Market Risk. Market Risk Group

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1 Market Risk Market risk refers to possibility of loss due to changes in the market factors such as interest rate, currency values, equity market rates, commodity market prices and changes in legal and regulatory requirements. It affects bank s earnings and its capital position leading to its inability to meet payment obligations. It also affects market value of assets held by the bank. Management of market risk begins at the level of Board of directors who in turn create functional authorities to deal with market risk. Risk management committee is created with a view to lay down guidelines for risk measurement to review risk limits and effectiveness of market risk system, to access the competence of the staff and oversee the complaints of market risk policy. Structure of the Market Risk Group in Banks Board of Directors Risk Management Committee Asset Liability Management Committee Market Risk Group Asset liability management committee is created to execute the risk policy relating to market risk. It is responsible for adherence to risk limits, decisions on maturity profile of assets and liabilities, decisions on business strategies and review of impact on balance sheet. Market risk group is created for analyzing, monitoring and reporting on risk to the ALM committee and prepare forecasts through simulation models. Measurement of market risk through value-at-risk concept is done for each position in a portfolio as well as on the overall portfolio. This identifies the potential loss or gain from market operations of the bank within a time horizon. Value-at-risk indicates the maximum loss possible given a confidence level and the time frame. Though it is arrived at using historical observations, several other value-at-risk models are futuristic and involve additional time and cost considerations for the bank. The value-at-risk arrived at is adjusted for other within risk factors and across risk factors so that estimates would involve minimal error in measurements. Basel committee norms prescribe capital adequacy for market risk wherein capital is classified as Tier I, Tier II and Tier III capital structures. Tier I capital consists of shareholder s equity and retained earnings. Tier II capital includes supplementary capital such as long term capital that are not necessarily from equity holders. Tier III capital include short term subordinate debts. These subordinate debts are expected to be limited to 250% of Tier I capital to support market risk. The substitution of Tier II capital by Tier III capital can be up to 250%. Tier III capital however though short term is subject to lock in periods.

2 The measurement of market risk is subject to several shortcomings. The historical price movements that are used in the measurement process are not normally distributed and normally exhibit fat tails in the distribution and significant extreme event occurrence for the bank. It is difficult to account for intra-day trading risks in the computation process. Most often history never repeats and if causes of market risk are not similar the measurement becomes unreliable for the bank. Basel Committee Recommendations Basel committee has formulated comprehensive guidelines for market risk computation and management. Based on these recommendations Reserve Bank of India issued guidelines for capital adequacy norms to cover market risk. A risk weight of 2.5% for investment in government and approved securities and a risk weight of 100% for foreign exchange and gold positions are to be followed. In case of small banks standardized method is recommended. Large and international banks have to adopt internal models for maintaining market risk requirements. Basel guidelines for market risk measurement suggest value-at-risk models and prudential valuation. Internal value-at-risk models adopted should consider reliability of the factors used in pricing, calculation procedures, model validation tests, relevancy of data and, weights used for historical data. The standardized measurement method for market risk ensures application of higher risk charges to instruments with high yield to maturity. It does not permit offsetting between instruments with high yield to maturity and other debt instruments. It requires proper definition of market risk. Specific Risk Capital Standardized Approach (External Credit Rating) AAA- to AA- A+ to A- BBB+ to BBB- BB+ to BB- Bellow BB- Credit Assessment Securitized exposure Re- Securitized exposure A-1 / p-1 A-2 / P-2 A-3 / p-3 Below A3/p3 Un rated 1.6% 4% 8% 28% Deduction 3.2% 8% 18% 52% Deduction

3 Internal Rating Based Approach Interest Rating Securitized exposure Re- Securitized exposure Senior Non - Senior Non - Senior Non - Senior BBB+ 2.80% 4.00% 8.00% 12.00% BBB / A3 / p - 3 BBB 4.80% 6.00% 12.00% 18.00% 8.00% 16.00% 28.00% BB % 24.00% 40.00% BB % 40% 52.00% BB % 60.00% 68.00% Below BB - /A-3 / p3 Deduction Note: -effective number of underlying exposure is 6 or more Non - - effective number of underlying exposure is les then 6 Internal Rating Based Approach Interest Rating Securitized exposure Re- Securitized exposure Senior Non - Senior Non - Senior Non - Senior AAA / A1 / p1 0.56% 0.96% 1.60% 1.60% 2.40% AA 0.64% 1.20% 2.00% 2.00% 3.20% A+ 0.80% 1.44% 2.80% 2.80% 4.00% A / A - 2 / p % 1.60% 2.80% 3.2% 5.20% A- 1.60% 2.80% 2.80% 4.80% 8.00% Note: -effective number of underlying exposure is 6 or more Non - - effective number of underlying exposure is les then 6 Internal rating methods look at classifying market exposures on the basis of credit rating and applying weights for capital adequacy.

