Chapter 6

Market Risk for Single

Trading Positions

Market risk is the risk that the market value of trading positions will be adversely
inuenced by changes in prices and/or interest rates. For banks, market risk occurs
because traders in the Financial Markets department trade for account and risk of
the bank: proprietary trading. Since the credit crisis, however, banks have become
more prudent in allowing their traders to take positions. Market risk of trading po-
sitions can be measured by sensitivity parameters, by the Value at Risk method,
by stress tests, by the extreme value theory and, nally, by the expected shortfall
method. In order to manage market risk, banks impose trading limits on their trad-
ers.

6.1 Market Risk Sensitivity Indicators

The rst way to measure market risk is the use of market sensitivity indicators.
Market sensitivity indicators indicate the sensitivity of a position in a nancial val-
ue to a pre-dened change in the price determining parameter(s) of that nancial
value. The following table shows an overview of the most commonly used sensitiv-
ity indicators.

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financial value sensitivity indicator price determining variable

Foreign Exchange Value of one point / pip FX rate

Interest Rate Derivatives Basis point Value Yield

PV01
Delta

Options Delta Price of the underlying value

Vega Volatility

Theta Remaining Term

Rho Interest Rate

6.1.1 Value of one point / pip

The value of one point gives the sensitivity of an FX position for a change in the FX
rate with one point or pip. For instance, if an FX trader holds a long position in euro
against Sterling for a nominal amount of EUR 10,000,000, the value of one point of
this position is 10,000,000 x 0.0001 = GBP 1,000. This means that the trader gains
1,000 pound Sterling for every rise in the EUR/GBP FX rate and loses 1,000 pound if
the euro depreciates with one basis point against the pound Sterling.

The value of one point is also used as a risk indicator with short-term interest rate
futures (STIR futures). It represents the change of the value of one futures contract,
e.g. a short Sterling contract or Eurodollar contract, if the futures price changes
with one (basis) point.

6.1.2 Basis Point Value

The basis point value (BPV), also called PV01 or (interest) delta, species how much
the price of an interest bearing instrument changes if the interest rate changes by 1
basis point (0.01%).

The equation for the BPV is:

Basis point value = dirty price s duration s 0.0001

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 market risk for single trading positions

example

If the price of a bond is 98.70 and the bond has a duration of 4.6, the basis point val-
ue of this bond is:

BPV = 98.7 x 4.6 x 0.0001 = 0.045.

This means that the price of the bond will decrease from 98.70 to 98.655 if the inter-
est rate rises by 1 basis point.

A disadvantage of the modied duration and the way in which the basis point value
is used above, is that it assumes implicitly that all zero coupon rates move in the
same direction and magnitude; in other words that the yield curve moves in a paral-
lel way. The eect of a parallel shift is shown in gure 6.1.

Figure 6.1 Value of a loan with a face value of EUR 100 million before and after a rise
in interest rates by 1 basispoint

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Figure 6.1 shows that the value of the above loan as a result of a parallel interest rate
rise of 1 basis point has fallen by EUR 47,417.60. This is also the basis point value for
this bond.

In practice however, instead of assuming a parallel interest rate shift, sensitivity-

analyses to interest rate movements are made per time interval or bucket. Thus,
separate analyses are made of the impact of a change in the one year zero coupon
rate, in the two year zero coupon rate, etc. By doing this, it will become clear that the
interest rate sensitivity is almost always dierent in all time buckets:

bucket (year) amount present value modified basis point

duration value

0.5 - 1.5 6,000,000 5,788,712 1 / 1.0365 558

1.5 - 2.5 6,000,000 5,579,480 2 / 1.037 1,076
2.5 - 3.5 6,000,000 5.372,630 3 / 1.0375 1,554
3.5 - 4.5 6,000,000 5,168.468 4 / 1.038 1,992
4.5 - 5.5 106,000,000 87,755,301 5 / 1.0385 42,251

As might be expected, the table shows that the interest rate sensitivity of the bond
principally lies in the ve year bucket. After all, this is where the largest cash ow
appears.

The above table is often referred to as a gap report. Financial institutions use these
kinds of gap reports in order to determine how their interest rate exposure is spread
across the various maturity periods. If a bank has a clear idea about the interest rate
movement in a specic part of the yield curve, it can use this detailed information
to ne tune its hedge transactions.

