Chapter 4 – Market Risk

Market Risk in Banks

Market Risk : It is the risk of adverse variation in the market value (called marked to market) of the trading Portfolio of a bank at current prices (investments in various securities & instruments), as a result in market movements during the period, when these investments are held by the bank (i.e. till the time required for liquidation).The longer this period, larger the possibility of these variations. If the variation is favourable, there is possibility of earning profits and if these are un-favourable, that would result into loss to the bank.

Liquidation risk : It is the risk that arises on account of lack of trading liquidity in the market and involves the asset liquidity risk and market liquidity risk. Asset liquidation risk is the risk when a specific asset (a security) faces liquidation problem due to poor liquidity in that security.

Market liquidation risk refers to a position when there is general liquidity crunch in the market that affects the trading liquidity adversely for all securities and not a particular security. When the liquidity is high in the market, the variation ‘ in price is lower compared to a situation, when the liquidity is poor.

Liquidation risk arises on account of :

• Adverse change in the market prices
• Inability to liquidate position at a fair market price
• Liquidation-of position causing large price change
• Inability to liquidate a position at any price

Credit & counterparty risk : The market participants keep on valuing the credit risk of the issuers of the securities, taking into account, the credit rating by credit rating agencies, from time to time. The credit risk is the risk that arises on account of default by the issuer of a security or because of rating migration of the security. When rating of a security is downgraded, it results in decline in the price of that security. As a result of such change in the price of security, there is possibility of a default by a party dealing in that instrument, which is called counter-party risk.

Organizational Structure

The organizational set up for Market Risk Management comprises:

• The Board of Directors
• The Risk Management Committee
• The Asset-Liability Management Committee (ALCO)
• The ALM support group/ Market Risk Group
• The Middle Office

Risk identification

Banks are required to analyze all products (both standard and non-standard products) and transactions for the risks associated with them. Standard products have ‘Product Program’ for each of them. All Risk Taking Units are required to operate within an approved Market Risk Product Program, which defines procedures, limits and controls for all aspects of the product.

New Products or non-standard products operate under a Product Transaction Memorandum on a temporary basis when the full Market Risk Product Program is being prepared. At the minimum, this should include procedures, limits and controls. The final- product transaction program should include market risk measurement at an individual product and aggregate portfolio level.

Risk Measurement

The market risk measures capture the variations in the market value of the portfolio due to uncertainties associated with various risk parameters. These are based on 1. Sensitivity and 2. downside potential.

1. Sensitivity

Sensitivity measures the variance in market price due to unit movement of a single market parameter (like interest rate, market liquidity, inflation, exchange rate, stock prices etc). A change in current interest rate, for example, will bring change in the market value of the bond. However, this does not take into account the effect of simultaneous change in other parameters. It is measured as a change in the market value due to unit change in the variable.

For example, if market value of a bonds portfolio changes by Rs.100,000 for a 1% change in rate of interest, interest rate sensitivity of the portfolio is Rs.1,00,000. Sensitivity include Basis point value and duration also.

Basis Point Value (BPV) : BPV is used as a measure of risk. It is the change in the value of a security (say a bond), due to one basis point (0.01%) change in market yield. With higher change in BPV, there is higher risk associated with the bond. It can be calculated as under :

• At current market yield of 8%, a 10 year-9% bond, has a price of Rs.92 (face value Rs.100). The yield changes to 7.95% due to change in current interest rates, which leads to new price of Rs.92.10. Hence, for one BP fall in the yield, market price changes by Rs.0.02 (for 5 BP the change being 10p). Hence, on an investment of Rs.1 cr, the gain will be Rs.2000 and the gain on change in price from Rs.92 to Rs.92.10 (i.e. 10p), would be Rs.20000 (10×2000).

Duration: The concept was first proposed by Macaulay to describe a bond’s price sensitivity to change in yield with a single number. Duration is defined as the weighted average of the time until expected cash flows from a security are received, relative to the current price of the security. The weights are the present values of each cash flow divided by the current price. The duration measures changes in economic value resulting from a %age change of interest rates under the simplifying assumptions that changes in value are proportional to changes in the level of interest rates and that the timing of payments is fixed.

