04 - Ind - L1 - ch4 - July06

Part B
An introduction to market, credit and operational risk

4 The nature of market risk and
treasury risk
This chapter provides an introduction to the nature of market and

treasury risk. These risks will affect almost all banks and failure to
manage them can have disastrous effects on a bank’s profitability and
reputation.
This chapter will help students gain an understanding of the underlying

concepts involved in managing market risk. These concepts will then be
used to explain how market risk is regulated under Basel I and II.
Students will also gain an understanding of the concepts involved in

managing treasury risk.
On completion of this chapter the candidate will have a basic understanding

of:
the nature of market risk

the different types of trading instruments and their financial features
the types of trading activities carried out by banks
the pricing and mark-to-market procedures for trading instruments
treasury risk and asset and liability management.
4.1 The nature of market risk
Market risk is defined as the risk of losses from on- and off-balance
sheet positions arising from movements in market prices. Banks that
hold positions in financial instruments on their balance sheet will be
subject to market risk to a greater or lesser extent. However, banks that
act as intermediaries in a transaction that is not booked on the bank’s
balance sheet will not be subject to market risk on that transaction.
Market risk is comprised of:
Specific risk which is the risk of an adverse movement in the price

of an individual security due to factors that only apply to that security
or issuer. An example would be the fall in the price of a bond
because the credit rating of the issuer had deteriorated (see Section
4.3.2). This information would specifically affect the bonds of this
issuer and would not affect bond prices in general.
© Global Association
Global Association of Risk Professionals,
of Risk Professionals, Inc. &Inc.
Badan Sertifikasi Manajemen Risiko B:3
Part B: Traded market risk management and regulation
General market risk (systematic risk) is the risk of an adverse

movement in market prices that are applied across a range of
instruments. For example, a reduction in official interest rates usually
causes a fall in market interest rates, which would affect the value of
all interest rate-related instruments.
General market risk is split into four main categories for purposes of
analysis. These categories are:
interest rate risk

equity position risk
foreign exchange risk
commodity position risk.
It should be noted, however, that each risk category is not mutually exclusive
because changes in the value of one risk could affect other types of market
risk.
Interest rate risk
Interest rate risk is the potential loss due to an adverse change in

interest rates. This is calculated for all instruments that use one or more
yield curves to calculate a market value (see Section 4.4.2).
Example Orange County
In December 1994 the government of Orange County, in the US state of

California, stunned the markets by announcing that its investment pool had
suffered a USD 1.6 billion loss. This was the largest loss ever recorded by a
local government authority in the US. The loss was the result of investments
by the county treasurer who was responsible for managing a portfolio of USD
1
7.5 billion belonging to county schools, cities and the county itself.
The treasurer’s investments in derivatives assumed that interest rates would

either fall or remain low. This investment strategy worked well until 1994
when the Federal Reserve Board instigated a series of interest rate increases
causing severe losses in Orange County’s investments. The investment pool
was liquidated in December 1994 realizing losses of USD 1.6 billion.
Soon after the liquidation interest rates fell by 2.5 percentage points which,
had the portfolio been maintained, would have reduced the losses. However,
at the time few market experts expected interest rates to fall so fast in 1995.
Equity position risk
Equity position risk is the potential loss due to an adverse change in

the price of stocks and shares. This is applied to all instruments that use
equity prices as part of their valuation.
1
Orange County Case: Using Value at Risk to Control Financial Risk.
Professor Philippe Jorion, www.gsm.uci.edu/~jorion/oc/case.html, April 2005.
B:4 Global Association of Risk Professionals, Inc.

© Global & Badan
Association Sertifikasi
of Risk Manajemen
Professionals, Inc. Risiko
Chapter 4: The nature of market risk
Example Morgan Grenfell Private Equity
In February 2001 it was reported in the Financial Times that Morgan Grenfell
Private Equity (MGPE) had made a loss of GBP 150 million on its holding of
2
shares in EM.TV, a stricken German media group. MGPE had acquired the
share originally as part of a transaction to sell its stake in Formula One in
return for shares in EM.TV. The shares in EM.TV subsequently fell by 90%.
Foreign exchange risk
Foreign exchange risk is the potential loss due to an adverse change in

foreign exchange rates. This risk applies to all exchange rate-related
products and positions valued in a different currency to the bank’s reporting
currency.
Example Telekomunikasi Indonesia
In August 1998 it was reported that Telekomunikasi Indonesia had incurred a

loss of USD 101 million, as a result of movements in foreign exchange rates.
The losses were due to borrowings of USD 306 million, JPY 11 billion and
FRF 130 million, each of which had been converted into rupiah, the local
currency. The devaluation of the rupiah against the US dollar, yen and
3
French franc, meant that the net cost of repayment increased dramatically.
Commodity position risk
Commodity position risk is the potential loss from an adverse change

in commodity prices. This applies to all commodity positions and any
derivative commodity positions.
Example Sumitomo Corporation
In 1996 Sumitomo Corporation discovered that a senior trader had been

carrying out unauthorized copper trades over a ten-year period. During this
4
time the trader lost Sumitomo Corporation USD 2.6 billion. According to
estimates at the time investment banks dealing in commodity derivatives had
collectively lost as much as USD 100 million as a result of the volatility in the
price of copper caused by the trader’s activities.
There are other types of market prices that relate to derivatives trading,
such as volatility rates, which will have the same risk profile as the
categories above.
Market prices are driven by a number of factors including:
supply and demand for a product will influence the short-term level of
its price because market makers adjust their prices to take account
2
See Financial Times, February 12, 2001.
3
Peachey, Alan. Great Financial Disasters of Our Time. Berlin: BERLIN
VERLAG Arno Spitz GmbH, 2002.
4
See Financial Times, May 25, 2000.
of market activity. The time it takes for the changes to take effect will
vary between markets and with the volume of business seen by the
market makers
liquidity can have a substantial effect on market prices. A liquid
market has a large number of market makers and supports a high
volume of business. Dealing spreads are small which means dealing
costs are lower for traders. Illiquid markets have wider spreads and
are not actively traded. Liquid markets could become illiquid before
public holidays or economic announcements
official intervention by the financial authorities may have an
immediate short-term effect on the level of prices in the market.
There may be longer term changes if, for instance, the intervention
signals a change in economic policy
arbitrage, whereby the level of one market price is set or constrained
by the level of one or more other market prices, will affect day-to-day
movements in prices. For instance, if a share is traded on the
London and New York stock markets and the price in London is
higher than the price in New York, traders would sell the share in the
London market and instantly buy the share in New York for an
immediate profit. This factor ensures that market prices are
consistent between markets such that, in general, it is not possible to
profit from trading one market against another. However, such
opportunities can arise for short periods of time
economic and political events together with natural disasters can
have dramatic short-term effects on market prices. Some effects may
be localized in certain markets while major events may affect world
markets as a whole
underlying economic factors are the strongest drivers of the long-
term level of market prices. For example, over the long term, the
level of the exchange rate between two countries will reflect the
relative inflation rates and the relative real economic performance of
each country. However many other short-term factors may make it
difficult to discern this relationship in any given period.
4.2 Trading activities
4.2.1 Development of trading activities
A bank’s trading operations buy and sell financial instruments in the

bank’s name. The aim is to make a short-term profit from a favorable
move in the market prices that determine the value of the instrument.
This activity also means the bank is at risk to losses should the value of
the financial instruments fall.
Banks may adopt one of three broad trading strategies for each product
that they trade. The strategy with the least market risk is when a bank
runs a ‘matched book’. A matched book strategy means the trading desk
matches all customer positions immediately with an equal and opposite

