Risk Management has become an essential tool for safe investing practices. It is advised to use this tool whenever you are investing or trading to reduce the chances of extreme losses. Over time, regulatory bodies have defined various metrics to make risk management a strictly followed practice. Value at Risk (VaR), Extreme Loss Margins (ELMs), and Adhoc Margins are the few risk management measures that are required to be followed during the trade to assess and control the exposure to market volatility.
Value at Risk (VaR) is a statistical measure used to estimate the potential loss an investment portfolio or trading position may incur over a given time period with a specified level of confidence. VaR is calculated using historical data.
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The greatest assumption that it makes is that the past is more likely to repeat itself in the future. Therefore, the behavior and volatility of the securities are mimicking the past in the future. Even though it is a little fictitious, this assumption has helped investors detect unanticipated risks arising due to unforeseen market volatility.
There are several ways to calculate the VaR of security. They are broadly defined as parametric and non-parametric approaches. Parametric approaches include methods like historical simulation and moving averages, whereas parametric approaches include methods like backtesting and Monte Carlo simulation.
Let’s take an example to understand the concept better:
A 95% VaR of Rs. 1 lakh means that there is a 5% chance that the portfolio will lose more than Rs. 1 lakh over a specific time horizon.
To calculate the VaR, the exchanges have classified all securities into three groups, with each group having its own set of metrics for calculation. VaR is calculated by applying the exponentially weighted moving average to daily returns. The upfront collection of the VaR margin involves adjusting it against the member's total liquid assets at the time of the trade.
Extreme Loss Margin (ELM) is another tool used in coherence with the VaR to identify the extreme events of unregarded market volatility. These events are usually outliers and do not have a high probability of occurrence over time. Yet the intensity of these events is high enough to cause huge financial losses to investors. Earthquakes are a good example of extreme events.
Therefore, to be able to identify these events and take precautionary measures, extreme loss margins were added by the exchanges. ELM acts as a buffer to account for extreme market movements that may exceed the estimated VaR. It provides an additional layer of protection by ensuring that market participants have sufficient funds to cover potential losses during extreme market conditions.
ELM is typically calculated based on historical price movements, stress tests, and other risk management techniques. BSE and NSE have their own specified ELM requirements. It is usually a small percentage of the total trade value of the member.
Adhoc Margins are temporary margin requirements imposed by exchanges or clearinghouses during periods of heightened market volatility or when there is an increased risk of default. These margins are implemented on top of the regular initial and maintenance margins and serve as an additional safeguard against potential losses.
Adhoc Margins are often imposed in response to specific events or market conditions that pose a significant risk to the stability of the financial system. They are designed to enhance market integrity, ensure liquidity, and protect market participants from excessive risk exposure. Adhoc Margins may be applied to specific asset classes, individual securities, or across the entire market, depending on the nature of the risk.
Adhoc margins are calculated using a simple average of the intra-day price movement of security for three consecutive days in the previous month. Again, for Adhoc Margins, both NSE and BSE have specified the requirements that are needed to be fulfilled by the members.
In conclusion, Value at Risk (VaR), Extreme Loss Margin (ELM), and Adhoc Margins are indispensable tools in risk management, allowing financial institutions and investors to assess and mitigate potential losses in the face of market volatility. While VaR estimates expected losses, ELM provides a buffer for extreme events, and Adhoc Margins offer additional protection during heightened risks. However, these tools have limitations and require ongoing monitoring and adaptation. By employing these risk management strategies, stakeholders can better navigate market uncertainties and safeguard their investments.