In addition to the basic point value that presents the change in value of an inter-
est bearing instrument or future cash ow as a result of a change of 1 basis point
in the zero coupon rate, there is a comparable indicator. This indicator shows the
change in value of an interest bearing instrument or a single cash ow as a result of
a change of 1 basis point in the credit spread. This indicator is called the credit BPV
or CV01, although some banks still use the term PV01 for this.

6.1.3 The Greeks

We have seen that the level of the option premium is determined by several parame-
ters, which may interfere with each other. The extent to which the option premium
changes due to a change in one of these price determining factors is indicated by
the Greek letters: delta (and gamma), vega, theta and rho.

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6.1.3.1 delta

Delta shows the relationship between the absolute change in the option price and
an absolute change in the price of the underlying value. A delta of 0.6, for instance,
means that the option premium increases by 60 euro cents if the price of the under-
lying value increases by 1 euro. The delta also provides an indication of the chance
that the option will be exercised. A low delta means that this chance is small, whilst
a high delta means that the chance of exercising is high. For instance, a delta of 0.9
indicates that the probability that an option will be exercised is 90%. The table be-
low shows the development of the delta of a GBP call / USD put option with a strike
price of 1.6000 and a remaining term of three months for dierent GBP/USD FX
forward rates (volatility is 15%).

gbp/usd intrinsic value time value option premium delta

forward rate

1.5000 0 0.0125 0.0125 0.20

1.5100 0 0.0145 0.0145
1.5950 0 0.0475 0.0475 0.50
1.6050 0.0050 0.0475* 0.0525
1.6900 0.0900 0.0145 0.1045 0.80
1.7000 0.1000 0.0125 0.1125

* Note that the time value of the in-the-money options is equal to the time value of the equal out-of-the-
money options

With a GBP/USD rate of 1.6900, the delta can, for instance, be calculated as follows:
(0.1125 0.1045) / (1.7000 1.6900) = 0.80.

Call options have a positive delta (between 0 and 1) and put options have a negative
delta (between 0 and -1). The delta for an option that is far otm is close to zero, the
delta for atm options is always around 0.50 (+0.50 for calls or -0.50 for puts) and the
delta for an option that is deep itm is almost equal to 1 (or -1).

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Figure 6.2 The development of the delta of a call option with various prices for the
underlying value (delta as a percentage)

Figure 6.2 shows that the development of the delta depends on the remaining term
of the option contract. As the remaining term decreases, the development of the
delta becomes less gradual. Just before expiry, the delta for atm options changes
dramatically as a result of small price movements.

6.1.3.2 gamma

Figure 6.2 also shows that the delta changes if the price of the underlying value
changes. Each time that an option becomes less otm or more itm, the delta increas-
es. The degree to which this happens is represented by gamma. Gamma describes
the relationship between the change in the delta and the change in the price of
the underlying value. If an option is very far otm, the change in the delta is always
small. The same applies for an option that is very far itm. In both cases, the gamma
is small. For atm options, however, the gamma is high. This is especially the case if
the option is approaching its expiry date. This is shown in gure 6.3.

Figure 6.3 The development of the gamma at diering prices for the underlying value

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Figure 6.3 also shows that the gamma increases as the remaining period to maturity
of an option contract becomes shorter.

6.1.3.3 vega/volatility

Vega gives the change in the option price due to a change in volatility of 1% point
(for example, from 20% to 21%). Vega decreases if the remaining term of the option
becomes shorter.

When option traders quote prices for volatility, they take into account the so-called
smile eect. This means that they use lower volatilities for atm options than for far
itm or otm options. The line reecting the relationship between exercise price and
volatility therefore looks like a smile. This is shown in gure 6.4.

Figure 6.4 Volatility Smile

6.1.3.4 theta

The option premium decreases as the remaining term for an option becomes short-
er. After all, an option that still has only one day left oers much fewer (additional)
prot opportunities than an option that still has a year to run. The relationship be-
tween the decrease in the option price and a reduction in the remaining term by
one day is given by theta. Because the option premium decreases as time passes, the
thta is always a negative number.

As time passes, the theta of an option becomes progressively more negative; in oth-
er words, the option premium diminishes to a greater extent day by day. For options
that have nearly expired, the thta is the most important parameter with regard to
changes in the option premium.
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6.1.3.5 rho

Rho gives the sensitivity of the option premium to a change in interest rates of 1 per-
centage point (for instance, a change from 5% to 6%). The sensitivity of the option
premium to changes in the interest rate is related to the delta-hedge.