© Global & Badan
of Risk Manajemen
position by trading internally or with another bank. The only market risk
taken is the chance that market prices will move in the time between
executing the deal with the customer and executing the offsetting
transaction which is known as a ‘covering’ or ‘hedging’ transaction.
The second strategy is to manage positions in the product by executing

covering deals or hedging deals at the discretion of the trading desk. In
this strategy the trading desk would have a market risk limit in order to
control the risk the bank would have at any one time. The positions could
be taken because of customer transactions or by the traders creating
positions by dealing in the market. This strategy allows the traders to
time their position-taking activities to take advantage of favorable moves
in market prices.
The third strategy is to be a ‘market maker’ for a product. This means that the
traders will quote a buy and sell price to customers and other banks and trade
at the relevant price on whichever side of the market (buy or sell) the
counterparty chooses. This strategy relies both on the market being liquid and
there being a number of other market makers with whom the traders can
cover their risk.
A market maker that attracts buy and sell orders can make a profit from the
spread quoted between the buy and sell price. Market makers can also
benefit from the market information they get from the trades they are asked
to execute. This helps them predict future movements in market prices. The
risk in this strategy is that traders have to take positions that may quickly
incur a loss. It is important, both that traders are disciplined in the
management of the risk, and that the bank sets and monitors appropriate
limits.
Banks have tended to change strategy as their business grows, and there
will be more than one strategy in use across the products in a bank’s
trading book. Historically, many banks’ trading activities grew from their
desire to service their customers’ commercial activities. This can be seen in
the development of banks’ trading activities in the foreign exchange
markets. This market has become one of the most freely traded markets in
the world, but its origins can be traced back to the introduction of floating
exchange rates in the 1970s (see Chapter 2). For customers engaged in
international business, this created new risks which they managed through
the services offered by their bank.
Retail exchange rates are those given by banks to their customers

(primarily corporate customers) that include a margin over the wholesale
rate that is available in the interbank market. The margin was large in the
early stages of the market’s development. This meant that the banks’
income grew quickly with the increased market activity even though their
own positions were relatively small. As volumes increased further, and
banks became more confident in their ability to manage foreign exchange
positions, the activity changed from a customer driven service to a
wholesale trading operation.
Those banks with a large customer base and a large volume of foreign
exchange transactions were able to use these ‘retail’ positions to
influence short-term movements in the wholesale foreign exchange
market. This presented profit-making opportunities over and above the
margin available from customer business.
To exploit this opportunity banks began to hold larger positions in their

books. This process continued to develop and as competition increased,
margins on customer business decreased. As a result market volume in
the world’s major traded currencies, such as USD/EUR, USD/JPY and
USD/GBP, is now dominated by interbank trading with customer volume
accounting for a relatively small part of the market.
The development of the foreign exchange market is a good illustration of

how trading in any instrument tends to develop within a bank. The first
stage is where a bank will maintain a matched position in an instrument.
This means the bank deals with a customer and immediately hedges its risk
by entering into a transaction with another bank that perfectly matches the
customer transaction. The profit for the bank would come from the
difference in the price given to the customer and the interbank price. An
example is given below.
Example Foreign exchange matched position trading
Bank A is asked by a customer to buy US dollars and sell Japanese yen as it

wants to pay its Japanese supplier JPY 100 million.
Bank A does not hold yen so it asks for a quote to buy yen in the market. The
market rate is 100. The bank quotes a selling rate of 99 to its customer, sells
the yen, and receives USD 1,010,101.
It immediately buys the yen in the market at 100 and pays USD 1,000,000.
This leaves the bank with no market risk and a profit of USD 10,101.
The second stage in the development of a bank’s trading activity occurs

when the bank ‘holds’ the position created by the customer transaction
in anticipation of a favorable move (for the bank) in market prices over a
short-term period. The trader’s permitted holding period would lengthen
as the bank became more experienced in trading the instrument.
Ultimately, this development process will lead to the bank initiating a
trading position in anticipation of a move in market prices. At this point,
the trading activity is no longer dependent on customer activity.
4.2.2 Position management and hedging
Market risk occurs in the banking book as well as the trading book (see
Section 1.2.4). Positions held as part of the banking book, although not
held for trading purposes, will create market risk because they are
valued using current exchange and commodity rates. Management of

© Global & Badan
of Risk Manajemen
interest rate risk in the banking book is usually carried out by the bank’s
Treasury function.
Management of market risk in the trading book is carried out

continuously in bank dealing rooms by traders who are authorized to
take market risk positions up to the limits set by the bank. The traders
are authorized to execute deals in the bank’s name and commit the bank
to a financial liability. This activity must have rigorous controls
independent of the traders to ensure the bank has full knowledge of the
risks in its books.
Traders manage their risk by trading in instruments closely matching

their current risk position. However, this is not usually the most profitable
method of covering their risk; thus hedging techniques are often used.
Traders can ‘hedge’ their risks by taking an appropriate position in the
underlying instrument. However they could also hedge the portfolio risks
by taking a position in a different instrument.
The instrument may have different characteristics but changes in its

market value will mirror those of the original transaction. Therefore, for a
fully hedged portfolio any changes in market prices will produce little or
no change in the market value of the portfolio. Often, a number of hedge
positions will be required to match the underlying transaction completely.
Example Commodity hedge
A bank buys 25 tonnes of copper for delivery in four-months’ time. After a

month it becomes concerned that the price of copper could fall. To hedge
against this risk it sells a copper futures contract. This offsets the risk from
the bank’s future purchase of copper as it sets the price for selling the copper
in three-months’ time. The bank has now hedged against a movement in the
copper price by using a liquid futures contract.
Traders will regularly hedge with a more liquid instrument than the
underlying transaction so that they are able to execute their hedging
strategy quickly. In addition, dealing costs are generally lower in more
liquid markets, which helps reduce costs. Traders can hedge all or part
of their risk which allows them to create the risk position they feel will be
profitable without trading in the underlying instrument.
While customers often ask banks to provide underlying cash

transactions such as loans, hedging is usually carried out by using
derivative instruments. This is because in general derivatives have the
following advantages over cash instruments:
lower credit risk

lower funding requirement
lower capital charge
greater liquidity
lower dealing costs.
Hedging has many advantages but it does require careful management,

