Market Risk Cheryl J. Rathbun Citigroup Chief Operating Officer U.S. Basel II Implementation Director Citigroup @all rights reserved November 2008

· Market risk is defined as the potential change in the current economic value of a position (i.e., its market value), due to changes in the associated underlying market risk factors The four standard market risk factors include: --Equity Risk, or the risk that stock prices will change. --Interest rate risk, or the risk that interest rates will change. --Currency risk, or the risk that foreign exchange rates will change --Commodity risk, or the risk that commodity prices (I.e., grains, metals, etc.) Market Risk is often linked to and impacted by by other forms of financial risk such as credit and liquidity risk. For example, a downgrading of the credit worthiness of an Issuer could lead to a drop in the market value of securities issued by that issuer.

Measurement of Market Risk It is important for all banking institutions to develop a sound and well informed strategy to manage market risk. The strategy should first determine the level of market risk the institution is prepared to take. This level should be set with consideration given to, among other facts, the amount of market risk capital set aside by the institution. In setting its market risk strategy, an institution should consider the following factors: Economic and market conditions and their impact on market risk Whether the institution has the expertise to profit in specific markets and is able to identify, monitor and control the market risks in those markets The institution’s portfolio mix and how it would be affected if more market risk was assumed

VaR – Market Risk Management Approach VaR (Value at Risk) is a number that expresses the maximum expected loss for a given time horizon and for a given confidence interval and for a given position or portfolio of instruments, under normal market conditions, attributable to changes in the market price of financial instruments. Example, if we are investment managers with positions in foreign exchange, fixed income and equities. We need an assessment of what we can expect the worst case to be for the position overnight with a 95% degree of confidence. The VaR number gives us this measurement. The portfolio manager might have 100 million dollars under management and an overnight-95% confidence interval VaR of 4 million dollars. This means that 19 times out of 20 his biggest loss should be less than 4 million dollars. Hopefully, he is making money instead of losing money. You can also express VaR as a percentage of assets, in this case 4%. VAR is a statistical measure of market risk and is expressed in USD terms. VAR represents the potential decline in value of a trading position, which is marked-to-market daily, over a specified period of time (usually one day):         E.g., if the value of an equity position potentially could decrease from $1 MM to $0.9 MM over a one day period, then its VAR would be $0.1 MM

VaR is not:  VAR only captures the potential losses associated with changes in the end-of-day value of trading positions VAR is calculated assuming a certain “confidence level” (usually 99%):        E.g., if a $10 MM one-day VAR is calculated at a 99% confidence level, VAR would indicate that in 99 out of 100 days, the daily changes in the value of the trading positions would generate either profits or losses that were less than or equal to $(10) MM. The potential negative changes in the value of end-of-day trading positions are expected to be worse than $(10) MM only in one out of 100 days.

More on VaR VAR is Not… · VAR is not a Profit & Loss (P&L) predictor: o         VAR is not a stress test predictor: o         VAR only represents a “bad day” (i.e., what would happen in 99 out of 100 days), not a potential stress scenario           VAR is required to be calculated by federally regulated financial institutions that engage in mark-to-market trading activities. In addition, there is an industry convention for other financial institutions with trading businesses to disclose VAR. There are no prescribed regulatory requirements as to which methodologies to use when computing VAR.