do with modi ratio take like t diffe clai sets % of ent spurt ers, n wh ustry s as ither, of do s r r d m y s d m e e y 10 ate s, com he op If we would ves fo lia, m ted A mes ue fro rom a custo conce her in usine ies denc and a m h f ? r r t t n u b a n r o e s d ig e le to ajo tr se so s o the axon e a te phes So r pay s from ught peop er re Aus k We ly con ts rev ffere ucts e m tro RM r ith k t u ag a i t av n h d is rea ly tho some ide ot four' i of R lly on rates ave s g pro also man eal w g ris sts h catas ing E ? The k h d a e s n ly e s e s n sur eal a longs e 'big ut 10% gener gen ed to selli risk i ise ris ng to reati k ana trem sform ix thi draw c n g x f d o it to vi e m k is ss ra th 't r pr ra in ig a mbe from k is ab al ris bank s see usine y cred enter m ha aren rise r in on in. T an we aken d ma t a l s c b n r rp e nu on nk el is fro II tal illar I nal r erati itiona n ba pical , sur ely fo ape team t ente hom k dom how have edit a gle w a sc ty lia P ut ug op is at lly tio cr .I les ad sk ng pera tive, se tr ustra der a m sa ortun can e ny ri n. Wh usua nal r risk b ERM rom ill str ing to f u a o t A o o F w s ,o ec t si tio ely ersp beca ugh, con nts fr ous? team lly, m derati os tha pera arke fixing reats ams are g es. Le o e i a to m ri k th k te you mat wh o ce lp ri ho , cia finan ally t were paym st se so ris dition r cons cena s the it or lies t eats ti ll ris o rs, c we d r fo sk s f rd cred app it tr rise y side ot es ty wa g w g i o m a A n n i e w e e b tl n t ld . Iro ; if s r rp ri k. sp g side or set k is th numb et ris matt cific ven to ed fo initely o tha ente side ude' er na odelli n i s ri th er ks pe m ny ef rk nd is a iers t ris pital nit sa ma ats a out s ally d ly cov hat d olved at ma re ris mag o ano ution th ppl wha a c t d u su ow omic it an thre drive norm perb nd t be ev s th mpa ncy x n int strib m o kn con cred ising that re m su es a can urdle to co que to ru he di fr a d l o e t s t t h f i u g re o wo erate lm o prior shops ercise far fr ying g work gous wan not 'f goin ork, rea ren't work is ex und e sa rame mon if you ions also amew gen heMarket f a riskskis a major continual which impacts all , u ilynearly fr and t re ktoday utbusinesses so s ththreat lys and ato rbeenstwritten blyeffects in bits ri need rib oufora therisISO tounderstood. risk paper g, hhas a n a i a be This 31000 a g t g b e i m y r f o ri as d nt, tin arias ris le oguide tin a ca assistance ou risk is, how it pro practitioner P r a p y t . a r a ‘foundational’ to explaining what market i e n t l k i n ente oup sk rem ta in ris s ri31000 ll s skimeasured scemanaged fac can c rwith urisk framework. a e be se anreISO n e ainline s a toand s s i i a e eas ous d p xp r th RM ays how e ar m e e e k E nt is, eral w c on .Ther rue e r. IE; to ris ogen e i y t m h sev emat natel sure ann roac re ho m a o h p i u e t p ic sc port o m metr tion a 't cap t o r y a p y tr can ibu pa r the in a distr f you i a s thi mpt hort, e att a. In s dat

31000 Risk Frameworks

Framework Foundations Version 1.00 (DRAFT) Martin Davies | Causal Capital © 2013 [email protected]

31000 ISO 31000 is a risk standard for

market risk specifically. In this paper to be real too and we need to accept

managing enterprise risk across a

we take a look at market risk, what it that market risk, like all risk

business, of which market risk

is, how it can be measured, reported disciplines is complex and this

would feature. However, ISO 31000

and finally we deliver some insight document is a brief introduction to

doesn’t specifically state how a risk

into how a finance department may market uncertainty and should be

manager can measure or manage

control their market risks. We have seen as a preamble on market risk.

