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MARKET RISK MEASUREMENT Pearson Correlation Coefficient

A Gaussian default rime copula can be used for


Commonly used co measure the linear measuring the joint probability of default between
ANDMAN E NT relationship between two variables: cwo assets.
Regression-Based Hedge
PXY =
covxv
Value at Risk (VaR)
VaR for a given confidence level occurs at the axay pR x OVOlN
FN
=
x
cutoff point that separates the tail losses from the ovo1R
remaining distribution. Spearman's Rank Correlation
Historical simulation approach: order return Step 1: Order the set pairs of variables X and Y where:
observations and find the observation chat with respect co sec X. fR =face amount of hedging instrument
corresponds co the VaR loss level. Step 2: Determine the ranks of X and Y for each fN =face amount of initial position
I I

Parametric estimation approach: assumes a time period i.


Bond Valuation Using Binomial Tree
distribution for the underlying observations. Step 3: Calculate the difference of the variable
Using backward induction, the value of a bond at

Normal distribution assumption: rankings and square the difference.


a given node in a bino1nial tree is the average of
VaR =
(-r + ar X ZC't'.)
6
n

I: dr the present values of the two possible values from


the next period. The appropriate discount rate is

Lognormal distribution assumption: Ps = 1- n(n2 -1) i=I


the forward rare associated with the node under
VaR = (l - ellr-OrXZ(\) analysis.
Where n is the number of observations for each There are three basic steps co valuing an option
Expected Shortfall variable and d is the difference between the on a fixed-income instrument using a binomial
I

Provides an escimace of tail loss by averaging rhe ranking for period i. tree:
VaRs for increasing confidence levels in the cail. Step 1: Price the bond value at each node using
Kendall's T
Weighted Historical Simulation the projected interest rates.
Approaches
'T
= _ c -_, n,_
n-"- ,d _
n(n - 1) I 2
Step 2: Calculate the intrinsic value of che

Age-weighted: adjuses the most recent (distant) derivative at each node at maturity.
observations co be more (less) heavily weighted. Step 3: Calcltlace the expected discounted value of
Where the number of concordant pairs is

Volatility-weighted: replaces historic returns with represented as nc (pair rankings in agreement), the derivative at each node using the risk
vo latility adj ust ed returns; actual procedure of
-
and the number of discordant pairs is represented neutral probabilities and work backward
estimating VaR is unchanged. as nd (pair rankings not in agreement). through the tree.

Correlation-weighted: updates the variance


Interest Rate Expectations
covariance matrix between assets in me portfolio. Mean Reversion

In1plies char over time variables or returns regress Expectations play an important role in

Filtered historical simulation: relies on


back co the 1nean or average return. determining the shape of the yield curve and
bootstrapping of standardized returns based on

Mean reversion race, a, is expressed as: can be illustrated by examining yield curves that
volatility forecasts; able co capture conditional
volatility, volatility clustering, and/or data Sc - Sc-I =a( - Sc-I) are Rae, upward-sloping, and downward-sloping.
asymmetry.

The coefficient of a regression is equal co me If expected 1-year spot rates for the next three
negative of the mean reversion race. years are r1, r2, and r3, tl1en the 2-year and 3-year
Peaks-Over-Threshold (POT)
Autocorrelation spot rares are computed as:
Application of extreme value theory (EVT) co the
distribution of excess losses over a high threshold.

Measures the degree mac a variable's current value r(2)
=
J(l + r1 )(I + rz) - l
is correlat ed co past values.
One of the goals of using the POT approach is
Has che exact opposite properties of mean
to compute VaR. From estimates of VaR, we can .
reversion.
derive the expected shortfall (ES).
The sum of the mean reversion rate and the one
Backtesting VaR period autocorrelation race will always equal one. Convexity Effect

Compares the number of instances when losses All else held equal, che value of convexity
Correlation Swap
exceed the VaR level (exceptions) with the number increases wi ch maturity and volatility.

Used to trade a fixed correlation between cwo or
predicted by the model at tl1e chosen level of Term Structure Models
1nore assets with a realized correlation.
Realized correla tion for a portfolio of n assets: Model 1: assumes no drift and that interest rares
confidence.

Failure rate: num b er of exceptions/nu1nber of


2

are normally discribuced:


Prealizcd LPi,j
=
observations. 2
n - n .. dr =adw

The Basel Committee requires backcescing at che 1> J


99o/o confidence level over one year; establishes Model 2: adds a positive drift cerm co Model l
zones for the number of exceptions wim
Payoff f or correlation swap buyer: char can be interpreted as a positive risk premium
corresponding penalties (increases in me capital notional amount x (P,...i; - pfixed) associated with longer rime horizons:
multiplier). dr =A.de + crdw
Gaussian Copula
Mapping where:

