Market Risk

What is Market Risk?

Market risk, also known as Systemic risk, refers to the exposure that banks face due to adverse movements in the overall financial markets. Systemic risk is the concern that any activity within individual institutions could cascade and cause the collapse of the entire financial system.  Market risk can be caused by macroeconomic or geopolitical factors, or policy changes which can alter interest rates, commodity prices and FX.

If we look closer at a Bank’s exposure to market risk – we can conclude that if it owns a financial assets and the potential market price movements larger, the bank is more exposed to market risk. This is because a wider range of potential outcomes makes it harder to predict the future value of the asset. A bank may incur larger losses before exiting their position. This is referred to as the volatility of the asset.

How Market Risk Equities Work

An investment bank holds financial assets, such as equities, with the intention of selling them in the short term. These equities, recorded as held-for-trading assets, appear on the bank’s balance sheet and are valued daily through a process called marking to market. If the bank incurs losses on these equity investments, those losses are absorbed by the bank’s equity.

In our example let’s assume initially that a bank’s total assets amount to 160. Of these, 100 are marked-to-market equities. On the funding side, the bank has 20 units of equity. If the bank experiences a 10% fall in equity markets, the marked-to-market value of the equities on their balance sheet decreases to 90, resulting in a loss of 10. However, this entire loss is absorbed by the equity, which acts as a buffer to maintain the bank’s solvency.

However, equity has fallen by 50%, leaving only 10 units of equity. This means there’s a higher chance of insolvency if a similar mark-to-market loss occurs in the future.

Types of Market Risk

The different types of market risk are shown below:

• Market liquidity risk – this is the risk that the level of market activity might decrease and in certain cases cease making an asset illiquid to trade
  • This may mean a bank may not be able to transact business or execute trades in an orderly manner
• Interest rate risk – this is exposure to instruments whose values change due to changes in interest rates
• FX risk – FX or currency risk is the exposure to holdings and future cash flows that are not denominated in USD (or local currency of the investment bank)
• Issuer credit risk – there is risk associated with the value of an asset when the credit rating associated with the issuer changes
• Equity market risk – equity market risk changes in the value of an instrument linked to the ownership interest in a company
  • This includes shares, ADRs, convertible bonds, equity options, equity TRS, equity futures etc
• Commodity risk – commodity risk changes in value of futures, forwards, swaps and options linked to the value of commodities such as oil, metals etc
• Model risk – model risk is risk of adverse consequences arising from decisions based on incorrect or misused models

Download a free Financial Edge cheat sheet covering the different types of Market risk.

How to Mitigate Market Risk

Banks employ several strategies to mitigate and manage market risk effectively:

1. Hedging: this involves taking offsetting positions to counterbalance potential losses from market movements. Common hedging techniques include using derivatives like futures, options and swaps.
2. Diversification: by diversifying portfolios across different asset classes, sectors, and geographies, banks can reduce their overall market risk exposure. This ensures that potential losses in one area can be offset by gains in another.
3. Risk Limits and Policies: banks establish risk limits and policies to control exposure to market risk. These may include position limits, stop-loss orders, and value-at-risk (VaR)
4. Stress Testing: stress testing involves simulating extreme market scenarios to assess the potential impact on the bank’s portfolio. This helps identify vulnerabilities and take appropriate mitigating actions.
5. Risk Management Function: a dedicated risk management team is responsible for identifying, measuring, monitoring, and controlling market risk. They ensure adherence to risk policies and provide regular risk reporting.
6. Regulatory Compliance: banks must comply with regulatory requirements, such as the Basel Accords and capital adequacy norms, which mandate maintaining sufficient capital buffers to absorb potential losses from market risk.

Market Risk Example

In this chart Security A and Security B’s value moves from 100 to 110 over the course of one year. However, Security A (the dotted green line) follows a linear path, making it relatively easy to predict. Security B (the red line) shows erratic price movements throughout the year. At some points it declines below 100, while at other times, it may surge above 110.

If a bank were to sell its investment at any point during the year, Security A’s value would be more predictable, whereas Security B’s value would be much harder to anticipate. In simpler terms, Security B carries more market risk due to its greater uncertainty.

