Assessment of Market Risk

Risk arising from movements in the

market price of assets and positions
that can be traded in a defined market
 Market Risk: Types Of Risk
Interest Rate Risk
Foreign Exchange Risk
Equity Risk
Commodity Risk
Oil/Gas
Precious Metals
Pork Bellies
Telecom Bandwidth
Weather Risk (via weather derivatives).
 Market Risk: Typical Traded
Products
Cash products
Spot FX
Equities, fixed income securities (bonds), etc
Loans
Derivatives
FX, Interest Rate, Commodities, Equity, Weather, etc
Difference between swaps and options
Credit derivatives are a refinement of guarantees in a more
tradable form.
Note that exchanges for credit derivatives have not yet been
developed.
Trading intent of credit derivatives involves hedging rather than
selling positions.
Spread Betting
Allows heavily leveraged positions.
 Impact of Market Risk on Banks
Via Trading Book
Own account trading undertaken purely for profit.
Usually involves significant unhedged positions.
Via Banking Book
Structural positions which occur in core banking
business, for example:
Interest rate risk associated with fixed rate mortgage
portfolio.
Foreign exchange risk associated with a foreign currency
loan portfolio funded by local currency deposits.
Banks can usually hedge these risks if they wish to.
Hedging usually transforms the risks into different
types of risk, rather than removing them completely.
INTEREST RATE RISK
 Interest Rate Risk
Gap Analysis
Note that regulatory capital does not explicitly
allocate capital to the interest risk inherent in a
banks banking book.
Define this interest rate risk as the effect of
interest rate changes on net interest income
Typical methodology is gap analysis:
group assets & liabilities into time buckets based on period until
maturity or next repricing;
compare rate-sensitive assets (RSAs) to rate-sensitive liabilities (RSLs)
in particular time frame
gap= RSAs-RSLs
Assumes management takes no action during the time period
 Gap Summary
Gap Change in Change in Relative Change in Change in
Interest Interest Change Interest Net
Rates Income Expense Interest
Income
>0 + + > + +
>0 - - > - -
<0 + + < + -
<0 - - < - +
0 + + = + 0
0 - - = - 0
Example of Gap Calculation

Case A
Scenario I Assets Average Yield Liabilities Interest Costs
Rate-sensitive 500 12% 600 9%
Fixed-rate 350 15 220 8
Nonearning/Nonpaying 150 100
Total 920
Equity
80
Total 1,000
Net interest income = 0.12(500) + 0.15(350) - 0.09(600) - 0.08(220)
=112.50 - 71.60
=40.90
Net interest margin =40.90/850 = 4.81%
GAP = RSAs - RSLs =500 - 600 = -100
 Interest Rate Risk
Derivatives can be used to alter interest rate sensitivity
interest rate swaps
futures, forwards.
Interest rate risk must be managed by currency.
More difficult to hedge interest rate in emerging market
currencies.
Those currencies may need to be naturally hedged.
Modeling tools improve measurement of interest rate
sensitivity, but do not stop management from taking risks.
Techniques are only as accurate as the assumptions underlying
them.
FOREIGN EXCHANGE RISK
 Foreign Exchange Risk
The risk of loss from an unexpected movement in
exchange rates.
Losses can occur:
Gradually as currencies shift against each other
Suddenly arising from market corrections.
Removal of fixed exchange rate regime represents most extreme
form of market correction.
Arises from:
trading activities;
lending activities;
investments in foreign branches and subsidiaries.
 Foreign Exchange Risk
Consider in which currencies a bank is running
open positions?
Is bank only operating in hard currencies?
Does it have an exotics business?
What is the total open position allowed as a
percentage of own funds?
How does this compare to the regulatory minimum?
Regulatory requirements do very between countries in this area?
15% of capital is a good benchmark for regulatory minimum.
Hidden Foreign Currency Risk
Has currency risk been passed to clients in the
form of currency denominated loans?
If so, is the client naturally hedged?
Only exporting companies or any other company with natural
FX income would be naturally hedged.
In this world changes in FX rates will show as asset
quality deterioration.
The foreign subsidiaries of many banks run
significant FX risk as they lend in local currency
but do not have a natural local currency funding
base.
 Foreign Exchange Risk
When the local currency is pegged to a major
international currency:
Ddoes the bank allow unlimited positions against the
peg currency?
What procedures are in place to manage the effect of
a devaluation?
Is a bank naturally hedged for a devaluation?
This could happen if the deposits are in the local currency,
but the asset base is mainly held in the foreign currency.
Remembering that in this case, the devaluation could have a
harmful impact on corporate creditworthiness.
EQUITY RISK
 Equity Risk
Equity is not usually a significant market risk
for most commercial banks.
Equity trading business often booked in
separate subsidiary.
Banks in some countries have traditionally
taken equity stakes in their large corporate
customers.
Germany & Japan typified by this approach.
Cross shareholdings have been largely
unwound in recent years.
 Equity markets I
Less well established local equity markets are prone to
bubble events not driven by global economic trends.
e.g. Cyprus
Stock Exchange launched 1996
CSE Index 1.1.99 was 97
CSE Index 1.12.99 was 852
CSE Index 30.9.01 was 103.
Volume of funds invested in the market outpaced the
volume of companies listing on the Exchange.
Example of irrational exuberance.
 Equity Markets II
Reliable, sustainable valuations are difficult in the
face of:
Low market capitalisation
Excessive market concentration in certain sectors
Relatively few market participants
Thin liquidity.
Many emerging markets display these
characteristics.
Ensure that banks have extremely prudent
valuation policies and do not rely on equities for
either liquidity or budgeted profit
COMMODITY RISK
 Commodity Risk
As for equity risk, commodity risk is rarely a
significant risk for most banks.
Commodity positions usually booked in separate
commodity trading subsidiaries.
Some emerging market banks have large
implicit exposure to commodity markets:
Corporates in primary product producing countries will
see volatility of profit based on world commodity
markets.
This can adversely impact asset quality in the banks
lending to those companies.
MARKETS & PRODUCTS:

KEY POINTS WHICH MIGHT

IMPACT BANKS
 Market Liquidity
Most analysis of market risk is based on
statistical work carried out in the US
Note that the US has the most liquid markets of any country in
the world.
It is important to consider if banks are using market risk tools
appropriate to their local market conditions.

As soon as market liquidity dries up,

market risk becomes credit risk, as the
underlying instrument can no longer be
traded.
 Local Capital Markets
What is the level of development of the financial
markets?
Consider both by country and by product
For instance, countries with no private sector pension funds
tend to have less active local capital markets.
Number of participants
Own account traders
Local professional investors
International participants
Capital Market Regulation
Availability of local ratings
Maturity of funds on offer
 Debt securities
Debt securities are important to banks as
Funding tools
To hold in liquidity portfolios
To hold in trading portfolios
Bond markets in most emerging markets
Have relatively few issuers
Have quite short maturities
Are illiquid and unrated
Sell bonds mainly to banks as proxies for loans
Can be subject to fraud and insider trading
 Valuation of debt securities
Investigate carefully the valuation procedures for local
debt securities
Are these marked to market on a regular basis?
If not, why not?
What alternative techniques are used to value debt securities?
Note that many credit-linked products do not have an active
market and are often marked-to-model.
If there is not a regular mark to market, ensure that the
bank is aware of any hidden gains or losses in its
portfolio
What will a bank do to ensure that it does not have to realise any
hidden losses? Is there temptation to mis-value the portfolio?
 Derivatives - Credit Risk
Risk that a counterparty will fail to perform on an
obligation to the banking institution
Measured by the potential amount to be owed the bank
at any point in the life of the contract
Broadly Current Mark to Market plus Expected Future Exposure
Managing Counterparty Risk
Historically derivative counterparties have been some of the
most creditworthy entities.
As investment banks were downgraded and weaker
counterparties entered the market, collateralization of
counterparty risk became commonplace.
Key issue when assessing banks, as if market deteriorates a
bank can face significant collateral demands on its derivatives
portfolio, which can undermine liquidity of the bank.
 Derivatives
Other Non Market Risks
Market Liquidity Risk
Risk that bank is unable to hedge open positions, as it is unable
to find any counterparty willing to take an opposite risk view.
Operational Risk
Rogue Dealer.
Back office mistakes which could leave transactions unrecorded
or unsettled.
Model risk.
Occurs when the risk management model does not accurately
reflect the true underlying risk of the banks portfolio.
Legal risk.
Largely mitigated under standard ISDA documentation.
Ultra-vires issues Hammersmith & Fulham.
 Derivatives
Hammersmith & Fulham
Hammersmith & Fulham is a metropolitan council in
West London.
Local Authorities in UK have limited borrowing powers.
In 1980s, following public expenditure cuts, H&F took almost $10
billion of exposure in swaps market.
Objective was purely speculative to make profits to replace lost
income from central government.
Interest rate changes in 1989 resulted in significant losses.
H&F could not pay under the swap contracts, so rather than
default, the council claimed the swaps were invalid and illegal as
the council did not have the power to enter into the contract.
View was upheld by House of Lords in 1991 which clarified that
local councils should never enter into swaps contracts.
Banks lost about $1 billion on the H&F debacle.
 Derivative Markets I
Few countries have developed derivative exchanges.
Exchange traded derivatives reduce counterparty risk as the
derivative is traded against the exchange.
Exchanges are more transparent and usually more liquid than
the Over-The-Counter (OTC) market.
Valuation of derivatives can be harder in the OTC
market.
Understand the basis of valuation of the contract.
Does the valuation assume normal market conditions?
What would be the forced valuation of the position in an
adverse market?
 Derivative Markets II
Understand who the main market participants
are?
Is risk being transferred out of the banking
sector?
Could this pose an issue for systemic risk in a
country?
Internationally this debate is very active at present with
regard to the Hedge Funds.
LTCM (Long Term Capital Management) illustrates the
possible systemic risk of positions being moved out of the
regulated sector by derivative trading.
 Derivative Markets III
How much expertise is there amongst market
players?
Do they understand the downside as well as the upside?
Are banks writing options as well as buying options?
International investment banks tend to view small local banks as
end users of this product and will market risk accordingly.

