Definition: Market Risk
Market risk is the risk of losses to the business or firms arising from movements in market prices as a result of changes in interest rates, foreign exchange rates, and equity and commodity prices. There are two major components of market risks; General Market Risks and Specific Risks.
General Market Risks also referred to as systematic risk, affect similar financial assets or financial markets. It is the risk due to adverse impact on market prices that is generalized across a range of assets. Specific Risks are risks that affect individual financial assets and is caused due to the adverse movement of the individual asset.
Categories of Market Risk
There are generally four categories of market risks:
- Interest Rate Risk
- Freign Exchange Risk
- Equity Risk
- Commodity Risk
Interest Rate Risk
Interest Risk is the potential loss due to movements in interest rates. This risk arises because bank assets (loans and bonds) usually have a significantly longer maturity than bank liabilities (deposits). This risk can be conceptualized in two ways. First, if interest rates rise, the value of the longer-term assets will tend to fall more than the value of the shorter-term liabilities, reducing the bank’s equity. Investors can reduce interest rate risk by buying bonds that mature at different dates. They also may allay the risk by hedging fixed-income investments with interest rate swaps and other instruments.
Equity Risk
Equity Risk is the potential loss due to unfavourable change in the equity investment i.e. price of stock. Banks can make equity investment in various companies to maintain/manage their investment portfolio, exposing them to the risk of the changing value of those equity investment shares.
During the 1990s, investment in tech-based companies and the internet sector increased rapidly. To cash in these opportunities, heavy investment was done in similar businesses. From March 2000 to October 2002, the dot-com bubble burst and stock price of many tech-based and internet sector firms crashed leading to loss of 50% or more to shareholders.
Foreign Exchange Risk
Foreign Exchange Risk is the risk due to currency exchange rate fluctuation. Banks have the function of payment services which involve foreign exchange i.e. banks buy and sell foreign currency and involve in various intermediaries transactions(international trade) on the behalf of their customers.
There is regular fluctuation of foreign exchange rate which may lead to either gain or loss in foreign exchange transactions which is uncertain.
Commodity Risk
Commodity Risk is the potential disadvantage due to an adverse change in commodity prices. There are different types of commodities, including agricultural commodities i.e. wheat, corn, soybeans etc., industrial commodities i.e. metals, and energy commodities i.e. natural gaese, crude oil. The value of the commodity fluctuates a great deal due to changes in demand and supply just like foreign currency. Commodity market is mature in developed countries and banking institutions do participate in commodity related transactions.
Market Risk Reporting
Market Risk Reporting means communicating and sharing the market risks with traders, risk managers, senior management, and members of the board of directors so that effective risk management strategies can be discussed and properly executed. The report must adhere to some basic structure defined by the risk management committee or any regulatory bodies. The report must include:
- Information on trading and balance sheet position
- Detailed information for the position
- Information regarding current profit/loss position
Risk reports must include current risk metrics which are calculated by evaluation. Market Risk can be evaluated using VaR (Value-at-Risk), Stress Testing and Scenario Analysis. VaR provides an answer to the question, “ How much could we lose in the next day, week, month or year? VaR predicts loss at a specific confidence level over a given period of time. Scenario analysis evaluates the performance of a portfolio in different states of the world, either hypothetical or historical. Stress testing is a statistical technique used to test the flexibility of investment portfolios against possible future financial events.
Reference
- Apostolik, R., Donohue, C., & Went, P. (2009). An Overview of Banking, Banking Risks and Risk-Based Banking Regulation . Hoboken, New Jersey: John Wiley & Sons, Inc.
- Investopedia