Financial and
D) Additional measures Back-testing
Back-testing is a comparative analysis between Value at Risk (VaR) estimates and the daily results actually generated. The purpose of these tests is to verify and measure the precision of the models used to calculate VaR.
The analyses of back-testing carried out by the Santander Central Hispano Group comply with the BIS recommendations regarding the verification of the internal systems used to measure and manage market risks.
12.2 Control system
The process of setting limits is the instrument used by the Group to establish the level of equity that each activity has available. Setting the limits is conceived as a dynamic process which responds to senior management’s risk acceptance level.
12.3 Risks and results in 2002 A) Trading activity
Quantitative analysis of daily VaR in 2002
The Group’s risk performance with regard to trading activity in financial markets during 2002, measured by daily VaR, is shown in the following graph.
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It can be observed that the Group has a low/medium risk profile, which was actively managed throughout the year. This active level of risk management allows changes of strategy to take advantage of opportunities in an environment of uncertainty and high volatility. At times during the year there were sharp reductions in the risk exposure, showing that the Group is capable of adapting to changing circumstances and quickly changing its risk profile.
The maximum risk level was reached on October 11 (US$46.3 million in VaR terms) and the minimum on January 17 (US$11 million), due to the crisis in Argentina. The improved expectations regarding the end of the US recession initially favored an increase in the levels of risk in Mexico, although the changes in the positions were not the only
reasons for this increase. The levels of volatility in markets rose, derived from developments such as the floating of the Venezuelan bolivar in February, the crisis of confidence in the US fed by new accounting scandals in large companies in June and political uncertainty ahead of Brazil’s presidential elections in October. The average risk in 2002 was US$25.4 million in VaR terms.
The risk histogram shows the distribution of frequencies of average risk in daily VaR terms during 2002. The maximum and minimum risk levels were reached at specific moments; the daily VaR was higher than US$40 million on only two occasions. The minimum levels were more frequent and it was lower than US$14 million on 20 occasions.
Risk histogram
143 Risk by product
The minimum, maximum, average and year-end 2002 values in VaR terms were as follows:
VaR statistics by product
US$ million
Minimum Average Maximum Year-end
Total trading
Total VaR 11.0 25.3 46.3 24.2
Diversification effect (2.3) (12.5) (38.6) (11.1)
Fixed income VaR 9.0 19.0 37.0 15.9
Equity VaR 1.4 3.2 6.1 1.4
Currency VaR 2.9 15.6 41.7 17.9
Latin America
Total VaR 5.7 17.9 42.1 20.4
Diversification effect (2.3) (8.9) (23.1) (8.0)
Fixed income VaR 4.6 9.3 19.0 9.3
Equity VaR 0.5 2.2 4.6 1.2
Currency VaR 2.9 15.2 41.5 17.9
US
Total VaR 0.7 8.8 23.9 1.1
Diversification effect 0.4 (1.4) (11.8) (0.5)
Fixed income VaR 0.2 8.4 24.0 1.0
Equity VaR 0.1 0.3 0.9 0.1
Currency VaR 0.0 1.4 10.8 0.4
Europa
Total VaR 2.8 6.8 17.6 12.3
Diversification effect (0.2) (2.2) (10.6) (1.0)
Fixed income VaR 2.3 6.0 17.6 12.3
Equity VaR 0.5 2.0 5.6 0.8
Currency VaR 0.2 1.1 5.0 0.2
Asia
Total VaR 0.1 0.2 0.4 0.1
Diversification effect 0.1 (0.0) (0.1) 0.1
Fixed income VaR 0.0 0.2 0.4 0.0
Equity VaR 0.0 0.0 0.0 0.0
Currency VaR 0.0 0.0 0.1 0.0
The average risk in Latin America in VaR terms was US$17.9 million, ending December with a VaR of US$20.4 million. The
Group’s risks were concentrated in fixed income (average daily VaR of US$19.0 million, located in both Latin America and the US). The market risk in the US is generated by strategic and directional positions of Latin American fixed-income instruments denominated in US$ and located in markets in the US.
Observation of the daily VaR underscores the Group’s flexibility and agility in adapting its risk profile on the basis of changes in strategy resulting from a different perception to market expectations.
Detail of currency positions
The figures on the next page reflect in US$ million the net open position in each currency (i.e. subject to exchange risk).
The long-term positions or assets are shown with a (+) and the short-term or liabilities with a (-). Forward operations and the equivalent Delta risk of currency options are also included.
The table shows that the greatest concentration is in the main Latin American countries.
Distribution of risks and results
a) Geographic distribution
During 2002, the main feature of the geographic distribution of the results of the Group’s trading activities was a greater concentration in Latin America and to a lesser extent in Europe, with particular importance in Brazil and Mexico. Of note was Latin America’s contribution to the Group’s total VaR (53%). Europe contributes only 20% of risk in VaR terms, compared with 24% of results. This difference is due to the significant franchise of clients in Spain, which allows low risk profiles to obtain high levels of revenue from intermediation, sales and market making. The US, on the other hand, does not have this franchise and so its average level of daily VaR is relatively higher than the accumulated result.
The geographic contribution, in percentage terms, both in risks as well as in results over the Group’s total VaR and net operating revenue from trading activity, is shown in the graph.
