Market Risk

Learning Outcomes (18.1 – 20.6)

1 Market Risk (LO 18.1 – 18.4)

2 Foreign Exchange Risk (LO 19.1 – 19.6)

3 Cash flow exposures (LO 19.7 – 19.15)

4 Liquidity risk (LO 20.1 – 20.6)

Market Risk
LO 18.1: Define market risk

 Market risk is “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)
Market Risk
LO 18.1: Define market risk

Assets Liabilities
Investment Loans Capital
(Banking)
Other illiquid assets Deposits
Book
Bonds (long) Bonds (short)
Commodities (long) Commodities (short)
Trading Book FX (long) FX (short)
Equities (long) Equities (short)
Derivatives (long) Derivatives (short)
Market Risk
LO 18.1: Define market risk
Securitization
Assets Liabilities
Investment Loans Capital
(Banking)
Other illiquid assets Deposits
Book
Bonds (long) Bonds (short)
Commodities (long) Commodities (short)
Trading Book FX (long) FX (short)
Equities (long) Equities (short)
Derivatives (long) Derivatives (short)
Market Risk
LO 18.2: Describe five reasons why market risk
measurement is important

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.
Market Risk
LO 18.3: List the models being used to calculate
market risk exposure.
RiskMetrics (variance/covariance)
• Market Risk = Position 
(Confidence)(Volatility)(Sensitivity)

Historic or back simulation

• When returns are non-normal
• Simple

Monte Carlo simulation

• When actual data is limited
• Like historic, percentile (%) rank
Market Risk
LO 18.3: List the models being used to calculate
market risk exposure.
1st Model: RiskMetrics Model for Daily Earnings at
Risk (DEAR)
Market Risk
LO 18.3: List the models being used to calculate
market risk exposure.
1st Model (Variance Covariance) Fixed Income

Daily Price Volatility = Modified Duration 

Adverse Daily Yield Move
Market Risk
LO 18.3: List the models being used to calculate
market risk exposure.
1st Model (Variance Covariance) Equities

Total Risk = Systematic risk +

Unsystematic risk

    
i
2
i
2 2
m
2
ei
Market Risk
LO 18.3: List the models being used to calculate
market risk exposure.
2nd Model: Historic or Back Simulation Approach
The RiskMetrics model assumes normality. Due to this drawback,
most banks deploy market risk models that use a historic or
back simulation approach. There are six steps to the historic
approach (using foreign exchange as an example):
1. Measure exposures
2. Measure sensitivity
3. Measure risk
4. Repeat Step 3
5. Rank days by risk from worst to best
6. Determine VAR.
 Market Risk
LO 18.3: List the models being used to calculate
market risk exposure.
Rank
days
by risk:
worst
Measure Measure
to
exposures risk best

Measure Repeat Determine

sensitivity Step 3 VAR
Market Risk
LO 18.3: List the models being used to calculate
market risk exposure.
3rd Model:The Monte Carlo Simulation Approach

 The Monte Carlo approach overcomes the problem of

limited observations. A typical Monte Carlo simulation
produces a large number of synthesized observations—
sometimes a very large number.
Market Risk
LO 18.4: List the methods the Bank for International
Settlement uses to regulate market risks

 The Bank for International Settlement (BIS) includes the

largest central banks in the world. Since January 1998,
banks in BIS member countries can calculate market risk
(i.e., market risk only, not credit and operational risk)
exposure in one of two ways:
1. Use a simple standardized framework.
2. Use an internal model, contingent on regulatory approval.
However, an internal model is subject to regulatory
audit(s) and certain constraints.
Market Risk
LO 18.4: List the methods the Bank for International
Settlement uses to regulate market risks
Fixed Income
 Specific Risk Charge
 The specific risk charge measures the risk of a decline in the liquidity or credit
risk quality of the portfolio over the holding period. Multiplying the absolute
dollar values of the long and short positions by the specific risk weights
produces a specific risk capital (or requirement charge) for each position.
Summing the individual charges for specific risk gives the total specific risk
charge.
 General Market Risk Charge
 The general market risk charges the product of the modified durations and
interest rate shocks expected for each maturity. The positive or negative dollar
values of the positions in each instrument are multiplied by the general market
risk weights to determine the general market risk charges for the individual
holdings. Summing these gives the total general market risk charge of the entire
fixed-income portfolio.
Market Risk
LO 18.4: List the methods the Bank for International
Settlement uses to regulate market risks
Fixed Income
 Vertical Offsets
 The BIS model assumes that long and short positions, in the same maturity
bucket but in different instruments, cannot perfectly offset each other. Thus, the
general market risk charge tends to underestimate interest rate or price risk
exposure. To account for this, BIS requires additional capital charges for basis
risk, called vertical offsets or disallowance factors.
 Horizontal Offsets within Time Zones
 In addition, the debt trading portfolio is divided into three maturity zones.
Because of basis risk (i.e., the imperfect correlation of interest rates on
securities of different maturities), short and long positions of different
maturities in these zones will not perfectly hedge each other. This results in
additional (horizontal) disallowance factors for each maturity zone, as follows:
 Zone 1 (1 to 12 months): 40%
 Zone 2 (>1 year to 4 years): 30%
 Zone 3 (> 4 to 20 years or more): 30%
Market Risk
LO 18.4: List the methods the Bank for International
Settlement uses to regulate market risks
Foreign Exchange (Under BIS Standardized Framework)
 The standardized model or framework requires the bank to calculate its
net exposure in each foreign currency and then convert this into dollars at
the current spot exchange rate. The BIS standardized framework imposes
a capital requirement equal to 8% multiplied by the maximum absolute
value of the aggregate long or short positions.
Market Risk
LO 18.4: List the methods the Bank for International
Settlement uses to regulate market risks
Equities (Under BIS Standardized Framework)
Two sources of risk in holding equities: (1) a firm-specific, or unsystematic, risk
element and (2) a market, or systematic, risk element.
 Unsystematic risk is charged by adding the long and short positions in any
given stock and applying a 4% charge against the gross position in the stock.
(This is called the x factor).
 Market or systematic risk is reflected in the net long or short position.
The capital charge is 8% against the net position. (This is called the y
factor).
 The total capital charge for the stock is the “x factor” plus the “y
factor”.
This approach is crude and does not fully consider the benefits of portfolio
diversification (i.e., that unsystematic risk is not diversified away).
FX Risk
LO 19.1: Describe the different sources of foreign
exchange risk exposure

