This presentation provides a highlight of the key issues in the management of Market Risk. It touches briefly some of the elements of the Basel 2 Accord with respect to Market Risk

1. Fundamentals of Market
Risk Management
.
By
DR. EMMANUEL MOORE ABOLO
08021003297
aboloemma@gmail.com
mail@drabolomoore.com

2. 2
Types of Financial Risk
Concept of Trading and Banking Book
 IFRS Categorization of Banks Assets and Liabilities
 Trading Book & Banking Book
Introduction to Risks in Trading and Banking
 Sources of Risk in Trading & Banking Book
 Classification of Market Risk
 Market Risk
 Sources of Market Risk
 Interest Rate Risk in the Banking Book
Introduction to Instruments
 Instruments Classification
Market Risk Framework
 Best Practice in Market Risk Management
 Market Risk Framework Diagram
 Risk Identification Matrix
Market Risk Measurement Framework
 Market Risk Measurement Techniques

3. 3
Setting Limits
 Setting Up Limits
 Risk Monitoring & Control, Risk Reporting
 What is Basel Says
 Structure of the New Basel Capital Accord
 Pillar 1: Minimum Capital Requirements
 Capital Computation Approaches
 Rethinking the Market Risk Process
 Establish Top Management Oversight
 Deploy Best Practices Framework
 Adopt appropriate Organisation Structure
 Invest in Good Technology
 Use Hedging Techniques Judiciously
 Ensure Robust Market to Market
 Establish Good Operational Processes
 Measure, Monitor & Manage – Value at Risk
Summary

4. 4
Types of financial risk
Financial
Risks Liquidity Risk
Operational Risk
Regulatory Risk
Human Factor
Risk
Market Risk
Equity Risk
Interest Rate Risk
Currency Risk
Commodity Risk
Trading Risk
Gap Risk
Credit Risk
Portfolio
Concentration Risk
Transaction Risk Counterparty Risk
Issuer Risk

5. 5
Concept of Trading and Banking Book

6. 6
Held to Maturity (HTM)
 Financial Instruments held with the intention of holding till maturity are
classified under this category.
Held for Trading (HFT)
 Financial instruments acquired or incurred for the purpose of sale or
repurchase in the near term.
Available for Sale (AFS)
 Financial Instruments which cannot be classified as HFT or HTM are
classified under this category.

7. 7
What is Trading Book?
 Positions taken with the intent of benefitting from short term price
movement in market prices, and hence with an intent of trading in
short term, are assigned to Trading book.
What is Banking Book?
 Positions that are not included in the Trading Book are part of the
Banking Book.
Assets
Sr No Particulars Amount % Contribution
1 Cash and short-term funds 30,510 1.19%
2
Due from banks and other financial
institutions 434,032 16.87%
3 Treasury bills 127,716 4.96%
4 Long term investments 23,886 0.93%
5 Trading securities 569,432 22.13%
6 Loans and advances 1,039,462 40.40%
7 Advances under finance 9,512 0.37%
8 Other assets 297,096 11.55%
9 Fixed assets 41,056 1.60%
Total Assets 2,572,702
Trading Book
Sr
No Particulars Amount
1 Trading Securities xxxx
Total xxxx
Banking Book
Sr
No Particulars Amount
1 Banking Book Items xxxx
Total xxxx

8. 8
Introduction to Risks in Trading and Banking Book

9. 9
Sources of Risks in Trading & Banking Book
Sources of Financial Risks in
Trading & Banking Book.
Interest Rate Risk
in Trading &
Banking Book*
Equity Risk
in Trading &
Banking Book
FX & Gold Risk
in Trading &
Banking Book
Commodity Risk
in Trading &
Banking Book
Liquidity Risk
Across Trading &
Banking Book**
Credit Risk
in Trading &
Banking Book
* Interest Rate Risk in the Banking book is handled under Asset Liability
Management.
** Liquidity risk across Trading & Banking book are covered under Asset
Liability Management