• Duration is equal to the time that the holder of the bond has to wait to receive the present value of the cash flow. For example, if the duration is say 3.7 years for a 5-year 6% bond with face value of Rs.100 with semi-annual interest, the total cash flow to be received over the 5-year period, of Rs.130 (interest principal), would be equal to receiving Rs.130 at the end of 3.7 years, as a bullet payment.

2. Downside Potential

It captures possible losses by ignoring the profit potential. Downside risk is the most comprehensive measure of risk. It integrates the sensitivity and volatility with the adverse effect of uncertainty. It is most relied upon by banks and their regulators. The downside potential takes into account Var, back testing and Stress testing.

Value at RiSk (VaR) : VaR is defined as an estimate of potential loss in a position or asset/liability or portfolio of assets/liabilities over a given holding period at a given level of certainty. VaR measures the risk. VaR is an estimate of the potential loss (and not gain) likely to be suffered and not the actual loss. The actual loss may be different from the estimate. VaR measures the probability of loss for a given time period over which the position is held. The given time period could be one day or a few days or a few weeks or a year. VaR will change if the holding period of the position changes. The holding period for an instrument/position will depend on liquidity of the instrument/ market With the help of VaR, we can say with varying degrees of certainty that the potential loss will not exceed a certain amount. This means that VaR will change with different levels of certainty.

• Approaches for calculation of Var: There are 3 main approaches to calculating value-at-risk: (a) the correlation method – variance/covariance matrix method; (b) historical simulation and (c) Monte Carlo simulation.
• All 3 methods require a statement of 3 basic parameters i.e. (a) holding period, (b) confidence interval and (c) the historical time horizon over which the asset prices are observed

(a) The correlation method – variance/covariance matrix method :

Under the correlation method, the change in the value of the position is calculated by combining the sensitivity of each component to price changes in the underlying assets, with a variance/covariance matrix of the various components’ volatilities and correlation. It is a deterministic approach.

(b) Historical simulation :

The historical simulation approach calculates the change in the value of a position using the actual historical movements of the underlying assets, but starting from the current value of the asset. It does not need a variance/covariance matrix.

(c) Monte Carlo simulation :

The monte carlo simulation method calculates the change in the value of a portfolio using a sample of randomly generated price scenarios. Here the user has to make certain assumptions about market structures, correlations between risk factors and the volatility of these factors.

• Limitation of VaR : VaR as a useful MIS tool has to be ‘back tested’ by comparing each day’s VaR with actuals and necessary re-examination of assumptions needs to be made so as to be close to reality. It cannot substitute sound management judgement, internal control and other complementary methods

Back Test : The Bank for International Settlements outlines back-testing best practices in its January 1996 publication “Supervisory framework for the use of `back-testing’ in conjunction with the internal models approach to market risk capital requirements. Back test is a process where the model based VaR is compared with the actual performance of the portfolio. Back tests compare the realized trading results with model generated risk measures, both to evaluate a new model and to reassess the accuracy of existing models. Although no single methodology for back-testing has been established, banks using internal VaR models for market risk capital requirements must back test their models on a regular basis. Banks should generally back test risk models on a monthly or quarterly basis to verify accuracy. In these tests, they should observe whether trading results fall within pre-specified confidenCe bands as predicted by the VaR models. If the models perform poorly, they should probe further to find the cause (e.g., check integrity of position and market data, model parameters, methodology).

Stress Testing : Stress testing is used by banks to gauge their potential vulnerability to exceptional events. It addresses the large moves in key market variables of that kind that lie beyond day to day risk monitoring but-that could occur. The process of stress testing, involves first identifying these potential movements, including which market variables to stress, how much to stress them by, and what time frame to run the stress analysis over. Once these market movements and underlying assumptions are decided upon, shocks are applied to the portfolio. Revaluing the portfolios allows one to see what the effect of a particular market movement has on the value of the portfolio and the overall Profit and Loss. Stress testing and value-at-risk: Stress tests supplement value-at-risk (VaR)

1. Simple Sensitivity Test

A simple sensitivity test isolates the short term impact on a portfolio’s value of a series of predefined moves in a particular market risk factors. For example, if the risk factor is exchange rate, the shocks may be exchange rate changes of +/_2% , 4% , 6% and 10%

2. Scenario Analysis

A scenario analysis specifies the shocks that might plausibly affect a number of market risk factors simultaneously, if an extreme, but possible, event occurs. It seeks to assess the potential consequences for a firm of an extreme, but possible, state of the word. A scenario analysis can be based on a historical event or a hypothetical event.

