Financial Risk

Management
 hello!
I am Ruchit Chaturvedi
You can contact me at [email protected] or
900 420 5947 (only in urgent need)

2
 Objective of the course
Objectives - This course aims to:
❑ Familiarize the participants with risk universe of business from a general manager’s perspective
❑ Explain elements of a robust (financial) risk management system
❑ Explain fundamentals of three main types of (financial) risk – credit / counterparty, market, and
operational risk
❑ Teach basic quantitative techniques of risk assessment and management
❑ Undertake case studies and projects to apply the concepts in real life situations

It does not aim to:

❑ Make the participants experts in risk management
❑ Teach advanced quantitative techniques is risk assessment and management
Outline of the course

Use word document

 Pedagogy & assessment
Each class will feature presentation by the instructors and class discussion on the topic
❑ Text book chapters and other readings for each topic are mentioned in the course outline

Assessment for this course will be based on:

❑ Class participation
❑ Case studies and assignment
❑ Project (Group)
❑ Exams

Groups to be formed by students with not more than 5-6 students per group
❑ Cases, projects, and assignments will be assigned to the groups
❑ Case analysis, project report and assignments will have to be presented by the group to the whole
class
 1.
Introduction to Risk
Management

6
 What is Risk?
✘ Impact of uncertainty on objectives…

✘ Cost of uncertainty…
✘ Deviation from expectations...

The definition of financial risk is far from being uniformly agreed.

What about unexpected profits?
What about appropriate loss benchmark?

7
 Components of Risk Management Framework
Risk Risk Monitoring and
Risk Mitigation Governance
Identification Measurement Reporting
• Identification • Includes • Decide on • Helps identify • Implementatio
of Risk quantification which risks to the n of the
Universe of potential mitigate performance framework
• Categorization loss- either • Assessment of • Information to • Defining
into Core and specific or limit structure Management, authorities and
Non Core Risk aggregate • Products to Regulators, accountabilitie
use shareholders s
• Capital etc
Allocation

All companies face risk; it is inherent in the nature of business. The key objective is to
manage the risks to pre-defined acceptable levels and ensure there are ABSOLUTELY

No Surprises
 Risk Universe- a sample

Market Risk • Loss on account of change in overall market factors

• Risk of Economic Loss due to the failure of a counterparty to fulfill it’s

Credit Risk contractual obligations
• Risk of loss resulting from inadequate or failed internal processes, people and
Operational Risk systems or from external events
• Risk of financial loss on account of Legal issues or change in regulatory
Legal and Regulatory Risk framework

Strategic Risk • Risk of significant investment for which there is high certainty about profitability

Business Risk • Anything that threatens a company's ability to achieve its financial goals

• Data security either on account of cyber security issues or flaws in operational

Information Risk processes
• Belief that the organization can fulfill obligations and/or is a fair dealer and
Reputation Risk follows ethical practices

HR Risk • Issues on account of incorrect hiring of human resources

 Financial Risk Universe

Equity Price Risk

Interest Rate Risk

Market Risk
FX Risk

Commodity Price
Financial Risks Issue Risk
Risk

Transaction Risk Issuer Risk

Credit Risk
Portfolio Counterparty
Concentration Risk Credit Risk
 Risk prioritization
Classify risks into categories such as ‘core / no core’ so as to focus efforts on the most important risks

Two dimensions
❑Likelihood - probability of a risk event occurring
❑Impact – extent of (negative) consequence from the event

Assessment on both these dimensions would require extensive analysis

❑Data on past events
❑Modelling of scenarios – changes in conditions etc
❑Experience of peers / other organisations
 Risk prioritization

High likelihood – low impact

Primarily managed through process Core
control Risks

Likelihood

Low likelihood – low impact Low likelihood – high impact

Mostly ignored “Event” risks , consider Insurance

Impact
 Risk measurement
Risk measurement essentially is quantifying (as far as possible) the financial impact of key risk events
❑ Need to capture both the likelihood and the impact
❑ Operational risks are generally hard to quantify

Use of right metric to measure risk is critical; key attributes:

❑ Objectivity
❑ Accuracy
❑ Reliability

Risk metrics form the basis of defining risk policy which guides the entire risk management process
❑ Risk limits
❑ Authorisation structure
❑ Mitigation actions
❑ Risk reporting (MIS)
 Risk mitigation
Risk mitigation is the process and actions taken to reduce the risk exposure within the tolerance levels
of the company

A well articulated Risk Policy is critical to effective risk mitigation. A Risk Policy must include
❑Clear description of the risk universe and identification of ‘core risks’
❑Metrics to measure core risks
❑Risk appetite / tolerance described in terms of limit structure for identified core risks
❑Responsibilities for managing risks, authotisation structure
❑Approved set of instruments, counter parties, transactions, etc
❑MIS and reporting
 Corporate Governance- in general

❑ Corporate Governance is a system of policies and processes by which companies are

directed and Controlled.

❑ Board of Directors are responsible for the governance of the company.

❑ The responsibilities of the board include setting the company’s strategic aims, providing the
leadership to put them into effect, supervising the management of the business and
reporting to shareholders on their stewardship.

❑ This structure defines the allocation of authority and responsibilities by which the business
and affairs of an institution are carried out by it’s board and senior management
 Corporate Governance- Risk

Risk Governance Structure to

❑ Set in place policy framework for Risk Management
❑ Create Risk Management Organisation
❑ Report to Board on issues of risk management
❑ Ensure compliance with policies to ensure risk exposure remain within appetite
❑ Monitor existing risk and identify emerging risks
❑ Ensure sufficient resource allocation to risk management
 thanks!
Any questions?

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 Credits
Special thanks to all the people who made and released
these awesome resources for free:
✘ Presentation template by SlidesCarnival
✘ More info on how to use this template at
www.slidescarnival.com/help-use-presentation-
template

19
 Market Risk
Volatility Estimation
AGENDA

• Importance of data
• Introduction to Market Risk
• Types of Market Risk
• Volatility
• Defining Volatility
• Historical Volatility
• Estimating Volatility
• Geometric Brownian Motion
• Moving Averages (Simple and Exponential)
• ARCH/GARCH Models

2
Data quality: Junk in Junk Outty

Historically, financial institutions have suffered from poor data quality, primarily
caused by
• having vast amounts of unstructured data stored in a plethora of antiquated
systems
• People lacking knowledge about importance of data
• Redundant IT architectures
• Decentralization of data storage
Example- Stress Loss calculation
• In order to assess the worst loss that can occur
Commodity Futures Futures Spot Max Spot Max
to a Clearing House during, a stress test is max DoD max DoD DoD DoD
performed based on pre-defined scenarios. increase decrease increase Decrease
• The stress test is performed based on both Soybean 7% 6.5% 14.67% 18.25%
spot market and derivatives contracts.
Wheat 8.02% 7.82% 19.28% 15.76%
• As is the general practice the worst of the two
is considered for assessment of stress loss. Castor 9.79% 9.73% 12.29% 17.91%
• The organization is expected to keep capital Sugar 9.50% 8.70% 11.71% 16.44%
aside equivalent to the amount of stress loss.
• It was observed, consistently the maximum
stress loss was there in spot market instead of SGF requirement Max of Spot Futures
and Futures Stress Loss
futures that is managed by the Clearing House.
Stress Loss
• Due to multiple factors like holiday, season
Top 2 Member Scenario 99.81 64.55
change etc spot data was corrupt.
25% of the market scenario 92.00 55.65

50% of the market scenario 183.99 111.30

Example- Continuous Time Series
Soybean Near Month Time Sseries
4000

3900

3800

3700

3600

3500

3400

3300

3200

3100

3000
03-Sep-2018 03-Oct-2018 03-Nov-2018 03-Dec-2018 03-Jan-2019 03-Feb-2019 03-Mar-2019 03-Apr-2019 03-May-2019 03-Jun-2019 03-Jul-2019 03-Aug-2019

Unsmoothed Smoothed

Un-smoothed Annualised Standard Deviation = 16.48%

Smoothed Annualised Standard deviation = 15.00%

What is Market Risk
Market risk is the risk of losses on financial investments caused by adverse price movements.

Types of Market Risks

• Interest Rate Risk
• Price Risk (be it Equity/bullion/soft commodity etc)
• Exchange Rate Risks (kind of price risk)
• Liquidity Risk (indirectly part of market risk)

Market Risk is denoted by Volatility i.e. a measure of dispersion (size of distribution of values)
of returns. This is generally represented by Standard Deviation (not the best measure).

In financial markets, when people refer to volatility, they basically refer to how large the asset
prices swing around the mean- defined dispersion again
What are we trying to calculate?

We want to estimate the worst 1% (or any pre-defined %) of the outcome

Why?

Close Prices Nifty

13,000

12,000

11,000

10,000

9,000

8,000

7,000

6,000

5,000
1-Oct-19 1-Nov-19 1-Dec-19 1-Jan-20 1-Feb-20 1-Mar-20 1-Apr-20 1-May-20 1-Jun-20 1-Jul-20 1-Aug-20 1-Sep-20

We want to know how much this market could possibly move against us, so we know how much
capital we need to support the position
Defining Volatility
Basic Definition – “Annualized standard deviation of the change in price or value of a financial security”

Virtually all the financial uses of volatility models entail forecasting aspects of future returns

Such forecasts are used in risk management, derivative pricing and hedging, market making, market timing, portfolio
selection and many other financial activities.

There are a number of approaches that are generally used. However there is a huge amount of research that has been
done in this regard. As a result there are a number of new approaches that are proposed and tested frequently.

Estimation Approaches
➢ Historical Volatility measures
➢ Moving Averages
➢ ARCH/GARCH Models
➢ Implied Volatility from Market Prices (assuming you have already read about Option Pricing)

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Why do we use returns
Frequency distribution of Nifty prices

• It is believed most financial time series follow Total

60
random walks, which means, amongst other 50
40
things, that the best estimator of tomorrow’s 30
20
10
value is today’s value 0

• Since random walks are not bounded,

predicting a future path is difficult Total 2 per. Mov. Avg. (Total)

• It is assumed that asset prices are log

normally distributed that means, it can not go Frequency distribution of Nifty Returns
below zero.
• Benefit of using returns, versus prices,
Total
is normalization: measuring all variables in a 100
80
comparable metric, thus enabling evaluation 60
40
of analytic relationships amongst two or more 20
0

variables despite originating from price series

of unequal values.
Total 2 per. Mov. Avg. (Total)
Estimating Volatility-Standard Deviation

In the most basic form, volatility can be defined as

Standard Deviation of Returns provided by an
asset.

Computing Volatility from Historical prices

➢ Prices of an asset from Time (t+1) points
{𝑃𝑡 , t = 0, 1, 2, . . . , T}

➢ Returns of the asset for T time periods

𝑃𝑡 Annualised Standard
{𝑅𝑡 = 𝐿𝑜𝑔 , 𝑡 = 1,2,3 … . . 𝑇
𝑃𝑡−1
Nifty Deviation

➢ {𝑅𝑡 ) 𝑎𝑠𝑠𝑢𝑚𝑒𝑑 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑆𝑡𝑎𝑡𝑖𝑜𝑛𝑎𝑟𝑦 𝑤𝑖𝑡ℎ 1 year - Annualized Standard Deviation 31.40%
6 Months- Annualized Standard
𝜎= 𝑣𝑎𝑟 𝑅𝑡 = 𝐸[(𝑅𝑡 − 𝐸 𝑅𝑡 )2 Deviation 21.96%
3 Months- Annualized Standard
➢ Annualized Values Deviation 16.42%
1 Month- Annualized Standard
Deviation 20.14%
෢ =
𝑉𝑜𝑙 𝑇𝑖𝑚𝑒 𝜎ො 30
Estimating Volatility-Weighting Schemes

Standard Deviation gives equal weights to all the deviations irrespective of the time period.

The objective is to estimate current level of volatility,σ. Makes more sense to provide more weights to recent data

A more appropriate model would be

Where α denotes a positive weight given to observation “I” days ago. So effectively less weight is given to older
observation. Though weights must sum to 1.

If we extend this idea and assume there is a long run average variance rate and this core variance rate should also be
given some weight.

This is known as ARCH (m) model suggested by Engle 31

Estimating Volatility-Exponentially Weighted Moving
Average (EWMA)
In EWMA, weights α decrease exponentially as we move back through time.

The estimate,𝜎𝑛 of the volatility of a variable for day n is calculated from 𝜎𝑛−1 and 𝜇𝑛−1

At any given time only the current estimate of the variance rate and the most recent observation on the market
variable is required.

This is designed to track changes in volatility suppose there is a big change in the market variable on day n-1, so that
2
𝜇𝑛−1 is large, the estimate of volatility increases.

In this case the value of λ governs how responsive the estimate of the daily volatility is to the most recent daily %
change.

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Estimating Volatility-GARCH (1,1)

Loosely speaking, combination of below

Effectively saying, this model assign a certain weight to long term core variance in addition to the exponential weights
to previous day volatility such that the sum of three weights =1

This model recognizes that over time the variance tend to get pulled back to a long term average level of 𝑉𝐿 , i.e. mean
reverting.

