Market risk
Encyclopedia
Market risk is the risk
that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The associated market risks are:
. The conventions of using Value at risk is well established and accepted in the short-term risk management practice.
However, it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The Value at Risk of the unchanged portfolio is no longer relevant.
The Variance Covariance and Historical Simulation
approach to calculating Value at Risk also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress.
In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.
, a section on market risk is mandated by the SEC
in all annual reports submitted on Form 10-K
. The company must detail how its own results may depend directly on financial markets. This is designed to show, for example, an investor who believes he is investing in a normal milk company, that the company is in fact also carrying out non-dairy activities such as investing in complex derivatives or foreign exchange futures.
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The associated market risks are:
- Equity riskEquity riskEquity risk is the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods...
, the risk that stockStockThe capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
or stock indexes (e.g. Euro Stoxx 50, etc. ) prices and/or their implied volatilityImplied volatilityIn financial mathematics, the implied volatility of an option contract is the volatility of the price of the underlying security that is implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, when used in a particular pricing model,...
will change. - Interest rate riskInterest rate riskInterest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
, the risk that interest rates (e.g. Libor, EuriborEuriborThe Euro Interbank Offered Rate is a daily reference rate based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market .-Scope:...
, inflationInflationIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
, etc.) and/or their implied volatility will change. - Currency riskCurrency riskCurrency risk or exchange rate risk is a form of financial risk that arises from the potential change in the exchange rate of one currency in relation to another...
, the risk that foreign exchange rates (e.g. EUR/USDCurrency pairA currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The currency that is used as the reference is called the counter currency or quote currency and the currency that is quoted in relation is called the base...
, EUR/GBPCurrency pairA currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The currency that is used as the reference is called the counter currency or quote currency and the currency that is quoted in relation is called the base...
, etc.) and/or their implied volatility will change. - Commodity riskCommodity riskCommodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc...
, the risk that commodity prices (e.g. cornCornCorn is the name used in the United States, Canada, and Australia for the grain maize.In much of the English-speaking world, the term "corn" is a generic term for cereal crops, such as* Barley* Oats* Wheat* Rye- Places :...
, copperCopperCopper is a chemical element with the symbol Cu and atomic number 29. It is a ductile metal with very high thermal and electrical conductivity. Pure copper is soft and malleable; an exposed surface has a reddish-orange tarnish...
, crude oil, etc.) and/or their implied volatility will change.
Measuring the potential loss amount due to market risk
As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use Value at RiskValue at risk
In financial mathematics and financial risk management, Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets...
. The conventions of using Value at risk is well established and accepted in the short-term risk management practice.
However, it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The Value at Risk of the unchanged portfolio is no longer relevant.
The Variance Covariance and Historical Simulation
Historical simulation
Historical simulation in finance's value at risk analysis is a procedure for predicting value at risk by 'simulating' or constructing the cumulative distribution function of assets returns over time. Unlike most parametric VaR models, Historical Simulation does not assume any distribution on the...
approach to calculating Value at Risk also assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress.
In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.
Use in annual reports of U.S. corporations
In the United StatesUnited States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, a section on market risk is mandated by the SEC
United States Securities and Exchange Commission
The U.S. Securities and Exchange Commission is a federal agency which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets in the United States...
in all annual reports submitted on Form 10-K
Form 10-K
A Form 10-K is an annual report required by the U.S. Securities and Exchange Commission , that gives a comprehensive summary of a public company's performance...
. The company must detail how its own results may depend directly on financial markets. This is designed to show, for example, an investor who believes he is investing in a normal milk company, that the company is in fact also carrying out non-dairy activities such as investing in complex derivatives or foreign exchange futures.
Risk management
All businesses take risks based on two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance.See also
- Systemic riskSystemic riskIn finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
- Cost risk
- Demand risk
- Risk modelingRisk modelingFor risk modeling in general see risk modelingFinancial risk modeling refers to the use of formal econometric techniques to determine the aggregate risk in a financial portfolio...
- Risk attitude
- Modern portfolio theoryModern portfolio theoryModern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...