Risk Management,Swaps & VAR

The potential loss an asset or a portfolio is likely to suffer due to a variety of reasons.

Risk Categories
Business risks

Business environment Economic cycles Industry cycles Industry trends Technology change Vision/strategy
Credit risk Market Risk

Inherent risk
Primary/ Financial Non Financial/ Operating
Transaction processing Liquidity risk

Legal

Compliance

Liability

Security

Tax

Reputation risk

Market, Credit and Operational Risk

Exposure to movements in risk factors

Market Risk

On positions which we can choose to close out

Risk factors in trading positions (and issuer risk)

Exposure to failure to perform

Credit Risk

Cannot choose to close out underlying transaction Although we may be able to distribute risk

Operational Risk

Exposure to failure of people, processes and systems both internal and external do not choose to take on

Harder to measure
Concentration on identifying / mitigating

NON-FINANCIAL RISKS

Operational Risk arises as a result of failure of operating system in the bank due to certain reasons like fraudulent activities, natural disaster, human error, omission or sabotage etc. Systemic Risk is seen when the failure of one financial institution spreads as chain reaction to threaten the financial stability of the financial system as a whole. Political Risk arises due to introduction of Service tax or increase in income tax, freezing the assets of the bank by the legal authority etc. Human Risk Labour unrest, lack of motivation, inadequate skills, problems faced by the bank after implementation of VRS lead to Human Risk. Technology Risk Obsolescence, mismatches, breakdowns, adoption of latest technology by competitors, etc, come under technology risk

Credit Risk in banks

Traditional banking products, e.g.

Loans commitments to lend letters of credit

Traded products e.g.

OTC derivatives Repos (and reverse repos) Securities borrowing and lending
Foreign exchange

Plus settlement risk on e.g.

Statistical view of Credit Risk

Counterparty/ Group level Probability of default x Loss given default x Exposure at default Theoretical expected loss Building block for
Credit portfolio
Frequency

Cost of credit risk

Portfolio level

s
Loss

Statistical loss

Stress loss

MANAGEMENT OF CREDIT RISK

Measurement through Credit Rating / scoring Quantification through estimate of expected loan losses Pricing on a scientific basis Controlling through Effective loan review mechanism and portfolio management

TOOLS OF CREDIT RISK MANAGEMENT

EXPOSURE CEILINGS :Setting
of prudential norms related to the Banks exposure to a single borrower / group borrowers / sectorial borrowers

REVIEW / RENEWAL :

This involves multi-tier credit approving authority, constitution wise delegation of powers, higher delegated powers for better rated borrowers, discriminatory time for credit review / renewal, hurdle rates / benchmarks for fresh exposures & periodicity for renewal based on risk rating.

COMPREHENSIVE RISK RATING MODELS

RISK BASED SCIENTIFIC PRICING:
pricing to expected loss Linking loan

PORTFOLIO MANAGEMENT :

Stipulate quantitative ceiling on specific rating categories, distribution of borrowers in various industries / business groups , rapid portfolio reviews, ongoing system for identification of credit weaknesses well in advance, initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision making process.

TOOLS OF CREDIT RISK MANAGEMENT

LOAN REVIEW MECHANISM : This should be done independent of credit operations & administration and cover all the loans above certain cut-off limit ensuring that at least 30 40% of the portfolio is subjected to LRM in a year.

Operational Risk

This is the risk arising out of inadequate or internal processes, people and systems from external events. The best protection against operational risks consists of - redundancies of systems - clear separation of responsibilities with strong internal controls - regular contingency planning.

12

Barings ( 1995)

233 year old bank collapses under $1.24 Billion loss Lack of Internal Controls No segregation of duties (Front and back office) Poor authorisation procedures Lack of management awareness of inherent risk Fraud Market risk

Operational Risk Definitions

Transaction Processing Risk (TPR) is the risk of financial loss due
to deficiencies in transaction processing systems or internal controls front to back.

Liability Risk is the risk of loss

arising from potential or actual liability resulting from a legal or equitable claim, including contractual and legal claims, debt, and actions based on breach or default of contract, commitment of tort, violation of criminal law, infringement of trademark or antitrust action.

Compliance Risk is the risk of loss

incurred by the Bank by not adhering to the applicable laws, rules and regulations, local and international best practice (including ethical standards) and our own internal standards.

Security Risk is the risk of loss or

damage to our reputation arising from a loss of confidentiality, integrity or availability of our information or assets.

Legal Risk is the risk of financial loss

resulting from the non-enforceability of rights arising under a contract or from property or under the general law.

Tax Risk is the risk of loss due to tax

authorities successfully opposing the Banks position in tax returns.

What?

Who?

How?

Why?

You

Operational Risk Drivers

High Profile Losses Reputational damage Regulatory Pressure SOX (Sarbanes Oxley Act) Basle II MiFID (Markets in Financial Instruments Directive) Competitive Advantage Outsourcing / Offshoring Technology Advancement Business Growth (Trade volume and human capital) Product Complexity and Evolution Emerging Market Opportunity

Structuring RM functions

Set firm-wide policies Develop methodology Set RM structure Risk communication

Active Risk Management

Allocate capital
Stress Market, Credit VaR Monitor Identify and avoid

RAROC

Risk Analysis

Limit Management

RAROC

Risk Adjusted Rate of Return

Performance measurement
Marginal impact of any new

transaction

Consistent pricing

Risk Measurement

Consistent market based method Old

limits duration, ALM

VaR + Stress Backtesting

Organizational structure

Front office

Middle office
Back office

Front office

execution
risk taking marketing

Middle office

risk management
pricing

economic forecasts

Back office

verification
booking reporting collection settlement

ALCO

Assets Liability management committee responsible for

establishing documenting enforcing all policies involving market risk

FX liquidity interest rate

Interdependence of RM
Senior Management
Trading Room

Risk Management

Operations

Finance

Senior management

Approves business plan and targets Sets risk tolerance Establishes policy Ensures performance

Trading Room Management

Establishes and manages risk exposure Ensures timely and accurate deal capture Signs off on official P&L

Operations

Books and settles the trades Reconciles front and back office positions

Prepares and decomposes daily P&L Provides independent MTM Supports business needs

Finance

Develops valuation and finance policy Ensures integrity of P&L Manages business planning process Supports business needs

Risk Management

Develops risk policies Monitors compliance to limits Manages ALCO process Vets models and spreadsheets

Provides independent view on risk

Supports business needs

Risk Limits

Global risk limit Risk limits for trading desks/units Dynamic monitoring and adjustment

Risk Approaches

Accounting - reported P&L Economic - value Liquidity needs

Liquidity Rank

Based on forecasts and potential availability

of funds.

Hot funds - can be withdrawn quickly.

Stable funds - typically to maturity.

Qualitative Requirements

An independent risk management unit Board of directors involvement Internal model as an integral part Internal controller and risk model Backtesting Stress test

Quantitative Requirements

99% confidence interval 10 business days horizon At least one year of historic data Data base revised at least every quarter All types of risk exposure Derivatives

Types of Assets and Risks

Real projects - cashflow versus

financing

Fixed Income

Options
Credit exposure

Legal, operational, authorities

Risk Factors
There are many bonds, stocks and currencies. The idea is to choose a small set of relevant economic factors and to map everything on these factors.

Exchange rates Interest rates (for each maturity and indexation)

Spreads
Stock indices

Swap

currency or interest rate two loans with swapped payments low credit risk

changes exposure:

currency

duration

Description

A swap is an agreement between two parties to exchange (swap) payments at certain dates in the future.

As payments to B

Counterparty A
Bs payments to A

Counterparty B

Plain vanilla swap

Counterparty A is called the fixed rate payer or swap buyer Counterparty B is called the floating rate payer or swap seller

Fixed rate payments

Counterparty A
Floating rate payments

Counterparty B

Example

In this five-year swap, 12-month LIBOR is swapped for 2.67% fixed, on $100 million. At initiation, the planned payments are:
Hypothetical 5-year Swap
Year 0 1 2 3 4 5 1-yr LIBOR 1.52% 2.00% 2.60% 3.30% 4.12% Floating Leg Payment $ $ $ $ $ 1,520,000 2,000,000 2,600,000 3,300,000 4,120,000 Fixed rate 2.67% 2.67% 2.67% 2.67% 2.67% Fixed Leg Payment $ $ $ $ $ 2,670,000 2,670,000 2,670,000 2,670,000 2,670,000

Value at Risk

The Question Being Asked in VaR

What loss level is such that we are X% confident it will not be exceeded in N business days?

Choice of confidence level 95%

5%

95%
Investment returns

Normal market conditions the returns that account for 95% of the distribution of possible outcomes. Abnormal market conditions the returns that account for the other 5% of the possible outcomes.

If a 95% confidence level is used to estimate Value at Risk for a monthly horizon; losses greater than the Value at Risk estimate are expected to occur one in twenty months (5%).

Common Interpretations of Value at Risk:

an attempt to provide a single number for senior management summarizing the total risk in a portfolio of assets Hull an estimate, with a given degree of confidence, of how much one can lose from ones portfolio over a given time horizon Wilmott

Value at Risk:

ValueAtRisk V0 (1 e )
r*

m r* 1.645 * s

Conclusions:

Value at Risk can be used as a stand alone risk measure or be applied to a portfolio of assets. Value at Risk is a dollar value risk measure, as opposed to the other measurements of risk in the financial industry such as: beta and standard deviation. We are X percent certain that we will not lose more than V dollars in the next N days. Hull

Measures of Risk

Standard Deviation (s) Beta () Value at Risk (VaR)

Measured by VAR

Measured by

Stand-Alone Risk Or Total Risk

Systematic Risk NonDiversifiable Risk

Unsystematic Risk Diversifiable Risk

Market Risk

CompanySpecific Risk

Risk Measure - Beta ()

Beta () formula:
Cov(ki , k m ) Var (k m ) Beta measures the portfolios systematic risk, that is, the degree to which its return is correlated with the return on the market as a whole. Stock with high beta (>1) is more volatile than the market taken as a whole.

Risk Measures Value at Risk (VaR)

VaR is a measure of risk based on a probability of loss and a specific time horizon. VaR translates portfolio volatility into a dollar value. Measure of Total Risk) rather than Systematic (or Non-Diversifiable Risk) measured by Beta.

Advantages of VaR

It captures an important aspect of risk in a single number It is easy to understand It asks the simple question: How bad can things get?

Advantages of VaR

VaR can measure the risk of many types of financial securities (i.e., stocks, bonds, commodities, foreign exchange, off-balance-sheet derivatives such as futures, forwards, swaps, and options, and etc.) As a tool, VaR is very useful for comparing a portfolio with the market portfolio (S&P500).

VaR vs. C-VaR

VaR is the loss level that will not be exceeded with a specified probability C-VaR Conditional VaR(or expected shortfall) is the expected loss given that the loss is greater than the VaR level C-VaR is not widely used