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Value at Risk (VaR) Models
AGENDA
• Market Risk Measures
• Value at Risk
• Methodologies
• Parametric VaR – Single asset
• Parametric VaR – Fixed Income
• Covariance and Correlation
• Parametric VaR- Multiple Assets
• Marginal VaR
• Historical Simulation

2
 Market Risk Measurement

Market Risk Management involves measuring the amount of risk a portfolio is

exposed to.

Some common measures of market risk include

• Notional amounts
• Standard Deviation (mean to refer Volatility)
• Beta (CAPM fame)
𝑅𝑝 −𝑅𝑓
• Sharpe Ratio -Recommends return per unit of risk=
𝜎𝑝
• Sensitivities
• Value at Risk (VaR)
• Conditional VaR (aka Expected Shortfall)
 Value at Risk

In its most general form, the Value at Risk measures the potential worst loss in value of a risky asset or
portfolio over a defined period with a given confidence interval (specified probability).

If the daily VaR of an asset or portfolio is $100mm at a 95% confidence level, there is a 5% chance that
the value of the portfolio will drop more than $100mm over any given day.

This also means that the realized daily losses from the position will on an average be higher than
$100mm 1 day every 100 trading days (i.e. 2-3 days each year)

First propounded by Riskmetrics (erstwhile JP Morgan Company) in 1994, though not a new concept
and had been used earlier also.

Important tool for assigning limits at trader/desk level and/or allocating capital against a portfolio.

Specifically VaR is a measure of losses in “normal” market movements. It does not provide any
information about how bad the losses might be if the VaR level is exceeded. Essentially what will
happen in the 5% scenario if that happens
Value at Risk
Advantages Disadvantages

the risk of different assets can be combined to Computationally intensive

produce a single number that reflects the risk of the
portfolio
Easy to understand metric for senior management Requires major adjustments for non-linear assets
like options
Can be used to limit exposure by business Can be misleading- false sense of security

Can also be used to determine the impact on risk of Does not measure worst case loss
changes in a portfolio’s composition
Probability of a given loss can be calculated using Not additive
VaR

It’s “another brick in the wall” of risk management process and must be complemented with
other tools
 Methodologiesty
There are three basic approaches that are used to compute Value at Risk, though there are numerous
variations within each approach. The primary approaches include

• Parametric VaR
• Historical Simulation
• Monte-Carlo Simulation
 Methodologies- Parametric VaR- single Asset

• VaR of a single asset is the value of the asset multiplied by its volatility at a desired
confidence interval
• Hence VaR = 𝑝𝑜𝑠𝑖𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 ∗ 𝑍𝛼 (𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑐𝑜𝑛𝑓𝑖𝑑𝑒𝑛𝑐𝑒) ∗ 𝜎𝑎
• The biggest assumption in this approach is that returns follow normal distribution

*Picture source: Essentials of Risk Management by Michel Crouhy and Dan Galai
 Methodologies- Parametric VaR- ingle Asset

• The daily variance of Nifty Returns between 1st Oct,19 -29th Sep, 20 was 0.000390

• This would mean a standard deviation of (Sqrt of Variance) = 0.000390 = 1.97%

• In order to get the required confidence interval, we need to identify a σ multiplier that
covers desired (let’s say 99%) area of the Normal Distribution curve. In this case it would
be 2.33

• VaR = 2.33σ = 2.33*1.97% = 4.599%

• We can conclude that we do not expect to lose more than 4.599% of our portfolio over a 1
day period with 99% confidence.
 Methodologies- Parametric VaR- single Asset

• In reality, Nifty lost more than 4.6% about 9 times in 1 year (252 days) or about
3.6% of times.

• While this figure is approximately accurate, it illustrates a problem VaR has in

certain markets, that it occasionally underestimates the number of large market
moves
 Methodologies- Parametric VaR- Single Asset -
Review
1. Collect price data
2. Create return series
3. Estimate variance of return series
4. Take square root of variance to get volatility (standard deviation )
5. Multiply volatility by required multiplier and position size to get estimate of
required worst case loss.
Methodology: Fixed Income

• Fixed income instruments require an adjustment to this method.

• This is because time series generally available for fixed income securities are
yield series, while we are concerned with price behavior.
• The adjustment requires expressing the volatility in basis points and the
position in terms of sensitivity to a 1 basis point movement in yields.

Equities, Foreign Exchange, Commodities: position * 𝜎𝑝𝑟𝑖𝑐𝑒 * 2.33 (or 1.64 for 95%)

Fixed income:
Position*PV01*Close (yield)*𝜎𝑦𝑖𝑒𝑙𝑑 *2.33 (required multiplier)*100

position sensitivity to
potential movement in yields measured in BP
a one BP movement
in yields
Methodology: Fixed Income- Duration Vs DV01

• Duration measures the weighted average time to a security’s cash flows, where
the weighting is the cash flow.
• Duration also shows the percentage change in price per change in yield.
• DV01 provides a similar measure, but often per 1 million of face value.
• Bond traders think in DV01’s; portfolio managers think in terms of duration.
• Either measure is effective but BE CAREFUL OF THE UNITS. This is one of the
easiest errors to make!
 Methodology: Adding Other Assets - Covariance
• The notion of covariance allows us to consider the way assets’ prices behave with respect to each
other.

Technically :

In other words, it says how much (and in which direction) y moves when x moves.

Variance (x+y) = Variance (x) + Variance (y) + 2*Covariance(x,y)

2
𝜎𝑥+𝑦 = 𝜎𝑥2 + 𝜎𝑦2 + 2 ∗ 𝐶𝑜𝑣(𝑥, 𝑦)
 Methodology: Adding Other Assets – Parametric
VaR
• As mentioned in slide 13:

2
𝜎𝑎+𝑏 = 𝜎𝑎2 + 𝜎𝑏2 + 2 ∗ 𝐶𝑜𝑣 𝑎, 𝑏
2
𝜎𝑎+𝑏 = 𝜎𝑎+𝑏

𝜎𝑎+𝑏 = 𝜎𝑎2 + 𝜎𝑏2 + 2𝜌𝜎𝑎 𝜎𝑏

VaR = 𝑝𝑜𝑠𝑖𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒 ∗ 𝑍𝛼 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑐𝑜𝑛𝑓𝑖𝑑𝑒𝑛𝑐𝑒 ∗ 𝜎𝑎+𝑏

However as we add more assets it get messy very fast. For example for a 3 asset portfolio
Variance(x+y+z)= Var(x)+ Var (y)+Var(z) + 2 Cov(x,y)+2Cov(x,z)+2Cov(y,z)
 Methodology: Adding Other Assets - Correlation
• How is correlation different from Covariance?

We can scale covariance to get correlation

𝐶𝑜𝑣(𝑥, 𝑦)
𝜎𝑥 ∗ 𝜎𝑦

• Does it matter which one we use?

- As long as we adjust for units, no
Time Period Coverage
• How far to go back?
• Data availability
• Change in pricing regimes
• Brexit
• 2008 Crises
• Existence of market anomalies
• Possible for traders to take advantage
Marginal VaR

• Refers to additional amount of risk that a new position adds to a portfolio

• Highlights natural hedges
• Shows efficacies of hedges
• Here one compares VaR with each addition/deletion with the original VaR to
assess the marginal risk contribution of each position
Historical Simulation

• Simple theoretical approach that requires relatively few assumptions about the
statistical distribution of underlying market factors
• Assumes that history will repeat itself from risk perspective
• Historical simulation simply marks the portfolio to market using the rates and
prices observed over a certain historical period
• These P&L figures are then ranked and the order statistic derived by taking the nth
worst outcome
• n is a function of significance (usually 1%) and how much data is available
Historical Simulation - Steps

1. Collect Position Data

2. Calculate sensitivities (DV01 etc)
3. Collect historical data
4. Calculate returns
5. “Shock” portfolio with returns data
6. Calculate P&L Figures
7. Rank P&L figures and get order statistic

Should always be used in conjunction with Stress Testing and Scenario Analysis
Value at Risk (VaR) Models
AGENDA
• Historical Simulation
• Monte Carlo Method
• Conditional Value at Risk a.k.a. Expected Shortfall
• Coherent Risk Measures
• Backtesting

2
Historical Simulation

• Simple theoretical approach that requires relatively few assumptions about the
statistical distribution of underlying market factors
• Assumes that history will repeat itself from risk perspective
• Historical simulation simply marks the portfolio to market using the rates and
prices observed over a certain historical period
• These P&L figures are then ranked and the order statistic derived by taking the nth
worst outcome
• n is a function of significance (usually 1%) and how much data is available
Historical Simulation - Steps

1. Collect Position Data

2. Calculate sensitivities (DV01 etc)
3. Collect historical data
4. Calculate returns
5. “Shock” portfolio with returns data
6. Calculate P&L Figures
7. Rank P&L figures and get order statistic

Should always be used in conjunction with Stress Testing and Scenario Analysis
 What is Stochastic?
• A stochastic process, or sometimes called random process, is a process with some indeterminacy in
the future evolution of the variables being examined (i.e. Stock Prices, Oil Prices, Returns of the
Finance Sector, etc…)
• These are widely used models in fields that appear to vary in a random manner. Used in a number of
fields including rocket science
• Seemingly random changes in financial markets have motivated the extensive use of stochastic
processes in Finance

However, that is well beyond the scope of this course, what we will do is to have a visual interpretation of
stochastic process and how they are used though

The objective is to analyze how stock prices progress over time, which is a stochastic process

First, Non-stochastic process (simple)

 As simple as it gets
What we know…
• Price of the Stock today
• Some approximation of μ i.e. mean return or drift

∆𝑆𝑡 = 𝑆𝑡−1 𝜇∆𝑡

 Geometric Brownian Motion
This assumes stock prices follow some form of random walk and are consistent with (at the very least)
weak form of Efficient Market Hypothesis (EMH) - past price information is already incorporated in the
prices and the next price movement is “conditionally independent” of past price movements

∆𝑆
= 𝜇∆𝑡 + 𝜎𝜖 ∆𝑡
𝑆𝑡−1

∆𝑆 = 𝑆𝑡−1 ∗ (𝜇∆𝑡 + 𝜎𝜖 ∆𝑡)

Drift Shock

For each time period, the prices will drift up by the expected return. But the drift will be shocked (added or
subtracted) by a random shock
A more realistic graph
Monte-Carlo Simulation

• The Monte Carlo model was the brainchild of Stanislaw Ulam and John Neumann, who developed the
model after the second world war.

• The basis of a Monte Carlo simulation is that the probability of varying outcomes cannot be determined
because of random variable interference.

• A Monte Carlo simulation applies a selected model (that specifies the behavior of an instrument, using a
PDF function) to a large set of random trials in an attempt to produce a plausible set of possible future
outcomes.
Monte-Carlo Simulation

• Monte Carlo simulations can be best understood by thinking about a person throwing dice.

• A novice gambler who plays craps for the first time will have no clue what the odds are to roll a six in any
combination (for example, four and two, three and three, one and five).

• Throwing the dice many times, ideally several million times, would provide a representative distribution of
results, which will tell us how likely a roll of six will be a hard six.

• Similarly in Monte-Carlo as the number of simulations increase to millions, if not more, the expectation is
to achieve a reasonably higher probability estimation.
Monte-Carlo- Process

• Identify basic market factors and obtain a formula expressing Mark to Market value of the portfolio in
terms of market factors
• Determine a specific distribution for changes in the basic market factors and to estimate the parameters
of that distribution
• Generate pseudo-random numbers to identify the hypothetical values of changes in market factors. On an
average over 10,000 simulations are performed
• Calculate the N hypothetical mark to market values for the portfolio
• Subtract actual mark to market value of the portfolio to obtain N hypothetical daily profit and loss
• The mark to market profits are ordered from largest profit to largest loss .
• Value at Risk would be the required percentile from the above.
Monte Carlo-Process-Random Number Generation

Three types of Random Numbers

• Truly Random Numbers- use unpredictable physical means to generate numbers (radioactive decay). Can
not be generated by computer systems

• Quasi Random Numbers –concept of physics, designed to have high level of uniformity in multi-
dimensional space. Not statistically independent

• Pseudo Random Numbers – Generated using some computer algorithm, look independent and uniform
Comparison in Methodologies
Basis of Comparison Historical Simulation Variance/Covariance Monte Carlo Simulation
Approach

Able to Capture the risks of Yes, regardless of the Options No, except when computed Yes, regardless of the Options
portfolios that include Content of the Portfolio using a short holding period content of the portfolio
Options with limited options content
Easy to implement Yes for portfolios for which Yes for instruments and Yes for instruments and
past data is available currencies covered by “off currencies covered by “off
the shelf” software the shelf “ software
Computations performed Yes Yes No, except for relatively small
quickly? portfolios
Easy to explain to senior Yes No No
management
Produces misleading Yes Yes, except when alternative Yes, except that alternative
estimates when recent past if correlations/Standard parameters may be used
typical Deviations may be used
Easy to prevent “What if” No Able to examine about Yes
analysis correlations/standard
deviations
Expected Shortfall a.k.a Conditional VaR
• As we discussed VaR is a measure of losses in “normal” market movements. It does not provide any
information about how bad the losses might be if the VaR level is exceeded. Essentially what will happen
in the 5% scenario if that happens

• Expected Shortfall is defined as the average of all losses which are greater than or equal to VaR, i.e. the
average loss in the worst (1-p) % cases, where p is the confidence level.

