Chapter 2 - Market Risk Flashcards
What is market risk management?
The management of…
1. Interest rate risk and
2. Market risk
…in a banking operation
How do interest rate risk and market risk differ from credit risk?
They relate to changes in interest rates and prices for market instruments affecting profitability and value, unlike credit risk.
Which type of risk exposure remains the main type for the majority of the world’s retail banks?
Credit risk
What activities are banks, particularly investment banks, often involved in?
- Trading securities
- Brokerage services
- Market-making in individual securities
What is market making?
The quotation of a bid price and an offer price for securities
What do market makers profit from?
The spread between bid and offer prices.
What are the three primary reasons banks trade?
- To meet the needs of Counterparties
- To Hedge/lower its own risks
- To take a Speculative position
What are derivatives?
Financial contracts with a value derived from the performance of underlying securities, interest rates, currencies, and other assets.
What is basis risk?
The risk that a derivative does not perform in the expected direction or magnitude.
List the most common types of derivatives.
- Futures
- Options
- Swaps
What is the role of a Central Clearing Party (CCP)?
To interpose itself between counterparties in a financial transaction, reducing counterparty credit and liquidity risk.
What are the benefits of margin requirements?
- Reduction of Systemic risk
- Promotion of Central clearing
What is initial margin?
Collateral posted at the outset of a derivatives transaction to protect against unexpected credit and operational risks.
What does variation margin reflect?
The current market value of the trade, paid daily between counterparties.
What is Counterparty Credit Risk (CCR)?
The risk that the counterparty to a transaction could default before the final settlement.
What does Credit Valuation Adjustment (CVA) risk represent?
The potential source of loss due to changes in Counterparty Credit Spreads and other Market Risk Factors.
What is Expected Exposure (EE)?
The positive mark-to-market values that represent situations where the institution would incur a loss if the counterparty defaults
What is Effective Expected Positive Exposure (EEPE)?
The weighted average over time of Effective Expected Exposure (EPE) or maximum expected exposure
What are the shortcomings of EPE that the EEPE measure solves for?
- EPE may neglect very large exposures present for a short time
- EPE may underestimate exposure for short-dated transactions
What does the term ‘wrong-way risk’ refer to?
An exposure to a counterparty that is adversely correlated with the credit quality of that counterparty.
What is the role of the International Swaps and Derivatives Association (ISDA)?
To provide a standard suite of documents applicable to all OTC derivative transactions.
Result:
* lower legal and operational risks
* sound risk management (reduce counterparty credit risk and enhance market stability)
* market efficiency (through standards and transparency in the markets)
* industry advocacy (representing interests of its members with policymakers and regulators)
Fill in the blank: The total collateral requirement on any given trading day is the sum of the _______ and variation margin requirements.
[initial margin]
True or False: Only standardised derivatives are suitable for central clearing.
True.
What is the main argument for requiring initial margin?
Variation margin may not be sufficient to cover credit losses under unusual market conditions.
What are the two types of collateral required in derivatives markets?
- Initial margin
- Variation margin
What is the purpose of standardised documents in OTC derivative trade execution?
To optimise OTC derivative trade execution and management without re-negotiating terms or documenting each transaction separately
Standardised documents include Master Agreement, ISDA schedule, Confirmations, Credit Support Annex (CSA), and ISDA definitions.
What are some issues firms may encounter when entering into a Credit Support Annex (CSA)?
- Operational costs
- Liquidity planning and management
- Negative carry on posted collateral
These issues arise alongside the benefits of entering into a CSA.
What regulatory requirements may affect collateral management?
Margin requirements for non-cleared derivatives, prudential framework for liquidity
These requirements may place competing demands on high-quality assets.
What is the definition of Interest Rate Risk in the Banking Book (IRRBB)?
Current or prospective risk to a bank’s capital and earnings arising from adverse movements in interest rates affecting banking book positions
Defined by the Bank of International Settlements (BIS).
