Market Risk Management

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Market Risk Modeling, Validation, Software Solutions and Consulting

Market Risk Modeling

Market risk captures the risk that the value of an instrument or portfolio will decrease as result of adverse movements in financial markets. Market risk encompasses a number of subtypes which are directly linked to a particular market risk factor (price or spread), namely interest rate risk, currency price risk (FX risk), equity price risk, commodity price risk, real estate price risk, inflation risk and credit spread risk.

Business & Decision RTC has proven expertise in the implementation of the essential tools for an efficient Market Risk Management, as well as the architecture and interfaces needed to gather the trade and market data:

  • Choose the best method for Value-At-Risk (VaR) or conditional Value-At-Risk (cVaR)* calculation:
    • Delta-normal: for large portfolios where optionality is not a major factor
    • Delta-gamma-Monte Carlo or grid Monte Carlo: for fast approximations of option values, mixed methods are efficient
    • Full valuation may be necessary for portfolios with substantial optionality, many risk factors and/or long horizons
  • Build Stress-Tests that compliment the VaR, measures the impact of scenarios on all possible risk factors, with shifts defined at the most granular level, taking optionality into account
  • Build reporting on the positions, with and without netting, with adequate exploration dimensions on the business units, financial instruments, markets, risk factors
  • Perform sensitivity reporting, that highlights the sensitivity to global risks for small and big shifts, taking optionality into account
  • Use Extreme Value Theory and Copulas to Evaluate Market Risk

** In the regulatory framework, VaR 99% will be replaced by cVaR 97,5% for the tracking portfolio

Equity Model Simulation - VaR Value at Risk

Market Risk Validation

Models developed for the risk computation have to be revalidated regularly.

On one side, the second pillar of Basle regulation implies that supervisors check that risk models are always performing consistently. On the other side, recent crisis has drawn the attention of internal stakeholders of the bank (business, CRO) to a higher interest on the models.

The validation process consists in a review of the development process and all related aspects of model implementation. It can be split in two parts:

  • Quality control worries about the ongoing monitoring of the model use, the quality of the input variables, the judgmental decisions, and the resulting model output.
  • Quantitatively, the backtesting compares statistically the predicted risk parameters with the actual outcomes.

Regarding market risk specifically, backtesting is particularly important. In the formula to compute the regulatory capital, there is a factor whose value depends on the number of VaR violations during the last 12 months. However, the number of failures in itself is not enough to assess the validity of the VaR model: one should also considers at least the eventual dependence between the violations and their severity. A lot of tests have been introduced recently (see below White Paper on Backtesting of Value-at-Risk models): B&D RTC can help you in the implementation of those tests, understanding and analysing their results.

VaR model backtesting example

White Paper - Market Risk Management: Backtesting Value-at-Risk Models

Date : 19/05/2015

Abstract

Basel regulation provides a framework that links the regulatory capital to the Value at Risk. Banks have thus been obliged to implement VaR models, predicting future risks.

These models have to be regularly back-tested to prove their accuracy. A large variety of testing methods have been proposed in the scientific literature. The first goal of this document is to provide a survey of them and discuss their strengths and weaknesses. Then, it addresses some recommendations for an optimal methodology in testing.

Click on the image to download

RTC Whitepaper - Backtesting Value at Risk Models

 

Why B&D?

Experience has show that the Market Risk manager needs several essential tools:

  • Dynamic reporting on the positions, with and without netting, with adequate exploration dimensions on the business units, financial instruments, markets, risk factors
  • Sensitivity reporting, that highlights the sensitivity to global risks for small and big shifts, taking optionality into account
  • Stress-Testing, measures the impact of scenarios on all possible risk factors, with shifts defined at the most granular level, taking optionality into account
  • Value-At-Risk, statistical measure of the worst possible short-term loss in a given confidence interval

Business & Decision has proven expertise in the implementation of those tools, as well as the architecture and interfaces needed to gather the necessary trade and market data in a timely fashion.

  • Ensure that methodological and modeling items are consistent across your organization
  • Assess that models developed internally comply with corporate business objectives
  • Check if model monitoring policies are coherent and in conformity with the model
  • Update model documentation to make it transparent for business continuity purposes
  • Ensure that models remain minimally in line with market standards
  • Enforce traceability of all the model lifecycle steps with a model inventory

 Business & Decision Risk Technology Consulting can assist with the technical and functional expertise in the key points of model development:

  • Initiation
  • Improvement
    • Request
    • Design
    • Prototyping
    • Model Analysis & Documentation
  • Model Management Cycle
    • Review
    • Validation

Case Studies

Validation of FX options market risk model for a British clearing house

The context: The client, one of the top central clearing counterparty houses, has developed its own methodology to compute the initial margin and the stress testing, for FX options (listed and OTC).

The needs: The client wanted to assess the compliance of this new methodology with the requirements of European Market Infrastructure Regulation (EMIR). It also wished a re-evaluation of the revised margin model in the context of adequacy and prudency.

The answer of Business & Decision Risk Technology Consulting: 

  • The model developed by the client has been replicated.
  • The initial margin, based on the historical VaR, has been back tested through a series of validation tests, as well as the stressed VaR and the liquidity add-on.
  • Analysis has highlighted few defaults in the current methodology and permitted to fix them.

Software used: MatLab

Partners

Business & Decision - Risk Technologies

Want to know more?

Contact Business & Decision Risk Technology Consulting

Backtesting VaR Models

Click on the image to download the White Paper - Market Risk Management: Backtesting Value-at-Risk Models

RTC Whitepaper - Backtesting Value at Risk Models