📊💰🏦📉

MARKET RISK
Bank Financial Management — Chapter 14

📘 CAIIB / Bank Exam Study Notes

Simple Language • Word Meanings • Examples
Big Fonts • Bold Highlights • Easy to Remember
 📑 Table of Contents
1. 14.0 Objectives
2. 14.1 Market Risk — Concept (Mr. X Example)
3. 14.2 Market Risk in Banks (Trading Book)
4. 3 Risks: Market, Liquidity, Credit & Counterparty
5. Trading Liquidity Risk & Asset/Market Liquidation Risk
6. Credit Risk, Counterparty Risk & Settlement Risk (RTGS, CCIL)
7. 14.3 Market Risk Management Framework (4 Questions)
8. 14.4 Organisation Structure (Board, RMC, ALCO, Middle Office)
9. 14.5 Risk Identification (Standard vs Non-Standard Products)
10. 14.6 Risk Measurement — Sensitivity, BPV, Duration
11. Downside Potential, VaR (3 Methods)
12. Why VaR is Useful + Limitations
13. Estimating Volatility, Conditional VaR (ES)
14. Back Testing, Stress Testing (4 Techniques)
15. 14.7 Risk Monitoring & Control
16. 14.8 Risk Reporting
17. 14.9 Managing Trading Liquidity (Mr. X Stock 'A')
18. 14.10 Risk Mitigation Strategies (Sensitivity, Correlation, IRS, Options)
19. Let Us Sum Up + Quick Revision

📚 14.0 — OBJECTIVES OF THIS CHAPTER

💡 What will we learn?
This chapter helps you understand MARKET RISK — the risk banks face when prices in the market
move in the wrong direction!
This chapter will be helpful in understanding:

📘 Concept of Market Risk

🏦 Concept of Risk in Banks
🛠️ Market Risk Management Framework
📊 Market at Risk
📉 Value at Risk and Stress Test
🔄 Back Test and Approach to Market Risk Mitigation
📋 General issues involved
 📊 14.1 — MARKET RISK CONCEPT
📖 The Mr. X Example — Step by Step
💡 In simple words
Market Risk = the risk that you LOSE money because prices in the market MOVE AGAINST YOU (e.g.,
share prices fall when you have bought).

The best way to understand the market risk is to be in the market.

🌟 Mr. X's Investment Story (No Leverage)

Say Mr. X has raised a CAPITAL of ₹10,000 and invests in shares of ABC Ltd. being quoted at ₹100.
So:

💰 He buys 100 shares

📉 Next day, share drops 5% in share price
💸 Portfolio value reduces to ₹9,500
❌ LOSS = ₹500 — directly to the extent of loss incurred by him in market price

📖 Difficult Word Meanings

Capital – money invested/owned for business
Portfolio – collection of investments/holdings
Adverse movement – movement against you, downward
Liquidate – sell assets quickly in advance
Leverage – using borrowed money to invest more
Permissible limit – maximum allowed limit
Asset Liquidity – availability of buyers/sellers in overall market
Market Liquidity – weak buying interest in the overall market
Exposure – investment position or amount at risk
 ⚠️ What if Mr. X had LEVERAGED his capital?
The loss to movement in market price would be MORE if he had leveraged his capital!

🌟 Mr. X — 9x Leverage Disaster

Say Mr. X has ₹10,000 as capital and ₹90,000 as borrowings. Now he is allowed to borrow 9 times
his capital! His total resources amount to ₹1,00,000. If he had invested the entire resources
available to him in the shares of ABC Ltd., i.e., 1,000 shares at ₹100 each:

📉 He would have lost ₹5,000 due to adverse movement

❌ His capital would have been REDUCED BY 50%
💀 In other words, he would have LOST HALF of capital !
Please note that we have not taken into account any transaction costs or cost of borrowing. If we
take these into account, Mr. X would lose much more!

⚠️ The Forced Liquidation Cascade

If we take the capital into account, Mr. X's problems are NOT OVER YET, since he is permitted to raise 9
times his capital as borrowings. Mr. X's capital stands at ₹5,000 only. He has to liquidate his holdings by
₹50,000!

⚠️ The Cascading Disaster

He has to liquidate his holdings by ₹50,000 to bring borrowings within his permissible limit. Now if
the market, anticipating Mr. X's problems, drives the share price further down, resulting in losses,
Mr. X has become illiquid as far as this share is concerned. The risk of asset liquidity would result
in further depletion of capital requiring further liquidation of his holdings.

He would also face the same situation, if in further losses that would result in further depletion of
capital requiring further liquidation. The lack of result in further losses in the meanwhile the
market had undergone a change for the worse. The lack of result in further losses in the market
would have driven the share price further down, resulting in losses!

🎯 The 3 Risks Mr. X Faced

Mr. X has in fact faced the following risks by taking an exposure on a security that is being traded in the
market:

🎯 THE 3 RISKS (MEMORISE!)

1. 📉 Risk of ADVERSE MOVEMENT in the price in the market for a specific security = PRICE
RISK → Premoves against you, you lose money
2. 💧 Risk of REDUCED LIQUIDITY in the market for a specific security = MARKET LIQUIDITY
RISK
3. 🌊 Risk of POOR MARKET LIQUIDITY – weak buying interest in the overall market = ASSET
LIQUIDITY RISK → Poor market liquidity

⚖️ The Two Sides — Profit OR Loss

Of course, Mr. X would have made profits if the price had moved favourably and that had been the
motivation for him to be in the market in the first place. But these are the risks that he is taking the
moment he invests in market traded securities!

💭 Imagine what would have happened if share prices of ABC Ltd. had fallen by 10%! Well, his
entire capital would have been WIPED OUT , resulting in him being OUT OF this business!

⭐ Mr. X, before he enters this business should have a FRAMEWORK that provides him with:

1. (a) An APPROACH to manage the risks

2. (b) A MEASURE of risk that can tell him about the possible downside potential (POSSIBLE
LOSS)
 🏦 14.2 — MARKET RISK IN BANKS
💡 In simple words
Just like Mr. X (an individual), BANKS too have several activities that result in market exposure. They
are NOT immune to these risks!

Similar to the example given above of an individual, Banks also have several activities and undertake
transactions that result in market exposure. They are not immune to these risks and have to face them
too. All such transactions are reflected in the TRADING BOOK.

📚 What is a Trading Book?

📌 TRADING BOOK
A trading book consists of a bank's PROPRIETARY POSITIONS in financial instruments covering:

📋 TRADING BOOK COMPONENTS

📜 Debt Securities
📊 Equity
💱 Foreign Exchange
🌾 Commodities (NOT permitted in our country presently)
📈 Derivatives held for Trading
The trading book also includes positions in financial instruments arising from matched principal brokering
and market making, or positions taken in order to hedge other elements of the trading book.

📖 Word Meanings
Proprietary positions – positions where bank itself holds (own account)
Hedge – to protect against loss
 Matched principal brokering – matching buyers and sellers
Adverse changes – unfavourable changes

🎯 Trading Intent
The proprietary positions are held with TRADING INTENT and with the intention of BENEFITING in the
SHORT-TERM from actual and/or expected differences between their buying and selling prices or hedging
other elements in the trading book.

