Risk Measures and Valuation under Interest Rates and Equity Risk Factors - Essay Example

In order to solve this problem, two vital problems have to be managed: first problem is that the market rates are correlated but they behave randomly and the second problem is that the portfolio structures are high–dimensional and conventionally non-linear. The well-known techniques of risk measurement can be classified into two categories. The first category is the stochastic approach, in which the profit and loss distribution of the portfolio is taken in to consideration. Value-at-Risk (VaR) is the most famous risk measure in this category.

VaR conventionally denotes the 1% or 5 % quantile of the profit and loss distribution. The second category includes the Maximum Loss (ML) methodology, in which the risk is estimated with the help of the value of the worst case scenario. ML analyzes a finite set of scenarios to determine the worst case out of them and it does not consider the correlations among the risk factors, such as the stress testing. The Maximum Loss methodology employs a very specific choice of feasible domains that are referred as the trust regions.

The trust regions determine the correlation structure of the market rates through their shape acquired from the examination of a certain percentage of all future outcomes. This paper first derives the standard assumptions of the financial risk management with the help of the fundamentals of financial calculus. Then, it presents some of the established techniques of risk measurement in a unifying framework along with discussing their basic properties. The paper describes the concept of Maximum Loss towards its end. 1. Introduction to Market Risk Under the intricate and changing set-up of today’s world, it is impracticable to attain stability in relation to mere minor volatility since mature markets are being formed subsequently, with the help of fast global information, which has further escalated competition.

Thereby, globalization is encouraged and financial institutions are compelled to augment their performance. Hence, the implications of market volatility are now very essential to understand. Market risk, which is also often referred as price risk, specifies the uncertainty created by the market volatility that is defined as the prospects of money loss subject to the variations in the market prices. Although quantitative techniques for examining distinct financial instruments are entrenched, however, more research is still required for measuring risk related to the entire financial portfolios.

The supervisory authorities are liable to ascertain that the economic-capital-cushions are held adequately to provide security against any possible unanticipated losses. Hence, the requirements of regulations imposed by the supervisory authorities give rise to the need for risk measurement. The banking sector, until the 1980’s, profoundly stressed upon the credit business. The number of banking failures rose with the increase in competition and the Basle Committee was established for banking supervision, in the year 1988, under the control of the BIS (Bank for International Settlements) in Basle, which published the document called ‘Basle Accord’ that included information on ‘