What does the Market Risk Department Do?
Market risk is unavoidable but not unmanageable. Market risk tends to occur when an unpredictable turn of events such as fluctuation in exchange rates, fluctuations in the prices of traded assets and commodities lead to a change in the value of financial instruments held by a firm. Assessing market risk is not unlike predicting the weather, where at best indicators can be provided and precautions taken. Reliable and objective data to measure market risk is not always possible. Illiquid assets can see their potential value changing due to varying types of market risk. What initially appears to be a case of simple credit risk enters the domain of market risk. For example, a bank faces credit risk predominantly when it advances a loan with collateral to a client. However, when the prices of real estate start moving strongly it moves to the realm of market risk.
Banks try to mitigate the impact of risk by creating reserves and limits. Market risks are booked in the trading book. Banks tend to inflate reserves for credit risk, to provide cover for market risks that may be hidden.
It is difficult to demarcate where market risk begins and say operational risk ends. To classify risks into neat categories and manage them is not practical. The risks that an organization faces are more dominoes like in nature. The mortgage sector is affected by the rise and fall in prices in the realty market. Similarly the pension payouts are affected by the rise and fall of the stock markets where pension funds plough their funds into. Risk needs to be understood comprehensively before identifying the type of risk and managing it.
Market risk departments in banks conduct their business by identifying, assessing, monitoring and controlling or mitigating risk. Of course this is true for both financial and non-financial institutions and for all kinds of risk.
Identification: Market risks do not come announced. Spotting and identifying an impending risk is by itself quite difficult. This can be due to over-familiarity with the risks or a complete lack of knowledge of them. Sometimes despite knowing the risks quite well, but not being fully prepared for the size of market risk can lead to problems. LTCM the hedge fund could not meet its commitments due to a variety of factors. The East Asian financial crisis, the exit of Salomon brothers, the Russian bond default due to the Russian financial crisis and a panic that led to people selling their European and Japanese bonds as well led to LTCM facing $1.85 billion loss in the market. LTCM suffered heavily due to lack of measures to identify market risks particularly when a big chunk of their portfolio was in volatile Russia and other emerging markets.
Assessment: A firm needs to have an arsenal of assessment tools to measure the risk. Risks refer to future potential losses. Historical data, scenario analysis, and different strategies for certain parameters can be used to assess market risk. Based on these assessments broad capital reserves have been suggested by Basel. It is important however that individual banks assess their risks based on their individual portfolios and monitor them.