⚠️ Bank's 3 Main Risks

A bank's trading book exposure has the following risks, which arise due to adverse changes in the market
variables such as interest rates, currency exchange rate, Commodity prices, market liquidity, etc., and
their volatilities impact the bank's earnings and capital adversely.

🎯 THE 3 MAIN RISKS (MEMORISE!)

1. 📊 MARKET RISK
2. 💧 LIQUIDITY RISK
(a) Asset Liquidity Risk
(b) Market Liquidity Risk
3. 💳 CREDIT and COUNTERPARTY risks

NOTE: The market liquidity risk is DIFFERENT from FUNDING the LIQUIDITY RISK that arises due to
ASSET-LIABILITY MISMATCH and is a subject matter of Asset Liability Management!
 📉 RISK 1 — MARKET RISK
📌 MARKET RISK
Market Risk is the risk of ADVERSE DEVIATIONS of the MARK-TO-MARKET (MTM) value of the
trading portfolio, during the period required to liquidate the transactions!

📋 Key Points About Market Risk

Market movements, during the period required to liquidate the transactions, are critical to assess such
adverse deviations. If the period of liquidation of the position gets longer, the possibilities of larger
adverse deviations from the current market value also increase!

📖 Mark-to-Market (MTM)
Mark-to-Market = valuing your position at CURRENT MARKET PRICE daily (not the price at which
you bought)!

Earnings for the market portfolio are the profit or loss arising from transaction. The profit or loss
between two dates are the variation in the market value. Any decline in value, results in a market loss.

⏱️ Liquidation Period Varies By Instrument

However, it is possible to liquidate tradable instruments or to hedge their future changes of value at any
time. This is the rationale for limiting market risk to the liquidation period. The period varies with the type
of instrument. It could be:

📅 SHORT (1 day) for foreign exchange and much longer

📅 MUCH LONGER period for "exotic" derivatives
NOTE: Market risk does NOT REFER to market losses due to causes other than market movements,
loosely defined as 'LIQUIDITY RISK' . Any deficiency in the monitoring of the market values
deviating by any magnitude until liquidation finally occurs. In the meantime, the potential deviations
can exceed by far any deviation that could occur within a short liquidation period. This risk of NOT
MONITORING the market or not monitoring with due care is an OPERATIONAL RISK, NOT a market
risk!
 💧 RISK 2 — TRADING LIQUIDITY RISK
📌 TRADING LIQUIDITY
Trading liquidity is the ABILITY to FREELY TRANSACT in markets at reasonable prices. Trading
liquidity is the ability to liquidate positions WITHOUT:

1. 📊 Affecting market prices

2. 👀 Attracting the attention of other market participants

📊 Trading Liquidity vs Market Liquidity

Trading liquidity allows one to transact WITHOUT compromising on counter-party quality. Liquidation
involves asset and market liquidity risks. Price volatility is NOT the same in:

✅ HIGH-LIQUIDITY environment, vs
❌ POOR-LIQUIDITY situations
When liquidity is high, the adverse deviations of prices are much LOWER than in a poor-liquidity
environment, within a given horizon. 'PURE' market risk , generated by changes of market parameters
under fair liquidity situations, differs from market liquidity risk!

📈 Liquidity in Emerging Markets

This interaction raises important issues. What is the 'NORMAL' volatility of market parameters under fair
liquidity situations? What could it become under poorer liquidity situations? How sensitive are the prices
to liquidity crises?

Prices in emerging markets often DIVERGE CONSIDERABLY! Liquidity issue becomes critical in
emerging markets. Liquidation risk arise from a theoretical 'fair value'. Liquidation risk arise from
LACK of TRADING LIQUIDITY and results in:

📉 Adverse change in market prices

❌ Inability to liquidate position at a fair market price
 💸 Large price changes caused by liquidation of position
🚫 Inability to liquidate position at any price

💧 Asset Liquidation vs Market Liquidation Risk

📊 Asset Liquidation Risk
Asset liquidation risk refers to a situation where a SPECIFIC ASSET faces LACK of TRADING
LIQUIDITY and trade taking place for other asset classes! There is good liquidity in the overall
market, but the specific asset is illiquid.

🌊 Market Liquidation Risk

Market liquidation risk refers to a situation when there is a GENERAL LIQUIDITY CRUNCH in the
market, which affects trading liquidity adversely and market becomes SHALLOW!

📖 Word Meanings
Liquidity – ability to convert to cash quickly
Crunch – sudden shortage
Shallow market – very few buyers and sellers
Diverge – move apart
 💳 RISK 3 — CREDIT & COUNTERPARTY RISKS
🏦 Credit Risk
📌 CREDIT RISK
Markets value the credit risk of issuers and borrowers and it reflects in prices. Credit risk of:

💰 Debts (such as bonds and debentures)

📜 Commercial papers, etc.
...is indicated by 'CREDIT RATING' assigned by rating agencies.

💡 In simple words
Credit rating indicates the risk level associated with the instruments and is factored into add-ons to
the risk-free rate of the corresponding maturity. The LOWER the risk level, the LOWER the spread
over risk-free rate!

📊 Credit Risk Migration

Credit risk may arise either on account of DEFAULT of the issuer/borrower OR because of RATING
DOWNGRADE (rating migration). When rating of a financial instrument is lowered, the spread over the
risk-free rate increases. The market demands higher yield on a higher risk instrument. Since yield goes up,
this results in DECLINE IN PRICE of the instrument!

Where a default in payment of either the installment (EMIs) OR the price of the financial
instrument arises because of deterioration of the credit quality of the financial instrument
deteriorates. Here the adverse impact on the credit quality of the instrument arises because of
deterioration of the credit quality of the issuer/borrower.

🔁 Derivatives & Credit Risk

Derivatives can be OVER-THE-COUNTER (OTC) instruments (interest rate swaps, currency swaps, options)
— NOT as liquid as the other market instruments. Theoretically, banks hold these assets until maturity,
and bear the credit risk since they exchange flows of funds with counterparties subject to default risk.

💡 For Derivatives
Credit risk interacts with market risk in that the mark to market (liquidation) value depends on
market rates. For derivatives, on a derivative arises when mark to market value is negative. It is
interesting to note that credit risk movements is the present value of all future flows at market
rates.

📈 Mark-to-Market Movements
📈 When mark to market value is POSITIVE, counterparty is exposed to credit risk as he carries a
receivable

📉 When mark to market value is NEGATIVE, implying a receivable from the counterparty
Under a 'HOLD TO MATURITY' view , the potential future values exposure because they are the values of
all future flows that the counterparty may not pay. This risk is termed as COUNTERPARTY RISK.

💰 Current Credit Risk Exposure

The current credit risk exposure is the CURRENT LIQUIDATION VALUE. There is the ADDITIONAL RISK due
to the potential upward deviations of liquidation value from the current value during the life of the
instrument.

