Module 5: Market Risk Assessment
Market Risk Management
1. Introduction
2. Risk Drivers
3. Assesment and mitigation
4. Capital Charge
Trading Book- The trading book represents the banks portfolio of financial instruments that are intentionally held for short-term resale and typically marked to market. What does marked to market mean? This means that the bank has to intentionally account for the price that the instrument is curretly trading in the market for valuation of the instrument.
Banking Book consists of other assets mainly loans that are held to maturity and typically valued on a historical cost basis.
Sometimes the regulator in a country may waive the need for marking to market for some financial instruments which are perceived to be less risks eg government bonds, provided they are held to maturity. These instruments are then part of banking book. These instruments are held to maturity to meet some statutory requirements such as the liquidity coverage ratio.
Banks investments are divided into three types of portfolios:-
1. HTM- Held to Maturity
2. AFS- Available for Sale
3. HFT- Held for Trade
If a financial instrument is part of banking book it is parked in HTM portfolio. As the bank is holding the instrument till maturity it is not affected by market risks. The value of instrument may be changing every moment in the market. But the bank need not be concerned as it will be getting fixed coupons and the principal back at maturity.
Trading book is further divided into AFS and HFT. Here the instruments have to be marked to market. The purpose of investment is making profits in short term through buying and selling. Securities held in HFT have to be sold in 90 days.
The third concept is accounting for appreciation and depreciation in value of instruments when marking them to market. Let’s understand this concept through an example! Suppose the Book value of a Bond is 90 and the Market Price that is the price at which the Bond is currently trading, becomes 95. Hence, there is an appreciation of 5. Second case, suppose now the Market Price of the Bond is 85 i.e. a depreciation of 5. What is to be done for the appreciation and depreciation? For countries where International Financial Reporting Standards that is IFRS or US-GAAP have been adopted, both appreciation and depreciation have to be accounted for. However, in places such as India where Banks are yet to migrate or converge to IFRS, only depreciation is to be accounted for and investment depreciation provisions have to be made. However, any Mark to Market appreciation is ignored.
Another important concept is that of Primary Market & Secondary Market. If a company has come up with an Initial Public Offer or Follow-on Public Offer. An investor applies and is allotted some shares, then he has got the shares from the Primary Market. On the other hand if the investor buys the shares from Stock Exchange after the Company has listed, then, he has bought it from the Secondary Market. Another concept is of Exchange Traded and Over The counter (OTC). Let us take the example of an importer. The importer has to make a payment in US dollars in 6 months. He wants to ensure that the price in dollar he has to pay is fixed today that is he wants to hedge his exchange rate risk. What does he do? He has two options. He goes to the Bank and buys a 6-month forward contract for USD. The contract will provide him USD for the exact amount on the exact date of payment. This is an example of Over the Counter or OTC Product, a bespoke customized product as per the customer’s requirement. The importer has another option- he can buy a futures contract from exchange to hedge his exchange rate risk. Futures contracts are standardized, that is they will not be customized to the importers requirements. There could be a mismatch in the date or amount. Hence the risk would not be fully hedged, some exposure would remain. This would be a Exchange Traded Product. So, Futures are not usually used for hedging, they have to be marked to market daily and are used by traders for speculation.
REPO seller, sells securities to borrow funds with an agreement to repurchase the securities, at a future date, at a price which is fixed today. Difference between the current Market Price and the fixed future price is the interest cost. So, Repo Seller, is the seller of securities and borrower of funds, as he needs liquidity. Repo buyer, is the buyer of securities and lender of funds as he has surplus funds and needs interest income. Central Bank acts as a REPO buyer to provide short term liquidity to banks against government securities. Central Bank fixes this rate as the REPO rate. When the Central bank wants to reduce excess liquidity in the banking system, it acts as a REPO Seller. The Central Bank now borrows funds from the bank by selling securities. This rate is fixed by Central Bank as Reverse REPO rate. REPO can also take place between two market players which is called the Market REPO. There is also a Triparty REPO where a Central Counterparty such as Clearing Corporation of India or CCIL acts as a custodian of securities. So this was about the Short Term Market or Money Market.
