Value at risk (‘VaR’)
It is a technique for estimating potential losses on risk positions as a result of movements in market rates and prices over a specified time horizon and to a given level of confidence. The use of VaR is integrated into market risk management and calculated for all trading positions regardless of how it is capitalised.
The VaR model formulated by HSBC is predominantly based on historical simulation that incorporates the following features:
- Historical market rates and prices, which are calculated with reference to foreign exchange rates, commodity prices, interest rates, equity prices and the associated volatilities;
- Potential market movements utilised for VaR, which are calculated with reference to data from the past two years; and
- VaR measures, which are calculated to a 99% confidence level and use a one-day holding period.
The models also incorporate the effect of option features on the underlying exposures.
Market risk is the risk that movements in market factors, such as foreign exchange rates, interest rates, credit spreads, equity prices and commodity prices, will reduce the income or the value of the portfolios. In HSBC the exposure to market risk is separated into two portfolios:
- Trading portfolios; and
- Non-trading portfolios.
Market Risk in 2018
Global markets were characterised by robust economic sentiment at the start of the year. As the year progressed, economic activity diverged across the global economy against a backdrop of continuing trade and geopolitical tensions; concerns around slowing growth in China; and the continuing uncertainty around the shape of the UK’s withdrawal from the EU.
Monetary tightening started across the developed world. The US Federal Reserve raised official interest rates multiple times during the year. Bond yields started to increase but remained low by historical standards. In the eurozone, the European Central Bank ended its bond-buying programme, although softening growth and inflation prospects add to the uncertainty of the timing of the next interest rate hike.
Trading value at risk (‘VaR’) ended the year lower when compared with the previous year. The trading VaR composition remained largely the same, with interest rate trading VaR being the largest individual contributor to overall trading VaR. Non-trading interest rate VaR ended the year lower when compared with the previous year as exposures were managed down.
I. Trading Portfolios
Trading VaR predominantly resides within Global Markets where trading VaR was lower at 31 December 2018 compared with 31 December 2017. The contributions of each asset class were largely range bound during the year.
The decrease in trading VaR from the equity and credit spread trading VaR components was partially offset by an increase in the interest rate and foreign exchange trading VaR components. The effects of portfolio diversification reduced the overall trading VaR.
II. Non-Trading Portfolios
Non-trading VaR of the Group includes contributions from all global businesses. There was no commodity risk in the non-trading portfolios. The non-trading VaR ended the year lower compared with the previous year, due to a reduction in the non-trading interest rate VaR component. This was caused by the reduction of the risk in our investment portfolio, specifically from reduced interest rate risk on US Treasuries and agency mortgage backed securities.
Basel III conditions to calculate VaR
According to the Basel III framework the banks have flexibility in the calculation of their capital requirements, but there are some minimum standards which they have to adhere.
- The basis of the calculation is the VaR computed on a daily basis, using a 99th percentile, one tailed confidence interval.
- The 10-day-returns of the portfolio must be used, which can be approximated by using the 1-day-returns and scale them according to a normal distribution by √10 up to ten days.
- Furthermore, the length of the sample period underlying the calculation must be at least one year.
- Besides that the banks are free to choose between models based on variance-covariance matrices, historical simulations or Monte Carlo simulations.
- Moreover, the Basel III market risk framework defines a SVaR, which is calculated on the same basis as the VaR, but in a period of significant stress for the bank’s portfolio.
The length of the period must be twelve months and the choice of the period has to be approved by the supervisor as well as reviewed regularly.
Limitations of VaR
Although a valuable guide to risk, VaR should always be viewed in the context of its limitations:
- Use of historical data as a proxy for estimating future events may not encompass all potential events, particularly extreme ones.
- The use of a holding period assumes that all positions can be liquidated or the risks offset during that period, which may not fully reflect the market risk arising at times of severe illiquidity, when the holding period may be insufficient to liquidate or hedge all positions fully.
- The use of a 99% confidence level does not take into account losses that might occur beyond this level of confidence.
- VaR is calculated on the basis of exposures outstanding at the close of business and therefore does not necessarily reflect intra-day exposures.
- While calculating VaR of a portfolio, it is required to measure or estimate the correlations between the return and volatility of individual assets. With growing number and diversity of positions in the portfolio, the difficulty (and cost) of this task grows exponentially.