💭 Such drifts depend on the market parameter volatilities and on the instrument's sensitivity. In
other words, the value of a financial instrument varies depending upon the market factors; the
credit risk amount also varies.

🏛️ Settlement Risk & RTGS

In a market transaction, there is ONE PARTY that PAYS money and RECEIVES a given quantity of financial
papers. The other party or the counterparty does the OPPOSITE!
⚠️ Settlement Risk
The counterparty receives the money and parts with the given quantity of financial papers. If any
one of the transacting party defaults in completing the settlement, the other party suffers. This is
known as SETTLEMENT RISK ! This risk may lead to SYSTEMIC RISK.

In India, the Reserve Bank of India has since put in place a RISK-FREE SETTLEMENT SYSTEM in
place — 'REAL TIME GROSS SETTLEMENT SYSTEM' (RTGS) for the purpose!

In markets like government securities, foreign exchange, etc., where RTGS cannot be used for
settlement, central counterparties such as the CLEARING CORPORATION OF INDIA (CCIL) are used
to mitigate the settlement risk.

📖 Word Meanings
Settlement – completion of a trade (paying and receiving)
Systemic risk – risk that affects the whole system
RTGS – Real Time Gross Settlement System
CCIL – Clearing Corporation of India Ltd.
Counterparty – the other party in a transaction
OTC – Over the Counter (not on exchange)
 🛠️ 14.3 — MARKET RISK MANAGEMENT
FRAMEWORK

🎯 4 Key Questions
💡 In simple words
Market risk management involves answering 4 KEY QUESTIONS! These are the 4 PILLARS of risk
management.

📋 THE 4 KEY QUESTIONS

A. What are the risks?
B. What is the quantum? How much could the price change? What would be the effect on
profit and loss?
C. How can we monitor and control price risk?
D. Can we reduce the risk? And, if so, then how?

📋 4 Components of Risk Management

Management, management processes are designed essentially to answer these questions. Accordingly,
management processes are SUB-DIVIDED into the FOLLOWING 4 PARTS:

⚙️ 4 RISK MANAGEMENT COMPONENTS (MEMORISE!)

1. 🔍 Risk Identification
2. 📏 Risk Measurement
3. 👁️ Risk Monitoring and Control
4. 🛡️ Risk Mitigation
An effective market risk management framework in a bank comprises of risk identification, setting up of
limits and triggers, risk monitoring, models of analysis that value positions or measure market risk, risk
reporting, etc.

Financial instruments take their price from the market and that depends upon the INTERACTION OF
MARKET VARIABLES. Hence, market risk management processes do not have a RISK PRICING
PROCESS. But, management of market risk needs an ORGANISATION STRUCTURE in place that can
carry out the functions required for the purpose!
 🏛️ 14.4 — ORGANISATION STRUCTURE
💡 In simple words
Banks need a PROPER STRUCTURE with clear roles for managing market risk. It starts from the TOP
(Board) down to the working level (Middle Office)!

Management of market risk is a major concern of the top management of banks. Successful
implementation of risk management process emanates from the top management in the bank. The main
challenge centres on facilitating implementation of risk and business policies simultaneously in a
consistent manner.

Modern best practices consist of setting risk limits based on economic measures of risk while ensuring
the best risk adjusted return keeping in view the capital that has been invested in the business. It is a
question of taking a balanced view on risks and returns and within the constraints of available capital.

🏢 Market Risk Management Organisation

🏛️ MARKET RISK MANAGEMENT ORGANISATION STRUCTURE (MEMORISE!)
1. 👥 The Board of Directors
2. ⚖️ The Risk Management Committee
3. 💰 The Asset-Liability Management Committee (ALCO)
4. 📊 The ALM Support Group / Market Risk Group
5. 🎯 The Middle Office

👥 Role of the Board of Directors

The Board of Directors has the OVERALL RESPONSIBILITY for management of risks. The Board articulates
the market risk management policies and procedures, the aggregate risk limits, the review mechanisms
and the reporting and auditing systems. The Board should decide the risk management policy of the
bank and set limits for liquidity, interest rate, foreign exchange, and equity-price risks.
⚖️ The Risk Management Committee
📌 RISK MANAGEMENT COMMITTEE (RMC)
The Risk Management Committee is a BOARD LEVEL SUB-COMMITTEE. The responsibilities of Risk
Management Committee with regard to market risk management aspects include:

📋 RMC RESPONSIBILITIES (5 POINTS)

1. 📜 Setting guidelines for market risk management and reporting
2. ✅ Ensuring that market risk management processes conform to the policy
3. 📏 Setting up prudential limits and their periodical review
4. 🔧 Ensuring robustness of measurement of risk models
5. 👨‍💼 Ensuring proper manning for the processes

💰 ALCO — Asset-Liability Management Committee

📌 ALCO
The Asset-Liability Management Committee (ALCO) is responsible for IMPLEMENTATION of risk and
business policies simultaneously in a consistent manner and decides on the business strategy to
achieve these objectives. Its role encompasses the following:

📋 ALCO ROLE (8 FUNCTIONS — MEMORISE!)

1. 💲 Product pricing for deposits and advances
2. 📊 Protecting and improving the NIM (Net Interest Margin) of the bank
3. 📈 Maturity profile and mix of incremental assets and liabilities
4. 💹 Articulating interest rate view of the bank
5. 💵 Funding policy
6. 👁️ Monitoring the liquidity position of the bank and the industry and taking steps to protect
the bank from coming under any liquidity trap/risk
7. 🔄 Transfer pricing
 8. 📋 Balance sheet management
It sets up operating prudential limits and is the review authority for the line management.

📊 ALM Support Groups

The ALM Support Groups analyses, monitors and reports the risk profiles to the ALCO. It also examines
the effects of various possible changes in market variables and recommends the action needed.

🎯 The Middle Office

📌 MIDDLE OFFICE
The Middle Office, which normally OVERSEAS the risk profile of the integrated treasury of bank, is
responsible for the critical functions of independent market risk monitoring, measurement,
analysis, and reporting to ALCO.

Middle Office provides the independent market risk assessment which is critical to ALCO's key-function
of controlling and managing market risks in accordance with the mandate established by the Board/Risk
Management Committee. Middle Office functions independently of the treasury function. It also
independently validates the prices in respect of treasury deals, more particularly in respect of structured
products.
 🔍 14.5 — RISK IDENTIFICATION
💡 In simple words
Before you can manage risk, you must FIRST IDENTIFY what risks exist! Standard products have
known risks; non-standard products need closer analysis!

All products and transactions should be analysed for risks associated with them. While various risks
associated with a STANDARDISED product stand analyzed, the risks in case of a NON-STANDARD product
need to be analysed more closely. Therefore, the approach to deal in standard and non-standard products
differs!

📋 Standard vs Non-Standard Products

We have seen under the general approach to risk management that the guidance for risk taking differs at
the transaction level comes from the corporate level. It applies to the management of market risk too.

