Market Risk Management
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Learning Objective
Define Market Risk
Explain the importance of market risk
Differentiate Market Risk from other risks
Describe the Market Risk Management Tasks
Describe the organization of Market Risk Management
Explain Market Risk Management in Fund Management
Explain Market Risk Management in Banking
Explain Market Risk Management in Nonfinancial firms
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Market Risk
Market risk
Changes in values of financial contracts or instruments (bond, equity, FX SWAP etc.) due to unpredictable
fluctuations in market variables like interest rates, foreign exchange rates, commodities and other traded
assets.
Important terms
Mark-to-Market (MTM): MTM value of a contract or instrument is its current market value based on
current market variables impacting the instrument. For instance, a bond with a coupon of 10% would
record MTM losses when market yields (on similar bonds) increase above 10%.
Mark-to-Model: For some instruments, relevant market variables may not be observable on the MTM
date. These instruments are the priced on basis of some model (financial, statistical). For instance, in the
present credit crisis, many instruments (Credit derivatives, securitization tranches) cannot be priced as no
trader is quoting prices for these instruments. To fulfill MTM requirement, these instruments are priced on
basis of some model.
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Market Risk(Cont)
Exposures taken by a bank are classified into:
Banking book: These are exposures that a Bank classifies as hold-till-maturity (HTM). Since these
exposures would be HTM, they are not required to be MTM during the lifetime of the exposure. For
instance, even if a bond has MTM loss, it doesnt impact the bank if the bank does not intend to sell the
bond prior to its maturity (i.e. bond is classified as HTM). In such a case, only risk present is credit risk
(would the borrower be able to pay interest and principal, as and when due).
Trading book: These are exposures held with a trading intent (say, sell the instrument if there is a gain)
or to hedge other trading book exposures. Since banks intention is to trade these instruments, it is
important to compute their MTM value. Trading book exposures, therefore, require periodical MTM (as
frequent as daily).
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Distinguishing Market Risk from other Risks
Market, credit and operational risks are inter-linked with each other
A balance must be struck
Between the degree of specialisation of risk management functions, so that market risks can be distinguished
from other risks and managed separately, and
The degree of interaction and coordination between functions so that they can operate coherently
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Risk Management
Risk management is a four-step process, as laid down by the Basel Committee on Banking
Supervision:
Risk identification
Risk assessment: Measurement of risk
Risk monitoring
Risk management and mitigation: through hedging (taking opposite position through a new instrument) or
cutting of existing positions etc. Hedging might be:
Selective hedging: hedging only for certain risks
Momentary hedging: hedging for certain time periods
Organization of Risk management function
Board and senior management oversight
Risk management should work independently of business units and should have independent sources of
information
Risk management function should report regularly to senior management and board
Risk management process should be well-documented and audited by internal and external auditors
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Market Risk Management
Market risk management is required in:
Fund management
Means investing funds and taking market risks for the purpose of generating returns as per their investment
objective like Mutual fund, Hedge funds.
Identification: Liquidity risks especially by hedge funds who might have substantial positions related to market
size should not be ignored
Assessment: Performance analysis maybe done using Risk-adjusted performance measures (Sharpe ratio
etc.)
Control/ Mitigation
Selective hedging, Momentary hedging
Managing for a Risk-adjusted performance target
Market risk management in banking
Banks are generally good at market risk management, as they have inbuilt infrastructure to analyze and
monitor risks and they are well regulated.
At the same time, market risk management is important for banks as they need to maintain their stability and
trust to attract client deposits
Market risk management in Non-financial firms (corporate dealing in forex, commodities, derivatives,
interest rate markets)
Identification of market risks is the most difficult task for non financial firms as it is not their core competence.
They would be better off outsourcing market risk management to professional analysts
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Questions
Periodical Mark to Market computation is required for
A. Banking Book
B. Trading Book
C. Both Banking and Trading Book
D. None of these
The correct order for Risk management process as laid down by the Basel Committee is
A. Identification, Assessment, Monitoring, Management & Mitigation
B. Assessment, Identification, Monitoring, Management & Mitigation
C. Monitoring, Assessment, Identification, Management & Mitigation
D. Identification, Monitoring, Assessment, Management & Mitigation
Which of the following is false with respect to Organization of Risk management function?
A. Board and senior management oversight is required in risk management
B. Risk management process should be well-documented and audited by internal and external auditors
C. Risk management should work in tandem with business units and should have pooled sources of
information
D. Risk management function should report regularly to senior management and board
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Solutions
Banking book does not require MTM computation during the lifetime of the HTM exposure while
Trading book requires periodic MTM computation
B. Trading Book
The correct order for Risk management process as laid down by the Basel Committee is Identification,
Assessment, Monitoring, Management & Mitigation
A. Identification, Assessment, Monitoring, Management & Mitigation
Risk management should work independently of business units and should have independent sources
of information
C. Risk management should work in tandem with business units and should have pooled sources of
information
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End of Market Risk Management
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