Here is an essay on ‘Market Risk in Banks’ for class 11 and 12. Find paragraphs, long and short essays on ‘Market Risk in Banks’ especially written for school and banking students.
Market Risk in Banks
Essay Contents:
- Essay on the Introduction to Market Risk in Banks
- Essay on the Market Risk Management Framework
- Essay on the Organisation Structure of Market Risk
- Essay on the Risk Identification of Market Risk
- Essay on the Risk Measurement of Market Risk
- Essay on the Risk Monitoring and Control of Market Risk
- Essay on the Risk Reporting of Market Risk
- Essay on Managing Trading Liquidity
- Essay on the Risk Mitigation of Market Risk
Essay # 1. Introduction to Market Risk in Banks:
Banks also have several activities and undertake transactions that result in market exposure. They are not immune to these risks. They face it too. All such transactions are reflected in the trading book.
1. A trading book consists bank’s proprietary positions in financial instruments covering:
i. Debt Securities
ii. Equity
iii. Foreign Exchange
iv. Commodities
v. Derivatives held for Trading.
2. They also include positions in financial instruments arising from matched principal brokering and market making, or positions taken in order to hedge other elements of the trading book.
They are held with trading intent and with the intention of benefiting in the short-term, from actual and/or expected differences between their buying and selling prices or hedging other elements in the trading book.
A bank’s trading book exposure has the following risks, which arise due to adverse changes in market variables such as interest rates, currency exchange rate, Commodity prices, market liquidity, etc., and their volatilities and impact bank’s earnings and capital adversely.
A. Market Risk
B. Liquidity Risk:
(a) Asset Liquidity Risk
(b) Market Liquidity Risk
C. Credit and Counterparty risks.
Note:
The market liquidity risk is different from funding liquidity risk that arises due to asset-liability mismatch and is a subject matter of Asset Liability management.
A. Market Risk:
Market risk is the risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions. The period of liquidation is critical to assess such adverse deviations. If it gets longer, so do the possibilities of larger adverse deviations from the current market value.
Earnings for the market portfolio are Profit and Loss (P&L) arising from transaction. The P&L between two dates is the variation of the market value. Any decline in value, results in a market loss.
However, it is possible to liquidate tradable instruments or to hedge their future changes of value at any time. This is the rationale for limiting market risk to the liquidation period. In general, the liquidation period varies with the type of instrument. It could be short (1 day) for foreign exchange and much longer for ‘exotic’ derivatives.
Note:
Market risk does not refer to market losses due to causes other than market movements, loosely defined as inclusive of liquidity risk. Any deficiency in the monitoring of the market portfolio might result in market values deviating by any magnitude until liquidation finally occurs. In the meantime, the potential deviations can exceed by far any deviation that could occur within a short liquidation period. This risk is an operational risk, not a market risk.
B. Trading Liquidity Risk:
Trading liquidity is ability to freely transact in markets at reasonable prices.
Trading liquidity is ability to liquidate positions without:
1. Affecting market prices
2. Attracting the attention of other market participants.
Trading liquidity allows one to transact without compromising on counter-party quality. Liquidation involves asset and market liquidity risks. Price volatility is not the same in high-liquidity and poor- liquidity situations. When liquidity is high, the adverse deviations of prices are much lower than in a poor-liquidity environment, within a given horizon. ‘Pure’ market risk, generated by changes of market parameters (interest rates, equity indexes, exchange rates), differs from market liquidity risk.
This interaction raises important issues. What is the ‘normal’ volatility of market parameters under fair liquidity situations? What could it become under poorer liquidity situations? How sensitive are the prices to liquidity crises? The liquidity issue becomes critical in emerging markets. Prices in emerging markets often diverge considerably from a theoretical ‘fair value’.
Liquidation risk arise from lack of trading liquidity and results in:
1. Adverse change in market prices
2. Inability to liquidate position at a fair market price
3. Liquidation of position cause large price change
4. Inability to liquidate position at any price.
Asset liquidation risk refers to a situation where a specific asset faces lack of trading liquidity.
Market liquidation risk refers to a situation when there is a general liquidity crunch in the market and it affects trading liquidity adversely.
