10/11/2012

Few types of Financial Risks

Market Risk
Risk of losses due to movements in financial market prices or volatilities
Credit Risk
Risk of losses due to the counterparties unwilling/unable to fulfill contractual
Risk Management obligations
Operational Risk
Risk of loss due to failed/inadequate internal processes, systems and
people, or from external events

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Market Risk Management Market Risk Management

Potential changes in asset prices for changes in factors that influence Sources of Risk
asset prices. Currency Risk
Examples:
Fixed Income Risk
Changes in Value of Fixed Income portfolio for changes in interest rates.
Changes in Value of a Currency portfolio for changes in exchange rate & interest Equity Risk
rates. Commodity Risk
Changes in Value of a Equity portfolio for changes in value of component stocks.
Decomposition of Market Loss:
Market loss = Exposure Adverse movement in financial variable
Exposure to the factor Choice variable
Movement of the factor itself External to portfolio
Eg. 1: For a fixed coupon bond, potential loss is dp = -(D*P) x dy
Dollar duration (D*P) is the choice variable
Changes in yield (dy) is external to portfolio
Eg. 2: For a stock, Return Ri = i + i x RM + i i x RM (ignoring constant i & diversifiable i)
Dollar change in price of the stock dPi = RiPi (iPi) x RM
(iPi) is the choice variable
RM external to portfolio
Eg. 3: Similarly for Options, df = x ds where is the choice variable and ds is external to portfolio

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Currency Risk Fixed Income Risk

Risk caused by movements in foreign currencies Primary factor affecting nominal Bond yield is
Currency-specific volatility inflationary expectations.
Pure currency float Volatile due to Depreciation or Appreciation Global Interest Rate Risk
Devaluation risk Real Yield Risk
Fixed currency system Less volatile but risk of devaluation
Credit Spread Risk
Shift in currency regime
From less volatile fixed currency system to more volatile Floating currency
Prepayment Risk
system
Correlation across currencies
Some currencies are more correlated than others
Lower diversification benefits from holding highly correlated currencies.
Interest rate risk raising rates to reduce depreciation of currencies

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Equity & Commodity Risk Prerequisite!!!

Equity: Asset Pricing methods
From potential movement in the value of stock prices. How to price -
Market risk (diversifiable) & Stock-specific risk (not-diversifiable) Bonds
Commodity: Equities
Movements in values of commodity contracts Forwards, Futures & Options

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Risk Management Tools Market Risk Measurement

Multitude of financial instruments in the market
Each instrument has a measure of risk
Notional Amounts
Need for a single measure for the management, which
Notional provides indication of the potential loss
summarizes the risk of the entire portfolio
Sensitivity Measures
Provides sensitivity of the asset (e.g., a bond to interest rate)
Scenarios
Allows to analyze nonlinear and extreme effects in price
These measures DO NOT provide any probability
associated with the risk

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Value At Risk (VAR) Few caveats

Value At Risk (VAR) VAR does not describe the worst loss
is a statistical measure of downside risk. Losses can be more than VAR number with a frequency of p (5 days out
of 100)
aggregates the risks across the whole portfolio.
VAR does not describe the losses in the left tail
takes into account leverage and diversification Rather, it indicates the probability of such a value occurring
is a risk measure with an associated probability
VAR is measured with some error
VAR is the maximum loss over a target horizon such that Change in the sample size can produce a different VAR number.
there is a low, pre-specified probability that the actual loss Limited precision in VAR number.
will be larger.
E.g.: Assume a bond, in which we have invested $100MM, has modified
duration of 12 yrs. Consider a worst increase in yield at 95% level is 2% in a
day.
VAR = Market Value x Modified Duration x Worst yield increase
i.e., VAR = $100MM x 12 x .02 = $24MM
The maximum loss is about $24MM over one day at the 95%
confidence level
Though VAR represents loss, it is reported as a +ve number.
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Eg. for VAR Alternative measures of Risk

Let P be a portfolio with the returns from it as in the table: VAR for a portfolio is
The Entire Distribution
Return
Range of VAR numbers for increasing confidenceq levels. q
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The conditional VAR is negative of EX | X q xf ( x)dx f ( x)dx
45 Expected value of loss that exceeds VAR.

-66 i.e., Average of loss, conditional on it is > VAR.

