Derivatives V --- Risk Management
Traders and banks take risks to make money and risk management is about measuring and controlling risks.
Risk is managed by numbers. But how to pick relevant and convincing numbers are more of art. For example, how a bank’s earning is affected by interest rate. To select an interest rate gives others convincing signal that the rate change would occur but also you don’t want to pick a rate very unlikely occur so that it would scare others not to take risk.
Banks’ management should understand derivatives and risks thoroughly. If not, at least can spell these two words (plural in derivatives). Risks are 4 groups: market risk, credit risk, liquidity risk, and operation risk. They are quite self-explained. For banks, credit risk, liquidity risk and operation risk are the first three ranking risks. Market risk is less serve. On the other hand, non-financial entities are exposed to much higher market risk.
Risk is measured in terms of VAR --- value at risk. VAR calculates the distribution of price changes in the past. It signifies the maximum amount that you could lose as a result of market moves for a given probability over a fixed time. For example, a VAR of $50M at a 99% 10 day holding period means that the bank has 99% probability that it will not suffer a loss of more than $50M over a 10-day period. The probability is calculated from the famous Gaussian distribution to price movement.
The assumption of Gaussian distribution on price movement brings in doubters on VAR. Price movements are not Gaussian distributed. VAR did have times of flaw such as in 1998 Crisis where the historical data was too mild to predict the scale of the storm. Another classic example of VAR’s failure is LTCM. So another theory, called EVT, stands for extreme value theory, was born. It is similar to the Stress Tests the government just did on the 19 largest banks. The goal is to see how the banks can survive if the worst conditions occur. It came from physical sciences.
Besides financial risks, others are harder to measure. For example, ERM (enterprise risk management) encompasses personnel risk, operation risk, system risk, and legal risk. These are hard to quantified. The hardship doesn’t mean they can’t be measured but just mean the outcome is difficult to validate.
Risk is managed by numbers. But how to pick relevant and convincing numbers are more of art. For example, how a bank’s earning is affected by interest rate. To select an interest rate gives others convincing signal that the rate change would occur but also you don’t want to pick a rate very unlikely occur so that it would scare others not to take risk.
Banks’ management should understand derivatives and risks thoroughly. If not, at least can spell these two words (plural in derivatives). Risks are 4 groups: market risk, credit risk, liquidity risk, and operation risk. They are quite self-explained. For banks, credit risk, liquidity risk and operation risk are the first three ranking risks. Market risk is less serve. On the other hand, non-financial entities are exposed to much higher market risk.
Risk is measured in terms of VAR --- value at risk. VAR calculates the distribution of price changes in the past. It signifies the maximum amount that you could lose as a result of market moves for a given probability over a fixed time. For example, a VAR of $50M at a 99% 10 day holding period means that the bank has 99% probability that it will not suffer a loss of more than $50M over a 10-day period. The probability is calculated from the famous Gaussian distribution to price movement.
The assumption of Gaussian distribution on price movement brings in doubters on VAR. Price movements are not Gaussian distributed. VAR did have times of flaw such as in 1998 Crisis where the historical data was too mild to predict the scale of the storm. Another classic example of VAR’s failure is LTCM. So another theory, called EVT, stands for extreme value theory, was born. It is similar to the Stress Tests the government just did on the 19 largest banks. The goal is to see how the banks can survive if the worst conditions occur. It came from physical sciences.
Besides financial risks, others are harder to measure. For example, ERM (enterprise risk management) encompasses personnel risk, operation risk, system risk, and legal risk. These are hard to quantified. The hardship doesn’t mean they can’t be measured but just mean the outcome is difficult to validate.
posted by Intl.investment.services at
11:24 AM
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