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Market risk is defined as the risk to a financial portfolio from movements in market
prices such as equity prices, foreign exchange rates, interest rates, and commodity
prices.
Related terms:
Interest Rate, Stock Market, Financial Market, Risk Management, Volatility, Risk
Premium, Operational Risk
Market Risk
Market risk is the potential loss of value in assets and liabilities due to changes in
market variables (e.g., interest and exchange rates, equity and commodity prices).
This covers assets and liabilities in trading books, but also could include the market
risk of assets and liabilities classified as available for sale, or even hold-to-maturity
assets and liabilities. Banks often limit the scope of market risk to the assets and
liabilities in their trading books, which is in line with the definition of market risk
in the regulatory solvency regime for banks.
We will limit market risk to trading assets and liabilites in this book, and include
the market risk for other assets and liabilities in asset-liability management risk.
We note that the market risk for trading positions also includes market liquidity
risk, that is, the risk that a firm cannot easily offset or eliminate a position without
significantly affecting the market price because of inadequate market depth or
market disruption.3
Market Risk
Market risk is the potential for events in the markets—usually adverse price move-
ments for one or more instruments—to have a negative impact on a portfolio or
on a market participant (see Figure 2.2.4). Leveraged positions can cause extreme
losses. An instrument that is sold short may have to be covered under extremely
adverse conditions. Speculators may profit on this situation in what is known as a
short squeeze. Market risk in many ways corresponds to the notion of diversifiable
risk that we considered when describing Modern Portfolio Theory in Book 2, Part 1.
Figure 2.2.4. Market risk occurs when prices move in an adverse direction from the
perspective of a trader or investor.
17.1 Introduction
Market risk is a major concern for all types of traders and investors. This chapter
concisely presents the widely used risk measures and the way they are implemented,
particularly in the banking industry. Market risk refers to the risk of financial assets
whose prices are determined exogenously in financial markets. If an instrument is
held until maturity, then it is not subject to market risk.
There are various concerns and criticisms in measuring market risk. These include
the choice of the appropriate holding period, backtesting issues, the problems with
association measures, reporting and putting limits on trading activities, and so
forth. Any other question brings a new assumption into the risk model, causing
the model to drift from reality. This raises an even bigger concern. In reality, is the
cash amount reported by the risk calculation a value or just a kind of index helping
managers develop a rough idea on their risky positions? Apparently, we need some
additional mapping effort or a fine-tuning for the reported risk value to reflect the
real amount of money to be lost.
This chapter focuses on the most popular definitions of risk and risk computation
methods as well as the technical details practitioners have to consider, through
specific examples.
Credit risk is defined as the risk that an obligor will not be able to meet its financial
obligations toward its creditors. Under this definition, default is the only credit
event. The weaker definition of credit risk is based on market perception. This
definition implies that obligors will face credit risk even if they do not fail their
financial obligations yet but the market perceives they might fail in the future. This
is known as the mark-to-market definition of credit risk and gives rise to migration
as well as default as possible credit events. Perception of financial distress gives rise
to credit downgrade.
Value at risk (VaR) is an estimate of the maximum loss that can occur for a portfolio
under market conditions and within a given confidence level over a certain period
of time. VaR has become an increasingly important measure for strategic risk
management. Recent market events, including the Asian crisis and market collapse
in Russia, have underscored the importance of complementing VaR analysis with a
comprehensive stress-testing program.
New models and techniques for the trading book portfolios are needed to calculate
the market risk. Credit is now playing a role in pricing—credit spreads are key factors
for pricing many instruments. Specific risks arise from credit quality changes in the
market place. Thus the changes in credit risk affect market prices through spreads
or credit ratings, infringing on the purity of the market risk estimation.
As credit markets expand and deepen, information such as spreads and downgrades
contributes directly, in an increased manner, to the positions' valuation in the
corporate bond portfolios. Similarly, because market rates drive the value of fixed
rate bonds, counterparty credit risk can only be assessed in such portfolios when
exposures are evaluated under a variety of market conditions. Hence market risk
factors are fundamental for a correct measure of credit risk. Credit risk modeling is
one of the top priorities in risk management and finance.
