RSK4805 – Learning units
Please note that the primary study material to be used is indicated on myUnisa. All
changes and additional material will only be available from myUnisa. This PDF
document of the learning units is just for you to be able to also do some of the work
offline. You will still be required to access myUnisa in order to download the relevant
documents and do the activities as indicated. This document should not be used in
isolation.
RSK4805 – Topic 1
Topic 1 covers learning units 1 to 3 and introduces market risk management, including
sources and challenges of market risk management, concepts relating to risk and
return (LU1), an overview of the financial services industry (LU2) and the regulatory
requirements for market risk management (LU3). First complete the short quiz at the
end of learning unit 0 before you continue with Topic 1. You need to work through the
study material for this topic.
Learning unit 1
You have to work through chapter 1 of the prescribed textbook.
Please note that if you are unfamiliar with any of the topics discussed, you have to do
additional reading on your own to update your knowledge on those topics.
1. Introduction to market risk
Risk management is an increasingly important aspect of organisational structure. Risk
management can be defined as the process of identifying, evaluating, measuring and
managing risk on a continuous basis. Risk comprises two categories, namely, financial
risk and non-financial risk, as indicated in figure 1.1.
1
Figure 1.1 – Categories of risk
Credit risk
Financial risk
Market risk (including
commodity risk, equity risk,
exchange rate risk and
interest rate risk)
Operational risk
Risk
Non-financial risk
Reputational risk
Legal risk
Technology risk
Strategy risk
Operating environment risk
Money-laundering risk
Control risk
Adapted from Ghosh (2012:5) and Chance (2003:570).
This module focuses on the management of market risk within an organisation. Within
the Postgraduate Diploma in Risk Management, you will also study topics related to
operational risk management, credit risk management, risk financing, and corporate
governance and compliance.
1.1
Sources of market risk management
Market risk can be defined as the risk of loss due to changes in the value of the
underlying financial instrument held by an organisation. The underlying financial
instrument can be bonds, shares, loans or commodities. There are four major types of
market risk, namely, interest rate risk, equity price risk, foreign exchange risk and
commodity price risk.
The following website contains definitions of the four major types of market risk that
you need to read: https://financetrain.com/types-of-market-risk/. Interest rate risk is the
risk that an underlying price might decrease due to an increase in the interest rate.
Included in this field is basis risk, repricing risk, yield curve risk and options risk. Equity
price risk is the risk that arises from the volatility in the price of a security. Foreign
exchange risk is the risk that arises due to fluctuations in exchange rates. Commodity
price risk is the risk of unanticipated changes in commodity prices.
2
1.2
Challenges in market risk management
Market risk management attempts to put a value on the risk of loss due to changes or
movements in the financial market. This concept is important for all public and private
organisations, not only financial institutions. The following slides point out some of the
challenges in practical market risk management:
https://www.slideshare.net/CRISILLimited/challenges-in-market-risk-management
In the next section, we will look at various concepts relating to risk and return. Riskaverse investors (and companies) want the maximum amount of return on their
investments for the minimum amount of risk. It is therefore important for an
organisation’s management to understand the basic concepts pertaining to risk and
return in order to make informed decisions on how to manage and hedge the various
kinds of risk within the organisation.
Study chapter 1 of the prescribed textbook
1.3
Concepts relating to risk and return
The term “Treasury bill yield” is used in the textbook (page 2). Treasury bills or
government bonds are seen as risk-free investments because they are guaranteed by
the various governments where the bonds or bills are issued. If this rate is given, you
can use it as the risk-free rate for the specific investment. A spreadsheet containing
the risk-free rates for South Africa can be downloaded from the SARB’s website at
https://www.prudentialauthority.co.za/Publications/Detail-ItemView/Pages/Publications.aspx?sarbweb=3b6aa07d-92ab-441f-b7bfbb7dfb1bedb4&sarblist=21b5222e-7125-4e55-bb65-56fd3333371e&sarbitem=8142.
Page 3 of the textbook shows how to calculate the expected return if an investment
was made in a share or stock. This calculation is as follows:
Expected Return(E(R))   0.05  0.50    0.25  0.30    0.4  0.10    0.25  0.10    0.05  0.30 
 0.025  0.075  0.04  0.025  0.015
 0.10
 10%
In mathematics the rule is: multiplication and division before addition and subtraction.
Therefore, the order in which you do the calculation is important. If you are
uncertain, please read Annexure A on the order of calculations.
To quantify risk, we can use the standard deviation formula:
 
  E R 2  E  R  
2
In the example, the expected return has already been calculated as 10%.
3

 
 
 
 
Expected Return(E(R2 ))  0.05  0.502  0.25  0.302  0.4  0.102  0.25  0.102  0.05  0.302
 0.0125  0.0225  0.004  0.0025  0.0045
 0.046
 4.6%
Now we can calculate the standard deviation:
 
  E R 2  E  R  
2
 0.046  0.12
 0.046  0.01
 0.036
 0.1897
 18.97%
Activity 1.1
You need to complete activity 1.1 under Online Assessment tool
1.4 The efficient frontier
The efficient frontier shows all possible portfolios that can be created from a group of
individual possibilities. Let’s look at an example of the efficient frontier.
Figure 1.2 – Efficient frontier of alternative portfolios
4

Source: Hull (2018:6)
Portfolios that lie on the efficient frontier either have a higher rate of return for an equal
amount of risk, or a lower risk for the same return than those portfolios that are below
the frontier (the dots). Therefore, portfolio A as indicated in the figure is better than
portfolio C because it currently has the same expected return but a lower risk than
portfolio C. Similarly, portfolio B will be preferred over portfolio C since portfolio B has
a higher expected return for the same amount of risk as in portfolio C.
1.5 The capital asset pricing model (CAPM) and the arbitrage pricing theory
(APT)
Most of you will have come across the term “capital asset pricing model” in your
undergraduate studies or work environment. Those of you who are not familiar with
5
this concept need to read more on the topic. Most books on financial management
contain a section on the CAPM and the APT.
The total risk of a security consists of both unsystematic risk and systematic risk.
Unsystematic risk can be diversified, whereas systematic risk cannot. The CAPM
describes the linear relationship between required return and systematic risk.
E(R)=RF    RM  RF 
The assumptions of the CAPM are as follows:






risk-averse and rational investors
able to borrow/lend at the risk-free rate
homogeneous expectations
same time horizon
no taxes
different investments are independent
Factors that influence the APT model include growth in GDP, exchange rate changes,
interest rate changes and inflation. With the APT module, investors want to find ways
of eliminating these factors from their portfolios.
1.6
Risk vs return for companies
Study the section in the textbook on how companies decide between the risk and
return of new investments.
1.7
Risk management by financial institutions
Study the section in the textbook on risk decomposition and risk aggregation in
financial institutions.
6
1.8
Credit ratings
There are three major credit rating agencies, namely, Moody’s, S&P and Fitch. The
credit rating agencies rate the quality of various debt instruments. These ratings
include both corporate and sovereign ratings.
Activity 1.2
Discuss the following questions in the Discussion Forum 1.2 with your fellow
students:


Identify three South African companies and find their credit ratings. Based on the
companies’ credit ratings, will you invest in them?
What is the current credit rating of South Africa?
1.9
Summary
In learning unit 1 we looked at the definition of market risk, concepts relating to risk
and return, and risk management within companies and financial institutions. In
learning unit 2 we will look at the various financial institutions.
Activity 1.3
Complete the practice questions and problems at the end of chapter 1 of the
textbook.
1.10
References
Chance, DM. 2003. Analysis of derivatives for the CFA Program. Baltimore:
Association for Investment Management and Research.
Ghosh, A. 2012. Managing risks in commercial and retail banking. Available at:
https://books.google.co.za/books?hl=en&lr=&id=EU25GRS92wwC&oi=fnd&pg=PT1
1&dq=managing+risks+in+commercial+and+retail+banking&ots=0InDPr2LVo&sig=
9JR_ZSA5Vp988P_S7CDLWG7lHuE (accessed on 19/08/2015).
Hull, JC. 2018. Risk management and financial institutions. 5th edition. Hoboken, NJ:
Wiley.
7
RSK4805 – Topic 1
Topic 1 covers learning units 1 to 3 and introduces market risk management, including
sources and challenges of market risk management, concepts relating to risk and
return (LU1), an overview of the financial services industry (LU2) and the regulatory
requirements for market risk management (LU3). You must first complete the short
quiz at the end of learning unit 0 before the study material for Topic 1 will become
available. You need to work through the study material for this topic. Thereafter you
have to complete an online assessment that will count towards your year mark.
Learning unit 2
You have to work through chapters 2 to 4 of the prescribed textbook (Hull 2018).
Please note that if you are unfamiliar with any of the topics discussed, you have to do
additional reading on your own to update your knowledge on those topics.
2.1
Overview of financial institutions
Financial institutions are created to conduct financial transactions, and include banks,
insurance companies, mutual funds or any organisations that are depository
institutions and that are registered with the Financial Services Conduct Authority as
providers of financial advice.
Chapters 2 to 4 give an overview of banks, insurance companies, pension plans,
mutual funds, exchange-traded funds (ETFs) and hedge funds. This section mostly
contains information on international banks. You have to read the section and make
sure that you understand how the various concepts relate to the context of South Africa
or the country that you reside in.
2.2
Banks
You have to work through chapter 2 of the prescribed textbook (Hull 2018).
The traditional role of banks was to take deposits and to make loans. Banks are mostly
divided into commercial banks and investment banks. Go to the following website for
a list of the locally controlled banks, foreign controlled banks, mutual banks and
cooperative banks in South Africa:
https://www.resbank.co.za/PrudentialAuthority/Deposit-takers/Banks/Pages/SouthAfrican-Registered-Banks-and-Representative-Offices.aspx
The economic role of banks has changed very little over the past decade although the
banking environment changes constantly due to technological developments,
regulatory changes and changes to the competitive environment of banks.
8
Let’s first look at the difference between the front office, the middle office and the back
office within a bank before we look at the different banking structures.
Front office
The front office of a bank is the division that deals directly with clients and customers.
Clients can include both individual clients and corporate clients.
Examples: traders, brokers, asset managers, researchers, sales personnel, corporate
finance
Middle office
Most of the risk management, compliance and technology (IT) departments of a bank
form part of the middle office and they are there to support the front office. Not all risk
management functions are part of the middle office – they can also be part of the back
office.
Back office
The back office includes the functions that are behind the scenes and ensure that
payments are processed (i.e., administrative support – human resources, technology,
central compliance and marketing).
You can do additional reading on the abovementioned functions and the skills required
for the various positions within financial services.
2.2.1 Commercial banks
Commercial banks mostly partake in deposit and lending activities, including both retail
banking and wholesale banking. This sector is regulated in most countries in order to
give consumers confidence in the banking industry.
In South Africa, there are five big retail banks, namely, Absa, FirstRand (FNB),
Nedbank, Capitec and Standard Bank. The following article compares the various
banks on different metrics based on their 2016/2017 financial results:
https://businesstech.co.za/news/banking/182873/battle-of-the-banks-how-sas-bigfive-banks-compare/
2.2.2 Investment banks
The main function of investment banks is to assist companies, mostly corporates, and
governments in raising debt and equity financing.
The financing can take place in one of the following ways:


private placement
public offering
9
Investment banks also offer advisory services to companies regarding mergers and
acquisitions, corporate restructuring and other management functions.
2.2.3 Conflicts of interest
Both commercial and investment banks also offer trading activities. However, there
are various conflicts of interest between the commercial banking, investment banking
and securities services when they are all performed by the same entity.
2.2.4 Risks in banking
The operations of a bank give rise to various risks, which include credit risk, market
risk and operational risk.
Read the following article by PwC on the future of banking in South Africa:
https://www.pwc.co.za/en/assets/pdf/strategyand-future-of-banking.pdf
The banking sector is strictly regulated. The regulation of banks will be discussed in
learning unit 3.
Activity 2.1
Complete the practice questions at the end of chapter 2 in the prescribed textbook.
2.3
Insurance companies and pension plans
You have to work through chapter 3 of the prescribed textbook (Hull 2018).
The function of insurance companies is to provide protection against adverse events.
Most of you have car and house insurance, which is classified as short-term insurance
or nonlife insurance. You can also take out long-term insurance, which is classified as
life insurance. In the textbook, nonlife insurance is also referred to as property-casualty
insurance.
A pension plan, on the other hand, is a type of insurance that is usually arranged by a
company for its employees to provide them with income after retirement.
In the following article, Deloitte provides an outlook for the insurance industry in 2019
and highlights some of the strategies that insurance companies require in order to stay
competitive:
https://www2.deloitte.com/us/en/pages/financial-services/articles/insurance-industryoutlook.html
2.3.1 Life insurance
Life insurance or long-term insurance is based on unforeseen life events, for example,
death and disability. Life insurance policies vary between countries. Read up on the
following products in South Africa:
10




term life insurance
whole life insurance
endowment insurance
group life insurance
Follow these links to read about the different types of life insurance in South Africa:
https://www.lifeassurance.org.za/life-insurance/the-different-types-of-life-insurancein-south-africa/
https://www.life-insurance-info.co.za/2259/advice/types-insurance-policies-southafrica
2.3.2 Property-casualty insurance
Property-casualty insurance is short-term insurance of usually one year that can be
renewed on an annual basis. Insurance companies calculate various ratios in relation
to property-casualty insurance:





Loss ratio: the ratio of the pay-outs they make to the premiums they receive
from their customers
Expense ratio: the ratio of expenses to premiums earned in a specific year
Combined ratio: the sum of the loss ratio and the expense ratio
Combined ratio after dividend: the combined ratio minus the dividend payout to policyholders
Operating ratio: the combined ratio after dividends minus investment income
Follow this link to read PwC’s analysis of the insurance industry in South Africa for
2016, which includes an industry overview:
https://www.pwc.co.za/en/assets/pdf/insurance-industry-analysis-2016pdf.pdf
2.3.3 Heath insurance
Health insurance will vary depending on the extent to which health care is provided in
a specific country. In South Africa, health insurance takes the form of medical
aids/schemes/funds to which members pay a monthly premium in order to have
medical cover.
2.3.4 Reinsurance and capital requirements
Reinsurance in South Africa is required if an insurance company wants to insure
expensive valuables such as antiques, works of art and high-value vehicles and if it
wants to provide catastrophe insurance (insurance for catastrophic events, e.g.,
natural disasters). Reinsurance therefore represents insurance for the insurer. The
primary insurer shifts part or all of the risk to another company, called the reinsurer,
and the insurance company then protects itself against large losses.
11
Insurance companies transfer business to a reinsurer because



the financial capacity to accept risk increases (they can take on more contracts)
it decreases the insurance companies’ reserve requirements
it assists in stabilising profits and it evens out losses
Table 2.1: Examples of expensive valuables
Category of expensive valuables
Catastrophe risk
Examples
Natural disasters, including hail storms,
floods and earthquakes
Work of art
Paintings
Antiques
Valuable items or objects
Art collections
High-value executive vehicles
Sports cars
Luxury sedans
Premises of non-standard construction
Thatched roof houses
Timber houses
Historical buildings
The capital requirements of life insurance and property-casualty insurance companies
will differ due to differences in their balance sheets and the risks they take. Insurance
companies, unlike banks, have exposure to both the liability side and the asset side of
a balance sheet and must carefully evaluate the reserves required to survive.
2.3.5 Risks and regulation in insurance companies
Insurance companies face the risk that their reserves will not be sufficient to cover
claims, as well as risk concerning the performance of investments. They are further
exposed to liquidity risk, credit risk, operations risk and business risk. The insurance
industry is regulated by the Insurance Act 18 of 2017.
Compare the regulation of the South African insurance industry with that of the
insurance industries in the United States and Europe.
12
2.3.6 Pension plans
Pension plans are usually set up by employers for their employees and provide those
employees with income after retirement. Contributions to a pension plan are made by
both the employer and the employee. These plans can be in the form of a defined
benefit plan or a defined contribution plan. Evaluate your own pension plan in terms
of whether you have a defined benefit plan or a defined contribution plan.
The following article points out that the five major trends that shaped the insurance
industry in 2018 were regulation, climate change, stringent underwriting measures,
product innovation and technology:
https://www.fanews.co.za/article/intermediaries-brokers/7/general/1227/5-trendsshaping-the-insurance-industry-in-2018/23601
Activity 2.2
Complete the practice questions at the end of chapter 3 in the prescribed textbook.
2.4
Mutual funds, ETFs and hedge funds
You have to work through chapter 4 of the prescribed textbook (Hull 2018).
The purpose of mutual funds, ETFs and hedge funds is to invest money on behalf of
individuals or companies. Usually, funds are pooled together in order to meet certain
objectives.
2.4.1 Mutual funds
Mutual funds are sometimes also referred to as unit trusts. Mutual funds provide
diversification for small investors. Resources are pooled to receive the benefit of
diversification.
The following website provides basic information on what a mutual fund is, how it can
meet your needs, reasons for investing in mutual funds and how mutual funds are
valued:
https://www.franklintempleton.co.za/en_ZA/investor/investor-education/introductionmutual-funds
Mutual funds can be in the form of open-end and closed-end funds.


Open-end funds
o money market mutual funds
o equity mutual funds
o bond funds
o hybrid funds
o index funds
Closed-end funds
13
Below are links to two articles about the biggest unit trusts in South Africa in 2018:
https://businesstech.co.za/news/business/219861/these-are-the-20-best-performingasset-managers-in-south-africa/
https://www.businessinsider.co.za/ranked-the-10-biggest-unit-trusts-in-south-africa2018-5
Activity 2.3
Under Discussion Forum 2.3 on myUnisa, list the current top five mutual funds/unit
trusts in South Africa.
2.4.2 Exchange-traded funds
An ETF is a passive investment vehicle that has grown over the past few years. In the
United States, the most widely known ETF is the Spider. In South Africa, the Satrix
Top 40 was voted the most popular ETF in 2018. The following news article gives
some background on the risk of ETFs and ETF investment in South Africa:
https://www.fin24.com/Finweek/Investment/the-rise-of-the-etf-20170913
Visit the website of etfSA at http://www.etfsa.co.za/ for current information on the
monthly South African ETF, ETN and Unit Trust Passive Index Tracking Performance
Survey (http://www.etfsa.co.za/perfdata_month.htm)
2.4.3 Management style and regulation
An ETF or a mutual fund can either be managed by means of a passive management
style, where the fund tracks the index, or through an active management style, which
relies on the selection and timing skills of the manager. Mutual funds and ETFs are
regulated since they receive funds from investors.
2.4.4 Hedge funds
The prescribed book indicates that hedge funds differ from mutual funds in that they
are not regulated. However, this was only true in South Africa before 2015. In 2015,
regulations changed to allow for the regulation of a hedge fund as a product.
Hedge funds make use of various strategies, which include
o
o
o
o
o
o
o
o
o
long/short equity
dedicated short bias
distressed securities
merger arbitrage
convertible arbitrage
fixed-income arbitrage
emerging markets
global macro
managed futures
14
The performance of hedge funds is not easy to assess. However, one of the
advantages of hedge funds lies in the improvement of risk-return trade-offs for pension
funds.
Activity 2.4
Complete the practice questions at the end of chapter 4 in the prescribed textbook.
2.5 Summary
Mutual funds and ETFs give individual investors the opportunity to benefit from
diversification by pooling their resources. Hedge funds, on the other hand, cater more
for the large investor and they charge higher fees for managing portfolios. South Africa
is one of only a handful of countries that currently regulate products of the hedge fund
industry. The next learning unit will deal with various regulations that affect market risk
management, in particular.
2.6 References
Hull, JC. 2018. Risk management and financial institutions. 5th edition. Hoboken,
NJ: Wiley.
15
RSK4805 – Topic 1
Topic 1 covers learning units 1 to 3 and deals with market risk management, including
sources and challenges of market risk management, concepts relating to risk and
return (LU1), an overview of the financial services industry (LU2) and the regulatory
requirements for market risk management (LU3). You must first complete the short
quiz at the end of learning unit 0 before the study material for Topic 1 will become
available. You need to work through the study material for this topic. Thereafter you
have to complete an online assessment that will count towards your year mark.
Learning unit 3
You have to work through chapters 15 and 18 of the prescribed textbook (Hull 2018).
Please note that if you are unfamiliar with any of the topics discussed, you have to do
additional reading on your own to update your knowledge of those topics.
3.1
Introduction
The Basel Accord of 1988, or Basel I, heralded the introduction of international
standards for banking regulation. Banking regulation is an ever-changing environment.
Consequently, several Basel Accords have been released since 1998, the current
accord being Basel IV.
The main purpose of banking regulation is to ensure that banks keep enough capital
for the various risks that they undertake. Although the Basel Accord focuses on
regulating the banking industry, the underlying principles of risk management are
applicable to other business organisations, too.
Regulatory requirements
Regulating the financial sector of a country is an important part of risk management.
In the past, the banking industry was one of the most regulated industries because a
lack of confidence in the financial system will have negative effects on the entire
economy of the country.
The three objectives of regulation and supervision are to ensure systemic stability, to
enhance efficiency and to protect investors and depositors. Since these objectives are
related, the function of regulation and supervision is normally performed by the same
authority. Bank supervision and regulation are usually performed by the central bank
of a country.
Valid reasons for regulating banks are
16




