Modelling Market Risk
No aspect of financial mathematics has had anywhere near as much investment in both intellectual and computer technology as market-risk modelling. This is rather ironic, as market risk (in the form of actively tradable instruments) is a relatively recent phenomenon, and still forms only a small part of most banks' overall risk profile. There have been very few bank failures due to excessive market risk exposures,1 and the amounts lost pale into insignificance when compared with credit risk. The emphasis on market risk came about partly as a result of the explosion in activity in this area, with both traditional bank managers and supervisors concerned about exposures which they could not understand. In part, the development of market-risk modelling was itself part of the activity—the technology required to model the risks in complicated derivative products is the same technology as is required to develop and trade the instruments in the first place.
As a consequence of the high level of investment and the profile of this topic at conferences and in professional journals, the techniques for modelling market risk are well-understood and the basic framework has become an industry standard.
Market risk in this chapter covers both the trading book and the interest rate risk on the banking book.
THE VALUE-AT-RISK (VAR) CONCEPT
The approach to measuring market risk capital is in principle quite straightforward: take the value of the portfolio at a given point ...