The Bank for International Settlement (BIS) defines market riskas “the risk of losses in on- and off-balance-sheet positions arising from movements in market prices.”1
The main factors contributing to market risk are equity, interest rate, foreign exchange, and commodity risk. The total market risk is the aggre- gation of all risk factors. In addition to market risk, the price of financial instruments may be influenced by the following residual risks: spread risk, basis risk, specific risk, and volatility risk:
• Spread riskis the potential loss due to changes in spreads between two instruments. For example, there is a credit spread risk between corporate and government bonds.
• Basis riskis the potential loss due to pricing differences between equivalent instruments, such as futures, bonds, and swaps.
• Specific riskrefers to issuer-specific risk—e.g., the risk of holding a corporate bond versus a Treasury futures contract. How to best manage specific risk has been extensively researched and is still a topic of debate. According to the capital asset pricing model (CAPM), specific risk is entirely diversifiable. (See Section 2.4.1 for a discussion of the CAPM.)
• Volatility riskis defined as the potential loss due to fluctuations in (implied) volatilities and is referred to as vega risk.
To determine the total price riskof financial instruments, market risk and residual risk have to be aggregated. Risk is not additive. Total risk is less than the sum of its parts, because the diversification between different assets and risk components has to be considered (i.e., the correlation would never be 1). This effect is described as diversification effect.High di- versification effect between market and residual risk is expected due to the low correlation.
Table 2-1 lists the key risk dimensions that give rise to market and credit exposure.
Risk can be analyzed in many dimensions. Typically, risk dimen- sions are quantified as shown in Figure 2-1, which illustrates their interre- lationship. Fluctuations in market rates can also give rise to counterparty credit exposure and credit risk, as an increasing interest-rate level makes it more difficult for the issuer to pay the accrued interest rate from the oper- ative cash flow, and as the higher interest rates lower the profit margin.
Counterparty trading limits should be in place to limit credit exposure due to market-driven instruments, such as swapsand forwards.The man- agement of credit exposure for market-driven instruments is discussed further in Chapter 3.
Business risk is not included in the definition of risk used in this book (see Chapter 1). Business and market risk are two key sources of risk that can impact a company’s ability to achieve earnings or cash-flow targets (see Figure 2-2). The relative magnitude of business risk to market risk varies from company to company and thus reflects the approach and pol-
Market Risk 35
T A B L E 2-1
Key Risk Dimensions Giving Rise to Market and Credit Exposure
Dimension Example
Risk taker Position, portfolio, trading desk, business unit Risk factor Equity, interest rate, foreign-exchange currency,
and commodity
Country or region Europe, Americas, Asia Pacific Maturity or duration 1 week, 1 month, 3 months . . . 30 years Instrument or instrument type Cash, options, forwards, futures Counterparty Crédit Suisse, UBS, Morgan Stanley
Risk Taker Region Risk Factor Horizon Instrument Market Risk
Counterparty
Credit Risk
Market Risk
Risk Taker Region Risk Factor
Duration Instrument
Credit Risk Operational Risk
F I G U R E 2-1
Key Risk Dimensions Giving Rise to Market and Credit Exposure. (Source: Modified from RiskMetrics Group,Risk Management: A Practical Guide, New York: RiskMetrics Group, 1999, p. 15. Copyright © 1999 by RiskMetrics Group, all rights reserved. Risk- Metrics is a registered trademark of RiskMetrics Group, Inc., in the United States and in other countries. Reproduced with permission of RiskMetrics Group, LLC.)
icy for managing both types of risks; it also helps set the tone for a com- pany’s risk management culture and awareness. When discussing business risk,we are referring to the uncertainty (positive and negative) related to the business decisions that companies make and to the business environ- ment in which companies operate. For example, business risk can arise from investment decisions and strategy, product development choices, marketing approaches, product placement issues, and client behavior un- certainty. Broadly speaking, these are decisions with an inherent long-term horizon and involve structural risks that companies are “paid to take” in order to generate profits. Companies evaluate and take business risks in areas based on their expertise and, to varying degrees, with significant in- fluence over potential returns. In contrast, market risk refers to the uncer- tainty of future financial results that arises from market-rate changes.
Market risk can impact on a company’s business in many different ways. For example, operating margins can be eroded due to the rising prices of raw materials or depreciating currencies in countries in which a company has foreign sales (direct market risk impact). Changes in the mar- ket environment may eventually force companies to adjust the prices of their products or services, potentially altering sales volumes or competi- tiveness, depending on the positioning and market exposures of the com- pany’s competitors (the indirect impact of market risk on business results).
Some organizations may be “paid” to take market risks (e.g., financial or- ganizations), but most seek to manage the impact of market risk on finan- cial results (this is especially true of most nonfinancial organizations).
Financial organizations have overlapping business and market risks.
However, as their “raw materials” are currencies, interest rates, etc., fi- Operational
Systems People Data quality Controls
Transactions
Market
Foreign exchange
Interest rate
Liquidity Commodity Equity
Business
Marketing Sales
Reputation
Quality Product placement
Credit
Default Transition Concentration Counterparty
Country Recovery
F I G U R E 2-2
Differentiation Between Market Risk and Business Risk. (Source: Modified fromRisk- Metrics Group,CorporateMetrics—Technical Document,New York: RiskMetrics Group, 1999, p. 5, chart 1. Copyright © 1999 by RiskMetrics Group, all rights reserved.
CorporateMetrics is a registered trademark of RiskMetrics Group, Inc., in the United States and in other countries. Reproduced with permission of RiskMetrics Group, LLC.)
nancial organizations have to keep business and market risks separated to realize success from intended business strategies and decisions, and from the risk-return relationship of these decisions.
2.3 CONCEPTUAL APPROACHES