Market risk

Risk Management course Corvinus University of Budapest 4th March 2010

Petra Kalfmann, pkalfmann@bankarkepzo.hu Director

Market risk
Every asset that has quoted price on the market (~ traded assets) are exposed to market risk Market risk factors
Interest rates (bond prices) Stock prices FX rates Commodity prices Volatility
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% 2,5

0,5

1,5

3,5

4,5

2006.12.29 2007.03.01 2007.05.01 2007.07.01 2007.09.01

Interest rate risk

2007.11.01 2008.01.01 2008.03.01 2008.05.01 2008.07.01 2008.09.01 2008.11.01 2009.01.01 2009.03.01 2009.05.01 2009.07.01 2009.09.01 2009.11.01 2010.01.01

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EUR 5Y yield

EUR 3M yield

Interest rate risk

Interest rate risk related assets bonds Relationship between interest rate and bond price: Duration and Convexity
Duration: sensitivity of bond price on interest rate movement linear component Convexity: sensitivity of bond price on interest rate movement non-linear component

Volatility of shorter maturities is higher Longer the maturity longer the duration higher the effect on bond price
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Volatility of interest rates and impact on bond prices

15,00% 10,00% 5,00% 0,15% 0,00% -5,00% -10,00% -15,00% 0,00% -20,00% -25,00% -30,00% -0,05% -0,10% 0,10% 0,05% 0,25% 0,20%

Characteristics of 1 day logreturns of 3M yields and its effect on price of 3M zero bond:
change in 3M 1 day r(log) bond price average -0,30% 0,0010% volatility 2,71% 0,0124%

2007.01.02

2007.03.02

2007.05.02

2007.07.02

2007.09.02

2007.11.02

2008.01.02

2008.03.02

2008.05.02

2008.07.02

2008.09.02

2008.11.02

2009.01.02

2009.03.02

2009.05.02

2009.07.02

2009.09.02

2009.11.02

change in EUR 3M yield

change in 3M bond price based on D&Cx

Why logreturn?

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Volatility of interest rates and impact on bond prices

8,00% 6,00% 4,00% 2,00% 0,00% -2,00% -4,00% -6,00%

Characteristics of 1 day logreturns of 5Y yields and its effect on price of 5Y zero bond:
change in 3M 1 day r(log) bond price average -0,06% 0,0165% volatility 1,37% 0,2343%

change in EUR 5Y yield

change in 5Y bond price based on D&Cx

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Stock price risk

35000 30000 25000 300 20000 15000 10000 100 5000 0 50 0 250 200 150 450 400 350

Characteristics of BUX and MAX 1 day logreturns:

average volatility

BUX 0,04% 1,68%

MAX 0,03% 0,44%

BUX (left)

MAX (right)

BUX: stock price index of Budapest Stock Exchange MAX: price index of long maturity bonds

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Characteristics of stock price movements

On efficient markets, assuming a huge sample the daily log returns are Independent and Normally distributed

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Independency
BUX
15%

10%

5%

r(t)

0% BUX -5%

-10%

-15% -15% -10% -5% 0% r(t-1) 5% 10% 15%

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10%

12%

14%

16%

0%

2%

4%

6%

8%

-8,0% -7,5% -7,0% -6,5% -6,0% -5,5% -5,0% -4,5% -4,0% -3,5% -3,0% -2,5% -2,0% -1,5% -1,0% -0,5% 0,0% 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 3,5% 4,0% 4,5% 5,0% 5,5% 6,0% 6,5% 7,0% 7,5% 8,0%

Normal distribution

BUX empirical distribution Normal distribution

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FX risk
350

300

Characteristics of EUR and USD FX rate 1 day logreturns:

250

200

EUR FX USD FX

150

average volatility

EUR 0,00% 0,63%

USD -0,02% 0,97%

100

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Volatility as traded asset

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What is the price of risk?

Risk premia: the additional return of a risky asset over the return of the risk-free asset US data: Roger Ibbotson Rex Sinquefield (1982): Stocks, Bonds, Bills and Inflation
Data as of 1998: T-bills: 3 month Some above inflation, avg. return is 3.75% Long term goverment bonds: 200 bp premia (5.75%) US stocks: 700 bp premia (10.75%) Small stocks: additional 200 bp premia (12.75%)

BUX-MAX

Avg. risk premia p.a. 2003 18,9% 2004 31,7% 2005 25,7% 2006 11,1% 2007 -0,5% Avg. 98-07 -2,0%

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Measurement of risk
The easiest way of measuring risk is: volatility (avg. deviation from the mean) 2
=
Avg. daily return Avg. daily volatility Volatility p.a.