112 Denominator Probability of loss exceeding VAR (also, p = 1-c)
Also called as expected shortfall, tail conditional expectation, conditional loss, or
-14 expected tail loss.
-143 The Standard Deviation N

x E ( X )
1
SD( X )
2
-7 N 1 i 1
i
Takes into account all observations:
124 But, symmetricalno distinction between large losses Vs gains
141 The Semi-Standard Deviation
Considering only negative data points N

Min( x ,0)
-43 1
SDL ( X )
2
But less intuitive i
-160 NL i 1

-61
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Cash Flow at Risk Parameters of VAR

VAR developed to mark-to-market risk of commercial banks.
Now, spread to other financial institutions and investment mgmt
industry.
Objective function in each case: Market value of the portfolio
VAR measure spreads to other sectors (non-financial!!!)
CFAR Worst shortfall in cash flows due to unfavorable
movements in market risk factors.
Involves quantity Q, unit Revenue P, unit cost C.
CF = Q X (P-C)
Consider exchange rate as the market risk factor
P & C can be denominated in FX.
Q can be affected by foreign competition.
Two quantitative parameters: Confidence Level & Horizon
Confidence Level:
Higher confidence interval, greater VAR measure.
Higher confidence level creates larger but less likely loss.
As c increases, the number of occurrences below VAR comes down
leading to poor measures of high quantiles.
Choice of CL depends on use of VAR:
If VAR is used to decide on capital adequacy (amount of capital set aside to
avoid bankruptcy), then high confidence level is used.
If VAR is used as a benchmark measure of downside risk, consistency of the
VAR confidence level across trading desk is important
VAR models are useful only when they are verifiable.
Higher CLs (such as 99.99%) leaves very few (eg. 1 observation in 10000
trading days), and so not useful to verify.
Implication: Choose a confidence level that is not too high. (like 95% to 99%).

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Parameters of VAR Contd. Elements of VAR system

Two quantitative parameters: Confidence Level & Horizon Contd. Steps in VAR:
Horizon: Portfolio positions.
Assume all positions constant over the
Extrapolating VAR for a one-day horizon to a longer horizon horizon
Assuming the returns are i.i.d., and the distribution of daily returns is a simplification; differs if traders churn
unchanged for longer horizons, portfolio actively.
VAR(T days) = VAR(1 day) T Risk factors
Choice of Horizon depends on Interest rates in the case of fixed-
income instruments
the characteristic of the portfolio
From market data, construct the
how quickly positions change or exposures change due to price changes
distribution of risk factors.
- For trading desks, 1 day; for pension funds, one month.
- For capital adequacy purposes, long horizon is advisable. Map the portfolio positions onto the
Increasing horizon creates slippage in VAR measure. risk factors
the use of VAR Portfolio VAR
for benchmarking, relatively shorter horizon Construct it using a chosen VAR
for capital adequacy, long horizon method:
Linear (fixed-income method)
Non-linear (options)

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Stress-Testing Stress-Testing Contd.

VAR does not account for extreme losses. Stress testing is useful against the event risk
Need to complement VAR with stress testing. risk of loss due to an unobservable political or economic event - usually
relatively rare and difficult to anticipate.
Stress Testing identifying situations that could create Changes in government (leading to changes in policies)
extreme losses Changes in economic policies

Scenario analysis Example: Nationalization of cement companies in Venezuela.
Political instability like coups, civil wars, invasions etc.
Moving key variables one at a time.
Difficult to assess realistic co-movements of financial variables. Goal of Stress testing: To identify areas of potential vulnerability.
Using historical scenarios (like stock market crash) Doesnt imply you are protected against every possible risk
Creating prospective scenarios. Would make it impossible to take any risk.
Stressing models, volatilities and correlations, and Objective of Stress-Testing:
Policy response development to ensure mgmt can withstand likely scenarios without going bankrupt.

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Liquidity Risk .
Viewed as component of market risk ..
Asset Liquidity Risk or market/product liquidity risk
Transactions not possible due to size of required trade relative to normal
trading lots.
Can be managed by setting limits on certain markets or products and
through diversification.
Funding Liquidity Risk or Cash Flow Risk
When the institution can not meet payment obligations.
Can be managed by proper planning of cash flows needs.

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