Risk Management Definition

Risk Management

2007-2008

Introduction

Risk management has to determine what risks exist in an investment and handle the risks in good investment objectives.

Risk management is very important in Finance. In this assignment, we will understand in a first part the basic measures of the risk management. Then we will have more interest of the implementation of the Value at Risk. In the environment of Hedge Fund, we have to develop the risk factors. And finally, in order to manage a trading book, we will describe the limit structure and the tools to use in order to measure the risk.

1. Describe the advantages and disadvantages for each of the following risk measures:

a. DV01

Definition: DV01, also called dollar value of a 1 basis point move, is a measure showing the dollar value of a one basis point decrease in interest rates.

It shows the change in a bond's price compared to a decrease in the bond's yield.

It is also the reference for the Basic Point Value, a method to measure interest rate risk.

Advantage Disadvantages

- It makes easier to calculate the BPV

DV01 = Initial Price вЂ" Price at 1BPV

- Permit to observe the higher risk level of future trade

- Easy to understand

- Thanks to the calculation of BPV and the correlation with DV01, we can:

- apply some approach to financial instrument (know the cash flow) в‡' we can calculate BPV for money market products and swaps

- calculate simple hedge ratios - We don’t know how much the yield curve can move on a day-to-day basis with the BPV.

- With BPV, the yield can move up or down in a parallel manner, it’s not always the same.

b. Stress testing

Definition: A simulation technique used on asset and liability portfolios to determine their reactions to different financial situations.

Stress-testing is a useful method of determining how a portfolio will fare during a period of financial crisis.

A stress test is a scenario analysis relative to extreme change.

Advantage Disadvantages

- In one hand, it permits for the risk managers and to the CEO to have a good analysis in order to understand the bank exposure.

- Complement the VAR circulation

в--Љ Isolate risk by risk factors

в--Љ Quantifies how large a loss could occur in an extreme market move

- Give a good precision in calculation

- More difficult to manipulate the result than VAR

c. Scenario testing

Definition: It is a calculation of portfolio return and other statistics as duration, yields, expected prepayment rates, etc… through a future horizon date under hypothetical changes to term structures of interest rates, asset spreads and currency exchange rates.

Advantage Disadvantages

- forecast several possible scenarios for the economy (e.g. rapid growth, moderate growth, slow growth)

- forecast financial market returns (for bonds, stocks and cash) in each of those scenarios - Difficult to foresee what the future holds в‡' the actual future outcome may be entirely unexpected),

- Difficult to foresee what the scenarios are

- Difficult to assign probabilities to them

d. Value at Risk

Definition: It is a calculation which permits to quantify the worst case loss within a certain confidence level or probability level.

VAR is incontrovertible method in market risk evaluation.

Advantage Disadvantages

- Allows measurement of market risk across multiple asset classes (and currencies) to be aggregated into one number.

- Captures “portfolio effects” of risk (i.e., correlation effects).

- Provides a methodology to set risk limits.

- Provides a way of comparing risk across different market sectors and asset classes.

- Useful when attempting to measure risk-adjusted returns.

- The key risk factors responsible for that potential los sis unknown.

- the potential risk of an extreme market move, e.g., market crash, is not predicted

2. In implementing a VaR model, what considerations would you give to each of the following:

a. Product complexity

In implementing a VAR, we have to give an important consideration to the product complexity. According to the “Detailed risk Versus Product Matrix”, product complexity belong to the transaction risk.

Product complexity is the number of interrelated elements, the degree of integration, and the criticality of the characteristics of each product. Indeed, it is the correlation between product, markets, currencies, and counterparties.

b. Liquidity

Liquidity risk is composed of the market liquidity risk and the funding risk. Liquidity risk is also a risk due to the lack of marketability of an investment which cannot be bought or sold quickly enough to prevent or minimize a loss .

It is very important in implementing a VaR Model due to the reflection of the large price movements.

c. Diversity

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