• It is important to clarify that Expected Shortfall is NOT the worst case scenario – the worst case scenario is
always a 100% loss, and in case of many leveraged instruments, a loss exceeding 100% of the initial
investment.

• Expected Shortfall is simply an average of losses past arbitrarily selected risk threshold – so for 95% VaR,
Expected Shortfall will represent the average of outcomes in the worst 5% of the cases.
Expected Shortfall a.k.a Conditional VaR
Expected Shortfall values are derived from the calculation of VaR itself, the assumptions that VaR
is based on, such as the shape of the distribution of returns, the cut-off level used, the
periodicity of the data, and the assumptions about stochastic volatility
Coherent Risk Measure
Artzner defined a set of properties that a model risk measure should have. These include
1. Monotonicity : If a portfolio produces a worse result than another portfolio for every state of the world,
its risk measure should be greater.
2. Translation Invariance: If an amount of cash K is added to a portfolio, its risk measure should go down by
K.
3. Homogeneity: Changing the size of a portfolio by a factor λ while keeping the relative amounts of
different items in the portfolio the same, should result in the risk measure being multiplied by λ.
4. Subadditivity: The risk measure for two portfolios after they have been merged should be no greater
than the sum of their risk measures before they were merged.

VaR satisfies first 3 conditions. However the condition of subadditivity does not always get
satisfied. On the other hand, Expected Shortfall is always coherent.
 Back-testing
What is a backtest?
➢ Comparison of predicted VaR and actual realized P&L
➢ Usually VaR @ time T and P&L @ time T+1

Why back test?

➢ Provides a reality check on calculations
➢ Helps find errors
➢ Can be used to refine the assumptions, models etc
➢ We are required to
Predominantly three categories
• Coverage Tests – assess whether the frequency of exceedances is consistent with the quantile of
losses a VaR model is intended to reflect
• Distribution Tests – goodness of fit tests applied to overall loss distributions forecasts
• Independence Test – Assess whether results appear to be independent from one period to the next
 Back-testing

Some update regarding back-testing performed at NCCL

• Contract Level for each commodity – basically to assess whether the VaR based margins charged is
sufficient to cover the price movement on a daily basis
• Calendar Spread – Offsetting positions at different months leading to limited risk and hence limited
margins(VaR). Assesses pre-dominantly basis risks.
• Spread in a Commodity Complex – Offsetting exposures in commodities with causal relationship
leading to limited risk and hence limited margins (VaR)
• Portfolio Level - Assess the sufficiency of margins on hedged portfolios
• High Low Prices – Compares margin against “highest and lowest prices” over a predefined period
• Expected Shortfall based back-testing
Key Market Risks
AGENDA
• Commodity Risks
• Currency Risk
• Interest Rate Risks
• Liquidity Risk
• Stress Testing & Scenario Analysis

2
 Commodity Risk
It refers to the uncertainties of future market values and the size of future income caused by the
fluctuations in the prices of Commodities. This basically include:
• Price Risk – arising out of adverse movement in commodity prices
• Quantity or Volume Risk- Uncertainties in quantity of production/consumption. Reasons for
this may include adverse weather conditions, plant availability and at time regulatory
interventions
• Cost Risk – Input price risk, storage costs
• Political Risk – change in regulatory conditions prohibiting certain action resulting in lesser
recoveries like export ban etc.
• Other Factors- seasonality aspects, convenience yield, perishability issues (in case of
agricultural commodities), environment issues etc
 Currency Risk
A.k.a. Exchange Rate Risk, is the possibility that currency depreciation will negatively affect the value of
one’s assets, investments, and their related interest and dividend payment streams, especially those
securities denominated in foreign currency. Types of FX Risk include
• Economic Risk – Economic risk is the risk that a company’s market value is impacted by
unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by
macroeconomic conditions such as geopolitical instability and/or government regulations.
• Contingent Risk - when bidding for foreign projects, negotiating other contracts, or handling
direct foreign investments. Such a risk arises from the potential of a firm to suddenly face a
transnational or economic foreign-exchange risk contingent on the outcome of some contract
or negotiation.
• Transaction Risk - The risk is the change in the exchange rate before transaction settlement.
Essentially, the time delay between transaction and settlement is the source of transaction
risk.
• Translation Risk- A firm's translation risk is the extent to which its financial reporting is
affected by exchange-rate movements.
 Interest Rate Risk
Sources of Interest Rate Risk
• Interest Rate Risk is the risk of adverse change in
the value of an asset resulting from the changes in
the prevailing interest rates. Repricing Risk Yield Curve Risk
•Arise due to assets and •Risk due to change in yield
• A bank’s main source of profit is converting the liabilities having different curve from time to time
maturities, repricing rates etc. depending on repricing and
liabilities of deposits and borrowings into the other factors
assets of loans and securities. It profits by paying a
lower interest on its liabilities than it earn on its Basis Risk Optionality
assets (Net Interest Margin) •Arises when interest rates of •Pre-payment of loans and
different assets /liabilities bonds(with put/call option
• Two Common Approaches change in different magnitude and/or premature withdrawal
of deposits
• Funding Gap Assessment Approach
• Duration Based Approach
 Interest Rate Risk – Funding Gap Assessment
• Interest rate fluctuation impact the Net Interest Income for an Institution.
• Divide up assets and liabilities into maturity buckets
• Within each bucket, determine the value of Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities
(RSL)
𝑭𝑮𝑨𝑷 = 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝑹𝑺𝑨 − 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝑹𝑺𝑳

+ $Gap - $Gap 0 $Gap Months

Particulars 0-3 months 3-6 Months 6-12 Months9-12 months
Assets 80 0 0 70
RSA>RSL RSL-RSA RSA=RSL Liabilities 20 130 0 0

↑Interest Rates ↑Interest Rates ↕Interest Rate Gap 60 -130 0 70

Cumulative Gap 60 -70 -70 0

↑Net Interest ↓Net Interest Stable Net

Income Income Interest Income
 Interest Rate Risk- Duration
• Duration is the measure of sensitivity of the price of a bond/bond portfolio with respect to a change
in the interest rates.
• Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the
bond’s total cash flows. In general, the higher the duration, the more a bond price will drop as
interest rates rise.
• Similar to VaR, Duration rolls up several bond characteristics (such as maturity, coupon etc) into a
single number that gives a good indication of how sensitive a bond’s (or Bond portfolio’s) price is to
interest rate changes.
• Factors that impact duration
• Time to maturity – the longer the maturity, the higher is the duration and hence the interest
rate risk
• Coupon rate - The higher the coupon rate, the lower the duration, and the lower the interest
rate risk.
 Interest Rate Risk- Duration

The duration in practice can refer to

➢ Macaulay Duration- the weighted average time until all the bond's cash flows are paid. By
accounting for the present value of future bond payments, the Macaulay duration helps an investor
evaluate and compare bonds independent of their term or time to maturity
➢ Modified Duration - measures the expected change in a bond's price to a 1% change in interest
rates .
➢ Effective Duration - Effective duration is the sensitivity of a bond‘s price against the benchmark
yield curve. Generally used for bonds with non-normal features like optionality.
 Interest Rate Risk- Duration

Macaulay Duration Modified Duration

𝑀𝐷
1 ∆𝑃 𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
𝐷=− ∗ 𝑌𝑇𝑀
𝑃 ∆𝑦 1+( )
𝑘
Such that ∆𝑃 = −𝐷 ∗ 𝑃 ∗ ∆𝑦
where Δy is a small change in the bond’s yield 𝑦 = 𝑌𝑇𝑀

Using calculus notation, 𝑘 = 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

𝑡𝑖 = 𝑇𝑖𝑚𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠 𝑢𝑛𝑡𝑖𝑙𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑
1 𝑑𝑃
𝐷=− 𝑃 = 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐵𝑜𝑛𝑑
𝑃 𝑑𝑦
PV =Present Value of the cash Flow
Alternatively,

𝑛
𝑃𝑉𝑖
𝐷 = ෍ 𝑡𝑖 ( )
𝑃
𝑖=1
 Interest Rate Risk- Duration

Consider a 3 year Note with a face value 100 and 10% coupon selling at 94.21 yielding 12%

Weights
(PV at each Macaulay Duration
Time in time /total Time x
years Cashflow Present value PV) Weight D=2.653
0.5 5 4.709 0.050 0.02
1.0 5 4.435 0.047 0.05 Modified Duration
1.5 5 4.176 0.044 0.07 D* = 2.653/1+(.1237/2)=2.499
2.0 5 3.933 0.042 0.08
2.5 5 3.704 0.039 0.10 ∆𝑃 = −𝑀𝐷 ∗ 𝑃 ∗ ∆𝑦
3.0 105 73.256 0.778 2.33 = -2.653*04.213*Δy
130 94.213 2.653
𝑛
𝑃𝑉𝑖
𝑀𝐷 = ෍ 𝑡𝑖 ( )
𝑃
𝑖=1
𝑀𝐷
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
𝑌𝑇𝑀
1+( )
𝑘
 Interest Rate Risk- Effective Duration a.k.a. Option
Adjusted Duration
Effective duration is the sensitivity of a bond‘s price in non-normal bond structures. In other words, the
measure takes into account possible fluctuations in the expected cash flows of a bond

The effective duration is used for hybrid securities, which can be divided into a bond and an option
(callable bonds). Embedded bonds increase the uncertainty of cash flows and make it difficult for
investors to measure the internal rate of return.

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = (𝑃𝑉−∆𝑦 − 𝑃𝑉+∆𝑦 )/(2𝑃𝑉∆𝑦)

Where
∆𝑦 = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑦𝑖𝑒𝑙𝑑
𝑃𝑉+/−∆𝑦 = 𝑃𝑉 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑤ℎ𝑒𝑛 𝑦𝑖𝑒𝑙𝑑 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒/𝑓𝑎𝑙𝑙𝑠𝑏𝑦 𝑎 𝑐𝑒𝑟𝑡𝑎𝑖𝑛 %
 Interest Rate Risk- Duration Gap
Duration Gap is the difference between average duration of assets and average duration of liabilities.
Example of a hypothetical Bank is given below
Assets Value Rate Duration Liabilities Value Rate Duration

1 Yr TD 520 9% 1
Cash 100 0 0
4 Yr CD 400 10% 3.49
3yr Loan 700 14% 2.65
Total Liabilities 920
7yr bond 200 12% 5.97
Equity 80

1000 Total 1000

𝑁
𝑀𝑉𝑖 𝑁
𝐷𝐴𝑠𝑠𝑒𝑡𝑠 = ෍( )𝐷 𝑀𝑉𝑖
𝐴𝑠𝑠𝑒𝑡𝑠 𝑖 𝐷𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = ෍( )𝐷
𝑖=1
700 200 𝐴𝑠𝑠𝑒𝑡𝑠 𝑖
𝐷𝐴 = 2.65 + 5.97 = 3.05 𝑌𝑒𝑎𝑟𝑠 𝑖=1
1000 1000 520 400
𝐷𝐿 = 1.00 + 3.49 = 1.92 𝑌𝑒𝑎𝑟𝑠
1000 1000
 Interest Rate Risk- Duration Gap
Duration Gap is the difference between average duration of assets and Average duration of liabilities.

𝐷𝐺𝐴𝑃 = 𝐷𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐷𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 3.05 − 1.92 = 1.13 𝑌𝑒𝑎𝑟𝑠

For the Bank, if Interest rate rises, Net Worth falls and vice versa

In general
∆𝑖
%∆𝐸𝑞𝑢𝑖𝑡𝑦 = −𝐷𝐺𝐴𝑃 ∗
1+𝑖

Issues

• Requires calculation of all assets and liabilities, hence a bit complex

• Need estimates of changes in different maturities and risk
• Duration changes over time and at different rates for different securities, so requires frequent
adjustment
 Interest Rate Risk- Convexity

• The duration estimates change in bond price along

with a straight line that is tangent to curved line.
• For small yield changes, the duration approximation
works, however as yield changes grows larger, the
difference become significant
• Convexity is a measure of the curvature, or the degree
of the curve, in the relationship between bond prices
and bond yields.
• Convexity demonstrates how the duration of a bond
changes as the interest rate changes.
• Convexity is the second derivative of the price of the
bond with respect to interest rates (duration is the
first derivative). 𝑑 2 𝑃𝑉 𝑟
𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 =
𝑃𝑉 ∗ 𝑑 ∗ 𝑟 2
Where
d=duration
PV=price of the bond
R=interest rate
 Interest Rate Risk- Portfolio Immunization

• Immunization is a process of reducing the impact of interest rate swings on the portfolio.
• Using a perfect immunization strategy, firms can nearly guarantee that movements in interest rates will
have virtually no impact on the value of their portfolios.