2

Market Risk

7 Firm Wide Sources Seven most commonly accepted areas of market risk concern, there may be more.

Cross-border FX cash flow is variant against a home currency.

Cross-border payments also suffer from uncertainty in FX volatility. | 3 Month Libor-OIS Spread during the GFC

M

arket risk is not defined in ISO 31000 but the standard does recommend in principal 5.3.5 that “the nature and types of causes and consequences that can occur from

Causal Capital - 31000 Frameworks

risk should be measured”. So let’s start off with a definition of

Interest rates are floating and effect the cost of both equity and debt capital.

market risk and I revert to the Basel II banking accord for this lead, just as a simple source of accepted practice. Interest rate volatility changes the floor benchmark on a valuation after a valuation has been completed.

The supply and demand of If I was to select one, just one of the most catastrophic examples of market risk during our last century, it would have to be the volatility

commodities is uncertain and this translates to price / volume volatility.

of the 3 Month Libor-OIS spread when Lehman Brothers collapsed. The Libor-OIS spread is the difference between Libor and the Overnight Index Swap rate and the index is a direct measure of the health of the money markets.

Assets held & marked on a balance sheet may change in value, simply from a market perception alone.

A move of 50 basis points in a day would be extreme in this index but when Lehman Brothers hit the wall, we threw the needle off the dashboard, the money markets froze and the global banking system

The Unit of value of an asset

imploded.

depreciates through time.

1 Interconnected

There is a lot that can be learned from the Global Financial Crisis

Extreme market events can impact more than one market & can leap across jurisdictions.

(GFC) and for businesses away from banking, I list a few points to the right which need consideration. One apparent observation would be

31000

ISO 31000 Context

that market risk can have general or expected uncertainty, normal volatility if you prefer and catastrophic tail like events. This isn’t so

2 Tail Events

different to the uncertainty we experience in weather, a little bit of

Tail events can be difficult to identify with risk systems based on historical data alone.

drizzle on one day and torrential flooding every decade or so. We’ll keep this point in mind because our market risk framework is techniques for different types of uncertainty or stress.

There is a difference response required for market tail risk events versus normal volatility.

4 No Planning

Let’s move away from stories of the spectacular for a moment, it always sells well, quite exciting I know but that shouldn’t distract us

Millions of people suffered from the GFC & many of them will never recover what they lost.

from the simple fact that normal volatility or market price uncertainty is a risk problem that needs treatment from the outset.

3

Market Risk

3 Policy Response

going to need to have alternate policy responses and measurement

Imagine a company selling products overseas, any product, car parts to agricultural commodities and in doing so, it will suffer many threats from market risk. Firstly the price of its inventory is floating but so to is the settlement currency of the transaction. In the example to the left, we can see a standard process for quoting, invoicing and payment. A process that every company around the world is quoting prices and accounts receivable are collecting but between these two moments in time, the price of what has being sold could move in the market. This is especially the case when a business is settling in an offshore currency. In our example, a 5.8% FX move in the USD / GBP currency cross would cost the seller over 20k in losses, that might be more than their entire profit | Market risk shown in invoice cycles

in this deal.

In a matter of moments, the entire value of this deal was eradicated. ISO 31000 defines risk as “ ” and it has a process flow for framing the management of this uncertainty that goes under Clause 5. While ISO 31000 neatly describes operational risk in the “31010Risk Assessment Techniques”, it doesn’t have guidelines for

other risks types such as Market or Credit risk. Nonetheless, we can align the requirements for fulfilling the management of Market Risk and we’ll start off by taking Clause 5 of the ISO 31000 guide as workable framework for which market risk activities can be assigned and aligned.

