of sell offs can further result in lower asset prices or more savings withdrawals. If left unchecked, the crisis can cause the economy to go into a recession or depression.
VaR is commonly used by banks, security firms and companies that are involved in trading energy and other commodities. VaR is able to measure risk while it happens and is an important consideration when firms make trading or hedging decisions.
For historical simulation the model calculates potential losses using actual historical returns in the risk factors and so captures the non-normaldistribution of risk factor returns. This means rare events and crashes can be included in the results. As the risk factor returns used for revaluing the portfolio are actual past movements, the correlations in the calculation are also actual past correlations. They capture the dynamic nature of correlation as well as scenarios when the usual correlation relationships break down.
As with historical simulation, Monte Carlo simulation allows the risk manager to use actual historical distributions for risk factor returns rather than having to assume normal returns. A large number of randomly generated simulations are run forward in time using volatility and correlation estimates chosen by the risk manager. Each simulation will be different but in total the simulations will aggregate to the chosen statistical parameters (that is, historical distributions and volatility and correlation estimates). This method is more realistic than the previous two models and therefore is more likely to estimate VaR more accurately. However its implementation requires powerful computers and there is also a trade-off in that the time required to performcalculations is longer.
The higher the perceived credit risk, the higher the rate of interest that investors will demand for lending their capital. Credit risks are calculated based on the borrowers' overall ability to repay. This calculation includes the borrowers' collateral assets, revenue-generating ability and taxing authority (such as for government and municipal bonds).Credit risks are a vital component of fixed-income investing, which is why ratings agencies such as S&P, Moody's and Fitch evaluate the credit risks of thousands of corporate issuers and municipalities on an ongoing basis.
Counterparty RatingsBecause A is a counterparty to B and B is a counterparty to A both are exposed to this risk. For example if Joe agrees to lends funds to Mike up to a certain amount, there is an expectation that Joe will provide the cash, and Mike will pay those funds back. There is still the counterparty risk assumed by them both. Mike might default on the loan and not pay Joe back or Joe might stop providing the agreed upon funds. For example, two companies might enter into an interest rate swap contract as follows:-For three years, Company A pays Company B 5% interest per year on a notional principal amount of $10 million.-For the same three years, Company B pays Company A the one-year LIBOR rate on the same notional principal amount of $10 million.This would be considered a plain vanilla interest rate swap because one party pays interest at a fixed rate on the notional principal amount and the other party pays interest at a floating rate on the same notional principal amount.
Banks and financial institutions closely monitor aggregate risk in order to minimize their exposure to adverse financial developments - such as a credit crunch or even insolvency - arising at a counterparty or client. This is achieved through position limits that stipulate the maximum dollar amount of open transactions that can be entered into for spot and forward currency contracts at any point in time.Aggregate risk limits will generally be larger for long-standing counterparties and clients with sound credit ratings, and will be lower for clients who are either new or have lower credit ratings. Replacement cost insurance can be purchased to protect and cover a company or individual from this type of cost. This insurance pays the full amount needed to replace the asset or property. The gradual reduction of the asset value or depreciation is not taken into account for insurance purposes.
Operational risk can be summarized as human risk; it is the risk of business operations failing due to human error. Operational risk will change from industry to industry, and is an important consideration to make when looking at potential investment decisions. Industries with lower human interaction are likely to have lower operational risk.
Measuring risk essentials of financial risk management
Essentials of Financial Risk Management Chapter 9: Measuring Risk Lecture : Prof: Chheang Meng Hiek Prepared by: PHET CHHO DIEP ROUMKaren A. Horcher John Wiley & Sons, Inc. 1
Measuring RiskI. What is Risk?II. Measures of ExposureIII. Value–at–RiskIV. Credit Risk MeasurementV. Operational Risk MeasurementVI. SummaryKaren A. Horcher John Wiley & Sons, Inc. 2
Chapter be able to• Differentiate between measures of exposure and measures of risk.• Consider the strengths and weaknesses of risk measurement Methodologies.• Identify alternative strategies for estimating risks.Karen A. Horcher John Wiley & Sons, Inc. 3
I. What is Risk?• Risk is the business of probabilities….can be defined as the chance of something happening that will impact upon objectives.• The estimated chance - The chance that an investments actual return will be different than expected.• A probabilities or threat of a damage, Loss, or other negative occurrence that is caused by external or internal vulnerabilities.Karen A. Horcher John Wiley & Sons, Inc. 4
Category of RiskKaren A. Horcher John Wiley & Sons, Inc. 5
Category of Risk - ContKaren A. Horcher John Wiley & Sons, Inc. 6
Category of Risk - ContKaren A. Horcher John Wiley & Sons, Inc. 7
Category of Risk - ContKaren A. Horcher John Wiley & Sons, Inc. 8
II. Measures of Exposure• What is the exposure? A problem when you have a number of possible risks is that it can be difficult to decide which risks are worth putting effort into addressing. One component of risk management. Risk Exposure is a simple calculation that gives a numeric value to a risk, enabling different risks to be compared. Risk Exposure of any given risk = Probability of risk occurring x total loss if risk occursKaren A. Horcher John Wiley & Sons, Inc. 9
