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Strategies for Excellence

Market Risk Management


by
R. Ravimohan
CEO & MD CRISIL

Presentation at FICCI Conference on


”Global Banking Paradigm Shift”
On Sept 14, 2003, Bangalore
What is Risk?

•Risk, in traditional terms, is viewed as a ‘negative’. Webster’s


dictionary, for instance, defines risk as “exposing to danger or
hazard”.

•The Chinese give a much better description of risk


>The first is the symbol for “danger”, while
>the second is the symbol for “opportunity”, making risk a mix of
danger and opportunity.

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Risk Management

Risk management is present in all aspects of life; It is about the


everyday trade-off between an expected reward an a potential
danger. We, in the business world, often associate risk with some
variability in financial outcomes. However, the notion of risk is
much larger. It is universal, in the sense that it refers to human
behaviour in the decision making process. Risk management is
an attempt to identify, to measure, to monitor and to manage
uncertainty.

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Types of financial risk
Equity Risk Trading Risk
Market Risk
Interest Rate Risk
Gap Risk
Currency Risk

Commodity Risk

Transaction Risk Counterparty Risk


Credit Risk
Financial Portfolio Issuer Risk
Concentration Risk
Risks Liquidity Risk

Operational Risk

Regulatory Risk

Human Factor
Risk

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Understanding Market Risk

It is the risk that the value of on and


off-balance sheet positions of a
financial institution will be adversely
affected by movements in market rates
or prices such as interest rates, foreign
exchange rates, equity prices, credit
spreads and/or commodity prices
resulting in a loss to earnings and
capital.

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Why the focus on Market Risk Management ?

• Convergence of Economies
• Easy and faster flow of information
• Skill Enhancement
• Increasing Market activity

Leading to

•Increased Volatility
•Need for measuring and managing
Market Risks
•Regulatory focus
•Profiting from Risk
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Best Practices
in
Market Risk Management

1. Rethinking the Market Risk process

2. Establish Top Management Oversight


3. Deploy Best practices framework
4. Adopt appropriate Organisation Structure
5. Invest in Good Technology

6. Use Hedging techniques Judiciously


7. Ensure Robust Marking to Market
8. Establish good operational processes
9. Measure, Monitor & Manage – Value at Risk
10. Explore quantitative models for default prediction

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1. Rethinking the Market Risk process

 Increased reliance on objective risk assessment

 Investment process differentiated on the basis of risk, not size

 Investment in workflow automation / back-end processes

 Align “Risk strategy” & “Business Strategy”

 Active Portfolio Management

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2. Establish Top Management Oversight

Board and senior Management Oversight

 Delineate banks overall risk tolerance in relation to market risk

 Ensure that bank’s overall market risk exposure is maintained at prudent levels
and consistent with the available capital

 Ensure that top management as well as individuals responsible for market risk
management possess sound expertise and knowledge to accomplish the risk
management function.

 Ensure that the bank implements sound fundamental principles that facilitate the
identification, measurement, monitoring and control of market risk.

 Ensure that adequate resources (technical as well as human) are devoted to


market risk management.

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3. Deploy Best practices framework

 Investment & Market Risk Policies should be comprehensive

 Investment organisation - Independent set of people for front,


mid & back offices

 Set exposure Limits On Different Parameters – dealer wise,


transaction, instruments, broker, & other counter parties

 Implement straight - through processing

 Operationalise stop-loss limits

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4. Adopt appropriate Organisation Structure

Organization Structure
The structure should conform to the overall strategy and risk policy set
by the BOD
 Those who take risk (front office) must know the organization’s risk
profile, products that they are allowed to trade, and the approved limits.

Apart from BOD responsibility to be assumed by forming following


 The risk management function should be independent, reporting
directly to senior management or BOD.
 The Risk Management Committee

 The Asset-Liability Management Committee (ALCO)

 The Middle Office.

