Understanding Market Risk

• Risk is the volatility of returns leading to unexpected losses, with higher volatility indicating higher risk
• The volatility of returns is directly or indirectly influenced by numerous variables known as risk factors, and their interaction.
• Risk factors can be grouped into major categories like market risk, credit risk, liquidity risk, operational risk, legal/regulatory, business, strategic, and reputation risk.
• Market and credit risk are considered financial risks.
• Market risk can be divided into equity price risk, interest rate risk, foreign exchange risk, and commodity price risk.
• Interest rate risk includes trading risk and gap risk, the latter concerning balance sheet sensitivities to interest rate changes.
• Comprehensive risk categorization and detailed decomposition enhance risk capture; however, this is limited by model complexity, available technology, and data costs.

Market Risk

• Market risk is the potential reduction in a security or portfolio's value due to changes in financial market prices and rates.
• Price risk has two components: general market risk- the risk that the entire market declines, and specific market risk, which is unique to an individual financial transaction.
• Risk in trading activities arises from unhedged positions and imperfect correlations between positions meant to offset each other.
• Market risk can be called "tracking error" when referring to a fund and how well it performs against a benchmark.
• Basis risk describes the potential breakdown in the price relationship between a product and its hedging instrument.
• The four main types of market risk are interest rate risk, equity price risk, foreign exchange risk, and commodity price risk.

Interest Rate Risk

• Interest rate risk, in its simplest form, is the potential for a fixed-income security's value to decrease with rising market interest rates.
• Complex portfolios of interest-rate-sensitive assets are exposed to various risks due to differing maturities and reset dates.
• "Curve" risk can occur when portfolios with long and short positions of different maturities are hedged against parallel shifts in yields but not changes in the yield curve's shape.
• Basis risk can emerge in offsetting positions, even with the same maturity, if their rates are imperfectly correlated; an example of this is three-month Eurodollar instruments and Treasury bills.

Equity Price Risk

• Equity price risk refers to the risk correlated with stock price volatility.
• General market risk of equity describes an instrument or portfolio's sensitivity to broad stock market index level changes.
• Specific, or idiosyncratic, equity risk is the portion of a stock's price volatility that is determined by company specifics like its business, management quality, or production breakdowns.
• Portfolio theory states that general market risk cannot be eliminated through diversification, but specific risk can be.

Foreign Exchange Risk

• Foreign exchange risk arises from open or imperfectly hedged postions in foreign currency, causing fluctuations in profits or values relative to a local currency.
• Foreign exchange volatility can negate cross-border investment returns and put firms at a competitive disadvantage.
• Key drivers of foreign exchange risk are imperfect correlations in currency price movements and international interest rate fluctuations.
• Valuation of foreign exchange transactions requires knowledge of domestic and foreign rates and spot exchange rates.

Commodity Price Risk

• Commodity prices differ from interest rates and exchange rates because supply is concentrated among a few suppliers, magnifying price volatility.
• Due to a limited number of market players with direct commodity exposure, trading liquidity affects price volatility.
• Fundamentals impacting commodity prices include the ease and cost of storage.
• Commodity prices can have higher volatilities and larger price discontinuities compared to most traded financial securities.
• Commodities are classified as hard commodities (nonperishable), soft commodities (short shelf life, hard to store), and energy commodities.
• Hard commodities are divided into precious metals with a high price/weight value and base metals.
• Soft commodities are agricultural products while energy commodities consist of oil, gas, and electricity.

Credit Risk

• Credit risk is the potential for financial loss due to a counterparty's failure to meet contractual obligations, or the increased risk of default during a transaction.
• Credit risk in bank loan portfolios arises when borrowers fail to make contracted payments.
• Default risk is a debtor's inability or refusal to meet debt obligations beyond a reasonable grace period, typically 60 days.
• Bankruptcy risk is the risk of assuming assets of a defaulted counterparty, where in the case of a bankrupt company, debt holders are taking control of the company from the shareholders.
• Downgrade risk is the potential deterioration of a borrower or counterparty's creditworthiness, often leading to a rating agency downgrade, which increases the risk premium or credit spread.
• Settlement risk is the risk due to exchanging cash flows when a transaction is settled, caused by counterparty default, liquidity constraints, or operational issues, and is greatest when payments occur in different time zones.
• Credit risk is an issue when a position has a positive replacement value (i.e. an asset), where the firm loses the market value of the position if the counterparty defaults.
• Recovery value is the estimated value recovered after a credit event, while loss given default (LGD) is the expected loss amount.
• LGD on derivatives if lower than face value because the economic value of a derivative instrument is related to its replacement or market value rather than its nominal or face value.
• Credit exposures from derivatives are dynamic, requiring firms to examine both current and potential future exposures until deal termination.

