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SAS : A Point of View on Market Risk VaR

SAS: A Point of View on MARket RiSk VAR

Table of Contents
Revaluing growing numbers of increasingly complex financial instruments ...2 Choosing between numerous approachesfor modeling risk factor evolution ..2 Accessing, integrating, cleaning, and maintaining market and position data ..3 Meeting internal and external reporting requirements.....................................6 Deciding at which aggregation levels to set and monitor VaR-based limits ....7 Determining optimal actions, hedges and integration with enterprise risk management initiatives ....................................................................................7 Summary ..........................................................................................................9

SAS: A Point of View on MARket RiSk VAR

An industry best practice for estimating the market risk of trading operations involves projecting profit-and-loss distributions of portfolios of financial instruments over short time horizons and then summarizing that information into single numbers, such as value at risk (VaR) and expected shortfall. Easy to understand and conceptually straightforward, VaR has long been an industry standard for estimating market risk. The means by which it is calculated and used in practice to manage risk, however, present a number of modeling, data management and reporting challenges. This paper addresses ways in which SAS can help clients overcome these challenges to better measure and manage their market risk. SAS offers a comprehensive platform for: automating the collection and preparation of market data; modeling risk factor evolution and instrument valuation to create profit/loss distributions; and accessing results at their most granular levels from interfaces that are already familiar to business users and quantitative resources. By eliminating time-consuming manual and redundant data management tasks, market risk analysts have more time to spend on more productive tasks, such as exploring strategies for controlling and managing market risk. By providing a range of modeling approaches that vary in their level of sophistication, market risk analysts can uncover sensitivities of market risk estimates to model selection and parameter uncertainty. By comparing the results and time constraints of different modeling approaches, analysts can decide upon the most appropriate approaches for meeting their internal and external market risk estimation requirements. Finally, by providing accessibility to results through numerous interfaces, such as a Web browser and Microsoft Excel, all levels of business and quantitative users can explore (at any level of detail) the profit/loss distributions from which market risk estimates are derived. Challenges in measuring market risk with VaR include: Revaluing growing numbers of increasingly complex financial instruments. Choosing between numerous approaches for modeling risk factor evolution. Overcoming performance problems due to growing trading volumes and instrument complexity to meet existing and future time constraints. Accessing, integrating, cleaning and maintaining market data and position data. Meeting internal and external reporting requirements.

SAS: A Point of View on MARket RiSk VAR

Challenges in managing market risk with VaR include: Deciding at which aggregation levels to set and monitor VaR-based limits. Determining optimal actions, hedges and integration with enterprise risk management initiatives.

Revaluing growing numbers of increasingly complex financial instruments

Derivatives and other complex instruments, such as structured products, often have contingent, path-dependent cash flows. Many such instruments do not have closedform analytical pricing functions, so numerical techniques (such as lattice building and Monte Carlo simulation) are employed to value them. Performance concerns regarding full valuation approaches often lead to the use of analytical approximations for estimating price changes of complex instruments. In SAS, internal or third-party pricing models, prepayment models, term structure models, default models, credit spread models and deal waterfall libraries are all integrated within one environment so that users have a choice of using full valuation or approximations approaches for revaluing all types of instruments in a market risk simulation.

Choosing between numerous approaches for modeling risk factor evolution

In selecting an appropriate risk factor evolution model, the strengths and weaknesses of various approaches must be weighed. Tradeoffs between accuracy and efficiency, internal resource and system constraints, and internal and external reporting requirements must also be considered. Like any model, a risk factor evolution model cannot be expected to fully emulate all of the complexities of how risk factors are likely to move individually and in relation to one another. SAS offers users the flexibility to pursue a number of different approaches for modeling the evolution of risk factors, including delta normal, historical simulation, and variance-covariance and model-based Monte Carlo simulation (see Figure 1). Users can simultaneously run multiple market risk analyses in SAS, each one using a different risk factor evolution approach, and then compare the resulting profit-and-loss distributions and VaR numbers to gain insights into model sensitivity in calculating VaR.

SAS: A Point of View on MARket RiSk VAR

Non-simulation based Simulation based

Delta Normal Historical Simulation Variance-Covariance Monte Carlo Simulation Model-Based Monte Carlo Simulation

Predefined or ad hoc risk factor changes

Stress Testing Scenario Analysis Scenario Simulation

Figure 1. Risk factor evolution models.

Overcoming performance problems due to growing trading volumes and instrument complexity to meet existing and future time constraints The quicker a firm can reanalyze and assess its risks, the quicker it can take actions to mitigate those risks. Product commoditization has compelled dealers to set aggressive growth targets for exotic and plain-vanilla derivatives trading volumes. Increasing numbers of increasingly complex financial instruments create valuation challenges in achieving real-time or near-real-time intraday market risk analysis. SAS meets real-time or near-real-time internal market risk requirements through its: out-of-the-box, grid-based, distributed and parallel processing capabilities for complex instruments; linear scaling to handle large trading volumes; and flexibility for users to define and value new instruments by calling internal or external pricing functions written in C or C++.

