MARKET RISK INTRODUCTION

MARKET RISK INTRODUCTION

1. Definition : Market risk : the risk that a financial institution will lose money as a result of change in the market value of assets and liabilities caused by the movements in market prices.

2. It is the risk that changes in market conditions will have a negative impact on the value of financial securities held by a financial institution

3. Market prices can change due to changes in

   • Interest rates = interest rate risk
   • Foreign Exchange rates= foreign exchange risk or currency risk
   • Market value of investments held by the institution = price risk or equity position risk in the case of equities
   • Commodities prices

4. Factors affecting the financial institution's exposure to the market risk

   • the longer the position is held there is a greater possibility of an adverse market price movement
   • the sensitivity of the price to underlying factors. Derivatives prices move far quicker than the price of the underlying equity
   • the liquidity or the ease of resale when the level of risk becomes unacceptable for the holder. the longer it takes to find a buyer/seller the greater the risk of price movement
   • the volatility of price fluctuations. Some emerging market equities have fluctuating prices whereas many types of gilts have relatively stable prices

5. Market risk can take several forms , depending on the behaviour of the underlying financial market fundamentals

   • Liquidity : the risk that arises from the difficulty of selling an asset. an insufficient secondary market may prevent the liquidation or limit the funds that can be raised from an asset sale
   • Funding: the risk that it might be difficult to realize assets or otherwise raise funds to meet commitments associated with financial instruments. This may give rise to losses associated with higher funding costs, or from a lack of funds to finance a project or meet financial obligations
     • example : northern Rock
   • Basis risk /correlation: = spread risk is the market risk related to differences in the market performance of two similiar positions. The more the instrument used for the hedging and the actual underlying are imperfect substitutes, the bigger the basis risk
   • Model -related risk : can be driven by various modelling-related issues, where the modelling assumptions made dont reflect the market fundamentals or behaviour. Given the dynamic nature of financial markets, models which were correctly reflecting the underlying the processes in the past may no longer work now
   • Reinvestment : the risk resulting from the fact that the return ( investment, dividends) generated by an investment cannot be reinvested in such a way that would generate the same return as the invested funds that generated them in the first place