Market Risk
Market risk is a type of financial risk that arises from the volatility of financial instruments and their underlying assets. It is the risk of losses in the value of a portfolio due to changes in market conditions, such as fluctuations in interest rates, currency exchange rates, commodity prices, and stock prices.
Market risk is a significant concern for financial institutions, as it can have a substantial impact on their profitability and solvency. In order to manage market risk, financial institutions employ various risk management techniques, such as diversification, hedging, and risk modeling.
Diversification involves spreading investments across a variety of asset classes and securities to reduce the impact of market volatility on the overall portfolio. Hedging involves using financial instruments such as options and futures contracts to offset potential losses from adverse market movements. Risk modeling involves the use of mathematical and statistical techniques to estimate the potential impact of market fluctuations on a portfolio.
Overall, market risk is an essential aspect of financial risk management, and effective management of this risk is critical to the long-term success of financial institutions.
Banks take positions on the market for investments or to hedge their positions partially to reduce risk. The market positions via cash or derivative products make the bank vulnerable to large and unexpected adverse market movements. Classical sources of market risk are large movements in equity prices, foreign exchange rates, commodity prices and interest rates:
- Equity risk: Stock prices are volatile and can exhibit significant fluctuations over time. The equity risk on the portfolio denotes the possible downward price movements of the equity in the portfolio. The main products subject to equity risk are common stocks (voting and non-voting), convertible securities, commitments to buy or sell equities and derivative products.
- Currency risk: Currency risk arises from price changes of one currency against another. It occurs when making investments in different currencies, especially when making cross-border investments. When a European bank invests in US stocks, the risk arises from equity risks on the stocks, but also from exchange rate risk on the euro/dollar rate. Gold is either seen as a commodity or as a currency. In terms of volatility, it behaves more like a currency. Currency risk is applicable to products and commitments in a foreign currency. The currency risk is perceived lower in fixed-currency regimes than floating regimes, but even in such cases devaluations or revaluations that change the parity value of the currencies and changes from fixed to floating regimes represent currency risk.
- Commodity risk: Commodity risk arises from uncertain future market price changes of commodities. A commodity is a physical product that can be traded on the secondary market. Examples of commodities are agricultural products (grains, cattle), precious metals (silver, copper) and minerals (iron ore, gas, electricity). Prices depend significantly on changes of supply and demand. Commodity markets can be less liquid than interest rate and currency markets, which makes the risk management of commodities more complex.
- Interest rate risk: The price of some investments depends on the interest rate. Interest rates are expressed as levels or as the difference with respect to a chosen benchmark or reference rate (e.g., government rate, LIBOR or swap rate). The difference (yield spread) can be due to credit quality (credit spread), liquidity (liquidity spread), tax reasons (tax spread) or the maturity (term spread).
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