ACCY 511 Class Notes Day 3 Concepts of Risk and Uncertainty Measurement of Risk Risk: The possibility of suffering

g a loss. It derives from the uncertainty in predicting future outcomes. C ance of an outcome !"ain or loss# occurrin": The relative frequency of the outcome occurring. Thus, the chance of, say, loss is the ratio of the number of losses likely to occur compared to the larger number of possible losses in a given group. Example: 1, cars in a to!n are susceptible to the risk of collision. If past

experience indicates that " of these cars are likely to be in a collision during a given time period #year$, then the chance of loss due to a collision is " %1 & . " #"'$. Objective measurement

De"ree of Risk: The amount of objective risk present in a situation. The degree of risk tells us ho! far from our target our relative frequency number can be. (e calculate the degree of risk as the ratio of the range of ho! many observations !e actually get to ho! many !e expect to get. )egree of risk & #maximum * minimum$%expected or in general the ratio: #+robable variation of actual from expected losses$ % #Expected losses$ Variability of possible outcomes Example: There are 1 , buildings in each city, ,rbana and -hampaign fires per year. .ut closer look at the past

and, on average, each city has 1

data suggests that in ,rbana the actual number of fires !ill range from /0 to
1

1 0. 1o!ever, for -hampaign the range is expected to be larger, say from 2 to 1" . The degree of fire risk for each city is: 3ire 4isk in ,rbana & #1 0 5 /0$ % 1 &1 ' &6 '

3ire 4isk in -hampaign & #1" 5 2 $ % 1

The numbers sho! that the risk of fire in -hampaign is four times the risk of fire in ,rbana, even though the relative frequencies of fires are the same #1 %1 , $. This result is counter5intuitive for most people. 1o! can the risk of fire in -hampaign be four times greater !hen the probability is the same 1 in 1 in both cities7 (hat am I missing7 8 portfolio example is more illustrative. $%ample: (e have t!o portfolios, one !ith equities and one !ith bonds. 9ver the past " years each of the portfolios has earned an average of :' per year. 1o!ever the returns on the bond portfolio ranged from ' to 1"' !hereas the returns on the equity portfolio ranged from a loss of /' to a gain of "1'. .ond 4isk & #1"' 5 '$ % :' & " ' Equity 4isk & #"1' 5 #5/'$$ % :' & 0 ' 8lthough the expected return is :' for both portfolios, the risk on the equity portfolio is "; times that of the bond portfolio. 4isk is the chance that !e do not get the expected return of :'. The degree of risk in equities is "; times greater because, !hen !e are !rong, !e lose more. The !orst case scenario !ith bonds is that !e make no gains at all< the !orst case scenario !ith equities is that !e lose /' of the value of the portfolio. 8lthough the expected number of fires in both ,rbana and -hampaign is 1 out of every 1 buildings, the risk is four times higher in -hampaign. The degree of risk is not the chance that there may be a fire but the chance that the number of fires !ill be different from the expected number of 1. Note: 9utcome variability #variance of the outcome distribution$ determines the degree of risk.
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Re&ie' some statistical concepts 5 +robability: the long5term frequency of occurrence of an event. - +robability distribution: a mutually exclusive and collectively exhaustive list of all events that can result from a chance process and contains the probability associated !ith each event. 8 probability distribution is useful for evaluating the expected frequency of an event. Take t!o coins and toss them into the air. Table 1 sho!s all possible outcomes and that the probability of each outcome is "0'. The probability of heads is 0 ' and the probability that !e get one head and one tail is also 0 '. 9ur expectation is !rong 0 ' of the time. Table 1 * +robability distribution of a t!o coin toss 1eads, 1eads 1eads, Tails Tails, 1eads Tails, Tails "0' "0' "0' "0'

Table " * +robability distribution of a t!o dice thro! Total +rob " 1%=: = "%=: 6 =%=: 0 6%=: : 0%=: > :%=:
=

2 0%=: / 6%=: 1 =%=: 11 "%=: 1" 1%=:

The probability distributions in Tables 1 and " are theoretical. (e calculate them because !e kno! ho! a pair of unbiased coins or dice is supposed to !ork. If the probability distribution is equal to anything else then the coins or the dice are crooked and the game is invalid.

(e could toss the dice =:, times and observe the outcome. This is called a ?onte -arlo simulation and can be done easily #if slo!ly$ !ith excel. Table = sho!s that the observations are close, but not exactly equal, to the theoretical distribution in Table ".

