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Trading and Capital-Markets Activities Manual

Trading Activities: Market Risk 
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

Market risk is the potential that changes in the market prices of an institution's holdings may have an adverse effect on its financial condition. The four most common market-risk factors are interest rates, foreign-exchange rates, equity prices, and commodity prices. The market risk of both individual financial instruments and portfolios of instruments can be a function of one, several, or all of these basic factors and, in many cases, can be significantly complex. The market risks arising from positions with options, either explicit or embedded in other instruments, can be especially complex and difficult to manage. Institutions should ensure that they adequately measure, monitor, and control the market risks involved in their trading activities. 

The measurement of market risk should take due account of hedging and diversification effects and should recognize generally accepted measurement techniques and concepts. Although several types of approaches are available for measuring market risk, institutions have increasingly adopted the ''value-at-risk'' approach for their trading operations. Regardless of the specific approach used, risk measures should be sufficiently accurate and rigorous to adequately reflect all of an institution's meaningful market risk exposure and should be adequately incorporated into the risk-management process. 

Risk monitoring is the foundation of an effective risk-management process. Accordingly, institutions should ensure that they have adequate internal reporting systems that address their market-risk exposures. Regular reports with appropriate detail and frequency should be provided to the various levels of trading operations and senior management, from individual traders and trading desks to business-line management and senior management and, ultimately, the board of directors. 

A well-constructed system of limits and policies on acceptable levels of risk exposure is a particularly important element of risk control in trading operations. Financial institutions should establish limits for market risk that relate to their risk measures and are consistent with maximum exposures authorized by their senior management and board of directors. These limits can be allocated to business units, product lines, or other appropriate organizational units and should be clearly understood by all relevant parties. In practice, some limit systems often include additional elements such as stop-loss limits and other trading guidelines that may play an important role in controlling risk at the trader and business-unit level. All limits should be appropriately enforced and adequate internal controls should exist to ensure that any exceptions to limits are detected and adequately addressed by management. 


Interest-Rate Risk 

Interest-rate risk is the potential that changes in interest rates may adversely affect the value of a financial instrument or portfolio, or the condition of the institution as a whole. Although interest-rate risk arises in all types of financial instruments, it is most pronounced in debt instruments, derivatives that have debt instruments as their underlying reference asset, and other derivatives whose values are linked to market interest rates. In general, the values of longer-term instruments are often more sensitive to interest-rate changes than the values of shorter-term instruments. 

Risk in trading activities arises from open or unhedged positions and from imperfect correlations between offsetting positions. With regard to interest-rate risk, open positions arise most often from differences in the maturities or repricing dates of positions and cash flows that are asset-like (i.e., ''longs'') and those that are liability-like (i.e., ''shorts''). The exposure that such ''mismatches'' represent to an institution depends not only on each instrument's or position's sensitivity to interest-rate changes and the amount held, but also on how these sensitivities are correlated within portfolios and, more broadly, across trading desks and business lines. In sum, the overall level of interest-rate risk in an open portfolio is determined by the extent to which the risk characteristics of the instruments in that portfolio interact. 

Imperfect correlations in the behaviour of offsetting or hedged instruments in response to changes in interest rates-both across the yield curve and within the same maturity or repricing category-can allow for significant interest-rate risk exposure. Offsetting positions with different maturities, although theoretically weighted to create hedged positions, may be exposed to imperfect correlations in the underlying reference rates. Such ''yield curve'' risk can arise in portfolios in which long and short positions of different maturities are well hedged against a change in the overall level of interest rates, but not against a change in the shape of the yield curve when interest rates of different maturities change by varying amounts.