 Net exposurei = (FX assetsi - FX liabilitiesi) +

(FX boughti - FX soldi)
= Net foreign assetsi +
Net FX boughti

i = ith currency
Positive net exposure: net long a currency
Negative net exposure: net short a currency
FX Risk
LO 19.2: Explain the different types of foreign trading
activities and the sources of most profits and losses
on foreign exchange trading.
Purchase/sale of foreign currencies
1. To allow customers to participate in international
commercial trade transactions
2. To allow customers to take positions in foreign
investments (real or financial assets)
3. For hedging purposes—i.e., to offset currency exposure
4. For speculative purposes
FX Risk
LO 19.3: Describe foreign exchange exposure resulting from
mismatches between foreign financial asset and liability
portfolios, and explain how returns and risks of foreign investing
can impact returns.

Assets Liabilities
$100 million, US Loans, US $200 million U.S. Dollars
Dollars
$100 million equivalent, Foreign
Loans, Foreign Dollars
FX Risk
LO 19.4: Explain on-balance-sheet hedging

Assets (loans) Liabilities (CDs)

Invest: Lend:
$100.00 $ @ 9% $100.00 $ @ 8%
$100.00 £ @ 15% $100.00 £ @ 11%

$/£
Start $1.60
End $1.45

$100.00 £62.50 $100.00 £62.50

$104.22 £71.88 $100.59 £69.38
4.22% 0.59%

ROA 6.61% COF 4.30%

ROI 2.31%
FX Risk
LO 19.4: Explain on-balance-sheet hedging

Assets (loans) Liabilities (CDs)

Invest: Lend:
$100.00 $ @ 9% $100.00 $ @ 8%
$100.00 £ @ 15% $100.00 £ @ 11%

$/£
Start $1.60
End $1.70

$100.00 £62.50 $100.00 £62.50

$122.19 £71.88 $117.94 £69.38
22.19% 17.94%

ROA 15.59% COF 12.97%

ROI 2.63%
FX Risk
LO 19.5: Explain off-balance-sheet hedging
Assets (loans) Liabilities (CDs)
Invest: Lend:
$100.00 $ @ 9% $200.00 $ @ 8%
$100.00 £ @ 15% $0.00 £ @ 11%

$/£
Spot $1.60
Discount $0.05
Forward $1.55

$100.00 £62.50
Loan @ 15%
Returned (£) £71.88
Returned ($) $111.41
Loan Return 11.41%
ROA 10.20% COF 8.00%
ROI: 2.20%
FX Risk
LO 19.6: Explain why diversification in multicurrency
foreign asset-liability positions could reduce portfolio risk.
 To the degree that domestic and foreign interest rates
(or stock returns) are not perfectly correlated, potential
gains from asset-liability portfolio diversification can
offset risk of asset-liability currency mismatch
FX Risk
LO 19.6: Explain why diversification in multicurrency
foreign asset-liability positions could reduce portfolio risk.
 To the degree that domestic and foreign interest rates
(or stock returns) are not perfectly correlated, potential
gains from asset-liability portfolio diversification can
offset risk of asset-liability currency mismatch

ri  rri  ii
e

ri  The nominal interest rate in country i

rri  The real interest rate in country i
iie  The expected one-period inflation rate in country i
Cash flow exposures
LO 19.7: Distinguish among transaction exposure,
contractual exposure, and competitive exposure to
exchange rate fluctuations.
 Transaction exposure (to a currency) is the exposure due
to holding receivables and payables (in a foreign currency).
Transaction exposure results from past business deals.
 Contractual exposure (to a currency) is exposure due to
contractual commitments.
 Competitive exposure is when the cash flow is exposed
to a change in the firm's competitive position. Competitive
exposure broadly defined; all firms have competitive exposure.
Cash flow exposures
LO 19.8: Explain the interaction of price risk and quantity risk in
terms of the additional challenges to hedging using examples of
industries where the association between price and quantity of
the risky factor is negative and where it is positive.

 Price risk: unexpected changes in price

 Quantity risk: unexpected changes in the exposure
Cash flow exposures
Assume: For U.S. Company, cost to make widget is $100
U.S. company want to receive $120 per widget (i.e., $20 profit)

Baseline, "Before" the Currency Move

Pegged exchange rate: 7.50 Y Yuan/$
$0.1333 $/Yuan

Price of a Widget (Y) 900.00 Y

Converted ($) $120.00

Two Scenarios:
Yuan Yuan
Appreciates Depreciates
Yuan per 1 US$ 7.00 Y 8.00 Y
US$ per 1 Yuan $0.1429 $0.1250

"Negative" Relationship
Price in Yuan 840.00 Y 960.00 Y
Converted to US$: $120.00 $120.00

"Positive" Relationship
Price in Yuan 900.00 Y 900.00 Y
Converted to US$: $128.57 $112.50
 Cash flow exposures
LO 19.9: Explain the implications of perfect positive correlation,
zero correlation, and perfect negative correlation between price
risk and quantity risk for the optimal hedge ratio and the risk of
the hedged versus the unhedged cash flows.

Dollar
Price of Cash flow in Sw. Francs Cash flow in US $
Swiss Pos Neg. Pos Neg.
franc (+) None (-) (+) None (-)
$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75
$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75
$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75
$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75

Average $1.00 $1.25 $1.00 $0.75

Covariance 0.50 0.25 -
Variance 0.25
Hedge Ratio 2.00 1.00 -
 Cash flow exposures
LO 19.9: Explain the implications of perfect positive correlation,
zero correlation, and perfect negative correlation between price
risk and quantity risk for the optimal hedge ratio and the risk of
the hedged versus the unhedged cash flows.

