Cooking with Basel II: Market Risk
Basel II Recipes: Internal Models Approach for Measuring Market Risk
The Internal Models Approach is more sophisticated than using the
Standard Framework. Its use must be approved by authorities and
requires:
  1. A risk management system conceptually sound and
    implemented with integrity; AND
  2. a staff sufficiently skilled in use of the model; AND
  3. a reasonable track record for the model in measuring risk;
    AND
  4. ability to conduct stress tests; AND
  5. model is subject to qualitative and quantitative criteria
    detailed in 718(lxxiv) - 718(ic)
Qualitative criteria include
  1. Have an independent group responsible for design and
    implementation of the Internal Model; AND
  2. Have senior management and Board of Director
    involvement in the processes; AND
  3. Close integration to the day-to-day risk management
    process; AND
  4. Have stress testing abilities (I translate this to mean 'have
    the ability to determine outliers of distributions'); AND
  5. documentation, documentation, documentation.
Quantitative criteria include:
  1. Although no type of model is specified, the model must
    capture all material risks per 718(lxxv); AND
  2. Some Value-at-Risk must be calculated to a 99th
    percentile, one-tailed confidence interval (asking for VAR
    immediately biases the type of model); AND
  3. Model must capture empirical correlations within risk
    categories; AND
  4. Use instantaneous price shock equivalent to a 10-day
    movement in prices; AND
  5. documentation, documentation, documentation.
Requirements for Stress Testing
If an organization uses the Internal Models Approach, the
organization must include rigorous and comprehensive stress
testing.
The purpose of stress testing is to provide a measure of risk
where large changes are made in risk factors. This is the
missing element of Value-at-Risk calculations where small,
linear changes occur in risk factors.
The downside of stress testing include:
there is no indication which stress factors the most significant
problems;
stress values in potential risk factors are not necessarily totally
correlated or completely uncorrelated.
A promising alternative to the Value-at-Risk and stress testing
Internal Models Approach is application of Levy flights (a
spin-off of physics applications) and Extreme Value Theory.
I believe these few pages describing Market Risk as part of the
Basel II Accord form a fundamental understanding of the
subject. I welcome corrections, critiques, and comments.