✅ Standard Products
Usually all standard products would have an APPROVED 'PRODUCT PROGRAMME' for each of them! All
Risk-Taking Units operate within an approved 'Product Programme'. Units and controls for all aspects of
the product. The Product programme defines procedures, limits and controls for all aspects of the
product. The product programme also specifies market risk measurement at an individual product level
and at aggregate portfolio level.

⚠️ Non-Standard Products
New products or non-standard products may operate under a 'PRODUCT TRANSACTION
MEMORANDUM' on a temporary basis while a full Market Risk Product programme is being prepared!

Products approved at corporate level shall provide for screening procedures, appropriate
safeguards, product-wise limit on exposure, and necessary guidelines on risk taking. In fact, the
guidelines help in standardising risk content in the business undertaken at the transaction level.
Any new product or any deviation from the directed procedures and safeguards add to the risk
content of the exposure and needs a clearance at the corporate level where risk return
characteristics and risk quantification forms the basis of decision-making. Impact of risk taking at
TRANSACTION level on the PORTFOLIO RISK is the CRITICAL ISSUE here !
 📏 14.6 — RISK MEASUREMENT
💡 In simple words
How do we MEASURE risk? We use numbers and formulas to quantify how risky something is!

Market risk management framework is HEAVILY DEPENDENT upon the quantitative measures of risk. The
market risk measures seek to capture variations in market value arising out of UNCERTAINTIES associated
with market risk elements.

These provide an OBJECTIVE MEASURE of market risk in a transaction or of a portfolio. Market risk
measures are based on:

📊 2 MAIN RISK MEASURES

1. 📐 SENSITIVITY
2. 📉 DOWNSIDE POTENTIAL

📐 1. Sensitivity
📌 SENSITIVITY
Sensitivity, as had been stated in 'Unit-1', captures DEVIATION OF MARKET PRICE due to UNIT
MOVEMENT of a single market parameter. Supply-demand position, interest rate, market liquidity,
inflation, exchange rate, stock prices, etc., are the market parameters which drive market values.

🌟 Sensitivity Example
Change in interest rate would drive the market value of bonds and forward foreign exchange held
in a portfolio. If liquidity rate would drive the market value of bonds and forward foreign exchange
held in a portfolio, in turn may increase the market price.

Sensitivity is measured as change in market value due to unit change in the variable. For example,
the interest rate sensitivity of the portfolio is Rs. 1,00,000 for 1% change in the rate of interest,
 where the market value of a portfolio changes by Rs. 1,00,000. This gives us a measure of risk
associated with interest rate sensitivity vis-à-vis change in rate of interest.

📖 Word Meanings
Sensitivity – how much price changes for 1 unit change in market variable
Vis-à-vis – in relation to
BPV – Basis Point Value
Yield – the return on a bond
Coupon – interest paid on a bond

⚠️ Limitation of Sensitivity
This measure suffers from the fact that it does NOT consider the impact of the other parameters, which
may also change simultaneously! Secondly, the measure does not remain constant for all the values of the
variable.

🌟 Bond Yield Example

Say, the interest rate sensitivity of a bond is Rs. 100 when the yield on the bond is 5%. If the yield on
the bond rises to 8%, its interest rate sensitivity would NOT remain at Rs. 100!

Nevertheless, sensitivity is relied upon as a measure, particularly in those cases that are based on changes
in interest rates. Two of them — BASIS POINT VALUE (BPV) and DURATION that are used quite frequently,
are discussed below.

💹 2. Basis Point Value (BPV)

📌 BASIS POINT VALUE (BPV)
BPV is the CHANGE IN VALUE due to 1 BASIS POINT (0.01%) change in the market yield! This is used
as a measure of risk. The HIGHER the BPV of a bond, the HIGHER is the risk associated with the
bond. Computation of BPV is quite simple.

🌟 BPV Example
 For example, a 5-year 6% semi-annual bond @ market yield of 8%, has a price of Rs. 92. So, for one
BP fall in yield, market price changes by Rs. 0.02 or gains to Rs. 92.10 at a yield of 7.95%. So, for one
BP fall in yield, market price changes by Rs. 0.02 or gains to Rs. 2,000 per Rs. 1 crore face value.
BPV of the bond is, therefore, Rs. 2,000 per crore face value .

📐 Formula
BPV = Change in Bond Price for 0.01% change in yield

This also helps us to quickly calculate profit or loss for a given change of yield. If the yield on a bond with
BPV of Rs.2,000 declines by 8 BPs, then that would result in a profit of 8 × 2000 = Rs. 16,000 per crore of
face value. If one is holding Rs. 10,00,000 face value of this bond, he makes a profit of Rs. 1,600.

BPV changes with the remaining maturity. Suppose the bond described above has 5 years to mature
and the present BPV is 2000, the BPV will DECLINE WITH TIME and on the day of maturity it will be
ZERO !

⏳ 3. Duration (Macaulay's Duration)

📌 MACAULAY'S DURATION
Macaulay's Duration was first proposed by Frederick Macaulay in 1938 as a means of describing a
bond's PRICE SENSITIVITY to yield change with a single number! This is equivalent to time, on
average, that the holder of the bond must wait to receive the PRESENT VALUE OF THE CASH
FLOWS.

🌟 Duration Example — RBI Bond

Assuming, RBI has today issued a Bond for Rs. 100/- for 3 years with a coupon of 8% and interest is
paid annually. Let us assume Coupon and interest rate are same. The cashflows and the present
value of the cashflows are captured in the table given below:

📊 BOND CASH FLOW TABLE

Year Cash Flow Interest Rate Revised Price Year × Revised
 1 8 8/1.08 7.40 7.40

2 8 8/1.08² 6.86 13.72

3 108 108/1.08³ 85.74 257.22

TOTAL 100.00 278.34

📐 Duration Formula
Duration = Cumulative Revised Price / Revised Price

Duration = 278.34 / 100 = 2.7834 years

= 2 years, 9 months & 12 days

In other words, duration represents cash flow 'CENTRE OF GRAVITY' ! It implies that if a 5-year 6%
bond face value of Rs. 100 with semi-annual interest has Macaulay's duration say 3.7 years, then
total cash flow to be received over the five-year period of Rs. 130 from the bond would be
equivalent to receiving Rs. 130 at the end of 3.7 years as a bullet payment.

📐 Modified Duration
📌 MODIFIED DURATION
Modified duration is Macaulay's duration discounted by 1 PERIOD YIELD to maturity. By definition,
Modified Duration measures the change in the price of a bond, given a yield change of 1% or 100
basis points!

📐 Modified Duration Formula

Modified Duration = Duration / (1+r)

Applying the formula:

= 2.7834 / 1.08
= 2.57
 ⭐ Modified Duration signifies that if the bond yield changes from 8% to 7%, the price of the bond
would go up by Rs. 2.57 or vice versa!