as the instruments used are not identical to the original transaction.
There will usually be some residual risk that is left uncovered and this
must be measured and controlled. In some cases, the interaction of the
hedge and the original risk position can create new risks for large trading
positions.
Basis risk is one of the most significant residual risks usually found in a
portfolio of similar deals. Basis risk is the risk of a change in the
relationship between the price of a risk position and the price of the
instrument used to hedge the risk position. Basis risk arises in situations
where the underlying market prices are different for each type of
instrument, but which are still very closely related. Where the divergence
in the daily movement of the different rates is generally small, a bank will
tend to hedge the general market movements and manage the basis risk
separately.
Example A US company has a loan from Bank A on which it is paying the Prime
lending rate. The Prime rate is a floating rate charged on loans to customers
with a high credit rating.
Bank A wishes to fix the rate on the loan as it feels rates are going to fall.
Bank A enters into an interest rate swap with Bank B to receive a fixed rate
and pay six-month LIBOR. It proposes to offset the Prime rate interest
received from the loan against the six-month LIBOR interest paid on the
swap. It believes the difference in the floating rates is compensated by the
favorable level of the fixed rate received from the swap.
This creates a basis risk because the difference between the Prime rate and
the six-month LIBOR rate will fluctuate over the life of the swap. Any changes
in the difference between the rates will have an impact on the revenue of
Bank A. The figure below shows the relationship of the rates over a three-
year period.
Figure 4.1 Difference between Prime rate and six-month LIBOR
4.2.3 New product development
Trading activities have become more complex as markets have become

more ‘liquid’ and sophisticated. In addition, some banks have felt the
need to trade a portfolio of instruments more widely than the demand
B : 10 Global Association of Risk Professionals, Inc.

© Global & Badan
of Risk Manajemen
generated by its customer base. This has led to banks buying in trading
expertise to expand their trading portfolio. It is important in these
circumstances that banks also invest in their control structures to ensure
that they have the expertise to manage the risks created by the new
trading activity. It can be tempting for a bank to move into a new market
without waiting for the development of an adequate control structure.
A key element in the inspection of a bank’s trading activities by its

supervisors will be the independence of its approval procedure for the
introduction of new trading products. It is important that there is a
rigorous approval procedure that involves all relevant departments within
the bank.
The approval procedure should address the following issues where

applicable:
regulatory approval – does the bank have approval for this product?
regulatory capital impact – how will the product affect the regulatory
capital requirement of the bank?
tax issues – will the product create new tax issues?
accounting procedures – can the bank account for the product within
its existing procedures?
legal and documentation procedures – have all the legal
requirements been satisfied and the documentation approved?
IT system requirements – will the current trading and settlement
systems need enhancing?
operational support – can the bank accurately book and manage the
settlement of the transactions?
risk management reporting – can the bank’s risk systems capture
and report the risk position created by the product?
pricing and valuation – has the pricing and mark-to-market procedure
been approved?
funding requirements – will the product make a significant impact on
the bank’s funding requirements?
credit risk implications – does the bank have sufficient credit lines to
support the product?
compliance procedures – will the product require the development of
new compliance procedures?
The questions raised above highlight the kinds of issues that a bank’s
management must consider when introducing a new product. Following
approval of a product it is important that the volume of trading is
monitored. This is to ensure that if the product is a business success, it
does not become a management problem.
Moving into new markets or products is often a sign that a bank’s trading
operation is successful and that it is looking to expand its portfolio to
increase its revenue. However, it is also a testing time for a bank’s
management as it may be necessary to curtail profitable business to
Badan Sertifikasi Manajemen Risiko B : 11
ensure that it maintains prudential control over the risks and the capital
required to support the new trading activity.
4.3 Trading instruments
4.3.1 Introduction
Trading instruments come in many types and ‘flavors’. For purposes of

the Certificate the common products that are, in terms of volume, the
main instruments traded globally. These are usually termed ‘vanilla’
products because they are plain with nothing complex added. However,
for every standard product there is also likely to be a complex version.
What is more, new products are continually being developed to meet
customer demand. For all the instruments discussed below, the main
currencies traded are the US dollar, euro, Japanese yen and the British
pound.
It is important for the student to recognize that the number of trading

instruments is constantly expanding or contracting to meet the demands
of the market. All products, no matter what their level of complexity, can
be broken down into their component risk factors. This may be achieved
by analyzing the pricing model or, alternatively, by observing the change
in value over a number of market price scenarios.
The definitions of the various instruments provided below describe the

risks generated by each instrument regardless of the underlying
currency. However all instruments valued in a currency other than a
bank’s reporting currency will generate foreign exchange risk.
4.3.2 Cash instruments
Foreign exchange transactions are a commitment to exchange one

currency for another at an agreed date in the future. The date of the
exchange will determine the type of deal and the market for it.
Spot foreign exchange transactions
Spot foreign exchange transactions are for exchange two business

days in the future, which is known as the ‘spot date’. The two-day
timeframe came into practice when settlement instructions between
banks were effected by telegraph and banks needed two days to ensure
that instructions could be issued and acted upon. Although settlement is
now carried out electronically, the two-day basis remains. The market for
spot transactions is perhaps the most liquid market in the world. Spot
transaction deals generate foreign exchange risk.

© Global & Badan
of Risk Manajemen
Forward foreign exchange transactions
Forward foreign exchange transactions are for exchange at an agreed

date later than the spot date. For example, a US company needs to pay
for a shipment of Japanese goods that is due in three-months’ time. It
must pay its supplier JPY 100 million. To ensure the US dollar cost of the
shipment, it agrees with its bank to buy JPY 100 million at the current
forward rate for three months which is 100. This fixes the cost of the
shipment at USD 1 million. In three-months’ time the company pays USD
1 million to the bank and receives JPY 100 million which it pays to its
supplier.
The forward market trades for maturities up to one year although some
banks quote prices for longer periods. Forward exchange transactions
create both exchange rate and interest rate risk. This is because the
forward exchange rate is determined by the relative level of the interest
rates between the two currencies, combined with the current spot
exchange rate.
Foreign exchange rate swap
A foreign exchange rate swap is a combination of a spot deal and a

forward deal. The two parties execute a spot deal at the spot rate and a
forward deal at the forward rate simultaneously for the same principal
amount of base currency. The difference in the two rates represents the
differential between the interest rates of the two currencies for the period
of the deal. Foreign exchange rate swaps generate interest rate risk. The
following example will illustrate why a foreign exchange transaction with
a value date in the future will generate interest rate risk.
Example Bank A could buy US dollars and sell Japanese yen for 90 days ahead at a
rate of 99.5 yen to the US dollar. Alternatively it could buy the dollars on the
spot date at a rate of 100.
If Bank A bought USD 10 million and sold JPY 1,000 million for delivery on
the spot date, and held the currency position for 90 days, the bank would
need to borrow JPY 1,000 million and lend USD 10 million for 90 days.
If the rate for the US dollar is 3% and for yen is 1% the interest flows would
be:
JPY 2,500,000 paid (1,000,000,000 x .01 x 90/360)