Risk Drivers
Interest Rate as a Market Risk Driver
Let us see how
Interest Rates affect the price of a bond.
Suppose we buy one, 10% fixed annual coupon paying bond, maturing in 5
years at the par value (usually Rs. 100), what are the returns we get?
We will get 10% of the par value that is Rs. 10 every year for 5 years.
At the end of the 5th year, I will also get the principal of Rs. 100 back.
How are these cashflows affected by interest rates prevailing in the
market?
They are not!
The cash flows are not affected.
Then how do interest rates act as Market Risk Drivers?
Remember! We discussed the concept of Banking Book and Trading Book in
the section on Market Risk Concepts.
If the bank is holding this bond till maturity in its banking book, it
is not affected by changes in Market Interest Rates.
Market Interest Rates act as Market Risk Drivers when the bond is being
held in the trading book, that is with the intention to trade and make short
term profits. When the Bond is being held in Trading Book, it has to be marked
to market.
What will be the Mark to Market price or the current market price of the
bond?
This price will be affected by the prevailing market interest rates
(yield) and the time value of money.
Yield
The bond we have purchased for Rs. 100 is paying 10% that is Rs. 10
every year. Now the yield that is the prevailing market interest rate has gone
up to 12%.
What does it mean?
It means that an investor who invests Rs. 100 now will get 12% annually
that is Rs. 12 every year.
Now, suppose this investor is interested in purchasing our bond, will he
pay Rs. 100?
If he pays us Rs. 100 he will get a coupon of Rs. 10 every year, while
if invests Rs. 100 in the market, he will get Rs. 12 every year.
So, the investor will not be ready to pay us Rs. 100 for the bond, he
will pay something less.
Hence, the market price of our bond has come down due to increase in the
yield.
If the yield goes down below 10%, the market price of our bond will go
up.
This is the inverse relationship between price and yield.
When yield goes up price comes down and vice versa.
Time value of money
Another concept which affects the current market price is the Time value
of money.
Which is more valuable?
Someone pays me Rs. 100 today or Rs. 100 after 1 year?
Obviously Rs. 100 available today is more valuable as it can be invested
for 1 year to earn interest.
Hence, when computing the current market value of any Market product.
The Present Value of future cash flows is calculated. This gives us the current
market price of the product.
The Present Value is calculated by discounting the future cash flows by
the prevailing market interest rate or yield.
Let’s see an example:
An investor buys one coupon paying Bond at the par value of Rs. 100. The
Bond pays a annual coupon of 10% and has maturity of 2 years. The prevailing
market rate (yield) is 5%. What will be the Current Market Price of the Bond?
First, we look at the Cash Flows from the Bond.
After 1 year investor will get Rs. 10 (10% Coupon on par value of 100)
At the end of 2nd year investor will get Rs. 110 (10 Coupon + 100 Principal)
The get the Market Price of the Bond we have to find Present Value of
these cash flows by discounting them by the Market Yield of 5%.
|
|
Year 1 |
Year 2 |
Total |
|
Cash Flow |
10 |
110 |
120 |
|
PV Formula |
10/(1+0.05)^1 |
110/(1+0.05)^2 |
|
|
Present
Value |
9.52 |
99.77 |
109.29 |
So, Market Price of the Bond is Rs. 109.29
When the investor purchases this bond at Rs. 109.29, his annual return
or yield comes out be 5%. This is called his Yield To Maturity (YTM)
Equity Price as a Market Risk Driver
Stock prices keep on changing with time. In other
words stock prices are volatile. Volatility of stock prices results in equity
price risk. While favorable movements in stock prices result in Mark to Market
(MTM) gains, adverse movements result in MTM losses.