Table = * ?onte -arlo simulation of a t!o dice thro! Total " = 6 0 : > 9bs +rob 1, ", / 1%=: "%=:

=,111 =%=: =,2>2 6%=: 0, 1> 0%=: 0,/6= :%=:

6

2 / 1 11 1"

6,//0 0%=: 6, 60 6%=: ",/06 =%=: 1,//0 "%=: 1, 0= 1%=: =:,

T!o types of probability distributions are used: empirical and theoretical. 9ne forms an empirical probability distribution by observing the events that actually occur as in table =. (hen !e have some basis for understanding the nature of a distribution, the toss of a coin, the thro! of the dice, the pull of a single card for a deck of 0" cards, then !e can use a theoretical distribution. 3or more complex relationships !e use more complex theoretical distributions based on mathematical formulas. The .inomial, the @ormal and Aog@ormal, and the +oison are theoretical probability distributions !idely used in risk management. They are also fairly easy to model and are built into most spreadsheet programs. .ut Bust as !e need to assume that the coin is fair, the dice evenly !eighted, and the deck of cards contains only one 8ce of Cpades, !e must also be able to assume that events are random and independent. 9ther!ise the distribution !ill be misleading. Every financial statements has a probability distribution. There are different observations for different accounts. Draph the observations to get the distribution, analyEe the mean 1. Take revenues for 2 quarters. F1: G". F": G".". HH F2 : G0. ". 3ind the mean =. -alculate the variability around the mean: standard deviation

Random: the probability that any one event !ill occur is equal to the probability that any other event !ill occur. Co !hen I thro! a die the probability of a 1 equals the probability of a " equals the probability of a = etc. (ndependent: !hen one event occurs the probability that a second event !ill occur is not changed. If I thro! a : then this does not alter the probability of a : on the next thro!. Independence is often a difficult concept to internaliEe. If I thro! 1" tails in a ro! then I believe the universe !ould not be so cruel as to give me a 1=th tail. I anticipate a 1=th tail as though the probability of thro!ing it is the same as the probability of getting 1= tails #1%2,1/"$ rather than the probability of getting the 1=th tail after I have already thro!n the first 1" tails. #1%"$ If the events against !hich !e manage are not random and not independent then the risk manager is in the same position as the gambler playing !ith loaded dice: thereIs no !ay you can !in. To effectively use theoretical distributions, the risk manager must be reasonably confident that the distribution of the firmJs events is similar to the theoretical distribution chosen. - ?easures of central tendency of a probability distribution: ?ean, median, and mode. - ?easures of variation of a probability distribution: Ctandard deviation, variance, coefficient of variation. $%pected )alues and Risk *remiums The Expected Kalue, ELKM, of a risky prospect is the value of each possible outcome !eighted by its probability. Cince the ans!er comes out in dollars and cents this is a convenient !ay to measure risk aversion. $%ample: Nou are faced !ith the choice bet!een a certainty of G0, and a risky opportunity under !hich you !ill get G",0 plus some probability x' of an extra G1 , .

8t first x is only 1' #//' of G",0 risk and take the G0,

and 1' of G1 ,

$ so you decline the

. If you do not take the risk then it is offered to

someone else. If no one takes the risk at 1' then x is increased to "', =', 6', etc. In general, x depends on someoneIs attitude to!ards risk #risk preference or subBective risk$. Nou take the risk !hen x is 60' Nou have demonstrated that you are indifferent bet!een G0, certainty and a risk of G",0 !ith 00' probability and G1 , probability. (e calculate this decision #potential proBect$ as $%pected )alue: ELKM & .00 O ",0 Certainty $+ui&alent: -E & G0, Risk *remium: 4+ P .60 O 1 , !ith !ith 60' & G0,2>0

#keep the money in the bank$ & G2>0

& ELKM 5 -E & G0,2>0 5 G0,

Qohn takes the risk !hen x is 0 '. 1e is more risk averse than you are. 3or Qohn, the expected value of the risk is G:,"0 , and his risk premium G1,"0 . Qohn is !illing to forego G1,"0 to avoid this risk !hereas you are !illing to forego only G2>0 to avoid the risk. 8ndre! is unacquainted !ith the concept of risk aversion. 1e calculates that he should take the risk !hen x is == '. 1e thus takes the gamble !ith a risk of G",0 !ith ::' probability and G1 , !ith ==' probability. $%pected )alue: ELKM & .::: O ",0 & G0, & ELKM 5 -E & G0, 5 G0, &G P .=== O 1 , & G0,