3. Maximum Loss Approach

A maximum loss approach assesses the risks of a portfolio by identifying the most potentially damaging combination of moves of market risk factors.

4. Extreme Value Theory (EVT)

Extreme value theory is a means to better capture the risk of loss in extreme but possible circumstances.

Risk Monitoring & Control

Risk monitoring and control requires setting up of risk limits or controlling market risk, based on economic measures of risk while ensuring appropriate risk adjusted return. Controlling market risk means keeping the variations of the value of a given portfolio within given boundary values through actions on limits, which are upper limits imposed on the risk. This can be accomplished through:

1 Framing policy for limiting the roles and authority

2 Structure of limits and approval process

3 Systems and procedures for products and transactions, to capture all risks

4 Guidelines on portfolio size and mix

5 Systems for estimating portfolio risk under normal and stressed situations

6 Defined policy for marking to market .

7 Limit monitoring and reporting

8 Performance Measurement and Resource allocation

Limits and Trigger’s

 All trading transactions will be booked on systems capable of accurately calculating relevant sensitivities on a daily basis; usage of Sensitivity and Value at Risk limits for trading portfolios and limits for accrual portfolios (as prescribed for ALM) must be measured daily. Where market risk is not measured daily, Risk Taking Units must have procedures that monitor activity to ensure that they remain within approved limits at all times.

• Mandatory market risk limits are required for Factor Sensitivities and Value at Risk for mark to market trading and appropriate limits for accrual positions including Available-for-Sale portfolios. Requests for limits should be submitted annually for approval by the Risk Policy Committee. The approval will take into consideration the Risk Taking Unit’s capacity and capability to perform within those limits evidenced by the experience of the Traders, controls and risk management, audit ratings and trading revenues.
• Approved Management Action Triggers or Stop-loss are required for all mark to market risk taking activities.
• Risk Taking Units are expected to apply additional, appropriate market risk limits, including limits for basis risk, to the products involved; these should be detailed in the Market Risk Product Program.

Risk Monitoring

• A rate-reasonability process is required to ensure that all transactions are executed and revalued at prevailing market rates; rates used at inception or for periodic marking to market for risk management or accounting purposes must be independently verified.
• Financial Models used for revaluations for income recognition purposes or to measure or monitor Price Risk must be independently tested and certified.
• Stress tests must be performed preferably quarterly for both trading and accrual portfolios. This may be done when the underlying assumptions of the model/ market conditions significantly change as decided by the Asset Liability Committee.

Models of analysis

• Line Management must ensure that the software used in Financial Models that value positions or measure market risk is performing appropriate calculations accurately.
• The Risk Policy Committee is responsible for administering the model control and certification policy, providing technical advice through qualified and competent personnel. It is left to the bank to seek any independent certification.
• Financial Models must be fully documented and minimum standards of documentation must be established.
• Someone other than the person who wrote the software code must perform certification of models; testers must be competent in designing and conducting tests; records of testing must be kept, including details of the type of tests and their results. Assumptions contained in the Financial Models must be documented as part of the initial certification and reviewed annually. Unusual parameter sourcing conventions require annual approval by the Risk Policy Committee.
• Any mathematical model that uses theory, formula or numerical techniques involving more than simple arithmetic operations must be validated to ensure that the algorithm employed is appropriate and accurate.
• Persons who are acceptable to the Risk Policy Committee and independent of the area creating the model must validate models in writing. It is left to the bank to decide on who should validate, whether internal or external, at the discretion of the Risk Policy Committee.
• Models to calculate risk measures like Sensitivities to market factors either at transaction or portfolio level and Value at-Risk should be validated independently.
• Unauthorised or unintended changes should not be made to the models. These standards should also apply to models that are run on spreadsheets until development of fully automated processors for generating valuations and risk measurements.
• The triode’s should also be subject to model assumption review on a periodic basis. The purpose of this review is to ensure applicability of the model over time and that the model is valid for its original intended use. The review consists of evaluating the components of the financial model and the underlying assumptions, if any.

