Market risk
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Market risk is the
risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
of losses in positions arising from movements in market variables like prices and volatility. There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the most commonly used types of market risk are: * '' Equity risk'', the risk that
stock In finance, stock (also capital stock) consists of all the Share (finance), shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which owners ...
or stock indices (e.g. Euro Stoxx 50, etc.) prices or their
implied volatility In financial mathematics, the implied volatility (IV) of an option (finance), option contract is that value of the Volatility (finance), volatility of the underlying instrument which, when input in an Valuation of options, option pricing model (such ...
will change. * ''
Interest rate risk In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpt ...
'', the risk that
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s (e.g.
Libor The London Inter-Bank Offered Rate is an interest-rate average calculated from estimates submitted by the leading banks in London London is the capital and List of urban areas in the United Kingdom, largest city of England and the Unite ...
,
Euribor The Euro Interbank Offered Rate (Euribor) is a daily reference rate, published by the European Money Markets Institute, based on the averaged interest rates at which Eurozone banks offer to lend unsecured loan, unsecured funding, funds to other ...
, etc.) or their implied volatility will change. * '' Currency risk'', the risk that foreign exchange rates (e.g. EUR/USD, EUR/GBP, etc.) or their implied volatility will change. * ''
Commodity risk Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodity, commodities. These commodities may be grains, metals, gas, electricity etc. A commodity ...
'', the risk that
commodity In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the beh ...
prices (e.g.
corn Maize ( ; ''Zea mays'' subsp. ''mays'', from es, maíz after tnq, mahiz), also known as corn ( North American and Australian English Australian English (AusE, AusEng, AuE, AuEng, en-AU) is the set of variety (linguistics), varieties ...
,
crude oil Petroleum, also known as crude oil, or simply oil, is a naturally occurring yellowish-black liquid mixture of mainly hydrocarbons, and is found in geological formations. The name ''petroleum'' covers both naturally occurring unprocessed crude ...
) or their implied volatility will change. * '' Margining risk'' results from uncertain future cash outflows due to margin calls covering adverse value changes of a given position. * '' Shape risk'' * '' Holding period risk'' * '' Basis risk'' The
capital requirement A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simulta ...
for market risk is addressed under a revised framework known as " Fundamental Review of the Trading Book" (FRTB).


Risk management

All businesses take risks based on two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance.
Risk management Risk management is the identification, evaluation, and prioritization of risks (defined in ISO 31000 as ''the effect of uncertainty on objectives'') followed by coordinated and economical application of resources to minimize, monitor, and con ...
is then the study of how to control risks and balance the possibility of gains. For a discussion of the practice of (market) risk management in banks, investment firms, and corporates more generally see .


Measuring the potential loss amount due to market risk

As with other forms of risk, the potential loss amount due to market risk may be measured in several ways or conventions. Traditionally, one convention is to use
value at risk Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by ...
(VaR). The conventions of using VaR are well established and accepted in the short-term risk management practice. However, VaR contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The VaR of the unchanged portfolio is no longer relevant. Other problematic issues with VaR is that it is not sub-additive, and therefore not a coherent risk measure. As a result, other suggestions for measuring market risk is conditional value-at-risk (CVaR) that is coherent for general loss distributions, including discrete distributions and is sub-additive. The variance covariance and historical simulation approach to calculating VaR assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress. However these assumptions are inappropriate as during periods of high volatility and market turbulence, historical correlations tend to break down. Intuitively, this is evident during a financial crisis where all industry sectors experience a significant increase in correlations, as opposed to an upward trending market. This phenomenon is also known as asymmetric correlations or asymmetric dependence. Rather than using the historical simulation, Monte-Carlo simulations with well-specified multivariate models are an excellent alternative. For example, to improve the estimation of the variance-covariance matrix, one can generate a forecast of asset distributions via Monte-Carlo simulation based upon the Gaussian copula and well-specified marginals. Allowing the modelling process to allow for empirical characteristics in stock returns such as auto-regression, asymmetric volatility, skewness, and kurtosis is important. Not accounting for these attributes lead to severe estimation error in the correlation and variance-covariance that have negative biases (as much as 70% of the true values). Estimation of VaR or CVaR for large portfolios of assets using the variance-covariance matrix may be inappropriate if the underlying returns distributions exhibit asymmetric dependence. In such scenarios, vine copulas that allow for asymmetric dependence (e.g., Clayton, Rotated Gumbel) across portfolios of assets are most appropriate in the calculation of tail risk using VaR or CVaR. Besides, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.


Regulatory views

The Basel Committee set revised minimum
capital requirements A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simulta ...
for market risk in January 2016. These revisions, the "Fundamental Review of the Trading Book", address deficiencies relating to the existing ''Internal models'' and ''Standardised approach'' for the calculation of market-risk capital, and in particular discuss the following: * Boundary between the " Trading book" and the " Banking book" * Use of
value at risk Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by ...
vs.
expected shortfall Expected shortfall (ES) is a risk measure—a concept used in the field of financial risk measurement to evaluate the market risk Market risk is the risk of losses in positions arising from movements in market variables like prices and volati ...
to measure of risk under stress * The risk of market illiquidity


Use in annual reports of U.S. corporations

In the
United States The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country Continental United States, primarily located in North America. It consists of 50 U.S. state, states, a Washington, D.C., ...
, a section on market risk is mandated by the SEC in all annual reports submitted on
Form 10-K A Form 10-K is an annual report required by the U.S. Securities and Exchange Commission (SEC), that gives a comprehensive summary of a company's financial performance. Although similarly named, the annual report on Form 10-K is distinct from the oft ...
. The company must detail how its results may depend directly on financial markets. This is designed to show, for example, an investor who believes he is investing in a normal milk company, that the company is also carrying out non-dairy activities such as investing in complex derivatives or foreign exchange futures.


Market risk for physical investments

Physical investments face market risks as well, for example real capital such as real estate can lose market value and cost components such as fuel costs can fluctuate with market prices. On the other hand some investments in physical capital can reduce risk and the value of the risk reduction can be estimated with financial calculation methods, just as market risk in financial markets is estimated. For example energy efficiency investments, in addition to reducing fuel costs, reduce exposure fuel price risk. As less fuel is consumed, a smaller cost component is susceptible to fluctuations in fuel prices. The value of this risk reduction can be calculated using the Tuominen-Seppänen method and its value has been shown to be approximately 10% compared to direct cost savings for a typical energy efficient building.Tuominen, P., Seppänen, T. (2017)
Estimating the Value of Price Risk Reduction in Energy Efficiency Investments in Buildings
Energies. Vol. 10, p. 1545.


See also

*
Systemic risk In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpt ...
*
Cost risk A cost overrun, also known as a cost increase or budget overrun, involves unexpected incurred costs. When these costs are in excess of budgeted amounts due to a value engineering underestimation of the actual cost during budgeting, they are know ...
* Demand risk * Valuation risk * Risk modeling * Risk attitude *
Modern portfolio theory Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of Diversificatio ...
* Risk return ratio * Fundamental Review of the Trading Book (FRTB) ** Internal models approach (market risk) ** Standardized approach (market risk)


References

*


External links


Bank Management and Control
Springer Nature – Management for Professionals, 2020
Managing market risks by forwarding pricing

How hedge funds limit exposure to market risk
{{Authority control Pricing Statistical deviation and dispersion Market failure