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VAR-METHODOLOGY IN RISKMANAGEMENT OF THE BANK’S
INTEREST RATE AND
EXCHANGE RATE: IS IT
POSSIBLE, USEFUL AND VALID
IN THE UKRAINIAN BANK
A thesis submitted in partial
fulfillment of the requirements for the degree of Master of Arts in Economics National University “Kyiv-Mohyla Academy” Economics Education and Research Consortium Master’s Program in Economics Approved by ___________________________________________________
Ms. Svitlana Budagovska (Head of the State Examination Committee) __________________________________________________
Program Authorized to Offer Degree Master’s Program in Economics Date _________________________________________________________
National University of “Kyiv-Mohyla Academy” Abstract
VAR-METHODOLOGY IN RISKMANAGEMENT OF THE BANK’S
INTEREST RATE AND EXCHANGE RATE:
IS IT POSSIBLE, USEFUL AND VALID IN
THE UKRAINIAN BANK MARKET?
by Olha Venchak Head of State Examination Committee: Ms. Svitlana Budagovska, Economist, World Bank of Ukraine This thesis is devoted to risk-management in Ukrainian banks. Value-at-Risk methodology, which is widely used in developed countries, is not popular among Ukrainian risk-managers. The main stone on the road was the transition conditions inside the country, which disturbs market mechanisms.
Today the situation is changed!
On the example of one of Ukrainian commercial banks “Kredyt-Bank (Ukraine)” I applied VaR to calculating exchange rate risk and interest rate risk. In calculating exchange rate risk I used untraditional approach.
Simulations in VaR for both kinds of risk were made by standard (variancecovariance) and historical simulations methods. Results, which I got, are very useful for planning the stable, profitable and prosperous future of the bank.
By Basel Committee (2004), banks that want to cooperate on the open financial market and to be a strong competitor to developed banks must use in its risk-management VaR methodology.
It is the time to be on the same level with leading countries!
TABLE OF CONTENTS
List of Figures and Tables
List of Appendix Figures and Tables
Chapter 2. Literature Review
2.1 History of Risk Management
2.2 Risk Classification
2.3 Basel Committee and Value-at-Risk
2.4 Value-at-Risk Classification and Methodologies
Chapter 3. Methodology
3.1 Classical VaR Computation
3.2 Parametric and Non-Parametric Approaches to VaR
Table 1. Types of E rrors According to Type of Decision
Table 2. Basel Committee Requirements to Exceptions
Table 3. VaR for the Credits to the Firms
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Figure A1. Back-Testing for the Exchange Rate Risk
Figure A2. Back-Testing for the Interest Rate Risk, UAH
Figure A3. Back-Testing for the Interest Rate Risk, EUR
Figure A4. Back-Testing for the Interest Rate Risk, USD
Table A1. Summary Statistics for Exchange Rates
Table A2. Assessment of Parametric and Non-Parametric VaR Models.
...........56 Table A3. Results with Calculated Possible Loss According to the Interest Rate Risk
Table A4. Results with Calculated Possible Loss According to the Interest Rate Risk
I would like to express my hearty thanks to my advisor Prof. Tom Coupe for his very helpful and careful supervision, for his friendly and wise advises during the whole process of work on my research. I also would like to thank Prof. Volodymyr Bilotkach and Prof. Polina Vlasenko for their thorough reviews and valuable comments. The special sincere gratitude I would like to give to Kredyt-Bank’s (Ukraine) Risk Manager Anton Kirkach for competence in providing necessary information and data for my research. I give the special thank to my fiancé Taras Bunds for his gentle support during the difficult period of thesis writing. Also I would like to give special gratitude to God for His help and to my family for their support and understanding.
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Adequacy of Capital – the possibility of bank to cover its loans with the own capital.
Future value – capital’s value after the certain period of time with the interest rate profit.
GAP-method - the difference between some group of assets with respective interest and the same group of loans with respective interest:GAPt = At − Lt, it shows positive or negative gap.
Present value - today’s value of future cash flows.
Value-at-Risk - tool for estimation the exposure to different kinds of risk, which gives the worst expected loss at a given confidence level with the probability of 95% or 99%.
–  –  –
Each year banking sector problems attract greater attention on the Ukrainian financial market. Today, the banking system is the main “blood system” between borrowers and lenders; it is the way of almost all possible business finance communications. Its solidity, stability and security show the healthiness of the whole country’s economy.
The main issue in this sphere is the improvement of the financial stability and increasing the bank’s financial result. “Life is risky”, everyone knows this, and hence, one of the basic determinants which directly influence the stability and the result, is risk. Nevertheless, in finance almost everyone would like to benefit from taking additional risk, since every additional risk can be rewarded by the risk premium. Where is the risk coming from? The answer is that the risk has its origin in many sources: human-created (business cycles, inflation, wars) and natural phenomena. It also can be created from the long-term economic growth, technological innovations and so forth. Financial markets cannot be completely protected against all risks (Jorion 2000).