USD 75,000 received (10,000,000 x .03 x 90/360)
After 90 days the bank’s position would be:
‘Long’ USD 10,075,000 and ‘Short’ JPY 1,002,500,000
By dividing the yen position by the US dollar position an effective exchange

rate of 99.5 is obtained.
Example This is the forward rate the bank could have dealt at rather than entering into
continued a spot foreign exchange transaction together with a loan and a deposit.
The forward price is calculated from the interest rate differential to ensure that
there are no arbitrage (see Section 4.1) opportunities in the market.
Therefore the forward price is sensitive to any changes in either interest rate.
Loans and deposits
Loans and deposits are traded between banks at fixed interest rates for
an agreed period. Maturities range from overnight to five years. However
there are few trades that have a maturity of more than one year. Interest
is paid on the maturity date with the repayment of the principal unless the
maturity is over one year when an interest payment is made on each
anniversary of the transaction. The interbank money market is where
banks trade loans and deposits with each other. It is used by banks to
take positions in anticipation of a favorable movement in interest rates.
However much of the volume in the market is driven by banks needing to
match their funding requirements to maintain their liquidity positions.
(Liquidity positions are explained in a later Level of the Certificate.)
Loans and deposits generate interest rate risk.
Bonds
A bond is a transferable long-term debt instrument issued by a borrower

(issuer) on receipt of the principal amount from an investor (holder). The
bond issuer is obligated to pay the holder a specified amount of interest,
usually at regular intervals, during the life of the bond and repay the
principal, usually at maturity.
Bonds are issued by a variety of organizations and each bond represents

a financial claim on that organization. A ‘vanilla’ bond will normally pay
fixed interest, known as a ‘coupon’, on set dates during the life of the bond
with the principal repaid on maturity. The term ‘vanilla’ is used to indicate
a bond that has standard market features. However, bonds may also
incorporate many other financial incentives to encourage investors. The
price of the bond will be affected by the general level of interest rates and
the financial standing of the issuer. Ratings agencies, such as Moody’s
Investors Service and Standard & Poor’s produce a wide range of risk
sensitive grades which cover the credit risk of bonds (the financial
standing of the issuer). These range from AAA (bonds where the issuer’s
ability to pay interest and principal is very strong) to D (bonds are in
default). This is sometimes referred to as the credit rating of a bond.
Bonds generate general interest rate risk and specific risk. Non-vanilla
bonds may expose the holder to other types of risk such as liquidity risk.

© Global & Badan
of Risk Manajemen
Equity trading
Equity trading is the buying and selling of the shares of companies

quoted on recognized stock exchanges around the world. Ordinary
shares represent a stake in the ownership of a company. The holder will
expect to receive a regular dividend, which is paid from the profits made
by the company. The holder will also gain from an appreciation in the
value of the shares. Therefore the more successful the company the
better the return earned by the holder. The price of a share represents
the market perception of a company’s current value and the value of its
projected earnings. The price will fluctuate as the market adjusts its
valuation of the company in response to new information about the
company. Share positions generate general equity risk and specific risk.
Commodity trading
Commodity trading is the buying and selling of physical products that

are traded on secondary markets. These include agricultural products,
oil, and precious metals. Products are bought and sold for physical
delivery at a specified location on an agreed date. There is a spot and
forward market for many products and each product will have additional
features that relate directly to its physical properties.
An example of product specific features can be seen in the oil market. In

addition to crude oil, a number of products are traded in the oil market.
These products are produced by refining crude oil and each product has
its own market and price. In addition, location is very important to the
buyer. For example a tanker of crude oil in the US will have a different
value to a US buyer than a tanker of oil in Malaysia due to the different
demand/supply balance in each region and the cost of transporting the
oil between regions.
Commodity positions generate commodity risk and forward positions

have additional interest rate risk in the same way as the forward foreign
exchange contracts above.
4.3.3 Derivative instruments

Derivatives have grown to become a major constituent of market risk
over the last 20 years as banks have sought to create innovative
products for their customers. The products described so far are often
termed cash instruments, as they are the underlying instruments for
derivative products.
The key feature of most derivatives is that the principal amounts of the
transaction are not exchanged. This substantially reduces credit and
settlement risk. They are often called ‘contracts for difference’ as the only
exchange that takes place is the result of changes in the relative prices of
the underlying cash instruments. By reducing credit risk banks are able to
trade derivatives with many more counterparties than would be possible
with cash instruments. This in turn has made the market more liquid, which
has led to a growth in trading volume and the amount of risk taken.
Some derivatives are traded on futures exchanges and others are traded
on the so-called over-the-counter (OTC) market. The OTC market is
where banks trade directly with each other rather than through an
exchange. There are many types of ‘exotic’ derivatives that have a
combination of risk and payment profiles. However almost all of them
can be broken down into the vanilla products described below.
One of the most important types of derivative is futures contracts. Such

contracts are traded through an exchange, which acts as a clearing house for
all the counterparties. All trades are legally traded with the exchange. This
means banks are not exposed to credit risk with numerous counterparties but
only to the credit risk of the exchange itself. A futures contract delivers a
position in an underlying instrument at a date in the future. There are futures
contracts for most cash instruments from bonds to commodities.
In general, futures contracts have the following features:
exchange traded
fixed amount per contract
fixed dates for delivery
precise delivery conditions
daily margin calls.
Futures contracts are subject to the same risks as the underlying

instrument and there will be additional interest rate risk due to the future
delivery date.
Example A bond future, trading for delivery in December 2006 will be based on the
forward price of the underlying bond for the delivery date in December.
If the buyer holds the position until the delivery date, the seller will be obliged
to deliver the bond specified in the contract to the buyer. However physical
delivery rarely takes place in practice. This is because a cash settlement is
made for the difference between the price of the original futures contract and
the price on the delivery date.
Interest rate swaps
Interest rate swaps are an OTC derivative that allows banks and customers
to access long-term interest rates without having to use long-term funding.
Credit risk and liquidity requirements are a major constraint on a bank
providing long-term funds to customers. Conversely, many customers have
long-term projects that need long-term funding at a fixed rate. Interest rate
swaps provide a solution by allowing two counterparties to swap interest flows
without swapping principal amounts.

© Global & Badan
of Risk Manajemen
Interest rate swaps are traded for maturities of up to 30 years although

there is only a small volume of trades above 10 years. The maximum
maturity varies between currencies and depends on the underlying bond
market in the currency concerned. This is because bonds are used to
hedge swaps.
Vanilla swaps have a fixed interest rate that is ‘swapped’ against a

floating rate index such as one-month, three-month or six-month LIBOR.
This means that the parties agree to exchange the difference between
these two interest rates. Given that the LIBOR rate will change regularly
the net exchange will differ over time.
The interbank market mainly trades vanilla swaps but there are many
variations traded with end-users to match their requirements. One side
of the swap will be designed to match customers’ interest flows with the
other side set to match their funding requirements. Banks use a mixture
of hedging instruments to manage the interest rate risk created by a
swap. Interest rate swaps generate interest rate risk.
Example XYZ company obtains a loan from Bank A for two years paying a floating
interest rate set every six months at LIBOR. The company feels interest rates
will rise over the two-year period and wants to ‘lock in’ a fixed rate. However
Bank A does not wish to give the company a fixed rate loan. Therefore, the
company goes to Bank B and enters into an interest rate swap where the
company will pay to Bank B a fixed rate of 5% every six months calculated on
the same principal amount as the loan. In return, the bank will pay a floating
interest rate set every six months at LIBOR to the company.
The company is now paying LIBOR every six months on the loan and
receiving the same interest flow from the swap. This leaves the company with
net interest flows equal to the fixed rate of 5% being paid via the swap. There
is also the flow of principal on the loan but no principal flows on the swap as
only interest is exchanged.
Figure 4.2 below shows the interest flows from these transactions for XYZ
company.
Example Figure 4.2

