Q1) Write an Essay on VaR as a tool for Market Risk Management?

Value-at-risk (VaR) is a probabilistic metric of market risk (PMMR) used by banks and other organizations
to monitor risk in their trading portfolios. For a given probability and a given time horizon, value-at-risk
indicates an amount of money such that there is that probability of the portfolio not losing more
than that amount of money over that horizon. It is the most probable loss that we may incur in normal
market conditions over a given period due to the volatility of a factor, exchange rates, interest rates or
commodity prices. The probability of loss is expressed as a percentage VaR at 95% confidence level,
implies a 5% probability of incurring the loss; at 99% confidence level the VaR implies 1% probability of
the stated loss. The loss is generally stated in absolute amounts for a given transaction value (or value of
a investment portfolio).
The VaR is an estimate of potential loss, always for a given period, at a given confidence level. A
VaR of 5p in USD / INR rate for a 30- day period at 95% confidence level means that Rupee is likely to lose
5p in exchange value with 5% probability, or in other words, Rupee is likely to depreciate by maximum 5p
on 1.5 days of the period (30*5%).
A VaR of Rs. 100,000 at 99% confidence level for one week for a investment portfolio of Rs.
10,000,000 similarly means that the market value of the portfolio is most likely to drop by maximum Rs.
100,000 with 1% probability over one week, or, 99% of the time the portfolio will stand at or above its
current value.
Different choices for the probability and time horizon correspond to different value-at-risk metrics.
Actually, a value-at-risk metric is specified with three items.
a) Time horizon- one trading day
b) A probability 95% or 99%
c) A currency- USD, INR
VaR is answer for maximum loss over a specific time period where there is a low probability that actual
loss will exceed VaR. VaR will change if the holding period of the position changes. The holding period for
an instrument/position will depend on liquidity of the instrument/ market. With the help of VaR, one can
say with varying degrees of certainty that the potential loss will not exceed a certain amount. This means
that VaR will change with different levels of certainty
Advantage of VaR
1. Value-at-risk is prospective: For example, a firm might monitor market risk by tracking daily fluctuations
in the value of a trading portfolio and reporting the 100-day rolling standard deviation of those values.
Doing so would be easier than calculating value-at-risk, but it would be retrospective. The rolling standard
deviation would show how risky a portfolio had been over the previous 100 days. It would say nothing
about how risky the portfolio is today. For organizations to manage risk, they must know about risks while
they are being taken. If a trader mis-hedges a portfolio, his employer needs to find out before a loss is
incurred. Value-at-risk quantifies market risk while it is being taken, based on the current composition of
the portfolio and current market conditions.
1

2. Value-at-risk is broadly applicable: Many metrics of market risk are narrow. For example, if a portfolios
delta for stock A is INR 800,000 that says nothing about its gamma for stock A. It says nothing about the
portfolios overall market risk. With a single number, value-at-risk summarizes the market risk of an entire
portfolio, taking into accountat least in theoryall holdings and all components of market risk. As an
analogy, risk metrics such as delta show us the trees. With value-at-risk, we see the forecast.

Methodologies of using VaR

There are three main approaches to calculating value-at-risk:
a) the correlation method, also known as the variance/covariance matrix method;
b) historical simulation and
c) Monte Carlo simulation.
The volatility for calculation of VaR is usually specified as the standard deviation of the
percentage change in the risk factor over the relevant risk horizon. All three methods require
a statement of three basic parameters: holding period, confidence interval and the historical
time horizon over which the asset prices are observed and hence calculated.
Correlation Method
The change in the value of position is calculated overall sensitivity of each component to price
change of underlying assets.
Historical Simulation Method
It calculate the change in position value utilizing the historical movement of underlying assets
initiating from the current value of assets. If historical period is too short it fail to capture events
and their relationship between assets and within each asset classes and long period disrupt the
prediction. As it capture historical movement therefore no assumption of correlation is
considered
Monte Carlo Simulation Method
It calculate the value of the portfolio by using sample of randomly generated price scenarios. The
assumptions regarding market structure correlation between risk and volatility factors.
Closer the model fit economic reality, more accurate estimated VaR numbers and thereby lead
to better prediction
Daily earnings at risk (DEAR) = (Value of the position) * (Price sensitivity) * (Potential adverse
move in yield)/ Daily earnings at risk (DEAR) = (Value of the position) * (Price volatility)
Limitation of VaR
VaR can lead to false sense of security
VaR does not quantify the amount of loss and maximum possible loss within 1% of trading
days.
VaR sometime is not feasible enough to calculate large portfolio where there is large
diversity of correlation
VaR of two respective portfolio containing two different assets is not equal to
combination of respective assets in single portfolio.
Wrong assumption and inputs lead to wrong calculation of VaR
Different methodologies lead to different result
(941 Words)
2

Q2) Discuss the Basel II Principles as notified by RBI on Minimum Capital

Requirement on Market Risk?
The first pillar: Minimum capital requirements:
The first pillar of Basel II deals with maintenance of regulatory capital required by banks for calculation
of three major types of risk that a bank faces:
Credit risk,
Operational risk,
Market risk.
Other risks that bank face are not considered fully quantifiable at this stage.

