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.
Monitoring: It is important that all exposures be monitored from time to time. The firm’s exposures must be monitored and risks reassessed periodically. Market risk is a result of constant changing global factors. Therefore strategies need to be revisited periodically.
Risk Mitigation: By this we mean that we need to understand that all exposures are exposed to risk. Firms need to find a way to arrive at an optimum risk return balance. It is critical that treasury managers not be sitting duck for market risk. They need to arrive at active strategies that can send up red flags and investigate deeper for what kind of risk it might be and take appropriate measures.
The risk management function must do so independently with inputs from the risk takers. They in turn need to provide guidelines, limits and information on the various exposures to the risk takers. It must be able to assess and forecast possible market risk scenarios based on the available information. Daily reports must be provided to the top brass and management. These reports must contain detailed and aggregate risk estimates and comparison with existing limits. Profit and credit exposure reports and estimated potential risks must also be estimated in the reports. Statutory reports for risk supervisors also fall under the purview of this department.
Another key deliverable of the risk management department is the risk management policy document which after scrutiny by the senior members of the board needs to be signed off on. Market risk managers are sometimes responsible for calculating provisions and deferred earnings, establish controls for new products and verify valuation models and methodologies used by traders. They may also be asked to take a call on their firm’s capital and to risk budgeting with the objective of arriving at the optimum risk adjusted return on capital.
These reports must be subject to scrutiny by external auditors as well to maintain the rigor and the overseeing function of the risk management function.
The top management must support the market risk management function. A coherent risk management policy, strategy, and implementation are key to any organization, even those who go out of their way to avoid it.