Generating distributions for calculating Value-at-Risk (VaR)

In Chapter 12 of Hull, we learned that market risk is the risk related to the
uncertainty of a financial institution’s earnings on its trading portfolio caused by
changes, especially extreme changes, in market conditions such as asset prices,
interest rates, market volatility and market liquidity. Value-at Risk (VaR) is
used to assess (calculate) an FI’s exposure to market risk.
To calculate VaR, we first need to select the factors that drive the volatility of
returns in the FI’s trading or investment portfolio. We can then use these risk
factors to generate the forward distribution of the changes in the value of the
portfolio. After we have generated the distribution, we can calculate the mean
and the quantiles of this distribution to arrive at the portfolio VaR.
The change in the value of a portfolio is driven by changes in the market factors
(or risk factors) that influence the price of each instrument in the portfolio.
The first part of Assignment Question 1 is to identify the various risk factors
in a portfolio comprising:
 USD/EUR forward contracts
 USD/EUR call options
 Shares in various listed companies
 Bonds issued by government and corporate borrowers.
Having identified the risk factors that generate the volatility in the portfolio
returns, the Analyst (‘you’) must then choose an appropriate methodology for
deriving the forward distribution (of the changes in the value of the portfolio).
We learned in Chapters 13 and 14 of Hull that three alternatives are available.
These are the:
 analytic variance-covariance approach (RiskMetrics);
 historic (or back) simulation approach; and
 Monte-Carlo simulation approach.
The second part of Assignment Question 1 is to:
 describe (or explain) each of the three alternative approaches;
 clearly highlighting the procedures – various steps – used in the three
approaches to derive the forward distribution (of the changes in the
value of the portfolio); and
 compare the advantages (‘pros’) and disadvantages (‘cons’) of the
different approaches.
It is not expected that you would use ‘elaborate’ mathematics (as in Hull) to
answer this part of the question. Good, clear and concise explanation (or
description) in plain English would likely earn you a better mark than including
equations or formulas that you may not fully understand!
Question 2 :
Bank capital and risk management regulations devised by the Basel
Chapters 15 & 16 of Hull described various bank capital and risk management
regulations devised by the Basel Committee on Banking Supervision over the
past 25 years. A time-line of the development of the ‘BIS regulations” is as
 July 1988 Basel I (the Basel Accord) issued
 December 1992 Basel I fully implemented
 December 1996 Market risk amendment issued
 December 1997 Market risk amendment implemented
 June 2004 Basel II issued
 December 2006 Basel II implemented
 December 2007 Basel II advanced approaches implemented
 July 2009 Revised securitisation and trading book rules issued
 December 2009 Basel III consultative document issued
 November 2010 G20 endorsed Basel III
 December 2011 Trading book rules implemented
 January 2013 Basel III implementation begins
 January 2019 Proposed full implementation of Basel III.
For Assignment Question 2:
 Describe (a) the requirements imposed on banks under the Basel Accord
and (b) the key weaknesses of Basel I.
 Explain the principal market risk amendments introduced in 1996 and why
were these considered necessary
 Describe the minimum capital requirements for credit risk introduced in
Basel II and their calculation using the Standardised approach and the
internal-ratings-based (IRB) approach.
 Describe the ‘enhancements’ to the Basel II framework introduced in
response to the 2007-2009 global financial crisis.

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