Chapter 7: Market risk Flashcards
Market Risk
The risk of loss from movements in prices in the financial markets.
Typically, it arises from movements in interest rates, foreign exchange rates, and market prices of commodoties and equities.
Interest risk is, therefore, a form of market risk.
Market risk can arise on any position (on or off balance sheet) in cash, securities, derivatives, customer lending, etc.
Difference between Banking and Trading book
Banking book: Assets, such as loans, that can be regarded as “held until maturity”
Trading book: Assets, such as securities and derivatives, that can be regarded as “held for sale”
VaR Measure of Market Risk
Definition:
VaR is the maximum possible loss a portfolio can suffer with a specific level of confidence over a specific timeframe.
Special Terms
* 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 portfolio has observed historically.
Uses
* VaR and SVaR are used to set regulatory capital levels
* Point-in-time VaR is used for limit monitoring.
Advantages and Disadvantages of
Expected Shortfall (ES) for Market Risk
BACK
Advantages of ES
* Measure allows for losses Beyond VaR
* can be Aggregated across business units
* Coherent risk measure
Disadvantage of ES
* No intuitive (easy-to-Know) meaning and cannot be directly linked to the current value of the assets
Advantages and Disadvantages of TailVaR for Market Risk
BACID
Advantages of Tail VaR
* Measure allows for losses Beyond VaR
* can be Aggregated across business units
* Coherent risk measure
* Better Intuitive meaning than ES as the conditional loss assuming losses exceed VaR
Disadvantage of Tail VaR
* More Difficult to explain than VaR
Market risk hedging tools
- Forward contracts
- Futures
- Swaps
- Options
Market Risk Capital Requirement under Standardised Approach
= Sensitivities + DRC + RRAO
Sensitivity Component of Market Risk
Sensitivity-based method must be calculated by aggregating delta, vega and curvature.
Delta:
The delta is defined as the sensitivity of an instrument to regulatory delta risk factors (e.g. to price changes of the underlying asset of an option or equity prices, foreign exchange rates, interest rates, commodity price, etc.)
Vega:
This measures the sensitivity to regulatory vega risk factors (e.g. changes in the underlying asset volatility for an option portfolio)
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 risk factor.
(AKA gamma)
Default Risk Capital Component of
Market Risk Capital
Default Risk Capital (DRC) attempts to capture Jump-To-Default (JTD) risk that is not captured by sensitivities based method.
Steps:
* Gross JTD risk of each exposure is calculated separately. For the same obligor, long and short positions are offset — giving the Net JTD position.
* Net JTD positions are then allocated to buckets of similar risk characteristics.
* Within each bucket a hedge benefit ratio is calculated using net long and short JTD risk positions. = risk-mitigating effect of short positions on long positions.
(short positions = hedges; long positions = assets)
* This ratio acts a discount factor that reduces the amount of net JTD short positions to reflect the risk reduction.
* Bucket level DRCs are aggregated as a simple sum across buckets to give the overall DRC
Residual Risk Add-On (RRAO)
Component of Market Risk
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
1. Risk weight for instruments with an exotic underlying is 1%
2. Risk weight for instruments bearing other residual risk is 0.1%
Minimum Requirements to Use
Internal Model Approach for Market RIsk
RiS DiS VECMA
General
* 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 (back office = finance, audit, risk; front office = trading desk)
* trading Desk risk management model has a proven track record of reasonable accuracy measuring risk
* regularly conduct Stress tests
Model Stuff (VECMA)
* 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
* meet Compliance with a documented set of internal manuals, policies, controls, and procedures concerning the operation of the model
* the positions included in the bank’s internal trading desk risk management Models for determining the capital risk requirement are held in trading desks Approved to use those models
Changes introduced in
Basel IV for market risk
Fundamental Review of the Trading Book (FRTB)
* Boundary between trading and banking book:
Reduce incentives for a bank to try to achieve 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:
New emphasis on 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
Internal Models Approach:
* Attempts to better capture risks (especially tail and illiquidity risks). Previously, was very reliant on VaR and didn’t explicity address market illiquidity.
* Models are approved at a more detailed level, especially those used for trading purposes. (stricter criteria)
* 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.
Market Risk 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
* apply a standard set of stresses and then compare than to ICAAP. The bank then needs to justify any deviances.
Market Risk in Trading Book
- Trading book assets have to be marked-to-market
(i.e., their fair value has to be adjusted upwards or downwards in line with market values) - If no market value is available, the assets have to be market-to-model.
Advantages and Disadvantages of VaR
TUTI DUE
Advantages
* can be used across market risk Types
* easy to Understand
* easily be Translated into a risk benchmark
* allows for Interaction between risks
Disadvantages
* 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 only if Elliptically distributed
