Market Risk

CAIIB

Bank Financial Management

Module B

Risk Management
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 Market Risk

Marketing Risk: Market risk is the risk of adverse deviations of the

mark-to-market value of the trading porfolio,due to market movement.

Earnings for the market portfolio are profit and loss (P&L) arising from
transaction. The P&L between two dates is the variation of the market
value. Any decline in value, results in a market loss.

Trading Liquidity Risk: It arise due to not attracting the attention of

other market participants which affecting Market Prices.

Asset liquidation risk It refers to a situation where a specific asset

faces lack of trading liquidity.

Market liquidation risk refers to a situation when there is a general

liquidity crunch in the market and it affects trading liquidity adversely.
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 Market Risk

3. Credit and Counterparty Risks:

Credit risk may arise either on account of default of the borrower
or because of rating migration.

Counterparty Risk:
'Hold to maturity' view, the potential future values over their life is
the credit risk exposure because they are the value of all future
flows that the defaulted counterparty will not pay.

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 Market Risk

Market Risk Management Framework:

1. Risk Identification
2. Risk Measurement
3. Risk Monitoring and control
4. Risk Mitigation

An effective market risk management framework in a bank

comprises risk identification, setting up of limits and triggers, risk
monitoring, models of analysis that value positions or measure
market risk, risk reporting, etc.

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 Market Risk
Organisation structure:

1.The Board of Directors

2. The Risk Management Committee
2. The Asset-liablity management committee (ALCO)
4. The ALM support group/Market Risk Group
5. The Middle office

Risk Identification:

There is proper risk identification is require. When product

approved at corporate level shall provide for screening
procedures, appropriate safeguards, product-wise limit on
exposure and necessary guidelines in risk taking.
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 Market Risk
Risk Measurement:
It is depend on quantitative measures of risk Like:

1. Sensitivity: Sensitivity is measured as change in market value

due to unit change in the variable.Sensitivity measure based on
changes in interest rates like 1% change.

These included two measures like

a. Basis Point Value(BPV)

Change in value due to 1 basis point (0.01%) change in market
yield. This is used as a measure of risk.

The higher the BPV of a bond, higher is the risk associated with
the bond.
Example: Page No: 244
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 Market Risk

1 A 5-year 6% semi-annual bond @ market yield of 8%, having a price of Rs. 9

2, falls to Rs. 91.80 at a yield of 8.10%, what is Basis Point Value (BPV)?*

1) Rs. 0.20 2) Rs. 0.10 3) Rs. 0.02 4) Rs. 0.05

2. When the market value of a portfolio changes by Rs. 200000 when there is
2% increase in rate of interest, what is the sensitivity?*

1) Rs. 200000 2) Rs. 100000 3) Rs. 400000 4) Rs. 50000

Ans: 1–3 2-2

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 Market Risk
Duration:

Mc Cauley's Duration = Modified Duration * Yield Change

• Here, Yield Change = (1+ Yield)

Example : Page no. 256

Also,
% change in price = Modified duration * Yield change.

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 Market Risk
2. Downside Potential:
It is only captures possible losses ignoring profit potential.
Downside risk is the most comprehensive measure of risk as it
integrates sensitivity and volitility with the adverse effect of
uncertainty.

Downside Potential include VaR as measurement:

Value at Risk (VaR): VaR is defined as the predicted worst-case

loss at a specific confidence level cover over a certain periodof
time assuming ' Normal Trading Conditions'

VaR is used to measure and manage market risks in trading

portfolio and investment portfolio. (Example Page no:245)

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 Market Risk

Relationship between Yield vs Price Volatility:

Yield Volatility is degree of variance of yeild
Price volatility is degree of variance in price.

So,
Price volatility = (Yield volatility * Basis Point Value * Yield )/Price
.

3. Back Testing: Back testing is a process where model based

VaR is compared with the actual performance of the portfolio.
This is carried out for evaluating a new model or to assess the
accuracy of existing models.
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 Market Risk
4. Stress Testing: Stress test takes into account the worst-case
scenario. Stress testing cover 4 types of techniques:

1.Simple Sensitivity test.- It is short-term impact on a portfolio's

value due to market risk factors.
2. Scenario Analysis- It is specifies the shocks that might affect
a number of market risk factors simultaneously if an extreme,but
possible event occur It is based on historical data. It is currently b
est and leading stress testing technique.
3. Maximum Loss- It assesses the risks of a portfolio by identifyi
ng the most potentialy damaging combination of moves of market
risk factors.
4. Extreme value theory - This theory is a means to better captu
re the risk of loss in extreme but possible circumstances. it shows
very high and low potential values.
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 Market Risk

Risk Monitoring and Control:

It can be done by limit and triggers (Stop-loss)

Accrual portfolios are measured daily. Where market risk is not

measured daily.

Decide Triggers or stop-loss in advances for marke risk control.

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 Market Risk

Risk Mitigation:
Risk mitigation measures aim to reduce downside variability in
net cash flow but it also reduces upside potential or profit
potential simultaneously.

There is 3 strategies for mitigation of risk.

a. Strategies using sensitivity measures: Example Pg. No: 252

b. Strategies using correlation Measures:Example Pg. No: 253
c. Strategies using Market Instruments: It is done by hedge market risk
. like option.

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 Market Risk

Thank You

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