Credit Risk Framework Cont (Setting credit limits for trade book and loan…
Credit Risk Framework Cont
Setting credit limits for trade book and loan products
should be in place for every counterparty
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.
The advantage of having limits in place is to control exposure and to present warning signs against which to manage changing counterparty risk.
It is vital that all the limits are regularly monitored and acted upon if breached.
Controlling trading book risk
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.
Confidence intervals are used to indicate the reliability of an estimate
Limitations of credit risk measurement
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.
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.
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.
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.
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.
Controlling concentration 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
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.
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.
Asset and liability risk
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.
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
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.
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.
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.
Mitigation of market risk
are a device for authorising specific forms of risk taking. For example:
Positions (foreign exchange and interest rates)
Diversification – by currency and maturity band to avoid over-concentration of risk
Spreads – control risk that related products may behave inconsistently
Optionality – option values do not move in straight lines
Maximum loss limit
Mark-to-market referral limit for accrual book positions
VAR – aggregate exposures in terms of potential loss (at branch level only).
strives to smooth out risk events in a portfolio so that the positive performance of some investments will neutralise the negative performance of others.
describes any activity which offsets or mitigates a risk in taking a position in a market. Examples include Derivatives
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.
Fosters understanding and improves mitigation
Enables an organisation to assess the impact on its business of significant but likely changes to its business.
Stress tests are mostly used in market risk.
Market risk modelling makes assumptions.
If considering a single variable is this realistic?
Is varying more than one variable too hard?
How good is the modelling in the first place?
Stress Testing Approach
1- Understand your business
2 - identify key elements that vary
3 - work out the distribution that fits the data
4 - vary the data by unitary amounts
5 - evaluate the differentials.
Real life events that can be used as comparitors
Financial market crisis (July – October 1998)
Czech’ scenario (May 1997)
Credit crunch (pre-2007 to 2008)
Lehman Brothers collapse (September 2008)
Oil prices hikes
1973-1974 oil price movement
Both Gulf wars
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.
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 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.
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.
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
In addition to the price level changing, the speed of that change and its magnitude represents what is known as
represents the shortage of supply, which is a phenomenon commonly experienced in commodity markets.
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
Market risk management
Risk managers must ensure that traders understand what they are responsible for.
The firm should not trade in markets and take risks in assets that it does not understand