10. 10
Classification of Market Risk
Market Risk
Interest Rate Risk Equity Position Risk Commodities RiskForeign Exchange Risk
Change in
Base rate
Price Risk
Options
Risk
Transaction Risk Options Risk
Price Risk
Options
Risk
Change in
Spread
Yield Curve
Risk
Basis Risk
Options
Risk
Basis Risk
Forward
Gap Risk
Interest
Rate RiskInterest Rate
Risk

11. 11
Market Risk
Definition:
 Risk of loss in On and Off Balance-sheet positions arising from movements in Market prices.
 It can also be defined as the potential loss resulting from declining prices on the financial market
 It includes stochastic market risk factor: - interest rate, FX, Comm odity& Equity
Market Risk Types Instruments Examples
Interest Rate Risk Derivatives Futures/Forwards/Swaps/Option
Non-Derivatives Debt Securities
Equity Risk Derivatives Futures/Forwards/Swaps/Option on
Individual Equity/Index
Non-Derivatives Cash Position in Equity
Foreign Exchange Risk Derivatives Futures/Forwards/Swaps/Option in
Foreign Exchange
Non-Derivatives Cash Positions in Forex/Gold
Commodity Risk Derivatives Futures/Forwards/Swaps/Option in
Commodities
Non-Derivatives Cash positions in commodities

12. 12
Sources of Market Risk
Sources of
Market Risk
Interest Rate Risk
in Trading Book
Equity Risk
in Trading Book
FX & Gold Risk
in Trading &
Banking Book
Commodity Risk
in Trading &
Banking Book
Market Risk primarily arises on account of Trading activities

13. 13
Interest Rate Risk in the Banking Book
Interest Rate Risk in the Banking Book
 Interest Rate Risk in the Banking book is defined as the current or prospective risk to both the
Earnings and Capital of the Bank arising out of adverse movements in interest rates.
Interest Rate Risk
in the Banking Book
Repricing Risk Basis Risk Yield Curve Risk Options Risk

14. 14
Introduction to Instruments

15. 15
Instruments Classification
Financial
Instruments
Spot Instruments
1. Bond
2. Equity
3. Commodity
4. Foreign Exchange
Spot Instruments
1. Bond
2. Equity
3. Commodity
4. Foreign Exchange
Derivative Instruments
1. Forwards & Futures
2. Forward Rate Agreements
3. Interest Rate Swaps
4. Options
5. Credit Default Swaps
6. Cross Currency Swaps
Derivative Instruments
1. Forwards & Futures
2. Forward Rate Agreements
3. Interest Rate Swaps
4. Options
5. Credit Default Swaps
6. Cross Currency Swaps

16. 16
Market Risk Framework

17. 17
Best Practices in Market Risk ManagementMarket Risk Management
1. Rethinking the Market Risk process
2. Establish Top Management Oversight
3. Deploy Best practices framework
4. Adopt appropriate Organisation Structure
5. Invest in Good Technology
6. Use Hedging techniques Judiciously
7. Ensure Robust Marking to Market
8. Establish good operational processes
9. Measure, Monitor & Manage – Value at Risk
10. Explore quantitative models for default prediction –
Stress Tests

18. 18
Market Risk Framework
Risk
Identification
Risk
Measurement
Risk
Reporting Ongoing
Risk Monitoring &
Control Setting up of
Risk Limits
>>>>Not an end in itself, but a key instrument to meet the objective

