For capital-markets and trading activities, risk is generally deﬁned as the potential for loss on an instrument, portfolio, or activity. Thus, the risks referred in this article are discussed in terms of the impact of some event on value(value-at-risk) and income (earnings-at-risk) from the instrument, activity, or portfolio being addressed.

Some of the risks inherent in the trading process are described below:

Market (price) risk is the risk that the value of a ﬁnancial instrument or a portfolio of ﬁnancial instruments will change as a result of a change in market conditions (for example, interest-rate movement).

Funding-liquidity risk refers to the ability to meet investment and funding requirements arising from cash-ﬂow mismatches.

Market-liquidity risk refers to the risk of being unable to close out open positions quickly enough and in sufﬁcient quantities at a reasonable price to avoid adverse ﬁnancial impacts.

Counterparty credit risk is the risk that a counterparty to a transaction will fail to perform according to the terms and conditions of the contract, thus causing the holder of the claim to suffer a loss in cash ﬂow or market value.

Clearing/settlement credit risk is (1) the risk that a counterparty who has received a payment or delivery of assets defaults before delivery of the asset or payment or (2) the risk that technical difﬁculties interrupt delivery or settlement despite the counterparty’s ability or willingness to perform.

Operations and systems risk is the risk of human error or fraud or the risk that systems will fail to adequately record, monitor, and account for transactions or positions.

Legal risk is the risk that a transaction cannot be consummated because of some legal barrier, such as inadequate documentation, a regulatory prohibition on a speciﬁc counterparty, and nonenforceability of bilateral and multilateral close-out netting and collateral arrangements in bankruptcy.

Reputational risk is the risk arising from negative public opinion regarding an institution’s products or activities.

Risks Inherent in Trading Activities

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

Basic Measures of Market Risk

Market-risk limits are fundamental controls over the risks inherent in trading activities. Banks need to establish market risk limits related to their risk measures and these limits should be consistent with maximum exposures authorized by their senior management and board. These limits are also allocated to business units and individual traders. The risk management function is responsible for ensuring that exceptions to limits are identified and addressed by management. Some limit systems also include additional features, such as stop-loss limits and trading guidelines.

Financial institutions usually use the following limits:

Limits on net and gross positions: Gross positions, net positions or both can have limits placed on them. The size of a long or short position of an instrument is restricted when limits are placed on gross positions. Net position limits aim to identify natural offsets of long and short positions. Both these limits are useful tools in risk management.

Maximum allowable loss (‘‘stop-loss’’): Each position will be given a maximum allowable loss. When such a limit is crossed it sends up a red flag, and a decision needs to be taken by the management to either liquidate or hedge that position. These limits are more specific to that position rather than broad category limits. Most stop-losses cover losses for a day, a week or month. Limits are set based on historical information over a certain time period.

Value-at-risk limits: Another manner of setting limits is by examining underlying risk factors that affect a portfolio. Limits can be custom set for particular kind of scenario, or for certain kind of scenarios defined at some specified confidence level derived from internal VAR measures. Historical volatilities of risk are used to arrive at measures of sensitivity.

Maturity gap limits: Sometimes rates need to be adjusted to counter the adverse changes that happen to them in the institutions planning horizon. Limits in this case are set so that they can hedge against stated absolute amounts for each time frame. They can also be set to weighted limits that emphasize increasing rate-movement exposure applicable to the relative distance into the future in which the gap appears. The limits need to specify the maximum maturity of the specific instrument or combination of instruments. Maturity gap limits are employed to control risks arising from nonparallel shifts in yield curves and forward curves.

Limits on options positions: It is important that limits be placed on unique limits on options positions to adequately control trading risks. Options limits should include limits which address exposures to small changes in the price of the underlying instrument (delta), rate of change in the price of the underlying instrument (gamma), changes in the volatility of the price of the underlying instrument (vega), changes in the option’s time to expiration (theta), and changes in interest rates (rho).

Limits for volatile or illiquid markets: Volatile or illiquid markets need to have clear limits. In the event that this is not done, its losses could accumulate and management may be forced to take a loss to close a position it cannot offset.

Market Risk Limits

Every time an institution extends a loan, it faces credit risk. It is the risk of economic loss when an obligor does not fulfill the terms and conditions of his contracts. Credit risk is seen in all such activities that are impacted by borrowers, issuers, and counterparties, capital-market transactions that have credit exposure. Over the counter derivative transactions that include foreign exchange, swaps and options in particular have both large and dynamic credit exposure. It is important therefore to identify, measure, monitor, and control the credit risks that are inherent while trading in derivative and non-derivative products.

