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# chap10 - Money is better than poverty if only for financial...

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Saunders & Cornett, Financial Institut 1 “Money is better than poverty, if only for financial reasons,” Woody Allen

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Saunders & Cornett, Financial Institut 2 Market Risk The impact of unanticipated changes in market conditions (interest rates, exchange rates, securities prices) on the market value and earnings of the FI. Widespread adoption of Value at Risk (VaR) methodologies. VaR is the minimum losses incurred under adverse market conditions. That is, if tomorrow is a “bad day” measured statistically such that only 1% of all days have even worse conditions. First commercially available VaR model was RiskMetrics.
Saunders & Cornett, Financial Institut 3 The Concept of VAR Example of VAR applied to market risk. Market price of equity = \$80 with estimated daily standard deviation = \$10. If tomorrow is a “bad day” (1 in 100 worst) then what is the value at risk? If normally distributed, then the cutoff is 2.33 σ below the mean = \$80 – 2.33(10) = \$56.70. 99% VAR = \$23.30 Figure 6.1.

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Saunders & Cornett, Financial Institut 4 Time 1 Day (Tomorrow) P = \$80 P = \$56.7 2.33 σ = \$23.3 0 (Today) Figure 6.1 The VAR of traded equity.
Saunders & Cornett, Financial Institut 5 Appendix 1.1 A Brief Overview of Key VAR Concepts Banks hold capital as a cushion against losses. What is the acceptable level of risk? Losses = change in the asset’s value over a fixed credit horizon period (1 year) due to credit events. Figure 1.1- normal loss distribution. Figure 1.2 – skewed loss distribution. Mean of distribution = expected losses (reserves). Unexpected Losses (UL) = %tile VAR. Losses exceed UL with probability = %. Definition of credit event: Default Mode: only default Mark-to-market: all credit upgrades, downgrades & default.

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Saunders & Cornett, Financial Institut 6 FIGURE 1.1 Expected Losses (EL) EL - σ EL + σ Confidence Interval Unexpected Losses, VAR (UL) Loss Distribution Probability % 99.5 th Percentile (Maximum) Value 0.5% Figure 1.1 Normal loss distribution.
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chap10 - Money is better than poverty if only for financial...

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