Learning Outcomes

• Understand the following aspects of Market Risk:

• Types of market risk (Interest Rate, Equity, Currency, Commodity)

• Market Risk in the Trading Book : How it arises and accounting impact

• The use of Risk Measures: key concepts of Value at Risk (holding periods,
confidence levels, VaR calculation, Limitations of VaR, Expected Shortfall)

• The use of quantitative techniques (Risk Factors and Loss Distributions,

Variance-Covariance Method, Historical Simulation , Monte Carlo)

• Limit structures in the dealing room

Principals of Risk • Capital treatment of market risk under Basel III

Learning Outcomes (continued) Learning Outcomes (continued)

• Understand the following aspects of Credit Risk: • Understand the following aspects of Operational Risk:
− Sources of operational risk; systems, people, processes and external events
• Categories of credit risk: lending, issuer, settlement, counterparty credit risk − Reasons for banks to control operational risk: legal and regulatory requirements
− Best practice management procedures
• Managing credit risk: Limits and safeguards, Credit approval authorities and
transaction approval process, Aggregating exposure limits by customers, • Understand the following aspects of Legal, Regulatory and Reputation
sectors and correlations
Risk:
• Credit mitigation techniques: collateral; termination clauses, re-set clauses, − Sources of reputation risk and relationship to other risk groups
cash settlement, netting agreements
• Understand the following aspects of Liquidity Risk:
• Documentation: covenants, ISDA / CSA and other collateral
− Objectives and importance of a funding strategy
− Lessons learned from crises in liquidity risk management; Off-balance sheet
• Fundamentals of credit risk capital measurement: probability of default (PD), contingencies, complexity, collateral valuation, intra-day liquidity risks and cross-
exposure at default (EAD), loss given default (LGD) and correlation border liquidity, Measuring and managing stress scenarios, Early warning indicators of
liquidity risk
• Capital treatment of credit risk under Basel III (Standardised approach, − Liquidity coverage ratio and Net stable funding ratio
Foundation and advanced internal ratings based approaches, Regulatory
capital treatment for derivatives)

Types of Risk
• Fundamental risks
– Systemic Risk
– Unsystemic Risk

• Financial Risks
– Market Risk
– Liquidity Risk
– Credit or Default Risk
– Operational Risk
– Country Risk
– Foreign Exchange Rate Risk
– Interest Rate Risk
Risk – Political Risk
– Reputational Risk
 Fundamental Risks Fundamental Risks
• Systemic risk • Unsystemic Risk

– The risk that exists purely from being active in that specific asset class or – This is a specific risk applicable to a small or specific asset
business • E.g. news related to one specific stock will make that stock move irrespective of
the market.
– There is hardly any way in which to eliminate, reduce or avoid this risk
– This type of risk is reduced via the process of diversification
– It generally is the core risk that remains that are priced or compensated for,
when doing business
• E.g. a fire fighter will always have the risk of getting burnt

– Similarly, investing in the stock market in general has risks that affect the
entire universe of stocks that cannot be diversified away

Financial Risks Market Risk

• These are risks that are generally associated with dealing in and with • Often the most visible
the financial markets
• Quite often the most tricky
• This typically would be risks which banks would identify and allocate a
• All financial assets have a price
specific limit towards – The present value of all expected future cash flows to be received from this

• Many of these risks cannot be eliminated but when viewed holistically • Prices change daily (and literally by the minute in some cases)
one can stomach each due to the collective revenue potential, and risk – New information makes its way into the system
mitigation of a bank not just doing business in one product, with one – Global events
client in one region. – Market sentiment
– Economic conditions not as expected
– Flavour of the month goes sour

Liquidity Risk Credit Risk

• A key characteristic of a good investment is the ability to move in and out • Also often referred to as Default Risk
of the investment with ease and at a reasonable price.
• The risk that a counterpart is
• In the absence of the above, pricing is usually adjusted to consider – Unable to honour their financial commitments arising from the trade
– Not a broad range of market makers – Or is Purposely unwilling to do so
– Not a lot of the particular security available (or alternatively it does not trade
frequently) • This risk is not only applicable to bonds (i.e. where the issuer can’t
service the bond coupons or principal redemption)
• Implications
– Price may not be a true reflection of value
• Any contractual obligation entered into between clients and their banks
– Price may not be a true reflection of exit value
– Exaggerated market movements
have the risk of default. Examples include:
– Holding period may be longer than expected – Forward Exchange Contracts
– Forward Rate Agreements
– Swaps
 Credit Risk Question
• Default Risk
What are the primary reasons for taking an initial margin in a
– The possibility that the issuer will fail to meet its obligations under the bond indenture.
– In event of default – investors may be able to recover some or all of the monies owned.
classic repo?
– The % amount recoverable is called the recovery rate.
a. Counterparty risk and operational risk
b. Counterparty risk and legal risk
• Credit Spread Risk c. Collateral illiquidity and counterparty risk
– Is the excess return above the return on the benchmark demanded by investors to
d. Collateral illiquidity and legal risk
compensate for additional risk
– This changes with risk appetite and company specific news