6.2 Value at Risk

The value at risk (VaR) method is a way of estimating the size of market risk under
normal market conditions. A sensitivity parameter shows how much the value of a
position changes as a result of a standard change in the price determining param-
eter. The value at risk tells you how much the value of that position changes as a
result of a specic scenario of the price determining parameter. Therefore, a sen-
sitivity indicator, in fact, merely gives information about the size of a traders posi-
tion whilst the value at risk gives an approach for the actual loss that a trader can
suer under the current market conditions.

To calculate the VaR, each day market risk managers determine a number of scenar-
ios for the market parameters that determine the value of a position or a portfolio
for the next day. Which scenario will ultimately be chosen as VaR scenario depends
on the desired condence interval. This indicates the degree of statistical certainty
with which the chosen scenario really can be considered as a worst-case scenario.
Market risk managers generally use a condence interval of 99%.

Next, the market risk manager calculates how much the value of a trading position
would fall if the VaR scenario would actually come true. The result is referred to as
the value at risk of the trading position.

The period over which the value at risk is calculated is called the holding period or
time to close position. The duration of the holding period depends on the speed with
which a position can be closed. Trading positions in liquid markets can be closed
quickly. For this reason, the holding period for these positions is set at one day.

For single trading positions, the historical VaR method is used. This is a way of de-
termining the VaR scenario where price changes over a specic historical period are
used in a straightforward way. For trading positions, banks generally use the last
250 to 400 daily price movements.

These historical observations are ranked from the most unfavourable price move-
ment to the most favourable. If a bank wants to use a desired probability percentage
of 99%, for instance, it will choose the observation from the list for which only 1%
of all observations were even less favourable as the VaR scenario.

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example

On 15 June 2009, the market risk system calculated the VaR scenario for the price of
Heineken shares using the last 250 daily price changes.

The system ranked the 250 most recent daily relative price changes for the Heineken
share price. For each observation, a condence level was calculated. The condence
level of the worst observation is 100%. After all, based on these 250 scenarios, it
must be 100% certain that the price on the next trading day will not fall by more
than 4%.

scenario 250 249 248 247 246 245 244 243 ... 2 1

% Price change -/-4% -/-3.5% -/-3% -/-2.7% -/-2.5% -.-1.7% -/- 1.6% -/-1.5% + 3% +3.5%

Probability 100% 99.6% 99.2% 98.8% 98.4% 98% 97.6% 97.2% 0.8% 0.4%

This system, however, was programmed with a probability percentage of 99%. As

VaR scenario, therefore, it chooses the scenario with the next higher probability per-
centage. This is scenario 248, which indicates a price fall of 3%.

If the share trader of this bank has a long position of 100,000 Heineken and the cur-
rent price of the Heineken share is EUR 20, the market risk system calculates the
traders Value at Risk as: 3% x EUR 2,000,000 = EUR 60,000.

6.3 Stress tests

We have seen that banks use a particular condence interval to determine the VaR
scenario. This means that the largest negative extremes are kept out of the analysis.
Furthermore, banks only use the price movements from the last 250 or 350 days.
This means that banks that use the VaR method not only ignore the most negative
scenarios from the historical period that the observed, but that they also take no ac-
count of any disaster scenario that took place earlier in the past.

For this reason, banks also use another method in addition to the VaR method to
indicate their market risk. This method provides information about the risks under
extreme market circumstances or market events. This method is called stress test-
ing. The objective of stress tests is to evaluate if a bank is able to survive exceptional
shocks in the nancial markets. The loss on a trading position that appears with a
stress scenario is called event value at risk.

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With a stress test, a bank calculates the eect of one or more possible market events
on the value of its trading positions. The scenarios used for a stress test can be
drawn up in various ways. The rst possibility is to use scenarios that have actu-
ally happened, such as nine eleven (11-9-2001). However, the disadvantage of this
method is that events from the past are highly unlikely to happen again in the same
way in the future.

Banks have therefore also made up their own hypothetical scenarios for extreme
market circumstances. For instance, they assume a change in exchange rates of
10% or an interest rate change of 100 basis points. Many banks use both, historical
and ctitious scenarios.

Apart from stress tests, banks are required to perform reverse stress tests. The pur-
pose of a reverse stress test is to identify scenarios and circumstances that will
cause the banks business model will become unviable.

