SESSION 3

Suppose that S is the value of a variable on day i. The volatility per day is the standard deviation of
i
ln(S /S )
i i-1

Or

S –S /S
i i-1 i-1
Normally used in risk management

POWER LAW

-a
Prob(v > x) = Kx

This seems to fit the behavior of the returns on many market variables better than the normal
distribution

▷Suppose by empirical view for a financial variable

α = 3 and (p) that v >10 is 0.05

Power Law states that

0.05 = K * 10^(-3)

K = 50
Probability that v>20 can be calculated:

50*20^(-3) = .00625

GARCH MODEL – IN PPT IF REQUIRED

SESSION 4

PROPERTIES OF RISK MEASURE

1. Monotonicity
2. Translation Invariance

3. Homogeneity
4. Subadditivity

VaR

▷We are X percent certain that we will not lose more than V dollars in time T
Session 6 cash flow mapping
Session 7 hedging and Greek letters

Session 7 important for delta gamma vega theories and long call, short put etc.
Session 9 for EaR and bucketing

Gap Position Change Change in Net

in Interest Income
interest
rate

Positive Increase Increase

Positive Decrease Decrease

Negative Increase Decrease

Negative Decrease Increase

 Tools used to measure/Manage Interest RateRisk
Traditional GAP Analysis(TGA)
GAPreport is generated by grouping Interest rate sensitive
Assets and Liabilities into buckets according to residual time
to maturity or the time until the first possiblerepricing.
Rsin crores
Time bucket RSA RSL GAP Cumulative
Gap
Up to 3 months 15000 12000 (+) 3000 (+) 3000
>3 m up to 6 8000 10000 (-)2000 (+) 1000
months
>6 m up to 9 10000 12000 (-)2000 (-) 1000
months
>9 m up to 1yr 20000 15000 (+)5000 (+)4000
Total 53000 49000 (+)4000

Earning at Risk
TheTraditional GAP analysis is particularly helpful from measuring interest risk from
earning prospective. Forexample, Impact of a1%increase in interest rate on NII as
using Gap table
Time bucket GAP Residual period Interest gain orLoss
in one year
Up to 3 (+)3000 12-1.5=10.5 m (+)3000 x 10.5/12x0.01= (+)
months 26.25
>3 m up to 6m (-) 2000 12-4.5=7.5 m (-)2000 x 7.50/12x0.01=(-)
12.50 cr
>6 m up to 9m (-)2000 12-7.5=4.5 m (-)2000 x 4.5 /12x 0.01 = (-)
7.50cr
>9 m up to 1yr (+)5000 12-10.5=1.5 m (+)5000 x 1.5/12x0.01= (+) 6.25 cr

Total Impact (+) 12.50 cr

how residual is 1.5 for 3 months?

Relationship between MDG and sensitivity of MVE to interest rate changes

Concept of Duration • MD of an asset or liability measures the approximate percentage change in its
value for a 100 basis point change in the rate of interest.
• Duration :- How long it takes in years for an investor to
be repaid the bond’s price by the bond’s total cash • The MDG framework involves computation of Modified Duration of RSA (MDA)
flow. and Modified Duration of RSL (MDL). MDA and MDL are the weighted average of
– Sum of (PV of each cash flows/Total) = Duration the Modified Duration (MD) of items of RSA and RSL respectively. The MDG can be
– More the duration more is the sensitivity of bond calculated with the help of the following formula:

• Modified Duration : How much bond’s price will change

with change for each 1% rise or falls is known as
modified duration • The MDG as defined above reflects the degree of duration mismatch in the RSA
and RSL in a bank’s balance sheet. Specifically, larger this gap in absolute terms,
the more exposed the bank is to interest rate shocks.
• Modified Duration of Equity: How much equity shall be
impacted with change in 1% rate if interest.
 Illustration:

A
Relationship between MDG and sensitivity of MVE to interest rate changes(2)
• The impact of changes in the interest rates on the MVE can be evaluated by computing ΔE with the
help of following formula

ΔE= -[MDG]*RSA* Δ i

• In the above equations: • Equity would mean Networth as defined in DBS Circular No.
DBS.CO.PPD.ROC. 12 /11.01.005/2007-08 dated April 7, 2008.

• ‘ ΔE’ stands for change in the value of equity

• ‘ Δ i’ stands for change in interest rates in percentage points ( 1% change to be written as 0.01)

• Ideally, in the calculation of changes in MVE due to changes in the interest rates, market values of
RSA and RSL should be used. However, for the sake of simplicity, banks may take the book values of
the RSA and RSL (both inclusive of notional value of rate sensitive off-balance sheet items) as an
approximation

Session 10 about liquidity only :-

Liquidity Standards - Mitigation

LCR & NSFR

Level 1+Level 2A+ Level 2B ( after adjusting for hair cuts)
LCR = ----------------------------------------------------------------- X 100
Total net cash outflows in the next 30 calendar days

Available stable funding (ASF)

NSFR = ----------------------------------------------------------- X 100
Required Stable funding (RSF) over one year

Session 11= FTP fund transfer pricing.