Are risk controls procedures adequate?

A sophisticated Value At Risk model in the wrong hands can be
dangerous.
Is there enough historical data to justify use of a Value at Risk
model?
How long should a holding period used in the VAR model be in less
liquid market markets?
 MARKET RISK:
ANALYSING BANK
SPECIFIC ISSUES
 Market Risk Appetite
What is the banks appetite for market risk?
Can be difficult to ascertain from the financial statements.
Financial statements only show a snap shot of market exposure,
which is always historic.
Banks often reduce their market exposure at financial year end?
What instruments are traded?
Use your own dealing room to get a feel for the type of
deals being done by a counterparty.
Use the management review at the front of the annual
report to understand the attitude of management to
market risk.
Can history of trading profits easily be explained by
macro-market movements?
 Market Risk Expertise
Sophistication of bank?
Is the bank a wholesale or retail taker of market risk?
Does dealing room originate products?
Is it an end-user?
Rationale for market risk business?
Is it underpinned by customer needs?
Is it purely speculative?
Has percentage of profits derived from trading increased?
How good is risk management?
Does the bank have its own risk management department?
Which models are used?
Does the bank fully understand off-the-shelf models which it uses?
Does the Board of Directors have the expertise to
understand the market risk profile of the bank?
 Trading Limits
Limits should be consistent with a banks:
overall risk management and measurement process;
risk appetite;
corporate objectives;
financial strength.
Limits should be reviewed regularly.
Bank should have a process for approving limit excesses
when these are requested.
Bank should have clear disciplinary steps for traders that
exceed limits.
Large unhedged risk positions are not a macho status
symbol.
 Other Basic Principles of
Managing Market Risk
A strong middle office/risk management department is
vital.
Information in the risk model must include ALL positions,
including structural positions not managed by the trading floor.
Information in the risk model must be accurate and up to date.
Market data must be verified independently from the trading
floor.
Assumptions must be regularly updated.
Back-testing should be used to confirm accuracy of the
risk model.
compares actual mark-to-market P&L against P&L the risk model
has predicted.
 Value At Risk
A method of measuring market risk.
The amount of money an institution could lose or
make due to prices in the underlying markets
changing.
Attempts to encapsulate a firms total market risk into
a single number.
Each bank uses a slightly different VAR model.
A useful tool for internal management.
For the external analyst:
Difficult to understand what the VAR number is saying.
Very difficult to compare VARs between banks.
 Value At Risk
VaR answers the question:
how much can I lose with x% probability over a pre-
set time-horizon?
Interpretation of VAR requires knowledge of:
the holding period
the proportion of price changes covered by the model
(the confidence interval)
how much historic market data is used & whether this
includes certain key market events
The greater the security desired, the longer the
time horizon and the higher the confidence
interval specified
CASE STUDIES
 Barings I What Happened?
Year February 1995
Dealer Nick Leeson
Location London (parent), Singapore
(operating subsidiary).
Type of Loss Futures Trading
Size of Loss GBP850 million
Result Barings insolvent. Bank of
England refused to rescue bank. ING
ultimately bought bank for a token sum.
 Barings II Why?
Periphery Risk loss occurred in Singapore.
Operational Problems:
Lack of top management accountability.
Absence of management supervision over activities of traders.
Lack of segregation of front office and back office duties
Nick Leeson managed both in Singapore Futures trading subsidiary.
Insufficient action taken in response to warning signals.
Margin payments to the Singapore exchange were getting
increasingly larger.
London was not sufficiently inquisitive about why Singapore was
demanding larger intra-group deposits to pay these margins.
Absence of risk management function