6.4 Extreme value theory

An alternative for stress testing is studying the behaviour of what can happen dur-
ing unusual market conditions by using a technique that is referred to as extreme
value theory. The rst step of extreme value theory is to identify the observations
during a specic observation period that can be used to characterize the extreme
losses. There are two kinds of model for collecting the extreme observations. The
rst one is the block maxima model. This model divides the observation period in
blocks and then takes the maximum loss within each block as a data. For example,
if the observation period is one year and the daily results are registered on a dai-
ly basis, we can choose the worst outcome for each month as an extreme. This is
shown gure 6.5 where the observation period is from March until March the fol-
lowing year. The extreme for each month is indicated by a bold x.

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Figure 6.5 Block Maxima model

The second, and more commonly used method, is the peak over treshold (POT)
model. In this model all large observations that exceed a certain threshold during
the observation period are identied as extremes. For example during the above
mentioned observation period every outcome over a daily change in prices or rates
of 2% is identied as an extreme. This is shown in gure 6.6. The extremes are
again indicated by a bold x.

Figure 6.6 Peak over Treshold Model

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Once the extremes are identied, a distribution for extreme tail loss is made. This
distribution provides information about the market behaviour during extreme situ-
ations. The most important problem of the extreme value theory is obviously the
fact that there are are little data. This can be solved by decreasing the time period of
the blocks in the Block Maxima model or by lowering the threshold in the Peak over
Treshold model. However, in that case it is questionable whether the observations
in the then larger sample can be considered as extremes.

6.5 Expected shortfall

The expected shortfall, also referred to as conditional VaR, (expected) tail loss or av-
erage VaR, is dened as the conditional expectation of loss given that the loss is be-
yond the VaR level. The expected shortfall is the mean of all the potential losses that
exceed the VaR. Where VaR asks the question how bad can things get?, expected
shortfall asks if things do get bad, what is our expected loss?.

example

The expected shortfall in the example in paragraph 6.2 can be calculated by taking
the mean of losses under the extremes -4% -3.5% and -3%. These losses are respec-
tively 80.000, 70.000 and 60.000.

The expected shortfall is (80.000 + 70.000 + 60.000) / 3 = 70.000

6.6 Trading limits

A trading limit indicates the maximum open position that a trader is permitted to
hold. Trading limits may apply either for an entire department within the dealing
room (trading desks) or for individual traders. The trading limit for a trading desk
is determined by the committee that is responsible for drawing up the limit control
sheet (LCS).

The allocation of limits between individual traders at a specic trading desk is the
responsibility of the desks departmental head. Junior traders are generally allowed
to hold only small positions. A traders limit is raised as his experience and as his
protability increases. Banks use two types of trading limits to manage market risk,
value at risk (VaR) limits and nominal limits. At any moment in time, a trader must
satisfy all his limits.

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6.6.1 Value at risk limit

A VaR limit sets a limit to the VaR of a trader, however, it does not set a xed limit to
the nominal position of a trader.

example

A shares trader has a VaR limit of EUR 500,000. If the VaR scenario for today is a
price decrease of 2%, the maximum allowed market value of the shares position, ac-
cording to this VaR limit, is EUR 25 million. After all, the VaR is then 2% of EUR 25
million = EUR 500,000.

For a VaR scenario of 1%, however, the maximum allowed market value of the posi-
tion would be EUR 50 million.

In quiet market conditions, the price changes in the VaR scenarios are relatively
small. If a bank would only use a VaR limit, a trader could hold very large trading
positions. This is dangerous because, even after a very quiet period, the market can
suddenly become extremely volatile and the possible losses could then become very
large.

6.6.2 Nominal limits

With the VaR limit, the allowed size of a position is dependent on the current mar-
ket circumstances. A nominal limit, in contrast, set an absolute maximum on the
size of a trading position. Since the credit crisis, banks have become much more
careful about using only VaR limits, and they are increasingly using nominal limits
in addition to VaR limits.

Nominal limits impose a limit to the size of a trading position regardless of market
developments. The most simple nominal limit is a positions limit. A positions limit
sets an unconditional limit on the market value of a position. An example is an FX
trading limit where the EUR/USD FX trader is allowed to hold a position of maxi-
mum EUR 5 million long or short. For interest rate positions and options, dedicated
limits are used. Finally, sometimes traders are assigned a stress test limit.

6.6.2.1 nominal limits for interest positions

A gap limit sets a limit to the mismatch position in terms of volume and time. A
money market trader is, for instance, only allowed to have a mismatch position in a

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single maturity bracket of not more than 100 million. Another exeample is an inter-
est rate derivative trader who is only allowed to take positions not longer than ve
years.

If an FX trader is allowed to trade FX forwards, he is also assigned a gap limit. The

same is true for FX swap traders.