Accessing, integrating, cleaning, and maintaining market and position data

SAS is uniquely positioned to address a number of market risk challenges surrounding market and position data. For market data, SAS data integration tools enable automation of many market data feeds as well as internal data feeds. For position data, the SAS data model and data integration tools significantly reduce the efforts involved in configuring and maintaining a securities master. Whether working with an existing securities master or one built in SAS, data integration tools in SAS allow users to build metadata-driven visual process flows that automate the process of accessing, cleaning and merging detailed position data (see Figure 2).

SAS: A Point of View on MARket RiSk VAR

The notion of metadata (information about data) in SAS is broad, comprehensive and compatible with industry standards. The SAS open metadata repository (OMR), built on top of the OMGs Common Warehouse Metamodel, contains approximately 165 metadata types and associations between these types much more than the basic technical metadata about data relationships and definitions. This broader definition of metadata means not only are physical descriptions of the tables/columns (etc.) contained in the metadata repository, but additional information detailing an applications use of data, called application metadata, is also stored in the metadata repository. The SAS OMR leverages this broader definition of metadata to contract an end-toend metadata object lineage, such that any application used to create analytic or reporting output and the data that feeds that process (as well as the process that created and manipulated the data used as input to those application processes), can be tracked from an end-to-end perspective thereby enabling transparency and auditability on top of a secured environment. Given that risk management analytic processes are inherently complex, the SAS OMRs broad support of all types of metadata allows arbitrarily complex processes to remain fully transparent, and allows users and managers to track the lineage of any output or input into those processes ultimately reducing the operational risk aspect that is associated with any complex risk analytic and reporting process. Via metadata-driven data integration process flows, position data originating from internal source systems and third-party vendors (such as Bloomberg) can be processed in SAS and subsequently stored in a single data target the SAS data model. As a centralized and reliable data store, the SAS data model can be used to update an existing securities master, it can become a securities master itself and it can provide a single version of the truth for source system data; therefore, it can be shared with other solutions and risk analyses beyond market risk, such as for counterparty credit risk analyses of OTC derivatives from a market risk trading portfolio.

SAS: A Point of View on MARket RiSk VAR

Figure 2. Metadata-driven visual process flows: point-and-click, drag-and-drop interfaces for automating data management.

SAS: A Point of View on MARket RiSk VAR

Data stored in the SAS data model includes not only instrument attributes, but also derived data that is calculated during the course of market risk analyses such as implied volatilities that are backed out of option prices as well as credit spreads, zero spreads and OAS. This derived data can then in turn be used in subsequent risk factor projections in market risk or counterparty credit risk analyses, as well as for FAS 157 and NAV purposes. Market-implied assumptions that could be backed out of an instruments current mark-to-market price could be stored as part of the historical record for that instrument in the data model. This automated ability to take derived data from one market risk analysis and then write it back to a data model for future use in subsequent market and counterparty credit risk analyses creates greater consistency between these two different risk analyses an important consideration for enterprise risk management and economic capital initiatives.

Meeting internal and external reporting requirements

SAS provides an infrastructure for automating the production and distribution of daily valuation and risk reports. SAS provides Web portals and customizable dashboards for users to access published reports. Users can run dynamic, parameter-driven risk analyses remotely from these and other interfaces, such as Microsoft Excel, and have the results returned within the originating interface in real time. Since SAS can retain all of the intermediate results generated in a market risk simulation, including individual risk factor changes and instrument revaluations, reaggregation along any dimension can be performed on the fly at the reporting level. Users can filter by instrument type, trader, desk, business unit, or individual or groups of risk factors to generate new profit/loss distributions and VaR. Greater insight into risk at different aggregation levels means more informed decisions regarding corrective actions that might be needed for managing market risk. External reporting requirements of regulators, rating agencies and investors as well as those for internal purposes such as trading limits management, enterprise risk management and economic capital initiatives all differ. The strategic implications of risk analyses for internal risk budgeting and capital allocation implies a need for more accurate risk calculations, and may require more rigorous valuation and risk factor modeling approaches than those used for meeting external reporting requirements. SAS provides a single platform where multiple approaches can be simultaneously implemented and reported upon all from the same consistent data integration, analytical and reporting platform.

SAS: A Point of View on MARket RiSk VAR

For trading operations subject to Market Risk Amendment regulatory requirements, specific risk and incremental default risk present challenges for market risk measurement. In SAS, credit spreads can be modeled via transition matrices or as functions of macroeconomic risk factors, and credit models can be incorporated into simulation analyses, including structural, reduced form, and hybrid models of default and migration for long time horizons.

Deciding at which aggregation levels to set and monitor VaR-based limits

Measuring market risk by creating realistic profit/loss distributions and deriving VaR and expected shortfall is important, but these measures alone do not specifically address the management of market risk. Aside from regulatory capital requirements and other external reporting needs, market risk is measured so that it can be managed versus internal trading limits and for economic capital purposes. VaR-based trading limits are one of the original uses of VaR, but it is not obvious at what aggregation level they should be applied. Should limits be set and monitored at the business unit, desk or trader level? The implications of where you set limits are important in determining what actions should be taken to prevent limits from being exceeded. In SAS, firms can simultaneously monitor market risk at the business unit, desk or trader level, or at any user-defined level of aggregation for multilevel, limit-setting schemes. An enterprise view of market risk across the entire firm will highlight diversification benefits across trader positions.