Causal Capital - 31000 Frameworks

following nearly everyday. Sales teams are

31000

Communication and Consultation would identify those who are accountable for market risk and consult with them to assist with the development of requirements for designing or acquiring and then operating a final market risk solution. This is very important and ensures that there is buy-in from the coal face of the business and that relevant resource gaps can be negotiated with senior management. Establishing context captures objectives of those impacted by market risk, these objectives are recorded as constraints and goals for the final market risk solution. A gap study may be

4

launched to identify the types of market risks, their potential

Market Risk

impacts, levels of existing accountability and control operations that are in place. A final report would allow stakeholders to view how market risk is impacting their objectives and its current treatment efficiency. Should clearly identify what causal factors drive market risk and how they intertwine. Market risk is an exogenous threat and consequently careful structuring can result in its avoidance in part. Many firms without market risk solutions tend to | ISO 31001 Clause 5 Schematic

operate inappropriately in the background of price volatility.

Causal Capital - 31000 Frameworks

31000

Activity Type

Description

Establish Framework Project

Propose / Receive directive identify stakeholders + objectives Capture data sources, regulation, market practices + providers

1

5.2

2

5.3-2

Establish external context

3

5.3-3

Establish internal context

4

5.3-4

Context of risk management

5

Zone 5.4

Data sourcing / repository

Design + develop + test data feed and repository

6

Zone 5.4

Model development

Design develop various models on specific market risk areas

7

Zone 5.4

Report design

Develop various reports for market risk causes / impacts

8

Zone 5.4

Policy and appetite response

Capture policy response & report market risk profiles

10

Zone 5.4

Treatment evaluation / execution Identify and explore different treatment alternatives

Operator objectives, constraints, controls, policy practices, opportunities, culture, contract relationships, risk appetites Register how market risk impacts business objectives, identify assessment methodologies, identify target operating models

| Market risk framework activities would see different measurement techniques being explored and tested against the stakeholder requirements identified in 5.2 and 5.3 of the ISO 31000 standard. Market risk like all risk disciplines can be measured very quickly but such rapid solutions usually have model flaws that will need to be enhanced away through continual design improvements overtime. This roadmap for market risk needs to be clearly

documented and tracked under clause 5.6 of the ISO 31000 standard. In the table above, we have listed some of the various risk management activities which can be entertained to bring the measurement and management of market risk into a formal operation within a business.

31000

Measuring Market Risk The field of market risk quantification is absolutely massive and has been written about by many people, over many years. It is awash with mathematical and statistical theories as well as various trader-like mechanisms. The purpose of this paper is not to promote one specific approach over another but to explain how market risk may be measured where its implications are experienced. By reviewing the variance within a time series of data often

the

first

step

risk

analysts

entertain

for | Value at Risk Example Value at Risk does have some hurdles which need to be overcome and every model in finance or risk will have constraints and limitations. For VaR these four below need to be kept in mind by risk analysts. [ ] How does VaR translate to tradable policy

Market Risk

5

points and against a companies position or objective, is

[ ] VaR created from historical data is backward looking [ ] Aggregation can lose component effects in risk [ ] Normal distributions in VaR may be the wrong curve Once these fundamental solutions are in place and back tested, market risk analysts should expand their analysis | Univariate Time Series There are many statistical ways in which volatility

to consider some of the types of additional impacts market risk presents to their business. These top four are very common concerns which need solutions.

value this uncertainty with varying results.

[ ] Volatility clustering & seasonal trend analysis [ ] Effects from additional liquidity risk

understanding how uncertainty or market price volatility

[ ] Portfolio correlation effects

may impact the value of assets they have booked on their

[ ] Stress testing of tail event scenarios

firm’s balance sheet.

Each one of these market risk goals is more than likely a

Most market risk analysts kick their modelling efforts off

model in its own right, needs to be described separately

by attempting to measure this variance within a univariate

and will end up being integrated into an overall market

time series. This is the volatility of a single price changing

risk reporting system.

through time. However, many other analysts simply entertain a Value at Risk measure to capture the outcomes from market volatility their positions may have. Value at Risk can be defined as a threshold value that the

Common market risk models to consider Value at Risk representation of variance outcomes

probability that a mark-to-market loss on a single position

Option pricing models (eg spark spread / real option)

or in a portfolio will not exceed a specific value within a

ARMA, ARCH, GARCH, time series sequencing

specific confidence level over a unique time horizon.