Historic VaR by product
US$ million
1 JAN 1 FEB 1 MAR 1 APR 1 MAY 1 JUN 1JUL 1 AUG 1 SEP 1 OCT 1 NOV 1 DEC 31 DEC
2002 Fixed-income VaR Equity VaR Currency VaR
45
144
The minimum, average, maximum and year-end risk values in VaR terms, by geographic area, are shown in the table.
Risk statistics in 2002
US$ million
Minimun Average Maximun Year-end
Total 11.0 25.3 46.3 24.2
Europe 2.8 6.8 17.6 12.3
Asia 0.1 0.2 0.4 0.1
US 0.7 8.8 23.9 1.1
Latin America 5.7 17.9 42.1 20.4
b) Monthly distribution
The graph shows that at the beginning of 2002 there was a growing trend in the level of risk during the first half of the year, which was reversed in the second half. As regards income, it can be seen that the differences with respect to the risk assumed intensified in the months of highest volatility (February, March, June and as of September) when emerging markets became more unstable.
Currency positions at 31.12.2002 US$ million
EUR US$ ARS BRL CLP COP MXN PEN UYP VEB JPY (+) (-)
Total trading -9.1 818.2 -0.7 -325.1 -196.6 -1.8 -76.1 -1.5 -6.0 -216.3 11.5 4.4 -0.6
Latin America 0.5 829.7 0.0 -324.1 -198.0 -2.2 -84.5 -1.3 -6.0 -216.3 0.6 0.9
US 5.8 -13.2 0.1 -0.9 0.8 0.5 6.1 0.1 0.1 0.3 0.1
Europe -15.4 1.7 -0.8 -0.1 0.5 -0.1 2.3 -0.3 -0.1 10.5 3.4 -0.5
Asia 0.0 0.0 0.1 0.0 -0.1
Average positions during 2002 US$ million
Total trading EUR US$ ARS BRL CLP COP MXN PEN UYP VEB GBP JPY
Annual average position 32.6 571.7 -10.2 -124.5 -131.3 -25.8 -26.9 -50.6 -3.5 -236.8 -6.2 6.9
Contribution of risk by unit
%
Annual result Average VaR
Latin America Madrid Resto of Europe US Asia 70
145 Histogram of the frequency of daily mark-to-market
results (MtM)
The histogram of daily Mark-to-Market (MtM) results frequency shows how these are distributed on the basis of size.
The most common yield interval was US$0-US$3 million, which occurred on 56 days (22% of the year). During 50% of the year the interval was between -US$3 and US$6 million.
Risk management of structured derivatives
Structured derivatives activity (options outside of organized markets) is mainly focused on designing investment products and risk coverage for clients.
These transactions include options on equities, fixed-income and currencies.
The units where this activity takes place are: Madrid, New York, Portugal, Brazil and Mexico. The average VaR was US$1.4 million, the maximum US$4.1 million and the minimum US$0.65 million.
Profitability-risk analysis
The graph shows on the y axis, the accumulated MtM result for the year and on the x-axis the return or risk-profitability ratio, expressed as the relationship between the accumulated MtM result for the year and the average VaR. A return of 20 signifies that the results achieved were 20 times higher than the average risk to which the Group was exposed in order to obtain them. The size of the circles represents the level of risk which in average terms a business unit maintained, expressed as average VaR.
This analysis measures the return of the different business units and enables one to make comparisons. Thus the greater or lower effectiveness in terms of risk adjusted return determines the position in the graph.
Units located in the quadrants on the right display high returns, with results equivalent to at least ten times the average risk incurred in VaR terms. In the quadrants on the
left are units with a moderate or low profitability-risk, but making also a distinction between those units whose contribution to total MtM results is significant (upper quadrant), and those where the contribution was less significant (lower quadrant).
Lastly, the different diameters of the circles allow one to compare the risk levels of the different business units.
Stress Test
Different stress test scenarios were analyzed during 2002. A scenario of maximum volatility, applying six standard deviations to different market factors, with results as at December 31, 2002 is provided below.
Maximum volatility scenario
The table below shows, at December 31, 2002, the maximum losses of value of each product (fixed-income, equities and currencies), in a scenario in which a volatility equivalent to six standard deviations in a normal distribution is applied.
Maximun volatility Stress
US$ million
Fixed Exchange
income Equities rate Total
Total 22.5 -2.8 35.2 54.9
Latin America -14.6 -5.8 30.0 9.6
US -2.4 0.3 -2.1
Europe 39.8 2.9 4.9 47.6
Asia -0.3 -0.0 0.0 -0.3
Histogram of the frenquency of daily results (MtM)
Daily results in US$ million
< -12 -12 to -9 -9 to -6 -6 to -3 -3 to 0 0 to 3 3 to 6 6 to 9 9 to 12 12 to 15 15 to 18 > 18
MtM annual result (US$ million)
Return (annual result/average VaR)
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The stress test shows that the economic loss suffered by the Group in the MtM result would be, if this scenario materialized in the market, US$54.9 million.
Stress test statistics
The following table of statistics is based on the aforementioned scenario. It shows the minimum, average, maximum and year-end loss of each scenario during the year.
Stress Test statistics
US$
Scenarios Minimun Average Maximun Year-end
Maximun volatility 59.4 -8.1 -59.3 54.9