Strategies for Excellence

Market Risk Managementby

R. Ravimohan CEO & MD CRISIL

Presentation at FICCI Conference on”Global Banking Paradigm Shift”

On Sept 14, 2003, Bangalore

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What is Risk?

•Risk, in traditional terms, is viewed as a ‘negative’. Webster’s

dictionary, for instance, defines risk as “exposing to danger or hazard”.

•The Chinese give a much better description of risk

>The first is the symbol for “danger”, while

>the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.

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Risk Management

Risk management is present in all aspects of life; It is about the everyday trade-off between an expected reward an a potential danger. We, in the business world, often associate risk with some variability in financial outcomes. However, the notion of risk is much larger. It is universal, in the sense that it refers to human behaviour in the decision making process. Risk management is an attempt to identify, to measure, to monitor and to manage uncertainty.

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FinancialRisks Liquidity Risk

Operational Risk

Regulatory Risk

Human FactorRisk

Market Risk

Equity Risk

Interest Rate Risk

Currency Risk

Commodity Risk

Trading Risk

Gap Risk

Credit RiskPortfolio

Concentration Risk

Transaction Risk Counterparty Risk

Issuer Risk

Types of financial risk

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Understanding Market Risk

It is the risk that the value of on and off-balance sheet positions of a

financial institution will be adversely affected by movements in market rates or prices such as interest rates, foreign

exchange rates, equity prices, credit spreads and/or commodity prices resulting in a loss to earnings and

capital.

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• Convergence of Economies• Easy and faster flow of information• Skill Enhancement• Increasing Market activity

Why the focus on Market Risk Management ?

Leading to

•Increased Volatility•Need for measuring and managing

Market Risks•Regulatory focus•Profiting from Risk

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Best Practicesin

Market Risk ManagementMarket Risk Management

1. Rethinking the Market Risk process

2. Establish Top Management Oversight

3. Deploy Best practices framework

4. Adopt appropriate Organisation Structure

5. Invest in Good Technology

6. Use Hedging techniques Judiciously

7. Ensure Robust Marking to Market

8. Establish good operational processes

9. Measure, Monitor & Manage – Value at Risk

10. Explore quantitative models for default prediction

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1. Rethinking the Market Risk process

Increased reliance on objective risk assessment Increased reliance on objective risk assessment

Align “Risk strategy” & “Business Strategy” Align “Risk strategy” & “Business Strategy”

Investment process differentiated on the basis of risk, not size Investment process differentiated on the basis of risk, not size

Investment in workflow automation / back-end processes Investment in workflow automation / back-end processes

Active Portfolio Management Active Portfolio Management

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2. Establish Top Management Oversight

Board and senior Management Oversight

Delineate banks overall risk tolerance in relation to market risk

Ensure that bank’s overall market risk exposure is maintained at prudent levels and consistent with the available capital

Ensure that top management as well as individuals responsible for market risk management possess sound expertise and knowledge to accomplish the risk management function.

Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of market risk.

Ensure that adequate resources (technical as well as human) are devoted to market risk management.

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Investment & Market Risk Policies should be comprehensive Investment & Market Risk Policies should be comprehensive

Set exposure Limits On Different Parameters – dealer wise,

transaction, instruments, broker, & other counter parties

Set exposure Limits On Different Parameters – dealer wise,

transaction, instruments, broker, & other counter parties

Investment organisation - Independent set of people for front,

mid & back offices

Investment organisation - Independent set of people for front,

mid & back offices

Implement straight - through processing Implement straight - through processing

3. Deploy Best practices framework

Operationalise stop-loss limits Operationalise stop-loss limits

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4. Adopt appropriate Organisation Structure

Organization Structure

The structure should conform to the overall strategy and risk policy set

by the BOD

Those who take risk (front office) must know the organization’s risk

profile, products that they are allowed to trade, and the approved limits.

Apart from BOD responsibility to be assumed by forming following

The risk management function should be independent, reporting

directly to senior management or BOD.

The Risk Management Committee

The Asset-Liability Management Committee (ALCO)

The Middle Office.

Organization Structure

The structure should conform to the overall strategy and risk policy set

by the BOD

Those who take risk (front office) must know the organization’s risk

profile, products that they are allowed to trade, and the approved limits.

Apart from BOD responsibility to be assumed by forming following

The risk management function should be independent, reporting

directly to senior management or BOD.

The Risk Management Committee

The Asset-Liability Management Committee (ALCO)

The Middle Office.