continued
Currency swap
A currency swap has the same features as an interest rate swap except
that the interest flows are expressed in different currencies. This product
is used to swap, say, US dollar interest flows for euro flows. A key
difference between interest rate and currency swaps is that principal
amounts are exchanged for a currency swap at the spot rate. Currency
swaps generate interest rate risk in two currencies and foreign exchange
risk.
Forward rate agreements
Forward rate agreements (FRAs) are OTC derivative contracts that

allow banks to take positions in forward interest rates. The contract gives
the right to lend/borrow funds at a fixed rate for a specified period
starting in the future. There is no exchange of principal, and on maturity
a cash settlement is made for the difference between the rate of the
contract and the current LIBOR rate for the period. FRAs are the OTC
version of interest rate futures contracts and provide more flexibility than
futures. FRAs generate interest rate risk.
Option contracts
An option contract gives the buyer the right, but not the obligation, to
enter into an underlying contract at an agreed price. This means that the
underlying transaction will only be executed if the rate is favorable to the
buyer. The seller has an open-ended risk on the contract and receives a
premium in compensation. Option contracts introduce new risks over and
above the risk inherent in the underlying instruments. Options can be
created on almost any cash or derivative instrument and there are even
options on options.

© Global & Badan
of Risk Manajemen
The key terms used to describe options are:
Call – a call option gives the buyer the right to buy the underlying
instrument
Put – a put option gives the buyer the right to sell the underlying
instrument
Premium – sum paid to the seller by the buyer
Strike Price – price at which the underlying transaction will be
executed
Exercise – the buyer ‘exercises’ the option to enter into the
underlying contract
Expiry Date – the last date by which the option must be exercised
American – an option that can be exercised on any date up to the
expiry date
European – an option that can only be exercised on the expiry date.
Option pricing is based on the probability of the option being exercised.

To calculate the option value a volatility measure is used. The volatility
of the price is a market rate that reflects the market’s expectation of how
much the price will move in either direction over the life of the option.
The volatility used for pricing options is determined by the market and is
a risk in its own right. Option pricing is explained further in Section 4.4.
Options generate the risks inherent in the underlying instrument which is due
to be delivered if the option is exercised. In addition, options have volatility risk
and interest rate risk due to the future delivery date of the underlying
instrument. For instance an option on a bond has the same risks as the
underlying bond as well as a risk to changes in the volatility of the bond.
Example A Japanese company may need to buy USD 10 million in three months’ time
if it buys a US factory. It does not want to commit to buying USD 10 million
but it does need to protect itself from a rise in the US dollar so it decides to
buy an option.
Figure 4.3 illustrates how the cost of the factory in Japanese yen would vary
without the option contract. The figure shows that the company would lose
JPY 100 million if the spot rate moved up to 110.
Figure 4.3 Change in cost in yen without option
Example Figure 4.4 Possible outcomes if factory purchased

continued
If the purchase of the factory did not take place the company would be left
with the option. Figure 4.5 shows the possible values of the option for
different spot rates at expiry. If the rate had fallen at expiry the company
would lose the premium. If the rate had risen above 103 the company would
make a profit.
Figure 4.5 Option values if factory not purchased
4.4 Pricing and mark-to-market requirements
4.4.1 Pricing
One of the most important controls that a bank has at its disposal in
managing a trading operation is to ensure that its open trading positions are
valued daily using current market prices. The process of revaluing positions
using current market prices is called marking-to-market. To understand
what is required to mark positions to market we must first look at how
instruments are valued.
The pricing of financial instruments ranges from a simple single price

comparison to complex financial models with multiple inputs. Students

© Global & Badan
of Risk Manajemen
should note that for the purposes of the Certificate, the general
principles of pricing for the main trading instruments are discussed
below. However, we have not gone into the mathematical details of the
various models.
4.4.2 Yield curves
All financial instruments with future cash flows are valued by calculating
the present value of the future cash flows due under the instrument. The
present value of any future cash flow is calculated by discounting its
future value using current interest rates. Therefore, a market interest
rate is required for any date on which there is a cash flow. To calculate
the required market rate banks create a yield curve using a yield curve
model. The description below is simplified to illustrate the construction of
a yield curve. The yield curves used by traders are more complex and
are derived from a number of instruments to ensure the curve is
consistent.
The inputs for our simplified model will be the market interest rates for
discrete periods. The periods will be 1, 2, 3, 6 and 12 months and 2, 3, 5
and 10 years. The graph below shows the shape of the curve.
Figure 4.6 Yield curve
It can be seen that rates for the standard maturity dates can be observed
from the curve but any rates for other dates must be calculated from the
input rates. This process is called ‘interpolation’.
The value of interest rate-related products, as well as all products with cash
flows at a future date, will be sensitive to changes in the yield curve. A
product’s value may be sensitive to changes in one or more of the yield
curve rates depending on the maturity and financial properties of the
instrument.
In practice, each major currency will have a number of yield curves in

use at the same time. The difference between the curves will primarily
be the difference in the underlying instruments used to create the

discrete points. The main types of interest rate-related yield curves are:
Cash – these are used to revalue loan and deposit positions. The
points on the curve are defined by the standard maturity dates traded
in the interbank market
Derivative – these curves are used to value all types of derivatives
including options. The points on the curve are determined by a
mixture of instruments beginning with cash rates at the short
maturities followed by futures contracts. Finally, long-term rates are
determined by swap rates for the standard traded periods. The
mixture of instruments is closely related to the underlying hedge
instruments used by banks to hedge derivative risk
Bond – bonds are valued on a price basis by taking the closing price
for the day. However, some bonds are not actively traded and may
not trade each day. Banks may use a bond curve to derive a notional
closing price from the closing price of actively traded bonds. The
curve is usually defined by the standard maturities traded in the
government bond market. Bonds may then be valued as a spread
over the corresponding government benchmark bond when a market
price cannot be obtained. This reflects differences in the liquidity of
the bond and the credit standing of the issuer
Basis – not all interest rates are actively traded in the interbank
market and primarily exist for historical reasons or to service
customer demands. The rate set by the central bank for discounting
bills (known as the Base Rate in the UK) is a good example. Basis
curves are created to price instruments in these non-interbank based
rates. A curve is usually expressed as a spread over or under a
standard curve. Each point on the curve will have a unique interest
rate differential to its corresponding maturity on the standard curve.
4.4.3 Bonds, equities, commodities and foreign exchange
Bond, equity, spot foreign exchange and spot commodity transactions

are valued by taking the difference between the original traded price and
the current market price.
Forward foreign exchange rates are created by adjusting the current

spot rate by the appropriate forward margin. An approximate margin can
be calculated using the formula below:
Forward margin = Spot x Interest differential x Time / (Days in year

x100)
Interest differential is the absolute difference between the base

currency and the foreign currency
Time is time to maturity in days
Days in year is usually taken as 360 by convention but 365 is used
for some currencies.

