1 USE OF VAR FOR MARKET RISK Dr Philip Symes Copyright 2006 Asymilate Consulting Ltd. All Rights Reserved
Introduction 2 This presentation focuses on several questions about the use of VAR: How should VAR analysis best be used? In what context is VAR an effective management tool? How should VAR be used by management?
Why VAR? 3 Why did banks choose to implement VAR? Perceived best practice, e.g. in RiskMetrics. One number for senior management focus Regulatory capital benefits. Economic capital benefits. BUT: Some traders saw opportunities for increased market risk limits Banks did not always follow a logical path to introducing VAR Methodologies were introduced without proper understanding
Why VAR? 4 How is VAR now used? Risk Control monitor VAR against limits Limits are normally at business unit rather than desk or trader Trading limits using sensitivities still preside over VAR with higher granularity P&L attribution is performed using sensitivities not VAR
Using VAR 5 Some examples of when VAR changes: market rate changes with positions unchanged positions change, market rates stay the same the historical time series used is modified All three of the above have an impact on daily profit and loss but the change in VAR is NOT the change in valuation of the transactions There are complexities: If VAR is deemed the market risk capital what returns should be used for a risk-adjusted calculation? Should we split the return into its component parts (market, credit, operational, other risks?) How do we deal with intra-day trading the P&L for which is in returns but not in VAR?
Using VAR 6 VAR can best be used as a blunt trading management tool or a robust risk control/management tool: Consolidate risk across the firm for management Provide a portfolio view of risk across multiple trading desks exposed to the same risk factors Provide traders with an alternative view of risk in their books to the more accepted sensitivities risk analysis Delta VAR, intra-day can provide the sole market risk limit allocation methodology but end of day can t Quickly Focus trading management on market risk concentrations requiring remedial action by traders
Using VAR 7 Using VAR day-to-day: Daily risk appetite set by the Heads of Investment Bank Trading at morning meetings End of day VAR numbers distributed from central engine to dealers trading systems New VAR limits set in morning meeting by unit and translated into sensitivities for trading Delta VAR method used for intra-day reporting to senior management (e.g. linear mark-to-future ) Global books passed to next time zone Repeat process
Pros & Cons of VAR 8 Pros of using VAR: Tool for performance measurement based on risk taken, not just today s gross return Defines what is low or high risk Constant reference point for staff Allows for risk-reducing benefits of diversification at a portfolio level More informed decision making on trading strategy and pricing Corporate focus on understanding, measuring and controlling risk Consistent measurement tool
Capital Management 9 Cons of using VAR: Not all trading instruments have definable risk parameters Loss estimates dependent on chosen confidence level Difficult to determine the impact of market liquidity Future M-to-M values, especially for complex derivatives, can be complex and is still evolving Volatilities and correlation's are difficult to project and varyy over time Organizational issues that can limit effectiveness Systems limitations Inadequate operational Controls
Summary 10 There are still questions about the proper use of VAR Need to understand why it is being used Sometimes VAR might not be properly understood VAR needs to be reassessed daily There are pros and cons for using VAR It should be used as one part of a holistic risk analysis VAR calculation is not a substitute for business judgement and strong internal controls.