Measures of Exposure – Cont There are two views of risk management. The day to-day or tactical standpoint. High-level or strategic view. To sum up: In order to manage risk, it is necessary to have the capability to monitor risk from both standpoints in order to assess potential loss to the organization. Risk management requires both quantitative and qualitative analysis.Karen A. Horcher John Wiley & Sons, Inc. 10
Measures of Exposure – Cont• Gap Analysis Measures the sensitivity of an exposure, asset, or portfolio to market rate or price changes by considering the mismatch between assets and liabilities. Currency exposure-arising from foreign currency - Cash flows For example, if an organization has more euro inflows than outflows in a given period, but the mismatch reverses the following period, then the euro cash flows offset one another with only a timing difference. If over the course of a longer period, such as a fiscal cycle, there are more euros coming in than going out, the difference provides exposure to a falling euro.Karen A. Horcher John Wiley & Sons, Inc. 11
Measures of Exposure – Cont• Leverage and Direction The use of leverage increases the potential for loss. Therefore, the impact of any leverage or gearing strategy is important to consider when calculating the amount that an organization could potentially lose. The calculation of potential loss without considering the impact of leverage underestimates potential losses. Direction is the nature of an exposure or trading position, either long or short. A long position will obviously benefit from a rise in prices, while a short position benefits from a price decline. Both leverage and direction are factors in the potential size of a loss given an adverse market move.Karen A. Horcher John Wiley & Sons, Inc. 12
Measures of Exposure – Cont• Instrument Sensitivity Can be a useful way to measure potential for risk. Duration - Estimate of the sensitivity of fixed income securities’ prices to small changes in interest rates. For assessing gaps between assets and liabilities. Convexity, Measures the rate of change of duration, Be used to further refine the sensitivity of a fixed income security or exposure to interest rate changes. Option delta- the option’s value given a change in the price of the underlying.• Scenario Analysis Commonly focuses on estimating what a portfolios value would decrease to if an unfavorable event, or the "worst-case scenario", were realized. involves computing different reinvestment rates for expected returns that are reinvested during the investment horizon.Karen A. Horcher John Wiley & Sons, Inc. 13
Measures of Exposure – Cont• Stress Testing A simulation technique used on asset and liability portfolios to determine their reactions to different financial situations. Stress tests are also used to gauge how certain stressors will affect a company or industry. They are usually computer-generated simulation models that test hypothetical scenarios.• Financial Crises A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated with a panic or a run on the banks, in which investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution. Not Predictable. Correlations between markets and instruments, may break down entirely.Karen A. Horcher John Wiley & Sons, Inc. 14
III. Value–at–Risk• Used measure of market risk. It is the maximum loss which can occur with X% confidence over a holding period of n days.• Used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.• Systematic methodology to quantify potential financial loss based on statistical estimates of probability.• Can be used by any entity to measure its risk exposure.Karen A. Horcher John Wiley & Sons, Inc. 15
Value-at-Risk – Cont• Methods to Calculate Using historical data Using stochastic simulation, random or Monte Carlo scenario generation. Monte Carlo simulation is based on randomly generated market moves. Volatilities and correlations are calculated directly from underlying time-series data, assuming a normal distribution. Value-at-risk using the variance/covariance (parametric) approach. Volatilities and correlations are calculated directly from the underlying time series, assuming a normal distribution.Karen A. Horcher John Wiley & Sons, Inc. 16
Value-at-Risk – Cont• Variance-Covariance Method Normally Distributed – Correlations Historical data on investment returns Simple historic volatility: this is the most straight forward method but the effects of a large one-off market move can significantly distort volatilities over the required forecasting period.Example:An IBM stock is trading at $115 with a 1-year standard deviation of 20%. Inthe normal distribution, 95% confidence level is 1.645 standard deviationsaway from the mean.Therefore, our VaR at 95% confidence level will be: VaR (95%) = 115* 0.20 * 1.645 = 37.835Karen A. Horcher John Wiley & Sons, Inc. 17
Value-at-Risk – Cont• VaR of a Portfolio Generally VaR will not be calculated for a single position, but aportfolio of positions. In such a case will require the portfolio volatility.The portfolio volatility of a two-asset portfolio is given by:• W1 is the weighting of the first asset• W2 is the weighting of the second asset• Q1 is the standard deviation or volatility of the first asset• Q2 is the standard deviation or volatility of the second asset• P is the correlation coefficient between the two assetsKaren A. Horcher John Wiley & Sons, Inc. 18
Value–at–Risk - Cont• Historical Simulation Method Finances VaR analysis-Procedure for predicting VaR for many portfolio Determined on the basis of the information about potential profit and loss gained from the simulation scenarios. Avoids some of the pitfalls of the correlation method (normally distributed returns, constant correlations, constant deltas)• VaR (1 – ) is the estimated VaR at the confidence level 100 × (1 – )%.• (R) is the mean of the series of simulated returns or P&Ls of the portfolio• R is the worst return of the series of simulated P&Ls of the portfolio or, in other words, the return of the series of simulated P&Ls that corresponds to the level of significanceKaren A. Horcher John Wiley & Sons, Inc. 19
