Taking Value-at-Risk Analysis beyond the Trading Floor

By Lacross, Dave | American Banker, June 3, 1996 | Go to article overview

Taking Value-at-Risk Analysis beyond the Trading Floor


Lacross, Dave, American Banker


Investigators will spend years probing the debacles last year involving Orange County and Barings, when two seemingly solid players in the market collapsed under the weight of unforeseen trading and investment risks.

But the problems that brought down Barings and buffeted Orange County could have been avoided if management had followed two essential practices: performing value-at-risk analysis across the enterprise and separating the people responsible for measuring and analyzing value-at-risk from those charged with running the trading operation.

Value-at-risk, associated mainly with the trading room operation, consists of a complex series of detailed calculations that quantify investment risks over a specified period of time. Advanced approaches to value-at-risk incorporate explicit risk/return trade-offs and feature Monte Carlo simulations, the results of which reveal the magnitude and nature of the risk.

Value-at-risk addresses the problem of interest rate fluctuation, a key wild card in the investment analysis. A shift in interest of just a few basis points can trigger a string of actions that directly affect the current and future value of an investment and an entire portfolio.

But banks increasingly are recognizing that value-at-risk analysis should not be limited to the trading room. Rather, it provides valuable insight when applied across the entire institution. These managers are finding, often to their surprise, that in areas not traditionally associated with value-at-risk analysis, they indeed have significant interest rate risk.

Almost every department, from revolving credit to deposits, has portfolios that are affected by interest rate shifts. In this period of intense competition, when banks must introduce new products quickly to meet market demands or to counter competitive activities, a bank can find itself in a situation where the very success of a marketing campaign for a particular product may be overloading the bank with unacceptably high levels of risk. Unaware of the value at risk, managers fail to take the necessary hedging and risk management measures that prudence requires.

The problem is most acute where there is extensive interest rate optionality risk, everything from adjustable-rate mortgages to credit card teaser promotions. For example, the "double-up" certificate of deposit has emerged as a popular new product in certain areas of the country. With a double-up CD, the investor has the option to increase the investment at the existing rate during the life of the CD. This puts the bank at significant interest rate risk. Should interest rates drop during the life of the program, the bank will likely find itself committed to twice the amount at the higher initial rate. Without value-at-risk analysis, managers may initiate a successful marketing campaign that serves to compound dangers they haven't fully assessed. Before they know it, the bank is holding millions of dollars in paper and scrambling to put together a hedging strategy.

This does not mean that banks should avoid such products, rather that managers must fully assess this risk through enterprise wide value-at-risk analysis as they design and introduce products. …

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