Market Risk

When you are willing to make sacrifices for a great cause, you will never be alone.
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Market Risk Identification

Banks undertake transactions and hold positions with trading intent and with the intention of benefiting in the short-term, from actual and/or expected differences between their buying n selling prices or hedging other elements in the trading book. This results in market exposure. All such transactions reflect in the trading book.

A trading book consists of the banks proprietary positions in financial instruments including:
Debt securities; Equity; Foreign Exchange; Commodities; Derivatives held for trading.

They also include positions in financial instruments arising from matched principal brokering n market making, or positions taken in order to hedge other elements of the trading book.
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Market Risk Identification (Contd.)

A banks trading book exposure has the following risks, which arise due to adverse changes in market variables such as interest rates, currency exchange rate, commodity prices, market liquidity, etc., and their volatilities that impact the banks earnings n capital adversely. 1. Market Risk
Interest Rate Risk Equity Price Risk Foreign Exchange Risk Commodity Price Risk

2. Liquidity Risk
Asset Liquidity Risk Market Liquidity Risk

3. Credit n Counter party Risks 4. Model Risk

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Market Risk
Market risk is the risk of adverse movements of the mark to market value of the trading portfolio, due to market changes/ movements, during the period required to liquidate the transactions. The period of exit or length of holding period is critical to assess such adverse deviations. If it gets longer, so do the deviations from the current market value. Changes in market prices, if adverse, reduce the value of an instrument or the portfolio. Yield of a market portfolio is the profit or loss arising from the transaction. The profit between two dates is the variation of the market value of an asset or a portfolio of assets. Any decline in value, results in a market loss. However, it is possible to liquidate tradable instruments or to hedge their future changes of value at any time. This is the rationale for limiting market risk to the liquidation period. Market risk does not refer to market losses due to causes other than market movements.
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Interest Rate Risk

A fixed income security or a security with a predetermined cash flow would have interest rate risk. Market value of such securities is the discounted value of cash flow n as the interest rate changes, the market value also changes. Market value of these securities falls as interest rate rises n rises as the interest rate falls. Determining risk interest rate changes on such portfolio or portfolio risk exposure on account of interest rate change would depend on a combination of factors like maturities, reset dates n nominal values. In case of financial instruments backed by hedge, basis risk may develop because of non-parallel adverse movement of the price of an instrument n that of its hedge. The basis risk comes in as gap between the discounted cash flows of the portfolio n that of hedging instrument, which gets created because of non5 parallel shifts of yield curve.

Equity Price Risk

Stock prices keep on changing with time. Volatility of stock prices results in equity risk as stock prices may move adversely as soon as it is purchased n taken in the books. While favourable movement adds to the profits, adverse movements results in affecting profit & loss adversely. Stock prices may move on account of market factors n also on account of firm specific factors. Movement of prices that can be attributed to market factors is called general market risk of equity while the movement of prices on account of factors specific to the firm is called specific or idiosyncratic risk of equity. General market risk of equity refers to stocks sensitivity to the change in broad market indices such as Sensex, Nifty, etc. For example, if a stocks price movement is twice that of market indices, then the stocks sensitivity is 2 n that gives an indication of the general market risk associated with that stock. While in case of a single stock both the risks are to be determined, in case of a well diversified portfolio of stock, only general market risk becomes relevant as in case of a well diversified portfolio the specific or idiosyncratic risk stands eliminated substantially.
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Foreign Exchange Risk

Forex positions arise in the ordinary course of business n through assuming a trading position in forex. Volatility of exchange rates may result in adverse movements of rates giving rise to forex risk. Favourable movements in rates give rise to profits. Forex positions also include forward positions as well. Forex rates are also time dependent. One month forward rate will be different from two-month forward rate n they keep changing with time. Usually, forex portfolio consists of pen positions n imperfectly hedged positions. The open positions result in exchange rate risk n it mainly depends upon movement of spot exchange rate of two currencies. Imperfectly hedged position gives rise to gap risk. Gap risk depends upon besides the movement of spot exchange rate of two currencies, interest rate differential o the two currencies.
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Commodity Price Risk

Commodity market differs from interest rate market or equity market of forex market. The reasons are:
Commodity prices are strongly demand supply dependent. Where the market is dependent on fewer suppliers, price volatility is higher.

Market liquidity or depth of trading market varies frequently n that adds to the commodity price volatility.
Transaction cost in commodity market are not uniform as depends on the ease n cost of storage, which varies across commodities. Commodities have different characteristics. Some are perishable n have short shelf life (agricultural n energy commodities). Some are non-perishable with high-price to weight ratio like gold, silver or platinum. Some are base metals with low price to weight ratio.