Value-at-Risk – Cont• Monte Carlo Simulation Analyze (complex) instrument, Portfolios and investment by simulating thevarious sources of uncertainty affecting their value, and then determining theiraverage value over the range of resultant outcomes. To calculate VaR using M.C. simulation we Value portfolio today Sample once from the multivariate distributions of the xi Use the xi to determine market variables at end of one day Revalue the portfolio at the end of day Calculate P Repeat many times to build up a probability distribution for P VaR is the appropriate fracted of the distribution times square root of N For example, with 1,000 trial the 1 percentile is the 10th worst case. Use the quadratic approximation to calculate PKaren A. Horcher John Wiley & Sons, Inc. 20
IV. Credit Risk MeasurementDefinition One of the most fundamental types of risk. it represents the chance the investor will lose his or her investment. The probability of loss as a result of the failure or unwillingness of a counterparty or borrower to fulfill a financial obligation.Issue: Exposure to credit risk increases with the market value of outstanding financial instruments with other counterparties, all else being equal. Whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Lenders risk that borrower will not repay or The total amount of credit extended to a borrower by a lender.Karen A. Horcher John Wiley & Sons, Inc. 21
Credit Risk Measurement - Cont• Counterparty Ratings The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract. The other party that participates in a financial transaction. Every transaction must have a counterparty in order for the transaction to go through. More specifically, every buyer of an asset must be paired up with a seller that is willing to sell and vice versa. In most financial contracts, counterparty risk is also known as "default risk".• Notional Exposure In an interest rate swap, the predetermined dollar amounts on which the exchanged interest payments are based. Notional principal never changes hands in the transaction, which is why it is considered notional, or theoretical. Neither party pays or receives the notional principal amount at any time; only interest rate payments change hands.Karen A. Horcher John Wiley & Sons, Inc. 22
Credit Risk Measurement - Cont• Aggregate Exposure The exposure of a bank, financial institution, or any type of major investor to foreign exchange contracts - both spot and forward - from a single counterparty or client. Aggregate risk in forex may also be defined as the total exposure of an entity to changes or fluctuations in currency rates.• Replacement Cost The cost to replace the assets of a company or a property of the same or equal value. The replacement cost asset of a company could be a building, stocks, accounts receivable or liens. This cost can change depending on changes in market value. Also referred to as the price that will have to be paid to replace an existing asset with a similar asset.Karen A. Horcher John Wiley & Sons, Inc. 23
Credit Risk Measurement - Cont• Credit Risk Measures Probability of counterparty default, which is an assessment of the likelihood of the counterparty defaulting. Exposure at counterparty default, which takes into account an organization’s exposure to a defaulting counterparty at the time of default. Loss given counterparty default, which considers recovery of amounts that reduces the loss otherwise resulting from a default.• Future of Credit Risk MeasurementKaren A. Horcher John Wiley & Sons, Inc. 24
V. Operational Risk MeasurementOverview of Operational Risk• Inadequate or failed internal processes: Marketing material can be mailed to the wrong customers, account opening documentation can turn out not to be robust, transactions can be processed incorrectly, etc.• People: violation of employee health and safety rules, organized labor activities and discrimination claims. inadequate training and management, human error, lack of segregation, reliance on key individuals, lack of integrity, honesty, etc.• Systems: The growing dependence of financial institutions on IT systems is a key source of operational risk. Data corruption problems, whether accidental or deliberate, are regular sources of embarrassing and costly operational mistakes.• External events: This source of operational risk has at least two discernible dimensions to it, firstly the extent to which a chosen business strategy pursued by a bank may expose it to adverse external events, and secondly external events that impact it independently, emanating from the business environment in which it operates.Karen A. Horcher John Wiley & Sons, Inc. 25
Operational Risk Measurement - ContSome methods that have been used to measure orindicate potential for operational risk in financialinstitutions and other organizations include: Number of deviations from policy or stated procedure Comments and notes from internal or external audits Volume of derivatives trades (gross, not netted) Levels of staff turnover Volatility of earnings Unusual complaints from customers or vendorsKaren A. Horcher John Wiley & Sons, Inc. 26
VI. Summary• The concept of probability is the central tenet of risk, and the business of risk measurement involves estimating the probability of loss.• Scenario analysis involves using a set of predetermined changes in market prices or scenarios to test the performance of the current portfolio or exposure.• The most commonly used measure of market risk is value at risk, a systematic methodology based on statistical estimates.• As the costs of computation decline and user sophistication increases, the number and variety of risk management tools has increased substantially. More rigorous measurements of risk will likely become commonplace.Karen A. Horcher John Wiley & Sons, Inc. 27
Discussion Thank You.Karen A. Horcher John Wiley & Sons, Inc. 28