CHAPTER 15

Market Risk

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Calculating Market Risk Exposure
 Many market risk models are developed.
 Generally concerned with estimated
potential loss under adverse circumstances
 Three major approaches of measurement:
– JPM RiskMetrics (or variance/covariance
approach)
– Historic or Back Simulation
– Monte Carlo Simulation

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 RiskMetrics Model
– The ultimate objective of the market risk
measurement can be seen in this
statement; “At close of business each
day tell me what the market risks are cross
all the business and locations”
– Or it can be seen in this “ I am X% sure
that the FI will not lose more than $VAR in
the next T days”
– FIs have an active trading positions in
fixed income securities, FX, derivatives,
proprietary assets…etc.
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 RiskMetrics Model
– So FI’s managers need to know a single
dollar number to tell what FI’s market risk
exposure will be next day- especially if
those days turn out to be extremely “bad”
days.
– That is, FI concentrates on measuring the
market risk exposure at the close of
business day (on daily basis), because it
concerns with how to preserve equity if
market conditions move adversely next
day.
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 RiskMetrics Model
– Market risk = Estimated potential loss under
adverse circumstances.
– Idea is to determine the daily earnings at
risk, which has three components
= dollar market value of position × price
sensitivity × potential adverse move in yield
or,
DEAR = dollar market value of position ×
price volatility.

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 RiskMetrics Model
Where,
price volatility = price sensitivity of position ×
potential adverse move in yield

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Market risk of Fixed-Income Securities
 When FI hold Fixed-income securities in its
trading portfolio, then it want to know
potential exposure that it could face should
interest rate move against the FI.

 The amount of loss depends on the bond’s

price volatility.

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Market risk of Fixed-Income Securities
 Daily price volatility can be stated as:
DPV = (MD) × (potential adverse daily yield
move)
where,
MD = D/(1+R).
MD = Modified duration
D = Macaulay duration

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Market risk of Fixed-Income Securities
– Example: Suppose that we are long in 7-
year zero-coupon bonds, with face value
$1,631,483 and 7.243% yield.
– The market value of this position is
&1,000,000.
– The risk in this case will be result from the
change in the yield (i.e. an increase in the
interest rate).
– So, we need to define the probability of
“bad” yield changes; suppose that there is
only a 5% chance of the yield change.
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Market risk of Fixed-Income Securities
– Based on the probability of outcome; The
point here is to determine the amount of
the adverse change in the yield.

– To do so we use the normal distribution (of

the past changes in yields of 7 year zero
coupon bond) to get an estimate of the
size of the adverse rate move through
building of the confidence intervals.

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 Confidence Intervals
– If we assume that changes in the yield are
normally distributed, we can construct
confidence intervals around the projected DEAR
(other distributions can be accommodated but
normal is generally sufficient)
–Assuming normality, 90% of the time the
disturbance (i.e. yield changes )will be within
±1.65 standard deviations of the mean
 (5% of the extreme values remain in each tail of
the distribution)
 10% of the area under the normal distribution is
found beyond ±1.65σ .
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 Confidence Intervals: Example
– Thus, the adverse move in the yield will be
±1.65 σ (the yield have fluctuated by more
than ±1.65 σ )
– Concern is that yields will rise more than the
expected deviation. If the standard
deviation is 10 basis points. this corresponds to
16.5 basis points.

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Adverse 7-Year Rate Move

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 Confidence Intervals: Example
 Yield on the bonds = 7.243%, so MD =
6.527 years
 Price volatility = (MD)  (Potential
adverse change in yield)
= (6.527)  (0.00165) = 1.077%
DEAR = Market value of position  (Price
volatility)
= ($1,000,000)  (.01077) = $10,770
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Confidence Intervals: Example
 To calculate the potential loss for more
than one day:
Market value at risk
(VARN) = DEAR ×
 Example:
For a five-day period,
VAR5 = $10,770 ×
= $24,082

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 Foreign Exchange
 In the case of foreign exchange, DEAR
is computed in the same fashion we
employed for interest rate risk
 DEAR = dollar value of position × FX
rate volatility, where the FX rate
volatility is taken as 1.65 sFX

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 Foreign Exchange
 Example: Suppose the FI had a 1.4 million
trading position in spot Euros.
 The risk exposure in this case, is that the next
day will be the bad day with respect to the
value of the euro against dollar.
 If the volatility or standard deviation of daily
changes in the spot exchange rate is 56.5
bp.
 Suppose that FI is interested in adverse
move; the probability of bad moves is 5%.
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 Foreign Exchange
 So if historical exchange rats are normally
distributed, then the exchange rates must
change in the adverse direction (i.e. volatility)
by 1.65 X .

