Presentation onPresentation onFinancial Risk Management Financial Risk Management
Market Risk Market Risk Treasury OperationsTreasury Operations
Highlights of the Presentation
What is Market Risk and Basel II Approaches
Financial Markets
Structure, Transactions and Functions of Treasury
Risks and their Controls for Treasury Activities
Managing Risk Effectively: Three Critical Challenges
Management Challenges for the 21st Century
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What is Risk?
•Risk, in traditional terms, is viewed as a ‘negative’. Webster’s
dictionary, for instance, defines risk as “exposing to danger or hazard”.
•The Chinese give a much better description of risk
>The first is the symbol for “danger”, while
>the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.
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Risk Management
Risk management is present in all aspects of life; It is about the everyday trade-off between an expected reward an a potential danger.
We, in the business world, often associate risk with some variability in financial outcomes. However, the notion of risk is much larger. It is universal, in the sense that it refers to human behaviour in the decision making process.
Risk management is an attempt to identify, to measure, to monitor and to manage uncertainty.
Risk Assessment
Assess your risk bearing capacity
How much risk can you tolerate?
How much risk protection can you afford?
How much risk are you willing to accept
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Risk Management
Risk management integrates production, marketing & financial decisions
Risk management is a planning process where you assemble and assess information
Every management decision carries risk management implications
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Risk Management Requires
Understanding of Your financial situation
Understanding sources of risk and potential risk
Understanding of risk management tools
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Risk Management Includes:
Evaluation of alternative plans & risk management strategies
Implementation of the plan
Monitoring the plan
Developing probabilities to formalize risk assessment
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Steps in theRisk Management Process
• Determine the corporation’s objectives• Identify the risk exposures • Quantify the exposures • Assess the impact• Examine alternative risk management tools• Select appropriate risk management approach• Implement and monitor program
The Bottom Line:It All Boils Down to Capital
• “Capital”– Assets less liabilities; owners’ equity; net worth
– Support for (riskiness of) operations
– Thus, supports profitability and solvency of firm
• “Capital Management”– Determine need for and adequacy of capital
– Plans for increasing or releasing capital
– Strategy for efficient use of capital
Why Do We Care About Managing Capital?
• Leads to solvency and profitability
• Benefits of solidity and profitability– Higher company value
– Happy shareholders
– Better ratings
– Less unfavorable regulatory treatment
– Ability to price products competitively
– Customer loyalty
– Potentially lower costs
What Does Capital Management require?
CapitalManagement
ProductPricing Financial
Risk Mgt.
SettingObjectives
RaisingCapital
StrategicPlanning
LiabilityValuationAsset
Allocation
RiskManagement
Role of Capital in Financial Institution
• Absorb large unexpected losses• Protect depositors and other claim holders• Provide enough confidence to external
investors and rating agencies on the financial heath and viability of the institution.
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Type of Capital
• Economic Capital (EC) or Risk Capital. An estimate of the level of capital that a firm requires to
operate its business.• Regulatory Capital (RC). The capital that a bank is required to hold by regulators in
order to operate.• Bank Capital (BC) The actual physical capital held
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Economic Capital
• Economic capital acts as a buffer that provides protection against all the credit, market, operational and business risks faced by an institution.