• Downgrade Risk
– Is the risk that a bond is reclassified as a riskier security by a credit rating agency.
– The yield on the bond will change to reflect the new rating

Answer Question
What are the primary reasons for taking an initial margin in a Which of the following statements is correct?
classic repo?
a. The best strategy to treat and mitigate risk is avoiding the risk by
a. Counterparty risk and operational risk avoiding the business
b. Counterparty risk and legal risk
c. Collateral illiquidity and counterparty risk b. The best strategy to treat and mitigate risk is transferring the risk to
d. Collateral illiquidity and legal risk another party, e.g.by transfer to an insurance company

c. The best strategy to treat and mitigate risk is to establish the

appropriate processes for identifying, assessing, managing,
monitoring and reporting risks

d. The best strategy to treat and mitigate risk is to reduce the negative
effect of the risk, e.g.by hedging

Answer Operational Risk

Which of the following statements is correct? • This risk refers to those aspects required in “support” of the business
activity engaged in.

a. The best strategy to treat and mitigate risk is avoiding the risk by
• In other words, the risks associated in delivering the product/service to
avoiding the business
the client
b. The best strategy to treat and mitigate risk is transferring the risk to – Trade data captured correctly
– Correct products traded with the correct counterpart, and their authorised
another party, e.g.by transfer to an insurance company
representative
– Confirmations department assists in ensuring everyone confirms the trade
c. The best strategy to treat and mitigate risk is to establish the
details asap
appropriate processes for identifying, assessing, managing, – Settlements Department has its own risks
monitoring and reporting risks • Did they settle the correct amount
• In the correct currency
d. The best strategy to treat and mitigate risk is to reduce the negative • To the correct counterparty
effect of the risk, e.g.by hedging • On the correct day
• In the correct direction
 Country Risk Foreign Exchange Rate Risk
• On a macro scale • Two types of risks associated with FX
– The risk that a country may not be able to honour their debt and obligations – Translation Risk
– A recent example is Greek Government Bonds – Cash Flow Risk
– Or when Argentina defaulted on their debt in the 90’s
• Translation Risk
• On a micro scale – Assume you expanded the bank and set up new premises in the UK
– The risk that changes made to/in the country may affect the value of your – The capital amount spent on this expansion project shows up in your
investment balance sheet as an investment (or loan to the sub)
– Tax laws changing – The reporting currency of your bank is NGN
– Exchange control laws changing – Without doing ANYTHING differently, the value of that asset will change
– Country banning repatriation of funds (e.g. Zimbabwe) every single year at reporting time, based on the prevailing GBP/NGN
exchange rates.

Foreign Exchange Rate Risk Interest Rate Risk

• Cash Flow Risk • The risk associated with the effects a change of interest rates has on the
– Assume you borrowed NGN in order to expand the bank, setting up new value of an investment, loan or commitment.
premises in the UK

– You now have a loan which needs to be repaid in NGN, and you banked on • This risk will obviously affect interest bearing instruments more than for
a set number of GBP to come your way every month example stocks (though it may also effect stocks)

– This cash flow of GBP was intended to be used to service the loan • Bonds for example will have material price changes should interest rates
change
– What if the NGN strengthens against the GBP
• Similarly, from an issuer point of view it may have some implications.
– The monthly amount of GBP converts into fewer and fewer NGN

– May result in the bank not being able to service the loan • In broader terms it may also affect clients
– E.g. the case of a fast growing Clothing company.