Certainty $+ui&alent: -E Risk *remium: 4+

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1e is risk neutral in that he !ill not sacrifice Expected value in order to gain certainty at all. The risk premium is the amount of money you are !illing to give up to avoid the risk of loss or alternatively the amount you are !illing to earn to assume the risk. +eople !ith positive risk premiums are called risk averse. +eople !ith negative risk premiums are called risk lovers. +eople !ith Eero risk premiums are called risk neutral. Conservative managers forgo good projects Aggressive managers take on riskier projects. The utility function is a construct economists use to represent dollar amounts in terms of their utility to the individual, using the individualIs o!n subBective risk preference. In other !ords, the utility function is a construct that reflects someoneIs subBective risk preferences. The utility function is -oncave for a risk averse person. The utility function is -onvex for a risk loving person. The utility function is a straight line for a risk neutral person. The utility function is C5shaped for a person !ho is a risk lover for lo! !ealth levels and risk averse for high !ealth levels. Decreasin" Risk A&ersion: (ith a larger !ealth base an individual can take more risk and thus !ould pay or give up less to avoid risk #risk premiums decrease$. Implication: cash rich firms can become more aggressive #more risk$. 8uditors, be a!are. .ig firms are !illing to take on more risks. ?anagers tend to be empire building.

, y do 'e mana"e risk- .ecause of the asymmetry bet!een losses and gains, i.e. the utility lost from G1 loss is larger than the utility gained from G1 gain #risk aversion$. ?ore later !ith finance reasons. Measurement of Risk: The variance of the future outcome distribution. Modern (n&estment . eory #1arry ?arko!itE$: Investors are RMeanvariance optimizersS i.e. they form a RportfolioS #a combination of investments$ !ith the lo!est possible return variance for any given level of mean #expected$ return. This suggests that the variance of an investment return is the appropriate measure of risk. Graph of efficient portfolio frontier Mean/&ariance analysis: ?athematical description of ho! the risk of individual assets contributes to the risk and return of portfolios. ,seful in asset allocation decisions #ho! much in stocks, bonds, etc$. ,seful to corporate managers in selecting among investment proBects #a firm is a portfolio of real and financial assets$. ?anagers !ant to kno! ho! the risk of individual investments affects the overall risk of the firm #expected earnings and their variability$. 3oundation of the -apital 8sset +ricing ?odel #-8+?$ !hich is the theory that relates risk to return.

Market Risk and )alue/at/Risk !)AR# Market Risk is the risk of loss arising from adverse c an"es in market rates and prices, such as interest rates, foreign currency exchange rates, commodity prices, and similar market rate or price changes #e.g. equity prices$. 8lternatively, market risk is the uncertainty resulting from changes in market prices. 1istory Explosion in financial innovation in the 1/2 s o ?any 3inancial instruments discovered and used in the market place Cignificant changes in market !ide factors o E.g. interest rates o E.g. exchange rates o E.g. stock prices o E.g. commodity prices The changes imply turmoil in the macro environment, the changes are unexpected !hich implies increased uncertainty !hich in turn implies higher cost of capital and potential for negative earnings. Cignificant losses for many firms, e.g. +roctor and Damble, Dibson Dreetings, Qapan 8irlines, .arings .ank o The need for a statement of R+robable lossS became apparent o Q+ ?organ chairman )ennis (eatherstone demanded a simple report at the end of each day on ho! the firmIs position could change due to market risk: the 6.10 report o Q+ ?organ analysts came up !ith Kalue at 4isk #K84$ o Droup of = largest banks in 1//= recommended K84 as a measure #internal$ of a firmIs overall market risk o Q+ ?organ further developed !hat is kno!n as 4isk ?etrics no! used around the !orld and disclosed in financial reports
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 In 1//6 the 38C. issued C38C 11/ RDisclosures about derivative financial instruments and fair value of financial instrumentsS )isclose a$ )etails about current positions and activity during the reporting period b$ The hypothetical effects on equity, or on annual income, of several possible changes in market prices, e.g. interest rates c$ 8 D8+ analysis of interest rate repricing D8+ is the difference bet!een dollar amounts of interest rate sensitive assets and interest rate sensitive liabilities. D8+ & change in net interest income due to a percent change in interest rates. D8+ is for groups of instruments. d$ The duration of financial instruments #ho! sensitive each financial instrument is to changes in interest rates$ If you kno! the sensitivity and kno! the direction of interest rates you can calculate the potential loss and take action for that instrument. )uration is the interest rate sensitivity of each instrument # per instrument$ different from D8+ #group of instruments$ e$ The firmIs K84 from financial instruments and from other positions at the end of the period and the average value over the period. CE- #1//>$ o -ommon frame!ork to enhance the comparability #important obBective of financial information$ of market risk disclosures across firms and types of market risk exposures. o It required three disclosure alternatives Tabular * #a$ T #c$ of C38C 11/ Censitivity analysis * #b$ T #d$ of C38C 11/ K84 * #e$ of C38C 11/