Dollar
Price of Cash flow in Sw. Francs Cash flow in US $ Futures Gain/Loss Net Gain/Loss
Swiss Pos Neg. Pos Neg. Pos Neg. Pos Neg.
franc (+) None (-) (+) None (-) (+) None (-) (+) None (-)
$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75 ($1.00) ($0.50) - $1.25 $1.75 $0.75
$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75 ($1.00) ($0.50) - $1.25 $0.25 $0.75
$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75 $1.00 $0.50 - $1.25 $1.25 $0.75
$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75 $1.00 $0.50 - $1.25 $0.75 $0.75

$1.00 $1.25 $1.00 $0.75 Average

0.50 0.25 - Covariance
0.25 Variance
2.00 1.00 - Hedge Ratio
 Cash flow exposures
Positive Correlation (price, quantity): it can be hedged
Negative Correlation (price, quantity): already “naturally” hedged!
No Correlation (price, quantity): “partial” hedge does not totally work
Dollar
Price of Cash flow in Sw. Francs Cash flow in US $ Futures Gain/Loss Net Gain/Loss
Swiss Pos Neg. Pos Neg. Pos Neg. Pos Neg.
franc (+) None (-) (+) None (-) (+) None (-) (+) None (-)
$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75 ($1.00) ($0.50) - $1.25 $1.75 $0.75
$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75 ($1.00) ($0.50) - $1.25 $0.25 $0.75
$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75 $1.00 $0.50 - $1.25 $1.25 $0.75
$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75 $1.00 $0.50 - $1.25 $0.75 $0.75

$1.00 $1.25 $1.00 $0.75 Average

0.50 0.25 - Covariance
0.25 Variance
2.00 1.00 - Hedge Ratio
Cash flow exposures
LO 19.10: Describe how the exposure of cash flow to a
risk factor, such as exchange rate risk, is measured.

 Exposure of cash flow to a specific risk factor is

measured by: the change in value of the cash flow
(or the fair value of the asset) for a given unit change
in the risk factor. Specifically,

Cash flow per unit

Exposure 
Risk factor
Cash flow exposures
LO 19.11: Using supply (marginal cost) and demand analysis, illustrate
the competitive exposure to exchange rate risk for an exporting firm,
considering changes in (i) exchange rates between the firm’s currency
and the currency of the importing country and (ii) exchange rates
between the currency of a third country (that has exporters that
compete with the firm) and the currency of the importing country.

 Imperfect (limited) competition = elastic demand

 Perfect competition = producer is a “price taker”

who cannot increase prices (i.e., perfectly elastic)
 Cash flow exposures
Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’
£
Pounds
MC

DD
MR

Q
Impact on pound price of cars sold in U.S.
Depreciation of dollar
Limited Competition = Elastic Demand
 Cash flow exposures
Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’

£’
Pounds MC

MR’

DD’

Q’
Impact on pound price of cars sold in U.S.
Depreciation of dollar
Limited Competition = Elastic Demand
Cash flow exposures
Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’
£
£’
MC

MR’

DD
MR DD’

Q’ Q
Impact on pound price of cars sold in U.S.
Depreciation of dollar
Limited Competition = Elastic Demand
 Cash flow exposures
Price $ Quantity @ MR = MC
Quantity’ @ MR’ = MC’
$
Dollars
MC

DD
MR

Q
Impact on dollar price of cars sold in U.S.
Depreciation of dollar
Limited Competition = Elastic Demand
 Cash flow exposures
Price $ Quantity @ MR = MC
$’ Quantity’ @ MR’ = MC’
Dollars
MC’

DD
MR

Q’
Impact on dollar price of cars sold in U.S.
Depreciation of dollar
Limited Competition = Elastic Demand
Cash flow exposures
Price $ Quantity @ MR = MC
$’ Quantity’ @ MR’ = MC’
$ MC’

MC

DD
MR

Q’ Q
Impact on dollar price of cars sold in U.S.
Depreciation of dollar
Limited Competition = Elastic Demand
Cash flow exposures
Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’

£’
MC

£ DD = MR

Q
Impact on pound price of cars sold in U.S.
Depreciation of dollar
Perfect Competition = Perfectly Elastic ()
Cash flow exposures
Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’

£’
MC

DD’ = MR’

Q
Impact on pound price of cars sold in U.S.
Depreciation of dollar
Perfect Competition = Perfectly Elastic ()
Cash flow exposures
Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’

£’
MC

£ DD = MR

DD’ = MR’

Q
Impact on pound price of cars sold in U.S.
Depreciation of dollar
Perfect Competition = Perfectly Elastic ()
Cash flow exposures
Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’

$’
MC

$ DD = MR

Q’ Q
Impact on dollar price of cars sold in U.S.
Depreciation of dollar
Perfect Competition = Perfectly Elastic ()
Cash flow exposures
Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’
MC’
$’

$ DD = MR

Q’ Q
Impact on dollar price of cars sold in U.S.
Depreciation of dollar
Perfect Competition = Perfectly Elastic ()
Cash flow exposures
Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’
MC’
$’
MC

$ DD = MR

Q’ Q
Impact on dollar price of cars sold in U.S.
Depreciation of dollar
Perfect Competition = Perfectly Elastic ()
Cash flow exposures
LO 19.12: Outline the steps in determining cash flow exposure from a pro
forma analysis when the correlation of the quantity sold with the risk factor
is zero, positive, and negative.

If we change the risk factor

Base (scenario-based change to
Cash flow Line Item Case the risk factor):
Sales (Cash receipts) S +/-S = S Adjusted
Cash Cost of Goods Sold (COGS) -W +/-X = W Adjusted
Cash (SG&A) Expenses -X +/-Y = X Adjusted
Cash Taxes -Y +/-X = Y Adjusted
Net Cash Flow =Z = Z Adjusted
Cash flow exposures
LO 19.13: Explain how the optimal hedge ratio is determined in
the context of pro forma cash flow analysis with one risk factor.

cov(C ,G)
h
var(G)

cov[Cash flow, S ]
h
var(S )
Cash flow exposures
LO 19.14: Illustrate the concept of the delta exposure of cash flow, and
describe how it is estimated in practice for non-linear exposure to a risk
factor.

