Market Risk

Market Risk

Market risk refers to the risk of losses, or risk of decrease in

income, that a FI would be subjected to as a result of
fluctuations in interest rates, changes in foreign exchange
currency rates or in prices of equities and commodities.

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 Market Risk
Introduction to Market Risk

Market risk has two components:

General market risk that affects similar financial assets or
financial markets .

General market risk or systematic risk is the risk of an

adverse movement in market prices that is applied across a
range of assets.
Specific risk that affects only individual financial
assets.

Specific risk is the risk of an adverse movement in

the price of an individual asset due to factors that
apply only to that security or issuer and is not related
to the general movement of the markets.
 Markets
Financial market players:
• Borrowers,
• Lenders,
• Liquidity Providers, Dealers and Traders
• Regulators
• The Instruments, Institutions and Markets are the result of
fundamental compromises between the market players
• Lenders and borrowers have different objectives.
• Liquidity providers take on the liquidity risk of other players
and transform it into market risk

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 Markets
• Lenders Want High returns, with low credit risk
• Borrowers Want Low financing costs
• Regulator Create or enhance conditions that enable financial
markets to develop
• Intervene to correct market failures
• Provide coordination and direction for market development.

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 Money Market-Capital Market

• The Money Market is a short-term, unsecured debt market.

• The Capital Market is a long-term market
secured by claims on assets.

 CDs, T.B.,
 Bankers Acceptances
 Swaps
 Repo
 Money Market Futures
 Interest Rate Options
 Commercial paper and Money market fund

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 Capital Market

• Capital Market is distinguished from the Money Market by

use of the instruments.
• Capital market instruments will generally develop after the
basic money markets have been introduced, but corporate
bond and equity markets may take a very long time
Capital Market instruments as
Bonds
Equities

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 Managing Market Risk

Market risk: the risk that the value of an investment will

decrease due to moves in market factors. The four standard
market risk factors are:
– Equity Risk-the risk that stock prices will change.
– Interest Rate Risk-the risk that interest rates will change.
– Currency Risk-the risk that foreign exchange rates will
change.
– Commodity Risk-the risk that commodity prices (i.e.
grains, metals, etc.) will change.
 Focus of Market Risk
 Liquidity risk
Interest rate risk
Foreign exchange risk

Commodity price risk

Equity price risk
The Basel Committee on Banking Supervision defines
market risk as
the risk of losses in on- or off-balance sheet positions that
arise from movement in market prices.

Market risk therefore refers to risk arising from movements

of interest rate, foreign exchange rates and prices of
instruments in the money and capital markets which
negatively affect the earnings and liquidity.
Market risks are hereby classified
into:
 Liquidity Risk
 Interest Rate Risk
 Foreign Exchange Risk
 What is ……
Interest Rate Risk??
Interest rate risk is “the uncertainty of future
earnings resulting from changes in market
conditions” (in this case changes in the market
interest rate.
Interest Risk is a risk that earnings or capital may be
negatively affected from changes in interest rates of
assets, debts, and off-balance sheet items, all of which are
rate-sensitive items.
By affecting net interest income, market value of the
trading investment, incomes and other expenses
associated to interest rates, interest rate risk inherently
affects bottom line results, and eventually bank capital.
 
Factors that Affect Interest Rates Interest rates are a
 • Expected levels of inflation
 • General economic conditions
 • Monetary policy and the stance of the central bank
 • The greater the term to maturity, the greater the
uncertainty.
 Interest rates are also reflective of supply and
demand for funds.
 Foreign exchange market activity
For example, suppose interest rates in the domestic country
increase, relative to interest rates in the foreign country.
The domestic demand for foreign bonds will decrease,
reducing the demand for foreign currency in the foreign
exchange rate.
The foreign demand for domestic bonds will increase,
increasing the supply of foreign currency in the foreign
exchange rate.
As a result of these movements of the supply and the demand
curves in the foreign exchange market, the price of the foreign
currency in terms of domestic currency will decrease.

The Effect of an Increase in Domestic Interest Rates relative to

Foreign Interest Rates
What is ……
Forex Risk??
Foreign Exchange
Forex is a risk that earning or capital may be
negatively affected from exchange rate fluctuations
linked to transactions in a foreign currency or from
holding an asset or debt in a foreign currency.
Exchange rates reflect the relative value of one
currency in relation to another currency.
For instance, if the exchange rate between the GBP (British
pound) and the USD (United States dollar) is 1.50, this
means that for each GBP you receive, you must pay USD
1.50.
It also means that for each USD you receive, you must pay
GBP 0.67 (= 1.5/1.0).
What is ………
Liquidity Risk?
Liquidity
   Risk

Liquidity risk is the potential for loss arising from either:

Inability to meet its obligations as they fall due; or
The need to fund assets increases while incurring
unacceptable
   costs, or even losses

Liquidity risk includes the inability to manage unplanned

decreases or changes in funding sources.

Liquidity risk also arises from the failure to recognize or

changes in market conditions that affect the ability to
liquidate assets quickly and with minimal loss in value.
 
 
Liquidity risk is considered to be the most sensitive risk
center. It arises when the cushion provided by the liquid
assets are not sufficient enough to meet maturing
obligations.

In such a situation, often meets its liquidity requirements

from the market.

However, conditions of funding through the market depend

upon liquidity in the market…etc.

Accordingly, liquidity may at times come at heavy cost,

resulting in a loss of earnings.
Liquidity risk Identification

The following events represent areas that should be closely

monitored
The list, which is not exhaustive, should be primarily observed ;
 Currency fluctuation affecting asset or liabilities base
 Deterioration in the quality of the portfolio
 A negative trend or significantly increased risk in any
area (in credit risk or market risk, for any reason)
 Concentration in resources or uses area
 Growth in the cost of funds
 Causes of Liquidity Risk

Asset side
– May be forced to liquidate assets too rapidly resulting n
“fire sale prices”
– May result from loan commitments
Liability side
• Reliance on demand deposits
– Core deposits (provide long term source of funds)
– Need to be able to predict the distribution of net deposit
drains
Richard Apostolic, Christopher Donohue, (2005 ) An Overview of
Financial Risk and Risk-Based Regulation, Published by John Wiley
& Sons, Inc., Hoboken, New Jersey
ISBN 978-1-119-10639-5 (ePDF

Karen A. Horcher, ESSENTIALS of Financial Risk Management, John

Wiley & Sons, Inc

Consultative Document Principles for the Management and

Supervision of Interest Rate Risk Issued for comment by 31
October 2003