Political Risk Reputational Risk

• This type of risk has become very real and very visible • Banks very strongly defend their reputations as fair, reasonably priced,
– Egypt transparent, and involved in their communities.
– Turkey
– Ukraine • Why?
– How do banks make money?
• The risk of political unrest wreaks havoc on markets
– They require a deposit base to place funds with them, in order to allow them
the ability to on-lend, or create opportunities with the funds to make more
• New political regimes bring with it new rules, regulations money (i.e. utilising the deposit base as a cost, investing it in projects,
and policies products, opportunities at a rate higher than the cost, with the aim of making
– How corrupt is the new vs old government a profit)
– Any new business levies
– Ease of doing business • A good reputation is imperative to ensure funds still are deposited
– Political framework for growth and expansion
• Also for the bank to be viewed as a fair market participant, in order to
view and be invited to their share of what the economy offers
Call And Prepayment Risk Yield Curve Risk
• A bond with a call feature gives the issuer the right to repay the bond • Bond is made up of several coupon payments over its term –
before maturity each coupon payment can be viewed as a zero-coupon
bond
• Cash flows become unpredictable - life of the bond could be shorter
than the term to maturity
• Cash flows on a bond have different maturities – ranging
• Bondholder exposed to risk of investing proceeds at lower interest rates
from time to next coupon to final maturity date. A different
after bond is called discount rate applies to each cash flow

• Potential for price appreciation is reduced - call limits the price of bond • Shifts in the yield curve – parallel or non-parallel is a source
near the call price
of risk and known as yield curve risk
• Known as call risk
• Sometimes called Pivot risk

Reinvestment Risk Liquidity Risk

• When bond holder receives coupon payments – bears risk of • Represents the likelihood that an investor will be unable to sell the
reinvesting at a yield that is lower than the promised yield on security quickly and at a fair price
a bond
• If prices fluctuate wildly from transaction to transaction in absence of
interest rate changes – the security is said to trade in an illiquid market
• E.g.. If interest rates reduce – reinvestment rate will be lower
• Liquidity can be estimated through the bid-ask spread
• Known as reinvestment risk
• Liquidity risk impacts portfolios in two ways:
– Marking positions to market
• Reinvestment risk is minimized with low or zero-coupon – Conducting transactions in a security over time
bonds when time horizons are short

Exchange Rate Risk Inflation Risk

• When bond payments – coupon and/or principal – are • Refers to the possibility that prices of general goods and
denominated in foreign currency services will increase
– investor bears risk of receiving uncertain amounts when converted to
home currency
• Bonds pay a constant coupon and increasing prices will
erode the buying power associated with bond payments

• Known as inflation risk

Event Risk
• Disasters such as hurricanes, earthquakes or industrial accidents can
impair the ability of a borrower to meet its debt obligations (cash flow
impacted)

• Corporate Restructurings such as LBOs and Mergers may affect the

obligations of company by affecting its cash flows or assets that serve
as collateral

• Regulatory Issues such as clean air requirements may cause large cash
expenditures to meet new regulations
Value at Risk
• Political Risk consists of changes in the governments of countries, which (VaR)
may affect their desire to repay their debt obligations

Value at Risk (VaR) Value at Risk (VaR)

• Before measures like VaR, one could argue banks took on • Traditional risk control measures were mostly based around
“silo” risks. physical limits of risk traders could take on their books :

– Net open positions

• Was very difficult to measure risk across the firm

– Greek based limits

• Imagine trying to quantify an interest rate risk in relation to
an equity derivative exposure? – Sector, region, country limits

• It became quite difficult for risk committees to adequately – Maturity mismatch

manage this risk as even the hedges put on, may in fact
exaggerate the risk when viewed holistically

Value at Risk (VaR) What is Value at Risk (VaR)?

• Firm wide risk management vs individual exposure • A summary number
management
• Quantifies the worst possible loss of a portfolio
• VaR was created out of the need to evaluate risk on a
portfolio basis and no longer on a segregated approach • Over a given time horizon

• This allowed risk managers the ability to look at a • With a given confidence level (usually 95% - 99%)
probability distribution of the potential losses across a
portfolio of securities
Calculating Value at Risk (VaR)? Components of VaR
• Standard Deviation – How clustered are the potential
outcomes.