This credit risk management process must be independent and formal. The process needs to be formulated at a policy level and then enumerated through procedures. Looking at historical data and stress testing, one can arrive at methods of measuring credit risk. The limits set should be done based on realistic estimates of the credit-risk exposure. The exposures must then be monitored closely for any sudden changes, which will help the bank prevent against credit risk in an appropriate and timely fashion.

Some of the most common forms of credit risks encountered in trading activities are issuer credit risk and counterparty credit risk. The risk of defaults or credit deterioration of an issuer of instruments that are held as long positions in trading portfolios is known as issuer risk. The issuer credit risk for short time horizon of trading activities is limited in the case of high-quality, liquid instruments. However for more illiquid instruments like loans, emerging market debt and below investment quality debt instruments the issuer credit risk is high.

One of the most significant types of credit risk that banks hedge against is counterparty credit risk. This is the risk that the obligor will default on the terms of contract or the payment contrary to the terms of contract or agreement. There are therefore two types of counterparty credit risk: presettlement risk and settlement risk. By presettlement risk we mean the risk of loss due to counterparty’s failure to perform on a contract or agreement during the life of a transaction. The duration of such transaction is usually a few hours or days, and the presettlement risk is limited to this period. In the event that the exposure may exist for many years at a time, as is the case with derivative products, it is critical banks assess and hedge against such presettlement risk carefully.

Settlement risk on the other hand is the risk of loss when an institution meets its obligation under a contract, through either an advance of funds or securities before the counterparty meets its obligation.

Counterparty default, operational problems, market liquidity constraints, and other factors are some of the reasons for failures to perform at settlement. The window between the time an outgoing payment instruction cannot be recalled until the incoming payment is received with finality is when settlement risk exists. This risk exists with any traded product and is greatest when delivery is made in different time zones.

Credit Risk and Counterparty Credit Risk 

BASEL II advises two methods of capital allocation for banks to use to measure credit risk and allocate capital to protect them against such credit risk. They are the standardized approach and the internal rating approach.

All financial institutions must based on their size arrive at methods to measure, monitor and protect themselves against credit risk. Smaller trading companies for instances will require simple checks and balances in place. Larger institutions with more complex loan instruments on the other hand will need to invest and maintain automated systems and policies and highly qualified staff that can use the same.

The importance of a sound credit risk management framework cannot be emphasized enough. It needs to be discussed and formalized at the highest level that is the board and implemented to the last credit officer. The formation of a credit risk policy, a credit risk committee, a credit-approval process, and credit risk management staff who measure and monitor credit exposures throughout the organization is vital.

Despite multiple organizational approaches to manage credit risk, the credit risk management of trading activities should be integrated into the overall credit-risk management of the institution to the best extent possible. Banking organizations usually have extensive written policies covering their assessment of counterparty creditworthiness for the initial due-diligence process (that is, before conducting business with a customer) and ongoing monitoring. The challenge is in how such policies are structured and implemented.

The credit risk management procedure has the following steps:
<ol>
	<li>Developing and approving credit-exposure measurement standards</li>
	<li>Setting counterparty credit limits</li>
	<li>Monitoring credit-limit usage and reviewing credits and concentrations of credit risk</li>
	<li>Implementing minimum documentation standards</li>
</ol>
The staff that approves exposures must be separate from the staff responsible monitoring risk limits and measuring exposures. Traders and marketers can assume risks that are within institutional credit-risk controls. The credit-risk-management function must be independent of the credit function in the trading area that have high expertise in trading-product credit analysis and meet the demand for rapid credit approval in a trading environment. This is so that they may carry out these responsibilities without compromising internal controls of these marketing and trading personnel who are directly involved in the execution of the transactions.  The credit staff in the trading area may possess great expertise in trading-product credit analysis, but the persons responsible for the institution’s global credit function should have a solid understanding of the measurement of credit-risk exposures in trading products and the techniques available to manage those exposures.

Credit measurement is an integral part of effective credit risk management in trading operations. For example for most cash instruments, presettlement credit exposure is measured as current carrying value. However, in the case of many derivative contracts, especially those traded in OTC markets, presettlement exposure is measured as the current value or replacement cost of the position, plus an estimate of the institution’s potential future exposure to changes in the replacement value of that position over the term of the contract.

The methods to measure counterparty credit risk need to be commensurate with the volume and level of complexity of the instruments involved. The most important thing with credit measurement is that it must assess and calibrate the risk and therefore limits as close to the true nature of the credit exposures involved. Over protecting against credit risk would mean losing out on some quality customers. The choice of technique to measure the credit risk must therefore be realistic. Unrealistic measures in the credit risk management process require a review of the credit risk measurement system and must be reevaluated as soon as possible.