Stock price of a scrip may move on account of
market factors and also on account of firm specific factors. Adverse movement
in price attributed to market factors is called General Market Risk or
Systematic Risk, while the adverse movement in stock price on account of factors specific to the firm is called
Specific/ Idiosyncratic or Unsystematic Risk.
General Market Risk refers to stock’s sensitivity
to the change in the broad market indices such as Sensex, Nifty etc. For
example, Stock price movement is twice that of market index Nifty then the
stock’s sensitivity is 2 and that gives an indication of the general market
risk associated with that stock.
Specific or Idiosyncratic Risk of equity arises on
account of for specific reasons related to the company, such as change in
outlook for its line of business, change in management policy, Revenue or
profit going up or down.
Thus, all stocks are affected by both General
Market Risk (GMR) and Specific Risk (SR). However, if a portfolio of stocks is
diversified enough, Specific Risk can be zeroized (at least theoretically!).
However, General Market Risk always remains.
Exchange Rate as a Market Risk Driver
Role of Exchange rate as a Market Risk Driver can be understood through
the concept of Interest Rate Parity.
Concept of interest rate parity
Let us assume that risk free interest rate for one-year deposit in India
is 7% and in USA it is 2%. For an investor in USA, it looks like that he can
make substantial gains (7%-2%) if he invests in India instead of USA. However,
the concept of Interest Rate Parity ensures that the investor will get the same
return whether he invests in USA or India. Products affected by exchange rate
risk such has Forwards and Futures are priced based on the concept of Interest
Rate Parity.
Let us see an example:
Suppose, For USDINR, Spot Rate denoted by “S” is 70 and 1 year Forward
Rate is denoted by “F”.
Further, lets assume that risk free interest rate for one-year deposit
in India is 7% (RD) and in USA it is 2% (RF).
1st Scenario:
If a US investor, invests 1 dollar in USA for 1 year.
At the end of the year, the investor would get: $1x(1+RF) or $1x(1+0.02)
or $1.02.
2nd Scenario:
US Investor brings the $1 to India (We are assuming that there are no
restrictions in the movement of currency), converts it in INR and deposits it
for one year in India. After one year, the money has to be returned back to
USA.
The $1 is converted into INR at the Spot Rate (S) of 70. This INR 70 is
invested at the rate RD of 7%. deposited in India for one year at interest rate
of (RD) 7%.
At the end of one year, Investor receives $1xSx(1+RD) or $1x70x(1+0.07)
or INR 74.9
Now, this money has to be converted back to USD for returning it back to
USA. The exchange rate used for conversion from INR to USD will be the 1 year
Forward Rate (F) fixed at the time sending $1 to India.
So the Dollar amount to be sent back to USA will be $1xSx(1+RD)/F.
As per the concept of Interest Rate Parity, this amount should be equal
to the amount in Scenario 1st: $1x(1+RF).
This will result in the formula:
$1x(1+RF) = $1xSx(1+RD)/F
or,
F = Sx(1+RD)/(1+RF)
This is how Forward rates are determined using Interest Rate Parity so
as to ensure no arbitrage opportunity.
Various Market Risk Tools are used for assessment and mitigation of Market Risk. These can be categorized as under:
· Risk Sensitivity Measures (Modified Duration, PV01 & Option Greeks)
· Value at Risk (VaR) & Back Testing
· Stressed VaR
· Stress Testing
· Net Overnight Open Position (NOOP)
· Risk Adjusted Performance Analysis
· Limit Management
Risk Sensitivity Measures
i. Sensitivity denotes how much the Market Price of a
security/ position/ portfolio changes due to a small change in the value of the
underlying Market variable (e.g. Interest Rate).
ii. Duration: It measures the time (in years) in which the
investor is repaid the Bond price by the Bond’s total cash flows. It is the
weighted average time in which the investor gets back his cash flows. It is a
sensitivity measure as duration changes with the change in interest rates.