Ri ,t  i  i Rx ,t   i ,t
Ri ,t  firm cash flow or return on securities
i  constant
i  exposure of firm to specified risk factor
Rx ,t  return of the risk factor
 i ,t  error term
Cash flow exposures
LO 19.15: Describe the steps in using Monte Carlo simulation to estimate the
volatility-minimizing hedge ratio and the circumstances under which this
approach has significant advantages.

Express Cash Flow as function of risk

factor(s)

Identify distribution of risk factor

Random number generator: 10,000

random risk factors

Produces 10,000 “simulated” cash flows

Identify specified percentile (95th

percentile, 99th percentile)
Liquidity risk
LO 20.1: Explain the interrelationship between funding
liquidity risk and market liquidity risk

 Funding liquidity risk

Not enough balance sheet cash
to fund ongoing operations
(or precipitous drop)
Concern of corporate Chief Financial Officer (CFO)

 Market liquidity risk

Deterioration in asset value:
• Cannot liquidate the position, and/or
• Cannot sufficiently hedge the position
Concern of market traders and market participants
Liquidity risk
LO 20.2: Describe alternative methods for measuring
liquidity risk.
 Liquidity gap = Liquid assets minus (–) volatile
liabilities
Liquidity risk
LO 20.2: Describe alternative methods for measuring
liquidity risk.
 Liquidity risk elasticity (LRE)
 Given a small increase in bank’s liquidity premium (LIBOR
+ spread) on the marginal funding cost  Δ net of assets
over funded liabilities
NA(t ) A(t ) L(t )
 w
  
 A(t), L(t) are current values of assets, liabilities
 w is proportion of liabilities funded with the assets
 Ξ is the liquidity premium on the firm’s funding cost
LRE Limitations: (i) works for small Δ in funding costs, and
(ii) assumes parallel shift in funding costs
Liquidity risk
LO 20.3: Discuss factors that impact an asset’s
liquidation cost

Time horizon
Liquidity risk
LO 20.3: Discuss factors that impact an asset’s
liquidation cost

Time horizon
Asset type
Liquidity risk
LO 20.3: Discuss factors that impact an asset’s
liquidation cost

Time horizon
Asset type
Asset fungibility
Liquidity risk
LO 20.3: Discuss factors that impact an asset’s
liquidation cost

Time horizon
Asset type
Asset fungibility
Market microstructure
 Temporal aggregation (call or continuous)
 Dealership structure (decentralized 
centralized)
Liquidity risk
LO 20.3: Discuss factors that impact an asset’s
liquidation cost
Time horizon Market microstructure
Asset type  Temporal aggregation
(call or continuous)
Asset fungibility  Dealership structure
(decentralized  centralized)
Bid-ask spread
Liquidity risk
LO 20.4: Discuss problems with using the bid-ask
spread as a measure of liquidity.

 Bid–ask spread: price difference between buyers and

sellers of the same asset at the same time
Liquidity risk
LO 20.4: Discuss problems with using the bid-ask
spread as a measure of liquidity.

 Problems with the bid-ask spread:

 Assumes trades can be crossed simultaneously
 Presumed to reflect a stable market impact function
that relates the cost of the transacting to order size.
 Often different sets of bid–ask spreads; may be hard
to know which spread to use
Liquidity risk
LO 20.5: Calculate liquidity-adjusted VAR.

LVARj ( )  Vt ,j[  j  ( ) j  1 St ,j ]

2
St,j  bid-ask spread
Vt , j  value of asset
j  mean
j  standard deviation
 ( ) = confidence parameter
Liquidity risk
LO 20.5: Calculate liquidity-adjusted VAR.

 Assume
 Initial asset value of $100
 Expected return () of 10% per annum
 Spread = 0.2
 Standard deviation () of 25%
 Level of significance = 5%
 Time horizon = 1 year
 What is the liquidity-adjusted VAR?
Liquidity risk
LO 20.5: Calculate liquidity-adjusted VAR.
 Initial asset value of $100
 Expected return () of 10% per annum
 Spread = 0.2
 Standard deviation () of 25%
 Level of significance = 5%
 Time horizon = 1 year

Absolute VAR (Culp’s method)

LVAR j ( )  Vt , j [ j   ( ) j  1 St , j ]
2
LVAR j (5%)  100[10%  (1.645)( 25%)  1 (0.2)]
2
 $31.13  $10  $41.13
Liquidity risk
LO 20.5: Calculate liquidity-adjusted VAR.
 Initial asset value of $100
 Expected return () of 10% per annum
 Spread = 0.2
 Standard deviation () of 25%
 Level of significance = 5%
 Time horizon = 1 year

Relative VAR
LVAR j ( )  Vt , j  ( ) j  1 St , j 
 2 
LVAR j (5%)  $100 (1.645)(25%)  1 (0.2)
 2 
 $51.13
Liquidity Risk
LO 20.6: Discuss ways firms can minimize their
exposure to liquidity risk.

