UNIT: 4 MARKET RISK MANAGEMENT

Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The associated market risks are:

Equity risk, the risk that stock prices and/or the implied volatility will change. Interest rate risk, the risk that interest rates and/or the implied volatility will change. Currency risk, the risk that foreign exchange rates and/or the implied volatility will change. Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change. Equity risk is the risk that one's investments will depreciate because of stock market dynamics causing one to lose money. The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as "risk", some economists prefer other means of measuring it. This is all wrong!

Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration. Asset liability management is a common name for the complete set of techniques used to manage risk within a general enterprise risk management framework.

Calculating interest rate risk Interest rate risk analysis is almost always based on simulating movements in one or more yield curves using the Heath-Jarrow-Morton framework to ensure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible. The Heath-Jarrow-Morton framework was developed in the early 1990s by David Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert A. Jarrow of Kamakura Corporation and Cornell University. There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:
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1. Marking to market, calculating the net market value of the assets and liabilities, sometimes called the "market value of portfolio equity" 2. Stress testing this market value by shifting the yield curve in a specific way. Duration is a stress test where the yield curve shift is parallel 3. Calculating the Value at Risk of the portfolio 4. Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves 5. Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time. 6. Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first. Banks and interest rate risk Banks face four types of interest rate risk: Basis risk The risk presented when yields on assets and costs on liabilities are based on different bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses. Yield curve risk The risk presented by differences between short-term and long-term interest rates. Shortterm rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower rates) and investing in long-term assets (at higher rates). But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses. Repricing risk The risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate. Option risk It is presented by optionality that is embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due to prepayment speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is difficult to measure and control. Most banks are asset sensitive, meaning interest rate changes impact asset yields more than they impact liability costs. This is because substantial amounts of bank funding are not affected, or are just minimally affected, by changes in interest rates. The average checking account pays no interest, or very little interest, so changes in interest rates do not produce notable changes in
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interest expense. However, banks have large concentrations of short-term and/or variable rate loans, so changes in interest rates significantly impact interest income. In general, banks earn more money when interest rates are high, and they earn less money when interest rates are low. This relationship often breaks down in very large banks that rely significantly on funding sources other than traditional bank deposits. Large banks are often liability sensitive because they depend on large concentrations of funding that are highly interest rate sensitive. Large banks also tend to maintain large concentrations of fixed rate loans, which further increases liability sensitivity. Therefore, large banks will often earn more net interest income when interest rates are low.

Hedging interest rate risk Interest rate risks can be hedged using fixed income instruments or interest rate swaps. Interest rate risk can be reduced by buying bonds with shorter duration, or by entering into a fixed-for-floating interest rate swap. Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

Transaction risk is the risk that exchange rates will change unfavourably over time. It can be hedged against using forward currency contracts; Translation risk is an accounting risk, proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.

The exchange risk associated with a foreign denominated instrument is a key element in foreign investment. This risk flows from differential monetary policy and growth in real productivity, which results in differential inflation rates. For example if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change of the Canadian dollar against the U.S. dollar. Suppose that you realized a return in the stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you would make a small loss. When a firm conducts transactions in different currencies, it exposes itself to risk. The risk arises because currencies may move in relation to each other. If a firm is buying and selling in different currencies, then revenue and costs can move upwards or downwards as exchange rates between currencies change. If a firm has borrowed funds in a different currency, the repayments on the debt could change or, if the firm has invested overseas, the returns on investment may alter with exchange rate movements this is usually known as foreign currency exposure.

Currency risk exists regardless of whether you are investing domestically or abroad. If you invest in your home country, and your home currency devalues, you have lost money. Any and all stock market investments are subject to currency risk, regardless of the nationality of the investor or the investment, and whether they are the same or different. The only way to avoid currency risk is to invest in commodities, which hold value independent of any monetary system. Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities.[1] These commodities may be grains, metals, gas, electricity etc. A Commodity enterprise needs to deal with the following kinds of risks:
1. Price risk (Risk arising out of adverse movements in the world prices, exchange rates, basis

between local and world prices)

There are broadly four categories of agents who face the commodities risk
1. Producers (farmers, plantation companies, and mining companies) face price risk, cost risk

(on the prices of their inputs) and quantity risk

up-country purchase buying and sale, typically at the port, to an exporter. 3. Exporters face the same risk between purchase at the port and sale in the destination market; and may also face political risks with regard to export licenses or foreign exchange conversion. 4. Governments face price and quantity risk with regard to tax revenues, particularly where tax rates rise as commodity prices rise (generally the case with metals and energy exports) or if support or other payments depend on the level of commodity prices.