to ensure the stability of a country’s financial system
to uphold domestic and international confidence in a country’s financial system
to ensure monetary stability by controlling the growth of the money supply
to protect clients against malpractice in financial institutions
Regulation and supervision merely set guidelines for correct practices in financial
institutions and do not always guarantee sound management decisions or ethical
practice. Regulation and supervision cannot eliminate risk within the activities of
financial institutions completely but are regarded as preventive measures against
excessive exposure to risk.
Visit the SARB’s website, where you will find information on the various Acts related
to financial institutions in South Africa, as well as the changes that were implemented:
https://www.prudentialauthority.co.za/Deposit-takers/Banks/Pages/default.aspx
3.2
Basel I
The BIS Accord, or Basel I, was the first attempt internationally to set minimum
standards for the capital requirements within banks. One of the key outcomes of Basel
I was the Cooke ratio, according to which credit exposure was divided into three
categories, namely, (1) on-balance sheet assets, (2) off-balance sheet assets and (3)
over-the-counter derivatives. Basel I required a bank to keep capital equal to 8% of its
risk-weighted assets, with at least 50% of the capital falling within tier 1.
Although the G30’s policy recommendations are not regarded as being regulatory in
nature, they have been influential in the development of risk management practices,
especially with respect to market and credit risk management.
Netting determines that all over-the-counter derivatives with a counterparty are treated
as a single transaction in the event of default. Basel I was modified in 1995 in order to
allow banks to reduce the credit equivalent totals if bilateral netting agreements were
in place.
In 1996, an amendment was made to the Basel Accord pertaining to the capital
required for market risks that were associated with trading activities. The 1996
amendments to Basel I were only implemented in 1998 and required banks to hold
capital for market risk for all instruments in their trading books, including off-balance
sheet items. Therefore, the total capital that banks were required to keep after the
amendments of 1996 was the sum of credit risk capital equal to 8% of their riskweighted assets and market risk capital.
3.3
Basel II
Although Basel I improved the capital requirements within banking institutions, it had
various weaknesses. Therefore, Basel I was re-evaluated, and Basel II was
17
implemented in 1999 and revised in the years to follow. The rules were finally
implemented in 2007. Basel II was based on three pillars, namely, (1) new minimum
capital requirements for operational and credit risk, (2) supervisory review and (3)
market discipline.
Under Basel II the capital requirements for credit risk changed, the capital requirement
for market risk was still calculated based on the 1996 amendments and capital
requirements were introduced for operational risk. The various methods for calculating
these capital requirements are explained in the prescribed textbook.
Basel II.5 was introduced during the credit crisis, when it was recognised that the
calculation of capital for market risk had to be changed. These changes included



the calculation of stressed VaR
new incremental risk charges
the introduction of a comprehensive risk measure for instruments dependent on
credit correlation
3.4 Solvency II
Although the insurance industry is not internationally regulated, it has been making
use of Solvency I and II as a regulatory framework. Solvency I included the capital
required for underwriting risks and Solvency II included investment risks and
operational risks within the framework. There are various similarities between
Solvency II and Basel II. Solvency II, for example, is also based on three pillars. In the
case of Solvency II, these pillars are (1) a minimum capital requirement and solvency
capital requirement, (2) a supervisory review process and (3) disclosure of risk
management information in the market.
Activity 3.1
Complete the practice questions at the end of chapter 15 in the prescribed textbook.
3.5 Basel III
The Basel III proposal was first published in 2009. The final version was published in
December 2010 after consultation with various stakeholders. Basel III consists of the
following six parts:






capital definition and requirements
capital conservation buffer
countercyclical buffer
leverage ratio
liquidity risk
counterparty credit risk
18
The six parts are explained in detail in the prescribed textbook.
Activity 3.2
Complete the practice questions at the end of chapter 16 in the prescribed textbook.
3.6 Regulation of the OTC market
You must read the chapter on regulation of the OTC market for background
information. You will not be examined on this chapter.
3.7 Review of the trading book
The Basel Committee introduced a major revision of the way regulatory capital for
market risk is calculated, referred to as the fundamental review of the trading book
(FRTB). The FRTB introduced important changes to the calculation of market risk
capital, in terms of which market risk capital is calculated from a stressed expected
shortfall measure and the liquidity risk is taken into account. The amendments also
included a better distinction between the trading book and the banking book and a
clearer indication of where various instruments should be placed.
Activity 3.3
Complete practice questions 18.1, 18.4 and 18.5 at the end of chapter 18 in the
prescribed textbook.
3.8 Summary
Learning unit 3 dealt with the various regulatory changes that have occurred within the
financial sector, such as the introduction of the international regulatory framework for
banks, the Basel Accords, over the years. Regulation is important to ensure a sound
financial and economic market.
3.9 References
Hull, JC. 2018. Risk management and financial institutions. 5th edition. Hoboken, NJ:
Wiley.
19
Topic 2 – Managing market risk
Topic 2 covers learning units 4 to 6 and deals with financial derivatives, interest rate
risk, volatility, correlation and how traders manage risks. Market risk is defined as a
decrease in profitability due to adverse events within an organisation. Market risk
includes commodity risk, equity risk, exchange rate risk and interest rate risk.
Learning unit 4: Trading in financial markets
You have to work through chapter 5 of the prescribed book.
Please note that if you are unfamiliar with any of the topics discussed, you must do
additional reading on your own to update your knowledge of those topics.
4.1
Introduction
Financial instruments can either trade on a formal exchange like the Johannesburg
Stock Exchange (JSE) or over the counter, which includes a network of financial
institutions, corporations and fund managers. A clearing house administers exchangetraded derivatives. In South Africa, JSE Clear has been appointed as the clearing
house and central counterparty of the JSE for all transactions in listed derivatives.
You can read a description of JSE Clear at the following link:
https://www.jse.co.za/content/JSEEducationItems/JSE%20Clear%20Public%20Desc
ription.pdf
4.2 Long and short positions in assets
When you purchase an asset for cash, you take a long position. When you sell an
asset that you own, you take a short position. When you sell an asset that you do not
own, it is stated that you have a short sale.
Work through the examples in the prescribed textbook.
4.3
Derivatives market
A derivative is a financial instrument whose value is derived from the value of an
underlying instrument. The derivatives market includes futures contracts, forward
contracts, swaps and options.
4.3.1 Futures
A futures contract is a variation of a forward contract that essentially has the same
basic definition but a few clearly distinguishable additional features, the most important
20
being that it is not a private and customised transaction. It is a public, standardised
transaction that takes place on a futures exchange.
This concept is dealt with in more detail in learning unit 6.
4.3.2 Forwards
A forward contract is an agreement between two parties in which one party, the
buyer, agrees to buy from the other party, the seller, an underlying asset at a future
date at a price established today. The contract is customised, and each party is subject
to the possibility that the other party will default.
This concept is dealt with in more detail in learning unit 6.
4.3.3 Swaps
A swap is an agreement between two parties in which each party agrees to pay the
other party a series of cash flows at specified dates over a specific period.
This concept is dealt with in more detail in learning unit 6.
4.3.4 Options
An option can be defined as a contract that gives you the right but not the obligation
to buy or sell an underlying instrument at a predetermined price and period in the
market.
A call option gives the holder the right but not the obligation to buy the underlying
asset at a certain time. A put option gives the holder the right to sell the underlying
instrument at a certain time.
Options can be either American options or European options. American options can
be exercised at any time whereas European options can only be exercised at
expiration.
Options can also be classified as in-the-money, at-the-money or out-the-money
options, as outlined below:



in-the-money option: underlying price is greater than strike price
at-the-money option: underlying price is equal to strike price
out-the-money option: underlying price is smaller than strike price
This concept is dealt with in more detail in learning unit 5.
4.4
Non-traditional derivatives
Over the years, derivatives have been developed to meet specific needs. These
derivatives include weather derivatives, oil derivatives, natural gas derivatives and
electricity derivatives.
21
4.5
Exotic options and structured products
Exotic options and structured products trade on the over-the-counter market and are
important to banks because they sometimes generate higher profits than plain vanilla
options. Exotic options include Asian options, barrier options, basket options, binary
options, compound options and lookback options. You only have to know the
definitions of these exotic options.
4.6
Risk management challenges
Derivatives can be used for hedging, speculation or arbitrage.
•
Arbitrage
Arbitrage refers to any trading strategy that requires no cash and where there is some
probability of making a profit without incurring the risk of a loss. It is the simultaneous
purchase and sale of identical or equivalent financial assets in order to benefit from a
discrepancy in their price relationship. Arbitrage is a low-risk trading strategy that is
linked to hedging (risk transference) and speculation (risk acceptance).
•
Speculation
Speculation refers to the buying, holding and selling of assets to profit from fluctuations
in price in the short term, as opposed to buying for long-term gains (buy and hold) or
income (dividends). Associated with day trading, it relies on market timing and implies
a riskier proposition than investing.
•
Hedging
Hedging refers to the practice of offsetting the price risk inherent in any spot market
position by taking an equal but opposite position in the futures market. Risk is
neutralised and transferred to someone for whom holding that particular risk would
reduce an existing but opposite exposure. A counterparty without pre-existing
exposure (speculator) would accept the risk (long or short the derivative asset) to
possibly benefit from an anticipated movement in price. Work through the examples
on hedging different instruments using futures contracts.
It is important for organisations to set up control measures to ensure that derivative
instruments are used for their intended purpose in order to manage their risks.
4.7
Summary
This learning unit dealt with the financial market and the various derivative instruments
that are available. The derivative instruments will be explained in more detail in
learning units 5 and 6.
22
Activity 4.1
Complete the practice questions and problems at the end of chapter 5 of the textbook.
4.8
References
Hull, JC. 2018. Risk management and financial institutions. 5th edition. Hoboken, NJ:
Wiley Publishing.
4.9
Additional reading
The following books contain information on options, futures, forwards and swaps:
Bodie, Z, Kane, A & Marcus, AJ. 2019. Essentials of investments. 11th edition.
McGraw-Hill. (Chapters 15 to 17)
De Beer, JS. 2011. Introduction to financial derivatives. 1st edition. Pretoria: Van
Schaik Publishers.
Faure, AP. 2015. Derivative markets: an introduction. Available at:
https://bookboon.com/en/derivative-markets-an-introduction-ebook (accessed on
16/08/2019).
Hull, JC. 2016. Fundamentals of futures and options markets. 9th edition. London:
Prentice-Hall International, Inc.
23
Topic 2 – Managing market risk
Topic 2 covers learning units 4 to 6 and deals with financial derivatives, interest rate
risk, volatility, correlation and how traders manage risks. Market risk is defined as a
decrease in profitability due to adverse events within an organisation. Market risk
includes commodity risk, equity risk, exchange rate risk and interest rate risk.
Learning unit 5: Interest rate exposure
You have to work through chapters 8 and 9 of the prescribed book.
Please note that if you are unfamiliar with the topics that are discussed, you must do
additional reading on your own to update your knowledge of the relevant topics.
5.1
Introduction
The trading function in financial institutions are referred to as the front office. The
middle office is concerned with overall level of risk being taken and the back office
deals with the record keeping functions (see Learning unit 2).
Trading risk are managed in the front office through hedging risks and the middle office
adds the exposure to make sure the risk is acceptable. The Greek measures include
the following:

Delta
Delta measures the sensitivity of the option price to changes in the underlying
instrument.

Gamma
Gamma is defined as the rate of change of portfolios delta with respect to the price of
the underlying asset.

Vega
Vega is defined as the rate of change of the value of a portfolio with respect to volatility
of the underlying asset price.

Theta
Theta is defined as the rate of changes of the value of a portfolio with respect to the
passage of time (all else remaining the same).

