This section describes the principal sources of market risk (interest-rate risk, price risk, ex- change risk) and the investment policies adopted by the Bank. The investment portfolio of the Group’s banks is administered centrally by the Parent Bank’s Finance Department.
1.2.1 Interest rate risk
Interest rate risk represents the risk that the banks will incur losses due to adverse changes in market rates.
There are three types of rate risk:
– level. Risk associated with an absolute change in the forward structure of interest rates affect- ing the value of a portfolio position (parallel shifts in the yield curve);
– curve and fundamental. The first identifies the risk affecting the value of the various elements of a position or a portfolio deriving from a relative change in the structure of interest rates, while the second derives from the imperfect correlation of the elements of a position;
– credit spread. Risk deriving from changes in the prices of bonds and credit derivatives associ- ated with unexpected changes in the issuer’s credit rating.
The Group’s investment strategies are designed to optimize the risk/yield profile and imple- mented with reference to the forecast trends in interest rates.
The Group’s investment policy (BPVI also manages the investment portfolios of the other group banks, under the terms of individual management mandates) is focused on the optimization of operating results and the reduction of their volatility, taking account of ALM requirements. Dur- ing 2005, implementation of this strategy involved constant spread trading between the various maturities on the curve, via both cash transactions and derivative transactions; as well as a steady reduction in the holdings of government securities, due to the progressive widening of the Ital- ian credit spread, and the positioning of the bond portfolio on short/medium-term maturities, with particular emphasis on the corporate sector.
1.2.3 Price risk
The price risk represents the risk associated with changes in the value of equity portfolios due to fluctuations in market prices. This analyzed between:
– generic risk. Change in the price of an equity instrument following fluctuations in the stock market concerned;
– specific risk. Change in the market price of a specific equity instrument due to revised market expectations about the financial strength or prospects of the issuer.
The trading portfolio is managed in accordance with the strategic guidelines provided by the Board of Directors and the tactics provided by the Finance Committee. Consistent with the above and given the improvement in economic conditions during the year, a steady increase in equity holdings, with a particular focus on Italy and Europe, was achieved via both cash trans- actions and alternate strategies with emphasis on the banking sector. The remaining portfolio was broadly diversified among different issuers and sectors, while remaining within the man- date received.
1.2.5 Exchange rate risk
Exchange rate risk represents the risk associated with changes in the value of positions denomi- nated in foreign currencies deriving from unexpected variations in the cross rates.
Support for commercial activities in foreign currency and for trading in foreign securities repre- sents the Bank’s principal source of exchange risk.
Automatic network systems interfaced with a single position-keeping system enable the Finance Department to monitor constantly, in real time, the currency flows that are instantaneously transferred to the interbank forex market.
A dedicated team within the Finance Department manages the exchange derivative positions and products held on own account, in order to meet the various hedging requirements of customers.
A proprietary control system (Murex) and a system of external pricing (SuperDerivatives) en- sures the efficient management of spot and forward flows and options, within the specified oper- ating limits.
All the positions are revalued each day using the European Central Bank’s reference rate and re- flect the contribution made by foreign currency activities to the overall profitability of the Bank.
Management and measurement of market risk
This paragraph presents the indicators that are monitored and the related limits, as well as the first and second level controls over finance department transactions. In general, the limits distin- guish between the various types of risk (rate, price and exchange) which, however, are managed within a unitary framework developed following consistent logic.
There are four operational levels within the finance department of the Parent Bank: – operational limits
– position limits: concentration and credit risk – stop loss limits
– Value at Risk (VaR) limits
The structure of operational limits involves use of the following indicators:
– exchange rate risk: delta in monetary terms (cash equivalent position for spot, forward, ex- change derivative portfolio)
– equity risk: delta equivalent (market value of shares and cash equivalent position for equity derivatives)
– interest rate risk: sensitivity (change in profit or loss on a parallel shift in the reference curve by one-hundredth of a point)
– maximum invested amount: book value of cash securities/funds (gross of the derivatives’ delta) to ensure that assets and liabilities are balanced within the assigned budget limits. The position limits set
– limits on the acceptance of credit risk: overall limits are established for the exposure to each rating class, especially those below investment grade;
– limits on the concentration of lending on individual issuers / issues, with tighter restrictions as the rating class of the issuer diminishes.
ceed twice the monthly stop loss limits.