There are three common approaches followed by Institutions

➢ Dollar Gap Management
➢ Duration Matching
➢ Hedging using other products
 Interest Rate Risk- Portfolio Immunization Example

Cash Flow Matching Duration Matching

Assume an investor needs to pay a $10,000 In the same example, multiple approaches can be followed
obligation in five years. to match the duration
• Purchase a zero coupon Bond of same amount same
To immunize against this definite cash outflow, maturity
the investor can purchase a security that • Purchase several bonds having five year duration and a
guarantees a $10,000 inflow in five years. total of $10,000
• Purchase several bonds having an average duration of 5
Investor buys a five-year zero-coupon bond years and a total value of 10,000
with a redemption value of $10,000.

This matches the expected inflow and outflow

of cash, and any change in interest rates would
not affect his ability to pay the obligation in
five years.
 Liquidity Risk
• Liquidity basically refers to the ability to pay off financial obligation as and when they become due.
• Different from Solvency i.e. a company having more assets than liabilities and hence having positive
equity value
• A perfectly solvent company can become technically bankrupt for not repaying its short term
obligation.
• Types of Liquidity Risk (different from general definition)
➢ Market Liquidity Risk – is the cost of closing out it’s positions in the market. This is generally
highlighted by the impact cost calculated from the bid-ask difference for a given quantity at a
given time.
➢ Funding Liquidity Risk – relates to the ease with which a financial institution can obtain
funds. This can further be categorized into
✓ Short Term Funding – generally refers to the period of upto 1 month.
✓ Long Term Funding Risk - generally refers to the funding structure of an organization
covering the period of 1 year and beyond.
 Significance of Liquidity Risk
• Before the meltdown in 2007, financial markets used to be flexible with liquidity available at low
cost. This resulted in a practice of funding long term assets with short term liabilities assuming
➢ Short term interest rates remain at lower levels compared to long term rates
➢ Liquidity in short term funding markets
• During the crisis, liquidity dried away and funding sources stopped lending leading to failure to roll
over short term loans. This subsequently led to fire sale of assets at discounted prices (realized
loss), downward pressure on capital markets (unrealized mark to market losses) and in some
instances, Bankruptcy (total loss)
• Subsequent to the financial crisis, the Bank of International Settlement prescribed Basel III norms
that were focused on liquidity risk management through two ratios viz. Liquidity Coverage Ratio and
Net Stable Funding Ratio
 Liquidity Measures before Basel III

• Add on model with bid-ask spread (1999)

• Transaction Regression Model (2000)
• Volume based price impact (2001) Market Liquidity
measures
• Liquidity Balance (2003)
• Current Ratio and Liquidity Ratio
• Non-performing assets ratio Structural Liquidity
• Govt Securities Ratio measures
• Maximum Cumulative Outflow

The problem with most of these measures was that they did not
consider stress in the market and focused primarily on the “as is”
situation
 Liquidity Risk Measurement

In its most basic form liquidity risk is measured through Contractual maturity mismatching across
different time buckets in normal scenario as well as stressed scenario
Particular Overnight Day 2-7 Day 7-15 15 days-
1 month

Expected outflow under stress scenario

Cash Collateral release (Highest % of cash release to members’
100.0 70 40 0
total cash deposit)
Total outflow 100.0 70 40 0
Expected inflow 0
Liquid investments (10% haircut) 162.2 20 0 0
Clean overdraft (if any) - 0 0 0
Liquidation of member collaterals (75%) 30 0 0
Liquidation of member collaterals (25%) 30 0
Total inflows 162.2 50 30 0
Surplus/(Deficit) 62.2 (20) (10) 0
Net Surplus/Deficit (Cumulative) 62.2 42.2 32.2 32.2
Cumulative inflows as % of cumulative cash outflow 162% 124% 115% 115%
 Liquidity Risk Measurement- Stress Testing

• Apart from normal assessment of liquidity, stress testing for liquidity resources is also commonly
performed. Here variables are stressed wherein the inflows are delayed and outflows are advanced.
An example of such scenarios is given below:
Parameters Scenario - I Scenario - II Scenario - III
Outflows
% of cash release to members’ total cash deposit 50% 60% 70%
Stress loss for Core SGF 100% in overnight
Settlement Bank Default Highest settlement exposure (higher of pay-in/pay-out) to a non D-
SIB in the past 3 months shall be considered as an outflow
Inflows
Haircut on investments 15% 17.5% 20%
Core SGF Investments 15% 17.5% 20%
Liquidation of member’s collateral, in case of default 50% can be liquidated in Day 2-7 bucket and 25% in greater than 7
days bucket and 25% cannot be liquidated
 Liquidity Coverage Ratio (LCR)
• Assumes a short period of stress in the market for up to 30 days period
• Requires that an institution’s stock of Unencumbered High Quality Liquid Assets (HQLA) be larger
than the projected Net Cash Outflow (NCOF) over a 30 day horizon under a Stress Scenario

𝑯𝑸𝑳𝑨
𝑳𝒊𝒒𝒖𝒊𝒅𝒊𝒕𝒚 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒂𝒕𝒊𝒐 =
𝑵𝑪𝑶𝑭

• These HQLAs are categorized into Level 1, 2A and 2B with certain restrictions on Level 2A and 2B.

• Level 1 includes Cash and sovereign debt of pre-defined countries generally including UST, JGB, UK
Gilts, Euro Govies etc.
• Level 2A and 2B generally includes certain equities, multilateral development banks, and
investment grade corporate bonds

• Total expected cash outflows are calculated by multiplying the size of various type of liabilities and
off balance sheet commitments by the rates at which they are expected to run off or be drawn down
in the stress scenario

• The ratio should generally be >100%

 Net Stable Funding Ratio

• The basic purpose of the measure is to assess the long term funding structure of the institution.
• Seeks to calculate the proportion of long term assets that are funded by long tern stable funding.
• To limit over reliance on short term whole sale funding during times of buoyant market liquidity and
encourage better assessment of liquidity risk across all on and off balance sheet items

𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔

𝑁𝑆𝐹𝑅 =
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔

For both funding and assets, long term is mainly defined as more than one year .

• Available Stable Funding broadly regards the most stable source of funding to be regulatory capital,
deposits and funding maturing beyond a year.

• Required Stable Funding grades various assets in in terms of proportion of stable funding required.
For example loans to Fis beyond one year would require matched stable funding while residential
mortgages would require stable funding for upto 65%of the mortgage amount.
 Funding Liquidity Risk Mitigation
There is no hard and fast rules, following are some of the guidelines that are considered for an efficient
liquidity risk management. However it should also be noted that Liquidity has a cost involved, excessive
liquidity would pull down returns and hence these approaches should be used judiciously
• Lower Funding concentration –try to distribute the sources of funds over multiple tenors avoiding
excessive withdrawals
• Minimize size of gaps by matching sources and uses of funds
• Improving funding sources
• More liquefiable assets
• More and better funding sources
 Scenario Analysis and Stress Testing
Stress Testing involves estimating how the portfolio would perform under scenarios involving extreme
(but plausible) market moves. The key issue is how to choose these scenarios
• Stressing Individual Variables – Under this approach, a large move is assumed in one variable
keeping other variable constant. Examples can include stressing a parallel yield curve shift of
100bps keeping all other factors (correlations, spreads etc) constant.
• Stressing multiple variables - usually when one variable shows an extreme move, other variables
are also impacted. For example a significant change in T bills rate would impact the equity markets
also. A common practice for such tests is to assume extreme movement in market variables that ave
occurred in the past.
• User defined scenarios - In many ways, the scenarios that are most useful in stress testing are those
generated by the management based on their understanding of the market/portfolio.
• Reverse Stress Testing - Reverse stress testing involves the use of computational procedures to
search for scenarios that lead to a failure of the financial institution.
• Regulatory Stress Test Scenarios
Hedging
AGENDA
• What is Hedging?
• To hedge or not to hedge
• Ways of Hedging
• Derivative Instruments for Hedging
• Basis Risk
• Dynamic Hedging

2
 Risk Management

Once we have identified the risks that we are exposed to, the next question is what do we do with these risks

In general we have three choices

• Not do anything and let the risks pass through to the investors – stockholders in public limited
firms or owners in case of private business
• Try to protect ourselves against the risks using a variety of approaches- hedging
• Intentionally increase the exposure to some of these risks if we believe we have significant
advantages over competition - We will look at first two approaches here
 What is Hedging
• To Hedge, in English, means to build a wall or a fence. In financial markets, hedging is a strategy that
tries to limit risks.
• Hedging is somewhat analogous to taking out an insurance policy. If you own a home in a flood-
prone area, you will want to protect that asset from the risk of flooding—to hedge it, in other
words—by taking out flood insurance.
• However this still has a cost. A reduction in risk, however always (almost) mean a reduction in
profits.
• So hedging, for the most part, is a technique to reduce losses (NOT to maximize profits).
• In a nutshell, the objective is to reduce the volatility of returns (risk) in the portfolio. However in the
investment space, hedging is both more complex and an imperfect science
 To Hedge or not to hedge
To decide whether to hedge or not depends on potential cost and benefits of hedging; in effect we
hedge the risks where the potential benefits exceeds the cost of hedging

Cost of Hedging Benefits of Hedging

Hedging is not costless. In certain cases, like insurance, the • Reduced volatility in income - with risk hedging,
cost i.e. the premium, is explicit while in case of earnings will be lower than they would have been
derivatives, are costs are implicit. without hedging, during periods where the risk does
not manifest itself and higher in periods where there is
A farmer that buys futures contracts to lock in a price for risk exposure.
his produce may face no immediate costs (in contrast with • Better investment decisions
the costs of buying put options) but will have to give up • Lesser distress costs -While bankruptcy can be the final
potential profits if prices move upwards. cost of distress, the intermediate costs of being
perceived to be in trouble are substantial as well.
Explicit costs reduce the earnings in the period in which
the protection is acquired, whereas the implicit costs
manifest themselves only indirectly in future earnings.
 Ways of Hedging
There are a whole range of choices when it comes to hedging risks. Not all choices are feasible or
economical.

• Diversification either in the form of holding cash or by investment in multiple assets - By holding
uncorrelated assets as well as stocks in a portfolio, overall volatility is reduced.
• Financing choices- Firms can impact their overall exposure through their financing choices. A firm
that expects to have significant cash inflows in yen on a Japanese investment can mitigate some of
that risk by borrowing in yen to fund the investment. A drop in the value of the yen will reduce the
expected cash inflows (in dollar terms) but there will be at least a partially offsetting impact that
will reduce the expected cash outflows in dollar terms.
• Buying Insurance – either in the form of actual insurance from an insurance company or a
structured note from a financial participant
• Using financial derivatives
 Derivative Instruments for Hedging
• Forwards
• Futures
• Options
• Swaps
 Derivative Instruments for Hedging - Forwards
• Bilateral agreement between two parties to engage in a pre-defined financial transaction at a pre-
determined price at a pre-determined time in future.
• Long Forward – Agree to accept delivery of the securities at a future date subject to terms of
agreement. Hedge against price rise, since the price is fixed now.
• Short forward – Agree to deliver securities at a future date subject to terms of agreement. Hedge
against price fall.
Example:
A Farmer Produce Organisation (FPO) agree to sell 100 MT of Wheat to ITC on 20th February 2022 at a
pre-decided price of Rs 1700 per quintal. By entering this transaction, both ITC and the FPO locked the
price at Rs. 1700 per quintal. Assume the following scenario on 20th Feb, 2022:
Price in Rs./Quintal Payoff to ITC Payoff to FPO
1600 Loss of Rs.100 per quintal- cost of hedging against Profit of Rs. 100 per quintal- prevented loss
price rise against price fall
1700 0 0
1800 Profit of Rs. 100 per quintal –prevented loss Loss of Rs. 100 per quintal – cost of hedging
against price rise against price fall
 Derivative Instruments for Hedging - Futures
• Standardised forward contracts traded on an Exchange thereby reducing counterparty credit risk.
• Long Forward – Agree to accept delivery of the securities at a future date subject to terms of
agreement. Hedge against price rise, since the price is fixed now.
• Short forward – Agree to deliver securities at a future date subject to terms of agreement. Hedge
against price fall.
Example:
A manufacturer expects to be paid $1 million in two months for the sale of equipment in Europe.
Currently, the spot exchange rate is 75 and the manufacturer would like to lock-in that exchange rate.
 Derivative Instruments for Hedging - Futures
The manufacturer can use the USD/INR Futures contract traded on NSE’s platform to accomplish this.
• The manufacturer sells $1million worth of futures contracts. Considering one contract is for $1000,
the seller would have to sell 1000 contracts.
• As the exchange rate (and the futures price) fluctuates during the two months, the value of the
margin account will fluctuate. If the value in the margin account falls too low, additional funds may
be required. This is how the market is marked to market
• Assume the following scenario on 20th February. Irrespective of where the market goes, the
manufacturer will receive INR 75 millions

Exchange Rate Payoff on Spot Payoff on Futures in Net Profit/Loss

position in INR INR millions
millions
70 70-75= -5 75-70=+5 0

75 0 0 0

80 80-75=+5 75-80 =-5 0

 Derivative Instruments for Hedging – Interest Rate
Swap
An interest rate swap (IRS) is a financial derivative instrument in which two parties agree to exchange
interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or
vice versa) or from one floating rate to another.
Fixed for Floating IRS
Coupon swaps involve an exchange of fixed rate for floating rate payments on a notional amount during
a period.
 Interest Rate Swap – Fixed for floating

Example:
Assume an exporter receives a floating rate loan for EUR 1,000,000, 3 year maturity at Euribor +100bps.
Current Euribor is 1.12%. The exporter has a risk that with an increase in the Euribor rate, the cost of
funding will increase. Hence she enters in an IRS with Credit Suisse receiving 1yr Euribor paying 3year
fixed rate @1.87%

Net payoff for exporter = -(1.87%) – (Euribor+1%)+ Euribor = -(1.87% +1%)= 2.87% (3 year swap rate+
the spread of 100 bps)
 Derivative Instruments for Hedging – Forward Swaps

When plain vanilla IRS are used in hedging floating interest rate loans, the IRS cash flow exchange takes
place from inception, though, in fact, the first loan payment does not incorporate any risk, since it is
known from the beginning.
In our example (IRS), the first year Euribor has been already established (at 1.12%) and only the second
and subsequent cash flows of the loan are unknown.

