Market Risk

Welcome:
Here is a scenario of the Ethiopian bank, which has a well-
diversified portfolio. It has its investments in equities, shares,
real assets, and others.

The bank had a good financial year by making considerable

profit. The bank wants to invest this profit into a best option.

The Chief Risk Officer at the Ethiopian bank suggested two

options – A and B. Option A is an investment of rupees 10,000
crore in a risk-free deposit and Option B is an risky investment
of rupees 10,000 crore in shares. The expected returns from
Option A is 2% and from Option B is 14%.

Have you wondered how the Chief Risk Officer of the Ethiopian
bank concluded that the options are risky and risk free?

The Chief Risk Officer has analysed the present market and
used the risk measuring tools to measure the risk.
Wonder what this is all about. Welcome to the module on
market risk.

Learning Objective:
On completing this module, you will be able to:
• Explain the market risk.
• Compare the trading book and banking book.
• Explain the capital charge.
• List the methodologies to measure market risks.
• Explain the duration method.
 • Explain the Value-at-Risk (VaR) method.
• Explain the Internal Model Approach (IMA).
• Explain stress-testing framework.

Introduction to Market Risk

Let us begin this module by defining market risk. Market Risk is

defined as “the risk that the value of ‘on’ or ‘off’ balance sheet
positions will be adversely affected by movements in equity and
interest rate markets, currency exchange rates and commodity
prices”.

Bank of India has a well-designed and a robust Risk

Management Framework. The Bank’s Market Risk
Management Framework aims to establish the broad outlines of
the processes. Through this, the market risks carried by the
bank are managed, i.e. identified, measured, controlled and
monitored in such a way that the risk taken is within the
approved risk tolerance limits.

Scope of Market Risk

What all the market risk includes?

The market risk includes:

Open positions in foreign exchange, including foreign
exchange derivatives, in any currency other than its reporting
currency
Bullion positions either in physical form or open position in
bullion derivatives.
Positions taken in other commodities whether such positions
are held in physical form or open position in derivative
instruments
Trading book positions in interest rate sensitive securities,
including interest rate derivatives.
Trading book positions in equity securities or equity
derivatives. As per RBI guidelines only following market risk
positions are subjected to capital charge requirements.
Risks pertaining to interest rate related instruments and
equities (including securities which exhibit market behaviour
similar to equities, such as mutual funds) in trading book.
Foreign exchange risk (including open positions in precious
metals) throughout the Bank i.e. both banking and trading
positions.

Comparison between Trading and Banking Book

Before we discuss about the capital charge, it is important to

know the comparison between trading and banking book.

Securities held under Held for Trading (HFT) and Available for
Sale (AFS) category shall be considered to be part of Trading
Book. The Bank shall maintain appropriate capital charge for
the same for Basel II capital adequacy purposes.

Interest rate sensitive assets and liabilities such as borrowings,

structured deposits, loans and advances to customers (fixed or
floating) etc. are part of Banking Book.

The position held in trading book should be frequently and

accurately valued and the portfolio should be actively managed.
Capital Charge

Let us understand how capital charge plays an important role in

market risk.
The capital charge for interest rate related instruments would
apply to current market value of these items in bank’s trading
book. The minimum capital requirement is expressed in terms
of two separately calculated charges.
‘Specific Risk’ charge for each security, to protect against an
adverse movement in the price of an individual security owing
to factors related to individual issuer.

General Market Risk charge towards interest rate risk in the

portfolio where long or short position can be off-set.

Capital Charge of Interest Rate Risk

For the debt securities held under AFS category, in view of the
possible longer holding period and attendant higher specific
risk, the banks will hold total capital charge for market risk
equal to greater of either of the following options.

“Specific risk” capital charge computed notionally for the AFS

securities treating them as held under HFT category plus
“General Market Risk”.

OR

Alternative total capital charge for the AFS category computed

notionally treating them as held in the banking book. The
Market Risk Capital Charge will be higher of “Specific Risk
Charge “plus “General Market Risk” or Alternative total capital
charge.

