Market Risk

What is Market Risk?

 Market risk is the risk that an investor faces

due to the decrease in the market value of a
financial product arising out of the factors
that affect the whole market and is not
limited to a particular economic commodity.
Often called systematic risk, the market risk
arises because of uncertainties in the
economy, political environment, natural or
human-made disasters, or recession.
Equity price risk
Equity price risk is the risk that arises from security price volatility – the risk of a
decline in the value of a security or a portfolio. Equity price risk can be either
systematic or unsystematic risk. Unsystematic risk can be mitigated through
diversification, whereas systematic cannot be.

For example, you buy 500 ABC stocks for $20 per stock with the aim of selling the
shares at a higher price. But then, the unexpected resignation of the CEO causes
the share price to drop to $14. If you sell the shares then, you will make a $3000
loss. That is the equity price risk you must carry.
Foreign Exchange Risk
Foreign exchange risk is the chance that a company will lose money on
international trade because of currency fluctuations. Also known as currency
risk, FX risk and exchange rate risk, it describes the possibility that an
investment’s value may decrease due to changes in the relative value of the
involved currencies. It affects investors and any business involved in
international trade.

The risk occurs when a contract between two parties specifies exact prices for
goods or services as well as delivery dates. If a currency’s value fluctuates
between the date the contract is signed and the delivery date, a loss for one of
the parties could result.
Commodity Price Risk

Commodity price risk is the financial risk on an entity's financial performance/ profitability
upon fluctuations in the prices of commodities that are out of the control of the entity
since they are primarily driven by external market forces.

Commodities include agricultural products such as wheat and cattle, energy

products such as oil and natural gas, and metals such as gold, silver and
aluminum. There are also “soft” commodities, or those that cannot be stored for long
periods of time, which include sugar, cotton, cocoa and coffee.
 Types of foreign exchange risk
Transaction Risk

Occurs when a company buys products from a supplier in another country, and price is
provided in the supplier’s currency. If the supplier’s currency appreciates vs. the buyer’s
currency, the buyer will have to pay more in its base currency to meet the contracted
price.

The risk of transaction exposure typically impacts one side of a transaction: the business
that completes the transaction in a foreign currency. The company receiving or paying a
bill using its home currency is not subjected to the same risk.
Translation Risk
Refers to how a foreign exchange transaction will impact financial reporting; i.e., the risk
that a company’s equities, assets, liabilities or income will change in value as a result of
exchange rate changes.

This risk occurs because subsidiaries of a parent company in another country denominate
their currency in the countries where they are located. The parent company faces potential
losses when it must translate the subsidiaries’ financial statements into its own country’s
currency.
Economic Risk
Also known as operating exposure, this refers to the impact on a company’s market
value from exposure to unexpected currency fluctuations. This can affect a company’s
future cash flows, foreign investments and earnings.

Economic exposure can have a substantial impact on a company’s market value:

•Exposure is greater for multinational companies with many overseas subsidiaries and a
large number of transactions involving foreign currencies.

•Globalization has increased economic exposure for all companies.

•Effects are far-reaching and long-term in nature.

•Economic exposure is difficult to measure precisely.

How you exchange foreign currency can affect the results from expanding your
business globally. Here are two examples.

1. An American equipment distributor agrees to buy 100 cases of

equipment from a Spanish supplier at 500 euros per case, or 50,000
euros total, with payment due upon delivery.

•The U.S. dollar and Euro are at parity: $1 = 1 Euro

•The American company expects to pay the agreed-upon amount of 50,000 euros
upon delivery, when value of the purchase was $50,000

•Due to production problems, delivery is delayed three months, and the value of
the U.S. dollar depreciates against the Euro during that time, so 1 euro now
equals $1.10.

•The contracted price remains 50,000 Euro, but the dollar amount that the U.S.
company must pay is $55,000.
2. A U.S.-based company intends to purchase a product from a
supplier in England.

· The American company agrees to negotiate the deal when the

pound/dollar exchange rate is at a 1-to-1.3 ratio (1 pound = $1.30).

· Once the agreement is complete, the sale could take place in days,
weeks, or months. During that time, the exchange rate may change, for better
or worse to the American company.

· When the sale is completed and payment due, the exchange rate ratio
might have shifted to a more favorable 1-to-$1.25 rate or a less favorable 1-to-
$1.40 rate.
Causes of Foreign Exchange Risk
Foreign exchange risk is caused by fluctuations in international currencies. There are several
causes of these fluctuations

•Macroeconomic factors such as significant swings in exchange rates

•Government policies
• Can result in a dip or hike in market movement
• Changes in inflation, interest rates, import-export duties and taxes impact the
exchange rate
•Sovereign risk: that a government is unable to repay its debt and defaults on its payments
• Can have a direct impact on investment rates as repercussions can trigger other
business-related troubles.
• Includes political unrest and even a change in government policies, which can impact
the exchange rate and, in turn, affect business transactions.
•Collapse of a foreign government
•Credit risk: that the counterparty will default in making the obligations it owes
• Out of a seller’s control as it depends on another party’s commitment to pay its debts
• Counterparty’s business activities must be monitored so business transactions are
closed at the right time without risk of default
Value at Risk (VaR)

 Value at risk (VaR) is a statistic that quantifies the extent of

possible financial losses within a firm, portfolio, or position over a
specific time frame. This metric is most commonly used by
investment and commercial banks to determine the extent and
probabilities of potential losses in their institutional portfolios.

