Market risk

Market risk is the risk of losses in positions arising from movements in market prices.

There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the most commonly used types of market risk are:

• Equity risk, the risk that stock or stock indices (e.g. Euro Stoxx 50, etc. ) prices and/or their implied volatility will change.
• Interest rate risk, the risk that interest rates (e.g. Libor, Euribor, etc.) and/or their implied volatility will change.
• Currency risk, the risk that foreign exchange rates (e.g. EUR/USD, EUR/GBP, etc.) and/or their implied volatility will change.
• Commodity risk, the risk that commodity prices (e.g. corn, crude oil) and/or their implied volatility will change.
• Margining risk results from uncertain future cash outflows due to margin calls covering adverse value changes of a given position.
• Shape risk
• Holding period risk
• Basis risk

Risk management

All businesses take risks based on two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance. Risk management is the study of how to control risks and balance the possibility of gains.

Measuring the potential loss amount due to market risk

As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use value at risk (VaR). The conventions of using VaR are well established and accepted in the short-term risk management practice.

However, VaR contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The VaR of the unchanged portfolio is no longer relevant.

The Variance Covariance and Historical Simulation approach to calculating VaR also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress.

In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.

Use in annual reports of U.S. corporations

In the United States, a section on market risk is mandated by the SEC in all annual reports submitted on Form 10-K. The company must detail how its own results may depend directly on financial markets. This is designed to show, for example, an investor who believes he is investing in a normal milk company, that the company is in fact also carrying out non-dairy activities such as investing in complex derivatives or foreign exchange futures.

See also

• Systemic risk
• Cost risk
• Demand risk
• Risk modeling
• Risk attitude
• Modern portfolio theory
• Risk Return Ratio

External links

• Managing market risks by forward pricing
• Bank Management and Control, Springer - Management for Professionals, 2014
• How hedge funds limit exposure to market risk