What is hedge accounting?
An accounting method that allows the offset of changes in fair value of derivatives against the exposures they are meant to hedge
This reduces volatility in earnings.
What are the three types of hedging relationships under IFRS 9?
- Fair value hedge
- Cash flow hedge
- Net investment hedge in foreign operations
What is a hedged item?
The item or structure that is being hedged, such as a floating rate loan
The hedging instrument is the item intended to hedge the hedged item.
What are critical terms in the context of hedging?
Salient features of the hedged item that a hypothetical perfect hedge must match
Examples include maturity, nominal amount, cash flow dates, and interest rate basis.
What is the significance of IFRS 9 for hedge accounting?
Introduces new hedge accounting requirements and simplifies the process by removing the retrospective effectiveness test
Prior guidance was provided under IAS 39.
What does the term ‘gap risk’ refer to?
Risk arising from the timing of instruments’ rate changes and the term structure of banking book instruments
It depends on whether changes occur consistently across the yield curve.
What is basis risk?
Impact of relative changes in interest rates for financial instruments with similar tenors but different interest rate indices
This can affect the pricing of similar instruments.
What is option risk?
Risk arising from option derivative positions or optional elements embedded in financial instruments affecting cash flows
Includes automatic option risk and behavioral option risk.
What does the accounting method ‘amortised cost’ entail?
Values based on initial cost less accumulated depreciation, considering expected life/maturity of the item
It contrasts with fair value accounting.
What is the difference between fair value and amortised cost accounting?
Fair value is based on market prices or net present value of expected cash flows, while amortised cost is based on initial cost
Fair value can vary significantly due to market changes.
What is a hypothetical perfect hedge?
A notional derivative that matches the critical terms of the hedged item perfectly
It is used to measure the change in value of the hedged item against changes in the hedging instrument.
True or False: IFRS 9 requires a retrospective effectiveness test for hedging relationships.
False
The retrospective test has been removed under IFRS 9.
What must a hedging relationship meet to qualify for hedge accounting under IFRS 9?
- Economic relationship between hedged item and hedging instrument
- Credit risk is not the primary driver
- Hedge ratio must match actual quantities used
What is the impact of changes in interest rates on a bank’s earnings?
They alter interest-rate-sensitive income and expenses, affecting net interest income (NII)
This can pose a threat to a bank’s capital base.
What is the hedging rationale for banks managing interest rate risk?
To mitigate downside losses while taking advantage of upside potential
This involves assessing risk versus reward.
What does the term ‘naked position’ mean in interest rate risk management?
Running the risk open without any risk mitigation strategy in place
This exposes the bank fully to interest rate movements.
What does IRRBB stand for?
Interest Rate Risk in the Banking Book
What are the three sub-types of IRRBB?
- Economic Value of Equity (EVE) Risk
- Net Interest Income (NII) Risk
- Basis Risk
What is the purpose of the PV01 measure?
To measure the present value of exposure based on a one basis point shift in interest rates
If you are receiving a fixed interest rate, how is this represented in the PV01 profile?
As a negative number
What is CSRBB?
Credit Spread Risk in the Banking Book
What does CSRBB refer to?
Any kind of asset/liability spread risk of credit-risky instruments not explained by IRRBB
What is an interest rate swap (IRS)?
A financial contract between two counterparties to exchange interest rate payments on a predefined notional amount
What is the primary risk of a fixed-rate loan if interest rates drop?
Opportunity cost due to paying a higher nominal value over the loan period
What are swaptions?
Derivative instruments that give the right, but not the obligation, to enter into a swap
What is the purpose of rolling hedges?
To provide risk mitigation at a lower cost through continuous adjustment of hedges
What is a repo?
A contract where one counterparty sells an asset and commits to repurchase it at a future date
What are the regulatory requirements for banks regarding high-quality liquid assets (HQLA)?
