Market risk is defined as the exposure of a portfolio of assets to movements in market variables. For the EEA, the relevant variables are primarily interest rates, exchange rates, and the spreads between the yields of securities issued by sovereigns and by other types of issuer. The Bank monitors and controls market risk using a Value-at-Risk (VaR) model, which predicts, at a specified confidence level, the maximum likely loss for a portfolio over a certain time period. In agreement with HMT, the Bank applies a 99% confidence interval and a ten-day holding period, such that in 99 ten-day periods out of a hundred, losses should not exceed those suggested by the model. These VaR estimates are derived from the past volatility of, and correlations between, returns on different assets in the portfolio. The Bank measures the EEA's VaR exposure against limits set by HMT in the Service Level Agreement (SLA).
In addition, for internal Bank management control purposes Delta is also measured. Delta is the change in value of the portfolio for each one basis point shift in the relevant yield curve. It supplements the VaR measure, and helps to test the sensitivity of the portfolio to changes in interest rates.
Furthermore the Bank conducts regular stress tests to explore the vulnerability of the EEA to potential severe market movements and to estimate the potential losses (or gains) in these extreme conditions.
The management of the reserves involves taking credit exposures to banks and to the issuers of sovereign, supranational and commercial paper. The creditworthiness of these banks and issuers is subject to regular scrutiny by the Bank's internal Credit Risk Advisory Committee (CRAC). As part of this process, limits are agreed for the maximum exposure to each bank and issuer in terms of both amount and maturity. Such exposures are monitored in real time against the limits. In addition, there are limits to contain exposure to each country's banking system, and limits that apply to certain instrument types. Certain derivative instruments entered into by the EEA are conducted under master legal agreements that permit collateralisation of outstanding exposures.
In agreement with HMT, a core level of liquidity is specified in the Bank's asset allocation model, leading to minimum holding thresholds in particular asset classes.