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 Foreign Exchange
 First: find the dollar value of the position: FX
position X exchange rate ($ per unit of foreign
currency)
 Dollar value of position = 1.4 X 0.714286 = $ 1 m
 Second: DEAR = Dollar value position X FX
volatility
 DEAR= $1m X (1.65 x 56.5 bp) = $9,320

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 Equities
 For equities, total risk = systematic risk +
unsystematic risk
 Systematic risk reflects the co-movements of
the stock return with market portfolio and it is
measured by beta
 Unsystematic risk is the risk related to the firm
itself.
 If the portfolio is well diversified, FI’s portfolio
follows stock market portfolio, then the
standard deviation of the portfolio will be
equal to the standard deviation of the stock
market index. 10-20
 Equities
 If the portfolio is well diversified, then
DEAR = dollar value of position × stock market
return volatility, where
market volatility taken as 1.65 sm

 If not well diversified, a degree of error will be

built into the DEAR calculation
 That is, DEAR will not depend only on
systematic risk but also the effect of
unsystematic risk should be considered.
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 Equities
 If FI hold $1 million trading position in stocks,
which reflects the U.S stock market, assuming
that, over the last year, the deviation in daily
returns (Standard deviation) on the stock
market index was 200 bp, and the adverse
move in returns is expected to occur 5% of the
times. then
DEAR = $ value of position × stock market
return volatility
= $1,000,000 x1.65 x 0.02 = $33,000

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 Aggregating DEAR Estimates
 Cannot simply sum up individual DEARs, and
consider the total as aggregate risk of the entire
trading position. Why?
 Because these individual trading positions
represent a trading portfolio in which we cannot
ignore any degree of offsetting covariance or
correlation among different trading positions.
 More specifically, the adverse moves related to
each trading position may be negatively related.
 In this case, we apply the portfolio theory in
calculating the risk for the entire trading portfolio.
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 Aggregating DEAR Estimates
 In order to aggregate the DEARs from individual
exposures we require the correlation matrix.
 Three-asset case:
DEAR portfolio = [DEARa2 + DEARb2 +
DEARc2 + 2rab × DEARa × DEARb + 2rac ×
DEARa × DEARc + 2rbc × DEARb × DEARc]1/2

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DEAR: Large US Banks 2005 & 2008

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 Historic or Back Simulation
 Risk Metrics model assume a symmetric
distribution for all asset returns.
 Because of this, new market risk model has
been developed; Historic or Back Simulation
model, which is:
- simple
- does not require the normality assumption.
- does not require the calculation of the
correlation or standard deviation of assets
return.
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 Historic or Back Simulation
 Basic idea: Revalue portfolio based on
actual prices (returns) on the assets
that existed yesterday, the day before
that, etc. (usually previous 500 days)
 Then calculate 5% worst-case (25th
lowest value of 500 days) outcomes
 That is, only 5% of the time, the value
of the portfolio would fall below this
number (i.e. 25th lowest value).
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 Estimation of VAR: Example
 Convert today’s FX positions into dollar
equivalents at today’s FX rates
 Measure sensitivity of each position
– Calculate its delta
 Measure risk
– Actual percentage changes in FX rates for
each of past 500 days
 Rank days by risk from worst to best
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 Historic or Back Simulation
 Advantages:
– Simplicity
– Does not need correlations or standard
deviations of individual asset returns
– Does not require normal distribution of
returns (which is a critical assumption for
RiskMetrics)
– Directly provides a worst case value,
while Risk Metrics does not.
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 Weaknesses
 Disadvantage: 500 observations is not
very many from a statistical standpoint
 Increasing number of observations by
going back further in time is not
desirable
 Risk manager could either weight
recent observations more heavily and
go further back or use Monte Carlo
Simulation approach.
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 Monte Carlo Simulation
 To overcome problem of limited number of
observations, additional observations can
be generated.
 This can be done by Monte Carlo
Simulation: is a tool for considering portfolio
valuation under all possible combinations of
factors that determine a security’s value.
 This model generated random market
values drawn from the multivariate normal
distributions representing each variable.

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 Monte Carlo Simulation
 Employs historic covariance matrix and
random number generator to obtain
the additional observations
– Objective is to replicate the distribution of
observed outcomes with synthetic data
 These additional observations reflect
the probability with which they have
occurred in recent historic time
periods.
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