Correspondence: Benjamin M. Tabak, Banco Central do Brasil, Research Department, SBS Quadra 3, Bloco B. Ed. Sede, 9 andar, Brasilia DF 70074-900, Brazil. Tel: +55 61 34142045; Fax: +55 61 34142045; E-mail: Benjamin.tabak@bcb.gov.br

¹Gilneu F. A. Vivan is Head of the Off-Site Department of Banco Central do Brasil, holds an MSc in Economics and is a specialist in the analysis of banking system risk.

²Benjamin M. Tabak is Senior Advisor of the Research Department of Banco Central do Brasil, holds a PhD in Economics from Universidade de Brasilia and has published papers in portfolio and risk management areas in a variety of financial and economics journals.

Received 15 February 2007; Revised 15 February 2007.

Abstract

This paper aims at providing a new alternative for the collection of information on risks taken by financial institutions, which enables the calculation of risk tools usually used in risk management, such as VaR and stress tests. This approach should help risk managers, off-site supervisors and academics in assessing the potential risks in financial institutions principally due to derivatives positions. The basic idea, for linear financial instruments, like that traditionally used by the management risk systems, is to reduce positions in risk factors and then map the vertices. For the nonlinear financial instruments, all the positions in different types of options — European, American, exotic, etc — are represented as plain vanilla European options or replicated by portfolios of plain vanilla European options. The methodology was applied to Brazil, within the worst scenarios during the period from 1994 to 2004, and the paper demonstrates that the proposed approach captured the risks satisfactorily in the analysed portfolios, including the risk existent in the strategies involving options, given an accepted error margin. This approach could be useful for regulators, risk managers, financial institutions and risk management modelling as it can be used as an input in general risk management models.