RBS 2003 Annual Report Download - page 106

Operating and financial review continued
104
Operating and financial review
Market risk
The Group is exposed to market risk because of positions held
in its trading portfolios and its non-trading business including
the Group’s treasury operations.
The Group manages the market risk in its trading and treasury
portfolios through its Market Risk Management framework,
which is based on value-at-risk (“VaR”) limits, together with, but
not limited to, stress testing, scenario analysis, and position
and sensitivity limits. Stress testing measures the impact of
abnormal changes in market rates and prices on the fair value
of the Group’s trading portfolios. GEMC approves the high-
level VaR and stress limits for the Group. The Group Market
Risk function, independent from the Group’s trading
businesses, is responsible for setting and monitoring the
adequacy and effectiveness of the Group’s market risk
management processes.
Value-at-risk
VaR is a technique that produces estimates of the potential
negative change in the market value of a portfolio over a
specified time horizon at given confidence levels. For internal
risk management purposes, the Group’s VaR assumes a time
horizon of one day and a confidence level of 95%. The Group
uses historical simulation models in computing VaR. This
approach, in common with many other VaR models, assumes
that risk factor changes observed in the past are a good
estimate of those likely to occur in the future and is, therefore,
limited by the relevance of the historical data used. The
Group’s method, however, does not make any assumption
about the nature or type of underlying loss distribution.
The Group typically uses the previous two years of market
data. The Group’s VaR should be interpreted in light of the
limitations of the methodology used. These limitations include:
•Historical data may not provide the best estimate of the joint
distribution of risk factor changes in the future and may fail
to capture the risk of possible extreme adverse market
movements which have not occurred in the historical window
used in the calculations.
•VaR using a one-day time horizon does not fully capture the
market risk of positions that cannot be liquidated or hedged
within one day.
•VaR using a 95% confidence level does not reflect the extent
of potential losses beyond that percentile.
The Group largely computes the VaR of trading portfolios at
the close of business and positions may change substantially
during the course of the trading day. Controls are in place to
limit the Group’s intra-day exposure; such as the calculation of
the VaR for selected portfolios.
These limitations and the nature of the VaR measure mean that
the Group cannot guarantee that losses will not exceed the
VaR amounts indicated. For a discussion of the Group’s
accounting policies for, and information with respect to, its
exposures to derivative financial instruments, see Accounting
policies and Note 39 on the accounts.