Duration of a zero coupon (Non-interest paying) Bond is same as its residual
maturity.
iii. Modified Duration: Measures the
percentage change in Bond value for one percentage change in Interest Rate. It
shows the sensitivity of price of bond to interest rate movement.
Modified Duration = % change in price of bond
% change in yield
Also, in terms of Duration:
Modified Duration = Duration
(1+ Y/n)
(Where Y= Yield to Maturity of Bond
& n = the no. of coupon payments in a year)
iv. Present Value of a Basis Point (PV01): It is the amount by which the value of a Interest Rate Sensitive
Instrument (Bond or Derivative) changes for one basis point (0.01%) change in
Interest Rate. It is an absolute measure of price change.
If the Duration/ Modified Duration/ PV01 of a Bond is going up it
indicates that risk is going up.
v. Option Greeks: Represent
the sensitivity of the price of an Option to a change in underlying parameters.
Options will be elaborated on, in the next section on Derivatives. The Various
Option Greeks are as under:
· Delta: Rate of change of Option Value to a small change in the Price of the
underlying asset.
· Gamma: Rate of change of Delta with respect to a small change in the Price of
the underlying asset.
· Theta: Rate of change of the Option Value with respect to the passage of
Time.
· Vega: Rate of change of the
Option Value with respect to a small change in the volatility of the underlying
asset.
· Rho: Rate of change of the Option Value with respect
to a small change in the Interest Rate.
VaR & Back-testing
VaR is the estimation of the maximum amount of money that may be lost on
a portfolio over a given period of time at a given level of confidence under
normal market conditions.
If VaR for one day horizon, at a confidence level of 95% is Rs.10 crore,
it means:
The possibility that loss will exceed Rs.10 crore over the next 24 hours
under normal market conditions is 5%. Or, we can say with 95% confidence that
the loss over the next 24 hours shall not exceed Rs. 10 crore.
There are three methodologies for calculating VaR:
I.Variance-Covariance
II.Historical Simulation
III.Monte Carlo Simulation
Variance Covariance VaR
It is a parametric
method for computing VaR. It works with the assumption that the asset returns
are Normally Distributed. It uses statistical concepts such as standard deviation, correlation, covariance etc. for the estimation of VAR. It is also called Delta Normal VaR.
To compute VaR for an equity stock, the steps are as under:
(1) Measure Current Exposure (Position * Stock Price)
(2) Compute Standard Deviation (Volatility) of the historical price
returns of stock
(3) Express chosen Confidence Level as one tailed Z value (From Z table)
(4) VaR = Current Exposure * Standard Deviation * Z value
For e.g. To calculate One day VaR for an investment in XYZ stock at 99%
Confidence Level.
Investor is holding a position of 100 XYZ stocks. The current Market
Price of XYZ stock is Rs. 100. Standard Deviation (volatility) of XYZ’s daily
price returns is 10%.
The steps are:
Measure Current Exposure (Position*Stock Price) = 100*(Rs.) 100= Rs.
10,000
Standard Deviation = 10% (Given/ can be computed using historical price
returns)
Z value =2.33 (From Z table one tailed at 99%)
VaR = Rs. 10,000*0.10*2.33 =Rs. 2,330
This means that we can say with 99% confidence that loss over the next
24 hours for the Investor shall not exceed Rs. 2,330 under normal market
conditions.
Historical Simulation VaR
In this methodology the current portfolio is revalued using historical
returns (of the Look Back period). The assumption is that history will repeat
itself. It aims to predict future changes from actual distribution of Past
Returns.
The steps for computing VaR are as under:
(1) Measure Current Exposure (CE= Position* Price)
(2) Measure Price Returns for the past 250 or 500 trading days
(3) Multiply Past Price Returns by CE: (1)´(2)
(4) Rank Results generated in Step (3) from Worst to Best
VaR is the Result as per the Confidence Level
Monte Carlo VaR
The methodology is similar to Historical Simulation but uses
randomization function to simulate Returns.