Indireccly defines a correlation relationship
Mapping involves finding common risk factors
becween cwo variables. A =inceresc race drift
among positions in a given portfolio. It may be
Maps the marginal distribution of each variable
difficult and time consuming co manage che risk Ho-Lee Model: generalizes drifc co incorporate
to a standard normal distribution (done on
of each individual position. One can evaluate the rime-dependency:
percencile co percencile basis).
dr =A.(c)dc + adw
- -

value of portfolio positions by mapping chem


The ne\>V joint distribution is a multivariate
onto common risk faccors. standard normal distribution.
Vasicek Model: assumes a mean-reverting process
for short-term interest rates:
structured credit products. Their interest rates
include a credit spread above credit risk-free CS=-
(T-t)
l ] ()
x1n D -Rp
secur1t1es.
F
dr =k(9 - r)dt + crdw
where: where:
Expected Loss (EL)
k =a parameter that measures the speed of D =current value of debt
Expected value of a credit loss:
reversion adjusonent F =face value of debt
EL=PD (1 -RR) exposure = PD LGD
e =long-run value of the short-term rate
x x x

assuming risk neutrality Probability ofdefault (PD): likelihood that a Credit Risk Portfolio Models
r =current interest rate level borrower will default within a specified time These models attempt to estimate a portfolio's credit
horizon. value at risk. Credit VaR differs from market VaR
Model 3: assigns a specific parameterization of
Loss gi.ven default (LGD): amount of creditor loss in that it measures losses that are due specifically to
time-dependent volatility:
in the event of a default. In percent terms, it is default risk and credit deterioration risk.
dr =A(t)dt + cre...o.dw
equal to 1 minus the recovery rate (i.e., 1 -RR). CreditRisk+: determines default probability
where:
Exposure at default: amount of money the lender correlations and default probabilities by using a
a =volatility at t = 0, which decreases
can lose in the event of a borrower's default. set of common risk factors for each obligor.
exponentially to 0 for a > 0
The Merton Model CreditMetrics: uses historical data to estimate
Cox-Ingersoll-Ross (CIR) model mean-reverting the probability of a bond being upgraded or

A value-based model where the value of the firm's
model with constant volatility, cr, and basis-point downgraded using historical transition matrices.
outstanding debt (D) plus equity (E) is equal to
volatility, crJ;, that increases at a decreasing rate: the value of the firm CV). KMY Portfolio Manager: default probability is
dr = k(0-r)dt + crJ;dw

The value of the debt can serve as an indicator of a function of firm asset growth and the level of
firm default risk. debt. The higher the growth and lower the debt
Model 4 (lognormal model): yield volatility, Since E and D are co nti ngent claims, option

level, the lower the default probability.
is constant, but basis-point volatility, crr, pricing can be used to determine their values as CreditPortfolio View: multifactor model for
a,

increases with the level of the short-term rate. follows: simulating joint conditional distributions of
There are two lognormal models of importance: payment to shareholders: max(VM-DM, 0) credit migration and default probabilities that
(1) lognormal with deterministic drift and
payment to debtholders: incorporates macroeconomic factors.
(2) lognormal with mean reversion.
DM -max(D M - VM' 0) Credit Derivatives
Overnight Indexed Swaps (OIS) A credit derivative is a contract with payoffs
Interest rate swap in which a fixed interest rate

Equity is similar to a long call option on the value
of a firm's assets where face value of debt is the contingent on a specified credit event. Credit
is swapped for a floating interest rate. The OIS
strike price of the option. events include:
rate is the best proxy for the risk-free rate in the
Debt is similar to a risk-free bond and short put
Failure to make required payments.
valuation of collateralized derivatives portfolios. Restructuring that harms the creditor.
option on the value of a firm's assets where face

Put-Call Parity value of debt is the strike price of the option.


Invocation of cross-default clause.
c-p=S-Xe-rT

Bankruptcy.
The KMV Model
Credit default swap (CDS): like insurance; party
where: Built on the Merton model and tries to adjust
selling the protection receives a fee, pays based on
=price of a call for some of its shortcomings. Assumes there are
swap's notional amount in the case of default.
c
p =price of a put only two debt issues. The default threshold is a
First-to-default put: CDS variation where a party
S =price of the underlying security linear combination of these values and is equal
pays an insurance premium in exchange for being
r =risk-free rate to the par value of the firm's liabilities. A rule for
made whole for the first default from a basket of
T =time left to expiration expressed n
i years determining the default threshold is:
assets. More cost effective option than CDS if
short-term liabilities + 0.5 long-term liabilities
assets have uncorrelated default risks.
x
Volatility Smiles
Currency options: implied volatility is lower for The distance to default (DD) calculates the Total return swap: total return on an asset {bond)
at-the-money options than it is for away-from number of standard deviations between the mean is exchanged for a fixed {or variable) payment;
the-money options. If the implied volatilities for of the asset distribution and the default threshold. total return receiver gets any appreciation (capital
actual currency options are greater for away-from pected asset value - gains and cash flows), pays any depreciation;
------
ex

the-money than at-the-money options, currency default threshold


DD= payments take place whether or not a credit
traders must think there is a greater chance of standard deviation of event occurs. Buyer exchanges credit risk of issuer
extreme price movements than predicted by a
expected asset value
defaulting for the combined risk of the issuer and
lognormal distribution. the derivative counterparty.
Once DD is computed, the probability of default
Equity options: higher implied volatility for low Vulnerable option: option with default risk; holder
can be found by evaluating the DD of other
strike price options. The volatility smirk (half receives promised payment only if seller of the
firms that have defaulted.
smile) exhibited by equity options translates into option is able to make the payment.
a left-skewed implied distribution of equity price Credit Scoring Models Asset-backed credit-linked note: embeds a default
changes. This indicates that traders believe the Fisher linear discriminant analysis: segregates a
swap into a debt issuance. It is a debt instrument

larger group into homogeneous subgroups.


