Market risk management

Question 1

Definition Risk

Answer 1

Risk is defined as the (unexpected) deviation of a position’s value from its expected value.

The (unexpected) loss (i.e. the unexpected deviation of a price from its expected level) is the
risk faced by individuals, banks, …  So it’s all about the loss distribution!
 To measure risk means to measure the potential change of the (present/market) value of a
position.

Question 2

Definition Market Risk

Answer 2

BASEL II: Market risk can be defined as the risk of losses in on and off-balance sheet positions
arising from adverse movements in market prices

Market Risk can be regarded as systematic risk or non-diversifiable risk as opposed to
specific risk, i.e. the idiosyncratic risk of a single asset (see also: CAPM)
Market Risk is a financial risk, a performance risk

Question 3

Bond value

Answer 3

all bond cash flows are discounted to present with the
respective zero coupon rates

Question 4

What ist the DV01?

Answer 4

The DV01 (delta value of a basis point) measures the change in the present value of a future cash flow (CF) in case of a one basis point shift (=0.01%) of the relevant zero-coupon rate.

DV01 is a standard sensitivity measure of interest rate risk.

Example: CF in 3 years of CHF 1’000’000; 3y-zero-cpn rate = 5%:

(1 Mio / (1+0.0501)^3) - (1 Mio / (1+0.05)^3) = -246.76

Question 5

DV01 as IR Measure and Convexity

Answer 5

The impact of a larger shift in interest rates (e.g. 50 basis points) can be derived approximately as:
Change in PV of cash flow = 50 x DV01

∆PV is CHF 114.07 larger (“less” negative) than 50xDV01. This
difference is called “convexity”.

Question 6

VaR

Answer 6

Value at Risk (VaR) is a risk measure that tries to capture the
unexpected change in value (i.e. loss potential) of big price/rate moves of the analyzed positions in a otherwise well functioning market.

VaR = Worst loss that a position or a portfolio of financial instruments might experience under normal market conditions, during a defined holding period and at a defined confidence level.

Question 7

Expected Shortfall: Definition

Answer 7

As we have seen VaR only specifies the probability that a loss will not exceed a given amount (i.e. the VaR level) but not the maximum or average size of losses exceeding VaR.

The Expected Shortfall (ES) measures the “average” size of the losses exceeding VaR.

Question 8

What are the challenges of Market Risk Management?

Answer 8

Modelling Challenges
System & Data Issues
Regulatory Issues
Organizational Culture

Question 9

Let’s sum it all up

Answer 9

The regulatory authorities (e.g. BASEL I-IV) define market risk “as the risk of losses in on and offbalance sheet positions arising from adverse movements in market prices”
 When quantifying market risk, it’s important to understand how the value of financial instruments
behaves in relation to the change of underlying market factors
 The assessment of market risk can be done by calculating sensitivities (for small changes), Value at
Risk (for portfolios) or stress scenarios (for large market dislocations)
 Under BASEL II, minimum capital requirements for market risk may either be determined by the
Standardized approach or the Internal model approach
 BASEL IV will bring many improvements, e.g. better segregation of banking / trading book, more complex
Standardized approach, switch from VaR to ES in Internal model approach
 Market risk management is a continuous process with many best practice procedures in place and
many challenges to overcome

Question 10

Messmethoden zur Berechnung des Value-at-Risk

Answer 10

Variance-Covariance Approach
Historical Simulation Approach
Monte-Carlo Approach
Backtesting

Question 11

How can the assessment of market risk be done?

Answer 11

The assessment of market risk can be done by calculating sensitivities (for small changes), Value at Risk (for portfolios) or stress scenarios (for large market dislocations)

Question 12

How are the minimum capital requirements for market risk determined?

Answer 12

Under BASEL II, minimum capital requirements for market risk may either be determined by the Standardized approach or the Internal model approach

Question 13

Market Risk management: Standardized
approach

Answer 13

Building BlockApproach:
Capital charge captured separately for each risk, then summed. Trading book used for
general and specific IR and EQU risk, both
trading and banking book used for general
FX and COM risk

Question 14

Briefly explain the Variance/Covariance approach

Answer 14

Var/Cov makes often use of the normal distribution assumption (volatilities and correlations) based on market and /or statistical estimates.

Pros:
This method is very efficient. The position can be calculated easily even for a whole bank
# The risk factor distribution can be described by a variancecovariance matrix (unweighted/weighted)

Cons:
#Risk of fat tails or non-linearities can lead to a dramatic
underestimation of the real risks
# “Fat tails” in a crisis situation are not diversified away but rather
“accumulated”.

Question 15

Briefly explain the Monte Carlo approach

Answer 15

Monte Carlo simulates a profit & loss distribution based on statistically derived distributions of the risk factors.

Question 16

Briefly explain the Historical approach approach

Answer 16

Historical approach uses the price history to revalue the positions.

The major benefit of the approach is that the method is completely nonparametric (no pre-setting of parameters) and does not require any assumptions about the distribution of risk factors (no normal distribution required, fat tails are included as they have occurred)

The main weakness is the complete dependence on a particular set of historical
data. It is based on the implicit assumption that the past is a reliable representation of
the future (same level of volatility/risk in 2008 as 2004 – 2007?).