Jul-00 Bank of IsraelForeign Currency Dept. Active Risk Management Framework.

Jul-00 Bank of IsraelForeign Currency

Dept.

Active Risk Management Framework

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Major risksmanaged by the department

Measurable

• currency risk

• interest rate risk

• some credit risk

Hardly Measurable

• operational risk

• liquidity risk

• some credit risk

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Currently used methods

• benchmark as a starting point

• limits on position

• limits on counterparty

• other limits

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Proposed Scheme

Three layers:

1. Global (yearly) stop loss

2. Dynamic VaR bounds

3. Limits to non-measurable risk components

(credit, liquidity, etc.)

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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.

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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.

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Reporting and responsibility

• investment committee

• desk managers

• risk manager

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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 (?)

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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 (?)

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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

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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.

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VaR and stop-loss take-profits

P&L

1 day

1 week

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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

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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.

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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)

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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

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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).

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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

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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

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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

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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.)