Three Market Risk Management. 10 Introduction to Market Risk his chapter provides an introduction to market risk. Market risk is primarily measured with position-based risk measures such as value at risk (VAR). VAR is a statistical measure of total portiolio risk, based on the most current positions, which takes into account portfolio diversification and leverage. In theory, risk managers should consider the entire distribution of profits and losses over the specified horizon. In practice, this distribution is summarized by one number, the worst loss at a specified confidence level, such as 99%. VAR, however, is only one of the measures that risk managers focus on. It should be complemented by stress-testing, which identifies potential losses under extreme market condition: Section 10.1 gives a brief overview of financial market risks and the history of risk measurement systems. Section 10.2 then introduces measures of downside risk. It shows how to compute VAR for a very simple portfolio. It also discusses caveats, or pitfalls to be aware of when interpreting VAR numbers. Section 10.3 extends VAR methods to cash flow at risk. Section 10.4 turns to the choice of VAR parameters, that is, the confidence level and horizon, Next, Section 10.5 describes the broad components of a VAR system. Finally, Section 10.6 shows how to complement VAR by stress tests. 10.1 INTRODUCTION TO FINANCIAL MARKET RISKS 10.1.1. Types of Financial Risks Financial risks include market risk, credit risk, and operational risk. Market risk is the risk of losses due to movements in financial market prices or volatilities. This usually includes liquidity risk, which is the risk of losses due to the need to liquidate positions to meet funding requirements. Liquidity risk, unfortunately, is not amenable to formal quantification. Because of its importance, it will be covered in Chapter 25. Credit risk is the risk of losses due to the fact that counterparties may be unwilling or unable to fulfill their contractual obligations. Operational risk is the risk of loss resulting from failed or inadequate internal processes, systems, and people, or from external events. Oftentimes, however, these three categories interact with each other, so that any classification is, to some extent, arbitrary. 247