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Jul-00 Bank of IsraelForeign Currency
Dept.
Active Risk Management Framework
Zvi Wiener Bank of Israel slide 2
Major risksmanaged by the department
Measurable
• currency risk
• interest rate risk
• some credit risk
Hardly Measurable
• operational risk
• liquidity risk
• some credit risk
Zvi Wiener Bank of Israel slide 3
Currently used methods
• benchmark as a starting point
• limits on position
• limits on counterparty
• other limits
Zvi Wiener Bank of Israel slide 4
Proposed Scheme
Three layers:
1. Global (yearly) stop loss
2. Dynamic VaR bounds
3. Limits to non-measurable risk components
(credit, liquidity, etc.)
Zvi Wiener Bank of Israel slide 5
Global (yearly) stop loss
In order to avoid a big loss we should introduce a global
stop loss (like 30-40bp).
As soon as the portfolio approaches the stop loss, we
should decrease VaR limits for each desk, so that they
become zero as soon as the stop loss is reached.
Zvi Wiener Bank of Israel slide 6
Dynamic VaR bounds
Each desk will receive its weekly VaR that can be used for risk taking (like 3-5 bp initially).
This VaR can be used by each desk (or temporarily borrowed from another desk).
If at some time moment VaR limit is exceeded, the manager must return to the permitted VaR during one day (or get a special permission).
See example below.
Zvi Wiener Bank of Israel slide 7
Reporting and responsibility
• investment committee
• desk managers
• risk manager
Zvi Wiener Bank of Israel slide 8
Investment committee is responsible for
• setting the yearly stop loss limit
• setting VaR limits for each desk weekly
• supervising the desk managers
(but not interfering their decisions too much)
• supervising stress test results (?)
Zvi Wiener Bank of Israel slide 9
Desk manager is responsible for
• keeping the risk under his VaR limit
• returning to the limit if exceeded
• reporting to the investment committee on
• his current VaR and its components
• cases of overexposure and how it was handled
• reasons for the current exposure (?)
Zvi Wiener Bank of Israel slide 10
Risk manager is responsible for
• supporting and developing the VaR program
• measuring and reporting VaR of the whole
portfolio
• communicating to desk managers and investment
committee on diversification among desks
• backtesting, stress test
Zvi Wiener Bank of Israel slide 11
VaR and stop-loss take-profitsVaR can NOT replace the technique of setting stop loss and take profit limits.
However VaR can answer the following questions: what is the current probability that the stop loss (take profit) order will be met during some time interval, or to give the probability distribution over a specified time horizon.
Setting stop loss orders can reduce VaR.
Zvi Wiener Bank of Israel slide 12
VaR and stop-loss take-profits
P&L
1 day
1 week
Zvi Wiener Bank of Israel slide 13
Advantages
• This language of risk is used worldwide
• Uniformity of different risks
• More freedom to desk managers in risk allocation
• More transparency on current risks and potential
losses
• Cross time and cross asset comparison
Zvi Wiener Bank of Israel slide 14
Example (Tal, Zvi)
Assume that the short dollar benchmark has neutral duration of T=6 months.
Manager has VaR limit of 3 bp. and he has to make two decisions:
a – % of assets kept in spread products
q – duration mismatch
we assume that all instruments (both treasuries and spread) have the same duration T+q months.
Zvi Wiener Bank of Israel slide 15
q - durationmismatch
Contour Levels of VaR (static)
0 0.2 0.4 0.6 0.8 1
-6
-4
-2
0
2
4
6
a (% of spread)
Zvi Wiener Bank of Israel slide 16
0 0.2 0.4 0.6 0.8 1
-6
-4
-2
0
2
4
6
q - durationmismatch
a (% of spread)
position
VaR=2 bp
VaR=3 bp
Zvi Wiener Bank of Israel slide 17
0 0.2 0.4 0.6 0.8 1
-6
-4
-2
0
2
4
6
q - durationmismatch
a (% of spread)
In order to reducerisk one can increase duration(in this case).
Zvi Wiener Bank of Israel slide 18
0 0.2 0.4 0.6 0.8 1
-6
-4
-2
0
2
4
6
What we can do using limits
VaR = 6 bp
Zvi Wiener Bank of Israel slide 19
0 0.2 0.4 0.6 0.8 1
-0.2
-0.1
0
0.1
0.2
spread %
duration mismatch (yr)
Current position 2M,10% spread5% weekly VaR=2.2 bp
weekly VaR limit 3 bp
Zvi Wiener Bank of Israel slide 20
What should be done
• a simple VaR measuring tool at trading desks
professional software (RMG or other)
• reporting in terms of VaR
• to get used to this new language
• to build a historical data set
• backtest
• stress test library
Zvi Wiener Bank of Israel slide 21
Proposed Scheme
Three layers:
1. Global (yearly) stop loss (30-40 bp.)
2. Dynamic VaR bounds (initially 3-5 bp.)
3. Old limits to non-measurable components
(credit, liquidity, etc.)