 Risk managers use VaR to measure and control the level of risk
exposure. One can apply VaR calculations to specific positions or
whole portfolios or use them to measure firm-wide risk exposure.
What is interest rate risk?

All investments come with a certain amount of risk, but fixed-income securities such as
government and corporate bonds are generally less volatile than stocks. And although they
may carry less risk than stocks, bonds are still subject to losses in value. For example, when
interest rates rise above the rate locked in at the time of purchase, the bond's price falls.
This is known as interest rate risk.

The recent collapse of Silicon Valley Bank offers a real-world example of interest rate risk.
When interest rates were low, the bank moved tens of billions of dollars into long-term
bonds. But when the Federal Reserve raised rates over the course of 2022, newly issued
bonds had higher yields than the bonds SVB was holding, causing the value of SVB's bonds
to plummet.

This was a clear reminder that while Treasury securities are often billed as "risk free," that's
only the case when they're held to maturity.
Understanding Value at Risk
(VaR)
 VaR modeling determines the potential for loss in the entity being
assessed and the probability that the defined loss will occur. One
measures VaR by assessing the amount of potential loss, the
probability of occurrence for the amount of loss, and the time
frame.

 For example, a financial firm may determine an asset has a 3%

one-month VaR of 2%, representing a 3% chance of the asset
declining in value by 2% during the one-month time frame. The
conversion of the 3% chance of occurrence to a daily ratio places
the odds of a 2% loss at one day per month.
Using a firm-wide VaR assessment allows for the determination of the
cumulative risks from aggregated positions held by different trading desks and
departments within the institution.

Using the data provided by VaR modeling, financial institutions can determine
whether they have sufficient capital reserves in place to cover losses or whether
higher-than-acceptable risks require them to reduce concentrated holdings.
VaR Methodologies

There are three main ways of computing VaR: the historical method, the
variance-covariance method, and the Monte Carlo method.

Historical Method

The historical method looks at one’s prior returns history and orders them
from worst losses to greatest gains—following from the premise that past
returns experience will inform future outcomes.
 Variance-Covariance Method

Rather than assuming that the past will inform the future, the variance-covariance
method, also called the parametric method, instead assumes that gains and losses
are normally distributed. This way, potential losses can be framed in terms of
standard deviation events from the mean.

The variance-covariance method works best for risk measurement in which the
distributions are known and reliably estimated. It is less reliable if the sample size is
very small.

Monte Carlo Method

A third approach to VaR is to conduct a Monte Carlo simulation. This technique uses
computational models to simulate projected returns over hundreds or thousands of possible
iterations. Then, it takes the chances that a loss will occur—say, 5% of the time—and reveals
the impact.

The Monte Carlo method can be used with a wide range of risk measurement problems and
relies upon the assumption that the probability distribution for risk factors is known.
Advantages of Value at Risk (VaR)

There are several advantages to using VaR in risk measurement:

1.It is a single number, expressed as a percentage or in price units, and is easily

interpreted and widely used by financial industry professionals.

2.VaR computations can be compared across different types of assets—shares,

bonds, derivatives, currencies, and more—or portfolios.

3.Thanks to its popularity, VaR is often included and calculated for you in
various financial software tools, such as a Bloomberg terminal.
Disadvantages of Value at Risk (VaR)

One problem is that there is no standard protocol for the statistics used to determine
asset, portfolio, or firm-wide risk. Statistics pulled arbitrarily from a period of low
volatility, for example, may understate the potential for risk events to occur and the
magnitude of those events. Risk may be further understated using normal distribution
probabilities, which rarely account for extreme or black swan events.

Another disadvantage is that the assessment of potential loss represents the lowest
amount of risk in a range of outcomes. For example, a VaR determination of 95% with
20% asset risk represents an expectation of losing at least 20% one of every 20 days
on average. In this calculation, a loss of 50% still validates the risk assessment.

The financial crisis of 2008 that exposed these problems as relatively benign VaR
calculations understated the potential occurrence of risk events posed by portfolios of
subprime mortgages. Risk magnitude was also underestimated, which resulted in
extreme leverage ratios within subprime portfolios. As a result, the underestimations
of occurrence and risk magnitude left institutions unable to cover billions of dollars in
losses as subprime mortgage values collapsed.1
Value at Risk (VaR) Example

The formula sounds easy, as it only has a few inputs. However, manually
calculating the VaR for a large portfolio is computationally laborious.

Though there are several different methods of calculating VaR, the historical
method is the simplest:

Value at Risk = vm (vi / v(i - 1))

M is the number of days from which historical data is taken, and v i is the
number of variables on day i.

The purpose of the formula is to calculate the percent change of each risk
factor for the past 252 trading days (the total number in a year). Each percent
change is then applied to current market values to determine 252 scenarios for
the security’s future value.