probability of large down movements in price with its coupon and principal risk tied to an

Parametric discrimination: uses a score function
is greater than large up movements in price, as underlying debt instrument (e.g., bond or loan).
determine the members of the subgroups. The
compared with a lognormal distribution.
to

score determines which subgroup the observation is Spread Conventions


placed in (likely-to-default or not-likely-to-default Yield spread: ITM risky bond-ITM benchmark
group). government bond

K-nearest neighbor: categorizes a new entrant by how i-spread: ITM risky bond-linearly interpolated
CREDIT RISK MEASUREMENT closely it resembles members already in groups. ITM on benchmark government bond

Support vector machines: divides larger group into z-spread: basis points added co each spot rate on a
AND MANAGEMENT subgroups using hyperplanes.
benchmark curve
Credit Spread CDS spread: market premium of CDS of issuer
Credit Risk Difference between the yield on a risky bond bond

Credit risk is either the risk of economic loss from


(e.g., corporate bond) and the yield on a risk
default, or changes in credit events or credit ratings. Hazard Rates
free bond (e.g., T-bond) given that the two

Types of credit risky securities include: corporate The hazard rate (default intensity) is represented
and sovereign debt, credit derivatives, and instruments have the same maturity.
by the (constant) parameter A and the probability
of default over the next, small time interval, dt, ABS/MBS Performance Tools Threshold: an exposure level below which
is >..dt. Auto loans: loss curves, absolute prepayment speed. collateral is not called. It represents an amount of
Cumulative PD Credit card debt: delinquency ratio, default ratio, uncollateralized exposure.
If the time of the default event is denoted t*, monthly payment rate. Minimum transfer amount: the minimum quantity
the cumulative default time distribution F(t) Mortgages: debt service coverage ratio, weighted or block in which collateral may be transferred.
represents the probability of default over (O, t): average coupon, weighted average maturity, Quantities below this amount represent
weighted average life, single monthly mortality, uncollateralized exposure.
P(t* < t ) = F(t) = 1 - e->-<
constant prepayment rate, Public Securities Independent amount: an amount posted
The survival distribution is: Association. independently of any subsequent collateralization.
P(t* > t) = 1 - F(t) = e->-c Subprime Mortgage Market This is also referred to as the initial margin.

Subprime borrowers have a history of either default Rounding. the process by which a collateral call
Probability of Default or strong indicators of possible future default. amount will be adjusted (rounded) to a certain
Indicators of future default: past delinquencies,
The probability of default (PD) of a debt security mcrement.

can be calculated by using the following equation:


judgments, foreclosures, repossessions, charge-offs, Central Counterparties
CS and bankruptcy filings; low FICO scores; high debt
PD= The main role of a central counterparty (CCP)
LGD service ratio of 50o/o or more. is to manage and control systemic risk. The CCP

The vast majority of subprime loans are adjustable
CS represents the credit spread, which is the performs the following functions: valuation and
rate mortgages.
difference between the yield on risky debt and the settlement in OTC markets, trade compression
risk-free rate. Loss given default (LGD) is equal to
Counterparty Risk and netting, collateral managem ent, increase
The risk that a counterparty is unable or transparency, loss mutuali:zation, a.nd auction
one minus the recovery rate.
unwilling to live up to its contractual obligations. process for defaulted members.
Single-Factor Model Credit exposure: loss that is "conditional" on the
Examines the impact of varying default counterparty defaulting.
Credit Value Adjustment {CVA)
correlations based on a credit position's beta. Each Expected value or price of counterparty credit
Recovery: measured by the recovery rate, which
individual firm or credit, i, has a beta correlation, risk. A positive value represents a cost to the
is the portion of the outstanding claim actually
/3., with the market, m. Firm i's individual asset counterparty that bears a greater propensity
'
recovered after default.
return is defined as: to default. The CVA should account for the
Wrong-way exposures: exposures that are negatively
aI = A.m
1-'1 +Ji A7E.
1-'1 I correlated with the counterparty's credit quality.
counterparty's default probability, the transaction
in question, netting, collateral, and hedging.
where: They increase expected credit losses.
m
Mark-to-market (MtM): accrual accounting CVALGDx L: d(t i)xEE(t i)xPD(t i-1' ti)
Ji f3r = firm's standard deviation of measure that is equal to the sum of the MtM i 1
=

idiosyncratic risk values of all contracts with a given counterparty. where:


E; = firm's idiosyncratic shock
Credit Exposure Metrics d(t) discount factors
=

Originate-to-Distribute Model Expected MtM: forward or expected value of a Incremental and Marginal CVA
Incremental CVA calculates the cost of a new trade
Enables lenders to originate a loan based on transaction at a given point in the future.

risk/reward pricing and then outsource the risk Expected exposure (EE): amount that is expected versus an existing one to determine the effect
through various channels. This provides better to be lost (positive MtM only) if the counterparty that the new trade has on CVA The formula is
access to capital for less creditworthy borrowers defaults. identical to stand-alone CVA, except for the use of
and more diversification options for investors. Potentialfuture exposure (PFE): worst exposure incremental expected exposure.
Collateralized Debt Obligations that could occur at a given time in the future at a
Marginal CVA is used for trade level attribution.

General term for an asset-backed security that given confidence level. The formula is identical to stand-alone CVA,
issues securities that pay principal and interest from Expected positive exposure (EPE): average EE except for the use of marginal expected exposure.
a collateral pool of debt instruments. through time. Risk-Neutral Default Probability

In order to create a CDO, the issuer packages a Effective EE: equal to non-decreasing EE. Represents estimates of default probability based
series of debt instruments and splits the package Effective EPE: average of effective EE. on observed market prices of securities (e.g.,
into several classes of securities called tranches. Maximum PFE: highest PFE value over a stated bonds, credit default swaps).

The largest part of a CDO is typically the senior time frame. risk-neutral default probability real-world
tranche, which usually carries an AA or AAA credit
=

Credit Mitigation Techniques default probability + liquidity premium + default


rating, regardless of the quality of the underlying
Netting: a legally binding agreement that enables risk premium
assets in the pool.
Synthetic CDO: originator retains reference assets counterparties with multiple derivative contracts
Wrong-Way Risk vs. Right-Way Risk
on balance sheet but transfers credit risk to an to net their obligations (e.g., Party A owes Party B
Wrong-way risk increases counterparty risk
SPY, which then creates the tradable synthetic $50 million; Party B owes Party A $40 million, so
[increases credit value adjustment (CVA) and
CDO. This product bets on the default of a pool Party A pays a net $10 million to Party B).
decreases debt value adjustment (DVA)].
of assets, not on the assets themselves. Colla.tera/ization: if the value of derivative
Right--way risk decreases counterparty risk
contracts is above a stated threshold, collateral
Securitization (decreases CVA and increases DVA).
must equal the difference between the value of
Transforms the illiquid assets of a financial
the contracts and the threshold level. Collateral
institution into a package of asset-backed
agreements have two major benefits: (1) expand
securities (ABSs) or mortgage-backed securities
the list of potential counterparties because credit
(MBSs). A third party uses credit enhancements,
rating is a less important concern and (2) reduce
liquidity enhancements, and structuring to issue
economic capital requirements.
securities backed by the pooled cash flows (of the
same underlying assets). Modeling Collateral Risk-Adjusted Return on Capital

Credit enhancements include overcollateraliution, Certain parameters impact the effectiveness of The RAROC measure is essential to successful
subordinating note classes, margin step-up, and collateral in lessening credit exposure. These integrated risk management. Its main function
excess spread. parameters are as follows: is to relate the return on capital to the riskiness

The first-loss piece (equity piece) absorbs initial Remargi.n period: the time between the call for of firm investments. The RAROC is risk
losses and is often held by the originator. collateral and its receipt. adjusted return divided by risk-adjusted capital
(i.e., economic capital).
RAROC= Enterprise Risk Management (ERM) Loss Distribution Approach
In developing an ERM system, management The loss distribution apptoach (LOA) is used to
should follow the following framework:
revenues - costs- EL- tues +
meet the Ba.sel 11 operational risk standards for
rcrurn on economic capital uansfcrs
Dctenninc the firm's ac.ccptoblc lcvd ofrisk. regulatory capital. The LOA has several steps:
economic capital
Based on the firm's target debt rating, c:Stimore the
Organize and group loss data into a business line/

An adj usted RAROC (ARAROC) measure was


(i.e., buA'er) required to support the curre.nt
capitol a-cnt type mauix.
level of risk in che firm's operations.
W eight every data point in the matrix.
de veloped to better align the risk ofthe busin ess
Determine <he ideal mix ofcapitol and risk that will
Model a loss diS<rihurion in each cell of the matrix.
with the risk of the firm's equity. Determine <he operational risk capital requireme n ts
Adjusted llAROC RAROC e(l\., il,, )
achieve the appropriate debt r a ting .

