Essay: Risk Measurements of the Economy

Essay details:

  • Subject area(s): Economics essays
  • Reading time: 21 minutes
  • Price: Free download
  • Published on: July 24, 2019
  • File format: Text
  • Number of pages: 2
  • Risk Measurements of the Economy Overall rating: 0 out of 5 based on 0 reviews.

Text preview of this essay:

This page of the essay has 2481 words. Download the full version above.

Every new method that emerges in risk measurement has been developed by improving the weak aspects of previous models. Researchers and investors discovered those aspects in consequence of past experiences and economic crises in financial markets. For example in 1970’s, fluctuations in interest rates caused high inflation rates which were resulted as economic stagnation in the market. Also, on 19 October 1987 (Black Monday), stock markets around the world crashed with a significant margin ( around %23 in the United States) because of the program trading , illiquid markets, and excessive valuations. These events have shown to investors and academicians that conventional risk management techniques are not sufficient to predict the emerging crisis. Following the Black Monday crisis, at the beginning of the 1990s, these judgments were verified with the unexpected bankruptcy of large investment/finance organizations such as Barings Bank and Orange County. In order to understand Value at Risk method properly, this section will examine the events that underlie the development of the methodology. However, here the focus is on both the magnitude of loss and the events that have similar characteristics regarding applied strategy.
When Barings Bank, one of the UK\’s largest banks, with nearly 200 years of history, announced that it had ended its banking operations in February 1955, the community witnessed how such a large bank could be bankrupted by a Singapore broker. As a result of the transactions made by the chief trader of Barings Futures, the bank\’s Singapore subsidiary, 1.3 billion dollars was lost in derivative markets, the resulting loss completely eradicated the bank\’s equity, and as a result, the bank had to declare bankruptcy by failing to fulfill its obligations.
The process that led Barings Bank to this end began with the trader\’s position in the stock index futures contract on the Japan Nikkei 225 index. At that time, Barings Futures positions in the Singapore and Osaka stock exchanges rose by about $ 7 billion. However, later on in the first two months of 1995, as the current market declined by more than 15%, Barings Futures faced with the obligation to buy securities at a high price according to the contract despite this drop in the market. This meant that the bulk of Baring Futures\’ capital was gone. On the other hand, it continued to take a position in the market. However, the bank had to declare that it would not be able to meet this obligation at the end of the contract when the cash exchange delivery was requested by the relevant stock exchange.
Since Barings is known as a conservative bank in the world financial system, bankruptcy of the bank has had a cautionary effect on financial institutions around the world. The trader responsible for the transactions above was involved with both trading desk and back office. In general, the function of the back office is to check all business activities are conducted by rules and to ensure that the trade is verified. As in any bank, this bank also had to limit the amount of capital that traders could use, and therefore the position limits had to be tightly controlled. Also, it has become a necessity for banks to establish a separate risk management unit that provides different forms of control over traders.
In spite of this necessity, Barings Bank did not control the trader very well because of his successful career. In 1994, this person almost contributed $ 20 million to Barings, which is about %20 of the bank\’s total profit. This meant a huge premium for both trader and his superiors. Hence, it can be clearly seen here that the reason for the control over the trader is weak. For that reason, there were allegations that senior executives were aware of the risks facing the bank, and that it had transferred $ 1 billion for marginal payments arising from contracts entered by this trader. In addition, an internal audit report, which was presented in 1994 before the bankruptcy of Barings and warned that he had excessive authority, was not considered by the top management.
Ultimately, this event forced Barings\’ shareholders to meet the full loss they had. The company\’s market capitalization value of $1 billion has disappeared, and the value of shares have fallen to zero. Barings was then purchased by the Internationale Nederlanden Group (ING), a Dutch-origin financial services group, at the cost of $ 1.50 per share, provided that the resulting losses were met. The trader was sentenced to heavy imprisonment by Singapore law.
Orange County case is another example of market risk. This publicly owned local fund management agency was responsible for a $ 7.5 billion portfolio of fund managers, schools, private administrations and municipal governments. In order to increase the value of the portfolio, the manager invested approximately $ 12.5 billion in reverse repurchase agreements with a total of $ 20 billion in repayment at the end of the four-year maturity period. Since this transaction represents a higher investment than the current portfolio, a guarantor agreement has been made with Wall Street bankers to meet marginal liabilities. This strategy provided a significant return (especially when interest rates were falling) because short-term funding costs at that time were lower than medium term yields.
