Chapter 12

Market Risk

how it can threaten the solvency of FIs.

Market risk- uncertainty resulting from changes in market prices. Measured in terms of dollar exposure amount or as a relative amount against a benchmark. Why is Market Risk Measurement (MRM) Important? Management information, Setting risk limits, Resource allocation, Performance evaluation, Regulation. Calculating Market Risk Exposure RiskMetrics, Historic or back simulation, Monte Carlo simulation. The RiskMetrics Model

Market risk = Estimated potential loss under adverse circumstances. Daily earnings at risk (DEAR) = Dollar market value of the position Price volatility.

RiskMetrics calculates daily earnings at risk for: Fixed income, Foreign exchange, Equities.

The Market Risk of Fixed-Income Securities Daily price volatility can be stated as: (-MD) Confidence intervals: 90% of the time = adverse daily yield move MD = D/(1+R);

1.65 standard deviations of the mean. = (-6.527) (0.00165) = -1.077% = ($1,000,000) (0.01077) = $10,770 Example: For a five-day period, VAR = $10,770 5 = $24,082

Price volatility = (-MD) (Potential adverse change in yield) DEAR = Market value of position (Price volatility) Potential loss for more than one day:

Market value at risk (VAR)= DEAR N The Market Risk of Foreign Exchange Dollar equivalent value of position DEAR = = FX position

spot exchange rate FX volatility

dollar value of position

The Market Risk of Equities (CAPM) Total risk = systematic risk + unsystematic risk. Well-diversified Portfolio DEAR = dollar value of position stock market return volatility @ 1.65 sM. Less well-diversified FIs, effect of unsystematic risk on value of trading position added.

Portfolio Aggregation 7-year zero coupon bonds = $10,770, CHF spot: $9,320, Simple addition ignores correlations. Australian equities: $33,000. DEARs not additive, total DEAR $53,090. Portfolio DEAR calculated using a correlation matrix.

DEAR portfolio = [DEARa2 + DEARb2 + DEARc2 + 2rab DEARa * DEARb + 2rac DEARa DEARc + 2rbc DEARb DEARc]1/2/ The Historic or Back Simulation Approach Advantages/Strengths: Simplicity, No normal distribution assumption, No necessity to calculate correlations or standard deviations of asset returns. Disadvantages/Weaknesses: 500 observations Increasing # of observations by going back further in time not desirable. (Could weight recent observations more heavily and go further back.)

Calculation of value at risk (VAR): Measure exposure, Measure sensitivity: calculate its delta, Measure risk, Measure risk again, Rank days by risk from worst to best, VAR.

The Monte Carlo Simulation Approach Calc. of historic variancecovariance matrix Decomposition of matrix into two matrices Regulatory Models: The BIS Standardised Framework Simple standardised framework, Fixed Income and BIS Specific risk charge: risk weights absolute dollar values of long and short positions Decomposition allows us to set up scenarios Calculation of VAR. two ways of calculating market risk exposures: Use of internal models

General market risk charge: reflect modified durations expected interest rate shocks for per maturity.

Foreign Exchange and BIS Standardised model - calculation of net exposure. Converted into $ at current spot exchange rate. Capital requirement = to 8% of total long position of FI. Model involves partial offsetting of currency risk.

Equities and BIS Systematic risk unsystematic risk

BIS and systematic risk: reflected in the net long or net short position (BIS and unsystematic risk: 4% gross position in an equity). BIS and systematic risk: reflected in the net long or net short position (y factor).

The BIS Regulations and Large Bank Internal Models calculating DEAR, adverse change in rates defined as 99th percentile (rather than 95th under RiskMetrics). Minimum holding period is 10 days (means that RiskMetrics daily DEAR is multiplied by 10). Capital charge will be the higher of: Previous days VAR (or DEAR 10), Average Daily VAR over previous 60 days times a multiplication factor 3.