Value At Risk Measurement In Banking Finance Essay

We have talked about VaR measuring ; nevertheless whether it is practical depends on whether it helps better decision-making procedures. Therefore we need to cognize whether the steps such as the pricing guidelines and the hazard bounds can be used in organisational procedures.

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VaR theory was widely accepted in Bankss. IT systems were developed to mensurate the hazard and heighten the hazard direction in many western Bankss ( Yang et al. 2002 ) . This paper will discourse the elaborate VaR application in some countries in the followers.

2.1 General Risk Control in Banks

Hazard control does non intend to avoid hazard or cut down net income rate, but allocate the limited resource to the sections where the highest net income can be produced under the endurable hazard bound so as to optimise the resource allotment.

Risk direction is one of the most of import managerial undertakings particularly in commercial Bankss. Effective hazard rating for commercial bank increases its value on the market and assurance between possible investors ( Povilas et al. 2009 ) . Basel Committee of Banking Supervision, USA Federal Reserve System and USA Stock Committee in 1995, European Union Capital Requirements Directive in 1996 proposed to utilize value at hazard method as one for market hazard direction. So VaR should be applied to run into the external direction demand.

Ma et Al ( 2001 ) point out that some advanced large Bankss have the hazard control system composed of the forepart desk, in-between desk and rise up desk at present. As the concern at the forepart desk is largely fiscal tool dealing, the operators must cognize the hazard value of the dealing hard currency, so that they can guarantee the trade hazard within the hazard bound which they are allowed ; The in-between desk steps all sorts of separate trade hazard at the forepart desk comprehensively based on VaR ; The rear desk chiefly works on shaping, apportioning and seting the hazard capital bound, public presentation assessment of hazard accommodation and investing decision-making based on hazard analysis. During the whole procedure of hazard direction, VaR is the critical tool.

Using VaR method, foreign currency rate, market involvement rate, equity securities ‘ , stock monetary value fluctuations hazard can be estimated. The Bankss can gauge more exactly capital demand. VaR method helps to diversify hazard and prolong effectual hazard direction procedure in the Bankss.

VaR computation can be done in five stairss. First, place current place for the establishment. Second, place hazard factors related with the rating of these places. Third, place and delegate scenario possibilities for these hazard factors. Fourthly, define all places pricing map as a value map for hazard factors. Fifthly, grade places in all scenarios utilizing pricing map and obtaining consequences distribution. Banks can take to use a method of the discrepancy – covariance method, historical simulation method or Monte Carlo simulation method for their fiscal tool hazard rating. However, Monte Carlo is the most scientific one ( Zhou 2009 ) .

It is of import to do the market hazard limitations the bing systems of concern units clear to all possible users, so that the misunderstandings of hazard measuring results can be avoided. A careful cheque of the bing restrictions is of import when specifying a VaR bound system. It is non proper for a bank to either overestimate VaR or undervalue it. Model confirmation can be done through a series of tools, such as emphasis testing and back proving. Deutsche Bank clearly states in its 2005 one-year study that they use stress trial to apportion capital and usage separate day-to-day VaR bounds for the daily hazard direction.

Using back proving, each working twenty-four hours net consequence – income ( loss ) is compared with deliberate VaR method consequence. If the former exceeds the latter, it means the VaR method is non precise plenty. Povilas et Al ( 2009 ) argues that formal enrollment of divergences should get down no subsequently than the first twenty-four hours after VaR method application get downing. When there are a big figure of divergences, the VaR method has to be improved.

Zhou ( 2009 ) argues that at least one twelvemonth ‘s informations should be taken as historical observation value. The specified sample observation value can non be excessively small. Since the fluctuation of VaR in a short term can be terrible, the measured VaR does non profit the executing of an effectual policy if it is excessively much or excessively small. She besides argues that the database of the Bankss should be updated often, at least one time every three months. As VaR is affected by economic rhythm, it is normally larger at recession and smaller at comfortable clip. And VaR can be applied to non merely a individual capital but besides capital combination at the same clip.

2.2 Securities Market Risk Control

The Chinese stock market experienced a speedy comfortable period from 1996 to 2000 and terrible recession from 2001 to 2003, and the stock capital sum had kept over 100 billion RMB every twelvemonth in the recession, that means the market is of high flexibleness and many people speculate in it. This phenomenon predicts a possible loss or a bad finance event ( Fan 2000 ) . Therefore it is necessary to turn the unsure factors like fluctuation and guess to measurable hazard standards, so that the oversing units have dependable theoretical mention for control and intervention and the investors and bond bargainers can command their ain hazard better.