© Global & Badan
of Risk Manajemen
Example USD/JPY is quoted as the number of yen per one US dollar. This means yen
is the foreign currency and US dollars the base currency.
Let us assume:
Spot rate = 105

JPY one-month rate = 1%
USD one-month rate = 4%
Time to maturity = 30 days
Number of days in the year = 360
Forward margin = 0.2625 (105.00 x (4 – 1) x 30 / 36000)
This can be proved by looking at the equivalent interest flows:
At spot USD 1,000,000 JPY 105,000,000 = 105

Interest due USD 3,333.33 JPY 87,500
At maturity USD 1,003,333.33 JPY 105,087,500 = 104.74
Forward margin = - 0.26 (104.74 – 105)
Forward margins are actively traded in the interbank market. There are
quoted margins for standard periods much the same as for a yield curve.
Margins for dates in between the standard dates are found by
interpolation. Forward transactions are valued by comparing the original
margin to the current margin.
4.4.4 Options
Option pricing is a complex subject that is outside the scope of the

Certificate. The following description is simplified to give an outline of the
steps involved in pricing an option.
In simple terms, option pricing is based on the probability that the option
will have some value at maturity. The key determinants of the value of
the option are:
the level of the strike price relative to the current market price. If the
strike price is equal to the current market price the option is expected
to have a 50% chance of having value at maturity as it is considered
that there is an even chance of the exchange rate rising or falling
the time to maturity. The longer the time to maturity the higher the
premium as the option has more time to become valuable
interest rate applicable to the time to maturity
how volatile the market price is. The more volatile the price the
higher the premium.
The figure below shows the range of possible exchange rates for a
JPY/USD foreign exchange rate option to buy US dollars at a strike price
of 105 against Japanese yen. The current exchange rate is 100. Various
maturities up to 12 months and three different volatilities are shown for
comparison.
Figure 4.7 Call option strike 105
Figure 4.7 shows that higher volatilities and/or a longer maturity give the
option a greater chance of having some value at expiry. This higher
probability will be reflected in the cost of the option.
The strike price and the time to maturity are chosen by the buyer of the
option. Volatility is a statistical measure that can be obtained from
historical price movements. However, as is so often the case, history is
not always a good prediction of the future, and so the market uses
expected volatility rates. Volatilities vary by maturity and are expressed
as a curve using the same periods as a yield curve.
Figure 4.8 shows historical market volatilities for USD/JPY foreign

exchange options.
Figure 4.8 US dollar/yen foreign exchange option volatilities
Market volatility rates are entered into the option pricing formula along
with the current market prices for the underlying instrument to calculate
the current market value of the option.

© Global & Badan
of Risk Manajemen
4.4.5 Mark-to-market process

In large trading operations positions will change minute to minute as
traders manage their risk positions. Therefore it is important that the
senior management of a bank has a robust mark-to-market procedure in
place to monitor traders’ performances.
This is usually a daily process where a department, independent of the

traders, will obtain and verify market prices for all the instruments held in
the trading book. For any market where trades are made direct with
counterparties, closing prices will be obtained from brokers who are
active in the relevant markets. Brokers are independent of the banks
and, by the nature of their business, know the current market price.
Some prices may be obtained from official fixing rates which are set
daily. An important example of this is the daily fixing of LIBOR interest
rates by the British Bankers’ Association in London. These rates are
used to settle many derivatives contracts as well as for historical
analysis. Official ‘fixings’ occur in many centers around the world for
different types of rates.
In addition to brokers and official fixings, closing rates for some

instruments are obtained from official exchanges for some instruments.
For example, equity closing prices are officially set by the stock
exchange on which the share is quoted. These are used to mark-to-
market equity positions. Futures contracts and options on futures are
traded on futures exchanges around the world. Each exchange sets an
official closing price each day which is used to revalue all positions.
Futures contracts are traded for interest rates, foreign exchange, bonds,
commodities, energy and stock market indices. Futures exchanges are
constantly developing new contracts to meet changing market demand.
The mark-to-market procedure will consist of collecting and verifying the

prices and entering them into the bank’s revaluation system. The system
will then calculate a value for each instrument, which will be recorded in
the bank’s books. The current value is also called the replacement
value because it represents what the bank would have to pay if it
needed to replace the transaction at current market prices. Often the
system will also calculate the current risk positions generated by the
instruments revalued, although this is sometimes carried out by a
separate risk system.
The current value of a transaction is used for a number of purposes:
profit and loss calculations are made by comparing the current

values to the original values
counterparty credit risk calculations are made by analyzing the current
values of all deals with the same counterparty (See Chapter 2)
collateral calculations for OTC transactions use the current values of

instruments held as collateral to ensure they are sufficient when
compared to the exposure to a counterparty
margin calls by futures exchanges are based on the current market
value. ‘Margin’ is similar to collateral payments on OTC transactions
for cash settled instruments the final market value is used to settle
the transaction with the counterparty.
4.5 The nature of treasury risk
Treasury risk is defined as the risk of loss in the activities of a bank’s

Treasury and therefore depends on the risk management function of the
Treasury itself. While the role of a Treasury varies from bank to bank, it
normally includes the management of risks such as interest rate risk in
the banking book and liquidity risk.
In practice the functions of a bank’s Treasury can often include the

bank’s own trading activities. They are therefore excluded from the
definition of treasury risk given above which reflects the treasury
structure of banks with diverse businesses. Such banks often have their
trading business separate from their capital and liquidity management
activities, which tend to be carried out by the Treasury. This type of
treasury model is generally described as a ‘Corporate Treasury’.
The exact role of a Treasury, even when it does not include the bank’s
trading activities, depends on the business model adopted. For example,
in addition to the functions listed above a Treasury may also manage
other risks, such as the currency risk of overseas subsidiaries, both from
the profit and loss perspective as well as the capital management
perspective.
A Treasury may thus manage a large variety of risks in its treasury risk
management function; however the Certificate will only cover:
interest rate risk in the banking book, the most common form of
market risk in the banking book
liquidity risk, and
capital management.
All the above risks and a number of other related issues (such as asset
and liability funding concentrations, access to central bank liquidity,
payment systems collateral requirements, etc.) are likely to be
encompassed by what is called asset and liability management.