The steps for computing VaR are as under:
(1) Estimate parameters mean & standard deviation from Historical
Return Data
(2) Use randomization to generate Simulated Returns
(3) Revalue Current Exposure with the Simulated Returns
(4) Rank the Results from Step (3) from worst to best
VaR is the Result as per the Confidence Level
Comparison of VaR Methodologies
A comparison of the three VaR methodologies is as under:
|
Method |
Strengths |
Weaknesses |
|
Variance Covariance |
Simplest Method |
Normal Distribution Assumption Misses Fat Tails Non-linear structures not captured |
|
Historical Simulation |
Easy to implement and explain Most Commonly used Exponential weighting possible |
History must “repeat itself” Depends on “Look back” period |
|
Monte Carlo Simulation |
Most flexible Captures Non-linear products Captures futuristic behavior of risk factors |
Extensive system requirement Computationally very intensive Difficult to intuitively comprehend |
Back-testing
VaR model is subjected to continuous back testing. Back testing is
undertaken to test the robustness of VaR model. Back testing is to be carried
out daily at an asset-class level (interest rate, equity, FX, derivative) and
at a category level (AFS and HFT).
It is a process where the model based VaR is compared with the actual
performance of the portfolio. Back tests compare the realized trading results
with model generated risk measures to assess the accuracy of VaR model.
There are two types of Back testing: Clean (Hypothetical) back testing
and Dirty back testing.
Stressed VaR
It predicts a Loss level that will not be exceeded at a specified confidence level for a specified time horizon under Stressed Market Conditions.
Stressed VaR replicates a loss calculation that would be generated on the Bank’s current portfolio, if the relevant market factors were experiencing a period of stress. The stress period shall be a continuous 12 month period corresponding to 250 trading days of stress to the Bank’s portfolio.
Stress Testing
Stress Testing is conducted to estimate the probable loss under abnormal market conditions. It complements VaR. The shocks applied for Stress Testing should be extreme, but plausible. Stress Testing evaluates Bank’s capacity to withstand stressed conditions in terms of Profitability and Capital.
Various Stress Testing Methodologies are adopted as under:
- Sensitivity Analysis (Single Risk factor shocks)
- Scenario Analysis (Multi Risk factor shocks)
- Forward Looking Stress Testing
- Reverse Stress Testing
NOOP
Risk Adjusted Performance Analysis (RAPM):
It analyses the returns generated by treasury operations vis-à-vis the risk taken for generating the return.
Various methodologies are used for undertaking RAPM at portfolio level.
Sharpe Ratio: The ratio measures a fund's risk-adjusted returns using Standard Deviation. The higher a fund's Sharpe ratio, the better the returns are relative to the risk taken to achieve the returns.
Sortino Ratio: It measures the performance of the investment relative to the downward deviation. Unlike Sharpe, it doesn't take into account the total volatility in the investment but considers deviation only for those days in which the portfolio had a negative return. Thus, it considers only negative volatility and leaves out positive volatility.
Information Ratio (IR): It measures excess return over benchmark per unit of risk.
Jensen’s Alpha: Also known as the Jensen’s Performance Index, is a measure of the excess returns earned by the portfolio compared to expected returns suggested by the Capital Asset Pricing Model (CAPM).
Limit Management
Market Risk is managed by means of a limit structure that is approved by the Board and is consistent with the amount of capital that the Bank holds for Treasury activities.
The objective of setting Market Risk limits is to be within the risk appetite, to protect the capital and to reduce the volatility of trading returns. Limit Management endeavors to ensure that variation from expected outcome shall not exceed the prescribed risk appetite.