= - -

Give individual managers the information and the fur each bW1iness line.
incen tive they n eed to make decisions ppropriate
ModdRisk Frequency Distributions
to maint2in the risk/capitol trade-of!:
LOA models most ofren use the Poisson
Risk associated with using financial models to
Identify the risks ofthe firm.
The implementation steps ofERM arc as follows: distribution, the negative binomial distribution, or
simulate complex relationships. Sources ofmodel

the binomial distribution.


risk include model errors, errors in assumptions,
Oe>-dop a consistent method to evaluate the firm's
Practitionert suggest only using internal data
and errors i n implementation. Common model exposure to the idencified risks. because it is most relevant and it i.s difficult tO
errors include u nderestimating risk fuctors, Firm-Wide VaR ensure the completeness ofexternal data.
misapplying a mode l, and assuming con stan t
Firms that use value a t risk (VaR) to assess poten tial
Modeling the frequency distribution requires less
volatility, nor mal distributions, perfect markets, loss amounts will have m ultip le VaR measures <o da ta when compared to modeling severity.
and adequa te liquidity. manage. Severity Distributions
Market risk, credit risk, and operational rik
s will The sc:vcrity ofeach event follows a parametric
liquidity Risk

each produce ics own VaR measures. distribution, such os a lognormal distribution or a
lbe lack ofa market for a security to prevent i t Due to diversification dfcccs, firm-wide VaR will be Weibull distribution.

from being bought or sold quickly enough to


prevent or minimize a loss. It could result from
less than me sum oftheVaRs from each risk cagoty.
Severity distributions arc generally conside red morc
Leverage Ratio important than frequency distributions.
asse t allocation, funding strategies, collareral
recen t internal loss data may not be sufficient for
A firm's leverage ratio is equal to its assets divided
One problem with modeling severity is that
policies, or mismanagement of risks.
Transactions liquidity risk: ri sk that the act o f
by equ ity:
b uying or selling an asset will resul t in an adverse
A (E+D) D calibrating <he <ails of <he distribution.
L=-- = l+ .,-
Using extern! data usually requires scaling the data
E E E
Funding liquidity risk: results when a borrower's
price move. and oombining data from several soured.
Leverage Effect
credit position s
i either deteriorating or
Repurchase Agreements (Repos)
Return on equity (ROE) is higher as leverage
or a spcc:ilicd price with a commitment to buy bade

Bilateral conaaru where one pany sells a JCCUrity
is perceived by market participants to be increases, as long as the firm's return on assctS
deteriorating. (ROA) cxoecds t h e cost ofborrowing funds. m e the security at a furore dace at a higher price.

relatively chep sources ofshon-tc.rm funds.


liquidity-Adjusted VaR leverage effect can be expressed as:
From the perspective of the borrower. rcpos oA'er
The constant spread approach calculates liquidity ROE= (leverage rati o x ROA) -
adjusted Vall (LVaR) assuming the bid-ask spread ((leverage ratio- I) x cost of debt)

From the perspective ofthe lender. reverse repos arc
used for ei<her investing or financing purposes.
is co n stant .
LVaR = (V xz.,, x " + (o.5 x V x spread) Capital Plan Rule
) Transaction Cost
VaR + liqwdicy oost The 99% confidence n
i terval on transoction cost is:
2.33a) adequacy.
LVaR =
Mandates thor bnk holding companies develop a
+I- P x (s +
capitol plan and evaluate capital
where: Capitol adequacy process includes: risk
where:

V asset value management foundation, resource and loss


P estirrw:e ofthe next day asset midprice
estimation me thods, impact on capitol adcqucy,
=

>. VaR confidence parameter


s bid-ask spread
2.33a) 99% spread risk factor

capital plnning and internal controls policies, and
=

a standard deviation ofreturns


(s +
gCJVcrnance CJVtrsight.

(askprice - bidprice )
Operational Risk Data Elements Operational Risk Governance
ead
spr The four data elements that a bank m ust use in
The Basel Committee recognizes three common

(ask price + bid price) I 2


various com bin ation s to calculate the opera tio n al
lines of defense used <O control operational risks:
LVaR can also be calculated given the risk capital charge based on the AMA framework
(I) business line management, (2) independen t
(I) internal loss data, (2) external loss data,
(3) scenario analysis, and (4) business environment
are
distributional charaaeristics ofthe spread. This
is known as the =>gmtruSpreadapp roarh. Ifyou
operational risk management function, and
(3) independent reviews ofoperational risks and
arcgiven the mean and standard d eviation of the and internal control faaors (BElCFs).
risk m anagement.
spread, apply the following formula: Basel II Operational Risk Event Types
Risk Ap p etite Framework (RAF)
LVaR = VaR + 0.5 x(5 + z xas) x V
Internal Fraud.
l
Sets in p ae
c dear, fu<ure-oriented perspcccivc of

External Fraud.
the firm s target risk profile in a number of diA'erent
'

whe re:
Employment Practices and Workplace Safety.
scenarios and maps out a strategy fur achieving chat

Damage to Physical Assets.


s spread mean

Clien<s Products, and Business Practices.
risk profile.
,

spread standard deviation


is essentially a mission statement from a risk


as
Should start with a risk appetite state ment that

Z:,

Busin"" Oi.sruption and System r..Uures.

perspective.
spread confidence param eter Execution, Delivery, and Process Management.

