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Description of Setting Limits for Market Risk

There is a weapons race among the financial elite. The weapons in question are brains, computers, communications and sophisticated software. Preparation for the battlefield starts with the hiring of top-tier traders, ingenious financial analysts and the best 'rocket scientists' that can be found. Within each army there is a division between people who do things and people who get the credit.

The officers who set limits on exposure to interest rate risk, currency risk, country risk and other market risks belong to the former group, where there is less competition but also more by way of control.

In an age of financial engineering, a sound preparation for the financial industry includes a system of limits supported by the most flexible, knowledge-enriched technology platforms and their ingenious usage.
Excellence in the new products and services means:
mastering the global financial markets; developing the best-performing products; dealing with AAA clients;
having first-class internal controls; and managing risk efficiently.

The really important clients of any financial institution are those that are most advanced in their own financial weaponry, that know how to control risks while capitalising on deregulated environments around the world. A crucial question for every bank to ask itself is whether it is ready to trade with such clients. Being a player in markets that are more competitive than ever involves very serious challenges, which have to be met in a focused manner. At the top of the list are the market risks that this book addresses.

This book has been written for executives in the financial industry:bankers, investment advisors, loans officers, traders, financial analysts and rocket scientists. It is also structured to appeal to treasurers of major companies who operate as non-banks and to individuals of high net worth. The subjects covered are of interest to members of boards of directors and management boards, and their immediate assistants, who are concerned about risk and return, and wish to implement programmes which can enable them to grasp business opportunities while minimising exposure and failure.

The focus of the book is on setting limits within a comprehensive system of internal controls, including the management policies that are required to make the setting of limits effective. Accordingly, the book examines the challenges of developing and selling new financial instruments, explaining why business success is increasingly dependent on gaining the upper ground in new financial services without assuming an inordinate amount of exposure.

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Title Information

ISBN:

9781855646964

Pages:

190 pages

Format:

Paperback

Product Code:

10035

Publisher:

Euromoney Institutional Investor

Published:

01/01/1999

Edition:

1st Edition

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Contents of Setting Limits for Market Risk

Chapter 1 brings to the reader's attention the many aspects of an effective system of limits, the challenges involved in implementing it and the benefits available to top-tier banks. An aggregate view of limits is a prerequisite to any effort to diversify the risk profile of a bank's portfolio.

After Chapter 1 the reader can either study each major market risk in detail (Chapters 2 to 9), or address the dynamics and the mechanics of the precalculation of capital adequacy, through the integration of credit risk and market risk by major counterparties (Chapter 10).
Interest rate risk is addressed in Chapters 2 and 3.

Chapter 2 starts with the evaluation of position risk, accruals, duration and term buckets. It discusses sensitivity analysis and convexity with interest rate risk, then looks into different methods for offsetting this type of exposure. The theme of Chapter 3 is interest rate derivatives - options, futures, forwards and swaps - including fixed-rate and floating-rate deals and the risks inherent in the mispricing of financial instruments.

Chapters 4 and 5 examine currency risk. Chapter 4 starts with a brief overview of the foreign exchange eras that the markets have passed through since World War II. It explains what is meant by patterns of foreign exchange trading, looks into the mismatch risk in currency exchange and outlines the role of central banks in defending the currency. Chapter 5 discusses currency exchange options as well as how to study market movement in order to be ahead of the curve. Foreign exchange risk management also requires the setting of limits in connection with currency positions, a task which can be performed much more effectively with high technology.

The common theme of Chapters 6 and 7 is country risk. A basic issue in Chapter 6 is how to calculate country risk premium and how to set country limits. Other crucial subjects are volatility and liquidity in emerging markets, sovereign rating, premium rates, and legal risk.

Chapter 7 is proactive. Having asked whether the Euro is a synopsis of country risk, it provides answers from two perspectives: that of the 'Euro optimists' and that of the 'Euro pessimists'. Readers will wish to make up their own minds on the probabilities, after being informed of the facts.]

Chapters 8 and 9 address equity risk. Chapter 8 looks into common stocks,
preferred stocks, financing through debt and equity, book value, and market value. It explains what is meant by 'efficient frontier' analysis and discusses whether or not modern portfolio theory is of any real service. Chapter 9 takes a close look at the equity derivatives market, the allocation of limits to equities trading, stock market indices, delta hedging and the use of rocket scientists in conducting rigorous analyses of equity risk.

The book concludes with Chapter 10, which explains how institutions can precalculate their capital adequacy, as well as what is meant by precommitment. These relatively new and perhaps unfamiliar terms refer to a bank's ability to prognosticate its exposure over the next time period of operations. Based on mathematical models and interactive computational finance, both precalculation of capital adequacy and precommitment integrate credit risk and market risk by important customers handling exposure to other customers through statistical sampling. All 10 chapters emphasise the need to use both quantitative and qualitative criteria. Qualitative criteria help to provide perspective.

This does not mean that figures should be disregarded, but that players must look beyond the numbers as well as behind them, and ask how they have come about, what messages they convey and how likely is it that they will remain where they are. These are crucial questions of a qualitative and quantitative nature.

Providing factual answers to the queries that this book raises can be a daunting task. Financial analysts are not the only people who have to go through this exercise: other players who need to get involved include
bankers, treasurers and investors. On the one hand, investment decision processes may become easier as more figures are made available, better limits are set and more is known about how the market works.

All these things give answers to the question 'What'. On the other hand, if market participants are not able to respond to the question 'Why', then their projections will be half-baked at best. This is one of the basic messages that the book aims to convey.