Another alternative would be:

1. Leave the loan without any hedging instrument during the first year, that is to say, 1.12% + bank’s
margin = 2.12%.
2. Contract a forward swap, which is an IRS starting at a future date with a determined maturity since
that moment. In our case, starting in 1-year time for 2 years
3. The forward swap rate to be applied to those 2 remaining years is the one making both
alternatives financially equivalent
 Derivative Instruments for Hedging – Currency Swap

The currency swap (sometimes named cross currency swap) is an instrument that allows hedging a
stream of foreign currency cash flows in a single contract. For instance, the principal and interest
payments of a bond or loan denominated in a foreign currency. In that case, an appreciation of the
foreign currency (depreciation of the local) will cause more interest and principal to be paid in the
equivalent local currency.
 Derivative Instruments for Hedging – Equity Swap

Equity swaps are characterized by an exchange of cash flows in which at least one of them is an equity
flow. They can be classified into two types:
1. Transferring the change in equity results to a third party. Counterparty A makes payments to B by
the positive or negative returns on a determined stock or index (including dividends), while B pays
to A floating or fixed interest rate on the corresponding principal amount.
2. Swapping the results of two different equity assets or indices. A and B exchange returns based on
two different stocks or indices, for instance, A transfers to B the proceeds (positive or negative) on
NSE Nifty and receives from B that of the DJIA.
 Basis Risk
• Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience
price changes in entirely opposite directions from each other. This imperfect correlation between
the two investments creates the potential for excess gains or losses in a hedging strategy, thus
adding risk to the position.
• the sources of this risk can vary – relating to differences in timing or product that may only become
meaningful under certain conditions. For example, in the attempt to hedge against a two-year bond
with the purchase of Treasury bill futures, there is a risk the Treasury bill and the bond will not
fluctuate identically.

For example, Tata Motors stock is trading at a spot price of Rs

355 while March futures are quoting at Rs 355.40. You had a
long cash market position hedged through a short futures.

A week from now, the stock falls to Rs 340 and futures to Rs

350. So, the basis weakened as it fell from -0.40 to -10.
 Basis Risk
If asset being hedged is same as underlying asset:
a. Basis = 0 at expiration. (Arb!)
b. But Basis will not = 0 prior to expiration.
For low rf currencies, gold, or silver, F > S, so that Basis < 0 (contango).
For high rf currencies, & other commodities, F < S, so that Basis > 0 (backwardation).
c. If Basis , it “strengthens;” If Basis , it “weakens.”
d. Basis Risk for investment assets < for consumption assets
i. For investment assets, arbitrage leads to clear relation between F & S.
Not so for consumption assets (only inequality).
ii. For investment assets, basis risk is due to uncertainty about the riskfree rate.
iii. For consumption asset, basis risk is also due to imbalances between Supply and Demand, and
difficulties in storage (and thus large variations in convenience yield).
 Minimum Variance Hedge Ratio
• Minimum variance hedge ratio, or optimal hedge ratio is an important factor in determining the
optimal number of futures contracts to purchase to hedge a position.
• Important when Cross hedging- using two distinct assets having a positive correlation. Mainly used
in commodity markets 𝜎𝑠𝑝𝑜𝑡
𝑂𝑝𝑡𝑖𝑚𝑎𝑙 ℎ𝑒𝑑𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝜌𝑎𝑠𝑠𝑒𝑡1,𝑎𝑠𝑠𝑒𝑡2 ∗
𝜎𝑓𝑢𝑡𝑢𝑟𝑒𝑠
Example
Assume that an airline company fears that the price of jet fuel will rise after the crude oil market has
been trading at depressed levels. The airline company expects to purchase 15 million gallons of jet fuel
over the next year, and wishes to hedge its purchase price.
Further assume that the correlation between crude oil futures and the spot price of jet fuel is 0.95.
standard deviation of crude oil futures and spot jet fuel price is 6% and 3%, respectively.

0.03
Optimal Hedge Ratio = 0.95 ∗ = 0.475
0.06
The NYMEX Western Texas Intermediate (WTI) crude oil futures contract has a contract size of 1,000
barrels or 42,000 gallons.
The optimal number of contracts is calculated to be 170 contracts, or (0.475 * 15 million) / 42,000.
Therefore, the airline company would purchase 170 NYMEX WTI crude oil futures contracts.
 Derivative Instruments for Hedging – Options

Swaps protect the results of the firm from an upward movement in interest rates, but they do not
permit the firm to take advantage of a decrease in the financial expenses in the event of a fall in
interest rates. Options allow the right to buy (call) or sell (put) an underlying asset if convenient for the
buyer. Then, by using options, it is possible:
• To limit the financial cost by exercising the option if rates go above the protection level (exercise
price or strike).
• To benefit from a decrease in interest rates without exercising the option and consequently leaving
the rate of the financial structure as low as the market rate of the loan (if below the strike).
 Dynamic Hedging- why?
Hedging involves establishing a second position whose price behavior will likely offset the price
behavior of the original portfolio.

The trouble with hedging is that there are so many things that can happen in future. Take the example
of a 30 year mortgage. You are exposed to interest rate risk in a mortgage loan.

Even if interest rates can do only two things each year, in 30 years there can be hundreds of interest
rate scenarios.

It would seem impossible to hedge against so many contingencies. With a change in the market prices,
the variables can change as a result the hedged position may require adjustment.

The principle of dynamic hedging shows that it is enough to hedge yourself against the two things that
can happen in a short frequency(which is far less onerous), provided that each following year you adjust
the hedge to protect against what might occur one year after that.
 Meet the Greeks
Before getting into Option Hedging, it is a good idea to meet these characters. These will impact the
value of each option you trade.

The value of an option changes in respect to changes in the

• Delta – the amount by which option price is expected to change based on $1 change in the value of
underlying stock
• Gamma – the rate that delta will change based on a $1 change in the stock price. So if delta is the
“speed” at which option prices change, you can think of gamma as the “acceleration.”
• Theta - Time Decay, enemy number 1 for option buyers. Option Sellers best friend. Theta is the
amount the price of calls and puts will decrease (at least in theory) for a one-day change in the time
to expiration.
• Vega – Over caffeinated cousin of Delta- Vega is the amount call and put prices will change, in
theory, for a corresponding one-point change in implied volatility

• Like distant cousins in the Indian families, there can be many more such variables
 Delta
• Delta is the amount an option price is expected to move based on a $1 change in the underlying
stock.
• Calls have positive delta, between 0 and 1. That means if the stock price goes up and no other
pricing variables change, the price for the call will go up.
• Puts have a negative delta, between 0 and -1. That means if the stock goes up and no other pricing
variables change, the price of the option will go down.
• As a general rule, in-the-money options will move more than out-of-the-money options, and short-
term options will react more than longer-term options to the same price change in the stock.
• Here’s another useful way to think about delta: the probability an option will wind up at least
$.01 in-the-money at expiration. (technically this is not a valid definition)
 Delta
As an option gets deep in-the-money, the probability it will be in-the-money at expiration increases as
well. So the option’s delta will increase. As an option gets deep out-of-the-money, the probability it will
be in-the-money at expiration decreases. So the option’s delta will decrease.

K 50 Option Type Call

Time to Maturity 60 Days Delta 0.5
Stock Price 50 Otion Price 2

T+1 Alternative T+1

Stock Price 51 Stock Price 49
Option Price 2.5 Option Price 1.5

T+2 Alternative T+2

Stock Price 52 Stock Price 48
Delta ↑ 0.6 Delta↓ 0.4
Option Price 3.1 Option Price 1.1
 How Delta changes close to the Expiry
• As expiration approaches, the stock will have less time to move above or below the strike price for
your option.
• Like stock price, time until expiration will affect the probability that options will finish in- or out-of-
the-money.
• Because probabilities are changing as expiration approaches, delta will react differently to changes
in the stock price. If calls are in-the-money just prior to expiration, the delta will approach 1 and the
option will move penny-for-penny with the stock. In-the-money puts will approach -1 as expiration
nears.
• Using earlier example, if XYZ stock moves from $50 to $55, with only 1 day to expiry, the probability
of it being ITM is very high and vice versa.
• So as expiration approaches, changes in the stock value will cause more dramatic changes in delta,
due to increased or decreased probability of finishing in-the-money.
 Dynamic Hedging With Options- Delta
Let’s look at a real delta hedging example, the initial position is long 500 shares. In order to hedge the
exposure, the trader sells put options.

At Nov 27th, Stock price $100. Put Strike=

100
Position Contract Contract Position
Delta s Traded Delta
Shares 1 500 500

Long Puts -0.5 1000 -500

Net 0
position
Delta
 Dynamic Hedging With Options- Delta
Continuing with the same example, assume after 1 week prices either increase or decrease, put delta
will change and accordingly the hedge would require to be adjusted

After 1 week, if Stock price decrease to $90. After 1 week, if Stock price increase to $110.
Put Strike= 100 remains the same. Put Strike= 100 remains the same.

Position Contract Contract Position Position Contract Contract Position

Delta s Traded Delta Delta s Traded Delta
Shares 1 500 500 Shares 1 500 500

Long Puts -0.6 1000 -600 Long Puts -0.4 1000 -400

Net -100 Net +100

position position
Delta Delta
Dynamic Hedging With Options- Gamma
Gamma is the rate of change of delta with
respect to the price of the underlying asset

Mathematical Definition2
𝜕 𝐶
Γ= 2
𝜕𝑆
When the stock price moves from S to S′,
delta hedging assumes that the option price
moves from C to C′, when in fact
it moves from C to C′′.

The difference between C′ and C′′ leads to a

hedging error. This error depends on the
curvature of the relationship between the
option price and the stock price. Gamma
measures this curvature
Gamma
• Gamma is the rate of change in Delta vis-à-vis $1 change in underlying stock price. Ala Speed and
Acceleration
• Options with the highest gamma are the most responsive to changes in the price of the underlying
stock.

• For Option buyer, high Gamma is

generally good since it means as
option moves towards ITM, Delta
will quickly move towards 1
(assuming your forecast is right)

• For an option seller, if the forecast is

wrong, Gamma is an enemy.
Position works against you quickly
Gamma Hedging
• Gamma hedging is a trading strategy that tries to maintain a constant delta in an options position,
often one that is delta-neutral, as the underlying asset changes price.

• It is used to reduce the risk created when the underlying security makes strong up or down moves,
particularly during the last days before expiration.

• Achieving a gamma neutral position is a method of managing risk in options trading by establishing
an asset portfolio whose delta's rate of change is close to zero, even as the underlying rises or falls.