For illustration, let us assume that a bank’s Deposit profit centre has raised a 3 month deposit @
6.5% p.a. and that the alternative funding cost i.e. MIBOR for 3 months and one year @ 8% and
10.5% p.a., respectively. Let us also assume that the bank’s Loan profit centre created a one
year loan @ 13.5% p.a. The franchise (liability), credit and mismatch spreads of bank is as
under:
Deposits Funds Loan Total
Interest Income 8.0 10.5 13.5 13.5 Average cost – illustration
Interest Expenditure 6.5 8.0 10.5 6.5 Period O/ s amount Average Incremental Average Profit
cost % asset yield asset yield
Margin 1.5 2.5 3 7 % %

Loan Loss Provision 1.0 1.0 Year 1 100 5.00% 7.00% 7.00% 2.00
Year 2 200 6.00% 7.50% 7.25% 2.50
Deposit Insurance 0.1 0.1 Year 3 300 7.00% 8.00% 7.50% 1.50
Reserve Cost CRR/SLR 1.0 1.0
Over Heads 0.6 0.5 0.6 1.7 Period O/ s amount Incremental Incremental Incremental Incremental
amount cost % asset yield % profit
NII 0.8 1.0 1.4 3.2
Year 1 100 100 5.00% 7.00% 2.00
Under the FTP mechanism, the profit centers (other than funds management) are
Year 2 200 100 7.00% 7.50% 0.50
precluded from assuming any funding mismatches and thereby exposing them to market risk.
Year 3 300 100 9.00% 8.00% (-1.00)
The credit or counterparty and price risks are, however, managed by these profit centres. The
entire market risks, i.e interest rate, liquidity and forex are assumed by the funds management
profit centre.

A Caselet on Understanding Transfer Pricing

• Let us consider that there are 100 branches of a Bank. Business of these
branches in terms of total deposit and advances is under :
Scenario Deposits Advances Fund Position Treasury
20 Branches 90 % 10 % Surplus Lending
50 Branches 60 % 40 % Surplus Lending
20 Branches 40 % 60 % Deficit Borrowing
10 Branches 10 % 90 % Huge Deficit Borrowing
Ø Assumptions : 1) Branches are not allowed to enter money market
2) Only Treasury Branch is allowed to enter money market
Ø Issues : What interest rate to be paid to branches by treasury.
What are the different approaches adopted by banks ?
How this approach help in deciding the product pricing ?
Ø Factors Influencing the decisions : Deposit Mix ; Loan portfolio ;
Session 12
Basel I (July 1988) Basel I
• Set minimum regulatory capital adequacy requirements for • Risk Weighted Assets
banks – Calculated primarily for on and off balance sheet credit products
Regulatory Capital Funds (loans, guarantees etc) which are subject to credit risk
• (CAR) = ------------------------------------------- > 8%
• Credit risk weights were divided into 5 categories: 0%, 10%,
Credit Risk Weighted Assets
20%, 50%, and 100%
– All Commercial loans, for example, were assigned to the 100% risk
• Became effective from 1992 weight category
– Cash and investments in govt. securities given 0% risk weight
• Objectives – Loans secured by residential mortgages given 50% risk weight
– Safety and soundness of individual banks through adequacy of capital
to support business growth
– Level playing field for internationally active banks

Basel II Accord
} Defined new calculation of } Too much regulatory
Credit Risk compliance Basel II: Credit Risk Standardized Approach
} Ensuring that capital } Basic assumption was pre
calculation is more sensitive
Risk Weights
cyclical process which fails
} Addition of Operational Risk in
the existing norms to consider capital Claims on sovereigns Claims on banks and securities firms

} Basel II uses a "three pillars" requirement changes with Credit Credit assessment of Banks Claims on
Assessment Credit corporates
ECA risk Risk
system- inflation/deflation in scores Weight
assessment of
Sovereign Risk weight
Risk weight
for short-
◦ Minimum capital requirements economy term
(addressing risk)
◦ Supervisory review
} Heavy dependence on AAA to AA- 1 0% 20% 20% 20% 20%

◦ Market discipline external rating agencies A+ to A- 2 20% 50% 50% 20% 50%
BBB+ to BBB- 3 50% 100% 50% 20% 100%

BB+ to BB- 4~6 100% 100% 100% 50% 100%

Norms Pitfalls B+ to B- 4~6 100% 100% 100% 50% 150%
Below B- 7 150% 150% 150% 150% 150%
September 16, 2020 35 Unrated - 100% 100% 50% 20% 100%

Basel II: Risk Weighted Assets

Assets
Capital Charge for Credit Risk under Standardized Approach
Standardised Approach Risk Weight
Cash and Balances with Banks 6% RWA
Domestic Sovereigns 0%
Credit Risk 43%
Foreign Sovereigns 0% to rating Based
Investments 26% Public Sector Entities 20% to 150%
Market Risk 2% MDBs, BIS and IMF 20%
Risks in Banks 20% to 650%
Advances 64% Banking
Operational Risk 4% Primary Dealers 20% to 150%
Business
Corporates 20% to 150%
Fixed + Other Assets 4% Regulatory Retail Portfolios 75%
Total RWA (As % of On 49% Claims secured by Residential Property 50%, 75% & 100%based on LTV
and Off B/S Exposures)
Off B/S (as % of On B/S 22% Claims secured by Commercial Real Estate 100%
Assets)
NPA-Unsecured 50% to 150%
+ Secured 50% to 100% Depending upon Specific
Other Risks Provisions