 Companies can take at least two steps to

minimize liquidity risks:
 Diversify liquidity risks across sources
 Perform scenario analysis-based planning
Market Risk Market Risk
Learning Outcomes (18.1 – 20.6) LO 18.1: Define market risk

 Market risk is “the risk related to the uncertainty

1 Market Risk (LO 18.1 – 18.4)
of a financial institution’s earnings on its trading
2 Foreign Exchange Risk (LO 19.1 – 19.6) portfolio caused by changes in market conditions
such as the price of an asset, interest rates, market
3 Cash flow exposures (LO 19.7 – 19.15) volatility, and market liquidity”
(Saunders, Chapter 10)
4 Liquidity risk (LO 20.1 – 20.6)

Market Risk Market Risk

LO 18.1: Define market risk LO 18.1: Define market risk
Securitization
Assets Liabilities Assets Liabilities
Investment Loans Capital Investment Loans Capital
(Banking) (Banking)
Other illiquid assets Deposits Other illiquid assets Deposits
Book Book
Bonds (long) Bonds (short) Bonds (long) Bonds (short)
Commodities (long) Commodities (short) Commodities (long) Commodities (short)
Trading Book FX (long) FX (short) Trading Book FX (long) FX (short)
Equities (long) Equities (short) Equities (long) Equities (short)
Derivatives (long) Derivatives (short) Derivatives (long) Derivatives (short)

1
Market Risk Market Risk
LO 18.2: Describe five reasons why market risk LO 18.3: List the models being used to calculate
measurement is important market risk exposure.

1. Management information: MRM gives senior managers RiskMetrics (variance/covariance)

information about risk exposures. • Market Risk = Position 
(Confidence)(Volatility)(Sensitivity)
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. Historic or back simulation
4. Performance evaluation: Rather than pay traders merely • When returns are non-normal
for taking on more risk, considers the return-risk ratio, and • Simple
therefore helps for more rational compensation scheme.
5. Regulation: Because regulations may tend to over-price Monte Carlo simulation
some risks, the use of internal models may lead to superior • When actual data is limited
capital allocation. • Like historic, percentile (%) rank

Market Risk Market Risk

LO 18.3: List the models being used to calculate LO 18.3: List the models being used to calculate
market risk exposure. market risk exposure.
1st Model: RiskMetrics Model for Daily Earnings at 1st Model (Variance Covariance) Fixed Income
Risk (DEAR)

Daily Price Volatility = Modified Duration 

Adverse Daily Yield Move

2
 Market Risk Market Risk
LO 18.3: List the models being used to calculate LO 18.3: List the models being used to calculate
market risk exposure. market risk exposure.
1st Model (Variance Covariance) Equities 2nd Model: Historic or Back Simulation Approach
The RiskMetrics model assumes normality. Due to this drawback,
most banks deploy market risk models that use a historic or
Total Risk = Systematic risk + back simulation approach. There are six steps to the historic
Unsystematic risk approach (using foreign exchange as an example):
1. Measure exposures

    
i
2
i
2 2
m
2
ei
2.
3.
Measure sensitivity
Measure risk
4. Repeat Step 3
5. Rank days by risk from worst to best
6. Determine VAR.

Market Risk Market Risk

LO 18.3: List the models being used to calculate LO 18.3: List the models being used to calculate
market risk exposure. market risk exposure.
Rank 3rd Model: The Monte Carlo Simulation Approach
days
by risk:  The Monte Carlo approach overcomes the problem of
worst limited observations. A typical Monte Carlo simulation
Measure Measure
to produces a large number of synthesized observations—
exposures risk best
sometimes a very large number.

Measure Repeat Determine

sensitivity Step 3 VAR

3
Market Risk Market Risk
LO 18.4: List the methods the Bank for International LO 18.4: List the methods the Bank for International
Settlement uses to regulate market risks Settlement uses to regulate market risks
Fixed Income
 The Bank for International Settlement (BIS) includes the  Specific Risk Charge
largest central banks in the world. Since January 1998,  The specific risk charge measures the risk of a decline in the liquidity or credit
banks in BIS member countries can calculate market risk risk quality of the portfolio over the holding period. Multiplying the absolute
dollar values of the long and short positions by the specific risk weights
(i.e., market risk only, not credit and operational risk) produces a specific risk capital (or requirement charge) for each position.
exposure in one of two ways: Summing the individual charges for specific risk gives the total specific risk
charge.
1. Use a simple standardized framework.  General Market Risk Charge
2. Use an internal model, contingent on regulatory approval.  The general market risk charges the product of the modified durations and
interest rate shocks expected for each maturity. The positive or negative dollar
However, an internal model is subject to regulatory values of the positions in each instrument are multiplied by the general market
audit(s) and certain constraints. risk weights to determine the general market risk charges for the individual
holdings. Summing these gives the total general market risk charge of the entire
fixed-income portfolio.

Market Risk Market Risk

LO 18.4: List the methods the Bank for International LO 18.4: List the methods the Bank for International
Settlement uses to regulate market risks Settlement uses to regulate market risks
Fixed Income Foreign Exchange (Under BIS Standardized Framework)
 Vertical Offsets  The standardized model or framework requires the bank to calculate its
 The BIS model assumes that long and short positions, in the same maturity net exposure in each foreign currency and then convert this into dollars at
bucket but in different instruments, cannot perfectly offset each other. Thus, the the current spot exchange rate. The BIS standardized framework imposes
general market risk charge tends to underestimate interest rate or price risk a capital requirement equal to 8% multiplied by the maximum absolute
exposure. To account for this, BIS requires additional capital charges for basis value of the aggregate long or short positions.
risk, called vertical offsets or disallowance factors.
 Horizontal Offsets within Time Zones
 In addition, the debt trading portfolio is divided into three maturity zones.
Because of basis risk (i.e., the imperfect correlation of interest rates on
securities of different maturities), short and long positions of different
maturities in these zones will not perfectly hedge each other. This results in
additional (horizontal) disallowance factors for each maturity zone, as follows:
 Zone 1 (1 to 12 months): 40%
 Zone 2 (>1 year to 4 years): 30%
 Zone 3 (> 4 to 20 years or more): 30%

4
Market Risk FX Risk
LO 18.4: List the methods the Bank for International LO 19.1: Describe the different sources of foreign
Settlement uses to regulate market risks exchange risk exposure
Equities (Under BIS Standardized Framework)
Two sources of risk in holding equities: (1) a firm-specific, or unsystematic, risk  Net exposurei = (FX assetsi - FX liabilitiesi) +
element and (2) a market, or systematic, risk element. (FX boughti - FX soldi)
 Unsystematic risk is charged by adding the long and short positions in any = Net foreign assetsi +
given stock and applying a 4% charge against the gross position in the stock. Net FX boughti
(This is called the x factor).
 Market or systematic risk is reflected in the net long or short position.
The capital charge is 8% against the net position. (This is called the y i = ith currency
factor).
Positive net exposure: net long a currency
 The total capital charge for the stock is the “x factor” plus the “y
factor”. Negative net exposure: net short a currency
This approach is crude and does not fully consider the benefits of portfolio
diversification (i.e., that unsystematic risk is not diversified away).