2.2.1 Risk Measurement and Capital Allocation

VaR can mensurate the securities combined with difference market factors and different fiscal tools and the general market hazard exposure of different concern sections, which can non be done by the traditional fiscal hazard direction. Therefore it is applicable to all sorts of market hazard including involvement hazard, exchange rate hazard, stock hazard, trade good monetary value hazard and fiscal merchandise hazard. Banks can do capital allotment accommodation after all sorts of investing possibilities and extra VaRs are calculated ( Yang et al. 2002 ) .

Volt-amperes can be applied for bounds finding because it links loss value with chance. It besides can be applied for hazard concentration rating harmonizing to bargainer and market instruments.

Volt-amperes can be used to mensurate hazard one time hazard has been taken, but besides to put up antique ante bounds that can guarantee that hazards do non transcend the maximal hazard capacity the bank is willing to accept. The bank can implicitly allocate capital by specifying VaR bounds for single concern units and accept a certain possible loss.

2.2.2 Risk Adjustment and Investment Decision-making

The critical job in modern finance theory is to avoid fiscal hazard and guarantee the fiscal resource be safe, profitable and flexible. Therefore the investing activities should non harm the stableness of the fiscal system. We must be cognizant of the fiscal crisis in Mexico and South-east Asia that made the economic system autumn back in those states and addition experience on investing hazard control.

There are different steps to command the external and internal investing hazard. One step to avoid internal investing hazard is to command. VaR can assist to heighten the internal hazard control because it provides a direct intergraded quantitative standards for hazard measuring for the mention of the sensible judgement of the investors.

Fan ( 2000 ) thinks there is a job when Sharp index is applied to do hazard accommodation and investing decision-making. Suppose there are capital A and B, and capital A should be chosen harmonizing to Sharp index, but the adding of capital B will greatly cut down the general hazard because it is negatively relevant to the other capitals in the combination although it will convey less net income than capital A will. Therefore other marks can be considered for decision-making, such as the added value VaR ( IvaR ) . By and large, the new capital with less IvaR should be added to the investing combination. In order to administer the general hazard of the combination most efficaciously, a capital with nagative IvaR should be chosen.

Fan ( 2000 ) counted the general hazard of Shenzhen stock market with discrepancy and co-variance method at one twenty-four hours internal and a rhythm of 20 yearss. The sample informations is the day-to-day shutting monetary values of Shenzhen composite index from Jan 3, 1994 to Jan 23, 1998. The assurance degrees are set at 90 % , 95 % , 97 % and 99 % . The consequence shows that the higher the assurance degree is, the larger the hazard value ( mean, maximal and minimal ) is. This reflects the attitude of the investors toward the hazard. A cautious investor expects higher hazard, hence a higher assurance degree is needed for hazard measuring so that the investing hazard can be reduced. An aggressive investor is capable to take higher hazard, so a lower assurance degree is needed for his or her hazard computation so that the low hazard value will profit his or her active investing decision-making to derive higher net income.

2.3 Performance Measurement

Under the traditional hazard direction construction, the safety of the money corporations

depends on one or several directors, and the absolutism for the hazard control can convey

more hazard to the companies. Baring Bank went bankruptcy because the bargainer Nick Lesson took hazard to run without authorization and the VaR reached 800 million lbs on the twenty-four hours of bankruptcy, which exceeded the capital capableness of the bank excessively much ( Zeng 2003 ) .

It is unreasonable to put the net income as the public presentation mark of securities bargainers because this method will allow the bargainers to derive highest net income at the cost of highest hazard. Therefore the net income and the hazard should be considered together when the mark is being set. VaR describes the hazard degree with a information with mention to the net income, therefore it is better than the traditional net income mark. It makes it possible that the directors can set the net income position harmonizing to the hazard of the trade, and it besides settles the ineluctable job of moral hazard in the procedure of net income chase. RAROC ( Risk Adjusted Return on Capital ) has been adopted to do public presentation assessment in the universe for some clip. Francesco ( 2007 ) gave an illustration that a bank can give the directors maximal duty over determinations within their unit and usage VaR bounds to guarantee that the bank ‘s overall hazard remains within acceptable boundaries.

The bank can besides utilize VaR to measure the public presentation of different concerns by comparing net incomes with the hazard taken with the capital that has been allocated to them ( risk-adjusted public presentation measuring ) . The risk-adjusted public presentation measuring can impact top directors ‘ judgements about the past public presentation of different concerns and might impact the bank ‘s overall scheme.

