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Market Risk
Market Risk
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Overview
This chapter discusses how market risk arises and how it
can threaten the solvency of FIs.
We learn how to measure market risk.
We learn about the concepts of the RiskMetrics model
and the back simulation approach.
We discuss how regulators measure market risk exposures
for capital adequacy purposes.
123
Introduction
Market risk is the uncertainty resulting from changes in
market prices. It can be measured over periods as short as
one day.
Usually measured in terms of dollar exposure amount or
as a relative amount against some benchmark.
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Market Risk Measurement
Why is Market Risk Measurement (MRM) Important?
Management information,
Setting risk limits,
Resource allocation,
Performance evaluation,
Regulation.
Calculating Market Risk Exposure
RiskMetrics,
Historic or back simulation,
Monte Carlo simulation.
Normal distribution and confidence intervals
The normal distribution or Gaussian distribution is a continuous probability distribution that
often gives a good description of data that cluster around the mean.
The graph of the associated probability density function is bellshaped, with a peak at the
mean, and is known as the Gaussian function or bell curve.
Confidence intervals:
A range around some specific value which has a certain probability to occur.
Assuming normality, 90% of the time the disturbance will be within 1.65 standard
deviations (σ) from the mean (μ).
Probability (
μ  1.65σ < x < μ + 1.65σ) = 90%
Probability (x <= μ  1.65σ) = 5%
Probability (x >= μ + 1.65σ) = 5%
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The RiskMetrics Model
Developed by JP Morgan. The idea is to estimate the potential
loss under adverse market circumstances and use the estimated
loss to gauge the market risk exposure.
Daily earnings at risk (DEAR) =
Potential daily loss under
adverse circumstances = Dollar market value of the position ×
daily return under adverse circumstances (normally set as 5%
worst case, but you can make it 1% worst case if you are more
risk averse)
If daily return follows a normal distribution, Ret ~ N(μ, σ),
then from the previous slide we know that
daily return under
5% worst case =
μ  1.65σ (in most cases, we assume μ = 0,
then it is  1.65σ ). It is referred as
price volatility
in the
textbook. But this term is really confusing.
Implication of DEAR: the potential loss under adverse market
scenario, and the actual loss could go beyond this number,
which will occur with only a 5% chance. (so why set to 1% if
you are more risk averse?)
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Applying RiskMetrics to Foreign Exchange Position
Daily earnings at risk (DEAR) =
Potential daily loss
under adverse circumstances = Dollar market value
of the position × daily return under adverse
circumstances
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This note was uploaded on 05/26/2011 for the course FIN 5530 taught by Professor Lee during the Three '11 term at University of New South Wales.
 Three '11
 Lee

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