As a result of these factors, commodity prices have high volatility n larger price discontinuities prices leap from one level to the another. Hence exposure on commodity market carries relatively higher risk.

Liquidity Risk
Trading liquidity is the ability to freely transact n markets at reasonable prices. Trading liquidity is ability to liquidate positions without: 1. Affecting market prices 2. Attracting the attention of other market participants Liquidation risk arises from the lack of trading liquidity n results in:

1. Adverse changes in market prices

2. Inability to liquidate position at a fair market price 3. Liquidation of position causing large price change 4. Inability to liquidate position at any price. Asset liquidation risk refers to a situation where a specific asset faces lack of trading liquidity. Market liquidation risk refers to a situation when there is general liquidity crunch in the market n it affects trading liquidity adversely.
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Credit n Counterparty Risks

Markets value the credit risk of issuers n borrowers n it reflects in prices. Credit risk of traded debts such as bonds n debentures n commercial papers, etc., are indicated by credit rating, given by rating agencies.

Credit rating indicates risk level associated with the instruments and is factored in to as add-ons to the risk free rate of the corresponding maturity. The lower the risk level, the lower is the spread over risk-free rate.
Credit risk may arise either on account of default of the issuer/ borrower or because of rating migration. Derivatives are not liquid as market instruments. For derivatives, credit risk interacts with market risk in that mark-to-mare value depends on market movements. Under HTM, the potential future values over their life is the credit risk exposure because they are the value of all future flows that the defaulted counter party will not pay. This risk is termed as counter party risk. 10

Model Risk
Models are designed to predict values of variables for which it is specifically designed. Value of a given variable would depend upon one or more parameters, which influence the value of the given variable. Models, with the help of parameters predict the value of a variable. Pricing models n risk measurement models are the most commonly used models in market risk management. However, values predicted through models, when compared with actual observation, may show deviation, i.e., gaps may exist between predicted value n actual values observed. This is called Model Risk. Model risk arises because of following reasons: Assumptions which have become irrelevant or found to be incorrect;

Ignoring one or more parameters usually for simplification or for some practical reasons;
Errors of statistical techniques or insufficient data inputs; Incorrect judgment in dealing with outliers, etc.
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Market Risk
The relationship between frequency of loss, amount of loss, expected loss, stress loss, financial strength and economic capital can be seen in the following graph:

Unexpected loss

Stress loss

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Capital charge for Market Risk

Introduction Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet positions arising from movements in market prices. The market risk positions subject to capital charge requirement are:

(i) The risks pertaining to interest rate related instruments and equities in the trading book; and
(ii) Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books).

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Scope and coverage of capital charge for Market Risks

Trading book for the purpose of capital adequacy will include: (i) Securities included under the Held for Trading category (ii) Securities included under the Available for Sale category (iii) Open gold position limits

(iv) Open foreign exchange position limits

(v) Trading positions in derivatives, and (vi) Derivatives entered into for hedging trading book exposures.

Banks are required to manage the market risks in their books on an ongoing basis and ensure that the capital requirements for market risks are being maintained on a continuous basis, i.e. at the close of each business day. Banks are also required to maintain strict risk management systems to monitor and control intra-day exposures to market risks. 14

Measurement of Capital Charge for Interest Rate Risk

Capital Charge for Specific Risk: RBI guidelines prescribed a standardized capital charge for specific risk which depends on the issuer, type of security n remaining maturity of security. This varies from 0% for central n state government securities to 100% for securities rated B n below or are unrated.

Capital Charge for General Risk: Capital charge for general market risk is computed under standardized duration method using the following formula:
Capital Charge for General market Risk of a security = Modified Duration of the Security x Market Value of the security x Assumed Change in Yield
Where assumed change in yield is prescribed by regulator n that varies from 60 basis points to 100 basis points depending upon the maturity of the security.
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A brief description of various components of market risk

General Market Risk: This is the risk arising from movements in the general level of underlying risk factors such as interest rates, exchange rates, equity prices, etc. Specific Risk: This is the risk of adverse movement in the price of individual security resulting from factors related to the securitys issuer. Specific risk is further divided into four components explained below.
Default Risk: This means the potential for direct loss due to an obligors default as well as the potential for indirect losses that may arise from a default event. Credit Migration Risk: This is also called event risk or downgrade risk. This means the potential for direct loss due to an internal/external rating downgrade or upgrade as well as the potential for indirect losses that may arise from a credit migration event. Credit Spread Risk: Credit spread risk arises from the possibility that changes in credit spreads will affect the value of financial instruments. Credit spreads represent the credit risk premiums required by market participants for a given credit quality, i.e., the additional yield that a debt instrument issued by an AA rated entity must produce over a risk-free alternative (e.g., Government of India bond). For instance, widening of credit spread of a given credit quality ( e.g. A rating) due to change in perception of the credit worthiness of the issuer or liquidity of the position would lead to mark to market losses for the long position. Incremental Risk: This is the risk not captured by the VaR-based estimate of specific risk and the Incremental Risk Charge (IRC) is intended to complement standards being applied to value-at-risk modelling framework. IRC represents an estimate of the default and migration risks to the extent these are not captured by the VaR-based measure incorporating specific 16 risk.