• Gamma hedging consists of adding additional option contracts to a portfolio, usually in contrast to
the current position. For example, if a large number of calls were being held in a position, then a
trader might add a small put-option position to offset an unexpected drop in price during the next
24 to 48 hours, or sell a carefully chosen number of call options at a different strike price.
Theta
• Time decay, or theta, is enemy number one for the option buyer. On the other hand, it’s usually the
option seller’s best friend.
• Theta is the amount the price of calls and puts will decrease (at least in theory) for a one-day
change in the time to expiration.
• Essentially it means, lower the time to expiry, lower is the probability of option going in the money

The graph shows how an at-the-money option’s value

will decay over the last three months until expiration.
Notice how time value melts away at an accelerated
rate as expiration approaches.
Dynamic Hedging With Options- Vega

• Vega is the amount call and put prices will change, in theory, for a corresponding one-point change
in implied volatility.
• Typically, as implied volatility increases, the value of options will increase. That’s because an
increase in implied volatility suggests an increased range of potential movement for the stock.
• To hedge vega, it is necessary to use some combination of buying and selling puts or calls. As such, a
good way to limit the volatility risk is by using spreads.
• Vega does not have any effect on the intrinsic value of options; it only affects the “time value” of an
option’s price.
Credit Risk
AGENDA
• Introduction to Credit Risk
• Drivers of Credit Risk
• Evolution of Credit Risk measures – Regulatory
• Credit vs Market Risk
• Measuring Credit Risk
• Default Probabilities
• Recovery Rate
• Credit Exposure

2
 Credit Risk
• Credit Risk is the risk of economic loss from the failure of a counterparty to fulfill its contractual
obligation
• Traditionally, it refers to the risk that a lender may not receive the owed principal and interest,
which results in an interruption of cash flows
• Credit Risk involves the possibility of non-payment, either on a future obligation or during a
transaction
• Amount of risk-based capital for banking system reserved for credit risk is vastly greater than that
for market risk
Capital Requirements for Credit Risk as per Pillar 3 Disclosures (numbers in Rs millions) – March 31,2021
Bank Capital Requirements for Capital Requirements for
Credit Risk Market Risk
HDFC Bank 1,160,873 75,290

ICICI Bank 774,389 80,069

Axis Bank 622,030 53,844

Drivers of Credit Risk

“Ability” to “Willingness”
honor the to honor the
contract contract

All contractual (pre) conditions are met; no ➢ Strength of the legal contract and contract
dispute enforcement
Counterparty is in a position to honor the ➢ Consequence of default
contract ➢ Culture, behavior of the counterparty
➢ Financial (eg it is solvent)
➢ Operational (eg no disruption to its
operations)
➢ Legal (eg not prevented by law)
➢ Any other …
 Evolution of Credit Risk Measures- Regulatory

The evolution of credit risk management tools, based on regulatory guidelines, has gone through these steps
• Notional Amounts – Risk was measured through notional amount of exposures. A multiplier, say 8%, was
applied to this notional amount to establish the amount of required capital
• Risk Weighted Amounts - In 1988, the Basel Committee instituted a very rough categorization of credit
• risk by , providing risk weights to scale each notional amount
• External/Internal Risk Ratings
• Internal Portfolio Credit Models
 Credit vs Market Risk
The tools recently developed to measure market risk have proved invaluable to assess credit risk. Even so, there
are a number of major differences between market and credit risks.
Below table highlights some key differences

Particulars Market Risk Credit Risk

Sources of Risk Markets only Default Risk, Recovery Risk,

Markets, Liquidity
Distributions Mainly symmetric perhaps fat tails Skewed to the left

Time Horizon Generally short term Long Term

Legal Issues Limited Critical

Aggregation Business/trading unit Whole firm vs counterparty

 Credit Event
• A credit event is a discreet state. Either it happens or it doesn’t. The issue is the definition of event,
that must be framed in legal terms
• The definition given by S&P is
“The first occurrence of a payment default on any financial obligation, rated or unrated, other than a
financial obligation subject to a bona fide commercial dispute; an exception occurs when an interest
payment missed on the due date is made within the grace period”

• This definition however needs to be defined more precisely for credit derivatives where the payoffs
are directly related to credit events.
 Credit Event
The definition of credit event has been formalized by International Swap Dealers’ Association (ISDA)
that lists below events as credit events
• Bankruptcy – dissolution of obligor/assignment of claims/appointment of receivership etc
• Failure to pay – failure of creditor to make due payment
• Obligation/cross default- occurrence of default in any other similar obligation
• Repudiation/Moratorium – Counterparty is rejecting or challenging the validity of an obligation
(legal issues)
• Restructuring
In addition, other events generally included are
• Credit Downgrade
• Currency Inconvertibility
• Governmental Action
 Expected Credit Loss

• Probability that a loan/portfolio of loans will default over a

Probability of Default (pD) defined time period

• Total Exposure at the time of Default (current

Exposure at Default (EaD) exposure/potential future exposure)

• In the event of default, the amount that the creditor is likely

Loss Given Default (LgD) to lose (as a % of total amount owed) after resolution

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐶𝑟𝑒𝑑𝑖𝑡 𝐿𝑜𝑠𝑠 = 𝑝𝐷 ∗ 𝐸𝑎𝐷 ∗ 𝐿𝑔𝐷

 Default Risk
Default Risk can be measured using two approaches
1. Actuarial Methods – provide “objective” measures of default rates. Generally Assumptions are
made about the dynamics of the firm’s assets, it’s capital structure, debt etc. these measures
generally include
a) Credit Ratings
b) Historical Data
c) Other Models
2. Market Price Methods – infer from traded prices, the market’s assessment of default risk , along
with possible risk premium. These include
a) Corporate bonds
b) Credit Derivatives
c) Equities
 Probability of Default
❑ Likelihood that a credit (ie a loan) defaults over a predefined period typically a year for long term
credits
–Measured based on the financial conditions of the borrower
–Captures ‘ability’ to repay and not willingness

❑ Multiple methods of measuring

–Many players have proprietary internal models
–Well-known ‘academic’ models like the Altman Z score
–Rating agencies have their own models
–Historical Default Rates
–Based on market rates

❑ Probability of default is expressed in the form of ‘ratings’

–Bonds typically are mandated to carry ratings issued by registered credit rating agencies (CRAs)
–Even bank loans are rated by external ratings (ie from CRAs) under Basel II regime
–Each rating class corresponds to a level of pD; rating agencies periodically publicly disclose the
pDs of their rated portfolios based on historical data

❑ ‘Hazard rate’ is conditional probability of default; probability that a credit will default in the next
period not having defaulted thus far
Crisil Default Study - 2020

Crisil Ratings Report

 Bond Rating and Credit Spreads
❑ Corporate bond rating indicate the riskiness of the bonds
➢ Higher the rating lower is the perceived riskiness and hence lower is the perceived ex ante
probability of default

❑ Credit spreads are the premium over the risk free rate in bond yields, they suggest the ‘price’ that
investors are expecting for the credit risk
➢ Higher rated bonds have lower credit risk spreads
➢ Risk spreads vary with time

❑ Indian bond markets show some anomalies, bonds with the same rating often trade at different
levels of credit spreads
➢ Bonds issues by government backed entities trade at lower spreads compared to those issued
by private player even with the same rating
Risk Free Rates

IL&FS Default Covid Lock-down starts

Credit Spreads

Covid lock-down starts

IL&FS default
 Real World Vs Risk neutral Default Probabilities- a
comparison
❑ The default probabilities backed out of bond Historical Hazard Rates
prices or credit default swap spreads are risk- Hazard Rate (% from Bonds (%
neutral default probabilities Rating per annum) per annum) Ratio Difference
❑ The default probabilities backed out of historical
data are real-world default probabilities AAA 0.03% 0.60% 20.0 0.57%
❑ Using your text book, taken 7 year Hazard rates
from Moody’s Data (1970-2010). These are real AA 0.06% 0.73% 12.2 0.67%
world default occurrences
A 0.18% 1.15% 6.4 0.97%
❑ Taken Merril Lynch data (1996-2007) to estimate
average 7 year default from the bond prices.
Baa 0.44% 2.13% 4.8 1.69%
These are risk neutral default probabilities.
❑ Assume a risk free rate equal to 7 year swap rate Ba 2.23% 4.67% 2.1 2.44%
minus 10 basis points
B 6.09% 8.02% 1.3 1.93%

Caa 13.52% 18.39% 1.4 4.87%

 Wrong way Risk – Right Way Risk
Wrong Way Risk
❑ A form of counterparty credit risk, wrong-way risk arises when the exposure to a counterparty
increases together with the risk of the counterparty’s default.
❑ Let's say counterparty A enters into a trade with counterparty B.
❑ If, during the life of the trade, the credit exposure of counterparty A to counterparty B increases at
the same time that the creditworthiness of counterparty B deteriorates, then we have a case of
wrong-way risk (WWR).
❑ In such a scenario, the credit exposure to one counterparty is adversely correlated with the other
counterparty’s credit quality and ability to make payments when due.

Right Way Risk

❑ In contrast, right-way risk describes a situation in which credit exposure to a counterparty
decreases as its creditworthiness worsens. An example would be a gold producer selling gold
forward to a bank as a hedge. If the gold price falls, the producer is at greater risk of default;
however, the bank’s credit exposure to the producer decreases since the bank is paying fixed and
receiving the floating price.
 Exposure at Default
❑ Total amount owed by the debtor to the creditor at the time of default
➢ Includes accumulated interest and principal
➢ May include other charges such as fees, contingent claims (eg devolved letters of credit,
guarantees, etc)
➢ It not always easy to define the exposure amount

❑ ‘Quality’ of exposures varies

➢ ‘Secured’ versus ‘unsecured’
➢ Seniority of claims
➢ Financial versus operational creditors

❑ In the event of bankruptcy resolution ascertaining the extend and quality of claims become a
crucial task
➢ The bankruptcy process treats differentially different classes of creditors
 Loss given Default
❑ Loss suffered by the creditors on the event of default, depends on several
factors
➢ Security coverage- extent of the exposure covered by a security
➢ Liquidity of the security
➢ Laws that determine the process of dealing with default

❑ Collateralised loans with liquid collateral generally have lower LgD

➢ Liquid collaterals such as bullion (eg gold), liquid securities (eg blue chip shares,
government bonds, etc)
➢ Security of business assets (eg inventory, plant and machinery, etc) tend to have
lower liquidity
➢ Guarantees (corporate, personal0 as security influence the “willingness” to repay

❑ Recoverability’ is the inverse of LgD; ie Recoverability is (1- LgD)

➢ Historically Indian banking had very low recoverability due to poor laws and very long
time of recovery; net present value of the recovery is what matters
➢ Since the passing of the Insolvency and Bankruptcy Code (IBC) in 2015, the recovery
has improved slightly to around 30%, the time to recovery has come down
significantly
 Mitigating Credit Risk
❑ Improved underwriting and loan contracts
➢ Robust models to asses credit risk, use of financial as well an non financial information
➢ Loan covenants to protect creditor interests
➢ Use of collateral – higher coverage and liquidity

❑ Improved monitoring
➢ Constant and careful assessment of the debtor
➢ Exiting a loan before default happens

❑ Credit risk mitigation instruments

➢ Credit insurance
➢ Guarantees
➢ Credit default swaps
 Final Project Assignment
Group 1 to 4 – Preparation of Risk Management Policy for

Group No. Entity type Entity Name

1 Discount Broking Zerodha

2. Bank Yes Bank

3. Small Finance Bank AU Small Finance Bank

4. Real Estate DLF

Group 5: Risk Assessment of WazirX- Crypto Exchange in India

Group 6: Paper on Comparative Analysis of various value at Risk
approaches for Bank Nifty and recommendation on specific approach to
be used for risk estimation
Group 7 – Renewable Energy- Risk Assessment
Group 8 – Automobile - Tata Motors
 Altman’s Z Score Model
❑ Represents a model for calculating a company’s likelihood for financial distress in 1968
❑ This score is a function of five financial ratios
➢ Liquidity Ratio (X1)
➢ Leverage (X2)
➢ Profitability (X3)
➢ Solvency (X4)
➢ Sales Activity of Business (X5)

𝑍 𝑆𝑐𝑜𝑟𝑒 = 1.2𝑋1 + 1.4𝑋2 + 3.3𝑋3 + 0.6𝑋4 + 1.0 𝑋5

❑ The lower the score, the higher the probability of the company’s bankruptcy

Altman Z-Score Model: Likelihood of bankruptcy – Finrepo

Operational Risk
AGENDA
• What is operational risk
• Significance of operational risk
• Categorisation of Operational Risk
• Three Lines of Defense
• Basel Approaches for operational risk
• Basic Indicator Approach
• Standardised approach
• Advanced Measurement approach
• Mitigation

2
 Operational Risk

Definition-
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes,
people and systems or from external events.

• This is virtually present in all activities, systems and processes.

• Contrary to other risks (e.g. credit risk, market risk, investment risk etc) operational risks are usually
neither willingly incurred nor are they revenue driven. Moreover, they are not diversifiable and
cannot be laid off. This means that as long as people, systems, and processes remain imperfect,
operational risk cannot be fully eliminated
 Operational Risk- Risk Event type Categories
The Basel II accord defines the following as risk event types. However, the Basel Committee recognizes
that operational risk is a term that has a variety of meanings and therefore, for internal purposes, banks
are permitted to adopt their own definitions of operational risk, provided that the minimum elements
in the Committee's definition are included.
1. Internal Fraud – misappropriation of assets, tax evasion, intentional mismarking of positions,
bribery
2. External Fraud – theft of information, hacking damage, third-party theft and forgery
3. Employment Practices and Workplace Safety – discrimination, workers compensation, employee
health and safety
4. Clients, Products, and Business Practice – market manipulation, antitrust, improper trade, product
defects, fiduciary breaches, account churning
5. Damage to Physical Assets – natural disasters, terrorism, vandalism
6. Business Disruption and Systems Failures – utility disruptions, software failures, hardware failures
7. Execution, Delivery, and Process Management – data entry errors, accounting errors, failed
mandatory reporting, negligent loss of client assets
Three Lines of Defense
• Implemented by the unit, component or business
function that performs daily operation activities
Business Processes • They are expected to be fully aware of the risk factors
that should be considered in every decision and action.