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Financial Risk and Basel
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BASEL-I Capital Calculation
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Basel I Principles
Strengthen the stability of the international banking system
Create minimum risk-based capital adequacy requirements
Basel I Benefits
Relatively simple framework Widely adopted Increased banks’ capital
Credit Risk + Market Risk
Capital Capital Adequacy Ratio
RIWAC
=
Basel I Regulatory Capital Rules
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Market riskCapital(Tier 3)
Market riskCapital(Tier 3)
• Short-term subordinated debt
SupplementaryCapital(Tier 2)
SupplementaryCapital(Tier 2)
• Perpetual securities
• Unrealised gains on investment
securities
• Hybrid capital instruments
• Long-term subordinated debt with
maturity > 5 years
Core Capital(Tier 1)
Core Capital(Tier 1)
• Stock issues
• Disclosed reserves
– Loan loss reserves to cushion future
losses or for smoothing out income
volatility
• 50% of total capital
Types of capital
Balance sheet assets
Off-balance sheet assets
Non-Traded
Traded
Risk weights
Basel I capital calculation
Capital (Tiers 1, 2, 3)
Risk-Weighted Assets and Contingents
≥ 8%
RIWAC Calculation
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RIWAC
On-Balance Sheet
xCounterparty Weighting
Off-Balance Sheet Risk
xCounterparty Weighting
xCredit Conversion Factor
= +
RIWAC Weightings
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On-Balance Sheet Risk
Banks SovereignsCorporate
s
Non OECD
OECD Non OECD OECD
100% 20% 100% 0% 100%
Off Balance Sheet Risk Cont. liabilities
Financial Guarantees
100% 20% N/A N/A 100%
Transactional Contingents
50% 10%N/A N/A
50%
Secured LCs Issued
20% 4%N/A N/A
20%
BASEL I- RIWAC Examples
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CorporateXYZ Bank Lends USD 100 M to UAE Corporate for 1 year Capital = USD 100 M X 100% (Risk Weight) X 8% (Capital
Adequacy) = USD 8 M
BanksXYZ Bank Lends USD 100 M to Barclays Bank for 2 years Capital = USD 100 M X 20% (Risk Weight) X 8% (Capital
Adequacy) = USD 1.6 M
ContingentsXYZ confirms Sight L/C of USD 100 M issued by ABN AMRO Capital = USD 100 M X 20% (Risk Weight) X 20% (CCF) X
8% (Capital Adequacy) = USD 0.32 M
Basel I regulatory capital rules – Credit risk (1)
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Step 1: RWA = On BS exposure X Risk Weight
Step 2: Capital = 8% X RWA
Risk weight (%) On-balance sheet asset category
0Cash & goldObligations on OECD and PAK treasuries
20Claims on OECD banks Govt. agency securitiesClaims on municipalities
50 Residential mortgages
100Corporate bonds, equity, real-estateLess-developed countries’ debtClaims on non-OECD banks
On-balance sheet risk weights and Basel I capital calculation
Risk weight (%) Off-balance sheet asset category
0 OECD governments
20OECD banks and public sector entities
50Corporates and other counterparties
Credit Conversion Factor (%)
Off-balance sheet non-trading assets
0Undrawn commitments – Maturity ≤ 1 year
20Documentary credits related to shipment of goods
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Transaction-related contingencies – warranties, performance bonds
Undrawn commitments – Maturity > 1 year
100General guarantees, standby letters of credit, banker’s acceptance, etc
Off-balance sheet risk weights and Basel I capital calculation for non-trading assets
Step 1: Credit Equivalent Amount (CEA) = Notional amount X Credit Conversion Factor
Step 2: RWA = CEA X Risk Weight
Step 3: Capital = 8% X RWA
Basel I regulatory capital rules – Credit risk (2)Basel I regulatory capital rules – Credit risk (2)
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Credit Conversion Factor (%)
Interest rates FX and Gold Equity derivatives Precious metalsCommodity contracts
Less than 1 year 0.0% 1.0% 6.0% 7.0% 10.0%
1-5 years 0.5% 5.0% 8.0% 7.0% 12.0%
More than 5 years 1.5% 7.5% 10.0% 8.0% 15.0%
Off-balance sheet risk weights and Basel I capital calculation for trading assets
Step 1: Current Exposure (CE) = Current marked-to-market value of asset
Step 2: Potential Future Exposure (PFE) = Notional amount X Credit Conversion Factor
Step 3: Credit Equivalent Amount (CEA) = CE + PFE
Step 4: RWA = CEA X Risk Weight
Step 5: Capital = 8% X RWA
BASEL I- Draw Backs
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Criticisms of Basel I Accord
• Lack of risk sensitivity of capital
requirements
• One-size-fits-all’ approach to risk
management
• Limited attention to credit risk
mitigation
• Over emphasis on minimum
capital requirements
• Exclusive focus on financial risk
Consequences in the industry
• Sub-optimal lending
behavior
• Increased divergence
between regulatory capital
and economic capital
• Regulatory capital
arbitrage through product
innovation
Objectives “Basel II”
• The objective of the New Basel Capital accord (“Basel II) is:
1. To promote safety and soundness in the financial system2. To continue to enhance completive equality3. To constitute a more comprehensive approach to
addressing risks4. To render capital adequacy more risk-sensitive5. To provide incentives for banks to enhance their risk
measurement capabilities
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Comparison
Basel I Basel 2Focus on a single risk measure More emphasis on banks’
internal methodologies, supervisory review and market discipline
One size fits all Flexibility, menu of approaches. Provides incentives for better risk management
Operational risk not considered Introduces approaches for Credit risk and Operational risk in addition to Market risk introduced earlier.