Credit Risk at the Portfolio Level

• Credit risk in a portfolio is affected by the credit standing of specific obligors, requiring appropriate interest rates or spreads.
• "Concentration risk" refers to the lack of diversification across exposures and sectors.
• Economic conditions significantly influence portfolio risk; default frequency decreases during economic growth and increases during downturns.
• Credit portfolio models aid in identifying correlation/concentration risk in a bank's portfolio.
• Loan maturities impact portfolio quality, with longer loans generally being riskier.
• Banks can reduce portfolio maturity risk, also known as time diversification", by diversifying loan maturities which also reduces liquidity risk.

Liquidity Risk

• Liquidity risk includes funding and trading liquidity risk
• Funding liquidity risk is a firm's capacity to raise cash to cover debt, meet collateral needs, and handle capital withdrawals
• Funding liquidity risk can be managed by holding cash equivalents, establishing credit lines, and monitoring buying power.
• Trading liquidity risk, or "liquidity risk", refers to the inability to execute transactions at the prevailing market price due to a temporary lack of demand.
• A transaction that cannot be delayed may result in substantial losses
• Trading liquidity risk relates to size and immediacy and is hard to quantify; VaR models parameterize it based on the time to liquidate positions.
• Trading liquidity risk reduces a firm's ability to manage market risk, hedge, and cover funding shortfalls.

Operational Risk

• Operational risk is the possibility of losses resulting from operational weaknesses like inadequate systems, management failure, faulty controls, fraud, and human errors.
• In banking, operational risk includes natural and man-made disasters.
• Losses from derivative trading are often direct consequences of operational failures; derivative trading being more prone to operational risk due to its leveraged nature.
• Valuing complex derivatives increases operational risk and requires tight controls.
• A specific form of operational risk is human factor risk, involving losses from human errors.
• Technology risk is mainly computer systems risk and also falls into the operational risk category.

Legal and Regulatory Risk

• Legal and regulatory risks stem from various factors and relate to operational and reputation risks.
• A counterparty may lack legal or regulatory authority for a risky transaction.
• Under Basel II Capital Accord, legal and regulatory risks are classified as operational risks.
• Legal risks in derivative markets become evident when a counterparty sues to avoid obligations after losing money.
• Regulatory risk involves the potential impact of tax law changes on a position's market value.

Business Risk

• Business risk includes the classic risks such as uncertainties about product demand and delivering said products.
• Core management tasks like strategic decisions guide business risk.
• It has been debated whether business risks need to be supported by capital in the same way as credit and market risks.
• In the Basel II Capital Accord, regulators excluded "business risk" from the definition of operational risk.
• Business risk is affected by a firm's strategy, reputation, and other factors; It is common practice to view strategic and reputation risks as components of business risk.

Strategic Risk

• Strategic risk is the potential risk of significant investments with high uncertainty about profitability.
• It is also related to a change in the company's strategy in regards to its competitors.
• Unsuccessful ventures may lead to write-offs and damaged reputation among investors.

Reputation Risk

• Reputation risk can be divided into the belief that an enterprise will fulfill obligations and be a fair dealer following ethical practices.
• The importance of reputation was seen after the Lehman Brothers collapse in 2008
• A survey indicated that 34% of international bank respondents believed that reputation risk is the biggest risk compared to market and credit risk at 25%.
• Financial institutions depend on the confidence of customers, creditors, regulators, and the general market to maintain their reputation.
• Developing financial products may pressure accounting and tax rules to give rise to questions about legality which can damage an institution.
• Demonstrating ethical, social, and environmental responsibility is increasingly important; the "Equator Principles" emerged as a defensive mechanism by banks.

Systemic Risk

• Systemic risk is the potential for one institution's failure to trigger a domino effect, threatening financial markets and the global economy.
• Perception of increased risk can cause panic and lead to a "flight to quality" which can affect the markets.
• Market disruptions during a "flight to quality" may trigger panicked margin calls, where counterparties may have to put up more cash or collateral to compensate for falling prices.
• One proposal to address systemic risk would require firms to pay creating systemic exposure.
• Interconnections and dependencies exacerbate this risk during crises.
• Failures of Bear Stearns, Lehman Brothers, and AIG contributed to systemic risk during the 2007-2009 crisis.
• The Dodd-Frank Act addresses systemic risk by establishing the Financial Stability Oversight Council (FSOC), which recommends policies to regulatory bodies.
• The Dodd-Frank Act aims to move OTC derivatives to centralized clearing/exchange platforms, turning counterparty risk into exposure to central clearinghouses.
• While now posing a central clearinghouse risk, this risk must be regulated unlike private OTC markets because clearinghouses are supervised public utilities.