Measurement of capital charge for Equity Risk

The capital charge for equities would apply on their current market value in banks trading book. Capital charge for banks capital market investments, including those exempted from CME norms, for specific risk (akin to credit risk) will be 11.25 per cent or higher and specific risk is computed on banks gross equity positions. The general market risk charge will be 9 per cent on the gross equity positions. Specific Risk Capital Charge for banks investment in Security Receipts will be 13.5 per cent (equivalent to 150 per cent risk weight). Since the Security Receipts are by and large illiquid and not traded in the secondary market, there will be no General Market Risk Capital Charge on them.

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Measurement of Capital Charge for Foreign Exchange Risk

The banks net open position in each currency should be calculated by summing:
The net spot position (i.e. all asset items less all liability items, including accrued interest, denominated in the currency in question); The net forward position (i.e. all amounts to be received less all amounts to be paid under forward foreign exchange transactions, including currency futures and the principal on currency swaps not included in the spot position); Guarantees (and similar instruments) that are certain to be called and are likely to be irrecoverable; Net future income/expenses not yet accrued but already fully hedged (at the discretion of the reporting bank); Depending on particular accounting conventions in different countries, any other item representing a profit or loss in foreign currencies; The net delta-based equivalent of the total book of foreign currency options
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Measurement of Capital Charge for Foreign Exchange Risk

Foreign exchange open positions and gold open positions are at present risk-weighted at 100 per cent. Thus, capital charge for market risks in foreign exchange and gold open position is 9 per cent. These open positions, limits or actual whichever is higher, would continue to attract capital charge at 9 per cent. This capital charge is in addition to the capital charge for credit risk on the on-balance sheet and off-balance sheet items pertaining to foreign exchange and gold transactions.

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Aggregation of the capital charge for Market Risks

As seen above capital charges for specific risk and general market risk are to be computed separately before aggregation. For computing the total capital charge for market risks, the calculations may be plotted in the following table:
Risk Category I. Interest Rate (a+b) a. General market risk b. Specific risk II. Equity (a+b) a. General market risk b. Specific risk III. Foreign Exchange & Gold Capital Charge

IV.Total capital charge for market risks (I+II+III)

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Capital Charge for Market Risk: Internal Models Approach

Basel II Framework offers a choice between two broad methodologies in measuring market risks for the purpose of capital adequacy. One methodology is to measure market risks in a standardised manner as per the Standardised Measurement Method (SMM) which is being used by banks in India since March 31, 2005. The alternative methodology known as Internal Models Approach (IMA) is also available which allows banks to use risk measures derived from their own internal market risk management models. The permissible models under IMA are the ones which calculate a value-at-risk (VaR)-based measure of exposure to market risk. VaRbased models could be used to calculate measures of both general market risk and specific risk. As compared to the SMM, IMA is considered to be more risk sensitive and aligns the capital charge for market risk more closely to the actual losses likely to be faced by banks due to movements in the market risk factors.
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Capital Charge for Market Risk: Internal Models Approach

At present, the SMM is applicable to both Held-For-Trading (HFT) and Available for Sale (AFS) portfolios. Generally, the positions held in the AFS are more illiquid and the market prices for them may not be available or may be available with a very low frequency due to low trading volumes. Therefore, it would not be feasible to compute meaningful VaR measures for AFS portfolios. Accordingly, the trading book for the purpose of these guidelines will consist of only Held-For-Trading (HFT) portfolio, which will also include trading positions in derivatives and the derivatives transactions entered into for hedging trading book exposures. The AFS portfolio should continue to be under SMM for computation of capital charge for market risk.