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Important to: ?easure the exposure #is it material7$ Cet up control mechanisms for direct market risk and employee created risks #high risk trading5big bets$ 1edging mechanisms 9f interest to regulators #banks and insurance companies$ ?easurement It can be measured over periods as short as one day. ,sually measured in terms of dollar exposure amount or as a relative amount against some benchmark. o o o o o o ,seful for: ?anagement information for the risk positions taken Cetting limit positions in trading assets 4esource allocation to departments #risk%return tradeoff$ +erformance evaluation based on risks undertaken #bonuses$ 1elp develop more efficient internal models 4egulation #set capital requirements for bank and insurance firms$

Denerally concerned !ith estimated potential loss under adverse circumstances. Three maBor approaches of measurement o Q+? 4isk?etrics #or variance%covariance approach or +arametric or )elta 5 @ormal method$ o 1istoric or .ack Cimulation o ?onte -arlo Cimulation

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0*M RiskMetrics )etermine the )aily Earnings at 4isk #)E84$ for your trading portfolio )E84 is defined as the estimated potential loss of a portfolioJs value over a one5day period as a result of adverse moves in market conditions, such as changes in interest rates, foreign exchange rates, commodity prices, and market volatility. D$AR is comprised of #a$ The dollar value of the position, #b$ The price sensitivity of the assets to changes in the risk factor, and #c$ The adverse move in the return #yield$. D$AR 1 !a# % !2# % !c# *rice &olatility & #b$ x #c$, i.e. the product of the price sensitivity of the asset and the adverse move in the yield. D$AR 1 Dollar &alue of t e position % price &olatility o If !e assume that changes in the yield are normally distributed, !e can construct confidence intervals around the proBected )E84. #9ther distributions can be accommodated$. o 8ssuming normality, / ' of the time the disturbance !ill be !ithin 1.:0 standard deviations of the mean. #0' of the extreme values greater than P1.:0 standard deviations and 0' of the extreme values less than 51.:0 standard deviations$ $%ample 1: Cuppose that !e are long in >5year Eero5coupon bonds, !ith market value of G1, , , face value of G1,:=1,62= and current yield of >."6=' per year. (e define RbadS yield changes such that there is only 0' chance of the yield change being exceeded in either direction. 8ssuming normality, / ' of the time yield changes !ill be !ithin 1.:0 standard deviations of the mean. If the standard deviation is 1 basis points, this corresponds to 1:.0
1=

basis points #1 x1.:0$. -oncern is that yields !ill rise. +robability of yield increases greater than 1:.0 basis points is 0'. +rice volatility & ?odified )uration #?)$ +otential adverse change in yield & #:.0">$ # . 1:0$ & 1. >>' ?) & )uration%1P4 & >%1. >"6= & :.0"> )E84 & ?arket value of position #+rice volatility$ & #G1, , $ #. 1 >>$ & G1 ,>> (nterpretation: The potential daily loss in earnings on the G1, , position is G1 ,>> if the 1 bad day in " #0'$ occurs tomorro!. To calculate the potential loss for more than one day: ?arket value at risk #K84$ & )E84 U V@ $%ample: 3or a five5day period, K840 & G1 ,>> U V0 & G"6, 2" @ote: 3ive5day variance & one5day variance x 0 Taking squared roots of both sides !e get: 3ive5day standard deviation & one5day standard deviation x V0, i.e. W0 & W1 x V0 . e case of 3orei"n $%c an"e )E84 & dollar value of position U 3oreign Exchange #3X$ rate volatility 3X rate volatility is taken as 1.:0 x W3X $%ample 4: .ank of Couthern Kermont has determined that its inventory of " million euros#Y$ and "0 million .ritish pounds #Z$ is subBect to market risk. The spot exchange rates are G .6 %Y and G1."2%Z, respectively. The Is of the spot exchange rates of the Y and Z, based on the daily changes of spot rates over the past six months, are :0 bp and 60 bp, respectively.

