Market Risk

Explained:

Business activities entail a variety of risks. For convenience, we distinguish between different categories of risk: market risk, credit risk, liquidity risk, etc. Although such categorization is convenient, it is only informal. Usage and definitions vary. Boundaries between categories are blurred. A loss due to widening credit spreads may reasonably be called a market loss or a credit loss, so market risk and credit risk overlap. Liquidity risk compounds other risks, such as market risk and credit risk. It cannot be divorced from the risks it compounds.

An important but somewhat ambiguous distinguish is that between market risk and business risk. Market risk is exposure to the uncertain market value of a portfolio. A trader holds a portfolio of commodity forwards. She knows what its market value is today, but she is uncertain as to its market value a week from today. She faces market risk. Business risk is exposure to uncertainty in economic value that cannot be marked-to-market. The distinction between market risk and business risk parallels the distinction between mark-to-market accounting and book-value accounting. Suppose a New England electricity wholesaler is long a forward contract for on-peak electricity delivered over the next 3 months. There is an active forward market for such electricity, so the contract can be marked to market daily. Daily profits and losses on the contract reflect market risk. Suppose the firm also owns a power plant with an expected useful life of 30 years. Power plants change hands infrequently, and electricity forward curves don’t exist out to 30 years. The plant cannot be marked to market on a regular basis. In the absence of market values, market risk is not a meaningful notion. Uncertainty in the economic value of the power plant represents business risk.

The distinction between market risk and business risk is ambiguous because there is a vast "gray zone" between the two. There are many instruments for which markets exist, but the markets are illiquid. Mark-to-market values are not usually available, but mark-to-model values provide a more-or-less accurate reflection of fair value. Do these instruments pose business risk or market risk? The decision is important because firms employ fundamentally different techniques for managing the two risks.

Business risk is managed with a long-term focus. Techniques include the careful development of business plans and appropriate management oversight. book-value accounting is generally used, so the issue of day-to-day performance is not material. The focus is on achieving a good return on investment over an extended horizon.

Market risk is managed with a short-term focus. Long-term losses are avoided by avoiding losses from one day to the next. On a tactical level, traders and portfolio managers employ a variety of risk metrics —duration and convexity, the Greeks, beta, etc.—to assess their exposures. These allow them to identify and reduce any exposures they might consider excessive. On a more strategic level, organizations manage market risk by applying risk limits to traders' or portfolio managers' activities. Increasingly, value-at-risk is being used to define and monitor these limits. Some organizations also apply stress testing to their portfolios.