Broad brush structure More risk sensitivity 27
Economic Objectives
• Efficiency: best use of capital across business lines, impetus for risk based pricing and operational cost savings
• Stability: ensure capital protection consistent with shareholder value optimization
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Economic Objectives
• Growth sustainability: balanced Portfolio risk and return
• Equity: level competitive playing field across(big and small) banks
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Overview of Basel II Pillars
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The new Basel Accord is comprised of ‘three pillars’…The new Basel Accord is comprised of ‘three pillars’…
Pillar I
Minimum Capital
Requirements
Establishes minimum standards for management of capital on a more risk sensitive basis:
• Credit Risk
• Operational Risk
• Market Risk
Pillar IISupervisory Review
Process
Increases the responsibilities and levels of discretion for supervisory reviews and controls covering:
• Evaluate Bank’s Capital Adequacy Strategies
• Certify Internal Models
• Level of capital charge
• Proactive monitoring of capital levels and ensuring remedial action
Pillar III
Market Discipline
Bank will be required to increase their information disclosure, especially on the measurement of credit and operational risks.
Expands the content and improves the transparency of financial disclosures to the market.
Development of a revised capital adequacy framework Components of Basel II
31Pillar 1 Pillar 2 Pillar 3
The three pillars of Basel II and their principles
Basel II
Supervisory review process
• How will supervisory bodies assess, monitor and ensure capital adequacy?
• Internal process for assessing capital in relation to risk profile
• Supervisors to review and evaluate banks’ internal processes
• Supervisors to require banks to hold capital in excess of minimum to cover other risks, e.g. strategic risk
• Supervisors seek to intervene and ensure compliance
Market disclosure
• What and how should banks disclose to external parties?
• Effective disclosure of:- Banks’ risk profiles- Adequacy of capital
positions• Specific qualitative and
quantitative disclosures- Scope of application - Composition of
capital - Risk exposure
assessment - Capital adequacy
Minimum capital requirements
• How is capital adequacy measured particularly for Advanced approaches?
• Better align regulatory capital with economic risk
• Evolutionary approach to assessing credit risk- Standardised (external
factors)- Foundation Internal
Ratings Based (IRB)- Advanced IRB
• Evolutionary approach to operational risk- Basic indicator- Standardised- Adv. Measurement
Issu
eP
rin
cip
le
• Continue to promote safety and soundness in the banking system
• Ensure capital adequacy is sensitive to the level of risks borne by banks
• Constitute a more comprehensive approach to addressing risks
• Continue to enhance competitive equality
Objectives
Overview of Basel II Approaches (Pillar I)
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Approaches that can befollowed in determination
of Regulatory Capitalunder Basel II
Approaches that can befollowed in determination
of Regulatory Capitalunder Basel II
Total Regulatory
Capital
Total Regulatory
Capital
Operational Risk
Capital
Operational Risk
Capital
CreditRisk
Capital
CreditRisk
Capital
MarketRisk
Capital
MarketRisk
Capital
Basic IndicatorApproach
Basic IndicatorApproach
Standardized Approach
Standardized Approach
Advanced Measurement
Approach (AMA)
Advanced Measurement
Approach (AMA)
Standardized Approach
Standardized Approach
Internal Ratings Based (IRB)
Internal Ratings Based (IRB)
FoundationFoundation
AdvancedAdvanced
StandardModel
StandardModel
InternalModel
InternalModel
Score CardScore Card
Loss DistributionLoss Distribution
Internal ModelingInternal
Modeling
The Three Pillars
• The First Pillar - Minimum Capital Requirements
• The Second Pillar - Supervisory Review Process
• The Third Pillar - Market Discipline
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Pillar 1
• Calculation of the total minimum capital requirements for credit, market and operational risk.
• The minimum capital requirements are composed of three fundamental elements: a definition of regulatory capital, risk weighted assets and the minimum ratio of capital to risk weighted assets.
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RISK BASED SUPERVISION
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BASEL II : CAPITAL CHARGE
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Credit Risk
• The standardized approach• The Internal Ratings-Based Approach
– Foundation– Advanced
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Ops Risk
• The Basic Indicator Approach• The Standardised Approach• Advanced Measurement Approach
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Market RiskMarket RiskE q u ity P rice
In te res t R a te
F . E .
