Monetary and Economic Studies Vol.17, No.2 / August 1999

Risk Management for Equity Portfolios of Japanese Banks

Akira Ieda, Toshikazu Ohba

This paper verifies the impact of equity portfolio on bank management, underscoring the importance of managing the risks involved and suggesting "management of sensitivity to equity price risk" as a risk management technique that takes into account the correlation between equity price risk and credit risk. To do this, the paper focuses on the high correlation between "expected default probability estimated by the option-approach (Merton method)" using equity price information and "spread over Libor" observed in the bond market. This is used to calculate sensitivity (delta and vega) to changes in the equity price and its volatility. According to calculations for a sample portfolio, these two sensitivities have a degree of utility in measuring the distribution of risk exposure and in using equity price index futures and options as hedges. In the hedging of vega risk (which tends to reflect credit risk) in particular, long put positions in equity price index options are shown to be potentially effective.

Keywords: Equity portfolio; Loan; Expected default probability; Spread over Libor; Equity price risk; Credit risk; Sensitivity

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 1999 Bank of Japan All Rights Reserved.

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