Measuring risk and performance for a financial institution

Abstract

This research evaluates the use of Value at Risk (VaR) and Return on Risk-Adjusted Capital (RORAC) as risk and performance measures for financial institutions that use derivatives. The methodology simulates the value of a hypothetical financial institution's portfolio using historically observed yield curves. The hypothetical portfolios consist of vanilla interest rate options and a stream of fixed cashflows. The methodology provides valuable information to the financial risk management industry. Firstly, it is a conceptually simple full valuation approach to VaR that is computationally efficient and can be modified to price different instruments and simulate with different sets of historical data. Secondly, it approaches the topic of risk and performance of derivatives over a short-medium term horizon. The results indicate that selling options provides healthy returns to a financial institution. Furthermore, options sold with their key variables (strike price, volatility, and time to expiry) at certain levels have a relatively lower risk and/or higher return. This may be a side effect of the way the simulations are run, or imply that VaR incorrectly measures the downside risk from short selling options. RORAC is inadequate as a risk/reward performance measure. This is primarily because VaR is a factor in its calculation, but also because it is inconsistent when comparing assets with positive and negative returns. Furthermore, it assumes a linear risk appetite of potential users.