Derivative is a contract or a product whose value is derived from the value of some other asset known as the underlying. This underlying asset can be Metal such as Gold or Silver. Agricultural commodity such as Cotton or Wheat. Energy resource such as Oil or Electricity. Or a Financial asset such as Share, Bond or Foreign Exchange. What are the products available under Derivatives? There are 4 basic type of products: Forward, Futures, Swaps and Options. First is a Forward: A Forward is an agreement between two parties, to buy/sell the underlying asset, on a future date, at a future price, both of which are fixed today. It is an obligation on part of both the contracting parties to honour the agreement irrespective of the price of the underlying at the time of maturity. Forwards are over the Counter or OTC products as they are negotiated between two parties and the terms of the agreement are tailored to their needs. Let’s see an example of a Forward Contract which has USD INR rate as the underlying. Suppose the expiry of the contract is after one month with price fixed for delivery as 1 dollar at Rs. 70. Now, this is the At maturity payoff diagram for the party which has bought this Forward contract or in other words is long on the Contract. The X-axis depicts the USD INR rate and the Y-axis depicts the Profit & Loss or Payoff of the deal. Now, suppose at maturity the actual USD INR rate is 1 dollar for Rs. 75. The long position holder, that is the party which has bought the contract gains Rs. 5. He, will buy dollar at Rs. 70 and immediately sell the dollar at Rs. 75, pocketing a profit of Rs. 5 per dollar. What happens, if at maturity, the dollar is selling at Rs. 66? Now the Long position holder will lose Rs. 4, as he will have to honour his commitment to buy at 70, though the dollar is available at 66. What is the at maturity payoff for the party which has sold the Forward contract? This party is said to be holding a Short position. Derivatives are a zero sum game. When one party gains Rs. 5 the other party to the contract will lose Rs. 5. Hence, when the long position holder loses Rs. 4, the short position holder will gain Rs. 4. This is the seller’s Maturity Payoff diagram. We can understand this diagram as the mirror image of the buyer’s diagram. The mirror being placed on the X- Axis.
Second type of Derivatives are Futures: Futures are similar to a Forward except that the deal is done through an exchange rather than through direct negotiation between the parties. Hence, Futures can be termed as exchange traded forwards. Futures are standardized products. If an importer or an exporter tries to hedge his exchange rate risk through Futures. He may not be able to do a complete hedge as the product is not customized to his specific requirements. Third type of Derivatives are Swaps. Swap is an agreement between two parties, to exchange future cash flows as per the terms and conditions specified today. Suppose a Bank has given a loan at floating rate and is getting monthly interest cashflows at floating rates. Now, the Bank wants to convert these floating cashflows in to fixed cashflows.For this, it would enter into an Interest Rate Swap agreement with another Bank. The first bank gives the monthly floating cashflows to the second bank, which in turn gives fixed cashflows to the first bank. Thus, an exchange of Future cashflows takes place. Why would the second bank be interested in getting floating cashflows? Maybe, the bank has to make some payments at a floating rate. The two Banks would decide on the terms and conditions for the exchange of the cashflow streams. Hence, it is an OTC or Over The Counter Product, customized to the requirements of the parties to the contract. Fourth type of derivatives are the Options. Option is a contract, that gives the right, but not an obligation, to buy or sell the underlying asset at the specified price, on or before the specified date. If the option can be exercised only at the maturity date it is called the European Option. While the Option which can be exercised anytime till maturity, is called the American Option. As the Option is giving a right without the obligation to exercise the contract, the buyer of the Option pays a premium for it. The seller of the option who is also known as writer, receives the premium. The seller has the obligation to sell or buy the underlying asset if the buyer of the Option exercises his right to buy or sell. Let’s now understand the Pay off of an Option deal by differentiating it from a Forward. For simplicity, we shall discuss an European Option, that is the option which can be exercised only at maturity. So this was the Payoff of a Buy or Long Forward. e instead of buying a Forward, the party buys an Option with the maturity of one month and pre-determined price called the Strike price, of 1 dollar at Rs. 70. How will the Payoff change? The negative side of the Forward graph is gone. This happens as the Buyer of this Option, known as the Call Option, has the right but not the obligation to buy dollar at Rs. 70. If at maturity price of 1 dollar is above 70. The holder is In The Money. He will exercise his right to buy at 70 and book profits. The pay off above 70 is similar to that of the Forward. However, if