Modelling market risk
The increasing complexity of financial instruments traded on the market demands a variety of modelling approaches. We help you to develop market risk models to managing your risks and meet the regulatory requirements of pillars I and II of the Basel Accord. We have years of experience in the market risk context and in supporting the approval processes of internal market risk models.
Defining the risk position
A market risk calculation begins by defining which positions in the books are relevant to market risk. This may result in the following tasks:
- integrating different trading and settlement systems
- taking into account trades held in multiple front-office systems, internal transactions and late transactions
- quality assurance for trade data, instrument data, address data and market data
Although it is theoretically simple, this step proves to be complex at many banks with heterogeneous system landscapes. A detailed investigation and cross-organisational coordination process is thus essential.
Defining risk factors
Modelling market risk is largely based on the risk factors selected for interest curves, spreads, volatility surfaces, stocks, exchange rates, correlations and other valuation parameters. In doing so, the following points must be borne in mind:
- adequacy of the modelling of market risk
- quality of available market data
- performance of calculation
- modelling of general and specific risks
- application of single factor, multi-factor or other models
Risk model
The standard characteristic figure for quantifying market risk is Value-at-Risk (VaR). It is determined by stochastically modelling the daily return of the portfolio in question using the following techniques:
- analytical approaches (delta normal, delta gamma)
- Monte Carlo simulation
- historical simulation
You can benefit from our experience as you consider the different techniques as well as in using additional risk measurements.
Stress testing and backtesting
Every market risk calculation must be statistically validated via backtesting. Stress testing complements the VaR calculation by giving an estimate of the possible impact of extreme market movements not covered in the stochastic model. Essential for this are:
- development and implementation of backtesting processes
- reconciliation of economic P&L and backtesting P&L
- definition of historical, synthetic and macroeconomic stress scenarios
Through stress and backtesting, we assist you in not only meeting regulatory requirements but also in improving your practical risk measurement.
Business processes of market risk controlling
The importance of business processes is often underestimated when introducing a new market risk model. Successful implementation requires clearly defined processes in the following areas:
- market risk reporting
- back and stress testing
- risk analyses
- model validation
- limiting and risk management of trading
Streamlined and efficiently designed processes give your risk management the opportunity to not only report risks, but to also actively manage them.
Minimum regulatory requirements
In the following aspects, regulators have set forth detailed requirements for market risk control:
- data, models and processes independent of the trading organisation
- daily reporting of market risk and P&L
- consistency between market risk measurement and market risk management
We help you comply with the regulatory requirements that apply to you.
We are also happy to support you in obtaining approval for your internal market risk model for meeting regulatory equity capital requirements.
Current developments: Incremental Risks
For banks that also use or want to use their own internal market risk model to manage specific market risk components, Basel II requirements demand modelling of incremental risks based on a one-year horizon and holding equity capital against their contribution. Modelling of incremental risks means effectively integrating market and credit risks, and thus demands new modelling approaches that take details such as constant level of risk, liquidity horizon and dependency structures between share prices and spread changes into account. We support you during this process in:
- analyzing the regulatory requirements
- selecting a modelling approach
- analysing market data sources
- achieving integration into your existing risk model and risk measurement system
- combining regulatory requirements and internal risk management in your economic capital model
- performing trial calculations to estimate the impacts on equity capital requirements