Kupiec Backtesting for VaR reporting procedures

Originally created by the banking community, it usually represents risk as a probability distribution function that can show both the expected and tail risk together.

K-means cluster analysis / Various Copulas | Some example models used in Market Risk

Causal Capital - 31000 Frameworks

can be depicted. Different models in market risk

31000 Market Risk

6 | Market Risk Operational Framework & Community Market risk management is usually separated

risk management using Chinese walls, while other institutions

into

Information

may introduce structuring agents such as Credit Valuation

technology, risk modelling, daily risk monitoring

Adjustment or Delta Hedging desks that have specific tradable

/ control and finally position taking at the front

risk control remits. The objectives between these units needs to

office. Many firms segregate the front office from

be understood clearly to reduce institutional conflict.

several

concise

subunits:

of reference when a specific stakeholder needs support, reports or dialogue around market risk threats. Some businesses have When the average person is asked to think of who is impacted by market risk, there is a general tendency for people to focus on two communities;

enhanced either their risk department or the treasury unit for this end and the benefits of lower costs, as well as a standardised model for market risk are very attractive reasons to consider.

Causal Capital - 31000 Frameworks

Commodity traders and portfolio investment managers.

Business Unit Market Risk Impact on Objective

In reality, market risk touches more departments

CFO - Treasury

Increase and smooth cash flow yields

and objectives than would first seem obvious and

CFO - Treasury

Optimise funding and liquidity costs

CFO - Treasury

Cash management pool / sweep / invest

A business cannot have a single model for

CFO - Investment

Portfolio re balancing and optimisation

quantifying market risk when the objectives are

Financial Reporting Report material impacts from market risk

each department is impacted by market volatility in different markets as well as in alternate ways.

so diverse across a firm. On the table to the right, we have taken to list fifteen departmental

Cost Accounting

Cost and budget planning incl of market risk

functions that are inherently impacted by market

Raw Materials Plan Procurement costs of commodities

price uncertainty.

Accounts Payable Deferment costs and FX exposure Collections

With market risk being relatively pervasive across

Discounting costs and FX exposure

Strategic Planning Project opportunity valuation/benchmarking

a business, it would make logical sense to

Strategic Planning Cost of capital and funding structure

establish a central function that can support

Sales Revenue

Revenue forecasting inline with market risk

Product Pricing

Product pricing, banding, margin & mark up

these various business units when they measure and model market risk. This support unit may develop enterprise repositories for capturing large pools of data, it may standardise specific modelling techniques but it does become a point

Performance Plan JIT cost of inventory, efficiency & risk Waste Mng

Floating prices mng in waste~scrap markets | Departmental objectives from market risk

Market risk reporting needs to serve different members of the “market risk community” outlined in figure 8 & 9 of this document. Generally information is presented in unique ways to best represent whether objectives of

31000

Market Risk Reporting

each stakeholder are being met.

Executives and senior managers should be kept aware of limit utilisation, excesses and exceptions. Overall exposure against returns shows whether profits are consummate of the

7

| Market risk exposure report

Sound stress testing reports will allow managers to understand the impacts from systemic market shocks & are critical.

Risk takers need to be kept informed as to how

much

headroom

they

have

Market Risk

risk taken and are popular reports.

have

remaining and weather the are tracking against their strategic objectives.

Component risk reports and market heat maps assist portfolio teams to ‘zero in’ on risks and opportunities.

reporting and design reports with stakeholders requirements & inputs. | Asset volatility correlation map

Sample Risk Reports VaR over multiple horizons Limit utilisation & excess Stress Testing Report Component risk report Performance & Tracking Error Market Risk Dashboard Component risk report | Market risk stress test report

| Typical Market Risk Reports

Causal Capital - 31000 Frameworks

Avoid a one size fits all to market risk

T

here are numerous ways to treat or control Market Risk risk which in

31000

many cases requires the stakeholder to take another position in the same or a different but correlated market. The most common method

