Market Risk Measurement and Management
The term “Value at Risk” (VaR) first appeared in a published document in the Group of Thirty’s groundbreaking 1993 work Derivatives: Practices and Principles (a project in which the founding partner of Rutter Associates was intimately involved). Since that time, VaR has evolved into the primary metric for reporting the magnitude of Market Risk to the stakeholders of banks and other financial institutions. Rutter Associates was also at the forefront of the expansion of the VaR concepts of defined horizons, sensitivity metrics and probability distributions to risk measures that might be more relevant to non-financial firms that are less focused on mark-to-market valuations. For example, a Rutter Associates alumnus introduced “Cashflow-at-Risk” (CFaR) in a 1995 Risk Magazine publication.
Given our involvement in the development of Market Risk measures, it is not surprising that Rutter Associates and our people have been involved in “sound practice implementations” and “sound practice evaluations” of Market Risk measures and systems — not only for financial institutions but also for non-financial corporations and investment portfolios. And, Rutter Associates remains involved in developing and implementing expansions of VaR: VaR measures that are adjusted to reflect asset liquidity, volatility clustering, historical periods of stress (i.e., stressed VaR), fat tails and risk contributions (e.g., Incremental VaR and Marginal VaR) that are important to risk budgeting programs including investment portfolio management employing risk parity, risk-based pricing and risk capital allocation.
While used widely for reporting and managing Market Risk, the VaR measure has well-known limitations. These generally break into two distinct categories: one, highlighting the insufficiency of a VaR calculation that targets a specific percentile of a loss distribution as a risk indicator; and the other, highlighting the uncertainty in the process of estimating correlated probability distributions of risk/pricing factors and asset returns. In addressing the former, Rutter Associates commonly implements alternative, but related, metrics of conditional tail loss or expected shortfall for clients concerned with how much loss would be expected given that there is a loss in excess of a calculated VaR. In addressing the latter, we implement stressed VaR, highlighted above, to improve upon the estimation of the tail of the relevant probability distributions, but more importantly, we have been actively involved in creating and/or implementing stress tests as necessary complements to VaR metrics or in some cases, as alternatives to VaR. Stress scenarios, chosen as improbable but not implausible market events, are used in gauging capital adequacy assessments, identifying risk exposures that statistical methods might overlook and satisfying regulatory requirements. Although the importance of rigorous stress testing has been recognized for many years, the housing meltdown and ensuing financial crisis underscored the need for this complement to VaR among policy makers and corporate boards alike. Rutter Associates is well positioned to assist banks, CCPs and Market Utilities, Prime Brokers, Portfolio Managers and others in generating and implementing the “stress tests” required by regulators and stakeholders. Some banks and prime brokerages have all but abandoned VaR in favor of stress tests in recent years.
Users have been transforming the output of VaR and stress-test models to a measure of the Economic Capital needed to support the Market Risk faced by the firm and to evaluate its risk-return tradeoffs in RaRoC and SVA frameworks. Again, Rutter Associates has been at the forefront of this evolution.
- 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.
- 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 performed a “sound practice evaluation” of a multinational non-financial corporation’s risk management measures and practices.
- Rutter Associates advised a multinational oil company in the development of its market risk measurement and hedging policies.
- Rutter Associates reviewed the Market Risk function of a major Life Insurance Company to assist in a rating agency review.
- Rutter Associates developed an expected shortfall model for the CIO of a multi-billion dollar endowment fund.