Market Risk Flashcards
What is Market Risk?
Market risk is the risk that changes in financial market prices and rates will reduce the dollar value of a security or a portfolio.
Price risk for fixed income products can be decomposed into a general market-risk component (the risk that the market as a whole will fall in value) and a specific market-risk component, unique to the particular financial transaction under consideration, which also reflects the credit risk hidden in the instrument. In trading activities, risk arises both from open (unhedged) positions and from imperfect correlations between market positions that are intended to offset one another.
What are the 4 major types of Market Risk?
These are namely, interest rate risk, equity price risk, foreign exchange risk and commodity price risk. These risks relate to the major investment or trading markets for fixed income, equities, foreign exchange and commodities.
These subclasses of market risk also interact extensively. The modern day economy is a function of extensive interactions between the major markets for fixed income, equities, foreign exchange and commodities. For example, increases in interest rates usually leads to immediate falls in the fixed-income and equity market but rise in the price of the domestic currency.
What is the relationship between Credit Risk and Market Risk?
Credit risks posed by counterparties (especially financial institutions) are themselves affected by changes in the markets. Extremely volatile market movements will change the market values of major investment or trading positions. Such changes will impact the liquidity and even solvency of firms that have market exposures. Hence, changes in credit risks
are driven by exposures of firms to market risk.
What is the Interest-Rate Risk under Market Risk?
The simplest form of interest-rate risk is the risk that the value of a fixed income security will fall as a result of an increase in market interest rates.
But in complex portfolios of interest-rate-sensitive assets, many different kinds of exposure can arise from differences in the maturities, nominal values, and reset dates of instruments and cash flows that are asset like (i.e., “longs”) and those that are liability-like (i.e., “shorts”)
What is the Equity Risk under Market Risk?
This is the risk associated with volatility in stock prices. The general market risk of equity refers to the sensitivity of an instrument or portfolio value to a change in the level of broad stock market indices. The specific risk of equity refers to that portion of a stock’s price volatility that is determined by characteristics specific to the firm, such as its line of business, the quality of its management, or a breakdown in its production process. According to portfolio theory, general market risk cannot be eliminated through portfolio diversification, while specific risk can be diversified away.
What is the Foreign Exchange Risk under Market Risk?
Foreign exchange risk arises from open or imperfectly hedged positions in a particular currency. These positions may arise as a natural consequence of business operations, rather than from any conscious desire to take a trading position in a currency. Foreign exchange volatility can sweep away the return from expensive cross-border investments and at the same time place a firm at a competitive disadvantage in relation to its foreign competitors. It may also generate huge operating losses and, through the uncertainty it causes, inhibit investment.
The major drivers of foreign exchange risk are imperfect correlations in the movement of currency prices and fluctuations in international interest rates. Although it is important to acknowledge exchange rates as a distinct element of market risk, the valuation of foreign exchange transactions requires knowledge of the behaviour of domestic and foreign interest rates, as well as of spot exchange rates.
What is the Commodity Price Risk under Market Risk?
The price risk of commodities differs considerably from interest-rate and foreign exchange risk, since most commodities are traded in markets in which the concentration of supply in the hands of a few suppliers can magnify price volatility. Fluctuations in the depth of trading in the market (i.e. market liquidity) often accompany and exacerbate high levels of price volatility. Other fundamentals affecting a commodity’s price include the ease and cost of storage, which varies considerably across the commodity markets (e.g., from gold, to electricity, to wheat). As a result of these factors, commodity prices generally have higher volatilities and larger price discontinuities (i.e., moments when prices leap from one level to another) than most traded financial securities.
