Market Risk
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Market risk is an important element of any financial institutions risk management procedures. What is it? Market risk results as a change in the value of a contract caused by any movements in the level or volatility of the market price of the underlying instrument. Market risk ranks below that of credit risk but above operational risk and strategic risk. Market risk is usually measured with a Value-at-Risk method. The expected change in the value of a derivative resulting from a change of market movements with pre-determined probability over particular time period is assessed. Liquidity risks fall into two groups. Firstly that a financial institution can not offset any position due to adverse market conditions or can offset the position at a price well outside the expected range. Secondly, a financial institution can not meet payment obligations on a settlement date or meet margin calls. American-style options, where the exercise may take place prior to the due expiry date, generate a lot of this type of risk. Why? Movements in the prices of securities is what makes the City and Wall Street work. How much money the maked, depends on how they handle the risk inherent in the change. Over the past 4-5 years, hedge funds have been the darlings of the financial markets. They are very heavy users of derivatives designed to take advantage of the movements. They use massive amounts of leverage or debt. Unfortunately this means they can make massive loss as well. Consequently institutions need to constantly measure and manage risk. Two important regulatory changes have been introduced or are imminent. International Accounting Standard (IAS) 39, has imposed stringent controls on the reporting of derivatives. IAS 39 requires that the value of a derivative is displayed at 'fair value' in the income statement. The Basel II accord and the new capital adequacy rules will force banks to calculate the amount of risk that they carry. Once this has been calculated, the requlatory capital requirement can be calculated. When Especially in volatile environments such as hedge funds, risk has to be monitored and measured constantly. After all, risk is the foundation of the whole industry.. Who Everyone has to have an awareness of risk.Their perception depends on the job they do. For traders, they have to consider the returns they can expect to make, for taking on a certain amount of risk. Financial institutions will often employ people, solely for their risk analysis and measurement skills. How The need to constantly measure risk means that a Mark-to market process is required. Market risk emanating from exchange traded derivatives is relatively simple. The current market prices are available due to the way exchanges work.OTC derivatives however are more difficult, as obtaining the prices is more opaque. The Black & Scholes pricing model is commonly used to calculate the current value of a derivative. Value at Risk, as mentioned above is a commonly used measurement. Tool that can be used for this calculation include:- Global Margin Server and Adaptiv Risk. Incidentally, a book was published in June 2005 entitled Fischer Black and the Revolutionary Idea of Finance Stress tests for market risk are similar to those for software. These are undertaken by the financial institutions to find out how their institution in the event of a catastrophic event such as a market crash. Almonde Basel II and and Adaptiv Risk. again, can both handle this scenario for testing. liquidity risk tools include Almonde ALM
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