Strategies for Excellence
Market Risk Management
by
R. Ravimohan
CEO & MD CRISIL
Presentation at FICCI Conference on
”Global Banking Paradigm Shift”
On Sept 14, 2003, Bangalore
What is Risk?
•Risk, in traditional terms, is viewed as a ‘negative’. Webster’s
dictionary, for instance, defines risk as “exposing to danger or
hazard”.
•The Chinese give a much better description of risk
>The first is the symbol for “danger”, while
>the second is the symbol for “opportunity”, making risk a mix of
danger and opportunity.
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Risk Management
Risk management is present in all aspects of life; It is about the
everyday trade-off between an expected reward an a potential
danger. We, in the business world, often associate risk with some
variability in financial outcomes. However, the notion of risk is
much larger. It is universal, in the sense that it refers to human
behaviour in the decision making process. Risk management is
an attempt to identify, to measure, to monitor and to manage
uncertainty.
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Types of financial risk
Equity Risk Trading Risk
Market Risk
Interest Rate Risk
Gap Risk
Currency Risk
Commodity Risk
Transaction Risk Counterparty Risk
Credit Risk
Financial Portfolio Issuer Risk
Concentration Risk
Risks Liquidity Risk
Operational Risk
Regulatory Risk
Human Factor
Risk
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Understanding Market Risk
It is the risk that the value of on and
off-balance sheet positions of a
financial institution will be adversely
affected by movements in market rates
or prices such as interest rates, foreign
exchange rates, equity prices, credit
spreads and/or commodity prices
resulting in a loss to earnings and
capital.
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Why the focus on Market Risk Management ?
• Convergence of Economies
• Easy and faster flow of information
• Skill Enhancement
• Increasing Market activity
Leading to
•Increased Volatility
•Need for measuring and managing
Market Risks
•Regulatory focus
•Profiting from Risk
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Best Practices
in
Market Risk Management
1. Rethinking the Market Risk process
2. Establish Top Management Oversight
3. Deploy Best practices framework
4. Adopt appropriate Organisation Structure
5. Invest in Good Technology
6. Use Hedging techniques Judiciously
7. Ensure Robust Marking to Market
8. Establish good operational processes
9. Measure, Monitor & Manage – Value at Risk
10. Explore quantitative models for default prediction
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1. Rethinking the Market Risk process
Increased reliance on objective risk assessment
Investment process differentiated on the basis of risk, not size
Investment in workflow automation / back-end processes
Align “Risk strategy” & “Business Strategy”
Active Portfolio Management
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2. Establish Top Management Oversight
Board and senior Management Oversight
Delineate banks overall risk tolerance in relation to market risk
Ensure that bank’s overall market risk exposure is maintained at prudent levels
and consistent with the available capital
Ensure that top management as well as individuals responsible for market risk
management possess sound expertise and knowledge to accomplish the risk
management function.
Ensure that the bank implements sound fundamental principles that facilitate the
identification, measurement, monitoring and control of market risk.
Ensure that adequate resources (technical as well as human) are devoted to
market risk management.
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3. Deploy Best practices framework
Investment & Market Risk Policies should be comprehensive
Investment organisation - Independent set of people for front,
mid & back offices
Set exposure Limits On Different Parameters – dealer wise,
transaction, instruments, broker, & other counter parties
Implement straight - through processing
Operationalise stop-loss limits
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4. Adopt appropriate Organisation Structure
Organization Structure
The structure should conform to the overall strategy and risk policy set
by the BOD
Those who take risk (front office) must know the organization’s risk
profile, products that they are allowed to trade, and the approved limits.
Apart from BOD responsibility to be assumed by forming following
The risk management function should be independent, reporting
directly to senior management or BOD.
The Risk Management Committee
The Asset-Liability Management Committee (ALCO)
The Middle Office.