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)etermine the bankIs 1 5day K84 for both currencies. ,se adverse rate changes in the /0th percentile. 3X position of Y 3X position of Z 3X volatility Y 3X volatility Z )E84 )E84 of Y )E84 of Z K84 of Y K84 of Z & " m x .6 & G2 million & "0m x 1."2 & G=" million & 1.:0 x :0bp & 1 >."0bp, or 1. >"0' & 1.:0 x 60bp & >6."0bp, or .>6"0' & #G Kalue of position$ x #+rice volatility$ & G2m x . 1 >"0 & G20,2 & G="m x . >6"0 & G"=>,: & G20,2 x 1 & G20,2 x =.1:"= & G">1,="= & G"=>,: x 1 & G"=>,: x =.1:"= & G>01,=0>

. e case of e+uities Total risk & Cystematic risk P ,nsystematic risk If the portfolio is !ell diversified then )E84 & dollar value of position U stock market return volatility Ctock market return volatility is taken as 1.:0 x W?. $%ample 3: .ank of 8laskaIs stock portfolio has a market value of G1 million. The beta of the portfolio approximates the market portfolio, !hose standard deviation #m$ has been estimated at 1.0 percent. (hat is the 05day K84 of this portfolio, using adverse rate changes in the //th percentile7 )E84& #)ollar Kalue of portfolio$ x #".== x m $ & G1 m x #".== x . 10$ & G1 m x . =6/0 & G=6/,0 K84 & G=6/,0 x 0 & G=6/,0 x "."=:1 & G>21,0 :
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A""re"atin" D$AR estimates: -annot simply sum up individual )E84s. In order to aggregate the )E84s from individual exposures !e require the correlation matrix. T!o5asset case: )E84 portfolio & L#)E84a$" P #)E84b$" P "[ab U )E84a U )E84bM1%" $%ample 5: (e have a t!o5asset portfolio. 9ne asset has an expected return of " ', the other has 1"'. The variance of the first assetIs return is 6' and the variance of the second assetIs return is ='. The covariance of the t!o assets is "'. The t!o assets are equally !eighted in the portfolio. Expected portfolio return& .0O ."P .0O .1"& .1: Kariance of the portfolio return& # .0$" O . 6P# .0$" O . =P"O# .0$O# .0$O . "& . ">0 Ctandard deviation of the portfolio return& . ">01%" & .1:02 The 0' tail on the left of the returns distribution is: 1.:0 O .1:02 & .">=: a!ay from the mean. The /0' confidence level of K84 is .1: * .">=: & 5 .11=: i.e. there is a 0' chance the portfolio !ill lose more than 11.=:'. The 1' tail on the left of the returns distribution is: ".== O .1:02 & .=2:= a!ay from the mean. The //' confidence level of K84 is .1: * .=2:= & 5 ."":= i.e. there is a 1' chance the portfolio !ill lose more than "".:='.
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)erify t is solution usin" t e D$AR portfolio formula a2o&e6 . ree/asset case: )E84 portfolio & L#)E84a$" P #)E84b$" P #)E84c$" P #"[ab U )E84a U )E84b$ P "[ac U )E84a U )E84c P "[bc U )E84b U )E84cM1%" $%ample 5: The -39 of -hoice .ank is estimating the aggregate )E84 of the bankIs portfolio of assets consisting of loans #A$, foreign currencies #3X$, and common stock #EF$. The individual )E84s are G= ,> , G">6, , and G1":,> respectively. If the correlation coefficients iB bet!een A and 3X, A and EF, and 3X and EF are .=, .>, and . , respectively, !hat is the )E84 of the aggregate portfolio7

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 ##EA$" $ + ##EA$ ! $ + ##EA$EQ $ + #" ", ! % #EA$" % #EA$ ! $ #EA$ portfolio = + #" ",EQ % #EA$" % #EA$EQ $ + #" ! ,EQ % #EA$ ! % #EA$EQ $
" " " " "

