This book presents an inventory of different approaches to market, credit and operational risk. Define the key terms used to set up the scheme, such as systemic, market, credit and operational risk.
BACKGROUND
Among these conditions, private ownership of means of production, profit orientation and market economy mechanisms were formalized. The earliest form of shareholder organization, the joint stock company, appeared at the end of the seventeenth century.
RISKS: A VIEW OF THE PAST DECADES
This is not just a result of the increased number of risks we face; The severity and frequency of disasters have also increased. The term risks glittering with all the colors of the rainbow; it depends on how we define it.
DEFINITION OF RISK
Furthermore, we do not limit the scope of risks to circumstances in the external environment. The definition of expectations is absolutely crucial in the concept of risk because it is used to define the benchmark.
RELATED TERMS AND DIFFERENTIATION Frequently, terms such as peril, hazard, danger, and jeopardy are used inter-
Many crises in the economy and the financial services industry occur because of problems within organizations. This type of danger involves the character of the persons involved in the situation, which could increase.
DEGREE OF RISK
The danger varies from jurisdiction to jurisdiction, meaning global companies must keep a close eye on regulatory developments. Risk management has become a non-delegable part of the top management function and therefore a non-delegable responsibility and liability.
RISK MANAGEMENT
- Background
- History of Modern Risk Management
- Related Approaches .1 Total Risk Management
- Approach and Risk Maps
Trend: Combining approaches to generate the methodological basis of an enterprise-wide risk management approach. Ernst & Young's view is that effective enterprise risk management includes the following points (see Figure 1-6): 7.
SYSTEMIC RISK
- Definition
- Causes of Systemic Risk
- Factors That Support Systemic Risk
- Regulatory Mechanisms for Risk Management
Our understanding of the relationship between financial markets and the real state of the economy is. The risk of the OTC market, then, is that it is non-transparent, non-institutional and almost unregulated.
SUMMARY
The goal for both management and the supervisory authorities is to build and enforce an integrated risk management framework. The models and approaches used in the different risk categories must provide statements about the risk exposures and allow the aggregation of risk information across different risk categories.
NOTES
Bank for International Settlements (BIS), Basel Committee on Banking Supervision, Improving Bank Transparency, Basel, Switzerland: Bank for International Settlements, September 1998. Interactions with Highly Leveraged Institutions: Implementing the Committee's Good Practices Paper of Basel, Basel, Switzerland: Bank for International Settlements, January 2000.
BACKGROUND
DEFINITION OF MARKET RISK
Business and market risk are two major sources of risk that can affect a company's ability to achieve earnings or cash flow goals (see Figure 2-2). In contrast, market risk refers to the uncertainty of future financial results arising from market rate changes.
CONCEPTUAL APPROACHES FOR MODELING MARKET RISK
Hicks' article on liquidity (1962) is more specific about the formulation of risk, mentioning the standard deviation as a measure of "certainty" and the mean.8 The formalization was explained in a mathematical appendix to Hicks (1962) entitled "Pure Theory of Portfolio Investment". In 1938, Williams emphasized the importance of diversification.14 He concluded that the possible values of a security should be assigned probabilities and the average of these values should be used as the value of that security.
MODERN PORTFOLIO THEORY
- The Capital Asset Pricing Model
- The Security Market Line
- Modified Form of CAPM by Black, Jensen, and Scholes
- Arbitrage Pricing Theory
- Approaches to Option Pricing
All combinations are on the line between a risk-free investment and the uncertain investment of the efficient frontier. The generalizations of the Black-Scholes option pricing theory focus on the assumed asset price dynamics.
REGULATORY INITIATIVES FOR MARKET RISKS AND VALUE AT RISK
- Development of an International Framework for Risk Regulation
- Framework of the 1988 BIS Capital Adequacy Calculation
- Criticisms of the 1988 Approach
- Evolution of the 1996 Amendment on Market Risks
Positions greater than 25 percent of the bank's capital are not permitted (unless a bank has approval from the local regulator). The discussion with the Technical Committee of the International Organization of Securities Commission (IOSCO) – the international association of securities regulators of Western industrialized countries – failed because IOSCO members could not agree on a common approach. .