Banks must hold sufficient HQLA to withstand cash outflows during a 30-day significant stress scenario
What is the difference between a repo and a sale-and-repurchase agreement?
Repos are covered by a Global Master Repurchase Agreement (GMRA), while sale-and-repurchase agreements often are not
What is the repo rate?
The difference between the price paid at the start of a repo and the price received at the end, quoted as a percentage per annum
What is a key downside risk of rolling hedges?
Reinvestment risk of striking new hedges at less favorable rates
What is the role of governance in monitoring IRRBB?
To establish frameworks and policies governing metrics, limits, and triggers for monitoring
What happens when a trader exceeds their PV01 trigger level?
Mid-level risk managers discuss the exposure with the trader and desk head to agree on a remediation strategy
Fill in the blank: The present value of exposure based on a one basis point shift in interest rates is known as _______.
PV01
True or False: Hedging with gilts can create mismatch risk.
True
What is a gilt?
A government or quasi-government debt instrument, typically low-risk with a high credit rating
What is the impact of a deteriorating credit rating on client loans?
The bank receives a lower interest rate on loans than the credit rating suggests it should
What is gap risk in interest rate risk management?
The risk associated with the mismatch between asset and liability maturities
What does the term ‘stickiness’ refer to in liquidity risk analysis?
The likelihood of projected cashflows holding to maturity
What happens when a trader exceeds their PV01 trigger level?
Management action involves mid-level risk managers discussing exposure with the trader and desk head to agree on a remediation strategy.
This strategy is included in daily and monthly reporting.
What is required for large transactions that breach bank-level limits?
Pre-approval is often required, detailing the expected breach and remediation strategy.
This includes timelines to achieve de-risking.
What is the role of regulatory supervisors in capital adequacy and IRRBB risk?
They assess capital adequacy and IRRBB risk through monitoring key metrics and stress testing results.
Supervisors can require corrective action and capital buffer increases.
What key factors drive Foreign Exchange (FX) rates?
Key factors include:
* Inflation
* Interest rates
* Current account deficit
* Public debt
* Terms of trade
* Political stability and economic performance
* Recession
* Speculation
Understanding these factors impacts risk management approaches.
How does inflation affect a country’s currency value?
A country with low inflation typically sees a rising currency value, while a country with high inflation usually experiences currency depreciation.
What is the relationship between interest rates and currency appreciation?
Increases in interest rates cause a country’s currency to appreciate due to attracting more foreign capital seeking higher yields.
However, high inflation can mitigate this effect.
Define current account deficit.
It refers to a situation where a country spends more on foreign trade than it earns, requiring more foreign currency than it receives through exports.
This can lead to depreciation of the country’s FX rate.
What impact does public debt have on foreign investment?
Large public deficits and debts make a country less attractive to foreign investors due to inflation and default risk.
What are terms of trade?
The ratio of export prices to import prices, where an improvement occurs if export prices rise faster than import prices.
This leads to increased currency demand and appreciation.
How does political stability affect currency value?
Countries with sound financial policies attract more foreign investor capital, leading to currency appreciation, while political turmoil can cause depreciation.
What is speculation in the context of FX markets?
Speculative investors trade based on expected currency movements, hoping for profit from demand increases.
This can lead to currency value fluctuations.
What is the FX market convention for quoting currencies?
The stronger currency is quoted first in a pair, e.g., GBPZAR = 20 means GBP1 = ZAR20.
What is the significance of bid and offer prices in FX trading?
The bid price is what a trader is willing to sell at, and the offer price is what they are willing to buy at.
Example: GBPZAR 20,5/19,5.
What does ‘pips’ refer to in FX trading?
Pips are the smallest price move that a given exchange rate can make based on market convention.
Example: EURUSD 1,2151/1,2148.
What is a rolling hedge?
A strategy where businesses maintain multiple FX hedges with varying expiration dates to hedge expected cash flow against currency fluctuations.
