Market Risk

IntroductionIntroduction

Market risk management is no longer the Market risk management is no longer the domain of big investment banksdomain of big investment banks. . It is becoming It is becoming a buzz phrase across all areas of business, from a buzz phrase across all areas of business, from smaller banks and hedge funds to insurance smaller banks and hedge funds to insurance companies, pension funds, asset managers and companies, pension funds, asset managers and nonnon--financial companiesfinancial companies. .

The advances in market risk management are The advances in market risk management are part of a much broader trend in financial part of a much broader trend in financial markets and institutionsmarkets and institutions: : the recognition that the recognition that return is only one side of the performancereturn is only one side of the performance. . Information about risk, including relatively Information about risk, including relatively unlikely or unexpected risks, is necessary for unlikely or unexpected risks, is necessary for evaluating trading strategies, investment evaluating trading strategies, investment choices and asset allocationchoices and asset allocation..

Definition of market risk

-Market risk-Market risk is the risk that the value of is the risk that the value of an investment will decrease due to an investment will decrease due to moves in market factors.moves in market factors.

-Market risk is exposure to the uncertain -Market risk is exposure to the uncertain market value of a portfolio. A trader holds market value of a portfolio. A trader holds a portfolio of commodity forwards. he a portfolio of commodity forwards. he knows what its market value is today, but knows what its market value is today, but he is uncertain as to its market value a he is uncertain as to its market value a week from today. She faces market risk. week from today. She faces market risk.

Definition of market risk

The risk of losses in on and off-balance-sheet The risk of losses in on and off-balance-sheet positions arising from movements in market positions arising from movements in market prices. prices.

The dayThe day--toto--day potential for an investor to day potential for an investor to experience losses from fluctuations in securities experience losses from fluctuations in securities pricesprices.. This risk cannot be diversified away This risk cannot be diversified away. .

Also referred to as Also referred to as ""systematic risksystematic risk". ".

The beta of a stock is a measure of how much The beta of a stock is a measure of how much market risk a stock facesmarket risk a stock faces. .

Standard market risk factors

Equity riskEquity risk, or the risk that stock prices will , or the risk that stock prices will change. change.

Interest rate riskInterest rate risk, or the risk that interest rates , or the risk that interest rates will change. will change.

Currency riskCurrency risk, or the risk that foreign exchange , or the risk that foreign exchange rates will change. rates will change.

Commodity riskCommodity risk, or the risk that commodity , or the risk that commodity prices (i.e. grains, metals, etc.) will change.prices (i.e. grains, metals, etc.) will change.

Sometimes, a fifth risk factor is also considered:Sometimes, a fifth risk factor is also considered:

Equity index riskEquity index risk, or the risk that stock or other , or the risk that stock or other index prices will change. index prices will change.

Equity riskEquity risk

Equity riskEquity risk is the risk that one'sis the risk that one's investmentsinvestments will depreciate because ofwill depreciate because of stock market stock market dynamics causing one to losedynamics causing one to lose money.money.

The measure of risk used in the equity markets The measure of risk used in the equity markets is typically the standard deviation of a is typically the standard deviation of a security's price over a number of periodssecurity's price over a number of periods. . The The standard deviation will delineate the normal standard deviation will delineate the normal fluctuations one can expect in that particular fluctuations one can expect in that particular security above and below the mean, or security above and below the mean, or averageaverage. . However, since most investors would However, since most investors would not consider fluctuations above the average not consider fluctuations above the average return as return as ""riskrisk"", some economists prefer other , some economists prefer other means of measuring itmeans of measuring it..

Interest Rate RiskInterest Rate Risk

Interest rate riskInterest rate risk is the risk that the is the risk that the relative value of a security, especially a relative value of a security, especially a bond, will worsen due to an interest rate bond, will worsen due to an interest rate increase. This risk is commonly measured increase. This risk is commonly measured by the bond's duration by the bond's duration

Currency risk

Currency riskrisk is a form ofis a form of riskrisk that that arises from the change in price of onearises from the change in price of one currencycurrency against anotheragainst another. . Whenever Whenever investors or companies have assets or investors or companies have assets or business operations across national business operations across national borders, they face currency risk if their borders, they face currency risk if their positions are notpositions are not hedgedhedged..The exchange risk associated with a The exchange risk associated with a foreign denominated instrument is a key foreign denominated instrument is a key element in foreign investmentelement in foreign investment. . This risk This risk flows from differential monetary policy flows from differential monetary policy and growth in real productivity, which and growth in real productivity, which results in differential inflation ratesresults in differential inflation rates..