 Barings III Lessons Learned
Subsidiaries should be subject to same tight systems and controls
as parent.
Parent should ensure top quality staff are seconded to subsidiaries,
particularly those a long way from home.
Unusual flows of money within the group require investigation and
should be blocked until their rationale is explained.
Compliance & Audit functions need to be suitably staffed by experts
with market & product knowledge.
Consolidated supervision by regulators is not always perfect.
The regulatory function carried out by the futures exchange was not
enough to stop the firm specific problem.
LISTEN TO MARKET RUMOUR.
 Sumitomo I
Year 1996
Dealer Yasuo Hamanaka
Location Japanese firm trading on the London
Metal Exchange.
Type of Loss Copper Trading
Size of Loss - $2.6 billion.
Result Copper prices fell 10% once the
problem was exposed. Sumitomo shares fell, but
the company survived, due to having $12 billion
in capital.
 Sumitomo II
Hamanaka worked for the trading company in
the Sumitomo Group, NOT the bank.
Market was aware of what was happening.
Hamanaka known as Mr 5% as his team controlled
5% of the world copper supply.
Hamanaka was betting on higher copper prices.
Other investors, led by Soros, were trying to
bring copper prices down to the low prices then
being experienced by other metals.
 Sumitomo III
Hamanaka used a secret account to book trades
outside Sumitomos official records.
Due to profits this practice generated over a 10
year period, Hamanaka was given more
delegated power than most mid-level managers
would obtain in a Japanese firm.
Although the positions were traded on an
exchange, the Exchange was not able to stop
the firm specific losses.
 Allfirst Bank I
Year February 2002
Dealer John Rusnak
Location US subsidiary of Irish bank.
Type of Loss FX. Rusnak supposedly traded
plain vanilla FX, but used (unauthorised) options
to build up larger positions.
Size of Loss - $691 million.
Result Effectively wiped out AIBs 2001 profit.
AIB sold Allfirst Bank to M&T Bank (New York
state based regional bank).
 Allfirst Bank II
Regional US subsidiary of Allied Irish Banks plc (AIB).
Formerly known as First Maryland Bank (until 1999).
Located in Baltimore, Maryland.
Second largest bank in Maryland.
Bank was acquired by AIB in 1983 as main foothold in
the US market.
Although one of top 2 banks in Ireland, AIB itself is a
medium sized bank. In Ireland it has both retail &
corporate customers.
AIB has operated in UK corporate market for many
years.
In mid 1990s, AIB acquired a banking business in
Poland.
 Allfirst What Happened?
Periphery Risk loss occurred in Maryland.
Operational Problems:
Allfirst was run by strong minded, Maryland based group of
managers.
Maryland management resented close supervision by group
management in Dublin.
Maryland bank had more autonomy than other AIB international
subsidiaries, such as Zachodni WBK in Poland.
Rusnak was given too much freedom because of the large
profits he was making the bank.
Insufficient action taken in response to warning signals.
Senior management never asked how such large profits were
being made on low risk, plain vanilla trading.
Management ignored market rumours about the size of Rusnaks
positions.
 National Australia Bank I
Year 2001 to January 2004
Dealer 4 traders on FX options desk
Location Australia
Type of Loss Foreign Currency (Options)
Size of Loss A$360million (EUR225mn)
Result Removal of CEO & Other Senior
Staff
 National Australia Bank II
Traders concealed true profits by:
Recording real trades incorrectly;
Recording false trades.
NAB trading business was meant to be customer
focused.
Traders were taking non-customer related
positions.
Although trading losses were reported to
management by junior staff, no action was
taken.
 National Australia Bank III
PwC report on incident found following problems
in Markets Division:
Inadequate Management Supervision;
Significant gaps in back office monitoring functions;
Escalation processes that did not work properly;
Weaknesses in control procedures;
Failure of risk management systems;
An absence of appropriate financial controls.
It was felt that warning signals from regulators &
other market participants were not adequately
acted upon.
 Long Term Capital Management
(LTCM) I

