Foreign Currency Dept.

1
Active Risk Management Framework
2
Major risksmanaged by the department

• Measurable
• currency risk
• interest rate risk
• some credit risk

• Hardly Measurable
• operational risk
• liquidity risk
• some credit risk

3
Currently used methods

• benchmark as a starting point
• limits on position
• limits on counterparty
• other limits

4
Proposed Scheme

• Three layers
• 1. Global (yearly) stop loss
• 2. Dynamic VaR bounds
• 3. Limits to non-measurable risk components
• (credit, liquidity, etc.)

5
Global (yearly) stop loss

• In order to avoid a big loss we should introduce
  a global stop loss (like 30-40bp).
• As soon as the portfolio approaches the stop
  loss, we should decrease VaR limits for each
  desk, so that they become zero as soon as the
  stop loss is reached.

6
Dynamic VaR bounds

• Each desk will receive its weekly VaR that can be
  used for risk taking (like 3-5 bp initially).
• This VaR can be used by each desk (or temporarily
  borrowed from another desk).
• If at some time moment VaR limit is exceeded, the
  manager must return to the permitted VaR during
  one day (or get a special permission).
• See example below.

7
Reporting and responsibility

• investment committee
• desk managers
• risk manager

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Investment committee is responsible for

• setting the yearly stop loss limit
• setting VaR limits for each desk weekly
• supervising the desk managers
• (but not interfering their decisions too much)
• supervising stress test results (?)

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Desk manager is responsible for

• keeping the risk under his VaR limit
• returning to the limit if exceeded
• reporting to the investment committee on
• his current VaR and its components
• cases of overexposure and how it was handled
• reasons for the current exposure (?)

10
Risk manager is responsible for

• supporting and developing the VaR program
• measuring and reporting VaR of the whole
  portfolio
• communicating to desk managers and investment
  committee on diversification among desks
• backtesting, stress test

11
VaR and stop-loss take-profits

• VaR can NOT replace the technique of setting stop
  loss and take profit limits.
• However VaR can answer the following questions
  what is the current probability that the stop
  loss (take profit) order will be met during some
  time interval, or to give the probability
  distribution over a specified time horizon.
• Setting stop loss orders can reduce VaR.

12
VaR and stop-loss take-profits
1 day
1 week
PL
13
Advantages

• This language of risk is used worldwide
• Uniformity of different risks
• More freedom to desk managers in risk allocation
• More transparency on current risks and potential
  losses
• Cross time and cross asset comparison

14
Example (Tal, Zvi)

• Assume that the short dollar benchmark has
  neutral duration of T6 months.
• Manager has VaR limit of 3 bp. and he has to make
  two decisions
• a of assets kept in spread products
• q duration mismatch
• we assume that all instruments (both treasuries
  and spread) have the same duration Tq months.

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Contour Levels of VaR (static)
q - duration mismatch
a ( of spread)
16
q - duration mismatch
a ( of spread)
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In order to reduce risk one can increase
duration (in this case).
q - duration mismatch
a ( of spread)
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What we can do using limits
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duration mismatch (yr)
Current position 2M, 10 spread 5 weekly VaR2.2
bp
weekly VaR limit 3 bp
spread
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What should be done

• a simple VaR measuring tool at trading desks
  professional software (RMG or other)
• reporting in terms of VaR
• to get used to this new language
• to build a historical data set
• backtest
• stress test library

21
Proposed Scheme

• Three layers
• 1. Global (yearly) stop loss (30-40 bp.)
• 2. Dynamic VaR bounds (initially 3-5 bp.)
• 3. Old limits to non-measurable components
  (credit, liquidity, etc.)