C. Credit and Counterparty Risks:
Markets value the credit risk of issuers and borrowers and it reflects in prices. Credit risks of traded debts, such as bonds and debentures and commercial papers, etc., are indicated by ‘Credit Rating’ which is indicated by rating agencies. Credit rating indicates risk level associated with the instruments and is factored into as add-ons to the risk-free rate of the corresponding maturity. Lower the risk level, lower is the spread over risk-free rate.
Credit risk may arise either on account of default of the issuer/borrower or because of rating migration. When rating of a financial instrument is lowered, the spread over the risk-free rate increases as market demands higher yield on a higher risk instrument. This results in decline in price of the instrument.
Where a default, either in payment of installment or interest, takes place, market price of the financial instrument deteriorates. Here the adverse impact on price of financial instrument arises because of deterioration of the credit quality of the instrument.
Derivatives are over-the-counter instrument (interest rate swaps, currency swaps, and options) not liquid as market instruments. Theoretically, banks hold these assets until maturity, and bear credit risk since they exchange flows of funds with counterparties subject to default risk. For derivatives, credit risk interacts with market risk in that the mark to market (liquidation) value depends on market movements. It is the present value of all future flows at market rates.
It is interesting to note that credit risk on a derivative arises when mark to market value is negative implying a receivable from the counterparty. When mark to market value is positive, counterparty is exposed to credit risk as he carries a receivable. Under a ‘hold to maturity’ view, the potential future values over their life is the credit risk exposure because they are the value of all future flows that the defaulted counterparty will not pay. This risk is termed as counterparty risk.
The current credit risk exposure is the current liquidation value. There is the additional risk due to the potential upward deviations of liquidation value from the current value during the life of the instrument. Such drifts depend on the market parameter volatilities and on instrument sensitivity. In other words, as value of a financial instrument varies depending upon market factors; credit risk amount varies with the change in the value.
In market transaction, there is one party that pays money and receives a given quantity of financial paper. The other party or the counterparty does the opposite. The counterparty receives the money and parts with the given quantity of financial papers. If any one of the transacting parties defaults in completing the settlement, the other party suffers. This is known as settlement risk.
This risk may lead to systemic risk and therefore monetary authorities usually take steps to put in place a risk free settlement system to obviate the risk. In India Reserve Bank of India has since put in place ‘Real Time Gross Settlement System’ (RTGS) for the purpose. In markets like government securities, foreign exchange, etc., where RTGS can’t be used for settlement, central counterparties such as Clearing Corporation of India, are used to mitigate settlement risk.
Essay # 2. Concept of Market Risk:
Best way to understand the market risk is to be in the market. Say Mr. X has raised a capital of Rs 10,000 and invests in the shares of ABC Ltd. being quoted at Rs.100. He buys 100 shares. He has a portfolio valued at Rs 10,000 against his capital of Rs 10,000. Next day say there is a 5% drop in share price. The portfolio value now gets reduced to Rs. 9,500 and so does the capital, which stands reduced to Rs 9,500. The loss incurred by Mr. X affects his capital directly to the extent of loss incurred by him due to movement in market price.
His capital loss would be more if he had leveraged his capital. Say he is allowed to borrow 9 times his capital. Now Mr. X has Rs 10,000 as capital and Rs. 90,000 as borrowings. His total resources amount to Rs. 100,000. If he had invested in the shares of ABC Ltd. the entire resources available to him, i.e., had he purchased 1,000 shares at Rs. 100 each he would have lost Rs. 5,000 – due to adverse movement of market price and his capital would have been reduced by 50%.
In other words, he would have lost half the capital. Please note that we have not taken into account any transaction costs or cost of borrowing into account. If we take these into account, Mr. X would lose some more.
Actually, Mr. X’s problems are not over as yet since he is permitted to raise 9 times his capital as borrowings and now that his capital stands at Rs. 5,000 only. He has to liquidate his holdings by Rs. 50,000 to repay his borrowings, which is over and above his permissible limit. Now if the market, anticipating further fall in the price of shares of ABC Ltd. has become illiquid as far as this share is concerned, Mr. X would be able to liquidate his holdings only at a lower price — the risk of asset liquidity.
This would result in further losses that would result in further depletion of capital requiring further liquidation of his holdings to remain within the permissible borrowing limit. He would also face the same situation, if in the meanwhile the liquidity availability in the market had undergone a change for the worse. The lack of liquidity in the market would have driven the share price further down, resulting in losses.