Treatment

for negating away market risk is by squaring off a positional exposure by entering into a symmetrically opposite trade through a futures contract. In effect, if you are selling a commodity in 30 days time in the physical market, you can square this risk off by buying it back in the futures market on the same delivery date. If the notional value of your hedge is equivalent to the size of

Agribusiness Nearly all firms in agriculture suffer commodity price risk from demand / supply inefficiencies.

your physical trade, you have pretty much netted out your exposure from market risk. This isn’t to say that futures markets don’t present additional threats and there are always settlement issues to worry about when your

Market Risk

8

physical counterparty defaults on their obligations, only to leave you open in one market but in dispute in another. Secondly, by squaring off all your risk, you have also limited any upside from favourable market movements.

Power Production Electricity utilisation & fuel mixes cause complex pricing problems in power.

Manufacturing Raw materials planning, waste control and cross-border FX suffer substantial market risk.

Civil Aviation >30% of operating costs in aviation can be attributed to jet fuel pricing which is volatile.

Banks & Lenders Banks and lenders suffer deep asset liability mismatching from interest rate volatility.

| Hedging Payout Diagrams for various options strategies

Causal Capital - 31000 Frameworks

Item Treatment Strategy

| Many Sectors Effected

Description

1

Avoid Risk through Pools / Sweeps

Trade execution is carefully timed to maximise market upside

2

Futures and Forwards Delta Hedging

Futures and Over The Counter contracts to square off physical positions

3

Vanilla option strategies

Pay a premium up front to transfer the potential downside at a later date

4

Component option strategies

Multiple option strategies designed to cover specific market conditions

5

Forwards and Swaps

Cyclically transfer risk on multiple future states over long periods

6

Exotic option strategies

Over the Counter contracts for hedging multiple underliers & conditions

7

Physical Contractual Transference

Share / transfer the costs and losses of market risk in physical contracts

8

Reserving for volatility

Hold invested capital to cover for future losses on the trading book

10

Asset & Portfolio Diversification

Diversify the assets in a portfolio to reduce idiosyncratic risk | Various Hedging Strategies

Delta hedging is only the beginning on market risk

downside risk or volatility specifically, might consider a

treatment and different types of assets and trade tenors will

component option strategy such as a butterfly spread.

attract different types of treatment strategies. Trades with

Some traders may try to hedge multiple market risks such

long tenors and multiple payments generally favour swaps,

as a commodity and FX with one contract and they can

traders which want to remove both the upside and

select an exotic quanto option to do achieve this.

What is important to note is that hedging and treatment strategies should never be thought of as 100% cover or zero risk solutions. They need managing and there are specific market effects that can render hedging strategies as risky business in themselves.

Knock On Effects

31000

Constraints & Concerns

Market risk treatment transfers risk to other types of conditions

Crowded markets and liquidity risk One of the most frustrating side effects is basis risk. This can be flavours. Calendar basis occurs when there is a mismatch between the expiration date of the futures contract and the settlement date of the asset. In other cases the correlation between your physical market and

Basis risk from poorly aligned hedges Behavioural effects from risk appetites

your hedging market may be imperfect, it can diverge further during systemic market shocks. Which market should an airline hedge its jet

Wrong way risk / negative cross gamma

fuel on? Numex heating futures or ICE? Location basis, product / quality basis and calendar spread basis need

Tail risks and systemic market shocks

careful management in the realm of hedging. The knock on effects listed to right also need specific policy, models and careful monitoring.

The measurement of market risk has become more prolific as a consequence of specialist development from the software industry. Today there are a huge number of programs that firms can acquire to carryout their market risk measurements for them.

9

Market Risk

thought of as imperfect hedging and it comes in many different

| Other serious concerns

References Reading materials are worth reviewing inline with this paper

One particular software language that is becoming popular for measuring and reporting market risk is R-Project. The tool can be

LIBOR spread summary R Sengupta, Yu Man Tam

downloaded from the www.r-project.org portal for free and has several libraries for calculating Value at Risk, forecasting prices, reporting performance or measuring correlation effects in a portfolio. The

Modelling market volatility Elsheikh Ahmed, Z Suliman

program is also able to connect to live price data through various

The use of Garch models

packages and its extensible statistical libraries facilitate some of the

Robert Engle

more complex areas of market risk. Stress testing and back testing will eventually need to be considered and R-Project covers this.

