Home | Business News | Browse by Publication | E | Economic Bulletin

Measuring market risk in Norwegian financial institutions.

Article Excerpt
This article discusses two methods for analysing market risk in the Norwegian banking sector and in life insurance companies. The two methods, Value at Risk (VaR) and stress tests, are commonly used in individual institutions, but have been adjusted here for use on the available aggregate statistical data from the banking and insurance sector. The methods have to be simplified for use on these aggregate data, but the analyses nevertheless provide an indication of the vulnerability of the institutions viewed as a whole. Our analyses show that the market risk of commercial and savings banks, viewed in relation to total assets, is low. The market risk of life insurance companies is higher, but has fallen in recent years.

1 Introduction

Market risk is the risk of assets declining in value as a result of fluctuations in market prices. Financial institutions' portfolio of financial instruments consists of equities, fixed income instruments (bonds, notes and short-term paper) and derivatives. Market risk for equities relates to the possibility of equity prices falling, and for fixed income paper to the possibility of interest rates rising. The market risk associated with derivatives depends on the specific derivative position. For special derivative positions, even small changes in the prices of the underlying assets may result in a sharp fall in the value of the derivatives.

There are substantial differences between market risk in Norwegian banks and life insurance companies, a fact that has been fully illustrated by the sharp fall in equity prices in recent years. Norwegian banks own a relatively small amount of fixed income paper and very few equities (see Table 1) (1), so the direct impact on banks of the fall in equity prices has been limited. Because of their long-term obligations, life insurance companies invest a substantial share of their capital in equities and long-term bonds. At the end of 1999, over 30 per cent of their total assets were invested in equities. They were severely hit by the fall in equity prices, and had to sell equities to reduce their risk. In 2002, they purchased considerable amounts of bonds. This, along with the reclassification of some securities from the category fixed income paper held as current assets, brought about a sharp increase in the category 'bonds to be held to maturity', and they accounted for 30 per cent of total assets by end-2002. (2) About two-thirds of these bonds had maturities after 2005. 'Bonds to be held to maturity' are to be regarded as fixed assets, and are not included in the insurance companies' holdings in Table 1. (3) The reclassification of bonds to the category 'to be held to maturity' reduces market risk in the short term, but may also reduce the flexibility of fixed income management.

There are several methods for measuring market risk. In this article, Value at Risk (VaR) and stress tests are presented. VaR is a measure of the market risk associated with 'normal' fluctuations in securities markets, while stress tests are used to measure the effect of dramatic price changes.

Value at Risk (VaR)

VaR is a measure of the potential loss of value of a portfolio of assets in a given period of time for a given confidence level. Example: A VaR sum of NOK X, given a one-sided confidence level of 95 per cent and a period of 1 day, means that the probability of a fall in value in excess of X during the next 24 hours is 5 per cent. This means that on average losses can be expected to exceed VaR every 20th day. (4)

Most VaR models use historical data to estimate a probability distribution for the return on the portfolio. Given assumptions about the confidence level and time horizon, VaR is then estimated on the basis of this probability distribution.

Stress testing

Stress tests are used to estimate the change in value of the portfolio in the event of predefined market shocks. Common stress test scenarios are sharp falls in equity prices and steep rises in interest rates...

View this article FREE - Now for a Limited Time, try Goliath Business News
Free for 3 Days!