Market Risk, RiskMetrics Models, and Loan Types in Financial Institutions
Market Risk and Risk Management in Financial Institutions
Market Risk
Market risk is the risk associated with the uncertainty of a financial institution’s (FI) earnings on its trading portfolio due to changes in market conditions. These conditions include interest rate risk and foreign exchange (FX) risk. Market risk emphasizes the risks faced by FIs that actively trade assets and liabilities rather than hold them for long-term investment, funding, or hedging purposes. It represents the estimated potential loss under adverse circumstances.
RiskMetrics Models
RiskMetrics models address the question of how to preserve equity if market conditions move adversely.
Daily Earnings at Risk (DEAR)
DEAR, encompassing fixed income, FX, and equities, is calculated as follows:
DEAR = Dollar Value Position (Face Value / (1 + Today’s Yield on Bond)^Years to Maturity) * Price Volatility (Price Sensitivity * Potential Adverse Move in Yield)
Example: The potential daily loss in earnings on the X€ position is… if the worst-case scenario occurs tomorrow.
The potential daily earnings exposure to adverse euro-to-dollar exchange rate changes for the FI from the € million spot currency holding.
Modified Duration (MD) = D / (1 + R: Yield)
Potential Price Volatility = MD * Potential Adverse Daily Yield Move (Standard Deviation * 1.65)
Example: Adverse moves in yields decrease the value of the security. The probability of yield increases greater than 16.5 basis points is 5%, or 1 in 20 days.
N-day Market Value at Risk (VAR)
N-day VAR is calculated as:
VARn = DEAR * √N (Number of days the FI is forced to hold the securities)
Equity Risk
Equity risk has two types:
- Systematic Risk: Reflects the co-movements of a stock with the market portfolio, reflected by the stock’s beta and the volatility of the market portfolio.
- Unsystematic Risk: Is specific to the firm itself. If the portfolio is well-diversified, unsystematic risk will approach zero, leaving behind the systematic market risk.
Example: The FI stands to lose at least € in earnings if adverse stock market returns materialize tomorrow.
DEAR Portfolio
DEAR Portfolio = √(D1² + D2² + D3² + 2 * Correlation12 * D1 * D2 + …)
If the DEAR Portfolio is less than the sum of the individual DEARs, considering the risk of each trading position as well as the correlation structure among those positions’ returns results in a lower measure of portfolio trading risk than when risks of the underlying trading positions are simply added.
BIS Approach
The Bank for International Settlements (BIS) approach includes:
- Specific Risk Charge: Measures the risk of a decline in the liquidity or credit risk quality of the trading portfolio over the FI’s holding period. It is calculated as Risk Weights * Absolute Dollar Values of Long and Short Positions.
- General Market Risk Charge: Reflects the product of the modified durations and interest rate shocks expected for each maturity. It is calculated as Modified Durations * Expected Interest Rate Shocks for each maturity.
Internal Models
Internal models use a 2.33 (99%) confidence level and a minimum holding period (N) of 10 days. The FI must consider its proposed capital charge or requirement as the higher of:
- The previous day’s VAR (DEAR * √10)
- The average daily VAR over the previous 60 days times a multiplication factor with a minimum value of 3. Capital Charge = DEAR * 3 * √10.
The multiplication factor makes the required capital significantly higher than the VAR produced from private models.
Network Models
Network models simulate the direct contagion effect between banks. The interbank market can be seen as a network with bilateral lending relationships. The network structure, the level of banks’ capital, and the loss given default are key determinants of the model. Exposures and capital adequacy ratios can be obtained from prudential reporting data. Loss given default has to be estimated from balance sheet data.
Advantages: They explicitly model the transmission of shocks, which improves supervisors’ ability to identify weaknesses in the financial system.
Disadvantages: Due to data constraints, only a part of the global network system can be modeled.
Conditional Risk Models
- CoVAR: Is defined as the VAR of the overall system conditional on the VAR of an individual institution.
- Expected Shortfall Models: Systemic risk is measured by means of the portfolio expected shortfall for a confidence level of 99%. It measures the magnitude of the expected portfolio loss in the worst 0.1% of cases. Systemic risk contributions are defined as the banks’ marginal contributions to the portfolio expected shortfall.
Types of Loans
Syndicated Loan
A syndicated loan is a loan provided by a group of FIs as opposed to a single lender. It is structured by the lead FI (or agent) and the borrower. Once the terms (rates, fees, and covenants) are set, pieces of the loan are sold to other FIs.
Secured Loan, Unsecured Loan, Fixed-Rate Loan, Floating-Rate Loan
- Secured Loan: Backed by some collateral that is pledged to the lender in the event of default. The lender has rights to the collateral, which can be liquidated to pay all or part of the loan.
- Unsecured Loan: Has only a general claim to the assets of the borrower if default occurs.
- Fixed-Rate Loan: The interest rate is independent of market changes. The lender bears the risk of interest rate changes. If interest rates rise, the opportunity cost of lending is higher, while if interest rates fall, the lender benefits.
- Floating-Rate Loan: The interest rate changes with market conditions. Because it is harder to predict long-term rates, FIs prefer to charge floating rates for long-term loans and pass the interest rate risk on to the borrower.