Wednesday, March 30, 2011

Wrong Way Risk: A Primer

This article appeared in The Edge, Malaysia (Derivatives World) on Mar 14 2011

Wrong Way Risk:  A Primer

Wrong Way Risk has now been an important subject in contemporary risk management circles.  Wrong Way Risk is a hazard that is always present in the credit world but usually brushed off as negligent and remote. It is surprisingly easy to understand but difficult to quantify. This article will introduce the risk as plainly as possible and gradually move towards some quantification and valuation issues.
If I were to borrow some money from you, you would be concerned about my ability to repay. What is the probability of me defaulting on the loan? Here you are trying to assess the default risk or the exposure of the loan. Now, if I got ABC to guarantee my loan to you, how would you assess the exposure? If I defaulted on the loan, ABC steps in to repay my loan. You will probably be more interested in ABC’s credibility because ABC is now the ultimate borrower. You will also have better comfort in valuing the loan since ABC is expected to have a better credit standing.
Nothing to worry so far, or is there? What if ABC defaults together with me? What if ABC defaults before I do? Consider the scenarios below:

Auditing Derivatives: Value at Risk

This article appeared in The Malaysian Accountant journal, Jan-Feb 2011 issue

Auditing Derivatives: Things that can go wrong – Value at Risk

By Jasvin Josen

Value at Risk or just “VaR” has been around for many years and is a major risk management task of any investment bank. VaR has not been receiving good press lately, especially when it was accused for not foreseeing the 2008 crisis. In this article, we will analyse what can go wrong with value at risk and discuss the auditor’s approach.

What is Value at Risk
VaR is a technique for predicting the maximum losses from a portfolio of assests with a known level of confidence. For example, VaR might predict with a 95% confidence level that the maximum losses from a portfolio of risky assets would be RM 100,000. The effectiveness of this tool is in its ease of comprehension, making it a commonly used figure in boardrooms, with regulators and in annual reports.
VaR was developed as a risk assessment tool in the 1990s, driven by the failure in the risk tracking systems used in the early 1990s to detect dangerous risk taken by traders.  It became so widely accepted that regulators like the Basle Committee allowed banks to calculate their capital requirements for market risk with their own VaR models, using certain parameters provided by the committee.
Trades in any portfolio may consist of stocks, bonds, commodities, currency trades or derivatives. Their mark-to-market values will change depending on how the market factors (equity prices, interet rates, currency rates...) change. VaR attempts to develop techniques to change these market factors in a robust manner, to observe the possible changes to the portfolio value.
Three main basic methods are used – historical simulation, variance-covariance and Monte Carlo simulation. Briefly,
·         the historical simulation approach looks back at previous market factors behaviour and applies that same behaviour into the current portfolio to observe the changes in portfolio value.
·         in the Monte Carlo approach the market factors are simulated according to a defined statistical distribution. Then the simulated market factors are applied to the current portfolio to observe the changes in value.
·         the variance-covariance approach works differently. It derives historical risk measures like standard deviation and correlation for each market factor. Then it applies these risk measures to the current portfolio, (after breaking down the portfolio into standard instruments) to derive the value at risk.
What can go wrong in using VaR?