( x x)
n 1

BUX 0,03% 1,70% 26,82%

MAX 0,04% 0,33% 5,30%

RMAX 0,04% 0,09% 1,46%

Assumption: the return of financial assets has nomal distribution; in this case we can assume that the statistics representing the past can give a good foreast for the future Problems:
Positive and negative deviations from the mean has the same weight when calculating the volatility Absolute value it is not convenient for ranking investments without knowing the return of the investment

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Measurement of risk
4.15

V@R concept: Value at Risk

possible future loss in a given time period with a given probability in normal market environment

John Pierpont (J.P.) Morgan (1837-1913)

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V@R concept
45% 40%

Possible future loss at a given probability = VAR

35%

30%

25%

20%

15%

10%

5%

0%

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V@R interpretation
V@R (1 day, 99,9%) = 10 M
Optimistic 99,9% is the probability that we may lose less than 10 M forint tomorrow on a given financial asset/portfolio

Pessimistic 0,1% is the probability that we may lose more than 10 M forint tomorrow on a given financial asset/portfolio

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V@R parameters
Liquidation period: the liquidation period of the given financial asset the longer this period the higher the V@R Confidence interval: depends on the risk appetite of the bank the higher the confidence interval the higher the V@R

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V@R calculation
VaR = p Position Volatiltiy p parameter depends on the level of risk (probability)
1-p= 99% 1-p= 95% p = - 2,326 p = - 1,645

Volatility: volatility of the risk factor Position: value of position today

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V@R of one share

w = N S = position value
N: number of shares S: spot price S = wr P/L = w = N S = N S S w: position value r: return (logarithmic)

VaR = p w r
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Example
OTP What is the VaR of one OTP share?

OTP

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V@R of more than one risk factor

Portfolio effect => diversification The risk of portfolio depends on:
2 port

= wi w j ij
i j

the weight of each element in the portfolio the risk of each element in the portfolio the correlation between the returns of the elements of the portfolio

2 AB = ( wA A ) 2 + ( wB B ) 2 + 2 wA wB A B AB

Correlation: 1 1
Perfect co-movement (1) Perfect adverse movement (-1) covariance Neutral co-movement (0) covAB = A B AB
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V@R of more than one risk factor

Mapping the portfolio into risk factors: (w1; w2; w3 wn) wi: weight of risk factor i Assuming that the risk factors follow normal distribution:
portfolio risk

VAR = p w =

wCw

( w ) R ( w )

C is the covariance matrix of the returns of risk factors R is the correlation matrix of the returns of risk factors, r is the volatility vector of returns w is the weight of each risk factor in the portfolio
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Why banks have market risk?

Trading book vs banking book Trading book was launched in 1996 as amendment to the capital regulation on credit risk (so called Basel 1 regulation) Why? Banktrupcy of Barings in 1995
Operational risk: front-office (trading) and back-office (settlement) under the control of the same person (Nick Leeson) Market risk: huge volumes on futures market speculation on short side, but market turned to downside !
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Why banks have market risk?

Trading book: assets held with trading intent with the aim of reaching short term return
T-bond, T-bills (10-20% of all assets) Shares FX risk in the whole portfolio !

Capital requirement has to be measured and settled against the risk

In case of market risk capital requirement is necessary to cover the potential future losses ~ V@R

Two measures:
Simple risk weigths V@R methodology
with scaling factor: multiplier is 3 with predefined parameters: 99%, 10 days

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Why banks have market risk?

Market risk in the banking book:
FX risk: managed under trading book rules Interest rate risk yes, it must be managed under banking book as well

Interest rate risk in the banking book: risk arising from the different interest rate characteristics of assets and liabilities
Different maturities Different base rates Different repricing periods
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IR in banking book
Repricing risk Yield curve risk Basis risk Embedded options
Mortgage retail portfolios (refinancing option) Current accounts (no maturity)

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IR in banking book
Repricing GAP
GAPt = RSAt RSLt
NII exp = GAP iexp

RSA: risk sensitive assets RSL: risk sensitive liabilities NII: change of expected net income i: expected change in return

Duration GAP V@R methods

Earnings at Risk Economic Value of Equity
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Repricing GAP
Positive GAP Negative GAP

Increasing interest rates

Decreasing interest rates

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Value based approach

Measuring interest rate risk sensitivity with well knonw D(mod) and Cx

dP 1 * 2 = D dr + Cx dr P 2

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Duration GAP
Considers the risk sensitivity of assets and liabilities Assuming that assets and liabilities are bonds (predefined cash-flows)
Liabilities (deposits, money market liab): D(L) Market value of liabilities: MVL

Duration GAP of total bank portfolio:

Assets: D(A) Market value of assets: MVA

DGAP = DA (MVL MVA) DL

D( E ) = DGAP
EVE = DGAP [i (1 + i )] MVA

Equity: D(E) EVE=?

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Case study Interest rate risk exposure in the world nowadays in pictures

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Liquidity risk as market risk

Maturity mismatch between assets and liabilities at banks is natural Liquidity risk: the bank is not able to fulfill its liabilities at due date without suffering non expected loss Liquidity Solvency !

