Basic Measures of Market Risk

Market risk measures can be broadly classified as nominal measures and factor-sensitivity measures.

Nominal Measures

Nominal or notional measurements are the most basic methodologies used in market-risk management. They represent risk positions based on the nominal amount of transactions and holdings. Typical nominal measurement methods may summarize net risk positions or gross risk positions. Nominal measurements may also be used in conjunction with other risk-measurement methodologies. For example, an institution may use nominal measurements to control market risks arising from foreign-exchange trading while using duration measurements to control interest rate risks.

For certain institutions with limited, noncomplex risk profiles, nominal measures and controls based on them may be sufficient to adequately control risk. In addition, the ease of computation in a nominal measurement system may provide more timely results. However, nominal measures have several limitations.

Often, the nominal size of an exposure is an inaccurate measure of risk since it does not reflect price sensitivity or price volatility. This is especially the case with derivative instruments. Also, for sophisticated institutions, nominal measures often do not allow an accurate aggregation of risks across instruments and trading desks.

Factor-Sensitivity Measures

Basic factor-sensitivity measures offer a somewhat higher level of measurement sophistication than nominal measures. As the name implies, these measures gauge the sensitivity of the value of an instrument or portfolio to changes in a primary risk factor. For example, the price value of a basis point change in yield and the concept of duration are often used as factor-sensitivity measures in assessing the interest-rate risk of fixed-income instruments and portfolios. Beta, or the measure of the systematic risk of equities, is often considered a first-order sensitivity measure of the change in an equity-related instrument or portfolio to changes in broad equity indexes.

Duration provides a useful illustration of a factor-sensitivity measure. Duration measures the sensitivity of the present value or price of a financial instrument with respect to a change in interest rates. By calculating the weighted average duration of the instruments held in a portfolio, the price sensitivity of different instruments can be aggregated using a single basis that converts nominal positions into an overall price sensitivity for that portfolio. These portfolio durations can then be used as the primary measure of interest-rate risk exposure.

Alternatively, institutions can express the basic price sensitivities of their holdings in terms of one representative instrument. Continuing the example using duration, an institution may convert its positions into the duration equivalents of one reference instrument such as a four-year U.S. Treasury, three-month Eurodollar, or some other common financial instrument. For example, all interest-rate risk exposures might be converted into a dollar amount of a ‘‘two-year’’ U.S. Treasury security. The institution can then aggregate the instruments and evaluate the risk as if the instruments were a single position in the common base.

While basic factor-sensitivity measures can provide useful insights, they do have certain limitations—especially in measuring the exposure of complex instruments and portfolios. For example, they do not assess an instrument’s convexity or volatility and can be difficult to understand outside of the context of market events. Examiners should ensure that factor sensitivity measures are used appropriately and, where necessary, supported with more sophisticated measures of market-risk exposure.

Reference: Federal Reserve Board