Year 1998
Dealer Hedge Fund (not a single dealer)
Location New York.
 LTCM II
LTCM senior management included:
John Meriwether, ex bond trader from
Salomon Brothers (of Liars Poker fame).
Nobel prize winning economists Myron
Scholes & Robert Merton.
Ex Federal Reserve Board Vice Chairman,
David Mullins.
Management appeared well qualified for
success.
 LTCM III
Trading strategy was to use internal models to
find bonds which were mis-priced relative to one
another.
Take long position in cheap bond.
Anticipating a price increase.
Take short position in expensive bond.
Anticipating a price fall.
As pricing differences were small:
Positions had to be large to make a profit.
Fund had to be leveraged to be able to take such
large positions.
Early 1998, leverage was thirty to one.
Equity of $5 billion, borrowings of $125 billion.
 LTCM IV
Early 1998:
Funds under management c. $125 billion.
Equity c. $ 5 billion.
Notional swaps position c. $1.25 trillion.
Approximately 5% of global swaps market.
LTCM started to take emerging market positions.
LTCM was long Russian rouble denominated GKO bonds.
LTCM had partially hedged GKO exposure by selling
Roubles.
Bet that if price of GKOs fell, the loss on the bonds would be
offset, as Rouble would fall, resulting in an offsetting FX gain
for LTCM.
 LTCM V
August 1998.
Russia devalues Rouble & declares GKO moratorium.
What went wrong for LTCM?
Rouble hedge failed due largely to counterparty risk.
Banks which were counterparties to rouble fx transaction
failed.
Russian government prevented further trading in the Rouble.
LTCM could have survived the losses arising from the
loss of its Rouble hedge.
BUT..
 LTCM VI
The collapse of the Russian bond market triggered
global contagion and a significant flight to quality.
Many investors transferred funds to the US treasury
market, and in particular the most recently issued US
treasuries.
This resulted in significant price distortions, as some
parts of the market suffered from a lack of liquidity whilst
the recently issued US treasuries had over-liquidity.
This scenario was outside the parameters of LTCMs
models and the funds entire trading strategy was
undermined as the relative prices of bonds which
underpinned LTCMs portfolio shifted.
 LTCM VII
As the company began to report losses, limits
were placed on withdrawals and banks began to
worry about LTCMs ability to meet margin calls
on its positions.
Federal Reserve injects $3.5 billion into the fund
in exchange for 90% of its equity to avoid a
systemic market failure.
Individual banks report large losses on their
investments in LTCM:
UBS ($700mn); Dresdner ($145mn), Credit Suisse
($55mn).
 CASE STUDIES TAKE AWAY
As a risk, MARKET RISK can cause large losses.
However, most serious market risk losses have been
triggered by OPERATIONAL RISK.
Controls should limit the impact of market risk losses.
Breakdown of controls is usually the trigger for market risk losses.
Model Risk (LTCM) is an increasingly important aspect of model
risk.
Overall view of control environment in a bank can be
more important in assessing the risk a bank faces from
market risk losses than a detailed study of the financial
statements.
Larger banks better placed to survive market risk losses.