What is the purpose of securitisation within a bank?
To create securities from financial contracts that can be easily traded in the secondary market, enhancing liquidity.
This allows investors access to assets previously unavailable to them.
What distinguishes FX forwards from FX futures?
FX forwards are OTC contracts with predetermined rates and dates, while FX futures are exchange-traded with daily settlement and specified contract sizes.
What is translation risk?
The risk faced by multinational corporations due to fluctuations in FX rates affecting the value of assets or liabilities denominated in different currencies.
How do banks typically hedge dividend payments?
Banks forecast expected dividends based on budget forecasts and adjust hedges quarterly to lock in dividends in reporting currency.
What is the difference between translation risk and transaction risk?
Translation risk pertains to the impact of FX fluctuations on the financial statements of subsidiaries, while transaction risk relates to individual trades.
What is the impact of currency depreciation on hedged dividends?
If the local currency depreciates, the hedge would pay off, securing the expected dividend value in the reporting currency.
What is the primary difference between a bank loan and securitisation?
A bank loan is a contract between a lender and a borrower that is not readily tradable, while securitisation bundles loans into tradable securities.
What is securitisation?
The process of bundling individual bank loans and other financial assets into tradable securities sold in the secondary market.
What is a special-purpose vehicle (SPV) in the context of securitisation?
A legal entity under which securities are issued, isolating recourse in the event of default to the underlying assets.
What are Asset Backed Securities (ABS)?
Securitised products that are backed by a pool of financial assets.
What are Mortgage Backed Securities (MBS)?
A type of ABS that is specifically backed by mortgage loans.
What is a pass-through ABS?
The simplest form of ABS where full credit risk is passed from the bank to the investor.
What types of assets can be included in an ABS portfolio?
- Credit card receivables
- Student loans
- Trade finance receivables
- Vehicle finance receivables
- Mortgage loans
- Project finance
- Corporate loans
What is a collateralised debt obligation (CDO)?
Another name for an ABS, often with a focus on diversification and risk management.
How does correlation impact the structure of a CDO?
A low correlation between assets is required to achieve diversification and lower risk.
What are covered bonds?
Debt instruments secured by a cover pool of assets or public-sector debt, giving investors a preferential claim in case of default.
What are the two main types of pensions?
- Final salary (defined benefit)
- Defined contribution
What is the key difference between defined benefit and defined contribution pensions?
Defined benefit pensions guarantee a fixed retirement income, while defined contribution pensions depend on investment performance.
What is the IFRS 9 accounting treatment for equity instruments?
Equity instruments should be measured at fair value through profit or loss (FVTPL) unless the FVOCI option is taken.
What is the business model assessment required for debt securities under IFRS 9?
An assessment to determine if liquidity requirements can be met through investments in the equity portfolio.
How do younger individuals typically allocate their pension funds?
They have a larger equity investment weighting due to expected capital gains.
What is alpha in the context of pension fund management?
Positive alpha refers to a return above a defined benchmark.
What is the purpose of hedging in pension fund management?
To mitigate downside risk and maintain positive alpha.
What are interest rate and inflation swaps used for?
To convert fixed-rate returns to floating-rate returns in bond portfolios.
What is de-risking in pension fund management?
The process of reducing equity weighting and increasing cash and bond weighting as individuals approach retirement.
What is the rationale for transferring long-dated underperforming assets to pension funds?
To benefit from holding assets to maturity as they ‘pull to par’.
What types of assets are typically transferred to pension funds from banks?
Long-dated and illiquid debt instruments, such as sovereign or corporate debt.
What is the impact of interest rates during times of crisis?
Interest rates typically rise initially due to increased risk, but can be lowered through central bank intervention.
What is the relationship between developed market (DM) rates and emerging market (EM) rates?
EM rates trade at a spread above DM rates to compensate for additional risk.
True or False: Covered bonds are similar to ABS but differ in being listed bonds.