However, when market interest rates rose in February 1994, public debt securities in the portfolio began to suffer losses. Wall Street bankers, who provided short-term financing, demanded that their funds be covered by spreading the news that the funds they are insured were suffered loss. As a result, when Orange County declared its failure to meet its margin obligations, the loss after the liquidation of securities on the portfolio had exceeded $ 1.64 billion.
The process of dragging Orange County into bankruptcy have similarities with Barings Bank case. The common point in these organizations is the inadequacy of fund managers\’ control. In both cases, the managers have shown great success in the beginning to increase the welfare of their superiors. In this sense, for example, when the crisis began to manifest itself a few months before the bankruptcy of Barings Bank, another $ 850 million was sent by top management to support the hedged position. Likewise, in the case of Orange County, municipal inspectors have approved $ 600 million in additional support. However, a few months ago, the municipal government ignored warnings by the municipal treasurer that the fund manager\’s strategy was too risky and the fund would probably lose $ 1 billion. In addition, according to US legislation and accounting standards applied, the portfolio is shown only at a cost in the records since it is not compulsory for the local governments to keep records of earnings and losses arising from the fund management activities. Therefore, the audit was carried out at the cost value, not at the current prices. This has created a misleading effect on both the investors and the managers regarding the risk that the portfolio is being faced. However, investors and portfolio management could be more rational in decision-making if the risk value of the portfolio was calculated based on current prices at regular intervals, for example, months.
However, effective risk management is possible with sufficient information and data flow as well as effective control. In this respect, standard reports from trading desk and back offices, as well as audit reports and reports from additional risk management systems, provide a strong measure against malicious managers. The robustness of this measure can be ensured by the existence of an independent risk management unit and a good risk management system from other units within the organization.
In this context, the Value at Risk requirement has emerged in the last thirty years with an increase in the number of unusual fluctuations in exchange rates, interest rates and product prices subject to the financial system, and the corresponding number of derivative instruments. This increase is directly proportional to the increase in transaction volume of securities trading and the diversification of financial opportunities. Therefore, this means that growth in foreign trade and the increase of international financial relations between companies. As a result, many companies have begun to build portfolios that include large amounts of cash and derivatives. Due to the diversity of securities within the scope and the increase in transaction volume, the size of portfolio risk of companies is frequently changing and can not be monitored clearly. All of these developments have led to a claim that a senior manager responsible for the management of risk management can present a numerical benchmark against which a portfolio manager can report a summary report in order to express the market risk faced by the portfolio. Value at Risk is one of the strong criteria developed for this demand.
2.1 Value at Risk
The studies by the companies to measure all the risks within their institutions as a whole started in the 1970s. Later, these studies were sold to consulting firms and financial institutions and companies that are not in a position to develop a model but need such systems. The most famous of these systems is RiskMetrics, which is developed by JP Morgan and uses the Value at Risk.
Developed Value at Risk systems was not only based on portfolio theory, some using the historical method and others based on the Monte Carlo simulation technique. JP Morgan offered RiskMetrics and the data set for it free of charge in November 1994. Value at Risk then became more widely accepted and used, not only by those engaged in securities but also by banks, other financial institutions, and non-financial companies.
As Value at Risk systems become widespread, besides measuring market risk, which is the first development objective, it is developed to include credit, liquidity and cash flow risks. Value at Risk method can be defined in many ways in parallel with the diversity of studies related to the subject. Here are a few different definitions that point to distinctive features of the method.
• VaR measures the worst expected loss over a given horizon under normal market conditions at a given level of confidence

• VaR models seek to measure the minimum loss (of value) on a given asset or liability over a given time period at a given confidence level(e.g., 95 percent, 97.5 percent, 99 percent.)

