A new proposal for collection and generation of information on financial institutions' risk: The case of derivatives

Abstract

Practical applicationsThe following sections contain reports that reproduce the proposed information sets for linear and nonlinear instruments. The comments on the use of each one and the results of some tests are also presented. AbstractThis paper aims at providing a new alternative for the collection of information on risks taken by financial institutions, which enables the calculation of risk tools usually used in risk management, such as VaR and stress tests. This approach should help risk managers, off-site supervisors and academics in assessing the potential risks in financial institutions principally due to derivatives positions. The basic idea, for linear financial instruments, like that traditionally used by the management risk systems, is to reduce positions in risk factors and then map the vertices. For the nonlinear financial instruments, all the positions in different types of options -European, American, exotic, etc -are represented as plain vanilla European options or replicated by portfolios of plain vanilla European options. The methodology was applied to Brazil, within the worst scenarios during the period from 1994 to 2004, and the paper demonstrates that the proposed approach captured the risks satisfactorily in the analysed portfolios, including the risk existent in the strategies involving options, given an accepted error margin. This approach could be useful for regulators, risk managers, financial institutions and risk management modelling as it can be used as an input in general risk management models.