CAIIB BFM Unit 16 - Market Risk

Market Risk is simply risk of losses on Balance sheet and Off Balance sheet items basically in investments due to
movement in market prices. It is risk of adverse deviation of mark to Market value of trading portfolio during the period. Any decline in the market value will result into loss.

Market Risk involves the following:
1. Risk Identification
2. Risk Measurement
3. Risk monitoring and control
4. Risk mitigation.

ALCO: Assets Liability Committee meets at frequent intervals and takes decisions in respect of Product pricing, Maturity profiles and mix of incremental assets and profiles, Interest rate, Funding policy, Transfer pricing and Balance Sheet Management.

Market Risk measurement
Measurement of Market Risk is based on:
1. Sensitivity
2. Downside potential

Sensitivity Measurement
Change in market rate of interest has inverse relation with Value of Bonds. Higher interest rates lower the value of bond whereas decline in interest rate would result into higher bond value. Also More liquidity in the market results into enhanced demand of securities and it will lead to higher price of market instrument. There are two methods of assessment of Market risk:
1. Basis Point Value
2. Duration method

1. Basis Point Value
This is change in value of security due to 1 basis point change in Market Yield. Higher the BPV higher will be the risk.

Example
Face Value of Bond = 100/- Bond maturity = 5 years
Coupon Rate = 6%
Market price of Rs. 92/- gives yield of 8%
With fall in yield from 8% to 7.95%, market price rises to Rs. 92.10
Difference Yield = 0.5%
Difference in Market price = 0.10
BPV = 0.10/0.05 = 2 i.e. 2 basis points.
Face value of the Bond is 1.00 crore, BPV of the bond is Rs. 2000/- (1,00,00,000*.02/100)
Now, if the yield on Bond with BPV 2000 declines by 8 bps, then it will result into profit of Rs. 16000/- (8x2000).
BPV declines as maturity reaches. It will become zero on the date of maturity.

2. Duration Approach
Duration is the time that a bond holder must wait till nos. of years (Duration) to receive Present Value of the bond. e.g. 5 year bond with Face Value of Rs. 100 @ 6% having McCauley Duration 3.7 years. It means Total Cash Flow of Rs. 130 to be received in 5 years would be discounted with Present Value which will be equivalent as amount received in 3.7 years. The Duration of the Bond is 3.7 Years.

Formula of Calculation of McCauley Duration = ΣPV*T / ΣPV
Modified Duration = Duration / 1+Yield
Approximate % change in price = Modified Duration X Change in Yield

Example
A bond with remaining maturity of 5 years is presently yielding 6%. Its modified duration is 5 years. What will be the McCauley Duration.
Modified Duration = Duration/ 1+YTM
Duration = Modified Duration x (1+YTM)
= 5 x 1.06 = 5.30

3. Downside Potential
It captures only possible losses ignoring profit potentials. It integrates sensitivity and volatility with adverse affect of Uncertainty.

This is most reliable measure of Risk for Banks as well as Regulators. VaR is the method to calculate downside potential.

Value at Risk (VaR)
It means how much can we expect to lose? What is the potential loss?
Let VaR =x. It means we can lose up to maximum of x value over the next period say week (time horizon).
Confidence level of 99% is taken into consideration.

Example
A bank having 1 day VaR of Rs. 10 crore with 99% confidence level. It means that there is only one chance in 100 that daily loss will be more than 10 crore under normal conditions.
VaR in days in 1 year based on 250 working days = 1 x 250 / 100 == 2.5 days per year.