" .0

G= ,> + G">6, + G1":,> + "# .=$#G= ,> $#G">6, $ = + "# .>$#G= ,> $#G1":,> $ + "# . $#G">6, $#G1":,> $ = [ G"26,="",:":,

.0

] .0 = G0==,"1/

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)alue at Risk !)AR# is a summary statistical measure of market risk: the !orst loss possible under Rnormal market conditionsS for a given time period. It is constructed so that losses greater than the value at risk are suffered only !ith a specified small probability. Thus, using a probability of x percent and a holding period of t days, a firmIs value at risk is the loss that is expected to be exceeded !ith a probability of only x percent during the next t5day holding period. Example of a K84 statement: Rthere is a 0' chance the firm !ill lose more than G0 million over the next trading !eek.S K84 is also called a measure of RnormalS market risk, and the probability x is the cutoff that defines Ran abnormalS #!orst$ loss. Typical values for the probability x are 1', ".0' and 0' !hile common t periods are 1, ", and 1 business days and 1 month. -onstructing K84 using normal distribution a$ -alculate current market value of portfolio i$ .ased on todayIs trading prices ii$ .ased on todayIs discount rates b$ ?easure variability of risk factors i$ )iscount rates * bonds ii$ Ctock prices * options iii$ -ommodity prices * futures contracts c$ Cet time horiEon i$ 1 day ii$ = days iii$ 1 days d$ Cet confidence level i$ //' ii$ //.0' e$ -alculate )E84 and then K84 using the above formulas

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Anot er $%ample: suppose !e have G1 million invested in a stock that has a = ' standard deviation for a year and !e !ant the //.0' confidence K84 over 1 day. i$ (hat is the volatility over 1 day assuming independence7 #1$ (hat percentage of the year is 1 trading day7 #"$ (hat is the variance over 1 year7 #=$ (hat is the variance over 1 day7 #6$ (hat is the standard deviation over one day7 ii$ G1 million iii$ = ' O #1%"0"$1%" iv$ K841 & 1, , O#= 'O#1%"0"$1%" $O ".02 & G62,>0> 7istorical 8imulation ,se historical changes in market rates and prices to construct a distribution of potential future portfolio profits and losses. 4ank the profits and losses and choose a confidence level for the estimate. The value at that percentile in the distribution represents the K84 for the portfolio. E.g. Ka40',1day is the loss that is exceeded only 0' of the time over 1 day ,se current portfolio and subBect it to actual changes in market factors experienced in each of the last @ periods, i.e. revalue the portfolio for the change that !ould occur if history repeated itself. .y subtracting the future portfolio value from the current value you find the amount that !ould be lost due to market risk if these conditions occurred again. Monte Carlo 8imulation Identify market factors, i.e. change in stock price or change in discount rates. 8ssume a distribution for the change in these factors, e.g. the @ormal distribution Denerate hypothetical values for the changes 8s !ith the 1istorical simulation method calculate the G change in portfolio values 4ank the hypothetical profits and losses -alculate the loss that is equaled or exceeded 0' of the time.

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, ic met od is 2est-apturing risks of options5like instruments Cimulations methods !ork !ell even !hen !e have options. 4isk?etrics * normal approach assumptions need to be made to make the math tractable. (hen there are a lot of options it doesnIt !ork as !ell as the other methods Ease of implementation 1istorical simulation is easy to implement if !e have the data available. 4isk?etrics * normal method is available in soft!are so if the portfolio only contains interments and factors that are covered in the soft!are it is easy to implement ?onte -arlo simulation soft!are is also available Ease of communication 1istorical simulation is easy to understand 4isk?etrics * normal and ?onte -arlo methods are difficult for non5 technical people to understand. 4eliability of results 1istorical simulation may rely on data that is not representative. ?onte -arlo and 4isk?etrics * normal methods use historical data to get the parameters so there is also some risk that this data is not representative. 1o!ever the problem is less severe than for historical simulation. 1o!ever, ?onte -arlo and 4isk?etrics * normal methods assume distributions that may not be representative. 3lexibility of assumptions (hat5if analysis does not !ork !ell !ith historical simulation. 8lternatives to K84 Censitivity 8nalysis Imagine hypothetical changes in the value of each market factor. ,se pricing models to compute value of portfolio given the ne! value of the market factor.
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)etermine the change in portfolio value resulting from the change in market factor. (hen combined !ith kno!ledge of magnitude s of likely changes in factors these computations provide a good picture of the risks of portfolios. If there are many relevant factors, this !ill be over!helming.

