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Market risk

Market risk (also called position risk, trading risk and price risk) is the risk of a decline in the market value of financial securities (shares, debt and derivatives) that is caused by unexpected changes in market prices and interest rates, and changes in credit spreads.27

This definition requires elaboration:

• Market risk cannot apply to floating rate debt, which makes up the majority of banks' portfolios, because, as interest rates in general change, so do floating rates.

• Market risk can only apply to marketable securities, and these are shares, debt and derivatives.

• In the case of non-marketable assets and liabilities, as rates change there may be opportunity costs. For example, if a bank makes a 2-year fixed-rate loan at 10% pa and rates increase after the deal, the bank has missed an opportunity. We hastily add that this deal may be matched with a fixed rate liability, and there is no (interest rate) risk here.

• Marketable shares are straightforward: the market prices on the exchange are the market values.

• Fixed-interest debt is a little different: in most countries debt trades at a rate (yield, discount, etc.). The price of debt = the market value of debt, is derived from the secondary market trading rate. It should be evident that the relationship between rates and prices / market values of debt is inverse.

• Derivatives: The market risk in futures contracts is approximately the same as the underlying asset of the future. With options the extent of risks depends on whether the bank is the writer (= full market risk) or the buyer (= limited risk). These two risk possibilities apply to the other derivatives.

• Credit spread example: if the credit rating on the bonds of a corporate entity deteriorates, the spread above the benchmark rate (= government bond rate) will increase without the benchmark rate changing.

• It was mentioned above that at times banks may also have positions in commodities such as gold. The market value of such commodities = the market price.

Banks over many years have responded to narrowing margins and competition in many traditional areas of banking by increasing their trading activities, as reflected in the larger dealing rooms of banks, and the increased turnover in the various financial markets. This development has led to some banks holding larger positions in financial securities; this has increased exposure to market risk. The collapse or near-collapse of high profile banks in the US, the UK, Europe, Japan and elsewhere, due to losses on positions (particularly in derivatives) is well known.

The response of banks to these collapses and near-collapses of banks has been to sharpen risk management in this regard. This has entailed the introduction of controls and limits on dealers and the development of models to measure market risk exposure. At the same time, the regulators of the world have also sharpened their pencils and improved the regulation and supervision of banks' exposure to market risk.

Most bank regulators require banks to submit elaborate returns in respect of market risk on a monthly basis. One central bank28 elaborates on the purpose:

"The purpose of this return is to measure the extent of market risk (position risk) to which the reporting bank is exposed in respect of both its trading and banking activities."

Banks generally use the statistical Value at Risk (VaR) approach to market risk. One bank's29 approach is described as follows:

"Independent market risk management units, accountable to their ALCO, monitor exposures to market risk from trading operations. The units report the exposures and respective excesses monthly to each ALCO concerned and quarterly to the Board Risk Management Committee...

"The group manages market risk through risk limits. The group uses a range of risk measurement methodologies and tools to establish limits, including VaR, stress testing, loss triggers and traditional risk management measures.

"The group uses the VaR approach to derive quantitative measures, specifically for market risk under normal market conditions. While VaR, calculated on a daily basis, provides an indication of possible losses under normal market conditions, the group simulates extreme market movements using stress tests. The stress testing takes into account illiquidity, breakdowns in correlation and event risks which characterize the markets in which the group trades. Loss triggers are designed to contain daily, monthly and year-to-date losses for individual business units by enforcing management intervention at pre-determined loss levels. Several traditional measures specific to individual business units are used and deal with, for example, permissible instruments, concentration of exposures, gap limits and maximum tenor."

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