Enemal Loss Data


Benefits include assisting fums in preparing for the


liquidity at Risk (LaR)


IBMAlgo F!RS7: subscription database; includes


Maximum likely cash oudlow over the horizon uncxpcacd and greatly improving a firm's saatcgic
period at a specified confidence lc:vtl. descriptions and analyses of operational risk planning and tactical decision-making.
Also kn own as cash l!CJW at risk (CFR). events derived from legal and regulatory sources Basd II: Three Pillars
Pillar 1: Minimum capital requirements. Banks

A p ositive (negative) value for Lall means rhe and n ews articles.
worst outcome. will be assoca i ted with an outflow OpemtilJnal Rik
s data eXchange Association should maintain a minimum level of capital to
(in8ow) ofcash. (ORX): consortium-based risk event service; cover credit, market, and operati onal risks.
Pillar 2: Suisory rroinu proce.n. Banks should

LaR i.s similar to VaR, but nsi tead of a chnge in
gathers anonymous operational risk events from
assess the adequacy ofcapital relative to risk, and
valu e, it deals with cash l!CJWS.
members.
supervisors should review and take corrective Within each business line, gross income will
Established Financial Stability Oversight Council
action if problems occur. be multiplied by a fixed beta factor. The capital (FSOC).
Pillar 3: Market discipline. Risks should be charge for operational risk is the sum of eacl1 Establ is h ed Office of Financial Research (OFR).

adequately disclosed in order to allow market business line's cl1arges. The beta factors for the
Established Volker Ruic, intend ed to curtail
participants to assess a bank's risk profile and the eight business lines are as follows: proprietary trading by banks.
Banks considered too-big-to-fail must be identified
adequacy of its capital. Tradi ng and sales: 18%

and could be broken up if their living wills arc



Corporate finance: 18%
Basel II: Forms ofCapital judg e-cl unacceptable.
Payme nt, settlement: 18%
Tzer I: shareholder's equity, retained earnings;


Commercial banking: 15%

Increas e-cl regulation and improved transparency fur
nonredeemable, noncumulative preferred stock.
Agency scrvicc-s: 15% over-the-counter (OTC) derivatives.
Tzer 2: undisclosed reserves, revaluation reserves, Rcrail banking: 12 %
general provisions/general loan-loss reserves,
Retail b kerage: 12 %
ro

hybrid debt capital instruments, and s ubordinated


Asset management: 12%
term debt. AdvancedMeasurement Approach (AMA): lfa bank
Credit Risk Capital Requirements can meet more rigorous supervisory standards,
The standardized approach incorporates it may use the AMA for operational risk capital
risk weights based on external credit rating calculations. The capital charge for AMA is
Portfolio Construction Techniques
assessments. The amount of capital that a bank calculated as the bank's operational value at risk
Screens simply choose assets by ranking alpha.
must hold is specific to the risk of credit-risky (OpVaR) with a I-year horizon and a 99.9%
Stratification chooses stocks based on screens.;
assets, the type of institution the claim is written confidence level. Having insurance can reduce this includes assets from all asset classes.
on, and the maturity of those assets. capital charge by as much as 20%.
Linear programming attempts to construct a
The internal ratingr-based (IRE) approaches Basd III Changes portfolio that closely resembles the benchmark.
(foundation and advanced) use a bank's own
Raise capital sta
ndar ds (both quality and quantity).
Quadratic programming explicitly considers alpha,
internal estimates of creditworthiness to determine
Strengthen risk coverage of capital framework. risk, and transactions costs.
the risk weightings in the capital calculation.
Require k-veragc ratio to supplement capital Portfolio Risk
Foundation approach: bank estimates probability of rcqwrcmcnts. Divenified VaR:
default (PD}.
Promote countercyclical bulfers during financial
Advanced approach: bank estimates not only PD, shocks. w?o?+ wiaI +

VaRp=ZcxPx
bu t also loss given default (LGD), exposure at Instit ute policies to address systemic risk and 2w1w2"1 "2P1.2
default (EAD), and elfectivc mat ity (M).
ur interconnectedness.

Market Risk Capital Requirements



Institute global liquidity standard (liquidity, Undiverrifod VaR:
funding, and mon itoring me.tries}.
VaRp = r
_ _ _ _
VaR?_
a_ _ _+_ - _
_R _ _ _ _ _
Standardi.udmethod: determines capital charges +V 2VaR1 V a R2
associated with various market risk exposures Liquidity Coverage Ratio =VaR1 +VaR2

(equity risk, interest rate risk, foreign exchange Goal: ensure banks have adequate, high-quality
risk, commodity risk, and option risk). The liquid assets to survive short-term stress scenario. V..Rfor Uncorrelated Positions:
market risk capital charge for eacl1 market risk is LCR (stock of high-quality liquid ass ets I total net
=
2 2
VaRp= VaR1 + VaR2
computed as 8% of its market-risky assets. cash ou tAows over next 30 calendar days) > 100
Internal models approach (IMA): allows a bank Net Stable Funding Ratio Marginal VaR: per dollar change in portfolio VaR
to use its own risk management systems to Goal: protect banks over a longer time horizon that occurs from an additional investment in a
determine its market risk capital charge. The than LCR. pos1t1on.
NSF R (available. amount of stable funding I VaRp
market risk charge is the higher of (I) the =