RHO
RHO is defined as the rate of change of a portfolio with respect to the level of interest
rates.
24
Although you will not be required to calculate the various Greek values, you will be
required to interpret the values of the Greeks. The explanation of the interpretation of
the various Greek values can be found in your prescribed book.
5.2
Realities of hedging
In an ideal world traders will be able to adjust their portfolios frequently in order to have
a zero value for all Greeks, however in practice this is not the case. Read Business
snapshot 8.2 on how dynamic hedging works in practice.
You can leave out exotic options in the prescribed book.
5.3
Scenario analysis
Option traders should not only monitor risks such as delta, gamma and vega, but
should also conduct scenario analysis. This entails calculating the gain/loss of
portfolios given various scenarios. This will be covered in more detail in learning unit
10.
Traders needs to monitor the Greek values to make sure they fall within the limits of
their organisations. Traders usually rebalance their portfolios at least once a day to
maintain delta neutrality.
Activity 5.1
Complete the practice questions and problems at the end of Chapter 8 of the
textbook.
5.4
Introduction to interest rate risk
Market risk includes interest rate risk, equity price risk, exchange rate risk and
commodity risk. Interest rate risk is seen as more difficult to manage compared to the
other types of risk included in market risk.
5.5
Management of net interest income
One of the key risks that banks are required to manage is net interest income. It is the
function of the asset/liability management section of a bank to manage the risk of net
interest income. The liquidity preference theory states that long-term rates are usually
higher than the predicted future short-term rates. One method that banks can use to
manage this risk is interest rate swaps. Therefore, the management of net interest
income results in the net interest margin being stable. However, a mismatch between
assets and liabilities could lead to liquidity problems for an organisation.
25
The article that can be found at the following link contains a list of South African banks
that have failed in the last 30 years, the latest being VBS Mutual Bank, which was
placed under curatorship in 2018 by the South African Reserve Bank (SARB) due to
liquidity problems within the bank. VBS Mutual Bank is an example of a bank that
funded its long-term loans with short-term deposits.
https://businesstech.co.za/news/banking/231009/all-the-south-african-banks-that-havefailed-in-the-past-30-years/
Read the following related article:
https://www.iol.co.za/business-report/economy/vbs-is-not-the-only-bank-to-go-bust-checkout-the-list-13737762
5.6
Types of interest rates
This section deals with interest rates that are important to financial institutions. These
rates include treasury rates, LIBOR, swap zero curve, OIS rates and repo rates. The
research department of the SARB created a document on interest rates and how they
work. Go to the SARB website and read the document.
Go to www.resbank.co.za. Click on “About Us”, then “Publications and Notices”, “Fact
Sheets” and “No. 8 – Interest rates and how they work”.
Alternatively, follow this link:
https://www.resbank.co.za/Lists/News%20and%20Publications/Attachments/5000/Fact%20
Sheet%208.pdf
(Source: SARB 2015)
5.6.1 Treasury rates
Treasury rates are the rates available on treasury bonds and bills, which a government
uses to borrow in its own currency. Therefore, the South African treasury rate is the
rate at which the South African government borrows in rands.
26
Activity 5.2
Visit the SARB website at www.resbank.co.za to find the following treasury bill rates (go
to “Research”, then “Rates” and “Current market rates”):
Treasury bill
2018 rate (2018-08-08)
Treasury bill – 91 day
(tender rates)
7.07%
Treasury bill – 182 day
(tender rates)
7.28%
Treasury bill – 273 day
(tender rates)
7.32%
Treasury bill – 364 day
(tender rates)
7.29%
Current rate
5.6.2 London Interbank Offered Rate (LIBOR)
LIBOR is a rate used for borrowing between banks.
South Africa uses the Johannesburg Interbank Average Rate (JIBAR), previously
known as the Johannesburg Interbank Agreed Rate. JIBAR is also used in determining
the reset rate for over-the-counter swaps and forward rate agreements (FRAs).
Activity 5.3
Visit the SARB website at www.resbank.co.za to find the following current three-month
JIBAR (go to “Research”, then “Rates” and “Current market rates”):
JIBAR
three months
2018 rate (2018-08-08)
Current
6.98%
5.6.3 Overnight indexed swap (OIS) rates
In South Africa, a rate that is equivalent to an OIS rate is the South African Benchmark
Overnight Rate (SABOR). An OIS rate allows for overnight borrowing and lending to
be swapped for borrowing and lending at a fixed rate for a specific time period.
The following compulsory article explains LIBOR and OIS rates and concludes that an
OIS rate is a more appropriate rate to use in calculating no-default value. Read the
article by following this link:
27
https://www-2.rotman.utoronto.ca/~hull/DownloadablePublications/LIBORvsOIS.pdf
5.6.4 Repo rate
The repurchase or repo rate is the rate at which the SARB lends money to
private/commercial banks and that serves as a benchmark for the setting of short-term
interest rates.
Activity 5.4
Visit the SARB website at www.resbank.co.za to find the following current repo rate (go
to “Research”, then “Rates” and “Current market rates”):
Repo rate
2018 rate (2018-08-13)
Repo rate
6.5%
Current
Data on the various interest rates in South Africa can be obtained from
www.tradingecomomics.com. The following webpage indicates that the average interest
rate in South Africa over the last 20 years was 12,6% (2018):
https://tradingeconomics.com/south-africa/interest-rate
5.7
Duration and convexity
Interest rate risk is the possible impact that changing market rates will have on the
return of a bond. Duration and convexity can be used to measure the interest rate risk
and price sensitivity of a bond or bond portfolio.
5.7.1 Duration
Duration can be defined as the percentage change in the price of a bond in response
to a change in the yield of the bond. According to Marx et al (2017), the following
generalisations can be made in evaluating interest rate risk:



Long-term bonds have more interest rate risk than short-term bonds.
Low-coupon bonds have more interest rate risk than high-coupon bonds.
Low-yield bonds have more interest rate risk than high-yield bonds.
There is an inverse relationship between the price of a bond and the yield. If the yield
increases, the price of the bond will decrease and if the yield decreases, the price of
the bond will increase.
28
5.7.2 Convexity
Convexity can be defined as the measure of curvature in the relationship between
bond prices and bond yields. This demonstrates how the duration of a bond changes
in response to a change in the interest rate of the bond.
5.7.3 Portfolio duration and convexity
Duration and convexity for a single bond can be generalised to apply to a portfolio of
bonds. The portfolio duration is equal to the weighted average of the duration of the
bonds within the portfolio.
5.7.4 Nonparallel yield curve shifts
The following three methods can be used for nonparallel yield curve shifts: partial
duration, bucket deltas and the calculation of deltas to facilitate hedging.
5.8
Principle components analysis
Principle component analysis is a statistical approach to handling risks associated with
highly correlated market variables. The aim of principle component analysis is to find
sets of components or factors that will explain the movement in the market.
Activity 5.5
Complete the practice questions and problems at the end of chapter 9 of the
textbook.
5.9
Summary
In learning unit 7 we looked at the Greek measures, the management of net interest
income, types of interest rates, duration and convexity, and nonparallel yield curve
shifts. In learning unit 8 we will look at volatility and correlation in detail.
5.10
References
Hull, JC. 2018. Risk management and financial institutions. 5th edition. Hoboken, NJ:
Wiley Publishing.
Marx, J et al. 2017. Investment management. 5th edition. Pretoria: Van Schaik.
SARB. 2015. Interest rates and how they work. Available at:
https://www.resbank.co.za/Lists/News and Publications/Attachments/5000/Fact
Sheet 8.pdf (accessed on 06/02/2019).
29
Topic 2 – Managing market risk
Topic 2 covers learning units 4 to 6 and deals with financial derivatives, interest rate
risk, volatility, correlation and how traders manage risks. Market risk is defined as a
decrease in profitability due to adverse events within an organisation. Market risk
includes commodity risk, equity risk, exchange rate risk and interest rate risk.
Learning unit 6
You have to work through chapters 10 and 11 of the prescribed book.
Please note that if you are unfamiliar with any of the topics discussed, you have to do
additional reading on your own to update your knowledge of those topics.
6.1 Defining “volatility”
Financial institutions have to monitor the volatility of the various market variables,
which include commodity prices, equity prices, exchange rates and interest rates,
because the value of their portfolios depend on these variables.
Volatility can be defined as the standard deviation of annualised returns over a given
period. For risk management, volatility is defined as the standard deviation of
continuous compounded return per day.
This learning unit looks at the formal definition of volatility and how risk managers
monitor the volatility of variables. One of the issues is whether volatility should be
calculated using trading days or calendar days. Volatility is usually higher when the
markets are open compared to when the markets are closed. For this reason, most
traders and risk managers make use of trading days to calculate volatility. Read
Business Snapshot 10.3 for more information on this practice.
6.2 Exponentially weighted moving average (EWMA) model
The EWMA model gives exponentially decreasing weights to later variables.
Therefore, it places declining weights on past observations, and assigns greater
importance to the most recent observations.
If λ (or the decay factor) is lower in value, a greater weight is given to recent
observations.
Some of the attractions of the EWMA model are that



relatively little data needs to be stored
it only needs a current estimate of the variance rate and the most recent
observation of the market variables
it tracks changes in volatility
30

