Market Risk - Concept and Application

Definitions

The Basel Committee on Banking Supervision defines market risk as the risk of losses in on- or off-balance sheet positions that arise from movement in market prices. Market risk is the most prominent for banks present in investment banking. 

Market Risk or Systematic Risk is the possibility of an investor incurring financial loss as a result of unfavorable movements of the underlying factors that affect the value of the investment/asset.

Market Risk Asset Types in Banks and Financial Institutions

When it comes to Banks, there are predominantly two types of assets: Banking Book and Trading Book assets. Banking Book assets are mostly Loans that have been extended to the Bank’s customers and are usually held to maturity. While Banking Book assets are sensitive to market factors, they are not exchanged frequently between the Bank and 3rd parties.

Trading Book assets on the other hand are assets that the Banks uses for making a profit or loss or for hedging the profit/loss position and follow a mark to market approach as opposed to hold to maturity. These assets are at least as or more sensitive to market factors and can results in larger losses than Banking Book assets. There is also a requirement to hold VaR for the Trading Book to ensure enough capital has been held for a loss making events on a 99.9% calibration.

Market Risk in Banking is the possibility of a loss arising in either the Banking or Trading Book. This is usually when the values of the assets decline as a result of increases in interest rates, poorer liquidity conditions, decline in credit quality, volatility and several more factors. If the Bank is short some assets, then the risk is the increase in assets prices which is mostly a Trading Book phenomenon.

Example of a Simple Market Risk Concept

Imagine you wish to buy a car. You can purchase a new one under full warranty, or a second-hand vehicle with no warranty. Which one you choose depends on how much you can afford, which features are important for you, your knowledge of mechanics, and your risk tolerance.

As you check out different cars, you find that some makes and models perform better than others, and have superior repair histories.

However, regardless of which vehicle you eventually decide upon, there are several risk on the road which have nothing to do with your chosen car, but which can impact your driving experience considerably.

Examples include animals crossing the road, being hit by lightning, weather conditions, icy roads, traffic lights working incorrectly, being mugged by a street gang while you’re waiting at a red light, to mention just a few. While these factors might be beyond your control, you need to be aware of them.

Major Components of Market Risks

Interest rate risk

It’s the potential loss due to movements in interest rates. This risk arises because a bank’s assets usually have a significantly longer maturity than its liabilities. In banking language, management of interest rate risk is also called asset-liability management (or ALM).

Equity risk

It’s the potential loss due to an adverse change in the stock price. Banks can accept equity as collateral for loans and purchase ownership stakes in other companies as investments from their free or investible cash. Any negative change in stock price either leads to a loss or diminution in investments’ value.

Foreign exchange risk

It’s the potential loss due to change in value of the bank’s assets or liabilities resulting from exchange rate fluctuations. Banks transact in foreign exchange for their customers or for the banks’ own accounts. Any adverse movement can diminish the value of the foreign currency and cause a loss to the bank.

Commodity risk

It’s the potential loss due to an adverse change in commodity prices. These commodities include agricultural commodities (like wheat, livestock, and corn), industrial commodities (like iron, copper, and zinc), and energy commodities (like crude oil, shale gas, and natural gas). The commodities’ values fluctuate a great deal due to changes in demand and supply. Any bank holding them as part of an investment is exposed to commodity risk.

Measurement of Market Risk

Market risk is measured by various techniques such as Value at Risk (VaR)and sensitivity analysis. VaRis the maximum loss not exceeded with a given probability over a given period of time. 

VaR and can be measured using any of below methods.

1.) Parametric method (requires two parameters: mean and standard deviation)

2.) Historical simulation method (Uses historical data)

3.) Monte Carlo simulation Method (Uses random number theory to generate possible simulations)

Sensitivity analysisis how different values of an independent variable will impact a particular dependent variable.

Market risk is unavoidable but not unmanageable. Market risk tends to occur when an unpredictable turn of events such as fluctuation in exchange rates, fluctuations in the prices of traded assets and commodities lead to a change in the value of financial instruments held by a firm. Assessing market risk is not unlike predicting the weather, where at best indicators can be provided and precautions taken. Reliable and objective data to measure market risk is not always possible. Illiquid assets can see their potential value changing due to varying types of market risk. What initially appears to be a case of simple credit risk enters the domain of market risk. For example, a bank faces credit risk predominantly when it advances a loan with collateral to a client. However, when the prices of real estate start moving strongly it moves to the realm of market risk.

What do banks want from the market-risk management group? 

Primarily, they want to understand their market-risk profile, including both short-term profit-and-loss (P&L) volatilities and long-term economic risk. They want to know how much risk they have accumulated and how the total compares with the bank’s stated risk appetite. Banks also want the Risk Group to develop and win regulatory approval of a fair treatment of RWAs, allowing the bank to get maximum efficiency out of its capital. 

Banks try to mitigate the impact of risk by creating reserves and limits. Market risks are booked in the trading book. Banks tend to inflate reserves for credit risk, to provide cover for market risks that may be hidden.

It is difficult to demarcate where market risk begins and say operational risk ends. To classify risks into neat categories and manage them is not practical. The risks that an organization faces are more dominoes like in nature. The mortgage sector is affected by the rise and fall in prices in the realty market. Similarly the pension payouts are affected by the rise and fall of the stock markets where pension funds plough their funds into. Risk needs to be understood comprehensively before identifying the type of risk and managing it.

Market risk departments in banks conduct their business by identifying, assessing, monitoring and controlling or mitigating risk. This is of course true for both financial and non-financial institutions and for all kinds of risk. Top management must support the market risk management function. A coherent risk management policy, strategy, and implementation are key to any organization, even those who go out of their way to avoid it.