A.

Board practices Boards overall responsibilities Principle 1 The board has overall responsibility for the bank, including approving and overseeing the implementation of the banks strategic objectives, risk strategy, corporate governance and corporate values. The board is also responsible for providing oversight of senior management.

Principle 2
Board members should be and remain qualified, including through training, for their positions. They should have a clear understanding of their role in corporate governance and be able to exercise sound and objective judgment about the affairs of the bank.

Principle 3
The board should define appropriate governance practices for its own work and have in place the means to ensure that such practices are followed and periodically reviewed for ongoing improvement.

Principle 4
In a group structure, the board of the parent company has the overall responsibility for adequate corporate governance across the group and ensuring that there are governance policies and mechanisms appropriate to the structure, business and risks of the group and its entities.

Principle 5
Under the direction of the board, senior management should ensure that the banks activities are consistent with the business strategy, risk tolerance/appetite and policies approved by the board.

Principle 6
Banks should have an effective internal controls system and a risk management function (including a chief risk officer or equivalent) with sufficient authority, stature, independence, resources and access to the board.

Principle 7
Risks should be identified and monitored on an ongoing firm-wide and individual entity basis, and the sophistication of the banks risk management and internal control infrastructures should keep pace with any changes to the banks risk profile (including its growth), and to the external risk landscape.

 Effective risk management requires robust internal communication within the bank about risk, both across the organisation and through reporting to the board and senior management.

Principle 9
Principle 9 The board and senior management should effectively utilise the work conducted by internal audit functions, external auditors and internal control functions.

Market Risk
Trading Book Banks Proprietory positions in financial instruments Debt securities Equity Foreign exchange Commodities Derivatives held for trading

Market Risk
Interest rate risk Equity price risk foreign rate risk Commodity price risk Liquidity risk Asset Liquidity Risk market liquidity risk Model risk

Risk measurement
Nominal amount approach Sensitivity based approach Baisis point value

 BPV is a method that is used to measure interest rate risk. It is sometimes referred to as a delta or DV01. It is often used to measure the interest rate risk associated with swap trading books, bond trading portfolios and money market books.

 What does it show? BPV tells you how much money your positions will gain or lose for a 0.01% parallel movement in the yield curve. It therefore quantifies your interest rate risk for small changes in interest rates.

How does it work?

Let's suppose you own a $10m bond that has a price of 100%, a coupon of 5.00% and matures in 5 years time. Over the next 5 years you will receive 5 coupon payments and a principal repayment at maturity. You can value this bond by: A. Using the current market price from a dealer quote, or B. Discounting the individual bond cash flows in order to find the sum of the present values Let's assume you use the second method. You will use current market interest rates and a robust method for calculating accurate discount factors. (Typically swap rates are used with zero coupon methodology). For the sake of simplicity we will use just one interest rate to discount the bond cash flows. That rate is 5.00%. Discounting the cash flows using this rate will give you a value for the 5 year bond of $10,000,000. (How to do this using a financial calculator is explained on the second page of this document). We will now repeat the exercise using an interest rate of 5.01%, (rates have increased by 0.01%). The bond now has a value of $9,995,671.72. There is a difference of $4,328.28. It shows that the 0.01% increase in interest rates has caused a fall in the value of the bond. If you held that bond you would have lost $4,328.28 on a mark-to-market basis. This is the BPV of the bond.

 How do risk managers use this? BPV is an estimate of the interest rate risk you have. You can therefore use it to manage interest rate exposure. Some firms do this by giving traders a maximum BPV that they are permitted to run. For example, a limit where the portfolio BPV must not exceed $20,000. The more interest rate risk you are prepared to let dealers take the higher the limit

How do traders use this?

Traders can use BPV in order to adjust their exposure to interest rate risk. If a dealer expects interest rates to rise he will reduce the BPV of the portfolio. If he expects rates to fall the BPV will be increased.

 Dealers adjust the BPV by altering the positions they have. Here is an example. Let's suppose a dealer expects interest rates to rise and is long the $10m, 5 year bond from the previous example. The dealer will want to reduce the BPV being run. The BPV can be reduced by any of the following: Selling the $10m 5 year bond and investing in a 3 month deposit. The BPV of a $10m 3 month deposit is approximately $250. Selling another bond so the value of the long and short positions give a lower net BPV. Paying fixed interest on an interest rate swap so the BPV of the swap and bond give a lower net BPV. Selling interest rate or bond futures, again to reduce the overall BPV of the portfolio.