MVaR = xi3
re-quired amount of stable funding) > 100
previous day's VaR or (2) the average VaR over the 1 portfolio value 1

last 60 business days adjusted by a multiplicative Stressed Value at Risk How to use MVaR:
factor (subject to afloor of3). SVaR is calculated by combining current portfolio
Obtain the optimal portfulio: equate the excess
Backtesting VaR performance data with the firm's historical data rcturn/MVaR ratios of all portfulio positions.
An exception occurs if the day's change in value from a significantly financial stressed period in tl1e
Obtain the lowest portfolio VaR: equate just the
exceeded the VaR estimate of the previous day. same portfolio. Calculation of SVaR is defined as MVaRs of all portfolio positions.
When backtesting VaR, the number of exceptions follows: Incremental VaR: change in VaR from the addition
is determined for a 250-<lay testing period. Based max (SVaR,_p mulciplicarive factor x SVaR3vg) of a new position in a portfolio.
on the number of exceptions, the bank's exposure Component VaR: amount of risk aparticular fund
is categorized into one of three zones andVaR is Solvency II contributes to a portfolio of funds.
scaled up by the appropriate multiplier (subject to
a floor of 3).
Establishes capital requirements for tl1e operational, CVaRl = MVaR xwl x P =VaR xi3I x wt
investment, and underwriting risks of insurance

Green zone: 0-4 exceptions, increase in exposure companies. Risk Budgeting


multipli er is 0.
Specifics minimum capital requirements (MCR) Manager establishes a risk budget for the entire
Yellow zone:. 5-9 exceptions, exposure. multiplic.r and solvency capital requirements (SCR). portfolio and then allocates risk to individual

increases b etween 0.4 and 0.85. SC R may b e calculated using either standardized
Red zone: Greater than or equal to l0 exceptions,

positions based on a predetermined fund risk
approach or internal models approach.

multiplier increases by I. level. The risk budgeting process differs from


Standardized approach: Intended for k-ss
market value allocation since it involves the

Operational Risk Capital sophis tca


i tc..-d insurance firms; captures the risk
profile ofthe average insurance firm.
allocation of risk.
Requirements Budgeting risk across as1et clas1es: selecting assets
lnu:rna/ models approach: Similar to the !RB
Basic indicator approach: measures the capital

approach under Basel II. A VaR is calculat edwith whose combined VaRs are less than the total
charge on a firm-wide basis. Banks will hold capital a one-year tim e horizon and a 99.5% confidence allowed.
for operational risk equal to afixed percentage level. Budgeting risk across active managers: the optimal
of the bank's average annual gross income over allocation is achieved with the following formula:
the prior three years. The Basel Committee has Dodd-Frank Act
Intended to protect consumers from abuses and g
wei ht of portfolio managed b y manager i
proposed a fixed percentage equal to l 5o/o. I ; x portfolio ' s tracking error
R
prevent future bailouts and/or collapses of banks =
Standardi.udapproach: allows banks to divide I Rp x manager's tr acking erro r
activities along standardized business lines. and otl1er financial firms.
Liquidity Duration It can be illustrated by comparing the CML for
Approximation ofrhe numb ofdays ncccs.sary the market index and the CAL for the managed
to dispose ofa pcrtfolios holdings wirhout a
' portfolio. The difference in return between the

Risk
significant market impact. tw0 portfolios equals the M' measure.

_ number of shares of a security Performance Atttibution


Best Practices n i Management
LO Use long time periods to spot key trends.
[desired max daily volume (%)

Asset allocation attribution equals the difference Use more stress resting scenarios to take int0
X daily volume]

in returns attributable to active asset allocation account regime changes.


decisions of the portfolio manager.
Do not vic.."W risk-mitigatingactions in isolation.
Time-Weighted and Dollar-Weighted Selection attribution equals rhe difference in
Establish provisions fur loan losses.
Returns returns attributable to superior individual
Clear derivatives through a CCP.
Dollarwtighttd ratt ofreturn: the internal rate of security selection (corr= selection of mispriced
return (IRR) on a portfolio taking into account securities) and sector allocation (correct over and
Funding Mechanisms
Allow institutions to obtain short-term financing
all cash nflows
i and outHows. undCIWCigbt:ing ofsectors within asset classes). for funding requirements. Mechanisms include
Time-wtighttd ratt ofmum: measures compound
Hedge Fund Strategies commercial paper, asset-backed commercial
growth. It s
i rhe rare at which $1 compcunds over
Equity long/short strategy: go long and short paper, money masket mutual funds, repurchase
a specified time horizon. transactions, credit commitments, and dollas
Measures of Performance
similar securities to exploit mispricings
funding ofnonU.S. banks
decreases market risk and generates alpha.
.

