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Market & Operational Risk Henny Zahrany 2912551 MBA ITB 48 Risk Management

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Page 1: Paper Risk Management market and operational risk

Market & Operational RiskHenny Zahrany

2912551MBA ITB 48

Risk Management

Page 2: Paper Risk Management market and operational risk

What is Market Risk? “market risk" is the risk that changes in

financial market prices and rates will reduce the value of a security or a portfolio- Michel Crouhy.

“Market risk is the risk of losses owing to movementsin the level or volatility of market prices- Jorion.

Page 3: Paper Risk Management market and operational risk

Types of Market Risk According to Jorion, there are two forms of Market

risk, absolute (dollar terms/relevant currency) and relative (relative to benchmark index).

He also classified market risk into directional and non-directional.

Directional: exposures to the direction of movements in financial variables; stock price, interest rate, commodity prices, & exchange rates.

Non-directional: Involve the remaining risks; nonlinear exposures and exposures to hedged positions or to volatilities.

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Directional RisksInterest Rate Risk The risk that the value of a fixed-income security

will fall as a result of a change in market interest rates, Open positions arise most often from differences in the maturities, nominal values, and reset dates of instruments and cash flows that are assetlike (i.e., "longs") and those that are liabilitylike (i.e., "shorts").(Crouhy, 178).

Imperfect correlation between offsetting instruments, both across the yield curve and within the same maturity for different issuers, can generate significant interest rate exposures.

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Directional Risk (2)Equity Price Risk It has two components: 1. General Market Risk: sensitivity of an

instrument/portfolio value to a change in the level of broad stock market indices (can’t be diversified).

2. Specific/Idiosyncratic: risk refers to that portion of a stock’s price volatility that is determined by characteristics specific to the firm. (can be diversified).

Page 6: Paper Risk Management market and operational risk

Directional Risk (3)Foreign Exchange Risk It is from the imperfect correlations in

the movement of currency prices and fluctuations in international interest rates.

The valuation requires knowledge of the behavior of domestic & foreign interest rates, as well as of spot exchange rates.

Page 7: Paper Risk Management market and operational risk

Directional Risk (4)Commodity Price Risk Since most commodities are traded in

markets in which the concentration of supply can magnify price volatility.

Fluctuations in the depth of trading in the market often accompany and exacerbate high levels of price volatility.

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Measurement Ad Hoc Tools; notional amounts,

sensitivity measures, and scenarios. > Unsatisfactory because:

Don’t measure what matters, the downside risk for the total portfolio.

Fail to take into account correlations across risk factors

Don’t account for the probability of adverse moves in the risk factors

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Measurement (2) Value at Risk Jorion (2007) said that “VaR summarizes the worst

loss over a target horizon that will not be exceeded with a given level of confidence”.

Crouhy: “VaR is proving to be a very powerful way of assessing the overall risk of trading positions over a short horizon, such as a 10-day period, and under "normal" market conditions”

Crouhy: “The danger posed by exceptional market shocks can only be captured by means of supplemental methodologies such as stress testing and scenario analysis”.

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Value at Risk

“VaR measure does not state by how much actual losses will exceed the VaR figure; it simply states how likely (or unlikely) it is that the VaR figure will be exceeded”.

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Steps of Calculating VaR1. Derive the forward distribution of the

portfolio, or alternatively the returns on the portfolio, at the chosen horizon, H

2. Assume the confidence level, c, calculate the first percentile of this distribution.

3. VaR= Expected profit/loss – worst case loss at the _% confidence level, or

4. VaR= Worst case loss at the _% confidence level

Only the first definition of VaR (3) is consistent with economic capital attribution and RAROC calculations. In VaR the expected profit/loss is already priced in, and accounted for, in the return calculation. Capital is provided only as a cushion against unexpected losses.

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Operational RiskFinancial Risk

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History behind Operational Risk

The Basel Committee is proposing to establish capital charges for operational risk, in exchange for lowering them on market and credit risk. The proposed charge would constitute approximately 12% of the total capital requirement. This charge is focusing the attention of the banking industry on operational risk.

Page 14: Paper Risk Management market and operational risk

Definition A narrow view is that operational risk is

confined to transaction processing. Another, much wider definition views operational risk as any financial risk other than market and credit risk- Crouhy

Basel II:Operational risk is defined as the risk of loss resulting from inadequate or failed processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.

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Business Line

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Type of Operational Risks

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Two Broad Categories of Operational Risk

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Assessing Operational Risk Comparison of Approaches Top Down Models

Measure at the broadest level, a firm-wide or industry–wide data.

Bottom-up ModelsStart at the individual business unit or process level.

Actuarial ModelsEstimate the objective distribution of losses from historical data and are widely used in the insurance industry. Such models combine two distributions, loss frequencies and loss severities.

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Managing Operational Risk

•Capital Allocation & InsuranceThe Expected Loss The size of operational losses that should be expected to occurThe Unexpected LossThe deviation between the quantile loss at some confidence level and the expected lossStress LossA loss in excess of the unexpected loss

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Managing Operational Risk (2)

Mitigating Operational Risk Internal control methods:o Separation of functionso Dual entrieso Reconciliationso Tickler systemso Controls over amendments

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Managing Operational Risk (3)

External Control Methods:o Confirmationso Verification of priceso Authorizationo Settlemento Internal/external audits

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Four-Step Measurement Process for Operational Risk

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Four-Step Measurement Process for Operational Risk (2)

Step 1 – InputThe first step in the operational risk measurement process is to gather the information needed to perform a complete assessment of all significant operational risks.

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Four-Step Measurement Process for Operational Risk (3)

Step 2 – Risk Assessment Framework

Page 25: Paper Risk Management market and operational risk

Sample Risk Assessment Report

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Four-Step Measurement Process for Operational Risk (4)

Connectivity and Interdependencies

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Four-Step Measurement Process for Operational Risk (5)

Step 3 – Review & Validation1. ORMG reviews the assessment results

with senior business unit management and key officers in order to finalize the proposed operational risk rating.

2. Operational risk rating committee to review the assessment

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Four-Step Measurement Process for Operational Risk (6)

Step 4 – Output

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Four-Step Measurement Process for Operational Risk (7)

if a business unit falls in the upper right-hand quadrant, then the business unit has a high likelihood of operational risk and a high severity of loss, if failure occurs.

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References Jorion, 2003, Financial Risk Manager

Handbook Jorion, 2007, Value at Risk Michel Crouhy, Risk Management