19. 19
Risk Identification Matrix
Questionnaire for
Risk Identification
Interes
t Rate
Risk
Yield
Curve
Risk
Basis
Risk
Options
Risk
Foreign
Exchang
e Risk
Equity
Price
Risk
Commodi
ty Price
Risk
Pre
Settleme
nt Risk
Settleme
nt Risk
Post
Settleme
nt Risk
Currency Forward √ √ √ X √ X X √ √ √
Cross Currency
Swap
√ √ √ X √ X X √ √ √
Foreign Currency
Option
√ √ √ √ √ X X √ √ √
Foreign Currency
(Non -
Government)
Callable Coupon
Bond
√ √ √ √ √ X X √ √ √
Foreign Currency
(Non -
Government)
Coupon Bond
√ √ √ X √ X X √ √ √
Fixed Coupon
(Government)
Bond
√ √ √ X X X X X X X
Treasury Bill √ √ √ X X X X X X X
Commercial Paper √ √ √ X X X X √ √ √

20. 20
Market Risk Measurement Framework

21. 21
Market Risk Measurement Techniques
Scope of calculation
of capital charge
includes the following
categories:
Foreign Exchange
Gold, Commodities
Equities
Interest rate
instruments
Sensitivity
Measures
Duration, Convexity, Beta,
Greeks for Options such as
Delta, Gamma, Vega, Rho
Sensitivity
Measures
Duration, Convexity, Beta,
Greeks for Options such as
Delta, Gamma, Vega, Rho
Risk Measures based on Quantitative
Modelling
Value at Risk at Portfolio level
(Correlations & Copulas)
Extreme Value Theory
Spectral Risk Measures
Risk Measures based on Quantitative
Modelling
Value at Risk at Portfolio level
(Correlations & Copulas)
Extreme Value Theory
Spectral Risk Measures
Comple
xity of
Instrum
ents
Low
High
Evolution of Risk Measurement techniques
Risk Measures
based on
Quantitative
Modelling
Value at Risk at Instrument
and asset class level
Risk Measures
based on
Quantitative
Modelling
Value at Risk at Instrument
and asset class level
Notional
Amount
Notional
Amount

22. 22
Setting Limits

23. 23
Setting Up Limits
Limits for
Market Risk
Exposure
Limits
Risk
Limits
Stop Loss
Limits
Risk Limits are limits set based on the risk
measure for the particular exposure.
Exposure Limit (EL) reflects ceiling on a bank’s
exposure across banking and trading books on
any dimension such as industry, geography,
sector, counterparty etc. to avoid risk of
concentration.
Stop loss limits are defined as limits set on
losses in order to cut losses incurred in a security
or portfolio.

24. 24
Risk Monitoring & Control, Risk Reporting

25. 25
Risk Monitoring, Control & Reporting
Risk Management System
 Lines of Reporting
 Responsibility Allocation
Own Risk & Solvency Assessment
 Limit Setting & Risk Assessment
Internal Audit Function
Regulatory Reporting
Internal Reporting

26. 26
What Basel says?
Is it a fool proof system which will ensure NO LOSSES will occur?
What if LOSSES still occur?
Risk
Identification
Risk
Measurement
Risk
Reporting
Risk Monitoring &
Control
 Maintain Capital
 Basel Standards prescribe how to Measure how much capital to keep

27. 27
Structure of the New Basel Capital Accord
The New Basel Capital Accord consists of three mutually enforcing pillars. All three
pillars need to be applied by banks.
Pillar 1Pillar 1 Pillar 2Pillar 2 Pillar 3Pillar 3
Minimum Capital
Requirements
Supervisory Review
Process
Market Discipline
Establishes minimum
standards for
management of capital on
a more risk-sensitive
basis and specifically
addresses:
• Credit risk
• Market Risk
• Operational risk
Increases the responsibilities
and levels of discretion for
supervisory reviews and
controls covering:
• Processes for capital and
risk profile management
• Capital adequacy
• Level of capital charge
• Proactive monitoring of
capital levels and
ensuring remedial action
Expands the content and
improves the transparency
of financial disclosures to
the market, with disclosure
of:
• Description of risk
management
approaches
• Levels of capital
• Analysis of risk
exposures and capital
by businesses /
segments