The Sharpt ratio calculates the amount ofexcess Global macro strategy: makes leveraged betS on Lender ofLast Resort (IOLR) Lending
return (over rhe risk-free rate) earned per unit anticipated price movements in broad equity Can help stem a liquidity crisis before it worsens.
of total risk. It uses standard deviation as the and fixed-income markets, interest rates, foreign Liquidity regulations should complement LOLR

Advantages: {I) liquidity creation for socicral good


relevant measure ofrisk. solutions.
exchange, and commodities.
- -
_ RA - RF M ana
gedfo rum strattgy: focuses on investments
SA - and (2) promotes optimal levels ofliquidity and
oA
in bond, equity, commodity futures, and currency maturity transformation.
markets around the world. Employs a high degree Challenges: (I) potential moral hazard costs,
where: ofleverage because futures contraets are used.
Fixed-income arbitrage strategy: long/short strategy
(2) takes time to determine ifproblem is market
RA average account return wide liquidity event, and (3) taking too much
that looks for pricing n
i efficiencies between

RF = average
risk-free return collateral for protection.
various fixed-income securities.
The 11-tynor measure is very similar to the Sharpe
standard deviation ofaccount returns Dimensions ofLiquidity
Immediacy: Time to complete a transaction.
aA
Conwrtiblt arbitrage strategy: investor purchases
ratio cx.ccpt that it uses beta (systematic risk) as rhe a convcniblc bond and sells short the underlying Depth andmilience: Frequency oflarge trades and
stock. level ofwillingness and interest to transact.
Breadlh: Consincncy in distributing liquidity
measure ofrisk. It shows exce<,< return {over the

risk-free rate) earned per unit ofsystematic risk. Merger arbitrage straugy: involves purchasing
- - shares in a target firm and selling short shares n
i within assets and across maskets.
_ R A -RF
TA - the purchasing firm. lightness: Cost ofcompleting a transaction.
iJA Di.strwed inlNlstingstrategy: purchase bonds of Multi-dimensional: Combination of factotS. Includes
distressed company and sell short the stock, price-based rncasures and market impact rneasures.
where:
anticipating that the shares will eventually be Reforming Benchmark Rates
RA average account return
worthless. In order to make benchmark rates, such as

fJA = average beta


RF
= average risk-free return
Emerging marlrenstrategy: invests in developing LIBOR, less susceptible to manipulation, it is
jmsm's alpha si rhe difference bctwccn actual
recommended to {I) base benchmark rates on
traruactions {rather than submissions) and (2) use
countries' securities or sovereign debt.
Fund ofhe dgefonds: perform screening and due
return and return required to compensate for a second benchmark rate (e.g., frcasury bill rates,
diligence of other funds. Fees can be extensive,
and the due diligence does not always identify
systematic risk. To calculate the measure, subtract rates set by central banks general collateral repo
,

the return calculated by the capiral asset pricing rates, or rhe 01$ rate).
fraud. A key advantage is diversification benefit
model (CAPM) from the account return. without large capital commitment. Central Counterparty Failures
O'.A = RA - E(R.J Measures to decrease the probability or i1npact of
Illiquid A.uet Return Biases a CCP failure include increaserl regulation and
where: Biases that impact repcrted illiquid asset returns: standards for CCPs, recovery planning, emergency
liquidity available through the central bank, bank
O'.A alpha Surviwnhip biln: Poor performing funds ofu:n quit
n:porting results, ulrimatdy fail, or never begin

RA the return on the account


E(RA) R, +!iA[E(R,.,) - R,J n:porting rcturnS because pcrt'orrnancc is weak. resolution planning.
capiral requirements to cover CCP exposures, and

&ltion bias: Asset values and returns tend co be


reported when ihcy arc high.
The infomunion ratio is the ratio of surplus return

Stress Testing Ewlution


Infrequent t:rrtdjng: Betas, volatilities, and In November 20 I I, the Federal Reserve
{in a particular period) to its standard deviation.
It indicates the amount of risk undertaken

(denominator) to achieve a certain level of return correlations arc too low when they arc computed implemented a system ofannual capiral plan
using the reported returns of infrequently traded compliance known as the Comprehensive
above die benchmark (numerator).
-- assets. Capital Analysis and Review (CCAR) process. It
RA -Rs applies to bank holding companies (BHCs) with
IRA =
aA B S50+ billion in consolidated assets. This annual
review process enables the Fed to have more timely
PPN: 32007228
where: information and to properly assess bank health.
ISBN1 3 : 9781 475438208
RA average account return Cybersecurity Framework
Five core functions: (I) identify, (2) protect,

RF average risk-free return



aA " standard deviation of excess returns


(3) detect, (4) respond, and (5) recover.
measured as rhe difference between
Risk asscssmcnr includes classifying informacion,
account and benchmark returns identifying ihrcats and vulnerabilities, measuring
The Msquared (M2) measure compares return risk, and communicating risk.
Protcc.tion measures include customer
7 8 1 4 7 5 438208
earned on the managed portfolio against the

9 authentication, access controls data security, secure


market return, afrer adjusting for differences in
,

configuration, and fucwalls.


standard deviations between the tw0 pcrtfolios.
U.S.$29.00 C2016laplan, Inc. All Rights A