• Responsible for risk management development,

monitoring process and the implementation of the
Operational Risk company’s ORM framework.
Management • Set up a process to monitor the implementation of
framework

• Review and evaluate the design and implementation of

ORM framework holistically.
Internal Audit • Ensure the effectiveness of the first layer of defense and
the second-tier.
Operational Risk Events–Top 5 Loss Events 2020-21
Sr. No. Event Loss Amount Business line Event Type

1 Citigroup mistakenly pays $900 $520.4mm Commercial banking Transaction capture,

million to Revlon lenders in clerical execution and
error maintenance

2 Citibank pays $400 million over poor $400mm Corporate items Improper business or
risk management, data governance market practices
and control failures

3 Scotiabank agrees to pay over $127.4 $127.4mm Global Markets Improper business or
million to settle over commodities market practices
price manipulation
4 TD Bank to pay $122 million $122.0mm Card services Suitability, disclosure
restitution over overdraft enrollment and fiduciary
practices

5 European Commission fined a UBS: $210mm Global Markets Improper business or

number of Banks over Euro Govies Nomura: $158mm market practices
trading cartel Unicredit: $85.8mm

Source : www.risk.net
 Top 10 Ops Risk-2020-21
Risk Description Rating for 2020 Rating for 2021
IT disruption 1 1
Data Compromise 2 2
Theft and Fraud 3 4
Outsourcing and Third party Risk 4 5
Resilience Risk (lack of operational resilience i.e. ability of a process/system to react to and 5 3
recover from disturbances with minimal effects on dynamic stability)

Organizational Change 6 8
Conduct Risk 7 6
Regulatory Risk 8 7
Talent Risk 9 -
Geopolitical Risk (An example of geopolitical risk could include a flare-up of tensions between 10 9
Saudi Arabia and Iran that resulted in a spike in the price of oil

Employee Wellbeing - 10

Source: www.risk.net
 Basel II Approaches for calculating Operational Risk
Capital
Basel II and various supervisory bodies of the countries have prescribed various soundness standards
for operational risk management for banks and similar financial institutions. To complement these
standards, Basel II has given guidance to 3 broad methods of capital calculation for operational risk:
• Basic Indicator Approach – based on annual revenue of the financial institution (typically 15%)
• Standardised Approach - based on annual revenue of each of the broad business lines of the
Financial Institution. The capital charge for each business line is calculated by multiplying gross
income by a factor (denoted beta, varies from 12-18%) assigned to that business line.
• Advanced Measurement Approaches - based on the internally developed risk measurement
framework of the bank adhering to the standards prescribed (methods include IMA, LDA, Scenario-
based, Scorecard etc.)
 Approaches for calculating Operational Risk Capital-
Standardised Measurement Approach (Basel IV?)
• The inherent complexity of AMA and lack of comparability arising from a wide range of internal
models resulted in significant variability in risk weighted asset calculation.
• As a result, in March 2016, Basel Committee published a paper withdrawing all approaches
including the internal models based approaches and recommended Standardised Measurement
Approach that provides a non-model based approach for estimation of Operational Risk Capital.
• This approach consists of two components
• Business Indicator Component (BIC) - comprises of three main business lines (interest
component, services component and financial component)
• Internal Loss Multiplier (ILC)- multiplier defined on the basis of historical losses
• SMA capital charge = BIC * ILC
For details regarding computation approaches, please refer to below papers
• https://www.bis.org/publ/bcbs291.pdf
• https://www.bis.org/bcbs/publ/d355.pdf
 Proactive Approaches for Mitigation
There are certain proactive approaches that can be followed to avoid the occurrence of Operational
Risk Event
• Learn from risk events at other institutions
• Assess causal relationships between decisions taken and operational losses. For example, does
increasing the average educational qualifications of employees reduce losses arising from mistakes
in the way transactions are processed?
• Continual assessment of control framework – a common approach used is called Risk and Control
Self Assessment and Key Risk Indicators.
• Insurance - Insurance policies are available on many different kinds of risk ranging from fire losses
to rogue trader losses.
 Mitigating Operational Risk- Internal Controls
Approach
Indicative approaches from a financial institutions’ perspective
• Separation of Function – Individuals responsible for committing transactions should not perform
clearance and accounting functions
• Dual Entries – Inputs should be matched from two different sources i.e. the trade ticekts and
confirmation from back office
• Reconciliations – Outputs should be matches from different sources- for example capital allocation
estimates with the General Ledger
• Controls over amendments
• Tickler systems – Important dates for an activity (transaction) should be subject entered into a
calendar system that automatically generates pop ups
• End User Computing Controls – Reconciliation and other control in the manual spreadsheets to
avoid errors
 Mitigating Operational Risk- External Controls
Approach
Indicative approaches from a financial institutions’ perspective
• Confirmations- trade tickets need to be confirmed with the counterparty – this provides an
independent check on the transactions
• Verification of prices- to value positions, prices should be sourced from external sources
• Limited Authorizations- in order to maintain control, limited set of people should be provided the
authorization to clear a trade. The same list should also be provided to the counterparties to avoid
fraudulent trades.
• Extensive Internal/External Audit - these examinations provide useful information on potential
weakness areas in the overall control framework.
 Risk and Control Self Assessment and Key Risk
Indicators
• RCSA involves of assessment of processes by Business Unit owners to identify the potential risk and
controls in place to avoid these risks.
• A by-product of any program to measure and understand operational risk is likely to be the
development of key risk indicators (KRIs).
• They provide an early warning system to track the level of operational risk in the organization. Some
examples of these KRIs can include
• Staff Turnover
• Instances of Internal Frauds
• System latency time
• Number of regulatory breaches
 Risk and Control Self Assessment and Key Risk
Indicators
A common approach for RCSA is creation of Risk Rating and action Matrix where each potential risks
assessed with reference to the likelihood of occurrence and impact of such an event.
Guidance for Assigning Likelihood Scores

Likelihood Rating Occurance Probability*

Frequent 5 Every month
More than 75% chances of occurrence
Likely 4 Once in two months
51% to 75% chances of occurrence
Possible 3 Once in a year
16% to 50% chances of occurrence
Unlikely 2 Once in two years
10% to 25% chances of occurrence
Remote 1 Once in five Years
Less than 10% chances of occurrence

*Estimation of probability is on the basis of historical occurrences and subjective judgement by the respective department
 Guidance for Assigning Impact Scores
Impact Rating Criteria / Examples
1. Financial impact over Rs.20.0 Lakh
2. Major regulatory issues or non-compliance which might result in cancellation of Clearing
Extreme 5 Corporation certificate or heavy penal action
3. Issues impacting all the members or having severe impact on few members
4. Impacts reputation severely

1. Financial impact between Rs.10.0 Lakh to Rs.20.0 Lakh

2. Major regulatory issues or non-compliance which might result in penal action
Major 4
3. Issue impacting many members or having major impact on few members
4. Impacts reputation adversely

1. Financial impact between Rs.5.0 Lakh to Rs.10.0 Lakh

2. Moderate regulatory issues or non-compliance which might result into regulatory observations but
Moderate 3 no penal action
3. Issue impacting some members or having moderate impact on few members
4. Impacts reputation
1. Financial impact between Rs.0.5 Lakh to Rs.5.0 Lakh
2. Minor regulatory issue or non compliance
Minor 2 3. Issue impacting few members
4. No reputational impact
5. NCCL Policy/SOP non compliance
1. Financial impact below Rs.0.5 Lakh
2. No regulatory issue or non compliance
Negligible 1 3. Issue impacting one or two members & impact not severe
4. No reputational impact
5. NCCL Policy/SOP non compliance
 Roles and Responsibilities
Individual Departments
• The overall responsibility of operational risk management lies with the functional/departmental
head. The HOD will have the responsibility of implementation and periodic review of the Risk
Register.
• Each department to identify a Risk Champion who will be the responsible for maintaining the risk
register and will be point of contact in that department
• Maintain risk event registry at department level
• Propose mitigation plans for the residual risks.
• Finalization of the risk scores/categories
• Reviewing the registers at periodic interval but at least quarterly
• Reporting to Risk Management Department

Risk Management Department

• Guiding the departments in the process of preparation of the risk registers
• Finalization of risk registers along with the relevant department
• Reviewing the registers at periodic interval or as and when required
• Reporting to the IRC/RMC
 Loss Event Database
• This is a repository of Actual Loss Events that have happened in the past .
• These loss Event Databases highlights the inherent weaknesses in the processes and can help in
prioritization of mitigation efforts
• These generally include the details of events, cause and impact as well as the action taken to
control or mitigate the risk.
• In addition to recording of actual loss event, it is also important to record the near misses.
• These databases help in statistical analysis of loss distribution, capital calculation etc
 Loss Event Database
• This is a repository of Actual Loss Events that have happened in the past .
• These loss Event Databases highlights the inherent weaknesses in the processes and can help in
prioritization of mitigation efforts
• These generally include the details of events, cause and impact as well as the action taken to
control or mitigate the risk.
• In addition to recording of actual loss event, it is also important to record the near misses.
• These databases help in statistical analysis of loss distribution, capital calculation etc
 Loss Event Database- Template

Violation /
non- Status
Sn Depart Event Event Event complianc (Open/Closed Additional Action
. ment Date Title Details e Category Action Taken ) Closure Date Required Target Date
Date Event
on description in People / What action Date by which
Regulatory/
which Event detail Process/ has been taken Whether the Additional action this event is
Policy/SOP/
Departm event descrip including System / to risk is When was this required incase expected to be
others
ent occurre tion in cuase and External control/mitigte open/close risk event initial action is resolved after
Name d short impact the risk after the action resolved inadequate additional action
Credit Default Swaps
 Credit Default Swaps
A credit default swap (CDS) is a kind of insurance against credit risk
❑ Privately negotiated bilateral contract
❑ Reference Obligation, Notional, Premium (“Spread”), Maturity specified in contract
❑ Buyer of protection makes periodic payments to seller of protection
❑ Generally, seller of protection pays compensation to buyer if a “credit event” occurs and
contract is terminated.

Spread, ‘x’ basis points per

annum Protection • Notional $10 million
Protection • Spread 100bps per
Seller annum
Buyer
Payment on Credit Event • Quarterly payment
frequency – payment
of $25,000 per
Total Return less credit Reference quarter
loss on the reference
entity Entity
 Credit Default Swaps- types
Exist for both corporate reference entities and Asset Backed Securities (ABS)
❑ Corporate CDS are relatively simple; first emerged round about 1993; became widely used by late
90’s/early 2000’s, particularly after introduction of ISDA template in July 1999
❑ ABS CDS are more complex; first appeared around 2003; grew substantially in 2005 onwards
➢ Exist for a variety of types of ABS; most common for Residential Mortgage Backed Securities
(RMBS); but, size of markets for CDS on CDOs and CDS on Commercial Mortgage Bcked
Securities (CMBS) also substantial.
 Credit Default Swaps- Credit Events
❑ For corporates, quite straightforward
➢ Credit event results in payment from protection seller to buyer and termination of contract
➢ Most common types of credit events are the following
✓ Bankruptcy –Reference entity’s insolvency or inability to repay its debt
✓ Failure to Pay –Occurs when reference entity, after a certain grace period, fails to make
payment of principal or interest.
✓ Restructuring –Refers to a change in the terms of debt obligations that are adverse to
creditors
❑ If credit event does not occur prior to maturity of contract (typically, 2/5/7/10 years for corporates),
protection seller does not make a payment to buyer
 Credit Default Swaps- Settlement
❑ For corporates,
➢ Cash Settlement
✓ Dealer poll conducted to establish value of reference obligation (for example, x percent
of par)
✓ Protection seller pays buyer 100 –x percent of Notional
❑ CDS can be thought of as a put option on a corporate bond. Protection buyer is protected from
losses incurred by a decline in the value of the bond as a result of a credit event.
Example:
The protection buyer in a $5,000,000 CDS, upon the reference entity’s filing for bankruptcy protection,
would notify the protection seller.
A dealer poll would then be conducted and if, for instance, the value of the reference obligation were
estimated to be 20% of par, the seller would pay the buyer 4,000,000 USD.
 Credit Default Swaps- Settlement contd.
❑ For corporates,
➢ Physical Settlement
✓ Protection buyer sells acceptable obligation to protection seller for par
❑ Buyer of protection can choose, within certain limits, what obligation to deliver. Allows buyer to
deliver the obligation that is “cheapest to deliver.” Generally, the following obligations can be
delivered
➢ Direct obligations of the reference entity
➢ Obligations of a subsidiary of the reference entity
➢ Obligations of a third party guaranteed by the reference entity
 Credit Default Swaps- Settlement on ABS
❑ CDS referring ABS are more complex
❑ Attempt the replicate the cash flows of reference obligations- reflective of growing
importance pre GFC
❑ Floating Amount Event- contracts are generally not terminated
❑ Write down-reduction in principle of reference obligations
Consider a CDO with two tranches; senior tranche has notional of 150,000,000 USD;
Subordinate tranche has notional of 150,000,000 USD. If there’s only 225,000,000 USD of
collateral backing the deal, subordinate tranche will experience a 50% implied writedown
➢ Principal Shortfall - Reference Obligation fails to pay off principal by its legal final
maturity (typically approximately 20-30 years)
➢ Interest Shortfall - Amount of interest paid on reference obligation is less than
required. Protection seller has to make up any interest shortfall on bond- can be fixed
rate (i.e. up to ‘y’%) or variable rate (libor +’z’ bps) or no cap(i.e. full payment)
 Sample questions for the exam
Of the following statements, select the one(s) that is (are) most likely true with regards to a loan
portfolio:
i) Lowering the recovery rate + Increasing the default probability = an increase expected loss
ii) Increasing the recovery rate + Increasing the default probability = an increase expected loss
iii) Lowering the recovery rate + Lowering the default probability = an increase expected loss