Components of Capital Charge

The capital requirements for general market risk are designed

to capture the risk of loss arising from changes in market
interest rates. The capital charge is the sum of four
components. They are:

The net short position or long position in the whole trading

book;
A small proportion of the matched positions in each time-band
(the “Vertical disallowance”);
A larger proportion of the matched positions across different
time-bands (the “horizontal disallowance”); and
A net charge for positions in options, where appropriate.

Note that the short position is not allowed in India except in

derivatives.

Check your knowledge

It is time for a quick knowledge check. Read the question

carefully and then answer.

Vertical disallowance - Small proportion of the matched

positions in each time-band is called as vertical disallowance.
Horizontal disallowance - A larger proportion of the matched
positions across different time-bands is called as horizontal
disallowance.

Feedback for correct attempt: You got it right!

Small proportion of the matched positions in each time-band is
called as vertical disallowance.
A larger proportion of the matched positions across different
time-bands is called as horizontal disallowance.

Feedback for incorrect attempt: Oops! You missed it!

Small proportion of the matched positions in each time-band is
called as vertical disallowance.
A larger proportion of the matched positions across different
time-bands is called as horizontal disallowance.

Methodologies to Measure Market Risk

The Basel II Framework offers a choice between two broad
methodologies in measuring market risks for the purpose of
capital adequacy.

One methodology is to measure market risk as per the

Standardized Measurement Method (SMM) which is being used
in India since 31st March -2008.

The alternative methodology known as Internal Model

Approach (IMA) allows banks to use risk measures derived
from their Internal Market Risks measurement models.

Classification of Standardized Measurement Method

Under the standardised method, there are two principal

methods of measuring market risk. They are maturity method
and duration method.

We will discuss duration method in detail in the subsequent

slide.

Standardized Measurement Method-Duration Method

The banks are required to measure the general market risk by

calculating the price sensitivity (Modified Duration) of each
position separately.

The methodology is as follows:

First calculate the price sensitivity (modified duration) of each
instrument.
Next apply the assumed change in yield to the modified
duration between 0.6 to 1.0 percentage points depending on
the maturity of the instrument.
Slot the resulting capital charge measures into a maturity
ladder with the fifteen time bands.
Subject long and short position in each time band to a 5
percent vertical disallowance designed to capture basis risk.
Carry forward the net position in each time-band for horizontal
disallow as set out below:
Within the zones –Zone -1 40%, Zone -2 30% and Zone-
3 - 30%
Between adjacent Zones 40% and between 1 and 3
Zones 100%

Definition of Value-at-Risk (VaR)

Currently, banks in India calculate capital for market risk using

SMM and use different Value-at-Risk (VaR) methodologies for
calculating market risk for internal purposes.

Let us know what Value-at-Risk is. Value-at-Risk answers the

question ‘As an investor, what is the most I can lose on this
investment?’

Value at Risk tries to provide an answer, at least within a

reasonable bound.

Value-at-Risk of a portfolio is defined as the potential loss value

such that given a confidence level (i.e. probability), the
cumulative mark-to-market losses on the portfolio over a given
time horizon does not exceed this value (assuming normal
market conditions and no further trading in the portfolio.

Value-at-Risk (VaR) Methodologies

Calculation Methodology Value-at-Risk can be computed using

Historical simulation method or Variance co-variance method or
Monte-Carlo simulation.

Click each methodology to learn more.

Considering the wide acceptability of the methodology and
ease of computation, Bank of India have proposed to compute
VaR using Historical simulation.

Historical simulation method - Historical simulation method

re-organizes actual historical returns putting them in order from
worst to best and then assumes that history will repeat itself.

Variance co-variance method - Variance co-variance method

assumes that stock returns are normally distributed. It requires
estimation of only two factors- an expected (or average) and
standard deviation.

Monte-Carlo simulation Method -Monte-Carlo simulation

method involves developing a model for future stock price
returns and running multiple hypothetical trails through the
model.
Parameterization of Value-at-Risk (VaR)

Primary Dealers should calculate the capital requirement based

on their internal risk management framework based Value-at-
Risk model for market risk. According to RBI, the
parameterization of Value-at-Risk Model is as shown below.