📊 Duration & Price Sensitivity

The longer the duration of a security, the greater will be the price sensitivity to yield changes! The longer
would be the risk associated with the bond. Bond price changes can be estimated with the help of higher
duration by using the following relationship:

📐 Approx % Change Formula

Approx % change in price = − (Modified Duration) × (Yield Change)

🌟 Duration Example — Calculation

We can apply the formula for the above yield change from 8% to 7% as follows:

Yield change is represented by the symbol -1%

Minus × minus makes the output as +, that is, −2.57 × −1% = +2.57

It means we have to add the price change with the original price of the bond, that Rs. 100/-. So,
when the interest falls from 8% to 7%, the price of the bond would go up from Rs. 100/- to Rs.
102.57!
 📉 4. DOWNSIDE POTENTIAL & VALUE AT RISK
(VaR)

📉 Downside Potential
📌 DOWNSIDE POTENTIAL
Risk materializes ONLY when earnings deviate ADVERSELY ! Downside potential captures the
POSSIBLE LOSSES only and IGNORES the PROFIT POTENTIAL. Downside risk is the MOST
COMPREHENSIVE measure of risk!

Downside risk integrates sensitivity and volatility with the adverse effect of uncertainty. This is the
measure that is most relied upon by banking and financial service industry as also the regulators!

💎 Value at Risk (VaR)

💡 In simple words
VaR answers the question: "HOW MUCH CAN I LOSE in normal market conditions?" It's a NUMBER
that tells you the maximum likely loss!

Management of market risk is concerned with the question — "How much can we lose?" The answer is
that there is a possibility that we can lose everything, although it may have a VERY LOW PROBABILITY.
VaR attempts to create a more useful answer by altering the question — "How much can we expect to
lose?"

🌟 VaR Example
The answer could be that we can lose a maximum of Rs. X (the VaR) over the next week (time
horizon) and may expect that with 99% CONFIDENCE (i.e., it would be so 99 times out of 100). The
loss potential!
 📌 VAR DEFINITION
VaR is defined as the predicted WORST-CASE LOSS at a specific confidence level over a certain
period of time assuming 'NORMAL TRADING CONDITIONS'!

🌟 VaR Numerical Example

A bank having 1 day VaR of Rs. 10 crore with 99% confidence interval means that there is only one
chance in 100 (or 2.5 days per year based on 250 working days in a year) that daily loss will be more
than Rs. 10 crore under normal trading conditions. This also means that there is 1% chance that the
daily loss may exceed Rs. 10 crore under normal trading conditions!

It does NOT estimate losses in ABNORMAL situations. VaR measures the potential loss in market value
under normal circumstances of a portfolio using estimated volatility (rate or price move) and correlations
(how rates or prices move in relation to each other) measured with a given confidence interval.

📅 Longer the time horizon, more is the VaR

📊 In calculating VaR, we consider the volatility of prices and correlation of prices and
correlation of prices with respect to the fact that VaR is not a measure when the assets/liabilities
in the portfolio. Normal circumstances refer to when the market is under ABNORMAL
CONDITIONS!

📊 Yield Vs. Price Volatility

📌 YIELD VOLATILITY
Yield volatility is the DEGREE of VARIANCE in YIELD. This is largely UNAFFECTED by TIME and
DURATION. Yield volatility rises as yields fall.

📌 PRICE VOLATILITY
Price volatility is degree of variance in price. This is largely UNAFFECTED by yield and substantially
affected by time and duration.
 📐 Price Volatility Formula
Price Volatility = (Yield Volatility) × BPV × (Yield/Price)

🔢 Three Approaches to Calculating VaR

📊 3 METHODS TO CALCULATE VAR (MEMORISE!)
1. 🧮 The Correlation Method (also known as Variance/Covariance Matrix method)
2. 📜 Historical Simulation
3. 🎲 Monte Carlo Simulation

All the three methods are based on 3 BASIC PARAMETERS:

⏰ The HOLDING PERIOD

🎯 The CONFIDENCE INTERVAL
📅 The HISTORICAL TIME HORIZON over which the asset prices are observed
🧮 1. Correlation Method
Under the correlation method, the change in the value of the position is calculated by combining the
sensitivity of each component to price changes in the underlying asset(s), with a variance/covariance
matrix of the various components' volatilities and correlation. It is a DETERMINISTIC APPROACH.

📜 2. Historical Simulation
The historical simulation approach calculates the change in the value of a portfolio using a sample of
historical movements of the underlying asset(s), but starting from the current value of the asset. It does
not need a variance/covariance matrix. The length of the historical period chosen does impact the
results, because if the period is too short, it may not capture the full variety of events and relationships
between the various assets and within each asset class, and if it is too long, may be too stale to predict
the future.
 Advantage: It does not require the user to make any explicit assumptions about correlations and the
dynamics of the risk factors because the simulation follows every historical move.

Disadvantage: This method is that it is EXPECTING the market to behave in the SAME MANNER as
it behaved in the past, which may not come true!

🎲 3. Monte Carlo Simulation

The Monte Carlo simulation method calculates the change in the value of a portfolio using a sample of
RANDOMLY GENERATED price scenarios! Here the user has to make certain assumptions about market
structures, correlations between risk factors and the volatility of these factors. He is essentially imposing
his views and experience as opposed to the naïve approach of the historical simulation method.

💭 At the heart of all three methods is the MODEL! The closer the models fit economic reality, the
more accurate the estimated VaR numbers and therefore the better they will be at predicting the
true VaR of the firm. There is no guarantee that the numbers returned by each VaR method will be
anywhere near each other!

✅ Why VaR is Useful?

📋 7 REASONS VAR IS USEFUL
1. 🎯 Good tool for all banks, financial institutions, multinationals, fund managers for
protection of customers, shareholders, employees
2. 📊 Translates portfolio exposures into potential impact on Profit and Loss
3. 📈 Aggregates and reports multi-product, multi-market exposures into ONE NUMBER!
4. 📜 Meets external risk management disclosure requirements
5. ⭐ A vital component of current best practices in risk measurement
6. 👥 Embraced by practitioners, regulators and academicians
7. 📉 Valuable as a probabilistic measure of potential losses
 ⚠️ Limitations of VaR
VaR is NOT WORST-CASE scenario! It does NOT measure losses under any particular market conditions.
VaR by itself is NOT sufficient for risk measurement. Measures to get over the limitations of VaR include:

🔄 Back testing
📊 Model calibration
📈 Scenario analysis
⚡ Stress testing
👁️ Role of VaR in Control and Monitoring
VaR is used as an MIS TOOL in the trading portfolio to 'SLICE AND DICE' risk by
levels/products/geographic level of organisation, etc. It is also used to set risk limits.

In its strategic perspective, VaR is used for decisions as to what business to do and what NOT to do.
However, VaR as a useful MIS tool has to be 'BACK TESTED' by comparing each day's VaR with accruals
and necessary re-examination of assumptions needs to be made so as to be close to reality.

VaR, therefore, CANNOT SUBSTITUTE sound management judgment. It is used to measure and
manage market risks in internal control and other complementary methods. Volatility also does
NOT capture unexpected events or "EVENT RISK"! All these complicate the estimation of volatility.
VaR, therefore, should be used in combination with "BACK TESTING" and "STRESS TESTS" to take
care of event risks. Stress test takes into account the worst-case scenario.

