Market risk is the risk of adverse deviation of the mark–to–market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions. In simple words the market risk can be defined as the risk that is associated with the investment in form of realized returns being different to the expected return. The period of liquidation is critical to assess such adverse deviations. If it is longer, so do the deviations from the current market value.
Market risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:
Equity risk: The risk that is associated with the changes in the stocks prices.
Interest rate risk: The risk arising because of the changes in the interest rates.
Currency risk: The risk that arise because of the changes in the foreign exchange rates.
Commodity risk: This risk arise when the commodity prices (i.e. grains, metals, etc.) change.
Equity risk is the risk that one’s investments will depreciate because of stock market dynamics causing one to lose money.
Interest rate risk is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond’s duration, the oldest of the many techniques now used to manage interest rate risk. Asset liability management is a common name for the complete set of techniques used to manage risk within a general enterprise risk management framework.
Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.
Transaction risk is the risk that exchange rates will change unfavorably over time. It can be hedged against using forward currency contracts;
Translation risk is an accounting risk, proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.
Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc.
Measurement of Market Risk:
Market risk is typically measured using a Value at Risk methodology. Value at risk is well established as a risk management technique, but it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the single period of the model. For short time horizons, this limiting assumption is often regarded as acceptable. For longer time horizons, many of the transactions in the portfolio may mature during the modeling period. Intervening cash flow, embedded options, changes in floating rate interest rates, and so on are ignored in this single period modeling technique.
A variety of models exist for estimating VaR. Each model has its own set of assumptions, but the most common assumption is that historical market data is our best estimator for future changes. Common models include:
(a) variance-covariance (VCV) or delta-normal, assuming that risk factor returns are always (jointly) normally distributed and that the change in portfolio value is linearly dependent on all risk factor returns,
(b) the historical simulation, assuming that asset returns in the future will have the same distribution as they had in the past (historical market data),
(c) Monte Carlo simulation, where future asset returns are more or less randomly simulated