Risk Management

• There will be 2 and a half questions from the topics operational risk, market risk, foreign exchange risk, interest rate risk amnagement

• Technology
• Employees
• Customer relationships
• Capital assets
• External

Technology costs and Revenues
• Investments in technology are risky
– Potentially negative NPV projects due to uncertainty and potential competitive responses
– Potential agency conflicts:
• Growth-oriented investments may not maximize shareholder’s value
• Losses on technological investments can weaken an FI

• Programming error
• Model risk
• Mark-to-market error
• Management information
• IT/Telecomm systems outage
• Technology provider failure
• Contingency planning

• Employees
– Turnover
– Key personnel
– Fraud
– Rogue trading (Barings, Allied Irish, BNP)
– Money laundering
– Confidentiality breach- information in the bins
• Revelation of ethical problems via email exchanges

• Efforts to expand consumer acceptance of web-based services frustrated by scams
– Phishing
– “Spoofing” messages purported to be from FIs
– Identity theft concerns
• Vulnerability of online credit card usage

• International Technology Transfer Risk
• Crime and Fraud Risk
– Fraud risk, especially from FI employees increased
– ABN AMRO $80 million fine
• Regulatory Risk
– Technology facilitates avoidance of regulation by locating in least regulated state or country- Offshore banking units
• Tax Avoidance
• Competition Risk from non financial firms

Statistics and controlling
Operational Risk
• Loss prevention:
– Training, development, review of employees
• Loss control:
– Planning, organization, back-up
• Loss financing:
– External insurance
• Loss insulation:
– FI capital

• Important in terms of:
– Management information
– Setting limits
– Resource allocation (risk/return tradeoff)
– Performance evaluation
– Regulation
• BIS and Fed regulate market risk via capital requirements leading to potential for overpricing of risks
• Allowances for use of internal models to calculate capital requirements

Risk calculations methods
Monte Carlo
Simulation
Risk Metrics/ variance approach
Historic/ back simulation
Fixed
Income
Foreign
Exchange
Equities
Portfolio
Aggregation

Daily earnings at risk (DEAR)= (Dollar market value of position) × (Price sensitivity of the position) × (Potential adverse move in yield)
Price sensitivity is modified duration (MD) of bond i.e. MD=time/(1+rate of yield)
(Price sensitivity) x (adverse yield) = total price volatility of an asset hence
DEAR = Dollar market value of position × Price volatility.

Example for Fixed Income
Securities
• Suppose a FI has a market position of $1m n zero coupon bonds of 7 years to maturity with a face value of 1,631,483.
• Today yields on these bonds is 7.243% per year.
• These bonds are held as part of trading portfolio hence market value is $1m

Solution for fixed income securities
Formula
DEAR= (market value) x (MD) x (adverse daily yield curve)
Step1- MV= $1 million

Solution for fixed income securities
Formula
DEAR= (market value) x (MD) x (adverse daily yield curve)
Step2- MD= (Time to maturity)/(1+rate of yield) i.e MD= 7/(1+.07243)= 6.527

Solution for fixed income securities
Formula
DEAR= (market value) x (MD) x (adverse daily yield curve)
Step3- Adverse Daily Yield= we assume the possibilities are distributed along a Normal curve. We define the it is 5% chance that yield will exceed this amount in either direction i.e 1 in 20 can be bad outcomes

Adverse 7-Year Rate Move
In normal distribution curve middle 90% is found within +- 1.65 standard deviation from the mean. i.e. only 10% of the area fall outside the +- 1.65

Solution for fixed income securities
– Suppose that we are long in 7-year zero-coupon bonds and we define “bad” yield changes such that there is only 5% chance of the yield change being exceeded in either direction. Assuming normality, 90% of the time yield changes will be within 1.65 standard deviations of the mean. If the standard deviation is 10 basis points, this corresponds to 16.5 basis points. Concern is that yields will rise. Probability of yield increases greater than 16.5 basis points is 5%.

Solution for fixed income securities
Formula
DEAR= (market value) x (MD) x (adverse daily yield curve)
Step3- Adverse daily yield curve is 16.5bps or 0.00165 or 0.165%

Solution for fixed income securities
Formula
DEAR= (market value) x (MD) x (adverse daily yield curve)
Step4 - Result
$1,000,000*6.527*.00165
= $10,770

N
Solution for fixed income securities
• To calculate the potential loss for more than one day:
N
Market value at risk (VAR
N
) = DEAR ×
• Example:
For a fiveday period, √5 x DEAR
VAR
5
= $10,770 ×
= $24,082

Simulation vs. other methods of risk measurement
• Simulation
– Results are based on a huge number of situations and they can be increased as required .
– It involves VAR, Semi –Variance, Negative Variance, Standard
Deviation, etc
– One gives a vision of probabilities of outcomes Statistical methods
• Statistics analysis
– Results are based on the past performance. Recent economic events make all the statistical methods ineffective.
– Statistical methods involve Convexity, calculus.
– It is based on sensitivity to the change in some underlying risk factors.