AMENDMENT TO THE CAPITAL ACCORD TO INCORPORATE MARKET RISKS
Scope and Coverage of Capital Charges The final version of the amendment to the capital accord to incorporate
The trading book refers to the bank's proprietary positions in financial instruments (including positions in derivative financial instruments and off-balance sheet instruments) that are intentionally held for short-term resale. The bank may also acquire financial instruments with the aim of benefiting in the short term from actual or expected differences between their purchase and sale prices or from other fluctuations in prices or interest rates; positions in financial instruments arising from brokerage and market maintenance; or positions taken to hedge other elements of the trading book.79.
Countable Capital Components
Banks are entitled to use only Tier 3 capital to support market risks as defined in parts A and B of the amendment. This means that a minimum of around 28.5 percent of market risks must be supported by Tier 1 capital, which is not required to support risks in the rest of the book.
The de Minimis Rule
THE STANDARDIZED MEASUREMENT METHOD
General and Specific Risks for Equity- and Interest-Rate-Sensitive Instruments
In the standard approach, general and specific components of market risk for equity and interest rate sensitive instruments in the market. Total market risk corresponds to the fraction of market risk associated with the volatility of positions or a portfolio that can be explained in terms of general market factors, such as changes in the term structure of interest rates, changes in index prices of net capital, currency fluctuations, etc. .
Interest-Rate Risks
A short position in a fixed income instrument with a term corresponding to the remaining term of the swap. All long and short positions are entered into the corresponding time periods of the maturity ladder.
Equity Position Risk
Futures relating to stock indices must be reported as the market value of the fictitious underlying stock portfolio. The capital requirements for general market risk are 8 percent of the net position per domestic stock market or per single currency area.
Foreign-Exchange Risk
Positions that demonstrably serve on an ongoing basis as a hedge against currency fluctuations to safeguard the equity ratio. The capital requirements for foreign exchange and gold are 10 percent of the sum of the net long or net short positions in foreign currency, whichever is greater, translated into local currency, plus the net gold position, ignoring the plus or minus signs be left.
Commodities Risk
Commodity swaps in which one part is a fixed price and the other the current market price must be entered as a series of positions equal to the notional amount of the contract, with one position corresponding to each payment in the swap and entered into the maturity. according to the circumstances. Commodity swaps in which one part is a fixed price and the other the current market price must be entered as a series of positions equal to the notional amount of the contract, with one position corresponding to each payment in the swap and entered into the maturity. covers interest rates.
Treatment of Options .1 Segregation
The market value of the underlying security, multiplied by the sum of the specific and general market risk costs for the underlying security. The market value of the option. Gamma effect =0.5 ⋅ γ ⋅ δ2 (2.10) where γ indicates gamma and δthe change in the underlying value of the option.
Criticisms of the Standard Approach
This happened because the agencies focused solely on credit risk, that is, the possibility that a borrower would be unable to repay.
THE INTERNAL MODEL APPROACH
- Conditions for and Process of Granting Approval
- VaR-Based Components and Multiplication Factor
- Requirement for Specific Risks
- Combination of Model-Based and Standard Approaches
- Specification of Market Risk Factors to Be Captured
- Minimum Quantitative Requirements
- Minimum Qualitative Requirements
An important part of a bank's internal market risk measurement system is the specification of an appropriate set of market risk factors, that is, the market rates and prices that affect the value of the bank's trading positions. Ongoing review and updating of the documentation for the risk monitoring system (trading and control systems).
THE PRECOMMITMENT MODEL
The results of stress testing should be reviewed periodically by the responsible member of management and reflected in the policy and limits that are determined by management and the internal authority for direction, supervision and control. This part of the deal has been heavily criticized by the International Swaps and Derivatives Association (ISDA).
COMPARISON OF APPROACHES
Note that these issues do not detract from the usefulness of VaR models for enterprise risk management. The regulator can only compare ex post or realized performance with ex ante estimates of risk or maximum loss.
REVISION AND MODIFICATION OF THE BASEL ACCORD ON MARKET RISKS
The E.U. Capital Adequacy Directive The history of capital adequacy requirements in Europe must be put in the
It expanded the 1989 Solvency Ratio and Equity Guidelines, which were similar to the 1988 Basel Accord. The amendment to include market risks led to the updated version, CAD II (April 1997), which all E.U.
New Capital Adequacy Framework to Replace the 1988 Accord
Regulation of securities houses is primarily concerned with orderly liquidation, while bank regulators aim to prevent outright failure. Second, the CAD II guidelines came into force in 1996, while the Basel rules came into force in 1998, which left a period during which European firms had to comply with a separate set of guidelines.