📊 Estimating Volatility
VaR uses past data to compute volatility. Different methods are employed to estimate volatility. One of
the methods is the arithmetical moving average method. The other is the EXPONENTIAL MOVING
AVERAGE method.

In the exponential moving average method, the volatility estimates rise faster to shocks and decline
gradually. Further, different banks take different number of days of past data to estimate volatility.
Volatility also does not capture unexpected events or "event risk". All these complicate the estimation of
volatility.

📊 Conditional VaR (Expected Shortfall)

📌 CONDITIONAL VAR (CVAR / EXPECTED SHORTFALL — ES)
We have already seen that even though VaR is a good risk measurement measure, this has to be
supported by two arms — BACK TESTING and STRESS TESTING. One more drawback of VaR is that it
cannot measure risk under abnormal conditions. To overcome this, risk experts have come out with
a SLIGHTLY DIFFERENT and IMPROVED risk measure which is called as 'CONDITIONAL VaR' or
EXPECTED SHORTFALL (ES) method!

This measure considers SEVERE LOSSES which lies BEYOND the confidence level assumed by the
stakeholder. ES ensures capturing of a portion of TAIL RISK which falls beyond VaR. Therefore,
Conditional VaR is also called Expected Shortfall — ES of the financial system beyond VaR.

Calculating CVaR is simple once VaR has been calculated and then it is the average of the values that fall
beyond the VaR. Risk experts are fine tuning this risk measure and once perfected, regulators world over
may switch to this new risk measure!

🔄 Back Testing
📌 BACK TESTING
Back testing is a process where MODEL BASED VaR is COMPARED with the ACTUAL performance of
the portfolio. This is carried out for evaluating a new model or to assess the accuracy of the existing
models.

Back testing for evaluating a new model requires comparison with the actual performance on a
continuous basis for a given period.

📋 Assessment of Existing Models

Assessment of accuracy of an existing model needs back testing on a regular basis. Banks should back test
risk models on a monthly or quarterly basis to verify accuracy. In these tests, they should observe
whether trading results fall within pre-specified confidence bands as predicted by the VaR models. If the
models perform poorly, they should probe further to find the cause (e.g., check integrity of position and
market data, model parameters, methodology).

The BIS outlines back testing best practices in conjunction with the January 1996 publication
"Supervisory framework for the use of back testing" in conjunction with the internal models approach
to market risk capital requirements.

⚡ Stress Testing
💡 In simple words
Stress testing = TESTING the portfolio under EXTREME scenarios! Like, what if there's a market
crash? What if interest rates spike?

Market value of a portfolio varies due to the movement of market parameters such as interest rate,
market liquidity, inflation, exchange rate, stock prices, etc. Movement in market parameters, on a day-
to-day basis causes the change in the market value of the portfolio. This represents the normal risk that is
associated with normal day-to-day movements. There remains the risk of a LARGE NON-NORMAL
movement in market parameters that signifies abnormal market conditions.

Risks arising due to such movements fall beyond the day-to-day risk monitoring but that could potentially
occur. Stress testing essentially seeks to determine possible changes in the market value of a portfolio
that could arise due to non-normal movement in one or more market parameters. The process involves
identifying market parameters to stress, the quantum of stress and determine the time frame. Once these
are determined, it is applied on the portfolio to assess the impact on it.

🎯 4 Stress Testing Techniques

⚡ 4 STRESS TESTING TECHNIQUES (MEMORISE!)
1. 📊 Simple Sensitivity Test
2. 📜 Scenario Analysis
3. 💀 Maximum Loss
4. 📈 Extreme Value Theory
 📊 1. Simple Sensitivity Test
📌 SIMPLE SENSITIVITY TEST
A simple sensitivity test isolates the SHORT-TERM IMPACT on a portfolio's value of a series of
PREDEFINED MOVES in a particular market risk factor!

🌟 Example
For example, if the risk factor is EXCHANGE RATE, the shocks may be exchange rate changes of +/−
2%, 4%, 6% and 10%. It means that among the host of factors that impact the market, only one or
two factors are taken as input and stress test is conducted based on these one or two factors.

📜 2. Scenario Analysis
📌 SCENARIO ANALYSIS
Scenario analysis specifies the SHOCKS that might PLAUSIBLY affect a number of market risk
factors simultaneously, if an extreme, but possible, event occurs!

It seeks to assess the potential consequences for a firm of an extreme, but possible, state of the world.
Historical scenarios use a structure of shocks that occurred in specific historical episodes. Hypothetical
scenarios employ shocks that are thought to be plausible in some foreseeable, but unlikely circumstances
for which there is no exact parallel in recent history. Scenario analysis is currently the leading stress
testing technique.

💀 3. Maximum Loss
📌 MAXIMUM LOSS
Maximum loss approach assesses the risks of a portfolio by IDENTIFYING THE MOST POTENTIALLY
DAMAGING combination of moves of market risk factors!

Risk managers who use such 'maximum loss' approaches find the combination of exposures the output of
such exercises to be instructive but they tend not to rely on the results of such exercises in the setting of
exposure limits in any systematic manner, an implicit recognition of the arbitrary character of the
combination of shocks captured by such a measure.

📈 4. Extreme Value Theory (EVT)

📌 EXTREME VALUE THEORY (EVT)
Extreme value theory is a means to better capture the RISK of LOSS in EXTREME but POSSIBLE
circumstances! EVT is the statistical theory on the behaviour of the 'TAILS' (i.e., the very high and
low potential values) of probability distributions.

Because it focuses only on the tail of a probability distribution, the method of probability is more flexible.
For example, it can accommodate skewed and fat-tailed distributions. A problem can be more value
approach is adapting it to a situation where many risk factors drive the underlying with the extreme
distribution. Moreover, the usually unstated assumption that extreme events are not correlated with the
extreme distribution. Despite these drawbacks, EVT is notable for being the only stress test technique
that attempts to attach a PROBABILITY to stress test results!

✅ What Makes a Good Stress Test?

📋 A GOOD STRESS TEST SHOULD...
📌 Be relevant to the current position
📊 Consider changes in all relevant market rates
🔄 Examine potential regime shifts (whether the current risk parameters will hold or
breakdown)

💧 Consider market illiquidity

🔗 Consider the interplay of all risks and more particularly market and credit risk
✅ It should help the management to be FORWARD LOOKING!

📊 How Should Risk Managers Use Stress Test?

Stress tests produce information summarising the bank's exposure to extreme, but possible,
circumstances. The role of risk managers in the bank should be assembling and summarising information
to enable senior management to understand the strategic relationship between the firm's risk-taking
(such as the extent and character of financial leverage employed) and risk appetite. Typically, the results
of stress tests should be computed on a regular basis and monitored over time. Some of the specific ways
in which stress tests are used to influence decision-making are in:

📋 USES OF STRESS TESTS

💰 Managing funding risk
🔍 Providing a check on modelling assumptions
🚦 Setting limits for traders
📊 Determining capital charges on trading desks' positions

⚠️ Limitations of Stress Tests

Stress testing can appear to be a STRAIGHTFORWARD technique. In practice, however, stress tests are
often NEITHER TRANSPARENT NOR STRAIGHTFORWARD! They are based on large number of practitioner
choices as to what risk factors to stress, how to combine factors under stress, what range of values to
consider, and what time frame to analyse.