• Volatility – How volatile is it

VaR = Std Deviation x Volatility x • Exposure – What is the amount we have tied to the trader
Exposure (Face Value)

Considerations - VaR Considerations - VaR

• Based on the parameters used in the model • Tail events
– Events that occur very seldom
– Quality of data – The common reference “Black Swan”
– That data located past 3 Standard Deviations
– Time series – 0.2% of possible outcomes
– No way to quantify Possible Loss
– Confidence level

• Trading Horizon
– How long do we intend on holding the trade, and how quickly, should
we wish to, can we exit

Back-testing VaR Back-testing VaR

• How robust is the VaR calculation • How often was there a VaR break?
– It is important to “calibrate” the current VaR settings
– No use in measuring items via a process or sequence with little to
• If VaR breaks occur regularly one has to determine the
now value in relation to real life
– Back testing the VaR calculations against actual exposures, at best following:
provides a sense of comfort – Was it a break due to the valuation model being off
– Useful in determining Limits – A break as a result of limits not being adequate
– A break as a result of procedures not being follows
– I.e. a real break or a technical break
• How big was the VaR break?
– An important consideration is that there is no ability AT ALL to
determine maximum loss
– A VaR break only references the occurrence of unexpected
events, not the extent
Stress Testing Stress Testing
• Why do we stress test? • What is a reasonable scenario?
– There really is no one correct answer here
– Typically analysis is done on how a portfolio or asset will react to a
predetermined change in some variable – The same assets/securities could be stress tested with different parameters
at different times
– E.g. by moving the spot rate up by 1 unit, or a change of interest
rates by 1 unit (or more) – New information always finds its way into the markets and one can only
make decisions with current info on hand.
– The idea would be to try and create a risk grid where one would – Typically one would look at the period in question you wish to do the stress
estimate (via Monty Carlo usually) the various impacts changes in test for, then look back in history, over similar periods, what was the worst
these variables could have on a banks positions ever movement that occur.

– Numerous simulations are run, and then usually the worst outcomes – As with everything, these movements could be categorised, analysed, and
evaluated within a certain confidence level or standard deviation
are evaluated
– E.g. Stressing a bond portfolio, over a period of a week by moving interest
rates up by 1% and stating as a result of the analysis the size of interest
rate move is within 3 Standard Deviations.

Example : Historical Simulation Question

• Assume we have One year’s worth of returns for a similar portfolio (I.e. What is the correct interpretation of a EUR 2,000,000.00
252 business days)
overnight VaR figure with a 97% confidence level?
• We thus have 252 possible outcomes for our portfolio should we move
a. A loss of at least EUR 2,000,000.00 can be expected in 97 out of the
from today to tomorrow
next 100 days.

• By applying these returns to today’s portfolio value we will have 252 b. A loss of at most EUR 2,000,000.00 can be expected in 3 out of the
possible outcomes for tomorrow. next 100 days.

c. A loss of at least EUR 2,000,000.00 can be expected in 3 out of the

• Sort the simulated returns from lowest to highest
next 100 days.

• We can agree on a percentile value and use that to reference the d. A loss of at most EUR 2,000,000.00 can be expected in 6 out of the
possible return next 100 days.

Answer
What is the correct interpretation of a EUR 2,000,000.00
overnight VaR figure with a 97% confidence level?

a. A loss of at least EUR 2,000,000.00 can be expected in 97 out of the

next 100 days.

b. A loss of at most EUR 2,000,000.00 can be expected in 3 out of the

next 100 days.

c. A loss of at least EUR 2,000,000.00 can be expected in 3 out of

the next 100 days.
Control Environment
d. A loss of at most EUR 2,000,000.00 can be expected in 6 out of the
next 100 days.
Risks Risks
• Market Risk • Operational Risk
– The risk of losses in positions arising from movements in market prices, – Basel II: Operational risk is the risk of loss resulting from inadequate or
including Equity risk, Interest rate risk, Currency risk and Commodity risk failed internal processes, people and systems, or from external
events

• Credit Risk
– The risk of loss of principal or loss of a financial reward stemming from a • Reputational Risk
borrower's failure to repay a loan or otherwise meet a contractual obligation. – FT.com: A company’s reputation is perhaps its most valuable asset.
Reputational risk is the possible loss of the organisation’s
reputational capital.
Imagine that the company has an account similar to a bank
account that they are either filling up or depleting. Every time the
company does something good, its reputational capital account
goes up; every time the company does something bad, or is
accused of doing something bad, the account goes down

Risks Risk Mitigation

• Accounting risks • Confirmations
– OTC vs Exchange Traded
– Validity – Incoming
– Outgoing
– Completeness
– NACK
– Valuation
• Communications protocol to negatively acknowledge or
• The Treasury function is reject a received message, or to indicate some kind of error
exposed to all of the above, and – Disputes and impact on trade recognition
adequate controls need to be put – Follow up on long overdue items
in place to mitigate these risks

