Market Risk A Primer

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Market RiskA Primer

• Presentation by
• T S Chandra Sekaran,
• (B Sc, MA, LLB, CAIIB, CIA, CISA, CISM, CISSP,
  CBA, CIDA, AIQA)
• Head of Securities Operations,
• ABN AMRO Bank,
• Dubai, U. A. E.
• Member and Certified Associate, Indian Institute
  of Bankers, India
• Member, Institute of Internal Auditors, USA
• Member, Information Systems Audit Control
  Association, USA
• Member, ISC2, USA
• Member, American Institute of Certified Public
  Accountants, USA
• Associate, Chartered Quality Institute, UK
• Member, Association of Anti-Money Laundering
  Specialists, USA

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Market Risk

• Presentation Guidelines
• No Brand or Product Promotion
• No Bank Specific Questions
• A Generic Presentation on the subject
• The views expressed here are my own and does not
  represent those of my employers, past or present,
  or any of the professional organizations I am
  associated with.

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Market Risk

• Contents
• Introduction
• Basel Committee Guidelines
• RBI Guidelines/ Regulations
• Risk Measurement and Management
• Conclusion
• References

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Market Risk

• Introduction

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Market Risk

• Types of Risks
• Business Risks
• Credit Risks
• Settlement Risk
• Market Risk
• Position Risk
• Sovereign (Country) Risk
• Concentration (Industry) Risk
• Operational Risk,
• Regulatory/ Compliance Risk
• Reputational Risk, ..

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Market Risk

• What is Market Risk?
• Risk associated with a change in the position
  value relative to market movements
• Factors
• Interest rates
• Forex rates
• Equity Prices
• Spread Over Swap rates
• Spot Prices
• Volatilities (Interest/ Forex/ Equity Rates/
  Prices)

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Market Risk

• Basel Committee Guidelines

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Market Risk

• From Basel
• Market risk is defined as the risk of losses in
  on-balance sheet and off-balance sheet positions
  arising from movements in market prices.
• Market risk positions subject to capital charge
• Interest rate related instruments and equities in
  the trading book
• Foreign exchange risk (including open positions
  in precious metals) throughout the bank, both
  banking and trading books.

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Market Risk

• Capital Requirement
• Additional Risk weight of 2.5 on the entire
  investment portfolio
• A risk weight of 100 on open positions in FX and
  Gold
• Build up an Investment Fluctuation reserve of
  upto a minimum of 5 of the investments held in
  Held-for-Trading and Available-for-Sale
  categories in the investment portfolio

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Market Risk

• Methodologies for computation of Capital charge
• Standardized approach
• Internal risk management based models

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Market Risk

• RBI Regulations/ Guidelines

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Market Risk

• An effective framework comprising of1
• Risk Identification
• Setting up limits and triggers
• Risk Monitoring
• Models of analysis (to measure risk)
• Risk Control,
• Risk reporting,
• Organizational set-up
• 1- Guidance Note on Market Risk Management issued
  by RBI on October 12, 2002

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Market Risk

• Interim Measures adopted in India
• (For Market risks based on Basel Guidelines)
• Broad Brush and simplistic Standardized
• Explicit capital for market risks
• Includes securities included in Held-for-Trading
  and Available-for-Sale categories, open gold,
  open forex positions, trading positions in
  derivatives and derivatives entered for hedging
  trading book exposures

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Market Risk

• Scope and Coverage of Capital Charge2
• Manage market risks on an ongoing basis
• Capital requirements maintained on a continuous
  basis, at the close of business each day
• Maintain strict risk management systems to
  monitor and control intra-day exposures
• To start with adopt Standardized approach
• Specific risk charge for each security3 and
  General Market risk charge towards interest rate
  risk in the portfolio.
• 2 Ref DBOD No. BP.BC.13/21.01.002/2006-07
  issued on July 01, 2006.
• 3 Short positions not allowed in India, except
  in derivatives, hence includes only long
  positions.

