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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.
TYPES OF MARKET RISKS
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.
OPTIONS
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).
Continue to MARKET-RISK
MEASUREMENT
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