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- 1. 1DANIAL MUNSOOR FIN955 REPORT Table of Contents1 INTRODUCTION ............................................................................................................ 2 1.1 Background ................................................................................................................. 2 1.2 Objective ..................................................................................................................... 22 BANK CAPITAL STANDARDS AND MARKET RISK ............................................. 23 SIGNIFICANE OF MARKET RISK TODAY .............................................................. 2 3.1 Securitization............................................................................................................... 3 3.2 Growth of Financial Derivatives Market .................................................................... 3 3.3 Adoption of new Accounting Standards ..................................................................... 34 MORDERN APPROACHES TO MARKET RISK MEASURMENT ........................ 3 4.1 Value at Risk Models Responding to Market Risk ..................................................... 4 4.1.1 Variance Covariance Method .............................................................................. 4 4.1.2 Historical Method ................................................................................................ 6 4.2 Stress Testing .............................................................................................................. 85 VAR MODEL BACKTESTING AS PER THE BASEL COMMITTEE .................... 86 TRADITIONAL APPROACH TO MARKET RISK MEASURMENT ..................... 97 FIVE MAIN CATEGORIES OF MARKET RISKS .................................................. 108 MARKET RISK AND THE FINANCIAL CRISIS .................................................... 109 CONCULSION ............................................................................................................... 1110 REFERENCES ................................................................................................................ 12
- 2. 2DANIAL MUNSOOR FIN955 REPORT1 INTRODUCTION 1.1 Background: This report examines one of the most important risks associated with banks known as the Market Risk. Market Risk is defined as the risk of losses in the value of a bank’s Trading Portfolio due to the changes in market factors such as interest rates, stock prices, exchange rates, inflation, economic growth, unemployment etc. This risk is also referred to as Price Risk. 1.2 Objective: The objective of this report is to understand the origin of Market Risk, its significance today, and how it can be measured using Traditional and Modern techniques. The report also highlights as to how we can perform VAR Model Backtesting according to the Basel Committee. However, for a better understanding of the subject, graphs and case studies/examples have also been used.2 BANK CAPITAL STANDARDS AND MARKET RISK: The original Basel Agreement was unable to deal with one of the most important risk being faced by banks today i.e. Market Risk. Therefore, in January 1996, the Basel Committee on Banking Supervision modified the Basel Agreement by adding certain rules which permitted the largest banks to conduct risk measurement and estimate the amount of capital necessary to cover market risk (Rose and Hudgins, 2010:495).3 SIGNIFICANE OF MARKET RISK TODAY: Market risk has become significant due to banks’ involvement in Cross Border transactions and Diverse Markets around the globe. Hence they are exposed to price
- 3. 3DANIAL MUNSOOR FIN955 REPORT fluctuations in these markets that can adversely affect the earnings on their trading portfolios (Hughes and Macdonald, 2002:301). Market risk has been gaining importance on international financial markets over the last decade due to the following three reasons: 3.1 Securitization: The securitization process has resulted in illiquid assets (loans/mortgages) being increasingly replaced by assets that have a liquid secondary market, and therefore a price. This process has given rise to Mark to Market method for measuring the value of assets held by Financial Institutions (Resti and Sironi, 2007:106). 3.2 Growth of Financial Derivatives Market: This market mainly looks at the change in the relevant market value caused by changes in underlying asset prices (Resti and Sironi, 2007:106). 3.3 Adoption of new Accounting Standards: Adoption of new accounting standards, which particularly result in an immediate effect of profits and losses linked to short term changes in market conditions, have played an important role in making market risk effects more noticeable while highlighting their importance (Resti and Sironi, 2007:106).4 MORDERN APPROACHES TO MARKET RISK MEASURMENT: Market Risk can be measured using two very sophisticated and quantitative methods known as Value at Risk (VAR) and Stress Testing. However, these methods have been described below in great detail along with comprehensive case studies.
- 4. 4DANIAL MUNSOOR FIN955 REPORT 4.1 Value at Risk Models Responding to Market Risk: It is supposed to be the premiere risk management technique. This method measures market risk over a certain period of time under normal market conditions (Hughes and Macdonald, 2002:462). Due to the weakness in the original Basel Agreement and their lack of flexibility in responding to advances in finance industry, bank regulators started to allow the major banks to use their own internal models to determine the loses they might incur. These models are known as the VAR Models which determine the amount we tend to lose over a certain period for a given Confidence Level/Probability (Rose and Hudgins, 2010:495). The most commonly used confidence/significance levels are 1% and 5%. Suppose that the 1% Daily VAR is $18 million. Now this situation can be interpreted in two ways as shown below: There is a 99% chance that the daily losses will exceed $18 million or the maximum daily loss would be $18 million. There is a 1% chance that the daily losses will not exceed $18 million or the minimum daily loss would be $18 million. However, the VAR can be calculated using any one of the following methods: 4.1.1 Variance Covariance Method: This method assumes that portfolio returns are normally distributed i.e. it is described by its Expected Value (µ) and Standard Deviation ( ). To have a better understanding of this method, a case study has been discussed below which covers all the important aspects relevant to the VAR method.