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Liquidity risk as market risk

Funding liquidity risk: the bank is not able to renew its funds
in required volume at acceptable price

Asset liquidity risk: the bank is not able to sell its assets
at acceptable price in acceptable timeframe

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Source: HFSA

100%

120%

140%

160%

180%

200%

20%

40%

60%

80%

0%

2001. 12. 2002. 12. 2003. 03. 2003. 06. 2003. 09. 2003. 12. 2004. 03. 2004. 06. 2004. 09. 2004. 12. 2005. 03. 2005. 06.

Funding liquidity risk

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2005. 09. 2005. 12. 2006. 03. 2006. 06. 2006. 09. 2006. 12. 2007. 03. 2007. 06. 2007. 09. 2007. 12. 2008.01. 2008.02. 2008.03. 2008.04. 2008.05. 2008.06. 2008.07. 2008.08. 2008.09. 2008.10. 2008.11. 2008. 12. 2009.01. 2009.02. 2009.03. 2009.04. 2009.05. 2009.06. 2009.07. 2009.08. 2009.09. 2009.10. 2009.11.

gyflhitelek/gyflbettek Loans/Deposits

funding gap

EU average 122%

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Result of funding liquidity gap when liquidity of markets disapper Case study 1

Source: www.bearstearns.com, February, 2008.

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17 March 2008: JP Morgan announced the acquistion of BS with the financial help of FED

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The role of central banks in providing liquidity on the market (lender of last resort)
Concerns about credit exposure in financial markets began to surface in the summer of 2007 and credit spreads (the cost of credit) increased. The announcement by a major US investment bank of difficulties in one of its investment conduits and subsequent similar announcements by other banks led to a serious disruption in the medium term funding markets on 9 August 2007. This quickly led to severe restrictions in the liquidity of the short term wholesale markets. Despite these restrictions during August and early September 2007 Northern Rock continued to fund in the short dated wholesale markets and maintained significant balances of liquid assets. In the week commencing 10 September 2007, despite the fact that the Company continued to raise funds at shorter durations, the general tightening of longer term liquidity and the closure of the securitisation and medium term markets meant it was necessary to arrange a facility in case such markets failed to reopen. Therefore an approach was made to the Bank of England to provide a loan facility to the Group. (Annual Report 2007)

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Non derivatives CF

Funding Tightening of longer term liquidity and closure of securitisation and medium term financing markets led to the need to arrange a liquidity support facility from the Bank of England in the second half of 2007 The Bank of England loan facilities to Northern Rock as at 31 December 2007 stood at 26.9 billion and have since fallen to around 24 billion Full year net outflow of retail funds of 12.2 billion reflects significant withdrawals by retail depositors during the second half of 2007 Level of retail deposits since stabilised and showing signs of improvement in 2008 www.northernrock.co.uk

bank run

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Classification of liquidity risk

Classification
Maturity liquidity risk: risk arising from maturity mismatch Withdrawal liquidity risk: risk of withdrawal of huge volume of deposits before maturity (bank run) Structural liquidity risk: risk of renewal of funds and the shift in cost of funds Market liquidity risk: risk arising from the liquidity problems of the market (position cannot be closed in given timeframe)

Measurement
Static/dynamic maturity mismatch, limits Scenario analysis, expert estimation

Increasing risk premium increase in funding cost V@R V@R with longer liquidity horizon

MARKET RISK

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Thank you for your attention!

45

Effective and logarithmic interest rate

Effective interest rate is based on the compounding interest rate calculation Logarithmic interest rate calculation gives the same result but on a different scale (like Celcius and Fahrenheit both measures temperature but on a different scale) The relationship is as follows (i: log return)

1 + reff = e i = ln(1 + reff )

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Effective and logarithmic interest rate

Example
t 0 1 2 Total S 100 120 96 r eff 20,00% -20,00% -4,00% r log 18,23% -22,31% -4,08%

r(eff)1 = 120/100-1 = 20% r(log)1 = ln(120/100) = 18,23% Logreturn is additive => cumulated logreturn = sum of daily logreturns -4,08% = 18,23% -22,31% !
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Normal distrubution
Normal distribution: continuous distribution Characteristics: average, volatility: N(, ) Standard normal distribution: N(0, 1) Density function of normal distribution 45%
40% 35% 30% 25% 20% 15% 10% 5% 0% -5,0

-4,0

-3,0

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-1,0

0,0

1,0

2,0

3,0

4,0

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Important confidence intervals of normal distribution 95% one-side confidence interval

100%

95%90%
80% 70% 60% 50% 40% 30% 20%

5%

10% 0% -5,0

-4,0

-3,0

-2,0

-1,0

0,0

1,0

2,0

3,0

4,0

5,0

-1,645
Inverted function

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Important confidence intervals of normal distribution 99% one-side confidence interval

100%

99%90%
80% 70% 60% 50% 40% 30% 20%

1%

10% 0% -5,0

-4,0

-3,0

-2,0

-1,0

0,0

1,0

2,0

3,0

4,0

5,0

-2,326

2,326
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