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Financial risk is the prospect of financial loss or gain due to unforeseen changes in the
underlying risk factors market risk, credit risk, operational risk.
Market Risk
Market Risk is the risk of loss or gain arising from unexpected changes in market
prices such as security prices) or market rates (such as interest rates or exchange
rates).
Credit risk
The risk of loss arising from failure of counterparty to make a promised payment.
Operational Risk
Risk of loss arising from failure of internal systems or people who operate in them.
n this study emphasis is laid on one particular form of financial risk namely market
risk, or the risk of loss or gain arising from unexpected changes in market prices such
as security prices) or market rates (such as interest rates or exchange rates)
The theory and practice of risk management! and included within that risk
measurement ha"e de"eloped enormously since the pioneering work of #arry
Markowit$ in the %&'(s. The theory has attracted a huge amount of intellectual energy
from specialists and the theory has de"eloped to an extent that where risk
measurement is regarded as a distinct su)!field of finance.
*ne factor )ehind the rapid de"elopment of risk management was the high le"el of
insta)ility in the economic en"ironment within which firms operated. + "olatile
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en"ironment exposes firms to greater financial risks and therefore pro"ides an
incenti"e for firms to find new and )etter way of managing this risk7 the "olatility in
the economic en"ironment is reflected in the "arious factors8
Stock market Volatility
,tock markets ha"e always )een "olatile, )ut sometimes extremely so8 for example.
*n *cto)er %&,%&93 the 4ow :ones fell 0;< and in the process knocked off o"er = %
trillion in e>uity capital8 and from :uly 0%, through +ugust ;%, %&&9. The 4ow :ones
lost %9< of its "alue . *ther western stock markets ha"e experienced similar falls and
some +sian ones ha"e experienced much worse ones (the ,outh ?orean stock markets
lost o"er half of its "alue during %&&3).
Exchange rate Volatility
6xchange rates ha"e )een "olatile e"er since the )reakdown of the 5retton @oods
system of fixed exchange rates. n the early %&3(s occasional exchange rate crisis
ha"e also led to sudden and significant exchange rate changes, including! among
many others the 6RM de"aluations of ,ept %&&0, the pro)lem of the -eso in %&&1, the
6ast asian currency pro)lems of %&&3!%&&9, the Rou)le crisis of %&&9 and 5ra$il in
%&&&.
Interest rate Volatility
There ha"e )een maAor fluctuations in interest rates, with their attendant effects on the
funding costs, corporate cash flows and asset "alues , for example, the Fed Funds rate,
a good indicator of short term market rates in the B,, approximately dou)led o"er
%&&1.
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Commodity market Volatility
Commodity markets are notoriously "olatile and commodity prices often go through
long periods of apparent sta)ility and then suddenly Aump )y enormous amounts8 for
instance in %&&(, the price of @est Texas intermediate crude oil rose from a little o"er
=%' a )arrel to round =1( a )arrel. ,ome commodity prices also show extremely
pronounced day!to!day and e"en hour!to hour "olatility.
+nother factor contri)uting to the transformation of risk management is the huge
increase in trading acti"ity since the late %&D(s. There ha"e )een massi"e increases in
the range of instruments traded o"er the past two or three decades, and trading
"olumes in these new instruments ha"e new instruments ha"e also grown rapidly.
+ third contri)uting factor to the de"elopment of risk management was the rapid
ad"ance in the state of information technology impro"ements in T ha"e made
possi)le huge increase in )oth computational power and the speed with which
calculations can )e carried out. mpro"ements in computing power, increase in
computing speed and reductions in the computing costs ha"e thus come together to
transform the technology a"aila)le for risk management.
1. Introduction
The concept of Ealue at Risk has emerged as the centerpiece of the trend towards the
measurement and management of market risk in financial transactions.
Market risk has )een present in the process of financial intermediation all along.
,e"eral factors ha"e contri)uted to the increased focus on risk management8 the
deregulation of financial markets7 the increase in risk profile of organi$ations, with
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increased emphasis on acti"ities that re>uire the deli)erate assumption of risk7 the
"olatility of markets and its impact on financial institutions7 the pressure from capital
market in"estors for returns related to the relati"e riskiness of their in"estments7 and
the regulatory pressures on a risk management framework
The concept of risk has assumed a new paradigm. That is, the nature of risk!taking has
changed. Traditional risk!taking was confined to )alance!sheet!oriented interest rate
risk created )y deli)erate maturity mismatches. ,upplementary risk!taking may ha"e
)een present in areas such as currency or securities trading.
