Lesson 8: Market Risk Flashcards
What is meant by market risk?
Market risk is the risk related to the uncertainty of an FI’s earnings on its trading portfolio.
Market risk is caused by changes in market conditions such as interest rate risk and foreign exchange risk.
Market risk emphasises the risks to FIs that actively trade assets and liabilities rather than hold them for longer term investment, funding, or hedging purposes
What is meant by daily earnings at risk (DEAR)?
What are the three measurable components?
What is the price volatility component?
DEAR, or daily earnings at risk, is a measure of market risk over the next 24 hours. It is defined as the estimated potential loss of a portfolio’s value over a one-day period as a result of adverse moves in market conditions, such as changes in interest rates, foreign
exchange rates, and market volatility.
DEAR is comprised of:
- the dollar value of the position
- the price sensitivity of the asset to changes in the risk factor; and
- the adverse move in the yield
The product of the price sensitivity of the asset and the adverse move in the yield provides the price volatility component.
The DEAR for a bank is $8,500.
What is the VAR for a 10-day period?
A 20-day period?
Why is the VAR for a 20-day period not twice as much as that for a 10-day period?
For the 10-day period: VAR = 8,500 x [10]½= 8,500 x 3.1623 = $26,879
For the 20-day period: VAR = 8,500 x [20]½= 8,500 x 4.4721 = $38,013
The reason that 20-day VAR ≠ (2 x 10-day VAR) is because [20]½≠(2 x [10]½).
The interpretation is that the daily effects of an adverse event become less relevant as time moves farther away from the event
Bank Two has a portfolio of bonds with a market value of $200 million. The bonds have an estimated price volatility of 0.95 percent.
What are the DEAR and the 10-day VAR for these bonds?
DEAR = ($ market value of position) x (Price volatility)
= $200 million x 0.0095 = $1,900,000
10-day VAR = DEAR x √N = $1,900,000 x √10
= $1,900,000 x 3.1623 = $6,008,328