 It is relatively simple to calculate. It is intuitively easy to understand and has gained widespread acceptance with dealers. You can apply the same approach to financial instruments that have known cash flows. This means you can calculate BPVs for money market products and swaps. You can also amalgamate all the cash flows from a portfolio of transactions and calculate the portfolio BPV. It can be used by dealers to calculate simple hedge ratios. (If you are long one bond and short another you can calculate an approximate hedge ratio from the ratio of the two BPVs, more on this later).

 BPV has weaknesses, they are: You may know the BPV but you do not know how much the yield curve can move on a day-to-day basis. BPV assumes that the yield curve moves up or down in a parallel manner, this is not usually the case.

Can anything be done to improve BPV?

Yes. Firms that use BPV recognise these weaknesses and use additional risk limits. Some of these limits capture the risks that dealers have from a non-parallel shift in interest rates. Risk managers alter the shape of the yield curve. They make the yield curve steeper or flatter around a particular maturity and look at the impact that would generate on the P&L. Many firms have moved towards statistical techniques like value at risk. This provides a probability of loss. BPV cannot do this

 In order to accurately calculate BPV you need a spreadsheet or front office trading system that provides you with precise discount factors from market interest rates. However if you want a quick approximation of basis point value the following may help, you will need a financial calculator. Suppose you want to find the BPV of a $10m, 5 year bond with a coupon of 5% when interest rates are 5%. Input the following into your calculator: N = 5.00 I = 5.00% PMT = 500,000 FV = 10,000,000 Press PV and the calculator will give you 10,000,000 Repeat the exercise using 5.01% as the interest rate, I. The calculator now gives you $9,995,671.72 A difference of $4,328.28, the BPV of this bond.

 Use the following: N = 3.00 I = 5.00% PMT = 500,000 FV = 10,000,000 Press PV and the calculator will give you 10,000,000 Repeat the exercise using 5.01% as the interest rate, I. The calculator gives you $9,997,277.26 A difference of $2,722.73, the BPV of this bond. You can now see that longer dated bonds, (or swaps), give you higher BPVs and therefore greater interest rate risk.

 Hedge ratios Sometimes dealers construct trades that try to take advantage of anticipated changes in shape of the yield curve. For example they may expect short term interest rates to increase and longer term rates to fall. Using the 3 year and 5 year bonds how could this trade be constructed? You sell the 3 year bond and buy the 5 year bond. Because the two bonds have different BPVs you would want to weight or ratio the trade according to their relative risks. So if you bought $10m of the 5 year bond you would sell: 4,328/2,722 (BPV 5 year/BPV 3 year )x $10m = 15.9m of the 3 year bond. The BPV of the two trades would be zero. You have hedged parallel changes in the shape of the yield curve but are exposed to the nonparallel change you wanted.

Finally is BPV constant? No. As interest rates increase, BPV falls. You can see this if you calculate the BPV for the 5 year bond using interest rates of 10.00% and 10.01% respectively. The BPV falls from 4,328.28, (using 5.00% and 5.01%), to $3,305.71. As interest rates rise the BPV falls. Sometimes this is referred to as convexity. It can be important to traders because it can mean that the interest rate risk they have changes as interest rates move and any hedges they are using may need to be rebalanced. For risk managers this has important implications too. If you are using interest rates derived from swap rates to calculate the BPV of financial instruments and those instruments trade with credit spreads over or under swap rates then your BPV calculations will be approximations.

 Value at Risk tells you how much money you can lose over a given time period and for a given level of confidence from the positions you hold. But it is not a guaranteed maximum loss figure. Your positions could lose you a lot more than VAR indicates. Sometimes markets move by huge amounts in very short space of time. As a consequence your dealing positions can give you losses much greater than the VAR you have calculated. It is this point that senior managers should be aware of. VAR is not a guaranteed maximum loss figure. Giving your dealers a VAR limit will not mean they cannot lose more.

Four main factors influence your VAR number, they are: Exposure: In general the larger the position you have the greater the risk. Therefore large positions create greater VAR. Time: The longer you intend to hold the position the greater the VAR. As you may expect 10 day VAR is greater than 1 day VAR. (But not by a factor of 10, only the square root of 10). Confidence: If you want a VAR that is very unlikely to be exceeded you will need to apply more stringent parameters. All things remaining constant this will increase your VAR and make it less likely to be exceeded. Volatility: If you deal in risky things that have a history of going up and down in price, or if market conditions alter to make your positions move up and down in price your VAR will tend to increase. It is important to put any VAR number you see into context. This means that if you are provided with a VAR number you should also know: What is the probability that it will be exceeded? What is the holding period? Without this information you will be unaware of the parameters that have been used in the calculation of the VAR that you are working with.

What are the advantages?