Common practice still treats market and credit risk separately. When measuring
market risk, credit risk is commonly not taken into account; when measuring
portfolio credit risk (PCR), the market is assumed to be constant. The two risks are
then “added” in ad hoc ways, resulting in an incomplete picture of risk. In this study,
the focus is on integrated credit and market risk.
There are two categories of credit risk measurement models: counterparty credit
exposure models and PCR models.
Counterparty credit exposure is the economic loss that will be incurred on all outstand-
ing transactions if a counterparty defaults unadjusted by possible future recoveries.
Counterparty exposure models measure and aggregate the exposures of all trans-
actions with a given counterparty. They do not attempt to capture portfolio effects,
such as the correlation between counterparty defaults.
PCR models measure credit capital and are specifically designed to capture portfolio
effects, specifically obligor correlations. It accounts for the benefits of diversif-
ication. With diversification, the risk of the portfolio is different from the sum of
risk across counterparties. Correlations allow a financial institution to diversify their
portfolios and manage credit risk in an optimal way. However, PCR models either
fix market risk factors to account for credit risk or fix credit risk drivers to account
for market risk.
In this study, the portfolio credit risk engine (PCRE) is used, which is the first produc-
tion solution for integrated market and credit risk, based on conditional probabilities
of default.
Mark to future (MtF) is a concept where all financial instruments are valued across
multiple scenarios (developed on the underlying market and credit) risk factors and
across the time steps of interest. In the MtF concept, the calculations for pricing the
instruments and VaR estimates are retrieved to deliver any combinations of results
according to financial instrument, scenario, and time step.
If portfolio positions depend simultaneously on market and credit risk factors, the
nature of the risk assessment problem changes. If market and credit risks are
calculated separately, this is based on a wrong portfolio valuation and leads to a
wrong assessment of true portfolio risk.
A comprehensive framework requires the full integration of market and credit risk.
It is mandatory to model the correlations between changes of the credit quality of
the debtors and changes of market risk factors. By combining an MtF framework
of counterparty exposures (Aziz and Charupat, 1998) and a conditional default
probability framework (Gordy, 1998), one minimizes the number of scenarios where
expensive portfolio valuations are calculated and can apply advanced Monte Carlo or
analytical techniques that take advantage of the problem structure. This integrated
structure has the advantage of explicitly defining the joint evolution of market risk
factors and credit drivers. Market factors drive the prices of securities and credit
drivers are macroeconomic factors that drive the creditworthiness of obligors in the
portfolio.
Along with the RF volatilities (standard deviations of daily changes) and correlations
combined with the portfolio sensitivities [Greeks, Hull (1999)], the most widely
accepted methodology for measuring market risk is the Value-at-Risk approach.
The VaR can bedefined as the worst possible loss in the portfolio value over a
given holding period (1 or 10 days) at the 99% confidence level (Jorion, 2001;
Crouhy, Galai and Mark, 2001). Essentially, a mathematical model for VaR consists
of two main parts: (1) modelling of proper multivariate risk factor distributions
(processes) for the required time horizons; (2) evaluation of the portfolio (linear
instruments, options and other derivatives) changes for the risk factor scenarios
to produce a portfolio distribution. The evaluation part can be based on a full
revaluation for the prices of instruments or partial revaluation methodologies [for
example, Delta–Gamma–Vega approximation (Hull, 1999)]. Regulators also require
complementing the VaR analysis with stress testing (scenarios for crashes, extreme
movements in the market, stresses of volatilities and correlations, etc.). Traditional
methods of the VaR calculation are analytical (variance–covariance) method (JP Mor-
gan, 1996), historical simulation [combined with some bootstrapping procedures
or other non-parametric methods (Crouhy, Galai and Mark, 2001)], and parametric
Monte Carlo simulation approach [see Duffie and Pan (1997)]. Primarily developed
for the “normal” market conditions (multivariate Gaussian distribution for the risk
factors), the variance–covariance method can be applied only for linear portfolios.
The variance–covariance method can be extended from multivariate normal to the
non-normal elliptical RF distributions (see Section 3.3). VaR for option portfolios is
usually calculated based on simulation approaches. In this chapter, we concentrate
on the parametric modelling of the RF distributions based on the Monte Carlo
simulation procedures given an appropriate portfolio valuation methodology.