© Global & Badan
of Risk Manajemen
4.6 Asset and liability management
In most banks asset and liability management has the primary objective
of managing interest rate risk in the bank's balance sheet and ensuring
that the interest rate risk inherent in the bank’s underlying business does
not disrupt the production of a stable income stream over time.
This income stream is often largely represented by the net interest

income (NII) of the bank. NII is the difference between the interest cost of
raising deposits (and other liabilities) and the interest charged on loans
(and other assets). The current value (net present value) of the stream of
NII over time is the major contributor to the value of the bank, Thus the
NII stabilization objective may also be expressed as the stabilization of
business value over time, a description most commonly used in the US.
The emphasis a bank places on either of the two (very closely related)
objectives – managing risk or stabilizing business value – often depends
on the management accounting practices that it follows, i.e. the reports
primarily reflect either the management of income or value.
Management accounting constitutes a reporting structure based on

financial information that reflects the way the management of a bank
sees the business. In contrast, statutory financial accounts, (e.g. profit
and loss accounts and the balance sheet) must be prepared in
accordance with statutory reporting standards and must comply with
national accounting standards. Management accounting practices,
however, are often heavily influenced by the financial accounting
standards followed by the country where the bank is incorporated. A
detailed discussion of international accounting methods and standards is
beyond the scope of the Certificate.
Prior to discussing the activities within ALM (treasury risk management)

it is important for the student to understand the main risks it covers:
interest rate risk in the banking book and liquidity risk.
4.6.1 Interest rate risk in the banking book

Banking book market risk is the risk of loss where a bank is exposed to
the risk of market rates changing because of the underlying structure of
its business, such as its lending and deposit taking activities. Interest
rate risk in the banking book is the risk of loss due to adverse changes
in interest rates.
Interest rate risk in the banking book primarily results from the type of
business a bank undertakes with its commercial and retail customers.
Example Bank H offers its personal (retail) customers mortgages at interest rates fixed
every five years. This gives customers a mortgage at a fixed repayment rate
for a significant period and proves to be popular.
Bank H does not take customer deposits on a similar basis as most of its
deposits only have a very short contractual maturity. For example, deposits
that may be withdrawn on demand or after 30 days’ notice are the bank’s
most common deposit product. As a result the bank pays a one-month
market rate for these deposits.
Bank H is therefore running a business that has a significant amount of

interest rate risk. It is receiving the fixed five-year rate from its mortgage
customers and paying the one-month rate to its depositors. Unless Bank H’s
Treasury manages this risk in the wholesale financial markets, if interest rates
rise across the yield curve, the bank will have to pay more for its deposits
within a period of at most 30 days, but will not be able to increase all its
mortgage rates for up to five years.
The actual cost to Bank H will greatly depend on the average time to the
repricing of the mortgages. For example, the bank might have made some of
these loans four years and 364 days ago and will only have to wait one day
to raise the interest rate. However, it might also have made some of the loans
yesterday and therefore would have to wait four years and 364 days before it
could raise the interest rate on these loans.
The dangers of not managing interest rate risk in the banking book were
highlighted in the example of the American savings and loan crisis.
Example American savings and loan associations
The American savings and loan associations (S&Ls) are essentially mortgage
lenders, with the ability in some states to make direct investments to own
other businesses and carry out property development.
Until the 1980s they were mainly mutual associations owned by their
members; however, as a result of the financial disasters (described below)
they are now primarily owned by the federal government or by stockholders.
While estimating the total cost of the bailout of the S&Ls is difficult, some
reports put the figure as high as USD 500 billion. Although there were many
instances of fraud, the root cause of the disaster was twofold.
First, mortgages were issued on properties with greatly inflated prices. When
the property market collapsed the security on many mortgages was wiped
out. Second, although interest rates on a large number of mortgages were
fixed, many customers could repay their mortgages early without penalty
enabling them to refinance their mortgages at a lower cost when interest
rates started to fall. Unfortunately lenders were still locked into paying higher
interest rates on the borrowings they raised to fund the original mortgages.
This mismatched position of being locked into paying a higher rate for funds,
with the only source of income being new mortgages issued at lower rates,
caused many S&Ls to collapse with losses of billions of dollars.

© Global & Badan
of Risk Manajemen
Interest rate risk in the banking book is not covered in any detail in the
Basel II Accord. However in July 2004, the month after the Basel
Committee published “International Convergence of Capital
Measurement and Capital Standards: a Revised Framework”, it
published "Principles for the Management and Supervision of Interest
Rate Risk”. As its name suggests the paper primarily focuses on the
management of interest rate risk including that held in the banking book.
4.6.2 Asset and liability management activities
Asset and liability management is not just concerned with managing risk
and stabilizing business value. It is also concerned with:
maintaining the desired liquidity structure of the business

other issues which may affect a bank’s balance sheet shape and
structure, and
issues that may impact the stability of income over time.
There are numerous issues that can result in a need to balance the
shape and structure of a bank’s balance sheet. Many of these are
related to the problems generated by international banks that have
capital structures dominated by their home currency, but whose earnings
and many of their assets and liabilities are in other currencies. This can
introduce foreign exchange risk (see Section 4.1) into the bank’s
earnings. For example:
the present and future profits from overseas operations may be

volatile when translated into the bank’s domestic currency due to
changes in the exchange rate
the domestic currency capital allocated to overseas operations
support the foreign currency asset structure. This can produce a
volatile capital to assets ratio as exchange rates change.
Asset and liability management is often described as using risk

management techniques employed by bond portfolio managers and
applying them to the repricing of interest rates on retail assets and
liabilities. While in many ways this is true, the asset and liability
manager has to recognize that:
a commercial bank's balance sheet is not a stable collection of

assets and liabilities (new loans and deposits are continuously being
made and others mature)
repricing of the assets and liabilities in a commercial bank's balance
sheet is not all contractual, (there are often significant timing
differences between changes in market rates and changes in the
interest rates charged/rewarded on retail products)
there is frequently little or no correlation between retail products and
wholesale rates for pricing assets and liabilities (many marketing
issues impinge on the repricing of retail products that do not affect
wholesale products)
retail products frequently include embedded options which are often

not rationally exercised (retail customers usually have rights to
terminate contracts on very different terms than are common in
wholesale markets).
There are several reasons why a commercial bank with a significant

number of retail customers may find its balance sheet shape and
structure difficult to manage. They include:
commercial banks are often driven by relationship considerations not

simply contractual obligations, i.e. they are customer focused
attracting and retaining customers often involves offering retail
products whose features are different from wholesale market
products. Thus they are difficult to sell on into the wholesale markets
or difficult to risk manage using wholesale products.
pricing of retail products often has more to do with marketing
considerations rather than market price
the way retail customers behave in relation to the retail banking
products they hold often results in the apparent contractual
obligations of the parties providing a poor description of the actual
nature of the obligations. For example it may be contractually
possible to withdraw funds from a savings account on 30 days’
notice, but the customer has a right to leave the money on account
indefinitely. The balance on such accounts may behave more like a
three-year deposit account than either a 30-day deposit account or a
perpetual account.
It is often these inter-related customer and product behavior features

that give rise to the need to monitor and manage the stability of net
interest income (or present value of the business) and the liquidity of
these balances.