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Credit Risk Measurement and Management in Trading

The methods of determining the presettlement risk for different instruments vary. The presettlement credit exposure for cash instruments is measured as the current carrying value, which for trading operations is the market value or fair value of the instrument. The market values can be obtained from direct market quotations and pricing services.

In the case of more complex instruments, presettlement risk can be valued using generally accepted valuation techniques. The credit exposure for  derivative contracts, is measured as the sum of the current value or replacement cost of the position, and an estimate of the institution’s potential future exposure to changes in that replacement value in response to market price changes. Together, replacement cost and estimated potential future exposure make up the loan-equivalent value of a derivative contract.

Presettlement exposure to a counterparty exists whenever a contract’s replacement cost has positive value to the institution for derivative contracts and is known as “in the money”. The exposure has a negative value to the counterparty and is known as ‘out of the money’’. The current replacement cost of the contract is its mark-to-market value.

The other counterparty has an immediate exposure which must be filled if the counterparty defaults on a transaction before settlement of the deal.  The non-defaulting counterparty suffers a credit loss if the contract is in the money for the non-defaulting party. Any and all deals with a positive mark-to-market value represent actual credit exposure. The replacement cost of derivative contracts is usually much smaller than the face or notional value of derivative transactions.

Swaps and other derivatives involving firm commitments initially have a zero net present value and, therefore, no replacement cost at inception. The only potential for credit exposure these contracts can have at inception can arise from subsequent changes in the market price of the instrument, index, or interest rate underlying them. Positive contract values occur when market prices move which results in the contract developing its current credit-risk exposure of its replacement cost as well as the potential credit exposure that can arise from subsequent changes in market prices.

Swaptions and rate protection agreements which are options and derivative contracts which contain options face both current and potential credit exposure. The difference, however, with option contracts is that they have a positive value at inception reflected by the premium paid by the purchaser to the writer of the option. While the value of the purchased option may be reduced as a result of market movements, it cannot become negative. The seller or writer of an option receives a premium, usually at inception, and must deliver the underlying at exercise. Therefore, the party that buys the option contract will always have credit exposure when the option is in the money. The party selling the option contract will have no credit exposure other than settlement risk while awaiting payment of the premium.

Determination of Presettlement Risk in Different Instruments

Potential future exposure is an estimate of the risk that subsequent changes in market prices could increase credit exposure. In measuring potential exposure, institutions attempt to determine how much a contract can move in to the money for the institution and out of the money for the counterparty over time. Such is the importance of the interrelationships between the market-risk and credit-risk exposures involved in banks’ derivative activities that risk managers should be alert to situations in which banks may need to enhance their current computations of potential future exposures and loan equivalents used to measure and monitor their derivative counterparty credit exposure.

Estimating potential exposure is subjective, and different institutions approach its measurement in multiple ways. One method uses factors like percentages of the notional value of the contract, similar to the ‘‘add-on’’ factors used in bank risk-based capital. It is important that these factors help provide adequate estimates of potential exposure. The differences in the add-ons used for different instruments should reflect differences in the volatility of the underlying instruments. It should also reflect in the tenor (or maturity) across instruments, and should be adjusted periodically to reflect changes in market conditions and the passage of time.

Another method to estimate potential exposure, while being more complicated of derivatives is to statistically estimate the maximum probable value that the derivative contract might reach over a specified time horizon. This sometimes may be the life of the contract. This is done by estimating the highest value the contract will achieve within some confidence interval (for example, 95, 97.5, or 99 percent confidence) based on the estimated distribution of the contract’s possible values at each point in time over the time horizon, given historical changes in underlying risk factors. The specified percentile or confidence level of the distribution represents the maximum expected value of the contract at each point over the time horizon.