2.4 Clearer Management Information for General Control and Information Disclosure

Yang et Al ( 2002 ) argues that VaR provides more specified and simpler hazard information with badness of loss and possibility of the loss, therefore the decision-making procedure study can be easy demonstrated to the Bankss, the supervision organisations and the top direction.

VaR provides the hazard position of the whole bank in brief and makes it convenient for hazard information communicating between all the concern sections and the appreciation of the general hazard position by the top direction in clip, as it transfers the several sorts of market hazard into a mark information merely. Therefore it benefits the general control of Bankss really much.

In June 2001, Bacel Committee raised the complete information revelation thought in the New Capital Agreement. It is requested that non merely the hazard and capital sufficiency position information, but besides the procedure of hazard measuring, rating and direction, capital construction and hazard and capital duplicate information should be disclosed. VaR has been confirmed as the information revelation engineering by the international supervision organisation, and it has been applied by more and more Bankss.

2.5 Currency Rate Risk Control

Many international market participants face currency exchange rate fluctuations, because there is a deficiency of currency rate prediction theoretical account. So there is the demand for assorted currency rate hazard direction theoretical account development. It is possible to do hazard direction utilizing value at hazard ( VaR ) methods and complex discrepancy – covariance VaR theoretical account allows to chair rate hazard of a given currency. Risk value can be explained as the highest possible loss of separate place or trade portfolio, influenced by market parametric quantities change over selected or keeping period with acceptable assurance degree.

Povilas et Al ( 2009 ) propose to utilize discrepancy – covariance theoretical account for currency hazard rating. Hazard is valued for each currency place individually. VaR application to currency hazard direction allows to chair currency places up to acceptable degree. Open foreign currency place can be calculated after the highest acceptable one twenty-four hours loss degree is calculated. The highest allowable currency place can be estimated after acceptable loss degree and VaR values are known. Investing determinations can be made based on profitableness and assurance degree computations.

The theoretical account was tested with existent market informations from January 2006 to September 2007 by Povilas et Al ( 2009 ) . The consequence revealed that critical border of 5 per centum divergence was non over-passed by any tried currency for any period. So VaR theoretical account can be used to pull off currency rate hazard.

An illustration was given by Li ( 2008 ) . Company A received an order of one million dollars. The exchange rate was 1 dollar peers to 7.5831RMB when the contract was signed. While the exchange rate changed to 7.5712 in 20 yearss, the payment was received. The loss is 11, 900RMB. The deliberate VaR is 0.188556 % per dollar at 0.15 % fluctuation rate ( from historical informations ) and assurance degree of 95 % . The entire hazard value is 14, 298RMB. Since the existent loss is less than the hazard value, VaR computation is right.

Feng et Al ( 2009 ) researched the inter-bank adoption involvement rate in China. The VaR consequences from different theoretical accounts are stable no affair for the capital borrowers or the capital loaners.

2.6 Real Estate Risk Analysis

Volt-amperes can be used for existent estate hazard analysis, excessively. A existent estate hazard measuring theoretical account can be set up with the market hazard factors of GDP, added value in edifice industry, existent estate development investing and client monetary value index. Ruan et Al ( 2006 ) collected Hangzhou existent estate development informations from 1991 to 2003 and counted the VaR with arrested development analysis and Monte Carlo method. The VaRs at at assurance degrees of 90 % , 95 % and 99 % are 1689.1, 2718.2 and 5131.5 million RMB severally. That means we have 90 % assurance that the loss of the extra value of Hangzhou existent estate market will be less than 1689.1 million RMB in a twelvemonth. Since all the three VaRs are more than zero, there is possibility that the extra value will drop. When the VaRs are compared with the informations of 6331 million RMB in 2003, they equal to 26.7 % , 42.9 % and 81.1 % of it, so the value may drop greatly. In decision, the market has strong possible fluctuation and the accrued hazard degree of the market is high. Ruan et Al ( 2006 ) concluded the critical stairss in existent estate market hazard are the pick of VaR analysis norms and definition of market hazard factors.

To sum up, with a individual figure with mention to the benefit, VaR is applied widely in the fiscal hazard direction. It non merely provides a step for the possible loss in coming 24 hours or longer clip for the concerns under the market hazard, but besides is continuously being improved to go a needed tool in the country of fiscal hazard measuring and control.

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