Market Risk is a broad risk category that applies to financial or real assets that are actively traded in markets. It reflects the fact that future market prices are not certain and hence a position or portfolio of positions is subject to valuation losses at future dates.
In the context of bank risk management, market risk is relevant for positions included in the banks' trading book as well as interest rate and foreign exchange positions in the whole balance sheet.
Classification by traded asset types
- Equity risk (applicable to single stocks or indices). The risk that the level, volatility and correlations of various equity instruments will vary)
- Traded Credit risk (applicable to credit sensitive securities such as corporate or sovereign bonds or credit derivatives). The risk that the credit premium, volatility or correlations will vary and the possibility of an unexpected default event
- Interest rate risk (applicable to various maturities). The risk that the level, volatility and correlations of various rates will vary
- Currency (Foreign Exchange Risk) (applicable to various currency pairs). The risk that the level, volatility and correlations of various currency rates will vary
- Commodity risk (applicable to various commodities traded in organized markets). The risk that the level, volatility and correlations of commodity prices will vary
- Inflation risk (applicable to inflation indexed bonds and inflation derivatives). The risk that the level, volatility and correlation of inflation indices and inflation expectations will vary
While the market risk of the different assets classes shares many commonalities, there are also substantial differences
Classification by risk subtype
- Price risk: the general volatility of prices present even in the most well functioning markets
- Liquidity risk: the volatility of the bid-ask spread that reflects the depth of the market (the number of buyers and sellers)
- Gap risk: the risk that the market will crash through multiple price levels due to absence of transactions
- Event risk: the risk of very adverse market moves due to the announcement of dramatic news (e.g., merger, default or bankruptcy)
Classification by number of independent risk factors
- Idiosyncratic risk factors: Equities and Traded Credit markets exhibit market risk associated with individual positions that can, in part, be diversified.
- Systematic risk: FX, Interest Rate, Inflation and Commodity markets are macro markets, with a relatively small set of tradeable instruments
Identification & Measurement
Identification of market risk begins with the collection of position data. The next step is the assignement of "reference markets", i.e. those that offer the best proxy for valuing each position. Historical reference data together with revaluation of the position for each realisation is then used for measuring market risk by either:
- Using Value-at-Risk, namely statistical use of large number of scenarios and the resulting PnL distribution
- Stress Testing, using specified or historical shifts to various market levels
- Scenario Analysis, developing a consistent scenario and its implied shifts
Issues and Challenges
- The behavior of liquid markets is reasonably well understood and quantification of market risk in these circumstances (e.g. with VaR techniques) is a viable proposition.
- The causes, frequency and severity of discontinuous (gap) moves are less understood and are hence this type of market risk is more difficult to property identify and capture in measurment
- Credit instruments have proven in the financial crisis to be very illiquid, thereby challenging the management of this type of asset in market risk context
- There are further residual risks, e.g., Basis Risk when the actual traded instrument and instruments used to hedge and/or valuation are not 100% correlated
- When trading derivative instruments, there may be additional risks generated in the form of counterparty exposure (credit risk) if the position becomes unfavorable to the counterparty. Such exposures may exhibit wrong way risk if the exposure is likely to be positive when the counterparty is also likely to have a more deteriorated credit condition