4 Basel has also provided specific risk charges for unrated exposures at 8% of weighted average risk multiplied by a constant ratio as specified by the committee. Banks have to ensure an effective risk management system capable of handling sophisticated models for risk control and audit and have to assess their reliability at periodical intervals. Banks have to measure and set quantitative limits for risk control. They must have an independent risk control unit to evaluate risk exposures and report to senior management. Banks also integrate the risk control measures with their internal policy and their documentation requirements. It has to examine adequacy of documentation, effectiveness of organization of risk control units, approval process for risk pricing, validation of changes in risk measurement process and supervision of front and back office personnel. Quantitative standards prescribed may also consider limits for options positions taken by the bank if any. The risks are stated in terms of Vega (volatility factor), Delta (price change factor), Gamma (delta factor), Rho (interest factor). Capital requirement is computed taking the highest previous day s value-at-risk previous number and multiplied by a multiplication factor. Alternatively average of daily value at risk for the preceding 60 business days may be taken as the basis or higher of its latest available stressed value-at-risk number or average of the stressed value-at-risk number over the preceding 50 days could be considered as the basis for arriving at capital requirement. The multiplication factor chosen will be decided by the supervisory authorities. Capital Requirement Formula C = Max(V R : m V R ) a a avg t-1 b + Max( VaR t-1 : m VaR avg) VaR t-1 = previous day VaR Va R avg = Average daily VaR m b = multiplication factor svar = stressed VaR Va R avg = Average stressed Va R

5 Measurement of Market Risk Measurement of market risk involves both directional and relative value assessment. Market risk has two important components namely price risk and liquidity risk. The two important type of market risk measurements are scenario analysis and statistical analysis. Scenario analysis measures changes in market value for the anticipated changes in the market factor. Scenario analysis is complete when a stress test is used to measure the change in the market value of the portfolio. Value-at-risk measure is an important statistical approach for market risk assessment. There are three approaches for the measurement of market risk. They are the historical simulation, model building approach and Mote Carlo simulation. Value-at-Risk VaR (Value-at-Risk) is a measure of the risk in a portfolio over a period of time. It is quoted in terms of a time horizon, and a confidence level. For example, the 10 day 95% VaR is the size of loss X that will not happen 95% of the time over the next 10 days. 5% Value-at-Risk X 95% (Profit/Loss Distribution) Bank are required to keep capital for market risk coverage using average of value-at-risk estimates for the past sixty trading days multiplied by a multiplication factor decided by supervisory authorities. Usually the multiplication factor applied is Example Based on 60 days prior trading data the following computations have been made The volatility of a bank is 2% per day (about 32% per year) Assume N=10 and confidence level is 99 % The standard deviation of the change in the market price ( 60,000) in 1 day is 1,200 (2% x 60,000) The standard deviation of the change in 10 days is 1,200 x = 3, (1200 x )

6 Example Assume that the expected change in the value of the bank s share is zero. Assume that the change in the value of the bank s share is normally distributed Since N(0.01)= -2.33, ({Z<-2.33}=0.01). TheVaR is 2.33 x 3, = 8, VaR for one year (252 days) = 44, Assume Bank s Gross Income = 1,869, % of Gross Income = 56,097. Bank s capital charge for operational risk is 52,630 as per the basic indicator approach. Value-at-risk measure can be computed with reference to an asset, liability, a portfolio of assets or a portfolio of liabilities for a given holding period at a given level of confidence. Value-at-risk measures are used as an MIS (management information system) tool in the trading portfolio to set risk limits and to decide future business trends. The limitations of value-at-risk model sometimes could be due to misjudgments and improper internal control systems in the bank. Therefore these models require constant review, back testing and stress testing. Market Risk Management Banks have to create well established procedures, policies and internal structures to deal with market risk. The responsibility for market risk begins with the Board of Directors who will create an overall framework and also the functional authorities for managing market risk. The organization of risk management function consists of setting up risk management committee, asset liability management committee, market risk groups to carry out monitoring, controlling and reporting activities of the bank.

7 Efficient market risk management involves risk identification, setting limits and triggers for functional, departmental and overall levels, risk monitoring, developing risk analysis models and risk reporting. Risk identification involves stating the risk taking units, procedures and limits associated with the products introduced by the bank and controlling the implementation of product programs. Limits and triggers are set as sensitivity measures to monitor risk variations on a daily basis. Risk monitoring covers execution of transactions, periodic marking to market and stress test. Risk analysis models are developed for measurement of market risk position evaluation. These models are to be certified and executed through trained technical staff. Risk reporting is to be carried out on a daily basis highlighting significant variations and their impact. Questions 1. What is market risk? 2. Explain the components of market risk. 3. What are the factors influencing market risk variations? 4. Highlight important guidelines of Basel committee on market risk management. 5. Explain the guidelines of RBI for capital adequacy to cover market risk. 6. What is Value-at-Risk measure? 7. What are the various approaches for value-at-risk measure? 8. How is capital adequacy determined as per value-at-risk model? 9. What are the assumptions and limitations of value-at-risk model? 10. Discuss the measures to be initiated for effective management of market risk. Key words Market risk, on-balance sheet position, off-balance sheet position, market risk group, Tier 1 capital, Tier 2 capital, gamma risk, vega risk, delta risk, rho risk, scenario analysis, back testing, stress testing, market limits, market triggers, risk reports.