Even after such choices are made, a risk manager is faced with the considerable tasks of sifting through
results and identifying what implications, if any, the stress test results might have for how the bank should
manage its risk-taking activities.

💭 A well-understood limitation of stress testing is that there are NO PROBABILITIES attached to

the outcomes! Stress tests help answer the question — "How much could be lost?" The lack of
probability measures exacerbates the issue of transparency and the seeming arbitrariness of stress
test design. Systems incompatibilities across business units make frequent stress testing costly for
some banks, reflecting the limited role that stress testing had played in influencing the bank's prior
investments in information technology.
 👁️ 14.7 — RISK MONITORING AND CONTROL
💡 In simple words
After identifying and measuring risk, we need to WATCH IT regularly and CONTROL it within limits!

Risk monitoring and control calls for implementation of risk and business policies simultaneously. It
consists of setting the market risk limits or controlling the market risk, based on the economic measures
of risk while ensuring the best risk adjusted return. Controlling market risk means keeping the variations
of risk of the value of a given portfolio within the given boundary values through actions on limits, which
are upper bounds imposed on risks. This is achieved through the following:

📋 8 RISK MONITORING & CONTROL COMPONENTS

1. 📜 Policy guidelines limiting roles and authority
2. 🚦 Limit structure and approval process
3. 🔧 System and procedures to unbundle products and transactions to capture all risks
4. 📊 Guidelines on portfolio size and mix
5. 🎯 System for estimating portfolio risk under normal and stressed situations
6. 📋 Defined policy for mark-to-market
7. 👁️ Limit monitoring and reporting
8. 📊 Performance measurement and Resource Allocation

📐 Risk Measurement
Risk measurement has a CRITICAL ROLE in controlling and monitoring of market risk! Role of risk
measurement in controlling and monitoring involves setting up of limits and triggers and monitoring
them. Risk positions should also be reported to the designated/competent authority. Further, models are
used for risk measurement, valuations and mark to market of portfolio. This calls for a system to monitor
the models as well.

🚦 Limits and Triggers

Approved market risk limits for factor sensitivities and Value at Risk are duly set by the designated
authority (usually by the Risk Policy Committee). The approval is based on the unit's capacity and
capability to perform within those limits, effectiveness of controls and trading revenues.

🎯 Sensitivity and Value at Risk limits is not measured daily, Risk Taking Units must have procedures
that monitor activity to ensure that they remain within approved limits at all times

📋 Approved market risk limits for basis risk for the products, wherever applicable, in the Market
Risk Product Programme

👁️ Risk Monitoring
A monitoring process to ensure that all transactions are executed and revalued at the prevailing market
rates. The rates used at inception or for periodic marking to market for risk management or accounting
purposes must be independently verified. Financial Models used for revaluations for income recognition
purposes or to measure or monitor Price Risk must be independently tested and certified. Stress tests
must be performed preferably QUARTERLY with predetermined changes in the underlying assumptions of
the model/market conditions.

📊 Models of Analysis
📋 MODELS SHOULD BE...
✅ Appropriate and duly approved (usually by Risk Policy Committee) — model control and
certification policy

📜 Fully documented financial models

👤 Duly validated by the designated person, to ensure that the algorithm employed is
appropriate and accurate. At least once in a year, the model should be validated by a reputed
external agency also

🚫 No unauthorized or unintended changes should be made in models

📊 The models should also be subject to model assumption review on a periodic basis
 📊 14.8 — RISK REPORTING
💡 In simple words
After all this work, you must REPORT to senior management — clearly, accurately, and on time!

Risk report should enhance risk communication across different levels of the bank, from the trading desk
to the CEO. In order of importance, senior management reports should be:

📋 5 QUALITIES OF A GOOD RISK REPORT

⏰ Regular and in time
✅ Reasonably accurate
📊 Including highlights of portfolio risk concentrations & exceptional events
📝 Containing written commentary
📋 Concise
 💧 14.9 — MANAGING TRADING LIQUIDITY
Risk of trading liquidity is managed by AVOIDING:

⚠️ AVOID THESE
📊 Large market share in any given type of asset
📜 Infrequently traded instruments
🔧 Instruments with unusual tenors
⚖️ One-sided liquidity in the market

📐 Risk Terminology in Risk Measurement — Mr. X & Stock 'A'

🌟 Mr. X Stock 'A' Example
Say Mr. X takes a position in stock 'A' and wants to explain to his 'Boss' about the market position.
He can explain the position in 3 possible ways:

1. He tells his Boss that he purchased 1,000 shares of stock 'A' at Rs. 600 per share
2. He tells his Boss that he has taken a Rs. 6,00,000 position in stock 'A'
3. He tells his Boss that he invested in stock 'A'. He explains that if price changes by 1%, he
would have an impact of Rs. 6,000. But since the price is expected to fluctuate 3% daily (daily
volatility figure estimated from past data), he estimates the daily potential loss to be Rs.
41,868

📊 Mr. X's Position Analysis (Method 3)

📈 MR. X RISK TERMINOLOGY
1. Market factor – Stock price
 2. Market Factor Sensitivity – Rs. 6,000 (1% of total position)
3. Volatility (Daily) – 3%
4. Defeasance period – 1 day (i.e., to sell the stock)
5. Defeasance factor – at 3% volatility it is 3 × 2.326 (@ 99% Confidence level − standard
deviation value taken from the table given below)
6. Value at Risk (VaR) – Rs. 41,868 — This is also the potential loss amount under normal
market conditions!

🔔 Confidence Level Table (Z-Scores)

📊 Z-SCORE TABLE (MEMORISE!)
Probability Standard Deviation (Z-score)

68.30% 1

90% (Confidence) 1.65

95.50% (Confidence) 2

97% / 97.50% —

99% (Confidence) 2.326

99.7% / 99.9% 3

We can arrive at the VaR Limit once we know the confidence level and its corresponding "Z
SCORES" (standard deviation) which is arrived at from a normally distributed curve (bell shaped
curve)!
 🛡️ 14.10 — RISK MITIGATION
💡 In simple words
Risk Mitigation = STRATEGIES to REDUCE RISK! Banks use various tools and instruments to lower
their exposure to market risk!

Market risk arises due to volatility of financial instruments. The volatility of financial instruments is
instrumental for both profits and risk! Risk mitigation in market risk, i.e., reduction in market risk is
achieved by adopting strategies that eliminate or reduce the volatility of the portfolio. However, there
are couple of issues that are also associated with risk mitigation measures.

