assessing financial risks

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assessing financial risks risk management karimboev d.d. value at risk (var) definition: value at risk quantifies the potential loss in value of an asset or portfolio over a defined period for a given confidence interval (e.g., 95% or 99%). applications: common in market risk management, var helps organizations understand their exposure to market fluctuations. limitations: var does not provide insights beyond the confidence level, potentially underestimating extreme risks (tail risks). ing uses var as a key risk indicator in its trading and investment portfolios. following the 2008 crisis, ing re-evaluated its var thresholds to manage sudden market volatilities better and ensure capital adequacy. stress testing and scenario analysis definition: stress testing involves applying extreme scenarios to assess the impact on assets or portfolios under hypothetical but plausible adverse conditions. applications: commonly used to assess how financial institutions would perform in situations like economic downturns, natural disasters, or market crashes. limitations: …

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ic shutdowns. sensitivity analysis definition: sensitivity analysis measures how different variables (e.g., interest rates, currency exchange rates) affect financial outcomes. applications: used for understanding exposure to specific variables, especially in managing interest rate, currency, and credit risks. limitations: focuses on one variable at a time, which may not capture complex interactions between variables. ing applies sensitivity analysis to gauge the impact of interest rate changes on mortgage loan portfolios, particularly in european markets where variable-rate mortgages dominate. during low-rate periods, they tested potential impacts if rates normalized. credit scoring models definition: credit scoring assesses the likelihood of a borrower defaulting on a loan based on credit history, financial metrics, and other characteristics. applications: widely used by financial institutions to evaluate individual and corporate credit risk. limitations: models may lack adaptability to new economic conditions or unforeseen risks, and they often rely heavily on historical data. citi uses an internal scoring …

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ptions about distribution of losses may not always be realistic. if citi’s var at the 99% level for a portfolio is $30 million, and average losses beyond this point are $45 million, the expected shortfall would be $45 million. real-life application: citi and ing both incorporated es into their risk management frameworks to capture the tail risk exposure. ing particularly uses es for portfolios susceptible to extreme market swings, such as foreign exchange derivatives. monte carlo simulations definition: this method uses random sampling and statistical modeling to simulate a range of potential outcomes for financial variables.applications: useful for assessing the risk of complex portfolios by simulating various economic scenarios, often applied in market and credit risk.limitations: computationally intensive and relies on the accuracy of input distributions, which may not always reflect real-world dynamics. outcomescenario=f(random variable inputs) to assess the market risk of an equity portfolio, bank of america might simulate …

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ds spread on emerging market bonds signals rising default risk, prompting ing to reassess exposures. case study: during the european debt crisis, both ing and citi actively tracked cds spreads on eurozone sovereign debt, adjusting exposures and hedging strategies to mitigate risks associated with greek and italian bonds. liquidity coverage ratio (lcr) and net stable funding ratio (nsfr) definition: lcr and nsfr are regulatory metrics that assess a financial institution's liquidity risk by comparing liquid assets to anticipated cash outflows. applications: central to regulatory frameworks (e.g., basel iii), ensuring banks maintain sufficient liquidity for short-term and long-term obligations. limitations: these ratios are specific to financial institutions and may not apply directly to other sectors. bank of america maintains an lcr above regulatory minimums (100%) to ensure liquidity. in practice, this means holding assets that can be readily converted to cash to meet short-term obligations. real-life application: following basel iii guidelines, …

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n size (ead). case study: in response to the 2020 pandemic, bank of america adjusted pd and lgd assumptions for industries heavily impacted, such as travel and leisure, to better estimate potential defaults. risk-adjusted return on capital (raroc) definition: raroc assesses the return of an investment or business activity adjusted for the financial risk taken. applications: used to evaluate and compare risk-adjusted performance across business units or investment projects. limitations: can be complex to implement and interpret, especially when assumptions on risk-adjusted capital are not clear. citi has a commercial loan portfolio with: expected annual revenue: $100 million expected costs: $15 million expected loss (calculated based on pd and lgd): $10 million economic capital required for the portfolio: $500 million the risk-adjusted net income would be calculated as follows: risk-adjusted net income=100−15−10=75 million the raroc would then be: raroc=75 million/500 million=0.15 or 15 if citi’s internal threshold raroc is 12%, …

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assessing financial risks risk management karimboev d.d. value at risk (var) definition: value at risk quantifies the potential loss in value of an asset or portfolio over a defined period for a given confidence interval (e.g., 95% or 99%). applications: common in market risk management, var helps organizations understand their exposure to market fluctuations. limitations: var does not provide insights beyond the confidence level, potentially underestimating extreme risks (tail risks). ing uses var as a key risk indicator in its trading and investment portfolios. following the 2008 crisis, ing re-evaluated its var thresholds to manage sudden market volatilities better and ensure capital adequacy. stress testing and scenario analysis definition: stress testing involves applying extreme scen...

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