Modern risk!taking, howe"er, is more di"erse in nature. t encompasses traditional
forms of risk!taking and increased trading in other asset classes. This increased
trading focus is dri"en )y )oth client demands in terms of market making, and
proprietary or own!account trading, in search of return. This change reflects in no
small part the increasing di"ersity of the acti"ities undertaken )y financial institutions,
including acti"ities in all asset classes (de)t, currency, e>uity and commodities) and in
)usinesses ranging from )alance!sheet!dri"en acti"ities (such as lending), off!)alance!
sheet acti"ities (such as underwriting and securities distri)ution and risk management
instruments), to pure fee!)ased acti"ities (such as in"estment management, custody
ser"ices and cash!management ser"ices).
The remainder of the report has )een organi$ed as follows.
,ection 0 outlines the o)Aecti"es of the study. ,ection ; gi"es a )rief o"er"iew of
literature on Ealue at Risk. Further, ,ection 1 discusses the e"olution of Ealue at Risk
and the increasing importance of risk management )y taking cues from the financial
disasters of yesteryears, thus highlighting the importance of measuring and
monitoring such risks. ,ection ' gi"es a )rief introduction to the concept of Ealue at
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Risk (EaR). ,ection D descri)es the application of Ealue at Risk to "arious financial
instruments. ,ection 3 descri)es the three methods used for computation of Ealue at
Risk (EaR). ,ection 9 highlights the empirical work. ,ection & highlights the findings.
,ection %( tests the "alidity of the model. ,ection %% pro"ides the scope for further
research. ,ection %0 gi"es the limitation of the study and section %; concludes the
study.
2. Objectives of the study
This study explores the possi)ility of using Ealue at Risk (EaR) approach to >uantify
the risk associated with a trading portfolio. The EaR )ased margin will )e large
enough to co"er a one!day loss that can )e encountered on &&< of the days. t
computes the Ealue at Risk figure using the historical simulation and "ariance!
co"ariance method for a forex portfolio and tests the "alidity of the model to draw
specific conclusions.
3. Literature Review
The literature on EaR has de"eloped greatly in the last few years. Recent work that
has )een concluded on EaR is8
,unil ?umar and M. :ayade"
%
(0((1) computed the margin re>uirements )ased on
daily EaR for %'!sample commodity futures contracts from four exchanges and
compared them with margin computation traditionally used )y these exchanges.
%
CF+ :ournal of +pplied Finance
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/angadhar 4ar)ha
0
compute the EaR for a set of fixed income securities )ased on
extreme "alue theory. t compares the estimates of EaR for a portfolio of fixed income
securities across three methods8 Eariance!Co"ariance method, #istorical ,imulation
method and 6xtreme Ealue method and finds that extreme "alue method pro"ides the
accurate EaR estimator in terms of correct failure ratio and the si$e of EaR.
. !he evo"ution of #a"ue at Ris$
.1 Ris$ mana%ement before #a"ue at Ris$
/ap analysis
*ne common approach was gap analysis. /ap analysis )egins with determination of
an appropriate holding period and then determine how much of the asset or lia)ility
will re!price during this period and the amounts in"ol"ed gi"e us our rate!sensiti"e
assets and rate!sensiti"e lia)ilities. The gap is the difference )etween rate!sensiti"e
assets and rate!sensiti"e lia)ilities and the interest rate exposure is taken to )e the
change in net interest income that occurs in response to a change in interest rates. This
inturn is assumed to )e e>ual to the gap times the interest!rate change.
/ap analysis is simple to carry out, )ut has its limitations8 it only applies to on!
)alance sheet interest!rate risk, and e"en then only crudely7 it looks at the impact of
interest rates on income, rather than on asset or lia)ility "alues7 and results can )e
sensiti"e to the choice of hori$on period.
4uration +nalysis
4uration +nalysis is another method traditionally used )y financial institutions for
measuring interest!rate risks. The (MacaulayFs) duration 4 of a )ond (or any other
0
www.nseindia2researchpapers.com
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fixed!income security) can )e defined as the weighted a"erage term to maturity of the
)ondFs cash flows, where the weights are the present "alue of each cash flow relati"e
to the present "alue of all cash flows.
The duration measure is useful )ecause it gi"es an approximate indication of the
sensiti"ity of a )ond price to a change in yield8
< Change in )ond price G4
x
HI y2(l J y)
where y is the yield and Iy is the change in yield. The )igger the duration, the more
the )ond price changes in response to a change in yield. The duration approach is "ery
con"enient )ecause duration measures are easy to calculate and the duration of a )ond
portfolio is a simple weighted a"erage of the durations of the indi"idual )onds in that
portfolio. t is also )etter than gap analysis )ecause it looks at changes in asset (or
lia)ility) "alues, rather than Aust changes in net income.