Imperfect correlation in rates and values of offsetting positions within a maturity or repricing category can also be a source of significant risk. This ''basis'' risk exists when offseting positions have different and less than perfectly correlated coupon or reference rates. For example, three-month interbank deposits, three-month Eurodollars, and three-month Treasury bills all pay three-month interest rates. However, these three-month rates are not perfectly correlated with each other, and spreads between their yields may vary over time. As a result, three-month Treasury bills, for example, funded by three-month Eurodollar deposits, represent an imperfectly offset or hedged position. One variant of basis risk that is central to the management of global trading risk is ''cross-currency interest-rate risk,'' that is, the risk that comparable interest rates in different currency markets may not move in tandem. 

Foreign-Exchange Risk 

Foreign-exchange risk is the potential that movements in exchange rates may adversely affect the value of an institution's holdings and, thus, its financial condition. Foreign-exchange rates can be subject to large and sudden swings, and understanding and managing the risk associated with exchange-rate volatility can be especially complex. Although it is important to acknowledge exchange rates as a distinct market-risk factor, the valuation of foreign-exchange instruments generally requires knowledge of the behaviour of both spot exchange rates and interest rates. Any forward premium or discount in the value of a foreign currency relative to the domestic currency is determined largely by relative interest rates in the two national markets. 

As with all market risks, foreign-exchange risk arises from both open or imperfectly offset or hedged positions. Imperfect correlations across currencies and international interest-rate markets pose particular challenges to the effectiveness of foreign-currency hedging strategies. 

Equity-Price Risk 

Equity-price risk is the potential for adverse changes in the value of an institution's equity related holdings. Price risks associated with equities are often classified into two categories: general (or un-diversifiable) equity risk and specific (or diversifiable) equity risk. 

''General equity-price risk'' refers to the sensitivity of an instrument's or portfolio's value to changes in the overall level of equity prices. As such, general risk cannot be reduced by diversifying one's holdings of equity instruments. Many broad equity indexes, for example, primarily involve general market risk. 

Specific equity-price risk refers to that portion of an individual equity instrument's price volatility that is determined by the firm-specific characteristics. This risk is distinct from market wide price fluctuations and can be reduced by diversification across other equity instruments. By assembling a portfolio with a sufficiently large number of different securities, specific risk can be greatly reduced because the unique fluctuations in the price of any single equity will tend to be cancelled out by fluctuations in the opposite direction of prices of other securities, leaving only general-equity risk. 

Commodity-Price Risk 

Commodity-price risk is the potential for adverse changes in the value of an institution's commodity-related holdings. Price risks associated with commodities differ considerably from interest-rate and foreign-exchange-rate risk and require even more careful monitoring and management. Most commodities are traded in markets in which the concentration of supply can magnify price volatility. Moreover, fluctuations in market liquidity often accompany high price volatility. Therefore, commodity prices generally have higher volatilities and larger price discontinuities than most commonly traded financial assets. An evaluation of commodity price risk should be performed on a market-bymarket basis and include not only an analysis of historical price behaviour, but also an assessment of the structure of supply and demand in the marketplace to evaluate the potential for unusually large price movements. 


Exposure to any and all of the various types of market risk can be significantly magnified by the presence of explicit or embedded options in instruments and portfolios. Moreover, assessing the true risk profile of options can be complex. Under certain conditions, the significant leverage involved in many options can translate small changes in the underlying reference instrument into large changes in the value of the option. 

Moreover, an option's value is, in part, highly dependent on the likelihood or probability that it may become profitable to exercise in the future. In turn, this probability can be affected by several factors including the time to expiration of the option and the volatility of the underlying reference instrument. Accordingly, factors other than changes in the underlying reference instrument can lead to changes in the value of the option. For example, as the price variability of the reference instrument increases, the probability that the option becomes profitable increases. Therefore, a change in the market's assessment of volatility can affect the value of an option even without any change in the current price of the underlying asset. 

The presence of option characteristics is a major complicating factor in managing the market risks of trading activities. Institutions should ensure that they fully understand, measure, and control the various sources of optionality influencing their market-risk exposures. Measurement issues arising from the presence of options are addressed more fully in the instrument profile on options (section 4330.1). 


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