Data analysis for Financial Eng D.Ruppert

| Document references This document was never intended to be an all encompassing tome for market risk but was written to assist ISO 31000 practitioners understand what market risk is, how it can impact different objectives in their businesses and how a framework can be established to manage this risk class. To conclude, this brief should be seen as nothing more than a starting point on market risk and a fully fledged framework would need to be evolved past what has been described here.

Market risk is a substantial threat for lots of different business types, it shouldn’t be ignored and it can’t be swung into operational risk initiatives of an enterprise risk framework. Market risk needs its own framework & solutions.

Causal Capital - 31000 Frameworks

What Libor-OIS says Daniel L. Thornton

do with modi ratio take like t diffe clai sets % of ent spurt ers, n wh ustry s as ither, of do s r r d m y s d m e e y 10 ate s, com he op If we would ves fo lia, m ted A mes ue fro rom a custo conce her in usine ies denc and a m h f ? r r t t n u b a n r o e s d ig e le to ajo tr se so s o the axon e a te phes So r pay s from ught peop er re Aus k We ly con ts rev ffere ucts e m tro RM r ith k t u ag a i t av n h d is rea ly tho some ide ot four' i of R lly on rates ave s g pro also man eal w g ris sts h catas ing E ? The k h d a e s n ly e s e s n sur eal a longs e 'big ut 10% gener gen ed to selli risk i ise ris ng to reati k ana trem sform ix thi draw c n g x f d o it to vi e m k is ss ra th 't r pr ra in ig a mbe from k is ab al ris bank s see usine y cred enter m ha aren rise r in on in. T an we aken d ma t a l s c b n r rp e nu on nk el is fro II tal illar I nal r erati itiona n ba pical , sur ely fo ape team t ente hom k dom how have edit a gle w a sc ty lia P ut ug op is at lly tio cr .I les ad sk ng pera tive, se tr ustra der a m sa ortun can e ny ri n. Wh usua nal r risk b ERM rom ill str ing to f u a o t A o o F w s ,o ec t si tio ely ersp beca ugh, con nts fr ous? team lly, m derati os tha pera arke fixing reats ams are g es. Le o e i a to m ri k th k te you mat wh o ce lp ri ho , cia finan ally t were paym st se so ris dition r cons cena s the it or lies t eats ti ll ris o rs, c we d r fo sk s f rd cred app it tr rise y side ot es ty wa g w g i o m a A n n i e w e e b tl n t ld . Iro ; if s r rp ri k. sp g side or set k is th numb et ris matt cific ven to ed fo initely o tha ente side ude' er na odelli n i s ri th er ks pe m ny ef rk nd is a iers t ris pital nit sa ma ats a out s ally d ly cov hat d olved at ma re ris mag o ano ution th ppl wha a c t d u su ow omic it an thre drive norm perb nd t be ev s th mpa ncy x n int strib m o kn con cred ising that re m su es a can urdle to co que to ru he di fr a d l o e t s t t h f i u g re o wo erate lm o prior shops ercise far fr ying g work gous wan not 'f goin ork, u a e w t gen he re aren' work sis ex ound he sa fram umon , if yo tions e also rame f t r u t k y y in bably g ris anal g to s t as e risk big, h aril strib ou a risk i m y our pro litatin nario tartin a ca erpris le of k. Pri as d ent, ny i k p fac se sce s all s o skin n ent a cou ise ris ss ris surem data i i the RM ays t how a e are terpr expre k mea eous E n is, eral w c on .Ther rue e r. IE; to ris ogen i y t nne oach e hom sev emat natel sure a r m r sch portio mea etric n app aptu o c t o o pr y try aram ibuti can't p the in a distr f you i a s thi mpt hort, e att a. In s dat

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