The operational limits for group banks are governed by specific contracts that establish maxi- mum position, credit risk, concentration risk and VaR limits.
VaR limits: Value at Risk (VaR) represents an estimate of the maximum potential loss on a port- folio of securities due to adverse market conditions.
The Group has not established an overall limit, but set separate limits for the Parent Bank and for BPV Finance. These limits are established each year with reference to the strategies defined by the Parent Bank and must be accepted by Board resolutions adopted by the subsidiaries. The Group and the banks in the Group used a mixed approach throughout 2005 to calculate this indicator:
– parametric (variance-covariance) for the bond, equity and option element (delta equivalent method);
– based on historical simulations of the risk relating to OTC rate derivatives (IRS, Caps, Floors etc.) and of rate risk (spot and exchange derivatives) using the VaR module of the Murex front office system. This calculation did not cover the subsidiaries in 2005.
The holding period is 10 days and the confidence interval is 95%. For the parametric element, reference is made to the RiskMetrics standard method: the estimate of volatility and the correla- tion is based on 250 days (the working year) with a decay factor of 0.94; for the historical simula- tion element, 250 scenarios (the working year) are used.
The Risk Management Office is responsible for recording the VaR.
The analysis is performed each day for the three Group banks and weekly for BPV Finance, partly to check that the VaR continues to stay within the parameters set by the Boards of Di- rectors.
With regard to the elements estimated using the parametric method, the system also presents the situation under two stress scenarios.
The new RiskManager system from RiskMetrics© was implemented in early 2006, thus stan- dardizing the calculations made by the Parent Bank with the adoption of historical simulation methodology for the entire portfolio, based on 250 scenarios. At the same time, the confidence interval was raised to 99%, keeping the holding period at 10 days, and limits were fixed for the three rate, price and exchange categories, without distinguishing between operating units in or- der to allow greater flexibility. In each case, the risk exposure of the operational units is moni- tored on a daily basis.
Implementation of the recording system has been completed in relation to the investment port- folio, while work is ongoing with regard to the residual risk element of OTC rate and exchange derivatives deriving from trading on behalf of customers. This explains why the summation of the three risk categories is still partly additive.
The change in the recording system will also lead to changes in the stress testing scenarios, using situations that actually occurred in the past, and a procedure for the back testing of the model will also be implemented.
This logic will be extended to the other Group banks and companies that are subjected to moni- toring in the first half of 2006.
The VaR models are used solely for management control purposes and are not used for the cal- culation of capital adequacy.
The VaR of the entire portfolio
During 2005, the Value at Risk (VaR) 95% at 10 days of BPVi averaged just over Euro 8.6 mil- lion (in percentage terms, this is 0.84% of the theoretical market value of the portfolios ana- lyzed), with a maximum and minimum of, respectively, Euro 14.9 million (1.50%) and Euro 3.4 million (0.38%). VaR at the end of 2005 was Euro 7.12 million.
The average VaR (total of the rate risk and price risk elements) over the year for Banca Nuova was Euro 546 thousand, representing 0.37% of market value, with a peak of Euro 969 thou- sand (also 0.37% of the related market value). At year end, VaR amounted to Euro 262 thou- sand (0.30%).
With regard to CariPrato, the average VaR (total of the rate risk and price risk elements) of Euro 530 thousand (0.46% of market value) compares with a maximum of Euro 1.01 million (0.55% of the related market value). The VaR at 30 December 2005 was Euro 290 thousand (0.38%). The average VaR (total of the rate risk and price risk elements) of BPV Finance was Euro 920 thousand (0.20% of market value), while the maximum was Euro 1.7 million (0.35%). The VaR at year end was Euro 975 thousand (0.20%).