#owe"er, duration approaches ha"e similar limitations to gap analysis8 they ignore
risks other than interest!rate risk7 they are crude, and e"en with "arious refinements to
impro"e accuracy, duration!)ased approaches are still inaccurate relati"e to more
recent approaches to fixed!income analysis. Moreo"er, the main reason for using
duration approaches in the past G their (comparati"e) ease of calculation G is no
longer of much significance, since more sophisticated models can now )e
programmed to gi"e their users more accurate answers rapidly.
,cenario +nalysis
+ third approach is scenario analysis (or Kwhat ifF analysis), in which we set out
different scenarios and in"estigate what we stand to gain or lose under them. To carry
out scenario analysis, we select a set of scenarios G or paths descri)ing how rele"ant
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"aria)les (e.g., stock prices, interest rates, exchange rates, etc.) might e"ol"e o"er a
hori$on period. @e then postulate the cash flows and2or accounting "alues of assets
and lia)ilities, as they would de"elop under each scenario, and use the results to come
to a "iew a)out our exposure.
,cenario analysis is complex to carry out. + lot hinges on oneFs a)ility to identify the
KrightF scenarios, and there are relati"ely few rules to guide us when selecting them.
,cenario analysis also does not tell us anything a)out the likelihood of different
scenarios, so we need to use our Audgement when assessing the practical significance
of different scenarios. Thus, the results of scenario analyses are highly su)Aecti"e and
depend to a "ery large extent on the skill or otherwise of the analyst.
-ortfolio Theory
+ somewhat different approach to risk measurement is pro"ided )y portfolio theory.
-ortfolio theory starts from the premise that in"estors choose )etween portfolios on
the )asis of their expected return, on the one hand, and the standard de"iation (or
"ariance) of their return, on the other. The standard de"iation of the portfolio return
can )e regarded as a measure of the portfolioFs risk. *ther things )eing e>ual, an
in"estor wants a portfolio whose return has a high expected "alue and a low standard
de"iation. These o)Aecti"es imply that the in"estor should choose a portfolio that
maximises expected return for any gi"en portfolio standard de"iation or, alternati"ely,
minimises standard de"iation for any gi"en expected return.
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4.2 The origin and development of Value at Risk
n the late %&3(s and %&9(s, a num)er of maAor financial institutions started work on
internal models to measure and aggregate risks across the institution as a whole. They
started work on these models in the first instance for their own internal risk
management purpose!as firms )ecame more complex, it was )ecoming increasingly
difficult, )ut also increasingly important, to )e a)le to aggregate their risks taking
account of how they interact with each other, and firms lacked the methodology to do
so.
The )est known of these systems is the RiskMetrics system de"eloped )y :- Morgan.
+ccording to industry legend, this system is said to ha"e originated when the
chairman of :- Morgan, 4ennis @eatherstone, asked his staff to gi"e his a daily one!
page report indicating risk and potential losses o"er the next 01 hours, across the
)ankFs entire trading portfolio. This report!the famous K18%' reportF was to )e gi"en
to him at 18%' each day, after the close of trading. n order to meet this demand, the
Morgan staff had to de"elop a system to measure risks across different trading
positions, across the whole institution, and also aggregate these risks into a single risk
measure. The measure used was "alue at risk (or EaR), or the maximum likely loss
o"er the next trading day, and the EaR was estimated from a system )ased on standard
portfolio theory, using estimates of the standard de"iations and correlations )etween
the returns to different traded instruments. @hile the theory was straightforward,
making this system operational in"ol"ed a huge amount of work8 measurement
con"entions had to )e chosen data sets constructed, statistical assumptions agreed,
procedures determined to estimate "olatilities and correlations, computing systems
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esta)lished to carry out estimations, and many other practical pro)lems resol"ed.
4e"eloping this methodology took a long time, )ut )y around %&&(, the main
elements! the data systems, the risk measurement methodology and the )asic
mechanics!were all in place and working reasona)ly well. +t that point it was decided
to start using the K18%' reportF, and it was soon found that the new risk management
system had a maAor positi"e effect. n particular, it Ksensitised senior management to
risk!return trade!offs and led o"er time to a much more efficient allocation of risks
across the trading )usinessesF (/uldimann (0(((, p. '3). The new risk system was
highlighted in :- MorganFs %&&; research conference and aroused a great deal of
interest from potential clients who wished to )uy or lease it for their own purposes.