A basis point value limit sets a limit to the market value of an interestbearing port-
folio measured by its basis point value, assuming a parallel move of the yield curve.
If the BPV limit for a trader is, for example, EUR 50,000 this means that he is al-
lowed to hold the following positions:

market value modified duration bpv

500 mio 1 50,000

200 mio 2.5 50,000
50 mio 10 50,000

A variant of the basis point value limit is the credit spread sensitivity limit. This is a
limit to the market value of a bond portfolio measured by its change in price as a re-
sult of a change in the credit spread of the issuer of one basis point.

A slope risk limit sets a limit to the market value of an interest bearing portfolio
measured by the change in this value as a result of a pre-dened change in the
slope of the yield curve. For instance, a trader may not loose more than EUR 15,000
if the interest rates for the shorter periods, e.g. up to two and a half years, fall with
1 basis point and at the same time the interest rates for the longer periods rise. A
trader that holds the position that is shown in the table below, complies with this
limit.

bucket (year) basis point value result of the pre-defined scenario

0.5 - 1.5 EUR 10,558.43 + EUR 10,558.43

1.5 - 2.5 EUR 08,075.93 + EUR 08,075.93
2.5 - 3.5 EUR 06,553.23 EUR 06,553.23
3.5 - 4.5 EUR 09,991.22 EUR 09,991.22
4.5 - 5.5 EUR 12,238.79 EUR 12,238.79

Total change in market value EUR 10,148.86

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6.6.2.2 greek limits for option positions

Greek limits set a limit to the value of an option portfolio measured by its Greek pa-
rameters, the delta, gamma, rho and vega.

Delta limit and delta hedging

The delta limit sets a limit to the sensitivity of an option position to changes in the
price of the underlying value. The main business for option traders is trading vola-
tility. However, when an option trader opens a position by buying or selling an op-
tion, the value of his position is not only inuenced by changes in the volatility but
also, amongst other things, by the price movement of the underlying value. In other
words: the option trader also has a virtual position in the underlying value. If the
delta, for instance is 0.50, this means that an option position behaves in the same
manner as a position in the underlying value for half the contract amount. This is
called the delta position of the option position.

example

An option trader has a long position in call options with a contract volume of
100,000 shares. The delta of the options is 0.155. The current premium of the op-
tions is 4. This means that the market value of the options position is 400,000. If the
price of the underlying rises with 1 unit, the option premium rises with 0.155 and the
market value of the options position rises with 15,000 to 415,500.

The position thus reacts in the same manner to a change in the share price with one
unit as a long position of 15,500 in the underlying shares.

If the option trader would have sold this call option his position would react, of
course, in the opposite way: i.e. as a short position of 15,500 shares. The delta posi-
tion of this trader is a short position of 15,500 shares.

The common opinion amongst the management of Financial Markets Depart-

ments, however, is that options traders must leave trading in shares to share trad-
ers, in bonds to bond traders, in FX to FX spot traders et cetera. Options traders with
banks, therefore, normally are not allowed to be exposed to changes in the price of
the underlying value. In other words: their delta limit is set close to zero and they
must make sure that the delta of their position is zero.

Option traders theoretically can realize a zero delta position by always concluding a
call option and a put option with the same delta at the same time. If an option trad-
er, for instance, wants to have a long position in volatility, he can buy either a call

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option or a put option. After all, buying an option means buying volatility. However,
if the trader would only buy a call option , he would enter into a virtual long posi-
tion in the underlying value. To oset this delta positions, he could buy a put option
with the same (opposite) delta. And if he would only buy a put option, he would en-
ter into a virtual short position in the underlying value. Now he can oset his delta
position by buying a call option with the same delta. However, in reality the delta
position is neutralized in another way: the so-called delta hedge.

To neutralise the eect of price changes of the underlying value, option traders with
banks take a position in the underlying value that is exactly the opposite of their
delta position. This is called delta hedging. The option traders position is then said
to be delta neutral. The value of the composite position now only changes as a re-
sult of changes in volatility, the remaining term of the option and the interest rate.
In an ideal world, options traders would also want to make the value of their posi-
tion independent of changes in the remaining term and in the level of interest rates;
however, this is not possible. Fortunately, this is not a great problem because these
factors are much less volatile than the price of the underlying value and thus play
generally no major disruptive role.

