Lecture 4 Market Risk - McGraw-Hill/Irwin Lecture 4 Market...

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Unformatted text preview: McGraw-Hill/Irwin Lecture 4 Market Risk Instructor: Lixiong Guo Date: August 10, 2011 Overview of Lecture This lecture discusses the nature of market risk and appropriate measures RiskMetrics Historic or back simulation Monte Carlo simulation Links between market risk and capital requirements 4-2 Market Risk Market risk is the uncertainty resulting from changes in market conditions such as interest rates, foreign exchange rates, and other asset prices. Closely related to other risks but its focus is on risks arising from trading activities rather than from holding assets and securities for investment purposes. Large exposures to market risk pose a threat to solvency of FIs. 4-3 A conceptual separation of Investment and trading books 4-4 Income from trading activities are increasingly replacing income from traditional FI activities of deposit taking and lending. Recent Trading Loss Examples Trading exposes banks to risks Late 2006 through mid-2009: housing prices plummeted, affecting mortgage lending industry 2007: Bear Stearns hedge funds losses in subprime mortgage market 2007-2008: w Bankruptcy of Lehman Brothers w Merrill Lynch bought by BOA w WAMU acquired by J.P. Morgan Chase 4-5 Market Risk Measurement (MRM) Important in terms of: Management information Setting limits Resource allocation (risk/return tradeoff) Performance evaluation Regulation w BIS and Fed regulate market risk via capital requirements leading to potential for overpricing of risks w Allowances for use of internal models to calculate capital requirements 4-6 Calculating Market Risk Exposure FIs usually measure market risks over short time periods which can be as short as one day. Widespread adoption of Value-at-Risk (VaR) methodologies. VaR is the minimum losses incurred under adverse market conditions. Adverse condition is defined as a condition that statistically there is only a X% chance that conditions are likely to be worse than it. 4-7 The Concept of VaR We are X percent certain that we will not lose more than V dollar in the next N days. 4-8 Gain ($) Loss ($) (100-X)% of the area under the curve V VaR = V Probability distribution of the change in the portfolio value in N days RiskMetrics Daily Earnings at Risk ( DEAR ) = (Dollar MV of position) x (Price sensitivity of position) x (Potential adverse move)...
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This note was uploaded on 10/23/2011 for the course FINS 3630 taught by Professor Yip during the Three '09 term at University of New South Wales.

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Lecture 4 Market Risk - McGraw-Hill/Irwin Lecture 4 Market...

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