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Strategies for Excellence
Market Risk Managementby
R. Ravimohan CEO & MD CRISIL
Presentation at FICCI Conference on”Global Banking Paradigm Shift”
On Sept 14, 2003, Bangalore
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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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FinancialRisks Liquidity Risk
Operational Risk
Regulatory Risk
Human FactorRisk
Market Risk
Equity Risk
Interest Rate Risk
Currency Risk
Commodity Risk
Trading Risk
Gap Risk
Credit RiskPortfolio
Concentration Risk
Transaction Risk Counterparty Risk
Issuer Risk
Types of financial 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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• Convergence of Economies• Easy and faster flow of information• Skill Enhancement• Increasing Market activity
Why the focus on Market Risk Management ?
Leading to
•Increased Volatility•Need for measuring and managing
Market Risks•Regulatory focus•Profiting from Risk
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Best Practicesin
Market Risk ManagementMarket 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 Increased reliance on objective risk assessment
Align “Risk strategy” & “Business Strategy” Align “Risk strategy” & “Business Strategy”
Investment process differentiated on the basis of risk, not size Investment process differentiated on the basis of risk, not size
Investment in workflow automation / back-end processes Investment in workflow automation / back-end processes
Active Portfolio Management 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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Investment & Market Risk Policies should be comprehensive Investment & Market Risk Policies should be comprehensive
Set exposure Limits On Different Parameters – dealer wise,
transaction, instruments, broker, & other counter parties
Set exposure Limits On Different Parameters – dealer wise,
transaction, instruments, broker, & other counter parties
Investment organisation - Independent set of people for front,
mid & back offices
Investment organisation - Independent set of people for front,
mid & back offices
Implement straight - through processing Implement straight - through processing
3. Deploy Best practices framework
Operationalise stop-loss limits 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.
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
Cash MgmtAccounting
PaymentsDealingCurrency Interest Rate
Credit Liquidity
Risk
Management
Business
Process
Management
Improved ControlImproved Control
Enhanced ReportingEnhanced Reporting
Improved IntegrationImproved Integration
Enhanced ProductivityEnhanced Productivity
Straight -through Processing
Treasury Integration
Back Office Integration
MarketIntegration
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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
The need arises due to structured products and lack of liquidity results in
the absence of traded prices
CRISIL is the official provider of valuation services and appointed by
SEBI / AMFI for the Mutual Fund industry segment
CRISIL is the official provider of valuation services and appointed by
SEBI / AMFI for the Mutual Fund industry segment
In case of non-traded securities, marking to market is critical for
valuation & risk management
In case of non-traded securities, marking to market is critical for
valuation & risk management
In case of active investment management and for risk management,
the periodicity of daily valuation is required
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
sound treasury control
liquidity management
position keeping
limit management
risk management
settlement management
treasury accounting
middle office
back office
front office
Complete integration
Align Business strategy and treasury process
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9. Measure, Monitor & Manage
– Value at Risk
Value-at-Risk
Value-at-Risk is a measure of Market Risk, which measures the maximum loss in the market value of a portfolio with a given confidence
VaR is denominated in units of a currency or as a percentage of portfolio holdings
For e.g.., a set of portfolio having a current value of say Rs.100,000- can be described to have a 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
Value at Risk
Certainty is 95.00% from 2.6 to +Infinity
.000
.005
.011
.016
.022
0
108.2
216.5
324.7
433
1.5 2.9 4.3 5.6 7.0
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Variance-Variance-covariancecovariance
Matrix
Variance-Variance-covariancecovariance
Matrix
MultiplePortfoliosMultiple
Portfolios
YieldsDurationYields
Duration
Incremental VaR
Incremental VaR
Stop LossStop Loss
PortfolioOptimization
PortfolioOptimization
VaRVaR
Features of CRISIL VaR Model
Facility of multiple methods and portfolios in single modelReturn Analysis for aiding in trade-offFor Identifying and isolating Risky and safe securitiesFor picking up securities which gel well in the portfolioFor aiding in cutting losses during volatile periodsHelps in optimizing portfolio in the given set of constraints
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Managing Market Risk
Questions Internationalpractice
% of Bankswith + veresponse
1. Are all market risks centrallymanaged?
All Market Risks are centrallymanaged by Treasury / GlobalMarkets
100%
2. Do you measure Var of non-trading balance sheet?
Large International banksmeasure / Manage balance sheetRisks actively
0%
3. Is Funds Transfer Pricing policybased on marginal market rates?
Incremental Cost of Fundsreflects in Incremental TransferPricing on Assets / Liabilities
0%
4. Is board / senior managementinvolved in managing Marketrisks?
Board / Management Committeeoverviews the management ofMarket Risk
85%
5. Is there a central unit forimplementing Basle II guidelines?
Basel II is being managed as aproject with a central coordinatorfor the bank
70%
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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.
The present coverage include listed & Crisil rated companies
The product development work related to private firm model & portfolio management model is in process
The model is validated internally
CCoP is one of the most complicated product developed and with the help of in-house technology.
Derivation of Asset value & volatility Calculated from Equity Value , volatility for each
company-year Solving for firm Asset Value & Asset Volatility
simultaneously from 2 eqns. relating it to equity value and volatility
Calculate Distance to Default Calculate default point (Debt liabilities for given
horizon value) Simulate the asset value and Volatility at horizon
Calculate Default probability (EDF) Relating distance to default to actual default
experience
Use QRM & Transition Matrix Calculate Default probability based on Financials Arrive at a combined measure of Default using both
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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 Gain!No Risk …
To Summarise….
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for further details contact, . . .for further details contact, . . .
D.RavishankarD.RavishankarDirector,Director,Investment & Risk Management ServicesInvestment & Risk Management ServicesCRISILCRISILEmail : Email : [email protected]: 5653 7531Ph.no: 5653 7531