Pre-Class-PPT-4

8/11/2019 Pre-Class-PPT-4

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Introduction to Market Risk

Objective

To comprehend :

Market Risk and its variants


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Old wisdom dictates that one should avoid putting all eggs in the same

basket.

The risk involved in investing money in securities is reduced by

spreading the investments in a number of securities, which are less

than perfectly correlated or negatively correlated.

Diversification by itself does not reduce the risk below a minimum

level.

This minimum level of risk which is attributable to factors which are

external to portfolio ,such as micro economic factors like inflation,GDP

growth, interest rates etc. is the market risk or Systematic risk

The component of risk which can be reduced by diversification is

known as the unique or Non systematic risk


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Market Risk is the possibility of loss to a bank caused bychanges in the market variables.

Market risk is also defined as Therisk that the value of onor off balance-sheet positions will be adversely affected by

movements in equity, and interest rate markets, currencyexchange rates &commodity prices.

Thus Market risk is the risk to the banks earnings andcapital due to changes in the market level of interest ratesor prices of securities, foreign exchange, commodities &

equities as well as the volatilities of those prices. Market Risk Management of a bank thus involves

management of Interest rate risk, Foreign exchange risk,Commodity price risk & Equity price risk.


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Interest Rate Risk

Deregulation of interest rates has exposed the banks to theadverse impact of interest rate risk.

Interest rate risk as far as financial institution isconcerned, is the risk that the value of its assets and

liabilities as also its net interest income may get adverselyaffected on account of movements in interest rates.

Any mismatch in cash flows or reprising dates of assets orliabilities, expos banks NII or NIM to variations.

The market value undergo changes in response to changes

in the interest rates in the market. The realizable value of equity is the difference between the

market values of assets & outside liabilities.


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Types of Interest Rate Risks

The following are the variants of interest raterisks.

i. Mismatch risk or Gap risk

ii. Basis risk

iii. Yield curve risk

iv. Embedded option risk

v. Price risk

vi. Reinvestment Risk


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Foreign Exchange Risk

Foreign Exchange Risk is the risk arising from a foreignexchange exposure.

It may be defined as a risk that the bank may suffer lossesas result of adverse exchange rate movements during the

period in which it has an open position, either spot orforward or a combination of the two in an individual foreigncurrency.

Foreign currency exposures and the attendant risks arise,whenever a business has an income or expenditure or an

asset or liability in a currency other than the balance sheetcurrency.

Exposures will thus include foreign currency denominateditems in the balance sheet,


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Foreign Currency Exposures

Exposures will include:

Foreign currency denominated items in the

balance sheet.

Contracted purchases and sales

Foreign currency denominated receipts and

payments which could fructify if the proposedtrading activity is realized.


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Types of Currency Exposures

The commonly understood three types of

currency exposures are :

Transaction exposure

Translation exposure

Economic exposure


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Equity Position Risk

Changes in the Equity prices can result in

losses to the bank holding an equity portfolio.

Reserve Bank of India has issued detailed

guidelines on banks exposure to equity

market


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Commodities Price Risk

A commodity is defined as a physical product

which is or can be traded on a secondary

market.

E.g.

Agricultural products

Minerals

Oils

Precious metals


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Commodities Price Risk

In India banks have very little exposure tocommodities either in their banking or tradingbooks.

The price risk in commodities is often morecomplex and volatile than that associated withcurrencies and interest rates.

Commodity markets may also be less liquid andas a result of changes in supply and demand

conditions can make the market volatile makingeffective hedging of commodities risk ratherdifficult.

Pre-Class-PPT-4

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