❑ a. i only
❑ b. i and ii only
❑ c. i and iii only
❑ d. i, ii and iii
 Sample questions for the exam
If you are told that the daily, 90% confidence level, value at risk of a portfolio is $100,000, then you
would anticipate that:
i) 9 out of 10 times, the value of the portfolio will lose more than $100,000.
ii) 1 out of 10 times, we would expect the portfolio to lose $100,000 or less.
iii) 9 out of 10 times, the value of the portfolio will lose less than $100,000.
iv) 1 out of 10 times, we would expect the portfolio to lose $100,000 or more.

a. ii only
b. iii only
c. i and ii only
d. iii and iv only
 Sample questions for the exam
Using a daily EWMA model with a decay factor = 0.95 to develop a forecast of the variance, which
weight will be applied to the return that is four days old?

i) 0.000
ii) 0.043
iii) 0.048
iv) 0.950
 Sample questions for the exam
What assumptions does a duration-based hedging scheme make about the way in which interest rates
move?

i) All interest rates change by the same amount.

ii) A small parallel shift occurs in the yield curve.
iii) Any parallel shift occurs in the term structure.
iv) Interest rates’ movements are highly correlated.
 Sample questions for the exam
Which of these outcomes is not associated with an operational risk process?

i) The sale of call options is booked as a purchase.

ii) A monthly volatility is inputted in a model that requires a daily volatility.
iii) A loss is incurred on an option portfolio because ex post volatility exceeded expected volatility.
iv) A volatility estimate is based on a time series that includes a price that exceeds the other prices
by a factor of 100.
 Sample questions for the exam
You have granted an unsecured loan to a company. This loan will be paid off by a single payment of $50
million. The company has a 3% chance of defaulting over the life of the transaction and your
calculations indicate that if it defaults you would recover 70% of your loan from the bankruptcy courts.
If you are required to hold a credit reserve equal to your expected credit loss, how great a reserve
should you hold?
Financial Sector Regulation
 Components of Risk Management Framework -Recap

Risk Risk Monitoring and

Risk Mitigation Governance
Identification Measurement Reporting
• Identification • Includes • Decide on • Helps monitor • Implementatio
of Risk quantification which risks to the n of the
Universe of potential mitigate performance framework
• Categorization loss- either • Assessment of • Information to • Defining
into Core and specific or limit structure Management, authorities and
Non Core Risk aggregate • Products to use Regulators, accountabilities
• Capital shareholders
Allocation etc

All companies face risk; it is inherent in the nature of business. The key objective is to manage the
risks to pre-defined acceptable levels and ensure there are ABSOLUTELY

No Surprises
“Bank regulation is unnecessary. Even if there were no regulations,
banks would manage their risks prudently and would strive to keep a
level of capital that is commensurate with the risks they are taking.”
 Systemic Risks
❑ Systemic risk is the risk that a default by one financial institution will create a “ripple effect” that
leads to defaults by other financial institutions and threatens the stability of the financial system
❑ If Bank A fails, Bank B may take a huge loss on the transactions it has with Bank A. This in turn could
lead to Bank B failing. Bank C that has many outstanding transactions with both Bank A and Bank B
might then take a large loss and experience severe financial difficulties; and so on
❑ In most of the cases of failure in the Banking system, the government (rather the taxpayers) has
covered the cost of the failure in the belief that this would be less costly than letting a domestic
banking failure spread to the rest of the domestic economy
❑ Two primary sources of systemic risks
❑ Panicky behavior of investors/depositors- ala Bank run- can be on account of failure of an
institution or political shock or sudden drop in securities prices
❑ Interruptions in the payment systems - the failure of an institution or from a technological
breakdown in the payment system
 Risk Management and Financial Sector Regulations
❑ Not just companies but regulators of financial sector (banking, insurance and securities markets)
worry about risk
✓ Financial Sector entities are intricately interconnected; counterparties in all kinds of
transactions
✓ Risk events can quickly spread across entities, sectors, countries… remember Global Financial
Crisis
✓ Systemic risk is a major area of concern for regulators
❑ ‘Micro-prudential’ and ‘macro-prudential’ regulation
✓ Rules that individual entities have to follow and rules for the entire system
✓ Contain risk at the level of individual entity as well as the whole system
❑ “Supervision” is the process by which the regulators ensure adherence to regulations
❑ Presently, there is no agency to manage risks across sectors
✓ Sectoral regulators – RBI in Banking / NBFC, IRDA in Insurance, SEBI in Capital Markets
✓ Finance Sector Development Committee (FSDC) which is under the Ministry of Finance does
some inter sectoral coordination
 Context of Capital Regulation in Banking and
Insurance
❑ Banking and insurance businesses are critical to any economy
✓ Convert household savings into investment
✓ Provide households safe avenue for saving and risk management and also provide the
payments infrastructure
❑ Banks and insurances are by nature highly leveraged businesses
✓ Large liabilities issued (contingent liabilities in case of insurance) to public; relatively modest
level of risk can put the ability of these entities to meet their liabilities into question
✓ Ability to meet these liabilities anywhere and all the time is critical to maintain public faith in
the financial system
❑ Capital is the final line of defense against risk; ‘loss absorbing’ capital
✓ Higher the level of capital, lower is the ‘leverage’ and lower is that chance of liabilities getting
impacted upon asset side risks
✓ Capital acts like air bags in a car reduces the impact in the event of a crash; does not
necessarily reduce the probability of a crash
✓ Capital represents owner’s stake in the business and its erosion due to risk acts a check
against risk taking
❑ Capital has a cost and higher the level of capital lower is the return on capital
✓ Bankers try to optimize the return on capital
 Capital Adequacy Ratio

❑ Capital Adequacy provides regulators with the means of establishing whether Banks and Financial
Institutions have sufficient capital to absorb losses that may occur.
❑ Regulators use a Capital Adequacy Ratio, a ratio of Bank’s capital to its assets , to assess risk

𝐵𝑎𝑛𝑘 ′ 𝑠 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐶𝐴𝑅 =
(𝑅𝑖𝑠𝑘 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠)
𝑇𝑖𝑒𝑟 1 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑇𝑖𝑒𝑟 2 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
=
(𝑅𝑖𝑠𝑘 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠)

❑ Tier 1 Capital (core capital) – Bank’s highest quality capital since it is fully available to cover losses.
This includes share capital and disclosed reserves
❑ Tier 2 (supplementary capital) includes all other capital such as gains on investment assets, long
term debt with maturity greater than five years and certain other reserves. However short term
unsecured debt ( or debt without guarantee) are not included in the definition of capital
❑ The loss absorption capacity of Tier 2 capital is lower than Tier 1 capital
 Basel I

❑ Focused on Credit Risk – without a recognition of operational risk

❑ According to Basel I, the total capital should represent at least 8% of Bank’s Credit Risk
❑ The Basel I classification system group’s a bank’s assets in to five risk categories
➢ 0% Risk Weight – Cash, Central Bank and Govt Debt and any Organization for Economic Co-
operation and Development (OECD) Govt debt
➢ 20% Risk Weight – Development Bank Debt, OECD Bank Debt Non-OECD Bank Debt (under
one year of maturity, Cash in collection etc
➢ 50% Risk Weight – Residential mortgages
➢ 100% Risk weight – Private Sector Debt, Rela Estate, Plant and equipment etc
❑ The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets.
For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of
at least $8 million.
 Basel II

Pillar 1 Pillar 2 Pillar 3

Minimum Capital Requirements Supervisory Review Process Markets Discipline
➢ Describes the calculation of ➢ Facilitates market discipline by
Regulatory Capital for Credit, ➢ Gives supervisors discretion requiring increased disclosure
Market and Operational Risk to increase regulatory capital of capital requirements as
requirements. well as methods for risk
➢ The minimum capital adequacy assessment
ratio of 8% was prescribed ➢ Banks should have a process
to assess their overall capital ➢ Streamlined catalogue of
➢ However RBI in India prescribed a adequacy disclosure requirements
minimum CAR of 9% of Risk
Weighted Assets (9.5% for D-SIB ➢ Supervisors should review ➢ Close co-ordination with
Banks). Banks’ assessment International Accounting
Standard Boards

The main innovation of Basel II in comparison to Basel I is that it takes into account the credit rating of assets in determining
risk weights. The higher the credit rating, the lower the risk weight.
 Basel II- Credit Risk
There are four approaches for estimation of risk weighted assets
❑ Standard Simple - The bank allocates a risk weight to each of its assets and off-balance sheet
positions and produces a sum of risk-weighted asset values.
❑ Standard Comprehensive - Under this approach, a bank can allocate eligible financial collateral to
reduce the amount of the exposure to the counterparty.
❑ Foundation Internal Ratings Based Approach - The bank estimates each borrower's
creditworthiness through an assigned risk rating and related PD (probability of default). These
results, along with other inputs supplied by bank supervisors (such as LGD or Loss Given Default),
are translated into estimates of a potential future loss amount, and minimum capital requirements.
❑ Advanced Internal Ratings based Approach - The bank estimates the credit worthiness of
borrowers as well as other inputs for the determination of potential future loss amounts and
minimum capital requirements.
 Basel III
❑ Post occurrence of Global Financial Crisis, it was realized that a major overhaul of these regulatory
requirements was necessary.
❑ One of the major issue observed was the absence of recognition to liquidity risk in the system.
❑ In the final version of regulations published in 2010, there were following key parts
i. Capital Definition and Requirements- Minimum requirements on equity capital (minimum
4.5% of risk weights), total tier 1 capital (minimum 6% of risk weights) and overall capital
(minimum 8% of the risk weights
ii. Capital Conservation Buffer –Guidelines require a capital conservation buffer in normal
times consisting of a further amount of core Tier 1 equity capital equal to 2.5% of risk-
weighted assets.
iii. Liquidity Risk – Liquidity Coverage Ratio (short term liquidity) and Net Stable Funding Ratio
(long term liquidity) as additional measures were recommended
 The Indian Situation
❑ RBI has adapted Basel II
➢ It prescribes minimum capital at a higher level (9%) that is required, capital requirement for
NBFC is higher at 15%
➢ Most banks use internal ratings based approach but get the loan externally rated by rating
agencies
➢ Risk weights of various asset classes are defined by RBI and are changed from time to time

❑ Basel III is partially adapted

➢ Liquidity Coverage Ratio and Stable Funding Ratios have been prescribed in some form
➢ Counter cyclical buffers are supposed to be enforced but the implementation date keeps
getting postponed
➢ Implementation of the new accounting standard (IFRS or its Indian avatar Ind AS) also keeps
getting deferred for banks, already implemented for NBFCs
➢ Large share of PSU banks complicates situation

❑ We have had a very bad NPA situation between 2015 and 2019
➢ Government had to infuse nearly 3.5 lac cr of precious resources as capital into banks
➢ Even now India has among the highest rate of banking NPAs in the world
➢ Covid impact may create another spike
https://rbidocs.rbi.org.in/rdocs/notification/PDFs/58BS09C403D06BC14726AB61783180628D39.PDF
 Capital Regulation and Risk Management
❑ Capital regulation is the backbone of financial sector regulations
➢ Capital is seen as the major bulwark against risk
➢ Over the period of time the definition of what counts as capital and its minimum level have
been sharpened and made more stringent
➢ Post the GFC, a lot of attention to systemically important entities, off balance sheet
exposures and counter cyclical capital
❑ For risk managers, capital management and risk management are two sides of the same coin
➢ Maximizing risk-adjusted returns on capital is the objective of any risk manager
➢ Regulations prescribe the base level of capital requirements; risk management has to
understand risks and their capital implication at transaction level
❑ Increasing importance of risk governance
➢ Risk policies and organization, capabilities
➢ Risk underwriting processes, systems, and people
➢ Portfolio review
➢ Risk mitigation