The time horizon used to calculate potential future exposure can vary depending on the bank’s risk tolerance, collateral protection, and ability to terminate its credit exposure. Some institutions may use a time horizon equal to the life of the respective instrument. Such a time horizon is appropriate for unsecured positions, for collateralized exposures and the use of lifetime. Worst-case estimates of potential future exposure may be ineffective in measuring the true nature of counterparty risk exposure—especially given the increasing volatility and complexity of financial markets and derivatives instruments. The life-of-contract potential future exposure may help measure and provide an objective and conservative long-term exposure estimate, but they bear little relationship to the actual credit exposures banks typically incur in the case of collateralized relationships. In such cases, a bank’s actual credit exposure is the potential future exposure from the time counterparty fails to meet a collateral call until the time the bank liquidates its collateral. This is usually much shorter than the contract’s life. There is a need therefore, for some institutions, to have more realistic measures of collateralized exposures in times of market stress. Shorter time horizons, over which measures to mitigate losses need to be taken, must be factored in. They should also incorporate estimates of collateral recovery rates given the impact of potential market events on the liquidity of collateral values. Institutions with vigorous monitoring systems can employ additional credit-risk-measurement methodologies that will tend to generate more precise and often smaller reported exposure levels. Some institutions already calculate such measures by assessing the worst-case value of positions over a time horizon of one or two weeks—their estimate of a reasonable liquidation period in times of stress. Other institutions are moving to build the capability of estimating portfolio-based potential future exposures by any one of several different time horizons or buckets, owing to the liquidity and breadth of the underlying instrument or risk factor. Some institutions measure the “expected” exposure of a contract in addition to its maximum probable exposure. The expected exposure is the mean of all possible probability-weighted replacement costs estimated over the specified time horizon. This calculation may reflect a good estimate of the present value of the positive exposure that is likely to materialize.

Expected exposure can be an important measure for use in an institution’s internal pricing, limit-setting, and credit-reserving decisions. However, expected exposure is by definition lower than maximum probable exposure and may underestimate potential credit exposure. It is for this reason that expected exposure estimates are not frequently used as loan-equivalent amounts in assessing capital adequacy from either an internal or regulatory basis.

Statistically generated measures of future exposure use sophisticated risk-measurement models that, in turn, involve the use of important assumptions, parameters, and algorithms. Institutions using such techniques should ensure that appropriate controls are in place regarding the development, use, and periodic review of the models and their associated assumptions and parameters. The variables and models used for both replacement cost and potential exposure should be approved and tested by the credit-risk management function and should be subject to audit by  independent third parties with adequate technical qualifications. The data-flow process should also be subject to audit to ensure data integrity. Equally important are the approval and testing of information systems that report positions.  The functions responsible for managing credit risk should validate any modifications to models made to accommodate new products or variations on existing products.

Measuring Potential Future Exposure

Market liquidity risk is the risk of not being able to close your open positions in a reasonably short time and in sufficient quantities, at a reasonable price. What this means is that in a highly liquid market, you should be able to close out your sufficiently large position quickly without paying a high price. If the market liquidity is low, you will end up paying a huge premium to dispose your positions, that will be the premium due to liquidity risk.

In case of a dealers market, where dealers provide bid-ask spreads for various instruments, the size of the bid-ask spread is an indicator of the liquidity and depth of the market. Generally, the smaller the bid-ask spread, the higher is the liquidity, and vice verse. If markets become illiquid for any reasons such as market disruption, less market makers, or execution of large block transactions, the bid-ask spreads will widen. The market disruptions may be specific to an instrument, such as a change in supply /demand of a financial product, or they could be broad affecting the entire market, such as a stock market crash. Liquidity may also be affected by the presense of large institutional investors. When they exit the market, the liquidity may significantly decline.

Over-the-Counter Instruments

In case of <a href="https://financetrain.com/exchange-traded-versus-over-the-counter-otc-derivatives/">over-the-counter (OTC) markets</a>, which is primarily dealers market, the market liquidity largely depends on the acceptance of credit risk of major market makers. If, for example, a market maker is downgraded, and is therefore not accepted as a counterparty, this will reduce the market liquidity. If the activity is already concentrated to just a few market makers, the impact of elimination of a market maker will be even more severe. Even market makers can have credit risk concerns about their counterparties and they impose restrictions such as credit limits, shortening maturities, requirement of collateral, etc, which further reduces liquidity.

Unlike cash and exchange-traded instruments, the OTC off-balance-sheet instruments do not have a liquid secondary market which makes it difficult to close OTC derivative positions effectively. In general, most OTC instruments are illiquid.

Exchange-traded Instruments

In case of exchange-traded instruments, the clearing house takes the counterparty credit exposures, and is managed using netting and margin arrangements. Both, the margin requirements and netting arrangements of clearinghouses, are designed to reduce the spreading of credit and liquidity issues in case some customers are unable to meet their obligations. If, however, the market prices change significantly (read fall), the clearing house will require more <a href="https://financetrain.com/role-of-margin-money-in-futures-trading/">margin money</a> to mitigate its credit risk, which will affect the liquidity. The market participants will have to sell their assets to meet these margin calls. Such action may further increase the liquidity problem.