© Global & Badan
of Risk Manajemen
Sample questions
1. A forward foreign exchange transaction generates:
a) Foreign exchange risk only c) Foreign exchange risk and

interest rate risk
b) Interest rate risk only d) No risk
2. Banks make a profit from matched positions by:
a) Holding risk positions until c) Charging fees to the customer

market prices move
favorably
b) Earning interest on d) Charging a less favorable price
regulatory capital to the customer than the
current market price
3. The value of a future cash flow is sensitive to changes in:
a) Interest rates c) Equity prices

b) Volatility rates d) Commodity prices
4. A bank’s equity positions are officially valued against the:
a) Last price traded by the c) Stock exchange closing price

bank
b) Brokers real-time prices d) Trader’s price
5. Banking book market risk is primarily concerned with the management

of:
a) Foreign exchange c) Liquidity

b) Capital structure d) Interest rate risk
Answers can be found in the Appendix.
Summary
This chapter has introduced a number of key concepts and issues

involved in the nature of market risk and treasury risk. Students should
review this summary before proceeding.
The nature of market risk
Market risk is defined as the risk of losses from on- and off-balance
sheet positions arising from movements in market prices.
Specific risk is the risk of an adverse movement in the price of an
individual security due to factors that only apply to that security or
issuer.
General market risk is the risk of an adverse movement in market
prices that is applied across a range of instruments.
General risk is split into four risk categories:
- interest rate
- foreign exchange
- equity
- commodity.
Trading activities
The trading strategy with the least market risk is when a bank runs a
matched book.
Another strategy is to manage positions in the product by executing
‘covering’ deals or ‘hedging’ deals at the discretion of the trading
desk.
A market maker will quote a buy and sell price to customers and
other banks and trade on whichever price the counterparty chooses.
To hedge their risk position traders will take a position in a different
instrument. The instrument may have different characteristics, but
changes in its market value will mirror those of the original
transaction.
Hedging has many advantages but it does require careful
management, as the instruments used are not identical to the
original transaction. This means there will usually be some residual
risk that is left uncovered and this must be measured and controlled.
It is important that there is a rigorous approval procedure for the
introduction of new products that involves all the relevant
departments in a bank.
Trading instruments
Spot foreign exchange transactions generate foreign exchange risk.

Forward foreign exchange transactions generate foreign exchange
and interest rate risk. Foreign exchange swaps generate interest rate
risk.
Loans and deposits generate interest rate risk.

© Global & Badan
of Risk Manajemen
‘Vanilla’ bonds generate interest rate risk.

Share positions generate general equity risk and specific risk.
Physical commodity positions generate commodity risk and forward
positions have additional interest rate risk.
Interest rate swaps generate interest rate risk.
Currency swaps generate foreign exchange and interest rate risk.
Forward rate agreements generate interest rate risk.
Options generate the risks inherent in the underlying instrument
which is due to be delivered if the option is exercised. In addition,
options have volatility risk and interest rate risk due to the future
delivery date of the underlying instrument.
Pricing and mark-to-market requirements
All financial instruments with future cash flows are valued by

calculating the present value of the future cash flows due under the
instrument.
The value of interest rate-related products and all products with cash
flows at a future date will be sensitive to changes in the yield curve.
There are four main types of yield curve in the major currencies:
Cash, Derivative, Bond and Basis.
Option pricing is based on the probability that the option will have
some value at maturity.
The key determinants of the value of an option are its strike price,
maturity and volatility.
It is important that the senior management of a bank have a robust
mark-to-market procedure in place to monitor traders’ performances.
The current value of a transaction is also called the replacement
value because it represents what the bank would have to pay if it
needed to replace the transaction at current market prices.
The nature of treasury risk
Treasury risk is defined as the risk of loss in the activities of a bank’s

Treasury, and therefore depends on the risk management function of
the Treasury itself.
While treasury functions can vary from bank to bank, they normally
include the management of risks such as interest rate risk in the
banking book and liquidity risk.
Asset and liability management
Asset and liability management in most banks has the primary

objective of managing interest rate risk in the bank's balance sheet
and ensuring that the interest rate risk inherent in the bank’s
underlying business does not disrupt the production of a stable
income stream over time.
The emphasis a bank places on either of the two (very closely
related) objectives – managing risk or stabilizing business value –
often depends on the management accounting practices that it

follows.
Management accounting practices are often heavily influenced by
the financial accounting standards followed by the country where the
bank is incorporated.
Interest rate risk in the banking book is the risk of loss due to
adverse changes in interest rates.
Asset and liability management is concerned with
- managing risk
- stabilizing business value
- maintaining the desired liquidity structure of the business
- other issues which may affect a bank’s balance sheet shape and
structure, and
- issues that may impact the stability of income over time.
There are several reasons why a commercial bank with a significant
number of retail customers may find its balance sheet shape and
structure difficult to manage.

© Global & Badan
of Risk Manajemen

04 - Ind - L1 - ch4 - July06

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

04 - Ind - L1 - ch4 - July06

Uploaded by

Copyright:

Available Formats

Part B

An introduction to market, credit and operational risk

This chapter provides an introduction to the nature of market and

This chapter will help students gain an understanding of the underlying

Students will also gain an understanding of the concepts involved in

On completion of this chapter the candidate will have a basic understanding

the nature of market risk

4.1 The nature of market risk

Market risk is comprised of:

Specific risk which is the risk of an adverse movement in the price

General market risk (systematic risk) is the risk of an adverse

interest rate risk

Interest rate risk

Interest rate risk is the potential loss due to an adverse change in

Example Orange County

In December 1994 the government of Orange County, in the US state of

The treasurer’s investments in derivatives assumed that interest rates would

Equity position risk

Equity position risk is the potential loss due to an adverse change in

B:4 Global Association of Risk Professionals, Inc.

Example Morgan Grenfell Private Equity

Foreign exchange risk

Foreign exchange risk is the potential loss due to an adverse change in

Example Telekomunikasi Indonesia

In August 1998 it was reported that Telekomunikasi Indonesia had incurred a

Commodity position risk

Commodity position risk is the potential loss from an adverse change

Example Sumitomo Corporation

In 1996 Sumitomo Corporation discovered that a senior trader had been

Market prices are driven by a number of factors including:

4.2 Trading activities

4.2.1 Development of trading activities

A bank’s trading operations buy and sell financial instruments in the

B:6 Global Association of Risk Professionals, Inc.

The second strategy is to manage positions in the product by executing

Retail exchange rates are those given by banks to their customers

To exploit this opportunity banks began to hold larger positions in their

The development of the foreign exchange market is a good illustration of

Example Foreign exchange matched position trading

Bank A is asked by a customer to buy US dollars and sell Japanese yen as it

The second stage in the development of a bank’s trading activity occurs

4.2.2 Position management and hedging

B:8 Global Association of Risk Professionals, Inc.

Management of market risk in the trading book is carried out

Traders manage their risk by trading in instruments closely matching

The instrument may have different characteristics but changes in its

Example Commodity hedge

A bank buys 25 tonnes of copper for delivery in four-months’ time. After a

While customers often ask banks to provide underlying cash

lower credit risk

Hedging has many advantages but it does require careful management,

Figure 4.1 Difference between Prime rate and six-month LIBOR

4.2.3 New product development

Trading activities have become more complex as markets have become

B : 10 Global Association of Risk Professionals, Inc.

A key element in the inspection of a bank’s trading activities by its

The approval procedure should address the following issues where

4.3 Trading instruments

Trading instruments come in many types and ‘flavors’. For purposes of

It is important for the student to recognize that the number of trading

The definitions of the various instruments provided below describe the

4.3.2 Cash instruments

Foreign exchange transactions are a commitment to exchange one