Question Answer
The use of standard settlement instructions (SSI’s) is strongly The use of standard settlement instructions (SSI’s) is strongly
encouraged because: encouraged because:

a. It reduces operational risk a. It reduces operational risk

b. It splits differences arising from failed settlement between the two b. It splits differences arising from failed settlement between the two
counterparties counterparties

c. It removes the need for sending out swift confirmations c. It removes the need for sending out swift confirmations

d. The use of ssi’s secures the trading on more secure platforms d. The use of ssi’s secures the trading on more secure platforms
 Trade Confirmations
• Confirmation is the first step of the clearing process. When trades are
executed, buyers and sellers record trade details that gets passed on /
feed through to their back office functions for processing

• Manual trade confirmation process:

• Who
– Authorised signatory

• What
Confirmations – Trade details / characteristics (example below)

• When
– If trade settles T+1, is signed confirmation still required??

Trade Confirmations Trade Confirmations

Example: • Preliminary confirmation

• Local Bank and a South African Exporter enter into a EURZAR

transaction to put in place a hedge for future conversion of export
proceeds

• This is an OTC trade; transacted via telephone (taped line)

• Dealer sends preliminary confirmation (e.g. via e-mail) to client setting

out the trade details – acts as first level of protection against possible
dispute
• Trade details, as entered into the FO trade booking system, are picked
up by Operations who prepare a full form trade confirmation to be
signed by the client

Trade Confirmation Example - Trade Confirmation – Possible

Components Components
• Definitions • Early termination provisions

• Terms of the transaction • Additional representations (may reference ISDA

– Trade date agreement)
– Trade reference number(s)
– Expiration and Settlement date
• Settlement account details
– Buyer/Seller of Put/Call
– Put and Call Strike price
– Notional • Any FAIS required disclosures
– Option style (European or American)
– Premium payable / receivable
ISDA Agreement Risk Mitigation
• The ISDA Master Agreement (MA) is published by the International • Settlements
Swaps and Derivatives Association

• It is the most commonly used master contract for OTC Derivative – Segregation of duties is key
transactions internationally
– Interaction between FO, MO & BO
• The ISDA MA has established international contractual standards • FOBO Reconciliations
governing privately negotiated derivatives transactions that reduce
• BOBO Reconciliations
legal uncertainty and allow for reduction of credit risk through netting of
• Position checking & review
contractual obligations

• The MA is a document agreed between two parties that set out – Daily nostro reconciliations between bank accounts and schedule of
standard terms and definitions that apply to all the transactions payments / receipts
entered into between those parties. Each time that a transaction is
entered into, the terms of the MA do not need to be re-negotiated
– Escalation procedures
• See www.isda.org for more information

Settlement Processing
• Operations responsible for schedule of maturities / payments (interest,
coupon, principal, premium, etc.)

• Maturity convention: Modified Following Business Day

This implied rule states that if the payment date on a swap or other
contractual transaction does not fall on a banking day, then the modified
following date will be the next banking day unless that banking day
extends into a new month, in which case the banking day that precedes
the payment date is used

Settlements • Processing of settlements differ from manual transfers between

counterparty banks (individual or batch processing) to electronic
transfers using third party vendors and clearing agents

• Controls over the settlement processes are key

Third Party Vendors International Clearing Houses

• SWIFT • CHIPS (www.chips.org)
– The Society for Worldwide Interbank Financial Telecommunication (SWIFT) – The largest private-sector US-dollar funds-transfer system in the world
provides a network that enables financial institutions worldwide to send and
receive information about financial transactions in a secure, standardized • CHAPS (www.chapsco.co.uk)
and reliable environment – A Sterling payments scheme that processes and settles in real-time across
its Members’ settlement accounts at the Bank of England

– SWIFT transports financial messages in a highly secure way but does not
• EUROCLEAR (www.euroclear.com)
hold accounts for its members and does not perform any form of clearing or – Euroclear settles domestic and international securities transactions,
settlement. covering bonds, equities, derivatives and investment funds in more than 90
countries
– SWIFT thus does not facilitate funds transfer; rather, it sends payment
orders, which must be settled by correspondent accounts that the • CLEARSTREAM
institutions have with each other. Each financial institution, to exchange
banking transactions, must have a banking relationship by either being a • TARGET
bank or affiliating itself with one (or more) so as to enjoy those particular
business features
Risk Mitigation People Are The Core Of Any Control

• Controls - legal considerations • Expert staff and systems

– FICA
– KYC
• Timely and thorough review
– AML
– Third Party Payments
– E-mail indemnities • Strong management that
– Telephone Recording will resist Front Office
– FAIS Act, Companies Act, etc. pressure

• DR & BCP Testing