Msc.

in Banking and Financial Engineering

Internal Models for regulatory capital

Session 2- November 2016
 Internal Models for Market
Risk (VaR, SVaR, ES)

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 STANDARD RULES AND INTERNAL MODELS FOR
MARKET RISK

• What is market risk? « The possibility for an investor to experience losses

due to factors that affect the overall performance of the financial markets »
- Investopedia

• As for credit risk, regulation 575/2013 (CRR) lays out two choices: either:
• You capitalize against market risk using a standard approach ; the amount to
set aside depends on the type of trade and its maturity;
• You use an internal model – see article 364 of the CRR and beyond.

• The internal model approach used to solely rely on VaR. However, with
the 2008 crisis, additional metrics are now required such as SVaR
(stressed Value at Risk) and IRC/CRM (Incremental Risk Charge/
Comprehensive Risk Measure).

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 RISK FACTORS

• We can immediately see from the definition, the occurrence of the « risk
factor » terminology, when looking at Market Risk. Risk factors drive the
current and future prices of the bank’s portfolio of trades.

• In a VaR (Value at Risk) Model, we need to indentify the risk factors which
will drive the future price of our portfolio.

• Ex: if we have a treasury bond in our portfolio : this is going to be : Interest

Rates

• But what about a best-of option, delivering the best performance out of an
Equity basket? It will be sensitive to a much wider set of risk factors.
• Equity prices, Equity volatility, Equity volatility term structure, Equity volatility
smile, Implied correlations, Interest rates.

• The work of a VaR Methodology analyst is to identify these risk factors

and decide how we are going to shock them to see how they affect the
price of our portfolio of trades.
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 INTEREST RATES

• Interest rates are a risk factor for most financial instruments.

• Lets have a close look at the interest rate risk factor:

• You always need to specify the compounding: the more I reinvest, the
higher the Future Value. The higher I can go is continuous
compouding.
• You can use the following formulas to go from continuous (Rc) to
periodic (Rm).

Excel example:
Compounding

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 BOND PRICING
• A bond price is a series of discounted cash flows: the CFi below are the
Cash flows and the DFi are the discount factors, which depend on the
current zero rates (the used to discount, we call them zero rates, because
they are the rates used to price a zero coupon bond).
l example:
price, bond
• To calculate the price of a bond, either you write down the sequence of
yield
coupons and discount them, or you can use the excel formula
(PRIX.TITRE), assuming you know the yield.
• We can calculate the yield, which is the single rate which can be used to
discount all cash flows so that their sum is the price of the bond. In this case as
well, you can use the excel formula (RENDEMENT.TITRE).

• We can also calculate the par yield for a bond, which is the coupon rate
that causes the bond to equal its par value, using the following formula:,
with d being the value of $1 received at the maturity of the bond, A the
value of a annuity that pays $1 per year and m the number of coupons per
year.

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 BOND SENSITIVITIES (1/3)

• The MACAULAY duration tells you, when, on average you are going to
receive your cash flows. It is simply a cash flow weighted timing

Weight of
each cash
Excel example: flow
Bond Sensitivities
Timing

• If all the cash flows happen at the end: then the DURATION is the maturity
this is exactly the case for a zero-coupon bond.

• Modified duration is the true measure of sensitivity of the bond to moves in

interest rates (it is the same as duration for continuous compounding).

Compounding
Yield frequency
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 BOND SENSITIVITIES (2/3)

• With Modified duration, we can get the variation for the price of a bond for
a small move in price.

• But the payoff is convex, so clearly, this is NOT ENOUGH for larger
moves.

Excel example:
« why duration is
not sufficient »

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 BOND SENSITIVITIES (3/3)

• So we need to add convexity to get a better approximation for larger

moves (Taylor series approximation of order 2).

• When using continuously compounded yield, the formula for convexity is

the following:

• When using periodically compounded yields, the formula is as per

below:below.

Excel example:
Bond Sensitivities

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 SPOT AND VOLATILITY (1/2)

• As a reminder: an option gives you the right to buy (call) or sell (put) an
underlying at a certain price (strike).

• A European option can only be exercised at maturity, whilst an American

option can be exercised at any time.

• The typical formula to price call options is:

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 SPOT AND VOLATILITY (2/2)

• Options are sensitive, to the spot price: the sensitivity to this Risk Factor is
the delta (N(d1)). The sensitivity of the delta to the spot is called gamma.

• They are also sensitive to volatility (vega), which is a risk factor, to

interest rates (rho), and to time (theta).

• Is Rho a risk factor? - YES

• Is time a real risk factor? – NO, we cannot shock time!

• From the excel spreadsheet, you see that the greeks are not enough to
explain large moves and that they do a poor job when risk factors move
together, unless we add cross risk greeks such as Vanna, to the P&L
decomposition.

Excel example:
Option Prices

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 VOLATILITY SMILE

• Black Scholes assumes a lognormal distribution for the Equity prices.

• This is clearly not the case: as the excel example on the CAC 40 time
series shows.

• This is why we have a smile for volatility: which we can extract from
Option prices.

• In other words: Option prices are sensitive not just to implied volatilities
but to moves in the implied volatility smile! Volatility smile is therefore a
risk factor!

• Traders do have models that take into account this volatility surface (ex:
the SABR model, which assumes that volatility itself is stochastic).

Excel example: Lognormality is not

reality – The skew in the markets

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 RISK MEASURES

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 MEAN AND STANDARD DEVIATION

• Your basic risk measures in portfolio management for instance are mean,
and standard deviation.

• For instance your standard deviation measure is calculated the following

way when your returns are xi

• But capital requirements are driven by more « stressed » risk measures

than just standard deviation.

