Market Risk

By Prof. Divya Gupta

 Market Risk
 Market risk may be defined as the possibility
of loss to a bank caused by changes in market
variables.
 The BIS defines market risk as the risk that the
value of on-or-off balance sheet positions will
be adversely affected by movements in equity
and interest rate markets, currency exchange
rates and commodity prices.
 Need of Market Risk for banks in
India:
 A small change in market variables causes
substantial changes in income & economic
values of banks.
 Introduction of new products such as
Derivatives has made the market risk
management a critical important function for
the banks today.
 Components – Market Risk:
 Liquidity risk
 Interest rate risk
 Foreign Exchange risk
 Equity Price risk
 Commodity Price risk
 Liquidity risk
 Liquidity of a financial institution is its ability to fund
increases in assets and meet payment obligations, as they
fall due, both efficiently and economically.
 Liquidity management in a bank has essentially four
important functions:
a) It demonstrates to the market place that the bank is safe and
therefore capable of repaying its borrowings.
b) It enables bank to meet its prior loan commitments.
c) It enables bank to avoid unprofitable sale of assets.
d) It reduces need to resort to borrowings from the central bank
 Interest Rate Risk
 Interest rate risk as far as financial institution is
concerned, is the risk that the value of its assets and
liabilities as also its net interest income may get
adversely affected on account on movements in
interest rates.
 Types of Interest rate risks are:
a) Gap risk/mismatch risk
b) Basis risk
c) Price risk
d) Reinvestment Risk
e) Embedded option risk
 Example :
 Suppose a bank borrows Rs.100 crores form
the market for 2 years @ 10% p.a. and create
assets of the same amount for 5 years period
@12 % p.a. First there is a mismatch risk and
in case there is upward trend of interest rate
and the cost of liability goes up at 13% the
bank will post a loss of Rs1 crore.
 Foreign Exchange Risk
 Foreign exchange risk is the risk arising from a
foreign currency exposure.

 It may be defined as the risk that a bank may

suffer losses as a result of adverse exchange
rate movements during a period in which it has
an open position.
 Example
 A US FI gives a loan to an Indian company in
rupee. If the INR depreciates in value to USD,
the principle and interest payments to US FI
would be devalued in dollars. The situation
will reverse if Indian company takes the loan
in USD.
 Other Risks
 Equity Price Risk
Changes in the equity prices can result in losses to the
bank holding an equity portfolio.

Commodity Price Risk

Commodity is defined as a physical product which is or can be
traded on a secondary market. Commodity markets may also
be less liquid and as a result changes in supply and demand
conditions can make the market volatile making effective
hedging of the commodities risk rather difficult.
 Management of Liquidity Risk
 Need for managing liquidity risk

 Dimensions of Liquidity risk

Funding risk
Time risk
Call risk
 Management of Liquidity Risk
 Management of Liquidity Risk
The key ratios adopted across the banking
system are:
a) Loan to total assets
b) Loan to core deposits
c) Loan losses/net loans
d) Purchased funds to total assets
 Management of Interest Rate Risk
 Dedication
 Rate Anticipation
 Swaps
 Caps
 Floors
 Forward rate agreement
 Futures
 Options
Dedication:
 Effect of interest rate change on the value of the asset:

 Suppose a bank holding a bond of Rs.100 has

a coupon of 10% payable annually and tenure
of one year. The current yield to maturity of
same category bond is 11%. The change in
value of the bond will be the loss.
 MVE

(∆E) = (∆A) - (∆L)

Change in Market Equity = Change in Market
value of Assets – Change in Market value of
Liabilities
The method of valuing the securites of a bank at
the market value is known as Marking to
Market (MTM) method.
 Management of Foreign Exchange
Risk
 Internal Techniques
Netting
Invoice
 External Techniques

Forward contracts
Currency futures
Options
Swaps
 Management of Equity Risk
 Formulate a transparent policy and procedure
for investment in shares
 Build up adequate expertise in equity research
 Regular review
 Limit of direct 20% and indirect 20% of
banks’ net worth.
 Market Risk Measurement
 The market risk is measured in terms of VaR.
Risk Metric Model is a common approach to
measure market risk
 The Risk Metrics Model
 VaR or EaR
 DEAR (Daily Earnings at Risk)
 The objective of market risk management
model is the prediction of next day losses if
tomorrow is a bad day for business activities.
 DEAR
DEAR = Rupee Market Value of the position X Price
Volatility

Daily price volatility = Price sensitivity to a small

change in yield X Adverse daily yield move

So, it can be written as (-MD) X Adverse daily yield

move
MD = D/(1+R)
 VaR
VaR is defined as an estimate of potential loss in
a position of assets/liabilities over a given
holding period at a given level of certainty.
VaR = DEAR X √N

Case Illustration
Thank You!!!