Tuesday, August 9, 2011

Liquidity Crisis And Stress Testing

Liquidity risk cannot be treated satisfactorily by the VAR because it ignores the risk exposure of a portfolio during the process of its liquidation. A liquidity crisis is usually an extreme event, so it requires tools Stress testing more appropriate than the VaR.

To fight against liquidity crises, the scenarios of crisis of a financial institution must include all the fragility of its balance sheet, namely the possible mismatch between investments in illiquid assets and funding sources precarious liabilities. A Stress Test relevant to a financial institution would be important to consider the consequences of a simultaneous withdrawal of its market counterparties. This is the way in which JP Morgan is committed after the near-collapse of LTCM in 1998. JP Morgan has developed the "dealer exit stress tests" to estimate the risk of sudden drying up of market liquidity due to one or more of their counterparties. This kind of stress tests and allowed to become aware of the dangers of the high concentration of certain financial markets.

One of the limitations of VaR as originally calculated was based on an assumption of "normality" of events. Or rare events are more important in magnitude than the law says normal. The work was therefore directed towards the use of distributions from "fat tails". Stress Testing procedure has the advantage of circumventing this difficulty by specifying the desired magnitude of the event, regardless of its probability of occurrence. Therefore it is considered an extension of the VaR.

Although complementary, these two methods have significant differences, however, since they are far from operating in the same period. Indeed, while the VaR is a tool for highly automated daily monitoring, Stress Testing requires the intervention of a number of players and often requires a significant delay construction and analysis. Thus, if the answer to a VaR limit is exceeded is simple (just cut positions), the response to overexposure through a liquidity stress analysis is more complex (installation program or refinancing guarantees, etc.)..
Finally, unlike the VaR with the automatic calculation can facilitate the adoption of the outcome, the results of stress testing because they are developed from subjective elements, require a real effort to communicate and explain with decision-making bodies.

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VaR and Stress Testing

Stress Testing is the study of the effects on the valuation of a portfolio of a specified set of changes in risk factors resulting from exceptional but plausible events. This is a procedure to create stress tests, through stress tests that can be varied in nature. And said historical scenarios, that is to say based on past experience, can rub shoulders with hypothetical scenarios said, that is to say based on events deemed possible in the future knowing that any changes of macroeconomic factors , sociological or political. To stress tests can also be added sensitivity tests, the best known is to increase or degrade instantly settings of a risk / multiple degrees or in percentage terms.

Scenario building and testing should follow an iterative and collaborative approach. Indeed, the convergence of views of all stakeholders, whether financial (risk managers ...) or not (economists, business ...), is needed to reach a consensus and identify all the factors (economic, environmental, commercial ...) that would influence the risk parameters. The analysis then produced by stress testing, primarily intended for risk managers and the Directorate General of the institution, and should be a detailed analysis to understand the exposure of the bank. This team approach then facilitates the production process of risk management indicators (dashboards) and ownership of findings by the top management.


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Sunday, August 7, 2011

Market Risk Assessment -2

Using a single number, indicate the VaR of a portfolio exposure to market risk and the likelihood of loss under the conditions proposed. The risk is also measured in monetary units, the same as those in which balances are established. Finally, among its other benefits, VaR:

* To evaluate the performance and correct any risk-based.
* Promote the information and transparency to the extent that it is a measure expressed in non-technical terms and may be subject to periodic reports.
* To determine the allocation of funds to invest and set quantitative limits for risk managers.

Three calculation methods are generally used to estimate the distribution of losses. They have in common to estimate the potential change in portfolio value from the data of the past, however, differ on the following:

* The historical method: observation of the historical behavior of the position to estimate the VaR;
* The parametric method: decomposition of the position of instruments based on different risk factors (equity indices, rates of different maturities, exchange rates ...) and then estimate the probability distribution of risk factors;
* The Monte Carlo simulation Monte Carlo market factors from an a priori probability distribution and estimate the VaR, as the historical method, from the sample generated.