Mr. X has in fact faces the following risks by taking an exposure on a security that are being traded in the market:
1. Risk of adverse movement in the price – Price Risk
2. Risk of reduced liquidity in the market for a specific security – Asset Liquidity Risk
3. The risk of poor market liquidity – Market Liquidity risk.
Of course, Mr. X would have made profits if the price had moved favourably and that had been the motivation for him to be in the market at first place but then these are the risks that he is taking moment he invests in market traded securities. Imagine what would have happened if share prices of ABC Ltd. had fallen by 10%. Well, his entire capital would have been wiped out resulting in him being out of this business. It would be better if he had some measure of possible downside potential of the share price.
Mr. X, before he enters this business should have a framework that provides him with:
(a) an approach to manage the risks, and
(b) a measure of risk that can tell him of possible downside potential.
Essay # 3. Market Risk Management Framework:
Market risk management involves finding answer to four key questions:
A. What are the risks?
B. What is the quantum? How much could the price change? What would be the effect on profit and loss?
C. How can we monitor and control price risk?
D. Can we reduce the risk? And, if so then how?
Management processes for market risk management are designed essentially to answer these questions.
Accordingly, management processes are sub-divided into the following four parts:
1. Risk Identification
2. Risk Measurement
3. Risk Monitoring and Control
4. Risk Mitigation
An effective market risk management framework in a bank comprises risk identification, setting up of limits and triggers, risk monitoring, models of analysis that value positions or measure market risk, risk reporting, etc.
Financial instrument take their price from the market and that depends upon interaction of market variables. Hence, market risk management processes do not have a risk pricing process.
But, management of market risk needs an organisation structure in place that can carry out the functions required for the purpose.
Essay # 4. Organisation Structure of Market Risk:
Management of market risk is a major concern of top management of banks. Successful implementation of risk management process emanates from the top management in the bank. The main challenge centers on facilitating implementation of risk and business policies simultaneously in a consistent manner.
Modern best practices consist of setting risk limits based on economic measures of risk while ensuring best risk adjusted return keeping in view the capital that has been invested in the business. It is a question of taking a balanced view on risks and returns and within the constraints of available capital.
Usually, Market Risk Management organisation would consist:
i. The Board of Directors
ii. The Risk Management Committee
iii. The Asset-Liability Management Committee (ALCO)
iv. The ALM Support Group/Market Risk Group
v. The Middle Office.
The Board of Directors has the overall responsibility for management of risks. The Board articulates market risk management policies, procedures, aggregate risk limits, review mechanisms and reporting and auditing systems. The Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange, and equity-price risks.
The Risk Management Committee is a Board level Sub-Committee.
The responsibilities of Risk Management Committee with regard to market risk management aspects include the following:
1. Setting guidelines for market risk management and reporting
2. Ensure that market risk management processes conform to the policy
3. Setting up prudential limits and its periodical review
4. Ensure robustness of measurement of risk models
5. Ensure proper manning for the processes
The Asset-Liability Management Committee (ALCO) is responsible for implementation of risk and business policies simultaneously in a consistent manner and decides on the business strategy to achieve these objectives.
Its role encompasses the following:
1. Product pricing for deposits and advances
2. Maturity profile and mix of incremental assets and liabilities
3. Articulating interest rate view of the bank
4. Funding policy
5. Transfer pricing
6. Balance sheet management.
It sets up operating prudential limits and is the review authority for the line management.
The ALM Support Groups analyses, monitors and reports the risk profiles to the ALCO. It also examines the effects of various possible changes in market variables and recommends the action needed.
The Middle Office is responsible for the critical functions of independent market risk monitoring, measurement, analysis, and reporting to ALCO. Middle Office provides the independent risk assessment which is critical to Alco’s key-function of controlling and managing market risks in accordance with the mandate established by the Board/Risk Management Committee. Middle Office functions independently of the treasury function. It also independently validates the prices in respect of treasury deals, more particularly in respect of structured products.
Essay # 5. Risk Identification of Market Risk:
All products and transaction should be analysed for risks associated with them. While, various risks associated with a standardised product stands analyzed, that in case of a non-standard product needs to be analysed. Therefore, approach to deal in standard and non-standard products differs. We have seen under general approach to risk management; guidance for risk taking at the transaction level comes from the corporate level.