VaR regarding rate risk
The average VaR of the Parent Bank in 2005 was about Euro 3.1 million (representing 0.36% of the theoretical market value of the portfolios analyzed), with a maximum and minimum of, re- spectively, 4.4 (0.65%) and 1.6 (0.20%). At 30/12/2005 the VaR regarding rate risk was Euro 2.17 million.
With regard to Banca Nuova, the VaR regarding rate risk was Euro 216 thousand (0.14% of market value), with a maximum of Euro 712 thousand (0.32%). The parameter amounted to Euro 166 thousand (0.20%) at the end of 2005.
The parameters for CariPrato were as follows: average of Euro 234 thousand (0.21% of mar- ket value), maximum of Euro 656 thousand (0.44%) and a year-end value of Euro 187 thou- sand (0.27%).
For BPV Finance, the average VaR regarding rate risk was Euro 506 thousand (0.11% of market value), the maximum was Euro 873 thousand (0.19%) and the VaR at year end was Euro 643 thousand (0.13%)
VaR of the equity portfolio (price risk)
The VaR of BPVi’s equity portfolio averaged Euro 5.3 million in 2005, representing 3.08% of market value. The maximum amounts in value and percentage terms were, respectively, 11 mil- lion and 4.48%, with minimums of Euro 1.1 million and 1.94%. The equity VaR at the end of 2005 was Euro 4.58 million.
The equity VaR of Banca Nuova averaged Euro 330 thousand (2.96% of market value), with a maximum of Euro 772 thousand (4.63%). The parameter amounted to Euro 343 thousand (3.51%) at the end of 2005.
ket value), maximum of Euro 801 thousand (4.50%) and a year-end value of Euro 103 thou- sand (1.88%).
The average equity VaR of BPV Finance was Euro 414 thousand (3.31% of market value), the maximum was Euro 830 thousand (4.66%) while the VaR at year end was Euro 332 thou- sand (2.34%)
VaR of the exchange risk sector
The VaR of BPVi averaged about Euro 59 thousand for the Spot component (with a maximum of Euro 181thousand), while the average for the Derivatives component (Fx options) was Euro 126 thousand with a maximum of Euro 646 thousand. At 30/12/2005 the VaR was Euro 105 thousand.
1.2.6 Derivative products A. Financial derivatives
A.1 Regulatory trading: notional values at the end of period and average
Type of transaction/Underlyings Debt securities Equities Exchange rates and gold Other instruments 12/31/2005
and interest rates and equity indices
Listed Unlisted Listed Unlisted Listed Unlisted Listed Unlisted Listed Unlisted
1. Forward rate agreements – 179,534 – – – – – – – 179,534
2. Interest rate swaps – 14,102,176 – – – – – – – 14,102,176
3. Domestic currency swaps – – – – – – – – – –
4. Currency interest rate swaps – – – – – – – – – –
5. Basic swaps – 7,586,195 – – – – – – – 7,586,195
6. Swap of stock indices – – – – – – – – – –
7. Swap of real indices – – – – – – – – – –
8. Futures – – – – – – – – – – 9. Cap options – 73,097,873 – – – – – – – 73,097,873 – purchased – 35,712,188 – – – – – – – 35,712,188 – issued – 37,385,685 – – – – – – – 37,385,685 10. Floor options – 39,164,299 – – – – – – – 39,164,299 – purchased – 15,626,579 – – – – – – – 15,626,579 – issued – 23,537,720 – – – – – – – 23,537,720 11. Other options – 650,573 – 1,068,912 – 2,483,390 – – – 4,202,875 – purchased – 265,163 – 538,678 – 1,229,153 – – – 2,032,994 – Plain vanilla – 232,649 – 101,301 – 1,182,753 – – – 1,516,703 – Exotic – 32,514 – 437,377 – 46,400 – – – 516,291 – issued – 385,410 – 530,234 – 1,254,237 – – – 2,169,881 – Plain vanilla – 350,424 – 92,857 – 1,222,472 – – – 1,665,753 – Exotic – 34,986 – 437,377 – 31,765 – – – 504,128 12. Forward contracts – – – – – 467,058 – – – 467,058 – Purchases – – – – – 466,000 – – – 466,000 – Sales – – – – – 1,058 – – – 1,058
