Put-Call Parity: Arbitrage Opportunities in NIFTY Index Options Market

-- Chakrapani Chaturvedula

This paper aims to analyze the efficiency of the Nifty options market. The put-call parity relation is used to test the efficiency of the relative prices of calls and puts. For a sample of Nifty index options for the period 2001-2006, significant violations in put-call parity was observed after factoring the trading costs suggesting that options market is not efficient, thus lending credence to the observation that significant arbitrage opportunities might exist for alert traders.

© 2007 IUP . All Rights Reserved.

Issues and Challenges in Management of Operational Risks

-- Usha Janakiraman

Basel II has transformed the regulatory landscape for the banking industry. Regulatory capital required to be maintained by the banks is all set to change with the introduction of capital charge for operational risk, apart from the refinements in the area of credit risk. The paper begins with a brief overview of the capital adequacy guidelines under Basel II since its origins in the 1988 Basel Accord. It introduces the concept of operational risk, reviews the quantitative framework for operational risk under Basel II, and outlines the key challenges and varying practices in the development of an operational risk framework.

© 2007 IUP . All Rights Reserved.

Asset Quality Profile of Indian Commercial Banks: A Stochastic Frontier Approach

-- Ram Pratap Sinha

In the pre-financial sector reform period, Indian commercial banks operated under a system of financial repression, whereby their lending activities were subjected to a variety of regulatory controls. Given the scenario, risk management got little emphasis (if any) in the commercial banking sector. Things, however, changed drastically during the reform period following the introduction of prudential operational guidelines and of modern supervisory practices. Under the circumstances, the present paper makes a comparative study of the asset quality profile of the Indian commercial banks for the reform period using the stochastic frontier approach. Further, the paper seeks to analyze the impact of factors such as bank operating efficiency, capital adequacy, ownership and bank size on the asset quality of the observed commercial banks. From the technical efficiency scores relating to asset quality, it appears that the public sector commercial banks have out-competed their private sector counterparts. The econometric results show that operating profit ratio and capital adequacy are two important determinants of asset quality. However, the effect of size and ownership are found to be statistically insignificant. This is probably suggestive of the fact that the quality of bank management (which gets reflected in operating efficiency, capital adequacy and asset quality) is the key variable in separating good banks from bad banks.

© 2007 IUP . All Rights Reserved.

Extending the Market Risk Estimation Horizon: An Optimization Approach

-- Ajay Raina

Economic capital estimation for market risk requires a bank to extend its estimate of risk based on a smaller time horizon, n, which is generally one or ten days to a longer horizon, N, which is generally one year. This would require modeling of the possible changes in the portfolio over the horizon and calculation of the corresponding impact on the long-term loss distribution. Once the long-term distribution has been extended, economic capital can be estimated using various risk measures. The standard method used for extending economic capital based on a commonly used risk measure, Value-at-Risk (VaR), from n to N days is scaling it up by a factor of Ö(N/n). This paper adopts a different approach for extending the loss distribution. Rather than making assumptions regarding the nature of portfolio loss distributions across time and the risk measures used, optimal portfolio instrument weights relevant to the risk behavior of the trading desk historically, is calculated. This would require solving for optimal portfolio selection given the risk behavior of the desk and can potentially incorporate various other constraints such as limits on positions and portfolio amounts.

© 2007 IUP . All Rights Reserved.

An Extended Structural Credit Risk Model

-- Marco Realdon

This paper presents an extended structural credit risk model that provides closed-form solutions for fixed and floating coupon bonds and credit default swaps. This structural model is an "extended" one, as it allows for the default-free term structure to be driven by a multifactor Gaussian model, rather than by a single factor model. Expected default occurs as a latent diffusion process first hits the default barrier, but the diffusion process is not the value of the firm's assets. Liquidity risk is correlated with credit risk. Default can be "expected" or "unexpected". And it is not necessary to disentangle the risk of "unexpected" default from liquidity risk. A tractable and accurate recovery assumption has been proposed in this paper.

© 2007 IUP . All Rights Reserved.