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VaR
Value at Risk (VaR) is the most probable loss that we may incur in normal market conditions over a given period due to the volatility of a factor, exchange rates, interest rates or commodity prices. The probability of loss is expressed as a percentage VaR at 95% confidence level, implies a 5% probability of incurring the loss; at 99% confidence level the VaR implies 1% probability of the stated loss. The loss is generally stated in absolute amounts for a given transaction value (or value of a investment portfolio). The VaR is an estimate of potential loss, always for a given period, at a given confidence level.. A VaR of 5p in USD / INR rate for a 30- day period at 95% confidence level means that Rupee is likely to lose 5p in exchange value with 5% probability, or in other words, Rupee is likely to depreciate by maximum 5p on 1.5 days of the period (30*5% ) . A VaR of Rs. 100,000 at 99% confidence level for one week for a investment portfolio of Rs. 10,000,000 similarly means that the market value of the portfolio is most likely to drop by maximum Rs. 100,000 with 1% probability over one week, or , 99% of the 23 time the portfolio will stand at or above its current value.

VaR
Dennis Weatherstone, former chairman of J. P. Morgan (JPM):
"At close of business each day tell me what the market risks are across all businesses locations." In a nutshell, the chairman of J. P. Morgan wants a single dollar number at 4:15 PM New York time that tells him J. P. Morgan's market risk exposure on that day.

For a Bank, it is concerned with how much it could potentially lose should market conditions move adversely;

Market risk = Estimated potential loss under adverse

circumstances

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VaR
VaR can be defined as the worst loss that might be expected from holding a security or portfolio over a given period of time, given a specific level of probability.
Example: A position has a daily VaR of $10m at the 99% confidence level means that the realized daily losses from the position will, on average, be higher than $10m on only one day every 100 trading days.

VaR is the answer to the following questions:

What is the maximum loss over a given time period such that there is a low probability that the actual loss over the given period will be larger (than the VaR)?

VaR is not the answer to:

How much can I lose on my portfolio over a given period of time?
The answer to this question is everything.

VaR does not state by how much actual losses will exceed the VaR figure.
It simply states how likely it is that the VaR figure will be exceeded.
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VaR: RBI Perspective

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 risk. Risk is defined as the probability of the unexpected happening - the probability of suffering a loss. VaR is an estimate of the loss likely to suffer, not the actual loss. The actual loss may be different from the estimate. It measures potential loss, not potential gain. Risk management tools measure potential loss as risk has been defined as the probability of suffering a loss. 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.
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VaR Methodologies
VAR can be arrived as the expected loss on a position from an adverse movement in identified market risk parameter(s) with a specified probability over a nominated period of time. Volatility in financial markets is usually calculated as the standard deviation of the percentage changes in the relevant asset price over a specified asset period. The volatility for calculation of VaR is usually specified as the standard deviation of the percentage change in the risk factor over the relevant risk horizon. There are three main approaches to calculating value-at-risk: the correlation method, also known as the variance/covariance matrix method; historical simulation and Monte Carlo simulation. All three methods require a statement of three basic parameters: holding period, confidence interval and the historical time horizon over which the asset prices are observed.
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VaR Methodologies
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 asset(s), with a variance/covariance matrix of the various components' volatilities and correlation. It is a deterministic approach. The historical simulation approach calculates the change in the value of a position using the actual historical movements of the underlying asset(s), but starting from the current value of the asset. The length of the historical period chosen does impact the results because if the period is too short, it may not capture the full variety of events and relationships between the various assets and within each asset class, and if it is too long, may be too stale to predict the future. The advantage of this method is that it does not require the user to make any explicit assumptions about correlations and the dynamics of the risk factors because the simulation follows every historical move.
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VaR Methodologies
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. He is essentially imposing his views and experience as opposed to the nave approach of the historical simulation method. At the heart of all three methods is the model. The closer the models fit economic reality, the more accurate the estimated VAR numbers and therefore the better they will be at predicting the true VAR of the firm. There is no guarantee that the numbers returned by each VAR method will be anywhere near each other.

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VaR
Three measurable components for the FI's daily earnings at risk: Daily earnings at risk (DEAR) = (Value of the position) * ( Price sensitivity ) * (Potential adverse move in yield)

or
Daily earnings at risk (DEAR) = (Value of the position) * (Price volatility)
Suppose a Bank has a Rs1 million market value position in zerocoupon bonds of seven years to maturity with a face value of Rs1,631,483. Today's yield on these bonds is 7.243 percent per annum. These bonds are held as part of the trading portfolio. Thus: Value of position = $1 million

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VaR
The Bank wants to know the potential exposure faced by the bank should a scenario occur resulting in an adverse or reasonably bad market move against the bank. How much will be lost depends on the price volatility of the bond. From the duration model we know that: Daily price volatility = (Price sensitivity to a small change in yield) * (Adverse daily yield move) = (-MD) * (Adverse daily yield move) The modified duration (MD) of this bond is: D 1+R 7 (1.07243) MD = --------- = -- ----------- = 6.527 given the yield on the bond is R = 7.243 percent.
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VaR
Suppose we want to obtain maximum yield changes such that there is only a 5 percent chance the yield changes will be greater than this maximum in either direction. Assuming that yield changes are normally distributed, then 90 percent of the area under normal distribution is to be found within 1.65 standard deviations from the mean-that is, 1.65. Suppose over the last year the mean change in daily yields on seven-year zeros was 0 percent while the standard deviation was 10 basis points (or 0.1%), so 1.65 is 16.5 basis points (bp). Then:

Price volatility = (-MD)* (Potential adverse move in yield)

= (-6.527)* (.00165) = .01077 or 1.077% and Daily earnings at risks = (Value of position) * (Price volatility) = (l,000,000)* (.01077) = Rs10,770
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VaR
Extend this analysis to calculate the potential loss over 2, 3, ....., N days. Assuming that yield shocks are independent, then the N-day market risk (VAR) is related to daily earnings at risk (DEAR) by: VaR = DEAR x N If N is 5 days, then: VaR = Rs10,770 x 5 = Rs24,082 If N is 10 days, then:

VaR = Rs10,770x 10
= Rs34,057

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Limitations of VaR
Value At Risk can be misleading: false sense of security
Looking at risk exposure in terms of Value At Risk can be very misleading. Many people think of VAR as the most I can lose, especially when it is calculated with the confidence parameter set to 99%. Even when you understand the true meaning of VAR on a conscious level, subconsciously the 99% confidence may lull you into a false sense of security. Unfortunately, in reality 99% is very far from 100% and heres where the limitations of VAR and their incomplete understanding can be fatal.

VAR does not measure worst case loss

99% percent VAR really means that in 1% of cases (that would be 2-3 trading days in a year with daily VAR) the loss is expected to be greater than the VAR amount. Value At Risk does not say anything about the size of losses within this 1% of trading days and by no means does it say anything about the maximum possible loss. The worst case loss might be only a few percent higher than the VAR, but it could also be high enough to liquidate your company. Some of those 2-3 trading days per year could be those with terrorist attacks, Kerviel detection, Lehman Brothers bankruptcy, and similar extraordinary high impact events. You simply dont know your maximum possible loss by looking only at VAR. It is the single most important and most frequently ignored limitation of Value At Risk. Besides this false-sense-of-security problem, there are other (perhaps less frequently discussed but still valid) limitations of Value At Risk:
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Limitations of VaR
Value At Risk gets difficult to calculate with large portfolios
When youre calculating Value At Risk of a portfolio, you need to measure or estimate not only the return and volatility of individual assets, but also the correlations between them. With growing number and diversity of positions in the portfolio, the difficulty (and cost) of this task grows exponentially.

Value at Risk is not additive

The fact that correlations between individual risk factors enter the VAR calculation is also the reason why Value At Risk is not simply additive. The VAR of a portfolio containing assets A and B does not equal the sum of VAR of asset A and VAR of asset B.

The resulting VAR is only as good as the inputs and assumptions

As with other quantitative tools in finance, the result and the usefulness of VAR is only as good as your inputs. A common mistake with using the classical variance-covariance Value At Risk method is assuming normal distribution of returns for assets and portfolios with non-normal skewness. Using unrealistic return distributions as inputs can lead to underestimating the real risk with VAR.

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Limitations of VaR
Different Value At Risk methods lead to different results There are several alternative and very different approaches which all eventually lead to a number called Value At Risk: there is the classical variance-covariance parametric VAR, but also the Historical VAR method, or the Monte Carlo VAR approach (the latter two are more flexible with return distributions, but they have other limitations). Having a wide range of choices is useful, as different approaches are suitable for different types of situations. However, different approaches can also lead to very different results with the same portfolio, so the representativeness of VAR can be questioned.

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Capital Charge for Market Risk: Internal Models Approach

The capital requirement under IMA would be a function of three components as indicated below : Normal VaR Measure (for general market risk and specific risk) Stressed VaR Measure (for general market risk and specific risk) Incremental Risk Charge (IRC) (for positions subject to interest rate specific-risk capital charge). Value-at-risk must be computed on a daily basis. In calculating VaR, a 99th percentile, confidence interval is to be used. In calculating VaR, an instantaneous price shock equivalent to a 10-day movement in prices is to be used, i.e., the minimum holding period will be ten trading days.
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Capital Charge for Market Risk: Internal Models Approach

