Chapter 7: Market risk Flashcards
What is market risk
Market risk is the risk of loss from movements in the prices of the financial markets.
Market risk is primarily regarded for components in the trading book.
What is the difference between the banking and trading book
Banking book: Assets such as loans and deposits, that regarded as “held until maturity”
Trading book: Assets such as securities and derivatives, that be regarded as “held for sale”
How is VaR used to measure market risk and state the advantages and disadvantages of the technique
Value at Risk (VaR)
* VaR is the maximum possible loss a portfolio can suffer with a specific level of confidence over a specific timeframe. If the loss exceeds the VaR it is known as a VaR break.
* SVaR refers to a stressed VaR, which considers the worst losses a portfolios have observed historically. VaR and SVaR is used to set regulatory capital levels, while point-in-time VaR is used for limit monitoring.
Advantages of VaR
* Easy to understand
* Can be used across market risk types
* Allows for interaction between risks
* Easily be translated into a risk benchmark
Disadvantages of VaR
* No indication of the distribution of the losses in the tail
* Underestimates the loss for risks with an asymmetric or fat-tailed distribution
* Coherent risk measure for only elliptically distributions
Advantages and disadvantages of ES as a measure for market risk
Advantages of ES
* Measures allow for losses beyond VaR
* Coherent risk measure
* Can be aggregated across business units
Disadvantage of ES
* Little intuitive meaning and cannot be directly linked to the current value of the assets
Advantages and disadvantages of TailVaR as a measure for market risk
Advantages of Tail VaR
* Measure allows losses beyond VaR
* Coherent risk measure
* Can be aggregated across business units
* Better intuitive meaning than ES as the conditional loss assuming losses exceed VaR
Disadvantage of Tail VaR
* More complicated to explain compared than VaR
Market risk hedging tools
- Forward contracts
- Futures
- Swaps
- Options
Example of how a forward contract work
- A forward contract is an agreement between two parties to buy or sell an underlying asset, such as a currency, at a predetermined price and date in the future.
- Since Bank A is expecting their payments only in three year’s time, to mitigate any currency risk, the current exchange rate can be locked in the currency with settlement occurring in three years. This reduced any concerns that the exchange rate might drop by the time the payment will be received.
- If the exchange rate drops at the time of settlement, Bank A can still sell the currency locked in at the higher agreed-upon rate, protecting it from the currency risk. On the other hand, if the exchange rate rises, Bank A would be obligated to sell the currency at the lower agreed-upon
- The bank was still protected from potential losses it would have incurred if it had not entered into the forward contract.
Formula for capital requirement under the standardised approach for market risk
Capital Requirement=Sensitivities+DRC+RRAO
Explain the sensitivity component in the formula for capital requirement under the standardised approach for market risk
Sensitivity-based method must be calculated by aggregating delta, vega and curvature.
Delta: The delta is defined as the sensitivity to price changes of the underlying asset
Vega: This measures the sensitivity to changes in the underlying volatility
Curvature: Risk measure that captures the incremental risk not captured by delta for price changes. Based on two stress scenarios, an upwards and a downwards shock to each regulatory factor.
Explain the dcr component in the formula for capital requirement under the standardised approach for market risk
Default capital risk (DCR) attempts to capture jump-to-default (JTD) risk that is not captured by sensitivities based method
The approach to follow is as follows:
* The gross JTD risk of each exposure is calculated separately. With regards to the same obligor, long and short positions are offset.
* Net JTD positions are then allocated to buckets. Within each bucket a hedge benefit ratio is calculated suing net long and short JTD risk positions
* This acts a discount factor that reduces the amount of net short positions to be netted against net long positions within the bucket
* Bucket level DCR are aggregated as a simple sum across buckets to give the overall DRC
Explain the rrao component in the formula for capital requirement under the standardised approach for market risk
Residual risk add-on (RRAO) is calculated separately for all instruments bearing residual risk in addition to other components of the capital requirement under the standardised approach
The approach to follow is as follows:
* RRAO is the sum of gross notional amounts of the instruments bearing residual risk multiplied by a risk weight
* Risk weight for instruments with an exotic underlying is 1%
* Risk weight for instruments bearing other residual risk is 0.1%
Minimum requirements to use the internal model approach approach to calculate the capital requirement for market risk
Minimum requirements to be met:
* Supervisory authority is satisfied that the bank’s risk management system is conceptually sound and is implemented with integrity
* Bank has sufficient number of skilled staff to use the models
* Trading desk risk management model has a proven track record of reasonable accuracy measuring risk
* Regularly conduct stress tests
* The internal trading desk risk management models for determining the capital risk requirement are held in trading desks approved to use the model
* Meet compliance with a documented set of internal manuals, policies, controls and procedures concerning the operation of the model
* Internal models have been adequately validated by qualified independent parties of the model development process
* Banks must re-evaluate the models periodically, especially if there are any significant structural changes to the market
Changes introduced in Basel IV for market risk
Boundary:
A more explicit split between the banking and trading book. This split attempts to discourage banks to arbitrage regulatory capital between the two books
Internal models approach:
* Attempts to better capture risks (especially tail and illiquidity risks)
* Models are approved at a more detailed level, especially those used for trading purposes
* Limits placed due to hedging and diversification on the capital requirements
Standardised approach
* Fit for banks with little trading activity while being a reliable floor
* Sufficiently risk sensitive
Fundamental review of the trading book (FRTB)
* Boundary between trading and banking book: Reduce incentives for a bank to arbitrage its regulatory capital between the two regulatory books
* Treatment of credit: Securitised and non-securitised products will be treated differently
* Approach to risk management: Capturing the tail, so a move from VaR to ES
* Relationship between IMA and SA: Align approaches, so that difference in capital when using the two approaches is not too large
* Revised SA
Explain how market risk is measured in the pension book
Only applicable to defined benefit schemes
Banks need to quantify their pension obligations as part of ICAAP. Stress and scenario testing can be used to estimate the probability and severity should the pension fund experience a deficit
The regulator can adjust the capital requirement based on the robustness of assumptions in the ICAAP. The regulator can apply a standard set of stresses and then compare than to ICAAP. The bank then needs to justify any deviances.