The credit risk component can be calculated by banks in three different ways of varying degree
of sophistication, namely standardized approach, Foundation IRB, Advanced IRB and General IB2
Restriction. IRB stands for "Internal Rating-Based Approach".
For operational risk, there are three different approaches basic indicator approach or
BIA, standardized approach or TSA, and the internal measurement approach (an advanced form
of which is the advanced measurement approach or AMA).
For market risk the preferred approach is VaR (value at risk).

As the Basel II recommendations are phased in by the banking industry it will move from standardised
requirements to more refined and specific requirements that have been developed for each risk
category by each individual bank. The upside for banks that do develop their own be spoke risk
measurement systems is that they will be rewarded with potentially lower risk capital requirements. In
the future there will be closer links between the concepts of economic and regulatory capital.
Banks face high risks primarily because banking is one of the most highly leveraged sectors of any
economy. To tackle all the above mentioned risk and function efficiently, there is a need to manage all
kinds of risk associated with banking. Thus, risk management is core to any banking service. The ability
to gauge risk and take appropriate action is the key to success for any bank. It is said that risk-takers
survive; effective risk managers prosper and the risk averse perish. The same holds for the banking
industry. The axiom that holds good for all business is "No Risk No Gain"
A banks real capital worth is evaluated after taking into account the riskiness of its assets. It was earlier
hoped that the capital would provide banks with a comfortable cushion against insolvency, thereby
ensuring market stability. From cross country experiences, there is some evidence of a positive
association between capitalisation and risk assumption by banks due to the possibility that the one-sizefits all CAR causes bank leverage and asset risk to become substitutes. At policy levels, this has driven
research into alternative regulatory methods. After a brief discussion on Basel norms and
conceptualization, we review relevant literature and explain the need for the analysis and its objectives.
Then we discuss the Basel framework, its pillars and their implications for banking. Next, an empirical
examination of CAR values for selected Indian banks is carried out, identifying the underlying trend.
3

Structure of Basel II:

Basel II is designed to improve the way regulatory capital reflects the underlying risk. It consists of three
'pillars' which enshrine the key principles of the new regime. Collectively, they go well beyond the
mechanistic calculation of minimum capital levels set by Basel I, allowing lenders to use their own
models to calculate regulatory capital while seeking to ensure that they establish a culture, with risk
management at the heart of the organization up to the highest managerial level. The efficient
functioning of markets requires participants to have confidence in each other's stability and ability to
transact business.
At the top of the list are credit and market risks and not surprisingly, banks are required to set aside
capital to cover these two main risks. Capital standards should be designed in such a way that it allows a
firm to absorb its losses, and in the worst case, to allow a firm to wind up its business without loss to
customers, counterparties and without disrupting the orderly functioning of financial markets.
Tier 1 capital (core capital) is the most reliable form of capital. The major components are paid up
equity share capital and disclosed reserves, viz. statutory reserves, general reserves, capital reserves
(other than revaluation reserves) and any other type of instrument notified by the RBI for inclusion.
Examples of Tier 1 capital are common stock, preferred stock that is irredeemable and non-cumulative
and retained earnings.
Tier 2 capital (supplementary capital) is a measure of a bank's financial strength with regard to the
second most reliable form of financial capital. It consists mainly of undisclosed reserves, revaluation
reserves, general provisions, subordinated debt and hybrid instruments. This capital is less permanent in
nature. The former absorbs losses without the bank being required to cease functioning, while the latter
absorbs losses in the event of winding-up and thus provides a lesser degree of protection to depositors.
(784 Words)

Q3) Write an essay on Stress Testing and Back Testing?

Stress Testing can be defined as a risk management tool which tries to quantify the potential losses a
financial institution (bank) may suffer under certain stress events. Under this banks portfolio is
subjected to exceptional or extreme events which have a probability of occurrence and the potential
losses are identified.
It helps bank analyze its capital position with respect to events which will have a sizeable Impact on its
capital position. It alerts bank management to adverse unexpected outcomes related to a variety of risks
and provides an indication of how much capital might be needed to absorb losses should large shocks
occur.
Stress Testing plays a particularly important role in:

Providing forward-looking assessments of risk;

Overcoming limitations of models and historical data
Supporting internal and external communication
4

Feeding into capital and liquidity planning procedures

Informing the setting of a banks risk tolerance
Facilitating the development of risk mitigation or contingency plans across a range of stressed
conditions.