Measuring Market Risk

Measuring the market risk, or uncertainty surrounding an asset’s potential performance can be done using several techniques.

Risk Measurement Techniques

Value at Risk (VaR)

Value at Risk is a widely used measure that estimates the potential loss that could occur to an asset over a specific time horizon, given a certain confidence level. It provides an estimate of the maximum loss that an investment or portfolio may experience under normal market conditions.

The three common methods for computing Value at Risk (VaR) are:

• Historical simulation: this approach calculates VaR by using historical data. It involves ordering historical returns or price changes, selecting a confidence level, and identifying the loss value at the specified quantile.
• Parametric VaR: this method assumes that the distribution of returns follows a specific statistical distribution, often the normal distribution. It estimates the mean and standard deviation of returns and uses these parameters to calculate VaR at the desired confidence level.
• Monte Carlo simulation: this technique employs random sampling to generate numerous possible future scenarios for asset returns. Monte Carlo Simulation can handle complex portfolios and capture nonlinear relationships, but it can be computationally intensive and requires careful calibration of input parameters.

Stress Testing

Stress testing involves simulating extreme market conditions to assess the potential impact on the bank’s portfolio and identify vulnerabilities. This can help to quantify the market risk within a portfolio.

Risk Management Strategies

There are several ways to mitigate market risk within a portfolio. These can be undertaken at the time of the initial purchase or instigated at any point when market conditions or an investors’ risk appetite has changed.

1. Hedging: taking offsetting positions to mitigate market risk exposure
2. Diversification: spreading investments across different asset classes, sectors, and geographies to reduce overall market risk
3. Risk Limits and Policies: establishing appropriate risk limits and policies to manage market risk exposure effectively

A combination of these practises is typically used within financial institutions to manage market risk. Risk limits and policies should be updated to maintain regulatory requirements. Management may also deem it appropriate to establish limits and policies which are go beyond the minimal regulatory requirements.

Volatility

Volatility in financial markets refers to how much the price of an equity security fluctuates. Essentially, it measures the market risk associated with that security. Volatility quantifies how much an asset’s price is likely to change over time. It can be calculated using either the standard deviation of returns or by comparing an asset’s volatility against its relevant benchmark. This is known as beta.

The standard way to quantify volatility involves calculating the standard deviation of returns. Instead of merely measuring the average distance from the mean, we consider all differences from the mean. The process includes squaring these differences, summing them up for each data point, dividing by the number of data points, and then taking the square root.

There is always uncertainty regarding the future returns of an equity. This inherent uncertainty is the essence of market risk. Banks must estimate how future returns might unfold to gauge their market risk exposure.

The shape of equity returns is significantly influenced by the standard deviation of returns. The larger the standard deviation, the broader the potential distribution of future returns. Consequently, the bank faces greater market risk.

Consider American Airlines and Kellogg’s. American Airlines exhibits a wider distribution of returns, implying more market risk. In contrast, Kellogg’s values cluster more closely around the mean, indicating lower risk. While American Airlines has more market risk, it also offers more upside potential alongside its downside risk. Understanding and illustrating this risk allows for informed decision-making. If the future return distribution adheres to an identifiable probability distribution (such as the normal distribution), the bank can calculate probabilities. These probabilities help assess whether future returns will fall above or below certain levels.

Regulatory Requirements

Banks must comply with regulatory requirements related to market risk management, such as the Basel Accords and capital adequacy requirements. These regulations aim to ensure that banks maintain sufficient capital to absorb potential losses from market risk exposures.

Market Risk Governance

Effective market risk governance involves a robust risk management function responsible for identifying, measuring, monitoring, and controlling market risk. Regular risk reporting and oversight mechanisms are essential to ensure proper market risk management practices.

Conclusion

Market risk refers to the exposure that banks face due to adverse movements in stock prices, interest rates, exchange rates, and commodity prices. There are different types of market risk, including market liquidity risk, interest rate risk, FX risk, issuer credit risk, equity market risk, commodity risk, and model risk. Volatility quantifies the uncertainty regarding the future returns of an equity, which is the essence of market risk.

Download a free Financial Edge cheat sheet covering the different types of Market risk.

Additional Resources

Volatility

Value at Risk Var

Hedging Definition

Diversification