Market & Operational Risk

Henny Zahrany
2912551
MBA ITB 48
Risk Management

What is Market Risk?

market risk" is the risk that changes in

financial market prices and rates will
reduce the value of a security or a
portfolio- Michel Crouhy.
Market risk is the risk of losses owing
to movementsin the level or volatility
of market prices- Jorion.

Types of Market Risk

According to Jorion, there are two forms of Market

risk, absolute (dollar terms/relevant currency) and
relative (relative to benchmark index).
He also classified market risk into directional and
non-directional.
Directional: exposures to the direction of
movements in financial variables; stock price,
interest rate, commodity prices, & exchange
rates.
Non-directional: Involve the remaining risks;
nonlinear exposures and exposures to hedged
positions or to volatilities.

Directional Risks
Interest Rate Risk
The risk that the value of a fixed-income security
will fall as a result of a change in market interest
rates, Open positions arise most often from
differences in the maturities, nominal values, and
reset dates of instruments and cash flows that are
assetlike (i.e., "longs") and those that are
liabilitylike (i.e., "shorts").(Crouhy, 178).
Imperfect
correlation
between
offsetting
instruments, both across the yield curve and within
the same maturity for different issuers, can
generate significant interest rate exposures.

Directional Risk (2)

Equity Price Risk
It has two components:
1. General Market Risk: sensitivity of an
instrument/portfolio value to a change in
the level of broad stock market indices
(cant be diversified).
2. Specific/Idiosyncratic: risk refers to that
portion of a stocks price volatility that is
determined by characteristics specific to
the firm. (can be diversified).

Directional Risk (3)

Foreign Exchange Risk
It is from the imperfect correlations in
the movement of currency prices and
fluctuations in international interest
rates.
The valuation requires knowledge of
the behavior of domestic & foreign
interest rates, as well as of spot
exchange rates.

Directional Risk (4)

Commodity Price Risk
Since most commodities are traded in
markets in which the concentration of
supply can magnify price volatility.
Fluctuations in the depth of trading in
the market often accompany and
exacerbate high levels of price
volatility.

Measurement

Ad Hoc Tools; notional amounts,

sensitivity measures, and scenarios. >
Unsatisfactory because:
Dont measure what matters, the
downside risk for the total portfolio.
Fail to take into account correlations
across risk factors
Dont account for the probability of
adverse moves in the risk factors

Measurement (2)

Value at Risk
Jorion (2007) said that VaR summarizes the worst
loss over a target horizon that will not be exceeded
with a given level of confidence.
Crouhy: VaR is proving to be a very powerful way
of assessing the overall risk of trading positions
over a short horizon, such as a 10-day period, and
under "normal" market conditions
Crouhy: The danger posed by exceptional market
shocks can only be captured by means of
supplemental methodologies such as stress
testing and scenario analysis.

Value at Risk

VaR measure does not state by how much actual

losses will exceed the VaR figure; it simply states
how likely (or unlikely) it is that the VaR figure will
be exceeded.

Steps of Calculating VaR

1.

2.
3.
4.

Derive the forward distribution of the

portfolio, or alternatively the returns on
the portfolio, at the chosen horizon, H
Assume the confidence level, c, calculate
the first percentile of this distribution.
VaR= Expected profit/loss worst case
loss at the _% confidence level, or
VaR= Worst case loss at the _%
confidence level

Only the first definition of VaR (3) is consistent with economic capital
attribution and RAROC calculations. In VaR the expected profit/loss is
already priced in, and accounted for, in the return calculation. Capital is
provided only as a cushion against unexpected losses.

Operational Risk
Financial Risk

History behind Operational

Risk

The Basel Committee is proposing to

establish
capital
charges
for
operational risk, in exchange for
lowering them on market and credit
risk. The proposed charge would
constitute approximately 12% of the
total capital requirement. This charge
is focusing the attention of the banking
industry on operational risk.

Definition

A narrow view is that operational risk is

confined to transaction processing. Another,
much wider definition views operational risk as
any financial risk other than market and credit
risk- Crouhy
Basel II:
Operational risk is defined as the risk of loss
resulting from inadequate or failed processes,
people and systems or from external events.
This definition includes legal risk, but excludes
strategic and reputational risk.

Business Line

Type of Operational Risks

Two Broad Categories of

Operational Risk

Assessing Operational Risk

Comparison of Approaches
Top Down Models
Measure at the broadest level, a firm-wide or
industrywide data.
Bottom-up Models
Start at the individual business unit or process level.
Actuarial Models
Estimate the objective distribution of losses from
historical data and are widely used in the insurance
industry. Such models combine two distributions,
loss frequencies and loss severities.

Managing Operational Risk

Capital Allocation & Insurance

The Expected Loss
The size of operational losses that should be expected to
occur
The Unexpected Loss
The deviation between the quantile loss at some confidence
level and the expected loss
Stress Loss

Managing Operational Risk

(2)

o
o
o
o
o

Mitigating Operational Risk

Internal control methods:
Separation of functions
Dual entries
Reconciliations
Tickler systems
Controls over amendments

Managing Operational Risk

(3)

o
o
o
o
o

External Control Methods:

Confirmations
Verification of prices
Authorization
Settlement
Internal/external audits

Four-Step Measurement
Process for Operational Risk

Four-Step Measurement
Process for Operational Risk (2)

Step 1 Input
The first step in the operational risk
measurement process is to gather the
information needed to perform a complete
assessment of all significant operational risks.

Four-Step Measurement
Process for Operational Risk (3)

Step 2 Risk Assessment Framework

Sample Risk Assessment Report

Four-Step Measurement
Process for Operational Risk (4)

Connectivity and Interdependencies

Four-Step Measurement
Process for Operational Risk (5)

1.

2.

Step 3 Review & Validation

ORMG reviews the assessment results
with senior business unit management
and key officers in order to finalize the
proposed operational risk rating.
Operational risk rating committee to
review the assessment

Four-Step Measurement
Process for Operational Risk (6)

Step 4 Output

Four-Step Measurement
Process for Operational Risk (7)

if a business unit falls in the upper righthand quadrant, then the business unit has a
high likelihood of operational risk and a high
severity of loss, if failure occurs.

References

Jorion, 2003, Financial Risk Manager

Handbook
Jorion, 2007, Value at Risk
Michel Crouhy, Risk Management