C om m od ity P rice
Market
• Potential loss in value from market risk factors• Primarily through trading, off balance sheet and on
balance sheet items
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FinancialRisks Liquidity Risk
Operational Risk
Regulatory Risk
Human FactorRisk
Market Risk
Equity Risk
Interest Rate Risk
Currency Risk
Commodity Risk
Trading Risk
Gap Risk
Credit RiskPortfolio
Concentration Risk
Transaction Risk Counterparty Risk
Issuer Risk
Types of financial risk
Market Risk under Basel II
• Standardized ApproachBuilding Block Approach: Capital charge captured separately for each risk
and then summed. Trading book used for general and specific risk in interest and equities markets. Both trading and banking books are used for general risk in currency and commodities markets.
• Internal ModelVAR modeling: On daily basis and 99th percentile one-tailed confidence
interval is to be used, 10days holding period.
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• Convergence of Economies• Easy and faster flow of information• Skill Enhancement• Increasing Market activity
Why the focus on Market Risk Management ?
Leading to
•Increased Volatility•Need for measuring and managing Market Risks•Regulatory focus•Profiting from Risk
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Measure, Monitor & Manage
– Value at Risk
Value-at-Risk
Value-at-Risk is a measure of Market Risk, which measures the maximum loss in the market value of a portfolio with a given confidence
VaR is denominated in units of a currency or as a percentage of portfolio holdings
For e.g.., a set of portfolio having a current value of say Rs.100,000- can be described to have a daily value at risk of Rs. 5000- at a 99% confidence level, which means there is a 1/100 chance of the loss exceeding Rs. 5000/- considering no great paradigm shifts in the underlying factors.
It is a probability of occurrence and hence is a statistical measure of risk exposure
Value at Risk
Certainty is 95.00% from 2.6 to +Infinity
.000
.005
.011
.016
.022
0
108.2
216.5
324.7
433
1.5 2.9 4.3 5.6 7.0
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Variance-Variance-covariancecovariance
Matrix
Variance-Variance-covariancecovariance
Matrix
MultiplePortfoliosMultiple
Portfolios
YieldsDurationYields
Duration
Incremental VaR
Incremental VaR
Stop LossStop Loss
PortfolioOptimization
PortfolioOptimization
VaRVaR
Features of RMD VaR Model
Facility of multiple methods and portfolios in single modelReturn Analysis for aiding in trade-offFor Identifying and isolating Risky and safe securitiesFor picking up securities which gel well in the portfolioFor aiding in cutting losses during volatile periodsHelps in optimizing portfolio in the given set of constraints
Approaches to Market Risk Capital Calculation
ChoicesChoices
Standardized ApproachStandardized ApproachCapital requirement is the sum of capital calculated for
Interest Rate RiskEquity Price RiskForeign Exchange RiskCommodity Price Risk
Internal Model Internal Model ApproachApproach
Based on bank’s internal VaR models to quantify capital charge required
Financial Markets?
• Money Market– Trade in funds denominated in local currency and operate under local
regulations.– Commercial Banks, Central Banks, Large Corporations, Institutions and the
Public at large (every checking A/c holder is a participant).– Money or near money is bought and sold– Purposes: Legal Requirement, Trading, Investment, and Customers
Needs.– Statutory Liquidity Requirement (SLR) un-encumbered approved
securities, which shall not be less then 19% of DL at the end of any business day.
– Statutory Cash Reserve Requirement (CRR) 4% - 5% DL– Statutory Cash Reserve Requirement (CRR) 0% - 0% TL
Money Market• Transactions and Main Instruments;
– Reverse Repo/ Repo and Call.– Treasury Bills– Federal Investment Bonds (FIBs)– Pakistan Investment Bonds (PIBs)– Certificates of Investment / Deposits (COIs or CODs)– Term Finance Certificates (TFCs)
Foreign Money Market
• Foreign Inter-bank Placements1. Commerz Bank AG Germany2. Deutsche Bank AG Germany3. Fortis Bank, Belgium
• Placements with our overseas treasuries
Foreign Exchange Market
• Two different currencies are exchanged for each other at certain mutually agreed rate.
• Or paper denominated in a given currency is traded against paper denominated in another currency.
Transactions in Treasury
• Exports, Imports, Remittances, Export and Import Loans
• Ready, Tom, Spot, Forward, Swaps, Lending and Borrowing
• R/RR, Call, Security Trading/Lending, COI, LOP• Buying/Selling of Stocks in Ready/Future• Derivatives/ Options
Treasury’s Structure
Treasury Functions
• Assets Liability Management (ALM)• To Maintain Liquidity.• To use Excess Funds effectively.• To Borrow Necessary Funds at Minimum.• Trading (Currency, Papers).• Regulations Monitoring.• Risk Management.