Currency risk

For example if you are a UFor example if you are a U..SS. . investor investor and you have stocks in Canada, the and you have stocks in Canada, the return that you will realize is affected return that you will realize is affected by both the change in the price of by both the change in the price of the stocks and the change of the the stocks and the change of the Canadian dollar against the UCanadian dollar against the U..SS. . dollardollar. . Suppose that you realized a Suppose that you realized a return in the stocks of 15% but if the return in the stocks of 15% but if the Canadian dollar depreciated 15% Canadian dollar depreciated 15% against the Uagainst the U..SS. . dollar, you would dollar, you would realize no gainrealize no gain..

Commodity riskCommodity riskCommodity riskCommodity risk refers to the uncertainties of futurerefers to the uncertainties of future market valuesmarket values and of the size of the futureand of the size of the future incomeincome, , caused caused by the fluctuation in the prices ofby the fluctuation in the prices of commoditiescommodities. . These These commodities may becommodities may be grains,grains, metals,metals, gasgas ووelectricity etcelectricity etc. . A A Commodity enterprise needs to deal with the following Commodity enterprise needs to deal with the following kinds of riskskinds of risks::

Price risk (Risk arising out of adverse movements in the Price risk (Risk arising out of adverse movements in the world prices, exchange rates, basis between local and world world prices, exchange rates, basis between local and world prices)prices)

Quantity riskQuantity risk

Cost riskCost risk (Input price risk(Input price risk((

Political riskPolitical risk

Commodity risk

Groups at RiskGroups at RiskThere are broadly four categories of There are broadly four categories of agents who face the commodities riskagents who face the commodities riskProducersProducers)) farmers, plantation companies, farmers, plantation companies, and mining companiesand mining companies) ) face price risk, face price risk, cost risk cost risk ((on the prices of their inputson the prices of their inputs) ) and and quantity riskquantity risk

Buyers (cooperatives, commercial traders Buyers (cooperatives, commercial traders and trait antsand trait ants) ) face price risk between the face price risk between the time of uptime of up--country purchase buying and country purchase buying and sale, typically at the port, to an exportersale, typically at the port, to an exporter. .

Commodity riskCommodity risk

Exporters face the same risk between purchase Exporters face the same risk between purchase at the port and sale in the destination market; at the port and sale in the destination market; and may also face political risks with regard to and may also face political risks with regard to export licenses or foreign exchange conversionexport licenses or foreign exchange conversion. .

GovernmentsGovernments face price and quantity risk with face price and quantity risk with regard to tax revenues, particularly where tax regard to tax revenues, particularly where tax rates rise as commodity prices rise rates rise as commodity prices rise ((generally generally the case with metals and energy exportsthe case with metals and energy exports) ) or if or if support or other payments depend on the level support or other payments depend on the level of commodity pricesof commodity prices. .

Measuring market risk

Market risk is typically measured using a Market risk is typically measured using a Value at Risk methodology. Market risk Value at Risk methodology. Market risk can also be contrasted with Specific risk, can also be contrasted with Specific risk, which measures the risk of a decrease in which measures the risk of a decrease in ones investment due to a change in a ones investment due to a change in a specific industry or sector, as opposed to specific industry or sector, as opposed to a market-wide move.a market-wide move.

Market Risk managementMarket Risk management

All businesses take risks based on the All businesses take risks based on the two factorstwo factors: : the probability an adverse the probability an adverse circumstance will come about and the circumstance will come about and the cost of such adverse circumstancecost of such adverse circumstance. .

The same principles apply to market risk The same principles apply to market risk and, while smaller businesses may have a and, while smaller businesses may have a less formal approach to analyzing the less formal approach to analyzing the risks, larger businesses tend to use risks, larger businesses tend to use sophisticated software packages to help sophisticated software packages to help determine the best course of actiondetermine the best course of action..

