Estimating Bank Trading Risk: A Factor Model Approach

50 Pages Posted: 1 Nov 2005 Last revised: 20 Sep 2021

See all articles by James M. O'Brien

James M. O'Brien

Board of Governors of the Federal Reserve System - Trading Risk Analysis Section

Jeremy Berkowitz

University of Houston - Department of Finance

Date Written: September 2005

Abstract

Risk in bank trading portfolios and its management are potentially important to the banks%u2019 soundness and to the functioning of securities and derivatives markets. In this paper, proprietary daily trading revenues of 6 large dealer banks are used to study the bank dealers%u2019 market risks using a market factor model approach. Dealers%u2019 exposures to exchange rate, interest rate, equity, and credit market factors are estimated. A factor model framework for variable exposures is presented and two modeling approaches are used: a random coefficient model and rolling factor regressions. The results indicate small average market exposures with significant but relatively moderate variation in exposures over time. Except for interest rates, there is heterogeneity in market exposures across the dealers. For interest rates, the dealers have small average long exposures and exposures vary inversely with the level of rates. Implications for aggregate bank dealer risk and market stability issues are discussed.

Suggested Citation

O'Brien, James Michael and Berkowitz, Jeremy, Estimating Bank Trading Risk: A Factor Model Approach (September 2005). Available at SSRN: https://ssrn.com/abstract=804254

James Michael O'Brien (Contact Author)

Board of Governors of the Federal Reserve System - Trading Risk Analysis Section ( email )

Washington, DC 20551
United States

Jeremy Berkowitz

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States

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