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MARKET RISK
By Yoshiharu Harano - 042111233259
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INTRODUCTION
Market Risk and
Significance
Market risk refers to the potential loss that an
organization may incur due to changes in market
conditions, such as fluctuations in interest rates,
foreign exchange rates, and stock prices.
Effective market risk management is crucial for
organizations to minimize potential losses and
maintain financial stability.
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STANDARD DEVIATION
Definition: Standard deviation is a measure of the dispersion of a set of
data from its mean. It is used to measure the volatility of an asset's
returns.
The formula for calculating standard deviation is:
√(Σ(xi - x̄ )² / n),
where xi is the individual data point, x̄ is the mean, and n is the number of data points.
A higher standard deviation indicates a higher level of volatility, while a lower standard
deviation indicates a lower level of volatility. (High SD, High risk)
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VALUE AT RISK (VAR)
Definition: VAR is a measure of the potential loss that an
organization may incur over a specified time horizon, given a
certain level of confidence.
VAR is typically expressed as a dollar amount or a percentage of the portfolio's
value. VAR can be calculated using various methods:
1. Historical simulation,
2. Analytical methods, and
3. Monte Carlo simulation.
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VAR HISTORICAL METHOD (BACK SIMULATION)
Definition: Back simulation involves simulating historical market data to
estimate the potential losses that an organization may incur over a
specified time horizon, given a certain level of confidence.
VAR calculated using back simulation provides a historical perspective on potential losses and
can be used to inform risk management decisions.
VAR portfolio = (VARx^2+VARy^2+2pxyVARxVARy)1/2
Where:
VARx = VAR (Value at Risk stock X)
VARy = VAR (Value at Risk stock Y)
pxy = Correlation of returns on stock X with stock Y
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VAR MODELING METHOD (ANALYTICAL)
Definition: Analytical methods involve using mathematical
models to estimate the potential losses that an organization may
incur over a specified time horizon, given a certain level of
confidence.
Analytical methods assume that there is a certain distribution of returns or
prices. The normal distribution is used as an assumption in set price movements.
Next, the expected value and deviation from the expected value (standard
deviation) are calculated. The VAR will be calculated using the parameters
deduced from that distribution (in this case the expected value and its deviation)
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VAR WITH MONTE CARLO SIMULATION
Definition: Monte Carlo simulation involves simulating a large
number of scenarios to estimate the potential losses that an
organization may incur over a specified time horizon, given a
certain level of confidence.
Through Monte Carlo simulation, a certain distribution will be formed and this
distribution will be used to calculate VAR. VAR calculations using this simulation
require a computing tool in the form of a computer.
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VAR MODELING
Modeling in VAR is used to determine the effects of several scenario conditions
that may occur on business decisions.
e.g.) Suppose a company has a bond portfolio and the market price of bonds is
strongly influenced by interest rates. If interest rates rise, bond prices will fall
and vice versa. This company will focus on interest rate fluctuations and relate
changes in interest rates to the market value of bonds, then calculate the VAR
for the bond portfolio.
dP/P = -D*(dR/(1+R)
where:
dP = change in price
P = bonds price
D = bonds duration
dR = changes in interest rates
R = interest rates
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STRESS TESTING
Definition: Stress testing involves simulating extreme market
conditions to estimate the potential losses that an organization
may incur under those conditions.
Stress testing seeks to accommodate extreme events by asking the following
question: if an extreme event occurs, how will it impact the organization, or
portfolio? To carry out stress testing, certain parameters will be selected and
then (measured and simulated) the effect of changes in these parameters on the
organization or organizational portfolio.
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STRESS TESTING
Steps for stress testing:
1. Identify and select parameters that are expected to change.
2. Determine how much the parameter will change (distress)
3. See the effect of stress testing on portfolio value
4. Look at the assumptions used, change these assumptions if
necessary (for example, in a critical situation, assumptions that
usually apply may not be appropriate)
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BACK TESTING
Back testing is a term for the process of checking whether the model we use is in
accordance with existing reality.
e.g.) If you calculate 99% VAR-1 day and get a figure of IDR 100 million. If you
find that losses above IDR 100 million are around 1% or less, then it can be said
that the model is quite good, in accordance with existing reality. However, if it is
found that losses above IDR 100 million reach 10% of the total observations, then
the VAR model may need to be doubted, because it does not match the existing
reality and needs to be improved.
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THANK
YOU