Aug 20

Market Risk

by David Harper, CFA, FRM, CIPM

FRM | Risk |

intro_whatisMarketRisk4

Learning Outcomes

  • LO 18.1: Define market risk.
  • LO 18.2: Describe five reasons why market risk measurement is important.
  • LO 18.3: List the models being used to calculate market risk exposure.

Three risk buckets: credit, market and operational

The three risk buckets are credit, market and operational risk. They sometimes not easy to separate. Consider a corporate bond. Its price fluctuates with interest rates (rates rise, the price drops). Convexity and duration capture most of this price/yield relationship (not all of the price/yield relationship because, as first and second derivatives, they are linear approximations of a curvilinear relationship). So far, this price movement reflects market risk. But when the bond price decreases by more than convexity and duration, that may reflect credit risk. So the price reacts to market and credit risk factors. The Merton approach to default risk depends on a linkage between market risk and credit risk: here, the probability of default (a question of credit risk) is a function of the firm's asset value (a price that reflects much market risk). The premise of the Merton model is that equity prices (largely in response to market risk) contain information about credit risk; in summary, at some point market risk impacts credit risk.

Operational risk is the least well-defined of the group. The tempting plan is to call it the catch-all bucket for everything else: the risks that are neither market nor credit risks. But alas that doesn't capture all risks; e.g., the BIS definition of operational risk excludes strategic and reputational risk. Many think reputational risk should be included.

What is market risk?

Saunders (the assigned FRM reading) defines market risk as:

"the risk related to the uncertainty of a financial institution's earnings on its trading portfolio caused by changes in market conditions such as the price of an asset, interest rates, market volatility, and market liquidity" (Saunders, Chapter 10)

The Basel II definition is succinct:

"Market risk is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices."

Banking versus Trading Books

The 1996 Amendment to the Basel II Accord added a capital charge for market risk. It draws a difference between the banking book and the trading book:

tradingVersusInvestmentBook

The charge applies to:

  • All market risks in the trading book: interest rate, equity, forex, and commodity
  • Currency and commodity risk in the investment book

The key differences between the trading and banking book relate to holding intent, liquidity and mark-to-market valuation. This recent speech by an SEC Commissioner is instructive:

"The Basel Standard basically views risk positions as residing in either the "banking book" or the "trading book." Banking book positions look like traditional portfolio lending, with assets typically held to maturity and subject to accrual accounting. Consequently, the capital requirement is reflective of the longer holding period during which an institution is effectively "tied to the mast." Trading book positions have a more market risk flavor. These products are marked-to-market and actively hedged by the firm. In many instances they will not be held for an extended period of time by the firm, and in all instances they must be either easily sold or readily hedged. The capital charges for such positions reflect that institutions have more options than in the case of banking book positions to shed the positions, or the risk of the positions. The overwhelming bulk of the capital charges at commercial banks typically arise from the banking book. By contrast at securities firms, the trading book is substantial." Annette Nazareth's remarks before the SIFMA Risk Management Conference; June 27, 2007

So, while the banking book contains longer durations and are more often held to maturity, the other important difference between the books is valuation. The banking book is carried at historical cost (accrual accounting). Unrealized losses/gains are not recognized. The trading book, however, is revalued at market prices (market-to-market). Traditionally, you can see why the banking book is deemed riskier than the trading book (and why banks would have an incentive to classify into the trading book): these positions are less liquid and do not benefit from mark-to-market's ability to reveal market risks by way of the price discovery process.

But note the problem of the yellow arrow, which reflects a dynamic trend and helps to explain the thematic accounting pressure against historical cost in favor of fair value. As Saunders says, "with the increasing securitization of bank loans (e.g., mortgages), more and more assets have become liquid and tradeable (mortgage-backed securities)." Securitization achieves the conversion from illiquid positions in the banking book to liquid positions in the trading book. Indeed, this is a current concern of the SEC: the new array of instruments (e.g., securitizations, leverage loans) that qualify as 'trading book' may not be suited to value at risk (VaR), the primary approach to market risk measurement.

 

Why MRM is important

According to Anthony Saunders, MRM matters because: 

  1. Management information: MRM gives senior managers information about risk exposures.
  2. Setting limits: MRM helps set logical position limits
  3. Resource allocation: Because it compares return-versus-risk across asset classes, helps allocate capital effectively.
  4. Performance evaluation: Rather than pay traders merely for taking on more risk, considers the return-risk ratio, and therefore helps for more rational compensation scheme.
  5. Regulation: Because regulations may tend to over-price some risks, the use of internal models may lead to superior capital allocation.

 

Models used in MRM

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The models used are familiar, these are the three broad approaches to estimating value at risk (VaR)

  1. Monte Carlo simulation
  2. Historical simulation
  3. Variance/covariance (RiskMetrics)

 

Sources:

SEC Speech: Remarks before the SIFMA Risk Management Conference; New York, New York; June 27, 2007 (Annette Nazareth)

Basel II, Amendment to the capital accord to incorporate market risks

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