Utilization of VaR Framework in Risk Management - Essay Example

? Explain the VaR framework and its utility in Risk Management. Could its correct application prevent financial disasters like Barings Banks and Long-Term Capital Management? 1 Introduction In the background of financial disasters that occurred in the early 1990s when many industry giants like Barings, Orange County, Daiwa, and Metallgesellschaft declared bankruptcy and due to this, VaR (Value at Risk) as a new phenomenon of risk management was introduced. Due to poor supervision and control of financial risks, billions of dollars were lost. The origin of the VaR can be termed as the initiatives of Dennis Weatherstone, Chairman of the JP Morgan, who made his department to submit a simple report on the company’s financial vulnerability to risks on a daily basis. VaR can be said to be an easy method of measuring the market risk. As of date, VaR technology has spread its wings well beyond financial derivatives and is completely transforming the style the financial institutions’ approach to their financial risk. Initially, VaR is employed to measure the market risk, but now it is being employed to administer and control risk actively. The VaR methodology is now assisting the industry to reckon both operational and credit risk, resulting in the sangraal of companywide management of risk1. (Jorion 2009: x). VaR employs a method of valuation of risk that uses standard statistical methods employed regularly in other technical sectors. In simple terms, VaR can be explained as the most speculative loss over an objective horizon that will not be surpassed with a given level of confidence. Footed upon the company’s scientific founding stones, VaR offers users with a detailed synopsis of market risk. (Jorion 2009: x). . 2 Backgrounds For those companies and financial institutions that are vulnerable to risks, management of risk is a vital function. There has been a real reform in the risk-management process, especially in the last decade and VaR is regarded as one of the solutions that received wide publicity in business circles. As per Holton (2003), the main fundamentals of the VaR can be traced back to as early 1922 when the New York Stock Exchange prescribed capital norms for its members. Until 1952, research in VaR was not in progress. Two independent researchers namely Roy and Markowitz almost concurrently advanced but with different version of measuring the risks and the same were published in 1952. As per Holton (2003), the two authors mentioned above were engaged on establishing a way of choosing portfolios that would be facilitating to obtain the benefit for certain level of risk. Holton was of the view that it took nearly four decades until VaR measurement started to be broadly employed by companies and financial instructions. As per Fernandez (2003), the worst financial crisis that occurred in 1987 and the crisis that forced to find a solution by the Basel Committee that all banks should keep adequate cash reserves so that it can cover probable losses in their trading assortment over a 10 –day marked and 99% of their time. With the help of VaR, the quantum of cash to be maintained will be decided. Due to poor risk management process and poor supervision, a huge volume of money can be lost, which was well evidence from the past financial crisis. Thus, VaR has widely been acknowledged as a breakthrough process due to historical errors that crept into the risk -management process. (Holton 2002). As of today, the usage of VaR is being widely employed in financial institutions but there is only limited usage of VaR in non-financial firms. This can be explained that why companies do not employ VaR as they do not normally predict their profits and losses on daily footings that are not impacted by volatility in prices in the short-run. However, Mauro (1999) stresses that VaR can be employed even by non-financial firms (companies) that are not impacted by volatility in prices, especially in a short-time horizon. Thus, the chief advantage of VaR is that it is a yardstick that can be employed to almost every type of risk and in infinite ways one can work out VaR, each of the ways and means with its own benefits and disadvantages. This makes various VaR measurements, which is very difficult to contrast with each other as if they have not been worked out employing the same approach. (Mauro 1999) . 3 Analyses Advantages of VaR in the modern financial system As compared to primitive risk measurement technique, VaR has many advantageous traits. The advantages of VaR can be known from the fact that it is widely adopted and remain as a popular choice in the industry. It’s salient advantages can be detailed as follows: It is to be noted that VaR estimate offers a common reliable evaluation of risk across different risk positions and factors. VaR facilitates the risk manager to estimate the risk correlated with equity (for instance, a fixed-income position in a manner which is constant with the assessment of risks connected with equity or other positions. Customary positions are restricted in nature like Greek methods which are established for particular instruments like derivative position , portfolio mechanism can be applied to equity and convexity, and duration can be employed for fixed-income securities only.(Hofler 2008:20). VaR facilitates the risk manager to aggregate the cross-hedging and correlation risks between various risk factors or asset classes. VaR takes into account the offsetting of risks if by nature, two risks are capable of offset each other and this has been regarded as a unique functionality in managing with portfolio risks. As all driving factors are fully taken into account and hence, VaR can be regarded as an integral risk measurement mechanism as it highlights on a whole portfolio and not just on a sole position in a portfolio. Customary risk measures engage in considering various risk factors in sequential order and revert to simplifications to be summative of multiple risk elements. A probabilistic manner of estimating the future events is portrayed by VaR, which means the loss events are linked with probabilities. On the contrary, in case of Greeks, it will not offer loss probabilities but only offer an answer if what if question is put forth. For example, information like if the interest rates increase one bps, one may lose one Euro is detailed where in such scenario, the probability is not mentioned. In contrast, VaR addresses this issue and offers this vital information. In understandable unit, VaR is being reported that is in terms of lost money. Despite the complex nature of the portfolios, reporting of its market risk can be made, and it can be easily understood by even a non-technical savvy. As regards to VaR, a comparison of relative riskiness between two different portfolios is made easier, and hence it remains to be the most advantageous one. As VaR measures downside risks, risk-averse investors like pension funds may reap much advantageous out of it. VaR is being widely employed to measure various risks like credit risk, market risks, country-specific risks and operational risks. Introduction of a structured methodology for critically thinking about risk can be regarded as one of the greatest advantages of VaR. For those companies , which implement VaR pass through the introduction process and hence , it compelled to consider about perils in a style they have maybe never carried before.(Hofler 2008:22). Will VaR help to prevent a disaster in a financial system? VaR spotlights on downside risk and also relies on cost-benefit analysis, which spotlights on a substitute risk approach , and normally, spotlights on revenue maximisation thereby extending equal weight to probable large losses and revenues. VaR’s chief trait is that it permits for the estimation of probable loss exclusively and thus, evaluates the downside risk. A company’s holdings can be fine-tuned to minimise the extent of probable losses, despite this may also connote a trade-off in probable revenues. In a single figure, VaR is able to summarise the peril linked with intricate holdings. For instance, a financial portfolio may include derivatives that can create nonlinear returns pertaining to the worth of underlying assets thereby focusing the portfolio’s exact vulnerability to loss not obvious in nature. VaR takes into account the probability of distribution of returns. Thus, the collective impacts, for the particular probability level and for the specified time periods are taken as a distinctive value. Further, VaR is intuitive in nature as the values are taken in fiscal terms at particular probability levels. By using the same methods, when calculated the VaR, it results in water management policies or alternative investment environments, which are comparable directly. (Webby 2009:12). As per Jorion (1997), VaR is the financial –engineering concept which is widely employed as a mechanism of stochastic analysis. VaR is employed to assess the worst anticipated loss over a specified period of time interval at a given confidence level under the normal market scenario. As per ex -Vice-President and CFO of Dow Chemical’s co, namely Enrique C.Falla, VaR is being used at Dow mainly to evaluate the risks and to assess the return trade-off of substitute financial strategies. Further, at Dow, there was the delegation of authority for financial risk management functions; to have an effective control and communication over financial risks on an international level across interest rate and foreign exchange instruments and vulnerabilities. According to the ex-treasurer of Eastman Kodak namely Jesse Green, VaR being employed to assess the effect of commodity prices on the company raw materials, particularly that of silver and stress testing had also been carried over. According to Eugene Beard , ex- Vice-President of the Interpublic Group of Companies , Inc that VaR is more used by companies with larger derivative portfolios or companies with fixed long-term vulnerability .(Smithson 1988 :483). . 4 Case studies Barings Bank and Long-Term Capital Management LTCM (Long-Term Capital Management) was a successful and renowned hedge fund, and it collapsed in 1998. Its chief business strategy was concentrated on relative –value arbitrage, a process, which involves the usage of temporal price variances between associated assets, mainly due to their variance in their liquidity , by correspondingly , purchasing the assets at a cheap price and by disposing off the expensive assets. LTCM was able to achieve impressive but sustained profits and also won the admiration of its competitors. However, suddenly, in the September 1988, LTCM witnessed turmoil and but for Fed intervention, it would have filed for bankruptcy. Due to the Russian government announcement, on the 17th August 1998, about the moratorium on ruble-debt denominated debt, there was a flight to liquidity. Investors disposed off their most illiquid and riskiest assets so as to purchase safer government securities. Since, LTCM profoundly invested in illiquid assets, and as it was a large liquidity provider, the resultant pricing damage was extremely destructive to LTCM. Many scholars put the blame on VaR as the risk- management system employed by the market participants have been censured for being somewhat liable for the disaster. As per past empirical research studies carried over by Millo, MacKenzie and Holzer have suggested that perils created by VaR mechanism in a herding contour where agents have taken overlying positions. As per Millo and Holzer, the VaR of LTCM trading increased when volatility increases, some financial institutions had infringed their caps after the instability at the beginning due to the moratorium declared by the Russian, which compelled them to lessen their positions and in turn enhanced the instability, resulting in a fierce circle of market instabilisation. (Gil-Lafuentie & Merigo 2010:191). Though, there had been a risk management system in LTCM, which includes scenario testing and VaR, nonetheless, it appears that the testing was carried over in a scenario that did not contain market moves as severe as the incident that really happened, as such incidents had never happened or experienced earlier. (Cvitanic & Zapatero 2004:172). LTCM employed the VaR not as a scientific testing mechanism instead as a tool to win over the competition for capital from investors. Since LTCM got a large leverage, and had so many followers, its presumption footed upon how markets performed, which were liable to be invalidated. As a result, LTCM could no longer play game in the market as it was a market maker. Once the illusion that the trades were as a mattress disappeared, LTCM turned to be material of conjecture and there was the failure of hedge fund. Further, LTCM creditors which were giant security houses and big banks were also in red. Thus, VaR turned out to be a waterway of infection as it spread the ever enhanced volatility in trading thereby resulting in higher capital needs for trading companies all over, which compelled the cutting of positions in the market. (Dunbar 2011). At LTCM, VaR was continuously monitored. It was estimated that yearly VaR stood at $714 m with 99% confidence level with an equity cushion of just $ 4 to 6 billion. Total loses surpassed $553 m on August 21 alone. Many lessons were learnt from LTCM debacle. It is learnt that many sophisticated financial models always proved to be wrong as it was established that risks may fall outside the model. Further, LTCM debacle also taught not to follow blindly VaR, and it should be of cautious of ever transforming correlations. Barings Bank Debacle and VaR A financial trader namely Nick Leeson, whose rogue trading in derivatives in Singapore on behalf of Barings Bank resulted in the collapse of Bearings Bank. After serving in Morgan Stanley, an American Investment Bank, he joined in the Settlements Division in the Barings Securities, the trading wing of Baring Bank, the oldest merchant banks of UK, which was founded in as early as 1762. In 1993, Leeson reported a whopping profit of ? 10 m, which is about 10% of total profits of Barings Bank by dealing in derivative transactions on behalf of the bank. However, in reality, Leeson had incurred huge losses which he was able to hide the same in a dormant error account. At that time, there was a downturn in the financial markets in Asia with added oil to fire of Kobe, Japan’s worst earthquake. Finally, the Barings loss was estimated at ?208 m. As per audit team of Barings Singapore, an aggregate loss of ?827 m was incurred due to Leeson derivative trading activities, which were almost equivalent to the value of Barings’ aggregate assets. On February 26, 1995, Barings Bank collapsed and the same was bought by ING bank for just ?1. Failure or absence of control was the sole reason for the downfall of Barings which was attributed by the Bank of England’s investigation team. (Salinger 2011:493). Barings Bank collapsed suddenly in spite of oversight by VaR of its trading situations as some trades were obscured from the control of risk managers. Thus, failure of VaR in Barings Bank connotes that fraud cannot be arrested despite of VaR unless it is effectively introduced to the organisation. . 5 Conclusions To avoid financial risks what occurred in LTCM and in Barings, there should active involvement of Board and top management supervision, which should encourage a trait of responsible and compliance risk assuming or taking. Those senior managers should have adequate knowledge on the risky products which is dealt by their companies. There should be separation of front office and back –office operations and there should exist effective risk management controls. There should be clear and independent reporting lines and further, the company’s incentive system should not compel excessive risk assuming. It is very true that there exists no fool-proof system of controls that will be regarded as fool-proof and it is likely true that there should exists an ethnicity of accountability and honesty, the need for the existence of strong both back and front-office controls and effective and reliable risk management system like VaR is the need of the hour. VaR cannot be said as a panacea for financial disasters as it may not predict the losses that may occur in future well ahead. During the US dollar versus Mexican peso exchange rate crisis in 1995, there was very low instability just before the crisis and there had been no prior caution from the demeanour of exchange rate movement. As a result, VaR had signified that positions in the above currency had very low risk. Likewise, during the tumult in Asian economies in 1997, the Indonesia rupiah had the stable exchange rate till the shift towards the classic exponential curve of a market in just before the start of the financial crisis. In this crisis, VaR indicated a very low volatility and hence, low risk was predicted. The above illustrations indicate that VaR is not adequate mechanism to evaluate the quantum of risk by itself. (Lore & Borodovsky 2000:235). The above highlight there is a need to revamp the VaR mechanism. A more proper risk management methodology for dealing with the impact of intense price transformations in a class of method, which is christened as a stress testing is needed. The chief idea for stress testing is that to take into account the vast price changes or a combination of price changes and to apply them to a portfolio and to report the probable loss or profit that would happen.(Lore & Borodovsky 2000:236). List of References Cvitanic, J & Zapatero, F. (2004). Introduction to the Economics and Mathematics of Financial Markets. New York: The MIT Press Dunbar, Nicholas. (2011).The Devil’s Derivatives. Harvard: Harvard Business Press Gil-Lafuente, AM & Merigo, J. (2010) Computational Intelligence in Economics and Business Proceedings. London: World Scientific Hofler, B. (2008) Risk Measures –Vale at Risk. New York: Grin Holton, G A. (2002) History of Value –at-Risk:1922-1988. Econ papers Working Paper, July 25 Jorion, P. (2009) Value at Risk 3E .New Delhi: Tata-McGraw-Hill Education Lore, M & Borodovsky, L. (2000) The Professional’s Handbook of Financial Risk Management. New York: Butterworth Heinemann Mauro, A. (1999) Price Risk Management in the Energy Industry: The Value at Risk Approach. Social Science Research Network Salinger, L M. (2011) Encyclopaedia of White-Collar & Corporate Crime, Volume 1. London: SAGE Smithson, CW. (1998) Managing Financial Risk: A Guide to Derivative Products. New York: McGraw –Hill Webby, R B. (2009) Applications of Conditional Value-at-Risk. Adelaide: The University of Adelaide WilmerHale (2008) Rogue Traders: Lies, Losses and Lessons Learned [online] available from [accessed 11 May 2012] Read More