True
What is the term used for the rotation of investment funds from risky assets to safe haven assets during market turmoil?
Flight to quality
This term describes the behavior of investors seeking stability during high-risk events.
What is the impact of shallow market depth in emerging markets during financial crises?
Thin support for asset prices
Shallow market depth means fewer buyers are available to support prices during sell-offs.
During times of systemic risk, how does global correlation behave?
Higher correlation
This is due to widespread selling across markets, affecting all assets similarly.
What major event triggered a financial crisis in 2008?
Lehman Brothers bankruptcy
This event led to a loss of confidence in the banking sector, resulting in a liquidity crisis.
What role did central banks play during the 2008 financial crisis?
Lender of last resort
Central banks intervened to provide liquidity to banks facing insolvency.
What is ‘Nene-gate’?
A period of extreme market volatility in South Africa in 2015
Triggered by a surprise cabinet reshuffle by President Jacob Zuma, leading to a loss of investor confidence.
What happens to interest rates during a financial crisis?
Initial spike followed by a substantial decrease
Central banks often cut rates to stimulate the economy after a crisis.
What is the consequence of a one-sided market during a financial crisis?
Widened bid/offer spreads
More sellers than buyers lead to a lack of liquidity and increased transaction costs.
How does basis risk change during a financial crisis?
Increased basis risk
Proxy hedges become less effective due to dislocation in historic correlations.
What is ‘Interest Rate Risk in the Banking Book’ (IRRBB)?
Risk to bank’s capital and earnings from adverse interest rate movements
It affects positions in the bank’s banking book.
What can trigger movements in foreign exchange rates?
Factors such as interest rate changes, economic data releases, and geopolitical events
These factors influence currency supply and demand.
What is the effect of quantitative easing (QE) on asset prices?
Support for asset prices through large-scale bond purchases
Central banks buy bonds to inject liquidity into the economy and stabilize markets.
Fill in the blank: During times of low market turbulence, investors target higher yields in _______.
Emerging Markets (EM)
Higher interest rates in EM compensate for lower creditworthiness.
True or False: The ECB provided only euro-denominated funding during the European crisis.
False
The ECB also provided US dollar funding to European banks.
What is the definition of counterparty credit risk (CCR) in banking?
Risk that the counterparty to a transaction could default before final settlement
This can lead to economic loss for the lender.
What is IRRBB?
It is the prospective risk to the bank’s capital and earnings, arising from adverse movements in interest rates that affect the bank’s banking book positions.
What are the three types of IRRBB?
- Gap risk
- Basis risk
- Option risk
What is gap risk?
It arises from the term structure of banking book instruments, describing the risk arising from the timing of instruments’ rate changes.
What is basis risk?
It describes the impact of relative changes in interest rates for financial instruments that have similar tenors, but are priced using different interest rate indices.
What is option risk?
It arises from option derivative positions or from optional elements embedded in a bank’s assets, liabilities, and/or off-balance-sheet items, where the bank or its customer can alter the level and timing of its cash flows.
List some reasons for movements in foreign exchange rates.
- Inflation
- Interest rates
- Balance of payments
- Public debt
- Political stability
- Economic performance
- Recession or upturn
- Speculation
What is credit risk?
It is the risk that the counterparty to a transaction could default before the final settlement of the transaction’s cashflows.
What occurs if a counterparty defaults?
An economic loss would occur if the transactions or portfolio of transactions with the counterparty have a positive economic value at the time of default.
How does CCR differ from traditional credit risk?
CCR creates a bilateral risk of loss where the market value of the transaction can be positive or negative to either counterparty to the transaction.
What factors can affect the market value of a transaction?
The market value is uncertain and can vary over time with the movement of market factors.
What are the shortcomings of EEPE?
(Largely addressed via regulatory capital calculations set by BCBS)
by card 19
- EEPE does not account for wrong-way risk
- the measure is not appropriately estimated in periods of stress