VAR is just one number and in that sense becomes a lot easier to understand and monitor. VAR provides you with a statistical measure of the probability of loss. Risk measures like duration and basis point value, (DV01), do not provide a statistical measure of the likelihood of loss. They just give you an absolute risk figure rather than a probability of such a loss arising. Therefore VAR is an improvement on these techniques. VAR can be calculated for all types of assets. This means you can calculate VAR for interest rate risk, foreign exchange risk, credit risk and commodity price risk. Some firms add these individual VARs together to arrive at an overall VAR. You cannot do this with other risk measures.

What are the disadvantages of Value at Risk?

There are some weaknesses you should know about, they are: VAR is not a maximum loss figure. From time-to-time you may find that the actual amount of money lost exceeds the VAR. If you experience a loss greater than your VAR there is no guarantee that you will not experience another loss that exceeds your VAR the following day as well. Many IT systems find the calculation of VAR challenging. Sometimes banks rely on spreadsheets to do this. Calculation errors and stale data can lead to inaccurate VAR reports. Inaccuracy and doubts in the validity of VAR can also lead to it being used as a "soft limit". The breaking of a risk limit based on VAR is then treated with less seriousness than would otherwise have been the case. Banks using VAR for the first time may be tempted to set a VAR limit much higher than the risk they have. The limit is so far from being breached that no one pays attention to VAR as a risk measure. VAR does not deal with option positions very well. It also does not measure operational risks. This means that you can have losses that arise from poor controls and fraud.

Is there anything we can do to improve the situation?

Yes. Many firms do not solely rely on VAR to manage market risk. They use a variety of measures that may include traditional techniques like basis point value and stress testing. Stress testing shows what can happen when extreme market moves arise. It focuses attention to what can happen when markets move abnormally. You can see what a bad day could really cost you. By using several measures banks are looking for consistency in the reporting of risk. It is like having a second, third and fourth check on VAR.

 VAR & regulators Regulators will not tell you how to calculate your VAR. But they are known to probe the methodology that is being used, question how appropriate it is and also assess senior manager's understanding of the risk measures the firm is using. In general regulators are supportive of firms using VAR. Many firms have agreed with the regulator the use of VAR in order to calculate market risk and therefore the amount of regulatory capital required to support it. If you agree to use VAR then the VAR model needs to be an accurate assessment of the risks you run. Therefore if you expect your VAR to be exceeded only 1 day in 100 days your regulator will not appreciate a frequency that exceeds this. It would indicate that your VAR model is inaccurate and your regulator may decide to increase the amount of regulatory capital you are holding.

Finally a few numbers

By way of illustration the following provides a simplified VAR calculation. Suppose you own a bond that has a price of 100% and you have calculated that the daily price volatility is 0.5%*. Using statistics, (standard deviation, SD), there is an 84.1%, (1 SD), chance, that the price tomorrow will not fall below 100%-0.5%= 99.50%, a 97.7%, (2 SD), chance that the price tomorrow will not fall below 100%-1%= 99.00% and a 99.8%, (3 SD), chance that the price tomorrow will not fall below 100%-1.5%= 98.50%. Put another way you are 99.8% certain that in normal market conditions your loss on holding this asset for one day will not exceed 1.5%, ($150,000 on a $10m position), this is the VAR**. If you pick a more risky security, say one with a daily volatility of 1% your one day VAR for a 99.8% confidence interval is 3%, $300,000 on a $10m position. Increased volatility increases VAR. This also means that if volatility changes your VAR can increase or decrease even when you positions remain unchanged. What confidence interval and holding period should be used? That is entirely up to you. In determining the time horizon you may wish to consider how long it could take to liquidate positions. Many banks use between 5 and 10 days with a 2 or 3 standard deviation confidence interval. It just depends on how conservative you want your risk measure to be. ***

 Valye at Risk uses standard deviation; this is sometimes referred to by traders as volatility. A standard statistical text book will explain standard deviation; it can also be calculated using spreadsheet addin functions. It is a measure of the historic or implied price fluctuation of dealing positions and requires observing and collecting daily asset prices. Put simply the more an asset goes up and down in price the more volatile it is and the greater the perceived market risk. High price volatility equals high risk. **Because financial markets do not strictly conform to normal or lognormal distribution the probability of a loss exceeding the VAR is greater than would be indicated. In real life the "tail" under the distribution curve is fatter than expected. ***As a rule of thumb, VAR increases with the square root of time. So if you want to calculate the VAR with a 99.8% confidence interval for a 10 day holding period for the asset with a 0.5% daily volatility the 10 day VAR will be 3.16 (square root 10) x 1.5 = 4.74% or $474,000 for a $10,000,000 position.