at maturity, that is after one month, USD is selling at less than Rs. 70. Then the Call Buyer is Out of Money. That is if he buys at 70 he will lose. So. He will not exercise his right to buy. Remember, he does not have an obligation to buy. He will let the Option lapse. Hence, on the left side of 70 that is below 70. the payoff becomes a Straight Horizontal Line. But this line is not at zero. It is slightly below the x-axis. This depicts the Premium the buyer of the Option has paid. Thus, Call Option gives the holder the right but not the obligation to buy at a prefixed price called the Strike Price. The at maturity pay off diagram depicted here is of the buyer of the Call Option. Then, what is the payoff diagram for the seller of the Call Option. As we said for Forwards, derivatives are a zero-sum game. the seller of the Call Option will gain what the buyer will lose. Or the seller will lose what the buyer will gain.
We can understand this better by an example. Suppose in the previous year there was a great demand for potato and the potato crop sold at ery steep prices. Anticipating that the price could go up again this year, a farmer decides to grow twice the amount of potato. However, when he is nearing harvest, he observes that all the farmers have grown very huge quantities of Potato this year as compared to previous year. The farmer now fears that there will be a glut of potatoes this year and the price would go down. What should he do? The farmer can buy a Put Option on Potato. Suppose he buys a Put option on Potato at Rs. 70 maturing in one month. This gives him the right to sell potato at Rs. 70 after one month. Now, suppose, the price of potato after one month goes down to 50, the potato farmer, who is holder or buyer of the Put can still sell at 70. If the price goes above 70? The farmer will not exercise his Put option. He will sell his crop directly to the market. What will he lose? The farmer will only lose the premium that he had paid upfront for buying the Put. Now if place a mirror on the X-axis the reflection will depict the payoff of the seller of the Put Option. So, as in the case of Call Option, the maximum gain for the seller of put is limited to the premium earned. The loss is to the extent that the price of the underlying becomes zero. Who are the participants in the Derivatives Market? The participants in the Derivatives market can be categorized in to 3 categories. First are the hedgers. Hedgers actually, hold a position in the underlying asset. They are exposed to the risk of movement in the price of the asset and want to mitigate this risk through Derivatives. So Importers and Exporters or Banks which are holding positions, would act as hedgers. The second type of participants are the Traders or the Speculators. They don’t have an underlying position, but they have a view on the future movement in the price of the underlying asset. They buy sell derivatives based on this view. Why do traders prefer Derivatives, why not trade directly in the underlying asset? Traders prefer derivative as they provide leverage and are cheaper to trade. A trader can buy one stock of a company for a certain amount, or he can buy say 100 futures of the stock from the same amount. Futures are virtually free of cost except for a small margin. However, the possibility of gain or loss from one futures is same as the gain or loss from one stock. Hence by trading in futures rather than stock, the possible gain increases 100 times but, the possible loss also increases 100 times. The third type of participants are the arbitrageurs. Arbitrageurs look for mismatches in the price of the asset in different markets. For example, the same product may be selling at slightly different prices at two exchanges. There could also be a situation that there is a slight mismatch in the expected price of a derivative. Arbitrageurs keep looking for such opportunities to book small risk less profits. As soon as Arbitrageurs act the market starts correcting itself. A thing to remember here is that these roles are not fixed. The same market participant may play different roles in different situations. What are the types of Market for Derivatives? Derivatives are traded both on the exchange or Over The Counter. As we said earlier OTC products are customized and Exchange traded products are standardized. What are the Benefits of Derivatives? Derivatives result in better price discovery of the underlying assets, as the pricing takes into account the actual valuation as well as the future price expectations of the market participants. Derivatives helps in transfer of various risk from those who are exposed to risk but have low risk appetite, to participants who have high risk appetite and want to take on the risk for higher returns. For example Hedgers want to mitigate risk while traders want to take on risk. What are the Risks of Derivatives? Derivatives are extremely leveraged products, they offer opportunities for very high returns by taking equally high risks. Remember! we discussed Risk Reward ratio in Module I on Risk & capital. Derivatives are suitable for people with high risk appetite. A person who has little trading experience, limited resources or low risk appetite should avoid Derivatives.