Parameters for computing Stressed VaR In addition to the normal VaR, a bank must also calculate a Stressed VaR measure. This measure is intended to replicate a VaR calculation that would be generated on the banks current portfolio if the relevant market factors were experiencing a period of stress. The computation of stressed VaR should, therefore, meet the following requirements: a) It should be based on the 10-day, 99th percentile, confidence interval-VaR measure of the current portfolio; b) The stressed-VaR should be calculated at least weekly. c) The model inputs for the stressed VaR should be calibrated to historical data from a continuous 12-month period of significant financial stress relevant to the banks portfolio.
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Capital Charge for Market Risk: Internal Models Approach

Calculation of VaR, Stressed VaR and Capital Requirement

VaR Measures would be calculated, on a daily basis, as the sum of (a) and (b) below:
a) Normal VaR , which is the higher of (1) its previous days VaR number measured according to the parameters specified in this section (VaRt-1); and (2) an average of the daily VaR measures on each of the preceding sixty business days (VaRavg), multiplied by a multiplication factor (mc). b) Stressed VaR , which is the higher of

(1) its latest available stressed-VaR number (sVaRt-1); and

(2) an average of the stressed VaR numbers over the preceding sixty business days (sVaRavg), multiplied by a multiplication factor (ms).

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Capital Charge for Market Risk: Internal Models Approach

Therefore, the capital requirement C is calculated according to the following formula:
C = max {VaRt-1; (mc + pc)* VaRavg} + max {sVaRt-1; (ms+ps)* sVaRavg }

where:

mc and ms are the multiplication factors to be set by the

RBI on the basis of their assessment of the quality of the banks risk management system, subject to absolute minimum of three for both the factors; and pc and ps is the plus / add on factor, generally ranging from zero to one, to be decided by the bank based on the results of the back testing of its VaR model, as detailed below.

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Capital Charge for Market Risk: Internal Models Approach

Stress Testing Stress Testing is a valuable risk management tool which tries to quantify the size of potential losses under certain stress events. A stress event is an exceptional but credible event to which a banks portfolio is exposed. A stress event may involve subjecting the risk factors to shocks which itself is extreme but plausible movement of risk factor. Stress testing to identify events or influences that could greatly impact banks is a key component of a banks assessment of its capital position. A banks stress scenarios need to cover a range of factors that can create extraordinary losses or gains in trading portfolios, or make the control of risk in those portfolios very difficult. These factors include low-probability events in all major types of risks, including the various components of market, credit and operational risks. The market risk capital charge under IMA includes a stressed VaR measure. Banks would calculate Stressed VaR using the model inputs calibrated to historical data from a continuous 12-month period of significant financial stress relevant to the banks portfolio and 41 approved by RBI.

Capital Charge for Market Risk: Internal Models Approach

Stress Testing (Contd.): If a bank uses a 99% confidence level to calculate its value at risk, it generally expects to suffer a loss exceeding the value at risk on one day out of every 100. What happens, however, on the one day when the value at risk is exceeded? How large is the loss on this day? Could this be the one bad day required to break the bank? Such possibilities are considered under stress testing. Stress testing refers to techniques used by financial institutions to analyze the effects of exceptional but plausible events in the market on a portfolio's value.
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Capital Charge for Market Risk: Internal Models Approach

Stress Testing: (Contd.) Banks stress tests should be both of a quantitative and qualitative nature, incorporating both market risk and liquidity risk aspects of market disturbances. Quantitative criteria should identify plausible stress scenarios to which banks could be exposed. Qualitative criteria should emphasise that two major goals of stress testing are to evaluate the capacity of the banks capital to absorb potential large losses and to identify steps the bank can take to reduce its risk and conserve capital. This assessment is integral to setting and evaluating the banks strategy and the results of stress testing should be routinely communicated to senior management and, periodically, to the banks board of directors.
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Capital Charge for Market Risk: Internal Models Approach

Stress tests help financial institutions to:
overcome the shortfall of VAR models (as they deal with tail events neglected by many such models) communicate extreme scenarios throughout the institution, thereby enabling management to take the necessary precautions (limit systems, additional capital, and so on) manage risk better in more volatile and less liquid markets bear in mind, during less volatile periods, that the probability of disastrous events occurring should not be neglected

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Stress Testing
Single-Factor Stress Testing: Sometimes referred to as sensitivity testing/ analysis Single-factor stress testing involves applying a shift to a specific risk factor affecting a portfolio . Risk factors commonly used in sensitivity testing include changes in
interest rates, equity prices and

exchange rates.