For many exchange-traded instruments, the notion of liquidity is true as long as we are dealing with small lots. If one tries to execute a large block, it can significantly affect the price. Also, only a few instruments listed on exchanges trade heavily, exhibiting high trading volume, while others trade quite infrequently.

For exchange traded derivatives such as futures and options, the short-dated contracts are more actively traded than the long-term counterparts. In these contracts, the indicator of liquidity is the open interest or the transaction volume.

Market Liquidity Risk of Trading Activities

Most financial products, whether on-balance sheet or off-balance sheet, will generally contain more than one type of market risk exposure. Hedging one financial product will therefore require use of more than one hedging instrument. For example, a foreign-currency denominated coupon paying bond will have interest rate risk and foreign exchange risk, and both the risks need to be hedged using different hedging instruments.

Hedging can be simplified by unbundling or breaking down the <a title="Market Liquidity Risk of Trading Activities" href="https://financetrain.com/market-liquidity-risk-of-trading-activities/">market risk</a> of a product into its basic elements. These unbundled market risk exposures can then be managed separately increasing risk liquidity.  For example if we have a customized OTC contract, it may be illiquid; however, its component risk may be liquid, and hedgeable.

Once the market risk exposures have been unbundled, some unbundled exposures can be managed as separate transactions, while other others can be managed on a portfolio basis. The more closely hedged the risks in a transaction are, the less is the need to actively manage the residual risk. Dynamic hedging is used to hedge the uncovered risks.

When a large number of market participants use dynamic hedging  and trade, it introduces a feedback mechanism and tends to amplify the price movements. Some managers may estimate exposure on the basis of the assumption that dynamic hedging or other rapid portfolio adjustments will keep risk within a given range even in the face of large changes in market prices. However, such portfolio adjustments depend on the existence of sufficient market liquidity to execute the desired transactions, at reasonable costs, as underlying prices change. If a liquidity disruption were to occur, difficulty in executing the transactions needed to change the portfolio’s exposure will cause the actual risk to be higher than anticipated. Those institutions who have open positions in written options and, thus, are short volatility and gamma will be the most exposed.

Unbundling and Dynamically Hedging Risks

Sometimes the financial institutions may hold financial positions that are very large in size relative to the traded volume in a market for those securities. Whether these positions are long or short, when the bank decides to liquidate these positions, it may significantly affect the price of the securities and may disrupt the market. In such a scenario any market participant who wants to exit the position may suffer greater-than-expected losses. Due to this, the market makers should monitor the extent to which the positions they take constitute a large portion of open interest, volume, or some other indicator of market size.

Different products may have different market liquidity characteristics for many reasons, such as contracts that have different maturities or expirations, that are traded on different exchanges, or that represent even slightly different underlying. Such products need to be monitored separately and not as a group.

It is also suggested that the market makers:
<ol>
	<li>Monitor the concentration of positions of counterparties relative to the market and</li>
	<li>Recognize that counterparties that take on large positions relative to the market volume are taking on greater price risk and may have difficulty unwinding their positions without substantial losses.</li>
</ol>
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Concentrated Positions and Market Risk

The risk measures used by a bank under stress scenarios should be estimated over a number of different time horizons.

Most risk managers in banks use a short time horizon, such as a day, which may be useful for day-to-day risk management. Along with that prudent risk managers will also estimate risk over longer horizons because the use of a short horizon such as one day assumes that market liquidity will always be sufficient to allow positions to be closed out at no or minimal losses. However, this doesn’t hold true during the times of crisis. In a crisis, market liquidity, or the financial institution’s access to markets, may be so impaired that it may become impossible to close out or hedge an existing position. Even if the institution is able to do it, it will have to do so at extremely unfavorable prices. In such a scenario the institution may have to hold positions for longer than they envisioned.

This unforeseen lengthening of the holding period will cause a portfolio’s risk profile to be much greater than envisioned in the original risk measure, as the likelihood of a large price change (volatility) increases with the horizon length. Additionally, the risk profiles of some instruments, such as options, change radically as their remaining time to maturity decreases.

Market makers should consider the bid-asked spreads in normal markets and potential bid-asked spreads in distressed markets and establish risk limits that consider the potential illiquidity of the instruments and products. Stress tests evidencing the “capital-at-risk” exposures under both scenarios should be available for examiner review. Market makers should consider placing limits on the size of concentrated positions relative to the market volume.

Market Liquidity Risk Limits

Risk Management in Trading Activities

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COURSE

Risk Management in Trading Activities

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