Market Risk managementMarket Risk management

Market risk is managed with a shortMarket risk is managed with a short--term focusterm focus. . LongLong--term losses are avoided by avoiding term losses are avoided by avoiding losses from one day to the nextlosses from one day to the next. . On a tactical On a tactical level, traders and portfolio managers employ a level, traders and portfolio managers employ a variety ofvariety of risk metrics duration and convexityrisk metrics duration and convexity, , thethe GreeksGreeks, , beta, etcbeta, etc..—to assess their —to assess their exposuresexposures. . These allow them to identify and These allow them to identify and reduce any exposures they might consider reduce any exposures they might consider excessiveexcessive. . On a more strategic level, organizations On a more strategic level, organizations manage market risk by applyingmanage market risk by applying risk limitsrisk limits to to traders' or portfolio managers' activitiestraders' or portfolio managers' activities. . IncreasinglyIncreasingly, , valuevalue--atat--riskrisk is being used to is being used to define and monitordefine and monitor

Managing Market Risk by Forward Pricing

Forward pricing strategies can minimize the impact of market price variation. Strategies for making a profit:

-cost of production lower thanindustry average.-prevent selling prices below cost of

production.- sell significant annual production above

cost of production.

Business riskBusiness risk

Business risk is exposure to uncertainty in Business risk is exposure to uncertainty in economic value that cannot be markedeconomic value that cannot be marked--toto--market.market.Business risk is managed with a longBusiness risk is managed with a long--term term focusfocus. . Techniques include the careful Techniques include the careful development of business plans and development of business plans and appropriate management oversightappropriate management oversight. . bookbook--value accounting is generally used, so the value accounting is generally used, so the issue of dayissue of day--toto--day performance is not day performance is not materialmaterial. . The focus is on achieving a good The focus is on achieving a good return on investment over an extended return on investment over an extended horizon.horizon.

Market risk versus business riskMarket risk versus business risk

The distinction between market risk and The distinction between market risk and business risk is ambiguous because there business risk is ambiguous because there is a vast is a vast ""gray zonegray zone" " between the twobetween the two. .

The distinction between market risk and The distinction between market risk and business risk parallels the distinction business risk parallels the distinction between marketbetween market--value accounting and value accounting and bookbook--value accountingvalue accounting. .

ExampleExample

Suppose X firm electricity wholesaler is Suppose X firm electricity wholesaler is long a forward contract for onlong a forward contract for on--peak peak electricity delivered over the next 3 electricity delivered over the next 3 monthsmonths. .

There is an active forward market for There is an active forward market for such electricity, so the contract can be such electricity, so the contract can be marked to market dailymarked to market daily. . Daily profits and Daily profits and losses on the contract reflect market risklosses on the contract reflect market risk. .

ExampleExample

Suppose the firm also owns a power plant Suppose the firm also owns a power plant with an expected useful life of 30 yearswith an expected useful life of 30 years. . Power plants change hands infrequently, Power plants change hands infrequently, and electricityand electricity forward curvesforward curves don’t exist don’t exist out to 30 yearsout to 30 years. . The plant cannot be The plant cannot be marked to market on a regular basismarked to market on a regular basis. . In In the absence of market values, market the absence of market values, market risk is not a meaningful notionrisk is not a meaningful notion..

Uncertainty in the economic value of the Uncertainty in the economic value of the power plantpower plant represents business riskrepresents business risk..

Questions Questions and answers

What is the market risk in finance situations?

- It's the portion of the total risk It's the portion of the total risk attributable to volatility of the marketattributable to volatility of the market. .

Questions and answersQuestions and answers

• What is market risk premium? Or what is the What is market risk premium? Or what is the implication behind it? What does it represent?implication behind it? What does it represent?

- The market risk premium is most commonly The market risk premium is most commonly viewed as the expected return one would get viewed as the expected return one would get for investing in the stock market versus the for investing in the stock market versus the ""riskrisk--freefree" " rate rate ((government bondsgovernment bonds). ). So if So if government bonds yield 5%, and people expect government bonds yield 5%, and people expect the stock market to return 8% over a long the stock market to return 8% over a long period of time, then the market risk premium is period of time, then the market risk premium is 3%3%. . Academics often estimate the actual Academics often estimate the actual market risk premium to be 3-5%market risk premium to be 3-5%. .