• Value-at-Risk is a measure of the maximum potential change in value of a portfolio of financial instruments with a given probability over a pre-set horizon

The above definitions also include certain common attributes related to the concept of Value at Risk. These common characteristics that point at a given time, a certain probability and a particular hand can be expressed as:

• The data used in the VaR calculations for a certain time horizon is applied for a certain period. These periods can be daily, weekly, or monthly based on the risk priority of the institution that calculates the VaR.

• As in other statistical methods used in risk measurement, VaR calculation is based on a certain confidence interval. Therefore, the possibility of Value at Risk values also includes a probability. The existence of probability also points to a specific numerical, statistical or mathematical computing process. This means that in order to reach VaR values, information technologies should be used.

• The use of information technologies in the VaR calculation also pioneered the development of the Value at Risk methodology, which can also be used to calculate other risk types such as credit and cash flow risk

• VaR is calculated as a value rather than a coefficient. Therefore, unlike other risk measures, it shows the amount of loss that can be experienced under certain constraints.

• Above all, a unique Value at Risk approach can be mentioned within risk management. This points to and measures how VaR values can be used, how the institution should be restructured for this purpose, and how various common risk management resources will be implemented.

Value at Risk measures the amount of loss expected based on the likelihood of specific market movements over a given period of time. Thus, with this method, financial institutions have the possibility to summarize the market risk that they may face due to unexpected market conditions with a single numerical criterion. The capital requirement linked to market risk is based on VaR estimates calculated by banks and non-bank financial institutions using their risk management models. These models have been developed to predict the time-varying distributions of portfolio revenues. Actual VaR values are lower than estimates of these distributions. In other words, the VaR value is the estimate of the maximum portfolio loss that can occur over a given holding period, as determined by a certain confidence interval

In the case of the capital required to be held in exchange for the market risk, the holding period should be considered as overnight or weekly rather than a few months, annually or longer. Also, the analysis of the investment decision according to the daily or overnight holding period is difficult; it can lead to miscalculation of the VaR values by using the short holding period for the options (low liquidity) and the long holding period for the securities (high liquidity).

Many mathematical models are applied in the VaR calculation. These models based on linearity is insufficient for gap analysis as part of the pricing objective. The misstatement caused by the fact that the long-term holding period was chosen has caused many losses for brokerage houses in the developed countries. Because of this, testing of the sensitivity of VaR models is a necessity.

Under normal market conditions, since many positions in the bank portfolio can be converted to liquid within a shorter period of time, the 10-day holding period is criticized as being extremely conservative. However, the 10-day standard also reflects a need for risks that arise from options with non-linear price features and other positions. Sensitivities of options against changes in market risk factors should be selected as a one-day rather than a longer holding period, as these fluctuations may increase at a high rate, depending on the magnitude of these changes. For that reason, the choice of the 10-day holding period arises from the view that the VaR estimates used to calculate the capital requirement should be combined with the impact of the 10-day momentary price movements in market risk factors. Sensitivities of options against changes in market risk factors may increase at a high rate depending on the magnitude of these changes. So, longer holding period should be selected rather than a day period. For that reason, the choice of the 10-day holding period arises from the view that the VaR estimates used to calculate the capital requirement should be combined with the impact of the 10-day momentary price movements in market risk factors.

Another problem on the holding period arises from the comparison of VaR values calculated according to different periods. In order to be able to make a comparison by assumption or to be able to translate the obtained results according to different time periods, the series used in the calculation should be normally distributed. Under this assumption, the Basel Committee suggests the application of the \”square root of time\” technique as the conversion method.

...(download the rest of the essay above)

About this essay:

This essay was submitted to us by a student in order to help you with your studies.

If you use part of this page in your own work, you need to provide a citation, as follows:

Essay Sauce, Risk Measurements of the Economy. Available from:<https://www.essaysauce.com/economics-essays/risk-measurements-of-the-economy/> [Accessed 23-09-19].

Review this essay:

Please note that the above text is only a preview of this essay.

Name
Email
Rating
Comments (optional)

Latest reviews: