Returns - Opr Risk - Model Risk

FINANCIAL MODELLING
BASIS FOR
COMPOUNDING DISCOUNTING
COMPARISON
Meaning The method used to determine the future The method used to determine the
value of present investment is known as present value of future cash flows is
Compounding. known as Discounting.
Concept If we invest some money today, what What should be the amount we need
will be the amount we get at a future to invest today, to get a specific
date. amount in future.
Use of Compound interest rate. Discount rate
Known Present Value Future Value
Factor Future Value Factor or Compounding Present Value Factor or Discounting

Factor Factor
Formula FV = PV (1 + r)^n PV = FV / (1 + r)^n

R - rate of compunding / discounting
N- Period
 Cross-correlation is the comparison of two different time series to detect if there is a correlation
between metrics with the same maximum and minimum values. ...
 Auto-correlation is the comparison of a time series with itself at a different time.
 volatility clustering refers to the observation, first noted by Mandelbrot (1963), that "large changes
tend to be followed by large changes, of either sign, and small changes tend to be followed by small
changes."
 VOLATILITY : It is a rate at which the price of a security increases or decreases for a given set of
returns.
 If the prices of a security fluctuate rapidly in a short time span, it is termed to have high volatility. If
the prices of a security fluctuate slowly in a longer time span, it is termed to have low volatility.
 The unconditional probability of an event can be determined by adding up the outcomes of the
event and dividing by the total number of possible outcomes. - AVERAGE
 Conditional probability, on the other hand, is the likelihood of an event or outcome occurring, but
based on the occurrence of some other event or prior outcome.
Daily returns have very little autocorrelation.


Weekly and monthly portfolio returns are positively autocorrelated.

Short horizon returns on individual securities are negatively autocorrelated.

Volatility Clustering
 Different measures of volatility display a positive autocorrelation over several
days, which quantifies the fact high volatility events tend to cluster in time

Heavy tails
 The unconditional distribution of daily
returns has fatter tails than the normal
distribution.

Asymmetry
 The stock market exhibits occasional very large drops but not equally large up
moves. Consequently the return distribution is negatively skewed.

Leverage Effect
 Most measures of volatility of an asset are negatively correlated with the returns
of that asset.

Return interval and normality
 As the return-horizon increases, the unconditional return distribution changes
and looks more and more like a normal distribution.
Negative skewness occurs when the values to the left of (less than) the mean are
fewer but farther from it than values to the right of (greater than) the mean.
RETURNS ARE NEGATIVELY SKEWED
OPERATIONAL RISK AND MODEL RISK

Operational risk is the risk of losses caused by flawed or failed processes, policies, systems or events
that disrupt business operations.
 includes legal risk, but excludes strategic and reputational risk.
 Strategic risks arise when a business strategy fails to deliver the expected outcomes,
affecting the firm's development and growth.
 Reputational risk is a seperate type of business risk
The Basel Committee’s Seven Categories of Operational Risk
 Internal fraud:
 External fraud:
 Clients, products, and business practices:
 Employment practices and work safety:
 Damage to physical assets:
 Execution, delivery, and process management:
Large Operational Risks
 Cyber Risk
 Compliance Risks
 Rogue Trader Risk
Rogue trader risk occurs when an employee engages in unauthorized activities that consequently lead to
large losses for the institutions.
OPERATIONAL RISK SEVERITY GRAPH :
The Basel Committee recommends three approaches that could be adopted by firms to build a capital
buffer that can protect against operational risk losses. These are:
 Basic indicator approach
 Standardized approach
 Advanced measurement approach (AMA)
Basic Indicator Approach
Under the basic indicator approach, the amount of capital required to protect against operational risk
losses is set equal to 15% of annual gross income over the previous three years. Gross income is
defined as:
Gross income=Interest earned−Interest paid+Noninterest income
Standardized Approach
 bank’s activities are classified into eight distinct business lines, with each of the lines having a beta
factor.
 The average gross income for each business line is then multiplied by the line’s beta factor.
 After that, the capital results from all eight business lines are summed up. In other words, the
percentage applied to gross income varies in all business lines.
Advanced Measurement Approach (AMA) / AIRB
The AMA approach is much more complicated compared to other approaches. Under this method, the
banks are required to treat operational risk as credit risk and set the capital equal to the 99.9
percentile of the loss distribution less than the expected operational loss
Standardized Measurement Approach (SMA)
The SMA approach first defines a quantity termed as Business Indicator (BI).
BI is similar to gross income, but it is structured to reflect the size of a bank.
The BI Component for a bank is computed from the BI employing a piecewise linear relationship. The
loss component is calculated as:
7X+7Y+5Z
Where X, Y, and Z are the approximations of the average losses from the operational risk over the past ten
years defined as:
X – all losses
Y – losses greater than EUR 10 million
Z – losses greater than EUR 100 million
The computations are structured so that the losses component and the BI component are equal for a given
bank. The Basel provides the formula used to calculate the required capital for the loss and BI
components.
Preventing operational risk losses

Monitor - data sharing etc
Causal relationships - statistical analysis
Risk Control and Self Assessments (RCSA)
Key Risk Indicators (KRI)

Staff turnover
Failed transactions
Burn out
Insurance
Moral Hazard and Adverse selection
 moral hazard occurs when an entity has an incentive to increase its exposure to risk because it
does not bear the full costs of that risk.
 In the insurance industry, adverse selection refers to situations in which an insurance company
extends insurance coverage to an applicant whose actual risk is substantially higher than the risk
known by the insurance company.
Companies mitigate moral hazard issues by
 Deductible
 Coinsurance provision
 Policy limit
Mitigate adverse selection issues by

 Better underwriting - Separate good from bad
 Start with a higher premium and based on experience reduce it
MODEL RISK
the potential for adverse consequences from decisions based on incorrect or

misused model outputs and reports.
The main causes of model risk are:
Model error;
Wrongful implementation of a model.
MITIGATION
 Evaluation of conceptual soundness, including developmental evidence
 Ongoing monitoring, including process verification and benchmarking
 Outcomes analysis, including back-testing

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FINANCIAL MODELLING

Use of Compound interest rate. Discount rate

Known Present Value Future Value

Factor Future Value Factor or Compounding Present Value Factor or Discounting

Formula FV = PV (1 + r)^n PV = FV / (1 + r)^n

 Auto-correlation is the comparison of a time series with itself at a different time.

Daily returns have very little autocorrelation.

RETURNS ARE NEGATIVELY SKEWED

OPERATIONAL RISK AND MODEL RISK

 includes legal risk, but excludes strategic and reputational risk.

 Reputational risk is a seperate type of business risk

The Basel Committee’s Seven Categories of Operational Risk

Large Operational Risks

OPERATIONAL RISK SEVERITY GRAPH :

Basic Indicator Approach

Gross income=Interest earned−Interest paid+Noninterest income

Advanced Measurement Approach (AMA) / AIRB

Standardized Measurement Approach (SMA)

Preventing operational risk losses

Key Risk Indicators (KRI)

Moral Hazard and Adverse selection

Mitigate adverse selection issues by

the potential for adverse consequences from decisions based on incorrect or

The main causes of model risk are:

 Evaluation of conceptual soundness, including developmental evidence

 Ongoing monitoring, including process verification and benchmarking

 Outcomes analysis, including back-testing

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