- 5. 5DANIAL MUNSOOR FIN955 REPORT CASE STUDY: A portfolio manager at XYZ Bank is interested in computing the 5% Yearly VAR for a portfolio consisting of two classes of assets. The first asset class consists of a group of securities of the stocks traded on the NYSE. On an annual basis, the expected return on this asset class is 13.52% and the standard deviation is 12.97%. The second asset class consists of a group of securities traded on NASDAQ. The expected annual return on this asset class is 16.80% and the standard deviation is 25.78%. The correlation between the annual returns of the two asset classes is 0.79. The market value of the portfolio is $20 million, and the portfolio is invested 60% and 40% in the two asset classes, respectively (Source: Resti and Sironi, 2007) NYSE = 13.52% = 12.97% = 0.6 NASDAQ = 16.80% = 25.78% = 0.4 For such a scenario, we should first recall that the Expected Return of a Portfolio ( ) is a weighted average of the expected returns of its component stocks or asset classes, which in our case are NASDAQ and NYSE. We should also know that the Variance of a Portfolio ( ) is a weighted average of the variances and covariance of the component stocks or asset classes. In order to calculate and , we use the following formulas: = + = 0.60(0.1352) + 0.40(0.168) = 0.1483 = 14.83% = + +2
- 6. 6DANIAL MUNSOOR FIN955 REPORT = + + 2(0.60)(0.40)(0.1297)(0.2578)(0.79) = 0.0294 = = 0.1715 = 17.15% - 1.656 In order to calculate VAR we apply the following formula: 5% Yearly VAR = ( - 1.656 ) x Value of Portfolio = [0.1483 – 1.656 (0.1715)] x $20,000,000 = -$2.714 million It means that there is a 5% chance that the yearly loses will exceed $2.714 million OR there is a 95% chance that the yearly loses will not exceed $2.714 million. However the same procedure would be followed if we were to calculate 1% Yearly VAR. the only difference would have been that instead of using ( - 1.656 ) we would be using ( – 2.336 ) to calculate the 1% Yearly VAR. 4.1.2 Historical Method: This is another method which can be used to calculate VAR. This method uses data from the returns of the portfolio over a recent past period. To
- 7. 7DANIAL MUNSOOR FIN955 REPORT have a better understanding of this method, a case study has been discussed below. CASE STUDY: To keep the example simple, it is assumed that only one-stock portfolio is used. Suppose we have the following 16 worst monthly returns on IBM stock during the last 20 years. Assume that the value of the portfolio is $200,000 (Source: Resti and Sironi, 2007). -0.17867 -0.10655 -0.08065 -0.07220 -0.17505 -0.09535 -0.07779 -0.07126 -0.17296 -0.09348 -0.07237 -0.05031 -0.16440 -0.08236 -0.07234 0.04889 (Note: The data above has already been arranged in descending order) Before we proceed, the first thing to be noted here is that in 20 years we will have 240 monthly returns. But here we are able to see only 16 returns. However, the amount of data given above is sufficient to compute the VAR. Suppose that a financial analyst is interested in computing 1% and 5% monthly VAR. In order to calculate VAR he would do the following: For 5% monthly VAR: Out of 240 returns, 5% of them are the 12 worst returns (240 x 5%). Therefore, the historical VAR would be the 12th worst return. Since the data is already arranged in descending order, we can see from the table that this return is -0.07234 (highlighted in blue). So the VAR would be $14,468 (0.07234 x 200,000). For 1% monthly VAR: Out of 240 returns, 1% of them are the 2.4 worst returns (240 x 1%). In this situation we would probably use the 2nd worst return, which is -0.17505
- 8. 8DANIAL MUNSOOR FIN955 REPORT (highlighted in red). Therefore, the monthly VAR would be $35,010 (0.17505 x 200,000). 4.2 Stress Testing: It is a computer simulation technique that measures market risk over a certain period of time under abnormal market conditions. Stress tests provide information summarizing the firm’s exposure to extreme, but possible circumstances (Hughes and Macdonald, 2002). It identifies and manages situations which can cause extraordinary losses by revaluing the portfolio under simulated conditions (Resti and Sironi, 2007:218).5 VAR MODEL BACKTESTING AS PER THE BASEL COMMITTEE: The Basel Committee makes it obligatory for the banks to regularly backtest their VAR models on a quarterly basis, based upon 250 trading days. The table below helps a bank in performing a backtest in order to have an idea that whether its VAR model has a satisfactory quality level or not (Resti and Sironi, 2007:246). Area Number of Increase Multiplying Exceptions Factor Green 0 0.00 3.00 1 0.00 3.00 2 0.00 3.00 3 0.00 3.00 4 0.00 3.00 Yellow 5 0.40 3.40 6 0.50 3.50 7 0.65 3.65 8 0.75 3.75 9 0.85 3.85 Red ≥10 1.00 3.95 Suppose a bank is using a model to calculate Daily VAR at 99% Confidence Level. In this case, we are likely to expect loses only in 1% of the cases i.e. on 2.5 out of the 250