FX Risk FX Risk
LO 19.2: Explain the different types of foreign trading LO 19.3: Describe foreign exchange exposure resulting from
mismatches between foreign financial asset and liability
activities and the sources of most profits and losses portfolios, and explain how returns and risks of foreign investing
on foreign exchange trading. can impact returns.

Purchase/sale of foreign currencies

1. To allow customers to participate in international Assets Liabilities
commercial trade transactions $100 million, US Loans, US $200 million U.S. Dollars
2. To allow customers to take positions in foreign Dollars
investments (real or financial assets)
$100 million equivalent, Foreign
3. For hedging purposes—i.e., to offset currency exposure Loans, Foreign Dollars
4. For speculative purposes

5
FX Risk FX Risk
LO 19.4: Explain on-balance-sheet hedging LO 19.4: Explain on-balance-sheet hedging

Assets (loans) Liabilities (CDs) Assets (loans) Liabilities (CDs)

Invest: Lend: Invest: Lend:
$100.00 $ @ 9% $100.00 $ @ 8% $100.00 $ @ 9% $100.00 $ @ 8%
$100.00 £ @ 15% $100.00 £ @ 11% $100.00 £ @ 15% $100.00 £ @ 11%

$/£ $/£
Start $1.60 Start $1.60
End $1.45 End $1.70

$100.00 £62.50 $100.00 £62.50 $100.00 £62.50 $100.00 £62.50

$104.22 £71.88 $100.59 £69.38 $122.19 £71.88 $117.94 £69.38
4.22% 0.59% 22.19% 17.94%

ROA 6.61% COF 4.30% ROA 15.59% COF 12.97%

ROI 2.31% ROI 2.63%

FX Risk FX Risk
LO 19.5: Explain off-balance-sheet hedging LO 19.6: Explain why diversification in multicurrency
foreign asset-liability positions could reduce portfolio risk.
Assets (loans) Liabilities (CDs)
Invest: Lend:  To the degree that domestic and foreign interest rates
$100.00 $ @ 9% $200.00 $ @ 8% (or stock returns) are not perfectly correlated, potential
$100.00 £ @ 15% $0.00 £ @ 11%
gains from asset-liability portfolio diversification can
$/£ offset risk of asset-liability currency mismatch
Spot $1.60
Discount $0.05
Forward $1.55

$100.00 £62.50
Loan @ 15%
Returned (£) £71.88
Returned ($) $111.41
Loan Return 11.41%
ROA 10.20% COF 8.00%
ROI: 2.20%

6
FX Risk Cash flow exposures
LO 19.6: Explain why diversification in multicurrency LO 19.7: Distinguish among transaction exposure,
foreign asset-liability positions could reduce portfolio risk. contractual exposure, and competitive exposure to
exchange rate fluctuations.
 To the degree that domestic and foreign interest rates
(or stock returns) are not perfectly correlated, potential  Transaction exposure (to a currency) is the exposure due
gains from asset-liability portfolio diversification can to holding receivables and payables (in a foreign currency).
offset risk of asset-liability currency mismatch Transaction exposure results from past business deals.
 Contractual exposure (to a currency) is exposure due to

ri  rri  iie 
contractual commitments.
Competitive exposure is when the cash flow is exposed
ri  The nominal interest rate in country i to a change in the firm's competitive position. Competitive
rri  The real interest rate in country i exposure broadly defined; all firms have competitive exposure.
iie  The expected one-period inflation rate in country i

Cash flow exposures Cash flow exposures

LO 19.8: Explain the interaction of price risk and quantity risk in Assume: For U.S. Company, cost to make widget is $100
terms of the additional challenges to hedging using examples of U.S. company want to receive $120 per widget (i.e., $20 profit)
industries where the association between price and quantity of
the risky factor is negative and where it is positive. Baseline, "Before" the Currency Move
Pegged exchange rate: 7.50 Y Yuan/$
 Price risk: unexpected changes in price $0.1333 $/Yuan

 Quantity risk: unexpected changes in the exposure Price of a Widget (Y)

Converted ($)
900.00 Y
$120.00

Two Scenarios:
Yuan Yuan
Appreciates Depreciates
Yuan per 1 US$ 7.00 Y 8.00 Y
US$ per 1 Yuan $0.1429 $0.1250

"Negative" Relationship
Price in Yuan 840.00 Y 960.00 Y
Converted to US$: $120.00 $120.00

"Positive" Relationship
Price in Yuan 900.00 Y 900.00 Y
Converted to US$: $128.57 $112.50

7
 Cash flow exposures Cash flow exposures
LO 19.9: Explain the implications of perfect positive correlation, LO 19.9: Explain the implications of perfect positive correlation,
zero correlation, and perfect negative correlation between price zero correlation, and perfect negative correlation between price
risk and quantity risk for the optimal hedge ratio and the risk of risk and quantity risk for the optimal hedge ratio and the risk of
the hedged versus the unhedged cash flows. the hedged versus the unhedged cash flows.

