Market risk

Question 1

Market risk is a risk of financial institutions earnings decreasing due to uncertainties in the movement of market factors, such as changes in interest rates, asset prices, market volatility and market liquidity. We use Value-at-risk to calculate the exposure of the market risk to a financial institution.

There are various risk factors in a portfolio consisting of:

 USD/ EUR forward contracts.

This is a contract that of purchase or sale of a currency on a future date in the foreign exchange market. These forward contracts are mainly done over-the-counter.

 USD/ EUR call options

It is a contract that gives the holder the right, but not the obligation to exchange a currency during a specific time period.

 Shares in various listed companies.

This comprises of a unit of a corporation’s financial asset ownership.

 Bonds issued by government and corporate borrowers.

This is a security of the indebtedness to the bond holder by the bond issuer

The methodologies for deriving forward distribution of the changes in value of portfolio include:

• Analytic variance-covariance Approach

• Historic (or back) simulation Approach

• Monte-Carlo simulation Approach

Historic Simulation Approach.

It is a theoretical methodology that uses changes in historical market rates and prices to develop a distribution of possible portfolio of profits and losses in the future. Identify existing market factors and method of obtaining mark-to-market amount of forward contract, determine the historical values for the last X periods, Subject the existing portfolio to changes in price in market rates for the last 100 days, Arrange mark-to-market values from the largest, choose the loss equaled or exceeded 5% of time, that is value at risk.(Thomas & Neil 1996)

Variance-covariance Approach

Assumes the existing market factors have normal distribution which is multivariate. It uses the standard properties of normal distribution to obtain the loss that will be the value at risk. Select basic market factors and standardized positions and map forward contract onto them. Assume changes in market factors is zero and estimate the parameters, Use correlations and standard deviation to obtain standardized position changes, calculate the variance and standard deviation.

Monte-Carlo Simulation

Value at risk is determined from statistical distribution believed to approximate changes in underlying market factors, determine underlying market factors and mark-to-market value of contract formula. Estimate parameters of a distribution by assuming specific distribution for market factor changes. Use pseudo-random generator to get X value of changes in market factors and continue as in historical simulation.

Advantages and Disadvantages of the three Approaches

Implementation: Historical simulation is easy and simple to implement given past values of market factors. Monte-Carlo takes more time to implement.

Flexibility: It is easier to do “what-if” analysis with variance-covariance and Monte-Carlo compared to Historical simulation which uses past data.

Reliability: Historical simulation depends directly on past data unlike the other two hence unique and more reliable.

Question 2;

a) The requirements imposed on banks under Basel accord are;

 8% of risk of weighted value consist of capital

 A minimum of 50% of capital must be Tier 1

b) Key weaknesses of Basel 1;

 Basel I is too simple to explain complex activities in large banking organizations.

 May be uninformative and give wrong information since it states only four risk levels

c)The amendment in 1996 was a proposal to introduce capital charges to risks which banks incur due to changes in market prices. The objective of this amendment was to provide protection to banks for price risks they incur in the process of their trading activities.(Kamdem 2005)

d)Minimum capital requirements for credit risk introduced in

Basel II and their calculation using the Standardized approach and the

internal-ratings-based (IRB) approach.

Standardized approach

Rating AAA to AA- A+ to A- BBB+

to BBB- BB+ to

BB- B+ to

B Below

B- Unrated

Country 0% 20% 50% 100% 100% 150% 100%

Banks 20% 50% 50% 100% 100% 150% 50%

Corporates 20% 50% 100% 100% 150% 150% 100%

Internal-ratings-based (IRB) approach.

 Basel II provides a formula for translating PD

(Probability of default), LGD (loss given

Default), EAD (exposure at default), and M

(Effective maturity) into a risk weight

 Under the Advanced IRB approach banks

stimate PD, LGD, EAD, and M

 Under the Foundation IRB approach banks

estimate only PD and the Basel II guidelines

determine the other variables for the formula

e) Describe the ‘enhancements’ to the Basel II framework introduced in

response to the 2007-2009 global financial crisis.

Application of more weights to re-securitization

Application of more weights to the standardized risks.

Operational requirements for credit analysis must be met.

Liquidity facilities to be in a more standardized method.

Banks not being allowed to use ratings to guarantee themselves

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