It applies to the management of market risk too:
i. Usually all standard products would have ‘Product Programme’ for each of them. All Risk- Taking Units operate within an approved ‘Product Programme’. Product programme defines procedures, limits and controls for all aspects of the product. The product programme also specifies market risk measurement at an individual product level and at aggregate portfolio level.
ii. New products or non-standard products may operate under a ‘Product Transaction Memorandum’ on a temporary basis while a full Market Risk Product programme is being prepared.
Products approved at corporate level shall provide for screening procedures, appropriate safeguards, product-wise limit on exposure, and necessary guidelines in risk taking. In fact, the guidelines help in standardising risk content in the business undertaken at the transaction level.
Any new product or any deviation from the directed procedures and safeguards add to the risk content of the exposure and needs a clearance at the corporate level where risk return characteristics and risk quantification forms the basis of decision-making. Impact of risk taking at transaction level on the portfolio risk is critical issue here.
Essay # 6. Risk Measurement of Market Risk:
Market risk management framework is heavily dependent upon quantitative measures of risk. The market risk measures seek to capture variations in market value arising out of uncertainties associated with various risk elements. These provide an objective measure of market risk in a transaction or of a portfolio.
Market risk measures are based on:
i. Sensitivity
ii. Downside Potential.
Essay # 7. Risk Monitoring and Control of Market Risk:
Risk monitoring and control calls for implementation of risk and business policies simultaneously. It consists of setting market risk limits or controlling market risk, based on economic measures of risk while ensuring best risk adjusted return. Controlling market risk means keeping the variations of the value of a given portfolio within given boundary values through actions on limits, which are upper bounds imposed on risks.
This is achieved through the following:
1. Policy guidelines limiting roles and authority
2. Limits structure and approval process
3. System and procedures to unbundle products and transactions to capture all risks
4. Guidelines on portfolio size and mix
5. System for estimating portfolio risk under normal and stressed situations
6. Defined policy for mark-to-market
7. Limit monitoring and reporting
8. Performance Measurement and Resource Allocation.
Risk measurement has a critical role in controlling and monitoring of market risk. Role of risk measurement in controlling and monitoring involves setting up of limits and triggers and monitoring them. Risk positions should also be reported to designated authority. Further, models are used for risk measurement, valuations and mark to market of portfolio. This calls for a system to monitor the models as well.
Limits and Triggers:
Approved market risk limits for factor sensitivities and Value at Risk duly set by designated authority (usually by the Risk Policy Committee). The approval is based on unit’s capacity and capability to perform within those limits, effectiveness of controls, and trading revenues.
i. Sensitivity and Value at Risk limits for trading portfolios and accrual portfolios are measured daily Where market risk is not measured daily, Risk Taking Units must have procedures that monitor activity to ensure that they remain within approved limits at all times.
ii. Approved management triggers or stop-loss for all mark to market risk taking activities.
iii. Appropriate market risk limits for basis risk for the products wherever applicable in the Market Risk Product Programme.
Risk Monitoring:
i. A monitoring process to ensure that all transactions are executed and revalued at prevailing market rates; rates used at inception or for periodic marking to market for risk management or accounting purposes must be independently verified.
ii. Financial Models used for revaluations for income recognition purposes or to measure or monitor Price Risk must be independently tested and certified.
iii. Stress tests must be performed preferably quarterly with predetermined changes in the underlying assumptions of the model/market conditions.
Models of Analysis:
i. Appropriate and duly approved (usually by Risk Policy Committee) model control and certification policy.
ii. Fully documented financial models.
iii. Duly validated by designated person, to ensure that the algorithm employed is appropriate and accurate.
iv. No unauthorized or unintended changes should be made in models.
v. The models should also be subject to model assumption review on a periodic basis.
Essay # 8. Risk Reporting of Market Risk:
Risk report should enhance risk communication across different levels of the bank, from the trading desk to the CEO.
In order of importance, senior management reports should be:
i. Regular and in time
ii. Reasonably accurate
iii. Highlight portfolio risk concentrations & exceptional events
iv. Include written commentary
v. Concise.
Essay # 9. Managing Trading Liquidity:
Risk of trading liquidity is managed by avoiding:
i. Large market share in any given type of asset
ii. Infrequently traded instruments
iii. Instruments with unusual tenors
iv. One sided liquidity in the market
Risk Terminology in Risk Measurement:
Say Mr. X takes a position in stock ‘A’ and wants to explain to his ‘Boss’ about the market position.