There are some market risk measures other than VaR closely related to the tails of
the RF probability distributions, for example, Expected Shortfall [see Mausser and
Rosen (2000)]. The Expected Shortfall is defined as an average loss calculated from
the losses that exceed VaR. The Expected Shortfall, as a conditional mathematical
expectation, is an example of so-called coherent risk measures [see Artzner et al.
(1999)] that, contrary to VaR, possess a natural subadditivity property (total risk of
entire portfolio should be less or equal to a sum of risks of all sub-portfolios). In
some cases, Expected Shortfall reflects the market risk better than VaR (it gives an
answer to the question, what is the average of the worst case losses that occur at the
corresponding confidence level). This market risk measure is more sensitive to the
tail behavior than VaR. In general, it is wrong to say that only tails of the underlying
RF distributions are important for the VaR or other risk measures. For example, a left
tail for the portfolio of some barrier options or even European near at-the-money
options may mostly depend on the central part of the underlying distribution.
Therefore, it is a necessity to accurately model all parts of the RF distributions,
including peaks at the origin and tails.
Due to short time horizons utilized in Market Risk Management (1–10 business
days) contrary to Credit Risk Management with usual time horizons of years (Crouhy,
Galai and Mark, 2001; Duffie and Pan, 2001), the market risk factors are defined
as daily log-returns, relative or absolute changes in the underlying prices, rates
or implied volatilities, rather than these underlyings themselves. Such long-term
effects as mean-reversion in the interest rate, commodity price, and implied volatility
dynamics (with characteristic times 1–20 years) are not taken into account in the VaR
modelling. Most of financial variables are positive (although, spreads and interest
rate differentials may be negative). Except somerare situations (e.g., Japanese inter-
est rates), daily changes for the underlyings are much less than 100% of the notional
values, and, therefore, there is no need to apply any positive transformations to
the market variables, like exponential or square transformations. Heuristically, this
means that in most cases one can use “linear” RF simulation models for the VaR
calculation.
Equity Long position Short position Specific Risk General risk Capital req'd (x
(×) (net × 4%) (y) (overall net + y)
× 8%)
A 100 25 75 × 0.04 = 3 75 × 0.08 = 6 9
B 75 25 50 × 0.04 = 2 50 × 0.08 = 4 6
C 25 50 25 × 0.04 = 1 (25) × 0.08 = (1)
(2)
Subtotal 6 Subtotal 8 14
Note that for the purposes of calculating the required capital in the general risk
column, the position in equity C results in a reduction in required capital (from 10
to 8). The reason is that the bank in this example is short in equity C and the overall
short position is deducted from the net long positions in equities A and B.
A risk-free rate of return is one for which the expected return is certain. It is the
reward paid to an investor for postponing current consumption spending without
taking any risk. It represents the time value of money. For a return to be considered
risk free over some future period, it must be free of default risk, and there must
be no uncertainty about the reinvestment rate (i.e., the rate of return that can be
earned at the end of the investor's holding period). Despite widespread agreement
on the use of U.S. Treasury securities as assets that are free of default risk, there is
some controversy over whether a short- or long-term Treasury rate should be used
in applying the CAPM.
Whether you should use a short- or long-term rate depends on how long the
investor intends to hold the investment. Consequently, the investor who anticipates
holding an investment for five or ten years needs to use either a five- or ten-year
Treasury bond rate. A three-month Treasury bill rate is not free of risk for a five- or
ten-year period, since interest and principal received at maturity must be reinvested
at three-month intervals, resulting in considerable reinvestment risk. In this book,
a ten-year Treasury bond rate is used to represent the risk-free rate of return. This
would be most appropriate for a strategic acquirer interested in valuing a target firm
with the intent of operating the firm over an extended time period.
(7.1)
where
The 5.5% equity risk premium used in this book is consistent with long-term arith-
metic and geometric averages calculated elsewhere.3 Despite its intuitive appeal, the
CAPM has limitations. Betas tend to vary over time and are quite sensitive to the time
period and methodology employed in their estimation.4 Some analysts argue that
the “risk premium” should be changed to reflect fluctuations in the stock market.
