Commercial bank risk management and measuring portfolio risk via Monte Carlo VaR simulation method

Financial risk is the prospect of financial loss due to unforeseen changes inunderlying risk factors. In this study we are concerned with the measurement of oneparticular form of financial risk-namely, market risk, or the risk of loss arising fromunexpected changes in market prices or rates in the context of Basel Capital Accord.Regulatory requirements for financial institutions have been a major focus of interest inthe 1980s and 1990s, not least because of some rather spectacular financial scandalswhich have occurred. The reasons for regulatory control arise from different types ofmarket failure. The presumption here being that in a general competitive environmentgovernments ought to leave the market mechanism to reward and penalize the normalrisk taking activities of participants in the market.Predominantly, commercial banks as the most important participants in thefinancial industry hold large positions in marketable assets and are therefore prone tobig losses. Prudential considerations imply that ?capital? should be held as a bufferagainst potential losses, otherwise the banks may become insolvent. The New BaselCapital Accord finalized in 2005, which will be applied from 2009 in Turkey, lie in themidst of the risk, return and capital equilibrium. A significant component of proposedcapital adequacy arrangements is the opportunity for banks to use their internal VaRmodels. This empirical research study attempts to measure market risk of a bank?s FXportfolio for a period 2001-2003 by using Monte Carlo Simulation which is applied for2000 times. Subsequently, the computational results are compared to the other methods?figures computed and checked the accuracy of forecasts of portfolio VaR by back-testing. Findings are consistent with much of the existing literature on market riskmeasurement.KEYWORDS: Commercial Banking, Market Risk, Basel Capital Accord, Valueat Risk, Monte Carlo Simulation Method