Credit Risk Framework Cont (Setting credit limits for trade book and loan…
Credit Risk Framework Cont
Market risk - the risk that the value of a market position or investment portfolio will decrease due to the change in value of the market risk factors.
Market risk management
The firm should not trade in markets and take risks in assets that it does not understand
Risk managers must ensure that traders understand what they are responsible for.
The price of every tradable asset is effectively moving every minute of the trading day as a result of supply and demand factors, economic developments and other events.
Price Level Risk
represents the shortage of supply, which is a phenomenon commonly experienced in commodity markets.
In addition to the price level changing, the speed of that change and its magnitude represents what is known as
All trading and investment is subject to the value of money and the price at which it can be obtained. This presents the phenomenon of
interest rate risk
Market liquidity risk
, is the risk that a firm cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption.
is encountered when hedging positions using futures contracts. It represents the difference between prices in the spot market and the cash market, i.e. the price right now as against the future or forward price when looking ahead into the cost of carry going forward. It is therefore a familiar concept with forwards and futures markets.
When trading any asset from another part of the world the base currency of that tradable asset will be different from the home currency and therefore the ability to switch and convert from one currency to another opens the trader to an additional risk which is known as
is the risk that markets generally will fall.
Once a portfolio contains about 20 shares in different companies in different sectors, most of the unsystematic risk is diversified away.
is performed in order to test the reliability of a system or component to carry out a designated task for a particular period in a specific environment.
Real life events that can be used as comparitors
Both Gulf wars
1973-1974 oil price movement
Oil prices hikes
Lehman Brothers collapse (September 2008)
Credit crunch (pre-2007 to 2008)
Czech’ scenario (May 1997)
Financial market crisis (July – October 1998)
Stress Testing Approach
5 - evaluate the differentials.
4 - vary the data by unitary amounts
3 - work out the distribution that fits the data
2 - identify key elements that vary
1- Understand your business
How good is the modelling in the first place?
Is varying more than one variable too hard?
If considering a single variable is this realistic?
Market risk modelling makes assumptions.
Stress tests are mostly used in market risk.
Enables an organisation to assess the impact on its business of significant but likely changes to its business.
Fosters understanding and improves mitigation
Mitigation of market risk
describes any activity which offsets or mitigates a risk in taking a position in a market. Examples include Derivatives
strives to smooth out risk events in a portfolio so that the positive performance of some investments will neutralise the negative performance of others.
are a device for authorising specific forms of risk taking. For example:
VAR – aggregate exposures in terms of potential loss (at branch level only).
Mark-to-market referral limit for accrual book positions
Maximum loss limit
Optionality – option values do not move in straight lines
Spreads – control risk that related products may behave inconsistently
Diversification – by currency and maturity band to avoid over-concentration of risk
Positions (foreign exchange and interest rates)
Asset and liability risk
Asset liability management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates.
Banks manage the risks of asset liability mismatch by matching the assets and liabilities according to the maturity pattern or matching the duration, by hedging and by securitisation.
Interest rate risk
Changes in interest rates can significantly alter a bank’s net interest income (or NII), depending on the extent of the mismatch between the asset and liability interest rate reset times. Changes in interest rates also affect the market value of a bank’s equity
Methods of managing interest rate risk first require a bank to specify goals for either the book value or the market value of NII. In the case of the former, the focus will be on the current value of NII and in the latter, the focus will be on the market value of equity. In either case, though, the bank has to measure the risk exposure and formulate strategies to minimise or mitigate risk.
A model that is commonly adopted for asset and liability management measures the extent and the direction of mismatches between assets and liabilities through different maturities. It identifies the maturity gaps where these mismatches occur. A gap of zero is the optimum outcome
Modern risk management now takes place from an integrated approach to enterprise risk management that reflects the fact that interest rate risk, credit risk, market risk, and liquidity risk are all interrelated.
Setting credit limits for trade book and loan products
Controlling concentration risk
Concentration risk denotes the overall spread of a firm's outstanding accounts over the number or variety of debtors to whom the firm has credit risk.
Analysis of where the risk lies with respect to the concentration of risk against a single name or group is of significant importance as is the exposure towards a single country, region, industry or economic sector
Correlation is a measure of how the movement of one instrument impacts another.
Diversification is most effective when the investments combined are negatively correlated.
Correlations can change over time.
is the portfolio of financial instruments held by a firm. The financial instruments in the trading book are purchased or sold to facilitate trading for their customers and counterparties, to profit from spreads between the bid/ask spread, to generate profits by buying and selling or to hedge against various types of risk.
The bid price represents the maximum price that a buyer is willing to pay for a security. The ask price represents the minimum price that a seller is willing to receive.
is an accounting set of records that includes all securities that are not actively traded by the institution, that are meant to be held until they mature. These securities are accounted for in a different way than those in the trading book, which are traded on the market and valued by the performance of the market.
Limitations of credit risk measurement
One limitation concerns the application of limits themselves; If a risk is difficult to measure it may be hard to quantify that and a numerical limit may in fact be meaningless.
Credit ratings are limited and the quality of credit ratings are only really as good as the date they were published and the data and opinion upon which they were based at the date they were published. Owing to limited resources they must review them regularly but not at all times. So therefore there is an innate inability to have a real time measure here.
Many of the applications for measuring credit risk depend upon the use of models. Models are only as good as the data that is fed into them and the assumptions upon which the models themselves are based. There is therefore an innate limitation in this and indeed a source of risk – model risk itself is presented.
Controlling trading book risk
Confidence intervals are used to indicate the reliability of an estimate
Value at Risk (VaR)
VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.
should be in place for every counterparty
It is vital that all the limits are regularly monitored and acted upon if breached.
The advantage of having limits in place is to control exposure and to present warning signs against which to manage changing counterparty risk.
Limits should be based on a plethora of things, but the key consideration is and will always be the perceived ability of the customer to repay.