However, history shows that such fluctuations are relatively short term in nature.
Consequently, the risk premium should reflect more long-term considerations, such
as the expected holding period of the investor or acquiring company. Therefore, for
the strategic or long-term investor or acquirer, the risk premium should approximate
the 5.5% premium long-term historical average.5
Since CAPM measures a stock's risk only relative to the overall market and ignores
returns on assets other than stocks, some analysts have begun using multifactor
models. Such models adjust the CAPM by adding other risk factors that determine
asset returns, such as firm size, bond default premiums, bond term structure (i.e.,
the difference between short- and long-term interest rates on securities that differ
only by maturity), and inflation.
Studies show that, of these factors, firm size appears to be among the most impor-
tant.6 The size factor serves as a proxy for factors such as smaller firms being subject
to higher default risk and generally being less liquid than large capitalization firms.7
Table 7.1 provides estimates of the amount of the adjustment to the cost of equity
to correct for firm size, as measured by market value, based on actual data since
1926. The analyst should use this data as a guideline only. Specific firm business
risk is largely unobservable. Consequently, in applying a firm size premium, analysts
should use their judgment in selecting a proper size premium. This magnitude of
the firm size premium should be tempered by such factors as a comparison of the
firm's key financial ratios (e.g., liquidity and leverage) with comparable firms and
after interviewing management. The selection of the proper magnitude is addressed
in more detail in Chapter 10.
Source: Adapted from estimates provided by Ibbotson's Stocks, Bills, Bonds, and
Inflation Valuation Edition 2010 Yearbook.
Equation (7.1) can be rewritten to reflect an adjustment for firm size as follows:
(7.2)
where
FSP = firm size premium
Assume that a firm has a market value of less than $100 million and a of 1.75.
Also assume that the risk-free rates of return and equity premium are 5% and 5.5%,
respectively. The firm's cost of equity using the CAPM method adjusted for firm size
can be estimated as follows:
• Volume risks: We have already seen that access to sufficiently deep markets
for natural gas can be challenging. For a project to succeed, sufficient
long-term volumes of gas need to be sold to base customers. For some gas
projects, a single large power generation project has been the sole offtaker
of the gas. In other cases, established domestic gas grids are sufficiently
developed to offer relatively straightforward routes to sell large volumes of gas
to utility companies and distributors. Whatever the circumstances, however,
gas projects will only be viable if sales volume risks are minimised.
• Price risks: The gas volumes need to be sold at viable long-term prices. Many
factors influence the long-term gas prices and the negotiations between par-
ties to a natural gas contract are often protracted and difficult. Whatever
pricing mechanism is agreed between the parties needs to be realistic and
sustainable. Gas pricing is covered in more detail in Section 10.2.4.
• Credit risks: Gas contracts usually create long-term commercial relationships
involving considerable monetary amounts. Assuming annual sales of 10 billion
cubic meters of gas, then this is equivalent to approximately US$ 2 billion per
year or US$ 40 billion over 20 years, an enormous sum of money. The credit
risks associated with the length of time and sums of money involved in gas
contracts are thus significant. This is a critical bankability issue for natural
gas project finance and lenders to a project will spend a considerable amount
of time analysing the credit worthiness of potential offtakers.
Overall, gas market risks are considered to be high and, given the extended time
periods over which these risks exist, are difficult to mitigate
> Read full chapter
(7.1)
where
Despite its intuitive appeal, studies show that actual returns on risky assets frequent-
ly differ significantly from those returns predicted by basic CAPM.12 Since the CAPM
measures a stock’s risk relative to the overall market and ignores returns on assets
other than stocks, some analysts use multifactor models.13 Studies show that, of those
variables improving the CAPM’s accuracy, firm size tends to be among the more
important. The size premium serves as a proxy for factors such as smaller firms being
subject to higher default risk and generally being less liquid than large-capitalization
firms. Table 7.1 provides estimates of the adjustment to the cost of equity to correct
for firm size based on actual data since 1963.14
Eq. (7.1) can be rewritten to reflect an adjustment for firm size as follows:
(7.2)