Because the delta of an option changes when the price of the underlying val-
ue changes, an option trader must constantly adjust his delta position during the
term of the option contract in order to keep his position delta neutral. The size of
the transactions as a result of the delta hedging depends on the level of the gamma,
that represents the changes in delta. For a low gamma, only small transactions are
necessary. For a high gamma, however, an option trader must buy or sell more of
the underlying value to keep his position delta neutral.

example

An option trader has sold a GBP call / USD put option to a client with a strike price of
1.4800. The premium for this option is USD 0.0500 per GBP and the size of the op-
tion contract is GBP 1,000,000. At the start date of the option contract term, the del-
ta of this option is 0.25. The current GBP/USD FX forward rate is 1.4300. As an initial
delta hedge, the option trader has bought GBP 250,000 against USD.

On a later moment, the GBP/USD FX forward rate has risen to 1.4400. As a result, the
delta has also increased, for instance to 0.30. The option trader must now adjust his
delta position by buying 0.05 x 1,000,000 = 50,000 British pounds.

If, however, on a still later moment, the GBP/USD FX forward rate falls to 1.4000, and
the delta falls to, for instance, 0.18, the option trader must sell 120,000 British pounds.

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The above example shows that if the delta of an option position increases, an option
trader must buy the underlying value and if the delta of the position falls he must
sell the underlying value. With this, he will constantly suer small losses. This is
because, in contrast to the golden rule, he buys high and sells low.

The option premium is partially a compensation for these trading losses. When
quoting his option premium, an option trader makes an estimate of the volatility
of the underlying value (implied volatility). A high volatility means that the option
trader expects that he will have to adjust his delta position frequently and will have
to accept great trading losses. Thus, he asks a high option premium.

If the option trader estimated the volatility correctly, he earns the margin on the
premium that he had calculated. If he underestimated the volatility, he would suer
a loss. In this case, the premium is not sucient to oset the trading losses result-
ing from the delta hedge.

The delta hedge can also be used to explain the relevance of the interest rate for the
option premium. After all, an option trader who has a short position in call options
must buy the underlying value in order to perform his delta hedge. This will involve
interest costs. Similarly, an option trader who has taken a short position in put op-
tions must sell the underlying value. This produces interest income.

example

An option trader sells a call option on a share with a remaining term of three
months. The delta for this option is 0.25. The three month interest rate is 4%. The
current share price is EUR 40.

Due to the delta hedge, the trader must buy 0.25 shares for each option contract unit.
The interest costs of the delta hedge, therefore, are:

0.25 x EUR 40 x 90/365 x 0.04 = EUR 0.10.

The option trader will include the interest cost of EUR 0.10 in the option premium.

Gamma limit and vega limit

Even if an options position has a delta of zero, the position can be very risky. This is
especially the case if the remaining term is short and if, at the same time, the option
is at-the-money. In this case, a small change in the price of the underlying value can
lead to a large delta position that, by denition, only can be hedged at a consider-
able loss. Therefore all traders are assigned a gamma limit.

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The vega limit sets a limit to the sensitivity of an option position to changes in the
volatility of the underlying value of the options position. Together with the gamma
limit the vega limit is the most relevant limit for an option trader. After all, option
traders trade in volatility.

6.6.2.3 stress test limit and expected shortfall limit

A stress test limit or event risk limit sets a limit to the market value of a position as
a result of a pre-dened market disruption. In order to set an event risk limit, the
market risk management department must design so-called stress tests. With a
stress test, a bank draws up one or more future disaster scenarios in order to be
able to assess the risk associated with future extreme market movements. These
scenarios could be an actual historical scenario such as nine eleven (when the twin
towers came down in New York). The disadvantage with this method, however, is
that events from the past will most probably not occur again in the same way in the
future.

Market risk management will therefore also usually create its own imaginary disas-
ter scenarios. For example, it will assume a 10% change in the currency exchange
rates or an interest rate change of 100 basis points. Market risk management will
then calculate the possible losses for the traders as a result from these imaginary
disaster scenarios. A stress test limit is a nominal limit because, it is not inuenced
by the current market conditions.

Banks can also set a limit on the expected shortfall. The expected shortfall limit pre-
vents traders from taking very risky positions whilst at the same time they satisfy
with their VaR limits.

If, for instance, a trader has a one-day 99% VAR is $10 million, there is a danger that
the trader will construct a portfolio where there is a 99% chance that the daily loss
is less than $10 million and a 1% chance that it is $500 million. The trader is now
satisfying the VaR limits but is clearly taking unacceptable risks. By setting a limit
to the expected shortfall, banks can limit their risk more eectively than by only us-
ing VaR.

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