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 VAR AND EXPECTED SHORTFALL (1/3)

• If I tell you that my 1 day 99% VaR is $1m, it simply tells you that I am
99% certain that I will not lose not more than $1m during the next day.

• In mathematical words, a VaR at an α confidence interval is such as

Excel File: VaR Normally Distrib Portfolio

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 COMING BACK TO INTERNAL MODELS : VAR AND
EXPECTED SHORTFALL (2/3)

• The internal models for Market Risk are based on VaR, at least currently;
they will soon be re-based on Expected shortfall (also known as Tail
VaR or Conditional VaR), with the fundamental review of the trading book
(FRTB)

• Expected shortfall is the average loss in the tail (what is my average loss
across my very bad losses).

Average Losses above a

certain threshold

Excel File: VaR Normally Distrib Portfolio

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 WHY FAVOUR EXPECTED SHORTFALL

• Because VaR does not give you any information about what is going on in
the tail!. VaR is therefore not suitable for « extreme » products.
• Note also that VaR may not, in some rare occasions, be sub-additive which is a
desired property for a risk measure!
• For two portfolios A and B, VaR(A) + VaR (B) should be greater than VaR (A+B),
but this is not always the case.

• For a given confidence interval, ES will be greater than VaR.

• For a normal distribution, there is a relationship between ES and VaR,

where f is the standard normal distribution function (i.e, not the CDF)!
• In the formula below, q is the quantile and p is 1-q, i.e, the confidence level.

• With this formula we can see that a 99% VaR (current model framework)
is approximately equal to a 97,5% ES (FRTB framework).
Excel File: VaR Normally Distrib Portfolio; VaR not always sub-additive
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 THE CURRENT REGULATORY FORMULAS FOR
CAPITAL REQUIREMENTS

• Banks usually calculate 1 day VaR and not 10 day VaR because the
problem with 10 day VaR is that either you have overlapping time periods
or, if you decide not to have overlapping time periods, you have less single
10 day VaR moves.

• The regulator allows banks (article 365) to calculate 10 day VaR as:

• The regulatory formula is the following, with SVaR being VaR on a 1year
stressed period

• Why do you think the regulator likes SVaR?

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 HOW CAN WE CALCULATE THESE MEASURES:
HISTORICAL VAR

• Historical VaR: You use past data as a guide to the future. Let’s look at a
simple example for a bond.
• Sensitivities approach: the good thing is that you can

• A) decompose the risks into pieces (ex: for an option you

decompose it by delta, vega etc..) and you see what is driving
Excel File: VaR VaR.
Example for a
Bond
• B) It is quick: you don’t have to reprice the trades: some trades
are priced with thousands of monte carlo simulations, so not
having to reprice them for 780 scenarios makes it easier!

• C) But it is bad for complex portfolios with cross risks and larger
moves

• Full revaluation approach: the good thing is that you get the right
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results, but it can be slow…. 19
 HOW CAN WE CALCULATE THESE MEASURES:
PARAMETRIC VAR

• One parametric model is to state that the Portfolio is normally distributed

and centered in zero and you will assess VaR from that normal
distribution, using the typical quantiles.

• You also assume the distribution of the risk factors is normal and centered
in zero, and calibrate the standard deviation for each risk factor as well as
the correlations across risk factors.

• The objective is then to calculate the portfolio’s standard deviation.

• For a 2 assets portfolio, assuming it is only sensitive to first order “linear

risk”, we can use the following formula and then calculate a 99% VaR as
2,33*StandardDeviation

Excel File:
Parametric VaR

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 HOW CAN WE CALCULATE THESE MEASURES:
PARAMETRIC VAR – CORRELATION MATRICES

• When using parametric or monte-carlo VaR models, banks need to

calibrate large variance covariance or correlation matrices across risk
factors.

• Some time variances and covariances are not calculated consistently: for
instance, the variance of risk factor A can be calculated using 10 day
moves whilst the variance for risk factor B is calculated using 1 day
moves. This generates inconsistent correlation matrices.

• For instance lets look at the following correlation matrix: it is clearly

inconsistent.
RF1 RF2 RF3
RF1 1 0 0,9
RF2 0 1 0,9
RF3 0,9 0,9 1

• Statistical tools exist (diagonalizing the matrix and make all its eigenvalues
positive) to make these matrices semi-definite positive, i.e. consistent.

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 A VAR MODEL IS NEVER PERFECT

• Are you sure you have all the risk factors? Many of the risk factors are
Risks Not in VaR because you cannot find appropriate time series for
them!
• Example: exotic risk factors such as Inflation Volatility Skew, Implied
Correlations etc..

• You can have pricing errors: Large shocks to your current risk factors can
cause a failure to price!

• Your time series can be patchy or bad proxies

• Full reval VaR can take you so much time that you roll back to a sensitivity
approach.

• Are you sure you are using the right kind of shocks: absolute shocks or
relative shocks. Example: if, in the past, the CDS spreads on a certain
name went from 100 to 200 and you are today at 500, are you going to
reprice with a spread of 600 or a spread of 1000?
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 …SO WE NEED TO MONITOR THE NUMBER OF
EXCEPTIONS THROUGH A BACKTEST

• When we get our VaR, which is refreshed on a daily basis, we can

consider that we have the following bernoulli variable for the exception
(the P&L we see is worse than the VaR), for each day

Excel File :
Number of
exceptions

• For instance, with a 99% confidence interval:

• We can therefore look at the probability for a number of exceptions k over

N days as a Binomial Variable:

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 APPPENDIX 1: A QUICK VIEW OF THE MAIN CHANGES
DUE TO THE MOVE TO THE FRTB

• Source: Reply.com

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