Market Risk Measurement Research Based On Monte Carlo Method And Its Application In OTC Financial Derivatives Market In China

In recent years, as the People’s Bank of China accelerates the reform of interest rate liberalization and exchange rate regime, innovative financial derivatives such as interest rate swaps, currency swaps continually expand their domestic market scales, which put forward higher requirements for accurate measurement and effective management of their market risks. The international market experienced derivatives disasters because of poor risk control all the time:in 1995, Lesson from Barings Bank excessively speculated in the Nikkei index and Nikkei futures regardless of the risk, which led to losses about one billion dollars-directly led to the collapse of Barings Bank;in 2008, a trader from the French Bank Society General speculated in futures which leading to a loss about 7.1 billion;the subprime mortgage crisis in 2008 has caused the global economic disasters and the world’s economic has not relieved from its effect;then in 2012, J. P. Morgan’s "London whale" incident directly led to a loss of 5.8 billion dollars. All these disasters teach us a lesson that we should always take the risk measurement and management seriously. According to OTC derivatives’statistical data released by the Bank for International Settlements and the People’s Bank of China, this paper analyzes the development condition of the OTC derivatives market at home and abroad, and explore the effective methods for measuring Chinese OTC financial derivatives market risks.Based on the mature research results abroad, this paper studies on three sources of risk factor with simplified Monte Carlo, including China inter-bank fixed rate bond yield curve and USA bond yield curve fitted by the Hermite interpolation model, the RMB exchange rate against the dollar. First, multiple cash flows are discounted to the key rate duration according to the interest rate mapping method. Then using the simplified Monte Carlo simulation method to estimate VaR of the Chinese OTC interest rate and exchange rate derivatives-interest rate swaps, currency swaps and the portfolios of them. The process is as follows:first mapping the cashflows to the key interest rate, then using principal component analysis to simplify risk factor into three principal component factors, and then uses Monte Carlo simulation method to do some simulation on the interest rate swaps, currency swaps and the combination of them, in order to maintain a high calculation accuracy and reduce the amount of computation at the same time.Then this paper uses different risk measurement models such as the method of analysis (Variance-Covariance method), historical simulation method and so on to calculate the value at risk (VaR) of the derivatives and portfolio. Finally, through seven kinds of back testing indexes-Root Mean Squared Relative Bias(RMSRB), Mean Relative Bias(MRB), The Binary Loss Function(BLF),Multiple to Obtain Coverage(MOC).Average VAR to covered Losses Ratio(AVLR), Average Uncovered Losses to VAR Ratio (AULR) and Maximum Loss to VAR Ratio(MLVR), this paper analyzes and compares them from three dimensions of conservatism, validity and accuracy, and comprehensively evaluates the simplified Monte Carlo simulation model’s applicability in the calculation of Chinese OTC financial derivatives’ risks considering the accuracy, effectiveness and the possibility of financial practice angles.