- 9. 9DANIAL MUNSOOR FIN955 REPORT trading days. If the “Number of Exceptions”, i.e. the number of days on which loses are in excess of VAR, is lower than, equal to, or slightly higher than 2.5 we can assume that the model is working perfectly. However, if the number of exceptions is significantly higher than predicted by the adopted confidence level, we can assume that the model is encountering some problems (Resti and Sironi, 2007:246). The table above, which was developed by the Basel Committee in 1996, also shows that the Multiplying Factor ranges from 3 (if the number of exceptions is equal to a maximum of 4) to 4 (if the number of exceptions is 10 or more). Note that if the VAR model falls in the red area, the multiplying factor of 3 will be raised to 4. In other words, it means that the worse the model’s, performance the greater the increase (Resti and Sironi, 2007:247). Backtesting helps a bank to evaluate its past forecasting performance and also indicates a higher capital requirement if the bank has been inconsistent in forecasting, thus encouraging the bankers to develop better models.6 TRADITIONAL APPROACH TO MARKET RISK MEASURMENT: The Traditional Approach to market risk management was based on nominal values of individual positions. Moreover, the risk exposure was also directly proportional to the nominal value of the financial instruments (Resti and Sironi, 2007:107). This approach was well known because: It was simple to use Cost was relatively low It did not require much information and updates because the nominal value of an asset remains constant.
- 10. 10DANIAL MUNSOOR FIN955 REPORT On the contrary it also has several limitations out of which the three main ones are as follows: Nominal value of a position doesn’t reflect its market value Nominal values cannot capture the different degree of sensitivity of different securities to changes in market factors Nominal value does not consider the volatility and correlation conditions of market prices/rates7 FIVE MAIN CATEGORIES OF MARKET RISKS: As described in the report, Market Risk is the risk of loss associated with the unexpected movements in the market factors and is to be distinguished from other types of risks such as Credit (Default) Risk, Operational Risk etc. (Dowd, 2005:15). However, we cannot completely separate market risk from them because it can sometimes be created by them. For e.g. defaults can lead to changes in market prices and rates i.e. they might affect bond spreads or bond prices, which can result in market losses. On the other hand, operation failures can also lead to market losses (Dowd, 2005:15). The five main categories of market risk are: Equity Risk Commodity Risk Volatility Risk Exchange Rate Risk Interest Rate Risk8 MARKET RISK AND THE FINANCIAL CRISIS: The current “Financial Turmoil” has completely changed the picture of the finance industry for all institutions, including the banks as they are now operating in a rapidly changing environment. The crisis has forced many banks to think outside the box i.e.
- 11. 11DANIAL MUNSOOR FIN955 REPORT banks cannot rely heavily on their internal models for predicting stress events, asset price uncertainty, and ineffective hedge behaviour that leads to indirect deterioration of portfolio quality and pressure on net interest margin (African Development Bank, 2009). Current distorted and illiquid market conditions have created valuation challenges for the investment, borrowing and derivatives portfolio. Moreover, in a distressed liquidity and credit environment, “fire-sale” prices are often significantly lower than expected recovery values. And so, in spite of the credit downgrades of counterparties, it is difficult to liquidate positions (African Development Bank, 2009).9 CONCULSION: In conclusion, for Financial Institutions (FI’s) taking speculative positions in currencies, bonds or stocks, there is a high possibility that loses associated with market risk can eat the profits which have been realized over a period of time by these FI’s. Despite of market risk’s growing significance, the Basel Agreement was unable to deal with it, and therefore the bank regulators allowed the major banks to use their own internal model known as Value at Risk (VAR) model. As shown above, VAR helps a bank to determine the amount it tends to lose over a certain period for a given Confidence Level. Banks can also use Stress Testing to measure market risk under pessimistic scenarios. Apart from using the latter two modern techniques, banks can also use the Traditional Approach to measure market risk. Moreover, the current financial crisis also forced many banks not to rely heavily upon their internal models.
- 12. 12DANIAL MUNSOOR FIN955 REPORT10 REFERENCES: Hughes, J. & Macdonald, S. 2002, International Banking Text and Cases, Pearson Education, Boston. Resti, A. & Sironi, A. 2007, Risk management and shareholders’ value in banking, Wiley, London. Rose, P. & Hudgins, S. 2010, Bank Management and Financial Services, McGraw-Hill, New York. Dowd, K. 2005, Measuring Market Risk, Avaliable: http://books.google.co.uk/books?id=wL7hwpuTa9sC&printsec=frontcover&source=gbs _ge_summary_r&cad=0#v=onepage&q&f=false [Accessed 29th March, 2011] African Development Bank, 2009, Market Risk Review, Available: http://www.afdb.org/fileadmin/uploads/afdb/Documents/Financial Information/Market%20Risk%20Review%202009.pdf [Accessed 28th March, 2011]

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