After the 2008 crisis it was observed that in Stress testing also scenario selection was of extreme
importance, They should cover even the most extreme market events that shall occur. Now besides the
major components of Market risk, Credit risk & Operational risk other risk factors that are covered in
sufficient detail are:

The behavior of complex structured products under stressed liquidity conditions

Basis risk in relation to hedging strategies
Pipeline or securitization risk
Contingent risks
Funding liquidity risk

Forms of Stress Testing

Single Factor Stress Testing: involves applying a shift to a specific risk factor affecting a portfolio. Risk
factors commonly used in sensitivity testing include changes in interest rates, equity prices and
exchange rates. Examples of single risk factors may include:

A parallel shift in the yield curve of 150 basis points up and down
Yield curve steepening/flattening by 35 basis points
Stock index changes of 20% up and down
Movements of 8-10% up and down in major currencies (20-25% for other currencies) relative to
the USD.

Multiple Factor Stress Testing: In this a portfolio is simultaneously subjected to multiple risk factors
such as interest rates, exchange rates and stock prices. A comprehensive firm wide view is taken across
all business divisions. Banks also implemented hypothetical stress tests, aiming to capture events that
had not yet been experienced, so as to cover any potential loss events.
More general areas in which banks are considering future improvement include:

Constantly reviewing scenarios and looking for new ones

Examining new products to identify potential risks
Improving the identification and aggregation of correlated risks across books as well as the
interactions between market, credit and liquidity risk
Evaluating appropriate time horizons and feedback effects

Stress testing should form an integral part of the overall governance and risk management culture of the
bank. Stress testing should be actionable, with the results from stress testing analyses impacting
decision making at the appropriate management level including strategic business decisions of the
board and senior management. Board and senior management involvement in the stress testing
program is essential for its effective operation.
5

Back Testing
It is a statistical test which checks whether actual trading losses are in line with the VAR forecasts. A
periodic comparison of the banks daily value-at-risk measure is done with the subsequent daily profit or
loss ("trading outcome").The value-at-risk measures are intended to be larger than all except a certain
fraction of the trading outcomes. Comparing the risk measures with the trading outcomes simply means
that the bank counts the number of times that the risk measures were larger than the trading outcome.
It helps gauge the performance of the banks risk model.
Under the value-at-risk framework, the risk measure is an estimate of the amount that could be lost on
a set of positions due to general market movements over a given holding period, measured using a
specified confidence level.
The Basel back testing framework consists in recording daily exception of the 99% VAR over the last
year. That is, they attempt to determine if a bank's 99th percentile risk measures truly cover 99% of the
firms trading outcomes.
Even though capital requirements are based on 10 days VAR, back testing uses a daily interval, This is
done because comparing the ten-day, 99th percentile risk measures(VAR) with actual ten-day trading
outcomes would probably not be a meaningful exercise. As in any given ten day period, significant
changes in portfolio composition relative to the initial positions are common at major trading
institutions.
For this very reason the back testing framework for risk measure has a one day holding period If there
are too many exceptions to the VAR forecasts generated by the banks model.
The exceptions then can be classified into these categories:
Basic integrity of the model

The banks systems simply are not capturing the risk of the positions themselves (e.g. the
positions of an overseas office are being reported incorrectly)
Model volatilities and/or correlations were calculated incorrectly (e.g. the computer is dividing
by 250 when it should be dividing by 225).

Models accuracy could be improved

The risk measurement model is not assessing the risk of some instruments with sufficient
precision (e.g. too few maturity buckets or an omitted spread).

Bad luck or markets moved in fashion unanticipated by the model

Random chance (a very low probability event).

Markets moved by more than the model predicted was likely (i.e. volatility was significantly
higher than expected).
Markets did not move together as expected (i.e. correlations were significantly different than
what was assumed by the model)

While back-testing of 1% VAR is required to establish the accuracy of the model for the purpose of
capital adequacy, in order to dynamically verify model assumptions, banks may in addition back-test
VAR models based on 2%, 5% and 10% VAR
A 95% daily confidence level is generally considered practical for back-testing because one should
observe roughly one excess a month (one in 20 trading days). A 95% VAR represents a realistic and
observable adverse move
Classification Of VAR:
A bank will classify its back-testing outcomes into the following three zones depending on the number of
exceptions arising from back-testing:

If the back-testing results produce four or fewer exceptions, it falls within the Green Zone and
there may not be any increase in the multiplication factor beyond the minimum three for both
VAR and stressed VAR
If the back-testing results produce five to nine exceptions, it falls within the Yellow Zone and
there would be an increase in the multiplication factors for both VAR and stressed VAR.
If the back-testing results produce ten or more exceptions, it falls within the Red Zone and the
multiplication factors for both VAR and stressed VAR will be increased from three to four.
(1111 Words)