Value-at-Risk must be computed on a daily basis at a 99th

percentile, one-tailed confidence interval.
The minimum holding period is 10 days.
The choice of historical observation period (sample period) for
calculating Value-at-Risk will be constrained to a minimum
length of one year and not less than 250 trading days.
The data sets of Value-at-Risk should be updated at least
once in every 3 months.

Internal Model Approach (IMA)

The permissible models under IMA are the ones which
calculate a Value-at-Risk based measure of exposure to market
risk. Value-at-Risk based models could be used to calculate
measures of both general market risk and specific risk.

As compared to SMM, IMA is considered to be more risk

sensitive and aligns the capital charge for market risk more
closely to the actual losses likely to be faced by the banks due
to movements in the market risk factors.

The VaR components required under IMA are Normal Value-at-

Risk and Stressed Value-at-Risk.

Click each component to learn more.

Normal VaR -General Market Risk plus Specific Risk

Stressed VaR-The stressed VaR corresponds to the VaR that
would be generated on the Bank’s current portfolio if the
relevant market factors were experiencing a period of stress.
Incremental Risk charge - Incremental risk charge represents
the risk not captured by the VaR based estimate of the specific
risk.

Back-testing of VaR Model

Value-at-Risk models are useful only if they predict future risks

accurately. In order to evaluate the quality of the Value-at-Risk
estimates, the models should always be back-tested with
appropriate methods. Back testing will help to refine the
framework.

The bank will back-test the Value-at-Risk numbers on a daily

basis.
If Value-at-Risk is greater than P&L impact (loss component),
then the particular instance is recorded as a success.
If Value-at-Risk less than P&L impact (loss component), the
particular instance is recorded as a failure for the Value-at-Risk
Model.

The failure rate for the entire sample is computed and

compared with the confidence level using at which Value-at-
Risk has been computed.

If failure rate is less than (1-confidence level), the model is

verified to be operating correctly, else the model has failed the
back-test. If the model fails a back-test, the assumptions of the
model should be re-validated.
Back-testing should be performed for both hypothetical and
actual trading outcomes.

Stress-Testing Framework

Now it is time to perform the stress-test. Stress-testing should

be performed to supplement the risk analysis.
Stress-testing is a tool to evaluate the potential impact of a
specific event and/or movement in a set of financial variables.

Extraordinary losses may arise from such low probability,

adverse scenarios which can have a significant impact on the
earnings and capital positions of the bank.

Stress test simulate portfolio performance during abnormal

market periods. They provide information pertaining to risks
falling outside those typically captured by VaR Framework.

Let us take a look at the key work-steps in the stress testing

process. The steps are:
Identification of risk factors
Identification of stress scenarios
Current valuation of the portfolio
Valuation of portfolio under stress
Click each step to learn more.

Identification of risk factors -Risk factors are various

variables that have an effect on the valuation of a
product/portfolio.

Identification of stress scenarios - Stress test scenarios

represent the possible changes in the risk factors, which can
happen in stress event. The scenarios are typically improbable
but plausible events, which may be based on historical values
of the risk factors or be hypothetical in nature.

Current valuation of the portfolio - The bank's positions in

various instruments are valued as per the existing valuation
methodology so as to provide the value of the positions as of
on the stress testing date.

Valuation of Portfolio under stress – The portfolio is re-

valued after application of the stress scenarios on the risk
factors. The change in the value of the portfolio is the portfolio
profit/loss in the event of occurrence of the stress
event/scenario.

Check your knowledge -It is time for a knowledge check.

Read the question carefully and then answer.

Key:
Identification of risk factors
Identification of stress scenarios
Current valuation of the portfolio
Valuation of portfolio under stress

Feedback for correct attempt: You got it right! The steps

followed in the stress-testing process are:
Identification of risk factors
Identification of stress scenarios
Current valuation of the portfolio
Valuation of portfolio under stress

Feedback for incorrect attempt: Oops! You missed it! The

steps followed in the stress-testing process are:
Identification of risk factors
Identification of stress scenarios
Current valuation of the portfolio
Valuation of portfolio under stress

Summary:

Let us recapitulate our learning.

At the end of this module, you learned about:
Market risk
Trading book and banking book
Capital charge.
Methodologies to measure market risks
Duration method
Value-at-Risk (VaR) method
Internal Model Approach (IMA)
Stress-testing framework