Determining optimal actions, hedges and integration with enterprise risk management initiatives
When business units, desks or traders approach maximum VaR limits, it is not immediately obvious which positions should be unwound (or what overlays and hedges to put in place and at what level) without inadvertently exposing the portfolio to more risk. Forcing traders to prematurely unwind inventory positions intended for client sales can be avoided by traders themselves adding to their hedges, or by risk management overlaying hedges across desks or traders. What should those hedges be, and at what level should they be applied? How do you allocate the costs of overlay hedges across desks and traders? To answer these questions and find the optimal course of action, your risk system must offer the flexibility to quantitatively explore the implications of different actions.

SAS: A Point of View on MARket RiSk VAR

SAS offers numerous methods for exploring profit/loss distributions to identify hedging needs at different portfolio aggregations: (1) sensitivity analysis via second-order Taylor series approximations provides deltas and gammas of all portfolio aggregations, so you can look at approximate changes in profit/loss given multiple, simultaneous changes in risk factors; (2) profit/loss curves for changes in portfolio value given changes in a single risk factor, based on full revaluation of the instruments in the portfolio; (3) profit/loss surfaces for changes in portfolio value given changes in a pair of risk factors, also based on full revaluation (see Figure 3); and (4) sandbox functionality, where analysts can rerun simulations of portfolios that include hypothetical hedges in them.

Sensitivity analysis (via second-order Taylor series expansion of a portfolios valuation function). P/L curves. P/L surfaces. VaR. Expected shortfall. P/L distribution. All granular intermediate results that went into the creation of P/L distribution. User-defined aggregations for all of the above.
Figure 3. Examples of simulation-based market risk output.

Beyond hedges for maintaining targeted VaR-based limits, firms may wish to look more closely at the implications of various strategies upon the entire P/L distribution, and not just extreme values such as VaR. Instead of buying protection against just extreme moves, it may make sense to also hedge against more probable, less extreme (but still worrisome) market moves. By comparing and drilling down into hypothetical profit/loss distributions in SAS, firms can uncover hidden concentrations of exposure to particular market risk factors (as well as discover what types of plausible market moves create unacceptable losses) and use that knowledge to devise and implement better hedging strategies. Intraday revaluations when significant new positions and market changes occur, pretrade limit testing and possible actions to accommodate new trades all present special challenges that SAS can address in its market risk system. Finally, SAS provides an ideal data management, analytical and reporting environment for integrating its market risk analysis with longer-horizon enterprise risk management and economic capital initiatives, where performance of trading desks is considered simultaneously with that of other divisions of the firm.

SAS: A Point of View on MARket RiSk VAR

Summary
SAS provides flexibility, extensibility, scalability, accessibility and productivity gains in estimating market risk: Flexibility to implement a wide variety of approaches for risk factor modeling and instrument valuation. Extensibility to define and value any type of asset at any level of complexity internally, without having to rely on software updates or outside consultants. Scalability to handle extremely large numbers of portfolio positions, including complex instruments, via grid-based, parallel or distributed computing providing desired market risk estimates within required time frames. Accessibility to run risk analyses, query and drill down to highly granular position-level results via user-preferred interfaces, such as a Web browser and Microsoft Excel. Productivity gains for both business and quantitative users, who will spend less time preparing data and more time managing market risk. As firms seek to gain a deeper understanding of the drivers that affect their business and the interrelationships between them, they are increasingly turning to more sophisticated quantitative modeling techniques. Market risk management is no exception. SAS provides gold-standard econometric modeling capabilities for quantitative users, as well as access to the results of model-driven analyses for business information consumers. Automating data integration using SAS lets you eliminate redundant, manual efforts and better leverage the unique capabilities of your mathematically and statistically abstract quantitative resources and your pragmatic, results-oriented business users. In SAS, technical and quantitative resources can publish parameter-driven risk analyses for business users. These dynamic analyses, which also include automated data integration processes in SAS, can be run by business users from the interfaces that theyre most comfortable with (such as Microsoft Excel). Freeing business users from abstract models and time-consuming data access and preparation tasks means that risk analysts spend less time managing data, and more time managing risk. With SAS, the flexibility to implement many different modeling approaches for risk factor evolution and revaluation means that firms can pick and choose the appropriate methodology for a particular need. Whether for meeting regulatory, rating agency or investor disclosure requirements, or the internal needs of managing the market risk of trading operations and enterprise risk management, firms leverage SAS to complement their existing infrastructure. Using SAS, firms can pick and choose from a wide variety of best-of-breed components that snap together better than those of any other technology vendor. SAS provides an extensive analytical, data integration and reporting environment that is being used by firms, in whole or part, to build highly customized, flexible and extensible risk systems that will not only meet their current risk measurement and management requirements, but their future ones as well.
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