Banking risk means the probability of loss according to the specific operation that the credit institution is engaged in. So, the main task of risk-managers is seeking security and maintaining the equilibrium between chances to win (earn excess profit) and risks attached to these profits. To do this the riskmanagers should be able to identify, quantify and foresee risks.
There is a wide classification of risks. Banking risks are divided into market risk (interest rate risk, exchange rate risk, equity risk, liquidity, commodity risk and derivative market risk), credit risk (stock and individual) and operational risk (human risk, process risk, external event risk, and technology risk). But this classification can be flexible, every bank can decide about its own risk classification according to the market conditions it is working with.
Market risk is the next important group of banking risks after credit risk and it means the possibility of a change in the economic condition of the financial institution due to the influence of some market factors. This kind of
risk covers about 25% of risk capital in bank (Kumar 2003). He wrote:
“Market risk needs more attention in most banks, because if everything seems under control, you’re just not going fast…” In this thesis, I would like to pay the main attention to the risk of interest rate and to the risk of the exchange rate, the most significant types of market risks. The first one means the danger of possible loss because of the volatility of market interest rates and the related change in the values of credits, loans and their present values. The second is the probability of losing capital due to changes in the exchange rates of foreign currency to the domestic currency during the period from the signing of the contract to the real transaction.
Every bank tries to hold interest rate risk under control through the high quality of its management. Consequently, to ensure the most productive way of managing risk, instead of dictating capital and risk-management requirements through a uniform supervisory approach, banks are allowed by the Basel Committee1 to use their own models and expertise for computing the capital required and the risk value (Lucas 2001). This rule extends to all European countries, including Ukraine, but every bank in different countries should adjust its measures with the requirements of its Central Bank (National Bank of Ukraine in our case). Nevertheless, during long time and till now, the Basel Committee advises to use the Value-at-Risk (VaR) as the best method of 1 BaselCommittee on Banking Supervision (1988) is a Committee of banking delegated supervisory authorities, established by the central bank Governors of the group of ten leading countries: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States.
measuring banking risk in the money equivalent. This method predicts the possible losses that will not exceed (1-p) %. But, in 2007, when the Basel II2 will come into effect, VaR will be not only the recommended methodology, but also the required one for risk measuring in the accounts in those banks, which operate on the interbank market. At that time VaR-measuring will be obvious, but it will not forbid the parallel internal risk measuring, other than VaR. Hence, in the nearest future the National Bank of Ukraine will also require the VaR methodology. This information became available in the guidelines after the Basel Committee of Banking Supervision II. Also, those Polish professionals who already use the VaR-methodology and currently are cooperating with Ukraine’s banking system speak about the transformation of the standard system of our risk measuring (the largest Polish bank “PKO’’, which cooperates with the “Kredyt-Bank (Ukraine)”).
Modern European and USA financial markets offer enough instruments that allow full study of behavior of the interest rate and exchange rate and provide predictability of their movement through time. My paper will be the first attempt to describe the evaluation of the exchange rate risk through the VaR-method for the Ukrainian banking market. It will be also the first work in evaluating the interest rate risk through the method based on the VaR methodology and can be considered as the similar to VaR method.
There were no attempts for measuring the interest rate risk through the methods based on the VaR in Ukrainian banks till now. As to the exchange rate, it is possible to calculate VaR for it, but almost no bank (the exception are foreign banks) did this till now.
The attractiveness of VaR-methodology is in the simplicity of its idea and realistic predictions. It makes possible to provide single statistic estimating the potential loss to which a bank is exposed during a given period of time with a given degree of confidence (99%) according to the type of Basel II (2004) is the document (package) of recommendation for the Central Banks how to calculate the necessary amount of capital to cover bank’s risks.
operation or the portfolio under some market risks. The value of VaR ensures covering of possible losses x during time t with probability p, Pr (VaRx) = p. This VaR-methodology can be used for measuring different kinds of risk, measuring all of them by this methodology makes it possible for a bank to see the total value of capital under risk. Still banks in Ukraine did not use this method in prediction of possible capital loss because official regulations did not require such risk measuring. Moreover, to have the precise results of calculating VaR the market mechanisms should work well. As far we know market mechanisms in Ukraine are not high developed still. That is why, market interest rate in Ukraine still have very weak correlation with the real interest rate in Ukrainian banks.
The main condition for calculating VaR is simultaneous change of the capital value in response to a change in some factors (e.g. the exchange rate changes, the value of foreign capital changes too at the same time). It is impossible to calculate the traditional VaR for the interest rate risk, because there is no such immediate change of the capital after the change of the market interest rate (today we have already signed contracts of deposits and credits with adjusted interest rates). So the main investigation of this work will be in attempt to build the method based on VaR, which will show the risk of change the market interest rates for the present value of bank’s capital.
To use this VaR-modeling for exchange rate, I will need daily data on exchange rates for all foreign currencies included in a bank portfolio of foreign currencies. To apply my model, based on VaR, for calculating the
interest rate risk I will also need daily data across different interest rates:
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