Market Risk

Market Risk

1. Define

   • RIsk that changes financial market prices or a portfolio and rates will reduce the dollar value of a securit
   • Tracking Error, Basis Risk
   • Price risk = i/r risk
   • Affects credit risk of counterparties
     • Affected by change in market financially

2. Interest Rate Risk

   • The risk that the value of a fixed income security will fall as a result of an increase in market interest rates
     • i/r increase, price fall, reinvestment risk increase
     • Yield Curve Risk
       • risk of experiencing an adverse shift in market interest rates associated with investing in a fixed income instrument

3. Equity Risk

   • Risk associated with volatility in stock prices
     • systematic (general)
       • Cannot avoid
     • unsystematic (specific)
       • Can be mitigated through diversification

4. Commodity RIsk

   • volatility in market price due to price fluctuation of a commodity
   • Hard Commodities (Non perishable)
     • Precious Metal
       • Gold Silver & Platinum
     • Base Metal
       • Copper Zinc & Tin (perfect substitute)
   • Soft Commodities (short shelf life/hard to store)
     • Agricultural Products (Grains, Coffee & Sugar) (perfect substitute)
   • Energy Commodities
     • interrelated If oil price fall, carosine will tend to fall too

5. Foreign Exchange Risk

   • Risk that arises when there is volatility in currency exchange rates and when there is open or imperfectly hedged positions in a particular currency.
     • Exposed when conducting business due to imperfect hedges.

6. Hedging Instruments

   • SWAPS
     • CDS
     • Currency Swap
     • I/R Swap
     • 2 counterparties agree to exchange one stream of cash flows tie to one tpe of financial instrument against another stream tied to another financial instrument
   • Futures
     • Contract btwn 2 parties to buy or sell assets at a particular time in the future
       • Based on price agreed now
         • Settle & Delivery on maturity date
   • Options
     • Put
       • Right to sell an asset
     • Call
       • Right to buy an asset
     • Give the buyer the right to buy or sell a designated instrument at a specified price over a specific time period

7. Financial Engineering

   • Equity Linked Notes
     • Put Fixed Deposit
       • High i/r
     • Sell put option
       • Sell the right to sell an asset
   • Create complex instruments
     • To match the risk/return of clients
   • Eg.
     • Currency Swap
     • Back to Back Loan
     • Cross Currency Swap

8. VaR

   • The worst loss that might be expected from holding a security or portfolio over a period of time, given a specified level of probability
   • Only quantify min losses that will occur
     • 10M, 99% Confidence
       • In 100 days, 1 day may lose more than 10M
   • Allow you to quantify risk
   • Advantage
     • Understandable
     • Drill down capability
     • Provide an aggregate measure of risk
     • Common, consistent & intergrated measure of risk across factors, instruments, & assets classes on a firm wide basis
     • Allow assement on how it benefits from diversification
     • Provide senior mgt, the board of directors & regulators with an understandable risk measure
     • Effective internal & external reporting tool
   • Disadvantage
     • Apropriate only for relatively short horizon
     • Use & reliability are often dictated by the availability of data
     • Prices & values are assumed to have a 'smooth' behaviour that excludes the possibility of jumps & other extreme events.

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