– Currency against currency – – – – – – – – – –
13. Other derivative contracts – – – – – – – – – –
Total – 134,780,650 – 1,068,912 – 2,950,448 – – – 138,800,010
A.2 Bank book: notional amounts at period end and average A.2.1 For hedging
Type of transaction/Underlyings Debt securities Equities Exchange rates and gold Other instruments 12/31/2005
and interest rates and equity indices
Listed Unlisted Listed Unlisted Listed Unlisted Listed Unlisted Listed Unlisted
1. Forward rate agreements – – – – – – – – – –
2. Interest rate swaps – 40,034 – – – – – – – 40,034
3. Domestic currency swaps – – – – – – – – – –
4. Currency interest rate swaps – – – – – – – – – –
5. Basic swaps – 3,416 – – – – – – – 3,416
6. Swap of stock indices – – – – – – – – – –
7. Swap of real indices – – – – – – – – – –
8. Futures – – – – – – – – – – 9. Cap options – 19,500 – – – – – – – 19,500 – purchased – 19,500 – – – – – – – 19,500 – issued – – – – – – – – – – 10. Floor options – – – – – – – – – – – purchased – – – – – – – – – – – issued – – – – – – – – – – 11. Other options – – – 71,183 – – – – – 71,183 – purchased – – – 33,515 – – – – – 33,515 – Plain vanilla – – – 33,515 – – – – – 33,515 – Exotic – – – – – – – – – – – issued – – – 37,668 – – – – – 37,668 – Plain vanilla – – – 37,668 – – – – – 37,668 – Exotic – – – – – – – – – – 12. Forward contracts – – – – – – – – – – – Purchases – – – – – – – – – – – Sales – – – – – – – – – –
– Currency against currency – – – – – – – – – –
13. Other derivative contracts – – – – – – – – – –
Total – 62,950 – 71,183 – – – – – 134,133
A.2.2 Other derivatives
Type of transaction/Underlyings Debt securities Equities Exchange rates and gold Other instruments 12/31/2005
and interest rates and equity indices
Listed Unlisted Listed Unlisted Listed Unlisted Listed Unlisted Listed Unlisted
1. Forward rate agreements – – – – – – – – – –
2. Interest rate swaps – 902,134 – – – – – – – 902,134
3. Domestic currency swaps – – – – – – – – – –
4. Currency interest rate swaps – – – – – 25,907 – – – 25,907
5. Basic swaps – 76,408 – – – – – – – 76,408
6. Swap of stock indices – – – – – – – – – –
7. Swap of real indices – – – – – – – – – –
8. Futures – – – – – – – – – – 9. Cap options – 45,658 – – – – – – – 45,658 – purchased – 32,250 – – – – – – – 32,250 – issued – 13,408 – – – – – – – 13,408 10. Floor options – – – – – – – – – – – purchased – – – – – – – – – – – issued – – – – – – – – – – 11. Other options – 62,587 – 371,101 – 1,800 – 989 – 436,477 – purchased – 35,000 – 80,499 – 900 – 500 – 116,899 – Plain vanilla – – – – – – – – – – – Exotic – 35,000 – 80,499 – 900 – 500 – 116,899 – issued – 27,587 – 290,602 – 900 – 489 – 319,578 – Plain vanilla – – – 203,900 – – – – – 203,900 – Exotic – 27,587 – 86,702 – 900 – 489 – 115,678 12. Forward contracts – – – – – – – – – – – Purchases – – – – – – – – – – – Sales – – – – – – – – – –
– Currency against currency – – – – – – – – – –
13. Other derivative contracts – – – – – – – – – –
Total – 1,086,787 – 371,101 – 27,707 – 989 – 1,486,584
A.3 Financial derivatives: purchase and sale of underlyings
Type of transaction/Underlyings Debt securities Equities Exchange rates and gold Other instruments 12/31/2005
and interest rates and equity indices
Listed Unlisted Listed Unlisted Listed Unlisted Listed Unlisted Listed Unlisted
A. Trading