Risks in Treasury Transactions
• Market Risk– Position or Exchange Rate Risk (Price Risk)– Mismatch or Liquidity Risk (Interest Rate Risk)
• Credit or Counter-party Risk• Operational Risk
• Gaps/Mismatches– Banks create a gap (or mismatch) when the weighted-average maturity
of their financial assets does not equal the weighted-average maturity of their liabilities. This is equivalent to having a forward interest rate position.
Assets Liabilities
– When the weighted-average maturity of the assets exceeds that of the liabilities, it is called a positive gap.
Gaps/MismatchesLiabilities
Assets
– When the weighted-average maturity of the liabilities exceeds that of the assets, it is called a negative gap.
Assets Liabilities
– A current position like the above would need to be offset by the following transaction to eliminate the gap.
Liabilities Assets– Either the bank has to lengthen its liabilities or shorten
its assets until the weighted average maturity of both were equal.
• Positive Gaps– This is the equivalent of being long forward position. That is asset
maturities are greater than liability maturities. Conditions which adversely impact this position are:
Assets Liabilities– a general increase in rates, that is a yield curve
shift up. – a steeping yield curve slope, indicating longer-
term funding costs are becoming more expensive.
• Negative Gaps– This is the equivalent of being short forward position. That is liability
maturities are greater than assts maturities. Conditions which adversely impact this position are:
Liabilities Assets– a general decrease in rates, that is a yield curve
shift down. – a flattening or inverting yield curve, indicating
long-term lending costs declining.
Controlling Risk
• Position or Exchange Rate Risk• Currency Open Position (COP) Limits• Net Open Position (NOP) Limit• Intraday Limit• Stop Loss Limits
Controlling Risk
• Mismatch or Liquidity Risk• Individual Currency Gap Limits (ICGLs)• Aggregate Currency Gap Limits ‘bucket-wise’ (ACGLs)• Total Aggregate Gap Limit (TAGL)
Controlling Risk• Credit or Counter-party Risk– Contract Risk
• Pre-Settlement or Foreign Currency Dealing (FCDL) Limit
– Clean Risk• Settlement or Foreign Currency Settlement (FCSL) Limit• Nostro Limit• Clean Limit
– Sovereign Risk• Country or Cross Border Limit
Value at Risk-VAR• Value at risk (VAR) is a probabilistic method of measuring the
potentional loss in portfolio value over a given time period and confidence level.
• The VAR measure used by regulators for market risk is the loss on the trading book that can be expected to occur over a 10-day period 1% of the time
• The value at risk is $1 million means that the bank is 99% confident that there will not be a loss greater than $1 million over the next 10 days.
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Value at Risk-VAR
• VAR (x%) = Zx%σ
VAR(x%)=the x% probability value at riskZx% = the critical Z-value
σ = the standard deviation of daily return's on a percentage basis
VAR (x%)dollar basis=
VAR (x%) decimal basis X asset value
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Example: Percentage and dollar VAR
• If the asset has a daily standard deviation of returns equal to 1.4 percent and the asset has a current value of $5.3 million calculate the VAR(5%) on both a percentage and dollar basis.
• Critical Z-value for a VAR(5%)= -1.65, VAR(10%)=-1.28, VAR(1%)=-2.32 VAR(5%) = -1.65(σ) = -1.65(.014) = -2.31%
VAR (x%)dollar basis= VAR (x%) decimal basis X asset value
VAR (x%)dollar basis= -.0231X5,300,000 = $-122,430
Interpretation: there is a 5% probability that on any given day, the loss in value on this particular asset
will equal or exceed 2.31% or $122,430
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Time conversions for VAR
VAR(x%)= VAR(x%)1-day√J
• Daily VAR: 1 day• Weekly VAR: 5 days• Monthly VAR: 20 days• Semiannual VAR: 125 days• Annual VAR: 250 days
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Converting daily VAR to other time bases:
• Assume that a risk manager has calculated the daily VAR(10%) dollar basis of a particular assets to be $12,500.
• VAR(10%)5-days(weekly) = 12,500 √5= 27,951
• VAR(10%)20-days(monthy) = 12,500 √20= 55,902
• VAR(10%)125-days = 12,500 √125= 139,754
• VAR(10%)250-days = 12,500 √250= 197,642
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