⚠️ Risk Mitigation Trade-Offs

Risk mitigation measures aim to reduce downside potential or profit potential simultaneously! In
addition, risk mitigation strategies, which involve counterparty, will always be associated with
COUNTERPARTY RISK. Of course, where counterparty is an established 'Exchange' or a central
counterparty, counterparty risk gets reduced very substantially. In OTC deals, counterparty risk would
depend upon the risk level associated with party to the contract.

📊 Risk Mitigation Strategies

📐 1. Strategies Using Sensitivity Measures
Volatility of individual instruments is market determined. But, volatility of two or more different financial
instruments would have a different volatility. As a result, a portfolio of financial instruments can be
created with desirable volatility characteristics. Strategies to achieve it are discussed below.

🌟 Sensitivity Strategy Example — Bonds

Say a portfolio has two bonds A and B with BPVs of Rs. 675 and Rs. 205 respectively. The BPV of the
portfolio would be the weighted average of BPVs of all the bonds in the portfolio.

The portfolio BPV = (675 + 205)/2 = 440!

 Now if we intend to reduce the risk of this portfolio, we may add another bond in the portfolio. Say
we add one more bond B in the portfolio. BPV of the portfolio will get reduced to 361.7.

Similar strategies are possible using another sensitivity measure — DURATION! Portfolio duration
may be increased by adding higher duration instruments or by reducing low duration instruments.
Similarly, portfolio duration can be reduced by selling higher duration instruments or by adding low
duration instruments!

📈 2. Strategies Using Correlation Measures

Prices of two financial instruments that have perfect NEGATIVE correlation would move EXACTLY in
OPPOSITE direction! If the financial instruments have negative correlation and it is not perfect, then also
the prices would move in opposite direction but the movement will not be exact. In such a case, the price
volatility of the portfolio would exist, but it will be considerably low.

🌟 Correlation Example — Stock A & Stock Future

For example, a portfolio is long on a stock A and short in stock future of stock A. If the price of
stock A moves up, say by Rs. 10, the stock future would also go up, may not be exactly by Rs. 10 say
by Rs. 9. The portfolio will gain Rs. 10 on account of the long position on stock A, but will lose Rs. 9
on account of the short position in stock future. Reverse would also be true. The portfolio volatility
however, stands reduced or portfolio market risk stands mitigated.

💱 3. Strategies Using Interest Rate Swaps (IRS)

The same strategies are possible with interest rate swaps (IRS) also. An example could be a portfolio
having a fixed rate bond and an IRS with long on variable rate of interest. As market interest rates move
up, the portfolio will suffer losses on bond, as bond price would come down due to the upward
movement in interest rates. But swap valuation will increase as IRS being long on variable rate, will result
in higher interest receipts under the IRS and the portfolio would gain on account of fall in the price of the
bond. Or in other words, portfolio volatility stands reduced and with that the risk also.

🎯 4. Strategies Using Market Instruments (Options)

📌 OPTIONS
Financial instrument such as OPTIONS provide us with a method to hedge market risks. An option
provides a RIGHT but NOT the OBLIGATION, but it comes at a cost called paying UPFRONT OPTION
PREMIUM!

📊 CALL VS PUT OPTION

📈 LONG on CALL OPTION = right to BUY the underlying instrument at a predetermined price
called STRIKE RATE

📉 LONG on PUT OPTION = right to SELL the underlying instrument at the STRIKE RATE
Both provide means to arrest downside movement and may be used for HEDGING a portfolio!

💭 Essentially, the risk mitigation measures involve RISK RETURN TRADE-OFF, as the strategies to
reduce the risk also reduce the upward potential!
 📋 LET US SUM UP
🎯 Chapter Summary
A bank's trading book exposure has the following risks, which arise due to adverse changes in
market variables such as interest rates, currency exchange rate, Commodity prices, market liquidity,
etc., and their volatilities impact the bank's earnings and capital adversely.

📌 Key Takeaways
🎯 QUICK RECAP
🏦 Three main risks: Market Risk, Liquidity Risk, Credit/Counterparty Risk
📊 Trading book includes: Debt, Equity, FX, Commodities (not in India), Derivatives
⚙️ 4 Risk Management Steps: Identify, Measure, Monitor & Control, Mitigate
🏛️ Org structure: Board → RMC → ALCO → ALM Support → Middle Office
📐 Risk measures: Sensitivity (BPV, Duration), Downside Potential (VaR)
💎 VaR uses 3 methods: Correlation, Historical Simulation, Monte Carlo
🔄 Back testing: Compare predicted VaR with actual P&L
⚡ Stress testing: 4 types — Simple Sensitivity, Scenario Analysis, Maximum Loss, EVT
🛡️ Risk Mitigation: Sensitivity, Correlation, IRS, Options strategies
🇮🇳 RTGS & CCIL mitigate settlement risk in India
 📚 QUICK REVISION TABLES
🎯 Z-Score Table for VaR
Confidence Level Z-Score (Standard Deviation)

68.30% 1

90% 1.65

95.50% 2

99% 2.326

99.70% / 99.90% 3

📊 VaR Methods Comparison

Method Approach Strength Weakness

Variance/Covariance Assumes normal

Correlation Deterministic, fast
Matrix distribution

Historical No assumptions on
Uses past prices Past may not predict future
Simulation correlation

Monte Carlo Random scenarios Most flexible Requires assumptions

⚡ Stress Test Techniques

Technique What it Does
Simple Sensitivity Test Tests one factor (e.g., FX rate ± 2%, 4%, 6%, 10%)

Scenario Analysis Tests multiple shocks together (Currently leading technique!)

Maximum Loss Most damaging combination of moves

Extreme Value Theory (EVT) Statistical theory on tails — only one with probability!

🏛️ Key Personalities & Years

Person/Body Year Contribution

Frederick Macaulay 1938 Macaulay's Duration concept

BIS January 1996 Supervisory framework for back testing

RBI India Set up RTGS for settlement risk

CCIL India Clearing for govt securities, FX

📐 Key Formulas
BPV = Change in price for 0.01% change in yield

Duration = Cumulative Revised Price ÷ Revised Price

Modified Duration = Duration ÷ (1+r)

% Change in Price = − (Modified Duration) × (Yield Change)

Price Volatility = Yield Volatility × BPV × (Yield/Price)

VaR = Position × Volatility × Z-score

🎯 Mr. X VaR Calculation Recap
Position: 1000 shares × ₹600 = ₹6,00,000
Daily Volatility: 3% = ₹18,000
Z-score @ 99%: 2.326
VaR = ₹6,00,000 × 0.03 × 2.326
VaR = ₹41,868

✨ ALL THE BEST FOR YOUR CAIIB EXAM! ✨

🌟 Final Tip
Market Risk is one of the MOST IMPORTANT chapters in Bank Financial Management. Focus on:
✅ Mr. X examples (both leverage & stock 'A')
✅ 3 risks (Market, Liquidity, Credit)
✅ BPV, Duration, Modified Duration calculations
✅ VaR — definition, 3 methods, Z-score table
✅ 4 Stress Test techniques
✅ Risk Mitigation strategies (4 types)