Examples of single risk factors may include:

A parallel shift in the yield curve of 100 basis points up and down Yield curve steepening/flattening by 25 basis points Stock index changes of 10% up and down Movements of 6% up and down in major currencies (20% for other currencies) relative to the US dollar
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Capital Charge for Market Risk: Internal Models Approach

Stress Testing - Scenarios Analysis Evaluating the portfolios under various states of the world evaluating the impact changing evaluation models volatilities and correlations Scenarios requiring no simulations analyzing large past losses Scenarios requiring simulations running simulations of the current portfolio subject to large historical shocks e.g. 1987 crash, etc ... Bank specific scenario driven by the current position of the bank rather than historical simulation Much more subjective than VAR Can help to identify undetected weakness in the bank's portfolio 46

Limitations of Stress Tests

Stress testing can appear to be a straightforward technique. In practice, however, stress tests are often neither transparent nor straightforward. They are based on a large number of practitioner choices as to what risk factors to stress, how to combine factors stressed, what range of values to consider, and what time frame to analyse. Even after such choices are made, a risk manager is faced with the considerable tasks of sifting through results and identifying what implications, if any, the stress test results might have for how the bank should manage its risk-taking activities. A well-understood limitation of stress testing is that there are no probabilities attached to the outcomes. Stress tests help answer the question How much could be lost? The lack of probability measures exacerbates the issue of transparency and the seeming arbitrariness of stress test design.
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Capital Charge for Market Risk: Internal Models Approach

Back testing
Statistical testing that consist of checking whether actual trading losses are in line with the VAR forecasts The Basel back testing framework consists in recording daily exception of the 99% VAR over the last year

Even though capital requirements are based on 10 days VAR, back testing uses a daily interval, which entails more observations
On average, one would expect 1% of 250 or 2.5 instances of exceptions over the last year

Too many exceptions indicate that

either the model is understating VAR the Bank is unlucky How to decide ?

Statistical inference

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Back Testing: RBI view

While back-testing of 1% VaR is required to establish the accuracy of the model for the purpose of capital adequacy, in order to dynamically verify model assumptions, banks may, in addition, back-test VaR models based on 2%, 5% and 10% VaR. A 95% daily confidence level is generally considered practical for back-testing because one should observe roughly one excession a month (one in 20 trading days). A 95% VaR represents a realistic and observable adverse move. A higher confidence level, such as 99%, means that we would expect to observe an exceedence only once in 100 days, or roughly 2.5 times a year. Verifying higher confidence levels thus requires significantly more data and time.
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Frequency of Back-Testing
Banks should perform back-testing of the VaR-models for each of major risk categories separately wherever VaR for all major risk categories is computed separately. Banks should also perform back-testing of overall VaR, in case risk aggregation across all major risk categories has been done.

Banks should account for exceptions at least on a quarterly basis, but preferably on a monthly basis, using the most recent twelve months of data.
The implementation of the back-testing program should begin at least six months before the date the bank makes an application to RBI for approval of the model. In addition, the model should also be back-tested at least for two quarters post-RBI approval, before it is actually used for calculating regulatory capital.
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Reporting of Back-Testing Results to RBI n Supervisory Response

A bank should report to the RBI (Chief General Manager-inCharge, Department of Banking Supervision, Central Office) the results of their back-testing exercise every quarter before the last day of the month following the close of reporting quarter. In addition to exceptions, the report should include: i. The classification of exceptions and possible explanations for the same. ii. The proposed investigations, if not already completed. iii. Action already taken or proposed to be taken to improve the performance of the model. iv. Number of exceptions observed during each of the last three back-testing results excluding the one under reporting.

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Supervisory Framework for the Interpretation of the Back-Testing Results

A bank will classify its back-testing outcomes into the following three zones depending on the number of exceptions arising from back-testing: If the back-testing results produce four or fewer exceptions, it falls within the Green Zone and there may not be any increase in the multiplication factor beyond minimum three for both VaR and stressed VaR. If the back-testing results produce five to nine exceptions, it falls within the Yellow Zone and there would be an increase in the multiplication factors for both VaR and stressed VaR. If the back-testing results produce ten or more exceptions, it falls within the Red Zone and the multiplication factors for both VaR and stressed VaR will be increased from three to four.

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Computation of capital for Market Risk

In calculating the eligible capital for market risk, it will be necessary first to calculate the banks minimum capital requirement for credit and operational risk and only afterwards its market risk requirement to establish how much Tier 1 and Tier 2 capital is available to support market risk.
1. Capital Funds Tier 1 Capital Tier 2 Capital Total Risk Weighted Assets (RWA) RWA for credit and operational risk RWA for market risk Total CRAR Minimum capital required to support credit and operational risk (1000*9%) Tier 1 (@ 4.5% of 1000) Tier 2 (@ 4.5% of 1000) Capital available to support market risk (105-90) Tier 1- (55-45) Tier 2- (50-45) 55 50 1000 140 105

2.