Dollar Dollar
Price of Cash flow in Sw. Francs Cash flow in US $ Price of Cash flow in Sw. Francs Cash flow in US $ Futures Gain/Loss Net Gain/Loss
Swiss Pos Neg. Pos Neg. Swiss Pos Neg. Pos Neg. Pos Neg. Pos Neg.
franc (+) None (-) (+) None (-) franc (+) None (-) (+) None (-) (+) None (-) (+) None (-)
$1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75 $1.50 1.5 1.5 0.5 $2.25 $2.25 $0.75 ($1.00) ($0.50) - $1.25 $1.75 $0.75
$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75 ($1.00) ($0.50) - $1.25 $0.25 $0.75
$1.50 1.5 0.5 0.5 $2.25 $0.75 $0.75
$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75 $1.00 $0.50 - $1.25 $1.25 $0.75
$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75 $0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75 $1.00 $0.50 - $1.25 $0.75 $0.75
$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75
$1.00 $1.25 $1.00 $0.75 Average
Average $1.00 $1.25 $1.00 $0.75
0.50 0.25 - Covariance
Covariance 0.50 0.25 -
Variance 0.25 0.25 Variance
Hedge Ratio 2.00 1.00 - 2.00 1.00 - Hedge Ratio

Cash flow exposures Cash flow exposures

Positive Correlation (price, quantity): it can be hedged LO 19.10: Describe how the exposure of cash flow to a
Negative Correlation (price, quantity): already “naturally” hedged! risk factor, such as exchange rate risk, is measured.
No Correlation (price, quantity): “partial” hedge does not totally work
 Exposure of cash flow to a specific risk factor is
Dollar
Price of Cash flow in Sw. Francs Cash flow in US $ Futures Gain/Loss Net Gain/Loss measured by: the change in value of the cash flow
Swiss Pos Neg. Pos Neg. Pos Neg. Pos Neg.
franc (+) None (-) (+) None (-) (+) None (-) (+) None (-) (or the fair value of the asset) for a given unit change
$1.50
$1.50
1.5
1.5
1.5
0.5
0.5
0.5
$2.25
$2.25
$2.25
$0.75
$0.75
$0.75
($1.00) ($0.50)
($1.00) ($0.50)
-
-
$1.25
$1.25
$1.75
$0.25
$0.75
$0.75
in the risk factor. Specifically,
$0.50 0.5 1.5 1.5 $0.25 $0.75 $0.75 $1.00 $0.50 - $1.25 $1.25 $0.75
$0.50 0.5 0.5 1.5 $0.25 $0.25 $0.75 $1.00 $0.50 - $1.25 $0.75 $0.75

Cash flow per unit

$1.00 $1.25 $1.00 $0.75 Average
0.50 0.25 - Covariance
0.25 Variance
Exposure 
Risk factor
2.00 1.00 - Hedge Ratio

8
 Cash flow exposures Cash flow exposures
LO 19.11: Using supply (marginal cost) and demand analysis, illustrate Price £
the competitive exposure to exchange rate risk for an exporting firm, Quantity @ MR = MC
considering changes in (i) exchange rates between the firm’s currency
and the currency of the importing country and (ii) exchange rates
Quantity’ @ MR’ = MC’
between the currency of a third country (that has exporters that £
compete with the firm) and the currency of the importing country.
Pounds
MC
 Imperfect (limited) competition = elastic demand

 Perfect competition = producer is a “price taker” DD

MR
who cannot increase prices (i.e., perfectly elastic)
Q
Impact on pound price of cars sold in U.S.
Depreciation of dollar
Limited Competition = Elastic Demand

Cash flow exposures Cash flow exposures

Price £ Quantity @ MR = MC Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’ Quantity’ @ MR’ = MC’
£
£’ £’
Pounds MC MC

MR’ MR’

DD
MR
DD’ DD’

Q’ Q’ Q
Impact on pound price of cars sold in U.S. Impact on pound price of cars sold in U.S.
Depreciation of dollar Depreciation of dollar
Limited Competition = Elastic Demand Limited Competition = Elastic Demand

9
 Cash flow exposures Cash flow exposures
Price $ Quantity @ MR = MC Price $ Quantity @ MR = MC
Quantity’ @ MR’ = MC’ $’ Quantity’ @ MR’ = MC’
$ Dollars
MC’
Dollars
MC

DD DD
MR MR

Q Q’
Impact on dollar price of cars sold in U.S. Impact on dollar price of cars sold in U.S.
Depreciation of dollar Depreciation of dollar
Limited Competition = Elastic Demand Limited Competition = Elastic Demand

Cash flow exposures Cash flow exposures

Price $ Quantity @ MR = MC Price £ Quantity @ MR = MC
$’ Quantity’ @ MR’ = MC’ Quantity’ @ MR’ = MC’
$ MC’
£’
MC
MC
£ DD = MR

DD
MR

Q’ Q Q
Impact on dollar price of cars sold in U.S. Impact on pound price of cars sold in U.S.
Depreciation of dollar Depreciation of dollar
Limited Competition = Elastic Demand Perfect Competition = Perfectly Elastic ()

10
Cash flow exposures Cash flow exposures
Price £ Quantity @ MR = MC Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’ Quantity’ @ MR’ = MC’

£’ £’
MC MC

£ £ DD = MR

DD’ = MR’ DD’ = MR’

Q Q
Impact on pound price of cars sold in U.S. Impact on pound price of cars sold in U.S.
Depreciation of dollar Depreciation of dollar
Perfect Competition = Perfectly Elastic () Perfect Competition = Perfectly Elastic ()

Cash flow exposures Cash flow exposures

Price £ Quantity @ MR = MC Price £ Quantity @ MR = MC
Quantity’ @ MR’ = MC’ Quantity’ @ MR’ = MC’
MC’
$’ $’
MC

$ DD = MR $ DD = MR

Q’ Q Q’ Q
Impact on dollar price of cars sold in U.S. Impact on dollar price of cars sold in U.S.
Depreciation of dollar Depreciation of dollar
Perfect Competition = Perfectly Elastic () Perfect Competition = Perfectly Elastic ()