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5. Invest in Good Technology

Cash MgmtAccounting

PaymentsDealingCurrency Interest Rate

Credit Liquidity

Risk

Management

Business

Process

Management

Improved ControlImproved Control

Enhanced ReportingEnhanced Reporting

Improved IntegrationImproved Integration

Enhanced ProductivityEnhanced Productivity

Straight -through Processing

Treasury Integration

Back Office Integration

MarketIntegration

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6. Use Hedging techniques Judiciously

•Interest Rate Swaps

Forward Rate Agreements

Forward Contracts

Currency Options

Equity Derivatives

Equity Options

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7. Ensure Robust Marking to Market

The need arises due to structured products and lack of liquidity results in

the absence of traded prices

The need arises due to structured products and lack of liquidity results in

the absence of traded prices

CRISIL is the official provider of valuation services and appointed by

SEBI / AMFI for the Mutual Fund industry segment

CRISIL is the official provider of valuation services and appointed by

SEBI / AMFI for the Mutual Fund industry segment

In case of non-traded securities, marking to market is critical for

valuation & risk management

In case of non-traded securities, marking to market is critical for

valuation & risk management

In case of active investment management and for risk management,

the periodicity of daily valuation is required

In case of active investment management and for risk management,

the periodicity of daily valuation is required

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8. Establish good operational processes

sound treasury control

liquidity management

position keeping

limit management

risk management

settlement management

treasury accounting

middle office

back office

front office

Complete integration

Align Business strategy and treasury process

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9. Measure, Monitor & Manage

– Value at Risk

Value-at-Risk

Value-at-Risk is a measure of Market Risk, which measures the maximum loss in the market value of a portfolio with a given confidence

VaR is denominated in units of a currency or as a percentage of portfolio holdings

For e.g.., a set of portfolio having a current value of say Rs.100,000- can be described to have a daily value at risk of Rs. 5000- at a 99% confidence level, which means there is a 1/100 chance of the loss exceeding Rs. 5000/- considering no great paradigm shifts in the underlying factors.

It is a probability of occurrence and hence is a statistical measure of risk exposure

Value at Risk

Certainty is 95.00% from 2.6 to +Infinity

.000

.005

.011

.016

.022

0

108.2

216.5

324.7

433

1.5 2.9 4.3 5.6 7.0

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Variance-Variance-covariancecovariance

Matrix

Variance-Variance-covariancecovariance

Matrix

MultiplePortfoliosMultiple

Portfolios

YieldsDurationYields

Duration

Incremental VaR

Incremental VaR

Stop LossStop Loss

PortfolioOptimization

PortfolioOptimization

VaRVaR

Features of CRISIL VaR Model

Facility of multiple methods and portfolios in single modelReturn Analysis for aiding in trade-offFor Identifying and isolating Risky and safe securitiesFor picking up securities which gel well in the portfolioFor aiding in cutting losses during volatile periodsHelps in optimizing portfolio in the given set of constraints

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Managing Market Risk

Questions Internationalpractice

% of Bankswith + veresponse

1. Are all market risks centrallymanaged?

All Market Risks are centrallymanaged by Treasury / GlobalMarkets

100%

2. Do you measure Var of non-trading balance sheet?

Large International banksmeasure / Manage balance sheetRisks actively

0%

3. Is Funds Transfer Pricing policybased on marginal market rates?

Incremental Cost of Fundsreflects in Incremental TransferPricing on Assets / Liabilities

0%

4. Is board / senior managementinvolved in managing Marketrisks?

Board / Management Committeeoverviews the management ofMarket Risk

85%

5. Is there a central unit forimplementing Basle II guidelines?

Basel II is being managed as aproject with a central coordinatorfor the bank

70%

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10. Explore quantitative models for default prediction

Crisil’s Corporate predictor Model (CCOP) is a quantitative model to predict default risk dynamically

Model is constructed by using the hybrid approach of combining Factor model & Structural model (market based measure)

The inputs used include: Financial ratios, default statistics, Capital Structure & Equity Prices.

The present coverage include listed & Crisil rated companies

The product development work related to private firm model & portfolio management model is in process

The model is validated internally

CCoP is one of the most complicated product developed and with the help of in-house technology.

Derivation of Asset value & volatility Calculated from Equity Value , volatility for each

company-year Solving for firm Asset Value & Asset Volatility

simultaneously from 2 eqns. relating it to equity value and volatility

Calculate Distance to Default Calculate default point (Debt liabilities for given

horizon value) Simulate the asset value and Volatility at horizon

Calculate Default probability (EDF) Relating distance to default to actual default

experience

Use QRM & Transition Matrix Calculate Default probability based on Financials Arrive at a combined measure of Default using both

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Effective Management of Market Risk benefits the bank..

Efficient allocation of capital to exploit different risk / reward pattern across business

Better Product Pricing Early warning signals on potential events impacting business Reduced earnings Volatility Increased Shareholder Value

No Gain!No Risk …

To Summarise….

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for further details contact, . . .for further details contact, . . .

D.RavishankarD.RavishankarDirector,Director,Investment & Risk Management ServicesInvestment & Risk Management ServicesCRISILCRISILEmail : Email : dravishankar@crisil.comPh.no: 5653 7531Ph.no: 5653 7531