He can explain the position in three possible ways:
1. He tells his Boss that he purchased 1,000 shares of stock ‘A’ at Rs 600 per share
2. He tells his Boss that he has taken a Rs 600,000 position in stock ‘A’
3. He tells his Boss that he invested in stock ‘A’. He explains that if price changes by 1%, he would have an impact of Rs 6,000. But since the price is expected to fluctuate 3% daily (daily volatility – figure estimated from past data), he estimates daily potential loss to be Rs 41,874:
Mr. X’s position analysis using risk terminology will be:
1. Market factor – Stock price
2. Market Factor Sensitivity – Rs 6,000 (1% of total position)
3. Volatility (Daily)-3%
4. Defeasance period – 1 day (i.e., to sell the stock)
5. Defeasance factor – at 3% volatility it is 3 x 2.326 (@ 99% Confidence level)
6. Value at Risk (VaR) – Rs 41,874 – This is also the potential loss amount under normal market conditions.
Essay # 10. Risk Mitigation of Market Risk:
Market risk arises due to volatility of financial instruments. The volatility of financial instruments is instrumental for both profits and risk. Risk mitigation in market risk, i.e., reduction in market risk is achieved by adopting strategies that eliminate or reduce the volatility of the portfolio. However, there are couples of issues that are also associated with risk mitigation measures.
1. Risk mitigation measures aim to reduce downside variability in net cash flow but it also reduces upside potential or profit potential simultaneously.
2. In addition, risk mitigation strategies, which involve counterparty, will always be associated with counterparty risk. Of course, where counterparty is an established ‘Exchange’ or a central counterparty, counterparty risk gets reduced very substantially. In OTC deals, counterparty risk would depend upon the risk level associated with party to the contract.
Risk Mitigation Strategies:
Volatility of individual instruments is market determined. But, volatility of two or more different financial instruments would have a different volatility. As a result, a portfolio of financial instruments can be created with desirable volatility characteristics.
Strategies to achieve it are discussed below:
Strategies Using Sensitivity Measures:
Say a portfolio has two bonds A and B with BPVs of Rs 675 and Rs 205 respectively. The BPV of the portfolio would be weighted average of BPVs of all the bonds in the portfolio. The portfolio BPV will be (675 + 205)/2 = 440. Now if we intend to reduce the risk of this portfolio, we may add another bond in the portfolio such that its BPV is less than 440. Say we add one more bond B in the portfolio. BPV of the portfolio will get reduced to 361.7.
Similar strategies are possible using another sensitivity measure – duration. Portfolio duration may be increased by adding higher duration instrument or by reducing low duration instruments. Similarly, portfolio duration can be reduced by selling higher duration instruments or by adding low duration instrument.
Strategies Using Correlation Measures:
Prices of two financial instruments that have perfect negative correlation would move exactly in opposite direction. If the financial instrument have negative correlation and it is not perfect, then also prices would move in opposite direction but it will not be exact. In such a case price volatility of the portfolio would be there but it will be considerably low.
For example, a portfolio is long on a stock A and short in stock future of stock A. If the price of stock moves up say by Rs 10, the sock future would also go up may not be exactly by Rs 10 say by Rs 9. The portfolio will gain Rs 10 on account of long position on stock A but will lose Rs 9 on account of short position in stock future. Reverse would also be true. The portfolio volatility however, stands reduced or portfolio market risk stands mitigated.
The same strategies are possible with interest rate swaps (IRS) also. An example could be a portfolio having a fixed rate bond and an IRS with long on variable rate of interest. As market interest rates move up, the portfolio will suffer losses on bond, as bond price would come down due to upward movement in interest rates.
But swap valuation will increase as IRS being long on variable rate will result in higher interest receipts under the IRS and the portfolio would gain on account of that. The net impact on the portfolio will be reduction in losses (or may result in net gain also) on account of fall in the price of the bond. Or in other words, portfolio volatility stands reduced and with that the risk.
Strategies Using Market Instruments:
Financial instrument such as options provide us with a method to hedge market risks.
An option provides a right and not obligation but it comes at a cost called option premium. A position that is long on call option confers a right to buy the underlying instrument at a predetermined price called strike rate. A long position on put option confers a right to sell the underlying instrument at strike rate. Both provide means to arrest downside movement and may be used for hedging a portfolio.
Essentially, risk mitigation measures involve risk return trade-off as strategies to reduce the risks also reduce upward potential.