11
Cash flow exposures Cash flow exposures
LO 19.12: Outline the steps in determining cash flow exposure from a pro
Price £ Quantity @ MR = MC forma analysis when the correlation of the quantity sold with the risk factor
is zero, positive, and negative.
Quantity’ @ MR’ = MC’
MC’
$’ If we change the risk factor
MC Base (scenario-based change to
Cash flow Line Item Case the risk factor):
$ DD = MR Sales (Cash receipts) S +/-S = S Adjusted
Cash Cost of Goods Sold (COGS) -W +/-X = W Adjusted
Cash (SG&A) Expenses -X +/-Y = X Adjusted
Cash Taxes -Y +/-X = Y Adjusted
Net Cash Flow =Z = Z Adjusted
Q’ Q
Impact on dollar price of cars sold in U.S.
Depreciation of dollar
Perfect Competition = Perfectly Elastic ()

Cash flow exposures Cash flow exposures

LO 19.13: Explain how the optimal hedge ratio is determined in LO 19.14: Illustrate the concept of the delta exposure of cash flow, and
describe how it is estimated in practice for non-linear exposure to a risk
the context of pro forma cash flow analysis with one risk factor. factor.

Ri ,t  i  i Rx ,t   i ,t
cov(C ,G)
h Ri ,t  firm cash flow or return on securities
var(G)
i  constant
i  exposure of firm to specified risk factor
Rx ,t  return of the risk factor
cov[Cash flow, S]
h  i ,t  error term
var(S )

12
Cash flow exposures Liquidity risk
LO 19.15: Describe the steps in using Monte Carlo simulation to estimate the LO 20.1: Explain the interrelationship between funding
volatility-minimizing hedge ratio and the circumstances under which this
approach has significant advantages. liquidity risk and market liquidity risk
Express Cash Flow as function of risk  Funding liquidity risk
factor(s)
Not enough balance sheet cash
to fund ongoing operations
Identify distribution of risk factor (or precipitous drop)
Concern of corporate Chief Financial Officer (CFO)
Random number generator: 10,000
random risk factors
 Market liquidity risk
Deterioration in asset value:
Produces 10,000 “simulated” cash flows • Cannot liquidate the position, and/or
• Cannot sufficiently hedge the position
Identify specified percentile (95th Concern of market traders and market participants
percentile, 99th percentile)

Liquidity risk Liquidity risk

LO 20.2: Describe alternative methods for measuring LO 20.2: Describe alternative methods for measuring
liquidity risk. liquidity risk.
 Liquidity gap = Liquid assets minus (–) volatile  Liquidity risk elasticity (LRE)
liabilities  Given a small increase in bank’s liquidity premium (LIBOR
+ spread) on the marginal funding cost  Δ net of assets
over funded liabilities
NA(t ) A(t ) L(t )
 w
  
 A(t), L(t) are current values of assets, liabilities
 w is proportion of liabilities funded with the assets
 Ξ is the liquidity premium on the firm’s funding cost
LRE Limitations: (i) works for small Δ in funding costs, and
(ii) assumes parallel shift in funding costs

13
Liquidity risk Liquidity risk
LO 20.3: Discuss factors that impact an asset’s LO 20.3: Discuss factors that impact an asset’s
liquidation cost liquidation cost

Time horizon Time horizon

Asset type

Liquidity risk Liquidity risk

LO 20.3: Discuss factors that impact an asset’s LO 20.3: Discuss factors that impact an asset’s
liquidation cost liquidation cost

Time horizon Time horizon

Asset type Asset type
Asset fungibility Asset fungibility
Market microstructure
 Temporal aggregation (call or continuous)
 Dealership structure (decentralized 
centralized)

14
Liquidity risk Liquidity risk
LO 20.3: Discuss factors that impact an asset’s LO 20.4: Discuss problems with using the bid-ask
liquidation cost spread as a measure of liquidity.
Time horizon Market microstructure  Bid–ask spread: price difference between buyers and
Asset type  Temporal aggregation sellers of the same asset at the same time
(call or continuous)
Asset fungibility  Dealership structure
(decentralized  centralized)
Bid-ask spread

Liquidity risk Liquidity risk

LO 20.4: Discuss problems with using the bid-ask LO 20.5: Calculate liquidity-adjusted VAR.
spread as a measure of liquidity.

 Problems with the bid-ask spread:

LVARj ( )  Vt ,j[  j  ( ) j  1 St ,j ]
 Assumes trades can be crossed simultaneously 2
 Presumed to reflect a stable market impact function
that relates the cost of the transacting to order size. St,j  bid-ask spread
 Often different sets of bid–ask spreads; may be hard Vt , j  value of asset
to know which spread to use j  mean
j  standard deviation
 ( ) = confidence parameter

15
Liquidity risk Liquidity risk
LO 20.5: Calculate liquidity-adjusted VAR. LO 20.5: Calculate liquidity-adjusted VAR.
 Initial asset value of $100
 Assume  Expected return () of 10% per annum
 Initial asset value of $100  Spread = 0.2
 Expected return () of 10% per annum  Standard deviation () of 25%
 Spread = 0.2  Level of significance = 5%
 Standard deviation () of 25%  Time horizon = 1 year

 Level of significance = 5% Absolute VAR (Culp’s method)

 Time horizon = 1 year
 What is the liquidity-adjusted VAR? LVAR j ( )  Vt , j [ j   ( ) j  1 St , j ]
2
LVAR j (5%)  100[10%  (1.645)( 25%)  1 (0.2)]
2
 $31.13  $10  $41.13

Liquidity risk Liquidity Risk

LO 20.5: Calculate liquidity-adjusted VAR. LO 20.6: Discuss ways firms can minimize their
exposure to liquidity risk.
 Initial asset value of $100
 Expected return () of 10% per annum
 Spread = 0.2
 Companies can take at least two steps to
 Standard deviation () of 25% minimize liquidity risks:
 Level of significance = 5%  Diversify liquidity risks across sources
 Time horizon = 1 year
 Perform scenario analysis-based planning
Relative VAR
LVAR j ( )  Vt , j  ( ) j  1 St , j 
 2 
LVAR j (5%)  $100 (1.645)(25%)  1 (0.2)
 2 
 $51.13

16