Capital Charge
Introduction
Capital charge for Market Risk is required to be calculated for the following:
· Interest Rate sensitive instruments and Equity instruments in the Trading book.
· Foreign Exchange and Gold positions in both Trading Book and Banking Book.
Trading Book for the purpose of Market Risk Capital Charge comprises of:
· Securities included under HFT.
· Securities included under AFS.
· Open Gold position.
· Open Foreign Exchange position.
· Trading positions in Derivatives.
· Derivatives entered into, for hedging Trading Book exposure.
Market Risk capital charge has to be maintained by banks on continuous basis. Let us now learn various methodologies for computing Market Risk Capital charge.
Standardised Measurement Method (SMM)
Under SMM, Market Risk Capital Charge is computed using pre-defined risk weights. For computing the Total Capital Charge for Market Risk, capital charges for Specific Risk and General Market Risk are computed separately for Interest rate related instruments (Bonds & Interest Derivatives) and Equities in the Trading book. This is then aggregated with Capital charge for open Forex (including Gold) positions.
Aggregation of Market Risk Capital Charge
Risk Category |
I. Interest Rate (a+b) |
a. General Market Risk |
b. Specific Risk |
II. Equity (a+b) |
a. General Market Risk |
b. Specific Risk |
III. Foreign Exchange & Gold |
IV. Total Capital Charge for Market Risk (I+II+III) |
I Measurement of Capital Charge for Interest Rate Risk
The capital charge would be applicable on current market value of interest rate instruments in the trading book. Since banks are required to maintain capital for market risk on an ongoing basis, they are required to Mark to Market their trading positions on a daily basis. The current market value will be determined as per extant regulatory guidelines on valuation of investments.
The capital charge would be the aggregate of Specific Risk and General Market Risk.
Specific Risk
It is a charge which provides protection against adverse price movements in a security due to factors pertaining to the issuer of the security.
For example price of a company’s Bond falling due to some poor quarterly results of the company.
General Market Risk
The capital requirement provided protection against current market value of interest related instruments falling due movement in market interest rates. It is the total of four elements:
· The net short or long position in the whole trading book.
· A small proportion of the matched positions in each time-band.
· A larger proportion of the matched positions across different time bands.
· A net charge for Options.
II Measurement of Capital Charge for Equity Risk
The capital charge applies on the current market value of equities in bank’s trading book. The Capital charge is calculated as the sum of Specific Risk and General Market Risk.
III Measurement of Capital Charge for Foreign Exchange Risk
Foreign exchange open positions and gold open positions are risk weighted at 100 per cent. The capital charge for market risk in foreign exchange and gold open position is a fixed percentage of open position (Actual or Limit whichever is higher). This capital charge is in addition to the capital charge for credit risk on the on-balance sheet and off-balance sheet items pertaining to foreign exchange transactions.
Internal Models Approach (IMA)
. Revised Minimum Capital Requirements for Market Risk
The revised method is an initiative to overhaul Trading Book Capital Charge Rules. It aims to replace the SMM/ IMA guidelines with a more coherent and consistent framework.
Revised Minimum Capital requirements are to be adopted from 1st January 2023.
Banks in India are currently computing Market Risk Capital Charge (MRCC) as per Standardized Measurement Method (SMM).
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