Market Risk

By Prof. Divya Gupta

Market Risk  

Market risk may be defined as the possibility of loss to a bank caused by changes in market variables. The BIS defines market risk as the risk that the value of on-or-off balance sheet positions will on-orbe adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices.

Need of Market Risk for banks in India:   A small change in market variables causes substantial changes in income & economic values of banks. . Introduction of new products such as Derivatives has made the market risk management a critical important function for the banks today.

Components ± Market Risk:      Liquidity risk Interest rate risk Foreign Exchange risk Equity Price risk Commodity Price risk .

as they fall due. Liquidity management in a bank has essentially four important functions: It demonstrates to the market place that the bank is safe and therefore capable of repaying its borrowings. both efficiently and economically. It enables bank to meet its prior loan commitments. It reduces need to resort to borrowings from the central bank .Liquidity risk   a) b) c) d) Liquidity of a financial institution is its ability to fund increases in assets and meet payment obligations. It enables bank to avoid unprofitable sale of assets.

Interest Rate Risk   a) b) c) d) e) Interest rate risk as far as financial institution is concerned. is the risk that the value of its assets and liabilities as also its net interest income may get adversely affected on account on movements in interest rates. Types of Interest rate risks are: Gap risk/mismatch risk Basis risk Price risk Reinvestment Risk Embedded option risk .

Example :  Suppose a bank borrows Rs. .a. First there is a mismatch risk and in case there is upward trend of interest rate and the cost of liability goes up at 13% the bank will post a loss of Rs1 crore.100 crores form the market for 2 years @ 10% p.a. and create assets of the same amount for 5 years period @12 % p.

 . It may be defined as the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position.Foreign Exchange Risk  Foreign exchange risk is the risk arising from a foreign currency exposure.

Example  A US FI gives a loan to an Indian company in rupee. . The situation will reverse if Indian company takes the loan in USD. If the INR depreciates in value to USD. the principle and interest payments to US FI would be devalued in dollars.

Other Risks  Equity Price Risk Changes in the equity prices can result in losses to the bank holding an equity portfolio. Commodity markets may also be less liquid and as a result changes in supply and demand conditions can make the market volatile making effective hedging of the commodities risk rather difficult. . Commodity Price Risk Commodity is defined as a physical product which is or can be traded on a secondary market.

Management of Liquidity Risk  Need for managing liquidity risk Dimensions of Liquidity risk Funding risk Time risk Call risk  .

Management of Liquidity Risk Management of Liquidity Risk The key ratios adopted across the banking system are: a) Loan to total assets b) Loan to core deposits c) Loan losses/net loans d) Purchased funds to total assets  .

Management of Interest Rate Risk         Dedication Rate Anticipation Swaps Caps Floors Forward rate agreement Futures Options .

Dedication: .

Effect of interest rate change on the value of the asset:  Suppose a bank holding a bond of Rs. The current yield to maturity of same category bond is 11%. The change in value of the bond will be the loss.100 has a coupon of 10% payable annually and tenure of one year. .

(¨L) Change in Market Equity = Change in Market value of Assets ± Change in Market value of Liabilities The method of valuing the securites of a bank at the market value is known as Marking to Market (MTM) method.MVE (¨E) = (¨A) . .

Management of Foreign Exchange Risk Internal Techniques Netting Invoice  External Techniques Forward contracts Currency futures Options Swaps  .

.Management of Equity Risk     Formulate a transparent policy and procedure for investment in shares Build up adequate expertise in equity research Regular review Limit of direct 20% and indirect 20% of banks¶ net worth.

Market Risk Measurement  The market risk is measured in terms of VaR. Risk Metric Model is a common approach to measure market risk .

The Risk Metrics Model    VaR or EaR DEAR (Daily Earnings at Risk) The objective of market risk management model is the prediction of next day losses if tomorrow is a bad day for business activities. .

it can be written as (-MD) X Adverse daily yield (move MD = D/(1+R) .DEAR DEAR = Rupee Market Value of the position X Price Volatility Daily price volatility = Price sensitivity to a small change in yield X Adverse daily yield move So.

VaR VaR is defined as an estimate of potential loss in a position of assets/liabilities over a given holding period at a given level of certainty. VaR = DEAR X ¥N Case Illustration .

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