1140

3 4

9.21 90 45 45 15 10 5

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Internal Model Approach - Benefits

Internal VaR system is more precise VaR account for correlations Market risk charge under IMA likely to be lower With improvements in risk measurement techniques, enable capital charge to be more precise IMA will

Market Risk charge needs to be computed and monitored daily Each day VaR is compared with the subsequent Trading profit or loss Back Testing will help to refine the framework

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Internal Model Approach: Summary

Independent Risk Control Unit responsible for design and implementation of Banks risk management systems Regular Back-Testing Initial and on-going Validation of Internal Model Banks Internal Risk Measurement Model must be integrated into Management decisions Risk measurement system should be used in conjunction with Trading and Exposure Limits. Stress Testing Risk measurement systems should be well documented Independent review of risk measurement systems by internal audit Board and senior management should be actively involved

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Market Risk Management: Summary

Know your risks Control Measures
Duration Limits VaR Limits

Allocate Capital
Standardized Model Internal Model

Measurement Techniques Marking to Market

Stop Loss Limits

Duration, Convexity
Price Value of a Basis Point VaR - Forex (Spot & Forward) Stress Testing Scenario Analysis
Sophistication

Counterparty Exposure Limits

Country Exposure Limits

Stress Testing Value at Risk Duration

Cashflow analysis to measure the sensitivity of fixed income instruments Use of statistical Statistical analysis to determine maximum losses Use of What if scenarios to determine losses in extreme events

Mark to Market
Revaluation of the portfolio to measure notional P/L

Time
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Supporting Factors for Risk Management

1 4
Set up risk management system

Involve of the board of directors and high level management

2
Effective Risk Management

Formulate risk management policies and procedures

Establish a unit to operate risk management

3
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Limitations to Risk Management

Limitations
Involve of the board of directors and high level management Not enough cooperation Low qualification Lack of independence to make a decision Not transparence Policies/ procedures not match with risks Underdevelopment Infrastructure Rigid to implement Communication failure

Formulate risk management policy and procedures

Establish a unit to operate risk management

Lack of adequate structure Staff has less experience Lack of independence

No follow up and control system Not enough risk assessment/ management instruments Database and IT system
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Set up risk management system

Organisation of Market Risk Function of a bank

A typical organisational design of the market risk function of a bank conforming to standards of Basel II Framework for management and measurement of market risk would have the following independent elements: (i) Front Office/Trading unit: This unit comprises the trading desks and their immediate supervisors. (ii) Middle Office/Risk Control Unit: a) This unit is responsible for the design and implementation of the banks market risk management system. The unit should produce and analyse daily reports on the output of the banks risk measurement model, including an evaluation of the relationship between measures of risk exposure and trading limits. This unit must be independent from business trading units and should report directly to senior management of the bank. b) The unit should conduct a regular back-testing programme, i.e. an expost comparison of the risk measure generated by the model against actual daily changes in portfolio value over longer periods of time, as well as hypothetical changes based on static positions.
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Organisation of Market Risk Function of a bank (Contd.)

c) This unit should also conduct the initial and on-going validation of the internal model. However, the responsibilities for model construction and model validation shall be clearly and formally defined. Further, the staff performing model validation shall be independent of the staff who constructed the model (i.e. the bank shall ensure that there is no conflict of interest and that the staff performing the validation work can provide objective and effective challenge to the staff who construct the model). d) The unit will also be responsible for performing stress tests on the market risk exposures of the bank. (iii) Model Construction Unit: If a bank decides to construct the market risk model(s) in-house, it should constitute the model construction team comprising staff who are later not involved in the validation and internal audit of these models. (iv) Model Validation Unit: This unit will comprise the suitably qualified staff who were not involved in the model development process. However, the unit may be a part of the risk control unit.

(v) Back Office: This unit ensures the correct recording of transactions and 60 funds transfers.

Organisation of Market Risk Function of a bank (Contd.)

(vi) Internal Audit : An independent review of the risk measurement system should be carried out regularly in the banks own internal auditing process. This review should include both the activities of the business trading units and of the independent risk control unit. A review of the overall risk management process should take place at regular intervals (ideally not less than once a year) and should specifically address, at a minimum:
The adequacy of the documentation of risk management system and process; The organisation and functioning of the risk control unit; The integration of market risk measures into daily risk management; The approval process for risk pricing models and valuation systems used by front and backoffice personnel; The validation of any significant change in the risk measurement process; The scope of market risks captured by the risk measurement model; The integrity of management information system; The accuracy and completeness of position data; The verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; The accuracy and appropriateness of volatility and correlation assumptions; The accuracy of valuation and risk transformation calculation; The verification of the models accuracy through frequent back-testing
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