Market Risk Management

Managing risk associated with market forces undoubtedly remains a top concern of investors, bankers and corporate managers. Hundreds of particular types of risk caused by market factors can be observed today. But market risk is primarily anchored on the fall of investment values in terms of four standard factors:

• the risk related to the rise and fall of prices of stocks, or what is termed equity risk;
• the risk caused by the rapid changes of bank interest rate, or simply interest rate risk;
• the risk brought about by unstable foreign exchange rates, otherwise known as currency risk; and
• the risk arising form the volatile prices of commodities used in main industries (e.g. metals, raw chemicals) as well as staple food (e.g. grains, meat), or what is called commodity risk.

Another risk vulnerable to market factors is liquidity of assets. A bank whose assets are tied on foreclosed properties is vulnerable to financial trouble by its inability to operate due to lack of cash and fresh resources. Under this condition, a bank faces a market risk arising from the unstable price of real properties. This happens if much of the bank's financial resources are converted into real estates, acquired by foreclosure proceedings. To combat this risk, the bank should maintain a prudent amount of cash and other liquid assets to keep alive its normal daily transactions.

Banks have developed a complex benchmarking system to determine the right interest rate to protect itself from market risk. These benchmarks are aligned to a broad profile of 'assets and liabilities' - sensitive interest rate known in the financial language as floating rate and fixed rate. These types of detailed information and benchmark data are typically derived from the balance sheet.

Currency risk is controlled by matching the assets and liabilities of a bank using the same currency or 'units of account'. All its assets are valued in the denomination of its 'units of account' so that risk is calculated by potential fluctuation of its value in other currencies.

The maximum loss not exceeding the computed probable leeway, technically called in finance and economic jargon as Value at Risk or VaR, is now emerging as the most commonly used indicator for measuring investment market risks. However, VaR is limited to quantitative indicators of risk and does not show the severity of the loss being computed. Another risk indicator used is 'expected shorfall' or conventional VaR. Expected shortfall evaluates the risk in a more conservative way, particularly outcomes that are less profitable.

The standard deviation of the changing values of cash, ownerships, stocks or a benefit from a contract is called Volatility. This type of financial measurement is usually done on a per annum basis. Modern day trading of stocks deal with volatility using 'options' and 'variance swaps'.

Downside risk, the probability that a financial instrument (security, investment or stock) will have a decline in value or price, is also an indicator monitored in managing market risk. Downside risk includes the value of loss resulting from that possible decline of values.

The International Monetary Fund (IMF) assessed how individual firms behaved prudently in the recent years, and how this behavior probably contributed to the gentle and stable financial environment recently. They have concluded after simulation tests that there is a ground for believing that the above observation could be true. In the last five years that volatility showed a decline, most firms increased their risk-taking gradually. Such move resulted into more decline in volatility. VaR was touted by IMF as the tool used by most financial management analysts to take a cue from. It has influenced prudent investing and emphasized on greater management and analysis of risks.

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