Over the last decade, the understanding of risk measurement has become increasingly important as most international banks have adopted Value-at-Risk, economic capital, and risk-adjusted return on capital (RAROC) to control and price their risks. They use these tools to find the loans, trades, and deals that are most profitable, leaving the unprofitable ones for their less sophisticated competitors. The understanding of risk measurement is therefore vital to those who want to manage a bank safely and profitably.
The importance of these risk measurement tools has been greatly magnified by regulators, such as the Federal Reserve and the Bank of England, who plan to start using these concepts to calculate the minimum amount of capital that banks must hold. For competitive and regulatory reasons, it is now necessary for all banks to have a sound risk-measurement framework.
This book was written to address the growing need for easy-to-understand information about how banks can apply effective risk measurement techniques. The goals of this book are the following:
• Provide quick access to the whys and hows of risk measurement.
• Provide easy-to-understand information, including equations and examples, that can be quickly applied to most risk measurement problems.
• Provide information about how risk measurement is used in the management of risk and profitability.
This is a textbook to teach you how to measure risk. The book assumes that you have a general background in science, economics, or finance, and now have a need to quickly understand the field of financial risk analysis. Alternatively you may already have a good understanding of one area of risk but now seek to have an integrated understanding across all types.
The book is deliberately compact so it can be read and understood quickly. It includes background chapters for those unfamiliar with finance and statistics, and includes descriptions of the many techniques that are commonly used in risk measurement. It applies these techniques to the four major risks faced by banks: market risk, credit risk, asset liability mismatch, and operating risk.
The book begins with chapters describing how banks make, and often lose, money. It then describes the two fundamental building blocks of integrated risk measurement: economic capital and RAROC. Chapter 3 reviews the statistical relationships that are commonly used in risk measurement and provides reference material for the rest of the book. It is useful for those readers who do not have a recent working knowledge of statistics.
Market risks arise when the perceived value of an investment falls and is most closely associated with trading operations. The measurement of market risks is covered in Chapters 4 to 11. Chapter 4 gives an overview of the main traded instruments and how they can be valued. This chapter is useful for those readers who are new to the finance industry.
Chapter 5 describes the most common ways to measure market risks: sensitivity analysis (including duration and the Greeks), stress testing, scenario testing, the Sharpe ratio and Value at Risk (VaR). It gives detailed examples using each of the metrics. Of these metrics, VaR has become the standard approach for measuring market risk. Chapter 6 is devoted to explaining the details of the three common approaches to calculating VaR: parametric VaR, historical VaR, and Monte Carlo VaR. We work through increasingly complex examples and compare the strengths of each approach. In Chapter 7 the VaR contribution methodology is used to pinpoint the source of a portfolio’s risk.
Regulators allow banks to use their VaR caculators to set the amount of capital that they hold against market risks. Chapter 8 discusses the procedures required by regulators to test VaR calculators, and Chapter 9 shows how VaR can be used to calculate the economic capital for market risks. Chapter 9 also extends VaR to measure the risk of asset management operations.
Although VaR is the best single metric for market risks, it has several limitations. These limitations, and typical solutions, are discussed in Chapter 10. In Chapter 11 the market risk section concludes by describing how the results of risk measurement are used in risk management, including the procedure for setting VaR limits.
Chapter 12 introduces asset liability management (ALM). ALM is primarily concerned with the interest rate and liquidity risks that are created when commercial banks take in short-term deposits from customers and give out long-term loans. Chapter 12 describes how those risks arise and the risk characteristics of different types of deposits and loans.
The measurement of interest rate risk and liquidity risk for ALM is discussed in Chapters 13 and 14, including gap reports, rate shift scenarios, simulations, and models of customer behaviour.
Chapter 15 uses the ALM concepts to explain funds transfer pricing. This is one of the keys to integrated risk measurement and is a crucial component in measuring risk-adjusted profitability and setting prices to customers. A typical balance sheet is used to illustrate in detail how transfer pricing works.
Credit risk is the possibility of losses due to a counterparty or customer failing to make promised payments. It is covered in Chapters 16 to 23. Chapter 16 discusses the sources of credit risk and how measurement can be used to manage the risks. For readers who are unfamiliar with lending operations, Chapter 17 discusses the ways that credit exposures are structured in commercial and retail lending. It also describes the calculation of credit exposure for derivatives trading operations and gives an introduction to credit derivatives. Chapter 18 shows how the expected loss and unexpected loss for a single loan can be calculated from the probability of default, loss in the event of default, exposure at default and the grade migration matrix. These are the basic building blocks for both economic capital and the New Capital Accords from the Basel Committee.
Chapter 19 discusses the techniques that are used to estimate values for probability of default, loss given default, and exposure at default, including discriminant analysis and the Merton model. It also gives parameter values that can be used as the basis for the reader’s own models. The parameter values are used in examples to demonstrate how the credit risk calculations are used.
Chapters 20 and 21 describe the common methods used to estimate the overall risk for a portfolio, including the covariance approach, the actuarial model, the Merton-based simulation model, the macro economic default model, and the macro economic cash-flow model are used for structured and project finance. The chapters also discuss the different approaches available for estimating default correlations and how the correlations can be used to estimate the unexpected loss contribution and the economic capital for a single facility within a portfolio. The chapters conclude with a section describing how the different models can be combined in a unified framework to create an integrated simulation of all the bank’s risks.
The results for the credit portfolio models are used in Chapter 22 to give risk adjusted performance and pricing for loans. This chapter shows how to calculate the minimum price that should be charged to a loan customer. The analysis also shows how to include multiyear effects such as grade migration. Chapter 23 explains the New Capital Accords being introduced by the Basel Committee on Banking Supervision. This chapter summarizes the history of the Capital Accords, explains Tier I and Tier II capital, and details the three alternative capital calculations that will be allowed under the new accords. The chapter discusses the advantages and disadvantages of adopting each approach and the steps that a bank must take to comply with the new requirements.
Chapter 24 gives an introduction to the different types of operating risk and the approaches being developed to manage and measure these risks. The approaches are categorized as either qualitative, structural, or actuarial. Each approach is described, including key risk indicators and the approaches suggested in the Basel Accords.
The final chapter returns to the bank level and describes how all the models can be linked together to calculate economic capital and risk-adjusted profitability for the bank as a whole, including alternative methods for calculating inter-risk diversification. It concludes with the steps normally required to implement the bankwide measurement of economic capital and RAROC.