REGULATION OF NONBANKS
- Pension Funds
- Insurance Companies
- Securities Firms
- The Trend Toward Risk-Based Disclosures
- Disclosure Requirements
- Encouraged Disclosures
As in the case of FDIC protection, insurance contracts are ultimately covered by a government guaranty association. As in the case of the Basel Accord in early 1988, the new rules emphasized credit risk.
MARKET INSTRUMENTS AND CREDIT RISKS
For example, taking an offsetting swap with another counterparty to reduce market risk actually increases credit risk (one counterparty will always owe the party the net present value of the swap). As a seller of options, a party only incurs market risk (ie the risk that market rates will move out of its favour).
SUMMARY
NOTES
Bank for International Settlement (BIS), Basel Committee on Banking Supervision, Amendment to the Capital Accord to Incorporate Market Risks, Bazel, Zwitserland: Bank for International Settlement, januari 1996, gewijzigd in september 1997. Bank for International Settlement (BIS), Bazels Comité on Banking Supervision, Amendment to the Capital Accord to Incorporate Market Risks, Bazel, Zwitserland: Bank for International Settlement, januari 1996, gewijzigd in september 1997, para.
BACKGROUND
DEFINITION
CURRENT CREDIT RISK REGULATIONS Current credit risk regulations are based on the 1988 BIS guidelines. These
Through securitization and other financial innovations, many large banks have significantly lowered their risk-based capital requirements without materially reducing their overall credit risk exposure. The original agreement focused primarily on credit risk; it has since been amended to address market risk.
DEFICIENCIES OF CURRENT CONCEPTUAL APPROACHES FOR MODELING CREDIT RISK
The methodology used to backtest market risk value-at-risk (VaR) models is not easily transferable to credit risk models due to. A similar standard for credit risk models would require an impractical number of years of data given the longer time horizons of the models.
CONCEPTUAL APPROACHES FOR MODELING CREDIT RISK
Transaction and Portfolio Management Transaction and portfolio management serve complementary objectives
Depending on the credit risk management structure, various activities (such as securitization, credit derivatives, syndicated loans, etc.) are possible with the given infrastructure and management know-how. The impact of the credit structure and the options involved is important in the approach to credit risk management.
Measuring Transaction Risk–Adjusted Profitability
The probabilities are the same for all loans in a given category, regardless of the specific characteristics of the loan.
MEASURING CREDIT RISK FOR CREDIT PORTFOLIOS
- Economic Capital Allocation .1 Probability Density Function of Credit Losses
- Choice of Time Horizon
- Credit Loss Measurement Definition .1 DM Versus MTM Models
- Risk Aggregation
For marketing and other reasons, financial institutions prefer to express the risk of the credit portfolio by the unexpected credit loss, i.e., by the amount by which the actual losses exceed the expected loss. If a payment (interest rate, amortization, etc.) is contractually due on date t, the payment actually received by the lender will be the contractual amount only if the firm has not defaulted by date t. The lender receives a portion of the loan nominal amount equal to the loan rate minus the given default loss (an approach similar to that used in the default mode method) if the borrower defaults on date t, and the lender receives nothing on date if the borrower has previously defaulted to date. The loan value is equal to the sum of the present values of these derivative contracts (any payment obligation at the time it is considered an option).
DEVELOPMENT OF NEW APPROACHES TO CREDIT RISK MANAGEMENT
Background
The increase in credit exposure and counterparty risk, based on the phenomenal growth of derivatives markets, has extended the need for credit analysis beyond the loan book. The rise in off-balance sheet credit risk was one of the reasons for the introduction of risk-based capital.
BIS Risk-Based Capital Requirement Framework
In many cases they enable a better assessment of the credit risk of portfolios of loans and credit risk-sensitive instruments. Before we look at some of these models and new approaches to measuring credit risk, a brief analysis of the more traditional approaches will enhance the contrast between the new and traditional approaches to measuring credit risk.
Traditional Credit Risk Measurement Approaches
One of the reasons is the different focus of the approaches: Loan assessment systems are sup-. Another problem is that, with the exception of the market value of the equity period in the leverage ratio, the model is essentially based on accounting ratios.
Option Theory, Credit Risk, and the KMV Model .1 Background
Suppose the company borrows OB and the market value of the company's assets at the end of the period is OA2 (where OA2>OB). Value of the loan at the end of year 1, under different ratings (including first-year coupon).