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5. Invest in Good Technology
Treasury
Integration
Straight -through
Processing
Back Office Market
Integration Integration
Currency Interest Rate Dealing Payments
Business
Risk Process
Management Management
Credit Liquidity Accounting Cash Mgmt
Improved Control Improved Integration
Enhanced Reporting Enhanced Productivity
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6. Use Hedging techniques Judiciously
•Interest Rate Swaps
Forward Rate Agreements
Forward Contracts
Currency Options
Equity Derivatives
Equity Options
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7. Ensure Robust Marking to Market
The need arises due to structured products and lack of liquidity results in
the absence of traded prices
In case of non-traded securities, marking to market is critical for
valuation & risk management
CRISIL is the official provider of valuation services and appointed by
SEBI / AMFI for the Mutual Fund industry segment
In case of active investment management and for risk management,
the periodicity of daily valuation is required
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8. Establish good operational processes
Align Business strategy and treasury
process
Complete integration
front middle back
office office office
sound treasury control
liquidity management
position keeping
limit management
risk management
settlement management
treasury accounting
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9. Measure, Monitor & Manage
– Value at Risk
ValueatRisk
ValueatRisk is a measure of Market Risk, which
Value at Risk
measures the maximum loss in the market value of
.022 433 a portfolio with a given confidence
.016 324.7
.011 216.5 VaR is denominated in units of a currency or as a
percentage of portfolio holdings
.005 108.2
.000 0
For e.g.., a set of portfolio having a current value
1.5 2.9 4.3 5.6 7.0 of say Rs.100,000 can be described to have a
Certainty is 95.00% from 2.6 to +Infinity daily value at risk of Rs. 5000 at a 99%
confidence level, which means there is a 1/100
chance of the loss exceeding Rs. 5000/
considering no great paradigm shifts in the
underlying factors.
It is a probability of occurrence and hence is a
statistical measure of risk exposure
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Features of CRISIL VaR Model
Multiple Yields Incremental
Portfolios Duration VaR
VaR
Variance-
Portfolio
Stop Loss covariance
Optimization
Matrix
Helps
Facility
For
For
For
picking
in
Identifying
of
aiding
optimizing
Return
multiple
upinsecurities
Analysis
cutting
and
methods
portfolio
isolating
losses
which
forand
inaiding
Risky
during
the
portfolios
gelgiven
well
inand
volatile
trade-off
set
in
safe
inthe
of
single
securities
periods
constraints
portfolio
model
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Managing Market Risk
Questions International % of Banks
practice with + ve
response
1. Are all market risks centrally All Market Risks are centrally 100%
managed? managed by Treasury / Global
Markets
2. Do you measure Var of non- Large International banks 0%
trading balance sheet? measure / Manage balance sheet
Risks actively
3. Is Funds Transfer Pricing policy Incremental Cost of Funds 0%
based on marginal market rates? reflects in Incremental Transfer
Pricing on Assets / Liabilities
4. Is board / senior management Board / Management Committee 85%
involved in managing Market overviews the management of
risks? Market Risk
5. Is there a central unit for Basel II is being managed as a 70%
implementing Basle II guidelines? project with a central coordinator
for the bank
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10. Explore quantitative models
for default prediction
Crisil’s Corporate predictor Model (CCOP) is a
quantitative model to predict default risk
dynamically
Model is constructed by using the hybrid approach
of combining Factor model & Structural model
(market based measure)
The inputs used include: Financial ratios, default
statistics, Capital Structure & Equity Prices.
Derivation of Asset value & volatility The present coverage include listed & Crisil rated
Calculated from Equity Value , volatility for each companies
company-year
Solving for firm Asset Value & Asset Volatility
simultaneously from 2 eqns. relating it to equity value
and volatility
The product development work related to private
firm model & portfolio management model is in
Calculate Distance to Default
Calculate default point (Debt liabilities for given
process
horizon value)
Simulate the asset value and Volatility at horizon
The model is validated internally
Calculate Default probability (EDF)
Relating distance to default to actual default
experience CCoP is one of the most complicated product
Use QRM & Transition Matrix
developed and with the help of in-house technology.
Calculate Default probability based on Financials
Arrive at a combined measure of Default using both
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To Summarise….
Effective Management of Market Risk benefits the bank..
Efficient allocation of capital to exploit different risk / reward
pattern across business
Better Product Pricing
Early warning signals on potential events impacting business
Reduced earnings Volatility
Increased Shareholder Value
No Risk … No Gain!
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for further details contact, . . .
[Link]
Director,
Investment & Risk Management Services
CRISIL
Email : dravishankar@[Link]
[Link]: 5653 7531
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