Appunti Financial risk management

Titolo: MVA16 MVLMDA=MDL×  condition that implies the bank will not suffer consequences over the marketMVAvalue of equity in case of change in interest rate level.

The immunization condition implies a modified duration of assets higher than the modified duration ofliabilities (since the leverage ratio should always be lower than 1…).Imagine if duration of liabilities is 5 and the leverage ratio if 0,9, then 5x0,9=4,5 and 4,5 means that modifiedduration should be 4,5 when liabilities duration is 5 in order to be immunized, if the duration ratio is 0,9.

Exercise 1

a) Compute the duration gap of the bank.

b) Calculate the absolute and percentage impact of a 2% decrease in interest rate level on the the market value ofequity. MD = average

The MDA by taking into account the amount of each item in assets side. In the denominator, it will be the sum of all the amounts of items of assets. Even a small duration gap, multiplied for a big amount asset, may have impact that in percentage term of equities is quite dramatic, if there is a big shock in interest rate in the market.

Weaknesses of the duration gap:

• The duration gap changes continuously – because duration is a weighted average of maturity of cash flows. Each day the maturity changes. If today I calculate the duration of an item and in a month I retake the calculation, I will have different result because time has passed. This won't be a problem, if the duration would change in a linear way, with the time. But this is not the case because duration goes to 0 but does not go to 0 in linear way but following a curve, which depends on how the cash flows are structures.
• The hedging strategies have to be adjusted very frequently – because after a while my hedging

strategy won't work anymore. The duration gap is an approximate measure, just like the duration itself.

The indications are precise only if the change in interest rate level are not too large.

The duration gap assumes a uniform change of interest rate across different maturities (parallel shift).

The internal transfer rates

Not a measurement method, but a management method - it's not a way through which I just calculate a number that gives me a dimension to exposure to risk, but helps company in making decision, and if needed, mitigating risk exposure. It's about management and organization.

Main objectives:

• Transfer interest rate risk from various units of the bank that generate it (for instance, the branches) to a central unit (the Treasury Department)

Let's think about how banks are organized: it's formed by head quarter and branches in various parts of cities and various countries. Branches are units that have relationships with customers: when

information on clients asking for loan, undertaking risk and select the clients that are creditworthy. Even for the other hierarchical level to make the decision, it's important that in the branch information are collected in an appropriate way, in order to give good decision ground to the level of the bank. Branche do not manage interest rake, do not manage unbalance; consequently, branch should be evaluated in the operations, neutralizing the impact of movement of interest rates.

Imagine you are a branch manager; you have collected a lot of deposits and lend money to good clients paying regularly. Your margin should be very good, and you expect high premium for your work at the end of the year. Then there is ECB that decide to raise 1% interest rates and this damage your final results and your premium should have been 30k € and is now reduced to 15k €, just because the result of the branch has been damaged by an increase in the interest rate by ECB. If this happen, you will be

very disappointed, because there is an exogenous factor affecting my result, something from which I cannot be protected. This would be negative for many people and for their commitment in future years; the internal transfer rate, has the objective of having a result.

The Treasury Department acts as market maker towards the other operative units - Market maker is someone who decides rates, to be applied and communicate to others.

Different transfer rates should be set for different maturities - normally it is, unless market makers say that interest rates are equal.

The transfer rates should be in line with market rates and adjusted periodically (each week, for instance) - when there is a change in market level of interest rate, information on the change, will not affect the result for branch, but will be communicated to branches, so that the branch can adjust the condition they offer to clients.

Different transfer rates should be set for lending and borrowing.

operations – there will be a bid and askrate: bid rate is the interest rate at which treasury department is ready to receive funds from branches andask rate is the higher interest rate at which the treasury department is ready to lend money to branches.

The operative units systematically have:

• Repricing gap = 0 on every possible maturity band immunized against movement of interest rates
• Amount of lending equal to amount of borrowing

This achieves the first 2 goals (transferring interest rate risk and transferring unbalances between fundsraised and funds invested)

The interest rate exposure is transferred to Treasury Department

The mismatch between borrowing and lending is transferred to Treasury Department.

THE VALUE AT RISK (VAR)

The balance sheet of a bank has a distinction between banking book and trading book. The latter is composed byitems negotiated and kept with short time horizon. Depending on the type of bank, this trading activity, and soshort-term negotiation,

may be more or less developed.

Banking book is composed by types of operations and items that reflect medium and long activity (portfolio bonds example).

Market risk valuation in short term horizon

Main focus: negotiable securities held for trading purposes

Objective: measure potential losses due to market risk with a very short time horizon (movement of interest rate)

Most diffused metrics:

• VALUE AT RISK - is a technique proposed at the beginning of 90s, having wide success in the financial industry and then has been wide spreading to all other types of companies, not only financial companies. This technique shows some weaknesses that were clear during 2008, which was a severe financial crisis. Following this crisis, which highlighted weaknesses of value at risks, there were a short shift in expected shortfall.
• EXPECTED SHORTFALL

From traditional approaches to modern approaches It was a change in framework of thinking in measuring risks.

Example: imagine a bank has Expected got an

into account the volatility of prices: think about 2 equities portfolios, where I have stocks of Coca Cola, Walmart and Carrefour and another where I have Facebook, Amazon and Google. The volatility of prices of these 2 groups is very different: in the first group, it is more stable, the second is more volatile.

A step forward in measuring exposure to risk, is to include sensitivity measures – are indexes that convey information on volatility of financial securities including in certain portfolios. It adds a further degree of information to evaluation of risk exposure of certain portfolio.

From traditional approach to modern approaches

Imagine having these 2