Risk Reporting

Risk report should enhance risk communication across different levels of the bank, from the trading desk to the CEO. In order of importance, senior management reports should:

• Timely
• Reasonably accurate
• Highlight portfolio risk concentrations
• Include written commentary
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Risk Mitigation

Market risk arises due to volatility of financial instruments. The volatility of financial instruments in instrumental for both profits and risk. Risk mitigation in market risk, i.e., reduction in market risk is achieved by adopting strategies that eliminate or reduce the volatility of the portfolio. However, there couple of issues that are also associated with risk mitigation measures.

1. Risk mitigation measures aim to reduce downside variability in net cash flow but it also reduces the upside potential or profit potential simultaneously.
2. In addition, risk mitigation strategies, which involve counterparty, will always be associated with counterparty risk. Of course, where counterparty is an established ‘Exchange’ or a central counterparty counterparty risk gets reduced very substantially. In OTC deals, counterparty risk would depend upon the risk level associated with party to the contract.

Risk Mitigation Strategies

Volatility of individual instruments is market determined. But, volatility of two or more different financial instruments would have a different volatility. As a result, a portfolio of financial instruments can be created with desirable volatility characteristics. Strategies to achieve it are discussed below.

Strategies Using Sensitivity Measures

Say a portfolio has two bonds A and B with BPVs of Rs. 675 and Rs. 205 respectively. The BPV of the portfolio would be the weighted average of BPVs of all the bonds in the portfolio. The portfolio BPV will be (675 + 205)/2 – 440. Now if we intend to reduce the risk of this portfolio, we may add another bond in the portfolio such that its BPV is less than 440. Say we add one more bond B in the portfolio BPV of the portfolio will get reduced to 361.7.

Similar strategies are possible using another sensitivity measure – duration Portfolio duration may be increased by adding higher duration instruments or by reducing low duration instruments. Similarly portfolio duration can be reduced by selling higher duration instruments or by adding low duration instruments

Strategies Using Correlation Measures

Prices of two financial instruments that have perfect negative correlation would move exactly in the opposite direction. If the financial instruments have negative correlation and it is not perfect, then alt the prices would move in opposite direction but the movement will not be exact. In such a case, the price volatility of the portfolio would exist, but it will be considerably low.

For example, a portfolio is long on a stock A and short in stock future of stock A. If the price of stock moves up say by Rs. 10, the stock future would also go up, may not be exactly by Rs. 10 say by Rs. 9. The portfolio will gain Rs. 10 on account of the long position on stock A, but will lose Rs. 9 on account of the short position in stock future. Reverse would also be true. The portfolio volatility however, stands reduced or portfolio market risk stands mitigated

The same strategies are possible with interest rate swaps (IRS) also. An example could be a portfolio having a fixed rate bond and an IRS with long on variable rate of interest. As market interest rates move up, the portfolio will suffer losses on bond, as bond price would come down due to the upward movement in interest rates. But swap valuation will increase as IRS being long on variable rate, will result in higher interest receipts under the IRS and the portfolio would gain on account of that. The net impact on the portfolio will be reduction in losses (or may result in net gain also) on account of fall in the price of the bond. Or in other words, portfolio volatility stands reduced and with that the risk.

Strategies Using Market Instruments

Financial instrument such as options provide us with a method to hedge market risks.

An option provides a right but not the obligation, but it comes at a cost called option premium. A position that is long on call option confers a right to buy the underlying instrument at a predetermined price called strike rate. Along position on put option confers a right to sell the underlying instrument at the strike rate. Both provide means to arrest downside movement and may be used for hedging a portfolio

Essentially, the risk mitigation measures involve risk return trade-off, as the strategies to reduce the risks also reduce the upward potential.