Meanwhile, other financial institutions had )een working on their own internal
models, and EaR software systems were also )eing de"eloped )y specialist companies
that concentrated on software systems were also )eing de"eloped )y specialist
companies that concentrated on software )ut were not in a position to pro"ide data.
The resulting systems differed >uite considera)ly from each other. 6"en where they
were )ased on )roadly similar theoretical ideas, there were still considera)le
differences in terms of su)sidiary assumptions, use of data, procedures to estimate
"olatility and correlation, and many other KdetailsF. 5esides, not all EaR systems were
)ased on portfolio theory8 some Ksystems were )uilt using historical simulation
approaches that estimate EaR from histograms of past profit and loss data and other
systems were de"eloped using Monte Carlo ,imulation techni>ues.
These firms were keen to encourage their management consultancy )usinesses, )ut at
the same time they were conscious of the limitations of their own models and wary
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a)out gi"ing too many secrets away. @hilst most firms kept their models secret, :-
Morgan decided to make its data and )asic methodology a"aila)le so that outside
parties could use them to write their own risk management software. 6arly in %&&1,
Morgan set up the Risk Metrics unit to do this and the Risk Metrics model!a
simplified "ersion of the firmFs own internal model!was completed in eight months. n
*cto)er that year, Morgan then made its Risk Metrics system and the necessary data
freely a"aila)le on the internet8 outside users could now access the Risk Metrics
model and plug their own position data into it.
This )old mo"e attracted a lot of attention, and the resulting pu)lic de)ate a)out the
merits of Risk Metrics was useful in raising awareness of EaR and of the issues
in"ol"ed in esta)lishing and operating EaR systems. n +ddition, making the Risk
Metrics data a"aila)le ga"e a maAor )oost to the spread of EaR systems )y gi"ing
software pro"iders and their clients access to data sets that they were often una)le to
construct themsel"es. t also encouraged many of the smaller software pro"iders to
adopt the Risk Metrics approach or make their own ,ystems compati)le with it.
The ,u)se>uent adoption of EaR systems was "ery rapid, first among securities
houses and in"estment )anks, and then among commercial )anks, pension funds and
other financial institutions, and non financial corporates. .eedless to say, the state of
the art also impro"ed rapidly. 4e"elopers and users )ecame more experienced7 the
com)ination of plummeting T costs and continuing software de"elopment meant that
systems )ecame more powerful and much faster, and a)le to perform tasks that were
pre"iously not feasi)le7 EaR systems were extended to co"er more types of
instruments7 and the EaR methodology itself was extended to deal with other types of
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risk )esides the market risks for which EaR systems were first de"eloped, including
credit risks, li>uidity risks and cash!flow risks.
n the modern day risk management systems, Ealue!at!Risk (EaR) has )een widely
promoted )y regulatory groups and em)raced )y financial institutions as a way of
monitoring and managing market risk ! the risk of loss due to ad"erse mo"ements in
interest rate, exchange rate, e>uity and commodity exposures ! and as a )asis for
setting regulatory minimum capital standards. The re"ised 5asle +ccord, implemented
in :anuary %&&9, allows )anks to use EaR as a )asis for determining how much
additional capital must )e set aside to co"er market risk )eyond that re>uired for
credit risk. Market related risk has )ecome more rele"ant and important due to the
trading acti"ities and market positions taken )y large )anks. +nother impetus for such
a measure has come from the numerous and su)stantial losses that ha"e arisen due to
shortcomings in risk management procedures that failed to detect errors in deri"ati"es
pricing (.atwest, B5,), excessi"e risk taking (*range County, -roctor and /am)le),
as well as fraudulent )eha"ior (5arings and ,umitomo).
The Ealue!at!Risk (EaR) is now a widely used measure of market risk in finance and
economics literature. Following the recommendations of the 5asle Committee on
5anking ,uper"ision (5asle Committee, %&&Da) of the 5ank for nternational
,ettlement (5,), central )anks in almost all countries re>uire their super"ised )anks
to measure market risk with EaR. n principle, not only )anks )ut any in"estor also
can use EaR to assess the extent of possi)le loss in their portfolios due to market
fluctuations. ,o, today, EaR is perhaps the most common measure of a portfolioFs
exposure to loss (Chow and ?irt$man, 0((0).
