Market Risk Measurement and Management
Since our inception in 1999, Rutter Associates has been involved in “sound practice implementations” and “sound practice evaluations” of Market Risk measures and systems for financial institutions, non-financial corporations, and investment portfolios alike. Our partners have extensive backgrounds in market risk management extending back to the 1980s and our analysts have benefitted from academic training in financial engineering at the master’s level as well as earning the GARP FRM designation.
Indeed, our founder, Charles Smithson, was intimately involved in the Group of Thirty’s groundbreaking 1993 work Derivatives: Practices and Principles which may be the first published document to use the word “value-at-risk.”
Market risk is the risk of financial loss due to adverse changes in interest rates, commodity prices, foreign exchange rates, and equity and other asset prices. Market risk is generally gauged using two complementary approaches:
• Probabilistic methods such as Value at Risk or “VaR”, the minimum portfolio “tail” loss calculated at a specified level of probability and horizon, and Expected Tail Loss or “ETL”, the expected loss given that a loss actually occurs within that tail of the distribution.
• Deterministic methods including:
• • Calculation of sensitivities and shocks to underlying risk factors such as interest rates (e.g. duration, DV01, convexity, +/- 100bps), foreign exchange rates, equity prices, volatility, asset correlations, etc.
• • Stress tests involving calculation of portfolio losses under historical loss scenarios such as the 1987 stock market crash, “9/11”, the 2007-2009 “great recession”, the March 2020 – April 2020 deep but brief “covid recession”.
• • Stress tests involving hypothetical stress capturing improbable but not implausible shocks to rates and prices, including “reverse” stress tests designed to help understand “breaking points” of an institution.
Market risk management entails first understanding and articulating risk appetite and then articulating risk tolerance, typically expressed as both soft “yellow light” and hard “red light” limits on the metrics discussed above.
Rutter Associates is well positioned to assist banks, insurance companies, prime brokerages, portfolio managers and others in building out or reviewing market risk management programs, guidelines, and limit sets.
Representative assignments include:
• Rutter Associates assisted an arbitration panel in identifying and understanding the shortfalls in the market risk management of a prime brokerage operation th reat suffered large losses as a result of the failure of a large family office.
• Rutter Associates employed CCAR-type stress tests to assess the capital adequacy of a large financial institution.
• To help satisfy U.S. financial regulatory requirements, Rutter Associates reviewed a new Market Utility’s VaR-based margin calculator from both a theoretical standpoint and an empirical one, employing rigorous back-testing methodologies.
• Rutter Associates assisted a large U.S. bank in translating the CCAR “stress test” vectors specified by regulators into a larger set of transformed vectors that could populate the bank’s own risk management systems and permit robust stress testing consistent with the regulatory scenarios.
• Rutter Associates developed and implemented a VaR-based margin calculator for a Central Counterparty (CCP) and reviewed its Stress Test protocol used to establish capital adequacy and satisfy regulatory oversight.
• Rutter Associates advised a multinational oil company in the development of its market risk measurement and hedging policies.