Market Risk measurement

Market Risk measurement
Measurement of Market Risk is based on:
Sensitivity
Downside potential

Sensitivity Measurement
Change in market rate of interest has inverse relation with Value of Bonds. Higher interest
rates lower the value of bond whereas decline in interest rate would result into higher bond
value. Also More liquidity in the market results into enhanced demand of securities and it
will lead to higher price of market instrument. There are two methods of assessment of
Market risk: 1. Basis Point Value 2. Duration method

1. Basis Point Value

This is change in value of security due to 1 basis point change in Market Yield. Higher the
BPV higher will be the risk. Example
Face Value of Bond = 100/- Bond maturity = 5 years
Coupon Rate = 6%
Market price of Rs. 92/- gives yield of 8%
With fall in yield from 8% to 7.95%, market price rises to Rs. 92.10
Difference in Market price = 0.10
Difference Yield = 0.05%
BPV = Diff in Market price/Difference in Yield
BPV = 0.10/0.05 = 2 paisa per Rs. 100 i.e. 2 basis points per Rs. 100/-
If Face value of the Bond is 1.00 crore, BPV of the bond is Rs. 2000/- Now, if the yield on Bond declines by 8 bps, then it will result into profit of Rs. 16000/-
(8x2000). BPV declines as maturity reaches. It will become zero on the date of maturity.


$ Duration Approach
Duration is the time that a bond holder must wait till nos. of years (Duration)to receive
Present Value of the bond. e.g. 5 year bond with Face Value of Rs. 100 @ 6% having McCauley Duration 3.7 years. It
means Total Cash Flow of Rs. 130 to be received in 5 years would be discounted with
Present Value which will be equivalent as amount received in 3.7 years. The Duration of
the Bond is 3.7 Years. Formula of Calculation of McCauley Duration = ∑PV*T
∑PV
Modified Duration = Duration
1+Yield
Approximate % change in price = Modified Duration X Change in Yield
Example
A bond with remaining maturity of 5 years is presently yielding 6%. Its modified duration is
5 years. What will be the McCauley Duration. Modified Duration = Duration/ 1+YTM
Duration = Modified Duration x (1+YTM)
5 x 1.06 = 5.30 Ans. $ Downside Potential
It captures only possible losses ignoring profit potentials. It integrates sensitivity and
volatility with adverse affect of Uncertainty. This is most reliable measure of Risk for Banks as well as Regulators. VaR is the method
to calculate downside potential. Value at Risk (VaR)
It means how much can we expect to lose? What is the potential loss?
Let VaR =x. It means we can lose up to maximum of x value over the next period say week
(time horizon). Confidence level of 99% is taken into consideration. Example
A bank having 1 day VaR of Rs. 10 crore with 99% confidence level. It means that there is
only one chance in 100 that daily loss will be more than 10 crore under normal conditions. VaR in days in 1 year based on 250 working days = 1 x 250 == 2.5 days per year. 100
Back Testing
It is a process where model based VaR is compared with Actual performance. It tells us
whether results fall within pre-specified confidence bonds as predicted by VaR models. Stress Testing
It seeks to determine possible change in Market Value of portfolio that could arise due to
non-normal movement in one or more market parameters (such as interest rate, liquidity,

inflation, Exchange rate and Stock price etc.). Four test are applied:
$ Simple sensitivity test;
If Risk factor is exchange rate, shocks may be exchange rate ±2%, 4%,6% etc. $ Scenario test
It is leading stress testing technique. The scenario analysis specifies the shocks if
possible events occur. It assesses potential consequences for a firm of an extreme.
It is based on historical event or hypothetical event. $ Maximum loss
The approach assesses the risks of portfolio by identifying most potential
combination of moves of market risks
$ Extreme value theory
The theory is based on behavior of tails (i.e. very high and very low potential
values) of probable distributions.