28. 28
Pillar 1: Minimum Capital Requirements
A bank will determine the proportion of its capital that it must keep in reserve based on
this calculation:
Total capital (unchanged)
= The bank’s capital ratio ≥ 10%
Credit Risk + Market Risk + Operational Risk
Market Risk – Trading Book
The market risk element of
the denominator is the
market risk requirement
relating to trading books.
These rules were
introduced in the 1996
Market Risk amendment to
Basel 1 and are unchanged
under Basel 2.
Market Risk – Trading Book
The market risk element of
the denominator is the
market risk requirement
relating to trading books.
These rules were
introduced in the 1996
Market Risk amendment to
Basel 1 and are unchanged
under Basel 2.
Credit Risk – Banking Book
The credit risk element of
the denominator is the risk-
weighted assets. The risk-
weighted assets are
calculated through either
the Standardized, or the
Internal Ratings Based
(IRB) approaches.
Credit Risk – Banking Book
The credit risk element of
the denominator is the risk-
weighted assets. The risk-
weighted assets are
calculated through either
the Standardized, or the
Internal Ratings Based
(IRB) approaches.
Operational Risk
The operational risk
element of the denominator
is the operational risk
requirement which can be
calculated using either the
Basic Indicator, the
Standardized of Advanced
Measurement Approaches
Operational Risk
The operational risk
element of the denominator
is the operational risk
requirement which can be
calculated using either the
Basic Indicator, the
Standardized of Advanced
Measurement Approaches

29. 29
Capital Computation Approaches
Internal Models Approach
Banks can use risk measures derived from their own internal risk
management models subject to:
Qualitative standards for internal oversight of the use of models
Quantitative standards for use of minimum statistical parameters for
measuring risk
Guidelines for stress testing
Validation procedures for external oversight of the use of models.
Internal Models Approach
Banks can use risk measures derived from their own internal risk
management models subject to:
Qualitative standards for internal oversight of the use of models
Quantitative standards for use of minimum statistical parameters for
measuring risk
Guidelines for stress testing
Validation procedures for external oversight of the use of models.
Standardised Approach
The minimum capital requirement in terms of two separately calculated
charges : Specific charge – issuer risk; General charge – systemic risk
Basel suggests various methods to arrive at capital charge for
Interest rate risk, Equity risk, Foreign Exchange & Gold, Commodities and
Options.
Standardised Approach
The minimum capital requirement in terms of two separately calculated
charges : Specific charge – issuer risk; General charge – systemic risk
Basel suggests various methods to arrive at capital charge for
Interest rate risk, Equity risk, Foreign Exchange & Gold, Commodities and
Options.
Scope of calculation of
capital charge includes
the following categories:
Foreign Exchange
Gold, Commodities
Equities
Interest rate
instruments
All transactions including forward sale and purchases, shall be included in the calculation of Market Risk capital
requirements as from the date on which they are entered into.

30. 30
1. Rethinking the Market Risk process
 Increased reliance on objective risk assessment Increased reliance on objective risk assessment
 Align “Risk strategy” & “Business Strategy” Align “Risk strategy” & “Business Strategy”
 Investment process differentiated on the basis of risk, not size Investment process differentiated on the basis of risk, not size
 In workflow automation / back-end processes In workflow automation / back-end processes
 Active Portfolio Management Active Portfolio Management

31. 31
2. Establish Top Management Oversight
Board and senior Management Oversight
 Delineate banks overall risk tolerance in relation to market risk
 Ensure that bank’s overall market risk exposure is maintained at prudent
levels and consistent with the available capital.
 Ensure that top management as well as individuals responsible for market
risk management possess sound expertise and knowledge to accomplish
the risk management function.
 Ensure that the bank implements sound fundamental principles that
facilitate the identification, measurement, monitoring and control of market risk.
 Ensure that adequate resources (technical as well as human) are devoted
to market risk management.

