1. Stress testing:
– Stress testing is often employed as a complement to VAR, stress testing is just an extreme scenario.
– Scenario analysis is used to measure the effect on the portfolio of simultaneous movements in one or several factors. There are various form of scenario analysis: Stylized scenario, actual extreme events, hypothetical events.
– Stylized scenarios: The analyst changes one or more risk factors to measure the effect on the portfolio.
– Actual extreme events: The analyst measures the impact of major past events on the portfolio value.
– Hypothetical events: extreme events that might occur but have not previously occurred.
– Stress testing model and stressing models are just an extension of scenario analysis focusing on adverse outcomes. Stressing can be done as: factor push analysis, maximum loss optimization, worst case scenario.
2. Evaluating credit risk: Evaluating credit risk of an forward contract, swap and option position.
Projecting credit risk losses is a function of:
– The probability of default risk
– The amount of value lost if the default event occurs ( the loss and also any recovery after the initial loss)
Credit risk include:
– Current credit risk ( jump to default risk) is the amount of a payment currently due. Current credit risk is on the due dates of payments, and is zero on all other dates.
– Potential credit risk is associated with payments due in the future and exists even if there is no current credit risks. A firm can be currently solvent and able to make payment but that does not guarantees futures payments will be made.
Credit risk can also be affected by cross default provision. In most lending agreements, a debtor is considered in default of all obligations if it defaults on any of its obligations.
Creditors are exposed to potential credit risk from a debtor defaulting on an obligation to another creditor.
– Credit VAR also called credit at risk or default VAR: An expected loss ( due to default) at a given probability during a given time period.
– Credit VAR is the right tail risk ( credit risk is greatest when market value is highest), and market VAR is the left tail risk ( it occurs when returns on the asset are low)
– It is difficult to calculate the recovery rate and the correlation of default between each pair of exposures.
3. Managing market risks: Demonstrate the use of risk budgeting, position limits and other methods for managing market risk.
– Risk budgeting is the process of determining which risks are acceptable and how total enterprise risk is allocated across business units or portfolio managers.
– Position limits place a nominal dollar cap on a given position.
– Liquidity limits are related to position limits, risk managers may set nominal position limits as some portion of typical trading volumes.
– A performance stopout sets an absolute dollar limit for losses to the position over a certain period. If the stopout level is hit, the position must be closed to limit further loss.
– Risk factor limit: the manager must limit exposure to individual risk factors as prescribed by upper management.
– Scenario limits which require the manager to structure the portfolio so as to limit the impact of given scenerios.
– Leverage limits which limit the amount of leverage the manager can employ.
4. Managing credit risk: The use of exposure limits, marking to market, collateral, netting arrangements, credit standards, and credit derivatives to manage credit risk.
– Limiting exposure: is a rational first line of defense against credit risk, limitin the amount of loans to any individual debtor or the amount of derivative transactions with any individual counterparty.
– Marking to market: is employed with many derivatives contracts in which the value to one party will be positive while the value to the other will be negative. The party who value is negative pays this amount to the other party, and the contract will be repriced.
– Collateral: is often required in transactions that generate credit risk.
– Payment netting: is frequently required in derivatives contracts that can generate credit exposure to both sides.
– Closeout netting: is employed in bankruptcy proceeding. Al the transactions between the bankrupt company and a single counterparty are netted to determine the bankrupt company and a single counterparty are netted to determine the value exposure.
– Minimum credit standard, special purpose vehicles (SPVs) and enhanced derivatives procedures companies.
– Credit derivatives: Credit default swap, credit spread forward, credit spread option, total return swap.
5. Measuring risk-adjusted performance: Discuss the Sharpe ratio, risk-adjusted return on capital, return over maximum drawdown and the Sortino ratio as measures of the risk-adjusted performance.
– The Sharpe ratio:
Sp= ( Rp-Rf)/бp
– Risk adjusted return on invested capital (RAROC) is the ratio of the portfolio’s expected return to some measure of risk, such as VAR
– Return on maximum drawdown (RoMAD) is the annual return divided by the fund or portfolio’s largest percentage drawdown.
– The Sortino ratio is the ratio of excess return to risk.
Sortino = (Rp-MAR)/downside deviation.
MAR: the minimum acceptable portfolio return.
6. Setting capital requirements: Demonstrate the use of VAR and stress testing in setting capital requirements:
– VAR measures downside risk and has the benefit of considering correlation and the potential risk reduction through diversification across business units.
– A firm could project the expected profit to VAR of each unit and allocate more capital to the higher return to risk units.
– The process would be more complex than simply allocating all capital to the highest return to risk because the capital must be spread across units in order to achieve diversification.
– Stress testing is the natural complement to VAR as it can consider more extreme outlier events that may not be reflected in the VAR calculation.