LO 5.6: Describe the relationship between leverage, market value o f asset, and VaR

LO 5.6: Describe the relationship between leverage, market value o f asset, and VaR within an active balance sheet management framework.
When a balance sheet is actively managed, the amount of leverage on the balance sheet becomes procyclical. This results because changes in market prices and risks force changes to risk models and capital requirements, which require adjustments to the balance sheet (i.e., greater risks require greater levels of capital). Thus, capital requirements tend to amplify boom and bust cycles (i.e., magnify financial and economic fluctuations). Academic studies have shown that balance sheet adjustments made through active risk management affect risk premiums and total financial market volatility.
Leverage (measured as total assets to equity) is inversely related to the market value of total assets. When net worth rises, leverage decreases, and when net worth declines, leverage increases. This results in a cyclical feedback loop: asset purchases increase when asset prices are rising, and assets are sold when asset prices are declining.
Value at risk is tied to a banks level of economic capital. Given a target ratio of VaR to economic capital, a VaR constraint on leveraged investors can be established. An economic boom will relax this VaR constraint since a banks level of equity is expanding. Thus, this expansion allows financial institutions to take on more risk and further increase debt. In contrast, an economic bust will tighten the VaR constraint and force investors to reduce leverage by selling assets when market prices and liquidity are declining. Therefore, despite increasingly sophisticated VaR models, current regulations intended to limit risk-taking have the potential to actually increase risk in financial markets.
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2018 Kaplan, Inc.
Topic 5 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
K e y C o n c e p t s
LO 5.1
The proper time horizon over which VaR is estimated depends on portfolio liquidity and the purpose for risk measurement. It is important to incorporate time-varying volatility into VaR models, because ignoring this factor could lead to an underestimation of risk. Backtesting VaR models is less effective over longer time horizons due to portfolio instability.
LO 5.2
Exogenous liquidity represents market-specific, average transaction costs. Endogenous liquidity is the adjustment for the price effect of liquidating specific positions. Endogenous liquidity risk is especially relevant in high-stress market conditions.
LO 5.3
VaR estimates the maximum loss that can occur given a specified level of confidence. It is a quantitative risk measure used by investment managers as a method to measure portfolio market risk. A downside of VaR is that it is not subadditive.
An alternative risk measure is expected shortfall, which is complex and computationally difficult. Spectral risk measures consider the investment managers aversion to risk. These measures have select advantages over expected shortfall.
LO 5.4
Within a banks risk assessment framework, a compartmentalized approach sums measured risks separately. A unified approach considers the interaction among various risk factors. Simply calculating individual risks and adding them together is not necessarily an accurate measure of true risk due to risk diversification. The Basel approach is a non-integrated approach to risk measurement.
LO 5.5
A top-down approach to risk assessment assumes that a banks portfolio can be cleanly subdivided according to market, credit, and operational risk measures. To better account for the interaction among risk factors, a bottom-up approach should be used.
LO 5.6
When a balance sheet is actively managed, the amount of leverage on the balance sheet becomes procyclical. Leverage is inversely related to the market value of total assets. This results in a cyclical feedback loop. Financial institution capital requirements tend to amplify boom and bust cycles.
2018 Kaplan, Inc.
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Topic 5 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
C o n c e p t C h e c k e r s
Which of the following statements is considered to be a drawback of the current Basel framework for risk measurement? A. Risk measurement focuses exclusively on VaR analysis. B. The current regulatory system encourages more risk-taking when times are
good.
C. There is not enough focus on a compartmentalized approach to risk assessment. D. There is not a feedback loop via the pricing of risk.
What type of liquidity risk is most troublesome for complex trading positions? A. Endogenous. B. Market-specific. C. Exogenous. D. Spectral.
Within the framework of risk analysis, which of the following choices would be considered most critical when looking at risks within financial institutions? A. Computing separate capital requirements for a banks trading and banking
books.
B. Proper analysis of stressed VaR. C. Persistent use of backtesting. D. Consideration of interactions among risk factors.
What is a key weakness of the value at risk (VaR) measure? VaR: A. does not consider the severity of losses in the tail of the returns distribution. B. C. D. has an insufficient amount of backtesting data.
is quite difficult to compute. is subadditive.
Which of the following statements is not an advantage of spectral risk measures over expected shortfall? Spectral risk measures: A. consider a managers aversion to risk. B. are a special case of expected shortfall measures. C. have the ability to modify the risk measure to reflect an investors specific risk
aversion.
D. have better smoothness properties when weighting observations.
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2018 Kaplan, Inc.
Topic 5 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
C o n c e p t C h e c k e r An s w e r s
1. B
Institutions have a tendency to buy more risky assets when prices of assets are rising.
2. A
Endogenous liquidity risk is especially relevant for complex trading positions.
3. D
A unified approach is not used within the Basel framework, so the interaction among various risk factors is not considered when computing capital requirements for market, credit and operational risk; however, these interactions should be considered due to risk diversification.
4. A VaR does not consider losses beyond the VaR threshold level.
5. B Spectral risk measures consider aversion to risk and offer better smoothness properties.
Expected shortfall is a special case of spectral risk measures.
2018 Kaplan, Inc.
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The following is a review of the Market Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
S o m e C o r r e l a t io n Ba s i c s : P r o p e r t i e s , M o t iv a t io n , T e r m in o l o g y
Topic 6
E x a m F o c u s
This topic focuses on the role correlation plays as an input for quantifying risk in multiple areas of finance. We will explain how correlation changes the value and risk of structured products such as credit default swaps (CDSs), collateralized debt obligations (CDOs), multi- asset correlation options, and correlation swaps. For the exam, understand how correlation risk is related to market risk, systemic risk, credit risk, and concentration ratios, and be familiar with how changes in correlation impact implied volatility, the value of structured products, and default probabilities. Also, be prepared to discuss how the misunderstanding of correlation contributed to the financial crisis of 2007 to 2009.
F i n a n c i a l C o r r e l a t i o n R i s k

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