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5. Invest in Good Technology

Treasury
Integration

Straight -through
Processing
Back Office Market
Integration Integration

Currency Interest Rate Dealing Payments


Business
Risk Process
Management Management

Credit Liquidity Accounting Cash Mgmt

Improved Control Improved Integration


Enhanced Reporting Enhanced Productivity
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6. Use Hedging techniques Judiciously

•Interest Rate Swaps


Forward Rate Agreements
Forward Contracts
Currency Options
Equity Derivatives

Equity Options

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7. Ensure Robust Marking to Market

 The need arises due to structured products and lack of liquidity results in
the absence of traded prices

 In case of non-traded securities, marking to market is critical for


valuation & risk management

 CRISIL is the official provider of valuation services and appointed by


SEBI / AMFI for the Mutual Fund industry segment

 In case of active investment management and for risk management,


the periodicity of daily valuation is required

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8. Establish good operational processes

Align Business strategy and treasury


process
Complete integration
front middle back
office office office
sound treasury control

liquidity management
position keeping
limit management

risk management

settlement management

treasury accounting

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9. Measure, Monitor & Manage
– Value at Risk

Value­at­Risk

Value­at­Risk is a measure of Market Risk, which 
Value at Risk
measures the maximum loss in the market value of 
.022 433 a portfolio with a given confidence
.016 324.7

.011 216.5 VaR is denominated in units of a currency or as a 


percentage of portfolio holdings
.005 108.2

.000 0
For e.g.., a set of portfolio having a current  value 
1.5 2.9 4.3 5.6 7.0 of say Rs.100,000­ can be described to have a 
Certainty is 95.00% from 2.6 to +Infinity daily value at risk of Rs. 5000­ at a 99% 
confidence level, which means there is  a 1/100 
chance of the loss exceeding Rs. 5000/­ 
considering no great paradigm shifts in the 
underlying factors. 

It is a probability of occurrence and hence is a 
statistical measure of risk exposure
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Features of CRISIL VaR Model

Multiple Yields Incremental


Portfolios Duration VaR
VaR

Variance-
Portfolio
Stop Loss covariance
Optimization
Matrix

Helps
Facility
For
For
For
picking
in
Identifying
of
aiding
optimizing
Return
multiple
upinsecurities
Analysis
cutting
and
methods
portfolio
isolating
losses
which
forand
inaiding
Risky
during
the
portfolios
gelgiven
well
inand
volatile
trade-off
set
in
safe
inthe
of
single
securities
periods
constraints
portfolio
model
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Managing Market Risk

Questions International % of Banks


practice with + ve
response
1. Are all market risks centrally All Market Risks are centrally 100%
managed? managed by Treasury / Global
Markets
2. Do you measure Var of non- Large International banks 0%
trading balance sheet? measure / Manage balance sheet
Risks actively
3. Is Funds Transfer Pricing policy Incremental Cost of Funds 0%
based on marginal market rates? reflects in Incremental Transfer
Pricing on Assets / Liabilities
4. Is board / senior management Board / Management Committee 85%
involved in managing Market overviews the management of
risks? Market Risk
5. Is there a central unit for Basel II is being managed as a 70%
implementing Basle II guidelines? project with a central coordinator
for the bank

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10. Explore quantitative models
for default prediction

 Crisil’s Corporate predictor Model (CCOP) is a


quantitative model to predict default risk
dynamically

 Model is constructed by using the hybrid approach


of combining Factor model & Structural model
(market based measure)

 The inputs used include: Financial ratios, default


statistics, Capital Structure & Equity Prices.

 Derivation of Asset value & volatility  The present coverage include listed & Crisil rated
 Calculated from Equity Value , volatility for each companies
company-year
 Solving for firm Asset Value & Asset Volatility
simultaneously from 2 eqns. relating it to equity value
and volatility
 The product development work related to private
firm model & portfolio management model is in
 Calculate Distance to Default
 Calculate default point (Debt liabilities for given
process
horizon value)
 Simulate the asset value and Volatility at horizon
 The model is validated internally
 Calculate Default probability (EDF)
 Relating distance to default to actual default
experience  CCoP is one of the most complicated product
 Use QRM & Transition Matrix
developed and with the help of in-house technology.
 Calculate Default probability based on Financials
 Arrive at a combined measure of Default using both

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To Summarise….

Effective Management of Market Risk benefits the bank..


 Efficient allocation of capital to exploit different risk / reward
pattern across business
 Better Product Pricing
 Early warning signals on potential events impacting business
 Reduced earnings Volatility
 Increased Shareholder Value

No Risk … No Gain!

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for further details contact, . . .

D.Ravishankar
Director,
Investment & Risk Management Services
CRISIL
Email : dravishankar@crisil.com
Ph.no: 5653 7531

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