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Market Risk

• Market Risk Management

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Market Risk

• Market Risk Management
• Involves measurement and monitoring of various
  risk factors and establishing limits to
  exposures.
• Measurement
• Non Statistical
• Value at Risk (VaR)
• Stress Testing
• Back Testing
• Management
• Governance Framework
• Process

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Market Risk

• Non-Statistical
• Notional
• Net open position, Interest Rate Gaps, .
• Market/ Present value
• Stop Loss
• Sensitivity Measures
• Changes in market variables
• 1st Derivatives Delta, Vega, .
• 2nd Derivative Gamma,

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Market Risk

• Statistical
• Value at Risk (VaR)
• Worst expected loss over a given time horizon
• Normal market conditions
• Specified level of confidence (99, 95, .)
• Example
• Assuming a confidence level of 99 and a 1-day
  horizon, a VaR of 1 million means that under
  normal market conditions, there is a 1 in 100
  chance of a loss greater than 1million.

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Market Risk

• VaR Methodologies
• Historical
• Simulation of historical price changes over the
  specified historical window
• Monte Carlo (also called Model Building)
• Simulation based on assumed price changes under
  randomly generated market scenarios, calibrated
  to historical changes of market variables
• Variance-Covariance
• Based on standard deviation, assuming normal
  distribution for the return of the underlying
  asset.
• Volatility and Correlation are the main factors
  used.

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Market Risk

• Relative Advantages
• VaR Measures
• Identify overall exposure at the portfolio level
• Account for historical experiences
• Facilitate determination of loss appetite
• Non-Statistical Measures
• Identify exposures to individual market
  variables/sectors
• Identify funding liquidity risk
• Identify settlement and rate reset risks

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Market Risk

• Limitations
• VaR Measures
• Not forward looking
• Not position specific
• Computationally intensive
• Non-Statistical Measures
• Do not reflect exposure at the portfolio level
• Do not reflect statistical loss threshold if
  history is to repeat itself

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Market Risk

• Stress Testing
• Involves estimating portfolio performance under
  most extreme market conditions, both historical
  and hypothetical
• Examples
• 1987 Market crash
• 1994 Mexico Peso Crisis
• 1997 Asian Stock Market Crisis
• 1995 Kobe earthquake

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Market Risk

• Back Testing
• Involves estimating how well the VaR would have
  performed in the past.
• Basically evaluates the validity of the VaR
  prediction model
• Compares the PL with VaR

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Market Risk

• Risk Management
• Framework
• Policies
• Oversight
• MIS
• Control,
• Key Processes
• Limits
• Monitoring
• Reporting
• Resolution,

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Market Risk

• Conclusion

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Market Risk

• Case Studies
• Metallgesellschaft (1993)
• Proctor Gamble (1994)
• Orange County (1994)
• Barrings Bank (1995)
• LTCM (1998)

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Market Risk

• Recap.
• Policies and Procedures
• Sound Controls and Oversight Procedures
• Accurate Risk measurement methodologies/ systems
• Adequately trained staff and functions
• Reliable technology and validated models
• In sum, (PSP)2

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Market Risk

• References
• John C Hull, Options, futures and Derivatives,
  2003, Pearson education
• Reserve Bank of India, Guidance Note on Market
  risk Management, October 12, 2002
• CIDA Review Manual, Investment training and
  Consulting Institute, KS, USA
• DBOD No. BP.BC.13/21.01.002/2006-07 issued by
  Reserve Bank of India on July 01, 2006
• RBI Notification on Risk Management Systems in
  India, dated October 21, 1999
• http//www.garp.com/library/Articles/pub29.htm,
  Lang Gibson, Applying Proactive Market Risk
  Management
• Speeches delivered by
• Dr. Y V Reddy, Sep 22, 2001 at the Seminar on The
  future of Government Securities Market in India,
  held at Bangalore
• Shri Vepa Kesam, August 30, 2002, national
  seminar on Banking Reforms and Strategies, held
  at Hyderabad
• Dr. Rakesh Mohan, December 29, 2002 at the Bank
  Economist Conference, held at Bangalore
• Shri. V. Leeladhar, March 11, 2005 at the Bankers
  Club, Mangalore
• Shri. V. Leeladhar, November 14, 2005 at the
  Third Natarajan Memorial lecture, at Chennai

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Market Risk

• Questions