Cas 3lo' at Risk !CAR# -84 is similar to K84 but it differs in quantifying the potential loss in -ash flo!s rather than market values. ,sed by non5financial companies 8ll cash flo!s are considered not only those associated !ith marketable securities 3actors !ill include changes in customer demand, 4T) success etc. ,sed for internal planning 4equires a great deal of kno!ledge and Budgment. $arnin"s at Risk Earnings at risk is similar to K84 Fuantifying the potential loss in earnings rather than in market values. 9imitations of )AR K84 is a single summary statistical measure of market risk. It uses historical data and assumes that future !ill be like the past. 1istorical simulation directly uses past data ?onte -arlo and 4isk?etrics * @ormal method use the past to determine the appropriate distribution, mean and variance Cometimes the past isnIt very good for predicting the future Cystematic shift * internet bubble 1o!ever the alternatives are unappealing.

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Disclosure re+uirements Fualitative disclosures Identify primary market risk exposures )iscuss obBectives and general strategies used to manage exposures )iscuss significant changes in exposures or risk management strategies Fuantitative )isclosures CE- regulation C5\

:uantitati&e information a2out market risk6 #a$ 4egistrants shall provide, in their reporting currency, quantitative information about market risk as of the end of the latest fiscal year, in accordance !ith one of the follo!ing three disclosure alternatives.

#b$ In preparing this quantitative information, registrants shall categoriEe market risk sensitive instruments into instruments entered into for trading purposes and instruments entered into for purposes other than trading purposes.

#c$ (ithin both the trading and other than trading portfolios, separate quantitative information shall be presented, to the extent material, for each market risk exposure category #i.e., interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market risks, such as equity price risk$.

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16 .a2ular *resentation Information related to market risk sensitive instruments 3air values of the market risk sensitive instruments and contract terms sufficient to determine future cash flo!s from those instruments, categoriEed by expected maturity dates Information relating to contract terms shall allo! readers of the table to determine expected cash flo!s from the market risk sensitive instruments for each of the next five years. -omparable tabular information for any remaining years shall be displayed as an aggregate amount Instruments shall be grouped based on common characteristics. 46 8ensiti&ity analysis )isclosures that express the potential loss in future #i$ earnings #ii$ fair values #iii$ cash flo!s ?arket risk sensitive instruments resulting from one or more selected hypothetical changes in interest rates foreign currency exchange rates commodity prices, and other relevant market rates or prices over a selected period of time. 4egistrants shall provide a description of the model, assumptions, and parameters, !hich are necessary to understand the disclosure.

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36 )alue at risk disclosures Express the potential loss in future earnings, fair values, or cash flo!s of market risk sensitive instruments over a selected period of time !ith a selected likelihood of occurrence, from changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices. (hy three quantitative market risk disclosure alternatives7 The CE- argued that Rdisclosure requirements about market risk should be flexible enough to accommodate different types of registrants, different degrees of market risk exposure, and alternative !ays of measuring market risk.S

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:ualitati&e information a2out market risk To the extent material, describe: 1. The registrantJs primary market risk exposures ". 1o! those exposures are managed. Cuch descriptions shall include, but not be limited to, a discussion of the obBectives, general strategies, and instruments, if any, used to manage those exposures =. -hanges in either the registrantJs primary market risk exposures or ho! those exposures are managed, !hen compared to !hat !as in effect during the most recently completed fiscal year and !hat is kno!n or expected to be in effect in future reporting periods. Fualitative information about market risk shall be presented separately for market risk sensitive instruments entered into for trading purposes and those entered into for purposes other than trading. 8tress .estin" 4ecall that the main purpose of K84 is to measure potential losses under RnormalS market conditions. The problem is that K84 measures based on recent historical data can fail to identify extreme unusual situations that could cause severe losses. This is !hy K84 methods should be supplemented by a regular program of stress testing. Ctress testing can be described as a process to identify and manage situations that could cause extraordinary losses. This can be made !ith #a$ scenario analysis, #b$ stressing models, volatilities, and correlations, and #c$ policy responses. Ccenario analysis consists of evaluating the portfolio under various states of the !orld, mainly large movements in key variables.

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