λ = 0.94 has been found to be a good choice across a wide range of market
variables
6.3 Generalised autoregressive conditional heteroskedasticity (GARCH)
The GARCH model can be used to update covariance estimates and to forecast future
levels of covariance.
The GARCH model is theoretically more appealing than the EWMA model because
the GARCH model incorporates mean reversion whereas the EWMA does not.
Activity 6.1
Which of the following two statements on models for estimating volatility is incorrect?
Discuss this question with fellow students in Discussion Forum 6.1.
A. In the EWMA and GARCH models, some positive weight is assigned to the longrun average variance.
B. In the EWMA and GARCH models, the weights assigned to observations decrease
exponentially as observations become older.
6.3.1 Maximum likelihood method
In this method, the parameters are chosen in order to maximise the likelihood of the
data occurring.
Activity 6.2
Complete the practice questions and problems at the end of chapter 10 of the textbook.
6.4 Defining “correlation”
A positive correlation indicates a high exposure to risk whereas a zero correlation
indicates less risk, though the risk is still large. A high negative correlation indicates
low exposure.
Correlation between two variables is defined as covariance of the variables, divided
by the standard deviation of variable 1, multiplied by the standard deviation of variable
2.
6.5 Monitoring correlation
Chapter 10 shows how the EWMA and GARCH models can be used to monitor
variance. The same models can be used to monitor covariance between variables.
The covariance rate per day between two variables is defined as the covariance
between the daily returns of the variables.
31
6.6 Correlation and covariance matrices
Correlation and covariance matrices can be produced once variance, covariance and
correlation rates have been calculated. Not all matrices are internally consistent.
In this chapter of the prescribed book you only need to focus on the sections dealing
with correlation and covariance (i.e., sections 11.1 to 11.3). You can leave out the rest
of the chapter (i.e., copulas and the Vasicek’s model).
6.7 Summary
Financial institutions are required to monitor the volatility of various market variables,
including commodity prices, equity prices, exchange rates and interest rates. Learning
unit 6 dealt with the definition of volatility with respect to risk management, the
calculation of volatility using the EWMA and GARCH models, and the monitoring of
the correlation between variables and how variables relate to the management of
market risk within organisations.
Activity 6.3
Complete the practice questions and problems at the end of chapter 11 of the textbook.
6.8 References
Hull, JC. 2018. Risk management and financial institutions. 5th edition. Hoboken, NJ:
Wiley Publishing.
32
Topic 3 – Measurement of market risk
Topic 3 covers learning units 7 to 9 and focuses on how to measure market risk by
means of value at risk (VaR), scenario analysis and stress testing. The last learning
unit deals with the implementation of market risk within an organisation. The topic
covers chapters 7, 12 to 14, 22 and 29 of the prescribed book (Hull 2018).
Learning unit 7: Value at risk
You have to work through chapters 12 to 14 of the prescribed book.
Please note that if you are unfamiliar with any of the topics discussed, you have to do
additional reading on your own to update you knowledge of those topics.
7.1
Introduction
Chapters 8 and 9 explain how traders manage risk by calculating the Greek values. In
its day-to-day activities, an organisation produces thousands of market variables that
can be used to manage risk through risk measures such as the Greeks. However,
these risk measures do not always indicate the total risk that needs to be managed by
management. Two of these measures that can assist in indicating the total risk are
value at risk and expected shortfall.
7.2
Value at risk
VaR is a summary of the measurement of the downside risk expressed in money terms
(e.g., rand for South Africa). VaR is the most common method used to measure market
risk. VaR therefore measures the total portfolio risk, taking into account both portfolio
diversification and leverage.
Regulators traditionally made use of VaR to calculate the capital required by banks.
The market-risk capital is based on a 10-day VaR estimate, where the confidence level
is 99%.
Advantages of VaR are that it provides a single number for capturing important
aspects of risk, it is easy to understand and it provides information on how bad things
can get in the future.
7.3
Expected shortfall (ES)
Where VaR is the loss level that will not be exceeded with a certain probability,
expected shortfall is the expected loss given that the loss is greater than the VaR level.
Two portfolios with the same VaR can have very different expected shortfalls. One of
the benefits of ES is that it recognises the benefits of diversification whereas a
disadvantage is that it is not as easy to understand as VaR.
33
7.4
Coherent risk measure
A coherent risk measure is defined as the amount of cash that has to be added to a
portfolio to make its risk acceptable. A risk measure that satisfies all of the following
criteria is called coherent:




monotonicity
translation invariance
homogeneity
subadditivity
VaR satisfies the first three criteria whereas ES satisfies all four.
7.5
Parameters for VaR and ES
For both VaR and ES, the two parameters that are needed are the time horizon and
the confidence level.
To measure VaR, you need both the confidence level and the time horizon. The higher
the confidence level, the greater the VaR measure. The choice of confidence level will
depend on the use of VaR since it is simply used as a benchmark measure of
downside risk. The recommended confidence level is between 95 and 99 per cent.
The longer the time horizon, the greater the VaR measure. The choice of time horizon
also depends on the use of VaR. If it is used as a measure of downside risk, the time
period should be relatively short (less than the average period for portfolio
rebalancing). If VaR is used to set capital requirements to avoid bankruptcy, it is
advisable to choose a longer time period.
Basel III requires market risk measures to be computed within the following
parameters:
-
a time horizon of 10 trading days
a 99 per cent confidence interval
an observation period based on at least one year of historical data, updated
quarterly
Activity 7.1
To convert VaR from a one-day holding period to a ten-day holding period, the VaR
number should be multiplied by ______ .
Discuss the answer with fellow students on Discussion Forum 7.1 and indicate the
reason for your answer.
34
7.6
Backtesting
Backtesting is used to test certain risk measures. It tests how good a current procedure
would have worked in the past. Backtesting is therefore used as a statistical testing
framework that checks whether actual trading losses are in line with the VaR forecasts.
Activity 7.2
Complete the practice questions and problems at the end of chapter 12 of the textbook.
Note:
You can leave out sections 12.5.1, 12.7, 12.8 and 12.10.1 (you can read these
sections for additional information on aspects of market risk).
7.7
Historical simulation
Historical simulation is a popular method used to calculate VaR and ES for market
risk. The first step is to identify the risk factors affecting the portfolio, which can include
exchange rate, interest rate, stock indices, volatilities and so forth. Data is then
collected on the movement of these variables in the market.
The advantage of the historical method is that it does not impose distributional
assumptions about the return distribution. The main disadvantage of this method is
that it relies on historical information to infer movements in market prices.
Activity 7.3
Study the example of the calculation of VaR by means of the historical simulation
method in the prescribed textbook.
Read sections 13.3 to 13.6 in the prescribed book (you will not be tested on these
sections).
Activity 7.4
Complete the following practice questions and problems at the end of chapter 13 of
the textbook: 13.1, 13.3, 13.4 and 13.5.
7.8
Model-building approach
The model-building approach, also referred to as the variance-covariance approach,
is the simplest VaR approach because it assumes that the portfolio exposures are
linear and that the risk factors are normally distributed. The main advantage of this
approach is its simplicity. The linearity assumption is also its drawback since it cannot
account for nonlinear options. Another disadvantage of this approach is that it may
underestimate the occurrence of large observations.
35
The following z-values are used to calculate the VaR for a certain confidence level.
You will see that the prescribed textbook rounds to 3 decimals, for example, for a 99
per cent confidence level, 2.326 is used.
Confidence level
(%)
Level of significance z‐value
(%)
90
10
1.28 1.282
95
5
1.65
99
1
2.33 2.326
Activity 7.5
Work through section 14.3 by making use of the Excel spreadsheet (available on the
authors website as indicated in the prescribed book).
Read section 14.4 in the prescribed book.
7.9 Monte Carlo simulation
Monte Carlo simulation is one method that can be used to deal with nonlinearity.
This method is similar to the historical simulation method, except that the risk factors
are drawn from some distribution (e.g., joint distribution). This method is subject to
model risk. An advantage of this method is that it does not rely on normal distribution
and that it can handle complex relationships among risks. A disadvantage is that it is
very time-consuming and costly and that it requires estimates of input values, which
can be difficult to do.
You can leave out sections 14.7.3 and 14.7.4.
Activity 7.6
Complete the practice questions and problems at the end of chapter 14 of the textbook.
7.10 Summary
This learning unit focused on various methods that are used to measure market risk,
including value at risk, the historical method, the model-building approach and Monte
Carlo simulation. The model-building approach is used most frequently in investment
portfolios but is not used as often in trading portfolios since it is difficult to model
gamma by means of this method.
36
7.11 References
Hull, JC. 2018. Risk management and financial institutions. 5th edition. Hoboken, NJ:
Wiley Publishing.
37
Topic 3 – Measurement of market risk
Topic 3 covers learning units 7 to 9 and focuses on how to measure market risk by
means of value at risk (VaR), scenario analysis and stress testing. The last learning
unit deals with the implementation of market risk within an organisation. The topic
covers chapters 7, 12 to 14, 22 and 29 of the prescribed book (Hull 2018).
Learning unit 8: Scenario analysis and stress testing
You have to work through chapters 7 and 22 of the prescribed book.
Please note that if you are unfamiliar with any of the topics discussed, you have to do
additional reading on your own to update your knowledge of those topics.
8.1 Introduction
Financial institutions make use of both valuation and scenario analysis to estimate
their future cash flows. However, the objectives of these two methods are different. In
the case of valuation, the organisation wishes to estimate its future cash flows. In the
case of scenario analysis, the organisation explores the full range of situations that
might exist in the future.
Risk-neutral valuation relates to the fictional world where investors require no reward
for taking on risk. This valuation method allows one to value any derivative by
assuming a risk-neutral world exists.
8.2 Scenario analysis
Scenario analysis involves examining what might happen in the future and is not
concerned with the valuation of risk factors.
Study chapters 7 and 22 of the prescribed book.
Activity 8.1
Complete the practice questions and problems at the end of chapter 7 of the textbook.
8.3 Stress testing
Stress testing is used to evaluate the impact of extreme scenarios that are not
explained by VaR or expected shortfall (ES).
Study chapter 22 of the prescribed book.
Activity 8.2
Evaluate the JSE FTSE All-share Index for the past 20 years and identify dates on
which there were big movements in the equity prices and what happened on those
38
dates to influence the share prices. Discuss these dates with fellow students on
Discussion Forum 8.2.
Regulations require organisations to base their market risk calculations on both VaR
models and stress testing. An organisation’s top management and board members
should be involved in stress testing. Top management and board members should





set objectives for stress testing
set various scenarios
discuss the results of the testing
assess the various actions that need to be taken
make decisions
Basel sets specific requirements for banks.
One of the biggest problems associated with stress testing is how to use the results
effectively. The results are often ignored by senior managers. One way to overcome
this problem is to involve senior managers in setting various scenarios. Stress testing
should be incorporated within the VaR calculations in order to make it more useful for
managers.
Activity 8.3
Study the following article:
Bogle, JC. 2008. Black Monday and black swans. Financial Analysts Journal 64(2):30–
40.
8.4 Summary
Stress testing is an important part of risk management because it helps organisations
to consider the impact of extreme events, which is often ignored by models such as
VaR and ES. An advantage of stress testing is that it gives organisations a better
understanding of the nature of the various risks that they face in their portfolios.
Activity 8.4
Complete the practice questions and problems at the end of chapter 22 of the textbook.
8.5 References
Hull, JC. 2018. Risk management and financial institutions. 5th edition. Hoboken, NJ:
Wiley Publishing.
39
Topic 3 – Measurement of market risk
Topic 3 covers learning units 7 to 9 and focuses on how to measure market risk by
means of value at risk (VaR), scenario analysis and stress testing. The last learning
unit deals with the implementation of market risk within an organisation. The topic
covers chapters 7, 12 to 14, 22 and 29 of the prescribed book (Hull 2018).
Learning unit 9: Mistakes to avoid
You have to work through chapter 29 of the prescribed book.
Please note that if you are unfamiliar with any of the topics discussed, you have to do
additional reading on your own to update you knowledge of those topics.
9.1 Introduction
Many losses in financial markets can be attributed to the mismanagement of market
risk, as in the case of Nick Leeson’s rogue trading, which led to the closure of one of
the oldest banks in Britain, Barings Bank. Many of the losses that are made by
organisations are simply not known because the systems in place do not report on
those transactions. Therefore, it is important that risk managers think outside the box.
9.2 Risk limits
The need for risk limits is one of the key lessons that has been learnt from financial
losses. Organisations need to set clear risk limits at board level. Companies have to
report on their financial risk, which includes credit risk, liquidity risk and market risk, in
their annual financial statements.
9.3 Managing the trading room
It is important for an organisation to manage its trading room effectively and not to give
more privileges to traders who are preforming well and making profit. It is essential to
manage all traders in order to have a better understanding of the risk within the
organisation.
9.4 Liquidity risk
Liquidity risk is the risk that a company will not be able to meet its short-term financial
obligations when they are due. Read Business Snapshot 22.1 on the LTCM case and
liquidity risk.
40
Activity 9.1
Read Business Snapshot 5.5. Discuss with fellow students on Discussion Forum 9.1
how the organisation could have prevented the loss.
9.5 Summary
Market risk management should form part of all organisations. It is important for
organisations to manage risk and to report on all market risks in their financial
statements.
We hope that you enjoyed the module and now have a better understanding of market
risk management. Good luck in your preparation for the examination.
9.6 References
Hull, JC. 2018. Risk management and financial institutions. 5th edition. Hoboken, NJ:
Wiley Publishing.
41