Bank Financial Mgt Week 4 Lecture Slides - Full Size

Bank Financial Mgt Week 4 Lecture Slides - Full Size -...

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BUSINESS SCHOOL FINC3018 BANK FINANCIAL MANAGEMENT Week 4
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2 Objectives of this Week’s Session To examine the approaches to the assessment of Risk - Daily Earnings at Risk (DEAR) - Various Value at Risk (VaR) Models - Their application to portfolios - The broader application of VaR - To examine some of the strengths and weaknesses of the VaR approach
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3 Recap - The Factors in Measuring Bank Risk The likely Quantum or amount of the Loss arising from the risk event; Possibility or Probability of a risk event occurring; and Measured in financial terms Value at Risk can help with this analysis
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4 Value at Risk (VAR) Definition - “VAR measures the worst expected loss over a given horizon under normal market conditions at a given confidence level - “Value at Risk” Phillipe Jorion - Note this is not necessarily the worst actual loss
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5 Phillipe Jorion on VaR “The greatest benefit of VAR lies in the imposition of a structured methodology for critically thinking about risk. Institutions that go through the process of computing their VAR are forced to confront their exposure to financial risks and to set up a proper risk management function. Thus the process of getting to VAR may be as important as the number itself.”
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6 The Basis of VAR Initially developed as a measure of market risk - Has been extended to encompass other risks Reflects the Portfolio Manager’s - Beliefs about the future distribution of changes to the value of the portfolio - Relative aversion to the risk of loss Actual future loss is unpredictable but expected losses can be estimated
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7 VAR Fundamentals The expectation of loss relates to the probability of certain events occurring in the future The problem is that the future is unknowable - but can possibly be estimated by reference to the past VaR therefore observes and models past events and assumes that the results reflect likely or possible future events
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8 VaR - The Basics Observed Past Events and Consequent Changes in Value Change In Value ($) -30 -20 -10 0 10 20 30 Probability (%) 5 10 20 30 20 10 5 Cum. Probability (%) 5 15 35 65 85 95 100 If this represented all of the potential changes in the value of the portfolio over a given timeframe what is the VaR with 95% confidence and 85% confidence?
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9 The Resultant Loss Distribution The Probability of Loss 0 10 20 30 40 50 60 70 80 90 100 Amount of Loss Probability of Loss (%) 30 -20 10 0 0 30 Cumulative Probability Distribution
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VAR Fundamentals The expectation of loss relates to the probability of certain events occurring in the future Requires determining: - 1. The Relevant Probability distribution t o develop the probability distribution - VaR uses either or a combination of: - Historical Simulation (historical observations) - Estimated Variance - Co-Variance - Monte Carlo Simulation - We will focus on the historical method. -
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Bank Financial Mgt Week 4 Lecture Slides - Full Size -...

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