OVERVIEW OF VAUE AT RISK (VAR) THEORY
Value at risk is simply defined as maximum loss that would occur over a given period at certain confidence level. It measures the most severe expected loss at a certain confidence level. Value at risk is a technique which is used to control the level of risk which an organization faces. Normally investment banks use this technique to measure the market risk of their portfolio of assets.Suppose Risk manager reports that at 95% confidence level the maximum loss that would occur is $10000 it means there are 5% chances of loss may exceed from that amount(Anon., n.d.).Most common method for estimating value at risk is the historicalmarket data. Although there are two others method that is commonly used for estimating value at risk such as Variance-covarianceand Monte Carlo simulation. Value at risk is defined as how bad can things get. Value at risk is very easy to understand. Calculation of VAR, let’s assume expected return =$2000, standard deviation of return =$1000, confidence level 99% which yields 2.33.
VAR value is 2.33*800 – 2000 = $330.(Harel, n.d.)
Appropriateness of VAR Method for Managing Risk
JP MORGAN’s 2012 Londonwhale trading case. It was concluded that portfolio valuations had been manipulated by the employees of the Bank. Even they made easily amendments in a value at risk measure with a simple spread sheet(Anon., n.d.).
Value at risk has number of advantages that is why it is an appropriate method for managing risk in current trading scandal.
Interpretation. Value at risk is very easy to understand, since it is a number or percentage of portfolio asset. For example: if Risk manager reports that at 95% confidence level VAR is $1000 for a day. It means in a day loss would not exceed by $1000 but there 5% chances it could exceed that amount.
Financial software available for VAR.By using software you can easily calculate VAR. There is no extraordinary capabilities required in order to calculate VAR by using a software.(Anon., n.d.)
For financial Institution there is always important to assess the credit risk. Credit risk is defined as default risk of counterparty on its financial obligation that’s why bank assigns a lot of time to complete this task.
The most common model that is used to assess credit risk is that Merton’s Model.
The assumptions of this model is that company is having zero-coupon rate debt that will be mature at a future time. If promised debt amount is greater than value of entity then company will default, debt holders may force to liquidate(Hull, n.d.). This model is used for only Europeanoptions.
Inputs of Merton’s Model are as follows:
- Current value of the company’s asset.
- The volatility of the company’s assets.
- The outstanding debt and debt maturity.
- The risk free rate of return.
Merton’s model with evolution of black Sholes model is used in effective risk management for Interest rate swap and options / CDS.
Interest rate swapis where two parties agree to swap their liabilities for interest payments. Interest rate swap is used to protect yourself for the volatility of interest rates. For example Mr.A wants to take loan of fixed rate and Mr. B wants to take loan of floating rate. Interest rates for Mr A are 10% fixed rate and floating rate is Libor + 2%. Interest rates for Mr.B are 9% fixed rate and Libor + 1.5%. Arrangements of Interest swap are as follows:
Combined cost without swap Libor + 11.5%
Combined cost with swap Libor + 11%
Annual savings in interest is 11.5% – 11% = 0.5%.
Due to Interest rate swap organization can arrange the loan in a country where they can’t access loan. Typically swap of fixed interest rate or floating interest rate(Anon., n.d.).
Credit default swap (CDS) is a derivative that buyers use to protect themselves for default of counterparty. For example: If Mr. Saif has bond of $1000 par value of ABC company and its maturity period is 10 years. He has fear that ABC will default to fulfill its obligation. He enters into CDS with Mr. Maaz and agrees to pay him income payment of $30 (like insurance payments) each year equal with the annual interest payment on the bond, in return Mr. Maaz agrees to pay $1000 par value of the bond in addition to the any extra interest………………….
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