32. 32
 Investment & Market Risk Policies should be comprehensive Investment & Market Risk Policies should be comprehensive
 Set exposure Limits On Different Parameters – dealer wise, transaction,
instruments, broker, & other counter parties
 Set exposure Limits On Different Parameters – dealer wise, transaction,
instruments, broker, & other counter parties
 Investment organisation - Independent set of people for front, mid &
back offices
 Investment organisation - Independent set of people for front, mid &
back offices
 Implement straight - through processing Implement straight - through processing
3. Deploy Best practices framework
 Operationalise stop-loss limits Operationalise stop-loss limits

33. 33
4. Adopt appropriate Organisation Structure
Organization Structure
 The structure should conform to the overall strategy and risk policy set by the
BOD
 Those who take risk (front office) must know the organization’s risk profile,
products that they are allowed to trade, and the approved limits.
Apart from BOD responsibility to be assumed by the following:
 The risk management function should be independent, reporting directly to
senior management or BOD.
 The Risk Management Committee
 The Asset-Liability Management Committee (ALCO)
 The Middle Office.
Organization Structure
 The structure should conform to the overall strategy and risk policy set by the
BOD
 Those who take risk (front office) must know the organization’s risk profile,
products that they are allowed to trade, and the approved limits.
Apart from BOD responsibility to be assumed by the following:
 The risk management function should be independent, reporting directly to
senior management or BOD.
 The Risk Management Committee
 The Asset-Liability Management Committee (ALCO)
 The Middle Office.

34. 34
5. Invest in Good Technology
Cash MgmtAccounting
PaymentsDealingCurrency Interest Rate
Credit Liquidity
Risk
Management
Business
Process
Management
Improved ControlImproved Control
Enhanced ReportingEnhanced Reporting
Enhanced ProductivityEnhanced Productivity
Improved IntegrationImproved Integration
Straight - through
Processing
Treasury
Integration
Back Office
Integration
Market
Integration

35. 35
6. Use Hedging techniques Judiciously
 Interest Rate Swaps
 Forward Rate Agreements
 Forward Contracts
 Currency Options
 Equity Derivatives
 Equity Options

36. 36
7. Ensure Robust Marking to Market
 The need arises due to structured products and lack of
liquidity results in the absence of traded prices
 The need arises due to structured products and lack of
liquidity results in the absence of traded prices
 In case of non-traded securities, marking to market is critical for
valuation & risk management
 In case of non-traded securities, marking to market is critical for
valuation & risk management
 In case of active investment management and for risk
management, the periodicity of daily valuation is required
 In case of active investment management and for risk
management, the periodicity of daily valuation is required

37. 37
8. Establish good operational processes
Align Business strategy and treasury process
sound treasury control
middle
office
back officefront office
Complete integration
liquidity management
position keeping
limit management
risk management
settlement management
treasury accounting

38. 38
9. Measure, Monitor & Manage
– Value at Risk
Value-at-Risk
Value-at-Risk is a measure of Market Risk, which
measures the maximum loss in the market value of
a portfolio with a given confidence level over a
certain period of time
VaR is denominated in units of a currency or as a
percentage of portfolio holdings
For e.g.., a set of portfolio having a current value
of say N100,000- can be described to have a daily
value at risk of N5000- at a 99% confidence level,
which means there is a 1/100 chance of the loss
exceeding N5000 considering no great paradigm
shifts in the underlying factors.
Value at Risk
Certainty is 95.00% from 2.6 to +Infinity
.000
.005
.011
.016
.022
0
108.2
216.5
324.7
433
1.5 2.9 4.3 5.6 7.0

39.  Efficient allocation of capital to exploit different risk / reward
pattern across business
 Better Product Pricing
 Early warning signals on potential events impacting business
 Reduced earnings Volatility
 Increased Shareholder Value
39
No Gain!No Risk …
To Summarise….

40. 40

41. 41
Thank You for your attention