;
;
The )road categories of risk in financial markets are )usiness risk, strategic risk and financial risk. The financial
risks are of different type,like, credit risk, li>uidity risk, operational risk and market risk. The concept of EaR is
mainly concerned with market risk ("an den /oor)ergh and Elaar, %&&&7 Tsay, 0((0).
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.3 Lessons from &inancia" 'isasters
Source( www.%tnews.com
.3.1 Oran%e )ounty )ase
The purpose of this case is to explain how a municipality can lose =%.D )illion in
financial markets. The case also introduces the concept of LEalue at RiskL (E+R),
which is a simple method to express the risk of a portfolio. +fter the string of recent
deri"ati"es disasters, financial institutions, end!users, regulators, and central )ankers
are now turning to E+R as a method to foster sta)ility in financial markets. The case
illustrates how E+R could ha"e )een applied to the *range County portfolio to warn
in"estors of the risks they were incurring.
n 4ecem)er %&&1, *range County stunned the markets )y announcing that its
in"estment pool had suffered a loss of =%.D )illion. This was the largest loss e"er
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recorded )y a local go"ernment in"estment pool, and led to the )ankruptcy of the
county shortly thereafter.
This loss was the result of unsuper"ised in"estment acti"ity of 5o) Citron, the County
Treasurer, who was entrusted with a =3.' )illion portfolio )elonging to county
schools, cities, special districts and the county itself. n times of fiscal restraints,
Citron was "iewed as a wi$ard who could painlessly deli"er greater returns to
in"estors. ndeed, Citron deli"ered returns a)out 0< higher than the compara)le ,tate
pool.
Citron was a)le to increase returns on the pool )y in"esting in deri"ati"es securities
and le"eraging the portfolio to the hilt. The pool was in such demand due to its track
record that Citron had to turn down in"estments )y agencies outside *range County.
,ome local school districts and cities e"en issued short!term taxa)le notes to rein"est
in the pool (there)y increasing their le"erage e"en further).
The in"estment strategy worked excellently until %&&1, when the Fed started a series
of interest rate hikes that caused se"ere losses to the pool. nitially, this was
announced as a MMpaperNN loss. ,hortly thereafter, the county declared )ankruptcy and
decided to li>uidate the portfolio, there)y reali$ing the paper loss.
5o) Citron was implementing a )ig )et that interest rates would fall or stay low. The
=3.' )illion of in"estor e>uity was le"eraged into a =0(.' )illion portfolio. Through
reverse repurchase agreements, Citron pledged his securities as collateral and
rein"ested the cash in new securities, mostly '!year notes issued )y go"ernment!
sponsored agencies..
The portfolio le"erage magnified the effect of mo"ements in interest rates. CitronFs
main purpose was to increase current income )y exploiting the fact that medium!term
maturities had higher yields than short!term in"estments. *n 4ecem)er %&&;, for
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instance, short!term yields were less than ;<, while '!year yields were around '.0<.
@ith such a positi"ely sloped term structure of interest rates, the tendency may )e to
increase the duration of the in"estment to pick up an extra yield. This )oost, of course,
comes at the expense of greater risk.
The strategy worked fine as long as interest rates went down. n Fe)ruary %&&1,
howe"er, the Federal Reser"e 5ank started a series of six consecuti"e interest rates
increase, which led to a )lood)ath in the )ond market. The large duration led to a =%.D
)illion loss.
.3.2 *arin%s *an$ co""a+se
The collapse of 5arings )ank can )e traced to a trader, .ick Oeeson who )rought
5arings )ank to its knees with losses of more that % )illion pounds sterling.
.ick Oeeson was the Chief 4eri"ati"es trader on the ,ingapore 4eri"ati"es Market
for 5arings )ut in charge of ,ettlements at the same time. +s part of the settlement
duties, he arranged the payments to the stock exchange to co"er 5arings trading at the
end of each day.
Therefore, when he made a loss he was a)le to transfer it into another internal hidden
account, then keep on trading showing no loss, whilst regularly making up excuses to
his superiors a)out why he re>uired more cash to )e wired from Oondon to co"er his
trading. #e was in fact trading with 5arings money, not their clients.
6"entually, he had so much money at the mercy of the market, that any swing
downward (for the .ikkei :apanese index) would result in huge losses for 5arings.
Bnfortunately, for him and all his colleagues, there was an earth>uake in :apan and
the Market crashed and didnNt )ounce as heNd hoped.
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-erhaps one reason for the pro)lem was the lack of understanding of market risk and
risk management. Market Risk monitoring would ha"e shown his managers how risky
their trading methods were )efore.
.3.3 ,eta""%ese""schaft